Quote of the day: Mainstream Economy Slowly Cooked Alive while Central bankers Focus on their Taylor Models

Because zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment. Why that is true is not immediately apparent. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not. Instead they have plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage. But more importantly, zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society. These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8% over the long term. Now with corporate bonds at 2-3%, it is obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10% a year to meet the targeted assumption. That, of course, is a stretch of some accountant’s or actuary’s imagination.

Do central bankers not observe that Detroit, Puerto Rico, and soon Chicago, Illinois cannot meet their promised liabilities? Do they simply chalk it up to bad management and inept governance and then return to their Phillips Curves for policy guidance? Do they not know that if zero were to become the long-term norm, that any economic participant that couldn’t print its own money (like they can), would soon “run on empty” as Blackstone’s Pete Peterson once expressed it in describing our likely future scenario? The developed world is beginning to run on empty because investments discounted at near zero over the intermediate future cannot provide cash flow or necessary capital gains to pay for past promises in an aging society. And don’t think that those poor insurance companies and gargantuan pension funds in the hundreds of billions are the only losers. Mainstream America with their 401Ks are in a similar pickle. Expecting 8-10% to pay for education, healthcare, retirement or simply taking an accustomed vacation, they won’t be doing much of it as long as short term yields are at zero. They are not so much in a pickle barrel as they are on a revolving spit, being slowly cooked alive while central bankers focus on their Taylor models and fight non-existent inflation.

This is from bond guru Bill Gross from his monthly outlook at Janus Capital

Recommended Links: A Sense of Ending, Misplaced Belief in Central Bankers and Dangerous Delusions

Bond Maven William H Gross believes that the endgame for central bank magic nears. Selected excerpts from his monthly outlook at Janus Capital, (bold mine)

A “sense of an ending” has been frequently mentioned in recent months when applied to asset markets and the great Bull Run that began in 1981. Then, long term Treasury rates were at 14.50% and the Dow at 900. A “20 banger” followed for stocks as Peter Lynch once described such moves, as well as a similar return for 30 year Treasuries after the extraordinary annual yields are factored into the equation: financial wealth was created as never before. Fully invested investors wound up with 20 times as much money as when they began. But as Julian Barnes expressed it with individual lives, so too does his metaphor seem to apply to financial markets: “Accumulation, responsibility, unrest…and then great unrest.” Many prominent investment managers have been sounding similar alarms, some, perhaps a little too soon as with my Investment Outlooks of a few years past titled, “Man in the Mirror”, “Credit Supernova” and others. But now, successful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others warn investors that our 35 year investment supercycle may be exhausted. They don’t necessarily counsel heading for the hills, or liquidating assets for cash, but they do speak to low future returns and the increasingly fat tail possibilities of a “bang” at some future date. To them, (and myself) the current bull market is not 35 years old, but twice that in human terms. Surely they and other gurus are looking through their research papers to help predict future financial “obits”, although uncertain of the announcement date. Savor this Bull market moment, they seem to be saying in unison. It will not come again for any of us; unrest lies ahead and low asset returns. Perhaps great unrest, if there is a bubble popping…

At the Grant’s Conference, and in prior Investment Outlooks, I addressed the timing of this “ending” with the following description: “When does our credit based financial system sputter / break down? When investable assets pose too much risk for too little return. Not immediately, but at the margin, credit and stocks begin to be exchanged for figurative and sometimes literal money in a mattress.” We are approaching that point now as bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion. A rational investor must indeed have a sense of an ending, not another Lehman crash, but a crush of perpetual bull market enthusiasm.

Read the rest here

Sovereign Man’s Simon Black on Walter Bagehot’s exposition of the public's halo effect on central banking (bold mine)

Bagehot was Editor-in-Chief of The Economist at the time. He was a brilliant finanical thinker, and the book, Lombard Street: A Description of the Money Market, was his masterpiece.

For example, the book describes how, even though the British banking system was the most widely used and powerful in the world, it was dangerously overleveraged:

“There was never so much borrowed money collected in the world as is now collected in London,” writes Bagehot.

He further shines a huge spotlight on the risks of illiquidity, describing how Britain’s largest banks only held a very small percentage of their customer’s funds in cash:

“[T]here is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England.”

He continues:

“[T]he amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.”

…

Bagehot also blasts the central banking system (dominated by the Bank of England) which had effective control over the economy:

“All banks depend on the Bank of England, and all merchants depend on some bank.”

Of course, no one truly understood how that system worked. Everyone just had confidence that the central bankers were smart guys and absolutely would not fail:

“[F]ortunately or unfortunately, no one has any fear about the Bank of England. The English world at least believes that it will not, almost that it cannot, fail.”

“[N]o one in London ever dreams of questioning the credit of the Bank, and the Bank never dreams that its own credit is in danger.”

But as Bagehot points out, the data showed otherwise:

“Three times since 1844 [the Bank of England] has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so.”

Clearly these central bankers weren’t particularly good at their jobs. Bagehot sums it up like this:

“[W]e have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty—who might be called ‘amateurs’. . .”

Read the rest here

Former Chairman of Morgan Stanley Asia, now senior fellow at the Yale Institution worries over the world having gone mad, excerpts from the Project Syndicate

But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilizing imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US – the poster child of the new prescription for recovery. Although the Fed expanded its balance sheet from less than $1 trillion in late 2008 to $4.5 trillion by the fall of 2014, nominal GDP increased by only $2.7 trillion. The remaining $900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery, with real GDP growth holding to a 2.3% trajectory – fully two percentage points below the 4.3% norm of past cycles.

