The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery

``It is commonly appreciated that China has about $2 TN in reserves to go with its population of 1.3 billion. This alone provides China unprecedented reflationary capabilities. China also maintains a tight relationship between its banking system and government policymakers, and it is worth noting that recent reports have Chinese bank lending posting another eye-opening month of expansion ($234bn!). China is also now aggressively using currency swaps and other financing mechanisms to drive exports and trade, especially in Asia. There is also increased talk of the Chinese government providing global vendor financing for its major industries, a potentially huge development from both China and global perspectives. Clearly, if Chinese industrial policy seeks to elevate the status of key domestic industries, current global tumult provides quite a rare opportunity to press decidedly ahead. Moreover, if China moves to develop its northern region as it has developed the south, there is really no bounds to the amount of “money” that could be spent.”-Doug Noland, Periphery Rising

At the start of the year, we forecasted that the Asian and local markets will register gains at the end of the year.

Our idea is that this isn’t one coming out of a “valid” economic recovery but one from the tsunami of money being drenched into the financial and economic system that had been meant to offset the loses from the OECD financial sector and from the recessionary forces affecting the global economy.

Such trend seem to get reinforced by the day.

Into last week’s G-20 meeting the multinational assembly had produced a spending plan aimed to augment the resources of the IMF, funded by Japan and Europe. In addition, ``Rich countries such as America will provide a $500 billion credit line, known as New Arrangements to Borrow. This was trailed several weeks ago. Significantly, the IMF will print $250 billion of its own currency, known as special drawing rights, allocating sums to its members according to their quotas” reports the Economist (see table 1).

Table 1: New York Times: The G-20 Mission

Of course this won’t be complete without the additional promise of further inundation of fiscal stimulus programs which was pegged at $5 trillion aimed “to raise output by 4%” and “accelerate the transition to a green economy” as indicated by their official communiqué.

Politicians love to babble about promises which usually remain only as that…promises, considering that most of the agreement drawn appears to be “motherhood” statements and bereft of details.

But there is one thing we can be sure of, that which politicians love to do…spend!!! And spending we believe it would be.

From Core To Periphery

And with the augmented resources, revitalized role of a supercharged IMF, many see this as bolstering the positions of emerging markets.

Again from the same article in the Economist (bold highlight mine),

``Now the new money must be directed to developing countries, especially in eastern Europe. Many such countries have been loth to tap the fund because of the stigma involved. A pledge by the G20 to reform the fund’s governance soon may convince them that the leopard has changed its spots. This week Mexico secured a $47 billion credit line with the fund, with no strings attached, which may set a trend…

``The importance of offering new sources of funds to the developing world should not be underestimated, however. By some estimates poor countries have $1.4 trillion of debts to roll over this year alone and Western creditors are hoarding their cash. These countries have far less fiscal room for manoeuvre than rich economies. They are also areas of the world where growth could rebound quite quickly, because households are not weighed down by the crushing debts typical in America and Europe. In a further fillip to many of them, the G20 agreed to ensure $250 billion in trade finance to help reboot global trade—though it was not clear how much of this was new money.”

In short money appears as being transmitted to support growth in the developing countries as part of the collaborative efforts to inflate the system.

And some market savants seem to be looking from the same angle as we had projected.

This from Barron’s Randall Forsyth, ``Ms. Pomboy points out that while emerging economies account for 43.7% of global output, they represent only 10.9% of global stock market capitalization. China by itself makes up 15% of the global economy but less than 2% of market cap while the U.S. provides 21% of output but 43.4% of market cap.

``With so much room to grow…and so much money to flow..might the Emerging Markets become the next bubble?" she asks rhetorically. "All the ingredients are there, the persuasive story line (from their savings to their demographics), the dearth of compelling investment alternatives and, of course, the Fed's flowing font of cheap capital."

Oh lala.

More Evidence Of The Impact From PTSD

Moreover we pointed out that the severe drop in global trade had primarily been a function of a seizure in the operations of the US-European banking system, where the reemergence of barter trade belied the notion of an absolute deflationary collapse which had been propounded by deflation advocates.

For us, the disruption appears to have been a function of an anxiety disorder called PTSD or Posttraumatic Stress Disorder [see Global Posttraumatic Stress Disorder (PTSD): The After Lehman Syndrome], where a distressing shock event basically traumatized international trade flows.

