Phisix: BSP’s Tetangco Catches Taper Talk Fever

The BSP’s Version of Taper Talk

JUST a little over two weeks back, Bangko Sentral ng Pilipinas (BSP) Governor Amando Tetangco said that the low inflation environment, “gives us room to maintain interest rates and our current policy stance”[1].

In short, the easy money environment will prevail.

This week in an interview on Bloomberg TV, the gentle BSP governor signaled a forthcoming change in the BSP’s policy stance noting that since the Philippine economy is “strong”, “we don’t see any real need for stimulus at this point”[2].

Oh boy, the BSP chief echoes on the ongoing predicament of US Federal Reserve of testing the “tapering” waters.

The BSP was cited by the same Bloomberg article as raising its price inflation forecasts by putting the burden of inflation risks on the weakening peso.

So the BSP essentially has begun to signal a backpedalling from easy money stance.

As I’ve noted in the past, similar to the Fed’s “taper talk”, the BSP’s subtle change in communication stance represents “tactical communications signaling maneuver to maintain or preserve the central bank’s “credibility” by realigning policy stance with actions in the bond markets.”[3]

While the BSP’s preferred culprit has been the weakening peso, the reality has been that higher yields in the global bond markets including emerging Asia and the Philippines has forced upon this discreet volte-face.

The attempt to substitute the influence of bond yields on domestic monetary policies with the weakening peso, the latter having been premised on alleged expectations of higher price inflation represents, as the stereotyped political maneuver of shifting of the blame on extraneous forces—the self-attribution bias.

The peso as culprit for general price inflation has been premised on the fallacious doctrine of balance of payments. The weak peso, according to the popular view, will prompt for an increase in price inflation via higher import prices. But in reality, rising import prices will lead to reduced demand for imports or on consumption of other goods, thereby offsetting any increase in general prices.

This means that the depreciation of the Peso represents a symptom rather than a cause where the principal cause has been due to domestic inflationary policies.

As the great Austrian economist Ludwig von Mises explained[4]

Prices rise not only because imports have become more expensive in terms of domestic money; they rise because the quantity of money was increased and because the citizens display a greater demand for domestic goods.

Since 2001, the asset segment of the BSP’s balance sheet have ballooned by a Compounded Annual Growth Rate (CAGR) of 11% where International Reserves comprises 86% of the asset pie as of December 2012 based on the BSP’s dataset[5].

On the other hand, the gist of BSP’s liabilities or 73% has been on deposits. Special Deposit Accounts (SDA) constitutes 57% of total deposits with Reserve deposits from other deposit accounts signifying a 19% share and deposits from the Philippine treasury at 9%.

Meanwhile, currency issued, which had a 17.7% share of BSP’s liabilities, grew by 9.05% CAGR over the same period.

The rate of growth in the BSP’s balance sheet increased in 2006, but has been in acceleration in 2009 through today.

This also implies that the bulk of the credit expansion in the banking sector have ended up as deposits in the BSP.

The CAGR of BSP’s balance sheet at 11% has nearly been double the 5.97% CAGR of Philippine GDP at constant prices[6] over the same period.

Thus inflation pressures hardly emanates from imports but from the rising quantity of money and assets with moneyness functionality or money-substitutes[7].

Of course, when the BSP governor referred to a “strong” economy as basis for the subtle change in his policy signaling of a reduced need for stimulus, he has actually been resorting to the anchoring bias (behavioral finance) and to the time inconsistent dilemma. That’s because “strong” conditions had all been predicated on the easy money environment.

And with the projection of higher interest rates in a system whose leverage has been rapidly building up over the recent years, as shown by the double digit growth of overall banking debt (left) and the surging rate of loans on what I suspect as the epicenter of the Philippine bubble (right), this means higher cost of servicing debt and higher cost of capital. This also means interest rate and credit risk will mount.

And for the financial world who are dependent on computing for Discounted Cash Flows[8] (DCF) analysis based mostly from Net Present Value[9] (NPV), changes in discount rates will impact heavily on the feasibility of projects and investments. New projects or investments built upon discount rates at current levels will likely be exposed to losses from miscalculations or errors brought about by the expectations of the perpetuity of the low interest rate regime when the BSP officially begins its tightening.

All these means that if the path of interest rates is headed higher, as the BSP chief implies, then conditions will materially change and such will likewise be reflected on risks premiums.

