In the Mahabharat war, Arjuna vows to avenge the death of his son Abhimanyu by sunset the next day, and to kill himself if he failed. So, the Kauravas do their best to hide the main target of his vow, Jayadrathan. They nearly succeed and as the time of the sunset approaches, Lord Krishna covers the sun with his chakra (wheel). The Kauravas, thinking that the sun had finally set, bring out Jayadrathan and begin to celebrate. Then, Lord Krishna removes his chakra and the sun shines in all its glory again. Arjuna kills Jayadrathan and avenges his son’s death.
The American government took a leaf out of the pages of this story from the great epic. The August employment report showed that the economy shed 4,000 jobs. Jobs growth in July was revised down as well. The Federal Reserve was too stunned to wait for a trend to develop. It administered a double-booster shot to the economy. The Federal funds rate and the discount rate both were cut by 50 basis points each on 18 September.
Fast forward to 5 October. The job loss of 4,000 in August has been revised into creation of 89,000 jobs and the figure for July was revised up to 93,000 from 66,000 reported in September. With the rate cuts extracted, the American government “withdrew” the job loss of August just as Lord Krishna removed his chakra to reveal the splendour of the sun. Regardless of what this means for policymaking in the months ahead, investors in emerging market equities remain unfazed. The naysayers have their task cut out.
They point to two scenarios. One is that the American consumer buckles under a mountain of debt and falling home prices and begins to squirrel away savings for the rainy day. This lowers American growth and appetite for Asian exports, lowers growth in China and elsewhere in Asia and eats into corporate profits. Stock prices would drop more than corporate earnings would do, as expectations are rather elevated now. While the employment data for September has lowered the probability of this scenario, the danger remains.
The other scenario is that inflation shoots up as it began to in 1988. Soon after it had cut the Federal funds rate three times from October 1987 until March 1988, the Federal Reserve began raising it and did so by 300 basis points in the following 12 months. A new Federal Reserve chairman had to earn his credibility.
Investors are actually betting on a third scenario. That is one of 1998-99. Late in 1998, after the Asian crisis struck, after Russia defaulted on its debt and after a big hedge fund collapsed, the Federal Reserve cut the federal funds rate thrice (the third time was needless) and the technology-heavy Nasdaq Composite Index surged more than three times (200%- plus) from that point until it peaked in March 2000. This was on top of the impressive performance of Nasdaq index in the preceding five years (1993-97). The parallel with emerging markets now is remarkable. Emerging market equities have done well since 2003 and they now appear poised for that final assault on a Nasdaq-style peak.
The biggest support to this argument is that liquidity comes not just from the American Federal Reserve, which puts pressure on other countries to ease liquidity conditions to avoid currency appreciation, but also from China whose currency, de facto, is pegged to the US dollar. Emerging economies face a double-whammy here and they have no choice but to accept inflated asset prices if they wish to avoid an uncompetitive currency, not just versus the US dollar but also with respect to the Chinese yuan. Most investors are also of the view that China would not reverse its current policy stance until after the Olympic Games in an attempt to avoid any potential loss of face, since the Games are meant to stamp its arrival as a global superpower. A deflating asset bubble and slowing economy would not be allowed to rain on the parade.
Valid counter-arguments exist as well. In 1998, the US dollar rallied as the Fed cut rates. The credibility of the Fed was high and American economic fundamentals appeared sound otherwise. Fiscal deficit was rather low and so was the current account deficit. Short- and long-term rates in real terms were high and so was productivity growth. Commodity prices were subdued. This time, the dollar lurched lower swiftly in response to the Fed action. The credibility of the Federal Reserve is lower now. The current account deficit is high, the world is awash with dollars and commodity prices are already at a historical high. In this milieu, the Federal Reserve has attempted reflation in the US and triggered one in the rest of the world, too.
It is hard to believe that such behaviour would lead to sustainable asset prices but it is equally hard to sustain a quarrel with markets, especially when they are rising, and win.
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