Stock Markets and the Economic Disconnect: China Edition

Stock markets according to popular wisdom serves as an indicator of economic growth conditions.

This Bloomberg article shows why popular wisdom has been wrong when applied to China: (bold mine)

China’s 20-year economic boom has boosted the wealth of its 1.3 billion citizens at the fastest pace worldwide and spawned some of the biggest companies in history. Foreigners earned less than 1 percent a year investing in Chinese stocks, a sixth of what they would have made owning U.S. Treasury bills.

The MSCI China Index (M8CN) has gained about 14 percent, including dividends, since Tsingtao Brewery Co. (168) became the first mainland company to sell H shares to international investors in Hong Kong in July 1993. That compares with a 452 percent return in the Standard & Poor’s 500 Index (SPXT), 322 percent in the MSCI Emerging Markets Index and 86 percent from Treasuries. Only the MSCI Japan Index had a weaker performance among the 10 largest markets, losing about 1 percent.

While China’s shift toward a market economy has lifted per-capita incomes by 1,074 percent and helped its companies raise at least $195 billion through stock sales in Hong Kong, investors with $695 billion say that corporate governance concerns, competition and state intervention have eroded returns for minority shareholders. Now, as China allows unprecedented access to its local capital markets amid the weakest projected gross domestic product growth since 1990, Aberdeen Asset Management Plc says valuations must fall further before it buys.

China’s bear market means cheap valuation getting cheaper…

The gauge of companies from Industrial & Commercial Bank of China Ltd., the world’s second-largest lender by market value, to PetroChina Co. (857), the third-biggest energy producer, entered a bear market last month after falling as much as 22 percent from this year’s high in January.

The Hang Seng China Enterprises Index (HSCEI), a gauge of 40 H shares, has declined 18 percent this year. It’s up 138 percent, excluding dividends, since Tsingtao Brewery began trading on July 15, 1993. The Shanghai Composite Index (SHCOMP) of mainland-listed companies has dropped 10 percent this year and is up 143 percent during the past two decades…

China will increase a program for foreign funds to invest in its local financial markets to $150 billion from a previous limit of $80 billion, according to a statement posted on the China Securities Regulatory Commission’s website on July 12. The government restricts access to mainland markets through its Qualified Foreign Institutional Investor program, which has granted firms a combined quota of $43.5 billion as of June 26. That compares with the $3 trillion market value of locally-listed companies.

MSCI’s China measure trades for 9.3 times reported earnings, versus 16 times for the S&P 500index, the biggest discount since September 2003, weekly data compiled by Bloomberg show. The MSCI Emerging Markets index has a multiple of 11.

How state directed credit hurt the stock markets…

Under former President Hu Jintao, banks were directed to lend to local governments during the global financial crisis to boost growth, while artificially low fuel prices have hurt refiners such as PetroChina. ICBC, the Beijing-based lender, traded at a record low 4.9 times earnings last month, while PetroChina (857) fell on June 25 to its lowest valuation since 2011.

More than 25 percent of China’s state-owned enterprises are unprofitable and their productivity growth has trailed that of private firms the past three decades, the World Bank said in February 2012.

And how state interventions affects corporate governance…

China was ranked ninth out of 11 Asian countries for corporate governance as of September 2012 and had the biggest deterioration in the region since 2010, according to a survey by CLSA Asia Pacific Markets and the Asian Corporate Governance Association…

SOEs “primarily serve the interests of the government, frequently making decisions with little regard for return on investment,” Hsu said in an e-mailed interview on July 11. Hsu said he invests in Chinese companies run by entrepreneurs with large ownership stakes, while he’s selling short shares of state-owned companies.

The following charts from tradingeconomics.com demonstrates the relationship between China’s stock market and economic growth.

One of the major reason why China’s stock market has languished has been due to the boom-bust cycle.

Stock investors participants not only made miniscule returns over 2 decades, but lost money in terms of real or inflation adjusted returns.

China’s previous stock market boom has coincided with a surge in both domestic credit as % to the economy (middle) and the domestic credit provided by the banking sector as % to the economy (bottom). 

The implication is that a credit boom functioned as the backbone for the stock market boom. Unfortunately the unsustainable boom was not to last.

However, when China’s stock market bubble imploded along with 2008 global crisis, what spared the Chinese economy from going into a recession had been the huge RMB¥ 4 trillion (US$ 586 billion) stimulus whose unintended effects are presently being felt.