As I previously wrote[10], (bold original)

“Fundamentals” tend to flow along with the market, which is evidence of the reflexive actions of price signals and people’s actions. Boom today can easily be a recession tomorrow.

The Unwarranted Fixation on Credit Rating Upgrades

The continuing optimism by the BSP has been based on the fundamental assumption that changes in interest rates are likely to be gradual and stable.

This seems uncertain as the recent actions in the bond markets have been anything but gradual and stable.

Of course the BSP’s view has been consonant with the Philippine President’s Benigno Aquino III. Such concerted efforts are likely representative of a PR campaign to generate high approval ratings.

In his State of the Nation Address (SONA), the Philippine president blustered over the same 7.8% statistical GDP and of the recent “improvements” on trade competitiveness as key accomplishments of his administration. He also mentioned that current conditions should merit another credit rating upgrade.

Mr. Aquino declared[11] “For the first time in history, the Philippines was upgraded to investment-grade status by two out of the three most respected credit ratings agencies in the world, and we are confident that the third may follow”

Well the public just loves the visible which politicians gladly feed them with.

Yet people hardly realize that credit rating upgrades can even signify as the proverbial “kiss of death”.

A historical overview of some sovereign ratings changes from Fitch Ratings[12] serves as great examples. The above table reveals to us that credit rating agencies hardly sees risks even when these have been staring at them on their faces.

From 1995-2008, Greece (upper pane) had a series of upgrades and positive watches (blue box) in both the long and short term of foreign and local currency ratings. The Fitch began a string of downgrades on Greece only when the country’s debt crisis imploded in 2009[13]. Today Greece has been rated junk “substantial credit risk[14]”, four years after the unresolved crisis.

The successions of credit upgrades basically helped motivate the Greek government to indulge in a borrowing spree which eventually unraveled.

Venezuela has a different story (lower pane). But again we the same credit rating upgrades on the socialist country in 2005, who today suffers from a hyperinflationary episode or a real time destruction of the country’s currency the bolivar[15].

The Fitch eventually regretted their decision, they downgraded Venezuela. Ironically hyperinflating Venezuela has a higher rating than deflating Greece where both defaults on their debts but coursed through different means.

The above examples reveal of how credit rating agencies align their assessment with unfolding market conditions. Rating agencies hardly anticipate them accurately.

So a manipulated asset boom may easily draw credit rating agencies to upgrade sovereign debt.

It is important to draw some very vital lessons from history where banking crises, sovereign debt defaults, currency crises, and serial debt defaults, as chronicled by Harvard’s Carmen Reinhart and Kenneth Rogoff, which spanned “more than 70 cases of overt default (compared to 250 defaults on external debt) since 1800”[16] the common denominator has been overconfidence and denigration of history[17] (will not happen to us) [bold mine]

The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. The current boom, unlike the many booms that preceded catastrophic collapses in the past (even in our country), is built on sound fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes.

I would add my conspiracy theory. Credit rating upgrades have been tied with the US bases. The American government has been endeared with the incumbent administration because the President pursues the path of his mother, the former President the late Cory Aquino, who fought to retain US military bases here[18]. 

Today, using territorial disputes as an excuse or a bogeyman, the Aquino government has allowed and defended the so-called non-permanent access of “allies” on former US bases[19].

The Illusions of the Benefits from Government Spending

Another mainstream obsession today has been the devotion towards statistical economic figures which has been presumed as an accurate measurement of economic growth.

As explained last week[20], the statistical 7.8% growth has been mainly rooted on growth by the construction, real estate and financial sectors, as well as, government spending.

And much of the ballyhooed statistical growth in the private sector has been financed by an unsustainable credit bubble.

Yet the public has been mesmerized by the $17 billion of proposed investments by the incumbent government. 

If the government spending is the elixir, then why stop at $17 billion? Why not make it $1 trillion or even $ 10 trillion?

And if such assumption is true, then why has the communist models like China’s Mao and the USSR evaporated? 

Why has China’s recent economic growth been substantially slowing amidst a splurge of government spending in 2008-2009? The newly installed Chinese has announced another $85 billion of railway stimulus to allegedly stem the growth slowdown[21].

With enormous money thrown as fiscal stimulus from the late 90s to the new millennium, why has Japan’s lost decade been extended to two decades+ three years?

