So is this all there is to the biggest global recession since the World War II? Stocks down for slightly more than a year and then a spectacular pull back? Industrial production already back to double digits? The economy growing under 6% for a few quarters and then it’s back to 7%-plus growth? The dotcom bust had a much bigger impact on us—stocks remained down between 2000 and 2003 and economic growth was much lower.
The difference, of course, lies in the magnitude of the policy response. The monetary easing then wasn’t as extraordinary as this time, nor were there massive stimulus programmes. The response by governments and central banks and the V-shaped rise in the stock markets has led to more and more people believing the downturn is over. The bears are in disarray.
There’s absolutely no doubt we’ve seen a fantastic bounce back. Manufacturing growth is back and confidence has returned. Analysts are busy revising earnings upwards. In a recent note on global strategy, Citigroup Inc. points out that earnings recoveries are always V-shaped and it’s going to be no different this time. For Indian companies, while most analysts expect feeble growth this fiscal year, forecasts for growth in earnings of the Sensex companies in fiscal 2011 range between 18% and 26%.
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True, analysts are fond of talking about a “wall of worry” that the markets have been climbing. A report by Motilal Oswal Securities Ltd takes that analogy further and talks of the “loose bricks” that may lead to investors losing their foothold while climbing the wall. These include the too-rapid rise of the stock market, the drought, inflation, new issues sucking out liquidity, high valuations and the fiscal deficit. But it also tries to allay investors’ fears about these “loose bricks”. For instance, it points out, if the one-off rise in the Indian market after the elections is not taken into account, the Indian market has performed broadly in line with other emerging markets. Similarly, it says although valuations are no longer compelling, several sectoral and bottom-up opportunities exist.
Others are banking on liquidity. The combination of weak growth in the real economy and ultra-low monetary policy has resulted in a flood of money coming to emerging markets. As Larry Cantor, head of research at Barclays Capital, put it, “The combination of strong cyclical growth and crisis-level policy settings remains favourable for risky assets.” He calls it a “sweet spot” for risk assets.
All this is no doubt true, but a meeting with the research head of a foreign bank, who wishes to remain anonymous, forcefully brought home some of the assumptions behind that view. Perhaps the most important of them is that while the last bubble was created by taking on high levels of debt as a result of keeping interest rates very low, precisely the same mistake is being made this time, too. How on earth, said the research head, can the disease become the cure? This is a point that Morgan Stanley’s Stephen Roach has never got tired of repeating. And then there’s the fact that lower leverage will mean that consumption in the West will remain subdued for quite some time and the export-oriented economies of Asia will have to look for domestic sources of demand.
But that, too, does not worry people too much. A report on Asian Economies by HSBC Holdings Plc’s Robert Prior-Wandesforde and Frederic Neumann says, “Can the rebound last? Yes. Domestic demand, for one, should grow at a healthy pace over the coming few quarters.” The rise in the markets is not only good for companies as it has enabled them to repair their balance sheets, but it’s also good for confidence.
Perhaps, but the pessimistic research head, too, believed that stock markets were likely to do well in the short-term, for the simple reason that the government and the central bank would be very unwilling to slam the brakes and tighten policy. That is why it’s very likely that earnings growth in the short run will be even better than expected. Contrary to what analysts think, the force of the recovery in fiscal 2010 may be stronger than people expect, thanks to the easy money and the government stimulus. It’s what happens later that could be the problem.
The big concern is what will happen to demand once the stimulus is withdrawn. “If the auto sector grows by 30%, won’t the government take the opportunity to reverse the excise duty cuts they made?” asked the research head. Others believe that a revival of growth in the real economy could limit further market gains. As growth starts getting back to more normal levels, policy will start to reverse. Barclay’s Kantor says, “The strength of the initial recovery surge should limit its duration, as typically occurs in V-shaped business cycles.” He says when investors come to believe that policy will be reversed, the sweet spot will end and the markets will find the going much tougher.
So far, though, there are few signs of that happening. The increase in policy rate by the Reserve Bank of Australia was taken as confirmation of the recovery, sending the Australian market higher. Even the Chinese market is near the highs it made earlier this year, despite all the talk of tightening and in spite of a rash of initial public offerings. During the last boom, the markets continued to climb higher on the back of global liquidity despite a series of rate hikes. Are we setting the stage for the next asset bubble?
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org