Dear All, Hope you all are doing great. It has been a long gap since we have shared something at this blog. Actually recently, We have entered full time into Investment advisory services (SEBI IA registration Number INA000020244). Plus, for long time there was a demand from all of my readers to start a learning module which should cover all aspects of Investment world. So we are also starting the same from Mar-2026. Present study is a part of that learning module. In the learning Module we will be covering various topics affecting investment world like Fundamental and financial analysis, Economics, Company law, taxation, Business studies, Geopolitics and behavioural studies. Those who are interested please contact: gurpreet@oscillations.in and oscillationss9@gmail.com (https://oscillations.in).
The present study is about the factors affecting the forces responsible for economic growth/activity which moves in cycles and then world of investment of cyclical firms as to why Cyclical firms are valued as such and whether there is a need to review some factors. I have taken the case of Global shipping industry which is more closely related to global GDP growth and demand supply variables. Here, I have considered two Shipping sector stock (Great Eastern Shipping Company Ltd and Shipping Corporation of India Ltd) for explaining the valuation complexities of a cyclical stock. Please take note that this is not a recommendation for investment. I could have taken a stock of any other cyclical industry for study. It is just that I have considered Shipping sector because of so much of recent activity in this sector due to war and tariff issues.
The study is dividend in two parts- part first (Part A) is about economic cycles and factors/forces responsible for their movement and intensity. Part 2nd (Part B & C) is about factors/forces affecting the global shipping (Indian stocks GE Shipping and SCI in the background). The two parts are only due to size. Part C is about some factors/topics which I have not explained fully; only because of size of this study. I will take up these topics in the next study.
The world of Investment is an Upside Down Tree
श्रीभगवानुवाच |
ऊर्ध्वमूलमध:शाखमश्वत्थं प्राहुरव्ययम् |
छन्दांसि यस्य पर्णानि यस्तं वेद स वेदवित् || 1||
(Bhagavad Gita Chapter 15, verse 1)
The Supreme Divine Personality said: They speak of an eternal aśhvatth tree with its roots above and branches below. Its leaves are the Vedic hymns, and one who knows the secret of this tree is the knower of the Vedas.
Whenever I read the Bhagavad Gita I find it impossible to rate one verse over the others. I still can’t decide which the best one is. This is exactly how life is…the grading of good, bad, virtue etc. is relative to limited human perception because at the scale of life “experience” is the supreme. Life at (earth) basic level is not created with good or bad as the primary motivation or driving force. Many time I see people asking whether Lord Krishna really happened or just a part of mythology. Although it is not possible for someone to write these intricate verses about cosmology and science of spirituality unless he is the “Lord” but still I ask them whether this will increase or reduce the “Value” of the Gita. For us the Gita has its own Individual Value. If you ask me there may be some great books in this world where we don’t know the name of the creator but they held significant value. The case in the point is our Vedas who don’t have the names of creators.
The secrets revealed in the Gita are equally “Valuable” whether or not we believe in the existence of Lord Krishna or not. This is just like Lord Buddha who refused to talk about God because that was immaterial for the path to salvation. For Buddha rule was supreme…if Salvation is bonded with Law of Karma then understanding and experience of this Law is what matters and existence of God is immaterial if he has no “DIRECT” role to play (actually Lord Buddha sees any sort of belief as the biggest hindrance in the path of enlightenment. That’s why he puts emphasis only on “experience” not belief. For me, this is the sign of a Real Guru- a real Guru never asks anyone to believe him because he knows the value of individual experience. He just shares his experiences and guides others to follow their individual path. So sadly we can see that we have none in today’s world who can be regarded as Guru). Lord Buddha was like a Cosmic mathematician who was not going to give any hint/pointers for building hope/trust in God or supreme consciousness; so he was always going to share the rules/formulas/principles like a mathematician. And it is impossible for someone without real experience of supreme consciousness or divinity to understand these formulas. Like, there may be very few who really understand the Karma doctrine of Lord Buddha (it is not about Moral causations) and it is good that most don’t.
In this Verse, Lord has described the nature of this world because in order to transcend this world first we need to understand its very nature. To describe the nature of this world, the Lord has used the metaphor of a Banyan Tree which is upside down; roots are above while the branches are down (the similar metaphor is also used in Katha Upanishad and this makes some very interesting conclusions…more on this some other time). So this Upside down Tree with Roots on the up is not what a tree is for us. We see tree in a different way where root remain un-manifested for us while we only see and comprehend manifested part (branches, leaves, fruits). But lord says this is not like what our world is in real. We value only material and manifested part of world and perceive ourselves and our life in relation to this understanding. But Lord says that realty is quite the opposite with Root is at the top. We are accustomed or made to perceive that the root is not the top but below everything…at the bottom. And we are also taught to value the entities at the top not at the bottom. But Lord says when it comes about life or world don’t repeat this mistake because if you really want to understand this life then you need to understand the root.
A tree is a manifested part of a root but this is not growth…this is not the aim of the root. We understand like this only; that tree is the aim of the root. But Lord doesn’t want us to perceive the tree like this because tree is just the manifestation…and manifestation can’t be higher than the unmanifested and the root. Unmanifested is multi-dimensional and manifestation is always bounded by time and space. Root is the cause and meaning…root is the reason tree is alive every second. So this tree…the manifested part is not the growth or aim of the root…it is not the redemption of the root. We feel it like that always…but this is what Lord wants us to understand that if you want to understand the tree…the tree of life then go to the roots…understand the root…feel the root. Manifestation can’t be bigger than the root. Apparent world…manifested tree is always limited to Time and space and Lord says the ultimate truth is beyond time and space. And to feel the Divine…first thing we need to understand is that we need to leave the tree part…the manifested part. And the great thing about this is that UNDERSTANDING is linked with intellect…not experience. Because experience is a very tough and complex thing in this 3 dimensional world of ours. So luckily Lord has given us the easiest way- to understand with mind. But experience of the root is not with the intellect…because root exists beyond time and space and intellect is limited to time and space.
