A silver cloud ahead?

The worse is not yet behind us, as Ben Bernanke and Henry Paulson have warned. But we may be in for a slightly more optimistic week. Clearer indications that more help is on the way from the US government seems to have put a bottom under the market, helping the dollar recover somewhat, and is likely to encourage some cautious return to risk. That means emerging markets could see a rally this week unless more bad news comes concerning global growth and inflation.

Investors have been pulling money rapidly out of emerging markets for the past several weeks, and some analysts say markets are looking oversold. Roche's US$43.7 billion (Dh160.5bn) bid for Genentech could also buttress sentiment, providing a sign that there is still liquidity out there to drive deals. Oil is poised to rally, too, after last week's heavy sell-off, with traders now more sensitive to any sign of supply constraints such as political tensions, storms in the Gulf of Mexico, or Adnoc cutting oil production to conduct maintenance.

The US Government is doing its part, meanwhile, by tightening the economic screws on Iran. The White House is reportedly trying to hamper Iran's access to imports of refined Gulf fuel and insurance products from Dubai. This will likely prompt Iran to respond with its own bellicosity, pushing oil prices higher and potentially driving Gulf stocks lower. We'll just have to see what this means for the Gulf - whether rising oil prices rekindle the inflow of hot money or whether political tensions tug on local stock markets as investors hedge their bets.

Sentiment in the region is clearly souring, with Saudi business confidence falling as living costs rise to their highest in 20 years. The Gulf may finally be catching the pessimism that prevails elsewhere. The debate among economists as to whether the US government bailouts are creating a moral hazard or are a necessary form of intensive care for the ailing financial system are building. Some say the concern now is that no one will go into the market to provide a bottom, fearful that prices will only fall further. And even creditworthy home buyers and companies cannot find willing lenders at this point.

That means housing prices will likely fall even further and the economy will suffer as capital expenditure dries up. With Fannie Mae and Freddie Mac out of the picture for buying discounted mortgage-backed securities, the deleveraging of Wall Street and the cleanup of the subprime mess will take a lot longer now and likely end up requiring more US taxpayer funds. Some economists predict that scores of banks and other lenders are likely to fail amid the credit riptide. The irony is that Washington, in providing financial support, will tie it to greater regulation and oversight, which will in turn provide its own brake on financial innovation and investment in the same way that Sarbanes-Oxley did after the collapse of the dot-com bubble created the Enron/WorldCom mess.

Leaving this week's new optimism aside, another important question is how much upside - or how much downside - there is to emerging markets in a world where the overall amount of liquidity is declining and global growth is slowing. Some economists point out that the boom of the past few years was driven by the liquidity bubble and now that liquidity is drying up, emerging markets have limited upside. This would be an argument to sell property and equities in the Gulf and Asia, as well as equities. Economists vary on whether oil prices are likely to continue upwards over the long-term or not. If they do, it would argue for Gulf assets. But with some predicting that the long-awaited global slowdown is finally upon us, oil may be due to come back below $100 a barrel.

Still others will argue, however, that the liquidity bubble was driven by a glut of real savings by China and oil exporters and that those savings are still there to be invested. With the dollar declining over the longer-term and the momentum of growth shifting out of the West, there may be more impetus to invest closer to home. On the other hand, the declining value of dollar-denominated savings has put big emerging market investors in a quandary: either they double-down to help prop up their existing dollar holdings, or they try to walk quickly, but calmly to the exits. There's no doubt many have been burnt, whether by buying rapidly falling stakes in Citigroup and Merrill Lynch, AMD, Jones Laing or the debt of now failed IndyMac Bancorp. Foreign investors were present in force at last week's auction of short-term debt by Fannie Mae and Freddie Mac. Legislators in Washington have been asking the White House just how much of that was real interest, and just how much was the result of arm-twisting by the Bush Administration of China and its Asian allies. How the White House handles the bailout is crucial. If it fails to save the two institutions and the Chinese and Japanese get burnt on the over $500 billion in Fannie and Freddie's debt they hold, it may alienate foreign investors who have been financing the US current account deficit for so long. This would drive up US funding costs, ie interest rates. Incidentally, analysts say that any Gulf or Asian investors looking to double down and help prop up their dollar investments would probably have the greatest potential impact - and the highest potential returns - by going into the US housing market. Prices may be poised to drop in the short term, but by providing liquidity to a cash-starved market, they could spark a turnaround. @Email:warnold@thenational.ae