Tuesday, March 31, 2009

Some Unintended Consequences from Environmental Politics

Environmentalism today has morphed into a fad (yes...a frothy bubble) such that rampant imposition of regulations have led to undesired consequences.

And here we find some examples of the harmful side effects.

1. A ban on lead toys have halted sales of bikes and threatens a change in behavior of children...

From USA Today (all bold highlights mine) , ``A new federal law aimed at protecting children from lead in toys has also forced a nationwide halt in sales of off-road motorcycles and recreational vehicles built for young riders, killing off a multimillion-dollar industry that was thriving despite the recession.

``Thousands of powersports dealers were told to halt sales of vehicles designed for children 12 and younger because of new lead restrictions in an act of Congress that took effect Feb. 10....

``With the motor vehicle industry already hurting from recession, he said the ban means a 20% drop in sales of youth off-road motorcycles and the parts business for bikes already sold...

``The ban will have repercussions economically.

``The Motorcycle Industry Council estimates nearly 100,000 youth bikes were sold in the USA in 2008, though some were aimed at kids 13 and older and not covered by the ban. Dealernews, an industry trade publication, estimates that the value of inventory at U.S. dealers that can no longer be sold probably exceeds $100 million...

``Most cycles and ATVs are made overseas, but there are tens of thousands of jobs attached to the industry here. More than 13,000 powersports dealers sell products in the United States, according to the Motorcycle Industry Council, employing an estimated 124,000 people. Vitrano says the industry estimates the retail market value for all off-road cycles and ATVs is $14.5 billion a year, including sales, service, parts, accessories and payroll.

``Vitrano says the ban will have a perverse effect: Rather than no longer riding, kids who can't get a cycle their size may hop on a bike made for older children or adults — one inappropriate and dangerous for a smaller child...

``The economy notwithstanding, enthusiasts say the ban needlessly kills a family-oriented sport where children ride with their moms and dads and, like other sports, can induce children to behave."

2. Biking Scheme Ruined By Theft

From BBC (bold highlights mine), ``A popular bicycle rental scheme in Paris that has transformed travel in the city has run into problems just 18 months after its successful launch.

``Over half the original fleet of 15,000 specially made bicycles have disappeared, presumed stolen.

``They have been used 42 million times since their introduction but vandalism and theft are taking their toll.

``The company which runs the scheme, JCDecaux, says it can no longer afford to operate the city-wide network.

``Championed by Paris Mayor Bertrand Delanoe, the bikes were part of an attempt to "green" the capital...

``City hall has recently agreed to pay towards the costs of replacing the stolen or trashed bicycles but is refusing to bail out the company.

3. Manipulating environments have led to baneful environmental imbalances...

From New Scientist (bold emphasis mine) , ``Good intentions have rarely gone so awry. When conservationists tried to save an island's birds by culling its feral cat population, they overlooked one critical consequence: rabbits. A new study reveals that removing just 160 feral cats triggered a boom in Macquarie Island's rabbit population from about 4000 in the year 2000 to 130,000 in 2006.

``The cats were shot as they had been preying on the island's burrowing birds. But the newly rampant rabbits have devastated vegetation over 40% of the island. Clearing up the mess is expected to cost at least $16 million, and it remains unclear whether the island will ever fully recover.A landslip in 2006 that badly damaged a penguin colony has been blamed on rabbit destruction of the vegetation.

``A World Heritage Site halfway between Australia and the Antarctic, the Macquarie Island case is a tragic demonstration of why agencies in charge of conservation need to analyse all aspects of an eradication programme. "We need a culture change," says Hugh Possingham of the University of Queensland in Brisbane, Australia. "It's a generalisation, but people who do environmental work are often adverse to mathematics, and so avoid quantitative risk assessments."

My additional comment: the late author Michael Crichton has a great exposition on why attempts to manipulate environment almost always ends up opposite to the desired goal/s; see our previous post Michael Crichton And The Complexity Theory.

4. Green Policies have recently instigated a man made disaster -Australia's bushfire which claimed 173 lives ...

From theage.com.au (bold underscore mine), ``ANGRY residents last night accused local authorities of contributing to the bushfire toll by failing to let residents chop down trees and clear up bushland that posed a fire risk.

``During question time at a packed community meeting in Arthurs Creek on Melbourne's northern fringe, Warwick Spooner — whose mother Marilyn and brother Damien perished along with their home in the Strathewen blaze — criticised the Nillumbik council for the limitations it placed on residents wanting the council's help or permission to clean up around their properties in preparation for the bushfire season. "We've lost two people in my family because you dickheads won't cut trees down," he said.

``"We wanted trees cut down on the side of the road … and you can't even cut the grass for God's sake."...

``Another resident said she had asked the council four times to tend to out-of-control growth on public land near her home, but her pleas had been ignored...

``Of all the speakers who addressed the meeting, it was Arthurs Creek CFA Captain David McGahy who got the most rousing reception.

