World Financial Crisis Iii

World Financial Crisis III

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In this third and concluding part of the series on World Financial Crisis we will discuss different scenarios we may experience in times to come. So far we have covered topics regarding mortgage bubble that started showing its ugly sign in early 2007 and blew up unprecedentedly later, bailout plans and anatomy of the financial crisis. Here we will try to throw light on various possibilities that may take shape of the reality in next few years. Experts are drawing parallel lines to compare today’s scenario with what happened during great depression in 1930s or US financial crisis in 1907. And they say history repeats itself. There are people who still claim that the US will go in recession; some aver it is already in recession whereas some argue it’s just a mild recession.

All about recession Nifty

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We know that the US economy has suffered 10 recessions since the end of World War II. But what is recession after all? Before we explain you should remember that one has to fall to rise and vice versa. An economy which grows over a period of time tends to slow down the growth as a part of the normal economic cycle. An economy typically expands for 6-10 years and tends to go into a recession for about six months to 2 years. A recession is a decline in a country's gross domestic product (GDP) growth for two or more consecutive quarters of a year. A recession is also preceded by several quarters of slowing down. A recession normally takes place when consumers lose confidence in the economic growth and spend less. This culminates into a shrinking demand for goods and services, which in turn leads to a decrease in production, lay-offs and a surge in unemployment. Investors spend less as they fear stocks prices will fall and thus stock markets fall due to negative sentiment. Now we can relate to such scenario because this is what we are experiencing around us. By this definition we may deduce that the US is not in recession yet because the real GDP grew by 2.8% in Q2 versus 0.9% in Q1 2008. But there are enough reasons to expect that real GDP growth will slow sharply in 2009 thanks to the current housing market adjustment and the credit famine taking their toll on country’s demand. Slowing growth in the developed world will also arrest US export growth in 2009.

What happens in a recession?        Deepak Tiwari Research Analyst [email protected]

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Shrinking demand for goods and services due to less consumer spending Significant decrease in output, more layoffs and surge in unemployment Steep fall in stock markets due to strong negative sentiments Weaker demand for commodities which will ease off inflation Significant decline in consumer spending Credit crises likely to affect economic growth in the US and Europe for at least 2 years or so It will hit capex i.e. corporate expansion plans and consequently the employment generation. State’s cash injection into the system will further fuel the inflation while deteriorating the fiscal deficit. A high inflationary situation will mount pressure in the value of the country’s currency.

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US Economic Health O’meter: A snapshot 

The real GDP continuously grew by 2.8% in Q1 FY2008 against 0.9% in the previous quarter. It is expected to sharply fall further down in 2009-10.

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In the US payrolls have been chopped by 159,000, more than the 100,000 that was expected which was the ninth straight month of job losses. It is expected this trend will continue. The unemployment rate remained flat at 6.1%, as expected. It’s pertinent to note that a staggering 760,000 jobs have disappeared so far this year.

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The US September Retail Sales fell 1.2%, the largest drop since August 2005. Retail sales have now fallen for three consecutive months. Even excluding the struggling auto industry, sales fell 0.6%.

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Fed interest rate is already at the lowest level of 1.5% after a straight 8 cut and it is expected that Fed will cut further by 50 bps as inflation recede.

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The US Consumer price inflation pegged at 4.9% down 0.1% in the month of September 2008.

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US consumer confidence improved marginally for the third month in a row in September since a recent low in June, but remained at a dismal level compared with a year ago, according to The Conference Board Consumer Confidence Survey.

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US housing starts fell more than expected in September to 817k representing a month-over-month decrease of 6.3% against 6.2% in August pushing the number of starts to its lowest level since 1991 and second lowest level on record.

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Q2 corporate profits fell 3.8% sequentially versus a fall of 1.1 % in the previous quarter. Profits of domestic financial companies and net profits of US companies earned abroad accounted for nearly all of the decline. Barring Q2 2007, corporate profits have been declining since Q4 2006.

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Industrial production plunged a shock 2.8% in September, the steepest fall in 34 years, due to hurricanes in the Gulf of Mexico and a strike at Boeing. For the Q3 as a whole, industrial production decreased at an annual rate of 6%.

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What we can expect in the US next?     

