ASEAN’s Equity Divergence, Foreign Fund Flows and Politically Driven Markets

Trading is a psychological game. Most people think that they’re playing against the market, but the market doesn’t care. You’re really playing against yourself. You have to stop trying to will things to happen in order to prove that you’re right. Listen only to what the market is telling you now. Forget what you thought it was telling you five minutes ago. The sole objective of trading is not to prove you’re right, but to hear the cash register ring. Martin Schwartz

Divergence.

The week had been marked by divergences, where the ASEAN equity bellwether appears to have defied the performances of her contemporaries around the world.

The FTSE-ASEAN[1] (AWASEAN, yellow) scaled higher as the region’s index MSCI AC ASIA Pacific[2] (MXAP, red), the S & P Euro[3] (SPEURO, green) and the US S & P 500 seem to have rolled over on a year to date basis.

One would further note that except for the Eurozone, Asia, ASEAN and the S&P 500 came off from their recent highs.

It is an important reminder that any divergences should not be interpreted as representative of decoupling. Signs of decoupling will be manifested once the next crisis emerges. Yet given the depth or scale of today’s globalization or social interconnectedness which has not been limited to trade, labor, capital flows or to even monetary policies, I strongly doubt that this should transpire.

In addition I pointed out the commodities have been rallying in the face of an enfeebled global equity markets. We seem to be seeing some rotation from financial assets towards the commodity sphere as markets await political developments abroad.

And another significant point to consider is that given the variance in the political economic construct of each nation, the global transmission of credit easing policies and artificially suppressed interest rates everywhere would have different impacts on different asset classes.

Nations that had been least affected by the last bubble bust should outperform. And this perhaps explains the ASEAN divergence.

Yet this has been an important theme for us for the longest time.

Transmission Mechanisms from Policies Abroad

I have been saying that policies abroad are being transmitted to the Peso and the Phisix.

Interest rate spreads, devaluation policies, real economic growth rate differentials, degree of economic freedom and political, regulatory and tax costs and risks among the many other variables serve as major inducements to foreign money flows into the emerging markets.

Under current conditions, emerging markets are expected to receive fund flows to the tune of slightly $1 trillion for 2011.

Reports the Bloomberg[4],

Net private capital inflows to emerging market economies will keep growing this year and next to reach $1.1 trillion in 2012, attracted by economic growth above 6 percent in those countries, a banking industry group said.

The Washington-based Institute of International Finance today also raised its estimates for 2011 inflows by $81 billion to $1 trillion to reflect higher forecasts for Brazil and China. That more than offset lower flows to the Middle East and North Africa as a result of political turmoil there.

“The strength of capital flows is still presenting policy challenges in a number of emerging economies, especially those already facing pressures from rising inflation, strong credit and asset price growth and rising exchange rates,” the IIF wrote in its research note. Monetary policy in these countries is “generally too accommodative, in large part because policy makers are so focused on limiting capital inflows.”

Countries from Indonesia to South Africa are striving to manage inflows of overseas capital that put upward pressure on their currencies, making exports less competitive, and threaten to inflate asset-price bubbles. Nations including China and South Korea have argued that U.S. monetary easing has added to cross-border money flows in pursuit of higher returns.

The accompanying chart is from the IIF[5]

The Philippines is part of the EM rubric, thus should be one of the recipients of these fund flows.

Foreign trade has supported the current recovery, from the November 2010 consolidation or the profit taking phase, in the Philippine Stock Exchange.

Net foreign inflows, as of the end of May, tallied 14.3 billion php [US $324.127 million]. This accounted for about 40% of daily trade. Above chart shows of the weekly trend.

The big drop in foreign trade during the other week had been due to 2 special block sales in Meralco [PSE: MER] and San Miguel [PSE:SMC].

There is a strong correlation between foreign flows and the Peso. The vertical line from the Peso chart partitions the year-to-date performance.

The foreign volume inflow spikes in April and May appear to be reflected on the Peso (see two red arrows) with two concomitant surges over the same period.

Meanwhile the recent outflows seen from the special block sales have coincided with the recent price sluggishness of the Peso.

So even at 40% share of daily trades, foreign flows account for as a major determinant to the price activities in the Phisix and importantly the Peso.

And as I have long been saying the correlation between the Peso and other popular metrics as remittance or exports have been tenuous[6].

Foreign flows are representative of the degree of demand for a currency.

Hence, currency traders must take heed of the activities in the PSE as part of their studies from which to derive their predictions

Another aspect is that the above estimates made by the IIF, I think, largely depends on current conditions which seem to presuppose the QE in play.

Thus a furtherance of the QE should translate to more capital flows into emerging markets including the Philippines. This means buoyant stocks and a stronger peso.

QE’s basically connect the Emerging Markets by transmitting bubble conditions. Some countries appear to be aware of this, as the Bloomberg report says, “China and South Korea have argued that U.S. monetary easing has added to cross-border money flows in pursuit of higher returns”

So while some reads this as somewhat positive, this represents a bubble process at work. Boom days will be met by a greater bust. The success of a prudent investor would be how one negotiates the boom bust cycle.

Rotational Process Continues, Politics as Main Driver

Rotational activities continue to dominate the activities within the Philippine Stock Exchange.

The industrials spearheaded the gains of the Phisix. This was largely due to the upsurge in Meralco (6.35%) [PSE: MER], Energy Development Corporation (4.09%) [PSE: EDC] and San Miguel Corp (6.27%) [PSE: SMC].

The financial industry, which I earlier said could be a candidate likely to help buoy the Phisix[7], has taken the second place. Meanwhile the mining sector continues to bedazzle with the 10^th consecutive week of advances which has been defying my expectations[8]. In a bullmarket, overbought conditions can remain extended.

