Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited.”- George Soros

Activities in the financial markets can never be explained in a straightforward narrative manner.

You’d probably wonder why despite gloomy economic news in the US and in other major developed economies aside from declining corporate profits, global stock markets continue to remain elevated or are surprisingly even advancing.

Moreover, as commodities recently tanked some observers commented that the reason stocks are recovering could be due to falling inflation pressures which could likely improve corporate margins. Such argument appears unfounded.

If it is true that commodities prices have been boosted by soaring demand, then the present pace of decline should imply of contracting demand, which could be reflective of a meaningful downshift in global economic growth, see figure 5.

Figure 5: US Global Investors: Moderating Asian Exports

Asian exports are, as shown by US Global Investors, all rolling over led by a severe decline in US imports. Now the decline has been similarly seen with European imports but in a time lag. Imports of commodity producers have likewise “peaked”.

Thus, by sheer induction, equity asset prices should continue to face pressures from downside revaluation, unless the markets foresee a recovery over the near term (which is very unlikely).

In addition, if it is also true that the falling US dollar have prompted for a commodities “bubble” as argued by some then the recent US dollar rebound suggests of liquidity contraction or a monetary tightening which should also signify negatively for equities too.

Yet, stock markets continue to perform strongly even when seasonality factors such as “Sell in May and Go Away” say it shouldn’t.

Drooling Over US Financials

Meanwhile others have been drooling over at the gains accrued by the US financials following the recent bear market “reversal” marked by the buyout by JP Morgan of investment bank Bear Sterns under the facilitation of the US Federal Reserves. The impression etched by the rallying US financials is that it has bottomed or is on a path towards recovery.

We doubt such premise. To quote Mohamed El-Erian of PIMCO,

``Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.”

This means that even if the Fed have “successfully” patched some of the liquidity dislocations in the financial markets (as evidenced by some improvements or narrowing of credit spreads) by absorbing tainted assets as eligible collateral, recessionary pressures from the real economy could add to its portfolio (consumer) loan losses which are likely to require additional capital raising exercises given the delicately compressed capital ratios, as much it is likely to its impact business operations in an environment of slowing demand, tighter lending standards and reduced investments.

Nevertheless, the disruptions (unidentified losses) in asset securitization remain an unresolved problem aside from the onus of new government regulations.

Global Central Banks Inflating Away….

So, again why are the stock markets surging?

Quoting Fritz Machlup in The Stock Market, Credit and Capital Formation ``... 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.”

In contrast to mainstream analysis, our view on the stock market has always covered “inflationary” policies conducted by monetary authorities.

It is a reason why we believe stock markets don’t always relate to the oversimplified tale of micro/macro economics or corporate earnings and may diverge from “realities”. Because central banks can always excessively inflate the system, from which to serially “blow bubbles” in terms of assets or goods as the purchasing power of a currency erodes.

We always love to cite Zimbabwe as an example. The country has been suffering from successive years of chronic hyperinflationary depression whose inflation rate is 165,000%, has 80% unemployment rate and whose currency is traded at Zimbabwe $150 million per US dollar when officially pegged currency is at Zimbabwe $ 30,000 to a US dollar or 5,000x its official rates! You can just imagine the Philippine Peso pegged at 42 to a US dollar but whose black market rate is at P 210,000 to a US dollar.

Yet in spite of the depressed earnings (no earnings to talk about) and a recessionary economy, its stock market has soared by 360% in just three weeks! See the irreverence to mainstream analysis?

We seem to have the same dynamics today in global markets. What we could be witnessing is the impact of concerted REFLATIONARY policies by global central banks. And this has could have spurred the “rotation away” from commodities and into the general equity markets spearheaded by the financials (But this “rotation” isn’t likely to be a lasting trend).

This from Morgan Stanley’s Joachim Fels, ``global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years.”

So essentially, the Fed has been injecting steroids into the financial markets, as much as other major global central have provided liquidity support to a distressed financial system, while emerging markets have long undertaken expansionary policies that has nurtured explosive demand growth in food and energy. In addition the recent spikes of food prices have further aggravated such these inflationary measures of instituting safety nets to buy off political stability.

Figure 6 US Global Investors: Asian Real Rates are Negative!

So circumstantial evidence suggest that the recent bounce in global equity markets could have been in response to the expansionary monetary policies whose real interest rates has somewhat turned negative, as shown in figure 6 courtesy of US Global Investors which accounts for the average real rates in Asia. The region holds about 70% of foreign exchange reserves. Negative real rates are likely to support more leverage driven speculative activities.

Dissent Over Subsidies, Risks of Heightened Inflation and Moral Hazards

And the efforts to subsidize the financial system has not ended in the US as the US Federal Reserves continues to expand the scope of its outreach “nationalization” programs to cover unconventional areas as student loans, credit card debts and car loans as collateral for financial institutions.

Some experts/authorities have expressed dismay over the seeming relentless use of taxpayers money to support the financial sector…this quote from Bloomberg, ``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Two more quotes from the same article,

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The point is that policy measures undertaken by the Bernanke leadership have clearly caused some vocal dissent over the risks of increased inflationary pressures.

Snippets

The snippet of my observations:

-Inflationary activities (marked by negative real rates) by global central banks could have been responsible for bloating global equity markets.

-The recent outperformance of the financials which took away the centerstage from commodities isn’t likely to be an incipient long term trend, as continued inflationary “nationalization” programs are unlikely drivers for such reversal. Moreover, recessionary pressures in the US economy are likely to limit any progress for US financials.

-The commodity cycle works best in a negative real rate environment. This could mean that the recent decline of commodities doesn’t account for a hissing bubble but possibly of a normal corrective phase following its near parabolic ascent.

-The expectation of a reversal of the US dollar long term downtrend coming off a Fed pause is likely to be too optimistic. Since the Fed keeps expanding the reach of its bridge financing bridge facilities, this seems enough evidence that its credit system has not yet normalized and could signify as a considerable obstacle to expectations of an earlier recovery by the US economy relative to the world. In short, the US dollar’s recent rally could be an oversold technical bounce.

-While activities in the US treasuries could imply the end of the Fed rate cycle, this would likely depend on the activities in the US stock market which evidently has been proven as a mainstay barometer of Mr. Bernanke.

-Back to the Philippine Stock Exchange. Against a backdrop of recovering world markets, the Phisix seems to be the only laggard for unclear reasons. Yet, as we mentioned before, excessive negative sentiment, negative yield environment, extremely oversold levels and favorable external developments have recently aligned to suggest of a looming noteworthy tradeable bounce if not a potential bottoming process.

Figure 7: ino.com: Rice Prices Off the Record Highs

If the excuse for this slump has been predicated on the rice crisis, then as figure 7 courtesy of ino.com suggests, such “rationalization” may not hold soon.