No room for complacency

An article in Bloomberg earlier this week on investor attitude to risk (?What risk? Oil, gold, stocks show investors ignore world risk?) made interesting reading. A comment by George Magnus of UBS on how world stock and bonds markets held up very well right up to the breakout of World War I and then plunged might hold parallel to the present, should the global security environment deteriorate.

To be sure, surveys of investor attitudes and optimism do not show investors to be in complacent mood. At the same time, risky assets have rebounded. Equity markets in India and Russia are nearing their May highs. Emerging market bonds have gone up in value such that the yield premium they offer over the 10-year US Treasury yield is approaching the six-year low of 170 basis points that we saw in April.

Hence, the real question is whether the recovery in emerging market assets and weakness in the Japanese yen suggest a level of risk appetite that is not fully captured in such surveys.

While hedge funds and institutional investors have marked up the prices of bonds substantially in recent weeks, equity markets are sanguine about the outlook for profits. The combined message from bond and equity markets is one of benign growth slowdown, combined with a deceleration in inflation rates.

Let me explain. Bond investors are pricing in a higher probability of recession. That is why the yield on the 10-year US government bond has dropped from a high of 5.25% in June down to 4.75% more recently. Equity investors, on the other hand, expect a perfect world where growth in the US slows to around 3.0% and inflation stays close to 2.0%. Both cannot be right. In fact, equity investors appear more at risk of receiving a nasty surprise than bond investors.

That is, equity investors appear to either ignore the risks of a sharp slowdown in corporate profits if the US economy flirts with recession (which is what the bond market ex-pects) or the risks of higher interest rates if economic growth does not slow.

I still believe in my mulish expectation of a rebound in US growth and persistence in inflation causing the Federal Reserve to resume tightening later this year, perhaps in December. I shall re-state my arguments below.

First, I reckon that the recent reaction in financial markets to the prospect of slower growth would act, paradoxically, to rekindle growth. In recent weeks, long-term interest rates in the US have dropped sizeably. The price of crude oil and gasoline is lower. The hurricane season is well behaved so far. And, contrary to financial markets? interpretation, Federal Reserve officials don?t seem that relaxed about the outlook for inflation.

Second, popular commentary is full of speculation on the impending recession. Merrill Lynch puts the probability of a recession next year in the US at 40%. Nouriel Roubini (www.rgemonitor.com) also openly anticipates one. In his latest column in The New York Times, Pri-nceton economist Paul Krugman all but endorses Mr Roubini?s call.

However, the man who has been systematically tracking the housing market, Prof Robert Shiller, is not that sure. In an interview with Bloomberg (given on August 21st and a transcript is available on Bloomberg), he points out that history is split on the likely outcome. After a boom in the ?70s, home prices levelled off in the early ?80s and that was despite a substantial increase in US real rates. But, after the boom in the late ?80s, they fell significantly in the ?90s. Moreover, the interesting thing is that the collapse in house prices in the ?90s did not trigger a sharp reduction in personal consumption spending.

The only wild card this time around is the psychology of home prices. Since investors had got used to a near 60% increase in the median home price in the last five years up to 2005, even a sideways movement could encourage them to switch to greater savings and tip the economy into recession. Regardless, despite all the noise about the plunge in the US Home builders? index, the key point to note is that prices have not come down materially at all. Not yet.

Third, there is no strong evidence on slowdown in real economic data as much as there is, in sentiment data. Sentiment might be influenced by news that people hear, whereas actual spending could be influenced by their incomes and balance sheets that are healthy.

Fourth, other equally important indicators of US economic health such as orders for durable goods (excl. defence and aircraft) and demand for loans by businesses are rising at a healthy rate.

Therefore, a whiff of stronger growth would necessitate higher rates in the US (markets have almost brought the curtains down on rates) or a translation of sentiment into real data would see the growth in profits dip considerably. That is why I believe that the equity market does not appear to reflect either of these two risks adequately.

Needless to add, if either of these two risks materialise, emerging markets such as India would be extremely vulnerable. It is somewhat hard to believe but investors appear to have been too eager to cast aside the warning of the correction and rise in volatility in May-June.

?The writer is head of research, Asia-Pacific & Middle East, Bank Julius Baer, Singapore. These are his per- sonal views. He can be contacted at jeevatma@gmail.com