Global stock markets have rallied over the past few weeks, partly because crude oil prices have dropped from their recent highs. India has followed the global trend. But these are premature celebrations.
First, few seem to ask why oil prices have dropped so sharply of late. It’s not because of a spurt in supplies; instead, a fall in demand has done the trick. Less oil is being used because the world economy has slowed—and is likely to continue to do so in the quarters ahead.
The rise in equity prices is partly because investors are taking a sunny view of the scene and partly because money has moved into equities again.
Illustration: Jayachandran / Mint
Second, the shift of money from the oil market to the stock market does not change the underlying reality that there is too much liquidity in the global economy in the first place. The US has flooded money into the economy to keep recession at bay. The most likely result will be high inflation.
Some of this extra money has flowed into the financial markets. When it rushes into the oil market, prices of that commodity go up. When it flows into the stock market, equity prices rise. Both high commodity prices and high asset prices lead to their own sets of problems.
How equity prices move in the coming months will depend on three factors—one, whether central banks will keep pumping money to keep recession at bay or whether they will tighten money supply to fight inflation; two, the severity of the slowdown in economic growth; three, the news on the credit crisis.
There are mixed signals. The US Federal Reserve seems increasingly worried about inflation and the futures markets seem to believe that interest rates there will eventually be raised. The economic news from the US—and elsewhere—has not been as gloomy as many expected at the beginning of this year; there has been no recession as yet. And both the recent bailout of two large quasi-government mortgage lenders in the US and the widening spreads on overnight index swaps suggest that the credit crisis has not gone away.
And what about India? The economy is slowing, inflation is unlikely to get back into single digit at least for another six months, corporate earnings are growing at their slowest rate in many quarters and fiscal deficit is far too high for comfort.
A cause for caution—if not outright worry.
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