Indeed, notwithstanding the Fed’s massive liquidity injection, the American consumer – who suffered the most during the wrenching balance-sheet recession of 2008-2009 – has not recovered. Real personal consumption expenditures have grown at just 1.4% annually over the last seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated. For the beleaguered middle class, the benefits were negligible.

“It might have been worse,” is the common retort of the counter-factualists. But is that really true? After all, as Joseph Schumpeter famously observed, market-based systems have long had an uncanny knack for self-healing. But this was all but disallowed in the post-crisis era by US government bailouts and the Fed’s manipulation of asset prices.

America’s subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan, the genesis of this tale, has embraced a new and intensive form of QE, reflecting its apparent desire to learn the “lessons” of its own mistakes, as interpreted by the US.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. In the meantime, politicians are lulled into a false sense of complacency that undermines their incentive to confront the structural challenges they face.

Read the rest here

Bill Gross: Past Performance in the Age of the New Normal

In the age where central banks have been propping up asset prices via the “wealth effect” as a way to lubricate “aggregate demand”, generating returns from investments requires unorthodox or unconventional or methodological templates.

So says Bond guru Pimco’s Bill Gross.

From Bloomberg (bold mine)

Bill Gross, manager of the world’s largest mutual fund, said the most renowned investors from Warren Buffett to George Soros may owe their reputations to a favorable era for money management as expanding credit fueled gains in asset prices across markets.

The real test of greatness for investors is not how they navigated market cycles during that time, but whether they can adapt to historical changes occurring over half a century or longer, Gross, 68, wrote in an investment outlook published today entitled “A Man in the Mirror,” named after a song by Michael Jackson.

“All of us, even the old guys like Buffett, Soros, Fuss, yeah - me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience,” Gross wrote. “Perhaps it was the epoch that made the man as opposed to the man that made the epoch.”

Gross, one of the co-founders in 1971 of Newport Beach, California-based Pacific Investment Management Co., is examining his legacy as the bond shop he built over four decades is seeking to adapt to an environment that looks very different from the bull market that fueled Pimco’s growth to one of the largest money managers in the world. The prospect of elevated market volatility, an aging population and climate change could make investing far more challenging in the coming decades, Gross said.

Bottom line: Past performance does not guarantee future outcomes.

Relying on historical data or statistics will unlikely be of a big help in the era founded on the deepening frictions from market distorting central banking inflationism and politicization of the financial markets via financial repression relative to changes in demographics, globalization and the information age.

To quote from the investing sage of Omaha (now crony) Warren Buffett,

If past history was all there was to a game, the richest people will be librarians.

PIMCO's Bill Gross Endorses Ron Paul

In politics you should expect the unexpected.

Pimco's chief honcho Bill Gross, a Keynesian who previously seemed like an avid fan of Paul Krugman surprisingly endorses Ron Paul.

Here is the CNN interview

Minnesota a la Greece, Bill Gross says US Worst than Greece, PIIGS

If Greece has been one of Europe’s major headache, then the US has her counterpart, Minnesota.

From yahoo.com

Time is running out for Minnesota's parks, highway rest stops and public universities, not to mention 36,000 state employees.

If Gov. Mark Dayton and lawmakers don't agree on a budget by June 30, the state government is expected to shut down. The state moved one step closer to this outcome on Friday by sending layoff notices to much of the state workforce.

Should officials not resolve their differences in time, state parks and highway stops could be shuttered over the busy Fourth of July weekend. Forget about renewing a driver's license or taking classes at state colleges. Nonprofit agencies may have to suspend their social services if their state funding disappears.

As for the state workers, they'll have to wait to see who is deemed critical. The rest could lose their pay, and some their health benefits. The unions have already launched a campaign pressuring state officials to pass a budget.

At issue is whether to close a $3.6 billion budget shortfall by increasing taxes or making spending cuts. The decision must be made before the fiscal year ends on June 30.

I know Minnesota is small compared to Greece. But the point is both have been suffering from the same sin—profligate government spending—and now faces the consequences. Reality stares on them.

Yet seen from a relative standpoint, Pimco’s Bill Gross says that the US is in worst condition than Greece or the Eurozone.

Mr. Gross’ recent analysis or outlook squares with mine.

Incidentally Mr. Gross, formerly an apostle of Krugman, has reversed his position, since his uber-Keynesian partner Paul McCulley departed from (or kicked out of?) PIMCO in December 2010.

From CNBC, (bold emphasis mine)

When adding in all of the money owed to cover future liabilities in entitlement programs the US is actually in worse financial shape than Greece and other debt-laden European countries, Pimco's Bill Gross told CNBC Monday.

Much of the public focus is on the nation's public debt, which is $14.3 trillion. But that doesn't include money guaranteed for Medicare, Medicaid and Social Security, which comes to close to $50 trillion, according to government figures.

The government also is on the hook for other debts such as the programs related to the bailout of the financial system following the crisis of 2008 and 2009, government figures show.

Taken together, Gross puts the total at "nearly $100 trillion," that while perhaps a bit on the high side, places the country in a highly unenviable fiscal position that he said won't find a solution overnight.

"To think that we can reduce that within the space of a year or two is not a realistic assumption," Gross said in a live interview. "That's much more than Greece, that's much more than almost any other developed country. We've got a problem and we have to get after it quickly."

