It may take more than rate cuts by central banks to sustain the recovery
IT IS almost certain the United States Federal Reserve will answer the prayers of stock market traders across the globe and cut rates when it meets tomorrow.
A lower benchmark interest rate would mean more cash flowing into corporate coffers, which would have positive knock-on effects on markets globally, at least over the short term.
From the way international equity markets have regained their poise, one might be tempted to believe the problems that have beset the global financial system in recent months are over.
At home, the Straits Times Index (STI) closed at 3,536.4 points last Friday, after regaining lost ground, up 19.4 per cent from its Aug 17 intra-day low of 2,962.01. On Wall Street, the Dow Jones Industrial Average rose to within 4 per cent of its all-time highs.
Still, the situation might not be quite that simple.
The STI rebounded strongly after a boost from stocks linked to the booming offshore marine sector, as crude oil prices hit record highs. This more than made up for the pallid performance of the three local bank stocks, which make up about a third of the STI. These banks are still assessing the impact of the credit crunch plaguing global financial markets.
Despite the overall rally, DBS Group Holdings is trading 21.6 per cent off its year’s high, while OCBC Bank and United Overseas Bank are both about 10 per cent below their 12-month highs.
Risk of stagflation
INVESTORS could well be placing too much faith in a few rate cuts by major central banks such as the Fed.
The provision of this form of cheap credit by central banks in recent years was what caused the massive mispricing of risky loans to borrowers with poor credit histories.
The picture is further muddied by soaring crude prices, which hit US$80 a barrel last Wednesday, and by a falling greenback. It is hard to gauge how the global economy will react to the heady brew of a US Fed rate cut and high oil prices.
The conventional wisdom is that in times of rising prices – caused perhaps by higher oil prices – monetary policy should be tighter, not looser.
Such a scenario has not been seen for nearly 30 years. Those with long memories will recall that this mix pushed the US and the rest of the world into a long period of stagflation, characterised by a deep recession and high jobless rates with rampaging levels of inflation.
This vicious cycle was finally broken only when then Fed chairman Paul Volcker ignored the shrill screams of politicians and Wall Street, and relentlessly drove up interest rates to break the back of the inflationary cycle.
Wall Street’s sway factor
WHAT about the argument, increasingly peddled, that Asia has finally unhooked itself from Wall Street – so the credit crunch is a problem for the West, but not Asia?
It is an attractive notion, after years of Asian markets slavishly following the US lead, but it might be wishful thinking, for now at least.
True, China’s decisive intervention last month – it announced that it would allow its citizens to invest in Hong Kong equities – curbed the plunges on Asian bourses and sent the Hang Seng Index to record highs.
But the sheer size of Wall Street means Asia simply cannot ignore any wild US swings as investors sort out the mess surrounding sub-prime loans and agonise over a possible recession in the US economy.
With a market value of US$16 trillion (S$24.2 trillion), US bourses are still bigger than their Tokyo and European counterparts combined, and eight times larger than China’s, even after the giddy run-up there this year.
Therefore, it might be better to remain cautious, as all of the signs point to further trouble over the next 12 to 18 months.
Over the short term, central banks could literally paper over the problems caused by the credit crunch, flooding the markets with billions in fresh cash.
Seeds of trouble
HOWEVER, one big immediate problem remains unresolved: International banks are still struggling to borrow, either from each other or from external sources.
Last Wednesday, for instance, the European Central Bank had to pump another 75 billion euros (S$157.4 billion) into the region’s banking system to reduce the interest rate gap between overnight funding and lending over longer maturities.
And the cost of funds in the hard-hit interbank money markets – where banks borrow from each other – has surged to peaks last seen two decades ago, as the scramble for cash by financial institutions shows little sign of easing.
Observers say investors could be neglecting one key warning sign as they celebrate any easing by the Fed: the gridlock now experienced by the US$2 trillion market for short-term commercial bonds.
Most of these short-term bonds are sold to rich investors and cash-rich firms by special investment vehicles owned by banks. As such bonds mature within 30 or 40 days, this could intensify the credit crunch over the next few weeks, if investors refuse to extend the credit by rolling over their purchases.
In many cases, the sponsoring banks will have to take the risky assets back onto their balance sheets, which will force them to hoard their cash. This, in turn, will cause liquidity to dry up in the money market, whether central banks cut rates or not.
Some market experts have also argued that the current rebound has shaky foundations, as share prices are gaining ground on lacklustre volumes.
Over the past two weeks, average daily volumes on the STI have only reached 2.33 billion shares worth $2.03 billion, a far cry from the 4.4 billion shares worth $2.95 billion that changed hands daily in July when the STI was at a similar level.
More sober-minded observers with good memories suggest that 1998 offers a likely guide to the future direction of the stock market. Back then, panic selling in January was followed by an almost miraculous recovery, but that was snuffed out by a fresh round of bad news.
As the old maxim goes: One swallow does not make a summer. Investors might have to realise that a Fed rate cut is hardly likely to spur a renewed global bull-run that is sustainable.
Source: The Straits Times 17 Sept 07
