Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation

``Since the function of government in issuing money is no longer one of merely certifying the weight and fineness of a certain piece of metal, but involves a deliberate determination of the quantity of money to be issued, governments ..., it can be said without qualifications, have incessantly and everywhere abused their trust to defraud the people." Friedrich von Hayek, Denationalization of Money

The Philippines Phisix got afflicted with dengue fever even before the US caught cold.

Figure 6: courtesy of stockcharts.com: Phisix Underperforms The World!

Yes, world markets of late have been going down, but our Phisix have been totally battered or have underperformed relative to its peers see figure 6.

The Phisix is down against its neighbors as gauged by the Fidelity Southeast Asia fund (FSEA-at main window), it is also down against MIDDLE EAST and AFRICA (SPDR S&P Emerging Middle East And Africa-above pane), it is down against Asia ex-Japan (pane below main window) or relative to Emerging Markets (lowest pane)!

So what is going on?

As we previously discussed in Phisix: Domestic Participants Panic! Bottom Ahoy?!, the principal activities in the Philippine Stock Exchange has seen a marked shift from formerly massive foreign selling to an onslaught of impulsive retreat by undiscerning local players.

Yes, this time with foreign participants relegated to the sidelines, local investors continue to stampede out of the PSE!

Foreign participants constituted only 43% of the week’s transaction EXCLUSIVE of the Php 4.738 billion special block sales of Globe Telecoms with Net foreign selling amounting to a scanty Php 176 million.

If we include the special block sales of Globe Telecoms the net foreign buying balloons to P 4.49 billion but foreign trade as pc (%) of total trade increments to only 44%. On Wednesday the 25^th foreign trade accounted for only 30% of the overall trade. The seeming material reduction of foreign trade leaves the Phisix vulnerable to highly impetuous local players who don’t seem to know what is happening.

Reading the ASIAN Yield Curve, The Inflation Bogey

Figure 7 Asianbondsonline: ASEAN Yield Curve

Figure 7 courtesy of ADB’s Asianbondsonline.com depicts of the yield curve of ASEAN sovereign bonds.

For starters, on the Y-axis is the bond yield in %, while the tenor or the maturity in years is found on the X axis. The connected dots signify the yields of the sovereign bonds spread into years.

According to the Federal Reserve Bank of San Francisco, ``The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future. The shape of a yield curve also may provide clues to future interest rate movements—a humped curve indicating that short-term rates (over the next year) are expected to rise, but that over the long-run (several years) rates are expected to fall. The overall level of the yield curve also may shift up or down—at least in part because of changes in inflationary expectations over time.”

So by virtue of the yield curve, we can determine the market’s expectation of economic growth, prospective policy/-ies or inflation expectations that could ascertain the direction of the interest rate movement of a security or in this case of a particular country.

Unfortunately, while we can see the slope, shape and the steepness of the curve, we don’t see the shifts or movements of the curve from its previous position/s.

These are what we can deduce from the ADB yield curve picture.

One, the odd man out-Vietnam manifests of a significantly higher short term rates over long term rates. This implies that the market expects a tight monetary policy to be applied following a surge in inflation figures or expectations. Moreover, the humped or inverted curve also signifies the risks of a potential drastic economic slowdown or even a looming recession.

Two-Indonesia and the Philippines has a steeper sloping yield curve which is an example of how financial markets could be anticipating higher future interest rates arising from either higher inflation expectations or higher growth rates. Note that Indonesia has higher spreads and has a steeper slope which translates to even higher inflation expectations (or growth) relative to the Philippines.

Question is if the inflation has been the purported scourge to Asian markets why has Indonesia JKSE’s significantly outperformed the Phisix down only 15.06% (year to date) compared to the Phisix which has lost 31.90%? This week the Phisix lost 4.35% vis-à-vis JKSE’s -1.67%!

Three-the rest of the region shows of flat curves, which means a small premium in holding longer dated securities or possibly that the financial markets could be unsure of the risks of inflation as a major concern enough to impact the present economic growth.

Except for Vietnam, it seems that the Asian bond markets appear to be saying that inflation threat looks more of a bogey than a reality YET.

The Deflation Phantom, Real Risks Lies In Stagflation

Next, as we have repeatedly argued in Global Depression: A Theory Similar To A Horror Movie?, A Global Depression or Platonicity? II, A Global Depression or Platonicity?, the possibility of a deflation laced global depression on the Philippines or in much of Asia or emerging markets are significantly LESS likely.

Figure 8: ADB’s Managing Cities: Relative Size of Informal Economy

Why? A substantial segment of the emerging market economies thrives on the informal economy. For the Philippines, think of the ambulant vendors- Balut, cigarette or sampaguita; stall vendors- small eateries (carinderias or canteens); rolling store vendors-ukay ukay carts or fish ball or ice cream vendors and other home based business.

According to Asian Development Bank, ``Asian countries and their cities, in particular, have large informal economies. The growth of the informal sector is a rational response to economic opportunities, given the factors limiting entry into the formal sector. Informal housing investment and the use of the home to generate income reflect market realities. Furthermore, the distinction between the formal and informal sectors is often blurred where, for example, householders can work in one sector but live in another. In economic terms, the informal sector is a competitively remunerated population that has decided to live outside of the regulations of the formal sector because of its high transaction costs. The informal sector is the lifeblood of many Asians. Statistics on the informal economy are difficult to obtain and often unreliable. Nevertheless, a recent report shows that in 26 Asian countries, the informal economy contributed an average of about 26% of gross national product (GNP) nationally. The study estimates that the Central Asian republics have the highest proportion of GNP generated by the informal sector, while Bangladesh, Nepal, Philippines, Pakistan, Sri Lanka, and Thailand have more than one third of their GNP produced by the informal sector.”