``Choking back tears he told them: "I'm so terribly sorry. We desperately wanted to protect you but we couldn't. [my comment-too late the hero... officials have always been reactive]

``"In the cold analysis of light, it wouldn't have mattered if we'd have had 200 units here, all that would have happened is we would have ended up with a whole lot of dead firefighters. I've been at this game for about 40 years and I haven't experienced anything like that, not even remotely like it."

Ben O'Neill lays the blame squarely on socialism as to why such a devastating mishap occurred (all bold highlight mine),

``Because private ownership entails the right to control one's own property, and because some people may not wish to sacrifice their lives to prevent interference with local possums, environmentalists seek to achieve their goals through government ownership of landland socialism. In this endeavor, they have been very successful. State forests, national parks, and other Crown land in Victoria make up approximately one third of the state but contributed four-fifths of the February 2009 bushfires. And as with all examples of land socialism, the situation in Victoria has created an incentive structure that has destroyed accountability, thereby exacerbating the disaster.

``As mere caretakers of public land, bureaucrats and local politicians are not liable for any loss caused by their mismanagement. Nor do they have any personal stake in its capital value. When property is destroyed due to their ineptitude and their enslavement to the philosophy of environmentalism, their savings are not in danger. If anyone is required to pay for compensation, it is taxpayers who have had nothing to do with the whole mess. For the local councilor or the state or federal politician, what matters is getting the green vote, showing how "environmentally conscious" they are, and placating all those green lobby groups and media darlings that might say nasty things about them if they don't toe the line."

My comment: Politicians secure the power to engage in environmental socialism but hasn't be held responsible for the acts of neglect or omissions or damages accrued to the society. The irony is it is the taxpayer who suffers...as the victim (of the consequences of these perverse laws) and likewise bears the onus of indemnification of the victims.

The last word comes from Lew Rockwell who diagnosed the California bushfire in 2003 (as quoted by Ben O'Neill),

``What went wrong? The problem is in the theory of environmentalism. Under it, ownership is the enemy. Nature is an end in itself. So it must be owned publicly, that is, by the state. The state, in its management of this land, must not do anything to it. There must not be controlled burning, brush clearing, clear cutting, or even tourism. We can admire it from afar, but the work of human hands must never intervene.

``Then the brush begins to gather. It piles higher and higher. Old growth rots. Uncontrolled growing leads to crowding. When the weather gets hot the stuff combusts. Then the winds blow and the fires spread. It's been the same story for several decades now, ever since the loony theory that nature should be left alone took hold."

Lesson: the laws of nature eventually overwhelm human intervention.

Monday, March 30, 2009

Cartoon of the Day: Sons of Frankenstein

A recent headline from the Wall Street Journal says "China Takes Aim at Dollar".

Maybe this is the reason why....

Good humorous stuff from about.com

Expect A Different Inflationary Environment

``For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” -Henry Hazlitt, What You Should Know About Inflation p.135

Ever since the US Federal Reserve announced that it would embark on buying $300 billion of long term US treasury bonds and ante up on its acquisitions of mortgage-based securities by $750 billion, this has generated an electrifying response in the global financial markets.

First, it hastened the decline in the US dollar index, see figure 1.

Figure 1: stockcharts.com: Transmission Impact of the US Fed’s QE via the US dollar

Next, it goosed up both the commodity markets (as represented by the CRB-Reuters benchmark lowest pane) and key global equity markets, as seen in the Dow Jones World index (topmost pane) and the Dow Jones Asia ex-Japan (pane below main window). The seemingly congruous movements seem to be in response to US dollar’s activities.

At the end of the week as the US dollar rallied vigorously, where the same assets reacted in the opposite direction. So it is our supposition that correlation here implies causation: a falling US dollar simply means more surplus dollars in the global financial system relative to its major trading partners.

In other words, since the efficiency of the global financial markets have greatly been impeded by collaborative intensive worldwide government interventions, the main vent of the officially instituted policy measures have been through the currency markets.

And since the US dollar is the world’s de facto currency reserve, the actions of the US dollar are thereby being transmitted into global financial assets. As former US Treasury secretary John B. Connolly memorably remarked in 1971, ``The US dollar is our currency, but your problem!”

Bernanke’s Inflation Guidebook

And as we have long predicted, the US Federal Reserve will be using up its policy arsenal tools to the hilt. And if there is anything likeable from Mr. Bernanke is that his prospective policy directives have been explicitly defined in his November 21 2002 speech Deflation: Making Sure It Doesn’t Happen Here which has served as a potent guidebook for any Central Bank watcher.

For instance, the latest move to prop up the long end of the Treasury market was revealed in 2001 where Bernanke noted that ``a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities”, and the shoring up of the mortgage market as ``might next consider attempting to influence directly the yields on privately issued securities”.