Politicians and their fanatic worshipers think that money printing measures will help solve such dilemma by kicking the proverbial can down the road. They’re dead wrong. [If they have strong enough convictions, they should put all their money in shorting gold]

If Mr. Gross analysis is accurate, then this only shows that socio-economic problem of the US is so remarkably huge. And that if the US obstinately pursues on the money printing path, the scale of such undertaking would equally be colossal. This brings to fore the risks of hyperinflation, which is what US presidential aspirant and candidate Ron Paul has recently warned of and which could also be read as his prediction.

This is also why I have been saying that the next crisis will be even more devastating than 2008, as both the banking system and governments have already been pushed wall. The next crisis will likely see what I call the Mises Moment: either massive defaults by governments and a possible collapse of the banking sector or the worst alternative—hyperinflation. I can't fathom yet how the technology driven globalization will be impacted.

Yet hyperinflation would likely mean the end of the de facto US dollar standard or even the closure of US Federal Reserve as Nassim Taleb predicts or even possibly the disintegration of the Euro too (if the Euro would hyperinflate along with the US).

Finally there are many speculations on the new terminology of money printing or currently known as Quantitative Easing.

Jim Rogers calls sarcastically his version as the ‘cupcake’. Bill Gross sees a price cap on 2-3 treasuries and David Rosenberg calls his the ‘Operation Twist’

At the end of the day, what faces the world is the risk of debt defaults or default by hyperinflation.

Trojan Horse Advise Of PIMCO's Bill Gross

PIMCO's William Gross writes, (bold highlights mine)

``It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem, which only economists with names beginning in R seem to understand (there is no R in PIMCO no matter how much I want to extend the metaphor, and yes, Paul _Rugman fits the description as well!). If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.

``Even if your last name doesn’t begin with R, the preceding explanation is all you need to know to explain what is happening to the markets, the global economy, and perhaps your own wobbly-legged standard of living in recent years. Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. Stop whispering (and start shouting) the words “New Normal” or perhaps begin to pronounce your last name with an RRRRRRRRRRRR. Our global economy, our use of debt, and our financial markets have changed – not our alphabet or dictionary."

Well this is one good example why the Fed economist Kartik Athreya recently assailed on economic bloggers for trying to "oversimplify economics".

What's wrong with the picture described by Mr. Gross?

Many. But we will stick with two major flaws: Producers are painted to be distinct from consumers and that all debts are treated as equal.

Nations constitute people and that production and consumption are activities aimed at satisfying peoples' desire. In other words, people produce to consume. The difference is that in emerging markets, consumption is mostly funded by savings (surplus production output) and little of debt. In developed economies consumption is mainly financed by debt.

Mr. Gross wants EM economies and developed economies to trade places in terms of consumption and production. He sees government as using its force to make this shift on their people, according to his simplified gospel of prosperity.

He is not straightforward to say that when people undertake debt to finance spending on consumption goods, that would be equivalent to capital consumption (spending more than one earns). He isn't even candid to say that this had also been the root of the recent crisis.

In other words, to advance the notion that people should indulge in unproductive debt is equivalent to an advocacy of poverty. Therefore, Mr. Gross' recommendation would seem like an implicit trojan horse recipe for people in emerging markets-an advise that should be ignored. His agenda is that inflationism would lift total returns of investment portfolio for his self interest.

Moreover, I wonder how Mr. Gross would react if the US government strictly applies his recommendation---that would require him and/or PIMCO to forcibly go into manufacturing and forego of their current financial investments model. His outlook assumes that everyone else has a problem but him and his RRRR, such that government should apply his remedies only to the others.

Finally, another important thing Mr. Gross glosses over is that since governments are also run by people whose interests are determined mostly by local political factors, this translates to innate policy divergences in national and global issues for every country. Thus, there is such a thing as competition among governments. The other way to say this, is that harmonization of policies among governments is another mirage.

Bill Gross: Beware The Ring Of (DEBT) Fire!

Here is PIMCO's Big Boss Mr. Bill Gross who makes the case of HIGH DEBT-LOW Growth and LOW DEBT-HIGH Growth investment theme...

They can be broken down into 2: For risk assets-select Asia and emerging markets and for less risky fixed income assets low debt developed nations.
Here is Mr. Gross: (bold emphasis his)

1. Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy.

2. Invest less risky, fixed income assets in many of these same countries if possible. Because of their reduced liquidity and less developed financial markets, however, most bond money must still look to the “old” as opposed to the new world for returns. It is true as well, that the “old” offer a more favorable environment from the standpoint of property rights and “willingness” to make interest payments under duress. Therefore, see #3 below.

3. Interest rate trends in developed markets may not follow the same historical conditions observed during the recent Great Moderation. The downward path of yields for many G-7 economies was remarkably similar over the past several decades with exception for the West German/East German amalgamation and the Japanese experience which still places their yields in relative isolation. Should an investor expect a similarly correlated upward wave in future years? Not as much. Not only have credit default expectations begun to widen sovereign spreads, but initial condition debt levels as mentioned in the McKinsey study will be important as they influence inflation and real interest rates in respective countries in future years. Each of several distinct developed economy bond markets presents interesting aspects that bear watching: 1) Japan with its aging demographics and need for external financing, 2) the U.S. with its large deficits and exploding entitlements, 3) Euroland with its disparate members – Germany the extreme saver and productive producer, Spain and Greece with their excessive reliance on debt and 4) the U.K., with the highest debt levels and a finance-oriented economy – exposed like London to the cold dark winter nights of deleveraging.

