Government policies — both in developed and emerging markets — to smooth economic cycles may in fact be simply increasing volatility.

July in the US is one of the hottest months of the year. It certainly was on the US stock markets. The S&P has climbed almost 10% since the end of June. It has mimicked the rally that occurred this spring. Does this portend the beginning of a persistent recovery or is something else happening?
 
It was due to earnings. In both cases the rallies were caused by earnings, really good earnings. The present level of earnings for many companies and their forecasts of future growth have led to higher valuations for many US companies and a rise in their stock prices. Is this a prediction for better times? Probably not, but it does tell us something very important.
 
To start, earnings are always suspect. Accounting allows for many variables. Revenues can be brought forward, pushed back, extended, expanded, hidden, distributed or they can simply be made up. The same is true with costs.
 
Earnings are also retrospective. They represent information that can be several months old. They are based on trends and decisions of the past, not the future. So rather than crystal ball, they represent a rear-view mirror.
 
Still, the earnings this season have been very good. They have exceeded expectations by more than 10%. In the US markets with over 70% reporting second quarter earnings, profits look to have grown 42% and profit margins nearly 10%. Some companies have done very well indeed.
 
The American delivery company UPS’ earnings jumped 71% on revenue growth of 13% with improvement across all business units. Its competitor FedEx forecast earnings to grow by 32%. Two Dow Jones components — the US heavy machinery manufacturer Caterpillar and  the chemical giant DuPont both did well as did Cummins Engine Company, whose second-quarter profit more than quadrupled.
 
In contrast, other US companies, specifically companies selling to consumers in the US like Home Depot, Kellogg, Colgate and CVS all had disappointing earnings. The difference is important. The UPS, FedEx, Caterpillar, DuPont and Cummins earnings all had one thing in common. Most of their profits came from international sales and for international sales read Asia. For DuPont the Asia-Pacific region increased revenue by 47%. Cummins realised two-thirds of its revenue outside of the United States. UPS volumes in Asia grew over 40% and international operating profits soared 78%. The companies that did not do as well were focused on the US.
 
This is hardly news nor unexpected. It is common knowledge that emerging markets have been growing faster than developed markets. Recently markets have fallen because the recovery in the developed countries seemed to be in danger. Developed markets were plagued by worries about sovereign default and double dips, most of which turned out to be overblown. Now they are rising because of expectations of future growth in younger economies. But what if this is about to change?
 
Emerging markets have a different problem. Rather than slowing, they have been overheating. The main cause for concern in emerging markets right now is inflation. In India, Pakistan, Egypt and Vietnam the inflation rate is already at double digits. The Reserve Bank of India has raised interest rates in an effort to get ahead of the problem, but they already may be behind it. Inflation is accelerating.
 
In theory China’s inflation is contained. The government has imposed restrictions on the real-estate market to try and return the price rises to something that looks vaguely sane. But it has announced targets for new loans for 2010 at 7.5 trillion renminbi ($1.1 trillion). This is 90% more than the 4 trillion renminbi ($585 billion) in new loans extended in 2008. The mere size of this lending spree must ultimately unleash inflation. It has already created a potential loan default rate of 23% and rising. No doubt China’s tightening, if it is in fact tightening, is just beginning.   
 
It is really a question of the effectiveness of monetary policy. The fear has been that the loose monetary policy in developed markets would spark inflation. It hasn’t, but so far it has not been very effective in stimulating growth. In contrast, the contractions in emerging markets are supposed to cool inflation. If they don’t, will the monetary authorities in emerging markets follow their developed market colleagues and just apply more of the same medicine? If they do, will it choke off the present source for much of the world’s growth?
 
The real point is that despite the assurances of central bankers, government attempts to control markets can have enormous unintended consequences. Policies to smooth economic cycles may in fact be simply increasing volatility. The fall is coming and it is a season of dramatic change, for both the weather and the markets. The earnings optimism is likely to be as short as summer itself.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]). — William Gamble