Thursday, November 29, 2007

US Markets: Counting the Chickens Before They Hatch

This from CBSMarketwatch, ``U.S. stocks climbed for a second day Wednesday, with the Dow scoring its largest percentage leap so far this year, and a revived financial sector paving the way after a Federal Reserve official bolstered hopes for additional interest-rate cuts ahead.” (highlight ours)

This from New York Times, ``Stocks soared on Wall Street today after a top Federal Reserve official appeared to open the door for additional interest rate cuts, pledging to follow “flexible and pragmatic policy making” as the central bank decides how to cope with the current financial upheaval.” (highlight ours)

So aside from being oversold, obviously the US markets has been building its “bullish” foundations from expectations of further Fed Steroids or as they say "counting chickens before they hatch", this from Fed Governor Donald Kohn (emphasis ours)…

`` An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago. In general, nonfinancial businesses have been in very good financial condition; outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels. Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.”

…while ignoring hawkish comments from Philadelphia Federal Reserve Bank President Charles Plosser and Chicago Fed President Charles Evans or a case of "selective perception".

This only means that the FED has its hands tied, where it would need to appropriately respond to market’s expectations on December 11th else risks a collapse. A confirmation from Bernanke’s speech tonight could add to these expectations.

Remember, two rate cuts of 75 basis points and a bunch of policy palliatives have recently failed to boost the markets, hence yesterday’s dovish statements from Governor Kohn. This could simply be a clearing rally from technically oversold levels and is no guarantee that markets would resume their uptrend over the interim.

Sunday, November 25, 2007

Pervasive Losses In Global Financial Markets, US Treasuries Signal Rising Risk of Recession

``How, exactly, is enslavement won? Through a combination of fabricated “crises” and an insidious phenomenon known as “gradualism.” Create the crisis of your choice — global warming, education, Big Oil price gouging, home foreclosures … ad nauseam — then milk that fabricated crisis nonstop until gradualism is able to take hold and convince the brain dead that the only solution to the crisis is for government to step in and pass more laws to save us from imminent peril.” –Robert Ringer

AFTER two rate cuts (75 basis points), the opening of the discount window (including lowering of its rates), changing of some lending rules such as exempting banks to lend to broker subsidiaries and the widening of the eligibility of collateral acceptance and the injection of liquidity via repos and Federal Home Banks, where the US Federal Reserve appears to have utilized a panoply of monetary tools, including the unconventional ones, to cushion the impact of the housing recession triggered credit crisis, yet such dislocation continues to ricochet throughout the global financial markets.

Interest rates alone reflects on the recent stains where the “TED” spread or the difference between three-month US Treasury bill yields and Libor, the London interbank offered rate soared to record levels! We are thus witnessing a frenetic “flight to quality” in terms of a massive rally in US Treasuries, as shown in Figure 1.

Figure 1: stockcharts.com/ Ivan Martchev: Collapsing Yields of 10 Year Notes!

The last time US treasuries encountered such a colossal move was during the Nasdaq bubble implosion in 2000 that ushered in an economic recession. The blue horizontal arrow points to the closing prices of US the T-Note yields last Friday.

Don’t forget during this period, the US Federal Reserve slashed its Fed rates from 6% to 1% until mid 2003 in order to mitigate the economy’s deterioration but to no avail. Instead the ocean of US dollars generated consequent to such intervention has spawned a new monster; a US housing bubble buttressed by exploding leverage in terms of new financial instruments. Derivatives have now reached $516 trillion during the first half of 2007 (Bloomberg). And some of these are seen unraveling today.

Hence, the behavior of the US Treasury markets, relative to the speed and degree of its decline, suggests to us that a US recession is either imminent or now unfolding!

The impact of the credit crisis has apparently permeated to different sectors of the US economy from what we previously mentioned as signs of contamination in the commercial real estate to rising delinquencies in credit card, now globally to bond insurers (e.g Ambac Financials, FGIC Group, ACA Capital, French Natixis SA), reinsurers (e.g Europe’s Swiss Re), major mortgage lenders or “Government Sponsored Enterprises” (GSE’s) in Freddie Mac and Fannie Mae, Municipal Bonds (e.g. California’s downgrade) and even to rising incidences of default in US auto loans.

Mounting risks of losses from Australian and Japanese corporations loom on CDO downgrades, where recently major Japanese banks were reported to have accounted for ¥ 1.3 trillion yen or US $12 billion in US subprime exposure.

Even European banks have agreed to temporarily desist or suspend from trading on so-called “covered bonds”, or securities backed by mortgage or loans to public sector institutions (Bloomberg) `` to halt a slump that has closed the region's main source of financing for home lenders”.

Meanwhile, three month deposit yields in some Asian countries fell on contagion fears. This excerpt from Telegraph’s Ambrose Evans Pritchard (highlight mine),

`` The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety as investors across the region pull out of risky assets.

`` Yields on three-month deposits in China and Korea have plummeted to near 1pc in a spectacular fall over recent days, caused by panic withdrawals from money market funds and credit derivatives

`` Korean and Chinese three-month yields have fallen from 4pc to 1pc in a matter of days in an eerie replay of events on Wall Street in late August when flight from banks and the US commercial paper markets caused yields on three-month Treasuries to falls at the fastest rate ever recorded. Asian investors appear to be opting for deposit accounts with government guarantees.

`` It is unclear what prompted this latest "heart attack" in the credit system, though rumours abound that Asian banks have yet to own up to their share of the expected $400bn to $500bn losses from the US mortgage debacle.”

Even sovereign debts appear to be stomped by the ongoing stampede out of risk assets, from Financial Times (highlight ours),

``Investors are shunning European government debt issued by countries other than Germany as worries about a global economic slowdown prompt a flight to safety within Europe.

``There is a strong sell-off in sovereign debt relative to [German] bunds, ranging from top-rated Spain to eastern Europe,” said Ciaran O’Hagan, strategist at SG CIB.

``Credit spreads, derivatives, and currencies are all taking a whack as part of the flight to quality.”

These developments include emerging market debts which this week suffered quite heavily. Curiously, while most of the damages to emerging Asian debt had been relative to domestic currency denominated issues, the Philippines appears to have been the least affected in both local and US dollar issues, based on the data from Asianbondsonline.org. Of course this is not to suggest that we are “better off” than the rest of the pack, as one week does not a trend make.

Japan In “Bear Market”, Will Global Equities Follow?

``The ultimate driver of Japan’s adaptation today is globalization. In short, the world changed while Japan slept, as more and more developing countries became participants in the world’s economy and the old patterns of trade and capital flow went by the wayside. Now, as Japan reawakens, its challenge is to find a place in this different world, starting with its own backyard: Asia.”-Matthews Asian Fund

Figure 2: Stockcharts.com: Are Global Markets Headed Lower?

Major equity markets continues to be in a funk with Japan’s 39-year old broadest benchmark, the Topix, technically entering into a “bear market” when it declined below the yardstick of 20% from its 2007 peak last week. The Topix is down by over 21% as of Friday’s close. (Thursday to be exact-Friday was Labor Thanksgiving “kinro kansha no hi” holiday)

Another major Japanese equity bellwether, the Nikkei 225, a price weighted index of Japan’s top 225 blue chip stocks, as shown in the main window of Figure 2 courtesy of stockcharts.com, has been down by nearly 19% and is clearly approaching its pivotal support level at 14,000.

Meanwhile, Europe’s Dow Jones Stoxx 50 or (stoxx.com) a ``leading Blue-chip index for the Eurozone, provides a Blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain” have lost about 9.5% from its peak (shown in the upper pane below main window) and like the Nikkei 225 seems to be testing its critical support level at around 3,500.

