The markets seem to think the worst is over for equities, with the MSCI World index gaining 5.12% this month (till 24 April), the Emerging Markets index gaining 6.23% and MSCI India up 8.34%.
But is this rally sustainable? Well, the equity market crash was a fallout of the crisis in the credit markets. For the outlook on equities to improve, therefore, the credit markets must get back in shape.
That the tension in the credit markets has abated is clearly seen from the credit default swap (CDS) indices.
As on 23 April, the CDS spreads on the iTRAXX Euro index, which tracks the cost of insuring the debt of investment-grade companies in Europe, was 77 basis points—this spread had gone up to 160 basis points at the height of the crisis. A similar narrowing of CDS spreads can be seen from the North America CDX index as well: on 23 April, the spread on this index was 111 basis points, much lower than the spread of 172.3 basis points at the beginning of March.
However, at the end of April last year, when any talk of a credit crisis would have been dismissed as the delusion of a handful of perma-bears, the European iTRAXX spread was 18 basis points and the North American CDX spread 30 basis points. So, current credit spreads are certainly nowhere near pre-crisis levels, but the markets have pulled a long way back from the brink. That’s not surprising, with both US and European central banks doing all they can to ensure that banks remain liquid and sending clear signals that banks that get into trouble will be bailed out. In the US stock market, the impact of that reassurance can be seen from the Standard and Poor’s Financials index, which has gone up from a low of 302.8 on 17 March to 343 on 23 April, a rise of 13%.
Similar cues have also come in from the US fixed income markets. For instance, the yield on the two-year treasury bill has gone up to 2.2%—it had touched 1.35% on 17 March. That’s an indication that investors are no longer in a panic mode and that they’re moving out of ultra-safe treasuries.
However, there are still signs of risk aversion. For instance, medium-investment corporate grade bonds rated ‘Baa’ by credit rating firm Moody’s Investors Service have a yield of 6.95%, about 50 basis points higher than the yield prevailing on these bonds at the beginning of the year, despite the US Federal Reserve having reduced the policy rate sharply since then. Also, Bloomberg data shows that the interest rate in the US on the 30-year mortgage, at 5.8%, is higher than what it used to be a year ago, in spite of the rate cuts since then.
Nevertheless, the signs seem to point to the worst being over for the credit markets. That doesn’t mean there won’t be more write-downs by the big banks, but they will be spread over time and banks will be able to raise the capital needed to cover those write-downs. That is why, although the S&P Financials are up, the index is still 32% lower than the highs it reached in late May last year.
But even if the banks may have pulled back from the brink, that doesn’t mean the US economy is out of the woods. The US housing market remains in deep trouble and banks are tightening lending standards. Throw in a hefty dose of inflation and the US consumer is likely to find it heavy going. In fact, it’s the combination of good overseas sales and a weak dollar that are buoying the earnings of US companies. While the attention has so far been fixed on the credit markets, the full impact of the slowdown in US consumer spending is likely to be the focus from here on.
What about emerging markets? The problem is that what is seen as a cure for the US has become a bane for emerging markets. That’s because lower US interest rates lead to a weaker dollar, which in turn is one of the chief factors responsible for high commodity prices. True, supply constraints and strong demand from emerging markets have also buoyed commodities, but since the real Federal funds rate is now much below the inflation rate, it spurs speculative activity and this money finds its way to commodities, raising prices even further.
Unfortunately, emerging markets that are not big commodity producers are the main victims of this policy. Countries such as China and India are large consumers of commodities, including oil and food. Commodity-intensive manufacturing is the main contributor to China’s growth, while food forms a far larger portion of the emerging consumer’s basket. These emerging markets are, therefore, the worst affected by the rise in inflation.
To make matters worse, many of their currencies are pegged to the dollar in order to support their exports and their central banks buy dollars in an effort to manage the currency. That increases the money supply and adds to inflationary pressures. The rate of consumer inflation in China is 8.3% and in India, the wholesale price index is up more than 7%, while the inflation rate is much lower at 4% in the US and 3.6% in the euro area.
Ironically, central banks in emerging countries have little option, but to tighten monetary policy and slow growth at a time when the US Fed is doing exactly the opposite. While the credit crisis that precipitated the stock market crash in emerging markets may be getting better, markets in India and China are now hostage to inflation.