Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation

``Inflation is like sin; every government denounces it and every government practices it."- Frederick Leith-Ross, famous authority on international finance

We have been pounding on the table for the Bangko Sentral ng Pilipinas (BSP) to raise interest rates because of the external inflationary impact to the local economy (academic vernacular-cost push inflation), and true enough our BSP responded by raising 50 basis points to its policy rates to 5.75% but still way below the rate of inflation to suggest that Philippine monetary environment remains accommodative.

As we have argued in Has The Underperformance of Philippine Markets Been Due To Policy Credibility?, ``It would be a better option for the BSP to raise interest rates and reduce the negative real rates environment if they aim to defend the Peso and contain the consumer goods and services inflation pressures. But if the BSP is concerned about the impact to economic growth from higher interest rates, the market is doing it anyway for them through higher yields in domestic treasuries and from rising consumer prices. By closing the real rates gap at least they can’t be held solely responsible for “bad” policymaking.”

Domestic sovereign yields in local currency and have climbed enough to render a policy reaction or response from our BSP in spite of the IMF’s prodding. As we learned from Nassim Taleb of the Black Swan fame, policymakers are always reactive agents.

While the BSP continues to expect higher “inflation” over the rest of the year, it is likely that consumer price and goods inflation, which does NOT move in a straight line, has already peaked for this cycle.

Why?

Figure 3 stockcharts.com: Inflation Pressures Likely To Ebb

One, the decline of oil prices seems representative of a global growth slowdown as shown in Figure 3.

WTIC oil prices fell by 11% over the week below the $130 threshold crossing over the 50 day Moving Averages, which suggests that Oil is in a CORRECTIVE MODE which may last sometime.

Remember correction mode is a different animal from a Bubble bust; it is my belief that unless governments liberalize or open the oil industry by allowing increased private sector access to geological areas for exploration, or unless technology induced revolution via alternative energy that should gain the required economies of scale or unless innovative radical drilling equipments or rigs for non-conventional oil wells are introduced, oil supply will remain under pressure from declining major wells in spite of softening demand and thus put a floor on oil prices.

According to teachitworld.com ``Oil production is decreasing in 54 of the world’s top 60 oil-producing nations, including Britain (North Sea output, which peaked in 1999, has now plunged by more than half). The overall amount discovered has been falling for 40 years; easily reached oil fields are being depleted; untapped reserves are often small and hard to exploit. Many experts expect non-Opec production to peak around 2010; outside the cartel, the best hope is said to lie under the Arctic – but reserves are thought to be relatively limited, and conditions are horribly hostile.”

History has its lessons. In 2006 oil prices fell by 40% or from $80 to $50 (blue arrow) yet nearly tripled to hit $147.9 per barrel last July 11^th, from the trough of two years ago.

Two, it’s not only oil but apparently most of the commodity spectrum. The broad decline in commodity sector has likewise been reflected in the CRB index (lowest pane), while the softening of Dr. Industrial metals as shown by $GYX (pane below main window) seem indicative of slowing demand from emerging economies.

In consonance, the steep fall in WTIC Crude relative to the European benchmark Brent Crude (down only 5%) possibly signifying more economic weakness in the US. But it also suggests that Europe appears to be also losing strength.

Even the precious metal sector (above pane) has been shown in sympathy to its brethren.

Figure 4: ino.com: Softening Rice Prices

Three, with rice prices failing to breach the 50 day moving averages as shown in Figure 4, downside pressure in Rice prices means reduced “food” inflation for the Philippines or in most of the emerging world.

The infirmities in the Baltic dry Index also seems to chime in to the same tune.

Figure 5: Northern Trust: China Slows Down!

Most importantly, China’s moderating economic growth at 10.1% during the last quarter based on year to year comparison or even from first half growth of 10.4% in 2008 relative to 11.9% in 2007 (Forbes) appears to validate such thesis.

Figure 5 from Northern Trust shows of the rapidly falling rate of change in China’s real GDP aside from moderating consumer price index or “inflation”.

The declining phase in China’s economic growth suggests of a respite in resource intensive consumption, having been a major consumer of world commodities. It also suggests of a possible reprieve in rising export prices, having been the world’s second largest exporter.

It also confirms the deceleration in world trade, as one of the largest pillars of world trade and perhaps with reduced exports but with sustained outperformance of domestic demand, this should possibly translate to a slowdown in the accumulation of foreign exchange surpluses (unless speculative or hot money continues to pour in).

But if the Chinese economy decelerates further then China’s thrust to tighten might give way to policy directives towards growth (or easing bias) which may subside market expectations for the appreciation of the remimbi. This would suggest that the streak of hot money influxes could ebb.

All these adds up to a global economic slowdown which we believe has been reflected in global stock prices and should translate to lower inflation figures to the Philippine or world economy.

In the next few months, if global stock markets remain in a lackluster mode, while consumer goods “inflation” slows then the oversimplified singular causality linearly flawed inference of “high inflation equals high interest rates equals lower stock prices” will perhaps fade much like the Peso driven remittance argument of the past.

Thus the slackening the world economies are likely to magnify the downside risks of financial assets in economies that had experienced securitization backed housing boom bust cycles.

Some suggest that the next derivative pop via Credit Default Swap (CDS) would occur in Asia. We doubt this, considering the low exposure of CDS relative to US (45%) or Europe (27%) throughout the region (cumulative is 23%), with Japan accounting for about 55% of the region’s CDS, according to the Bank of International Settlements.

Although the slowing inflation backdrop will likely imply that governments, especially those exposed to the recent bust, are likely to undertake stepped up inflationary activities in the hope to “normalize” the financial system.

This in effects will breed the seeds for the next bout of inflation surges.