Markets needs “Goldilocks scenario” to maintain the momentum

The debate on “to tighten, or not to tighten” is gaining thrust. Australian central bank (CB) was the first to tighten rates thereby eliminating the “moral hazard” of other CBs who did not want to be seen as the first to start the tightening process (since the risks of policy mistakes are high). As the world cleans up after the U.S. housing debacle, central bankers are already fretting over how to tackle the next bubble, which may not be too far off as super-easy monetary policies worldwide leave financial markets flush with cash.

With CBs in a flux, markets are caught in a Catch-22 situation. Akash Prakash writes in his recent article, “If economic growth does bounce back with a vengeance, as some of the bulls think, it will force the hands of policy-makers to quickly pull back the emergency measures, which will ultimately be a strong negative for equity returns. It is unlikely that equity markets can continue their manic rise in the face of tightening liquidity conditions. Markets will probably do better if growth is slow enough to not force tightening. Yet, given the market reaction to the recent weak economic data, equities do not seem to be able to digest sub-par economic numbers, implying that an element of growth is already priced in. Markets seem to need incoming data to continue surprising positively to sustain the uptrend….Equities are only cheap if you believe in a strong earnings recovery. However, to get a strong earnings recovery, you need robust economic growth. As it is unlikely that corporate houses can do much more cost cutting, we now need top line growth. If we get a robust economic recovery (as earnings estimates imply), policy-makers will reverse the emergency fiscal and monetary measures, which will tend to be a drag on price-to-earnings (PE) multiples………… Thus, unless we get a perfect “Goldilocks scenario”, where growth is strong enough to deliver earnings, but slow enough to not force policy-makers’ hands, equities are going to have a choppy few months as the countervailing forces of economic acceleration and liquidity withdrawal fight each other. It is not clear who will triumph.”

Mr. Prakash continues, “Even in the Indian context, we need to worry about RBI beginning a new tightening cycle and rising interest rates. This tightening cycle will be a negative as RBI is not raising rates because the economy is overheating. The central bank is doing so because of inflation concerns in the face of spiking agricultural prices. G-sec yields are rising, hence, ultimately, interest rates will rise system-wide because of a huge government borrowing programme. In fact, bankers talk of a lack of credit demand from good quality borrowers. If interest rates were rising because of strong economic growth and an overheating economy, very strong corporate earnings would have compensated for the impact of rising rates on valuation multiples. However, rising rates will only damage multiples now, with no earnings offset. A strengthening rupee will further tighten financial conditions and damage profitability. We are also yet to see any credible plan from the government to put the fiscal in order. We all seem to be betting on growth to bail out government finances. Unless we find a path to bring the fiscal under control, at the first signs of strong credit demand from corporate India, rates will spike further and we will be hugely dependent on global capital flows to sustain growth………………………………………….….. Thus, while we may have a bit of a hiccup, if we can hold on and live through some short-term volatility and price declines, gains are likely. A correction is quite a possibility, which may even be severe but nothing like 2008.”


In another article Ruchir Sharma lucidly points out that the current synchronous global recovery has reached its mature stage and the extremely “high correlations are a symptom of a global boom-bust environment. Hopefully, after the tech and credit boom-bust cycles, it will be a while before the same mistakes are repeated and a relatively dull environment should prevail for the next few quarters. In such a scenario, it will be key to focus more on secular themes and less on cyclical movements…………..At the sectoral level, fortunes of sectors such as materials and energy will remain tied to global macro variables, but consumer stocks (both discretionary and staples) with exposure to emerging markets should show steady growth through cycles given the relatively low leverage of the consumer in many developing countries…….. Of course, the risk persists of the global economy suffering a major double-dip or conversely of a policy-induced synchronous melt-up in growth rates after the meltdown of last year. Either event will make the world continue to behave as just one market. However, the odds do not favour another extreme outcome and the markets are therefore likely to go horizontal after being vertical and highly correlated in the recent past. The time for taking aggressive oneway directional bets is probably behind us and the case for differentiation based on local influences is strong. The nature of markets is, in fact, to let new factors take on the reins just when everyone is convinced about the prevalence of a particular regime”

John Hussman writes in his column, “Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight…….the most important lesson I keep having to re-learn is how utterly myopic investors can be when there’s an uptrend to be played….…. Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can’t say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit.”

Finally, Macroman writes thus, “Markets might be screaming “you suck!” to Macro Man, but trust him: the feeling is mutual.”

Happy reading!!