Of all of the developed countries, three broad fixed-income observations stand out: 1) given enough liquidity and current yields I would prefer to invest money in Canada. Its conservative banks never did participate in the housing crisis and it moved toward and stayed closer to fiscal balance than any other country, 2) Germany is the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched. Think AIG and GMAC and you have a similar comparative predicament, and 3) the U.K. is a must to avoid. Its Gilts are resting on a bed of nitroglycerine. High debt with the potential to devalue its currency present high risks for bond investors. In addition, its interest rates are already artificially influenced by accounting standards that at one point last year produced long-term real interest rates of 1/2 % and lower.

End quote.

One last noteworthy quote...

"the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive."

Poker Bluffing Booby Traps: PIMCO And The PIIGS

``…the state consists not only of politicians, but also those who make use of the politicians for their own ends; that would include those we call pressure groups, lobbyists and all who wrangle special privileges out of the politicians. All the injustices that plague "advanced" societies, are traceable to the workings of the state organizations that attach themselves to these societies.”-Frank Chodorov, Gentle Nock at Our Door

The mainstream is loaded with booby traps.

Without critical thinking it would be easy for anyone to get entranced or fall victim to the metaphorical enchanting ‘songs of the Sirens’, as in one of Odysseus’ tests in his voyage home to Ithaca.

PIMCO’s Bill Gross: Do What I Say, Not What I Do

Basically a major objection to an upside market is that policy reversals from central banks are likely to lead to a withdrawal of liquidity, thereby adversely affecting market outcomes.

Here are some examples:

Pimco’s Bill Gross: ``if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.”

From John Maudlin: ``The Fed is going to stop the music in March. There will be a scramble for the chairs. This is a huge experiment with no precedent.”

The World Economic Forum chimes in, ``The risks of a sovereign-debt crisis, asset-price-bubble collapse and a hard landing for the Chinese economy will be high on the agenda of global leaders convening in Davos, Switzerland, for the World Economic Forum this month…

``The report found a collapse in asset prices to be the most severe and likely risk, amid concerns that the weak dollar and low global interest rates could fuel a liquidity-driven, rather than debt-driven, bubble.”

Note: Either the journalist here misquotes the authority interviewed or the authority doesn’t understand that liquidity is driven by debt.

In contrast, Morgan Stanley analyst Manoj Pradhan argues that liquidity won’t get affected by the reversal of policies, (bold highlights mine, italics his)

``Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB [Global Central Bank] is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

David Kotok of Cumberland Advisors has what I think the better perspective,

``In our opinion, we think the Fed is now trapped.

``By becoming the buyer of last resort, the Fed has now impacted the markets in such a way that the very idea that it may withdraw has caused mortgage interest rates to rise. Markets aren't dumb, and they realize that rates will rise, for two reasons. First, if the supply of funds to Freddie and Fannie stops with the Fed's purchases, then home-mortgage interest rates will have to rise. Moreover, they will rise even further if the Fed starts selling its existing securities into the market. What this also means is that the interest-rate risk associated with any future increases in interest rates will be shifted from the private sector to the Fed and ultimately the taxpayer – and this risk will grow as the Fed begins to unwind its current low-interest-rate policy.” (bold emphasis mine)

In other words, like us, Mr. Kotok believes that markets have essentially been propped up by the Fed and “exiting” the market could prompt for unwarranted uncertainty and result to increased volatility. Hence, Mr. Kotok prescribes a more transparent and credible strategy to alleviate the ‘exit risks’, as well as, raising reserve deposits to mitigate any incidental upsurge of the risks of inflation.

It’s true that markets aren’t dumb, but they haven’t been negatively reacting to the alleged ‘exit risks’ either, which is due on March. Maybe it’s because the Fed still covertly supports the stock market [as argued in Politics Ruled The Market In 2009].And importantly, markets aren't representative of their actual state, instead they represent distorted markets from massive interventions.

Moreover, it would also be quite naïve to think that Fed Chair Ben Bernanke or the US Federal Reserve backed by its huge platoon of economists and the sundry of employed experts, aside from their extensive network of allies in Wall Street or in the academia, are nitwits.

What we are suggesting is that these concerns are apparently NOT out of bounds for the Fed officials or authorities including Mr. Bernanke.

They know it.

On the contrary, asset prices seem to exhibit the top concern in the scale of priorities for authorities. And this has been flagrantly echoed by the official from the World Economic Forum, `` a collapse in asset prices to be the most severe and likely risk”.

They see it.

In short, global officials appear to prioritize the asset market dimensions as we have been arguing for the longest time.

They’d most probably act on it.

Hence, the other way to read the insights from Wall Street mainstays as Bill Gross is that they’re engaged in a psy-war, or particularly reverse psychology.

Being a political entrepreneur, who have constantly benefited from policy maneuvers by their central bank, one can’t ignore that the current missive by Mr. Gross signifies as tacit appeal to Ben Bernanke for maintaining or even expanding current policies.

Mr. Gross seems to be an avid adherent of the recent Nobel Prize winner and Keynesian high priest Paul Krugman, who proposed last December that the Federal Reserve should buy $2 trillion MORE of assets to jumpstart credit!

In other words, many of the talking heads seem to operate like masquerading propagandists, whose overall agenda have been cosmetically dressed up or disguised as ‘analysis’.

