It’s that time of the year again when market strategists start polishing their crystal balls in an attempt to predict the fate of the markets a year down the line. Most of these attempts are doomed to failure, but then even the International Monetary Fund’s (IMF) track record at predicting economic growth is suspect.
John Lipsky, IMF’s first deputy managing director, said recently that it would have to lower global growth rates again, even though a downward revision had been made just two months ago in October. And if forecasting economic growth is so fraught with danger, predicting the markets—which are much more uncertain—is far more so.
This year, the forecasting business is even trickier, because of the problems in the credit markets in the US.
But what do these problems have to do with the stock markets, especially with the Indian equity markets? The crux of the issue is the banks’ ability and willingness to lend. One thing is for sure—lending standards for housing loans in the US and elsewhere are going to get a lot tighter. If that affects consumer spending in the US, it could lead to a recession there, and with America accounting for a large chunk of exports from the rest of the world, it’s going to affect the global economy.
European exports have already been hit because of the weak dollar. So one channel of transmitting the credit crunch to the emerging markets is through a weaker US economy.
The second channel is through its effect on market liquidity. A recent news report, for instance, says Citi will take $49 billion (about Rs2 trillion) of structured investment vehicles (SIVs) on to its balance sheet. That will sharply constrain its ability to lend. Similar problems have arisen in other banks as well. And since banks have been the primary providers of liquidity to leveraged traders such as hedge funds, a cutback in bank lending will mean less money flowing to emerging markets.
And yet, markets in the developed world have remained remarkably resilient to the crisis, in spite of the direst predictions. As on Thursday, the Dow Jones Industrial Average was just 5% off its all-time high, while the FTSE was also less than 6% off its highs.
That’s probably because the markets are placing their trust in the healing powers of the central banks. But interest rates on 15 - and 30-year US mortgages are only slightly below the levels they were at three months ago, in spite of the Fed having cut its policy rate by 100 basis points since then. Nor have the Libor (London interbank offered rates), which are an indication of the costs of bank funding, fallen by as much as the Fed Funds rate.
However, while the lack of response in the credit markets could be due to disappointment with the scale of the central bank measures, the Fed has clearly signalled that it’s ready and willing to do all it can to bail out the banks.
The problem is that soaring oil prices and a weaker dollar are driving up inflation. Whether the Fed is willing to sacrifice its inflation objective to bail out the banks remains to be seen.
The other sources of liquidity have been China and the West Asian countries. As Strategic Forecasting Inc., a private intelligence agency more well-known as Stratfor, puts it: “We would argue that the money is coming from the dollar bloc and its huge free cash flow from China, and at the moment, the Arabian Peninsula in particular. This influx usually happens anonymously through ordinary market actions, though occasionally it becomes apparent through large, single transactions that are quite open. Last week, for example, Dubai invested $7 billion in Citigroup, helping to clean up the company’s balance sheet and, not incidentally, letting it be known that dollars being accumulated in the Persian Gulf will be used to stabilize US markets.”
Where does India fit into all this? Lehman Brothers Inc.’s outlook for 2008 says: “Soft Global Landing=Asia eventually overheats.” The report says, “Should the US Fed’s aggressive rate cuts avert a hard landing for the global economy, Asia ex-Japan—because of its high growth, relatively high interest rates and sound economic fundamentals—stands to attract massive capital inflows.” Morgan Stanley’s Malcolm Wood echoes that position: “We expect a combination of aggressive Fed rate cuts, a moderation of Chinese policy rhetoric, Asia’s strong fundamentals, and cautious investor sentiment to drive the Asia-Pacific ex-Japan (APxJ) market higher. Indeed, we see more than 25% upside for APxJ over the next year.” That’s a view backed by anecdotal evidence of money waiting in the wings to come to India—consider Gulf Finance’s recent deal to develop a $10 billion economic development zone near Mumbai.
But this optimistic scenario of money fleeing the devastated credit markets of the West for the safe havens of Asia has one flaw: it presumes that Asian central banks will be sitting idly by while asset bubbles form in their markets. With the examples of Japanese deflation and the Asian crisis fresh in their minds, it’s doubtful if Asian policy makers will do nothing. In India, for instance, the finance ministry was talking of capital controls when the inflows were very high. In short, the credit crisis, the high valuations of Indian equities and the determination of the authorities to prevent asset bubbles will all weigh on the markets in 2008, despite strong growth in the economy.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome firstname.lastname@example.org.