More Promises from ECB’s Mario Draghi and the US Federal Reserve

Central bankers continue to engage in talk therapy or jawboning the markets or manipulating the public's expectations in the hope that promises to inflate may be enough to rejuvenate the “animal spirits”.

From Bloomberg,

European Central Bank President Mario Draghi signaled the ECB intends to join forces with governments to buy bonds in sufficient quantities to ease the region’s debt crisis, while conceding that Germany’s Bundesbank has reservations about the plan.

ECB bond purchases would likely focus on shorter-term maturities, would be conducted in a way to soothe investors’ concerns about seniority, and wouldn’t breach European Union rules prohibiting the financing of government deficits, Draghi told reporters in Frankfurt today. ECB officials are working on the plan and details will be fleshed out in coming weeks, he said.

“Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner,” Draghi said at a press conference after keeping the benchmark interest rate on hold at 0.75 percent. “The euro is irreversible.” There is a “severe malfunctioning” in bond markets, he said.

This seems little different from the US Federal Reserve which has deferred from taking on more stimulus but gave a strong signal that such contingency would be used in case the economy deteriorates further.

From an earlier Bloomberg article,

The Federal Reserve said it will pump fresh stimulus if necessary into the weakening economic expansion to boost growth and reduce an unemployment rate that’s been stuck at 8 percent or higher for more than three years.

The Federal Open Market Committee “will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability,” it said today in a statement at the end of a two-day meeting in Washington. “Economic activity decelerated somewhat over the first half of this year.”

So far markets have held on well to such promises, although as I previously admonished, eventually markets will seek the real thing.

should markets continue to rise in ABSENCE of REAL actions from central bankers, we cannot rule out that the markets could fall like a house of cards (fat tail risks) or what I would call a Dr. Marc Faber event.

The market’s deep addiction to stimulus will eventually seek REAL stimulus more than just promises or in central bank lingo, signalling channel. Reversal of expectations can become violent.

Such opaqueness in policy directions only underscores the uncertainty of the financial marketplace which only amplifies the risks of sharp volatilities.

Be very careful out there.

What Draghi’s Statement “The ECB is Ready to do Whatever it Takes to Preserve the Euro” Means

I pointed out that ECB President Mario Draghi delivered a magical statement last week which sent markets soaring (I think much had to do with the covering of short sales).

For Professor Gary North such statement has the following implications…

What he said was in fact a cry of desperation. He does not know what to do, other than to inflate. He knows he must break the Maastricht treaty that created the EU, but he does not have any choice. He has defined out of existence the treaty's limits on the ECB. He defines his mandate broadly. He knows that Spain is close to default. The ECB must buy Spain's bonds, or else provide funds for some other agencies to buy Spain's bonds. The weekend summit meeting less than a month ago has already broken down. Spain's ten-year bond rate went above the failsafe 7% figure.

The European banking system is being propped up by monetary inflation. There are signs that this cannot go on much longer, but the central bankers have enormous self-confidence. They believe that fiat money can delay any major crisis. They believe that fiat money is the ultimate ace in the hole. So do Keynesians. So do politicians. They really do believe that the exclusive government monopoly authority to supervise the creation of digits is the basis of prosperity.

Investors invest digits called money. They are convinced that the ability of central banks to create digits has created a failsafe for investors' digits. They believe that a prudent mixture of digit-generating investments will gain them a positive rate of return, as measured in digits, just so long as the total number of digits is always increasing. This is the key to every investment strategy that is tied to "digits invested now, more digits to invest later": an ever-increasing supply of digits.

You might think that investors would judge their success in investing by increased real income: stuff, not digits. But the vast majority of investors assume that stuff will inevitably take care of itself, if only the supply of digits is increasing. Here is the mantra of this generation: "The system of stuff production depends on a steady increase in the supply of digits."

This is why there is no resistance to central bank monetization. On the contrary, there is cheering. The journalists follow the economists. The economists have adopted the mantra of digits with the zealous commitment of any priesthood. Milton Friedman is their high priest.

Professor North sees depression or another crisis ahead, but this will either be through hyperinflation or through mass defaults. He thinks that defaults will be the most likely outcome because the incentives guiding the career of central bankers have been tied with large banks.

I think that the both scenario has a level 50-50 odds, as central bankers will most likely underestimate the impact of their actions.

Read the rest here

The Magic of Central Banking Talk Therapy

The prospects of central banking inflation steroids bring hope to the forefront.

From Bloomberg,

The Dow Jones Industrial Average (INDU) climbed above 13,000, capping its longest weekly advance since January, amid speculation the European Central Bank will buy bonds to help lower borrowing costs and preserve the euro…

American stocks joined a global rally after two central bank officials said ECB President Mario Draghi will hold talks with Bundesbank President Jens Weidmann in an effort to overcome the biggest stumbling block to a new raft of measures including bond purchases. German Chancellor Angela Merkel and French President Francois Hollande echoed yesterday’s pledge by Draghi that they will do everything to protect the euro.

Bad news is good news: economic slowdown signifies as fodder for central bank support. More from the same article

Chart from tradingeconomics.com

In the U.S., data showed that the economy expanded at a slower pace in the second quarter as a softening job market prompted Americans to curb spending. Consumer confidence in July dropped to the lowest this year, according to a separate report. Cooling growth makes it harder to reduce unemployment, helping explain why Federal Reserve Chairman Ben S. Bernanke has said policy makers stand ready with more stimulus if needed.

