Money is pouring into the markets once again. Fund tracking outfit EPFR Global points out that the combined emerging market equity funds have now taken in $26.1 billion (Rs1.24 trillion) of net inflows year to date, a little more than half of the $50 billion in assets lost to net outflows from these funds in 2008. Credit spreads have narrowed and risk appetite is back.
Measures of volatility such as the Vix index have come down significantly. Companies have once again starting tapping the market for funds. And the Bank for International Settlements says the global recession may be past its worst, thanks to the efforts of governments and central banks.
Is it going to be back to business as usual? Some experts are already seeing a V-shaped recovery. Indeed, the rally in the markets has led to a scramble among analysts to revise their earnings estimates upwards. But as Citigroup equity strategist for the Asia-Pacific region Markus Rosgen put it, “Equity markets went from a low of 1.1 times Price/Book Value and are now trading at 1.8x P/BV. A P/BV of 1.8 times is by coincidence also the 10-year and 30-year average valuations for Asia ex-Japan. It requires some convincing that the world economy has reached ‘normality’ as witnessed over the last 10 or 30 years a mere 14 weeks post the March lows seen in equity markets.”
Moreover, what exactly does “back to business as usual” mean? Does it indicate that we have started on another bull run? Does it mean that we shall once again go back to the days of high leverage? Was all the talk of ‘global imbalances’ so much hot air? Does it indicate that the governments and central banks have been able to solve a problem caused by very low interest rates and too much liquidity by lowering interest rates even further and throwing even more money at the problem? Or is the stage being set for the creation of another bubble? Or could it be that things are going back to normal, if indeed the conditions prevailing in 2007 can be classified as normal?
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That’s the subject of Pimco chairman Bill Gross’ meditations this month. He says that growth is likely to remain subdued for a long time because of the effects of the crisis. According to Gross, GDP growth of 1-2% in the US is the “new normal” instead of the 3% plus they used to have in the boom years. He also says that means that trillion dollar deficits in the US are “here to stay”.
Lower US growth could be bad news for Asian economies dependent on exports to the developed markets. As Stephen Roach, chairman of Morgan Stanley Asia, put it in a Note titled “Risks of an Asian Relapse”, “With asset-dependent US households remaining income-short, overly-indebted, and saving-deficient, subdued consumption growth is likely for years.” And if that happens, “China is vulnerable to a relapse in 2009, as a fading investment stimulus is not countered by a US-led snapback in external demand.”
But perhaps the most cogent argument that a global recovery cannot be engineered by liquidity alone has been made by economist Andy Xie. He points out the reasons why Greenspan was able to boost growth. According to Xie, these included: first, the IT revolution, which boosted productivity and lowered the cost of communications; second, globalization, which saw the entry of billions of Indian, Chinese and East European workers into the global labour force, forcing wages down and allowing production to shift to low-cost centres, leading to global trade growing twice as fast as growth in GDP; and third, the collapse of the Soviet bloc and the economic contraction in those countries that led to a fall in demand for commodities and energy there.
While the rapid growth of China and India led to rising demand for resources, the Soviet contraction offset this inflationary force. The problem, says Xie, is that none of these conditions is now present. “IT has been absorbed into production already... The prices of manufactured goods already reflect wages in developing economies. Global trade no longer shifts prices down like before. And the demand for commodities in the ex-Soviet block is increasing, adding to the rising demand from China and India.” That means inflation is no longer going to be as tame as it used to be.
What then does Xie forecast? He says, “The current party is likely to be short-lived. Next year, inflation expectations may become apparent. That would lead to expectations of interest rate rises. While central banks will still be reluctant to raise rates, rising bond yields will force them to do so. But they won’t raise rates quickly enough to stem the inflation momentum. Stagflation will probably take hold.”
In the short term, though, the conditions for a bubble are already in place. In an interview to CNBC, CLSA equity strategist Christopher Wood said the biggest beneficiary of the dramatic monetary easing undertaken by the Western central banks won’t be American or British consumers or their stock markets.
The dramatic monetary easing could lead to massive asset bubbles in Asia and other emerging markets because the excess liquidity will flow to the best growth stories, which are Asia and emerging markets. Xie’s forecast may well be true, but till it happens, where will all the money go?
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com