Apparently this seemingly perpetual economic stagnation has prompted the new administration to launch the boldest monetary modern day experiment by a central bank which will be complimented by even more fiscal spending stimulus and on the minor side trade liberalization.

Yet growing internal dissension[22] on the risks of Abenomics even from within the ranks of the Bank of Japan has been hounding on the popular expectations of the success of such derring-do political program aside from the risks of a fallout from an economic hard landing in China.

No matter the glorification of mainstream media’s on the alleged success of such policies, Japan’s financial markets are saying otherwise. Has the denial rally in Japan’s major equity benchmark Nikkei fizzled? Japan futures suggest that Monday’s opening will likely break below the 14,000 threshold.

Obviously what government spends will have to be financed by debt, taxes or inflation. Or simply said, whatever government spends has to be taken from someone else’s savings and or productive output. Government spending represents thus a disequilibrating force, because the recourse to institutional compulsion to attain political objectives means a shift of resources from higher value (market determined) uses to lower value (politically determined) uses.

Importantly, since most of government services are institutionalized or mandated monopolies, the absence of market prices means that there hardly have been accurate measures to calculate on the cost-benefit utility of the services provided. And since there are no market price utilized, returns are non-existent. Government spending, hence, represents consumption and not investments.

So the contribution of government spending has mostly been negative rather than positive to real economic growth.

But this is a different story from the mainstream’s statistical aggregate demand management based point of view.

And relative to the statistical 7.8% growth, this only means two things, one—economic boom has largely been concentrated on a few sectors which has been benefiting from the zero bound rates induced credit fueled manic speculation on the asset markets, and two—beneficiaries from government spending have always been the political class, their politically connected affiliates and welfare beneficiaries

And regardless of the egging of the Philippine president, in the latest State of the Nation’s Address (SONA), on the Congress to revamp Presidential Decrees 1113 and 1894 which according to news has been a Marcos era legacy that favors “businessmen close to the dictatorial administration”[23], the politicization of economic opportunities, where the government “picks on the winner” means that cronyism and regulatory capture have been the natural consequences or outcome from such anti-competitive politically distributed economic arrangements.

Thus actions meant to purportedly sanitize projected “immorality” are good as photo opportunities or for Public Relations purposes.

The reactionary rant against officials[24] and personnel of the Bureau of Customs, Bureau of Immigration and Deportation and the National Irrigation Administration (NIA) whom the President severely criticized for an unabated smuggling in the SONA should be a great example. That’s because one of the tarnishes of the incumbent approval rating obsessed regime has been in smuggling, where critics have labeled the Philippines as “Asia’s smuggling capital”[25].

In the world of politics, moral order has mostly been a function of either populism or legalities.

Yet what is popular or legal have not always or frequently been moral. Venezuela’s late Hugo Chavez died a popular leader due to massive wealth redistribution even if he ran the Venezuelan economy aground. Adolf Hitler was also a popular leader until he was defeated in World War II.

In the eyes of populist politics, immorality has hardly been thought about as legal or institutional blemishes. It has always focused on personal virtues: the personality cult mentality.

As the 30^th President of the US Calvin Coolidge aptly warned[26]:

It is difficult for men in high office to avoid the malady of self-delusion. They are always surrounded by worshipers. They are constantly and for the most part sincerely assured of their greatness. They live in an artificial atmosphere of adulation and exaltation which sooner or later impairs their judgment. They are in grave danger of becoming careless and arrogant.

So when politicians or political leaders impose some edict or restrictions, they mostly expect people to behave like sheep. Such arrogant leaders forget that social policies affect people’s real lives, not limited to commerce. 

And in response to such laws, thinking and acting man intuitively find ways to sustain their preferred way of living, and in many times, acting in defiance of arbitrary legislations or regulations or the “rule of men”.

So, for instance, when the Philippine government via the BSP raised sales taxes significantly on gold sales, over 90% of gold output has been smuggled out in reaction[27]: the law of unintended consequences.

The same political agenda goes for India, where gold has a deep cultural attachment. The profligate Indian government wants to ‘balance’ fiscal conditions by reining on gold sales. First they apply import tariffs then restrictions spread to banks, bullion banks, and finally to the retail sector[28]. Remember the Indian government essentially has been attacking India’s culture in the name of fiscal balance.