“Growth has decelerated sharply,” said Philip Orlando, the New York-based chief equity strategist at Federated Investors Inc., which oversees $355.9 billion. He spoke in a telephone interview. “We need something to reverse that downtrend and that ‘something’ is policy.”

Consumers are cutting back just as Europe’s crisis and looming U.S. tax-policy changes dent confidence, hurting sales at companies from United Parcel Service Inc. to Procter & Gamble Co. Sales at almost 60 percent of S&P 500 (SPXL1) companies which reported second-quarter results missed estimates, data compiled by Bloomberg show. Still, 72 percent beat profit forecasts.

US equity markets have also been climbing amidst falling growth of money supply...

chart from St. Louis Fed

...also amidst declining forecasts or expectations for corporate earnings...

Dr. Ed Yardeni notes

As a result, the 2012 and 2013 estimates are at new lows of $104.11 and $116.41, respectively. These numbers imply earnings growth rates of 6% this year and 12% next year. They may still be too optimistic since revenue growth is likely to be closer to 5% during 2012 and 2013, while profit margins are likely to remain flat over this period.

Well, all these goes to show how financial markets, desperately seeking yields, have become ‘dopamine addicts’.

Douglas French at the Laissez Faire Books explains,

…cheap money combined with the herding animal spirits is a certain cocktail to engender bubbles. Tragically, these booms are followed by the inevitable busts, creating regret that is the difference in investors minds between the value of what is and the value of what could have been.

This is important because of dopamine, which is a chemical in the brain that helps humans decide how to take actions that will result in rewards at the right time.

People don’t get a dopamine kick when they get what they expect, only when they make an unexpected windfall. So, as Jason Zweig writes in Your Money and Your Brain, drug addicts crave ever-larger fixes to achieve the same satisfaction and “why investors have such a hankering for fast-rising stocks with ‘positive momentum’ or ‘accelerating earnings growth’.”

Also, dopamine dries up if the reward you expected fails to materialize.

The brain has 100 billion neurons and only one-thousandth of one percent produce dopamine, but “this minuscule neural minority wields enormous power over your investing decisions,” cautions Zweig.

Dopamine takes as little as a twentieth of second to reach your decision centers, estimating the value of an expected reward and more importantly propelling you to action to capture that reward. “We’ve evolved to be that way,” explains psychologist Kent Berridge, “because passively knowing about the future is not good enough.”

The effect of all this is what Zweig refers to as “the prediction addiction.” Humans hate randomness. We want to predict the unpredictable, which originates in the dopamine centers of the reflective brain, according to Zweig, leading humans to see patterns where none really exist…

The attempt to satisfy the dopamine which has been evoked by central bank policies, leads people to become increasingly more dependent on heuristics based thinking

More from Mr. French

We all tend to constantly feed our confirmation biases, seeking out experts that confirm our view of the world. We read writers that we agree with so that we can feel smarter, while ignoring or dismissing opinions different from our own.

Our brains are great for keeping us alive in the jungle. We look for patterns and motion. These instincts kept the cavemen alive, not to mention Wall Street’s technical analysts, but wreck the portfolios of investors.

Investors love a good story, but are vulnerable to anecdotes that mislead us, says Ritholtz.

No wonder markets are not sources of information, but instead sources of misinformation, according to resource investing guru Rick Rule…

“The information that people derive from markets is spectacularly wrong,” says Rule, a devotee of legendary investor Benjamin Graham. Like Graham, Rule looks for undervalued stocks and only wants to buy them when they are on sale. Quoting Graham, Rule says, “markets in the short term are voting machines, while in the long term they are weighing machines.”

Housewives are much more rational buying groceries than investors are in buying stocks. While a housewife will turn her nose up at expensive tuna fish, she will load up on it once it goes on sale. Conversely, her investor husband, in Rule’s story, is happy when the share price of his favorite stock goes up and he buys more. When the share price falls, he doesn’t buy more, as his wife does with tuna fish, but instead sells out in disgust.

In short, stock markets (and the financial markets) have been in disconnect with reality. Promises have been taken as facts.

Equity markets have mostly priced in prospective central banking support via QEs…

chart from Zero Hedge

The question now is how sustainable will this talk therapy rally be? Will talk therapy be enough to reinforce the current reanimated 'animal spirits' and filter into economic reality? What if central banks don't deliver as the markets expect?

P.S. I won’t be making my regular stock market commentary tomorrow.

Phisix and ASEAN Equities in the Shadow of Contagion Risks

The common feature for today’s global financial marketplace has been extreme volatility

Sharp price fluctuations are seen by scalpers and short term traders as wonderful opportunities. On the other hand, such landscape for me, exhibits signs of increasing market distress. From a trading perspective, this implies for a low profit-high risk engagement.

In short, when the risk is high or when uncertainty dominates, I opt to take a defensive posture. For me, it is better to lose opportunity than to lose capital.

The Philippine and ASEAN markets have not been spared of such volatility.

The local benchmark fell by a measly .07% this week. But this comes after the Phisix opened strongly on Monday, lifted by the late week rally of Wall Street from the other week. Unfortunately such one day rally failed to hold ground as the following sessions essentially more than erased Monday’s gains.

