The direction of markets will depend not only on when economies recover but on what happens after they do, says Abheek Barua
When will the bear market end? Most analysts seek an answer in their forecast of the first signs of recovery in the US. The consensus at this stage is that by the third quarter of this year, if not by the second, indications of a turn in the American business cycle will become clear. This would drive investors to slowly shed their aversion to risk and as they start chasing yields, asset markets will start moving up. The bears will give way to the bulls.
There are some problems with the consensus view, particularly the bets on recent policy initiatives to step up the effort to get credit flowing. Past efforts to get credit flowing by literally drowning banks in cash have failed to get the desired results. American policy makers have now come full circle and resurrected the idea of setting up entities that will buy ‘toxic’ assets off banks and free up liquidity in the process. Markets may have cheered this initiative but don’t seem to recognise the fact that some of the fundamental problems of this model (first introduced as the TARP last year) still remain. Of these, the challenge of finding the right price for these assets is critical. If either the banks feel that they are getting shortchanged or if the buyers feel that they are asking to pay too much. The new scheme plans to involve the private sector in a big way on the buy-side. Thus the probability of deals falling through on pricing issues is perhaps a little higher this time than in the earlier scheme where the government was the principal buyer.
Let’s get back to the problem of finding an end to the bear market. I would think that successfully forecasting the first sign of economic recovery in the US and the world economy is only part of the solution. We also need to figure out what happens afterward — that is, the likely course of events if indeed the US and global economy do a find a bottom soon. My sense is that three things are likely if there is indeed a turn in the global cycle.
First, central banks will have to start fretting about the possible impact of the high levels of cash that’s sloshing around the economy on prices of both assets and goods. The difference between a typical business cycle and this downturn is the amount of spare cash lying in the system and the risk of this spare liquidity feeding a quick price spiral remains high. Let me try and quantify this. The ratio of reserve money (M0 in the US case) to nominal GDP (expressed as a percentage) in a recessionary trough in the US (a measure of the cash that the US Fed creates in relation to GDP) is usually in the range of 6-6.5. Today it is above 12. Thus central banks have to be much more careful this time than usual.
While the rest of the world has been fretting about inflation, the Treasury inflation protected securities (TIPS) have been pricing this and break-even or embedded inflation expectations in these bonds. The fact that the US Fed has been extremely sensitive to developments in this market suggests that the US central bank, at least, shares this concern. What are central banks and regulators likely to do then? One option is to use a sledgehammer and start hiking rates soon after the economy begins to recover. This is likely to rein in both asset price inflation and price rises in goods and services. The other option is to focus on markets that tend to overheat quickly like commodities because of significant speculative positions. Given the experience with oil prices, regulators are likely to try and smother asset bubbles as soon as they appear. This is likely to mean higher margin requirements for funds, higher risk weights or capital requirements for banks and financial institutions with exposures to these assets and so on.
Second, as the recovery gains traction, governments will have to return quickly to the task of reducing their budget deficit. While governments might try to peddle the fiction that this can be achieved by rationalising expenditure or by simply letting better growth rates shore up the tax-take, the fact is that any attempt to bring deficits down will have to involve higher tax rates. Consumers, companies and financial markets will start factoring this in as economies begin to recover.
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Third, as economies begin to recover, the markets for toxic assets like mortgage securities will slowly start functioning again. Better economic growth is likely to mean lower default risk and this is likely to translate into better prices for mortgage-backed assets, to take an example. As this happens, governments, banks and investors who hold these assets will start selling these assets and booking profits. Thus the constant supply of paper into these markets will prevent any sharp upswing in prices.
To cut a long story short, any recovery in the global economy is likely to see a new set of policies — monetary, fiscal and regulatory — that quickly seek to address the very imbalances that were created to engineer the recovery. If policymakers fail to do this quickly enough, the global economy could slip into another crisis whose initial symptoms could be hyper-inflation and spiralling government bond yields. The policy prescriptions to tackle these imbalances — interest and tax rate increases etc — are all somewhat negative for the financial markets. Besides, the huge overhang of toxic assets will compete for investor wallet share as they lose their toxicity.
The limited point that I am making here is that the direction of financial markets in the next few years will depend not only on when economies recover but what happens after they do. A whole bunch of changes and adjustments have to be made before a period of sustained growth becomes feasible. These are unlikely to be positive for the markets. They may sail out of the doldrums that they are in now but to call that the beginning of a bull run will be folly.
The author is chief economist, HDFC Bank. The views here are personal