The broad based S & P 500 (pane above main window), a major US bellwether, is down by about 8.6% from its peak, relieved from its recent lows by a stern rally last Friday, but on lean volume, on an abbreviated trading day following the Thanksgiving Holiday. Incidentally, the Dow Jones Industrials has touched the 10% loss trigger point which should activate the next phase of the “Bernanke Put” this December 11th.

Like the Nikkei and the Dow Stoxx 50, the S & P 500 is nearly at the cusp of the crucial threshold level at 1,400.

On the other hand, the Dow Jones Asia Pacific ex-Japan stocks (lowest pane) surrendered about 14% of its gains from the recent highs and appear to be in a pronounced decline reflecting the same activities in the major markets.

From Bloomberg (emphasis ours), ``Global stock markets have lost $2.9 trillion since Oct. 31 and the collapse of the subprime market in the U.S. has triggered about $50 billion in writedowns among the world's largest banks.”

So, in a break from last week’s seeming indecision, global markets appear to be signaling in unison a forthcoming test of the respective critical support levels, which may determine the direction and returns for 2008.

With the recent performances of the US treasury markets indicative of an approaching US economic recession, plus Japan’s likely transition towards an interim bear market, the likelihood is that once these levels have been cleared, a “bear market” could be the hallmark of global equities in 2008, unless of course we see an elaborate turnaround soon.

A US Recession Will Initially Drag Global Equities Lower

``Recessions are not caused by a general shortfall in spending, but instead by a mismatch between the mix of goods and services supplied by the economy and the mix of goods and services demanded. Though demand shifts away from some kinds of output that the economy produced in the prior expansion (as we saw with tech and telecom in 2000-2002 and are seeing in housing today), we often see continued demand in other sectors, but the mismatch takes time to correct, and output and employment suffer as a result. Most job losses during a recession are typically concentrated in a small number of industries, while other industries experience growth and even growing backlogs and rising employment. So the next recession, whenever it occurs, will probably feature a good amount of dispersion. Most likely, we'll observe particular weakness in housing-related industries (and associated finance sectors), while a variety of sectors including technology, oil services, broadband telecommunications, and consumer staples may be better situated (though such stability still may not prevent stock price weakness).”- John Hussman, Hussman Funds

How does a US recession affect world equity markets?

Learning from the past using the 2000 model we can take note that global equity markets echoed the directional path of the US markets as shown in figure 3.

Figure 3: US 2000 Bubble Implosion Reverberated in Asian Markets

Where the US Tech bubble crashed in 2000 as shown in Figure 3 (see red line), the plight of the Philippine benchmark, the Phisix (shown by the black candle), which was in a bear market in the aftermath of the 1997 Asian Crisis, was further aggravated until it reached its trough in 2002.

The 1998-1999 cyclical rally amidst a secular bear market was mostly due to the reaction as a natural consequence to the violent 1997 selloff and in confluence to the seasonal “New President’s stockmarket honeymoon” following the Presidential election victory of Joseph E. Estrada.

As you can see, no trend goes in a straight line. And secular trends are usually pockmarked by intermittent cyclical countertrend movements or plainly said, a cyclical bear market amidst a bullmarket or a cyclical bullmarket amidst a bearmarket. 1998-1999 signified the latter.

Notice too, that Asian markets represented by Japan’s Nikkei (green line), Hong Kong’s Hang Seng (gold line) and Singapore’s Strait Times (blue line) all turned lower or inflected by 2000, stayed on a general declining trend for more than a year then bottomed out synchronically by 2002.

So if the past were to do an asymmetric reprise, then a US recession could likely lead to a similar decline in Asian markets, including our Phisix…initially.

Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?

``The more creative we get, the wider the diameter of our searchlight, the less likely we are to get blindsided. More things can happen than will. But more things will happen that we don’t expect. The best thing of all: tomorrow’s headlines will be full of interesting things that nobody could have ever predicted today would happen tomorrow.”-Josh Wolfe, Forbes Nanotech

Of course the debate about decoupling is mainly semantics.

Similar to the polemics of Market Failure premised on imperfect competition, some of such arguments are noticeably fallacies predicated on absolutes. Since a country has interactions with other nations (even communist countries) then linkages results to connections or correlations, which varies on the scale or degree of transactions involved. Since under such context, there is hardly anything as a perfect correlation, there would likewise be no perfect decoupling.

Since today’s globalization trends translate to increased collaboration through trade or financial channels, this should extrapolate to more linkages, thus heightened correlation. So, the argument of decoupling essentially boils down to its definition.

Decoupling defined in the economic context (wikepedia.org) ``refers to the lessening of correlation or dependency between variables.” (highlight mine)

In the financial markets, our observation is that decoupling is basically measured in the context of correlations of price trends among securities or markets.

A trend maybe said to be positively correlated when there is a (answers.com) ``Direct association between two variables. As one variable becomes large, the other also becomes large, and vice versa. Positive correlation is represented by Correlation Coefficients greater than 0”. (highlight mine) The movement of Asian markets relative to the US markets in 2000-2002 is an example of strong positive correlation.

A trend maybe said to be negatively correlated when there is an (answers.com) ``Inverse association between two variables. As one variable becomes large, the other becomes small. Negative correlation is represented by correlation coefficients less than 0.” (highlight mine)

My favorite example would be that of Zimbabwe, an African country that has been on sordid streak of economic, political and social despondency, as discussed in our April 9 to 13 edition, [see Zimbabwe: An Example of Global Inflationary Bias?]. The country’s inflation rate has incredibly soared to stratospheric levels at 14,841% (Bloomberg) in October albeit its stock markets continue to fly! Now relative to the correlation between economic health and stock performance then it can be said that Zimbabwe’s case signifies negative correlation or a decoupling.

Or let us take another example in Saudi Arabia’s major equity benchmark the Tadawul, shown in Figure 4, as a representative for Gulf Cooperation Council (GCC) whose other members include Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (UAE), where most of Gulf member bourses have been on an uptrend.

Figure 4: Bloomberg: Saudi’s Tadawul: Recovery Amidst Global Decline, Will it last?

We dealt with the potential “bottoming” of Saudi’s benchmark last May 28 to June 1, [see Could China’s Bubble Last Longer than Expected?], today the GCC bourses appears to have “defied gravity” or “decoupled” or has been “less correlated” relative to the ongoing global infirmities among its counterparts.

Our suspicion is that speculations on the fate of the GCC’s extant dollar peg (except Kuwait) which has resulted to greatly enhanced inflation pressures have been the primary driver of this seeming recovery. You see, the feasibility of the US dollar peg is now being questioned as the US dollar continues to fumble.

Investors appear to bet on the unplugging of the US dollar peg soon, where GCC member countries would be compelled to revalue their currencies to the upside. Hence, the expected strengthening of the region’s currency has provided incentives for investor to bid up on GCC equity assets. Again, expectations on monetary policy adjustments almost similar to the thesis underpinning China have become crucial drivers to global capital flows.

This excerpt from the Economist magazine’s recent article “Time to Break Free” (highlight mine) underscores our analysis,

``Nowhere are the dilemmas more acute than in the Gulf, where virtually all the oil-rich states peg their currencies to the greenback. The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation. When the Gulf states meet on December 3rd in Qatar, they should agree to loosen their ties to the dollar.

``The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff.

``Soaring oil prices have brought the Gulf Arabs huge riches. Their real exchange rates, as a result, ought to rise. The simplest way to do that is for the currency to strengthen, but the peg prevents nominal appreciation. Worse, the dollar itself has been falling. The result is rising domestic inflation. Some smaller Gulf economies now have inflation rates of around 10%...