The consequence: an explosion of gold smuggling. Cases of smuggling has shot up to 205 from 21 a year earlier, value of gold seized by officials has soared by 10 times or 270 million rupees compared to 25 million rupees over the same period, according to the Wall Street Journal[29]

So at the end of the day, the formal sector ends up in the informal ‘illegal’ sector. The government forced the average Indians to migrate underground to maintain tradition. Practicing tradition have now been rendered as illegitimate and a crime. Many will suffer from political oppression out of the insensitive and inhumane whims of the political leaders.

It is still nice to see that the average Indians still have practiced civil disobedience via smuggling. But if the political repressive dragnet intensifies, then perhaps it will not be farfetched to expect civil disobedience to transform into violent public protests, ala Turkey, Brazil, or Egypt.

The bottom line is politicization of the economy have been key sources of social strains. What the largely economically ignorant or politically blind public initially sees as a boon from interventionism and inflationism will mostly regret of their advocacies.

And another thing, in today’s euphoric phase, I even read a commentary proclaiming today’s boom as “unstoppable”.

Well Mr. Tetangco has just fired the warning shot across the proverbial bow. Yet if bond markets continue to unsettle, what has been bruited as “unstoppable”…will not only become stoppable, but they will likely stop soon.

Despite the recent advances, current environment remains risky.

Trade cautiously.

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[1] Malaya.com Tetangco: We will stay the course July 10, 2013

[2] Bloomberg.com Philippines Doesn’t Need Additional Stimulus, Tetangco Says July 26, 2013

[3] See Phisix in the Shadows of a Bursting Global Bond Market Bubble June 24, 2013

[4] Ludwig von Mises 1. Inflation III. INFLATION AND CREDIT EXPANSION Interventionism An

[5] Bangko Sentral ng Pilipinas Economic and Financial Statistics

[6] Tradingeconomics.com PHILIPPINES GDP CONSTANT PRICES

[7] Ludwig von Mises 11. The Money-Substitutes XVII. INDIRECT EXCHANGE Mises.org

[8] Wikipedia.org Discounted cash flow

[9] Wikipedia.org Net present value

[10] see Phisix: Don’t Ignore the Bear Market Warnings June 30, 2013

[11] Inquirer.net Aquino: No stopping change July 23, 2013

[12] Fitch Rating Complete Sovereign Rating History - Fitch Ratings

[13] BBC.com Timeline: The unfolding eurozone crisis June 13, 2012

[14] Fitch Rating Definitions of Ratings and Other Forms of Opinion

[15] See Hyperinflation: Venezuela’s Intensifying Stock Market Melt up Amidst a Currency Meltdown June 29, 2013

[16] Carmen Reinhart and Kenneth Rogoff, This Time is Different Princeton University Press p. 111

[17] Ibid p. 15

[18] See A US-Philippines Bases Treaty (2012 Edition) in the Making? January 26, 2012

[19] Inquirer.net Aquino defends use of bases by US, Japan July 3, 2013

[20] See Phisix: The Myth of the Consumer ‘Dream’ Economy July 22, 2013

[21] See China’s Railroad Stimulus is now Official: It’s an $85 billion boondoggle July 25, 2013

[22] Reuters.com Japan central bank finds the pessimists come from within, July 26, 2013

[23] Sunstar Aquino seeks Congress' approval of priority measures July 22, 2013

[24] Inquirer,net Of heroes, anti-heroes: Biazon offers to quit July 23, 2013

[25] Gulf News.com Aquino: Philippines not Asia’s smuggling capital April 11, 2013

[26] New York Times Unusual Political Career of Calvin Coolidge, Never Defeated for an Office, January 6, 1933

[27] See Gold Smuggling: A Deepening Trend Not Just in the Philippines November 24, 2013

[28] See Why the Indian Government’s War on Gold will Fail May 18, 2013

[29] Wall Street Journal Gold Smuggling Takes Off in India July 26, 2013

Booming Phisix-ASEAN Equities Amidst More Signs of Global Distribution

I talked about swelling signs of distribution before my dsl connection cut me off.

In spite of this week’s majestic breakaway run by the Phisix and a robust performance by ASEAN peers, there seems to be more evidence of global distribution in motion. Some would call this divergence or disconnect.

So far, ASEAN has been on the positive end and converging.

As of Friday’s close, the Philippine Phisix (Orange line) continues to provide leadership in the region up by .95% over the week or 19.69% nominal currency gains year-to-date.