Nevertheless PTSD’s seem to heal overtime.

Figure 3: Danske Bank: Global Business Cycle

And economic data appears to be reinforcing our stand, where global leading indicators and manufacturing orders of major OECD and BRIC economies appear to have meaningfully rebounded from the lows as shown in the Figure 3 from Danske Bank.

The appearance of synchronized recovery from the harrowing last quarter crash suggests that the massive decline could have been ‘overrated’.

Albeit we can’t rule out that a typical reactionary response from big crashes are large oversold bounces similar to the stock markets, our idea is that the flood of money generated by global governments to replace “lost demand” appears to be gaining traction especially in Emerging Market economies, who were disrupted not by a dysfunctional domestic financial system but by trade linkages brought about by credit freeze in the OECD banking system.

And given that EM economies have low leverage uptake, we believe that they have the potential to absorb much of the global government’s serial bubble blowing.

The Growing Validity Of The Reflexivity Theory

Importantly we believe that George Soros’ theory of Reflexivity has underpinned all these.

Here is what we wrote in Inflationary Policies Drives China’s Shanghai Market; Clues of Reflexivity Theory at Work

``…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….

``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).”

And suddenly we seem to be witnessing a growing number of observers acting as what we have long anticipated…

From Harvard Professor and former Chairman of President Ronald Reagan’s Council of Economic Advisors and President of National Bureau for Economic Research, Martin Feldstein (bold highlight mine)

``China is likely to be the first of the major economies to recover from the current global downturn. Its pace of expansion may not reach the double-digit rates of recent years, but China in 2010 will probably grow more rapidly than any country in Europe or in the western hemisphere.”

Further signs of the burgeoning bandwagon from China’s repeated gains…

From Bill Witherell of Cumberland Advisors, ``Japan surely will benefit from the expected resumption of strong growth in China and the anticipated beginning of a recovery in the US in the second half of 2009.” (bold highlight mine)

From John Derrick of USfunds.com, ``We may already be seeing early signs of the initial round of stimulus having an impact. China responded aggressively back in November announcing a $586 billion stimulus package. This week China’s purchasing manager’s index (10) rose to 52.4, indicating economic expansion and the first reading above 50 since September.” (bold highlight mine)

Figure 4: Shanghai’s Reflexivity Theory At Work

While most of China’s peers, namely Emerging Markets (EEM) and the Dow Jones Asia ex-Japan ($DJP2) have only seen a belated recovery last March, the Shanghai index has significantly pulled away breaking into bullish territory-namely a breakout from resistance levels and breakout from 200 day moving averages.

The Phisix which has lagged the latest market levitation due to local controversial quirks (particularly the Meralco and the PLDT affair) seems likely to follow suit.

In short, the reflexivity theory -from fact to perception and now perception to facts-seems to be succeeding at recalibrating the market’s mood.

G20: Fueling The Inflation Drama, Reprise Why A Different Inflationary Setting

`Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen. Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.” Peter Schiff, Let's Play Pretend!

As we have discussed last week in Expect A Different Inflationary Environment, we don’t believe that the US financial markets will see a renaissance during this inflationary episode nor do we believe it will lead the market out of the present bear market rut.

The stiff regulations to be imposed on the industry will be one major factor why. In addition, the G20 summit has equally accentuated the political demand to do so. Mass leverage from the system of 30 or 40 or 50 to 1 won’t be seeing the light.

Today’s leverage will mainly come from the global governments or if fortunate enough Emerging Markets or Asia whose credit system has been unimpaired from the recent crisis.

Moreover, as we discussed in Why Geither's Toxic Asset Program Won't Float spreading recessionary strains will further vitiate on the financial positions of banks, this percolating from the largest concentrated banks to regional banks.

While the recent changes in the FASB accounting standards may temporarily help alleviate the pressures to redress the balance sheets, it is unlikely for US banks to normalize the lending process in the possible understanding that gains from the overleveraged households and the financial sector may not be large enough to offset the risks of potential losses.

Next, there are regulatory concerns. The fact that the rules of the game are being changed daily and where a political backlash by the public on Wall Street has combined to turn off potential investors interests into participating in government sponsored programs.

Moreover there are major concerns like asset quality and the price discovery from the toxic assets which includes the gigantic credit default swap market and other forms of derivatives as the interest rate swap.