Lord doesn’t say that the Tree…physical part is worthless. He is the one who accepts everything…because he knows the limitless…the supreme. At that level there is nothing left to discard…because physical world and all other manifested becomes too immaterial. When they have access to the supreme then they don’t bother by the tiny. And we are defined by the physical…we feel ourselves through the physical. Even our understanding about feeling the supreme is through physical means…our religions…our rituals…everything we try to feel the Divine is related to physical. We make to understand that by eating some defined food or wearing some defined fabric or treating our bodies in some defined way we can experience the Divine. But Lord says that we need to understand the limitedness of physical part…it is not the WHOLE…and it is never the ULTIMATE GOAL. So he gives us the metaphor of a Tree…it is a metaphor because a tree (nothing from this physical world) can’t be a direct proxy of Divinity.
Lord doesn’t condemn the physical part…the tree…the branches. He just wants us to know that it is not the ultimate truth. Because in any case, this world…the tree is still connected to the root…the divine. So the Divine is not far away…it is here there everywhere…we just need to open eyes. If we see this verse carefully; in the next part Lord has said that leaves of this Upside down tree are the Vedic hymns. And this is very significant…leaves are farthest from the root…branches (the Worldly part) are near to root and Lord has said that Vedas are like leaves…so they are the farthest from the truth…the root. And Lord has a great reason to treat them so- Vedas can’t give you the experience…and Lord knows that if we treat Vedas as everything then we will miss the opportunity to have the real experience of Divine. So he wants us to understand that Vedas are the farthest.Even the worldly part he kept as branches…nearer to the root because the world at least is giving us some sort of experience.
Here, Vedas doesn’t mean THE VEDAS but anything which has the capacity to take us away from the real experience. But as I shared above, the Lord is not lowering the value of Vedas but he wants us to understand the value of real experience in the path to redemption…freedom. For some strange reasons, we have chosen to disregard the value of experience in the quest to understand our life and purpose as we are made to believe that just by keeping Vedas (read any religious text) with us we unfold everything while the reality is that we continue to live a lower quality, lower frequency life and feel terrible at the thought of death. So the Lord wants us to keep these distraction aside. And I keep the Gurus in this league…especially the current ones. There are two types of Gurus-First who wants us to experience and the second who wants us to believe. Lord is talking about the second ones. But Vedas never talk about belief…they are not anything about any cult…Hinduism. They are about cosmology…the nature of life and Universe at its elemental level. This is most relevant for today’s time where we don’t need these Belief Gurus at all….they are very dangerous.
Here I remember Jiddu Krishnamurthi…one of India’s greatest Mysticist (not Philosopher or spiritual speaker as he is generally referred as). Jiddu K was against this Guruism…formation of cult around an individual. I love him for that…really great. He said “truth is the pathless land”; if it is pathless then there is no place for any pre-defined system/rules. Very few in this world understands that truth unfolds to the one who is having INTENSE THIRST, when it is a question of life and death for him. Such seeker of truth doesn’t need any Guru because the Divine, the truth will rush towards him for the unfolding. This thirst is what defines religion or spiritualism. Jiddu always said that Truth could not be experienced through any external authority/personality or system or cult. He was of the view that guru-disciple relationship has no value in the experience. Jiddu Krishnamurti was in favour of understanding one’s own thirst for truth and own search…efforts and experience rather than following the directions of someone else.
If you ask me then I always feel that the inclination to form cults around individuals is what Lord Krishna describes as the “desire for the fruit or result”. Lord says that DETACHMENT (Virakti) is the path to Salvation. Not desiring the fruit is detachment and in my view formation of cult is attachment…by whatever name or aim we try to associate with it. Jiddu K also understands that cult can’t solve much for a true seeker…it has no role…in his view it has negative role in the life of a true seeker. A true seeker (should) pursue duty (dharma) rather than greatness (fruit of work)…this is detachment. Clinging to the goal or fruits is attachment…even if the goal is as noble as trying (or claim) to awake people. When an Enlightened one listens to a true seeker…understands his thirst…talks to him…tells him about his vital signs…his path and journey; it is not CULT formation. Cult is pronunciation…claim of one’s authority and Lord doesn’t find it impressive. This thirst for authority and pronunciation is a sign that we are still lost in this world.
The karma Doctrine of Lord Buddha is never about Moral causation but it is also about Detachment. But one very important thing- Detachment (Virakti) is being considered and perceived as something related to negative trait or stimuli as if it is absence of something; as if this is about absence of emotions. But Virakti is a positive spiritual element; a formational part of a consciousness of an enlightened person or a person on his path or journey towards enlightenment. Lord Buddha or Lord Krishna will see a person claiming to be an enlightened one (we have huge number these days) whether he is being attached to worldly phenomenon or crave for power/authority and just by this one element of their behaviour they would be able to see his spiritual standings (and moral also). And good thing is that most of our today’s Gurus will fail this test of the Lords.
Here I remember Robert Oppenheimer; he was the one who always said that a scientist should just focus on his duty as scientist and should not want or attempt to take the responsibility for the fruits of his work. He was the one who read The Gita deeply and his understanding about the “fruits of the work” is a sign that he really understood the significance of Detachment.
Then in the end the Lord has said that the one who knows the secret of this tree is the knower of the Vedas. This from the Lord is most significant. Here, the Lord says that the one who understands the essence of this UPSIDE DOWN tree i.e. who understands what really is causing the phenomenon to take shape, what really is the real essence of everything, what really is the source of everything, what is just a physical manifestation and hence not to be considered as something capable to transform your experience and purpose…he also understands the Vedas even without really reading them. Because even the Vedas are trying to convey the same truth; the difference between physical manifestation bonded by time and space and the one ultimate truth.
