The Asian-Emerging Market Momentous Historical Bubble?

``When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented.”- George Soros

Excess volatility is the name of today’s game.

Global equity markets have been in a wild rollercoaster ride of late.

While US and European markets continue to sag following last week’s sharp decline, many of key Asian markets rallied hard recovering substantial segments of losses from the previous week.

So we seem to be witnessing another round of divergences at play, see figure 2.

Figure 2: stockcharts.com: Asia and EM stocks OUTPERFORM anew

The Dow Jones Asian Index which includes Japan appears to be testing for a new high, along with the less robust Emerging Market index (EEM) and the US S&P 500 (SPX). The weakest link seems to be European Stocks (STOXX).

Momentous Historical Bubble, Elixir Trade Model

The same friend, who commented earlier about the temptations of falling captive to gravity pulled “knives” in a bearmarket, likewise remarked of his friend who earlier paid for a series of monthly subscriptions to a local analyst, who is on the business of issuing regular technical charting outlook.

His friend came to realize that chart reading can be variable, vacillating and couldn’t be relied on, and hence, after a few months desisted from extending this “privilege”.

It’s simply amazing how people can be so captivated or bedazzled by the allure of short horizon Holy Grail type of market approaches, such that they have been shelling out substantial amounts to pay for guidance that dwell mostly on momentum driven or support-resistance trades or simply confirming biases of market participants through the technical picture. It seems like an incredible business model, I might add.

Yes, although this has been an opportunity cost for me in terms of the newsletter business paradigm, nonetheless, we’d rather stick by our principles to deal with prudent investing.

So aside from illustrating the possible dynamics of how the retail market works and how the some local subscription model business had profited immensely from the need for elixir based trades, the point of this article is to prove that today’s market can truly confound mechanical technicians or even macroeconomic fundamentalists.

Why is this so?

To put on our Ivory Tower thinking cap, we quote Prof. Steve Horwitz in The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008, ``The Austrian approach to macroeconomics can already be seen as being fundamentally microeconomic. What matters for growth is the degree to which microeconomic intertemporal coordination is achieved by producers using price signals, especially the interest rate, to coordinate their production plans with the preferences of consumers. However, this coordination process can be undermined through economy-wide events that might well be called “macroeconomic.” In particular, the very universality of money that makes possible the coordination that characterizes the market process can also be the source of severe discoordination. If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result. When money is in excess or deficient supply, interest rates lose their connection to people’s underlying time preferences and individual prices become less accurate reflectors of the underlying variables of tastes, technology, and resources. Monetary disequilibria undermine the communicative functions of prices and interest rates and hamper the learning processes that comprise the market.” (emphasis added)

In short, too much of monetary inflation distorts the function of price signals which essentially increases speculative activities, massively misallocates capital away from consumer preferences and engenders excessive market volatility.

And if we go by the market savant George Soros’ perspective of the market, ``Many momentous historical developments occur without the participants fully realizing what is happening.”

Incidentally we’ll be quoting much of George Soros’ market wisdom for this article.

And such “momentous historical development” could essentially be a seminal formation of the next bubble, in Asia and in Emerging Markets, see figure 3.

Figure 3 US Global Investors: Excess Liquidity Drives Up Asian Markets

According to the US Global Funds, ``U.S. Federal Reserve’s reluctance to withdraw from quantitative easing programs should bode well for Asian asset prices going forward. The past 25 years suggest that when money supply expansion outpaced GDP growth in the U.S., excess liquidity would typically drive equity prices higher the following two years in emerging Asia.” (bold emphasis added)

Oops, let me repeat… “excess liquidity would typically drive equity prices higher the following two years in emerging Asia”!!!

We are hardly into the first year of liquidity driven boom, which subsequently means more upside ahead.

So while markets can go anywhere over the interim, and that infirmities may follow the recent strength due to numerous variables: such as technical corrective patterns in the US [see INO's Adam Hewison On The S&P 500: Market Tenor Has Changed, Emphasis On The Negative-this is assuming the Phisix will track the US] or in the Phisix itself, seasonality weakness (July to September statistically is the weakest quarter for stocks), volatility brought about by next wave of US mortgage resets [see US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!] and plain vanilla momentum- the sheer might of the combined stimulus package from Emerging Markets, (see figure 4) aside from those applied in OECD economies, could translate to an awesome impact for the markets in Asia and the Emerging markets to behold.