Nationalization of major financial institutions Cap on CEOs’ compensations Greater and stricter regulations Increased role and intervention of Govt. in business Return of an era of protectionist policies in US and the end of crony capitalism

Can it lead to depression? What's the difference between a recession and a depression? If the GDP of a country drops by at least 10% then this can be classed as a depression. By these standards, the last depression the US suffered was The Great Depression in the 1930's. By this definition we don’t expect this will lead to another depression in existing circumstances. Yes growth is already slowing down and will continue to slow down further but economy will bounce back in another 2 years. Moreover, situation is not that bad. As during Great Depression US saw unemployment rate of 25% which is 6.1% currently. During that time, thousand of banks failed and it took three years for the Govt. to take action, but this time the Govt. was quite active. This apart, this time we see coordinated efforts across the globe by various governments and central banks taking every possible step to shore up growth and stimulate respective economies. Current credit crises may recede in few quarters but likely to take two years for the economies to stabilise. However, we are yet to see ebb of European financial crises. There is risk that if the crisis in Europe deepens further it may offset the positive effects of measures taken by the US Govt. One wonders what will happen If this recession reaches Middle East or other emerging markets?

How to deal with recession? There are various steps a government takes to cope with recession. It includes tax cuts, hiking government spending in order to create more jobs and helping private sector through several measures to tide over such crisis. In the current case, the Bush government had proposed a $150-billion bailout package in tax cuts in January this year and likely to announce some more such incentives. Other steps that the US Govt. and its regulatory authorities and its European counterparts have taken so far are:     

Rate cuts SEC suggestions of relaxing on mark to market policy Fed to pay interest on reserves from October 1, 2008 Tax incentives in the form of cuts FDIC deposit insurance limit raised from $100k to $250k

How will such steps going to help? Recapitalization of banking financial system will encourage banks to begin lending again. We see despite central banks pumping liquidity into the banking system still banks are dithering to lend each other. Heightened risk aversion and cash hoarding amongst banks are to be blamed for the widening spread between LIBOR and the Overnight Index Swap (OIS) which is to unprecedented levels. Raising deposit insurance limit will enable banks to attract large inflows of funds. Steps will restore confidence of investors and depositors in banking system.

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Are emerging market leaders de-coupled? According to the IMF, in the past a 1% decline in US growth had led to a decline in growth in emerging economies by between 0.5% and 1%, depending on trade and financial links to the US. Now it’s needless to say that the proponents of the so called de-coupled theory have gone absconding. Also because that often goods traded among developing nations are eventually exported to the US or Europe. As far as India’s trade and financial links to the US is concerned, India’s share of exports of goods to the US has been consistently declining. In 2006 it was 16.8% of total exports at $17.35 billion which fell down to 14.9% at $18.85 billion in 2007 which further sagged to 12.7% at $ 20.71 billion. Contrary to this imports of goods from the US have been on the rise. The share of India’s imports from the US increased to 6.3% at $ 11.73 billion in 2007 to 8.4% at $ 21.02 billion in 2008. In other words, our trade with the US is growing but mostly in imports of goods as the trade balance is expanding sharply every year from just $ 14.3 billion in 2004 to $ 59.3 billion in 2007 to $ 88.4 billion. But India’s exports of services particularly IT and IT related services have been growing exponentially. A major chunk of it comes from America followed by the European countries. But such stream of revenues comes from BFSI segment which has been hit the most in current financial turmoil.

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Impact on India The India economy may lose 1- 2 percentage points or even more in GDP growth in this fiscal year. Indian IT firms and those having big export contracts in the US would see their bottom-line and margins shrinking. Moreover, IT firms will be under pressure and would not be allowed to bargain while renewing their expiring contracts at favourable prices. Agencies are already engrossed in scaling down India’s GDP growth forecasts. CMIE has revised its forecast for FY09 at 8.7% while CLSA’s prognosis is 7.3%. CLSA’s GDP forecast for FY10 is 6.5%.

