The Hindu Business Line : 2004: Year of risk appetite <I>vs.</I> aversion

For 2004, the name of the game is whether risk appetite wins over risk aversion. If so, it would be another good year for equities. If not, gold, currencies and bonds would end the year strong. The latter is better bet, as the euphoria is unlikely to last the whole year, as it would increasingly militate against peaking economic and earnings growth, says V. Anantha Nageswaran.

FINANCIAL market trends are usually marked by either greed or fear. When greed dominates, risky assets do well. When fear prevails, safe-haven assets dominate. Risky assets typically mean emerging market equities, bonds and technology stocks. Safe-haven assets include currencies such as the Swiss franc, gold, US Treasury bonds and the Japanese yen.

The peculiarity about 2003 was that both safe-haven and risky assets performed well. If the rise in gold and euro indicated rising risk-aversion, the solid performance of emerging market stocks and bonds signalled rising risk appetite. This cannot continue for long. Which way the world swings will determine whether relatively safer assets come back to the fore in 2004 or the dominance of the global stock markets and emerging country assets, in particular, would perpetuate itself. In other words, would the inflation-free global recovery continue to grow roots or stagnation with fears of deflation would return. If the former were to happen, the dollar weakness cannot continue and would probably reverse and gold would peak. That remains an alternative scenario not in favour in this corner of the boxing ring.

Equities are overdue for a correction

The author belongs to the club that still sees the global financial markets as a half-empty glass in fundamental terms. Asian stock markets (ex-Japan) had valuations on their side in the early part of 2003. But no longer. Their expected price-earnings multiples for 2004 are well above the averages of the last ten years. Hence, the recent euphoria is not sustainable.

For instance, India's long-term economic prospects are bright. The government, facing elections, has moved to normalise relations with Pakistan and has put many reform measures on track. America has authorised transfer of sensitive technologies to India. It signals `closure' of the tension that developed in 1998.

Hence, optimism in the stock market can be better justified in India than elsewhere. However, the Sensex target of 6000 was comfortable for end-2004 and not for end-2003! Perhaps, it is healthy that the Sensex has corrected heavily in the last two days. While the volatility and the magnitude are disconcerting, they are not unusual. Another few hundred points, the froth in the market would be gone and long-term investors can be back.

Barring fiscal policy risk, bond market should remain firm

As for American stocks, the fading of the momentum rally in global equities could happen in the first quarter of the New Year as investors begin to appreciate that even a rebounding capital spending in the US may not be strong enough to replace consumer spending and sustain the economic recovery. After couple of months of improvements in the index of `jobs easy to find' versus `jobs hard to get', as computed by the Conference Board, the latter jumped again and its gap over the former widened. Jobs remain hard to come by. One does not see that improving as to make a dent in unemployment levels and cause wage incomes to rise.

In December, the US economy added only 1000 new jobs while the market expected 150,000. Such a shortfall might be extreme and hence not likely to repeat itself. However, sustained and vigorous job growth would remain elusive. Waning consumption spending will be the key theme of 2004. If not, consumers will be deeper into debt, making the prospect of a financial crisis that much more likely in 2005.

Given the sluggish labour market and a likely slowdown in consumer spending, the US policy rates are poised to remain stable. It was underscored by Mr Ben Bernanke of the Federal Reserve Board. He said that the US policy rate — the Federal funds rate — was at appropriate levels. He is, perhaps, aware of the risks to economic growth that consensus opinion is yet to appreciate. Hence, US bond yields are unlikely to rise much in 2004. The risk to this scenario is, of course, the possibility that the Bush administration, desperate for re-election, further expands fiscal spending and causes the budget deficit to widen further. That would rattle American bond investors and yields would rise and prices drop. However, that would trigger economic weakness down the road, setting the stage for a bond market recovery.

Policy creates asset inflation but not goods inflation

Over the next several years, bonds are likely to perform better than equities, no matter what the short-term risks. This author reckons that long-term deflationary trend from ageing societies in the Western world, abundant manufacturing and labour capacity in China and in India would eventually prevail over central banks' determination to kindle inflation.

Central banks are creating inflation of a different variety. Low policy rates have created bubbles in real estate and stock prices in many parts of the world. If they burst, the risk of a more frequent repetition of the boom-bust cycle is likely with their deflationary consequences rather than the return of inflation.

