Inflationary Policies Drives China’s Shanghai Market; Clues of Reflexivity Theory at Work

This is an example of what I refer to as liquidity or inflationary policy driven and not earnings or economic driven markets.

From Bloomberg, (bold highlights mine)

``Chinese companies may be using record bank lending to invest in stocks, fueling a rally that’s made the benchmark Shanghai Composite Index the world’s best performer this year, according to Shenyin & Wanguo Securities Co.

``As much as 660 billion yuan ($97 billion) may have been converted by companies into term deposits or used to buy equities, Li Huiyong, Shanghai-based analyst at Shenyin Wanguo, said in a phone interview today, citing money supply figures.

``China’s banks lent a record 1.62 trillion yuan in January as part of a government drive to stimulate the world’s third- largest economy, while M2, the broadest measure of money supply, climbed 18.8 percent from a year earlier. The Shanghai Composite has surged 29 percent since the start of 2009, compared with a 10 percent decline in the MSCI World Index.

``“Part of the liquidity flowing into the stock market could be from companies using borrowed funds to invest in the stock market instead of working requirements,” said Li….

``Equity transactions rose last week to the highest in at least three years. The Shanghai and Shenzhen exchanges handled a combined 32 billion shares Feb. 13, the most since Bloomberg started compiling the data in January 2006. An average of 17.3 billion shares have changed hands daily this year, compared with 9.8 billion shares in 2008…

``“Corporates are in need of working capital right now,” said Gondard, who helps oversee about $7.2 billion. “There may be exceptions, but it’s not big enough an impact to explain the rally.”

``China’s domestic stock market capitalization has increased by $743.1 billion since November, when the government announced its 4 trillion yuan stimulus plan.

``The rally has drawn more Chinese investors. About 224,000 accounts were opened to trade equities on the Shanghai and Shenzhen exchanges last week, the fastest pace in almost two months. That’s still about a quarter of the record 1.07 million set up in the week to Sept. 7, 2007.”

Some may argue that this isn’t about the $580+ billion stimulus at all. This perspective sees only half of the picture.

There are two basic government policy measures: one is fiscal stimulus and the other is monetary stimulus.

Apparently, the Chinese government embarked on easing monetary policies since December of 2008.

From CCTV.com (all bold highlight mine),

``To begin with, China will implement a moderately easy monetary policy to promote reasonable growth in money supply and credit. It will also use various measures, including required reserves, interest rates and the exchange rate, to ensure an adequate supply of liquidity in the banking system. China will also add 100 billion yuan to the loan quota for policy banks by the end of the year.

``Meanwhile, local governments will be urged to inject money into credit guarantee firms and provide subsidies for them.

``More measures will be taken to stabilize stock markets and increase bond issuance. Infrastructure bonds in particular will be encouraged.

``Other moves include promoting insurance related to agriculture, the buying of houses and cars, healthcare and pensions. China will encourage insurance companies to invest in transport, communications, energy and other infrastructure projects.

``In addition, China will provide new financing channels, including loans for mergers and acquisitions, real estate investment trusts, private equity funds and private lending.

``Authorities will improve their management of foreign exchange to facilitate trade, while also upgrading its payments system. China will increase fiscal support to financial institutions to help tackle problems arising from non-performing loans.

``And finally, China will enhance the control of risk to ensure financial security.

From tradingeconomics.com

The above chart shows how China has rapidly cut its interest rates.

And as the news account say, the recent rally in the Shanghai index may have been fueled by a surge in corporate bank lending which had been channeled into stocks. This signifies China's inflationary policies at its incipient phase of gaining traction.

And this is what we have been saying all along; the directives or thrusts to drag down rates below market levels compels the public to speculate or "hunt for yields".

In today’s environment where there is a marked downdraft in the real economy, long term investments are likely to be postponed until the inflationary policies succeeds to alter people’s outlook.

Look at this news from Shanghai Daily,

``FOREIGN direct investment in China tumbled 32.7 percent to US$7.54 billion in January year on year, the fourth straight monthly decline, as companies scaled back spending in the face of the international financial turmoil, the Ministry of Commerce said yesterday.”

Hence, the propensity to speculate has resulted to a sharp ascent of the Shanghai index over the past week, but had been equally met by a drastic decline of late.

Today, the Shanghai index was down by over 4% following yesterday’s 2.93%.

