Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff

``What gave the west the edge over the east over the past 500 years? My answer is six “killer apps”: the capitalist enterprise, the scientific method, a legal and political system based on private property rights and individual freedom, traditional imperialism, the consumer society and what Weber probably misnamed the “Protestant” ethic of work and capital accumulation as ends in themselves. Some of those things (numbers one and two) China has clearly replicated. Others it may be in the process of adopting with some “Confucian” modifications (imperialism, consumption and the work ethic). Only number three – the Western way of law and politics – shows little sign of emerging in the one-party state that is the People’s Republic. Niall Ferguson, The decade the world tilted east

So what does the Policymaker’s poker’s bluff mean for Asian and Philippine asset markets, aside from emerging markets?

Widening Interest Rate Spread and the Carry Trade Arbitrage.

If Asian and emerging economies begin to tighten as we expect them to, and if we are correct about the implied devaluation policies by major economies as the US, Japan and the UK, then currency carry trade arbitrages will not only likely expand, but balloon.

This means we can expect foreign money to flood into these markets possibly triggering an asset meltup, meaning outperformance in stocks, currency and bonds.

Naturally, this won’t go in a straight line, and possibly be intermittently forestalled by internal policies to stanch flows such as capital controls similar to one imposed by Brazil.

Great Growth Story.

Asia and major emerging markets as noted above, having learned from the recent past crisis and having to embrace more globalization friendly policies particularly in trade, investment, finance and labor, will likely lure more funds given the relative its advantages-which means low debt, higher productivity, urbanization, demographic dividends and lower cost of living will likely magnify in the growth story.

Figure 5: Bloomberg: Goldman’s Call of Decade-Buy BRICs

An example would be Goldman’s Buy of the decade as shown in figure 5.

Policy Response and the Bubble Cycle.

Low systemic leverage and the largely uncontaminated banking system have responded “positively” to present policies that rejuvenated the markets and the economy.

As a reminder, manipulation of interest rates work similar to price controls, it leads to false signals which brings about massive distortions of the production and capital structure and gets magnified by people irrationality or in responding to the “bandwagon effect”.

As Henry Hazlitt explains, ``The credit expansion does not raise all prices simultaneously and uniformly. Tempted by the deceptively low interest rates it initially brings about, the producers of capital goods borrow the money for new long-term projects. This leads to distortions in the economy. It leads to overexpansion in the production of capital goods, and to other malinvestments that are only recognized as such after the boom has been going on for a considerable time. When this malinvestment does become evident, the boom collapses. The whole economy and structure of production must undergo a painful readjustment accompanied by greatly increased unemployment.”

Excessively low interest rates are the seeds to any bubble cycle which means that central bank policies have been a serial bubble blowing phenomenon.

And for this cycle, Asia and emerging markets are ripe as prime candidates for the next bubble.

Commodity Theme.

While we have greatly focused on the monetary aspects of commodity demand, there is also the policy and real economy facets that boosts the commodity dynamics.

This means that the traction generated by the recent policy actions could exacerbate a massive demand for commodity related investments and or speculation, following two decades of underinvestment.

Of course, the economic evolution where emerging markets outgrow advance nations would like spur heightened consumption.

Since commodity investments take time to materialize, the lag between the rapid growth in demand and availability of supply will be reflected on prices.

Redefining Markets And Asia’s Emerging Consumer Economy.

Since one the relative advantage of these economies have been scalability, whose rubric consist of more than half of the world’s population, what makes for the lost high value sales from the recession affected advance economies would probably be replaced by price sensitive massive volume based markets from Asian and the emerging economies.

Even Japanese exporters appear to be recognizing such reality [see Japan Exporters Rediscovers Evolving Market Realities].

In other words, global trade will likely be reconfigured, not because of mercantilist policies but of the shifting nature of consumer demands; this time brought about by the rapidly growing consumer dynamics of Asia and the emerging markets.

Leapfrogging The Industrial Age As A Candidate For Technology Ascendancy.

One of the major flaws by the mainstream is to ignore the tremendous contribution of technology in the form of increased information flows and enhanced efficiency of today’s marketplace.

Their outlook appears fixated on the industrial age paradigm even when they knowingly use the computers and the web to conduct exchanges and socially connect. Yet, ironically, they preach policies that would regress to medieval ages. These are the modern day Luddites.

Nevertheless, they are likely to be grossly mistaken. That’s because Asia has had a wide experience as an outsource agent for the western world, where it has learned to compete in the realm of technology.

