Emerging market equities continue to be in a festive mood. In this Vikram Samvat year 2064, long after the crackers have fallen silent, sweets and dry fruits are being provided by the US Federal Reserve and investors remain in a binge-eating mood.
Intermediaries in the credit markets have taken billions of dollars in write-downs and the problem is slowly spilling over into the next layer—called conduits or SIVs (structured investment vehicles). A $80 billion super-fund to rescue SIVs has been set up by several banks, but many on Wall Street are of the view that it is more likely to do harm than good. In any case, the decision by some large banks to bring SIVs on to their balance sheet may have put paid to the chances of any super SIV being hatched. There seems to be a good chance that SIVs owned and operated by hedge funds or independently (as distinct from those owned by banks) will fail or be severely impaired.
For the next two or three quarters, it is quite conceivable that the US economy grows at 1.5% or a lower rate. China and India, too, are likely to slow from their torrid pace, in a lagged response to tightening conditions through 2007. Europe (operating in macroeconomic terms as the 51st state of the US) and Japan are already slowing. So, there is definitely some “stag” in the air, as the economy hits stall speed in the G3 (the US, Europe and Japan).
In emerging economies, higher crude oil prices are feeding into headline consumer price inflation and the price of intermediate goods (though distorted by subsidies). Runaway food prices in Brazil, India and China seem to be here to stay.
The world is confronted with a rather unique “stag” there, “flation” here problem. At the same time that the Fed has eased, and the European Central bank (ECB) is on hold, the central banks of China, India and Australia, to name a few “here” countries, have tightened.
While the Fed is dealing with a liquidity—bordering on solvency —crisis, India and China are dealing with rapid rises in food prices and the distorting effects of energy subsidies. Many may disagree, suggesting instead that there is a potential for stagflation within the context of the US itself, rather than split in global terms. Policy response there will require a clear view of which of these alternatives is likely. I think evolving evidence will point to benign inflation (not considering crude oil) in the G3.
If so, what next?
I think global markets will go through a pretty serious indigestion phase until the trough of the credit-market crisis, which is likely to come in January or February. Many SIVs will fail and the portfolios of the ultimate buyers of structured paper (hedge funds, pension funds and other institutions) will have to be marked down. Simultaneously, the probability of a significant slowdown or recession in the US will be marked up.
This process will be self-feeding for a while until it becomes clear that the good news is the profitability of US corporations and the robustness of emerging market economies. That, in my view, will set up the final stage of this bull market that began in late 2002/early 2003. In typical late-stage fashion, the bubbling asset with good fundamentals (this time emerging markets) will have a parabolic move. It may end in tears, of course, but in the meanwhile there could well be a significant upward move of 50-100% in global equities lead by emerging markets.
The stag there, flation here scenario will be a tricky one for policymakers to manage. Many “here” economies (Hong Kong, Russia, China) have de facto dollar pegs or managed floats and have, therefore, little real control of interest rates. If the G3 doesn’t cut enough, we may well be stag everywhere (global recession), or if it cuts too much we could well have runaway inflation here, and quickly. Central bankers have a tough enough job managing their economies, they are unlikely to want to try to manage the global situation.
Sovereign funds picking up stakes in Western financial institutions, and massive liquidity injections of the recent ECB $500 billion variety are likely to characterize this new environment. The impact of these on emerging markets is unprecedented and may only be known as it happens. The long-term challenges presented by the unwinding of securitization and structured finance are formidable. In a place like India, where securitization is still in its infancy, the risk is that the baby gets thrown out with the bathwater.
The evolving evidence should sort itself out into low growth/low inflation in the G3 and solid growth/inflationary expectations in the emerging markets. The fuel that is likely to be poured there will keep the fire raging here. As a consequence, capital inflows will likely remain an issue for Indian policymakers in the coming year. In the absence of bold moves by the government to absorb flows, we can look forward to several administrative measures aimed at modulation.
Festive time indeed.
Narayan Ramachandran is country head, Morgan Stanley India. These are his personal views. Comments are welcome at email@example.com