It seems to be raining good news these days. US job losses for July were about 80,000 lower than the market consensus and the unemployment actually declined. The US Federal Reserve’s monetary policy committee followed this up by claiming that growth is ‘levelling out.’ The biggest surprise was the GDP data that came from Europe. While analysts had predicted a contraction, growth for the April-June quarter in both France and Germany turned out to be mildly positive (on a sequential quarter on quarter basis).
Local data has been encouraging as well. The June index of industrial production beat analyst expectations by a mile and grew by 7.8 per cent. The fear of severe drought is real but I hear a number of economists claim that while this might hurt agriculture directly, it might not necessarily crimp an industrial recovery. The green shoots of recovery don’t seem to have withered.
All this has to be good news for financial markets across the world. Growth is improving, the markets are awash with liquidity and inflation (at least in the G-7 economies) seems benign enough to keep central banks from hiking policy rates at this stage. Emerging markets like India that have strong domestic drivers could again ‘outperform’ the others. Policy signals (the new tax code, divestments and so on) have been positive and this could mean that investors would again be willing to pay a premium for a stake in India’s growth story.
Before we conclude that this is the beginning of another big bull run it might make sense to take stock of the risks going forward. More importantly, it is useful to gauge how many of these risks are ‘priced into’ asset valuations and to what extent the markets are glossing over some of them.
Let me start with China. There is growing concern among analysts and investors that Chinese asset markets have bubbled up again. Former Morgan Stanley Asia economist and ace bubble spotter Andy Xie writes in a blog: “I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter.” If this correction does happen as Xie predicts, the impact might not be confined to China alone. Emerging markets across the board could sell off in response — Indian markets might not be spared.
That said, it is quite unlikely that China’s government or central bank will use visible policy signals to poop the party just yet. The majority of China watchers thus do not expect a hike in interest rate or an adjustment in loan quotas. However, there is indirect government pressure on banks to try and cool things down. Chinese banks are finally beginning to recognise the probability of a sharp rise in non-performing loans. The mammoth China Construction Bank, for instance, plans to cut back on loans by as much as 70 per cent in the second half of this year. If Chinese growth were to moderate on the back of slowing credit, it is bound to hurt sentiment across a swathe of asset classes. Asian emerging market equities, industrial commodities are obvious candidates for correction.
Let me turn to the US. It is possible that the business cycle in the world’s largest economy has bottomed out. While that is reason to cheer it is also important to gauge the incline of the growth path going forward. I would argue that it is likely to be somewhat flat and the risk of dips along the way is high. For one, most analysts acknowledge the fact that the recovery is likely to be ‘jobless’ to a degree.
Employment is known to lag growth and it would be a while before companies start hiring again even if demand picks up. In fact some economists argue that the current unemployment rate does not capture the direness of the labour market situation. The reported unemployment is still in single digits because a large pool of workers is simply to discouraged to seek work while others are severely underemployed. If the unemployment rate were to be adjusted for this, it would be close to 16 per cent.
US households whose spending binge fuelled growth in the earlier years of this decade are repairing their balance sheets pushing up the overall savings rate. The household saving rate in the US has picked up from close to zero in early 2008 to almost 7 per cent now. The implication of a weak labour market coupled with a rising propensity to save is weak consumer demand and that is likely to check growth both in the US and the rest of the world, which would find it difficult to export goods and services to the US.
Then there is the issue of the housing market that lies at the very heart of the crisis. In the boom years, households encashed their home equity as house prices rose to splurge on things. The crash in the house prices destroyed this equity leaving households with negative net worth. Unless house prices rise substantially and net worth turns positive again, it will remain a drag on US households’ balance sheet and consumer demand as a whole.
This reversal in prices is unlikely to happen in a hurry. Using the current rate of household formation, the current stock of foreclosed homes and assuming a minimal rate of new home construction, some analysts predict that it will take at least five years for the glut to clear. In short, it will be a good five years before American homeowners start feeling rich again.
The euphoria over the recent macroeconomic data is natural as it suggests that the worst is over for the global economy. However, the fact that the worst is behind us does not necessarily mean that the best is around the corner. That’s something that all of us need to recognise.
The author is chief economist, HDFC Bank. The views here are personal