Such remarkable advance accounts for an average monthly return of about 5.6%. At the current rate of gains, the Phisix 10,000 in 2013 is still very much in play. Of course that’s unless some exogenous event, such as the growing risks of a crisis in Japan, may prove to be an obstacle to the current manic phase.

Our regional counterparts have also been showing signs of buoyancy. Indonesia’s JCI (yellow) has been a distant second to the Phisix after this week’s 1.24% advance which accrues to a 15.79% return year-to-date. Thailand’s SET (red orange) has recaptured double digit gains up 1.19 for the week or 11.3% returns for 2013. Thailand’s SET, which earlier had been neck to neck with the Phisix, has been derailed by interventions from regulators who recently raised collateral requirements for margin trades. Malaysia’s KLCI (green) has officially popped to the positive side (charts from Bloomberg)

The Philippine Mania in Motion

In the Philippines, the manic phase seems in full motion.

The manic phase as aptly described by Harvard’s Carmen Reinhart and Kenneth Rogoff in chronicle of their 8 centuries of financial, banking and economic crises in This Time is Different[1]:

The essence of this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us here and now. We are doing things better, we are smarter, we have learned from our past mistakes. The old rules of valuation no longer apply. The current boom, unlike the many booms that preceded catastrophic collapses in the past (even in our country), is built on fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes

A good example is the embarrassing gaffe by one of the leading broadsheets for publishing in the headlines a bogus or spoof pictorial of Time magazine featuring the Philippine President[2]. While the Philippine president did land in the Time’s list of 100 most influential people, he failed to grace the magazine’s cover. 

But the booboo shows exactly how media has functioned as mouthpieces for the government. 

More than that, mainstream media has been quick to hype on the supposed economic boom from alleged “good policies”.

Yet local media hardly covered World Bank’s latest implicit admission of emerging Asia’s bubble in progress, where the World Bank supposedly warned of “demand-boosting measures may now be counterproductive” (euphemism for asset bubbles) and that capital flows “may amplify credit and asset price risks”. Thus the World Bank prescribes that emerging Asia should put a break on easing policies[3].

In addition, local central bank chief also got accolades for taking the Philippine economy to the “stars”. 

The Wall Street Journal Blog reports[4]

Philippine’s central bank chief Amando Tetangco has taken to star gazing, of a kind, to guide the nation’s economy and so far he likes what he sees.

“The star of strong GDP growth and the star of low inflation,” Mr. Tetangco says in an upbeat interview during the Spring meetings of the International Monetary Fund. “This alignment of the stars is further strengthened by a healthy balance of payments surplus,” he said.

But it’s not all about the cosmic. The central bank boss also likes to draw on physics to explain how the quick growing South East Asian economy is faring between surging inward capital flows and risks posed by a sluggish global economy.

“I am not an astrologer but sometimes it is better to describe things like this,’ he says. Physics tell it best.

Amazing hubris.

Mr. Tetangco didn’t say it explicitly but his implication is that “healthy balance of payments surplus” serves as shield against a crisis. 

Mr. Tetangco does not distinguish between the various types of crises. While it is true that most crises has had the character of balance of payments deficits functioning as triggers to imbalances earlier accumulated that led to balance of payment or currency or exchange rate crises[5], there are other forms of crises.

They fall under the categories of debt crises, banking crises and serial defaults[6] (Reinhart, Rogoff 2011).

The above are examples of non-balance of payment crises. Particularly they are examples of two banking crises and a sovereign debt crisis.

Japan’s domestic asset bubbles[7] in the 1980s had been forged amidst current account surpluses. The 1990 bust led to a banking and economic crisis that still lingers 3 decades after…today.

UK’s secondary banking crisis of 1974-1975 also emanated from a prior property boom or the “last hurrah of the post war property boom” as noted by Wikipedia[8], which likewise has had a current account surplus going into the crisis.

Russia’s 1998 debt crisis[9] from unwieldy fiscal deficits that led to a massive government debt build-up was exacerbated by crashing commodity prices that led to a sovereign debt default. Going into the crisis, Russia posted current account surpluses from oil and commodity export receipts.

False assumptions and illusions brought about by a credit boom will eventually be unmasked. 

Such basking in narcissistic self-attribution glory reminds me of the Bank of Cyprus[10], one of the largest financial institutions of the recently stricken Cyprus.

