labels: rex mathew, economy - general, markets - general
The Greenspan factor on Indian stocksnews
02 May 2005

The US Federal Reserve meets on May 3, 2005, to consider an increase in short term interest rates. An analysis of the possible impact of its decisions on the Indian stock markets by Rex Mathew.

After the fantastic run up in 2004 and the first quarter of the current year, global equity markets retracted in April. Almost every major global stock index has declined, whether it is the Dow, NASDAQ and the Nikkei. India was no exception, as both the Sensex and Nifty lost over 10 per cent each from their March highs.

All eyes are now on the US Federal Open Market Committee meeting set to start on May 3. It is almost certain that the Fed will raise short term interest rates, in line with its stated policy of 'measured' increases to counter inflationary pressures. By measured, the Fed probably means a hike of 25 basis points as it did eight times consecutively in the recent past.

But there are many who believe that this time around the interest rate would be increased by 50 basis points. There was widespread speculation about a bigger rate increase in March when the Fed met last time. When the raise announced was only 25 points, many analysts expected the Fed to drop the word 'measured' from its policy statements.

When that too did not happen, they said it was a matter of time before it happened. Some even went to the extent of predicting the year-end interest rate at 4.75 per cent, an increase of 175 basis points over the year from the current rate of 3 per cent.

So, will Greenspan please them by announcing a 50 point hike? Or will he stick to his known position of 'measured' increases? In either case, what are the implications for global equity markets?

The answers to all these questions rest on the factors which force a change in the interest rate and the outlook for those factors.

First is economic growth in the US as well as globally. Continued economic expansion raises inflation worries in the minds of all central bankers. So they raise short term interest rates and try to divert the excess liquidity into more productive areas, to achieve the twin objectives of steady growth and prevention of overheating.

After shrugging off the post 9 / 11 blues and the bloody hangover of the dotcom bust, the US economy has been expanding at a steady pace for the last two years. The most important driver in this growth has been efficiency gains in the US economy. The second driver of this growth was an expansion of consumer spending, aided by cheap and plentiful credit.

The most recent economic data shows a slowdown in the US economic growth. GDP growth for the first quarter is down to 3.1 per cent from 3.8 per cent recorded for the last quarter of 2004. However, consumer spending continues to grow on the back of rising income levels. So clearly, business consumption is the culprit, which is supported by the first quarter data on corporate spending.

Can consumer spending also slow down and make matters worse? Unfortunately, it looks more probable than at any point during the last couple of years.

Consumer spending to some extent is driven by a feeling of being wealthy, whether real or imagined. A boom in real estate prices over the last 2 years and the recovery in stock markets helped US consumers feel better about their economic condition.

Unlike less developed markets like ours, a large percentage of residential real estate in the US is financed or, like the Americans call it, mortgaged. When asset prices go up, many such home owners get their property refinanced and pocket some cash. For example, if the value of a house purchased for $100,000 goes up to $150,000, the amount of finance a bank would extend would also go up proportionally. If the home owner gets the property refinanced, he can get the value appreciation in cash, like a personal loan, and spend it as he wishes.

US stock market investors have also recovered all their losses from the tech bubble crash. Along with the real estate boom, higher stock prices have pushed private wealth in the US to their all time highs.

But the situation is changing now. The stock market decline in April took away some of the paper wealth from the investors. Real Estate prices are hitting a plateau as interest rates on home loans have touched 6 per cent and are expected to rise even further. This may put an end to that part of consumer spending financed by asset refinancing.

The other factor influencing the Fed is inflation. After lying low for a longish period, inflation is showing some signs of revving up as March inflation rose to 1.7 per cent from 1.6 per cent reported for February. Higher crude oil prices are not the culprit as this figure excludes volatile items like fuel and food.

Going into the meeting, Greenspan and his fellow board members have conflicting signals. As some would argue, the rise in inflation even after the regular increases in short term interest rates should persuade the Fed to attempt a bigger hike this time. On the other hand, the first signs of a slow down in growth would have them thinking twice.

Therefore, the most probable outcome would be a 25 point hike and maintenance of the 'measured pace' position on future rate increases.

Going forward, what could change the current view of the Fed? The most potent near term trigger which could change the situation, ahead of future Fed meetings, is the much discussed revaluation of the Chinese yuan.

