The Hindu Business Line : Bounceback in prospect?

Stock markets, the world over, have gone into a free fall. It wasn’t hard to spot the reasons. Foremost was the increasing risk of a US recession. Second, despite the already large writeoffs and capital injections, global banks are yet to call finis to losses from their mortgage and sub-prime portfolios.

There is also the possibility of their having to make good on large amounts of credit default swaps (CDS), in which the underlying credit has gone bad. A related problem is that afflicting bond insurers – entities guaranteeing the bonds of local authorities. They are likely to be downgraded and this, in turn, will repercuss the ratings of guaranteed issues and force writedowns of municipal bond portfolios. The financial sector crisis is far from over.

Not a pretty picture

It is not a pretty picture as the Fed Chairman, Mr Ben Bernanke, acknowledged in his congressional testimony last week. More and more of his colleagues on the Federal Open Market Committee – which sets US interest rates – are speaking the language of aggressive rate cuts to prime the economy. A 50 bps cut at the month-end Fed meeting (or even before, considering the stock market rout) is taken for granted.

Will rate reductions alone do the trick? President Bush and Congress are working on a short-term stimulus package to lift the economy, but how far it will go in reversing the economy is a big question mark. Mired as the average American is in deep debt, uncertain employment and rising costs of living, it will need a lot more than Fed actions and a temporary boost to government spending to make a positive difference to consumer and business confidence, incomes and spending.

Credit contraction

Credit contraction, as banks hasten to control the damage to and repair their balance sheets, is another millstone around the economy’s neck.

Recession fears set back commodity prices — those of oil, gold and base metals. There has been a massive transfer of wealth to primary producers in the last few years amidst the boom in commodities. Giving up some of price gains could do wonders to the global economy and its revival.

Putting the decoupling theory to rest, the Sensex followed other markets in the selloff. The outlook is anything but rosy.

Bonds gain

Amidst the turmoil, bonds are making solid gains. Two year US treasury yields are down to 2 per cent and 10 years to 3.5 per cent levels, last seen in 2003 when the Fed Funds rate was 1 per cent.

Indian bonds too have rallied but not to the same extent. Those especially at the short end look set for a significant drop in yields.

Stock valuations have perhaps reached investible levels in many cases. There is no shortage of global savings in search of better returns. That, together with the certain interest rate cuts and recession-fear induced fall in energy and commodity prices, suggests an early recovery is a good prospect.

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