Global markets have closed mixed for the week.

Almost every major equity benchmark encountered a rollercoaster week. Like the Phisix most of the early gains came under pressure during the close of the week.

In the ASEAN region, there have been signs of rotation.

This year’s ASEAN laggards, Indonesia (+6.8% year-to-date) and Malaysia (+7.33% also y-t-d) ended the week strongly as ASEAN outperformers, the Philippines (+19.2%) and Thailand (+17.9%) retrenched.

This only goes to show that the destiny of the Phisix has been tied with that of the region. So any belief that the local benchmark may perform independently will likely be disproven.

Also given the rotational dynamics, we might see some “catch up” play or the narrowing of the recent wide variance between the laggards and leaders overtime. But this doesn’t intuitively mean that such gaps will close.

But the fate of ASEAN’s markets will ultimately depend on the unfolding events in the US.

US Markets and Economy as ASEAN’s Anchor

Yes there have occasional instances where the Phisix has diverged from US or world markets[1], but overtime, the mean reversion capabilities of the markets govern.

Thus, the exemplary performance of ASEAN markets can be traced to the buoyancy of the US markets.

For as long as the US remains firm, so will likely be the fortunes of ASEAN markets and vice versa.

The US markets has so far been resilient from the Europe’s crisis, partly due to the capital flight dynamics from the Euro into the US, and similarly from the slowdown from major emerging markets as the BRICs.

Nonetheless such sustainability must be questioned considering that much of the world’s major economies (developed and emerging markets) have been in a marked downtrend.

Unlike in 2008, there hardly will be any China and other major emerging markets to rely on to do much of the weightlifting. Many emerging markets, particularly the BRICs have been bogged down by their domestic quasi-bubble problems.

In addition, the US Federal Reserve continues to employ talk therapy (signaling channel or policy communications management) instead of undertaking real actions. Media continues to broadcast the prospects of a Bernanke Put (“bad news is good news”), as Fed officials continue to signal verbal support in projecting hope for the steroid addicted markets.

And importantly political gridlock and regime uncertainty has been worsening (taxmaggedon, fiscal cliff, debt ceiling, Dodd-Frank[2], Obamacare, the forthcoming national elections and lately even the controversial LIBOR[3] issue) will likely intensify the current business, economic and financial uncertainties.

And considering that the US markets and her economy has been bolstered by sustained injections of steroids, the lack of and the perceived dearth of policy palliatives, as evidenced by the decelerating money supply growth, will likely bring to the surface and expose most of the misallocated investments, which has been camouflaged by recent monetary policies.

Such dynamics will be manifested through an economic slowdown if not a recession—but again this would really depend on how Ben Bernanke and US Federal Reserve will react or respond to increasing evidences of a slowdown.

Lately even the New York Federal Reserve swaggered about having to boost to US stock markets[4], which they say without them would have been 50% lower!!!

Proof that low interest rates have hardly worked: record low mortgage interest rates[5] have been amiss in providing sustained recovery to US property markets[6].

Yet steroid addicted financial markets continue to look forward to the FOMC’s meeting during the end of July in the hope for another round of policy opiates.

Add to these the soaring costs of agricultural commodities (chart from US global investors)[7], which have been mostly attributed to weather or drought conditions.

This, I believe, has been exacerbated by easy money policies and other interventions (e.g. agricultural subsidies, tariffs and etc…) which should extrapolate to higher food prices.

So we seem to be witnessing incipient signs of stagflation as I have long been predicting.

[As a side note, a UBS analyst recently noted that the risks of hyperinflation has been greatest for the US and UK[8]. But he sees less than 10% chance for this to occur in the near future.

Yet he believes that hyperinflation results from “unsustainable deficits” which “occurs after central banks monetize a large amount of debt”. Thus hyperinflation is a fiscal phenomenon.

I’d still say that hyperinflation is a monetary phenomenon meant to address fiscal concerns. Yes hyperinflation signifies a means to an end approach.

In dire financial straits and in desperation due to the lack of access to domestic and overseas private sector financing, governments frenetically print money to preserve on their political entitlements and power.

At the end of day, all these unwieldy or unsustainable levels of debt expansion will be defaulted upon directly through restructuring, or indirectly through inflation, where hyperinflation may arise as consequence to policy miscalculation, if not deliberately.

And this is why the risks of hyperinflation shouldn’t be discounted[9] despite today’s low interest rate environment]

Also, Spanish bonds at record highs are manifestations of persisting and growing financial and economic stress in the Eurozone and of the extreme fluidity of current conditions, which will have an impact to the US and to the world.

Markets have never really anticipated this.

As Doug Noland of the Credit Bubble Bulletin rightly observed[10],

It was not that many months ago that Spain was viewed as part of a financially stable European “core.” Indeed, Spain (5-yr) CDS ended Q1 2010 at about 100 bps. Spain commenced 2010 with government debt at a seemingly healthy 54% of GDP. Few anticipated the incredible pace of fiscal deterioration. With the federal government on the hook for the EU’s 100bn euro bank bailout package, the IMF now projects Spain will end 2012 with debt at about 90% of GDP – and poised for continued rapid growth.

Who would expect that French bonds to dramatically narrow against German bunds, where “spreads on French debt have narrowed by 16 bps in the last month and are currently at their lowest levels of 2012”[11] as French government paper morph into a ‘safe haven’ from the Euro crisis?