Thus the side effects of 2008 stimulus are being revealed in “cheap” valuations which seem as getting even much more “cheaper”.

A potential financial crisis as indicated by the recent cash squeeze, purportedly to weed out shadow banks will only aggravate such dynamics.

You see the problem with relying on financial metrics? They are based on historical ex post events. 

If China’s economy has been materially slowing despite the recently announced marginally changed statistical growth data of 7.5% in the 2nd quarter from a government who hides, deletes and censors economic data, then an environment where a pullback of economic growth will also extrapolate to the slackening of sales, which should be reflected on cash flows, curtailment of investment expansions and eventually reflect on earnings. A crisis, which will be marked by massive liquidations, will exacerbate such conditions.

This means that today’s "cheap" valuations may become "pricey".

And another thing, given the non-resolution of the imbalances in China’s economy, the recent spike of credit or loans growth has only been redirected or rechanneled, instead of the stock markets, to the monumental and destabilizing debt fueled rampant speculations in the property sector, partly financed by shadow banking system, which China’s government has been attempting to regulate.

The disconnect or the apparent "parallel universe" between China’s stock market and the economy reveals of the huge effects of inflationism and interventionism in the economy.

As the Austrian economist Fritz Machlup wrote

A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply

China’s boom bust cycle should be a noteworthy example.

Why Current Market Conditions Warrants a Defensive Stance

Here is what I wrote last week[1],

Also the Phisix is likely to surf on the global ‘EU Summit honeymoon’ sentiment, as well as on the momentum from an imminent RECORD breakout.

Whether this breakaway run will be sustainable remains unclear as global markets will remain volatile on both directions.

Indeed the jubilation from the EU Summit combined with momentum powered the major local equity benchmark, the Phisix, to a fresh record high.

Of course this breakaway run will be subject to the question of sustainability given the recent developments abroad.

Nevertheless after 3 successive weeks of advances which racked up 8.53% in returns, it would be normal to see some profit taking.

Nonetheless today’s exemplary standings have more stories to tell.

The ASEAN Standout

From my radar screen of 70+ international equity benchmarks, the Phisix only ranks fourth among the best performers based on a year-to-date returns.

But the Phisix is the ONLY bellwether among the elite contenders that has been trading at record highs.

Except for Venezuela which has been drifting close to the recently etched milestone highs established last May, it is only Thailand that comes close to having a superb feat.

All the rest are still way off from their apogees set during the last 3-5 years

I do not count Venezuela’s stock market as a real contender for the simple reason that the outperformance of the Venezuelan stock market could be a reaction to the amplified risks of hyperinflation.

Due to a combination of price controls and massive imports by the government, Venezuela’s inflation rate has been down reportedly to 21.3% last June[2]. But this is likely to be temporary and designed for the reelection of President Chavez this October

Combined with falling oil prices and massively expanding government expenditures, the Venezuelan government will likely run out of hard currency or of foreign exchange which may force them to ramp up on the printing presses for financing.

Stock markets have been functioned as safehaven during episodes of hyperinflation as people jettison currency for real assets. A good example is the recent bout of horrific hyperinflation[3] endured by Zimbabwe which culminated in 2008[4].

Surging stocks amidst hyperinflation has barely been about real (investment) returns but about people trying to preserve savings through acquisition of claims on real assets (insurance against monetary disorder).

And going back to the top 11, Thailand’s stock market as measured by the major bellwether the Stock Exchange of Thailand (SET) is second only to the Phisix to demonstrate remarkable gains.

While the SET is at a milestone multi-year high, the Thai bellwether is still about 30% off from the 1994 pre-Asian crisis record.

Yet the best annual performers masks or are framed to exclude the position of the others. This shows why the use of statistics can tricky and can be tailored to fit a predetermined conclusion.

Indonesia and Malaysia may have posted moderate year-to-date returns relative to the Phisix, up only 6.1% and 5.87% respectively, but Malaysia, like Philippines, trades at record HIGHs.

Meanwhile Indonesia trades a few percentages or (3.5%) off the recent record.

So ALL four major ASEAN bourses are AT or NEAR landmark highs but so far the Phisix leads the pack.

Outside the region, I have not encountered any national stock markets that have come close to beating their 3-5 year highs.

Growing Detachment between Stock Markets and Real Events

It is obvious that any economic or financial gains would be used as political advertisement.

