A “Tipping Point” for the Philippine Capital Markets?

``The highest use of capital is not to make more money, but to make money do more for the betterment of life - Henry Ford

WHEN I came across one of last Sunday’s front page headlines from the Philippine Daily Inquirer entitled ``Why Pinoy savers are turning investors”, it brought a smile on my face for validating what we have LONG anticipated; a concrete testament of the emerging transformation on the psychological acceptability of domestic capital markets investing by the local populace.

Front page headlines reflect on national consciousness such that when the concept of capital markets investing turns topical and gets ingrained into the national level (to reach a proverbial “Tipping Point”), we should expect such trends to further deepen.

In Malcolm Gladwell’s marvelous bestseller the “Tipping Point”, this development could be classified as one of the key “principles of an epidemic”--the “Stickiness Factor” or the longer the idea/disease stays the more it is likely to get propagated.

The inherent strength of ANY capital markets basically lies with its domestic investor base or the so-called “home bias” rather than on foreign portfolio money. Unfortunately, local investors have in the past been geared towards a “US dollar bias” which resulted to the low penetration level of participants (demand side) or our much maligned state of the domestic markets which has been likewise reflected in the state of our national economy. This apparently is changing.

Technicians are wont to believe that they alone capture the directions of the markets by reading the psychological aspects from historical market action. In contrast, by understanding the Misesean standpoint of “Human Action”, where the late great Ludwig von Mises said ``Mans striving after an improvement of the conditions of his existence impels him to action. Action requires planning and the decision which of various plans is the most advantageous”, we asserted that prevailing global dynamics would work for this psychological shift among the local investing mindset.

In particular, we have long argued that our underappreciated, as epitomized by the low penetration level by local investors, and underdeveloped capital markets would mainly benefit from the “global liquidity” driven financial market activities, aside from deepening financial integration or globalization trends, as seen by the current symptoms in the APPRECIATING PESO, RISING PHISIX and RECORD LOW INTEREST RATES. And that such reported “savers turning into investors” signify our own version of “searching for higher yields” syndrome.

In other words, global economic trends have militated on local investor actions, notwithstanding, the activities in the Philippine asset classes in general.

Again we see this development under the rubric of Malcolm Galdwell’s third principle of an epidemic—the Power of Context, external or environmental influences play a far greater role than what we conventionally expect of them.

While the article served to highlight on the du jour accelerating trends, we’d like to make illuminate on some seemingly discrepant views covered.

First, the article quotes an official who says that “markets don’t move in the same direction” where he directly cites stocks and bonds moving inversely, as raison d’ etre for portfolio diversification.

Today’s markets have exhibited that some “textbook” concepts have ostensibly become “inapplicable” to a degree or even perhaps have turned “obsolete”.

Figure 1, from the IMF shows that global financial markets have been increasingly correlated in terms of performances gauged from different dimensions.

Figure 1: IMF (Global Stability Report): Growing Correlation Among Asset Classes and Across Borders

This is something I have shown in the past but would like to repeat to reemphasize on the point of correlation.

On the left panel of the chart is the Correlation of Asset Classes with the main US equity benchmark, the S & P 500, and its corresponding Broad market volatility while on the right panel is the Global Speculative Default rates.

The noteworthy aspect is that bonds or fixed income instruments and most especially commodities have in the past been NEGATIVELY correlated; today we are seeing a radical SHIFT where bonds and EVEN commodities or in fact ALL asset classes have been shown to be POSITIVELY correlated! All of the yellow bars signify positive correlation with that of the S & P 500 (right most yellow bar).

On the other hand, the right panel shows where emerging markets and OECD regions have had historically divergent spreads to reflect on the so-called “risk premia”. Today, such default rates have astonishingly disappeared or have even CONVERGED!!!

Again this is reflective of the prevailing perception of “sustainable” LOW RISKS environment where a country’s currency yield and economic growth factor has apparently taken precedence over other risk variables. In the same dimension we have previously showed that 90-day Philippine treasuries rates lower than its equivalent in the US.

From which again we ask; have investors come to price US treasuries as “riskier” than Philippine contemporaries? Has the emerging market class reflected significant improvement enough to classify its assets as equal or near equal to its developed market equivalent? Or has a new paradigm emerged? Or has this phenomenon simply exhibited a pricing misalignment? The future provides the answer in today’s juncture.

This from the IMF’s Global Stabilization Report (emphasis mine), ``...rising correlations in returns across asset classes have meant that the volatility of the overall market basket has not declined as much as the volatility of its component parts—indeed, by some measures it has increased. Insofar as markets have become overly complacent, they may not yet have priced in this covariance risk, which could lead to the further amplification of any volatility shock. For instance, the recent market sell-off in late February 2007 illustrated how seemingly minor, unrelated developments across markets quickly led to the unwinding of risk positions across a wide range of financial assets.”

In other words, traditional justifications for employing the conventional Portfolio Diversification model would simply be impertinent under present circumstances, where risks as well as rewards have been increasingly shared. So before listening to your financial advisor, who would advocate the traditional models of diversification, ask them of how to go around the risks of intensifying financial assets interlinkages.

The second issue which I wish to deconstruct comes from the statement ``This is the difference between a bank depositor and an investor—depositors can expect guaranteed principal and interest while investors can expect principal risk and yield.”

The implied premise is that bank depositors are “risk free” while investors are exposed to “principal risks”.

While this is TECHNICALLY true, that depositors can expect “guaranteed principal and interest”, the argument does NOT deal with the aspect of the depositor’s equivalent of PURCHASING POWER risks, as natural consequences of inflationary policies. This effectively translates to the risks of the erosion of the purchasing power of the depositor’s principal or an investor’s equivalent of principal risks in spite of guaranteed returns.

In the last issue we have dealt with Zimbabwe from where in 2006 their consumer prices indices have astoundingly soared by over 1,700% a year and yet where similarly its stock market has spectacularly spiked by over 12,000% in spite of an economic standstill (literally speaking).

What this means is that under such hyperinflationary environment, or translated to the currency’s massive loss in purchasing power, has compelled the general public to seek safe haven into the only most liquid asset, i.e. the stock market, which has acted as medium of insurance against the drastic fall in the value of its currency.

Since “guaranteed” fixed income instruments are almost equivalent to cash holdings, the loss of purchasing power translates to a loss in value for the depositor’s principal. While the nominal value of the currency remains, it buys increasingly less amount of goods or services in the marketplace.

Figure 2: Gavekal Research (Brave New World): Building an Efficient Portfolio in Our Brave New World

Put in a different perspective, fixed income instruments do well under disinflationary or deflationary environments as they increase the real value of the underlying currency’s purchasing power, while other assets as tangible assets or commodities normally serve as an insurance against a loss of purchasing power, as well as stocks under “hyperinflationary” mode as in the Zimbabwe or Germany’s 1920s Weimar experience. In the context of risks, even the US dollar which was once the Filipino’s favored asset class has shown of its vulnerability.

In Figure 2 courtesy of Louis Gave of Gavekal Research, the Gavekal team outlines a suggested portfolio allocation under FOUR different economic conditions.

In short, in this mortal world NOTHING is EVER “RISK FREE or GUARANTEED” (except for death and taxes). It is only the degree of risks that differs that which is determined by the nation’s primary economic activity.