So where do we stand?

Here is my theory of what is going to happen, some of which are facts and some of which are guesses which might turn out to be wrong.

Growth Rates:
a) Is US amidst a slowdown? Yes. Expect several quarters of -1% - +1% growth. However, it is not falling off a cliff. Strong exports are helping US.

b) Are Europe and Japan going to slow down? Definitely yes. UK, Spain etc have the same housing problem as US. Japan will be impacted, but it has hardly contributed anything to global growth in the past few years, except for its cheap yen. So I wouldnt worry about Japan.

c) Are emerging markets slowing down? Definitely yes. Emerging markets will get a lagged impact of US slowdown. Plus these countries face higher inflation from food as it is a bigger portion of their consumption basket, so their central banks are tightening.

If emerging market growth rate slows, US export growth will also slow down over the next few months. If not offset by something else (like govt spending, or the lagged benefit of substanital monetary policy easing) this could hit expected US GDP growth, and lead us into a vicious cycle.

d) Credit Crunch: Is there a credit crunch? Yes. Are banks more cautious than before? Yes. Will credit growth not be as fast as before? Yes. Does it mean that US falls off a cliff? No. It might merely stabilize for a long period of time. If credit contracts, it is dangerous, which is what we have had over last 9 months with runs on the shadow banking system. If it stabilizes, then we will avoid the worst come outcomes, which is where I think we are.

I believe monetary policy works. I think the US economy stabilizes around here for an extended period of time. The risk is more in Europe and emerging markets.

Inflation and Interest Rate:

a) Commodity Inflation: There has been a surge in commodity prices since Sep 2007 since Fed started cutting rates. For some commodities, rate cuts, dollar depreciation and speculation explain quite a bit of this latest surge. For some others, there could be supply-demand argument. After all, steel companies have negotiated iron-ore price increases with BHP - these are not being set on any exchange. Commodity price inflation is the real wildcard right now in any bull theory.

Of the various commodities, the most easiest and most difficult one to tackle is agflation. All one needs is a few good rains and monsoons in the world and wheat and rice prices go back to normal. All we need is a few rains not to happen and we get political and social unrest to change everything.

b) Will US inflation explode? No, because of various reasons. First, food is not a big part of consumption bucket. Second, rents and house prices are 30% of CPI, which are headed down because of housing oversupply. Third, Fed has cleverly defined a core inflation number and made sure everyone focuses on it over the last 30 years. Fourth and most importantly, the bond market is not very worried. Inflation expectations remain well anchored, and it is expectations that determine future inflation (inflation expectation theory). There is no question that Fed will cut more if credit markets start worsening again.

c) Will European inflation go up? I think inflation dynamics are the same in US and Europe, except that ECB focuses on overall inflation rather than just core inflation. BOE has already started cutting rates. How long ECB resists a rate cut is the million dollar question.

d) Emerging market inflation: This is the biggest problem, considering US is so heavily betting on export growth. Inflation here is driven by commodity prices, which is why they are wild card. If these countries tighten so much that they significantly slow down before US domestic economy has picked up, it will be a blow and lead to a vicious cycle.


Equity Markets:
a) US: Does 0% growth and higher inflation mean that equity markets need to crash and burn. Not necessarily.

First and most importantly, with dividend yield at 2.1%, savings account yield at 2% and headline inflation at 4%, there is no incentive to save. Any long-term cash needs to be parked in an index fund rather than in a bank account.

Second, the Fed is backstopping the equity markets to negate the effect of a decline in real estate wealth on consumers. While consumption elasticity to real estate wealth is higher than stock market wealth (this is a guess), a surging equity market helps.

Third, US markets are not outrageously expensive. Yes there will be earnings downgrades in the later half of this year, so S&P trades at 18x instead of 14x. But 18x is not outrageous - markets have traded here before. And maybe they are actually trading at 18x. Besides, by 2H08, investors will start looking at 2009.

It is not reality but expectations that sets equity prices. In a funny way, these expectations can then actually turnaround to impact reality. If equity prices remain high for a wrong reason but end up benefit consumer spending, it will help the underlying economy, which will then become a justification for higher equity prices.

b) India: Why US is so important for India is because of the amazing correlation between US and Indian stock markets. If US equity markets go up, the likelihood of Indian markets doing the same becomes very high.

There are a lot of concerns with India today. First, growth is expected to slow from 8.5% last year to around 7.5% this year. Second, inflation is high and is now running at 7.5%. Third, there are elections this year. So inflation becomes even more important. Fourth, fiscal deficit is widening each day that oil and fertilizer prices remain high. It has been the turnaround in fiscal deficit that has contributed the maximum to take India's saving rate/GDP from below 30% five years back to 35% today. If fiscal deficit remains persistently wide for a long time (2 years), savings will fall and investment will take a hit.

Does that mean that Indian markets will crash and burn? No. If US markets remain strong and Hong Kong and Brazil move up, India wont remain a terrible laggard. As equity prices go up, they create their own dynamic - where they impact reality as much as reality expects them. In the next post, I will discuss the stocks that are the most leveraged to this dynamic - the brokerage stocks.