For instance the recent S&P upgrade of the Philippine credit rating have been painted as a puffery of good governance. The fact is that whatever gains seen in the Philippines has been a regional dynamic. They are in reality symptoms of the boom phase of the business cycle that has mainly been driven by the domestic monetary policies through the negative real rate regime and supplemented by external monetary policies which has induced a search for yield dynamic from foreign investors in response to international easing policies. This ‘search-for-yield’ can also be interpreted as capital flight.

The current market conditions of the Phisix fit the inflationary boom scenario described by the late Austrian economist Fritz Machlup[5]

If, however, we inquire into the causes of the inflow of speculative capital from abroad which is so much objected to, we shall often find that it was the boom tendencies that were already present on the stock exchange which attracted the foreign funds. La hausse amene la hausse. The beginnings of the speculative boom originated in a flow of money from domestic sources. And as it is extremely difficult domestic to conceive of a sudden epidemic of saving, we are once again driven back to credit expansion by the banks. It is the "domestic" creation of credit which usually produces that sentiment on the stock exchange and that movement of stock prices, which act as an by foreign invitation to foreign funds.

The occasions when the short-term foreign funds flowing onto the stock exchange are to be regarded with real mistrust are when these funds owe their boom is existence to a credit inflation abroad. In this case foreign they bring the foreign “business cycle germ” into the home country

Yet the much ballyhooed upgrade has been based on superficial measures. They have most likely been influenced by surging prices in the asset markets (reflexivity theory), by political Public Relations campaign, particularly the phony war against corruption (where corruption is misleadingly portrayed as a function of ethical virtuosity rather than from real cause: arbitrary statutes and regulations[6]) and could even possibly be related to dwindling stock of “safe assets” for the global banking system than from real changes or market based economic reforms as I explained earlier[7]

What the credit upgrade does is to give license to the Philippine government to lavish on public expenditures. This would only promote crony capitalism, (yes guess which parties will be awarded with the proposed $16 billion of public work spending?) and that rewarding debt would work to the detriment of the economy over the long run through the adverse effects of the crowding out phenomenon[8], higher taxes and the serial blowing of the bubble cycles.

Grandiose skyscrapers (or the Skyscraper Index) have exhibited uncanny accuracy as harbingers of the bust phase of financial bubbles.

And believe it or not, 9 of the 10 of the world’s tallest building will rise in Asia and have been slated for completion from 2015 onwards—with China having four, South Korea three and one apiece for Indonesia (3^rd largest) and Malaysia[9].

So if the skyscraper index remains a functional indicator of financial excesses then we could or we may see a regional financial crisis anytime during the time window of 2015-2017.

Yet given the extreme fluidity of current conditions, such bubble conditions may be delayed or hastened depending on the direction of external and domestic social policies mostly channeled through monetary policies, particularly the complicit war by central bankers against interest rates (or the euthanasia of the rentier).

From the prescient admonitions of the great Ludwig von Mises[10]

Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation. In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy.

Of course, I see the soaring Phisix as effects of the bubbles parlayed as symptoms of Panglossian complacency (based on the belief that the Phisix or the region will decouple) or if not Pavlov’s classic mental conditioning (of the strongly held belief that central bankers will successfully bailout financial markets) or as effects of “jockeyed” markets.

As for the latter, aggressive buying in a landscape where global political authorities have been exhibiting anxieties over global economic conditions simply does not match with the current state of exuberance.

To give some examples.

The Bloomberg quotes IMF’s Christine Lagarde’s diagnosis of the world economy[11]

“Over the past few months, the outlook has regrettably become more worrisome,” Lagarde said. “Many indicators of economic activity -- investment, employment, manufacturing -- have deteriorated. And not just in Europe or the United States.”

Or how about the “45-minute salvo” fired by 3 central banks last Thursday as acts of desperation?

From another Bloomberg article[12]

Global central banks went on the offensive against the faltering world economy, cutting interest rates and increasing bond buying as a round of international stimulus gathers pace.

In a 45-minute span, the European Central Bank and People’s Bank of China cut their benchmark borrowing costs, while the Bank of England raised the size of its asset-purchase program. Two weeks ago, the Federal Reserve expanded a program lengthening the maturity of bonds it holds and Chairman Ben S. Bernanke indicated more measures will be taken if needed.

Many major global equity markets sagged following the news of the 45 minute interval coordinated easing from 3 major central banks.

The most curious response I saw came from China.

The Shanghai index remained wobbly and even traded on the negative for almost two thirds of Friday’s session which appeared to have discounted the interest rate cuts. The above chart from Bloomberg shows of the intraday actions. It took the last minute for the Shanghai index to surge, which according to news reports had been led by the property sector[13].