The world of Investment is Upside Down Tree
The beauty of the investment world is that it is like mysticism…like a mystery. A mystery is different from an ignorance; radio frequency was not a mystery 100 years ago but ignorance. The solution, understanding was always there in the Ether; only we were ignorant. But a mystery is something which will always remain a mystery because it is not ignorance. Similarly, the valuation of assets may always remain a mystery and may not be possible to have perfect formula for valuation like we have in physics.
So in order to solve this mystery…to achieve perfect way to understand valuation, we have created and devised many solutions or ways or even formulas to value an asset or a produce. We are still trying to better it. So we have “n” number of financial and qualitative solutions to valuation whether it is PE ratio, EBITDA, PEG ratio, Discounted cash flows or qualitative ones like Commodity stocks, Cyclical assets or stocks. The list is quite big. But one thing- if we can see all these are related to manifested part of an asset, a business or a market place where economic transactions takes place. Valuation is also a manifested entity. But first thing- here also there is a misconception about these manifested entities being the ultimate…the culmination…the essence. In treating these as the essence we missed the real source/cause which is the root. And this misunderstanding about the root has resulted in many inconsistent approaches to VALUATION which consistently fails the test of time and space (Valuation should not be confined to a particular time and space but it should be absolute). We capture the manifested world in time and space matrix.
In the coming paragraphs we will discuss more about this “Root” and will try to find out what is this root. But first let’s see what are those inconsistencies which are due to the wrong understanding of the root and I think when we understand these then perhaps we will also be able to understand the root. Today I want to take up one of the most widely used matric of valuation of stocks- Low valuation of cyclical stocks. So once a stock or asset is cyclical its valuation should be low relative to non-cyclical assets. But this is not as easy as it appears because first we need to define what is cyclical and as I said earlier whatever we try to define or capture should pass the test of time and space and we will understand many such definitions are not standing the test of time and space anymore and that means we may need to revise our approach in defining them.
Why Cyclical stocks have lower valuation- Case of Shipping Industry
Cyclical stocks are those whose earnings are closely correlated with the economic ups and downs. They do well when there is an economic boom and bad when there is an economic downturn. So their demand pattern is highly correlated with the economic activity; meaning their fortunes are tied with the level of economic activity/business cycle. But I don’t know whether it is for the surprise of many or not but cyclical industries are not an exceptional or something not the norm because as we can understand due to linkage with the economy most of the industries are cyclical. Examples of cyclical industries are Metals, Shipping, Hotels, Automobiles, Airlines, Tourism, construction and even banking. The most important factor here is that some are less cyclical while some are more cyclical and we can see that’s the reason each of the above sectors have different levels of valuations; they are not treated because they are cyclicals. So things are way more complex here then a plain generic statement that cyclical stocks have lower valuations.
Non-cyclical industries are the ones which perform better during the times of economic slowdown; means they are not or lesser impacted by the economic activity. These industries are called defensive sectors like Healthcare, Pharma, food/FMCG, energy, utilities etc. The demand pattern of these industries are quite stable but people can’t stop the consumption of these products even if there is downturn in the economy. There is some impact but very less as compared to the cyclical stocks. So cyclical stocks are the ones which are highly impacted by the economic variations…our so called high beta stocks.
So going by the available literature, stock market treatment of these stocks; it may appear that we understand what really is going on with the valuation of these stocks or industries.
But I think it is not the case.
I always say that when we endeavour to find solutions of a problem the first step is to properly understand and define the problem. So definition is the key and here I am of the view the definition should be as independent as it can be- it should be able to define itself without the use of relative things or definitions. Means it should be able to express itself as an independent unit or entity; not something which uses the reference of many other things while try to define itself. Like for example HEALTH- how one can define health? What we hear about the definition of health is that when we don’t have any disease. But it is a negative definition. Can we say that health is absence of something? Here, we are using “Disease” to define health so this is not the direct/individual definition of health. It is a derivative as it is derived from some other entity…means we need now to understand disease first only then we can understand health as per this definition. So if we can define health then it should be related to presence of something positive. (I don’t know how they are defining Health these days in medical books…I have just used it as an example).
So here, when we talk about the impact of economic variables on cyclical industries/stocks I always feel that we are missing something in our understanding of the issue. Here if you ask me, the issue is of Cause and Effect. We think that cyclical stocks or firms bear the effect of cyclical economy and because economy is down so cyclical stocks will see their revenue goes down. But there is no such thing as economy exists individually/objectively…economy is a summation of a large number of economic entities and many of these economic entities are considered cyclical. But the question here is- whether something physical happens to the economy that brings economy DOWN and because economy is DOWN so all or most of the economic entities (both cyclical and non-cyclical) would take the impact and would also go down? However, in reality, nothing like this happens because there is no individual existence at the level of economy…economy has no separate existence but it is a derivative. And when we say economy is going down it only means that demand for both cyclical and non-cyclical industries is coming down. Demand may be hit more in case of cyclical industries but economy has no role in this. So the REAL issue here is- demand slowdown in cyclical industries results in more economic downfall. And as we can see, economic downfall in fact is the result of demand slowdown in cyclical industries; it is not that economic downfall happens first and then cyclical industries face the demand slowdown. Economic growth/downfall is a derivative of net total economic activity.
And with this we move onto our next issue-what causes demand to get hit more in case of cyclical Industries. Right now in our study books we are reading that economic slowdown hits the cyclical industries but if we can see it is a mere statement…that too wrong. Because at first economic slowdown is not the cause but the effect of the demand slowdown in cyclical industries. So again, what is the reason that demand starts falling in these industries?
For me the reason is- because cyclical industries grow faster in good times so it is natural that they will see more slump in downfall. Or in a more direct way, cyclical industries due to their innate nature result in higher demand and capacity in the economy which in many cases may be more than what an economy really needs and so accordingly in subsequent periods this excess demand and capacity revert back to the normal and we see the slowdown in the economy. In a way this slowdown may be the course correction…averaging of economic growth. Naturally this excess demand and capacity do involves n number of other economic factors/variables like liquidity and interest rate in the economy. We will explore these aspects in more details in the coming paragraphs.