The Phisix continues to consolidate amidst signs of emerging weakness in the global markets. It is unclear if such divergences will hold or persist.

Although for as long as there would be no recession in the horizon, and where monetary conditions remain easy or accommodative as today, such variability in price actions remains a possibility.

True, there have been signs of economic slowdown in many parts of the world, but a downshift does not mechanically imply a collapse or a recession.

Seasonality can also be a factor. But this factor would come into play if other forces are restrained.

Yet barring any black swan or high sigma events, I don’t foresee any signs of an impending recession yet. So, over the short term, the Phisix or even global equity markets may just vacillate and look for direction.

Finally my expectations have largely been shaped by the prospective political actions by the political leadership, particularly by the US Federal Reserve on extending the QE program which is slated to end this month.

Although I expect that this extension won’t come automatically which I see as either tied to the US Congressional vote to raise debt limits or in reaction to growing pessimism in the some of the world’s economic environment due to a cyclical slowdown or to the accrued effects of signaling channels applied by governments or from mainstream’s addiction to inflationism. Besides if the debt ceiling will be raised this gives further excuse for the FED to activate QE 3.0.

However as clearly outlined, politics largely determines the outcome of the marketplace.

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[1] Bloomberg.com The FTSE Asean Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid capitalization universe for Developed and Emerging Market (Advanced Emerging and Secondary Emerging) segments. Base Value 100 as at December 31, 1986.

[2] Bloomberg.com The MSCI AC Asia Pacific Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1987.

[3] Bloomberg.com The S&P Europe 350 Index is a free float market cap weighted index that measuresthe performance of equities in 17 Pan-European markets, covering approximately 70% of the total market cap. It offers an effective balance between broad market representation and liquidity. The S&P Europe 350 is part of the S&P Global 1200. It has a base date of Dec. 31, 1997 with a base value of 1000.

[4] Bloomberg.com Capital Flows to Emerging Markets Seen Surpassing $1 Trillion, June 1, 2011

[5] Institute of International Finance Capital Flows to Emerging Market Economies, June 1, 2011

[6] See How The Surging Philippine Peso Reflects On Global Inflationism, December 6, 2009

[7] See A Bullish Financial Sector Equals A Bullish Phisix?, May 22, 2011

[8] See Phisix: Why I Expect A Rotation Out of The Mining Sector May 15, 2011

Are The Current External Event Risks Signals or Noise?

The twin result of the Federal Reserve’s increase in the money supply, which pushes interest rates below that market-balancing point, is an emerging price inflation and an initial investment boom, both of which are unsustainable in the long run. Price inflation is unsustainable because it inescapably reduces the value of the money in everyone’s pockets, and threatens over time to undermine trust in the monetary system. The boom is unsustainable because the imbalance between savings and investment will eventually necessitate a market correction when it is discovered that the resources available are not enough to produce all the consumer goods people want to buy, as well as all the investment projects borrowers have begun. The unsustainability of such a monetary-induced investment boom has been shown, once again, to be true in the latest business cycle.-Richard Ebeling

Libya’s civil war, the ongoing MENA People Power revolts, $100 oil and record food prices, recent credit downgrades of Greece and Spain[1], and just the other day, the 1-2 punch (earthquake-tsunami) disaster that slammed on Japan have all been buffeting on the markets which gives some good and noteworthy pitches to be on the bearish camp.

But one has to distinguish between noise and signal. Noises tend to have short term effects while signals tend to underpin the market’s fundamental drivers.

Noise and Signals

Are the above events representatives of as noise or as signals?

If one looks at the broad performances of the global financial markets, what you read in the news isn’t exactly the sentiments that appear as being ventilated on the markets; whether it is the global stock markets, commodity, currency or bond markets.

True, markets have been showing some indications of volatility but this does not automatically mean that they account for as evidence of signals.

In other words, media sentiment and the voting public represented by the market actions don’t seem to match.

Figure 1 Bloomberg: ASEAN Equities

ASEAN bourses seem to be good examples of demolishing misguided popular wisdom.

The year-to-date chart of the major ASEAN equity bellwethers-Malaysia KLSE (yellow), Philippine Phisix (green), Indonesia (JCI), and Thailand’s SET (SET) shows of a consolidation phase.

Yet the actions of the last three (Phisix, JCI and the SET) seems to parallel what you can see in an Olympic sporting event known as synchronized “swimming”. In short, ASEAN bourses have manifested strong or tight correlations.

Let me add that such tight correlations do not represent causation nor are they designed or engineered actions. The point is that certain underlying forces have been prompting market participants to act spontaneously but almost in the same manner.

The mainstream has lately been saying that the weakness of ASEAN markets reflected on high oil prices and the spreading unrest in the Middle East. Yet ASEAN markets have began to reverse to the upside even as Oil peaked (at $107.34 on March 7^th) and as MENA events has seemingly worsened, validating my argument that the mainstream tend to fixate on the available information[2] rather than indulge in critical analysis.

Yet in reflecting on the actions of the Philippine Phisix:

-where foreign trade has accounted for only 40.69% of overall trade (accrued year to date basis)

-where foreign trade has registered a substantial net negative figure year to date (6.3 billion pesos or about USD $144 million @43.65), and

-where the Peso has slightly firmed from the start of the year (43.84 at the close of 2010), and 43.65 last Friday

I can see a paradox—a strong Peso and equity outflows—or a meaningful divergence.

A side note: the bulk of the foreign selloff came in January but this has signficantly turned positive last week (1.954 billion pesos or USD $44.8 million @43.65).

What we can glean from these:

-local investors have been providing the crucial support to the markets during the past 2 months

- importantly, even as foreign trade in equity markets accounted for a negative, overall portfolio flows as reported by the BSP revealed a positive figure $428 million for January or a net $193 million[3]. These figures are lower than the past, but nonetheless STILL positive.