``A big uncertainty is what such a shift would mean for the dollar. In the short term, the effect on the Gulf states' appetite for greenbacks would not be dramatic, since the dollar would have a big weight in any basket. And there should not be a sudden sale of the oil exporters' dollar reserves. The worry is that the end of the Gulf states' dollar peg would send jittery investors into a panic. That risk is real. But with oil prices rising and the dollar falling, the dangers of inaction are greater. The Gulf states need to get rid of their dollar peg now.”

So while decoupling critics rightly argue that financial market activities could reflect on the technical economic, financial and trade interactivities that may result to higher correlation, one very important undefined outcome is how financial markets would react to forward monetary policies in response to today’s tensions which could affect the mobilization of money flows. As a Wall Street axiom goes, money flows where it is best treated.

Or will today’s financial market’s turmoil lead to a meltdown of the financial system as some would suggest, and thus pave way for a global deflationary depression scenario?

We doubt so, since the degree of exposure to the present systemic leverage cannot be applied similarly to all regions/countries ergo the relative effects will be different.

As an example the Philippines with its primordial markets have an infinitesimal degree of derivatives exposure compared to the US, so how can the effects be the same? While a recession in the US may affect trade, remittances or capital accounts and result to an economic growth slowdown, deflation is unlikely to happen since there has not been much debt built into system following the Asian Crisis. Moreover, our government is likely to undertake more inflationary policies on the account of “voter” demands.

Our favorite guru Dr. Marc Faber thinks such “deflation” scenario as unlikely. Dr. Faber writes (emphasis ours),

``With the propensity of the Fed and the ECB to flood the system with liquidity and to take “extraordinary measures” whenever problems arise, deflation is a remote possibility for the foreseeable future.

``So, before worrying about deflation, I would worry about inflation accelerating strongly in the years to come — especially if the US economy stagnates. But let us assume that at some point in the future deflation follows. What then? In my opinion, deflation could only be triggered by one event: a total collapse of the existing global credit bubble. And the only event I can think of that would trigger such a debt collapse would be a third world war. The failure of a large bank — say, Citigroup — wouldn’t do the trick, because the Fed would immediately bail it out (unless Ron Paul is US President).

``Now, in a debt collapse, where would you rather have your money? In bank deposits, in CDs, in dubious commercial paper, in bonds, in money market funds — all of which would experience soaring default rates — or in physical gold, ideally in a safe deposit box? I think that, particularly in a debt collapse, physical gold would shine, as people the world over would become extremely concerned about, not the return on their money (interest), but the return of their money. This would be particularly true of Asian central banks, which now have less than 2% of their reserves in gold but hold massive quantities of all kinds of debt securities.”

Now could the prospective easing policies initiated by global central banks alleviate the pains of today’s gridlock in the financial system or preclude a crisis?

It depends, as Austrian Economist Frank Shostak explains, ``As long as the percentage of wealth generators as a percentage of all acting individuals is still large enough Fed policy makers can get away with the policy of rescuing financial markets. However if this percentage falls to below 50 per cent then there is not going to be a sufficient amount of real savings to carry all the activities in the economy, a deep economic crisis emerges.”

As you can see conventional impressions or deductions can also be misplaced.

Figure 5: Rude Awakening: Emerging Markets Priced Safer than US Financials

Another example--Who, in the past, would ever discern that the biggest US financial companies would be perceived as “riskier” than emerging market bonds?

The cost of insuring US financial companies as exemplified by Merrill Lynch has become unbelievably higher today than Brazil’s sovereign bonds as shown in Figure 5. The chart likewise shows that the cost of Brazil bonds has painstakingly been on a downward trend overtime, which suggests of signs of strength rather than luck.

Eric Fry of Rude Awakening writes (emphasis ours), ``Buying five years of protection against a Brazilian default used to cost much more than buying five years of protection against a Merrill Lynch default.

``But now that Brazil has become as crisis-free as the U.S. financial sector has become crisis-prone, CDS prices have flip-flopped. Merrill CDS prices have jumped above those for Brazilian government debt! In other words, CDS buyers consider a Merrill Lynch default more likely that a Brazilian default.

``Maybe CDS investors have got it all wrong...or maybe the U.S. finance sector is in much deeper doo-doo than most investors believe. The "doo-doo" interpretation seems more plausible.

``CDS pricing is not necessarily indicative of future trends, but neither is it NOT indicative...Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance...”

While past performances or activities may have relative predictive value to future outcomes, they may not be so linearly correlated.

Plainly said, past performance may indicate future trends, but then again they may not. So under such premise, if today’s “safer” emerging market bonds become a definitive future trend, then these could be reckoned as signs of “decoupling” from past patterns, where investors would opt for emerging market assets than for US “riskier” dollar denominated assets. Otherwise, present trends could merely be indicative of an aberration, meaning a temporary phenomenon.

Differences of Tech Bust 2000 versus Credit Crisis 2007: US Dollar, Gold and Oil

``Throughout the 1980's and 1990's, all Asian asset classes had been highly correlated, highlighting Asia's status as an emerging market. However, since the late 1990's, Asian bonds, equities and currencies have "decoupled" as Asia took on the attributes of more developed markets.”-Gavekal Capital

This brings us to the last factor, the important distinction between the implosion of the Tech bubble in 2000 and today’s financial markets as shown in Figure 6, courtesy of economagic.com.

Figure 6: Economagic: Important Differences between Today and 2000: US dollar, Gold and Commodities

In figure 3, we showed that the US Technology bubble crash and the attendant economic recession dragged the Asian Markets along with it.

However, during such period, there had been some noteworthy nuances seen in the light of the trade weighted US dollar (red line), which had been in steady ascent until early 2002, while in contrast gold (green line), energy (gray line) and general commodities (blue line) were all in descent and gradually bottomed out at the twilight of the recession (shaded area) or in late 2001.

Meanwhile, today’s scenario has been in stark contrast, so far; falling equity markets and sharply rallying treasuries are seen under the backdrop of a LIFETIME low US dollar index, HIGHEST EVER oil prices and Record HIGH Gold prices as well as surging commodities. So relative to 2000, these signify signs of decoupling.

So what does this imply?

This suggests that what transpired in 2000 may not be exactly the same today.

If present price trends continue, then oil, gold and other commodities effectively “decouples” from its previous patterns. And so goes with the US dollar. Inflation and not deflation will be the cause of concern.

Of course, it may turnout that the decoupling critics could be right and recent trends could reverse, but for the present being, the burden of proof lies with these critics more than what price trends in various asset markets have been telling us.

It also implies that if the US dollar, gold and oil are responding to the anticipated changes in monetary policies, then the possible ramifications to other segments of the financial markets could be directed by similar predicate, anticipated changes in monetary policies.

It is from such grounds, we borrow the legendary oil and gas executive, T. Boone Pickens, line of forecasting, that the Phisix could backtrack to 2,800-3,000 before reaching 5,000 over the medium term, with 10,000 over the longer horizon.

Thursday, November 22, 2007

Thanksgiving or Turkey Day Message: Private Ownership and Free Markets

Americans today celebrate Thanksgiving day. Elliott Wave's Marketwatch tell us the reason why...

"The history books have it right in describing the Pilgrim's first harvest in 1620 as meager, followed by a miserable winter. It's also true that help from nearby Native Americans made for a better harvest in 1621, which led the Pilgrims to celebrate the Thanksgiving feast we all learned about as children.