Figure 4: Deutsche Bank: EM-Anti Crisis Measures

The Philippines relative to other Emerging Market contemporaries seems hardly one of the most lavish spenders for government stimulus. Think about it, if deficit spending equates to weak currencies as discussed last week in Philippine Peso: Interesting Times Indeed, then it follows that China, Russia, Hong Kong, Brazil, South Africa, Vietnam, Thailand would all have weak currencies relative to the US dollar due to their larger deficit spending. Unfortunately this hasn’t been the case.

Nonetheless, ``Asian and Latin American banks, notes the Deutsche Bank, “seem to have learnt from their past crisis episodes. In general, they have restricted foreign-currency exposures and funded credit expansion with domestic deposits. Thus, most banking systems have suffered from tighter liquidity conditions but only a few have needed recapitalisation (Korea, India and Hong Kong). On the fiscal side, government packages seek to neutralise the effect of shrinking domestic demand as well as supporting local companies unable to roll over their foreign debt obligations.” (emphasis added)

As we have long been saying, an unimpaired banking system in the region and in Emerging markets coupled with substantial savings has the potential to take up the credit slack from the bubble bust plagued OECD economies to shore up domestic demand. And this alone is a massive force to reckon with.

Another empirical example, just this week, it’s like I received numerous calls or text messages from different banks on daily basis, offering me bank loans mostly based on the unused portion of my credit cards. I’d assume that this applies to their entire customer base.

As the Deutsche Bank concludes, ``The crisis is not over yet and we do not rule out additional bumps in the road. However, it is fair to state that in a more globalised world characterised by stronger linkages among economies, emerging markets are proving to be better prepared to face external shocks than in the past.”

Well “proving to be better prepared to face external shocks than in the past”, can be interpreted in a relative sense and applicable only when compared today against the recent past.

But if the bubble cycle is brewing from within, then such conclusion won’t hold when the bubble pops.

Inflation Analytics Over Technical And Fundamental Approach

Remember in a highly globalized world, the transmission mechanism from inflationary policies could be very substantial and has far reaching consequences.

And that is why in spite of the most recent global meltdown, out of the 77 countries monitored by Bespoke Investments [see our earlier article Inflation or Deflation? The Global Perspective], 59 nations experienced consumer price inflation against 14 nations that saw consumer price declines (consumer price deflation) while 4 nations saw flat CPI rates. This translates to a ratio of 4:1 in favor of inflation with an average inflation rate at 4%! And that includes the peak of the meltdown!

For all the claptrap about the global deflation bogeyman, this should have disproved such an assertion.

Figure 5: Danske Weekly Focus: The tide is turning

And the credit boom appears to be filtering into the real economy as Industrial production in key Asian regions has sharply picked up, shown in Figure 5.

Nonetheless, aside from disoriented chart technicians, we also have conflicting predictions from multilateral agencies.

The readjusted outlooks saw the World Bank projecting a downgrade, whereas the IMF has raised its forecasts for world economic growth. On the other hand, OECD has joined IMF to forecast a modest increase in global growth.

2 out of 3 doesn’t mean that the majority is right.

Nonetheless, to put this anew in the context of George Soros’ reflexivity, `` The greater the uncertainty, the more people are influenced by the market trends; and the greater the influence of trend following speculation, the more uncertain the situation becomes.”

So yes, more reflexive actions are unfolding in the marketplace. As the market prices continue to move higher, the public will likely interpret market performance as indicative of the real economy.

Again from Mr. Soros, ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

So not only do we speak of excess liquidity, but of excess liquidity translated into a secular weak dollar trend see Figure 6.

Figure 6: US Global Investors: Inverse Correlation Weak US Dollar, Strong Asian Markets vice versa

The weak dollar has had a strong inverse correlation with the performance of Asian stock markets, where a strong US dollar trend translates to weak equity markets and weak US dollar equals strong Asian markets trends.

With the US dollar trade weighted index expected to suffer from a secular decline as a consequence to its massive deficit spending, the continuity of these correlation suggests of the persistence of a revitalized or reenergized Asian markets.

Moreover, the prospective weaknesses in the respective bubble bust scourged economies combined with the appearances of the “right” and “effective” remedy measures ensures that present policy directions will be sustained.

Proof?

The ECB recently announced that it will be lending a historic €442 billion ($621 billion) over the next 12 months to backstop liquidity within the region.

The US Federal Reserves’ FOMC meeting recently announced that it would be extending most of its liquidity facility programs specifically, the Board of Governors approved an extension to 1 February 2010 of the following: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF) Term Securities Lending Facility (TSLF).

