Emerging Markets and the Philippines: The Last Shoe to Drop?

``The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”-George Soros, The worst market crisis in 60 years

Global depression advocates were in boisterous gaiety following last week’s synchronized global equity carnage and used such occasion to pontificate and bash the topical “decoupling” paradigm as preposterous, a myth or a figment of imagination.

In our view, such “know-them-all” outlook ignores the general circumstances of the unfolding war of attrition between the forces of inflation and deflation, where the present episode of a battle won is unduly justified as equivalent to a final victory in war.

Yes, we agree that market forces will eventually undo every government induced imbalances, but the world is more complex than is commonly assumed even by these experts.

Austrian Economist and 1974 Nobel Laureate awardee Friedrich Hayek in Individualism and Economic Order explains of the dynamics of changes which emanates from the individual level, ``For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since only the tastes and not the actions of individuals can be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other peoples' actions, there is no reason why these processes of successive changes should ever come to an end.”

Put differently, an individual’s response to the conditions which one encounters differ from the response of other individuals, and these separate responses underpin such “change” dynamics which makes it hard to qualify and quantify. Thus, if a community of individuals has different reactions to variable conditions, could we be assured that the deduced proximate causal relationship based on the different levels of economic and financial interdependence as opined by experts lead to the same distribution outcome? Can we also expect of the same responses from government officials in the face of divergent political pressures?

In the recent past when developed economies as the US suffered from “shocks”, emerging markets bore the brunt of such radical adjustments, as shown in Figure 2, courtesy of IMF’s Global Financial Stability.

Figure 2: IMF Global Financial Stability Risk: Improving Performances of Emerging Market Assets

This is an important picture: notice that during the last 3 minor selloffs in the US markets prior to the July credit squeeze, which ranged around 5-7% (rightmost graph), namely in April-May 2004, May-June 2006 (Yen Carry Unwind) and February-March 2007 (Shanghai Surprise), the degree of the losses accounted for by emerging markets (leftmost graph) had been thrice as high at the start (2004 and 2006), but has considerably lessened (2007).

In short, the volatility trends in emerging markets has seen tremendous improvements relative to its Beta coefficient; the previously HIGH beta was cut by almost half in February 2007 when compared to the losses in the US S & P 500.

Today’s turbulent markets reflect the same improving dynamics. As earlier stated, the S & P 500 has lost 15% as of Friday’s close while the Phisix is down 16% from its peak and so with emerging markets (EEM) at 19%. If the same volatility had been applied relative to its 2004 and 2006 scale, then emerging market benchmarks and the Phisix would have caved in by about 45%!

Yes, we remain undoubtedly “coupled” to the US markets yet, but “recouplers” are “reading the tea leaves” from too much of only one facet of the “interrelated” global asset class.

Go back to figure 2 and I’ll show you more. In between the S & P 500 and the MSCI emerging market equity benchmark are three other benchmarks, respectively, external debt (EMBI Global), Local currency debt (GBI Emerging Market) and currency.

The same marvelous progression dynamics with the equity markets can be said of these asset classes except that…

Figure 3:asianbondsonline.com: Philippine Bond Yield on Major US Issues (left) and 2 year and 10 year Local Currency Yield (right)

…unlike in the past where emerging market equity volatility led to equivalent losses but at a very much mitigated degree, today’s volatility has even accounted for surprising gains (!), (read my lips G-A-I-N-S) -if one reads into the Philippine markets as a possible representative of the emerging markets.

Figure 3 courtesy of ADB’s asianbondsonline.com shows that bond yields of Philippine papers in both local currency issued sovereigns (left) and US dollar denominated sovereigns (right) are presently LOWER. Since bonds yields and prices are inverse, this means bond prices have been climbing HIGHER a year on year basis. In short, positive returns amidst a negative equity market landscape. The same holds true if compared with the JP Morgan Emerging Debt (JEMDX) funds on the same timescale.

Figure 4:asianbondsonline.com: Peso-US Dollar/ Peso Japanese Yen

Again if one looks at the Philippine Peso we see the same mechanics at work. The Philippine currency amidst the global turmoil continues with its winning streak, not only relative to the US dollar, in spite of the April-May 2004, May-June 2006 (Yen Carry Unwind), February-March 2007 (Shanghai Surprise), July-August 2007 (global credit squeeze) and today’s US recession concerns, but has also risen against the Japanese Yen as shown in Figure 4. This even comes in the face of a lower growth rate of the much ballyhooed Peso driven OFW remittances in November (inquirer.net).

Although we may not be bullish on the Peso relative to the Yen (global volatility should lead to possible repatriation Japanese money invested abroad which could mean rising Yen and a lower Peso), the point is global financial markets appear to be pricing in a market beta of “muted convergence” (a.k.a. recoupling) for the emerging markets ONLY in the dimensions of the equity markets!

Of course the markets may again rule against my outlook as in January 11, [see Windshield Outlook: NO Signs of Global Depression], but until we see these happen again, present trends appear to signal emerging market resiliency than weakness.

How can these not be, where US markets have been reeling from the heat of potential credit rating downgrades of key corporations, including major bond insurers as discussed last week (yes-more US taxpayers money coming- New York Insurance Superintendent Eric Dinallo to the rescue?) (cnnmoney.com), on capitalization, losses and lower earnings concerns, the Philippines has recently been stamped with good seal with an accompanying credit ratings upgrade from “stable” to “positive” from Moody’s (inquirer.net).

Further, recency bias had been exhibited by some ivory tower ensconced experts as highlighted by mainstream media, following the recent thrashing in the domestic equity markets. According to an alleged expert, one of the main risks of the local economy is that Business Process Outsourcing (BPO) will endure job retrenchment from a US slump. Huh? We don’t follow the logic.

The major reason, according to C/Net.com, why companies outsource some of their work is due to cost-cutting. A slump in the US will prompt for more cost-cutting measures, which possibly means more prospective outsourcing, not less. Remember the Y2K problem or the Millennium Bug Crisis of 2000 (news.com) in tandem with dot.com crash helped fueled the Indian-led outsourcing boom we are witnessing today.

Bottom Line: one of these markets will definitely be proven wrong soon. Will there be an emergent divergence in the global equity markets? Or, will emerging market bonds and currencies collapse under the weight of US-UK-EURO deflationary selling pressure?

The man who broke the Bank of England in the 1990s in the person of billionaire philanthropist George Soros (Financial Times) recently wrote, ``Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.” (highlight mine)

A bank analyst recently asked, ``will emerging markets be the last shoe to drop?”