Stock Markets: Monetary Policies Have Larger Impacts 2

``“Movie-plot threats”: the tendency of all of us to fixate on an elaborate and specific threat rather than the broad spectrum of possible threats. We see this all the time in our response to terrorism: terrorists with scuba gear, terrorists with crop dusters, terrorists with exploding baby carriages. It’s silly, really, but it’s human nature.’- Bruce Schneier, American Cryptographer and computer security expert, interview at Freakonomics

So where are we headed for?

Figure 4: Ratings and Investment Info: China’s Currency Reserves and the Shanghai Composite

First, we believe that monetary policies have very compelling influence on the directions of asset classes more than what the conventional wisdom leans on--predicated mostly on corporate earnings or on plain vanilla economic linkages as discussed last week.

Figure 4 from Ratings and Investments shows how China’s soaring foreign currency reserves have coincided with the spiraling Shanghai Composite Index. To fittingly quote Professor Michael Pettis of Peking University’s Guanghua School of Management, ``the root of China’s problem is the growth in the nation’s money supply caused by the currency regime.”

Second, the unfolding credit crisis which has been emblematic of the declining collateral values held by major financial institutions is about to test global central banks risk tolerance based on the prospects of deflation or of contracting liquidity.

As evidence, the rescue project by Secretary Paulson code named, “Hope Now Alliance” signifies the intent to slowdown the deterioration of the present financial conditions to the point of undeservingly manipulating contracts. In short, desperate times calls for desperate measures.

By our understanding of the ideological framework of Mr. Bernanke, based on his previous speeches Financial Accelerator and the Helicopter strategy, it is likely that the pursuit to preempt a deflationary outcome would be its principal policy activities. Hence, given such premise, it is our belief that the US Federal Reserve would cut no less than 25 basis points during the next FOMC meeting next week.

Nonetheless, there are other sources of potential risks, which we believe the authorities are well aware of, such as US commercial real estate, other asset backed assets as Auto Loans or Credit Cards, Credit Default Swaps, High Yield Bonds and Derivative Counterparty risks.

Third, with signs of decelerating economic growth becoming more apparent--OECD expects world growth in 2008 at 2.3% compared to 2.7% in 2007 (Canadian Press), global banks appear to be calibrating their policies with that of the US.

Hence, a prolonged turmoil in the credit markets, further downside volatility in asset prices and palpable signs of spillover to the real economy are likely to prompt for more liquidity spillage policies. The BoE and Bank of Canada’s actions are likely the first of a series of moves.

It takes only four central banks to make material impact on global liquidity at present; namely the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. Remember, as we mentioned in the past, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

While we expect the BoJ to remain on hold during this turbulent period, the rest including the hawkish ECB’s Jean Claude-Trichet, are likely to join the bandwagon once such dislocations become evident.

Figure 5: AMEINFO.com Arab General Index

Lastly, as we have been saying all along, we don’t claim to know or pretend to comprehend everything, because the world is too profound or complex to do a simple 1+1=2. There are simply too numerous variables to consider.

However, what we understand is that despite claims that the world financial markets in unison would suffer miserably due to a US hard landing, our perspective is that they could be subject to functional randomness based on the possibility of diverse responses to collective policy activities by global central banks. This could be due to the different state of developments of domestic financial markets, the divergent currency regimes or policies involved or exposure to leverage, as well as the distinctive constructs of the domestic economies, financial globalization notwithstanding.

Figure 5 from the Ameinfo.com tells us that the Arab General Index has climbed this year, unfazed by the recent tumult last August and September similar to China. This goes to show that not every equity bourse have their destiny tied with the fate of US markets…yet. Yes, we understand that most of the bourses indicated have not been significantly open to foreign investors, but our point is with prospects of more inflationary actions, money would have to flow somewhere.

Gary Danelishen writing for Mises.org gives a good account of inflation process (underscore mine), ``New money that enters the economy does not affect all economic actors equally nor does new money influence all economic actors at the same time. Newly created money must enter into the economy at a specific point. Generally this monetary injection comes via credit expansion through the banking sector. Those who receive this new money first benefit at the expense of those who receive the money only after it has snaked through the economy and prices have had a chance to adjust.”

As a saying goes, Discretion is a better part of valor.