Will “Divergences” Be A Theme for 2009?

``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity."-President John F. Kennedy

Doug Noland of the Prudent Bear’s Credit Bubble Bulletin rightly describes today’s market activities as a “divergence”.

Where most global economies seem to be phasing into an excruciating and punishing downside adjustment, there seems to be some signs of ``unequivocal signs of life” in select debt markets as important credit spreads have somewhat materially eased.

Although the surface may yet conceal the ``acute stress out there not visible to the naked eye,” our ‘biased’ conjecture leads us to interpret that these could be possible incipient signs of our long awaited “divergent” responses to the “convergent” policy approaches because of the “divergent” structural frameworks of each of the national political economies. In short, our “spillage effect”.

True, while most of the major equity markets remain under significant pressure. These could have been prompted by the market’s ingestion of the onslaught of the negative news, yet even in this aspect we can also see some indications “divergences”.

Visible Acute Stress In US Banking System

Last week, the developments in the US banking sector unveiled the second chapter of the massive transformation of the US banking system. The erstwhile marquee banking behemoths in the name of Citibank and Bank of America, which have been enduring the US government’s surgical knife, will undergo another major operation.

Citibank [C], like a work of karma, which ‘danced’ to the tune of the “securitization” during the pop music days of the shadow banking system, will possibly end up being ‘securitized’ itself; sliced, diced and sold to investors or as this CNN Money report calls it: “divestiture”, e.g. Citibank’s brokerage unit the Smith Barney is reportedly in a deal to be merged with Morgan Stanley.

On the other hand, Bank of America [BoA] will need to enhance and facilitate its digestive juices to reluctantly swallow, under the behest of the US government, another former investment banking titan Merrill Lynch. This deal reportedly will be backstopped by a $20 billion capital infusion and a $118 billion guarantee on the outstanding liabilities from the US government (Bloomberg). And this comes already after previous injections of $15 billion to Bank of America and $10 billion to Merrill Lynch.

All these demonstrate how the government has been dealing with the conundrum of debt overhang as aptly described by this article from the New York Times, where ``any systemic solution has to deal with the bad assets, once and for all.”

And yet the problem of managing “bad assets” is fundamentally one of valuations and asset identification from which the US government won’t allow markets to determine. This signifies as the ultimate paradox; the US government has been earnestly trying to discover an acceptable substitute for market based pricing to no avail-without having to overpay for these ‘toxic’ financial instruments (these might not qualify for as an ‘asset’ since they can be priced at zero or have negative value) at the expense of their taxpayers and the perpetuation of the perils of the moral hazard.

Meanwhile, banks have been refusing to sell these instruments because of the consternation of recognizing added losses which would further impair their already ruptured balance sheets, and most importantly, in the hope that the US government will ultimately rescue them from their miseries.

Yet expectations and government responses have been “divergent”, decrying the BoA deal the Wall Street Journal editorial wrote, ``…the feds believe that the way to calm financial markets is to force the nation's largest, and a heretofore healthy, bank to swallow toxic assets it didn't want.”

At the end of day, the US government’s effort to subdue markets forces will mean a critical choice between saving the taxpayers or the banking system, where the endgame could be the outright nationalization of its banking system or yielding to debt deflation.

And the dominant view has been fittingly enunciated by the same New York Times article, ``That is why you would need to throw more capital into the banks as part of a systemic solution…In past financial crises, it has often been the bold and brilliant stroke that has restored confidence and revived the financial system. During the German hyperinflation of the 1920s, the government actually created a new currency. During the Latin American crisis of the late 1980s, the United States government created so-called Brady bonds, which cleverly allowed banks to get their Latin American debt off their balance sheets by turning it into tradable instruments. And here we are again, in need of bold action and strategic thinking and the restoration of confidence.” (bold highlight mine)

Therefore ‘bold and brilliant strategic thinking’ extrapolates to the creation of more of the same actions that brought us here in the first place. To paraphrase the famous US Senator Everett Dickson quote, ``A trillion here, a trillion there, and pretty soon you're talking about real money.” And the painful reality is that real money is being diluted with the wave of paper money issuance.

As we have repeatedly been saying political choices will ultimately shape the rapidly evolving markets, the economic environment and geopolitical landscape.

Divergences in Asia, Select Credit Markets?

In the context of the discussion about divergences, Asian debt offering last week has been tremendously received by the debt markets following the pace setting actions of the Philippines (see last week’s Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?).

According to Bloomberg (bold emphasis mine), ``Bond markets in the Asia-Pacific region are having their busiest January for at least a decade, with $32.3 billion in sales, as government guarantees and stimulus plans help boost investor appetite.

``New issues almost tripled compared with the first two weeks of last year, and more than doubled the $12.4 billion of January 2007, data compiled by Bloomberg show…

``All the bonds sold in Australia this year have sovereign backing, and all the bonds sold in Asia without government guarantees were denominated in local currencies, Bloomberg data show. Sales in Asian currencies including the Chinese yuan and Malaysian ringgit rose 41 percent this month to $4.6 billion compared to the same period a year earlier.”

Such overwhelming response to G3 denominated Asian debt issuance could possibly be construed as “knee jerk” reactions to the previous liquidity squeeze amidst the frenzied mayhem which effectively closed the global debt markets last October.

Perhaps issuers sensing a positive aura have jumped into the bandwagon to immediately work on securing foreign currency financing requirements as insurance against the risks of potential recurrent bouts of volatility seen last semester of 2008 or from a possible drought of capital considering the prospective tsunami of issuers from a world obsessed with government sponsored guarantees and stimulus.

