Phisix: Throwing The Baby Out of the Water

``An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.”-Winston Churchill

The recent selloff in most of the global equity markets has led some doomsday proponents to pronounce the toxicity of the emerging asset class as evidence by a drop in global forex reserves. They believe that a paucity of liquidity compounded by a US recession would lead to collapsing asset classes or some form of a crisis in emerging markets.

Unfortunately we can’t be convinced by such deflationary recoupling scenario promoted by perma bears simply because such argument has been predicated on the “fallacy of composition” or the generalization of the whole when it is only true for some its parts.

For instance, in the case of Russia which had been used as an example, which we recently also posted in An Epitome of A Full Scale Bear Market:: Russia, the country’s problem has been mostly from the political imbroglio where it got into a military engagement with neighboring Georgia. A compounding factor had been the liquidity crunch and falling commodity prices.

We aren’t seeing the same dynamics here in the Philippines.

Emerging Markets Are Not The Same

As we have repeatedly been arguing, for the Philippines it has not been about the question of risks from a recession, overleverage, oversupply, overvaluation, excessive speculation, stifling new government regulations or taxes, war, or even insolvency as seen in the case of the US or other developed economies.

Nor is it in Brazil whose housing or property industry remains sizzling hot according to the Business.view of the Economist.

For the Philippines despite the announcement of several banks with exposures to the Lehman bankruptcy, we had been right to say that the potential loses from these ‘toxic’ US instruments had been inconsequential relative to the banking industry’s capitalization or assets.

This from the inquirer.net (highlight mine),

``Seven banks in the Philippines have a total of $386 million in exposure to bankrupt US investment banking giant Lehman Brothers, according to the central bank’s estimates, but the banking system is widely believed to be in a good position to withstand the world’s worst financial shake-out.

``Even assuming zero recovery of their exposure to Lehman, the fallout for the seven banks is not expected to exceed one percent of their total assets.

``According to estimates by the central bank, Bangko Sentral ng Pilipinas (BSP), obtained by the Philippine Daily Inquirer, the retail tycoon Henry Sy’s Banco de Oro Unibank has the biggest exposure to Lehman at $134 million, followed by state-owned Development Bank of the Philippines (DBP) at $90 million.

``The BSP data show Metropolitan Bank and Trust Co. (Metrobank) has an exposure of $71 million, Rizal Commercial Banking Corp. (RCBC) $40 million, Standard Chartered Bank’s Manila branch $26 million, Bank of Commerce $15 million, and United Coconut Planters Bank (UCPB) $10 million.

``As a percentage of total assets of the individual banks, the exposures are as low as 0.5 percent and as high as 1.7 percent, according to the estimates, which were discussed at a meeting of the BSP policymaking body, the Monetary Board, on Thursday.”

As we have pointed out the main risk from the external link would come from the extent of foreign selling of domestic assets on the account of today’s mostly US based ‘deleveraging’ process. While there could still be some exposures to ‘tainted’ US financial instruments that may implode in the future, our idea is that this is likely to be material to impact normal business operations of the local banking industry.

Moreover, if some of the estimates are correct that over 50% of portfolio flows to Asia has been redeemed (as pointed out last week) then we are most likely to have seen the worst of the depressed foreign sentiment which leaves us with sympathy selling.

Figure 5: PSE Net Foreign Selling

The Phisix suffered its second worst week of the year which lost 6.93% compared to the week that ended January 18^th which accounted for a 9.57% loss. But relative to the degree of foreign selling, (see figure 5 orange arrows) the amount has been less intense compared to the similar circumstances when the Phisix had been subjected to the same fate.

In fact, last Thursday, which likewise accounted for a 4% drop following a similar decline in the US markets, the Phisix saw significant reduction of foreign selling to the tune of only Php 256 million compared to the daily range of Php 500-950 million a day during the past 2 weeks. This leaves us to hypothesize that mostly momentum driven domestic retail investors “threw out the baby with the bath water” in panic!

