Stock Markets in 2018: Greed and fear in new year
Fear in the markets? Why, for crying out loud? Think for a moment and consider the perils the Indian markets faced last year. We survived the disruption in economic activity caused by demonetisation. We took in our stride the botched implementation of the goods and services tax (GST). Rising oil prices were a wholly unexpected threat. Our banking system, groaning under the weight of its bad loans, saw credit growth fall to new lows. Inexplicably, the government dragged its feet in recapitalizing the banks. Economic growth slowed sharply. Growth in corporate earnings, predicted with supreme confidence by sell-side analysts every year, once again proved elusive.
Consumption growth slowed as farmers were forced to sell their produce for a pittance and there were reports of widespread rural distress.
Exports grew in fits and starts. The information technology (IT) sector, a huge source of jobs for the middle classes, was badly hit by US President Donald Trump’s protectionist policies. The construction sector, a massive source of jobs for the masses, was deep in the doldrums.
The global situation, too, was fraught with risks. Take the sabre rattling between Trump and the North Korean dictator. Or consider the escalating war of words between the US and Iran. Policy rates finally started rising in the US. Question marks remain about Trump’s policies and about the high debt levels in China.
And how did markets cope with all these risks? Why, they had a splendid year. Markets soared while volatility fell.
Market wisdom was reduced to the mantra: Just Buy The Dips. And why not—that simple strategy served investors well for all of last year.
And now, when the Purchasing Managers’ Indices are showing a coordinated global recovery, when global trade has started picking up, when unemployment levels in the developed economies are so low, when the Chinese Communist Party has shown it has lost none of its ability to outdo capitalists at their own game, when everybody expects the Indian economy to regain its strength, when consumption is expected to do better on the back of rising rural demand and with the states implementing the Pay Commission recommendations, when the Indian government has finally agreed to recapitalize the banks, when the bankruptcy laws hold out the promise of resolving the logjam in stranded assets, why on earth should investors be fearful? Having battled so many demons so successfully last year, surely this, more than ever, is the time for greed? That is why, at the beginning of the New Year, there is hardly any fear in the markets.
Behind that confidence, behind that aplomb, lies the simple faith, tested time and again, that central banks in the developed economies will do nothing to disrupt the markets. The US Federal Reserve is going even slower than Alan Greenspan in raising interest rates. The European Central Bank and the Bank of Japan are certain to be even warier of unsettling the markets.
Are these central bankers not worried about the adverse effects their ultra-loose monetary policies are having on asset markets? Do they not know the frenzy in Bitcoin could merely be the tip of the iceberg?
They have one big comfort—the absence of inflationary pressures. Economists say that the lack of inflation, in spite of tightening labour markets in the US and elsewhere, is a puzzle. But if inflation is so low, so goes the logic, then it makes sense to keep interest rates down; and if interest rates are very low, then soaring asset prices are justified, especially as leverage is not unduly high. As the Bank of America-Merrill Lynch (BofA-ML) survey of global fund managers pointed out in its December 2017 report, the ‘Goldilocks’ economy of above-trend growth and below-trend inflation is now the consensus.
The question for markets is: will Goldilocks be scared away by the bears this year and, if so, which particular bear is likely to take the initiative?
One answer is the inflation bear. If inflation finally raises its head, then central banks will be forced to turn off the monetary taps and liquidity will tighten. Higher interest rates could then derail the party. It’s no surprise that the BofA-ML fund managers’ survey has Fed/European Central Bank ‘policy mistake’ cited as the biggest tail risk to markets. In India, too, inflation could be a spoiler, particularly if higher oil and commodity prices are a drag on the economy. The government is likely to ensure better prices for farmers before the 2019 elections, which could lead to higher food prices. The fiscal deficit could bloat. Bond yields have already started climbing. Bank lending rates will follow.
Of course, other risks, too, may crack the optimistic consensus. China, to take one example, remains a puzzle wrapped in an enigma. And it is never the predicted risks that derail the markets.
What about the pleasant surprises? They could happen, too, if oil prices fall again, export growth rebounds, the push to housing and road construction starts paying dividends or if inflation remains contained. Trouble is, valuations are already pricing in much of the optimistic scenario, leaving the door ajar for disappointment.