These variables appear to imply that the negative foreign trade in the PSE had NOT been repatriated abroad, but possibly rotated into other local assets.

And this perhaps explains the continued strenght of the Peso despite a weak equity market environment. Again, a divergence that is likely to be resolved soon.

Rotation To Property Sector and A Booming Credit Environment

Figure 2: IMF[4]: Philippine Real Estate Market

Further observation tells us that the local equity market rally over the past 2 weeks had been spearheaded by the property sector (+9.7% in 2 weeks) which could highlight on such rotational dynamics.

The actions in the local property market seem to have mirrored on the actions of the Philippine Stock Exchange (see figure 2).

The local property sector appears to be bottoming out (left window) following a short bout of credit boost during the climax of the global crisis in 2008. I am not sure why such boost has occurred, but I would suspect that this could be part of a government related stimulus spending.

But today, with a recovering credit environment emerging from the artificially suppressed interest rates, it isn’t far fetched to the suggest that long range capital intensive projects will be the principal beneficiaries of low interest rate regime. And it is why I see an imminent property boom here[5] if not in Asia.

And ASEAN property prices likewise appear to be recovering from the 2008 contagion (right window).

And speaking of the domestic credit enrivonment, many aspects seem to playout exactly as the Austrians have seen it through their Austrian Business Cycle Theory...

Credit growth has expanded to a 21 month high[6] from which the Manila Bulletin breaksdown the details[7] as,

Of the total, production loans, which account for more than four-fifth of commercial banks’ (KBs) loan portfolio expanded year-on-year by 12.4 percent over last December’s 10.1 percent.

The growth of consumer loans was almost steady at 8.7 percent, the BSP said.

The central bank traced the strong growth in production loans to higher lending extended to the manufacturing, which rose by 26.7 percent; electricity, gas and water, 21.3 percent; real estate, renting and business services, 17.7 percent; wholesale and retail trade, 14.2 percent; and agriculture, hunting and forestry, 6.4 percent.

Loans extended to construction sector also grew but at a slower pace of 7.8 percent compared to the 15.6 percent last December.

On the other hand, negative growth was registered in lending to financial intermediation at -5.7 percent and education at -13.1 percent.”

All these credit activities, mainly interpreted as demand based economic growth, will likely continue to energize the domestic financial markets, as well as, stoke consumer price inflation hidden from the eyes of the public[8].

As Friedrich von Hayek once wrote of the Austrian Business cycle[9]. (bold emphasis mine)

Now the chief effect of inflation which makes it at first generally welcome to business is precisely that prices of products turn out to be higher in general than foreseen. It is this which produces the general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper. Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply-all is saleable and everybody can continue what he had been doing. It is this seemingly blessed state in which there are more jobs than applicants which Lord Beveridge defined as the state of full employment-never understanding that the shrinking value of his pension of which he so bitterly complained in old age was the inevitable consequence of his own recommendations having been followed.

Conclusion

Going back to the equity markets, it is true that the above ASEAN bourses have been in the NEGATIVE zone as of Friday’s close, based on a year to date basis, following a downdraft that began in early November of 2010.

But when you input ALL of the aforementioned event risks, the comparative correlations reveal that the string of bearish news have been tenously linked to the activities of the region’s stock markets, and even possibly to the local property markets. Thus, it is likely that these negative events or what is perceived as exogenous event risks represents as more of noise than of meaningful signals that could impact the markets for long, unless these events turnout for the worse.

In other words, domestic factors such as the credit induced boom from an artificially suppressed interest rates seem to undergird the search for yield dynamics which is likely the key driver of the local financial financial markets (not limited to the equities) and perhaps of the ASEAN markets as well.

And the palpably auspicious local climate seems to be complimented by a still accommodative (policy divergent) global monetary environment as seen by the shifting nature of corporate activities worldwide—a boom in merger activities of emerging markets, primarily in the BRICs.

The Bloomberg reports[10],

The merger boom that started in 2010 isn’t looking like any of the past three. The takeover binge of the 1980s was fueled by Michael Milken’s junk bonds; the late- 1990s wave of Internet and telecom deals, by inflated stock prices; and the private-equity frenzy that produced a record year for deals in 2007, by leveraged loans.

The more recent surge comes from the expanding BRIC economies -- Brazil, Russia, India and China -- and beyond. Deals are rising among the companies that supply raw materials to these countries. Worldwide deals in energy, power and basic materials made up about a third of the merger and acquisition market in 2010, compared with about 20 percent in the previous decade, according to data compiled by Bloomberg. Companies with headquarters in emerging markets played a role in more than a third of 2010 takeovers, about twice their historical share.

Bottom line: Markets hardly ever move in a straight line (unless during episodes of hyperinflation). For as long as the key conditions that drives the current market trends persist, volatility can be read or construed as natural countercyclical flows present in every functioning markets. Hence, loosely correlated external event risks likely signify as false signals which largely appeals to the brain’s emotion processing mechanism—the amgydala[11] than as critical analysis.

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[1] Barley Richard, Europe's Ratings Rage Is Misdirected, Wall Street Journal, March 11, 2011

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

[3] Abs-cbnnews.com January hot money inflow of $428-M lowest in 6 months, February 18, 2011

[4] IMF.org Philippines: 2010 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Philippines March 2011

[5] See The Upcoming Boom In The Philippine Property Sector, September 2010

[6] Abs-cbnnews.com January bank lending at 21-month high, March 11, 2011

[7] Manila Bulletin, Banks' lending grows double-digit in January 2011, March 11, 2011

[8] See The Code of Silence On Philippine Inflation, January 6, 2011

[9] Hayek, Friedrich August Can We Still Avoid Inflation? The Austrian Theory of the Trade Cycle

[10] Bloomberg.com Goldman Heads M&A Rankings Spurred by Commodities Demand in BRIC Economies, March 7, 2011

[11] Wikipedia.org Amygdala. Shown in research to perform a primary role in the processing and memory of emotional reactions, the amygdalae are considered part of the limbic system

Phisix: What Market Internals Are Saying

A short comment on the market breadth of the Phisix.

