While US stocks have marched ahead on reflation hopes, bank credit and money creation have shrunk.
From the beginning of this year, it was almost a given that emerging markets like India would see rotation of funds to developed markets such as USA and Japan, as both these economies were expected to grow. In the US, all hopes were pinned on the Federal Reserve’s Quantitative Easing II, wherein the US Fed was to buyback $600 billion long-term US treasury bonds in November last year, in a bid to drive down long-term interest rates. If CLSA’s celebrated global strategist Russell Napier is to be believed, then “QE2 is not working”.
Under QE2, the US Fed was to buy long-term US government securities and create money literally out of thin air. The idea was to ensure that the money was readily available in the banking system, so that it could be lent to consumers and companies. And, inflation and growth were expected to be the by-products of such a stimulus. In anticipation of QE2 expanding the US economy, stocks raced, perhaps ahead of time. According to a report by Napier, dated March 18, on the current cyclically-adjusted PE of 23.4x, US equities are expensive. To justify such valuations, equities need to be in a period of economic growth and mild inflation.
The latest data emerging out of the US suggest that QE2 has not worked. The US economy has accelerated and asset markets have risen, but there is no change in money supply as credit has not picked up. Since November, M3 (money supply) has contracted at an annualised rate of 1.5 per cent. In his note, titled “QE2 fails, sell US equities,” Napier says, “…this situation cannot persist.” Personal credit is not growing in the US and companies are borrowing from outside the banking system. It implies that with broad money growth not taking place, expectations of growth and inflation in the US are too high.
Experts are already discussing QE3 and whether injection of fresh liquidity will help the world’s largest economy grow. Evidently, financial tinkering cannot spur growth or demand, as banks don’t want to lend at such low rates.
After months of talk on flow of funds reversing for emerging markets like India, it could well turn into an opportunity for such economies.
However, it would depend on whether Indian policymakers are able to deal with structural problems, including excessive credit growth and inflation. Unfortunately, emerging economies like India are choosing to respond to such problems with administrative measures, which is “bad for capital allocation and corporate profits”. If India Inc manages to survive rising oil prices and inflation, it’s anyone’s guess where the inflows will be headed.