Nevertheless even as Mr. Bernanke once said that ``I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar”, he believes in the ultimate antidote against the threat of deflation could be through the transmission effects of the US dollar’s devaluation, ``it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation” where he has showcased the great depression as an example; he said,`` If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Of course, this isn’t merely going to be a central bank operation but one combined with coordinated efforts with the executive department or through the US Treasury, again Mr. Bernanke, ``effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities”.

Although Mr. Bernanke’s main prescription has been a tax cut, he combines this with government spending via purchases of assets, he recommended `` the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

And the recent fiscal stimulus, guarantees and other bailout programs which have amassed to some nearly $9.9 trillion [see $9.9 Trillion and Counting, Accelerating the Mises Moment] of US taxpayers exposure plus the recent $1 trillion Private Investment Program or PPIP have all accrued in accordance to Mr. Bernanke’s design.

In all, Mr. Bernanke hasn’t been doing differently from Zimbabwe’s Dr. Gideon Gono except that the US Federal Reserve can deliver the same results via different vehicles.

Inflation is what policymakers have been aspiring for and outsized inflation is what we’re gonna get.

Stages of Inflation

There are many skeptics that remain steadfast to the global deflationary outlook based on either the continued worsening outlook of debt deleveraging in the major financial institutions and or from the premise of excessive supplies or surplus capacities in the economic system.

We agree with the debt deflation premise (but not the global deflationary environment) and pointed to the dim prospects of Geither’s PPIP program [see Why Geither's Toxic Asset Program Won't Float] precisely from the angle of deleveraging and economic recessionary pressures. However, this is exactly why central bankers will continue to massively inflate-to reduce the real value of these outstanding obligations. And this episode has been a colossal tug-of-war between government generated inflation and market based deflation.

It is further a curiosity how the academe world or mainstream analysis has been obsessing over the premise of the normalization of “borrowing and lending” in order to spur inflation. It just depicts how detached “classroom” or “ivory tower” based thinking is relative to the “real” functioning world.

We don’t really need to restore the private sector driven credit process to achieve inflation. As manifested in the recent hyperinflation case of Zimbabwe; all that is needed is for a government to simply endlessly print money and to spend it.

The sheer magnitude of money printing combined with market distortive administrative policies sent Zimbabwe’s inflation figures skyrocketing to vertiginous heights (89.7 SEXTILLION percent or a number backed with 21 zeroes!!!) as massive dislocations and shortages in the economy emerged out of such policy failures.

By the way, as we correctly predicted in Dr. Gideon Gono Yields! Zimbabwe Dump Domestic Currency, since the “Dollarization” or “rand-ization or pula-ization” of Zimbabwe’s economy, prices have begun to deflate (down 3% last January and February)! The BBC reported ``The Zimbabwean dollar has disappeared from the streets since it was dumped as official currency.” The evisceration of the Zimbabwean Dollar translates to equally a declension of power by the Mugabe regime which has resorted to a face saving “unity” government between the opposition represented by current Prime Minister Morgan Tsvangirai of the MDC and President Mugabe's Zanu-PF.

And going back to inflation basics, we might add that a dysfunctional deflation plagued private banking system wouldn’t serve as an effective deterrent to government/s staunchly fixated with conflagrating the inflation flames.

For instance, in the bedrock of the ongoing unwinding debt deleveraging distressed environment, the UK has “surprisingly” reported a resurgence of inflation last February brought about by a “rise” in food prices due to the “decline” in UK’s currency the British pound-which has dropped by some 26% against the US dollar during the past year (Bloomberg). While many astonished analysts deem this to be a “hiccup”, we believe that there will be more dumbfounding of the consensus as inflation figures come by. And we see the same “startling” rise in inflation figures reported in Canada and in South Africa.

What we are going to see isn’t “stag-deflation” but at the onset STAGFLATION, an environment which dominated against the conventional expectations during the 70s.

Why? Because this isn’t simply about demand and supply of goods and services as peddled by the orthodoxy, but about the demand and supply of money relative to the demand and supply of goods and services. Better defined by Professor John Hussman, ``Inflation basically measures the percentage change in the ratio of two “marginal utilities”: the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities.”

For instance mainstream analysts tell us that stock prices reflect on economic growth expectations and that during economic recessions, which normally impairs earnings growth, this automatically translates to falling stock prices.

We’ll argue that it depends--on the rate of inflation.

Figure 2: Nowandfutures.com: Weimar Germany: Surging Stock Prices on Massive Recession

This is basically the same argument we’ve made based on Zimbabwe’s experience, in the Weimar hyperinflation of 1921-1923, its massively devaluing currency, which accounted for as the currency’s loss of store of value sent people searching for an alternative safehaven regardless of the economic conditions.

People piled into stocks (right), whose index gained by 9,999,900%, even as unemployment rate soared to nearly 30%! It’s because the German government printed so much money that Germans lost fate in their currency “marks” and sought refuge in stocks. Although, stock market gains were mostly nominal and while the US dollar based was muted (green line).

In other words, money isn’t neutral or that the impact of monetary inflation ranges in many ways to a society, to quote Mr. Ludwig von Mises, ``there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways.”