In putting money where his mouth is, Mr. Gross’ PIMCO has actively been expanding its global equity exposure by incorporating emerging market specialists (‘pirated’ from the top notch Franklin Templeton firm) to its team.

According to citywire.co.uk, ``The group is also going on the offensive in the equity space, last month hiring leading global equity fund managers Anne Gudefin, Charles Lahr and Neel Kashkari from franklin Templeton to improve its level of expertise in the area.”

Moreover, PIMCO pared its holdings of US and UK debt and appears to have switched into Southeast Asia’s sovereign debts!

So if Bill Gross sees an ominous reckoning for 2010, ``If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy”, then why has he been aggressively expanding on his global equity-bond markets to even add Southeast Asian debts on his portfolio mix?

Apparently actions don’t match with rhetoric.

This category of bluffing appears to reinforce our thesis discussed last week. [see Poker Bluff: The Exit Strategy Theme For 2010].

The PIIGS Bogeyman

Another objection recently brought up has been the possible risks of contagion from Europe’s crisis affected PIIGS-most notably Greece, (as Ireland has reportedly been coping positively with present austerity policies).

I would place such “concern” in the same category of the Dubai Debt Crisis, as it would seem more of a political than of an economic/financial problem [see Why Dubai’s Debt Crisis Isn’t Likely THE Next Lehman].

Yet again this would seem to uphold my contention that today’s trend will be more on political bluffing aimed at perpetuating inflationary policies.

This fabulous excerpt from Danske Bank’s Fixed Income Research team (all bold highlights mine),

``Moody’s sent out a report on the European Sovereign outlook on Wednesday, in which they argue that countries such as Portugal and Greece could be facing a “slow death” as higher debt costs will cause the economies to “bleed” economic potential. Hence, a large part of the future public revenues would have to be spent paying off the debt rather than on welfare etc. Moody’s thinks that the risk of a “sudden death” is negligible, but warned that the countries have to act and do NOT have an open window indefinitely in order to restore public finances. Moody’s highlighted Greece, saying that it would have significantly less time than Portugal. Hence, if the forthcoming fiscal austerity plan from Greece is not considered to be sufficient, then Moody’s is very likely to downgrade Greece, and this will bring Greece closer to ECB’s temporary threshold of BBB-, as the other rating agencies will also act. Portugal tried to distance itself from Greece…

``Furthermore, the current rating threshold is only temporary and is valid until the end of 2010, and we do not think that Greece will have been able to stabilise its finances such that its rating will be at or above A-. The risk of Greece not being able to use its government bonds as eligible collateral was highlighted at yesterday’s ECB meeting. Here, Trichet said that ECB “would not change its collateral rule for the sake of any particular country”, although on the question as to whether Greece or any other country could leave the Euro area, Trichet replied that "I do not comment on absurd hypotheses".

What’s the article been saying?

For Greece, it means ‘Heads I win, Tails you lose’, a bailout is in order. Just look at Trichet’s statement, the dice is loaded for a Greece rescue.

Why?

Because the European Central Bank (ECB) is likely to suffer more from the ripples of a withdrawal (unlikely expulsion) which appear likely to risk materially undermining the political and monetary significance of the European Union.

More proof?

The ECB has recently issued a report on the prospects of a withdrawal or expulsion from ECB based on the LEGAL aspects,

Here is the Wall Street Journal Blog (all bold emphasis mine), ``Written by the ECB’s legal counsel, it notes that “recent developments have, perhaps, increased the risk of secession (however modestly), as well as the urgency of addressing it as a possible scenario.”

``It concludes that unilaterally withdrawing from the European Union “would not, as a matter of public international law, be inconceivable, although there can be serious principled objections to it; and that withdrawal from EMU without a parallel withdrawal from the EU would be legally impossible.”

``As for expulsion, “the conclusion is that while this may be possible in practical terms — even if only indirectly, in the absence of an explicit Treaty mechanism — expulsion from either the EU or EMU would be so challenging, conceptually, legally and practically, that its likelihood is close to zero.”

“Absurd hypotheses, legally impossible and close to zero” reverberates as strong political phrases which seem to reinforce our view that the obvious course of political action will be a bailout of Greece.

Yet even assuming the worst scenario that if Greece were to withdraw, considering its present financial and economic state, the most likely actions that she would undertake would be similar to the others-inflate by devaluing its resurrected currency, the drachma.

So it would be just a matter of WHO does the inflating, the ECB or Greece.

Of course the ECB bailout would come with the attendant ‘disciplining chastisement’ policies which mostly likely would signify melodious political leadership face saving soundbytes.

Besides, PIIGS sovereign debts account for only 38% of the Euro denominated Government Debt securities as of November 2009 as per the ECB. The biggest exposure would be Italy (20.16%) and Spain (12%) the balance spread between Ireland (1.506%), Portugal (1.91%) and Greece (2.43%).

Finally, if one were to argue that the hubbub over Greece should translate to a contagion, we should be seeing rising default risks in the credit standings of broader Europe (see figure 5)

Figure 5 Danske Bank: Smooth Credit Ratings Still Intact, Peak In Default Risks

Apparently this has not been the case, as seen in the iTraxx Europe CDS (left window) which consists of 125 investment grade companies, the iTraxx Crossover CDS (middle window) which comprises of 50 sub-investment grade credits and the default rates of Europe and the US (right windows) which appears to have peaked as measured by Moody’s and Danske Bank.

Like in last week’s article, I wouldn’t be calling on their bluff. Neither should you.