That last minute adrenalin shot may not persist as China’s Premier Wen Jiabao immediately shot down the notion of the lifting property controls in a comment today[14].

This is yet another example of the confounding stance by China’s political authorities.

The weaknesses in global markets following the reported near simultaneous interventions in the bourses of major economies could be deemed as “buy the rumor, sell on news” or of reality check relative to hope based expectations.

As I wrote a few weeks back[15],

One, if central bankers FAIL to deliver in accordance to market’s expectations, then we will likely see another huge bout of downside volatility in global equity markets….

On the other hand, if markets may be temporarily satisfied with REAL actions of central banks (e.g. $1 trillion bailout) then we should see a minor or a slight “sell on news”. But this should be seen as opportunities to RE-ENTER the markets incrementally.

Considering that the Phisix has soared since, I don’t see today as a providing a buying window, unless global central bankers would bring on their vaunted bazookas or until there will be meaningful improvements in the global economic arena

When financial markets flows into the opposite direction from the economy sans support from central bankers then the risks of a crash becomes a factor to reckon with.

One thing that could be justify divergences or decoupling is the possibility of intensified capital flight. While there are little signs of these affecting ASEAN markets yet, as explained last week, Denmark’s case seems like a relevant model.

Denmark’s bond markets which earlier have exhibited negative yields have now been reinforced by Denmark’s central bank policy of negative interest rates. Capital flight from the Eurozone to Denmark has prompted for an outperformance of Denmark’s equity markets[16] and has been on my top 11 list.

However the same capital flight phenomenon has not boosted the Switzerland’s Swiss Market’s Index in the same degree as Denmark. So we need to observe this further.

Outside More Central Bank Intervention, Expect Downside Pressures

Current conditions could be ripe for a significant retrenchment for global equity markets based on ‘fundamentals’.

Nearly 80% of the world’s industrial activities have been contracting[17].

Compared to 2007-2008 which had the US property bust as the epicenter, today’s slowdown has been coming from different directions, particularly, the Euro area and the BRICs.

Even in the US, both the industrial activities[18] and non-industrial activities[19] have been exhibiting considerable signs of weakening.

These may not signal yet the imminence of recession, but the risk of recession grows if both domestic and international conditions deteriorate further.

And the global economic slowdown has shown incipient signs of filtering into US corporate profits[20].

While the distribution of revenues from S&P 500 member companies has marginally been tilted towards US, nonetheless revenues from abroad still accounts for a substantial 45% share[21].

This means that slowing global economic growth will pose as material drag to current “fundamentals”.

So in the absence of further interventions by central banks or when steroid dependent markets have been left to their own devices, broad based downturns on the world economy would hurt profits and will get reflected on the stock prices.

The alternative view is that since global weakness has been coming from different directions interventions will require global coordination similar to the 45 minutes salvo.

In addition, “liquidity” conditions in emerging markets have reportedly been faltering.

This essentially reflects on the ongoing monetary tightening or increasing manifestations of bubble bust conditions in major economies as the Eurozone and the BRICs to Emerging Markets.

The transmission mechanism of which can be seen through the deterioration in trade balances which has been exacerbated by falling commodity prices, declining foreign reserve accumulation as some EM authorities have used excess reserves to support their domestic currency and a slowdown in capital inflows (which even may risk a reversal, if current conditions worsen)[22].

I would further point out that easing through interest rate policies will have miniscule effects to economies laden with debt.

Demand for credit will be limited as hock to the eyeball indebted individuals, households or corporations will be working to pay off existing liabilities. Further, impaired credit ratings diminish access to debt. Also supply of credit will be limited as institutions whose balance sheets have been compromised by problematic assets will work on building up capital reserves. Also, slowing of economic conditions will also hamper debt activities.

This means that unless global central banks pull out another rabbit out of a hat trick of aggressive ‘delaying the day of reckoning’ interventions through money printing, money conditions will tighten, as the malinvestments from previously inflated activities will have to undergo price adjustments that would need re-coordination in the transfer of resources from non-productive to productive activities.

So debt acquired during the bubble heydays will have to be dealt with eventually through the laws of economics.

Aside from the ECB, all eyes will be on the US Federal Reserve FOMC’s meeting on July 31 to August 1, 2012[23]

It would be interesting to see how the Phisix and ASEAN bourses will react in the face of a more pronounced slowdown in the US

Stay Defensive

The principal reason why the Philippines and her ASEAN neighbors have been more receptive towards negative real rates policies is that these economies has been excised of leverage as a result of the Asian crisis as shown in the above chart[24].

