Thank God it’s October 1st (TGIO).....

In the backdrop of an equity markets rout witnessed in Q3’15, market participants must have heaved a sigh of relief that the quarter has ended and it’s October1^st!.  With approximately $11 trillion of global market cap wiped out, global equities have witnessed its worst quarter since 2011. Based on anecdotal evidence, September quarter has been the worst for stocks and hopefully markets rebound from these levels.

The epicenter of this ‘stockquake’ was China and concerns related to its slowing economy which led to Shanghai stock index declining c28% in the quarter. The continuing slump in commodity prices on the back of lower global demand has in fact ‘exported disinflation’ across the globe. China also depreciated yuan by approximately 2% and has made its currency market linked (yuan has declined 2.5% vs. USD in Q3’15). The yuan depreciation spooked the Asian Emerging Markets (EMs) due to unfounded fears that the countries could use depreciating FX as a tool to gain competitive advantage in exports. This led to a sharp sell-off in Asian EM currencies against USD. Asian stock markets posted the weakest quarterly performance since 1998 due to decline in commodities prices and fears of Chinese slowdown. MSCI Emerging Market index declined c17% YTD (-18.5% in the quarter) while MSCI Frontier 100 index declined c16% YTD (-11.1% in the quarter).  The top 10 value destroyers (mcap>USD 20bn) were primarily Chinese stocks in Financials along with Petrobras.

Top 10 Value Destroyers in Asian/Emerging markets in Q3’15

Stocks having mcap>USD 20bn as of 7/1/15

In this EM turmoil, India was standing tall with relative outperformance, Nifty was down 5%, with FIIs pulling out approximately $5 billion out of Indian markets. The fall was stemmed due to buying by DIIs (Domestic Institutions) which has seen a steady inflow of domestic money from retail investors through Systematic Investment Plans (SIPs). However in dollar terms, decline was >10%+ in the quarter due to approximately 5% depreciation of INR vs. USD. The recent 50bps rate cut announced by India’s Central Bank (RBI) would provide some respite. Furthermore, India’s macroeconomic situation has been strongest ever in recent history due to slump in crude oil prices (WTI Crude down 24% in Q3CY15; -16% YTD) and commodity prices rout. India's current account deficit and fiscal deficit is expected to narrow down to 1.2% and 4% of GDP respectively in FY15-16 (from CAD: 1.7%, Fiscal deficit: 4.4% in FY14). Indian Central Bank also lowered its 2017 inflation expectation to sub 5% despite two consecutive droughts; a positive for Indian currency.

US equities also declined approximately 7-9% (S&P 500/-6.9%, NASDAQ/-7.4%, NYSE/-9.3%) in Q3CY15; however they have outperformed EM equities in dollar terms by about 10% YTD (20% in last two years). There is one school of thought who believes that US market valuations are not inexpensive in light of lack of earnings growth. US exporters and MNCs have been hit by a strong dollar while energy and oil dependent sectors have been hit hard by lower crude prices. The market is also apprehensive ahead of the US presidential elections scheduled in 2016 and would be susceptible to news flow in the build-up in the campaign trail. The case in point being the sell-off witnessed in the biotechnology stocks in response to Secretary Clinton’s tweet regarding high drug prices and a need to bring the prices down.  The top 10 value destroyers in this quarter were primarily stocks in Healthcare (Mylan NV), Energy, Information Technology and Consumer Discretionary sectors. 

Top 10 Value Destroyers in the US markets in Q3’15

Stocks having mcap>USD 20bn as of 7/1/15

The global markets have been patiently waiting for the last few months for the expected Federal Reserve (Fed) interest rate hike. Fed deferred the rate hike in September citing global slowdown concerns due to China as one of the reasons which has led to lower inflation rate as compared to its target rate. Hence although employment and labor market supported a case for rate hike, lower than expected inflation deterred Fed from pulling the trigger. This spooked the markets as the Fed’s commentary regarding weak global growth which doubts whether Fed knows something ‘nasty things’ about global economy which markets have not already discounted. The overhang of a possible rate hike in Dec 2015 policy meeting still persists.