That’s how swift and powerful events have been moving.

To consider, people stampeding into French bonds seem to have overlooked the many sins underpinning the French sovereign paper.

As the BCA Research explains[12]

The French public sector is not in good financial health and is in worse condition than that of Italy in many respects. Italy has run large primary surpluses through much of the last two decades, while France has run large deficits. The Italian debt/GDP ratio was rather stable, while France’s has been rising sharply. In fact, France has accumulated 60% more debt than Italy since 1999, and its debt service costs are rising. More worrisome is that France’s combined private and public sector debt load is higher than that of Italy, putting the French economy in a perilous situation. The only variable where France looks better is economic growth, but even this has mostly come from larger government spending, and in turn at the cost of escalating debt.

And considering the incumbent socialist administration’s penchant for more government spending, taxes and regulations[13] which again will translate to more debt, reduction of productivity and competitiveness and potential exodus of investors, today’s safehaven may become tomorrow’s epicenter for the progressing crisis.

So we are seeing existing policy error compounded by more policy errors that only aggravates such crisis conditions, from which the sentiment of financial markets shifts violently from one end to another.

Hence, while earnings report of US publicly listed corporations may seem buoyant which has given the impetus for the bulls to provide the recent strength to the US equity markets[14], all the above compounds to signify substantial headwinds that US financial markets (equities, bonds, commodities) will be faced with.

And to add, it would be big mistake to read current market activities as tomorrow’s outcome given the huge swings happening in the financial markets around the world. That’s how unstable and mercurial current conditions are.

China’s “Good News” Ignored by the Markets

Such unpredictability has been no different for China.

This week, there has been a torrent of supposed good news that should have reanimated, if not fired up, China’s financial markets.

China’s banking system has reportedly posted a big jump in loan growth or bank lending rose by 16% to 919.8 billion yuan (US$144.3 billion) last June[15]

While news say that this signifies a positive sign from government efforts, this seems largely unclear. I am not even sure if these have been contracted by the private sector. As in the recent past, most of the so-called stimulus has been directed to the overleveraged and overindebted State Owned Enterprises (SoE)[16] which only adds to the current juncture.

The property sector likewise reported a significant surge in bank loans from April to June, up by 20% from last year to the tune of 322.6 billion yuan ($50.64 billion)[17].

Reports also say that China will ease restrictions on her shadow banking system, as well as, double up investments on railway projects[18].

This goes in contrast to previous reports where 70% of China’s railways projects recently has been suspended as a result of ballooning deficit financing, as well as last year’s deadly train crash which has brought upon safety concerns and exposed corruption at the highest levels of the ministry[19]

The confusing signals from supposed government stimulus and support, as well as, positive developments seems to have been discounted by the China’s financial markets as both the major equity market bellwether, the Shanghai Composite (SSEC-top pane), and China’s currency the Yuan (CNY/USD-bottom pane) have not demonstrated auspicious responsiveness to such developments.

Unlike at the end of the 2012 where the SSEC hit a low but the yuan remain lofty, this time both the SSEC and the yuan have been treading downwards.

These are hardly reactions that could be reckoned as bullish.

In contrast these could be symptoms of deeper underlying malaise—a bursting bubble, punctuated by intensifying hot money outflows[20].

With scarcely any household savings to tap, most of the increases in savings are from government and corporations[21] there seems little room for bailouts without incurring risks of inflation.

So like the US, we have the same ingredients contributing to the current highly uncertain climate, ambivalent central bank (PBoC) and political stalemate which has been prompting for increasing manifestations of the unraveling of malinvestments that has been the driving force of the current slowdown.

The Asian Electronic Export Nexus

Many seem to have developed the hardened belief that domestic (or regional) markets have been made invincible by the recent events, particularly record high equities.

As I have been saying, today’s globalization has made the world much deeply interconnected through trade, capital, labor and even through the US dollar standard based banking system.

Embracing the idea of decoupling can be hazardous to one’s portfolio and detrimental to one’s emotions and ego.

In terms of trade, a slowdown in world growth will have impact negatively on Asia’s electronic exports.

As The Economist recently commented[22]

THE electronics industry accounts for two-fifths of manufacturing output in Asia, according to calculations by HSBC. So when electronics grows quickly, Asia's GDP tends to speed up too, to the tune of almost 0.2 percentage points for each full-point increase in the electronics sector. Unfortunately this correlation also applies when things slow down (see left-hand chart). And recent signs are that Asia’s electronics industry is doing just that: HSBC’s lead indicator, which gives a rough two-month preview of future production, has slowed sharply in recent months, in contrast to the latest available output figures. One bright side, given the economic woes of Europe and America, is that Asian manufacturing is no longer as closely tied to Western markets as it was. Three of the five components that comprise HSBC's lead indicator measure conditions within Asia. So when the next rebound occurs, it is likely to be home-grown.

Again while it is true that Asia has been less dependent on the West, there is no guarantee that other sectors will not be affected from slomo diffusing or spreading of the global debt crisis.

A slowdown in electronic exports incidentally constitutes about half of Philippine exports[23]

So those dreaming of immunity from a global slowdown will likely be refuted.

Bottom line: The contagion risk is real.