But this does not mean that the Philippine and ASEAN economies will be immune from a global economic slowdown. Again the exceptionalism and resiliency of ASEAN markets will be tested with a US economic slowdown.

Again since negative real rates rewards debt and speculation, today’s low debt era may easily transform low debt ASEAN economies into speculative and consumption activities based on debt similar to conditions which plagues developed economies today.

That’s the nature of bubble cycles.

For now, unless the US Federal Reserve (and or the European Central Bank) brings out the BAZOOKA soon, expect the Phisix, ASEAN and global markets to retrench.

At record and near record highs for the Phisix and ASEAN markets, retracements should be seen as normal countercyclical process.

But since events have been so fluid, we cannot discount the risks of a global recession emanating from continuing political stalemate, dithering over monetary policies and from policy errors. Recessions can turn bullmarkets into bear markets.

Oppositely, powerful responses from central bankers may alter the risk scenario for the benefit of the bulls for another short period.

And this is why excessive volatility in both directions will continue to characterize the financial marketplace.

Yet if the Phisix continues to soar, alone or along with ASEAN, despite all the mounting risks, and without support by the FED and or by the ECB, and if they are not driven by capital flight, the tail risks of downside volatility may become magnified.

The current conditions of financial markets can be analogized to navigating in treacherous waters where one’s survival depends on skillful handling of the steep ebbs and flows of the tides, and of course guided too by lady luck. Yet chance according to Louis Pasteur favors the prepared mind.

So still, I would advise that prudence will remain a better part of valor in terms of portfolio management

---

[1] See Why has the Phisix Shined? July 2, 2012

[2] Businessweek/Bloomberg Venezuela Inflation Slows for Seventh Month on Import Surge, July 3, 2012

[3] See Zimbabwe's Hyperinflation February 25, 2009

[4] See Zimbabwe In The Aftermath Of Hyperinflation: Free Markets November 16, 2009

[5] Machlup Fritz A Digression On International Speculation Chapter 10, The Stock Market, Credit And Capital Formation William Hodge And Company, Limited p.163 Mises.org

[6] See Doug Casey On Corruption: Laws Create Corruption And Corruption Engenders Laws February 10, 2011

[7] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 5, 2012

[8] Wikipedia.org Crowding out (economics)

[9] See Does the Skyscrapers Curse Signal a coming Asian Crisis?, July 6, 2012

[10] Mises Ludwig von 8. The Monetary or Circulation Credit Theory of the Trade Cycle XX. INTEREST, CREDIT EXPANSION, AND THE TRADE CYCLE Human Action Mises.org

[11] Bloomberg.com Lagarde Says IMF To Cut Growth Outlook As Global Economy Weakens, July 5, 2011

[12] Bloomberg.com, Central Banks Deliver 45-Minute Salvo As Growth Weakens, July 5, 2012

[13] Reuters.com China bank shares pull down Hong Kong HSI, property lifts Shanghai, July 6, 2012

[14] See China’s Property Controls: Mistaking Forest for Trees July 8, 2012

[15] See Dealing with Today’s Uncertainty: Patience is the Better Part of Valor June 17, 2012

[16] See Denmark Cuts Interest Rates to Negative, July 4, 2012

[17] Zero Hedge 80% Of The World's Industrial Activity Is Now Contracting July 5, 2012

[18] Yardeni.com US Manufacturing Purchasing Managers Index July 3, 2012

[19] Wall Street Journal Blog Vital Signs: Slowing in Nonmanufacturing, July 6, 2012

[20] Wall Street Journal Blog, Number of the Week: Rest of World Pulls Down U.S. Profits June30, 2012

[21] Businessinsider.com CHART: A Breakdown Of Where S&P 500 Companies Get Overseas Business, June 27, 2012

[22] See Emerging Market “Liquidity” Conditions Deteriorate July 5, 2012

[23] US Federal Reserve Meeting calendars, statements, and minutes (2007-2013)

[24] Zero Hedge, Asia's Downside Risk And The Three Big Hopes June 21, 2012

Chart of the Day: Earnings Don’t Drive Stock Prices

I’ve been arguing since that earnings have hardly been the principal drivers of stock prices.

Today’s Bloomberg’s chart of the day appears to bolster my case. And this time such dynamic applies to the S&P 500

Here’s a passage from the Bloomberg article,

Stocks with the most reliable earnings are underperforming those with the least predictable results by the most since at least 1997 and may soon start to outperform, Morgan Stanley Investment Management said.

