Friday, May 02, 2008

Equity markets as the solution..

Just expanding on the previous post here, in the wake of much better than expected employment numbers. There are 3 sources of money to drive consumption:

a) Income: If employment doesnt fall as much as expected, income would be better.
b) Wealth: Most of the wealth is tied in either real estate or equity markets. If real estate prices fall but equity prices go up sufficiently, it would be neutral.
c) Credit: which is where the fear is. But it is abating. And Fed is exchanging all sort of securities for pristine treasury securities. Banks are busy raising equity.

Household real estate in the US totaled $20.6bn at end of 2006. ( I guess prices peaked in summer of 2006, so it should be lesser now. Lets assume increase in homes offsets that impact. $9.8 trillion were liabilities. So wealth was $11 billion.

Suppose housing prices decline by 25%. Thats a loss of $5 trillion of wealth, or home equity falls from $11trillion to $6 trillion.

The total stock market cap in US is $25 trillion. If this goes up by 20%, the negative impact of household wealth would have been neutralized. Of course, the question of rapidly appreciating asset prices to drive up consumption growth will remain. But, the worst possible outcomes would have been avoided.

This is what the Fed is doing. It is making sure that equity markets don't fall and credit remains available. It has now cut interest rates to 2%, below S&P yield of 2.1%, making sure nobody keeps cash in bank. So the wealth effect is being taken care of.

It is all a cycle - either a virtuous cycle or a vicious cycle. Equity markets go up => consumer doesnt falter much => businesses dont take a massive hit => employment doesnt fall much + Fed eases a lot => house prices stabilize sooner rather than later => credit starts flowing more freely. If US stabilizes => Fed looks at increasing interest rates => dollar becomes stronger => commodites weaken, then it takes care of the inflation problem also.

I think there is now a fair chance that we see a massive rally. US economy is extremely resilient - it took multiple shocks in 2001 to take it into a mild recession. Fed has probably eased more than it should have but it is no hurry to increase rates soon. The emerging market bubble that we were all taking about 7 months ago started but burst in between. I think we are going to see a second coming.

1 comment:


Stocks markets are not the answer.