For example, it doesn’t mean just because gold prices hasn’t continually been going up that the inflationary process are being subverted by deflation.

As Henry Hazlitt poignantly lay out the divergent effects of inflation in What You Should Know About Inflation (bold highlight mine) ``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

In short, inflation comes in stages.

Let us use the example from the recent boom-bust cycle…

Figure 3: yardeni.com: US Debt as % of GDP

When the US dot.com bust in 2000 prompted the US Federal Reserve to cut interest rates from 6% to 1%, the inflationary pressures had initially been soaked up by its household sector which amassed household debts filliped by a gigantic punt in real estate.

As the speculative momentum fueled by easy money policies accelerated, monetary inflation were ventilated through three ways:

1. An explosion of the moneyness of Wall Street’s credit instruments which directly financed the housing bubble.

Credit Bubble Bulletin’s Doug Noland has the specifics, ``As is so often the case, we can look directly to the Fed’s Z.1 “flow of funds” report for Credit Bubble clarification. Total (non-financial and financial) system Credit expanded $1.735 TN in 2000. As one would expect from aggressive monetary easing, total Credit growth accelerated to $2.016 TN in 2001, then to $2.385 TN in 2002, $2.786 TN in 2003, $3.126 TN in 2004, $3.553 TN in 2005, $4.025 TN in 2006 and finally to $4.395 TN during 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage Credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds didn’t rise above 2% until December of 2004. Mr. Greenspan refers to Fed “tightening” in 2004, but Credit and financial conditions remained incredibly loose until the 2007 eruption of the Credit crisis.” (bold highlight mine)

2. These deepened the current account deficits, which signified the US debt driven consumption boom.

Again the particulars from Mr. Noland, ``It is worth noting that our Current Account Deficit averaged about $120bn annually during the nineties. By 2003, it had surged more than four-fold to an unprecedented $523bn. Following the path of underlying Credit growth (and attendant home price inflation and consumption!), the Current Account Deficit inflated to $625bn in 2004, $729bn in 2005, $788bn in 2006, and $731bn in 2007.” (bold highlight mine)

3. The subsequent sharp fall in the US dollar reflected on both the transmission of the US inflationary process into the world and the globalization of the credit bubble.

Again Mr. Noland for the details, ``And examining the “Rest of World” (ROW) page from the Z.1 report, we see that ROW expanded U.S. financial asset holdings by $1.400 TN in 2004, $1.076 TN in 2005, $1.831 TN in 2006 and $1.686 TN in 2007. It is worth noting that ROW “net acquisition of financial assets” averaged $370bn during the nineties, or less than a quarter the level from the fateful years 2006 and 2007.

In short, the inflationary process diffused over a specific order of sequence, namely, US real estate, US financial debt markets, US stock markets, global stock markets and real estate, commodities and lastly consumer prices.

Past Reflation Scenarios Won’t Be Revived, A Possible Rush To Commodities

Going into today’s crisis, we can’t expect an exact reprise of the most recent past as the US real estate and the US financial debt markets are likely to be still encumbered by the deleveraging process see figure 4.

Figure 4: SIFMA: Non Agency Mortgage Securities and Asset Backed Securities

Some of the financial instruments such as the Non-Agency Mortgage Backed Securities (left) and Asset Backed Securities (right), which buttressed the real estate bubble have materially shriveled and is unlikely to be resuscitated even by the transfer of liabilities to the government.

Besides, the general economic debt levels remain significantly high relative to the economy’s potential for a payback, especially under the weight of today’s recessionary environment.

Which is to say that today’s inflationary setting will probably evolve to a more short circuited fashion relative to the past.

This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.

Take for example China. China’s economy has generally a low of leverage which allows it the privilege of taking on more debts.

Figure 5: US Global Investors: China Loans and Fixed Asset Investment Surge

And that’s what it has been doing today in the face of this crisis-China’s national stimulus and monetary easing programs is expected to incur deficits of about 3-7% of its GDP coupled by the QE measures instituted by the US has impelled a recent surge in China’s domestic bank loans and real fixed investments.

Qing Wang of Morgan Stanley thinks that the US monetary policy measures has lowered “the opportunity cost of domestic fixed-asset investment”, which means increasing the attractiveness of Chinese assets.

According to Mr. Wang, ``In practice, lower yields on US government bonds means lower returns on the PBoC’s assets. This should enable the PBoC to lower the cost of its liabilities by: a) lowering the coupon interest rates it pays on the PBoC bills, which is a major liability item on its balance sheet; b) lowering the ratio of required reserves (RRR) on which the PBoC needs to pay interest; or c) lowering the interest rates that the PBoC needs to pay on the deposits of banks’ required reserves and excess reserves, currently at 1.62% and 0.72%, respectively. These potential changes should then lower the opportunity cost of bank lending from the perspective of individual banks.” (bold highlights mine)

In other words, low interest rates in the US can serve as fulcrum to propel a boom in China’s bank lending programs.