The CHART OF THE DAY compares the performance of so-called high-quality companies on the Standard & Poor’s 500 Index with low-quality businesses. S&P awards all equities a quality rating based on the sustainability and robustness of both their earnings and their balance sheets.

“Despite all the uncertainty in the market, quality is very cheap at the moment,” said Bruno Paulson, the portfolio manager of MSIM’s global franchise strategy, which has $6.3 billion under management, in London. “It’s not unreasonable to expect some re-rating from here. I don’t know what will trigger it; it might be the end of liquidity.”

So the quoted expert partly attributes ‘liquidity’ to this phenomenon but sounds rather tentative. I would suggest that this represents the mainstream view (again I am applying representative bias here) where the mainstream don’t get it.

Inflationism has been the main culprit. Flooding the world with too much money leads to speculative excess. This amounts to the bidding up of prices of low quality stocks more than the high quality counterparts. When people chase prices, rumor based plays are rife and earnings become a side story.

I would like to reiterate Austrian economist Fritz Machlup’s dictum (bold highlights mine)

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, a boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted, since even a large supply is ultimately limited. The supply of funds derived solely from current new savings and amortization current amortization allowances is fairly inelastic, and optimism about the development of security prices, inelastic would promptly lead to a "tightening" on the credit market, and the cessation of speculation "for the rise." There would thus be no chains of speculative transactions and the limited amount of credit available would pass into production without delay.

Each day that passes, evidences seem to emerge in favor our views.

Rampaging Global Equity And Commodity Markets Are Symptoms Of Rampant Inflationism!

Credit expansion not only brings about an inextricable tendency for commodity prices and wage rates to rise it also affects the market rate of interest. As it represents an additional quantity of money offered for loans, it generates a tendency for interest rates to drop below the height they would have reached on a loan market not manipulated by credit expansion. It owes its popularity with quacks and cranks not only to the inflationary rise in prices and wage rates which it engenders, but no less to its short-run effect of lowering interest rates. It is today the main tool of policies aiming at cheap or easy money. Ludwig von Mises

Global stock markets appear to be on a juggernaut!

Figure 1: Stockcharts.com: Where Is the Oil-Stockmarket Negative Correlation?

Figure 1 tells us that despite soaring oil prices, last traded at $113 per barrel as of Friday (WTIC), global equity markets have been exploding higher in near simultaneous fashion as demarcated by the blue horizontal line.

The Global Dow (GDOW)[1] an index created by Dow Jones Company that incorporates the world’s 150 largest corporations, the Emerging Markets (EEM) Index and the Dow Jones Asia Ex-Japan Index (P2DOW) have, like synchronized dancing, appear as acting in near unison.

We have been told earlier that rising oil prices extrapolated to falling stock markets (this happened during March—see red circles), now where is this supposed popular causal linkages peddled by mainstream media and contemporary establishment analysts-experts[2]?

Yet, the current actions in the global financial and commodity markets hardly represent evidence of economic growth or corporate fundamentals.

And any serious analyst will realize that nations have different socio-political and economic structures. And such distinction is even more amplified or pronounced by the uniqueness of the operating and financial structures of each corporation. So what then justifies such harmonized activities?

As we also pointed out last week[3], major ASEAN contemporaries along with the Phisix have shown similar ‘coordinated’ movements.

In addition, the massive broad based turnaround in major emerging markets bourses appear to vindicate my repeated assertions that the weakness experienced during the past five months had been temporary and signified only profit taking[4].

Yet if we are to interpret the price actions of local events as one of being an isolated circumstance, or seeing the Philippine Phisix as signify ‘superlative performance’ then this would account for a severe misjudgment.

Doing so means falling into the cognitive bias trap of focusing effect[5] —where one puts into emphasis select aspect/s or event/s at the expense of seeing the rest.

Ramifications of Rampant Inflationism

So how does one account for these concerted price increases? Or, what’s been driving all these?

We have been saying that there are two major factors affecting these trends:

One, artificially low interest rates that have driven an inflationary boom in credit.

That’s because simultaneous and general price increases would not be a reality if they have not been supplied by “money from thin air”.

As Austrian economist Fritz Machlup wrote[6],

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, a boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted, since even a large supply is ultimately limited. The supply of funds derived solely from current new savings and amortization current amortization allowances is fairly inelastic, and optimism about the development of security prices, inelastic would promptly lead to a "tightening" on the credit market, and the cessation of speculation "for the rise." There would thus be no chains of speculative transactions and the limited amount of credit available would pass into production without delay.