The expiration date for the Term Asset-Backed Securities Loan Facility (TALF) remains set at December 31, 2009. The Term Auction Facility (TAF) does not have a fixed expiration date. In addition, the temporary reciprocal currency arrangements (swap lines) between the Federal Reserve and other central banks have been extended to February 1. (Danske Bank)

The Swiss National Bank conducted a series of intervention in the currency markets last week to keep the Franc from rising amidst a deflationary environment and shrinking economic growth (WSJ).

And this hasn’t been confined to the Swiss Franc, market chatters speculated on possible government interventions in the currency market in the Kiwi (New Zealand Dollar), the Loonie (Canadian Dollar) and the Aussie (Australian Dollar). (Bloomberg)

Moreover, the issuance of the new Won 50,000 banknotes in South Korea, after 35 years (the largest had been Won 10,000), further fueled speculations that the South Korean government could be expecting higher inflation from current policies undertaken (Financial Times).

As you can see, global governments have been conducting mercantilist “race to bottom” policies for their respective currencies to maintain their “export” latitude.

And as Steve Horwitz, echoing the Austrian school perspective, says that, ``If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result.”

And the continuation of these developments will only compound on the growing risks of a global inflation crisis.

So in my view, globally coordinated policy based programs to ensure excess liquidity through zero bound rates, quantitative easing and intensive stimulus fiscal spending programs, which has been manifested in the steepening of the global yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle], a floundering US dollar, currency interventions or the implicit currency war, the reflexive market action which has been diffusing into the real economy and rising risk appetites based on credit boom outside the bubble plagued economies- all conspire to pose as more powerful or potent forces to deal with than simply technical or seasonal factors over the next “two years” at least.

Since market timing isn’t likely to be anyone’s expertise especially in the context of short term trades, we’d rather focus on the major trend as defined by George Soros.

The Boom Bust Cycle Of George Soros

This brings us to the boom bust stage cycle as defined by George Soros which we last mentioned in 2006:

1) The unrecognized trend,

2) The beginning of a self-reinforcing process,

3) The successful test,

4) The growing conviction, resulting in a widening divergence between reality and expectations,

5) The flaw in perceptions,

6) The climax and finally

7) A self-reinforcing process in the opposite direction.

In my assessment, present developments are highly indicative of the transition from 1) the unrecognized trend-as manifested by the substantial skepticism over the present market cycle and 2) the beginning of a self-reinforcing process.

In other words, the bubble cycle has much to accomplish yet.

Since this article has been a George Soros quotefest, the last statement belongs to Mr. Soros, ``Economic history is a never-ending series of episodes based on falsehood and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited"

Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally

``Big government reforms, bailouts, stimulus, and “change" in general create negative expectations of the future along with a great deal of uncertainty. This leads to inaction and fear — the preconditions for a crash in the stock market. All it needs now is the appropriate trigger.” Mark Thornton, Unhinged

Except for some currencies such as the Norwegian Krone, British Pound or the Swiss Franc, the US dollar surged against almost every major currency including those in Asia…the Philippine Peso included. (Be reminded this has nothing do with remittances)

Since the forex market is a huge liquid market, with daily turnover of nearly $ 4 trillion dollars, this means there has been an intense wave of ex-US dollar liquidation. And to see such a coordinated move suggests that the global financial system could be faced with renewed dislocations in a disturbing scale. So the likely suspects could be either major bank/s in distress, or a country or some countries could be at a verge of default.

Central an dEastern Europe’s “Sudden Stop”

With no major spike in the major indicators which we monitor, such as the Libor-OIS, TED Spread, EURIBOR 3 month, Hong Kong Hibor, BBA LIBOR 3 months and 3 MO LIBOR - OIS SPREAD, the epicenter of last week’s pressure appears to emanate from the Central and Eastern European (CEE) region.

Regional credit spreads and Credit Default Swap (CDS) prices soared, as credit ratings agency the Moody’s issued a warning last week of the possibility of credit ratings downgrades in the region’s debt amidst a deteriorating global economic environment, See figure 1.

Figure 1: Danske Bank: CEE Under Pressure

According to the Danske Bank, ``Credit spreads have had a hard time during the week – especially for banks. The investment grade CDS index, iTraxx Europe, currently trades at 174bp up from 154bp last Friday. The high yield index iTraxx Crossover currently trades at 1085bp up from 1070bp last week. The senior financial index has also widened considerably and now trades at 152bp. As long as sovereign CDS prices are under pressure CDSs on senior bank debt are also likely to suffer as the two are heavily interlinked due to the various state guarantees on bank debt.”