William Gross On The New Normal

Pimco's Bill Gross explains the "New Normal" at a recent CNBC interview

Not Just A Bear Market Rally For Philippine Phisix or Asia

``Key question then: why do smart people engage in negative thinking? Are they actually stupid? The reason, I think, is that negative thinking feels good. In its own way, we believe that negative thinking works. Negative thinking feels realistic, or soothes our pain, or eases our embarrassment. Negative thinking protects us and lowers expectations. In many ways, negative thinking is a lot more fun than positive thinking. So we do it. If positive thinking was easy, we'd do it all the time. Compounding this difficulty is our belief that the easy thing (negative thinking) is actually appropriate, it actually works for us. The data is irrelevant. We're the exception, so we say. Positive thinking is hard. Worth it, though.”- Seth Godin The problem with positive thinking

For many, the basic premise for today’s global market rebound has due to a “bear market rally”.

Dem Dry Bones

This especially holds true for the advocates of the global ‘deflation’ outcome and for those who interpret markets based on conventional methodology.

Nevertheless, predictions have underlying analytical foundations.

The basic pillar for such sponsorship is that the US will remain as the irreplaceable source of demand for the world. But laden with too much debt and hamstrung by a vastly impaired banking system, US consumers will be unable to take up the slack emerging from the recent bust, while the world will unlikely find a worthy substitute, and as consequence, suffer from the excruciating adjustments from the structural excesses built around them during the boom days.

Hence, the Dem Dry bones deduction-Toe bone connected to the foot bone, Foot bone connected to the leg bone, Leg bone connected to the knee bone. BOOO! We are faced with a Global Deflation menace.

We have spilled too much ink arguing against the seemingly plausible but fallacious argument simply because all these oversimplifies human action without taking into account how people will respond to altering conditions (creative destruction), overemphasis on the rear view mirror and importantly, such arguments tremendously underestimates the role money plays in a society (inflationary policies).

Moreover, the assumption that the world has been scourged with its arrant dependence on the US seems downright exaggerated as today’s market actions have shown.

In other words, yes while increased globalization trends has indeed integrated or has deepened the interlinkages of a large segment of global economies, particularly financial and labor markets and investment flows, it hasn’t entirely converged every aspect of the marketplace or the economy.

That’s because nations have their own cultural, religious and geographical traits that are unique to themselves that function as natural barriers.

Yet all these have significant impact on the motional profile of a country’s political economy. So every country (in terms of government and its constituents) will have to deal with its inherent domestic forces as much as it has to deal with fluctuating external factors, and all these dynamics will result to different or divergent responses.

Hence, national idiosyncrasies (or decoupling dynamics) will be retained and will continue to do so because of such intrinsic barriers. This, in spite of a prospective deepening globalization trends.

So individual values and actions will significantly matter more than perceived macro assumptions advanced by sanctimonious ivory tower experts.

This also means that the assumption that markets or economies will be totally convergent or “coupled” to each other is another false concept.

Four Stages of Bear Markets

Figure 1: US Global Funds: 4 Stages Of The Typical Secular Bear Market

Many have used this chart, the “four stages in the typical secular bear market”, which has floated around in the cyberspace, to justify the significance that today’s rising markets account for as a bear market rally (see figure1).

Right at the nadir of the market meltdown, triggered by the institutional bank run in the US [see October 26^th Phisix: Approaching Typical Bear Market Traits], we described how the Philippine Phisix reached the typical bear market levels in terms of depth or degree of losses and the timeframe covered, ``We are presently 15 months into the present bear market which begun in July of 2007. The last time the Phisix shadowed the US markets it took 28 months for the market to hit a bottom. I am not suggesting the same dynamics although, seen in terms of the US markets, the recent crash seems different from the slomo decline in 2000.”

From a hindsight view, we have been validated anew- we did not match the longest “slomo” decline of 28 months during the 1999-2001 cycle, but nevertheless clocked in as an extended cyclical bear market (15 months peak-to-trough), in terms of duration compared to 1987 (13 months) and 1989 (11 months).

Nonetheless the above chart of the 4 stages of a bear market has indeed traced out the bear market dynamics of the Phisix over the 1999-2002 period (see figure 2) but on a different timeframe scale relative to the US.

Figure 2: PSE Phisix: 4 Stages of Phisix Bearmarket

The Philippine market appears to have a slightly shorter cycle than its US counterpart if we are to base it on the first 3 stages (59 months US vis-à-vis 56 months). That is to repeat, in the context of a SECULAR bear market cycle.

But, I would caution you from interpreting the same operating dynamics today as that with 2001.

Besides, I would admonish any tautology that actions in the US markets should correlate with the Philippine markets-they shouldn’t. Not because of exports and not because of remittances.

Secular Bull-Cyclical Bear, Where The Rubber Meets The Road

The Philippines (Phisix and the economy) has essentially had some mixed blessings from its less globalized economy and market; she didn’t outperform during the boom days and conversely, didn’t fare as badly during the global recession.

But overall I don’t see this as being net beneficial for the country since trade openness and economic freedom is the source of capital accumulation. The semblance of any of today’s success could be attributed to more on luck than from any policy induced measures.

However, because boom bust or business cycles are fundamentally credit driven, then our eyes must focus on where the rubber meets the road.

The Philippine economy and its banking system have currently been operating from significantly reduced systemic leverage (in fact the private sector debt has been one of the lowest in Asia see Will Deglobalization Lead To Decoupling?).