European equities declined approximately c7-12% (FTSE 100/-7%, CAC40/-7%, DAX/-11.7%) in Q3CY15. This was impacted by Greek debt crisis which led to sharp YTD depreciation in euro versus dollar until the deal was clinched in August 2015. The deal marked an end to more than six months of turbulent negotiations between the Greek left-wing government and its creditors, other euro zone countries and the International Monetary Fund, that brought Europe’s currency union closer to the breakup. Europe also witnessed a ‘Black Swan’ event with Volkswagen (VW) episode weighing down on automobile & automobile ancillary industries in month of September. According to Fitch, the VW emissions scandal could prove a turning point for the whole automotive industry around the world. More broadly, the whole transportation sector could be affected if this emission test crisis fundamentally affects consumers and regulators’ attitude towards cars, driving and pollution. The top 10 value destroyers in this quarter were primarily from stocks in Consumer Discretionary (VW, Renault), Materials (Glencore), Financials.

Top 10 Value Destroyers in European markets in Q3’15

Stocks having mcap>USD 20bn as of 7/1/15

Outlook

Overall equity markets are likely to face turbulent times in next 2-3 quarters due to recalibration of Chinese economy, dislocation triggered by low crude oil & commodity prices and impact due to pending rate hike. There could be contraction in valuation multiples if the markets are not able to deliver commensurate earnings growth to support the valuations. We believe there could be greater interest in Indian equity markets over medium to long term as we expect India to ride this ‘economic storm’ better due to an improved macroeconomic situation and expected cyclical and structural earnings growth in FY17 driven by initiatives and measures taken by Modi Government. 

Catching the Falling Golden Knife

“The road to hell isn't paved with gold, it's paved with faith. Faith in a dollar that's backed by a belief that people have faith in other people's belief in it.” 

- Jarod Kintz, This Book is Not FOR SALE

Through the ages, men and women have cherished gold, and many have had a compelling desire to amass great quantities of it - so compelling a desire, in fact, that the frantic need to seek and hoard gold has been aptly named "gold fever." Gold was among the first metals to be mined because it commonly occurs in its native form - that is, not combined with other elements - because it is beautiful and imperishable, and because exquisite objects can be made from it.

The fundamental factors that determine the gold prices are - Central Banks selling and buying large quantities of bullion metal under monetary policy, International conflicts & crisis, and the demand for the jewelry by the industry and investors. The supply of newly mined gold (and thereby cost of mine production) is not a key factor determining the gold price as mining adds only about one (1) percent to the total supply each year. Nearly all gold in the world that has ever been produced is still held in same form; therefore the impact of mining production on the gold price is practically negligible. In another words, the gold hoarded as a monetary asset, and is not consumed like other commodities and thus the gold market, unlike other commodity markets, cannot be in a supply deficit.

      Source: Kitco, Maxim Research

Historically, the 1970’s experienced gold bull market as the US and European economies were characterized by low growth, high inflation and an unemployment rate. A common reason cited for holding gold is as a hedge against inflation and currency devaluation. Currency values fluctuate, but gold values, in terms of what an ounce of gold can buy, might stay more stable in the long term. Because gold holds value outside of politics, the world over gold is attractive as a low-risk, solid investment in the midst of floundering currencies. Further, increasing national debt and an expansion of money supply made the currencies less valuable. All these factors led investors to diversify their portfolios towards material assets, and gold in particular. In the next two decades, the gold price followed a completely different pattern; the gold market was bearish from 1980 to 2001 due to an end of the economic stagflation of the 1970s, with a stabilized economy and controlled inflation. More recently, in year 2008-2009, gold prices dropped due to financial crisis in the US. Economic/financial crisis leads to asset liquidation and dollar shortage, which leads to the appreciation of dollar & depreciation of gold. Accordingly thereafter in the year 2011, gold were at all time high due to the US debt ceiling crisis.