Euro to strengthen after some correction

Early in January, Mr Bernanke's remarks, instead of setting off a much-anticipated short-term turnaround in the dollar, compounded its misery by sending it to a fresh low against the euro to over 1.28. Mr Bernanke added fuel to the fire by suggesting that the dollar, in trade-weighted terms, was not very weak. According to him, it is only 7 per cent weaker than its 10-year average and still 17 per cent above its lows reached in 1995. From an American perspective, he was correct to implicitly sanction further dollar weakness. Foreigners pick up the bill.

Conventional measures might suggest that the euro was becoming overvalued, as the bilateral exchange rate of the euro/dollar is significantly higher than the 10-year average. However, such comparisons do not hold water when confronted by the fact that the US current account deficit has never been higher than it is now, both in levels and as a percentage of GDP. Therefore, there is more room for the dollar to weaken.

Recent trade data from the US clearly indicate that the weak dollar, more than anything else, is working to reduce the deficit. Hence, any premature strengthening of the currency would halt the process of reducing the American trade deficit.

Recent US dollar recovery is not fundamental, because...

The short-term rebound in the dollar was not denied for long. The rapid appreciation of the euro drew the attention of Eurozone politicians and the European Central Bank. Further, better than expected trade deficit, consumer confidence and foreign purchase of US assets in November all combined to boost the dollar in the past week. The euro swiftly descended from a peak of around 1.285 to around 1.23. Gold too slipped from a high of $428 per ounce to around $406. Is the market betting that greed would overcome fear?

Well, the bond market signals otherwise. The US 10-year Treasury yield had fallen below 4.0 per cent even as the dollar recovered its poise. This seems strange. The bond market is reacting to lack of inflation and the weak labour market while the dollar appears to be in the midst of a technical recovery. Of course, the opposite could be true too.

...US bond yields decline

The second interpretation is not convincing because, before the recent rally, the US bond market was not oversold and further, the rebound in net foreign purchase of US assets in November was mainly concentrated in US Treasuries and government-backed bonds. Hence, this was not a sign of a return of foreigner confidence. It was clearly a sign of desperation of foreigners to stop their currencies appreciating too fast against the dollar. As before, Japan led the charge. It bought nearly $25 billion of US Treasuries in November. China, including Hong Kong, bought about $5 billion. India too increased its holding of US Treasuries from $8.6 billion in January 2003 to $14.7 billion in November. Before 2003, India had not merited a separate line entry in this monthly statistics released by the US Treasury.

Hence, it seems entirely appropriate to view the appreciation of the US dollar as a correction within the context of an ongoing long-term decline.

Asia cannot sustain its mercantilism for long

However, it is likely that the currencies that appreciated against the dollar in 2002 and in 2003 will not make further gains. The onus of bearing the dollar weakness would then shift to Asian currencies. The benign transfer of wealth to America by Asia, via a weakening dollar, cannot continue indefinitely as the US is implicitly defaulting via a falling currency. As the American economy buckles under its own contradictions in 2005, if not in 2004, Asians would come to realise the futility of their mercantile policies and work seriously to boost domestic demand.

When that realisation arrives, it will be clearer that not all Asian economies are either ready to or capable of boosting domestic demand. Small and open economies would experience lower growth at least in the short-term. Those blessed either with sagacious leaders or bigger economies (India) would be relatively better off. Then, any ascent in asset prices would be more sustainable.

Key investment themes

In sum, for 2004, the name of the game is whether risk appetite wins over risk aversion. If it is the case, it is likely to be another good year for equities. If not, gold, currencies and bonds would end the year on a strong note. Our bet is on the latter even as we concede that, in the short-term, the euphoria would remain. It is unlikely to last the whole year, as it would increasingly militate against peaking economic and earnings growth.

The dollar would weaken and Asia find it hard to sustain its current madness of funding American consumption in return for accumulating the debt of a large indebted nation with a falling currency. As Asian countries pull back from the brink, the current boom would end but further recovery in select nations subsequent to that would be more sustainable as it would be better balanced.

The challenge for investors this year is to decide when to quit the party and return home sober.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. The views are personal. Comments may be sent directly to him at nageswar@singnet.com.sg)

More Stories on : Economy | Global Finance & Overview

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Making farm imports safe

Why cell-phones are a threat to air safety

2004: Year of risk appetite vs. aversion

Not Required in India?

Not by infotech alone!

Information by the block