In the mistaken perception that Cyprus successfully eluded the Euro crisis, and that they had become “immune” or has “decoupled” from the Eurozone, the Bank of Cyprus became a recipient of as many as 9 prestigious awards from February 2011 until September 2012[11]. As the Cyprus crisis emerged in March of 2013 or 5 months after the last award, depositors of the Bank of Cyprus may lose up to 60% of their savings[12] to bail-in the banks. Yes this is an example of a bizarre twist of fate.

I may add that for the mainstream, bubbles are after the fact knowledge.

As author Philip Coggan, and Economist contributor under the pen name of Buttonwood notes[13],

Ireland and Spain looked OK on government debt-to-GDP before the crisis but then they didn't.

And one of the haughtiest allusions has been to attribute policy success as “physics”. Such are patent symptoms of bubble mentality.

Positivist policies shaped by mathematical models will hardly extrapolate to “good policy”.

The presumption that natural science as equivalent to social science is a mistake. This has been based on faith or dogma and ego rather than reality. One cannot build on policies based on simplistic assumptions and mathematical aggregates when the fact is that the world is highly complex and where knowledge is distinct, diffused and fragmented. And because of such complexity, econometrics and statistical equations cannot model individual preferences, knowledge, emotions and value scales, since there is nothing constant in human action, especially with people’s interaction with each other or with the environment. 

Statistics are historical artifacts, relying on them means to wrongly assume the same circumstances will take hold in the future. Statistics and math alone cannot precisely foretell of the future. And policies based on statistics and math will be met with unintended consequences.

As the great Austrian economist Ludwig von Mises explained[14]

The natural sciences too deal with past events. Every experience is an experience of something passed away; there is no experience of future happenings. But the experience to which the natural sciences owe all their success is the experience of the experiment in which the individual elements of change can be observed in isolation. The facts amassed in this way can be used for induction, a peculiar procedure of inference which has given pragmatic evidence of its expediency, although its satisfactory epistemological characterization is still an unsolved problem.

The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged. Historical experience as an experience of complex phenomena does not provide us with facts in the sense in which the natural sciences employ this term to signify isolated events tested in experiments. The information conveyed by historical experience cannot be used as building material for the construction of theories and the prediction of future events. Every historical experience is open to various interpretations, and is in fact interpreted in different ways.

The postulates of positivism and kindred schools of metaphysics are therefore illusory. It is impossible to reform the sciences of human action according to the pattern of physics and the other natural sciences. There is no means to establish an a posteriori theory of human conduct and social events. History can neither prove nor disprove any general statement in the manner in which the natural sciences accept or reject a hypothesis on the ground of laboratory experiments. Neither experimental verification nor experimental falsification of a general proposition is possible in its field.

Growing Distribution or Divergences

Finally signs are pointing to a growing dynamic of divergence dynamic among global asset markets.

Among major equities, US and Japan continues to post gains even as much of the world appears to turning over. Of course this is with the exception of ASEAN. 

Despite the material year to date 9.1% gains by the S&P 500, internally the sectoral performance has diverged. Health Care, Consumer staples, utilities cyclicals and financials have boosted the S&P while materials, technology energy and industrials have weighed on the index. Perfchart from stockcharts.com

While I believe that much of the world will likely endure more pangs from growing signs of financial market weakness, it is unclear whether this will also impact the ASEAN markets whose mania phase has been running in full throttle.

This is of course unless there would be a major external financial smash up that could trigger a domino effect.

Nonetheless as market weaknesses becomes more pronounced, we should expect global authorities to jettison their “exit” meme that was really never meant to be and shift their tones to “dovish” or advocate on more inflationism. 

The recent quasi crash of gold-commodities which has been used by the mainstream as pretext to clamor for more central bank inflationism partly validates my earlier views[15].

And in contrast to the common reaction where crashes would lead to a loss of confidence and a ripple effect or a panic contagion, the quasi crash in paper gold at Wall Street, prompted for a near simultaneous frenzied or panic buying of gold in the physical markets[16] across the globe which also attained a milestone. For instance one day sales of US gold mint reached a landmark high[17]. 

In short, gold-commodity markets have also been diverging.

Yet this is hardly about “deflation” under the context of “aggregate demand”, and “liquidity traps” but about the dynamics of bubble cycles.

