Phisix: With A Little Help from Negative Real Rates

``All panics, manias and crises of a financial nature, have their roots in an abuse of credit.” Hyman Minsky

Because we believe in business and market cycles, our objective is to viably apply market cycle timing, where we try to identify which stage of the cycle we are in and allocate portfolio accordingly, instead of short-term technical “timing” the markets.

As for the current conditions, our view is that the Phisix like most global markets could possibly be undergoing a countercyclical interim bearmarket which could last anywhere from 3 months to over one year (hopefully I am proven wrong, so good times will continue-its bad enough to see 6 months of drought). As we have discussed in the past, we saw the same pattern during the last secular bull cycle in 1986-1996. There were two bearmarket cycles interspersed within the secular trend, particularly in 1987 and 1989 where the Phisix fell by over 40% on each occasion. Yet the Phisix rose by some 22 times from trough to peak in 10 years.

We see no difference today. Following the string of successes since the cycle turned bullish anew in 2003, one should expect normal countercycles or negative returns even during a secular bullmarket. One has to understand that “No trend goes in a straight line” as the legendary trader Jesse Livermore used to say and we have also been saying this since 2006.

More Decoupling Signs

Yet, we have been watching for signs of probable reversals. As earlier indicated, by measure of bonds and the Peso, the Philippines have gradually manifested incipient signs of “decoupling”. As to whether this is simply an anomaly-which will readjust or “normalize” when countenanced with more selling pressure from external sources or signifies seminal divergence-remains to be seen. The vitality of new trends needs to be successfully tested for several times, get entrenched over a longer period enough to draw in material following, otherwise the trend fails.

Earlier in the week, we were elated to see the Phisix impacted less significantly by the decline in the US. Last February 5, as the Dow Jones Industrials fell by 2.9%, the Phisix fell by only 1.2%! For the week, the Phisix was down a measly 1.6% when compared to the major US benchmarks which slumped by over 4.5%. One week does not a trend make though, but we could be seeing some signs.

Nonetheless this is not a one country event. Our neighbors also reflected the same dynamics, Indonesia recorded marginal losses of .29% and so as with Thailand .55%. On the contrary Malaysia even rose by a hefty 1.63%.

Moreover, the decline by the Phisix had been accompanied by subdued volume, implying a considerable moderation of selling pressure from foreign money. Could it be a bottom for the Phisix and Southeast Asian markets? Too early to tell, but under current global conditions our expectations is for the Phisix to form a more stable U-shaped recovery than an outright resurgence or recovery.

Remember, global markets are still reeling from the forcible selling from institutions holding toxic papers. Global markets are still repricing the readjustments of the balance sheets by major financial institutions as well as repricing of earnings to account for the economic slowdown, aside from repricing expectations from one that is risk tolerant to one of rising risk aversion.

As previously noted, this isn’t limited to the subprime space as the crisis has started to spillover to other facets of the US financial markets and to the real economy as seen in LBOs/junk bonds, Commercial Real Estate, bond insurers, municipal bonds, credit card and auto loans, etc. The economic slowdown emanating from the credit crisis is starting to impact other major economies. Many losses have yet to be identified, booked and priced in, so the risks of more selling pressures is still material.

Now of course, vexatious domestic politics has always been an obstacle to our domestic equity markets but this has largely been discounted. For as long as there won’t be a major political upheaval enough to destabilize and dislocate capital flows, the Philippine financial markets are likely to reflect global or regional sentiments.

Setting Up the Inflationary Credit Supply

However, an important thing to remember is that all major market/economic cycle reversals are characterized by one common variable: excessive leverage. Of course, excess leverage or rampant credit growth are essentially triggered by loose monetary conditions which is exacerbated by investor’s irrationality.

To quote Fritz Machlup in Essays on Hayek ``. . . monetary factors cause the [business] cycle but real phenomena constitute it.”

Or as in the case of stock market again as Fritz Machlup in The Stock Market, Credit and Capital Formation wrote ``... 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.” (highlight ours)

Since the Philippine financial markets have not reached such euphoric levels as to allow its domestic market participants to recklessly leverage and speculate, we believe that the recent US led volatility will impact our markets at the start of the global cycle (today) and eventually “decouple”-seen through either an earlier recovery or via monetary/ inflationary prompted “decoupling”.

With global equity markets still under duress, despite the aggressive monetary policy actions undertaken by the US Federal Reserve, one can expect global central banks to act in concert to avoid the furthering the risks of financial crisis by keep monetary conditions loose even when faced with signs of heightened inflation.

Recently the Bank of England followed the US with its own version of rate cut while speculations that ECB’s Jean-Claude Trichet has opened doors to follow suit caused the euro to tumble fiercely as we predicted at the start of the year.

In the Philippines the consumer price index soared to 4.9% in January largely on the account of rising food prices see figure 6. While local authorities as well as local experts attribute these to domestic factors, we think these is a global phenomenon. Others say it is due to climate change, growing wealth from emerging markets, rapid industrialization, surging oil prices and etc. While we agree that such could be part of the overall range of proximate causes, we believe that these are largely unintended effects from loose monetary policies, aside from distortions brought about by subsidies in the biofuel industry.

Figure 6: DBS Bank: Rising CPI, Declining Money supply

Figure 6 from DBS bank shows how Consumer Price Index has trended lower since the Peso began its rebound in 2005 and has contributed immensely in containing higher consumer prices. Talk about unsung heroes. However the spike in domestic money supply signified by the M3 (red line) in early 2007 may have contributed to the belated rise in the CPI.

Nevertheless, today’s sharp decline of the M3 has been due to the significant liquidity-absorbing effects of the Special Deposit Account (SDA) or a special facility accorded by the Bangko Sentral ng Pilipinas (BSP) to enable banks and Government Owned Companies to avail of higher rates compared to yields from government securities. If consumer prices continue to tread higher in spite of this, then it is likely that we are “importing inflation” via the commodity, oil and food channels.

Will Negative Real Rates Spur A Boom?

Since our 91 day Tbill yield stands at 3.673% according to the BSP, this brings about real interest rates to negative territory which means that holding onto cash or fixed income investments would bring about real losses in terms of purchasing power.

Negative real interest rates will compel the public to find an alternative ‘store of value’ as the Peso’s real purchasing power erodes. In Zimbabwe it is stock market, in Venezuela…it is cars?! From Boris Segura of Morgan Stanley, ``Another reason for the pent-up demand for cars is that they are increasingly being perceived as a store of value in an economy where there are few investment alternatives.”

Further, the public may be induced to pile into more debts for speculative purposes. It may even spawn an economic boom which will eventually turn to a future bust. Aside, negative real rates punish savers and subsidize debtors which will lead to propagation of malinvestments and eventually aggravate social inequality.

Negative real rates are likely to lend support to the Phisix, as Fritz Machlup said above, inflationary credit supply explains a rising stock market.

Figure 7 stockcharts.com: Inflation Paradox?

Talk of negative real interest rates, as major developed global central banks and policymakers work on to alleviate the woes in the financial sphere, we are seeing a resurgence in commodity indices as gold (pane below main window), food, oil (lowest pane) and surprisingly even the metal with a PHD….copper (center window) amidst chatters of a US recession-global slowdown or even a rising US dollar index (above window).

Is Dr. Copper’s present action a revelation of a resurgent global economic activity? Or is this merely a head fake? Or is Dr. Copper insinuating that the commodity inflation spectrum has just gotten wider?