The recent sharp pullback in the stock markets has scared investors. Perhaps the market went up too much too fast? Perhaps we won’t see the V-shaped recovery the markets were pricing in? But these concerns are not new and the market had risen in spite of them. As Barclays Capital put it so pithily in its Emerging Markets quarterly for September, it was a case of “The Wall of Worry meets the Wall of Money”. There were two channels through which liquidity gushed out. One of them was the reversal of the fear trade: The money that had been parked in safe haven US money market funds during the meltdown in the last quarter of 2008 found its way back into risk assets. The second was the ultra loose monetary policy adopted by central banks around the world. The new worry is that the tide of liquidity could be turning.
The argument is simple enough: As long as real economic growth remains low and liquidity continues to be abundant, the resulting excess liquidity boosts asset prices. But now that central banks have started to make noises about tightening policy on the one hand and as growth revives on the other, that excess liquidity will be wound down and asset prices will no longer gain so much.
Also Read Manas Chakravarty’s earlier columns
But first, a look at the US money market funds. On 28 October, these were $3.37 trillion (Rs158.4 trillion), down from a peak of $3.92 trillion reached in January. The data show that these assets were around $3.4 trillion in mid-September 2008, before the blow-up of Lehman Brothers Holdings Inc. sent the financial world into a tizzy. In other words, the unwinding from that panic-driven stampede into money market mutual funds in the US is now over.
But what about the reversal of stance by the central banks? What does history have to say about the impact of such tightening on the stock markets? If we look at the last recovery, the Reserve Bank of India (RBI) started to tighten monetary policy by raising the cash reserve ratio in September 2004. The reverse repo rate was raised in October that year to 4.75%, while the repo rate was at 6%. Thereafter, RBI continued to raise its policy rate at regular intervals, with the reverse repo rate going up to 6% by July 2006, while the repo rate was raised to 7.5% by January 2007. We all know, though, that these measures had little impact on the stock market boom.
Graphics: Sandeep Bhatnagar / Mint
But our markets are dependent on foreign portfolio inflows. What was the monetary policy stance in the US during those years? After the dotcom bust, the US Federal Reserve lowered interest rates to boost growth and it wasn’t until June 2004 that it started to tighten again by raising the Fed funds rate by 25 basis points to 1.25%. After that it continued to slowly and steadily raise the Fed funds rate till it reached 5.25% in June 2006. We know that the stock market boom continued in spite of the rate hikes.
Nor did rising interest rates in the US lead to money flowing out of emerging markets. That concern had been voiced by many market watchers, based on the experience in 1994, when the turning of the interest rate cycle led to funds flowing back to the US, leading to a collapse of emerging market stocks. The International Monetary Fund’s World Economic Outlook’s database shows private portfolio flows to emerging and developing economies fell from $71 billion in 1993 to $54 billion in 1994 and further to $23 billion in 1995. But, as the chart shows, there was no such fall in portfolio flows in either 2004 or 2005, although 2006 did see substantial outflows. During the late 1990s and the 2000s, the Asian crisis and the dotcom bust, respectively, kept fund flows negative. That said, there is no doubt that markets get jittery when there’s talk of rising interest rates. This was most clearly seen in May 2004, just before the US started raising rates, when emerging markets sold off. The Indian market suffered a double blow at that time, because the election threw up a government dependent on support from the Left. With the benefit of hindsight, we now know that panic reaction to the beginning of interest rate hikes was a great buying opportunity.
What about the argument that it is different this time? Here’s the bull case, compellingly stated by Hongkong and Shanghai Banking Corp. Ltd strategist Garry Evans: “We would point out to investors who want an example of a nastier recession that, in the 1930s in the US, the stock market rose by 371% between March 1933 and March 1937 and that real GDP (gross domestic product) growth was 11%, 9% and 13% in 1934-36. Deep recessions are usually followed by sharp rebounds even if, as in 1933-37 in the US, the long-term fundamental problems have not gone away.”
Manas Chakravarty takes a weekly look at trends and issues in the financial markets.
Your comments are welcome at firstname.lastname@example.org