This brings us to the next perspective, which assets will likely benefit from such inflationary activities.

Henry Hazlitt gives us again a possible answer ``In answer to those who point out that inflation is primarily caused by an increase in money and credit, it is contended that the increase in commodity prices often occurs before the increase in the money supply. This is true. This is what happened immediately after the outbreak of war in Korea. Strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits.” (bold highlight mine)

This suggests that expectations for more inflation are likely to trigger rising prices and growing shortages, which will likely be fed by more money printing, and eventually an increase in credit uptake in support these actions.

Some Proof?

China is on a bargain hunting binge for strategic resources, according to the Washington Post March 19th, ``Chinese companies have been on a shopping spree in the past month, snapping up tens of billions of dollars' worth of key assets in Iran, Brazil, Russia, Venezuela, Australia and France in a global fire sale set off by the financial crisis.

``The deals have allowed China to lock up supplies of oil, minerals, metals and other strategic natural resources it needs to continue to fuel its growth. The sheer scope of the agreements marks a shift in global finance, roiling energy markets and feeding worries about the future availability and prices of those commodities in other countries that compete for them, including the United States.”

China has also engaged in a record buying of copper, according to commodityonline.com March 14th, ``China has started to buy copper in a big way again. As part of the country’s strategy to make use of the recessionary trends in the global markets, China has hiked its copper buying during the past few months…

``According to recently released data, China’s copper import hit a record high of 329,300 tonnes in February, up 41.5 per cent from the 232,700 tonnes of January.”

Summary and Conclusion

Overall, these are some important points to ruminate on:

-It is clear that the thrust by the US government seems to be to reduce the real value of its outstanding liabilities by devaluing its currency. Since the US dollar is the world’s de facto currency reserve the path of the US government policy actions will be transmitted via its exchange rate value to the global financial markets and the world’s real economy. And this translates to greater volatility of the US dollar. Moreover, except for the ECB (yet), the QE efforts by most of the major central banks could translate to a race to the bottom in terms of devaluing paper money values.

-Collaborative global policy measures to inflate the world appear to be gaining traction in support of asset prices but at the expense of currency values.

-Global central bankers have been trying to revive inflationary expectations that are effectively “reflexive” in nature. By painting the perception of a ‘recovery’ through a rising tide of the asset markets, officials hope that this might induce a torrent of asset buying from a normalization of the credit process.

-The monumental efforts by global central banks to collectively turbocharge the global asset markets could eventually spillover to consumer prices and “surprise” mainstream analysts over their insistence to “tunnel” over the deflation angle. We expect higher consumer prices to come sooner than later especially if EM economies would be unable to fill the role of raising levels of systemic leveraging.

-Money isn’t neutral which means that the impact of inflation won’t be the same for financial assets and the real economy. Some assets or industries will benefit more than the others.

-We can’t expect the same “reflation” impact of the past episode to happen again as the ongoing tug-of-war between market-based debt deflation and government’s fixation to inflate the system has displaced the gains derived from the previous trends of globalization and the sophistication of financial markets. The US real estate markets will have surpluses to work off and the financial markets that financed the US real estate markets will remain broken for sometime and will take substantial number of years to recover.

-The impact of inflation will come in stages and perhaps accelerate in phases.

-The risk is that inflation could rear its ugly head in terms of greater than expected consumer prices earlier than what the consensus or policymakers expect. And if this is the case then it could pose as management dilemma for policymakers as the real economy remains weak and apparently fragile from the excessive dependence on the government and from the intense distortion brought about by government intervention in the marketplace. To quote Morgan Stanley’s Manoj Pradhan, ``Can QE be rolled back quickly? In theory, yes! Both passive and active QE could be reversed very quickly. The desire to hike rates above their currently low levels complicates matters slightly. Why? The effectiveness of passive QE depends on the willingness of banks to seek returns in the economy rather than simply parking excess reserves with the central bank. Hiking interest rates would reduce these incentives.”

Finally as we previously said it is increasingly becoming a cash unfriendly environment.

Sunday, March 29, 2009

Phisix: From Bust to Boom?

``We’re in a government-dependent financial system; I never thought I would live to see the day… We’ve got to fight to get away from that.” Paul Volcker, Volcker: China Chose to Buy Dollars

The Phisix stormed to an 11.25% gain over the past week, and was the second best performer over the adrenaline charged Asian equity markets (although it was mostly global affair), see figure 6.

So far the latest rally has pushed up many major stock markets into the positive zone [see Global Stock Market Performance Update: The Charge of the BRICs] led by the BRICS and many EM economies in contrast to the G-7 economies that have still been drifting in the negative zone but has seen vital improvements in their standings.

Figure 6: Stockcharts.com: Performance Chart of Key Asia Bourses

From January 6th to Friday’s close, only 4 regional benchmarks have cleared the winner’s zone and this includes China (pink), Taiwan (blue green), Indonesia (orange) and the Philippines (bright light green).

