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Wednesday, December 19, 2007

US Recession: Impact and the way forward

According to the “International Comparison Program” of 2005, which recently published its report, the largest contributor to the world GDP is US at 23%. Next comes china with 10%, Japan with 7%, whereas India stands fifth at 4%. This GDP contribution is PPP adjusted, which means that it takes into account the latest currency movement where the USD had depreciated against ALL the major currencies of the world, and the Indian Re appreciation wasn’t an isolated event.

US Recession: the impact

We believe, that with 23% and more than double of its nearest competitor (China), US is too important an engine for the world to go into recession. Approx. a quarter of China’s GDP comes out of exports, and more than half of the total exports, are to the US.

This means, that any slowdown in the US may immediately impact the GDP and hence the GDP growth of China too, immediately, ceteris paribus. This is just one case, and other countries like India again owe a major portion of their GDP to the ever-consuming shores of the US.

Scenario 1: Continued state of affairs

Which brings us to the scenario that any slowdown in the US juggernaut, will also spell significant losses for all the countries and world trade. Exploring further, when there is a slowdown in the earnings, then the likely fallout for the nations would be to sustain their flagging income streams with subsidies or exemptions etc. to do all of which, the Govt. will have to either cut down their own spending or draw down on the savings/reserves held.

Most if not all countries have hoarded their savings in form of US treasuries thereby allowing the US the luxury of consuming ever more, with their (US’s) spending/consumption being financed by the world. This is the reason why US has been able to get away from a major economic slowdowns just by reducing rates (or in other words, printing more money). Now, in a slowdown scenario, if all countries fall upon themselves to en-cash the US treasuries, it will be a glut of the paper with barely enough with the Fed to repay them with. In this light, the move of both China and India planning to invest their surplus reserves in assets, outside their own economy maybe makes more sense as a means for converting the intangible wealth to the real assets, which will have its value dependent on its own cash flows and therefore more stable form of asset class.

This is a catastrophe scenario and if and when happens, will have extreme effects. We don’t this to be happening anytime soon.

Scenario 2: A controlled devaluation of dollar
What appears more likely is that the world markets will continue to help US tide over this slowdown in its economy. A measured depreciation of the dollar will see a lot of positives for the US. The US demands for imports would re-align more realistically (rationalize) as well as reducing its consumption binge. The Fed rate cut should infuse liquidity and shore up some of the spending which should maintain or only allow a marginal decline in the level of consumption. The biggest impact will be that the property and other assets should see a cooling off in prices. They have been rising for a decade now, and sure some of the bubble pricking in that sense should actually do the economy good.

Wage rates are inflexible but only to a certain point. The rise of the offshoring of services, the huge inflow of cheaper textiles etc. indicate that US labor rates are too high (2-3x when compared to developing world), as compared to anywhere else in the world, maybe save the EU region which still demands more money for lesser pay.

Cooling off of real estate, and other articles of the cost of living should enable the cuts in the wage rates to happen. This said, it may unleash massive repricing of assets, commodities, services and thus lifestyles in the US and for a small while may see a de-growth. But in the long run, we will see a much sound and robust economy.

On the other hand, most of the China’s controlled prices regime would sooner than later end, and it has already started happening with the inflation rates at peaks. So the main supplier to the world will see its input costs rising and thus the output costs too moving in tandem

Does it bring global inflation?
We think no. As the decline in the US consumption growth will enable enough free resources for everyone to avoid a scarcity led price rise. However, we will all may well see a re-alignment of the forex rates of the world, more in line with the fundamentals of the economy rather than skewed pegging or manipulation.

Why this is more plausible?
The trend of USD depleting in value is evident, as it has declined vis-à-vis almost all the major currency of the world.

Seen also, in conjunction with the Global crude price rise in USD, whose rates rise can be explained due more to the erosion in the currency value. We talk about oil, as the supply of this commodity is almost entirely matched with demand at any given time. This implies that the value of Oil is to be more reflective of the purchasing power of the currency than any other indicator today, and this indicator clearly suggests that dollar is overvalued and can see some correction.

GOLD and OIL may be invested in, as they should appreciate against the US Dollar(Global currency)

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