Current Subprime crisis

In the current subprime crisis which left investors confused and volatility of market mixed with current Indian political situation, where netizens view left as a group of people who could do nothing right, I thought to bring an article which describes the best for current situation and implications of these crisis on Indian market in medium to Long-term.

Here goes it.... [Courtesy : Economic Times]


The global equities sell-off in the last four weeks reflects a sharp rise in risk aversion. Higher risk aversion has come on the back of the disarray in the credit markets and the growing concern that an emerging global "credit crunch" as well as the continuing US housing slump, will force the US economy into recession over the next 12 months.

In addition, the re-pricing of risk took on yet another ugly dimension on Thursday and Friday of the last week with the dramatic unwinding of "carry trades" across Asia leading to a sharp rise in the Yen, and further major declines in Asian equities, including the Sensex.

How should investors react? Clearly the last four weeks have been very painful for many and the immediate market outlook is very uncertain.

But long term investors should take comfort from the overall health of the world economy, including India. Outside the US housing sector, the world economy is very strong with good GDP growth, generally well-contained inflation, high corporate earnings, and healthy business and consumer sector balance sheets.

We believe that the most likely outlook is that global markets will calm down by or during September and that the sense of panic of recent weeks will recede.

In addition, if the markets sell-off does escalate further and seriously threatens the economic outlook, the US Federal Reserve has shown that it is sensitive to the threat that the re-pricing of risk becomes even more disorderly. The Fed (along with other central banks) has lifted its liquidity injections into markets and on Friday lowered the so-called discount rate at which it lends emergency funding to financial institutions - by 50 basis points to 5.75%.

In addition, if its largely technical measures do not do the trick in stabilising markets, the Fed has also indicated that if necessary it would also reduce its key policy rate - the Fed Funds rate (currently at 5.25%). The Fed remains reluctant to be perceived as bailing out investors for unwise decisions.

But US inflation is no longer a serious problem and markets may well have suffered enough pain for lessons to have been learnt. The risk of a US recession and a prolonged stocks meltdown is higher now than a few weeks ago but still looks only something like a 30% risk, in our view, over the next 12 months.

The fear in markets may take some time to dissipate and volatility is likely to stay high for a while. But a global equities rebound should come through over the next few months, and this should lift Indian markets as well. It will not be a straight line but our end 2007 target for the Sensex before the current turmoil was 16000, and we are sticking with that target. From the close on Friday August 17th, this implies a 12-15% climb and a 15% gain for 2007 as a whole.

The stocks turmoil stems from losses on US sub-prime mortgage lending, where lax lending standards in the US in 2005-06 combined with falling house prices in some areas since then are now bringing a wave of mortgage defaults.

Even on very pessimistic assumptions about the US housing prices, the total losses look set to be around $200 bn, losses which when spread around the world's investors should not be dangerously large.

But the problem is that many of the sub-prime mortgages have been packaged up into other securities, such as collateralized debt obligations (CDO's), which are now impossible to value.

The uncertainty over valuations caused the CD0 market to dry up in mid-August. This uncertainty, combined with the news of major losses from the general markets sell-off, have spread doubt about the liquidity of the financial system.

As a result, banks have been hoarding cash, pushing up short term lending rates and forcing central banks to respond by adding more liquidity into the system to keep market rates close to policy rates - 4% in Europe and 5.25% in the US. Have central banks now done enough to calm markets?

Central banks have probably done enough but it is far too early to be sure. In addition, the US housing sector looks almost certain to worsen further. The reduced availability of mortgages to weaker borrowers as well as higher interest rates will discourage new buyers. With many local markets already suffering from acute oversupply, this means that US house prices are likely to fall further and that the drag on the overall economy from the housing slump will probably continue into 2008.

The continued drag from housing makes the current crisis very different to the 1998 LTCM crisis when liquidity injections and Fed rate cuts quickly restored confidence. Nevertheless, the key economic uncertainty remains the extent to which house price weakness will translate into sharply weaker US consumer spending.

The good news here is that there are several reasons not to be overly pessimistic although much will depend on whether stocks weaken further. On the positive side, US household wealth remains strong and should be able to absorb the hit from weaker housing and the stocks sell-off. In addition, income gains remain solid and employment continues to expand.

The US economy should also continue to gain from strong exports whilst good corporate balance sheets should offset the negative impact on business investment of tighter lending standards.

As a result, a US recession still seems unlikely and we still expect that the Federal Reserves will be able to keep rates on hold at 5.25% into 2008.

But the uncertainties around this "no change" Fed Funds forecast are very large. If the current markets turmoil does escalate further and threatens the economic outlook, and/or the credit crunch widens even further from mortgage, then the Fed would respond quickly by cutting the Fed Funds policy rate.

The problems in the US will overhang Indian markets for a while but, provided the US avoids recession, the pressures should be manageable and Indian equities upswing should continue. Back in 2000-01, India and Asia more generally were far more dependent on the US and the US equities downturn hit very hard. In 2007 and 2008, economic growth in Europe and Japan should continue to be resilient to a weak US economy.

In addition, there are more alternative sources of domestic economic growth - from private consumption in India and business investment in India. In addition, the Reserve Bank has raised interest rates since 2004 and so now has plenty of scope to make monetary policy less stringent if the Indian economy looks like slowing significantly.

The key risk scenario for Indian equity investors is the threat that the US economy does move into recession over the next 12 months. A US recession would happen in 2008 if the contagion from the housing market is much more severe than we expect, and crucially, the Fed is too slow in responding to any systemic economic weakness and does not cut interest rates quickly enough.

In this event, Indian equities would likely move sharply weaker over the next few months. Investor should not rule out the Sensex falling back well below 10000 by end 2007 or early in 2008 before eventually finding a bottom. We do not think that this we happen but Indian investors would be wise to stay much more aware of the potential downside market risks.

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