Some of the after effects of the US recession are:      

FIIs exodus Slowdown in FDIs US companies to cut IT spend will hit IT firms Pressure on Indian Govt. for reform in financial sector. India Inc may be compelled to diversify to other geographies like China, Africa, West Asia and domestic markets. More bloodbath on the Dalal Street

Opportunities in disguise for IT firms What could go in our favour? In case of the US recession Indian rupee may strengthen against the greenback. But experts say a weak dollar could bring more foreign money to Indian markets. Oil may get cheaper brining down inflation. A recession could bring down oil prices to $50. Moreover, in the aftermath of the fall of financial giants of Wall Street like Lehman Brothers and Merrill Lynch, IT firms may find some interesting opportunities as western institutions would be under pressure to cut their costs significantly. And here our Indian companies see big opportunities there. We believe that after coping with Y2K and dot com era, Indian IT firms will once again stand tall and emerge stronger.

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World Indices since January 2008 % 18-Jan 17-Oct Change SENSEX 19,013.70 9,975.35 -47.5% NIFTY 5,705.30 3,074.35 -46.1% SHCOMP 5,180.51 1,909.94 -63.1% NIKKEI 13,861.29 8,693.82 -37.3% HSI 25,201.87 14,554.21 -42.2% STRAITS 3,050.09 1,878.51 -38.4% DJIA 12,099.30 8,852.22 -26.8% NASDAQ 2,340.02 1,711.29 -26.9% S&P 500 1,325.19 940.55 -29.0% FTSE 5,901.70 4,063.00 -31.2%

Impact on Indian equities The economy and the stock market are inextricably linked. We can see that Asian indices have borne the brunt of the sub-prime mess most than that of developed countries despite strong growth trajectory. The Indian bourses have lost close to 50% from the January 18, 2008 level. Interestingly the US and FTSE have lost the least.

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Major US Recessions so far and the Stock markets The US has seen two longest recessions during mid-1940s until 2007. And it lasted for 16 months each, one extending from November 1973 to March 1975, and the other from July 1981 to November 1982. In both of these cases there was a considerable decline in real GDP. Name

Period

Great Depression

Recession of 1953

Recession of 1957

1973 oil crisis

1929– 1939

1953– 1954

1957– 1958

1973– 1975

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How Dow Jones Fared?

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Stock markets crashed worldwide, and a banking collapse took place in the United States. This sparked a global downturn, including a second, more minor recession in the United States, the Recession of 1937.

Dow Jones lost 89.2% from its peak of 381 in March 1929 to low of 41 in July 1932. Further, it recovered only 32% until the end of 1939.

1 year

After a post-Korean War inflationary period, more funds were transferred into national security. The Federal Reserve changed monetary policy to be more restrictive in 1952 due to fears of further inflation.

Dow Jones experienced a long term consolidation phase since early 1951 and started nothbound journey only in 1954.

1 year

Monetary policy was tightened during the two years preceding 1957, followed by an easing of policy at the end of 1957. The budget balance resulted in a change in budget surplus of 0.8% of GDP in 1957 to a budget deficit of 0.6% of GDP in 1958, and then to 2.6% of GDP in 1959.

In this period too, Dow Jones struggled and began to advance only in early 1958.

2 year

A quadrupling of oil prices by OPEC coupled with high government spending due to the Vietnam War lead to stagflation in the United States.

During this period, Dow Jones lost 45.1% from its peak of 1,052 in January 1973 to low of 474 in June 1974. By the end of 1975, it retraced 58% of the loss in the period.

During this period Dow Jones traded in the ballpark of 759- 1,071 and remained lull before started surging in 1983.

Early 1980s recession

1980– 1982

2 year

The Iranian Revolution sharply increased the price of oil around the world in 1979, causing the 1979 energy crisis. This was caused by the new regime in power in Iran, which exported oil at inconsistent intervals and at a lower volume, forcing prices to go up. Tight monetary policy in the United States to control inflation lead to another recession. The changes were made largely because of inflation that was carried over from the previous decade due to the 1973 oil crisis and the 1979 energy crisis.

Early 1990s recession

1990– 1991

1 year

Industrial production and manufacturing-trade sales decreased in early 1991.

Dow Jones remained range bound in the range of 2,365 and 3,169.

Early 2000s recession

2001– 2003

2 year

The collapse of the dot-com bubble, the September 11th attacks, and accounting scandals contributed to a relatively mild contraction in the North American economy.

During this period, Dow lost 35.7% from its peak of 11,338 in 2001 to its low of 7,286 in 2002.

Source: Wikipedia, Artha Money Research, yahoo finance

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Sources and references: Yahoo Finance Wikipedia Bureau of Economic Analysis, US Dept. Of Commerce Artha Money Research.

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