Cash and crash cycles

GUEST COLUMN

Cash conservation becomes strategic, as the healthy disinflation era is challenged by rising food prices.

"We learn from history that we do not learn from history," these famous words of George Bernard Shaw are a befitting reality for mankind.

These people he talked about also dabble in stocks and commodities. And a majority of them are oblivious to these written words of fate. It's the few who understand while the majority perishes owing to short sightedness.

The rush of greed has historically overshadowed sanity. Personal skill and the power of state have always been overestimated.

Great nations have failed along with revered geniuses in front of market cyclicality. And till the time humans last, our love for speculation and war, boom and busts, creation and destruction, celebration and vilification will continue.

The great Manmohan of yester years is the weakest PM ever, says Advani. It is this cyclicality of mass psychology "� cheerful today and depressed tomorrow "� that pushes us to extreme behaviour where we don't know how to stop and hence the violent pause, which econohistory quotes as crash.

The ideal time to study econohistory is when sanity matters most and greed busters are needed. We really need them today. And nothing busts greed better than a pinch of econohistory. Spirituality can, of course, do it better than econohistory, but then use of religion to bust greed, seems a tall shot in the age of speculation.

We will stick to econohistory, which exhibits very well how long the current boom will last. The subject relies a lot on cyclicality and makes some bold findings. It proves that every generation has its war.

Every market has its crash, big and small. It also proves that economics cycles are driven by credit, which itself inflates and deflates cyclically. There is a shift from paper to hard assets and vice versa.

There are three stages linked with the credit cycle viz hyperinflation, disinflation and finally deflation. Disinflation is a period of low inflation and low prices for food and essential goods. This leads to economic growth.

While there is little literature available on the chronology of events, disinflation is the one preferred most by investors and market participants.

However, disinflation is generally perceived as beneficial, mass psychology extremes have been know to stretch the benefits to an extreme causing deflation. The most visible example of deflation is the 13-year slowdown of the Japanese economy.

The deflation period is one of decrease in the general price level over a period of time. Deflation is the opposite of inflation. During deflation the purchasing power of money increases. Many still consider deflation as a problem of the modern economy because the phenomenon can spiral into a depression.

Hyperinflation on the other hand refers to a period when inflation goes "out of control," as cash or currency rapidly loses its value. A monthly inflation rate of 20 per cent or more is hyperinflation time.

Although there is a great deal of debate about the root causes of hyperinflation, it becomes visible when there is an unchecked increase in the money supply or drastic debasement of coinage, and is often associated with wars, economic depressions, and political or social upheavals.

The worst case of hyperinflation happened in erstwhile Yugoslavia where inflation doubled every 16 hours. Hyperinflation destroys real money. So the talk of hyperinflation in India or the US is a clear misinterpretation.

There is a crisis of confidence. China between 1939 and 1945 is a classic example of government printing money to pay civil war costs. By the end, the currency was flown in over the Himalaya, and then old currency was flown out to be destroyed.

The chaos often ends with a civil conflict. And there are a lot of zeros in the currency and they keep adding. A majority of countries around the world have experienced this phenomenon. In recent times, it's happening in Zimbabwe. There is a crisis of confidence under Mugabe and the country is in a civil strife witnessing the biggest modern-day exodus.

So all our good times rest on how sustainable this current disinflation is, the good inflation. According to a research paper by Marc Hofstetter, Universidad de los Andes, very little is know about the sustainability of disinflations. The paper dispels misconceptions about disinflation and points food as the most essential sustainer of prosperous times.

One cannot blame the low sustainability of disinflations during the seventies on rising oil prices as Yale professors Boschen and Weiss state that world food prices are a significant predictor of inflation in OECD nations. And food inflation plays a bigger role in undermining positive disinflation than oil prices.

In fact, the significance of oil shocks turns out to be weak. The paper also comments on exchange rate regimes saying that an increase in exchange rate flexibility reduces the sustainability of disinflations.

Disinflations that bring inflation down to low rates of 5 per cent or lower (like we have today) are more likely to succeed in keeping those gains in place. Rogoff (2003) and Razin (2004) add the idea that globalisation played an important role in the recent worldwide disinflation.

Since the early nineties, an increasing number of developed and developing countries have adopted inflation targeting regimes to conduct monetary policy, which is ineffective in determining sustainability of disinflation.

Politics also seemed to have little effect. The most interesting aspect was the linkage of whether US inflation had something to do with worldwide prosperity since the nineties. Boschen and Weiss found strong evidence that US inflation plays an important role in triggering inflation abroad and US monetary shocks have important consequences abroad ie a higher

US inflation reduces the sustainability of disinflations abroad.

What all this means is that if food prices don't stop going up, the good times will come to an end. And there is nothing the central banker or the politician can do to sustain it. Grains are up and so are other agro products and this is just the beginning. We are looking at multi-year rises on food prices.

We are not bears at Orpheus. And it was here in this column we talked about energy outperformance and software underperformance in Jan 2007. It happened.

We also gave you sectoral winners like Reliance Energy which moved up 300 per cent since it appeared in The Smart Investor on June 25, 2007. We highlighted many other outperformers like Reliance Natural Resources and underperformers like Hindustan Zinc which we suggested exiting near Rs 1,000. But unfortunately we see a lot of unsustainable greed at current levels. And highlighting the importance of cash before the crash cycle can never be overstated.

The writer is CEO, Orpheus Capitals, a global alternative research company