Conditions in the credit markets in developed economies are getting worse. Global bond issuance in November was a trickle, down to its lowest level in the last six years. Corporate bond spreads are at their widest in years. One-month euro Libor rates are their highest since May 2001. The money markets are seizing up and the scale of the seizure can be seen from 17% shrinking of the commercial paper market in the US since last July.
Amid the carnage, stock markets are looking to a rate cut by the US Federal Reserve to bail them out. That may, however, be wishful thinking. One reason for that was pointed out last Thursday by Mervyn King, governor of the Bank of England. In his opening statement to the treasury committee, he said, “The committee’s current judgment is that the most likely outcome is for output growth to slow and inflation to rise, at least for a period.” That’s the recipe for “stagflation”—the combination of stagnation and inflation that plagued the 1970s. High crude oil and food prices continue to be a worry for central banks, inhibiting their ability to reduce rates. And if King is worried about inflation in the UK, with its strong currency, the US Fed should be far more concerned, thanks to the ultra-low dollar.
But it could be argued that if the US enters into a recession, inflationary pressures would ease and since monetary policy operates with a lag, it’s necessary for central banks to reduce interest rates now. The markets are in any case pricing in further rate cuts by the US Fed, and Bernanke’s recent speech has strengthened their belief.
The problem will arise if the rate cuts and the provision of additional liquidity to banks do not work. In a note titled Do not forget about changes in Velocity, independent research firm GaveKal had said last September that an increase in money supply may not necessarily lead to a rise in prices (including asset prices) or a rise in output. As proof, they point to the equation MV=PQ, also known as the quantity theory of money. M in the equation stands for the quantity of money, V for the velocity of money or the average number of times money changes hands in a year, Q for the quantity of real goods and services created, and P is the average price of those goods and services.
GaveKal says that most observers seem to be assuming that a rise in the money supply will automatically lead to a rise in output or inflation or asset prices. What they seem to be forgetting is the V of the equation, which has plummeted.
As a matter of fact, it is to offset the falling V that the US Fed lowered its policy rate in the first place. Said GaveKal: “The $100bn question for investors now has to be whether the world’s commercial banks will actively multiply the money that the Fed (and other central banks) have been injecting into their economies over the past few weeks. If they do, then the world should witness a roaring boom of unprecedented magnitude. If they do not, then the investment environment will have changed.”
GaveKal went on to list the reasons why they thought velocity was unlikely to accelerate. These were: Bank balance sheets are stretched, with the losses they have suffered; nobody trusts the rating agencies any more; and regulators and governments are likely to ask uncomfortable questions about how the mess started, leading to even greater caution by the banks. GaveKal’s analysis was bang on target.
Merely throwing money at the problem will not make it go away—that could very well be, in Keynes’ words, pushing on a string. And if that analysis is correct, then the rally induced by the Fed easing in September was nothing but a brief flareup before the final demise of the bull market.
Where will emerging markets feature in all this? The obvious parallel is that of 2000, when the bursting of the tech bubble not only led to a meltdown in the US stock market, in spite of several interest rate cuts by the Fed, but also led to sharp falls in emerging markets. More importantly, it took three long years for the markets to recover.
This time, the 50 basis point rate cut by the Fed last September saw a rush of money to emerging markets, giving rise to the hope that they would be safe havens against a US slowdown. But things have changed since then. This month, the MSCI World index is down 4.8%, but the Emerging Markets index is down 8.29% and the Bric (Brazil, Russia, India and China) index is lower by 7.76%. Emerging markets have been underperformers this month. The big difference between September and now is that, at that time, everybody expected the rate cuts to take care of the credit problems and set the US economy back on the growth path. That’s why US equities too rallied at the time.
Now, they’re not so sure, and almost everybody is predicting at least a 50% chance of a US recession next year. And when there’s a recession, fear triumphs over greed. That’s why US bond yields have plummeted, as investors rush to these safe havens.
For the week ended 21 November, data from research firm Trim Tabs show that US investors pulled out $7.93 billion (Rs31,482 crore) from funds that invest mainly in US equities and $2.22 billion from funds that invest primarily in non-US stocks. In short, funds flow to all equity markets—both US and non-US—have been affected. The hope is that once things settle down, investors will make a rational decision to prefer high growth markets such as India over those affected by a recession. But it’s still far too early for that.
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 at firstname.lastname@example.org.