In line with cyclicals we have commodity firms which are those who are producing products having no individuality i.e they are not valued for their products. There is no branding not product differentiation. The demand for their products are dictated by cyclical factors most of which are not in their hands so they are also cyclicals because underlying demand supply of their products is a function of economic activity. Both cyclical and commodity firms are not valued for their individual products (and services) but their valuation is a function of cyclicality of macro variables which mostly are out of their control.
What really causes the economic boom and bust (Business Cycles)?
Why economies grow and then why they falter? These are the questions for which our great economists still don’t have any standardized, concrete and empirical answers. And if you ask me; when we don’t understand the cause of a disease/impurity but still suggest a remedial medicine then the same is not more than a snake oil. So, in the name of cause of GDP growth/fall (better word is business cycles) we have been provided with a number of explanations/propositions: For some the reason is 1) Investments, for some it is 2) Monetary policy (Money supply & Interest rates), for some it is 3) technological advancements, 4) more reasons like Government policies (Fiscal policy), population growth, natural resources, geopolitical and global events like wars or growth in trade etc. So these are a lot of reasons. But can we say that these are the causations also i.e. these are the ones causing GDP growth/decline or business cycles? Then, which one of these is the real cause behind business cycles or whether they are all the cause? If these all factors can influence business cycle then can we say that business cycles are multi-cause. So we have 9-10 number of causes but if these all very different causes are leading to same effect (GDP growth/fall) then can we say that there is something common in all these? And that something common is the real ROOT!
Because if we can see then there must be SOMETHING which makes people/businesses to INVEST more; there must be SOMETHING which makes people to SPEND/INVEST more due to lower interest rates; there must be SOMETHING which makes people to focus on TECHNOLOGICAL ADVANCEMENT (not on finding safe JOB options). Can we say that this SOMETHING is ONE COMMON factor in all these reported causations and if yes then what is this common factor?
But before we try to find this common factor, we first need to understand what an economy is. An economy is a summation of a number of parts (sectors) and at first it is very natural for us to comprehend that because these parts are very different (agriculture, manufacturing, services, mining etc.) so an economy and its business cycles will be multi-cause with different factors effecting the growth/progression of different sectors. But before all this, an economy is a “Cause and Effect” thing and this is the most important factor. Demand supply are two forces directing the growth of an economy. But we need to see which event is happening first…what is the cause and what is the effect. Timing of an event in an economy is crucial. Demand supply events of all the economic entities (parts) are not happening at the same time. They don’t run parallel. Some parts of an economy are the ones which cause the economic events (from scratch) while some parts are the ones which “propagate or effect” the progression. So these “cause” events are like “roots” of the Upside down tree as explained by the Lord Krishna.
If we want to grow the size of the economy then we need to focus on “Cause” parts first. Just like the case of Pizzas in an economy, if people are not buying pizzas then lowering the prices won’t make people to buy them because the “cause” of not buying in first place can be the lower income levels. So if we try to lower the price or add more cheese or do something more with the pizzas, people are not going to buy them still. Because the demand for Pizzas is not the cause here; if people have more money to spend they will buy pizzas. So pizza demand is a propagation event not cause event. The same is true if we see people not buying premium shoes/clothes/tourism/cars.
If I break the window glass of my neighbour then I am contributing in the growth of the economy. But if we can see this spending on new window glass is “distribution of income earned already”. Breaking of windows are not growing to contribute to the economic growth unless people have income to buy new glass.
Most of the times when we see our policy makers making the strategies for economic growth, they are mostly trying to work on the “Propagation/Effect” parts of the economy and hence these policies are not going to work as desired because they are not touching the “cause” part of the economy. Further, in its natural form and existence an economy is only going to expand…growth and expansion is natural to the economy. The decline in the economy is not natural but a shock…unexpected event. If we leave aside natural shocks like Tsunami or earthquake which are rare then the only reason for the shock is the misallocation of resources in an economy. That Misallocation of resources can be inherent in the design and complexity of the economy or it is the result of policy mistakes/flaws. And so the actions we see from our policy makers in the name of strategies to make economy grow are actually the attempts to reverse the impact of earlier policy mistakes. One perfect example for this is the monetary policy or tax reforms. Because of their earlier decision to keep interest rates high which eventually hit the economy hard (demand and business investments), now they are trying to reverse the same by lowering the interest rates in the name of monetary policy.
And most surprising thing here is that when they make these policies, they try to ignore the fact that people are rational. They think people will consume like crazy when they lower the interest rate; businesses will invest big for expansion with low interest rates. But real world does not behave like this.
Monetary policy’s ability to direct and affect the “cause” factors is very limited. Most of the times, the aim behind monetary policies is to reverse the earlier actions or course correction. Like, take the case of interest rates; theoretically it appears that low interest rates will make firms to go for investments/expansions into new plants. But the real business world is a very different from theory. Interest rate is not the most relevant factor when firms take decisions about investments. Investments into new plant incurs high fixed costs along with the fact that the installation of a new plant takes a lot of time and so it does not increase the production capacity of the plant. In view of this, high fixed costs are a very important factor to consider before investing into a new plant. Then, if the expansion is in the existing plant then the same is required to be shut down till the new plant capacity comes online. And it is not always possible to install a large new production line/plant. Small plants are costly and for every expansion are required to be shut down. So these costs are much bigger factor than just the small difference of interest rates. Apart from these, the other biggest factor is that firms are required to forecast and assess the possible rise in demand for their products to be produced in the new plant along with any new capacity from the competition. So it is more about human assessment/factor and interest rate consideration is not the primary factor.