The Chinese currency's exchange rate to the dollar has been fixed ever since the Asian currency crisis. The Chinese authorities have steadfastly maintained the yuan within a narrow range till now. This has led to severe criticism from both the West and China's Asian neighbours who claim the Chinese are enjoying an unfair advantage by keeping their currency under valued.

The general perception in the US is that their massive trade deficit is to be blamed on this unfair exchange policy followed by China. Political pressure from Western governments on China to let the yuan appreciate has been tremendous in recent times. The tribe of those who believe that the Chinese are about to give in to such pressure is growing by the day.

A brief 20-minute spike in the yuan's value on April 29, which took it above the upper limit of its narrow trading range, created a buzz in global currency markets. While some analysts said it was a system error, most observers interpreted it as the Chinese authorities first testing the waters and checking their preparedness ahead of a revaluation. There was no official word from China. None was expected either as nobody would imagine the Chinese leaving their policy of being opaque anytime soon.

If the Chinese currency is indeed allowed to rise, it could possibly help in sustaining the growth momentum in the US and help ease some of the worries about the trade deficit. However, it all would depend on the extent of appreciation China is comfortable with.

A sudden and sizeable increase in the yuan's value would affect Chinese competitiveness adversely. On the other hand, they cannot keep on ignoring pressures from the West in a globalised world. By how much can we realistically expect the Chinese to let the currency appreciate?

Irrespective of the amount of pressure, the Chinese would do nothing which could drastically affect their growth. There are sure signs of a domestic demand slowdown in China. The recent troubles of Western car companies in China, like Volkswagen and General Motors, are one of the many pointers. So the Chinese have no option but to keep up exports to avoid a hard landing of the economy.

Therefore, the revaluation would be largely a symbolic one to take care of the pressures on them to do so. It would be much more modest than many expect.

While helping the US economy to gain growth momentum, the yuan revaluation could create a problem as well. One of the main reasons for low inflation in the US, despite good economic growth rates, is the subdued price levels of consumer goods. Often called the 'Wal-Mart control on inflation', this was achieved through massive imports of cheap consumer goods from China and other low cost locations by retail giants like Wal-Mart.

The impact on domestic US inflation of prices of Chinese goods going up as a result of the revaluation, is difficult to quantify at this juncture as it has never happened before. But it is safe to assume that it would push up price levels as Chinese imports into the US will not go away anytime soon.

So a revaluation of the Chinese currency would present another policy conundrum for the Fed. If the extent of revaluation is modest, as can be reasonably expected, it may not change the situation much. The effect of a larger appreciation of the yuan, unlikely though, could be even disruptive.

What does this all mean to global equity markets and particularly India?

A 25 point hike by the Fed would not have much impact on the markets as it is already discounted. A bigger raise of 50 points would surprise the markets and could lead to more weakness as equities would receive lower weights in many investment portfolios.

However, Indian markets would be relatively better off as compared to its Asian peers. Overseas inflows into Indian stocks may not be affected much by moderate increases in interest rates. It could have an impact, if the rate increases are more dramatic and unexpected.

The main reason for our relative insulation from global weakness is the continuing performance of Indian companies. The average profit growth for the over four hundred companies which have declared their March quarter results is well over 40 per cent. Revenues have grown over 20 per cent, maintaining the trend of previous few quarters.

It is a well recognised fact that India is more of a domestic story though exports have been contributing increasingly to growth in recent years. The country should be able to maintain its growth even on the face of a global slowdown as long as our monsoons do not fail.

At current levels, our markets are valued at around 14 times the previous year's earnings. The recent decline has helped in correcting some of the exuberance that prevailed in March after the budget. With a stable future outlook, even a modest decline in the event of further global weakness would make the Indian market a value buy.

Any major decline the US growth rates, which looks unlikely at least for now, could have an adverse impact on our software giants whose revenues are still US-dependent to a great extent. Since the software stocks have a disproportionately high influence on our market sentiment, we may see the markets drifting lower if such an event occurs. This is more so since there are not many domestic triggers in the markets for the month of May once the results season is over.

As for the less glamorous but much larger old economy stocks in the markets, from June onwards most days would begin with predictions from the weathermen on business TV channels for the next few months. The weathermen are sure to enjoy their season before the television cameras even if the markets do not enjoy what they say.


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The Greenspan factor on Indian stocks