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Living With Turbulence

The global economy will not mend anytime soon & the rise in risk aversion could recur several times…

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The global economic recovery has stalled and risk aversion has heightened once again. The impact on Indian markets has come in the form of foreign institutional investors (FIIs) withdrawing a humongous Rs 8,898.9 crore in August from India and the Sensex taking a (-) 9.9 per cent tumble (till August 23). Globally there has been a flight to safe-haven instruments such as the 10-year US treasury bond, whose yield has fallen (to about 2.1 per cent), and gold, whose price has soared to `28,000-plus (per 10 grams). After the Lehman Brothers collapse in 2008, the US government and the Fed had swung into action, rescuing financial institutions that were deemed too big to be allowed to fail. Then there followed a fiscal stimulus package, tax cuts and two quantitative easing programmes. What makes the current crisis frightening is that all magic bullets (fiscal stimulus, low interest rates, quantitative easing) have been tried and found wanting. Policymakers now appear to be groping in the dark for options.

No quick recovery
The first inkling that the US economy was in far worse shape than previously thought came on July 29, when the advance estimate for Q2 came in at a meagre 1.3 per cent. Even more disappointing was the news that the Q1 figure had been revised downward drastically from 1.9 per cent to just 0.4 per cent. The trend rate of growth (long-term historical average since 1948) for the US economy is 3.25 per cent. In the third year since the onset of the crisis growth is likely to be much below trend level. Estimates of a 2.5 and 2.6 per cent growth in 2011 by IMF and World Bank respectively will now have to be scaled downward. Nouriel Roubini, professor of economics at New York University’s Stern School of Business, popularly known as Dr Doom, is already prophesying a double-dip recession in the US. But most other private-sector economists think the US economy will grow in the 1-2 per cent range, unless a new shock pushes growth lower.
Kenneth Rogoff’s (professor of economics at Harvard University) research has shown that unlike a plain vanilla recession that is part of the economic cycle, a recession induced by a financial crisis is a long-drawn affair that on an average lasts 4.8 years. Going by this yardstick, the US seems to be in for a period of low growth till at least 2013. This lesson appears to have been forgotten by optimists hoping for an early recovery.
If an economy is to grow, some entity must invest or consume — households, government or corporates. US households are still heavily leveraged. A large number of them carry mortgages whose values are higher than those of the houses they bought against them. Negative housing equity and declining stock markets have combined to produce a negative wealth effect: households feel poorer and hence are reluctant to spend, especially in a scenario of high unemployment (9.1 per cent). They would rather save — a salutary trend in the medium- to long-term but a drag on the economic recovery in the short-term.
The government’s fiscal health has been dealt a double whammy by the recession. On the one hand, its revenue inflows have been poorer on account of lower growth, and on the other, it has had to incur huge expenditure in trying to stimulate the economy by undertaking countercyclical spending and offering tax cuts.

US corporates apparently have come out of this crisis relatively unscathed. The larger ones especially are sitting on piles of cash. But they are reluctant to invest it in the US in an environment of feeble demand and low business confidence, preferring to invest in high-growth markets abroad.

Damned if you do…
A debate is now on in the US regarding the best way forward. The Keynesians, among them Paul Krugman, would like the government to undertake more stimulus spending in the short run. Ignore the burgeoning debt level, they say. The government, according to them, will stand a better chance of achieving fiscal balance if the economy recovers and revenues turn buoyant. They compare the current reluctance to spend more to what happened in 1937 during the Great Depression, when a premature turn towards restoring the fiscal balance caused the economic recovery to stall.
Others, among them Raghuram Rajan, feel that offering more stimulus would be akin to the policy of certain First World War generals, who, when faced with a rout, sent in even more soldiers to get butchered. If the earlier round of fiscal stimulus did not work, argue the opponents, what is the guarantee that the next one will?
The Keynesians counter-argue that the outcome of the stimulus programme should be measured not against growth projections made by Administration officials, but against the fact that it pulled the economy out of a recession. And they ask: if you don’t offer more stimuli, then what is the alternative? To merely hope that the economy will work its way out of the current slowdown amounts to courting disaster.

Political tangle

What has muddied waters further and made the task of formulating a credible response to the crisis difficult is the bitter political wrangling in Washington. This was amply demonstrated in the run-up to the August 2 deadline for raising the debt ceiling. Recalcitrance on the part of Tea Party adherents (a group within the Republican Party comprising hardliners) ensured that a deal was struck only at the last hour. While downgrading the rating of US sovereign debt, Standard and Poor’s cited the growing gulf between the two main political parties and the unpredictability of policymaking as one of the reasons for the downgrade.
The US debt downgrade by S&P did not reduce the attractiveness of US treasury bonds in investors’ eyes (in fact, bond yields fell after the downgrade as risk aversion rose). But it has made the case for undertaking spending cuts stronger at a time when the economy is weak. Together Republicans’ stiff opposition and S&P’s downgrade have ensured that fiscal stimulus as a policy option is completely off the table.

QE3 on the cards
After its latest policy meeting, the US Fed pledged that it would keep policy rates near its current zero level till mid-2013. But instead of bringing cheer to the markets, this proclamation served only to reaffirm what many had feared — that the economy would remain in the doldrums at least until 2013.
With fiscal stimulus not possible, QE3, which was also regarded as an out-of-bounds policy option until a few months ago, may now be undertaken by the Fed. But going by past experience both in Japan and the US, most economists don’t believe it will do much good.

European crisis deepens
Lurching from one crisis to another, the Europeans are faring even worse than their Anglo-Saxon brethren across the Atlantic. After smaller nations such as Greece, Ireland and Portugal, now Italy and Spain appear to be on the verge of losing access to debt markets. At 440 billion euros, the size of the European Financial Stability Facility (EFSF, the fund put together by the European Union to rescue nations on the verge of default) is too small to rescue such large economies. In early August when yields on Italian and Spanish bonds rose, the European Central Bank (ECB) stepped in and bought these bonds (thus bringing down their yields). But this will provide only a temporary respite.
Many large European banks hold huge amounts of government debt. So a government debt default in Europe could quickly morph into a banking crisis.
The European crisis can only have the following denouement. One, the currency union may unravel. Having their own currencies will enable debt-laden countries to print money, giving them some manoeuvring room. Alternatively, the members will have to agree to a tighter fiscal union. The indebted nations may not agree to the loss of independence this will entail, while stronger nations like Germany may be reluctant to shoulder the additional fiscal burden this will impose upon them.

Turbulent times
Indian equity investors must accept that the crisis in US and Europe will not end anytime soon. These problems will wax and wane but not go away entirely for the next few years. Whenever risk aversion increases, FII outflows of the kind that happened in August will recur and our markets will decline. The only silver lining is that you may use such declines to fill your portfolio with high-quality stocks, which become more affordable in such times whereas normally they are expensive. Let the quality of your stock picks act as a shield against the difficult macro-economic conditions abroad.