Being a widely expected event, the increase in interest rates by the US Fed has already been factored in by the markets. Still, it would be interesting to find out if the US Fed will take into account the Chinese monetary action in its policy announcement
As legend has it, the iconic banker, JP Morgan, was once asked for guidance on the stock market by a young investor, still wet behind his ears. After considerable thought, he is famously said to have remarked, with a grave face “it will fluctuate”. The story is probably apocryphal but the problem is real. No one knows in which direction the market will move nor do we know why, although post facto rationalisation is bread and butter for many people who prefix Analyst, Fund Manager or Portfolio Manager prior to their names.
Stock prices usually reflect three parameters like fundamentals or corporate earnings, liquidity and sentiments. Although stock prices do go ahead of fundamentals and, as the last financial crisis showed us, they can do so significantly; eventually, over long periods, corporate earnings and stock prices move in tandem. Performance of the economy and of the corporate sector is a key determinant of stock returns.
In India, over the past 10 years, stocks have returned approximately 15% annualised. Corporate earnings have also grown at more or less at the same rate. However, there is absolutely no correlation between earnings and stock returns over relatively shorter periods. In 2010, for example, while earnings did not grow much, stocks rose by about 81%.
One of the key features of the last decade has been that the global economy has been awash with liquidity. This has been primarily due to high savings in countries like China, Japan and the oil producing countries. This liquidity was substantially boosted by the accommodative and liberal policies of central bankers – initially the US, later joined by Japan and European Central Bank (ECB).
Sentiments comprise the third leg of the trinity impacting stock prices. Quite like a beautiful young mind, sentiments are very fickle and we have no idea which way they will turn. Although, their impact is likely to be ephemeral, during this short period, sentiments can negate the impact of fundamentals as well as of liquidity.
Why the above is relevant is because of the interplay of fundamentals and liquidity currently taking place in the US and quite naturally, its impact on the rest of the world. Economic theory tells us that the first, and foremost, response to a recession must be the availability of sufficient liquidity. This is exactly what the US Federal Reserve (US Fed) did in response to the severe crisis of 2008. It reduced interest rates drastically, pumped in money by purchasing bonds and opened up its windows for anyone willing to borrow against collateral. Undoubtedly, this succeeded in limiting the impact of the crisis, which would have resulted in a far more severe recession, possibly a depression, but for the liquidity enhancement by the US Fed.
This policy of easy money, popularly termed quantitative easing, or QE, has run its course now. The US Fed is widely expected to increase interest rates for the first time in nearly a decade during its next policy review on 16 December 2015. The reversal has the potential to destabilise financial markets not only in the US, but globally. In some ways, being a widely expected event, the increase in interest rate has already been factored in by markets. However, the impact of such significant events can never be predicted accurately and we may see significant churn in the market. Bonds, which have enjoyed a good run over the last few years, may see a drop in prices, as may stock prices. The increased level of consumption in the US, which was based on high asset prices induced demand, may shrink leading to lower possible growth. Money may move out of emerging markets creating instability in both the economy and the markets. Merely a hint of such reversal, hidden in garbled Fed wordings in September 2013, had led to significant instability in emerging economies.
A significant determinant of the response would be the guidance the US Fed provides about the future and the possible pace of increase in interest rates. The US Fed has predicated reversal of QE on performance of the economy, most critically, the growth rate of national income and unemployment rate. Weak growth will slow the reversal. However, if there is evidence that growth is back on track and back for good, the US Fed will increase interest rates faster over time.
What this implies is that we will either have a poorly performing economy with low interest rates and easy money supply. Alternatively, if the economy is expected to perform well, the interest rates will go up and the era of easy money will be over. For the markets, it is a choice between the devil and the deep sea. We had earlier mentioned fundamentals of the economy and liquidity as two parameters impinging on the stock markets. Quite clearly, we can have either one or the other being favourable but not both in the coming years.
For the US Fed, this is uncharted territory since the world has never witnessed the extent of easy money policy pursued over past few years. Arguably, the severity of the crisis demanded extent of the response. But, the reversal of the policy will test the acumen of the US Fed, which must ensure that it is as painless as possible. This is easier said than done since the world has no prior experience in this regard. Economic theory is of little help here, since the impact of various options available to the US Fed cannot be tested in a lab. Theories of economics can only be applied in the real world, with consequences that are real.
There are two other factors we need to consider in this regard. Firstly, the ECB and the Japanese Central Bank are likely to continue, may be, and even pursue their monetary easing policy with greater conviction. Deflation is playing havoc with the two economies and monetary easing is one way of combating deflationary forces. This may dilute the reversal of QE by the US Fed.
Secondly, China has become an extremely critical piece of the puzzle. Over the last decade, China consistently purchased US Treasury Bonds to prevent its own currency from appreciating. It did not want an overvalued renminbi to affect its exports negatively. It has over this period accumulated about $4 trillion in reserves, although only about 60% to 65% are in US treasuries.
Now however, China does not want its currency to depreciate and is following exactly a reverse policy by selling foreign exchange and buying renminbi. The impact is also exactly the opposite of US Fed QE. In a sense, China’s selling of US treasury securities has pre-empted the reversal of the QE by the US Fed and increase in interest rate has already been injected into the market. (Information about China is scanty, and often unreliable, but estimates suggest that it has been selling $60 billion worth of US treasuries for the last few months. China is such a big player in the global scheme of things and, quite clearly, it does not shy away from demonstrating its strength). I am not really certain that the global economy can withstand simultaneous tightening by the two largest economies of the world. It would, of course, be interesting to find out if the US Fed will take into account Chinese monetary action in its own policy announcements. All in all, these are fairly interesting times ahead for the global economy and the financial markets.
(Sunil Mahajan, a financial consultant and teacher, has over three decades experience in the corporate sector, consultancy and academics.)