Unless we see aggressive collaborative actions from major central banks (which may place a temporary patch or booster to the markets), or signs of economic stabilization from developed nations or from major emerging economies (whom are experiencing market clearing liquidations from domestic bubbles), we should expect global markets to remain sharply volatile and erratic in both directions but faced with greater probabilities of “fat tail” risks.

As a final note: I don’t expect the coming State of the Nation Address by the Philippine President to have lasting effects. They are likely to be meaningless feel good political rhetoric whose goals are for his party to seize the majority in the coming congressional elections in 2013.

Bubble policies and the effects thereof will continue to be main drivers of the asset markets.

Approach the equity markets with caution.

---

[1] See Phisix: Will the Risk ON Environment be Sustainable? June 24, 2012

[2] See Infographic: Dodd Frank-enstein, July 21,2012

[3] See Barclay’s LIBOR Scandal: Self Fulfilling Turmoil July 19, 2012

[4] See Bernanke Doctrine: New York Fed Boasts of Pushing Up the US Stock Markets, July 14, 2012

[5] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[6] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[7] US Global Investors America’s Competitive Spirit, July 20, 2012

[8] BusinessInsider.com UBS: The Risk Of Hyperinflation Is Largest In The US And The UK, July 17, 2012

[9] See Taking The Hyperinflation Risk With A Grain Of Salt?

[10] Noland Doug Risk On, Risk Off And The Spanish/Chinese Tug Of War, Credit Bubble Bulletin PrudentBearcom July 20, 2012

[11] Bespoke Investment Group EU Sovereign Spreads, July 20, 2012

[12] BCA Research, Watching France, July 10, 2012

[13] See Quote of Day: The Last Hurrah of Socialist Welfare States May 8, 2012

[14] See US Stocks Markets: Earnings Trump Economic Data, Leading Economic Indicators Fall, July 20, 2012

[15] Channelnewsasia.com China bank loans rise in June, July 12, 2012

[16] See China’s New Loans Unexpectedly Surged in May June 12, 2012

[17] Reuters.com China Q2 property loans rebound with sales, July 19, 2012

[18] See Will China Ease Banking Curbs? Has the Railway Stimulus been Launched?, July 17 2012

[19] Payne Amy Morning Bell: Transportation Secretary Wants Us to Be Like Communist China, Heritage Network, July 9, 2012

[20] Zero Hedge, Forget China's Goal-Seeked GDP Tonight; This Is The Chart That Keeps The PBOC Up At Night, July 12, 2012

[21] See Contagion Risk: Watch for China’s Catastrophic Deleveraging, July 16, 2012

[22] Graphic Details Chips are down, The Economist July 18, 2012

[23] RGE Analyst Blog Philippines: Reconciling Short-Circuiting Electronic Exports, Economonitor, February 17, 2012

Pavlovian Markets Rise on Hopes of the Bernanke Put

More bad news is good news.

Asian equity markets rises on HOPES that Ben Bernanke will (tonight) deliver the much sought after opiate.

From Bloomberg,

Asian stocks advanced for a third day, oil climbed and the Japanese yen weakened as an unexpected drop in U.S. retail sales stoked speculation Federal Reserve Chairman Ben S. Bernanke will hint at further stimulus today. Corn rose toward a record as U.S. crop conditions worsened…

Bernanke will deliver his semiannual report on the economy and monetary policy before Congress today, after a report yesterday showing a contraction in June retail sales kindled speculation the Fed will introduce more measures to support the world’s largest economy. Corn has risen 55 percent since June 15 as further evidence of damage from the worst U.S. drought in a generation stoked concern yields will drop, hurting output in the biggest exporter and lifting global food costs.

“There is market positioning for Bernanke to deliver something today,” said Joseph Capurso, a strategist in Sydney at Commonwealth Bank of Australia, the nation’s biggest lender. “There is a high risk of more policy easing before the end of this year.”

A third monthly drop in U.S. retail sales showed limited employment gains are taking a toll on the biggest part of the economy. The IMF lowered its 2013 forecast for global economic growth yesterday to 3.9 percent from 4.1 percent as Europe’s debt crisis prolongs Spain’s recession and slows expansions in emerging markets from China to India.

Will hope become reality or will the Bernanke led FOMC give in to the yearnings of the steroid addicted markets?

What happens if the FOMC spurns the markets’ slabbering for more stimulants?

Until when will hope be able to forestall reality?

Reality versus Expectations: A Divided US Federal Reserve

A divided US Federal Reserve has been eroding expectations and hopes for the Bernanke PUT.

From the Bloomberg,

A few Federal Reserve policy makers said the central bank will probably need to take more action to boost the labor market and meet its inflation target, according to minutes of their June meeting.

“A few members expressed the view that further policy stimulus likely would be necessary to promote satisfactory growth in employment and to ensure that the inflation rate would be at the Committee’s goal,” according to the record of the Federal Open Market Committee’s June 19-20 gathering released today in Washington.

Deferment or reluctance to further inflate translates to a bursting of the asset bubbles—the RISK OFF environment.

The S&P 500 on a downdraft.

Yet once markets have fallen significantly enough they will likely reverse course and pursue aggressive inflationism.

Why Current Market Conditions Warrants a Defensive Stance

Here is what I wrote last week[1],

Also the Phisix is likely to surf on the global ‘EU Summit honeymoon’ sentiment, as well as on the momentum from an imminent RECORD breakout.

