The stock markets have been rallying for more than a year now starting from March 2009 and have sprung back sharply. Did the fundamentals change so drastically? What explains such a high pull back in the stock markets? At least the emerging market’s movement can be justified by its long-term growth story (Again there is questions about its sustainability and the extent of decoupling). How about U.S?
It is true that many blue chips are showing great profit numbers. But if so shouldn’t it reflect also in employment generation? Most the employment generated in the last few months is by government hiring (For Census work!!! - Temporary) If the demand is really picking up, with the amount of money pumped into the system, shouldn’t it result in inflation? Isn’t something missing here?
So if the profits are not through increase in demand, then how come the companies are posting profit? True that, though criticized by many, the TARP, cash for clunkers, active buying of securities of the Freddie Mac and Fannie Mae and other stimulant measures have been helping in keeping the consumer demand alive. But does it explain the growth story fully?
So what really explains the growth in profits? Recollecting our basic accounting, we know that the profit can be increased by two ways – Increase the income or decrease the expenditure. You got the point! Exactly! The companies, other than the meager rise in demand, mostly showed growth figure driven by cutting down the expenditure (and hence the sustaining unemployment growth) rather than the required top line growth!!
With the official unemployment figures still at 10% (unofficially by various estimates more than 20%) and the so called growth for Q1 at 1.6% (a minimum of 2.5% growth is expected to just keep the unemployment from rising), what is the probability of pickup and with now, the open expression of the fear of double dip by top officials, could the growth really turn red?
Fed Chairman keeps talking about the extra ordinary power of the Fed to boost the economy if needed. If it had such extra ordinary power, why not execute it? What are they waiting for? And the acclaimed Nobel Laureate, Paul Krugman suggests to buy even more bonds of the mortgage institutions (of Freddie and Fannie well known AAA rated junks) and act desperate to the extent of putting money directly into the pockets of the people to keep the consumption going on. The interest rates already near zero at 0.25%. How more can the Fed reduce it?
This combination of high stock market, with sky high P/E inadequately explained by the fundamentals of the underlying was once observed in history – in 1980s in Japan. The stocks more than being driven by the fundamentals, were driven by the cheap cost of capital resulting in loss of discrimination between assets of various risks and very high correlation among them. What else can explain the PE multiples of the stocks today? Economists suggest an interest rate of at least 3% to have a sustainable economy. Have they overdone in reducing the interest rates?
Other than the stock markets, what are the ill effects of the low interest rates? U.S economy is structurally very different from Japan, which has a very high savings rate and are more banks driven. Even if there is an external shock, there won’t be much impact on the prices. Domestic savings and the bank’s holdings of the government securities can be used control the interest rates. The case is different in U.S. The low interest rates have effectively dis-incentivized the savers resulting in the abysmally low savings. Of the trade deficit of 29 billion suffered by U.S, approximately 27 billion is against China. Any supply shock (possible because of the govt. policies to control over heating) and adverse currency movement of Yuan against the dollar (China can effectively control the over heating by letting the Yuan appreciate) could severe impact the prices within the U.S. Given the structural deficits built up within the state over these years, it will be difficult to cope up. That too with the still continuing benefits for the people, by the government (approx. $1900/month as unemployment benefit per head), there is very good chance of inflation -what scares both the republicans and democrats and made them work together to bring in the austerity measures. In such a situation, Fed’s act to buy its own bonds will only add fuel to the fire by infusing even more liquidity.
What is the way out? I don’t know! Let us wait and see what happens!!!