Further, businesses have the capability to assess the long term interplay of monetary policy and interest rates and they take their investment decisions based on the same not just on low interest rates. Central banks have very limited capacity to impact long term interest rates. In fact, as of now there is very limited knowledge about determinants of long term interest rates. Theoretically, long term interest rate is a function of short term interest rates plus a premium for riskiness of long term investments as economies are very hard to predict in the long term and plus a premium for inflation. So it all looks very easy but almost impossible in real life. Economic growth over long term is very difficult to assess because of complex interplay of technologies and demand supply scenarios (Still we can assess and model growing economies to replicate the history of developed economies like India can follow China and US and we can build a model around it). Inflation is almost impossible to assess; mainly because of our mis-understanding of whole thing…from conceptual to computational.
If we see how Inflation is defined; they say Inflation is a general increase in prices and fall in the purchasing value of money. When we read this we get the impression as if Inflation is some sort of natural economic entity and it happens naturally. But Inflation is not a DIRECT entity but end/resultant figure of something ELSE. Inflation occurs when some producers sell their products at higher price and earn more (profit Inflation)…it does not happen but it is done. And when producers earn more with inflation then what they do with those higher earnings is even more interesting and has very different and pronounced impact on the economy. One important aspect- when product prices come down in the future it doesn’t cause the reversal of earlier excess income earned by producers (will touch this in some other time).
So Inflation does a lot more things to the economy then just general price increase which is not captured in the definition (academic). I think the definitions of these “Transactional” economic entities should also capture the “Flow or Process” part of these (how and why); not just the end or culmination or climax part (Final Impact). Same is also true for the definition of economic growth where they don’t capture how and why economic growth happens. They just say that it is the increase in the production of goods and services. But if we look closely this “Increase” is the result of some other “economic entity or event” which is not at all captured in the definition.
Definitions are very important, especially when we are dealing with economic and commercial entities because incomplete definition can mislead badly and this can impact even the economic performance of the whole economy. Like, the definition of Income. At present Accounting standards define Income as inflows or enhancements of assets. So they have linked the income with Assets. But this Income definition is not independent as it does not define Income without referring to some other economic entity. Further, Assets are just a mode or outcome of income…end result of income generation process. Most importantly, concept of Assets contains the concept of income earning capacity of assets. This definition is confused in defining the purpose of income (asset creation) rather than what Income is. In my view, income is related to capacity to consume…what gives us the capacity to consume marketable “resources”.
Then the computational part of Inflation has even more limitations and lowers the relevancy of inflation figure considerably. For example- they have weights for each product category based on historical consumption pattern like having higher weights for veggies/pulses. When prices of vegetables and Pulses are jumped by 50% their inflation rate will show big increase because of higher weight but consumer will shift to products like Eggs having low price but since eggs have lower weight so much higher demand for eggs won’t reflect in the inflation rate and it will stay higher. So our Inflation formula is unable to adjust or recognize this substitution impact.
Hence Inflation is almost impossible to forecast. Monetary expansion is not the only reason for it. Competitive forces, tech development, saving rate in the economy, profit inflation etc. all play their part which are not easy to assess.
So we were talking about the capacity of central banks to impact long term interest rates. Central banks can’t dictate long term interest rates because they don’t have that much capital. But still they can do a lot of work indirectly. Now we know that theoretically Interest rates are a function of Inflation rate. So central banks with their expansionary monetary policy will give the indication that inflation will be higher in the future and so interest rates will take clue from that and will be adjusted accordingly. But still things are not that easy- central banks can plan for monetary expansion for 10 years but a lot of things can happen in between- new government can come with different mindset, economic scenario can change. But still Inflation is the play book of central banks.
However, things are very interesting here- when central bank lowers the short term interest rate with its expansionary monetary policy, market participants assess the impact of the same on the inflation in the future and accordingly it corrects the nominal interest rate (to rise) to reflect the Real interest rate. So low interest rate policy will eventually lead to reversal to normal interest rates thus neutralizing the monetary policy action. But still it all depends upon so many other relevant economic indicators not just inflation because as I shared earlier Inflation is not a direct entity but a result of interplay of other direct economic entities. And money expansion will not automatically create an environment for higher inflation (as Friedman put it), because inflation etc will depend upon the direction of this money/liquidity i.e. where this money has been used (for consumption, investments or buying new assets or buying old assets).
So we need to assess a lot of things to forecast long term interest rates- economic risks and Inflation. And as I shared earlier there is no model to assess these figures reliably. Human assessment is required for these variables which is influenced big time by behavioural and other factors. Human behaviour factor is not so far modelled in any economic model. During times of high uncertainty, people are ready for lower but assured returns (low interest rates) and again economic uncertainty is a very “subjective” human thing. So monetary policy is not the only thing which influences the behaviour of people towards a particular interest rate. Before assessing and committing their funds for a particular interest rates, people take into account other relevant factors like alternative investment options and their return profile, saving rate, general economic and political conditions etc.
Further, monetary policies primarily influence the demand side of an economy not the supply side. Supply side in an economy is the one responsible for economic growth. When interest rates are kept low then businessmen are not lured by that to invest; they are not fools to base their profit calculations on the low interest rates kept low artificially by monetary policy. They understand that central banks can’t keep lower interest rates forever and it will be reversed in the future so they make their investment decision keeping in mind that they will be profitable even if interest rates rise in the future.
Numerous studies have shown that our policymakers, economists and analysts are miserably wrong in predicting the future economic outcomes (Interest rates, GDP growth/recession). Their accuracy levels are around 40% for one quarter ahead predictions which is very low. But when they try to predict beyond one quarter it is miserable at .1% (read Zero). That’s why I never give any value to all the predictions made by our these people. But one thing- Because people believe them to be experts so if they shout “recession recession” then they can infuse an environment of fearwhich can eventually create some mess in the economy (as they say Choose your heroes wisely).
Our economists, analysts etc. are not yet clear as to what really creates money in the economy. Most of them still believe that banks are financial intermediaries. After the financial crisis of 2008, there is a widespread interest in as to how money is created in an economy. Credit creation by banks is the main force behind money creation but still there is no uniformity. Banks do really create new money when they lend but the problem is that one bank can give loan to two competitors for big investments in steel, telecom or hotel venture (or even two banks…does not matter). So the failure or underperformance of one is quite certain. This is what we have seen in India in case of Jio and Idea.