Skeptics have disparaged the recent the signs of recovery as some “false dawn”, where the 2 day slump have been quickly cheered as a reality check.

We aren’t convinced.

The Shanghai index has met some significant resistance at its 200—day moving averages (red line), which if it had succeeded to breakaway from, could have reinforced its progression to the advance phase.

However, what needs to be pointed out is that the Shanghai Index has been in an extremely overbought condition and deserves its much needed hiatus.

It could make another attempt for the 200-day moving average sometime in the near future after clearing its overbought state.

The furious pace of global central banks collectively printing money is bound to end up somewhere, and the above data serves only to validate this view.

Finally, markets aren't just about traditional economics or conventional finance. It is mostly about psychology or how government inflationary policies may trigger significant "reflexivity" in market psychology.

To quote anew the chief architect of the reflexivity theory, [The Alchemy of Finance p. 318], Mr. George Soros...

``The structure of events that have no thinking participants is simple: one fact follows another ending in an unending casual chain. The presence of thinking participants complicates the structure of events enormously: the participants thinking affects the course of action and the course of action affects the participants thinking. To make matters worst, participants influence and affect each other. If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

``How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.” (all emphasize mine)

The reflexivity theory applied to the Shanghai's index suggests that if the course of actions (inflationary policies) succeeds to alter participants thinking, then the subsequent changes in perception will ultimately be followed by changes in the facts.

Put differently, if the Shanghai Index's will continue to rally, it will be 'rationalized' by the public as a recovery (perception), when this is all about central banks' massive 'serial bubble blowing' inflation (fact).

Eventually when the perception of recovery is reinforced by economic data, (fact) the market trend deepens (perception).

Wall Street's Agenda Seem to Dictate on US and Global Policies!

When faced with strong political pressures from the ongoing disorders of social, economic or financial nature, as we said, it is NEVER a question about governments NOT doing anything, but a question public expectations on the outcome of such actions.

Despite the passage of the $850 billion Emergency Economic Stabilization Act (yes Virginia, additional $150 billion on added porks! From Congressman Ron Paul ``In fact, it wasn't until the Senate had a chance to load it up with even MORE spending, when it was finally inflationary and horrible enough, at $850 billion instead of a mere $700 billion, that it passed – and with a comfortable margin, in spite of constituent calls still coming in overwhelmingly against it. 57 members switched their vote!” How Pork Barrels can easily switch votes is not only a Philippine phenomenon but elsewhere like in the US too!), markets continued to display brutal rioting yesterday and today.

So the Fed came up with even more actions; it doubled its auctions of cash lending to banks to as much as $900 billion, announced the changes in debt issuance which reintroduced 3 year notes and began implementing the paying of interest in bank reserves (Bloomberg).

Nonetheless pressures from various influential quarters of Wall Street “suggesting” to them on how to solve the problem. Example, William Gross of Pimco recently wrote, ``We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.”

From the New York Times today (emphasis mine), ``Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

``While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.”

Nonetheless as the Bernanke's FED and Paulson's US Treasury deliberate on agreeing into Wall Street's formula to further use taxpayer money to thaw the frozen credit markets, Australia's central bank cut its interest rate benchmark by one percentage point to 6 percent from 7 percent signifying ``the biggest reduction since a recession in 1992, to cushion the nation's economy against fallout from a global credit freeze." (Bloomberg).

Most likely both the "suggestions" of lowering interest rates and FED buying of commercial paper will be effected with the former being a "common policy" adopted by most embattled OECD economies.

It's funny how global policymakers seem to tow the line of Wall Street's elixirs when the latter haven't been able to resolve their own problems, to borrow Kenneth Rogoff's quote on the bailout enactment, ``the central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so."

This basically serves as an example of regulatory capture where "a government regulatory agency created to act in the public interest instead acts in favor of the commercial or special interests that dominate in the industry or sector it is charged with regulating." (wikipedia.org )

Hopefully if the US government decides to abide by the recommendations of Wall Street despite the conflict of interest issues, global markets will finally embrace this for good.

The Mises Moment In Pictures

In Global Markets: From “Minksy Moment” To The “Mises Moment” we characterized our Mises Moment as ``governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.”

We have long said that politicians REACT to developments than PREMPT them arising from populist political concerns whether real or imagined. The belief that authorities can “do something” basically means manipulating varied legal tools (fiscal or monetary) aimed at controlling market forces for political objectives.