While many commentators have imputed the rising equity markets to “increasing risk appetite”, this needs to be qualified. Relative to global portfolio flows to emerging markets, the meat of the year-to-date inflows have only been accounted for just this week.

According to Marketwatch.com, ``Emerging Market Equity Funds tracked by EPFR Global took in the most money since mid-December during the week ended March 25. These funds absorbed $2.3 billion of inflows during the week, turning year-to-date flows positive by $2.03 billion.”

So nearly 90% of cross border flows came only this week. The current cross border flows signifies as marginal in comparison to size of the composite emerging market bourses. Nonetheless it can be seen as an improvement.

Here at the Philippine Stock Exchange (PSE), capital flows remains a net foreign selling for the end of the week, for the rest of the month and for the year.

This means that the recovery in the Philippine Stock Exchange has largely been a domestic investor affair. This also means that that the recent gains could possibly emanate from the transfer of local savings or possibly increased domestic leverage that could have been channeled into the local equity market. For the advanced EM markets, it could be also be due to short covering.

We can deduce such activities as largely a domestic ‘risk taking’ activity and not from the typical cross border flows.

Besides, given that most central banks have been forcing policy interest rates to approach zero levels or negative real rates regime, coupled with the transmission effects of the QE measures in many major economies the opportunity cost of holding cash have been materially rising.

Put differently, policies from the central banks of the US Federal Reserve and Bangko Sentral ng Pilipinas appear to be gaining traction and skewing people’s incentives to soak up more risk.

And faced with the imminent risk of inflation, staying in cash is now becoming increasingly a risky affair, as a sudden surge in inflation could wipe out the Peso’s purchasing power.

Remember except for the external liabilities of the government, the Philippines’ private sector, as segmented into corporation and individuals, are basically underleveraged. Nearly two fifths of our domestic output can be attributed to the informal economy. Thus, there could be a sizeable surge in private borrowing that may intensify the inflation transmission into the financial asset class. On the other hand, a considerable jump in consumer inflation could also be politically destabilizing.

The initial concerns about the corporate direction of PLDT and the corporate maneuverings at Meralco appear to have been overshadowed by the flush of money from global central banks.

From Bottom To The Advance Phase?

Nonetheless, signs are on the wall that the MONETARY risk environment together with significantly improving market internals seems to be suggesting of an important breakaway for the Phisix from its current “bottoming” cycle to the “advance” cycle.

Figure 6: Daily Traded Issues and Advance Decline Differentials

The Pink line represents the daily traded issues. This is one of the market breadth indicators which deals with the broad market sentiment. A surge in daily traded issues could mean broad based buying specifically when corroborated by an improvement in the advance decline differentials as shown at the same chart. Below is the daily traded issues. The green circle shows of the simultaneous progression.Figure 7: PSE Daily Trades: Another Improving Indicator

Another improving indicator is the number of daily trades. This market breadth indicator also reveals of the risk appetite of investors. A rising incidence of daily trades suggest of more market participants and or more churning activities from existing participants.

It essentially reveals of the market’s sentiment or as confidence barometer. In a bear market, a sudden spurt in daily trades frequently signifies panic selling as in the October-November 2008 experience.

For now, all three indicators are seemingly in synch adrift the resistance levels. And this synchronicity hasn’t been the seen for quite sometime.

Nevertheless, a breakout above the 2,100 level for the Phisix alongside with a breakout for these market internal indicators will indeed be very bullish for the Phisix. Of course, this has to be equally matched by improvements in the market’s overall volume.

As a short reminder, I don’t know when the Phisix will breakout. It could be next week or in the coming weeks or months. Sorry but I am not a seer. What we seem to be seeing is a long awaited improvement in the overall activities within the Philippine Stock Exchange. And if these should continue as I expect it would, then a breakout is more likely sooner than later.

And as stated before, the Phisix can’t rise alone. This means that the regional activities will likewise underpin the success or failure of today’s rally. Although given the conditions stated above, China has so far almost singlehandedly led the rally in the region and seems to have “pulled” many emerging markets along with it. Of course, it’s rather insane to suggest that a $4.22 trillion economy will pull the rest the world (US $14.33 trillion, Eurozone $18.85 trillion or Japan $4.84 trillion).

What we are likely witnessing is the impact from “combined” money printing by global central banks more than an economic recovery. If these measures succeed to buoy most of the region’s economies unimpaired by the credit maelstrom, the “super” inflation could be deferred.

Nonetheless today’s seemingly booming inflationary driven environment will also mean a forthcoming bust in the far end of the road (sometime 2013-2015?). But for now, present risks seem to emanate from a super inflation, than a deflationary bust.

Friday, March 27, 2009

US Treasury Bills Go Negative!

A return to normal times? Not quite. That's if we are to base it on US treasury bills which has struck a negative yield last night!

Another nice chart from Bespoke...

