A P: The One Number to Track

As we enter 2006, everyone's in-tray is invariably flooded with reports and emails detailing the investment outlook for the year. Most reports I have seen are quite optimistic and expect 2006 to be another good year for global equity markets. The optimistic message is not surprising: When was the last time one came across a forward-looking market forecast that was negative? Despite the cynicism, one still finds these reports useful in terms of trying to understand the logic used to justify the analyst's stance. It will also give you a good sense of the consensus.

While not entirely correlated, a strong outlook for global equity markets bodes well for the emerging markets asset class and hence India. If for no other reason than this, given our dependence on global flows to keep our markets rising, everyone should try to understand the bull case.

The investment argument for a benign equity market outlook in 2006 goes as follows:

1. Global liquidity conditions remain very strong, and though the Fed has hiked the interest rate by 325 basis points over the past year and a half, real interest rates both in the US and the G-7 more broadly are still at very low levels. (For the G7, real short rates remain at .5%.) The expansion of money supply is also healthy and does not indicate a liquidity squeeze in the offing. Equally important is the fact that in all probability the Fed is very much near the end of its tightening cycle, while the European Central Bank (ECB) is unlikely to move aggressively higher anytime soon, given the desire to prevent a short-circuiting of the fledgling euro-area recovery. Even in Japan, though economic conditions are improving and the markets have been on a roll, it is unlikely that the Bank of Japan (BoJ) will do anything immediate to move away from its zero interest rate policy. Thus, whichever way you cut it, it looks unlikely that global liquidity will tighten dramatically from here, at least not in the immediate future. This is an absolutely critical plank to the bull argument, for if global liquidity were to tighten, that would almost surely kill off any equity market gains in 2006. Easy money provides the fuel for rising financial markets, and as long as monetary conditions remain conducive, a decline in markets seems unlikely.

2. The bulls also point to continued strong economic growth as the second plank of their argument. While most observers expect the US to slow down in 2006, this will be led by a partial retrenchment of consumption as the housing market slows. The initial signs of a cooling in the US housing sector are already apparent, and if one were to go by the recent experiences of what happened in the UK and Australia, when real estate cooled off, one should expect consumption to be directly affected. This coming economic slowdown will however not result in a recession (provided the housing market does not collapse).

Providing a partial offset to the coming consumption slowdown is the expected drawdown of the huge financial surpluses lying with corporate America as fixed investment picks up.

A big difference in the global outlook this time as compared to previous years is the expectation that a US slowdown will not derail the global economy. The nascent recoveries in Europe and Japan should be able to withstand a mild US slowdown, and provide some ballast to the global outlook. The influence of the US has also declined somewhat in terms of a lower share of global trade (now below 16%, was over 20%). China is expected to have another strong year, with the recent revision of its national accounts, giving analysts less to worry on the investment-led skewed nature of its growth. This will further cushion the expected US slowdown.

The big assumption here is the ability of the US to effect a soft landing, given all its consumer debt issues, and the magnitude of the property market appreciation over the last five years. There does exist the possibility of an overshoot as property markets cool off, and consumers cannot factor in incremental wealth creation from this asset class.

3. The third plank to a benign global equity outlook is the fact that global valuations are not stretched, especially when factoring in current low interest rates and inflation. Using composite valuation indicators which combine all of the above factors, they in fact indicate that markets are as cheap as they have been in years.

Thus, the bull case looks quite compelling and difficult to refute. The bulls accept that global financial imbalances are large and still growing, but make the point that the day of reckoning will not arrive in 2006. It will arrive someday and with severe consequences, but not just yet.

The only worry in the above arguments to my mind is the implicit assumption that inflation will remain very tame and subdued. This is an absolutely critical assumption which anyone expecting benign financial markets in 2006 has to buy into. For, if inflation were to misbehave, all the three planks of the bull case will fall apart.

First, if inflation were to rear its ugly head, the Fed would have to immediately accelerate and prolong its tightening programme and impose a monetary squeeze to nip inflation expectations in the bud. Having killed off inflation over the last decade, the Fed will do whatever it can to not let this genie out of the bottle again.

A sustained Fed tightening cycle will tighten liquidity globally as other central banks will be forced to follow suit, killing off the easy money conditions so critical to sustaining current global financial markets.

A rise in inflation and the accompanying rise in interest rates will also have severe implications for the US housing markets. Any surge in rates will potentially disrupt the housing markets and cause recession as consumers are forced to retrench. If the US consumer were to retrench in a significant manner then it is unlikely that the global economy could withstand a growth shock of this magnitude. Earnings would disappoint and global equity markets would be likely to sustain losses.

Also if inflation were to spike, then the argument of valuations being reasonable on interest/inflation adjusted multiples would also fall away as these multiples would rise (along with the underlying interest rates/inflation rates) and no longer screen cheap.

Thus, while the bull case for benign financial markets in 2006 seems compelling, keep a watch on US inflation rates (particularly the core CPI)""it is probably the single-most important economic variable any investor can track in 2006.