The problem is that such intuitive attempt to defeat or suppress business cycles by perpetuating boom conditions has been the root of today’s crisis. In other words, deflating markets are a consequence of previous inflationary activities which has distorted price signals in the markets and has similarly led to capital misallocation in economies.

Yet, it appears that massive efforts are underway to reinflate, which risks intensifying or prolonging the crisis conditions.

To quote Friedrich Hayek in Monetary Theory and Trade Cycle, ``To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection -- a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.”

So even without the bailout package, the Federal Reserve has undertaken a massive campaign to flood the world with money.

And signs have been all over…

In the monetary system (data from St. Louis Federal Reserve)…

Federal Reserve Lending…

Changing Fed Balance sheet composition…

Courtesy of Cumberland advisors

Aside, the recent enhancement on TAF and swaplines with global central bank as declared by the Fed,

``Actions by the Federal Reserve include: (1) an increase in the size of the 84-day maturity Term Auction Facility (TAF) auctions to $75 billion per auction from $25 billion beginning with the October 6 auction, (2) two forward TAF auctions totaling $150 billion that will be conducted in November to provide term funding over year-end, and (3) an increase in swap authorization limits with the Bank of Canada, Bank of England, Bank of Japan, Danmarks Nationalbank (National Bank of Denmark), European Central Bank (ECB), Norges Bank (Bank of Norway), Reserve Bank of Australia, Sveriges Riksbank (Bank of Sweden), and Swiss National Bank to a total of $620 billion, from $290 billion previously.”

So the US isn’t just inflating its own financial system. As we have been saying it has also been inflating the world.

Foreign Money Governs PSE; Value Investing Amidst Fear

``The farther backward you can look, the farther forward you are likely to see." Winston Churchill

The PSE Playing Field

Retail investors according to the PSE registered only a scant 430,681 accounts for Filipino investors in 2007. This signifies less than 1% of the total population, something we talked about as early as 2004. Yet, of the total, only 103,412 have been active or involved in a trade in a year, which represents a grotesquely small figure even considering the run up over the past 4 years.

Of course, the PSE didn’t include those indirectly involved in the trade, which should have accounted for mutual funds and trusts funds offered by banking institutions such as Unit Investment Trust Funds (UITF) or by Life insurance companies such as Index Funds.

Even so, this implies that a reasonable ball park figure should account to some 1% of the population which means the Philippines remains one of the least exposed to the capital markets, which is one reason the Philippines remain poor.

Capital markets, as we have so frequently stated, function as an alternative source of financing next to banking.

Aside, they operate like money- they serve as a platform for conducting exchanges of financial instruments (medium of exchange), they are avenues for valuation and liquidity generation (unit of account) and are repository of assets (store of value), thus contribute to the mobilization of savings, the channeling of investments and help determine consumption patterns.

For instance, when an economy grows with an attendant rise in corporate profitability, if these companies are predominantly not publicly listed, then corporate profits contributes less to the consumption patterns because they don’t pay dividends or offer capital appreciation to a wider scope of ownership but the profits stay within the companies that generate or produce them.

However in countries with mature and deep capital markets, when profits rise, stock prices and dividends also tend to rise. Shareholders can easily sell or use their stockholdings as collateral to finance consumption or for reinvestment. They may also choose to use value added dividends to do the same. In essence, capital markets allows for a wider option for individuals or enterprises to access capital increase savings and investment returns or to even act as a hedge to an investment (for sophisticated markets).

Unfortunately most of the participants misunderstand this and sordidly treats the capital markets as some sort of an alternative avenue for gambling or a casino.

Of course, this is abetted by the woeful quality of information dissemination by the key participants themselves who engage the public into a short term perspective or to the allure or promise of easy money with a dearth of understanding between the tradeoff of risk and returns or of cost and benefits.

Half Full or Half Empty?

Overall there are two dimensions that can be gleaned from this-

One there is a commodious growth for the capital markets over the long term, especially if Asian markets will continue to outperform the world or converge with developed countries in terms of scalability, depth and sophistication.

As an example, despite the global credit crisis and stock market infirmities in the region, Asian merger and acquisitions continue to proliferate and outperform the world, this from the Financial Times (Sundeep Tucker),

``The aggregate value of announced cross-border deals between Asia-Pacific companies has totalled $54bn in the year to date, according to figures from Dealogic, the data provider. This compares to $25.7bn during the corresponding period last year.