In addition, the successes of the early movers appear to have triggered renewed appetite or unlocked anxious capital to possibly capitalize on the revitalized vigor in Asian credit markets.

Next, perhaps too, there could have been more demand for less credit risk prone Asian securities.

And lastly, possibly interest rate policies could be seen as starting to get some traction within the region.

Remember, Asia’s only link to the present crisis has been the trade and capital factor, and not balance sheets problems similar to its contemporaries in the Anglo Saxon economies. And as we have long argued, under the Austrian school of economics, interest rates tend to have different impact to economies based on the capital structure.

We quoted Arthur Middleton Hughes in our past article (see Global Market Crash: Accelerating The Mises Moment!) as saying, ``What this tells us is that the market rate of interest means different things to different segments of the structure of production.”

Figure 1: Danske Bank: Asia’s Bleak Exports and Industrial Production

It’s all gloom and doom out there. Such sentiment has been exacerbated by the preaching of the high priests of doomsday and by the negative economic data. For example, dramatic fall in China’s exports, which fell at the “fastest rate in a decade”-AFP (see figure 1 right window), have been compounded by the collapse of Industrial production seen in major Asian economies (left window). Nonetheless, all of these have eclipsed a scintilla of positive developments as evidenced by a surprising jump in China’s bank lending-WSJ (see figure 2) and an unexpected surge in China’s money supply-Forbes.

Figure 2: US Global Investors: Jump In China’s Bank Lending

According to US Global Investor’s: ``A significant rebound in money supply growth and bank lending in China during December suggests that the government’s stimulating policies may have achieved some success. However, challenges for the economy are likely to be sustained in the foreseeable future.”

We agree. And it is not just in the economic data but likewise seen from the relative strength of the equity benchmarks where from the start of the year, China’s Shanghai Index and the Philippine Phisix appears to have outperformed the region and the S&P 500 as shown in figure 3.

Figure 3: stockcharts.com: Divergences of Shanghai, Phisix vis-à-vis Asia and S & P

Since the advent of 2009, the Phisix (pane below center) is still up 4.13% alongside with the Shanghai’s Index up 7.3% (main window) while contemporary bellwethers of Asia and the US S&P 500 are all in the red.

Of course, two weeks of exemplary equity activities may not a trend make or it is simply too premature to tell. Or possibly too, China’s bank lending revival or resurgent money supply growth could merely be an anomaly. Yet these conflicting developments should make 2009 interesting as the unprecedented scale of government actions, which reflects on the grand struggle between government instituted policies and recessionary forces, will likely produce some unforeseen ‘black swan’ reactions.

And speaking of Black Swan, could the widely discredited “decoupling” a euphemism for “divergences” be the name of the game for 2009?

It has been our belief that Asia will probably recover earlier and outgrow the Western world over the coming years. This should possibly become evident once the global nexus of the forcible selling of the debt deflation process decelerates and as domestic economies adjust to the realisms of a “demand” slowdown in the West.

Many institutional analysts have been asserting that the world’s recovery will depend on the US, based on the Keynesian premise that the US comprises as the world’s only aggregate demand. We doubt so. In contrast, we believe that Anglo Saxon economies will be sternly hobbled by the gross inefficiencies brought by the stifling government interventions.

The onus of recompense on the burdensome costs of these interventions, the “crowding out” effect of government interventions on the private sector, and the reduced purchasing power from the torrent of stealth taxation policies combined could severely undermine the economic growth output potentials of the Anglo Saxon economies led by the US.

And unlike the mainstream view fixated with the aggregate demand dynamics, we believe that “supply” side adjustments (we are dissenters of the excess capacity argument) and “politically” motivated government policies will likewise militate on the highly fluid environment.

And as discussed in Phisix and Asia: Watch The Fires Burning Across The River?, we think that this crisis should serve as Asia’s window of opportunity to amass economic, financial and geopolitical clout amidst its staggering competitors. But this will probably come gradually and develop overtime and possibly be manifested initially in the activities of the marketplace.

And this spillage effect doesn’t seem contained to Asia alone, some emerging signs could be seen in the Euro zone, see Figure 4.

Figure 4: WSJ: ECB Rate Packs A Punch

The interest rate guided policies from the European Central Bank could have begun to influence bank lending rates to consumers.

According to the Wall Street Journal blog reports (bold highlight mine) ``But new data on the interest rates euro-zone banks charged households and firms in November suggest lower ECB rates did, in fact, make a difference. On Oct. 8, the ECB delivered its first rate cut of the crisis, taking its key rate to 3.75% from 4.25%. In November, they followed up with another half percentage-point cut to 3.25%. Today, the ECB noted in a statement that “almost all” average rates in November for the real-economy loans the central bank tracks “were lower than in the preceding month… Businesses also got some relief, with rates on new loans to non-bank firms falling to 5.53% in November from 5.86% in October. One month’s data, clearly, doesn’t confirm a trend.”

Again “divergences” could both signal a trend anomaly or an emerging inflection point, the path of which is unclear for the moment.

Thus from where we stand we have observed that despite the grim bleak outlook, some signs of “divergences” in Asia’s bond market, in select Asian equity markets and in some global credit risk barometers could transition to be important themes for 2009.

It is a suspicion that needs further confirmation by trend reinforcement.

We’ll keep vigil.