By R SIVANITHY
SENIOR CORRESPONDENT

 

THERE is really only one question that will drive stock markets this week - whether the US Federal Reserve will cut its short-term rate by 25 or 50 basis points to continue to try bailing out credit markets reeling from the mess they created in the first place. Beyond that there is year-end window-dressing to look forward to and, of course, the fabled January effect. But thereafter the picture becomes clouded by the increasing likelihood that Wall Street will run into a recession headwind which could upset equities.

 

First, tomorrow's Federal Open Markets Committee (FOMC) meeting. If this yields only a 25-point cut, markets would be highly disappointed. This is because the market has become conditioned to expecting a very accommodating Fed, thanks to a 50-point reduction at the Sept 18 meeting and blatant hints dropped by Fed chief Ben Bernanke and vice-chairman Donald Kohn about being 'alert and flexible' and 'nimble' when it comes to monetary policy a fortnight ago. So anything less than 50 points could spark a large selloff.

Then again, as pointed out in last week's column, there is a very strong likelihood that markets have 'bought in anticipation' of a 50 points rate cut and when it's actually delivered, markets might 'sell on news'. Much, of course, will depend on the Fed's accompanying statement and whether the language is hawkish or dovish.

Beyond that is the question of whether 50 points and more later will have any meaningful impact. We've discussed the similarities between the US's current credit problems and the late-1980s savings and loan (S&L) collapse in this column before and it appears that analysts are now starting to draw the same comparison.

Morgan Stanley, in a Dec 6 global currencies outlook report, looked at the S&L aftermath and the present sub-prime situation and said a 'rather significant Fed rate cut campaign' is needed to avoid a repeat of the S&L-led recession of the early 1990s. It added that its inhouse model implies a 48 per cent chance of a recession in the next 12 months. (Maybe Morgan Stanley's analysts haven't yet read the then-incumbent Fed chairman Alan Greenspan's book The Age of Turbulence, in which he expressed frustration that cutting rates 23 times between 1989 and 1993 failed to ease credit conditions causing the S&L collapse and failed to hoist the economy out of a recession).

Earlier on Dec 3, the US investment bank released a US economics report entitled The Earnings Recession in which it looked at narrowing US profit margins and said leverage works both ways. 'Operating leverage working in reverse and rising costs, dwindling pricing power and deteriorating credit quality will depress margins...an earnings recession is not in the price and the coming downturn likely poses downside risks to equities'.

'Lower interest rates won't bail out equities on a sustained basis because they are the product of a weaker economy. Thus, earnings disappointments likely will drag equities lower.' said Morgan Stanley.

So there you have it - tomorrow's FOMC meeting, whether the cut will be 25 or 50 points and what language will be used will set the short-term trading tone for the week ahead, though those currently in the market should be wary of the strong likelihood that markets may have bought ahead of the meeting only to sell after it's over.

Further ahead, the question of whether stocks can offer decent upside in 2008 hinges on several factors such as whether Asia can decouple from the US as many analysts would have you believe. This issue is perhaps too complex to fully explore now. Suffice to say that there will be short-term volatility ahead - recall the large rises then drops in the Straits Times Index last Thursday and Friday - and investors could find themselves disappointed if they're counting on Wall Street to provide the catalyst or leadership for more gains as we head into 2008.