Of course, we are not saying the Phisix is riskfree or immune. Any risk from the Phisix would likely come from the political spectrum, if not from inflation or higher food prices, which so far have begun to decline. Of course, the recent concerted central bank pumping of liquidity into the global markets may reverse this decline. But if the global equity asset classes manage to absorb these injections, then the increase in consumer inflation could likely be gradual.

Debating Keynesian Concepts

Besides, we don’t buy into the Keynesian connection that consumer spending drives the economy which leads to the myth that the wilting US consumers will automatically lead to a bust in the emerging markets. As Gerard Jackson of Brookesnews explains, ``consumer demand springs from production, meaning you cannot consume what has not been produced. Therefore when consumers demand goods they are in effect exchanging what they produced for the products of other consumers. This is why the classical school considered money to be a veil that concealed the process of production and exchange from the public eye.”

The notion of a consumer driven economy actually stems from monetary inflation which has a detrimental effect in shaping an economy’s capital structure, to quote Gerard Jackson anew, ``Monetary manipulation not only severely distorts a country’s capital structure by misdirecting production it can also lead to the currency being overvalued which in turn could induce some manufacturers to shift operations offshore when undistorted marketed conditions would have persuaded them to remain in the US”.

And if trade or current account balances signified of the symptom of inflationary monetary policies, then the Phisix hasn’t been in the same shape or conditions as the US enough to unjustly merit a “toxic” grade. Moreover, based on the account of real savings or savings from the actual stuff we produce, the Philippines with its large informal economy equates to a cash based society with minuscule leverage applied, meaning much of our economy has been based real output than from the influences of distortive monetary policies.

Besides, much of the angst from the past Asian financial crisis still lingers, as evidenced by the minimal exposure of the banking system to rubbish US papers and conservative lending schemes by the banking system.

Moreover, valuations in Asia ex-Japan have nearly fallen to its multi-year “floor levels” which may translate to a looming bottom, see figure 6.

Figure 6: Matthews Asia: Asia’s Valuations Near Extreme Lows

To quote Robert J. Horrocks, PhD of Matthews Asia, ``the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.” (highlight mine)

Like Mr Robert J. Horrocks, we have often stated that the decoupling recoupling debate is nothing but an invalid abstraction detached from the reality of the globalization process. And that from a valuations viewpoint, Asia has reached extreme lows and apparently has become detached from the real economy.

So while there might be additional sympathy selling pressures arising from the impact of the US financial crisis, this could be seen as opportunities from the facets of margin of safety to accumulate than to join the bandwagon of running for cover. Because markets are emotionally driven over the short term, they can always overshoot to the upside or the downside.

Recommendation: A Tradeable Rally Ahead?

Finally, some indicators suggest that we could have likewise bottomed out over the interim and a tradeable rally could be in the offing.

One, the restrictions on short selling of 799 financial stocks in the US and also adopted in the UK has moved the equity markets in seismic proportions last Friday. This should translate to a strong open in the PSE at the start of the week. However the effects from restriction curbs tend to be short term.

Two, as pointed out in my recent blog, Fear Index Pointing To Tradeable Rally Ahead?, each time the VIX or Fear Index peaks at above 30 it is usually followed by a bearmarket rally. The VIX or fear index hit a record high last week signifying outsized fear.

Three, the Phisix is coming from an oversold level, which means there could be more room for more upside traction.

So far, the recent lows have held its ground, giving us a clue of the possible strength of the aforementioned support level. The longer the Phisix maintains such support level the stronger it becomes.

Fourth, massive injections of bridge financing by global central banks tend to induce a period of lull following the recent turbulence. In addition, the proposed resurrection of the Resolution Trust Company RTC type of rescue package will entail a huge cost to US taxpayers. Over the longer perspective, this could lead to some capital reallocation of Asian capital to within the region and,

Lastly, any forthcoming rally, which would probably coincide with the closing of the seasonally weak September, may strengthen our case for a yearend rally.