According to Bespoke, ``While the equity rally is helping some investors feel like we are returning to something resembling a sense of normalcy, a look at the yield on the 30-Day US T-Bill shows that things are anything but normal in the credit markets. For the first time this year, its yield dipped back below zero this morning. Now the government is even taking money from people who want to loan it money!"

My comment:

These are not normal times, as markets have been severely distorted by massive government interventions.

Another, US treasuries are generally considered "risk free", yet the one month US T-bills yield returned marginally negative yesterday. Although an anomaly, this suggest that not even government backed papers can be qualified as entirely "risk free".

Global Stock Market Performance Update: The Charge of the BRICs

Year to date updated national stock market benchmark performances by Bespoke Invest...(as of March 26th)

Says Bespoke (bold highlight mine), ``Twenty-one countries are up year to date, while 62 are down. One positive that can be drawn from this table is that all four BRIC countries are now in the black for 2009. These countries were the leaders during the last bull market, and they have also been some of the biggest decliners during the bear. The fact that these key countries are now trending upward is a sign that global investors are beginning to take more risk. China is up the most of all countries at 29.71%, while Russia is up 19.11%, Brazil is up 12.13%, and India is up 3.69%."

My comment:

Risks can be defined in relative and/or subjective terms.

US policies have presently been directed towards the "nuclear option" of currency devaluation via the Quantitative Easing or "Gonoism". These suggest of increasing inflation, credit and currency risks for the US. Alternatively, the rising risk profile of the US implies that US assets are becoming "riskier" relative to the BRICs.

Besides, given that international portfolio flows are expected to markedly contract, the positive performances of the BRICs and EM economies could be a consequence of local savings flowing into local assets in response to the global negative interest rates regime.

This has been the case of the Philippine Phisix, which I suspect has been the same dynamic driving most of the BRICs or EM markets.

So one data can be interpreted from two opposing angles.

More from Bespoke ``Unfortunately, all of the G-7 countries are still in the red year to date. Canada has been the best among them, while Italy has been the worst. With a decline of 9.11% year to date, the US is performing slightly worse than the unweighted average of all countries."

My comment: If G-7 countries are down while BRIC are up, isn't this a sign of "decoupling"?

Thursday, March 26, 2009

Why Geither's Toxic Asset Program Won't Float

There are many reasons for us to share the distrust with the apparent misplaced optimism credited to Tim Geither's Public-Private Investment Program or PPIP. Chief among them are issues on market price discovery and distorted incentives from government subsidies.

Nonetheless, I'll leave it to the experts debate on it.

But aside from technicality issues the following charts should explain why this program isn't likely to attain its goals...
One, leveraged loans defaults are likely surge.

The Researchrecap.com quotes a Moody's study (chart above from researchrecap)

``“Given tight credit markets, a worldwide economic slump, and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009, while recovery rates are expected to fall further,” said Sharon Ou, Assistant Vice President in Moody’s Credit Policy Default Research Group.

``Moody’s U.S. leveraged loan default rate ended 2008 at 3.5%, up from the 0.3% recorded in 2007.

``The ratings agency forecasts that 11.1% of U.S. leveraged loan issuers will default by the end of 2009.

``First-lien loan recovery rates fell to 63.4% at the end of 2008, down from 68.6% at the beginning of the year. By comparison, senior unsecured bond recovery rates dropped from 61.8% to 33.0% during the same period." (bold highlight mine)

Next, Fitch Ratings says losses in Residential Backed Mortgage Securities will rise further, see above chart.

The Researchrecap.com wrote, ``A dramatic rise in delinquencies has led Fitch Ratings to raise its average loss estimates for recent vintage jumbo prime mortgage pools to between 3 and 5 times higher than its previous estimate...

``In analyzing recent prime mortgage performance Fitch found that:

``Loans with multiple risk attributes such as limited income documentation and second-liens, are defaulting at rates approximately three times that of loans without those characteristics;

``A growing percentage of prime borrowers have lost all home equity due to declining home prices. Borrowers with negative equity in some recent vintage mortgage pools are approaching 50%;

``After adjusting for home price declines to date, loans estimated to have no equity in the property are defaulting at rates approximately three times that of loans estimated to have equity remaining.

``In addition to high default rates, recovery rates on defaulted loans are also trending downward."(bold highlight mine)

Lastly, Commercial Mortgage delinquencies are likely to worsen, see above chart.

The Researchrecap wrote, ``Commercial mortgage delinquencies rose sharply in February, driven by retail properties and lodging, according to Standard & Poor’s Credit Research, which lowered ratings on more than 200 commercial-backed mortgage securities during the month.

``The delinquency rate in February for U.S. CMBS rose to 1.57 percent from 1.39 percent in January.

``The amount delinquent is rapidly approaching the $10 billion level, closing February at $9.68 billion. The amount delinquent has increased by over 40 percent since the start of 2009, but the rate of growth slowed in February."(bold highlight mine)

The Commercial Mortgage Backed Securities could be the next tsunami of the serial deflating debt bubble.

