The global markets have bounced back very nicely from their March lows. Despite the probability of a recession in the world’s largest economy, in spite of billions of dollars of write-downs by the world’s largest banks and regardless of turmoil in the credit markets, the MSCI World Index is lower by a mere 2.74% compared with the year-ago figure. The Dow Jones Industrial Index is above 13,000, within kissing distance of the level it was a year ago, notwithstanding the fact that the US is at the epicentre of the credit crisis. The Vix, a popular measure of the implied volatility of S&P 500 index options, is at a 10-month low. Credit spreads have narrowed considerably. If this is all the damage that the credit crisis and the bursting of the housing bubble has inflicted on the US, it seems to have got away very lightly indeed and the US Federal Reserve’s policy of aggressive rate cuts seems to have worked wonders.
There are several reasons for the rebound. When the credit crisis hit, it was widely predicted that liquidity would dry up as banks hit by capital constraints would be reluctant to lend. Moreover, the unravelling of the derivatives market implied that a lot of leverage would be unwound, adding to the squeeze in liquidity.
(Illustration by Jayachandran/ Mint)
What seems to have been underestimated is the swift response of the central banks, which ensured that the system did not seize up. Liquidity remains abundant, seen not only from the negative real interest rates in many countries, but also from the buoyancy of asset prices. What seems to have occurred is that money fleeing the credit derivatives and US housing markets has been searching for a new home and plenty of it has gone into commodities, some into equities and some into gold. Moreover, the resilience of the global economy to a US slowdown seems also to have been taken too lightly—Chinese growth is still above 10% and even the lowest estimates of GDP growth in India put it at 7%.
That doesn’t mean, however, that the global markets are out of the woods, although the panic seen in March is now behind us. Housing recessions are typically long-drawn-out and the jury is still out on whether the US consumer will finally capitulate. Inflation has emerged as a major threat to growth and the runaway rise in oil prices is certain to take its toll. In short, there’s a striking divergence between the equity markets and the “fundamentals” at the moment and the optimism in the markets may be premature.
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