There are a lot number of economic entities like this where we don’t have much clarity. That’s the reason that the major players in the bond market do not invest for earning interest income. The big investors invest for speculation gain or trade gains that arise from the sudden changes in the interest rates in the economy. They do it because they know that at any point of time, the prevailing long term interest rate is just a rough guess with not much certainty. So they focus on exploiting this inability of market forces to correctly assess the long term interest rate. The daily volumes in bond market is in trillions of dollars. This human behaviour takes into account large number of factors (including return rates of other assets) in trying to judge interest rates and place their bids with a focus on trading gains.
Banks do create the money but here also the biggest factor is not the credit creation because banks can’t create credit on their own- credit is created when people demand it. And people demand credit based on numerous factors and interest rate is only one of those. Further, when banks extend loans against collateral then the monetary asset is already present. Credit is just monetizing it. So in credit creation process, human factor is the primary driving force.
So monetary policy with its limitation of short term focus, limited capacity to effect long term interest rates, complexity in assessing/forecasting long term interest rates & inflation and then decision making of businessmen not taking much cognizance of interest rates; all this implies the incapacity of monetary policy to induce any meaningful impact on economic growth. At the most it can affect the effects of any earlier monetary policy actions like lowering interest rates to stimulate falling consumption due to earlier higher interest rate.
Whether it is to assess long term interest based on further assessing of inflation rates or to take an investment call based on the assessment of product demand or to take a call on bank loan; the primary driving force is the human factor. Monetary policy is not an auto tool to direct the movement of economic resources.
Technological development and Economic growth- this is one factor which really effects the “cause” parts of the economy. But what is that in an economy that causes or motivates technological development? There is some root cause for technological development of economies because not all economies continuously produce or develop new emerging tech. India is one case of doing very poorly on tech front while some countries like US, Germany, Finland, South Korea, Singapore, Japan, Switzerland, Israel etc. are the permanent leaders. But China is a surprise addition here in the last 10 years. In fact, China may overtake major innovators economies in the next few years. China’s R&D spending/investments has grown some 18 times in the last 20 years and now the second top spender globally. India is trying good (we are now at 38th place in Global innovation index from 66th place in 2013) but we are still lagging behind big time in critical innovation. China is at 10th place now as compared to 35th place in 2013.
India’s innovation standings have shown good growth in the recent years. Major contributor for this growth is the ICT export industry. But due to selection, sampling and evaluation criterion used for these Global innovation Index (GII) standings; Indian Innovation rise is more superficial. Indian ICT exports are not due to skilled IP driven workforce but it is due to cost arbitrage and Indian IT companies used the software developed by other economies/companies to provide low cost services. Indian Unicorns are getting venture capital (venture capital deal is one metric used in GII evaluation but it is just plain data) but they are using capital for already proven ideas in other economies (Zomato etc are doing nothing new). No IP led products have been created by these unicorns…they are just copying the ideas of other economies. Indian R&D spend as a percentage of GDP is still at .7% (same 10 years ago) while the likes of US/China are at 3-3.5%. Indian universities don’t have noteworthy deals with the industries for commercial IP product creation. Surprisingly, Lovely Professional University is filing large number of patent applications (1418 fillings in 2024, global scale)!!! Because GII rankings use quantitative data of patent filed not the conversion of these patents to commercial or marketable product. India’s rise in GII ranking is mainly due to efficiency in innovative outputs relative to inputs used. But India lags behind in Innovation inputs especially in R&D spending (.7% of GDP), Industry-Academia partnership, risk aversion for new unknown tech. University research often produces an underdeveloped proof-of-concept idea which require huge investments to make it a marketable commercial success, for which it needs the partnership with industries and it is where India lags big time.
India is very poor in Innovation in manufacturing, hardware, software products and cleantech. Indian Govt. needs to look beyond defence and space and invest for R&D in manufacturing sector. GII rankings do not consider defence sector innovation in their evaluation model due to reasons like secrecy in defence and focus on innovation improving public sector well-being and challenges. So in case of India, it is probable that the innovations India has achieved in defence sector has come at the cost of manufacturing sector. Defence sector innovations do not reflect and contribute significantly in general well-being and economic growth. But with schemes like PLI Indian Government is trying to play that model in present times ( but with no bar on foreign companies to set up manufacturing in India).
However, the most important thing about these global innovation ranking is that Individual high scores and rankings do not prove anything. It is the relative performance to the competition that matters the most.
Why People focus on Innovation: So we see some economies are continuously outperforming others in innovation and most importantly developing marketable products based on innovation. But what causes this differentiation? What causes people and industries to focus and spend resources on innovation taking big risks and why the same does not happen in some economies? We are getting to the root here…why would people and industries take risk of innovation. For making them motivated to take this risk, most important thing is the social and financial security. When people and Industries are provided an environment for financial security then they feel motivated to focus on creativity. Anyone living under consistent existential hardships can’t take the risk of putting his resources (skill, talent and capital) into the unknown. That’s where the role of State/Government is so important. It is their policies which provide assurance and protection to people and industries if they risk for innovation. Their policies create an environment where innovation blooms as Government becomes a partner in the process. It is the primary role of a Government to shift the risk taking in innovation to the state from the private sector and let better people use their skill for technological development in the economy. Revenue from taxes should be used primarily for this because technological development is the best tool if a government is serious for poverty eradication and economic growth.
