This is a conversation between a student of macro economics and his professor.
Student: Sir, you said that tapering of the quantitative easing will pave way to higher inflation because it will dry up liquidity and it is not happening. Why?
Professor: I honestly don’t know why? When I made that statement it looked logical.
Student: Sir, I also read that the US GDP for the first quarter was 0.1 percent and I read today that the IMF cut its growth forecast for this year to 2 percent below the 2.8 percent it predicted in April 2014. Also they said that full employment will not be achieved until the end of 2017.
Professor: It is becoming quite a challenge to predict as there are too many uncertainties. The consumers who contribute 72 percent to GDP change their consumption habits all of a sudden and the economists are not able to predict the change in their behavior.
Student: Sir, since attending your class I have been watching the behavior of government bonds across the world. You predicted that the yield on the government bonds of countries will eventually move up. But it is not moving up. For example, US bond field has dropped from 3 to 2.5 percent and the euro zone bond yield is around 1 percent. What has happened?
Professor: The world is heading towards deflation. Japan has been in deflation for 15 years. Euro zone inflation rate is 0.5 percent and is heading lower. Their unemployment rate is shooting up. US survived the deflation because of QE1, QE2 and QE3. But then how long can you keep the economy survive on borrowed money? Euro zone countries just lowered the interest rate and are waiting to do their quantitative easing to save their economies from going into full blown deflation.
Student: You kept telling us that the Indian economy is in doldrums and so should not expect the Indian stock market to perform well. But the market is hitting new highs every day. But you also mentioned that if Modi wins, the market is bound to get a boost. What is your view now?
Professor: The FIIs who are the largest players in the market have invested several billions of dollars in the market after Modi’s election and hence the rally. They always call the shots. They are the price giver while the retail investor is a price taker. They will stay in this market as long as they continue to make high returns. It is not easy to predict as to how much money they will bring in at any point in time but it is always their call.
Student: Are you saying that the FIIs determine the future of Sensex?
Professor: Yes, they suck in the retail investor make them invest and later create volatility. The retail investor runs for cover and looses significant portion of his capital by selling during volatility.
Student: Robert Samuelson in Washington post wrote that stocks and bonds are mixed and conceivably sending contradictory signals on the economic outlook.
Professor: You see, these days because of deflation the private banks are rushing to buy the government bonds which is driving the yield down. They are afraid to lend to the companies since the default rate is increasing. Borrowing to invest in the stock market enjoys low rate of interest. In fact dividend on some of the good stocks is much higher than the cost of borrowing. Finally, predicting human investment behavior is quite a challenge. Just because I know a little bit of macro economics doesn’t mean a thing about predicting how the investor will behave. The upsurge in liquidity which is happening now due to large FII investments upsets all predictions.
Student: Like every other retail investor, I want to chase the rainbow. I know that 8 out of 10 retail investors loose money. But I can’t resist the temptation and so I will invest some of my money in the Indian stock market.
Professor: Good luck. You must have heard the expression “fools rush in when angels fear to tread”.