The issue of price discovery isn’t a figment of anyone’s imagination. The fact that bid and ask can’t meet into a voluntary exchange means that this isn’t a liquidity problem but a valuations problem. Why? To be sure, this isn’t a market failure for the simple fact that incentives driving the financial sector have been totally severely distorted by excessive government intervention, moral hazard issues, and or the bailout mentality.

Simon Nixon of Wall Street Journal hit the nail in the head with this poignant commentary (all bold highlights mine), ``In a capitalist system, prices are set in the free market and providers of capital bear responsibility for their losses. Neither of these characteristics hold true of the banking system. The price of credit, the basic commodity of the financial system, was distorted first by implicit government guarantees to depositors and other providers of capital, and second by the tendency of governments to cut interest rates at the first sign of financial trouble.

``Financial theory says the cost of capital to an enterprise should rise in line with risk. But banks during the boom were able to leverage themselves more than 50 times yet see their cost of funding fall.

``That is hardly the sign of a well-functioning free market. Those who provided funding to banks correctly gambled that governments would ride to their rescue…

``Indeed, it has been axiomatic of the policy-maker response that bondholders should be kept whole to avoid the threat that the banking system would seize up completely or that the insurance industry, with large bond portfolios, would become the next domino to fall. Most Western bank bonds are now issued with an explicit government guarantee. The result is a distorted global financial system in which the true cost of capital is obscured.

``In a fully capitalist system, there would be no guarantees. The market would ensure banks didn't become too big or too leveraged.

``At least the current crisis is sure to lead to higher common-equity buffers for all. But since removing the guarantees and breaking up the banks is outside the realm of political reality, an alternative solution is to charge banks explicitly and upfront for all guarantees. The charges would rise in line with leverage. That at least would raise the cost of funding, helping to generate a price signal to the market.

``Instead, global governments are taking the opposite tack. Unable to remove the guarantees and unwilling to properly charge for them because the banks remain too weak, they will try to limit the risks through more intrusive regulation.

``The results, if that goes too far, should be clear enough: lower bank profits, less capital generated, less credit created, lower economic growth and more bureaucratic control over the banks and the wider economy.”

In short the market cleansing process has been skewed by government’s intense efforts to camouflage real price values, which has led to lack of trust and confidence among the financial institutions. Without government lifeline all these structures are most likely to collapse.

The deflationary pressures will ensure that the US government will continue to inflate the system. And inflating the system means that it would need to accelerate the rate of inflation.

The likely scenario will be a tug-of-war between inflation and deflation. Although, inflationary pressures outside the ongoing debt deflation zone will probably take a firmer root or become more entrenched.

As we stated last week, inflation appears in stages and with the OECD real estate sector and the securitization backed structured finance out of play, the inflation process will be short circuited and likely be in rotation or in a feeback loop within the commodity sector and the world stock markets particularly in Asia and Emerging Markets.

The tug of war of inflation and deflation will ensure that debt deflation affected markets will underperform relative to those whom are least affected. Although the sheer magnitude from collaborative effort to stoke inflation may put a floor to these markets at the expense of the currency values.

While the G 20 summit declares that they “will put in place credible exit strategies from the measures”, it doesn’t say how they would do it. The tug of war between deflationary pressures and inflation suggest that they will lean towards more inflation than risks towards deflation. This would account for as the mainstream economic ideology in practice, whose results will likely mirror that of the 70s but at a far wider damage.

Moreover another dubious assertion is that they “will refrain from competitive devaluation of our currencies”. The fact that the degree of fiscal stimulus or monetary inflation will be applied differently means that the currencies involved in huge programs will obviously be ventilated through prices. Hence, refraining from competitive devaluation is an example of a fashionable political statement than to be seen in actual practice.

Finally as we appear to be seeing today, initially “boom conditions” will prevail. The next phase of will likely see a spillover of high commodity prices into consumer prices. And some central banks may apply brakes which may cause increased volatility, although such volatility may again prompt central bankers to lean towards inflation. Then we should see an acceleration of inflation.

If Emerging Markets and Asia succeeds to soak up the inflation to generate a boom in their national markets and economies then a future bust with these regions as the epicenter of the next crisis.

Otherwise, the other possible risk is one of hyperinflation where the aftermath would result to the end of the reign of the US dollar as the world’s de facto currency reserve.