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Recent data and developments suggest that the intensifying credit market turmoil is likely to infect the real economy, especially in the developed world, through a full-blown credit crunch, says Stephen Jen, Morgan Stanley’s global head of currency research.

Jen, who has sharply changed his earlier bullish tone, warns that risky assets may be in jeopardy in the coming weeks. Even so, he adds, the mood swing in the markets in the past few days has been “quite extreme”.

The key issues, in Jen’s view, are:

• The previously bullish analysts and investors have turned quite bearish. “I don’t trust sharp mood swings in general.”
• So far, the sub-prime crisis is a ‘rich countries’ problem. While persistent profit downgrades by large financial institutions as they struggle to mark-to-market their exposure to various credit instruments and the resultant credit restraint will weigh on aggregate demand growth in the US, UK and Euroland, there are scant signs of stress in the credit markets in the emerging world.
• While there are good reasons to be more cautious about risky assets in the coming months (more below), says Jen, he disagrees that equities are fundamentally mis-priced, “particularly as interest rates decline in real terms”, and that we have entered a protracted bear market.

Bonds are paradoxically implying that the Fed is both behind and ahead of the curve – a scenario I don’t find compelling. Credit markets clearly have more scope for a correction. But few think that equities are mis-priced, unless one places an extraordinarily high emphasis on the temporary earnings deceleration in the immediate future. The fact is that there are compelling reasons to think that equities will resist being dragged down by the credit market. There will no doubt be volatility in equities, but I am not convinced that we have entered into a protracted bear market.

• In general, there are gross inconsistencies between various asset prices and macro signals. Investors should resist being affected by sharp mood swings. There are powerful tensions between (i) equities and bonds; (ii) equities and credit; (iii) developed and developing countries; (iv) the private sector and the official sector; and (v) commodity prices and the bearish investor mood.

The bottom line, according to Jen, is that risk and uncertainty have risen sharply, both on the outlook for the US economy and the extent to which the ‘economic de-coupling’ thesis will be stress-tested. The US housing market and an intensifying credit crunch are evolving, he warns, “from body blows to head punches to the US economy, with consequences for expected corporate earnings and equity valuation”.

The conclusion:

1. We are likely entering another bearish phase for global risky assets. The developed world is likely to downshift a couple of gears in the coming two quarters. However, investors should exercise care in tracking this slowdown, which Jen says has become a “consensus view with a well-understood storyline”. Investors are urged to pay attention to why the global economy has not yet followed this straightforward storyline yet.
2. The dollar’s safe-haven status is being tested. The ‘Dollar Smile’ (the thesis which stipulates that the dollar tends to do well, from a cyclical perspective, when the US economy performs very well or very poorly, and that the dollar is most vulnerable if it is in a soft landing) has not really kicked in, although the euro, emerging markets and commodity currencies have weakened somewhat now with general risk-aversion.

However, as long as countries like China and Australia continue to grow and their central banks remain on a tightening path, safe-haven flows into the dollar may be more muted this time around than in the past episodes of risk-reduction. The key call here – for the ‘Dollar Smile’ to be re-activated – is of course whether ‘economic de-coupling’ will continue.3. The yen, meanwhile, continues to move in the opposite direction to other key currencies. Given that AXJ (Asia ex Japan) countries are a net importer of capital goods from Japan, yen strength is a negative terms-of-trade shock to AXJ. Yen movements tend to push the AXJ currencies in the opposite direction. Jen targets a cycle-trough of Y106 to the dollar.

4. The debate on stagflation/inflation will persist, with the developed world entering a stagnant
period, while the developing world continues to generate inflationary pressures. The coalescing of these cross-currents is confusing investors and preventing the central banks of developed countries from easing as much as they want to in order to help support demand. This is a new source of uncertainty.

In Jen’s view, any stagflationary conditions will be temporary and inflation will eventually fall in the US and Euroland, as the economies slow in the coming two quarters. A year from now, however, the world may be marked by inflation and strong growth.

Then again, we wonder, maybe not.