The Phisix registered its first official weekly gain for 2011.

In 6 weeks through this year, the Phisix suffered 4 successive weekly losses and a nearly neutral week during the first trading week of the year.

So the bears have dominated.

I think that this will change quite soon.

Even if we set aside the argument of gold’s correlation and dissect on the market internals there are signs to suggest that the Phisix may have hit the bottom.

True, the rally last week had slim volume which usually demarcates a dead cat’s bounce.

However in furtherance of our earlier argument[1] where the extreme actions of retail participants represent as an opportunity to profit by doing the opposite, such signs seem to be reverberating.

One must realize that retail participants act mostly on the orientation of a very narrow timeframe, assess markets based on ticker based movements (linear thinking), and most importantly, are driven by emotions that are enveloped by mental biases and logical fallicies as rationalization.

That’s the reason why they are frequently referred to in Wall Street as the proverbial Pigs, who always get slaughtered by either the bulls or bears.

Figure 5 PSE: More Signs of Retail Selling

I have been saying that there have been signs of emergent market dissonance[2] which only proves that today’s falling Phisix signifies just a hiatus.

This includes the rising trend of local and regional currencies, divergences between developed economy and EM bourses, steepening of the yield curve, economic growth disparities, aside from net foreign trade.

As for the last aspect we can see some signs of diminished degree of selling (right window figure 5).

While it is true that advance decline spread has been deteriorating (left window), I think we have reached a point of climax where panicking retail participants appear to have capitulated during the previous week (not last week).

And with a significant number of Phisix composite issues now showing signs of stabilization, in terms of price action through the charts, my hunch is that today’s hiatus is bound for closure.

Go take advantage of this. Thank me later.

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[1] See Phisix: Panicking Retail Investors Equals Buying Opportunity, January 31, 2011

[2] See ASEAN Bourses Undergoing Interim Correction, February 14, 2011

Global Policy Divergences Favors A Rising Peso

``Governments remain today, as much as when Hayek spoke these words, under the sway of political ideologies that insist it is the duty of the state to regulate the market in the service of powerful special-interest groups, to redistribute wealth, and to secure “safety nets” under most aspects of everyday life. The budgets and deficits of many EU countries, and the fiscal crisis they have now gotten themselves into demonstrate this beyond any doubt.” Richard M. Ebeling

I’d like to bring about a small point on the Peso and the Phisix.

In contrast anew to domestic mainstream analysis, the Peso has been proceeding in accordance to our projection. The Peso should continue to appreciate (anywhere in the range of 43 to 44+ to a US dollar by the yearend) as the Phisix surges.

The Peso’s rise will reflect on many factors, but mostly on excess US dollar liquidity and divergences of monetary policies.

Not only has the Peso risen despite the recent lagging actions[1] relative to our neighbors, which I had suspected had been part of the political efforts to embellish of the image the new President during his first State of the Nation Address (SONA). As a political group the Peso has now become sensitive to the demands of OFWs. Hence, I suspect the constant involvement by the Bangko Sentral ng Pilipinas (BSP) or the Philippine central bank to stem any meaningful appreciation.

Notice too that the Peso immediately rallied fervently just right after the SONA. This only furthers my impression that our new President has been soooo obsessed with image preservation or maintaining high popularity ratings, therefore would resort to populist measures at the expense of the public. Sorry to say, but a majority of the people are economically unlearned to absorb such truths.

But unless the BSP would take the risk of severely undermining the Peso in order to match the inflationary policies implemented by the US authorities, efforts to keep the Peso from rising will only serve as temporary patches. But again unknown to the public, all interventions has attendant costs, and will be paid for by the public either through a lowered purchasing power (higher consumer prices) or higher taxes in the future.

Nevertheless as the US continues to manipulate her bond markets for the purpose of allegedly staving off deflation, such actions accentuate the increasingly gaping policy divergences between Asia and the US.

And foreign currency reserve rich China, perhaps anticipating such predicament, appears to join us in becoming more bullish with the austerity conscious Euro[2], and likewise parts of Asia, such as Japan and South Korea[3] where she had embarked on selling US dollar ‘bonds’ for Euro and the Asian ‘bond’ assets.

And the greater the policy divergences, the higher the allure to arbitrage against the US dollar for higher yielding assets (a.k.a. carry trade) like the Peso.

And as we have previously argued[4], the influx of foreign money will not only intensify the price actions in the Phisix (see Figure 6), it will also be reflected on other domestic assets as real estate, bonds (already happening) and hopefully into more investments.

Nevertheless all these will be vented on the price of the Philippine Peso.

Figure 6: Peso and Net Foreign Trade in the Phisix

We have previously pointed out (left window-Peso at the upper pane and foreign trade at the lower pane) that surging foreign interest in the Phisix coincided with a higher Peso.

By way of the recent market actions, this phenomenon seems to be taking place again and seems to build up pressures incrementally prior to a massive move (right window).

Of course, the caveat will be expectations of a reduction in liquidity (risk aversion) in the marketplace.

But given the prospects of a slowdown which has given rise to mainstream’s heightened need for more political actions, we can expect policymakers to go about unleashing a new wave of liquidity as had been in the Lehman episode of 2008 or during the Greece spurred Euro crisis of 2010.

At the end of the day, for policymakers it’s all about economic ideology, path dependency and adherence to superstitions cloaked with mathematical formalism.

But of course, all these won’t repeal the natural laws of economics.