According to the Wall Street Journal, ``Commercial real-estate debt is potentially more dangerous to the financial system than debt classes such as credit cards and student loans because of its size. The Real Estate Roundtable, a trade group, estimates that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt. Partly because the commercial real-estate debt market is nearly three times as big now as in the early 1990s, potential losses in dollar terms loom larger.

``According to an analysis of bank financial reports by The Wall Street Journal, the broad shift to real-estate lending can be seen by comparing commercial real-estate loans -- including both mortgages and construction loans -- with banks' so-called Tier 1 capital, a key indicator of a bank's ability to absorb losses. In 1993, less than 2% of the nation's banks and savings institutions had commercial real-estate exposure exceeding five times their Tier 1 capital. By the end of 2008, that had risen to about 12%, or about 800 financial institutions. A higher ratio means a thinner cushion for loans that go sour.

And in contrast to residential mortgages which had been held by a few but largest banks, the general "community based" banking system seems highly exposed to the probable deterioration of commercial loans-as banking capital hasn't kept pace with the identified risks.

Again the Wall Street Journal, ``Of $154.5 billion of securitized commercial mortgages coming due between now and 2012, about two-thirds likely won't qualify for refinancing, Deutsche Bank predicts. Its estimate assumes declines in commercial-property values of 35% to 45% from the peak in 2007. That would exceed the price drops in the downturn of the early 1990s.

``The bank estimates the default rates on the $700 billion of commercial-mortgage-backed securities could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s.

``Besides securities backed by commercial real-estate loans, about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012. Nearly 50% wouldn't qualify for refinancing in a tight credit environment, as they exceed 90% of the property's value, estimates Matthew Anderson, partner at Foresight Analytics. Today, lenders generally won't loan over 65% of a commercial property's value.

``In contrast to home mortgages -- the majority of which were made by only 10 or so giant institutions -- hundreds of small and regional banks loaded up on commercial real estate. As of Dec. 31, more than 2,900 banks and savings institutions had more than 300% of their risk-based capital in commercial real-estate loans, including both commercial mortgages and construction loans."(bold highlight mine)

So if "toxic" asset prices will remain under pressure, the PPIP won't be enough to provide support as a wider range of loans are likely to crumble from the pressures of the combined weight of economic weakness and persistent financial sector eleveraging.

Private investors who are aware of the situation might see this as tantamount to "catching a falling knife"- and may refrain from participating- even if the private sector's risk participation is said to be only 7% while the rest is guaranteed by the goverment. Otherwise this should translate to huge taxpayer losses.

Hence, we can expect Geither's plan to probably expand coverage or introduce more innovative forms of bailout packages-all at the expense of US taxpayers-or for the US government to print more money to make up for the financial blackhole.

A Tectonic Shift In The Global Banking Industry!

It is said that a picture is worth a thousand words.

Well below are some stirring graphs that highlights on the unexpected changes arising from the recent global financial crisis.

As the old saw goes, in every crisis there are opportunities. In the present case, we seem to witnessing an evolving transition to a new order in the global financial industry.

All graphs from Financial Times...

At the topmost window, the market cap of banks as % of the GDP of key developed nations depicts of a "leveling"-where the pecking order of market cap erosion have been heaviest in UK, followed by Europe, the US and Japan. This has led to nearly a congruous distribution of market cap as a ratio to GDP as the crisis evolved.

The next chart ("What difference a decade makes") is THE revelation: China has snatched the banking industry's leadership (lowest chart) from what used to be a stranglehold of the West (upper pane)!

And for a better visual, FT.com provides a great comparative breakdown of the top financial companies of the world in 1999 and in 2009...

The above had been the ranking of top global financial institutions based on market capitalization in 1999...

And the radical transformation seen in the present ranking.

As Peter Thal Larsen and Simon Briscoe wrote at the Financial Times, (bold highlight mine) ``New names have meanwhile arrived as if from nowhere. This is partly a reflection of shifting economic power: China’s three big banks dominate the rankings after joining the stock market in 2006 and 2007. Australian and Brazilian banks have also risen to prominence. But the shifting composition also offers evidence of how well different countries have managed their financial systems. Canada, for example, has been praised for its risk-averse approach to regulation. A decade ago, no Canadian bank made the list. Now there are five in the top 50."

So aside from China we have major commodity producers sharing the honors or a wider distribution of financial leadership.

But where will the next best growth area be?

Based on Boston Consulting Group's investment banking model, we will likely see a shift in the leveraged based business model to one of stabilizing profitability through a return to a simpler smaller model, smaller profit pools, greater client demand for simpler financial solutions and specialized capabilities of individual investment banks in an environment of increased regulatory and governmental influence.

And the region, as illustrated above, which has the least increase in government intervention could likely benefit most.

Combined with many other fundamental factors as high savings, growing middle class, demographic trends, urbanization and etc..., Asia looks likely a winner!