Role of Government in promoting Innovation: States of Japan and then South Korea used this model to make their economies global giant in technology. South Korea was a poor nation like India in the 1950s. But then their government got into the act and formulated policies that ensured that businesses made investments in innovation and technology. Government formulated policies that protected these industries from competition-licenses were used for industries, entry controls were used, taxes were lowered to give them more money for investments, tariffs were imposed on imports, financial incentives and subsidies were provided to specific industries. Their Industrial development banks were state owned and they kept their margins were low (Lending vs deposit interest rates) which boosted the profits of manufacturing sector and private capital flowed into manufacturing rather than financial business. Entry of new firms into specific sectors were controlled (Licensing) giving protection to operational firms from the competition. If you see it is better to have 4 highly profitable firms in an sector rather than having 8-10 low profit or loss making firms because higher profits can be channelized for innovation.
The present south Korean giants of Samsung and Hyundai have very humble beginnings. Samsung was a grocery trader and now it has some 13% share of Korean GDP. Hyundai started as a rice retail shop. LG was into chemicals. But these humble beginners turned into global tech giants entirely due to state policies. Like, when Hyundai started making cars in the 1970s south Korea implemented import tariffs which made Japanese and German cars very costly making it possible for Hyundai to sell their cars in South Korea at high prices. But they sold their cars in export market at 50% price; because of the super profits earned in the local south Korea market. This paved the way for the success of Hyundai and developing innovative tech. It would not have been possible without the state’s supporting policies. If we can see, the creation of local monopolies in the forms of Hyundai, Samsung were a sort of taxation imposed to fund the investments in innovations and new tech. But these firms were given these incentives to capture export markets.
(These days there is too much noise about the tariffs of Donald trump. In this regard just want to share my view-free trade policies are implementable only when local firms have the ability and capacity to take on the competition from foreign firms. So import tariffs are justified only when domestic firms are not matured enough to be competitive against foreign firms because without these tariffs foreign firms would kill the local industry and establish monopolies. I hope it is understandable why Trump’s tariffs are not justifiable in most cases).
Koreans used tariffs but they were smart enough to relax these on import of capital goods used for the production of final goods. Now we can also understand why South Korea needed to sell products cheaper in export market because it needed those foreign currency revenues to fund the import of capital goods required for economic growth.
Human factor behind the success of these policies: The most important factor in South Korea which was responsible for the successful implementation of these policies was the human factor in the form of competent and professional bureaucracy devoid of corruption. The human factor behind these policies were able to strictly focus on the implementation and success of these otherwise the story could have been very different for South Korea. Take the case of India which also tried to follow the Japanese and Korean model (License Raj) but failed miserably because of incompetent state machinery (Human factor). It may appear from the surface that these policies were the “Root” of the successful growth Tree of South Korea but the real “Root” was the human factor which could execute and grow these into the shape of a growth Tree.
Path to Innovation after an economy crosses a certain threshold: Evolution is embedded in the design by the nature. Growth and expansion are natural phenomenon. Economies starts their journey from simpler businesses catering to basic needs- clothing and food. So Industrial evolution journey starts from Food and textile businesses because these industries do not require Hi-tech and large capital because Manufacturing value addition is low in these industries. But then with this journey they start accumulating capital, knowledge and skills and with basic needs being taken care off they are ready for the transition to hi-tech industries and high economic growth. Here, what we mean when we say “Hi-tech Industries”? How to differentiate Hi-tech against Low-tech. In my view, the value addition factor is much high in Hi-tech industries with the use of sophisticated machines/equipment. The value added on Input is much higher and final output has much higher and wider functionality. Also, the use of cognitive abilities is higher in these Industries as compared to Low-the which are labour oriented. Basic textile sector also transforms and starts producing hi-tech technical textiles. I have no data to support this premise but a model can be built with historical data from various economies.
But after this initial low quotient Industrial growth, the role of government policies is also very critical as explained in the above paragraph. At this time some leading and channelizing force is required to direct the flow of resources towards that goal. And we again see the Human factor coming into play.
Varied impacts of various technological innovations: Further, it is not that all technological innovations have the same impact on economic growth. In fact, things here are very complex because many times it is the minor innovation reflecting huge impact on the economic growth. Like, for example take the case of elevators. Very small technological advancement but without it there would have been no skyscrapers and no big hi-tech cities. Similarly, take the case of shipping containers which are just metal boxes but they have revolutionized the shipping sector and saved huge costs in global transportation. In fact, shipping containers can be regarded as the top 10 inventions of this century keeping in the view the massive impact of these on global trade and reduction in shipping costs and time (due to ease of handling). The impact of these on global economic growth is huge.
Space technologies are very high tech and complex but their time has not come yet to be used by/for general public at large. So their economic impact was not and still not that high (although massive geopolitical and military impact). But the impact is growing fast now with the growth and advent of new associated technologies which has made the cost of space tech lower and use cases are also growing.
How technology grows the economic activity: So we can see that there is something which creates the conditions for a new technology to impart huge economic impact. What’s actually happening here is- If a new technology enables Mr. A to produce a new product “x” and in response to that Mr. B also produces a new product “y” and they both are exchanging these products then this will create strong ground for high economic growth. However if a new product “x” is such that it is creating a demand for itself without creating the conditions for a new reciprocal product based on same or another technology then this demand for “x” will either make people to spend their savings or people will increase the prices of their existing product. Both these transactions are not that ideal although the first one (spending savings) does increase the economic activity and GDP growth. But the best scenario is when a new technology creates a breeding ground for the production of multiple new products and people exchange these products. This is what GDP is- exchange of products and services. In this way, here, if we can see closely then it is the ability of a new technology to “increase the income exchange transactions between people” which will have much larger and comprehensive impact on economic growth.
Say, Mr. A has income of 1000 Bucks and he sells 2 things for 1000 and buys 3 things for 700 so 300 bucks is his savings. Same is the case for Mr. B with similar sort of transactions. So both have income of 1000 and Savings of 300 Bucks. Then Mr. B develops a Mixer grinder based on electricity and electric motor. Working on the same tech, Mr. A also develops a washing machine. As both the products have marketable value and required by both so Mr. A purchases Mixer grinder for 200 Bucks and his savings drops to 100 but then Mr. B purchases his washing machine for 200 bucks and the balance is restored to savings of 300 for both but the income of both increases to 1200 now. This is how new tech grows the economic activity and GDP by “increasing the income exchange transactions between people”. The rise of faster internet has done the same thing with new business models increasing the income and new products like online commerce and OTT etc. growing the spending side of the equation.
