Predictions 2008

Ever since I started thinking about the global economic scene, I have been reading and hearing a lot of counter arguments and all of them seem credible. Now, I know why two economists always come out with three predictions. I being a novice will assume anything can come true and let me try to list down the various things that could happen.

US

Fed has cut interest rates: This will impact:

1. Inflation

Scenario 1: Inflation will go up

Lower interest rates and hence lower saving rates, will increase the supply of dollar leading to inflation.

Scenario 2: Inflation will go down, leading to deflation

a) Lower demand of Oil and Commodities will drive prices down.

b) Some people may settle debt and hence will decrease dollar supply because of money multiplier effect .

Conclusion: Inflation will remain under check.

2. Dollar

Scenario 1: Dollar will become strong

US Treasuries are still the safest instruments in the world. Governments invest in US treasuries not because they want to earn returns from it, but because they want to hedge their dollar. Also, China and India have strong internal demand and there is some decoupling from the US economy for both of these countries. Therefore, these countries will still demand more commodities and oil and to make their exports competitive, they will do whatever they can to keep dollar stable. Attractive valuations for US companies and US real assets will increase demand for dollar and will push it northwards. Cheaper US exports will increase demand for dollar too.

Scenario 2: Dollar will weaken further

Cut in rates will make US treasuries less attractive. Though countries that have trade interests with US like India and China will not take any steps that will make their exports unattractive, there are others who do not care. US dollar is the fiat currency and is used across the world for all international trade. Oil rich countries are raking in a lot of moolah because of higher oil prices. They have no obligation to invest in US and are looking at other emerging economies to get higher returns. If they have money invested in US, they may even withdraw it, further increasing supply of dollar and weakening it. China already is facing the heat of high inflation because of artificially maintaining Yuan at lower levels and will try to slow down its economy or may appreciate Yuan. If China will stop buying dollars, that will also decrease demand.

Conclusion: The dollar may fall a little bit, but there will not be a free fall. Dollar will stabilize near the current levels.

3. Stock Markets

Scenario 1: Stock markets will go up.

People will have less motivation for saving in Fixed Income instruments, they will

a) increase consumption - leading to higher revenues for companies; or

b) invest in stock market, making it cheaper and easier for companies to raise money.

c) borrow at lower interest rates and invest in stock markets.

d) Weaker dollar will make exports attractive and help US companies increase revenues.

e) Companies from outside may look at acquiring US companies because of depreciating dollar getting them higher valuations. Cheaper credit also available.

f) Weaker dollar will make imports expensive and demand for imported good will go down increasing domestic consumption.

g) Cheaper oil and commodity prices will make raw materials cheaper and hence decrease costs for US companies.

Scenario 2: Stock markets will go down.

a) People are more risk averse and will shy away from investing in risky assets.

b) No new inflows to stock markets.

c) Consumption will go down as people will have insecurity of losing their jobs.

d) Credit will not be available for investing in risky assets like stocks.

Conclusion: Stock Markets will be steady as both forces will play out.

4. Sub-Prime

Scenario 1: Worst is over

Worse may be over. Lower interest rates will help people settle their debt. Since the Adjustable Mortgage Rate is dependent on base rate, it will go down and hence lesser probability of defaults. Sub-prime crisis may be halted. Lower interest rates may encourage people to borrow and invest in housing assets including foreign countries bring the zing back to real estate market.

Scenario 2: Worst is yet to come

Worst may be yet to come. As the teaser period of loans issued in last two years would get over and AMR applicable, more cases of defaults and foreclosures may happen, further weakening the real estate market. More companies will have to write down the losses. Although rates are decreasing, slow economy and loss of jobs will prevent people from settling their loans. With no correct valuation available as no sales are happening currently, even foreign investors will shy away from investing in this sector.

Conclusion: While it still remains to be seen what will be the total effect of sub-prime, the Fed is doing every bit to minimize the pain. Most companies have already written off their losses and are now looking forward to future. No fresh loans are being given which are as risky. It may take a few years to come out of the whole mess, but the worst may be over. Nevertheless, 2008 will still continue to face the consequences.

Overall Conclusion: I believe, it will be interesting to see which of the above scenarios will play out. Also, it will not be either of the two but will be a mix of two. Most will depend of the public sentiment and the direction that Fed and the government will give. The Iraq war is close to over and the spending there will be cut. I strongly believe that US will be able to come out of recession by end of 2008 because all factors will play in its favor, Fed and US govt will go whatever they can, and most countries in the world want US to do well. Most countries do catch cold when US sneezes. The forces of the economy will play out and free fall of such well connected economy will be very difficult. US has a lot of thought leaders, many of them from India and these sharp brains will make it happen!