"Yet here's the little-known part of the story: The harvest in 1622 was another failure, to the point that the remaining Pilgrims faced starvation. Why? Because during their first three years, these Pilgrims practiced "farming in common." The farmland belonged to the colony, and so did the food; portions were rationed out.

"So in the spring of 1623 the Pilgrims decided to take a calculated risk. They allocated individual plots of land for ownership among the families and members of the colony. In turn, each of the new owners was responsible for their property and for what it reaped.

"I'm sure you can guess the outcome of private ownership and individual incentives. The harvest in 1623 was plentiful -- and that was the year when the Pilgrims chose to set aside an annual day of thanksgiving to God. In a few short years, the colony produced abundance beyond its needs, and it was equipped to begin trading the surplus. They considered this turn in their fortunes to be miraculous; with the benefit of hindsight, what they had discovered was the miraculous benefits of private ownership and free markets."

Amen.

Sunday, November 18, 2007

The Economics of Philippine Election Spending

``The bottom line is that political campaigns are really good for the bottom line, especially the bottom line of media outlets. They are also great news for fans of wealth redistribution: campaigns take money from wealthy contributors and spread it around to everyone else.”-Stephen Dubner, Freaknomics

In a recent social gathering I attended, the topic of election spending was raised where it was attributed as an important contributor in today’s systemic “corruption”.

The commonly held view is that since the costs of getting elected continues to rise with each political exercise, any seeker of a public office would naturally attempt to recover from the attendant expenses incurred during the campaign and possibly profit from the position, mainly through from kickbacks via the Pork barrel or through other illegal or covert activities.

While of course, we do not dispute the inferences of causality that “expensive” elections most likely leads to corruption, what we believe is thoroughly missed by such argument is the economic dimension from which the whole cycle was brought upon in the first place. In our view, such exposition deals with only the symptoms but glosses over the genuine causes.

So why would any politician be so intensely keen with the so-called Pork Barrel? Dealing with basics is paramount for our wider understanding, from which we ask…what then is a Pork Barrel? According to Encarta Dictionary, it is ``government projects affording political opportunism: government-funded projects that bring jobs and other benefits to an area and give its political representative the opportunity to award favors and reap the ensuing prestige (highlight mine). Thus, Pork barrel is nothing more than Spending of Other Peoples Money (SOPM) at the discretion of an “elected” political representative.

In other words, Pork barrels are essentially meant as political financed solutions to the social problems (mostly economic) within the jurisdiction of a political representative. This also means that such power to redistribute wealth is “ideally” intended to address the needs or concerns of their constituents but, as Encarta describes, ends up serving other (self serving) purposes than originally intended.

Since the “cost” of getting elected has become pricier, then naturally such premise implies the basic economic concept of demand and supply at work.

The economic framework: Since the demand for political solutions to the nation’s social problems increases, then the functions of political wealth redistribution has to be accompanied with necessary increases in funding (print money, borrow or tax) and logistics via more bureaucracy (more personnel, police power, office equipments etc…). Remember, fundamentally each enacted law corresponds to additional costs. Why do you think the Philippines’ fiscal budget for 2008 has now ballooned to P 1.227 trillion, a 9% increase from last year? And since the supply for public positions that are bestowed with the power to redistribute wealth are limited then naturally the price of getting elected over such political jurisdiction increases!

Plainly said, when we demand for more social spending or welfare based programs to resolve our problems then we increase the funds allocated to politicians for their dispensation. Essentially, Pork Barrels signify our excessive dependence on government where the correlation of government spending and the price of getting elected are direct.

Now whether or not politicians “honestly” fulfill their missions, the main problem is that most redistributive wealth “subsidies” programs are inherently non productive and capital consuming, (e.g. massive “pump priming” by Japan in the late 90s failed to lift its economy out of the “lost decade” rut which instead resulted to a 160% public debt to GDP whose credit rating is now even lower than Africa’s Botswana! Talk about the theoretical feasibility of pump priming and its multiplier effects, duh!), which leads to more distortions in the economy, lower competitiveness, lack of investments, greater inequality, and therefore a more vicious inflationary cycle, which will be eventually felt through a higher cost of living in the future.

Is there any incentive for the incumbent politicians to reduce this? The answer based on cost benefit analysis is most likely a NO. Why? Because for most of the politicians, more power means more control over the system and its constituents which translates to more PERSONAL benefits, either economically or egotistically. Why should the politician give up on these all benefits? Think reduced bodyguards, diminished social status or privileges, as cars, overseas trip etc... Instead, the logical direction is to even look for more social programs or for more social dependence on them that would justify increased funding and the coincident discretionary spending power that comes with it. And social welfare dependency is what mainstream media promptly emphasizes. In short, we solve inflation with even more inflation!

So when we blame politicians for being “corrupt”, we are thus implicitly blaming ourselves simply because we empower them to do so by the provision of the disproportionate power over our resources and to our actions, as well as the opportunities to “corrupt”, in the name of public weal or in solving each and every aspect of our daily problems, when in most instances these politicians are reactive (policies based on popular short-term demands), biased (penchant to favor the interest or interest groups whom they understand more or are familiar with) and most importantly unmindful of the unintended consequences of their actions (who pays for policy mistakes? Not them but the people). As Ludwig von Mises wrote in Economic Policy ```Once you begin to admit that it is the duty of the government to control your consumption of alcohol, what can you reply to those who say the control of books and ideas is much more important?”

In effect, the Philippine political system which institutionalizes the Pork Barrel as a political “social” solution is in itself institutionalizing the venal patron-client or the patronage system which continues to serve as a major hindrance to our development. We tend to always look at personalities or at superficialities mostly fed by mainstream media when the problem is the system. That’s why personality based solutions are most likely to fail, since we do not deal with the causes but only with the symptoms and thus end up perpetuating the game of musical chairs. Again, we never learn.

Global Markets: Signs of Emerging Deflation?

``Liquidity exists when there are counterparties available to trade at any moment in time. It follows that liquidity is both an expression and a consequence of the ability of market participants to take risks on each other. For liquidity to exist, therefore, there must be a general sense, in the market, that each participant (or, at least, most of them) are suitably equipped to face the risks they are taking. This is what we call confidence.” Jean-Pierre Landau, Deputy Governor of the Bank of France

We were supposed to deal with the aspects of “decoupling” but a seemingly more important development has come to fore; global financial markets appear to signal the emergence of deflation!

Financial markets rarely transmit messages in consonance, but when they do we ought to pay attention.

Over the last two weeks, such latent messages have become more apparent as shown in Figure 1. But again the caveat is that two weeks may not a trend make.

Figure 1: Stockcharts.com: Signs of Deflation?

On the topmost pane, Dow Jones world equity index (blue arrow) has fallen steeply, just as gold (pane below center window-blue arrow) plummeted over 5% this week. Moreover, we see broad based US Treasuries massively rallying, where in terms of the benchmark 10 year (lowest pane-blue circle) its yields have dropped abruptly. Bond prices move inversely relative to yields. When US bonds rallies markedly, this signifies investor’s “flight to safety” on fears of an economic recession.

Now this comes as the US dollar index appears to be consolidating or forming a bottom, see main window, albeit this is too premature yet to conclude.

Again the US dollar’s action could be in reaction to technical oversold levels or possibly a reflection of a narrowing current account deficit or due to expectations on narrowing interest rate spreads, where the recent financial market crisis could possibly impel the Euro zone and the Bank of England to equally cut rates.

Since we have observed that the world has been outrageously levered via different mechanisms such as the CARRY TRADE, one notices that today’s downside volatility has been coincident with meaningful rallies in currencies which had been utilized as funding sources for cross asset arbitrage trades as shown in Figure 2.