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[1] See The Philippine Peso’s Lagging Performance July 18, 2010

[2] Bloomberg.com China Favors Euro to Dollar as Bernanke Shifts Course, August 16, 2010

[3] Bloomberg.com China Doubles Korea Bond Holdings as U.S. Debt Sold, August 18, 2010

[4] See Buy The Peso And The Phisix On Prospects Of A Euro Rally, June 14, 2010

Crack-Up Boom Spreads To Asia And The Philippines

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public. With inflation as well as with taxation, it is the citizens who must foot the total bill. The distinguishing mark of inflation, when considered as a method of filling the vaults of the Treasury, is that it distributes the burden in a most unfair way, overcharging those who are least able to bear it.”-Ludwig von Mises The Truth About Inflation

I received 4 text messages and 2 telephone calls anew this week from different banking institutions offering me loans. This seems like a defining activity since the start of the year. I don’t recall of such persistency to promote access to credit even prior to the Asian Crisis in 1997.

Yet I assume that this could be a national dynamic. Nonetheless, I can’t help but associate the actions in the Phisix to such anecdotal evidence.

Obviously, the domestic banking system which functions as the primary source of funding, has only been responding to regulatory policies.

While we don’t have available national data yet as proof for our assumption, a prolonged accommodative monetary environment will imply further space for mass speculation and a greater degree of consumption growth-that is likely to be reflected on our economic statistics.

And this seems to be the case for Asia, see Figure 1.

Figure 1: Danske Weekly: Recovery Gets More Visible

As Danske’s Fleming Nielsen wrote in his Weekly Focus, ``June’s economic data confirmed that Asia is experiencing a pronounced upswing, with strong industrial production numbers across the board. Countries such as South Korea and Thailand, which were hit exceptionally hard by the global financial crisis, are seeing industrial production recover to pre-crisis levels at a surprising clip. There are also signs throughout Asia that domestic demand is picking up – especially private consumption, with rising retail and car sales in the past couple of months.” (emphasis added)

For us, aside from the government policies, such intense reaction has been a manifestation of the “anomalous” collapse in the last quarter of 2008, which had been due to the seizure in the US banking system which rippled globally- a shock we called as Posttraumatic Stress Disorder (PTSD) [see What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis].

Apparently the current actions in the financial markets and economic stats have strongly been validating our views.

Moreover, we see other national and regional quirks posing as significant influences that can electrify the pricing of regional financial assets.

As discussed in Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble, ``it is likely that high savings rate combined with loose monetary policies to induce speculation, fiscal stimulus applied, largely unblemished banking system, and low systemic leverage that has impelled a bidding war in the stock markets and commodity markets.”

The Growing Inflationary Bias Of Asia’s Markets

For the longest time we had been advocating that in a world of central banking and virtual free lunch money polices, bubble cycles emanating from these are likely to be imbued more by Asia and emerging markets since developed economies have debts that have been “hocked to their eyeballs”.

Doug Noland in his Credit Bubble Bulletin says the same, `` The most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative flows. Things that the “developing” world needs (energy/commodities) and wants (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.”

And the transmission mechanism from US Federal Reserve policies into global assets have nowhere been more explicit see figure 2.

Figure 2: Stockcharts.com: US dollar Index’s Inverse Correlation

As we pointed out in Asia Sows The Seeds Of The Business Cycle, a breakdown in the US dollar index (USD) seem likely to propel a reacceleration of the asset bidding wars.

The USD indeed broke down last week which likewise brought many global stock market benchmarks to new post crisis highs (the Philippine Phisix nearly touched the 2,900 level). However, Friday’s announcement of the US unemployment data, which showed a modicum of progress, may have incited a USD short covering.

The fun part is identifying the apparently synchronized inverse correlation of oil (WTIC), Emerging Market stocks (EEM) and Asia ex-Japan (DJP2) where the crucial inflection point has been vividly demarcated in March (see the red horizontal line).

So those arguing on the basis of the traditional fundamentalist metrics seem to be looking at the wrong picture. Inflation appears to be increasingly the principal moving force behind the motions of the progressively interconnected global financial asset markets.

The Global Crack-Up Boom

Where financial markets once functioned as signals for economic transitions, it would now appear that financial markets have become the essence of global economies, where the real economy have been subordinated to paper shuffling activities.

What was once a feature dominated by the West, seem likely to get assimilated rapidly by the East as government policies appear to be directed at either juicing up or controlling the “animal spirits”.

Nonetheless today these dynamics have been “globalized”.

Proof?

We pointed out last week (see The Inflation Cycle Accelerates; Asia As Chief Beneficiary) how China has been dithering over the explosive rise of its stock and property markets wherein policymakers signaled intentions to rein the markets by restricting flow of credit. However, the violent response in the stock market compelled a retraction from authorities.

This week we see more of the same.

Publicly listed state owned China Construction Bank President Zhang Jianguo reportedly resolved to materially prune its credit expansion. According to Bloomberg ``the nation’s second-largest bank will cut new lending by about 70 percent in the second half to avert a surge in bad debt.”

The result had been the same, after a reaching a new high, China’s Shanghai Index crumbled over the last 3 sessions to end the week down 4.4%.

In the US, the path to serfdom continues, the Federal Trade Commission has issued new rules to ``crack down on fraud and manipulation that can drive up prices at the pump.” (Bloomberg) Oil prices which had been on a tear mostly reflecting on the US dollar’s earlier breakdown, had been tempered anew by the realized regulatory actions (more than just threats), aside from the sharp rally in the US dollar.

Still the WTIC rose by over 2% the week.

In the UK, the Bank of England (BoE) surprised the markets when it announced additional quantitative easing measures. This means that the central bank will be issuing ‘money from thin air’ to acquire domestic sovereign instruments (Gilt) as well as “high” quality corporate debt (Marketwatch). While directly such policies are aimed at propping up the financial system, implicitly it further implies support to financial asset prices. The British pound fell .21% over the week.

