As though it was paying homage to the memories of the 20th anniversary of the 1987 Wall Street crash that occurred on 19 October, most stock markets closed the week on a rather downbeat note,?with Wall Street plunging more than usual. It was, in some sense, a fitting tribute to the memory of that infamous crash. It might well be a replay of the exaggerated market turmoil that forced the hand of the Fed Reserve in August and September. The next meeting of the Fed is due on 30 October. However, legitimate grounds for anxiety seem to exist, too.
The Bank of America took a big hit on its earnings and indicated that problems in the broader credit markets were beginning, not ending. Other financial institutions, too,?reported disappointing quarterly earnings. Housing starts data plunged more than expected and home builder stocks are still looking for a bottom. A survey of economic conditions released by the Fed revealed much uncertainty about the economic outlook. Two structured investment vehicles in Europe are defaulting on their debts. Price indices of mortgage-backed securities are breaking new records as they fall freely. Credit concerns are back.
Nonetheless, I remain mildly comfortable with the view that the global liquidity environment remains supportive of broader emerging market assets. After all, the real interest rate in China remains significantly negative. Even though the Chinese government has leaked that the September inflation rate is 6.2%—lower than the 6.5% reported for August—its real rate is still below -2.0%. Thus, monetary policy remains highly expansionary. The government, fearing the consequences of decisive monetary policy action that alone could prick bubbles, is teetering among half-baked ideas— proposing one day, reversing the next. The environment thus remains conducive for breeding bubbles in China. Further, the surging price of crude oil continues to push surpluses into oil-exporting countries and they keep shopping for assets to park their surplus funds. These monies still seek to invest in emerging market assets, even as risks intensify. Nowhere are the challenges starker than in Asia.
Singapore had to let its currency appreciate to counter inflation rates now at a 12-year high. India is grappling with large capital inflows within a short period as the central bank judges that the economy is not fully readied to handle the inflows. Most of these go to stoke aggregate demand rather than enhance potential capacity. Hence the restrictive measures. But these measures can only be temporary. Over the long term, they cause more harm than good. Even in the short term, policymakers are taking a chance that more durable and long-term inflows continue allowing them to finance the current account deficit easily. That assumption could be tested in 2008—posing depreciation risks for the Indian rupee.
At the same time, in the face of rising crude oil, the government’s silence on raising the price of petroleum products is conspicuous. Recent fiscal improvement will be tested with the move to expand the largely wasteful National Rural Employment Guarantee Programme and the proposed wage revision to government employees without reforms on accountability and labour productivity. The risk of a short-term setback to the Indian growth story due to the lack of progressive policies and the resort to populism that are masked by the euphoria of rising asset prices is growing.
One small consolation—if it is one— is that most Asian governments have not used the recent prosperity to strengthen governance or institutions. In fact, they are resorting to exchange rate manipulation and sterilized intervention. They have no room to drop interest rates and if they do, they risk resurgence of consumer price inflation and overheating, as in India. Crude oil price appreciation, weaker dollar and yuan, and a possible slowdown in US consumer spending, will put the hypothesis of Asian resilience to a severe test next year and the smart money would reject the null.
In fact, with policy competence and spine at a premium globally, the smart money would also bet that most countries, when faced with an economic slowdown, would opt for reflation with adverse consequences for their currencies and for domestic inflation outlook. Even outside of economics, the risk that the world gets into a dangerous political vacuum (watch Pakistan for clues) with no clear leadership in the coming years is increasing. This makes the case for gold in personal portfolios rather compelling.
The story is going to get a lot more interesting in the coming months and years as the repeating sequence of comedy and farce finally ends in tragedy. Smart investors would take refuge in gold to distance themselves from the cumulative consequences of worldwide policy errors.
(V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org)