Goodbye to the Bulls?

The world is now engaged in a massive process of catch-up. Through the combination of a fiscal response and an emergency interest-rate cut, the United States has signaled an understanding of the severity of the situation facing its economy. At the same time, we are starting to see evidence of more-decisive actions on the part of new CEOs at major Wall Street firms that declared large losses in the past few weeks (such as Citigroup and Merrill Lynch). On both counts, there should be little doubt as to the willingness to react. But this does not necessarily signal the end of the phase of high volatility. There remains a legitimate question as to the impact. Accordingly, investors would be well advised to keep their seat belts tightly fastened.

El-Erian is co-CEO and co-CIO of PIMCO. He was previously president and CEO of Harvard Management Co.

'Discontent'
Ruchir Sharma
When sorrows come for markets, they come--to borrow a line from Hamlet--not in "single spies but in battalions." The news flow out of the U.S. economy had been deteriorating for many months, but global investors were hoping emerging markets led by China would save the day. But they will not be the havens of growth they had been in years past. Policymakers in these markets are more concerned about containing inflation than the U.S. slowdown--and for good reason: it is rising in four out of five developing countries and has accelerated, on average, by nearly 2 percentage points over the past six months. In many countries, inflation is now beyond the tolerance limit, often defined as a headline rate of 5 percent. The latest data out of China for December show consumer price index inflation running at 6.5 percent--close to a 10-year high. Rising food prices have accounted for 80 percent of the increase. The price leaps in China have triggered growing discontent. So for the first time in 15 years, Chinese policymakers are resorting to price controls. The good news is that inflationary pressure remains modest outside the food sector, and there is little reason to believe it will spread. Productivity growth remains high and wages are rising slower than the rise in output. But bull markets thrive on high growth and benign inflation--the two conditions that defined the global economic environment over the past five years. With the United States teetering on the brink of a recession, the world needs emerging markets--the growth leaders of this decade--to pick up the slack, just as the United States did in the late '90s following the Asian economic crisis. Back then, the U.S. Federal Reserve was able to cut interest rates and cushion the blow from emerging markets. But with China and other developing economies more preoccupied with fighting inflation than offering any stimulus, the bull market in emerging-market equities will remain suspended until the food inflation scare passes away.

Sharma is head of global emerging markets at Morgan Stanley Investment Management.

'Averting the Abyss'
Barton Biggs
The world is in an old-style financial panic out of the late 19th or early 20th century. Investors today, just as then, are human beings subject to extremes of greed and fear. Accountants and auditors are human also, and they are being pilloried for past sins of negligence and misconduct. I strongly suspect they are overreacting by compelling huge markdowns of the subprime paper held by their bank clients. Everyone is scared to death of being sued in a litigious world. These write-downs are crushing earnings, reducing book values and causing steep falls in the share prices of financial institutions.

This has happened before in banking crises. Sometimes the result was write-ups later of the value of the paper. It happened most recently in Asia in the late 1990s. This time, though, the scope of the crisis is far larger, and both the write-downs and the write-ups may be even greater. A lot depends on whether the financial contagion spreads and the United States and world economy slip into a prolonged period of stagnation and deflation like Japan. If so, the current conservative valuations will prove to be correct. On the other hand, the "authorities" in the United States (the Fed and the government) are now providing liquidity and spending stimulus. Unfortunately the European Central Bank still doesn't get it even though the European banking system is in just as much trouble as America's. The other factor in averting the abyss will be whether this year the United States and then the world economy falls into recession. The consensus believes it will, and in fact many loud voices say it already has. A U.S. recession could drag the world into recession and would set off a new round of contagion in leveraged debt. However, the data from the United States and the world at this moment do not support the recession conclusion. Meanwhile, stocks in the United States, Europe and Japan are cheap on all the valuation measures we use. Emerging-market equities are volatile but, considering their much faster growth prospects, they are intriguing. When the abyss is on the front page, as it is now, I am inclined to bet against the doomsayers.

Biggs is a managing partner of the Traxis Partners hedge fund in New York.

'Much Uncertainty'
Heizo Takenaka
Is the American credit crisis like the Japanese banking crisis of the 1990s? No. The key difference is between a liquidity crisis and a capital crisis. I don't see the systemic risk of a capital shortage like we had in Japan. That's the most important point. There are also similarities—for instance, the fact that the problem wasn't the bursting of the bubble, but mismanagement by the banks. Central banks can deal with a liquidity shortage, as we saw with the Federal Reserve's action last week. The Fed might have acted a little earlier, but by and large its reaction has been correct. The question is, will this create a capital shortage? I don't think so. Consider Citigroup. Last week its newest capital issue drew $25 billion in investor demand. The volume of recapitalization in the banking sector is massive. But it indicates there is still capital, and that we're not moving from a liquidity shortage to a capital shortage. The bigger danger is a second problem, the effect on household consumption and the macroeconomic slowdown we'll see in the second half of the year. This macro effect is more serious than the banking crisis. I don't believe in decoupling, and the slowdown in the United States will hit Asia hard.

The biggest risk factor is mismanagement and overreaction. Investors are reacting too negatively to the banking issue. The disclosure system is much better than it was in Japan, where banks hid their bad loans for 10 years and CEOs weren't fired. But it could still be better. There is a real risk of protectionism, as we're seeing in the reaction to sovereign wealth funds. With so much uncertainty, people will act on the worst assumptions. Everything is based on people's expectations. Finally, let's not blame the United States for everything. Japan and China have their own domestic economic problems that feed into this.

Takenaka is the director of the Global Security Research Institute at Keio University and former Economics minister of Japan.