Much of these informal sectors do not depend on banks or capital markets for access to financing nor do they depend on assets for collateral. Economist Hernando de Soto even identifies the Philippines as one of the representative nations plagued with “dead capital” (Mystery of Capital), or the inability to securitize (property) assets for capital raising or as collateral purposes.

In fact, based on empirical evidence, most of my neighborhood enterprises today avail of the micro financing of “5-6” or 20% interest rates a month (!) from mostly local based ethnic Indians or through some Pinoy moneylenders, which I think is a very popular source of informal financing for micro enterprises (Kyotoreview).

In addition based on the last Asian Financial crisis, while the liquidity crunch in the domestic money system had some impact to the informal sector (e.g. rising inflation/loss of purchasing power from Peso devaluation, increased incidences of non payment, etc…), this was easily covered by overseas Indians who extended financing to the local affiliates or relatives who were engaged in microfinancing via “5-6 schemes”, the growth of alternative financing methods called “Paluwagan” (mutual scheme of rotating savings) or the “Hulugan” (selling based on installment payments) and from Local government units via livelihood linked lending schemes (iadb.org- Prof. Mari Kondo, Asian Institute of Management, The Preliminary Findings on the Impact of the Asian Financial Crisis on Microfinance Institutions:A Case on the Public Market in the Philippines).

So the risks for emerging market economies seem likely to come from a stagflationary environment than from a deflation contagion.

Stocks As Inflation Hedge

Finally while the external environment looks quite hostile at the moment, we should think of this as windows of opportunities than simply join the ranks of the lemmings to the tune of the fabled Pied Piper of Hamlin.

US money policies are being circulated worldwide via low nominal interest rates or negative real rates as espoused by many central banks, this ensure a loss of purchasing power for the currency holder under this regime. According to Joachim Fels of Morgan Stanley, around 50 countries or one in four countries in the world are plagued by double digit inflation! This means that many countries are behind the curve in neutralizing domestic inflation.

Under this environment, whether you are in cash, bonds or in stocks most of the public have been losing money, directly (stocks or bonds) or indirectly (cash). Because inflation is a stealth tax against the country’s productive capacity, this loss of purchasing power is seen and felt via rising prices of goods and services. The natural beneficiaries are those who inflate the system (government).

The best insurance is to partially diversify into stocks because equity investments can account for as a store of value since they mostly represent storehouse of assets. Of course, not all stocks are cut from the same cloth.

In Vietnam, because of high inflation rates and the government’s constant intervention in the stock market to prevent its fall (down 67% after skyrocketing by over 7 times!) the public has sought protection in gold making it the largest gold market in the world. Yet the Vietnamese government, in order to maintain the faith of the public to its currencies, has barred gold imports.

This from Professor Michael Pettis of Peking University's Guanghua School of Management,

``Apparently, and in order to protect themselves from inflation, so many Vietnamese are buying gold that Vietnam has suddenly overtaken China and India as the world’s largest market for gold bullion. This orgy of gold buying has, of course, worsened Vietnam’s trade deficit, although I would argue that gold imports for investment purposes should be seen more as a reduction of the capital account surplus than an increase in the current account deficit, but either way it represents a drain on reserves. Although gold imports are regulated, until the suspension Vietnamese gold imports had soared. Gold imports for the first quarter of 2008 were up 71% over the same period last year, and imports of gold bar (which of course is what gold investors typically buy) were up 110%. I have said many times in this blog that I suspect that if we see problems with inflation or capital flight in China, one form these are likely to take are through gold purchases.”

If the Vietnamese understands that the insurance to the loss of purchasing power can be hedged by gold purchases, what does Filipinos understand as an inflation hedge? Politicians? The US dollar?

You can just see how the US markets reacted to the recent downfall in its equity markets last week…a corresponding surge in gold, gold mining and general mining stocks (revert to table 1)!

In addition, what do you think would happen to gold prices if Prof. Pettis is right, where 1.3 billion Chinese flee to gold as an insurance against inflation?

Anyway, in this cyclical bear market period whose bottom I think should be nearing, the following companies account for the highest dividend yields based on PSE’s April closing (source PSE monthly).

National Reinsurance 11.34%, PNOC-EDC 7.1%, Salcon power 20.5% First Gen 7%,Ginebra San Miguel 8%, Tanduay Holdings 7.45%, Holcim 6.18%, Anglo Phil 6.94%, Cebu Property Venture 6.25%, Polar property 6.35%, Aboitiz transport system 25% Republic Glass 8.82%, Pldt 8.74%, Globe Telecoms 8.86%, Asian terminals 7.27%, Far Eastern University 2.46% and Semirara Mining 8.16%.

Meanwhile, the Phisix has a dividend yield (annual dividend/ price per share) of 4.32% and 3.63% for the total market. Besides, April’s Price to Book Value for the Phisix is 1.77 while the Price Earnings Ratio is 12.29. With the Phisix down by over 10% as of Friday’s close relative to last April, this should pump up the figures of present dividend yield aside from depressing the PBV and PE ratios.

Many of the dividend yields have nearly caught up with present inflation rates (9.6% in May), or are nearly at par with benchmark 10 year Peso bonds (currently 9.496% as of June 27^th-asianbondsonline).

In short, the lower the Phisix goes the more attractive these yields offer relative to fixed income while the risks aspects into stocks diminishes.