Walking on eggs in a fog of uncertainty

IT has been very nervous times these past 30-odd days. As asset prices continue to tumble across the world, eroding investors? wealth and, in many cases, rudely erasing earnings and bonus expectations, the esoteric game of ?guess the (US) Fed? has taken on a frenetic quality. It is very interesting to see how the arguments are developed, for some of the reasoning is of high quality. And, of course, the US Fed in this conjuncture is centrally placed with respect to moving capital market in the near-term.

There seems to be a consensus of desire amongst commentators in the financial world that Mr Bernanke, chairman of the US Fed, should take his ?pause? (his word) now, in June, rather than later. The primary concern is that current inflation numbers (which are rising) were generated by developments a year or more earlier, that the cumulative impact of the massive tightening over the past year has yet to materialise fully. And there is a very real danger that excessive tightening might tip the economy into recessionary conditions.

The swings in expectations about what the Fed might do in its June meeting have been all over the place: from a 75% probability of a rate hike in end-June, to a 50% split after the May payroll numbers came out, and now back to mostly expecting one.

One commentator has put the dilemma well: yes, the near-term growth outlook could bias the Fed to pause in June, but the potential loss of inflation-fighting credibility is likely to outweigh concerns about adversely effecting near-term risks to growth.

The US Bureau of Labor issues monthly reports on increase in non-farm payrolls ? which is an estimate of fresh hiring ? and for May it reported that 75,000 jobs were created. This was well below expectations and was 50,000 less than the estimate for April. Further, it was the fourth month in a row, since February 2006, that the numbers have been sliding.

Primarily on the basis of this indicator, many are convinced that the US economy is sharply slowing (despite the GDP acceleration in the first three months of 2006) and there is a real danger of the Fed, in its bid to contain inflation (or its credibility to combat it, which is the same thing) raising interest rates to a point where it puts wheels under an already ongoing process of deceleration.

The suggestion is, of course, that the Fed should not raise rates now, but continue to sound powerfully hawkish about inflation.

The urgency in all this unsolicited advice is, of course, the state of the equity asset markets and the general gloom that has (as always) so quickly replaced the bonhomie of the past several years. Unlike previous episodes, there is no specific agency triggering the crisis. If we look back at the tumble the markets took in 1997 and 1998, there were several. The Asian currency crisis to begin with, followed by the Russian default, the related collapse of Long Term Capital Management (LTCM) and early in 1999, the Brazilian crisis. In 2000, we had the collapse of the dotcom bubble, followed in the next year by 9/11, the Enron and WorldCom sagas and the recession in the US and some West European countries.

This time in 2004, there is no trigger other than a structural one involving the pricing of risk, where investors in equity and corporate bonds, especially, but not exclusively in emerging markets, were willing to live with sharply lower premiums for credit, country and performance risk. In the US bond market, credit spreads for Aaa over Baa corporate bonds had declined to between 70-80 basis points (bps) from 100-120 bps in 2003. The last time credit spreads were this low was in the balmy days of 1999 and 2000. Likewise, the spread of US gilts over Aaa-rated corporate bonds had declined to 70-85 bps from over 120 in 2003. Emerging market bond spreads had also declined, as also the appetite of investors for aggressively priced convertible bonds out of India.

There is a related argument that the very low interest rates available in the US and Europe on government securities drove ?liquidity? into emerging market bonds. And that when these positions unwind, it will erode the growth potential of BRIC countries. And that will, in turn, take the heat off commodity prices and hence inflation, and therefore the US Fed is unnecessarily worried.

The corollary is that the hit to emerging markets is ?structural,? rather than transient. However, investors in US gilts do not just trot off and buy Brazilian corporate bonds or Indian IT stock. There is a rigid separation between classes of assets and capital does not flow like water across these separate channels. In any case, the decline in yields on long-term US gilts during 2001-03 was marginal and did not mirror the fall in short-term rates.

Finally, the rally last Friday brought losses in the Indian market more in line with other emerging ones. In terms of losses since May 10, Russia and India head the league tables with about 22% each, followed by Czech at 20%, Mexico and Poland at 18% each, and Indonesia, Brazil, Argentina and South Korea grouped around 15-17%.

In terms of year-to-date (calendar 2006) change, it is Czech (-16%) and South Korea (-10%). China has the largest year-to-date gain of 34%, followed by Russia (13%) and Indonesia (10%).

The trailing price/earning (P/E) ratio for the BSE Sensex, at 9,810, was 17.3 on June 9. This is lower than that on December 31, 2003, when the Sensex was at 5,839 and its P/E at 18.9, and also lower than that on December 31, 2005, when the Sensex was at 9,398 and its P/E at 18.6.

At the end of the day, as long as we can maintain the pace of economic growth and reforms, robust profitability and asset prices will follow in its wake.

?The writer is economic advisor, Icra