2008 has been described as a tale of two halves. In the first half, roughly speaking, investors believed that the financial crisis and its economic fallout would remain US-centric. Non-dollar assets like commodities and European bonds were the flavour of the season and the dollar was beaten down mercilessly.
In the second half, money managers realised that the world is flat after all and the contagion would spread from the US to the rest of the world. As risk aversion rose, people flocked to the safest of the safe havens; US treasury securities and the dollar gained at the expense of all other asset classes.
A growing number of analysts and market participants see 2009 as a year that is also likely to have two rather distinct segments. In the first, concerns about the global recession and the financial crisis will dominate and that will create a natural bid for the dollar.
In the second, the first signs of a bottom for the global economy will become visible (possibly led by the US) and the worst of the financial mayhem will be behind us. As investors sense this, they will seek higher yields as they slowly turn to assets that yield higher returns. This could include emerging market debt and equities, particularly those with strong domestic growth drivers.
This does not necessarily mean that macroeconomic data will improve dramatically. Growth and employment could depress for a while. The markets are, however, unlikely to bother with absolute levels. They will cheer a situation in which the numbers don't get any worse and show the mildest promise of improvement.
This is not entirely wishful thinking. For those who believe that the glass is half-full rather than half-empty, there is some evidence (albeit scant) to support their case. For one, the impact of the banking crisis on the asset markets has been vicious but quick. An implication could be that the recovery sets in swifter than in earlier episodes.
A recent paper presented at the American Economic Association by economists Kenneth Rogoff and Carmen Reinhart analyses the behaviour of asset prices and the real economy in the aftermath of financial crises both in developed and emerging markets. They find that the average decline (peak to trough) in house prices, for instance, is 35.5 per cent. The correction in US housing prices is already close to this level. Interestingly, the fall in house prices this time is already twice the fall seen during the great depression of 1929.
A similar result holds for equity prices. Rogoff and Reinhart also estimate that the average duration of a downturn in GDP lasts for 1.9 years. Assuming that the recession in the US set in at the end of 2007, there could be an inflexion in the third quarter of 2009. (I must mention that the average decline in GDP in the wake of crises is 9.3 per cent but it is skewed sharply by the experience of emerging economies.)
I would like to believe this prognosis and some of my forecasts reflect this. For example, I am forecasting mild but steady appreciation in the rupee from the second half of the year. This is premised on a revival in capital flows into India on the back of a search for higher yields.
In keeping with this theme, I am also predicting some weakness in the yen against the dollar from the second half. The argument is as follows -- as risk appetite increases, 'carry trade' will resume, with investors taking virtually zero-cost yen loans to invest in risky assets.
The problem with this prognosis is that there is growing consensus around it and my experience is that, often, consensus views run a fair risk of going wrong. Thus, the tale of two halves for 2009 has to come with appropriate riders.
Let me start with the risks, specifically for emerging markets. It is possible that, in the first phase of a US recovery, yield-seeking investments become more US-centric. In short, the first return of risk appetite could help only US assets -- corporate bonds, credit and equities -- and not lead to enhanced flows to other markets.
US fund managers are known to turn extremely insular during recessions and their initial response to any risk mitigation could be to increase their holding of domestic assets. One can even think of an extreme situation in which US investors greet the recovery by selling off non-US assets and binging on higher-yielding US assets.
The bigger risk, of course, is that there are no signs of a recovery and the global economy continues to decelerate. At this stage there are few signs that a bottom to the asset and business cycles could be in sight soon. There is some improvement in the short-term money and credit (commercial paper, for instance) and the hope that the Obama administration's aggressive fiscal plan would produce results relatively soon. On the other hand, the possibility of a sustained decline in consumption and weakness in non-residential investment remain key risks.
The bottom-line is that, for those who can avoid it, trying to time the recovery is dangerous. Traders will be better off taking a view only on the very short run; positioning themselves to take advantage of a turn in asset prices is extremely risky. Investors, on the other hand, need to take a very long-term, almost philosophical view that the tunnel might seem endless but there is light at the end of it.
The author is chief economist, HDFC Bank. The views here are personal.