The turbulence affected every financial market in the region; the CEE currencies crumbled, regional bond markets sovereign spreads widened, and regional equity markets tanked see figure 2.

Figure 2: Danske Bank: Emerging Europe currencies slump, Euro bonds

All these resemble what is known as the “sudden stop” or capital stampeding out of the region.

Somehow the CEE crisis approximates what had happened in Asia 12 years ago or what was labeled as the 1997 Asian Financial Crisis.

Central and Eastern European Crisis A Shadow of the Asian Financial Crisis?

So what ails the CEE?

As in all bubble cycles, the common denominator have always been unsustainable debt. And unmanageable debt acquired by the banking system and Eastern European households during the boom days had been manifested through burgeoning current account or external deficits. And these deficits had been balanced or offset by a flux in capital flows, mostly bank loans see figure 3.

Figure 3: Emerging Europe Crisis versus the Asian Crisis

The Bank of International Settlements (BIS) makes a comparison between the present developments in Emerging Europe with of Asia 12 years ago.

From the BIS, ``The crisis was preceded by rapid growth in credit to the private sector, with a significant share of loans denominated in foreign currency. East Asian economies also recorded large current account deficits, mainly induced by the private sector. These deficits were financed by strong debt inflows, which reversed sharply following the crisis. A further similarity lies in exchange rate policies. Prior to the crisis, East Asian economies had fixed nominal exchange rates (in their case against the US dollar). Moreover, the economies relied heavily on a single foreign creditor – Japanese banks. Emerging European countries currently show a similar level of dependence on a few European banking system creditors. For example, claims by Austrian-owned banks are equivalent to 20% of annual GDP in the Czech Republic, Hungary and Slovakia, while claims of Swedish-owned banks on the Baltic states are equivalent to 90% of their combined GDP. An adverse shock to one or more of these foreign banks could result in them withdrawing funds from emerging European countries.”

So the emerging similarities seen in both crises have been strong debt inflows, fixed nominal exchange rates and the concentration of source financing.

As the above chart shows, FDIs (red line) and Bank loans/Debt (blue line) composed most of the inflows in Emerging Europe (left window) whereas the Asian crisis bubble (right window) was almost entirely financed by debt from bank loans.

According to BIS, one marked difference for the strong capital flows in Emerging Europe had been due to the “strengthening in GDP growth and policy frameworks due to closer EU integration.” Plainly put, the integration of many of these countries into the Eurozone facilitated capital flows movement in the region, which may have abetted the bubble formation.

Moreover, another important difference was that Asian debt was principally channeled into the corporate sector while the liabilities in Emerging Europe have been foreign currency related.

Like the recent debacle in Iceland, Emerging Europe’s households incurred vast mortgage liabilities through their banking system in unhedged foreign currency contracts (mostly in Euro and Swiss Francs), which was meant to take advantage of low interest rates while neglectfully assuming the currency risk. In short, Emerging European households engaged in the currency arbitrages or otherwise known as the CARRY TRADE.

So when the sharp downturn in economic growth occurred, these capital starved economies failed to attract external capital, hence, the net effect was a drastic adjustment in their currencies which prompted for a capital flight.

Households which took on massive doses of foreign currency liabilities or loans saw their debts balloon as their domestic currency depreciated.

And it is not just in the households, but foreign investors too which incurred substantial exposure through local currency instruments. Morgan Stanley estimates Turkey, Hungary, Poland and Czech having non-resident exposures to equities and bonds at 30%, 18%, 17% and 10%, respectively.

Thus, the sharp gyrations in the currency markets have accentuated the pressures on the underlying foreign currency mismatches in the region’s financial system.

Another source of distinction has been the degree of exposure of the Emerging Europe’s debt to the European banking system. As noted by the BIS above, the Asian crisis further undermined Japan’s banking system, which provided the most of the loans, at the time when its domestic economy had been enduring the first leg of its decade long recession. On the hand, over 90% of the distribution of loans $1.64 trillion loans held by Emerging Europe have been scattered between the European and Swedish banks.

Doom Mongering: Will Eastern Europe Collapse the World?

Nonetheless this has been the key source of pessimism in media, especially by doom mongers whom have alleged that the failure to salvage East Europe will either lead to a worldwide economic catastrophe or to the disintegration of the Euro, as major European economies as Germany and France may opt NOT to bailout the crisis affected union members or union members whose banking system are heavily exposed to Eastern Europe of which may lead to cross defaults and culminate with a collapse in the monetary union.