Whether this breakaway run will be sustainable remains unclear as global markets will remain volatile on both directions.

Indeed the jubilation from the EU Summit combined with momentum powered the major local equity benchmark, the Phisix, to a fresh record high.

Of course this breakaway run will be subject to the question of sustainability given the recent developments abroad.

Nevertheless after 3 successive weeks of advances which racked up 8.53% in returns, it would be normal to see some profit taking.

Nonetheless today’s exemplary standings have more stories to tell.

The ASEAN Standout

From my radar screen of 70+ international equity benchmarks, the Phisix only ranks fourth among the best performers based on a year-to-date returns.

But the Phisix is the ONLY bellwether among the elite contenders that has been trading at record highs.

Except for Venezuela which has been drifting close to the recently etched milestone highs established last May, it is only Thailand that comes close to having a superb feat.

All the rest are still way off from their apogees set during the last 3-5 years

I do not count Venezuela’s stock market as a real contender for the simple reason that the outperformance of the Venezuelan stock market could be a reaction to the amplified risks of hyperinflation.

Due to a combination of price controls and massive imports by the government, Venezuela’s inflation rate has been down reportedly to 21.3% last June[2]. But this is likely to be temporary and designed for the reelection of President Chavez this October

Combined with falling oil prices and massively expanding government expenditures, the Venezuelan government will likely run out of hard currency or of foreign exchange which may force them to ramp up on the printing presses for financing.

Stock markets have been functioned as safehaven during episodes of hyperinflation as people jettison currency for real assets. A good example is the recent bout of horrific hyperinflation[3] endured by Zimbabwe which culminated in 2008[4].

Surging stocks amidst hyperinflation has barely been about real (investment) returns but about people trying to preserve savings through acquisition of claims on real assets (insurance against monetary disorder).

And going back to the top 11, Thailand’s stock market as measured by the major bellwether the Stock Exchange of Thailand (SET) is second only to the Phisix to demonstrate remarkable gains.

While the SET is at a milestone multi-year high, the Thai bellwether is still about 30% off from the 1994 pre-Asian crisis record.

Yet the best annual performers masks or are framed to exclude the position of the others. This shows why the use of statistics can tricky and can be tailored to fit a predetermined conclusion.

Indonesia and Malaysia may have posted moderate year-to-date returns relative to the Phisix, up only 6.1% and 5.87% respectively, but Malaysia, like Philippines, trades at record HIGHs.

Meanwhile Indonesia trades a few percentages or (3.5%) off the recent record.

So ALL four major ASEAN bourses are AT or NEAR landmark highs but so far the Phisix leads the pack.

Outside the region, I have not encountered any national stock markets that have come close to beating their 3-5 year highs.

Growing Detachment between Stock Markets and Real Events

It is obvious that any economic or financial gains would be used as political advertisement.

For instance the recent S&P upgrade of the Philippine credit rating have been painted as a puffery of good governance. The fact is that whatever gains seen in the Philippines has been a regional dynamic. They are in reality symptoms of the boom phase of the business cycle that has mainly been driven by the domestic monetary policies through the negative real rate regime and supplemented by external monetary policies which has induced a search for yield dynamic from foreign investors in response to international easing policies. This ‘search-for-yield’ can also be interpreted as capital flight.

The current market conditions of the Phisix fit the inflationary boom scenario described by the late Austrian economist Fritz Machlup[5]

If, however, we inquire into the causes of the inflow of speculative capital from abroad which is so much objected to, we shall often find that it was the boom tendencies that were already present on the stock exchange which attracted the foreign funds. La hausse amene la hausse. The beginnings of the speculative boom originated in a flow of money from domestic sources. And as it is extremely difficult domestic to conceive of a sudden epidemic of saving, we are once again driven back to credit expansion by the banks. It is the "domestic" creation of credit which usually produces that sentiment on the stock exchange and that movement of stock prices, which act as an by foreign invitation to foreign funds.

The occasions when the short-term foreign funds flowing onto the stock exchange are to be regarded with real mistrust are when these funds owe their boom is existence to a credit inflation abroad. In this case foreign they bring the foreign “business cycle germ” into the home country

Yet the much ballyhooed upgrade has been based on superficial measures. They have most likely been influenced by surging prices in the asset markets (reflexivity theory), by political Public Relations campaign, particularly the phony war against corruption (where corruption is misleadingly portrayed as a function of ethical virtuosity rather than from real cause: arbitrary statutes and regulations[6]) and could even possibly be related to dwindling stock of “safe assets” for the global banking system than from real changes or market based economic reforms as I explained earlier[7]

What the credit upgrade does is to give license to the Philippine government to lavish on public expenditures. This would only promote crony capitalism, (yes guess which parties will be awarded with the proposed $16 billion of public work spending?) and that rewarding debt would work to the detriment of the economy over the long run through the adverse effects of the crowding out phenomenon[8], higher taxes and the serial blowing of the bubble cycles.

Grandiose skyscrapers (or the Skyscraper Index) have exhibited uncanny accuracy as harbingers of the bust phase of financial bubbles.

And believe it or not, 9 of the 10 of the world’s tallest building will rise in Asia and have been slated for completion from 2015 onwards—with China having four, South Korea three and one apiece for Indonesia (3^rd largest) and Malaysia[9].

So if the skyscraper index remains a functional indicator of financial excesses then we could or we may see a regional financial crisis anytime during the time window of 2015-2017.