Many Asian companies have recently embarked on technology value added ventures that today challenges the supremacy held by the West, see our post Asian Companies Go For Value Added Risk Ventures.

They appear to have taken advantage of the recent recession and utilized their inherent strengths or competitive advantages (access to capital, free cash flows, more liberal markets, etc.) to expand while the western peers reel from the recent setback. This is a dynamic we’ve discussed during the peak of the crisis [see Phisix and Asia: Watch The Fires Burning Across The River?]

J. Michael Oh of Matthews Asia describes of the Asia’s quest to leapfrog to the information age,

Figure 6 Matthews Asia: Fastest Growth In Internet Usage Is In Asia

``Over the years, Asia has given birth to many great technology companies but the region has also become its own dominant market for various consumer technology products including personal computers. Asia now boasts the world’s largest Internet user community, accounting for more than 40% of the world’s usage and last year, China surpassed the U.S. as the world’s largest Internet market, with more than 300 million users. Yet, China’s Internet penetration is only at approximately 22% compared to about 72% for the U.S. When China reaches the 70% penetration level, its Internet community will be larger than the combined population of all G7 countries.”

In short, technology based market competition will likely engender high productivity and generate wealth and would favor economies that would intervene less in discovering the fast evolving consumer desires.

Enhancing The State Of The Financial Markets.

One of the advantages of the West is that it has deep and sophisticated markets that allow her to efficiently channel savings into different investment needs.

This story appears to be changing.

While the recent crisis has led to more regulation, administrative control of employees (payroll), and the stifling of competition in the West, emerging markets appear to be drawing from their latest experience and trying to emulate Western market standards.

According to John Derrick of the US funds, ``Regulators in Beijing have approved a variety of investment products and strategies that are commonplace in mature stock markets: margin accounts for trading, stock index futures and short selling.

``A trial period will come first, so it’s not yet clear when the millions of investors in China will be able to execute a short sale or buy stocks on margin. But just the decision to move forward on this front indicates that the government recognizes that its highly liquid markets are ready for more sophisticated strategies.”

China, aside from trying to expand investment instruments for its retail sector has also opened its version of the Nasdaq board last year (New York Times).

In other parts of Asia, Hong Kong has positioned to compete for a Swiss-style trading hub for the gold bullion market (marketwatch), Singapore has opened a new commodity derivatives exchange the SMX (Financial Times) and likewise would offer its version of the dark pool (Asian Investor). The Philippines is reportedly considering a commodity exchange.

One must also consider the immense growth potentials for the pension, health and insurance industries, which is largely underdeveloped relative to the West, the overdependence on the banking system for corporate and business financing and the underutilization of the capital markets and the low penetration level of population engaged in financial institutions among emerging economies,

All these aspects- Widening Interest Rate Spread and the Carry Trade Arbitrage, Great Growth Story, Policy Response and the Bubble Cycle, Commodity Theme, Redefining Markets And Asia’s Consumer Economy, Leapfrogging The Industrial Age As A Candidate For Technology Ascendancy and Enhancing The State Of The Financial Markets-greatly depends on economic policies that allow for a greater freedom of commerce.

For as long as present dynamics continue in these directions we can remain confident over the long term investment prospects in Asia and in select emerging markets.

Short Word On Risks

Finally, speaking of risks, the character of the 2008 crisis had been vastly different than the next crisis, that’s simply because the drivers of the past bubble-Wall Street firms, Fannie Mae, Freddie Mac, the FHLB, the massive securitization marketplace, derivatives, and the hedge funds-haven’t been much into play, except for some, like the GSEs, dispensing their on support roles, while the bank as trader model appears to have given lift to the US financials.

But generally, the underperformance of the US markets signifies the changing composition of today’s reflation game which has obviously evolved from the core (advanced economies) to the periphery (emerging markets and commodity themes) amidst the backdrop of vastly inflating government liabilities (pls revert to figure 4-right pane).

In short, today’s central banks appear to attain a pyrrhic short term victory; it took huge amounts of deficits and money printing activities to achieve stabilization of credit flows see figure 4, left pane. This likely implies future risks ahead which means that anything that could spike interest rates of debt afflicted deficit laden nations- a sovereign bond Keynesian debt crisis or a currency crisis or a failed auction or spiraling inflation.

For the moment and perhaps for 2010, these risks don’t look imminent, yet.