The gold prices are consistently falling since mid-June 2012. In late July this year, the price of gold fell almost 15%, from $1300 in Jan 2015. Following are the reasons why the Gold is slipping currently:

1) Likely Rate Hike in the US

With the US Fed likely to raise rates first time in nearly a decade, the fear of recession in the world's largest economy is easing. Gold does not earn any interest or dividend. If the US raises rates, interest income from US bonds will also rise. The relationship between interest rates and the gold is inverse- implying an increase in interest rate leads to decrease in gold prices. As a result, investors seek better returns by investing in holding Zero yield assets, treasury bills or other debt securities. So investors are preparing to move away from gold to bonds.

Fallout of the stabilizing US economy is the strengthening dollar which also impacts the Gold prices. The US dollar index, which tracks the price of the US dollar against the world’s currencies, has increased by more than 20% in the past year.  The Gold is priced in dollar and a stronger dollar means lower price of gold.

2) Geopolitical Stability

Gold is a hedge against inflation. The easy-money policy after the 2008 crisis led to fears of high inflation. But inflation stayed low in the US, Japan and Europe. Investors are now reluctant to buy gold. Furthermore, Iran nuclear deal has reduced chances of a conflict in the Middle East, and Greece too has avoided default. Greek bank, after a third bailout package agreement extended a €6.25bn bridging loan for the cash-starved country. As a result, the Greece economy stepped back from default possibility. Accordingly, risk-averse investors are comfortable holding high risk assets that earn better returns instead of holding gold. As geopolitical risks wane, investors are selling gold. 

3) Lower Demand from Chinese and Indian Central Banks

The economic boom in China led to huge demand for gold. With the country now facing an economic slowdown, in the first six months of 2015, demand has fallen by about 24%, leading to lower prices. China has increased its gold reserves by 57% to 1658 metric tons in last six year. People’s Bank of China revealed that it has been buying far less gold than expected. The analysts were expecting, it would announce reserve holding of at 2000-4000 metric tons (meaning there is a lot more gold in the Chinese retail market than expected, which otherwise would have gone to the coffers of the Central bank).

Traditionally among the largest gold buyers, central banks, especially from emerging countries, are buying less. But they are piling up dollars to counter outflows once the US raises rates. India's forex kitty in gold stands at 6%, down from 7%, five years ago.

The tepid growth of the Chinese economy shows no signs of returning to rapid growth, and when interest rates do begin to rise; investors will divert more of their savings away from gold and into interest-bearing ‘safe-haven’ debt securities. In addition, with gold prices falling, gold ETFs are facing redemption which is forcing them to sell the yellow metal. This has pushed gold prices into a vicious cycle. We expect the Gold to remain under pressure in the short term to medium term.

Indian Scenario

Looking at the Gold prices in India– the gold prices are determined in the international market and are denominated in dollars. The gold prices in rupee terms fluctuate along with the international prices and the foreign exchange rate between the rupee and the dollar. Thus, the depreciating rupee lends support to the gold prices here in India despite the gold price meltdown internationally.

The Government of India plans to issue sovereign gold bonds worth Rs 15,000 crore (US$2.4 billion), in the second half of the current fiscal year. The gold bonds are linked to the price of gold and provide an alternative to investment in physical gold. The move will help the government raise funds; and such bond issuance would result in curbing the demand for gold which in the past had been one of the main reason for the current account deficit. As, most of the gold demand in India is met by importing gold (which is paid in US dollars), it leads to current account deficit. This scheme is expected to bring the gold which is lying in households and temples into circulation in the economy. This will in turn help recycling of domestically held gold and reduce the reliance on jewelers on imported gold. 

Conclusion

The CEO of Barrick, the world’s largest gold miner, once announced that gold is the “default global currency”. But the question is – is it? Can we pay income taxes with bars of gold or get a soft drink from a vending machine with a quarter grain of gold or can we really use Gold for an international travel. In the long run, with all the dollars that the US has printed, if there is no strong alternative currency and it’s a total havoc, I prefer a gun instead of a Gold bar.