Figure 2: Carry Trade Unwind?

The Japanese Yen and the Swiss Franc has substantially gained during the past two weeks (bar chart and superimposed line chart at the main window, respectively) as markets resonated on the jitters from the unfolding credit crisis.

Notice that the Salomon Brothers Emerging Market Debt Index (pane below main window) appears to have peaked as the Yen-Franc tandem bottomed during early November. This could mean that levered arbitrage positions which were sourced from such currencies had been unwound.

Nonetheless if industrial metals are priced to reflect on global economic growth then the present streak of declines forebodes of decelerating trend of world growth as shown by the lowest pane in the chart via the Goldman Sachs Industrial Index.

Nevertheless, the issue revolves around the continuing saga of accelerating strains in the US credit markets which continues to ripple across the financial markets worldwide with some incipient signs of spillover to the real economy.

Aside, the US financial sector remains under severe pressure, compounded by the recent implementation of Statement 157, as required by the Financial Accounting Standards Board (FASB), a non-profit private organization, whose purpose is to standardize financial accounting and reporting guidance. The new reporting guidance requires firms to specifically disclose its assets into 3 three categories: Levels 1, 2 and 3 starting on the November 15th. Recent moves to defer the implementation were rejected.

Under the FASB, Level 1 is defined as liquid assets or assets that can be assessed or priced from the market or “marked-to-market”. Level 2 are assets with less liquidity but could be assessed or priced based on estimates from “observable inputs” from similar assets or otherwise known as “marked-to-model”. Meanwhile Level 3 is classified as highly illiquid assets with no point of reference or “unobservable” inputs. Level 3 is basically a guess.

Analyst Nouriel Roubini points out that some major financial institutions in the US have enormous level 3 assets exposure relative to equity capital base, he cites Citigroup 105%, Goldman Sachs 185%, Morgan Stanley 251%, Bear Stearns 154%, Lehman Brothers 159% and Merrill Lynch 38%. While this does not suggest that all Level 3 assets will go kaput, this suggests of the risks of incurring more losses from these institutions which should eventually be reflected in the financial markets.

This also implies that these institutions would be hoarding money to defend or buttress its capital base such that lending activities would be stymied. Essentially contracting liquidity in the marketplace and in the economy translates to a phenomenon called as deflation.

As example, Goldman Sach’s Jan Hatzius recently forecasted that financial institutions such as banks, brokerages and hedge funds would see a cut of liquidity or lending by as much as $ 2 trillion which could result to hard landing in the US.

Bloomberg quotes Hatzius, ``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' Hatzius wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.

In addition there have been signs that the housing recession has now began to spillover to the Commercial Real Estate, where office buildings, shopping malls and construction for structures for manufacturing have likewise began to crack.

Quoting Nouriel Roubini (highlight mine), ``And indeed the boom in CRE investment – with excessive construction of commercial real estate is leading – like in the case of housing – to a glut of unsold or empty properties that is leading to a fall in prices. As reported by the FT: “Moody’s index of commercial real estate prices is expected to show that prices flattened or fell in September, after rising nearly 14 per cent in the 12 months to August. RBS Greenwich Capital predicts that US commercial property prices will fall 10-15 per cent next year.”

``The coming meltdown of commercial real estate is also evident by the sharp widening in credit spreads for CRE mortgages and commercial mortgage backed securities (CMBS). One of the most clear signals of this extreme stressed in the non residential MBS (CMBS) market is given by the CMBX index that is reported by Markit. The data are scary: for BB tranches the spread is now over 1500bps; for BBB- the spread is 1,100; for BBB is 965; even for A is 540; and 326 for AA tranches. All these spreads have sharply widened compared to their spring 2007 levels. At these spreads the ability to finance any new CRE investment – apart from those already committed and financed – is practically null. After the pipeline of already financed projects is finished the market for financing and securitizing CRE – apart from the highest rates projects – is practically frozen. Indeed, the issuance of CMBS fell to $6.3 billion in October, down 84% from a record $38.5 billion in March that finance about half of commercial property purchases. So the CRE market now behaves similarly to the sub-prime market; it is totally frozen.”

Respected independent Canadian research outfit BCA Research somewhat shares the deflation outlook given the present readings from economic indicators as shown in Figure 3…

Figure 3: BCA Research: US Inflation…or Deflation?

From BCA (highlight ours), ``Core CPI is just over 2% on an annual basis, and is set to decelerate. Earlier upward pressure from the shelter component of CPI is easing, while goods prices are already firmly in deflationary territory. Service sector inflation (outside of housing) failed to gain a head of steam during the economic boom, and is likely to drift lower with the economy growing at a sub-par pace. Retailers are back in aggressive price discounting mode. Inflation is not going to be a constraint on the Fed, and we expect further rate cuts ahead, especially with the credit crunch continuing to roll on.”

Remember, US equity markets have now begun to falter anew even after TWO rate cuts, which means that the equity markets are currently anticipating even more forthcoming weaknesses and thus the renewed selling pressures.

Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts

``A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.”- Ben S. Bernanke, The Financial Accelerator and the Credit Channel

So with financial markets and some economic indicators pointing towards emergent signs of deflation, this ultimately leads us to the probable responses of US monetary authorities from which the direction of global markets will be anchored.

The question remains: Will Mr. Bernanke & Co face the music and save the US dollar by allowing deflationary trends to permeate and segue into a full blown recession or will they undertake measures to prevent the economy from falling off the cliff by utilizing its monetary tools?

We have long argued that the US Federal Reserve is sensitive to financial markets more than the economy [see sensitive August 13 to 17 edition, US FEDERAL RESERVE Is Financial Markets Sensitive!].

Our thoughts has been that given the Paper Money US Dollar standard from which the world operates on, the US Federal Reserve will do everything it can to sustain the present monetary system, which has given Americans an undue advantage over the rest of the world by simply issuing promises to pay (dollar notes) in exchange for goods or services. Hence for us, the Fed’s unstated mandate is to forefend its main constituents (banking system) from a collapse. Forget moral hazard, it’s all about perpetuation of the system.

We have also shown in the past that since Central Banking has been introduced in the US in 1913, the Purchasing power of the US dollar continues to approach ZERO, a natural predisposition of all paper currencies, see August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The plight of the purchasing power of the US dollar not only reflects on the impact of the cumulative inflationary policies but also of the historical responses by the US Federal Reserve when confronted with a financial or economic crisis, where the tendency has been to sacrifice the US dollar at the altar of the Paper Money-US dollar Standard.

So aside from the need to rescue its major conduits to sustain the system, the Fed likewise recognizes the overwhelming dependence of US households on financial assets to sustain their consumption patterns, which further buttresses the case for more intervention.

We are here to discuss not on the merits but on the proposed action and potential effects to the markets. As we always say, markets reflect on policies imposed.

And this bailout would come in the form of various monetary tools that the FED possesses such as injecting liquidity or manipulating interest rates to possibly even intervening directly in the financial markets. And such is the reason why a contingent executive committee, commissioned by EO 12631 in March 18, 1988, called as the Working Group on Financial Markets exists, or otherwise known as the Plunge Protection Team.

“Helicopter Ben” was the moniker Mr. Bernanke garnered following his November 21, 2002 speech Deflation: Making Sure "It" Doesn't Happen Here advocating the use of unconventional tools to fight deflation at all costs.

In a recent speech (June 15, 2007) entitled “The Financial Accelerator and the Credit Channel” by Fed Chairman Ben Bernanke, it appears that our thesis has gotten even more validation.

From Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

Figure 4: St. Louis Federal Reserve: FED Funds Futures

In figure 4, from the Saint Louis Federal Reserve Fed futures have placed a rate cut of about 25 basis points this coming December.

So what this means?

Despite the hawkish tone of “no further cuts” from Fed Governor Randall Kroszner and St. Louis Fed President William Poole, the continuing stress in the financial markets will most likely spur the FED to cut in the next meeting (December 11) otherwise risk a meltdown in almost all asset classes.

Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.

Besides many of these FED officials had been talking incessantly about “inflation” even prior to the first rate cuts but suddenly voted in favor of cuts during the past FOMC meetings which goes to show how these officials lack the credibility by saying one thing and doing another.

Like any politicians or bureaucrats, the FED will protect its interests.

Loosening Correlations Between Asia and the US Markets

``Large diversification flows — other than the currency-rebalancing exercise undergone in some foreign central banks — have been powerful undercurrents in the currency world, forcing the dollar and the JPY below their values that are consistent with the economic fundamentals. We believe that, in the coming years, we will witness a similar trend in large EM economies that have accumulated enough wealth and attained adequate confidence and knowledge about the international capital markets. In other words, while many of these EM economies have been acquiring foreign assets through their central banks and SWFs, we believe that the private sectors of these economies will be major exporters of capital to both the developed markets and to other EM economies.”-Stephen Jen, Morgan Stanley

Over the interim, the US markets could go either way. This means the same with global equity markets including the Philippine Phisix.

Figure 5: Chartoftheday.com: Pre-Election Cycle

On the bear side, the continued dislocations in the credit market and renewed selling pressures in the US equity markets aside from deflationary signals across asset markets are likely the risks to reckon with as the market awaits action from US Monetary authorities.

We are inclined to believe that any material threat to US markets would likely manifest itself by next year.

On the other hand, the bullish premise is that major US equity benchmarks appear to be technically oversold and could rebound soon, before ascertaining its next major move. Aside, the seasonal Presidential Pre-Election cycle in the US could also be of help to the bulls as shown in Figure 5.

So far, the rendition of the average Pre-election cycle by the US markets today has been quite in precision as shown by chartoftheday.com. Of course, we understand that past performance does not guarantee future outcomes, which is why we think markets can go either way.

Figure 6: Stockcharts.com: Phsix-US-Asia

In figure 6, the Philippine Phisix (main window) has shown a remarkable correlation with the US S &P 500 (chart below main window) anew, where both indices peaked out almost synchronically (see vertical blue line).

The basic difference is that of the degree of the reaction. Last August, the S & P 500 fell by about 10% from its peak (based on closing prices) and the Phisix reacted with extraordinary haste and intensity, the latter crashed by some 24% to 2,884 (see blue circles).

Today, the S & P is about 8% down from the October acme whereas the Phisix is stunningly down by about the same proportion as the US benchmark!

And to consider, market internals tell us that foreigners have been in a heavy retreat for 5 successive weeks (by about Php 11 billion!), which means the market has been bolstered and cushioned by the local investors! Foreign money accounted for a net selling of Php 3 billion this week. This significant support from domestic investors is a fresh development in this advance cycle which began in 2003, and became evident only during this July’s selloffs. We are inclined to believe that the Peso’s strength has a hand in this.

In addition, one could notice that Asian markets have belatedly responded to the US decline, as shown by the arrows in the Dow Jones Asia ex-Japan Index (middle pane) and the Fidelity Southeast Asia Fund (lowest pane), which suggests that previous tight correlations have now eased or relaxed.

So while it is true that US markets have still material influence to Asian markets we are witnessing some loosening correlations which if the pattern sustains, eventually should lead to a decoupling.

Sunday, November 11, 2007

What Media Didn’t Tell About the Peso

``If a man tries to question the doctrines of etatism or nationalism, hardly anyone ventures to weigh his arguments. The heretic is ridiculed, called names, ignored. It has come to be regarded as insolent or outrageous to criticize the views of powerful pressure groups or political parties, or to doubt the beneficial effects of state omnipotence. Public opinion has espoused a set of dogmas which there is less and less freedom to attack. In the name of progress and freedom both progress and freedom are being outlawed.”-Garet Garrett (1878-1954), American Journalist

Meanwhile, we are pleased to say that the first segment “Gold, US Dollar and Oil: Markets Simply REFLECT On Collective Policies Imposed!” has been featured at Canadian website Safehaven.com. http://safehaven.com/article-8759.htm

Oddball comment of the week, this from Bloomberg (emphasis mine),

``Mexico's central bank Governor Guillermo Ortiz said policy makers can do little to stem rising food prices, and future interest-rate decisions will focus on stopping the spread of inflation to wages and other costs.

``Increases in the price of wheat, milk and other food items pushed Mexico's inflation rate above the bank's 2 percent to 4 percent target band in eight of the past 12 months. The five- member board led by Ortiz unexpectedly raised the benchmark interest rate on Oct. 26 to 7.5 percent from 7.25 percent, the second increase this year.

``There's little central banks around the world can do to prevent food prices from rising,'' Ortiz, 59, said in an interview in Miami today. ``But we can react to avoid second- order effects.''

Since inflation is a product of government policies, then such statement is a practical admission of arrant incompetence. What good is it for central banks to exist when they can’t control the effects of their own policies?

What Media Didn’t Tell About the Peso

In an open forum of a recently hosted “market outlook” by an international bank, the company’s treasurer was asked by a client if the it was advisable to still hold the US dollar.

To our surprise the officer says that because the Philippines have been embroiled in too much politics, particularly tainted by “corruption”, the Peso’s strength was unlikely to last. Duh! This was the same line of reasoning we were confronted with when we audaciously took on the contrarian stand to forecast the Peso to strengthen at the end of 2004, (see November 29 to December 3, 2004 The Philippine Peso’s Epiphany?).

Yet the said official admitted that contrary to their head office which saw the Peso’s rising trend to continue, the advice had been a ‘personal opinion’.

The same perspective can be gleaned from the headlines. When the Peso goes to a milestone record we read economic “experts” instinctively denounce the Peso’s rise as “baneful” to the economy given the adverse implications to the “competitiveness” of our exports and the ramifications to the OFW’s “buying power”.

Nonetheless, the common denominators attributed to the Peso’s rise are the same grounds used for such criticisms and its implied course of action; primarily remittances and trade-economic linkages.

The Endogenous View and the Framing Effect

As a contrarian analyst we try to follow the principles of French liberal economist Frédéric Bastiat’s who wrote about the Parable of the Broken Window in the 1850 essay Ce qu'on voit et ce qu'on ne voit pas (That Which Is Seen and That Which Is Unseen). The precept, of which, centers on the hidden costs of every decisions or the law of unintended consequences (usually seen through the prisms of government interventions). For example, applied to our field, while contrarians tend to serendipitously make occasional major accurate forecasts, the hidden cost or side effect of going against the crowd or of espousing a radically unpopular theme have been ostracization.

Applied to the Peso, domestic experts tell us that exchange rates are determined by demand and supply. True enough. But when we are contented to look at remittances, trade balances or foreign direct investments, we are then vetting from THE INSIDE LOOKING OUT or these variables are seen only as a FUNCTION of the Philippine Economy. That is not the complete picture.

And quite importantly, when we become totally entranced with politics to the point of logical paralysis like a deer who freezes in front of the headlights, such is called obsession or fanaticism and not analysis.

Again while exchange rates are indeed a function of demand and supply, these views purposely limits the public’s perception to the dimension of the Philippine Peso relative to the US dollar ALONE. Since currency markets reflect a ZERO sum game, where one wins at the expense of the other then it is easy to build a case against the rising Peso.