Yet given the extreme fluidity of current conditions, such bubble conditions may be delayed or hastened depending on the direction of external and domestic social policies mostly channeled through monetary policies, particularly the complicit war by central bankers against interest rates (or the euthanasia of the rentier).

From the prescient admonitions of the great Ludwig von Mises[10]

Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation. In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy.

Of course, I see the soaring Phisix as effects of the bubbles parlayed as symptoms of Panglossian complacency (based on the belief that the Phisix or the region will decouple) or if not Pavlov’s classic mental conditioning (of the strongly held belief that central bankers will successfully bailout financial markets) or as effects of “jockeyed” markets.

As for the latter, aggressive buying in a landscape where global political authorities have been exhibiting anxieties over global economic conditions simply does not match with the current state of exuberance.

To give some examples.

The Bloomberg quotes IMF’s Christine Lagarde’s diagnosis of the world economy[11]

“Over the past few months, the outlook has regrettably become more worrisome,” Lagarde said. “Many indicators of economic activity -- investment, employment, manufacturing -- have deteriorated. And not just in Europe or the United States.”

Or how about the “45-minute salvo” fired by 3 central banks last Thursday as acts of desperation?

From another Bloomberg article[12]

Global central banks went on the offensive against the faltering world economy, cutting interest rates and increasing bond buying as a round of international stimulus gathers pace.

In a 45-minute span, the European Central Bank and People’s Bank of China cut their benchmark borrowing costs, while the Bank of England raised the size of its asset-purchase program. Two weeks ago, the Federal Reserve expanded a program lengthening the maturity of bonds it holds and Chairman Ben S. Bernanke indicated more measures will be taken if needed.

Many major global equity markets sagged following the news of the 45 minute interval coordinated easing from 3 major central banks.

The most curious response I saw came from China.

The Shanghai index remained wobbly and even traded on the negative for almost two thirds of Friday’s session which appeared to have discounted the interest rate cuts. The above chart from Bloomberg shows of the intraday actions. It took the last minute for the Shanghai index to surge, which according to news reports had been led by the property sector[13].

That last minute adrenalin shot may not persist as China’s Premier Wen Jiabao immediately shot down the notion of the lifting property controls in a comment today[14].

This is yet another example of the confounding stance by China’s political authorities.

The weaknesses in global markets following the reported near simultaneous interventions in the bourses of major economies could be deemed as “buy the rumor, sell on news” or of reality check relative to hope based expectations.

As I wrote a few weeks back[15],

One, if central bankers FAIL to deliver in accordance to market’s expectations, then we will likely see another huge bout of downside volatility in global equity markets….

On the other hand, if markets may be temporarily satisfied with REAL actions of central banks (e.g. $1 trillion bailout) then we should see a minor or a slight “sell on news”. But this should be seen as opportunities to RE-ENTER the markets incrementally.

Considering that the Phisix has soared since, I don’t see today as a providing a buying window, unless global central bankers would bring on their vaunted bazookas or until there will be meaningful improvements in the global economic arena

When financial markets flows into the opposite direction from the economy sans support from central bankers then the risks of a crash becomes a factor to reckon with.

One thing that could be justify divergences or decoupling is the possibility of intensified capital flight. While there are little signs of these affecting ASEAN markets yet, as explained last week, Denmark’s case seems like a relevant model.

Denmark’s bond markets which earlier have exhibited negative yields have now been reinforced by Denmark’s central bank policy of negative interest rates. Capital flight from the Eurozone to Denmark has prompted for an outperformance of Denmark’s equity markets[16] and has been on my top 11 list.

However the same capital flight phenomenon has not boosted the Switzerland’s Swiss Market’s Index in the same degree as Denmark. So we need to observe this further.

Outside More Central Bank Intervention, Expect Downside Pressures

Current conditions could be ripe for a significant retrenchment for global equity markets based on ‘fundamentals’.

Nearly 80% of the world’s industrial activities have been contracting[17].

Compared to 2007-2008 which had the US property bust as the epicenter, today’s slowdown has been coming from different directions, particularly, the Euro area and the BRICs.

Even in the US, both the industrial activities[18] and non-industrial activities[19] have been exhibiting considerable signs of weakening.

These may not signal yet the imminence of recession, but the risk of recession grows if both domestic and international conditions deteriorate further.

And the global economic slowdown has shown incipient signs of filtering into US corporate profits[20].

While the distribution of revenues from S&P 500 member companies has marginally been tilted towards US, nonetheless revenues from abroad still accounts for a substantial 45% share[21].

This means that slowing global economic growth will pose as material drag to current “fundamentals”.

So in the absence of further interventions by central banks or when steroid dependent markets have been left to their own devices, broad based downturns on the world economy would hurt profits and will get reflected on the stock prices.

The alternative view is that since global weakness has been coming from different directions interventions will require global coordination similar to the 45 minutes salvo.

In addition, “liquidity” conditions in emerging markets have reportedly been faltering.

This essentially reflects on the ongoing monetary tightening or increasing manifestations of bubble bust conditions in major economies as the Eurozone and the BRICs to Emerging Markets.

The transmission mechanism of which can be seen through the deterioration in trade balances which has been exacerbated by falling commodity prices, declining foreign reserve accumulation as some EM authorities have used excess reserves to support their domestic currency and a slowdown in capital inflows (which even may risk a reversal, if current conditions worsen)[22].