``Bankers report that deals currently in the pipeline should mean 2008 will be a record year for intra-Asian deals, eclipsing last year's mark of $76.2bn. The value of intra-Asian deals has risen steadily since 2004, when combined deal activity totalled $35.2bn…

``Regional consolidation has been led by outbound Chinese investment into the financial services and resource sectors. There has also been strong cross-border activity across south-east Asia.

``Bankers attribute the growth in Asian M&A to strong economic growth, increasing scale and financial capabilities of the region's corporations and rising confidence among senior management ranks to execute overseas deals.” (underscore mine)

Second, presently given the size and breadth of domestic investor’s participation, they seem serve as subaltern to foreign money. Although of course, we have noted that local participants have occasionally functioned as the alternative cushion to the market especially during the recent foreign driven selling, the dominance of foreign money is the explicit reason why our performance has been closely tied with activities abroad.

Yet, with a general negative sentiment (initially due to forced liquidation abroad for capital raising purposes) towards equity markets which resulted to a net foreign selling here, politicking has compounded on the domestic arena which persisted to weigh on the market, this time with local participants largely contributing to the selloff.

Of course, the idea that recoupling due to the gathering storm of deflationary forces or from the inflation contagion as the reason why global stock markets are being sold down the sewer can easily be rebuffed.

In my recent post Recoupling and Inflation Doesn’t Explain Everything…, we showed how bourses of some countries have defied gravity (uncannily some in Africa!) and continue to drift at record highs.

The point is that markets can act distinctly from the general observation for one reason or another.

Asia’s Leverage of More Policy Options

As for Asia, we think that the region’s Central Banks have more policy options compared to its counterparts in Europe or in the US which should allow Asian markets to recover rapidly.

Like us, University of California Berkeley Professor Barry Eichengreen believes that aggressively raising rates should be an instrument to consider,

To quote Prof. Eichengreen (RGE Asian),

``These negative interest rates and their artificial stimulus to consumption and investment are also why we haven’t seen more of a slowdown in Asia – why we haven’t seen more recoupling. But now that Asian central banks are being forced to tighten, we will see more evidence of their economies slowing down. Asian currencies will appreciate against both the dollar and the euro. Although the Fed and the ECB may raise rates as well, both inflation and growth are weaker than in Asia, so they will have reason to respond more moderately…

``Fortunately, there is another instrument for sustaining demand in these circumstances, namely fiscal policy. Higher interest rates will push up the exchange rate and damp down inflation. Tax cuts and increases in public spending on locally-produced goods will limit the contraction of aggregate demand. Insofar as these fiscal actions stimulate the demand for locally-produced goods, they will push up the exchange rate still further, which will moderate the rise in import prices and further contain inflationary pressure.” (highlight mine)

This means that public investments on infrastructure, as an example, may help offset (by lowering cost of transactions) any decline in the economic growth arising from the costs of higher interest rates. Besides, being a major commodity producer, expediting investments within or related to this field could help rebalance our economy aside from boosting foreign exchange revenues.

Yet, higher interest rates could induce for a firmer peso and could lure foreign money back to the Philippines and into local assets.

Remember, if you are concerned that local money will be diverted away from equities, just refer to the data from PSE and realize that foreign money and not local investors have been the key drivers of the financial markets (for the time being until perhaps certain higher levels of the Phisix would be attained).

Value Investing Amidst Fear

Figure 8 Phisix: Quarterly Chart

Yes, the bearmarkets (see figure 8) of the past whether as a countercycle of a bullmarket or during the main bearmarket cycle have shown the Phisix to have lost 50-60% before recovering.

While of course we can’t discount this to reoccur, we doubt this premise simply because the past conditions do not represent the same as today as we laboriously argued in Phisix: No Bubble! Time for Greed Amidst Fear.

Anyway as a matter of technicals, a 50% retracement should imply the Phisix at 2,450, otherwise if the market should fall further then a 61.8% retracement should imply the Phisix at 2,100.

But as Michael Maubossin of Legg Mason wrote in The Failure of Arbitrage, ``Trend followers, as emotion riders, are not concerned with price-to-value discrepancies. Price alone indicates whether a momentum investor is right or wrong. So while trend followers care only about price, value investors care about the discrepancy between price and value. The distinction in the perceived source of edge in the strategies is crucial because it implies very different roles in the market ecosystem.”

So at this point the investing perspective shifts from that of momentum (fear) to that of Value.