Another, the crisis adjustment pressures or the market clearing process coming off the excesses from the pre-Asian crisis boom have had most of its imbalances ventilated during the 1997-2003 cycle. That’s the essence of bear markets-sanitizing excesses and balancing imbalances.

In addition, the Philippine banking system has been extremely liquid, where total resources in the banking system as of April 2009 at Php 5.8 trillion (BSP Tetangco speech August 11^th).

Domestic banking system’s Non Performing Loans (NPL) has returned to pre-Asian Crisis levels of around 4%, which serves as evidence of the market clearing process (BSP Tetangco).

Besides, because the domestic banking system’s balance sheets have been least impaired due to largely missing out on the highly levered securitization shindig, the Philippine banking system remains adequately capitalized, well above the risk ratios as per BSP regulations (10%) and Bank of International Settlement (8%) standards (BSP Tetangco).

This low systemic leverage reflects, as well as, on our emerging Asian market peers, in contrast to the US and European counterparts.

Thus, Philippine economy and its financial markets appear to be coming off on a clean slate, enough to imbue additional leverage in the system to power the Philippine Phisix and the economy to another bubble.

Sorry to say, but central bankers, being legalized cartels, are innately enamored to blowing bubbles, due to the unlimited potentials to issue credits via the fractional reserve banking platform (or issuing of money more than bank holds in reserve) from which all global central banks operate on.

Lastly, the recent bear market cycle emanated from contagion effects than from internal adjustments from massive structural misallocations, which is what the US economy has presently been undergoing. This means that adjustments from the bust are likely to be minor.

So, distinctions matter.

In short, the last bear market cycle that the Philippine Phisix suffered WAS NOT a secular bear market but a cyclical one.

Inflation: Keys To Future Investment Returns

The same reasons are behind why the historically low interest rate regime pursued by the Bangko Sentral ng Pilipinas (BSP) has generated significant traction in the economy, as we have been anticipating.

Proof?

According to the BSP, Real estate loans have been picking up as of June 2009, so as with Automobile loans, credit card receivables and other consumer loans (appliance and other consumer durables and educational loans) over the same period.

And all these have likewise been reflected on the Phisix, which as of Friday’s close has been up 51.16% on a year to date basis, driven by local investors [as discussed in last week’s Situational Attribution Is All About Policy Induced Inflation].

This compared to the 2003-2007 cycle which had been foreign dominated. That’s another key point to reckon with.

Moreover, from a chartist viewpoint, not all the bearmarkets have the same patterns, (see figure 3)

Figure 3: Philippine PSE: 18 year Cycle

At over the 23 years from where the Philippine Phisix has undergone a full cycle (secular bull and secular bear market 1985-2003 or 18 years), the ‘cyclical’ bear market in 1987 (45% loss in 13 months) did show a short resemblance to the 4 stage bears, but the 1989 market had been a V-shaped recovery (62% loss in 11 months) [pls see blue ellipses].

The point is that there is a material difference in the performance of bear markets during secular and in cyclical trends.

In cyclical markets, while bear markets can be deep, they are likely to recover rapidly compared to secular bear markets, whose correction process takes awhile, for structural reasons stated above.

Apparently, the action in today’s market appears to account for such cyclical trend dynamics.

Because no trend moves linearly, we should expect bouts of interim weaknesses. However, this should serve, instead, as buying opportunities.

Moreover, I’d like to bring to your perspective the long term cycle of the Phisix as exhibited by the pink channels. You’d notice that the long term channel isn’t sideways or down BUT UP!!!

While other observers, especially those colored by political bias, could impute economic fortunes on this, my thesis is that the nominal long term price improvements reflect more on “inflation” than real output growth.

This is why the Phisix seems so highly sensitive to monetary fluxes. The lesser the efficient the market, the more sensitive to inflationary ebbs and flows.

And this long term chart has likewise been giving us a clue to where the Phisix is likely headed for-10,000, as emerging markets and Asia takes the centerstage of the bubble cycle.

But this inflation driven pricing isn’t relegated to the Phisix alone, but has been accelerating its influence over the world and even in the US markets.

Proof?

I am now really finding some “comfort with the crowds” (pardon me, I am also vulnerable to cognitive biases, but at least one that I am aware of) among big investing savants. Aside from Warren Buffett whom we featured in Warren Buffett’s Greenback Effect Weighs On Global Financial Markets, the world’s Bond King PIMCO’s top honcho, Mr. William Gross recently wrote about how asset pricing dynamics will be fueled by inflation.

These are the strategic scenarios which he enumerated as having a high probability of playing out:

(bold/underline highlights mine)

-Global policy rates will remain low for extended periods of time.

-The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.

-Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.

-Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.

-The dollar is vulnerable on a long-term basis.

In other words, US dollar vulnerability, QE and other monetary ‘bridge financing’ non interest rate tools, aside from fiscal policies and low interest rates are all inflationary policies that are “keys to future investment returns”.

Whereas Asia and Asian-connected economies, given their edge of low systemic leverage, unimpaired banking system and the thrust towards trade and financial integration with the world commerce, are likely to assimilate most of the circulation credit “inflation”, hence their likely dominance in terms of attaining the highest global economic “growth”.

I’m not suggesting that credit expansion equals sound economic growth. Instead what I am saying is that economic growth in Asia and emerging markets will be based on the public’s response to the incentives set forth by policies to sop up credit.