In anticipation of prospective inflation, Australia will be resurrecting issuance of inflation indexed bonds as a hedge. According to Bloomberg, ``Australia will sell its first inflation-indexed bonds in six years as record stimulus spending worldwide prompts speculation price increases will resume once the global recession ends…

``Asia-Pacific governments including Australia, Japan and Thailand had signaled they may sell inflation-linked bonds as improving economies threaten to boost the price of goods and services. Australia, which considered scrapping its bond market in 2003, boosted its debt outstanding by 67 percent to A$101.1 billion ($85 billion) in the year ended June 30, about 10 percent of its gross domestic product.”

The significance:

One, when government and financial claims grow more than real output or available economic resources the outcome is materially higher prices.

Two, governments are in a predicament, while they want to see sustained elevated or high financial asset prices, to give the impression of economic growth and to further unleash “animal spirits” or expand risk appetite, the demand from excessive money has also diffused into scarce economic resources which has compelled them to impose price controls [as previously discussed in The Inflation Cycle Accelerates; Asia As Chief Beneficiary].

Price controls will only cause arbitrages into markets that are more open, it would also reduce market pricing efficiency by distorting them and enhance shortages which would fuel more volatility.

Here, as expected governments are bent to deal with the symptoms than the cause. The superficial nature of policy actions enhances nurturing the bubble cycle.

Three, bubble affected economies will likely prompt for more borrowing (see figure 3) and more money issuance activities as signified by Bank of England’s QE or Secretary Tim Geithner’s request to the US Congress to expand debt limit to $12.1 trillion (HT: Craig McCarty).

As Doug Noland aptly observed of the inflationary pyramid being erected (from the same article), ``The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubble) implosion. Only “government” (Treasury, agency debt, GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDO, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.” (emphasis added)

Figure 3: Bloomberg Chart of the Day: Addiction To Debt

The above chart shows that in the US it now takes about $4 dollars of debt to generate $1 of economic output (left window), while debt to GDP ratio has soared to 372%, which is clearly unsustainable.

Yet the policy direction is assuredly headed towards engaging in more borrowing and issuance of paper or digital money. Recently the US extended $2 billion “cash for clunkers” program which incentivize people to replace old cars with new ones supported by government subsidies (Bloomberg) is another example of debt addiction.

As Ludwig von Mises warned, ``But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis." (emphasis added)

The end result would likely be a nasty choice between that of market compelled deflation or hyperinflation.

The institutional bank run in the US that triggered the 2008 meltdown (in financial markets and global trade) was a classic example of the near “collapse of the credit system”.

In short, what is unsustainable won’t last. Artificial measures will only aggravate the imbalances.

In sum, all these account for the phenomenon known as the “crack-up boom” applied on a globalized scale.

Hence a bubble based boom equals a prospective bubble bust and another crisis down the road. So relish the fun while it lasts.

Interim Pause, The Bubble Blowing Dynamics At Least Until The 2010 Elections

Friday’s torrid bounce in the US dollar index could signify as a worthwhile pause for the vastly overheated Asian-Emerging Market stock markets (see figure 4)

Figure 4: US Global Investor: Asia Technically Overbought

According to US Global Investors, ``For the first time since mid-1999, stocks in emerging Asia are trading at more than 35 percent premium to the 200-day simple moving average, an overbought condition which historically has resulted in sizable corrections in the following months.”

So if this should hold true, then a correction would likely be in the range of 10-20%.

Nonetheless we can expect any material decline would likely be met by anxious officials who would hastily act to restore boom conditions.

Remember, in today’s era where policies are skewed towards favoring paper shuffling activities and where the financial sector acts as the principal growth engine of the economy, rising prices are construed as the norm (for statistical purposes) regardless of the substance of the growth. So lofty prices in financial assets will likely be the undeclared policy thrust.

Nevertheless in a bull market hiatus, which is likely a function of profit taking than policy reversals, declines are less likely to move in tidal fashion, as some stocks may generate speculative attention because the marketplace would continually seek for yields in response to the loose monetary environment.

And applied to the Philippine Phisix, foreign buying, which has largely been absent for most of the first semester of the year, appears to have returned. For three successive weeks, we have seen a net buying from foreign funds in both nominal terms and in the broader market.

So the recent approach towards the 2,900 level could be interpreted as the bidding up of Philippine stocks compounded by foreign buying as we had been expecting. In Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble, we said, ``So renewed interests from foreign investors on emerging markets are likely to even propel stock prices to higher levels! We should see the same dynamics reinforced locally. This time it will probably be foreigners chasing stock prices.”

Nonetheless, foreigners entering the local market appear to have been responding to the decline of the US dollar index.

If the US dollar is expected to fall further especially against Asian currencies then such dynamics are likely to be sustained. This would function as an important support to key components of the Phisix which also means a cushion from any major correction.

Figure 5: PSE: Share of Foreign Trade

Yet, despite this foreign trade improvement, the shape of today’s rally has departed from the 2003-2007 paradigm, where this time, local investors have powered the market as shown in Figure 6. Foreign trade from the start of the year have seen only occasional bouts where it gone beyond the 50% level which characterized the previous run.

At the end of the day, domestic policymakers will also want to see such trend persist going into the local national election season, as this would boost the odds of reducing the negative rating of the incumbent President PGMA thereby improve the chances for her appointee during the national election derby.

Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble

``No two economies are ever alike in details. The composition of the industries changes. The expectations of people change. The government changes. The international linkages and governments change. The monetary systems vary. The skills and composition of the labor force change. The technology changes. The knowledge changes. The goods being produced and consumed change. The institutions change. Need I go on? No one understands an economy, and no one can understand a business cycle in an economy. I mean really understand it. Sure, there is a broad understanding. There is a grasp of certain features. We are not bereft of knowledge. But we do not know the details. We do not understand the linkages or what goes through people’s minds and affects their behavior. All the models we use, including the Austrian models, are more or less broad-brush affairs.”-Michael S. Rozeff Fiscal and Monetary Policy Annoy Me

As of Friday’s close, the Philippine Phisix passed the 2,500 Rubicon.

And by doing so the Philippine benchmark has recovered some 48% of its losses from the 2007 pinnacle and is now about 52% away from a full recovery, see Figure 1.

Figure 1: Phisix: On A Halfway Mark To A Complete Recovery

To attain the present levels, the Phisix has tallied a blazing 6 consecutive weeks of gains.

The Predicament of Mechanical Chart Reading

A mechanical chart practitioner, without the understanding of the underlying fundamental dynamics, would have seen resistance after resistance being broken, and as consequence, would either have been left behind watching in ‘shock and awe’ and immersed in ‘regrets’ (constantly muttering “I should have…” or “I could have…”) or have been frantically chasing after adrenalin infused stock prices.

True, technically speaking, the run in the Phisix have been overextended but the hallmarks of major trends can translate to serial bouts of trend overreach.

Moreover, historical actions can’t serve as precise guide simply because the underlying circumstances between the points of comparison could be distinct; where possible incidences of parallelism would depend on the degrees of circumstantial similarities.

Minyanville’s James Kostohryz, an investment banker, hits the nail in the head in his Anatomy of a Losing Trade, ``There's no such thing as a market being “overdue” for a correction. This is pure nonsense. There's no reason why a market has to behave in a fashion that one is comfortable with. Past experiences are only relevant to the extent that current circumstances are analogous. In this case, they weren't. So leaning on past experience was a mistake.”

The lesson is that mechanical chart reading signifies as oversimplification of reading and analyzing markets which is an inferior way to generate outsized returns.

Market-Real Economy Divergences Underscore Reflexivity Theory At Work

Yes, markets can go anywhere over the interim. This means that profit taking could surface or that a countertrend cycle can emerge.

And markets could use divergences in current events relative to markets to justify such actions.

Figure 2: NSCB: Philippine GDP At The Edge of Recession

Take for instance the descending trend of economic growth as shown in Figure 2. 1^st quarter Philippine GDP growth surprised to the downside with a substantial slowdown (NSCB).

However this hasn’t been the case. On the contrary, the Phisix got fired up to account for a remarkable 5.83% gain week on week and for a cumulative 35.02% advance year to date!

Of course we expect the mainstream to read this as an “inflection point” so as to “rationalize” current market actions. And this is what we have been expecting for sometime.

Although, it would be a paradox to note that the Phisix had been stabilizing in the first quarter even as the economy had been undergoing a belated precipitate decline in economic activities, the operating fundamental dynamics underscores the reflexivity theory at work.

As we wrote in The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery, ``In short, the reflexivity theory -from fact to perception and now perception to facts-seems to be succeeding at recalibrating the market’s mood.” Rationalizations of market actions (perceptions) to the real economy may indeed translate to a turnaround (prospective fact).

We see the same divergent mechanisms or reflexivity theory operating even in our regional contemporaries.

Except for Indonesia whose economic growth clip over the same period has marginally slowed but remains substantially up at 4.4% (guardian.co.uk), Thailand and Malaysia recorded negative growth and could be in the threshold of a recession.

Yet, Indonesia’s bellwether the JKSE has on a year-to-date basis displayed the bulls’ overwhelming dominance to account for 54% of gains, while Thailand’s SETI has tabbed 34% and Malaysia’s KLSE 23%.

BSP Policies To Add To Inflation Woes

Going back to the Philippines, the substantial decline in growth has extrapolated to a hefty drop in inflation which has prompted the Philippine central bank the Bangko Sentral ng Pilipinas (BSP) to cut rates to a 17 year low, see Figure 3.

Figure 3 Reuters: Philippine Inflation

The Consumer Price Inflation has basically fallen below Bangko Sentral ng Pilipinas (BSP) policy interest rates.

I don’t know how accurate this inflation gauge is, but to my observation, commercial rice prices in our location have remained at the price levels near the peak of the inflation cycle and haven’t manifested any meaningful deviation as accounted for by the published official statistical account. Rice is a key component in the inflation index (see chart here).

Nonetheless, the steep fall in the domestic inflation index appears analogues to the Posttraumatic Stress Disorder (PTSD) impact on global trade last year. It most likely reflects on a lagged impact of the global financial and economic shock from the seizure in the US banking system on the real Philippine economy, which is likely to be a temporary phenomenon, especially that prices of commodities have returned with a vengeance.

Yet like all central bankers who believes they can control the economy “to avert recession” by adjusting knobs through monetary tools, our BSP has joined its global peers to impose Zero bound policy rates and has declared the possibility of more rate cuts. And in doing so, have revved up the business cycle which has been premised on the unsustainable highly flawed economic ideology of borrowing, speculating and spending policies to boost the economy.

As you will observe, policymakers everywhere are innately reactive than proactive. Current market prices have been signaling a return of inflation yet the focus by policymakers have been on past data. Commensurately, the policy response is to address the past concerns. Unfortunately, such responses would result to short term gains but with lasting damage far greater than any interim benefits.

Hence, Philippine policies have been contributing to the global “super” inflation dynamics.

While it had been a delight to read that our honored BSP Governor Amando Tetangco quote one of our inspirational economic icons in his speech at the Australian-New Zealand Chamber of Commerce Philippines Annual General Membership Meeting, Makati-City last 14 April 2009, where he said, ``Frederic Bastiat, a 19th century French economic journalist, once said, “there is only one difference between a bad economist and a good economist: the bad economist confines himself to the visible effect; the good economist takes into account the effects that can be seen and those effects that must be foreseen”, disappointingly the venerable Governor doesn’t seem to be practicing what he had preached. And quoting Mr. Bastiat looks more like an ornament to spice up a talk.