So technology is a big enabler for effecting the cause part of the economy and economic growth. But how it does it- Human factor!!!
Human factor and forces of Hope and Optimism in the economy
Fear and optimism are the fundamental forces responsible for the direction of the economy. These are as abstract as something can be but still they have the powers to drive and motivate something as material as an economy. When people and entrepreneurs are hopeful and optimist they spend and invest which drives the overall growth of an economy. Major function of the governments is not micro managing productive resources and their allocation but to create an environment where people have the faith and optimism in the government policies and administration. So fear and optimism are not irrational random behaviour but are the driving forces responsible for growth and preservation in adversity.
It is a misconception that man, material, money and technology are the most important forces driving the economies. Actually economies are just like a big truck. But which part of the truck bears the maximum weight of the cargo/truck? I ask this question and most of the times I get answers like axle, wheel etc. But it is the humble AIR in the tyres which bears the maximum weight. So, the most insignificant, subtle and least-physical part holds together the most significant. Similarly, Confidence of the people in the economy and the Government is the most important factor driving the investments and thus growth. Opposite is true for fear. Businessmen invest when they are optimistic, general public consumes when they are hopeful. The moment there is environment of fear; fear of war, government frauds, incapability and everybody is cautious…spending stops, investments blocked. There is another fear…fear created by Doomsayers economists and analysts especially when people have faith in them…this is catastrophic.
Actually Just like Inflation, macro economy is not a direct economic entity but it is a derivation…derivation of millions of economic decisions taken by individuals at micro level. And those individual do not take decisions in auto mode or pre-fixed linear mode (like low interest rate does not mean that they will start spending or taking debt) but their spending and investment decisions are effected by their emotional reaction to their perception of general social and business environment near them and at gross economic level.
Economy Size is multi-layered: Here something very important- Not all economic decisions of Individuals are effected and guided by fear and optimism. There is a minimum threshold limit of economic activity in an economy which does not require any policy push because it is related to our basic needs of food, shelter, clothing, health etc. This basket of basic needs keep on expanding with the passage of time aligned with economic growth like now Internet is fast becoming a part of this basket. Spending and investments beyond this threshold layer are the ones guided and effected by sentiments and policy making can only impact the occurrence of economic activities beyond this layer. Like, take the case of food, every individual/family has their food basket settled and no matter what they will stick to it. There can be some small short term variations due to inflation etc. but they will stick to it. Policy making to control Inflation is about sustainability of this basket not economic growth. Here, a govt. can’t make policy to make people eat more meat or eggs to grow economic activity. A family eating meat once in a month will eat it every weak only if there is an increase in their income not otherwise even if Govt lowers the price of meat by some policy. This basket grows with the growth in income…not otherwise that people will start eating more meat or eggs and dairy and GDP will jump.
The layer after this basic needs is what we can call Spending and Investment decisions where policy and sentiments play big role. What will make people to buy ACs, Modular kitchen or car? People are going to take decision about saving or spending and if they don’t have savings then whether to take debt for these or not. So these decisions are the ones effected mainly by sentiments and we can also feel that able govt. taking rational decisions will make people feel better…sentiments will be higher. But this policy rationality is just one part of this.
And If we can see, our economy is not just a linear summation/derivation of economic events. In fact, Its size is composed of layers just like an onion. Basic needs is the first layer and more layers after that. Layer related to spending of savings and layer related to spending/investment with debt are the last two top layers. This layered economy design requires policymakers to perceive the economy and inter-relationship of its different layers differently.
It is not just the economy which has layered structure. Prices of goods and assets are also composed of layers. All the time, We hear our strategists crying about coming crash in the stock market because investors may shift money to bonds (for some reason like Interest rate rise) as if stock prices/valuation is all about bonds and interest rates. But stocks, Dollar, Oil, Gold, Bonds etc. don’t derive majority of their valuations from their inter-relationships. Most of the time and most of their valuation is impacted by their individual demand supply dynamics not the demand supply dynamics of other counterparts. Like, most of the valuation of the Bonds is impacted by its own demand supply dynamics rather than money from stock market entering bond market. Most of the money circulating in Bond market is meant for Bond market only and same is true for the stock market. Overlapping part is very less and shifting takes place mainly for short time. Like for example, the prices of Onions are settled based on its own supply demand dynamics. I call this price as Base price which is based on its own supply demand dynamics. Now suppose there is a big shortage of Tomatoes so people will shift some demand from tomatoes to onions and this will raise the price of onions over and above the base price. But the individual base price of the onion will still comprise the majority of the total price and for the purpose of long term decision making (like fresh cropping) the price impact due to tomatoes is not relevant and should not be considered.
So, in their present state of understanding, Economists try to assess the direction of the economy based on the data related to spending and investment decisions of individuals (A vast corporate is also run by Individuals) but they need to understand that this data is post-facto because their spending/investment actions are not the causations but the consequences of their perceptions about general state of affairs and economy. If they really want to capture the most basic ROOT cause of their economic decisions then it is about human beings and their emotional stimuli. And to capture this behaviour in a model should be the biggest challenge for economists and policy makers.
(2nd Part coming)
(Disclaimer: The above study is purely an educational content and is only for learning purposes. The Writer is a SEBI Registered Investment advisor (SEBI IA registration Number INA000020244) and the stocks discussed in this study are held by him in his personal capacity as well as by his clients. The above study is based on personal opinions and analysis. Please do not consider this study as an investment advice for investment in the stocks discussed in the above study and do your due diligence or consult a certified financial advisor before investing into these stocks. The content writer shall not be held responsible for any profits or losses incurred as a result of investment decisions made by readers based on the shared content).