I would further point out that easing through interest rate policies will have miniscule effects to economies laden with debt.

Demand for credit will be limited as hock to the eyeball indebted individuals, households or corporations will be working to pay off existing liabilities. Further, impaired credit ratings diminish access to debt. Also supply of credit will be limited as institutions whose balance sheets have been compromised by problematic assets will work on building up capital reserves. Also, slowing of economic conditions will also hamper debt activities.

This means that unless global central banks pull out another rabbit out of a hat trick of aggressive ‘delaying the day of reckoning’ interventions through money printing, money conditions will tighten, as the malinvestments from previously inflated activities will have to undergo price adjustments that would need re-coordination in the transfer of resources from non-productive to productive activities.

So debt acquired during the bubble heydays will have to be dealt with eventually through the laws of economics.

Aside from the ECB, all eyes will be on the US Federal Reserve FOMC’s meeting on July 31 to August 1, 2012[23]

It would be interesting to see how the Phisix and ASEAN bourses will react in the face of a more pronounced slowdown in the US

Stay Defensive

The principal reason why the Philippines and her ASEAN neighbors have been more receptive towards negative real rates policies is that these economies has been excised of leverage as a result of the Asian crisis as shown in the above chart[24].

But this does not mean that the Philippine and ASEAN economies will be immune from a global economic slowdown. Again the exceptionalism and resiliency of ASEAN markets will be tested with a US economic slowdown.

Again since negative real rates rewards debt and speculation, today’s low debt era may easily transform low debt ASEAN economies into speculative and consumption activities based on debt similar to conditions which plagues developed economies today.

That’s the nature of bubble cycles.

For now, unless the US Federal Reserve (and or the European Central Bank) brings out the BAZOOKA soon, expect the Phisix, ASEAN and global markets to retrench.

At record and near record highs for the Phisix and ASEAN markets, retracements should be seen as normal countercyclical process.

But since events have been so fluid, we cannot discount the risks of a global recession emanating from continuing political stalemate, dithering over monetary policies and from policy errors. Recessions can turn bullmarkets into bear markets.

Oppositely, powerful responses from central bankers may alter the risk scenario for the benefit of the bulls for another short period.

And this is why excessive volatility in both directions will continue to characterize the financial marketplace.

Yet if the Phisix continues to soar, alone or along with ASEAN, despite all the mounting risks, and without support by the FED and or by the ECB, and if they are not driven by capital flight, the tail risks of downside volatility may become magnified.

The current conditions of financial markets can be analogized to navigating in treacherous waters where one’s survival depends on skillful handling of the steep ebbs and flows of the tides, and of course guided too by lady luck. Yet chance according to Louis Pasteur favors the prepared mind.

So still, I would advise that prudence will remain a better part of valor in terms of portfolio management

---

[1] See Why has the Phisix Shined? July 2, 2012

[2] Businessweek/Bloomberg Venezuela Inflation Slows for Seventh Month on Import Surge, July 3, 2012

[3] See Zimbabwe's Hyperinflation February 25, 2009

[4] See Zimbabwe In The Aftermath Of Hyperinflation: Free Markets November 16, 2009

[5] Machlup Fritz A Digression On International Speculation Chapter 10, The Stock Market, Credit And Capital Formation William Hodge And Company, Limited p.163 Mises.org

[6] See Doug Casey On Corruption: Laws Create Corruption And Corruption Engenders Laws February 10, 2011

[7] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 5, 2012

[8] Wikipedia.org Crowding out (economics)

[9] See Does the Skyscrapers Curse Signal a coming Asian Crisis?, July 6, 2012

[10] Mises Ludwig von 8. The Monetary or Circulation Credit Theory of the Trade Cycle XX. INTEREST, CREDIT EXPANSION, AND THE TRADE CYCLE Human Action Mises.org

[11] Bloomberg.com Lagarde Says IMF To Cut Growth Outlook As Global Economy Weakens, July 5, 2011

[12] Bloomberg.com, Central Banks Deliver 45-Minute Salvo As Growth Weakens, July 5, 2012

[13] Reuters.com China bank shares pull down Hong Kong HSI, property lifts Shanghai, July 6, 2012

[14] See China’s Property Controls: Mistaking Forest for Trees July 8, 2012

[15] See Dealing with Today’s Uncertainty: Patience is the Better Part of Valor June 17, 2012

[16] See Denmark Cuts Interest Rates to Negative, July 4, 2012

[17] Zero Hedge 80% Of The World's Industrial Activity Is Now Contracting July 5, 2012

[18] Yardeni.com US Manufacturing Purchasing Managers Index July 3, 2012

[19] Wall Street Journal Blog Vital Signs: Slowing in Nonmanufacturing, July 6, 2012

[20] Wall Street Journal Blog, Number of the Week: Rest of World Pulls Down U.S. Profits June30, 2012

[21] Businessinsider.com CHART: A Breakdown Of Where S&P 500 Companies Get Overseas Business, June 27, 2012

[22] See Emerging Market “Liquidity” Conditions Deteriorate July 5, 2012

[23] US Federal Reserve Meeting calendars, statements, and minutes (2007-2013)

[24] Zero Hedge, Asia's Downside Risk And The Three Big Hopes June 21, 2012