Factoring in the Fed

Increase in interest rates by the US central bank will eliminate uncertainty and correct stock prices that have outpaced earnings

by Mohan Sule

The question is not if but when. After seven years of keeping interest rates near zero, the US Federal Reserve is preparing to gradually ramp up the cost of money. Inflation is moving up, house prices hardening and jobless claims falling. So there is every chance that the US central bank might muster courage and take the plunge. The possibility of such an eventuality has been in circulation even before its October meet, when it put off the decision. The blowout in China and the recession-like conditions in the euro region weighed on just as the fragility of the US economic recovery, spurring speculation that the Fed might even postpone the rate hike to 2016. The uncertainty about its moves seems to be tapering, with near 80% of international money managers in a recent poll ascertaining that December might be the month signalling a U-turn of the monetary policy. Yet, going by past experience, the bounce-back of the domestic economy might not be the only factor to contribute to such a reversal in stance. The poor health of the euro region and Japan along with volatility in the emerging markets in anticipation of such a step is likely to be factored in. Besides, a sudden rush of fund inflows from different corners of the globe has the potential to fuel inflation faster than that might be desired by the Fed. The already strong dollar will become mightier still, jeopardizing American exports. The result will be the reverse of what happened pre-global financial crisis: cheap dollars and yen flooded emerging markets in search of better yields. The fear of formation of asset bubbles forced central banks of these countries to ramp up interest rates, thereby disturbing the equilibrium necessary for long-term money to flow around the globe smoothly.

Despite apprehensions about the potential of the undercurrents to capsize the emerging markets’ currencies, the increase in US interest rates will be a welcome development for many reasons. First, it will be an unambiguous affirmation about the recovery of the US. Second, a booming America has the force to pull China’s and other emerging markets out of the rut. Before China became the pivot to the world, the global economy was US-centric. The country was the largest exporter and importer. The double-digit growth of the mainland was mainly due to American businesses’ quest to keep prices of output low. This was done by shifting manufacturing to China and back-office services to India. With domestic consumption low due to high savings, China suffered as the US went into a tailspin after the credit crunch. Third, tech companies have emerged as one of the significant sources of foreign exchange earnings. A weak rupee will be an attractive proposition for US clients while placing orders, propelling the sector’s growth and hiring. Fourth, the domino effect will increase China’s consumption of commodities, helping economies of metal and oil producers such as Brazil and Russia to recover from the slump. The euro region, whose health is increasingly linked to that of China, will be able to rapidly climb out of recession. Fifth, dumping of China’s cheap goods into India and other emerging economies will slow down, boosting domestic producers. Local sourcing will be important for infrastructure spending. In the process, commodity prices will not remain untouched. Blunting the implications of a ballooning import bill will be robust exports.

Oil producers have kept their output intact despite declining prices to neutralize the threat from shale gas. With this mind, it is unlikely that they will take advantage of increasing consumption to ramp up prices to unrealistic levels to profit from the situation. For one, it will provide support to the comatose US shale gas industry. Second, the global economy could once again slide into recession. The response of the stock markets in emerging market is not expected to be dramatic. Many have factored in the imminent increase in US rates. Corporate India’s earnings have not kept pace with prices and further correction, if any, due to acceleration in foreign fund outflows will provide an opportunity to enter quality stocks at reasonable valuations. IPO pricing, too, will get moderated, leaving scope for appreciation post listing as local big-ticket and small investors are more finicky about getting big bang for their bucks. Importantly, domestic institutions are buying even at the current level, spotting growth potential going ahead and perhaps in the belief that any decline from the current level might be short-lived. Against this backdrop, investors should hope that the Fed begins its course correction sooner than later.