However, in the short to medium term, the Gold will continue to be dictated by the likelihood of interest rate hike in the US and the strength of the US economy and thereby the Dollar. In addition, the current currency war wherein the major countries depreciate their currency (Dollar, Yen, Yuan, and Euro) by printing money to pay off debt will also support Gold prices in the near term. If there are eventual problems with the Dollar and if the dollar depreciates vis-à-vis the other currencies, the Gold price in the international market may shoot up but it may not benefit the Indian consumers that much as it will also mean the price in rupee terms might not see the same appreciation (due to appreciating rupee). We believe that Gold prices will stabilize somewhere near the production costs, in the long run and if the psychological barriers are broken, it may even go further down.

On a flip side though, going by the rational of the Gold bulls (‘Gold is money’ camp) - the price they believe gold should trade for, is equal to the amount of the U.S. monetary base divided by the official gold holdings of the U.S. Given a monetary base of $4.0 trillion and official U.S. gold holdings of 8,133 metric tons this yields a “shadow gold price” of over $14,000 an ounce. 

Appendix

Uses of Gold

Aside from monetary uses, gold is used in jewelry and allied wares, electrical-electronic applications, dentistry, the aircraft-aerospace industry, the arts, and medical and chemical fields

       Source: Metals Focus, ICE Benchmark Administration, World Gold Council

Value of Gold mined till date

It has been estimated that all the gold mined by the end of 2011 totaled 171,300 tonnes (source: World Gold Council).  At a price of US$1,100 per troy ounce, one tonne of gold has a value of approximately US$35.3 million. The total value of all gold ever mined would exceed US$6.0 trillion at that valuation

Central Banks buying/selling

On one hand, China, India and Russia central banks have been buying Gold in bulk while developed countries are getting rid of the Gold reserves - Switzerland has sold 877 tons over the past ten years, France some 589 tons, and Spain, the Netherlands, and Portugal have each disposed of more than 200 tons.

Countries with Largest Gold Holdings as on August 2015:

Rank	Country	Gold holdings (in tonnes)	Gold's share of forex reserves
1	United States	8,133.5	74.2%
2	Germany	3,183.4	68.0%
3	Italy	2,451.8	67.0%
4	France	2,435.4	66.2%
5	China	1,658.4	1.6%
6	Russia	1,275.2	13.3%
7	Switzerland	1,040.0	6.6%
8	Japan	765.2	2.4%
9	Netherlands	612.5	57.7%
10	India	557.7	6.0%

Source: World Gold Council

Consumption of Gold

China and India are driving the world Gold demand.

Employing Scuttlebutt research as a part of Investment Process

Employing scuttlebutt research as a part of the stock research process with valuations of large cap stocks approaching fair value or in an overvalued territory, investors shift focus to micro/small/mid cap stocks which offer strong growth prospects. These stocks are not on the radar of institutional investors and hence are not covered by the sell-side fraternity. While the return expectations are higher so is the risk element of investing in such stocks. However, risk taking investors and hedge funds are not averse to taking positions in these stocks in search of super normal returns. Hence it is very important for research firms like Maxim to identify “jewels in the haystack” of such microcaps which would not be extinct tomorrow but will be tomorrow’s mid/large caps. Maxim Research (www.research2win.com) specializes in doing independent research in identifying such ‘hidden jewels’. Apart from the traditional top-down fundamental research, Maxim employs techniques of scuttlebutt research and rigorous economic audit of financial statements to spot and identify earnings management techniques. The rationale is that during early stages of company growth, a detailed due-diligence is required on the strategic aspects (viability and sustainability of business model) and operational aspects (channel checks, check on product awareness etc) and on corporate governance (quality of financial statements, disclosures, check with bankers on cash balances, etc). The idea is to catch more than what meets the ‘eye’ to form a holistic view on the stock. This enables Maxim Research derive additional insights in the investment research process which are not available in the sell-side research available currently in the market. The activities undertaken by Maxim include conducting reference checks on promoters, Cold-calling suppliers, customers, competitors, etc., to get their perspectives on a particular company, visiting stores, plants, factories, etc. Hope the investment community is able to steer clear of innumerable financial frauds committed by erring corporations. The case in point is of Longtop Financial Technolgies, a Chinese financial software company, whose auditor was one of the Big 4 accounting firms and was rated Buy by big bulge investment banks. You have to raed the article below to understand the audacity of fraud committed.