In short, conventional analysis will continue to find enormous disconnect as inflationary policies amalgamates its presence on the markets.

But at least Mr. Gross have been candid enough to unabashedly admit looking for opportunities to strike lucrative deals with the government based on special ‘privileges’, “shake hands with government policies, utilizing leverage and/or guarantees to their benefit”…or euphemistically this is called political entrepreneurship or economic rent seeking from the US government!

Well, more signs of the Philippinization of the America.

The Applause Goes To Inflation

I wouldn’t shudder at the thought of policy tightening given the near unison of voices from the global authorities to extend the party.

Since inflation is a political process, then let us tune in to the statements of the political authorities to get a feel on their pulse and the possible directions of the markets.

From Caijingonline, ``China's economy is at a crucial juncture in its recovery and the government will not change its policy direction, Premier Wen Jiabao was cited as saying by Xinhua news agency September 1”…``China will stick to its moderately loose monetary policy as it strives to meet economic goals, Wen said during a meeting with visiting World Bank President Robert Zoellick.” (emphasis added)

From Bloomberg, ``China’s banking regulator said it will take years to implement stricter capital requirements for banks, seeking to assuage concerns the rules will cause a plunge in new lending.”

From Wall Street Journal, ``World Bank President Robert Zoellick said Wednesday it is too early for China to roll back its stimulus measures as the country's economic recovery could still falter.”

From Bloomberg, ``European Central Bank President Jean-Claude Trichet said the bank won’t necessarily raise interest rates when the time comes for it to start withdrawing other emergency stimulus measures. The term ‘exit strategy’ should be understood as the framework and set of principles guiding our approach to unwinding the various non-standard measures,” Trichet said at an event in Frankfurt today. “It does not include considerations about interest policy.”

From Wall Street Journal, ``Dominique Strauss-Kahn, managing director of the International Monetary Fund, warned world governments against “premature exits from monetary and fiscal policies” despite signs that “the global economy appears to be emerging at last from the worst economic downturn in our lifetimes.”

From Bloomberg, ``Federal Reserve officials in their August meeting discussed extending the end-date for purchases of mortgage bonds to minimize any market disruptions, and expressed concern about the pace of a likely economic recovery.”

As presciently predicted by Ludwig von Mises in Human Action, ``The favor of the masses and of the writers and politicians eager for applause goes to inflation.”

The global political leadership sensing short term triumph from current policies will continue to exercise the same “success formula” to limn on the illusion of prosperity.

Their actuations are so predictable.

The Deflation Bogeyman

I wouldn’t be a buyer of the global deflation thesis especially under the context that deflation is a monetary phenomenon.

That’s because the only transmission mechanism from so-called deflationary pressures, via the recession channel, would be from remittances and exports, which isn’t deflationary in terms of the potential to wreak havoc on the domestic banking system or even on the 40% informal cash based economy.

Said differently: Slower or negative exports or remittances will NOT contract the money supply and won’t be a hurdle from a Central Bank determined to inflate the system!

In the US, the fact that tuition fees from Ivy League Schools have been exploding to the upside, in spite of today’s crisis, dismisses the deflationary nature in the absolute sense for the US economy [see Black Swan Problem: Deflation? Not In Ivy League Schools].

What the US has been undergoing is a statistical deflation- a price based measure from the preferred numbers by the establishment.

In terms of political dimensions, scare tactics (deflation bogeyman) has been repeatedly used by authorities to justify inflationary policies to wangle out concessions aimed at rescuing select (political interest groups) entities or industries at the expense of the society.

And I think that the ultra low inflation (BSP) in the Philippines reflects on the same statistical mirage.

Just this week my favorite neighborhood sari-sari store (retail) hiked beer prices by 5%! While beer may not be everything (it may even be a store specific issue, which I have yet to investigate), looking at oil prices at $68 today from less than $40 per barrel in March signifies a price increase of 70%!

Seen from a lesser oil efficient use economy, the transmission mechanism, whose effect may have lagged, could be more elaborate than reflected on government based statistical figures.

To consider both the US and the Philippines will have national elections in 2010, senatorial and Presidential-senatorial respectively. So it wouldn’t be far fetched that the incentive for incumbent authorities from both countries to intervene (directly or indirectly) in order to create the impression of a strong economic recovery for the sole purpose of generating votes.

The fact the Philippine Peso continues to slide against the US dollar in the face of stronger regional currencies seems so politically suspicious.

The Peso’s woes can’t be about deficits (US has bigger deficits-nominally or as a % to GDP), or economic growth (we didn’t fall into recession, the US did), remittances (still net positive) or current account balances (forex reserves have topped $40 billion historic highs) or interest rates differentials (Philippines has higher rates).

In sum, when you factor in all the major variables that could influence the Phisix- local politics (national elections), geopolitics (such US elections), the “anxiety” from global central bankers which should translate to prolonged or extended monetary inflation, continued loose domestic monetary policies, long term technical trends, inflation sensitive fundamental issues (as systemic leverage, banking system) and the potential response from the public to loose monetary policies-it would seem highly probable that the domestic stock market is likely to continue with its long term ascent.

So I would NOT reckon this to be a bear market rally especially not from the flimsy excuse of global deflation.

Figure 4: Bloomberg: Possible Bear Market Rally

Bear market rally could be a US phenomenon (see figure 4), but is unlikely for Asia and Asian Emerging Markets.

Nevertheless, I would use the US dollar index, gold and oil as my main barometers for measuring liquidity conditions.