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Ben, where are you leading us? news
22 September 2007

Even as Ben Bernanke was getting ready for the most important policy meeting of the Fed since he became chairman, it was his predecessor Alan ''Wizard'' Greenspan who hogged the limelight last week with his much-awaited memoirs.

While the Wizard created a flutter with his criticism of President Bush and his treasury secretaries in his book, financial markets and commentators were less hopeful of Bernanke''s ability and inclination to spring a surprise. But with his first interest rate decision as Fed chairman, Bernanke has shaken up his image and has endeared himself to the financial markets.

But, as Shahin Shojai points out in his article (See: What should we deduce from the sudden, dramatic cut in US interest rates?), doesn''t a sharp cut in interest rates signal deeper worries of the central bank on the economic front? Essentially the US Fed is saying, the housing mess is much worse than we thought earlier and the recent belt-tightening in credit markets have made it an even bigger problem.

No more talk of US sub-prime woes being ''contained'' with ''little threat to the broader economy''. Obviously, Bernanke would loose credibility if he continues to say so when banks in far away Europe and China are providing billions of dollars to absorb their US mortgage-related losses.

Global economic outlook is now at probably its worst in the last three years. Until recently, it was hoped that the possible slowdown in US would be offset by sustained growth in the Euro area and Japan. And of course, China and India would continue to expand at a furious pace. But, of late, Japan and major economies in the Euro zone are showing signs of slipping. Though China continues to grow in double digits, higher inflation has already forced interest rate hikes that may cool growth. And growth in India is not expected to match last year''s high either.

If the US economic outlook - which in turn drives the global outlook - is so cloudy, why are equity markets rejoicing? Because that is exactly what investors want at this point! If US economic growth remains anaemic, the Fed will be forced to bring down rates even further. Declining rates will keep hopes of an economic recovery alive and markets always ride on dreams and fears of the future. It is now popular theory that the US housing slump can worsen and the Fed will be forced to drive rates lower to stabilise the housing market. Besides, lower interest rates will keep equities relatively more attractive than other asset classes.

So, where will this ''Bernanke Put'' or bailout take us? Most commentators who are critical of the steep rate cut argue that it will encourage credit market players to return to their bad ways and precipitate even bigger crises. They contend that, with the rate cut the Fed is conveying the message that ''if you mess up, make sure you mess up big time and we will come and rescue you with rate cuts''. But, even if this is the message, market players know that the rescue will not happen before some of them go through extreme pain. This week''s rate cut will help stabilise the debt markets, but it will take another wave of optimism for another round of excesses to happen.

Bernanke: ''Wizard Version 2''?
Two outcomes are possible. The more optimistic one is that cheaper credit will help sustain US consumer spending, even on the face of rising fuel costs, which will help mitigate the ill effects of housing weakness. But this will take some more rate cuts from the Fed. Then, slowly, housing will regain its legs and stabilise. Equity markets will realise that the music will play on for some more time and they don''t have to stop dancing. And we can all praise Ben Bernanke as ''Wizard Version 2''.

The pessimistic view is that this week''s bailout attempt is too late to ward- off a further slowdown in the US economy. Going by the established theory that all asset prices always retract to their long-term trend, US home prices have to decline more.

Greenspan, who is now being widely blamed for causing the housing bubble and the resultant sub-prime meltdown by keeping interest rates too low for too long earlier this decade, said last week that average home prices in the US could probably fall further by more than 10 per cent. If 10 per cent sounds small, consider this. All this housing mess in recent months has led to an average price decline of less than 2 per cent. Imagine what a further 10 per cent drop can do!

Will further rate cuts, which are now widely expected, trigger a recovery in the US housing market? Possible, but it will take some time. Buyers will not jump in fast as the recent pain is too fresh in their memory.

As Greenspan said in a TV interview this week, ''the one thing all human beings do when they are confronted with uncertainty is pull back, withdraw and disengage''. As long as the price outlook remains uncertain, buyers will hesitate. Those at the bottom of the pyramid, the much-maligned sub-prime borrowers, are anyway shut out from the market as lenders are not going to ease credit standards anytime soon.

Persistent inflation can make this scenario even worse. The Fed was wary of rising inflationary pressures until last month, before the market sneeze forced a re-focusing of short-term priorities. Even then, the Fed has not completely dropped rising prices from its radar. Obviously, it cannot do so when prices of crude oil and other commodities like wheat are scaling record highs.

What does it portend for India
It is possible that while the US economy remains subdued on continued housing market weakness, higher energy prices can stoke inflation. The cheaper dollar will add to inflationary pressures through costlier imports. If this scenario plays out, the Fed cannot maintain its easing bias and will be forced to hold rates steady, if not reverse direction and start hiking rates. Equity markets have not so far factored in this possibility, but bond markets have. Long-term US bond yields have moved up after the Fed rate cut on Tuesday, indicating heightened inflation fears.

What do these scenarios mean for Indian equity markets? Assuming that there are no more crises brewing, which will trigger another round of ''flight to safety'', Indian stocks may actually get a boost. While the US economic outlook remains cloudy, incremental investment flows into US equities could be limited even if the large companies see higher earnings from their overseas businesses - helped by the weak dollar. Then, where will the money go? Emerging market equities could be a major destination.

Among large emerging markets, China is red hot. If the mainland markets do not correct, some money could flow into Chinese stocks listed in Hong Kong, as there is a huge gap in valuation between these markets. Russia and Brazil will also continue to receive attention while oil and other commodity prices remain high.

India may be the most expensive among large emerging markets, but at the same time earnings visibility is also the highest here. As elections are due, nobody expects any major policy measures. But, political expediency may encourage the government to keep retail fuel prices unchanged. This will give the false impression that inflation is under control and may allow the RBI to lower interest rates modestly. Low inflation and moderate interest rates will be the dream of any incumbent government, ahead of elections.

Indian equity indices are now riding on three legs - oil and gas, banking and telecom. As long as oil prices remain firm, the oil biggies Reliance Industries and ONGC will do well. Markets can safely ignore the PSU oil marketing stocks, which will obviously bleed, as they do not pull much weight.

Banking stocks will do well on hopes of renewed credit growth if interest rates moderate. Telecom will continue to see incredible growth in the short to medium term, even if margins come under pressure. So, all the three leading sectors will continue to do well in the above scenario. Among the laggards, technology is likely to remain subdued as the rupee may retain its strength on continued inflows.

But, further gains will take Indian markets to bubble territory. There, stocks will be more prone to even more violent and painful swings triggered by shocks and surprises, which will not be in short supply as the country head into elections. This will be true for other emerging markets as well, especially China, which appears increasingly like a gambling den.

Alan Greenspan was accused of replacing the ''internet bubble'' with the ''housing bubble'', by taking interest rates to very low levels. Are we now witnessing the early stages of an ''emerging market bubble'' replacing the US housing bubble? Is that were you are leading us, Ben?
also see : General reports on Economy

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Ben, where are you leading us?