Policies Shape People’s Incentives, Foreign Funds Flows Recovering

Policies shape people’s incentives.

The low interest rate regime has begun to show signs of gaining traction. This has spurred a boom in domestic banking credit in April (BSP) and equally a hefty liquidity expansion as reflected by the domestic M3 which grew by 13.7% in April (BSP).

Of course while bank loans to industries may presuppose usage, we can’t say if the loans had actually been used as so designated. Possibly some of these could have been diverted to the stock market.

Figure 4: PSE: Percentage Share of Foreign Trade: Local Participants Dominates!

The present boom in the Philippine Stock Exchange (PSE) has been mostly due to local participants, see figure 4. This is in contrast to the previous cycle 2003-2007 where foreigners functioned as the market’s driver.

The share of foreign trade has hardly gone beyond the 50% threshold as exhibited by the black horizontal line, since the start of the year.

This local buying phenomenon has been a primary feature in the present epiphany of stock markets in Emerging Markets and in Asia.

To quote the high profile contrarian analyst from CLSA Mr. Chris Wood whose interview can be seen here, ``What is being positive there in the rally began in Asia in October-November last year, is that we've seen growing local investor participation in Asian market, so the people who bought earlier in this rally since late last year weren't foreign fund managers but local investors throughout the region. That growing local investor participation is a long term positive.” (bold highlight mine)

For us, it is likely that high savings rate combined with loose monetary policies to induce speculation, fiscal stimulus applied, largely unblemished banking system, and low systemic leverage that has impelled a bidding war in the stock markets and commodity markets.

Of course, for media and mainstream, it would prominently be the “high” economic growth story which we won’t disagree with.

Figure 5: PSE: Improving Foreign Trade

Notably, foreign trade on the account of the falling US dollar index has also been improving see figure 5. For most of the year, foreign trade has largely been a net selling.

I excluded from the chart the April 30 foreign trade data which incorporates the special block sale of San Miguel Brewery to Kirin, because it skews the chart by making little visibility to current market action. Nevertheless, the red line manifests the reemergence of foreign buying activities but has remained minor to local activities.

And this hasn’t been an insulated event. Fund flows to emerging markets have begun to pick up steam.

According to this report from Bloomberg (bold highlight mine), ``Emerging-market equity funds received $3.79 billion in net inflows for the week ended June 3, led by investments in Asia excluding Japan, EPFR Global said.

``Funds that invest in Asian stocks excluding Japan added $1.54 billion, the most in dollar terms, while global emerging- market equity funds attracted $1.07 billion, the Cambridge, Massachusetts-based research company said in a report dated yesterday. Latin America stock funds drew inflows of almost $1 billion, while funds investing in Europe, the Middle East and Africa gained $230 million.

``Emerging-market stock funds have taken in $26.1 billion of net inflows this year, following 13 straight weeks of gains.”

So renewed interests from foreign investors on emerging markets are likely to even propel stock prices to higher levels! We should see the same dynamics reinforced locally. This time it will probably be foreigners chasing stock prices.

The Peso Riddle

For me one of the current major puzzles has been the underperformance of the Philippine Peso, in spite of the spirited rally of the Phisix and in the face of the sagging US dollar.

While the Peso has been marginally up from the start of the year, it has underperformed most of its contemporaries.

My conjecture is that foreign portfolio flows could have had considerable influence to this and my suspicion is that since foreigners had been basically net sellers the Peso hasn’t responded positively.

However, if foreign flows into the Philippine Stock Exchange continue to improve then we might see a sizeable move in favor of the Peso.

The other possible factor is government intervention.

Officials could be intervening in the currency exchange markets so as to “contain” appreciation of the Philippine Peso relative to the US dollar.

Lately some accounts of such intrusions have been observed in the region, according to the Wall Street Journal, ``central banks in South Korea, Thailand, Taiwan, Singapore and India are believed to have sold their currencies”.

So considering the economic ideological underpinnings by our officials, there is a good chance that government involvement to support “OFWs” which has been a popular cause, and exporters could have been a factor for the Peso’s inferior performance.

Conclusion

The flagrant disconnect between markets and the real economy has reached Philippine shores, where monetary forces seem to be the overwhelming driver of the rejuvenated Phisix.

While the Philippine economy has been less sensitive to exogenous bubble bursting woes abroad, local policies have now been contributing to the collective global efforts to “reflate” economies. And mounting evidence shows that markets have been increasingly responding to these policies.

The positive signs from current market actions are likely to have some influence to the real economy, which essentially validates the reflexivity theory. Although, present policies will likely fillip speculative spirits instead of promoting real investments.

Moreover, the resumption of the bear market in the US dollar has now widened the portal for foreign money flows into emerging market financial markets. As the initial thrust over the past months had been due to local money, foreign money could now function as the secondary engine to sustain the upswing in the domestic financial markets. This dynamic could also tilt the fate of the Peso which could have been hampered by previous accounts of net foreign selling or by government intervention in the currency markets.

With monetary forces clearly at the driver’s seat, the Phisix could be on its way to a full recovery and could even prompt for our target of Phisix 10,000 (perhaps sooner than later).

The unfortunate part is that we are clearly in an embryonic phase of the next bubble, thanks to policies that cater to economics of abundance in a world of scarcity.

And unlike the 2003-2007 cycle, which saw the Phisix as a victim of contagion, if present internal policies and external transmission persists to inflate the bubble, then the bubble dynamics will become structural for the Phisix and the Philippine economy.