Some good anecdotal examples:

Credit booms are being manifested in several segments of the finance sector across the world, such as the US Collateralized Mortage Obligations (CMO)

From Bloomberg[7], (bold emphasis mine)

The biggest year since 2003 for the packaging of U.S. government-backed mortgage bonds into new securities has extended into 2011, bolstered by banks seeking investments protecting against rising interest rates.

Issuance of so-called agency collateralized mortgage obligations, or CMOs, reached $99 billion last quarter, following $451 billion in 2010, according to data compiled by Bloomberg. The creation of non-agency bonds, which force investors to assume homeowner-default risks, is down more than 90 percent from a peak with parts of the market still frozen.

Facing limited loan demand and flush with deposits on which they pay close to zero percent, banks are turning to agency CMOs to earn more than Treasuries and gird for when the Federal Reserve boosts funding rates. Insurers, hedge funds and mutual- fund managers such as Los Angeles-based DoubleLine Capital LP are seeking different pieces of CMOs, which slice up mortgage debt, creating new bonds that pay off faster or turn fixed-rate notes into floating rates.

Or in Europe, the leveraged buyout markets...

Again from the Bloomberg[8], (bold emphasis mine)

ING Groep NV, the top arranger of buyout loans in Europe this year, sees a “liquidity bubble” building as lenders forego protection and accept lower fees.

“There is a liquidity bubble in the European leveraged loan market at the moment, driven by institutional fund liquidity,” said Gerrit Stoelinga, global head of structured acquisition finance at Amsterdam-based ING, which toppled Lloyds Banking Group Plc as no. 1 loan arranger to private-equity firms, underwriting 10 percent of deals in the first quarter.

Investors more than doubled loans to finance private-equity led takeovers in the first quarter to $6.7 billion as the economy shows signs of strengthening, reducing risk that the neediest borrowers will default. Inflows to funds dedicated to loans and floating-rate debt jumped to $8.5 billion this year, compared with $1.7 billion in the same period in 2010, data from Cambridge, Massachusetts-based EPFR Global show.

Second, it’s all about the dogmatic belief espoused by the mainstream and the bureaucracy where printing of money or the policy of inflationism is seen as an elixir to address social problems.

Figure 2: Swelling Central Bank Balance Sheets and Commodity Prices (Danske Bank[9] and Minyanville[10])

The balance sheets of developed economies central banks have massively been expanding (except the ECB, see figure 2 left window), as respective governments undertake domestic policies of money printing or Quantitative Easing (QE) programs, even as the global recession has passed.

Commodity prices have, thus, risen in conjunction with central banks QE programs (right window).

What this implies is that both inflationary credit and the ramifications of various QE programs appear to be mainly responsible for the rise in most commodity markets. This is a phenomenon known as reservation demand, which as I wrote in the past[11]

“commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.”

As the great Ludwig von Mises explained[12], (bold highlights mine)

with the progress of inflation more and more people become aware of the fall in purchasing power. For those not personally engaged in business and not familiar with the conditions of the stock market, the main vehicle of saving is the accumulation of savings deposits, the purchase of bonds and life insurance. All such savings are prejudiced by inflation. Thus saving is discouraged and extravagance seems to be indicated. The ultimate reaction of the public, the “flight into real values,” is a desperate attempt to salvage some debris from the ruinous breakdown. It is, viewed from the angle of capital preservation, not a remedy, but merely a poor emergency measure. It can, at best, rescue a fraction of the saver’s funds.

Ironically as I earlier pointed out, even the Bank of Japan (BoJ) has recognized the causal effects of money printing and high food prices[13], but they continue to ignore their own warnings by adding more to their own “lending” program using the recent disaster as a pretext [14]!

Yet despite increases of policy rates by some developed economy central banks as the European Central Bank (ECB) and the Denmark’s Nationalbank[15], not only as interest rates remain suppressed but the ECB pledged to continue with its large scale liquidity program[16].

To add, policy divergences will likely induce more incidences of leveraged carry trade or currency arbitrages.

Record Gold Prices and Poker Bluffing Exit Strategies

And it is of no doubt why gold hit new record nominal highs priced in US dollars last week (now above $1,470 per oz.)