In other words, such arguments facilely plays into the variant of an economic concept known as the Dutch Disease, (wikepidia.org), ``The theory is that an increase in revenues from natural resources will deindustrialise a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive”. In our case, it is not natural resource exports yet, but of HUMAN exports.

Unfortunately this form of presentation is called the Framing Effect or (wikepidia.org) ``the packaging of an element of rhetoric in such a way as to encourage certain interpretations and to discourage others.” (highlight mine).

Objective analysis attempts to look from a balanced angle against biased analysis whose views are directed by a certain desired outcome. In the markets, losses are usually suffered by those who are consumed by their biases. It certainly seems applicable to everything we do. Since extreme biases “tunnels” our vision to the point of absolute rigidity, we become less open and flexible and squarely insist on our perceived outcomes. We simply cannot move forward if we are drowned by false expectations.

Myths versus Observable Reality

Well in contrast to such views our thoughts is that the currency markets operate from three divergent angles; namely endogenous, exogenous and market expectations (speculative capital). Hence the domestic frame we presented above could be called as endogenous or internal view.

Initially to give us a broader perspective let us examine the historical performance of Philippine Peso from two horizons, a long term 62 year time frame and a medium term 7 year period, as shown in Figure 1.

Figure 1: Philippine Peso’s Long Term or 62 year (left) and Medium Term or 7 year Historical Performance (right)

Since 1945, the Peso (left chart) has experienced about 60 years of continued depreciation relative to the US dollar with only marginal stability attained during the early 1990s or when the Philippines and the PSE’s Phisix was buoyed by a REGIONAL boom. Most of the recent decline came in the wake of the Asian Crisis.

It is important to emphasize that the Philippines has NOT moved beyond what its neighbors have been, which means luck played a substantial role when we advanced (shown below), instead of policy choices.

In short, like today, the Philippine financial markets and its economy has been captive to external forces rather than internal driven factors, subjecting us to external risks more than the internally generated one in contrast to what the others say.

Under such premise it pays to understand how the Philippines have been latched to the global economy, its shifting role relative to regional and world dynamics and the underlying drivers that could hold sway to the direction of both its financial markets and economic path.

As you can further see in the long term chart, it is only during the present period where the Philippine Peso has made a meaningful advance, particularly during the inflection point in 2005.

One should note that in 2005, the Peso attempted to advance in January but was spurned by “politics”, remember the “Hello Garci” scandal? Yet by September, the markets have simply discounted the political window and went on to adjust materially (see left chart of Figure 1). Since then, all of the significant blips of the Peso had been due to external factors. Not even the recent Glorietta blast was enough to turn the Peso around.

Before we proceed, it is an important reminder that the charts of Figure 1 or the historical trend of the Philippine Peso would serve as an ANCHOR for comparison to the subsequent charts in our discussion.

Figure 2: IMF: Remittance Flows (left), Yardeni.com: Philippine Trade Balance (right)

Mainstream media and their attendant experts always impress upon us that the strength of the Peso has been primarily due to remittances, which has now comprises about 10% of the GDP.

While we do not deny the fact that remittances has immensely added to our foreign exchange reserves and has been an important contributor to our economy, as a market observer we find the correlation or the causation of the remittance driven Peso argument as quite doubtful.

The left pane of figure 2 from the IMF (2007 country report) shows of the remittance trends of the Philippines since 1995. What can be observed are as follows:

One, remittance trends has been on a 10 year uptrend and steadily growing since and

Second, the rate of remittances has accelerated since 2002.

Now revert to figure 1 or the peso’s 7 year chart (left); notice that since 2002 the Peso continued to decline in spite of the acceleration of remittances. Again the Peso made its successful turnaround only in September of 2005 a full three years after the quickening of the upside pace. Yet, the most notable part is that in all the years prior to or before 2005, even as remittances rose, the Peso continued to fall!

So the attribution of a causality relationship with its present action or otherwise stated as the rise of the Peso as due to the gains in remittances has NOT been DIRECT. The easy way to say this is that the rise of the Peso cannot be adequately explained by the remittance trends, or simply put, PRESENT correlation does not imply causation! It is a puzzle how so called experts appears to chime in on a supposed “cause and effect” when such has not been supported by price actions.

Of course there will always be some justifications for such incongruence or a simplified explanation for such outcomes such as a “lagged effect” or the Peso could have reacted only after it reached a certain unidentified level called as the “critical mass” level which ultimately served as a tipping point.

We do not argue against these premises (here we are preempting on possible responses), but our question remains which do we follow, a 10 year or 3 year lag? Or what then has been the pivotal measure for the “critical mass” of remittances, 8-10% GDP perhaps?

Then there is the argument that the state of the Peso could also reflect our trading patterns, which appears to be even more defective. Figure 2 courtesy of Yardeni.com tell us that the Philippines have been trading on a deficit (as of August)!

Figure 3: Deutsche Bank: FDI Flows (left), IMF: Net Portfolio flows ex-US dollar assets

On the other hand, others contend that Foreign Direct Investments may have spearheaded the Peso’s rise. Figure 3 from Deutsche Bank shows that FDI compared to our neighbors have severely lagged or has not shown any vital improvements as to equally reflect on the Peso!

Next, media tells us that stock market flows have been one of its factors behind it. While this could have been true in the past, data from the Phisix should tell us of the validity of such claims.

Since the week that ended September 7, the Peso has gained by about 8% or more than half of its year to date gains of about 14%.

The reason we chose the two months of time line is to smooth out away from the talks of the latest developments in the corporate world such as San Miguel’s recent divestment of Australian Dairy National foods and Australian Premier Brewer J Boag & Son (which for us is a questionable strategy in the bottomline enhancement issue; instead the company plans to emigrate to a divergent platform of unrelated interests such as mines, energy-which deserves another article) and the privatization of PNOC-Energy Development Corp, which is said to affect further the Peso’s firming trend.

Not that we disagree with these; we do subscribe to the grounds that these “corporate events” could further support gains of the Peso. But our point is, beyond all these chatters, the fact is since September 7th the Phisix has accrued some Php 7.0356 billion of net foreign selling in contrast to what has been reported. This foreign selling occurred in 7 out of the 10 weeks, which suggests that this has not been a one-off event. Therefore, we have not seen inflows material enough to extrapolate that the Peso rose because of stock market activities.

Of course, alternatively, we do not know if the past selling activities by foreign money actually translated into outflows since the proceeds could have been used to either acquire other Peso denominated assets or remain liquid or deposited in some banks or financial institutions.

The point of all of these is to demonstrate what is reported in media which is supported by the mainstream “experts”, has less to do with the function of the Peso’s present conditions than commonly believed. In short, the Peso as a function of the Philippine economy, the ENDOGENOUS VIEW, is only one factor but has not been accurately the ENTIRE picture.

The Exogenous Perspective

Here are some empirical based analysis alluding to the themes which supports our second thesis of what drives the Peso; the EXOGENOUS perspective.

From the prolific Stephen Jen of Morgan Stanley (highlight mine), ``Exchange rates are no longer driven by trade or concerns about trade imbalances. We don’t remember the last time someone told us that they were selling the USD because of its C/A deficit. Rather, more than ever, exchange rates are driven by cross-border flows, e.g., diversification flows by central banks in Asia and the Middle East, and structural portfolio adjustments in the private sector, as ‘home bias’ declines worldwide. These flows are very powerful, and have little to do with where USD/CNY is.”