In addition, they further assert that due to the huge extent of financing requirements, the IMF would deplete its funds and may be compelled to sell its gold hoard in order to raise cash. And to prim their narrative, they’ve made use of the historical parallelism to bolster their views or as possible precedent; the Austrian bank collapse in 1931 triggered a chain reaction which ushered in an economic crisis in Europe during the Great Depression years.

We are no experts in the Euro zone and Emerging Europe markets, but what we understand is that these doomsayers appear to be inherently biased against the Euro (on its very existence, even prior to these crisis), or alternatively, have been staunch defenders of the US dollar as-the-world’s-international-currency-standard, and have used the recent opportunities to promote their agenda.

Moreover, these doom mongers appear to be interventionists who peddle fear to advocate increased government presence and interference, which ironically has been the primary cause of the present predicament.

Be reminded that the fiat paper money system exists on the basis of trust by the public on the issuing government. Conversely, a lost of faith or trust, for whatever reason, may indeed undermine the existence of a monetary framework, such as the US dollar or the Euro. Thus rising gold prices are emblematic of these monetary disorders and we can’t disregard any of these assertions.

Although, for us, the claims of the tragic collapse from the ongoing CEE crisis could be discerned as somewhat superfluous.

One, the argument looks like a fallacy of composition- as defined by wikipedia.org-something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).

Figure 4: BIS: Foreign Liabilities Varies Across EM Regions

The CEE debt problem has been interpreted as something with homogeneous like dynamics, where the assumption is that every country appears to be suffering from the same degree of difficulties even when the economic structures (leverage, deficits etc.) are different.

They even apply the same logic to the rest of the world including Asia, where, as can be seen in Figure 4, have different scale of foreign liabilities exposure.

Two, because a large part of the Emerging Europe’s banking system is owned by European banks (see Figure 5) some have alleged that European governments have been indiscriminately pressuring their domestic banks with exposures to Eastern Europe to abruptly reduce or pullback their exposure to these countries, such as Greek banks in Balkans. There may be some cases, but a wholesale withdrawal would seem unlikely.

Figure 5 BIS: Foreign Bank Ownership in Emerging Markets

Yet according to the BIS, ``a large part of most emerging European banking systems is foreign owned. These banking groups appear to be financially strong currently, as reflected in standard –albeit backward-looking – measures of financial strength such as capital adequacy ratios and profitability. The foreign subsidiaries should have better risk management techniques in place, more geographically dispersed assets and, in principle, good supervision (from the home country on the consolidated entity).” [bold highlight mine]

Three, emerging markets have been reckoned as “more inferior and risk prone” asset class compared to the securitized instruments sold by the US.

As the Europe.view in the Economist magazine aptly remarked, ``Foreign-currency borrowing by east European households was seriously unwise. But it does not compare with the wild selling of sub-prime mortgages in America that turned balance sheets there to toxic waste. It may be necessary to restructure some of these loans, or convert them into local currency (perhaps with statutory intervention). That will hurt bank profits. But it will not mean American-style write-offs. Bank lending to foreign companies based in eastern Europe is still a good business.”

Divergences Even Among Emerging Markets?

While it could be true that some European banks could be heavily levered compared to their US counterparts and has significant exposure to the CEE region- where the latter seem to be encountering an Asian Crisis like unraveling due to outsized external deficits, large internal leverage and foreign currency mismatches in their liabilities- it is unclear that the deterioration in the financial and economic environment would result to an outright disintegration of the Euro monetary union or trigger an October 2008 like contagion across the globe.

Figure 6 Danske Bank: EM Stock markets

The fact that EM stockmarkets have been performing divergently as shown in figure 6, where LATAM (blue), Asia (apple green), CIS (Commonwealth of Independent States-gray) appear to be recovering, while the CEE (red) and MSCI (dark green) index are down, hardly implies of a contagion at work yet.

Moreover, as we earlier noted, credit spreads of major indicators haven’t seen renewed stress and seems to remain placid despite the recent CEE ruckus.

Thus from our standpoint the present strength of the US dollar encapsulates the ongoing Emerging Market phenomenon called the “sudden stop” or capital “flight” (resident capital) or “exodus” (non-resident capital) from the region, which has siphoned off the availability and accessibility of the US dollar in the global financial system which has probably led to the steep rally in the US dollar almost across-the-board.

We believe that 2009 will be a year of divergence as concerted policy induced liquidity measures will likely have dissimilar impact to all nations depending on the economic, financial markets, and political structures aside from the policy responses to the recent crisis and recession.

Even among Emerging Markets such divergences will likely be elaborate.