Figure 3: Surging Gold prices versus G-5 currencies (gold.org)

It wouldn’t be fair to say that gold has been going ballistic only against the US dollar because gold has been in near record or in record territory against almost all major developed and emerging market currencies.

Gold, as shown in Figure 3, has been drifting near nominal record highs against G-5 currencies[17] (US dollar, euro, Yen, sterling and Canadian dollar).

Figure 4: Gold Underrepresented as an Asset Class (US Global Investors[18])

Gold, despite record nominal prices, appears to be vastly underrepresented as a financial asset class compared to other assets held by global finance, banking, investment, insurance and pension companies.

Should the scale of inflationism persists, which I think central bankers will[19], considering the plight of the foundering “too big to fail” sectors or nations e.g. in the US the real estate markets (see figure 5), in Europe the PIIGS, this will likely attract more of mainstream agnostics (see figure 4) to gold and commodity as an investment class overtime.

This only implies of the immense upside potential of gold prices especially when mainstream finance and investment corporations decide to load up on it or capitulate.

Figure 5: Tenuous Position of US Real Estate, Bank Index and Mortgage Finance

This brings us back anew to “Exit” strategies that is said to upend gold’s potentials.

The Fed can talk about exit strategies for all they want, but they are likely to signify another poker bluff similar to 2010[20].

The Fed’s inflationist programs which had been mostly directed at the US banking system seem to stand on tenuous grounds despite all the trillions of dollars in rescue efforts.

US real estate appears to stagger again[21] (left window), while the S & P Bank Index (BIX) and the Dow Jones Mortgage Finance (DJUSMF) appears to have been left out of the bullish mode seen in the S&P 500 Financials (SPF) and the Dow Jones US Consumer Finance (DJUSSF), possibly reflecting on the renewed weakness of the US real estate.

In addition, there is also the problem of financing the enormous US budget deficits. And there is also the excess banking reserves dilemma.

So in my view, the US Federal Reserve seems faced with the proverbial devil and the deep blue sea. Other major economies are also faced with their predicaments.

Going back to the stock markets, as Austrian economist Fritz Machlup explained[22],

if all of these indices show an upward (or downward) movement, the presumption is very strong that inflation (or deflation) in the sense defined is taking place, even if the level of commodity prices does not show the least upward (or downward) tendency.

Well some commodity prices have paralleled the actions in the stock markets if not more.

Bottom line: Rampaging stock markets and commodity markets are symptomatic of rampant inflationism.

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[1] Wikipedia.org The Global Dow

[2] See “I Told You So!” Moment: Being Right In Gold and Disproving False Causation, March 6, 2011

[3] See Phisix and ASEAN Equities: The Tide Has Turned To Favor The Bulls! April 3, 2011

[4] See I Told You So Moment: Emerging Markets Mounts A Broad Based Comeback! April, 8, 2011

[5] ChangingMinds.org, Focusing Effect

[6] Machlup, Fritz The Stock Market, Credit And Capital Formation Mises.org p.92

[7] Dailybusiness.com CMO sales at 7-year high as banks gird for Fed: credit markets, Bloomberg, April 5, 2011

[8] Bloomberg.com ING Sees ‘Liquidity Bubble’ in European LBO Financing Market, April 5, 2011

[9] Danske Bank Flash Comment Japan: BoJ upgrades its view on economy, April 7, 2011

[10] Minyanville.com When Will Fed-Created Melt-Up Turn Into a Meltdown?, April 8, 2011

[11] See Oil Markets: Inflation is Dead, Long Live Inflation November 4, 2010

[12] Mises, Ludwig von The Effects of Changes in the Money Relation Upon Originary Interest, Human Action, Chapter 20 Section 5 Mises.org

[13] See Correlation Isn't Causation: Food Prices and Global Riots, April 2, 2011

[14] Bloomberg, BOJ Offers Earthquake-Aid Loans, Downgrades Economic Assessment, April 7, 2011

[15] Reuters.com Danish c.bank raises lending rate by 25 bps, April 7, 2011

[16] See ECB Raises Rates, Global Monetary Policy Divergences Magnifies, April 8, 2011

[17] Gold.org, Daily gold price since 1998

[18] Holmes, Frank The Bedrock of the Gold Bull Rally, US Global Investors

[19] See The US Dollar’s Dependence On Quantitative Easing, March 20, 2011

[20] See Poker Bluff: The Exit Strategy Theme For 2010, January 11, 2010

[21] Economist.com Weather warning America's housing market is in the doldrums, March 30, 2011

[22] Machlup, Fritz Op.cit p.299