From another article “Global Official Reserves Just Breached US$6.0 Trillion” by the same author Stephen Jen (highlight mine), ``…while the depreciation of the dollar has led to some valuation gains of EUR, GBP and other currencies, in dollar terms, most of the increases in the official reserves reflected actual interventions. Thus, the dollar has indeed weakened this year, but the size of the interventions conducted by the emerging market central banks is rather extraordinary.

From RGE Monitor’s astute Brad Setser, ``That story – when augmented with a story about rising oil savings and the investment of the oil surplus in (offshore) dollar assets – describes the world from 2001 to 2005 rather well. The US deficit rose from $385b to $755b (an increase of $370b). That increase offset a $127b increase in developing Asia’s surplus and a $263b increase in the surplus of the oil exporters.

``But as the dollar-RMB depreciated against Europe and oil-exporters started buying more European assets, the system evolved. China started to run large bilateral surpluses with Europe. And if 1/3 of the $1.2 trillion increase in official assets is invested in Europe, Europe is now receiving a $400b capital inflow from emerging market central banks and oil funds. That inflow seems to have induced a swing in Europe’s current account balance – This swing doesn’t show up in the data for the Eurozone as clearly as it shows up in the data for the European Union as a whole. That makes sense. Eurozone banks take the inflow from Asia and the oil states and lend it to Eastern Europe. But the overall result is clear: the IMF now forecasts that the rise in the emerging world’s surplus will be offset by a rise in Europe’s deficit.”

Notice some key words: “trade/current account imbalances”, “driven by cross-border flows”, “diversification flows by central banks”, “interventions of emerging markets” and “oil savings and the investment of the oil surplus”, where none of these delve with the issues of domestic currencies relative to its respective domestic economy but rather in the context of the currency’s relationship seen in the spectrum of global trade, savings, investments and/or finance flows.

Succinctly put, the Philippine Peso can be seen as a function of the global dynamics, particularly of the present Fiat Paper money standard.

Figure 4: RB of Australia/IMF: Regional Movement

To illustrate, since we have introduced the macro perspective in currency market dynamics, the left chart in Figure 4 shows to us how ASEAN countries have performed since 1985, courtesy of Glenn Stevens Governor of the Reserve Bank of Australia in his July 18th speech.

Since 1997, ASEAN countries have moved almost uniformly in terms of the general trend, i.e. from crash to recovery, albeit, the distinguishing factor comes with the degree of relative price actions.

In the right side of the same chart, courtesy of IMF, shows of how Asian Currencies have generally appreciated in 2006. In pecking order, the Philippines ranked fifth following Thailand, South Korea, Indonesia and Singapore.

Again our point is, evidences point toward the Philippines’ predisposition to move along with the region, concomitantly or belatedly.

Figure 5: Yardeni.com: Philippine Foreign Exchange Reserves (left), Joey Salceda/PSE Economic Stock Briefing-Feb 21, 2005 right

The right frame of Figure 5, from a PSE presentation of Presidential Chief of Staff Joey Salceda shows how the Peso severely lagged the region in early 2005, hence its present outperformance could viewed from a perspective of a “catch-up mode”.

Nonetheless, the left frame of figure 5, again from yardeni.com manifests of the explosion of Philippine forex exchange reserves at the end of 2004. This forex trend appears to show of more correlation to the Peso than that of the others, but then again such correlation seems to have incepted only in 2005.

Like us, the IMF believes that portfolio flows have been a key variable in determining the Peso’s increase here is what they wrote (emphasis ours), ``There was also a pronounced acceleration in net portfolio inflows once global risk appetite resumed in Q3 following the sell-off in May-June, with net portfolio inflows from July through November of $1.3 billion, five times the level in the same period in 2005 (Chart 8) [figure 3-ours]. Against this backdrop, the peso appreciated by 7½ percent against the U.S. dollar during 2006, even as the Bangko Sentral ng Pilipinas (BSP) continued to build reserves, while using off-balance sheet currency swaps with local banks to reduce the impact on reserve money. The authorities also used the greater availability of foreign exchange to repay external debt, and to reduce their reliance on external borrowing."

So the IMF tells us that global dynamics have had a hand in influencing portfolio inflows which has coincided with the strength of the Peso.

Hence from an exogenous point of view, one has to factor in demand and supply relative to global monetary and fiscal policies (e.g. which countries are printing more money, forex reserves allocation and trends of sovereign wealth/pension funds), global trading patterns (e.g. growing regionalization trends), macro savings and investment dynamics (e.g. oil surpluses recycled into domestic real estate investments, Japan housewives “Mrs. Watanabes” into carry trades, and demographic trends), global financing and market trends (e.g. US-Asian/Petro Economies-Vendor Financing scheme or the “Bretton Woods 2”, McKinsey’s New Power Brokers-Petro dollars, Asian dollars, Hedge funds and Private equity), evolution of the financial markets (e.g. integration and consolidation of markets, innovative securitized or structured finance products), cross border capital flows, geopolitics and economic linkages.

In our point of view, the premier variable in today’s Peso is the state of the US dollar as a consequent to these agglomerated variables. The alternative aspect is that the Philippine Peso has not been rising but rather the US dollar has fallen against almost all currencies, given the US dollar’s de facto reserve currency status in today’s Paper Money system. Given the change of perspective the issues hinged from the domestic angle changes.

Market Expectations or Speculative Capital

Non market practitioner-experts usually view issues from the perspective of theories but usually base their analysis from select or preferred statistics. Some of such analysis most frequently discounts on the dynamism of market forces, where the nomenclature is that people act or behave like automatons; easy to diagnose, responds uniformly and actions easy to forecast. This resonates very rigid thinking.

In contrast, many market practitioners clearly understand that markets reflect on the psychological output from collective investors. As such, given that people are inherently emotionally driven, markets could occasionally mirror bouts of irrationality or undergo emotional vertigos at certain points of a trend.

Since the Peso, which is traded in the currency market, is rated by investors, speculators and other market participants who are responsible for setting a price for it, based on subjective opinions then they are equally subject to such volatilities and extremities.

Hence we will borrow from George Soros’ as our third view for the currency market, called the “Speculative Capital” or in our terminology the market’s expectations.

Speculative capital essential deals with returns expectations, where as George Soros wrote in his book the Alchemy of Finance (highlight ours), ``moves in search of the highest total return. Total Return has three elements: the interest rate differentials, the exchange rate differentials, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.”

The basic motive by any market participant is to seek the highest returns. And when a confirmatory trend is set, investors tend to pile in so as to reinforce the beliefs or convictions established by the nascent trend. Hence momentum sets in which allows for the trend to persist until a certain phase where the cycle turns or inflects.

Adds Mr. Soros (highlight ours), ``To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely. The situation is highly unstable: if the opposite bias prevailed, it could validate itself. The greater the relative importance of speculation, the more the unstable the system becomes: the total rate of return can flip-flop with every changes in the prevailing bias.”

So while “fundamental factors” such as Endogenous or Exogenous facets could be utilized to establish rational based valuations for investors in the currency market, cyclical factors based on price based expectations can thus lead investors to make fundamental justifications based on prevailing price actions, instead of the other way around.

Hence, under extreme ends experts are likely to be susceptible to justify or provide simplified explanations based on present prices even if the markets have been in essence prompted by unstable speculation. A view likely to be erroneous.

This is why in contrast to the “know-them-all experts” we can say through our experience that markets can in itself become inexplicable at certain times.

So as Mr. Soros implicitly warns, one must not always trust or depend on fundamental based views when markets could actually be swayed by sheer emotions, and thus lend to boom busts cycles.

We share such view.