Navigating today’s treacherous market requires prudence, as incessant interventions has rendered markets highly susceptible to magnified volatility and whose state of fragility raises the risks of bubble busts, whose trigger may emanate from anywhere.

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[1] Carmen M. Reinhart and Kenneth S. Rogoff This Time is Different p.15 Princeton Press 2009

[2] Rappler.com Inquirer: Fake Aquino Time cover ‘honest mistake’ but... April 20, 2013

[3] See World Bank: Developing Asia Should Put a Brake on Easing Policies April 16, 2013

[4] Wall Street Journal Blog Philippines Stars Line Up, Thailand Looks for a Lady’s Touch April 19, 2013

[5] Wikipedia.org Currency crisis

[6] Carmen M. Reinhart and Kenneth S. Rogoff From Financial Crash to Debt Crisis, Harvard University August 2011

[7] Wikipedia.org Japanese asset price bubble

[8] Wikipedia.org 1998 Russian financial crisis

[9] Wikipedia.org 1998 Russian financial crisis

[10] Wikipedia.org Bank of Cyprus

[11] See Example of the Mania Phase: Awards Received by the Bank of Cyprus March 27, 2013

[12] Bloomberg.com Bank of Cyprus Clients May Lose Up to 60% on Deposits April 2, 2013

[13] Philip Coggan Buttonwood Rotation schmotation April 18, 2013 Economist.com

[14] Ludwig von Mises 1. Praxeology and History Chapter II. The Epistemological Problems of the Sciences of Human Action Human Action Mises.org

[15] See I Told You So: Gold Slump Used as Justification for MORE QE April 17, 2013

[16] See Gold Price Crash Spurs Boom in Physical Gold Markets April 18 2013

[17] Frank Holmes Gold Buyers Get Physical As Coin and Jewelry Sales Surge US Global Investors April 19, 2013

Learning from Past Crisis; History As Basis For the Future

``When you see that trading is done, not by consent, but by compulsion - when you see that in order to produce, you need to obtain permission from men who produce nothing – when you see money flowing to those who deal, not in goods, but in favors – when you see that men get richer by graft and pull than by work, and your laws don't protect you against them, but protect them against you – when you see corruption being rewarded and honesty becoming a self-sacrifice – you may know that your society is doomed.” Ayn Rand, Atlas Shrugged

Most of us would like to know when this crisis might come to a close. Most of us would also like to know when life might ‘normalize’.

Of course, life, as we know it, won’t likely be the same or “normalize” as it had been during the past decade.

We are likely to live in a world which will be governed by more regulations, higher interest rates, lower leverage, higher taxes, possibly diminished ‘globalization’ in terms of trade, and capital flows and reduced political freedom especially seen through the lens of the once liberal Anglo-Saxon world, as discussed earlier in 2009: Asian Markets Could OUTPERFORM.

Yet even as they undergo rehabilitation, we can’t discount the reemergence of bubbles through other asset classes and the reorientation of the conduct of the world’s political economy. Remember, bubble cycles are the inherent character of our paper money system.

Historical Roadmap

Moreover, while history may not exactly repeat, the lessons of the past may provide us with some essential clues or may function as some sort of a roadmap to help guide us in navigating our way through the present financial crisis.

As we have discussed in Will Previous Crisis Serve As Deserving Guidepost For Today’s Crisis?, Harvard Professor and former IMF chief economist Kenneth Rogoff and Carmen Reinhart recently updated a study of the previous world crises, see figure 1.

Figure 1 Rogoff-Reinhart: Learning From The World’s Past Real Estate-Banking Crises

In the Rogoff-Reinhart paper, the ‘Aftermath of the Crisis’, we are treated to 18 major post war banking-real estate crises of advanced economies including some of the recent emerging markets crises and its consequent impact to domestic real estate and the equity market in terms of pricing based losses and the periods of agonizing adjustments (peak-to-trough).

We can observe that the typical or average housing cycle (right window) losses of real housing prices have been 35.5% and has lasted an average of 6 years. As you may notice, the Philippines, in the wake of the Asian Crisis in 1997, suffered the second biggest loss of 50% after Hong Kong, and where our painstaking market cleansing cycle culminated after 6 long years. It is also important to note that the longest real estate bear market cycle was recorded in Japan and which registered over 15 years of losses.

Next, equity losses averaged 55.9% which lasted for about 3.4 years.

In addition, a defining characteristic of such crises is that the real public debt exploded as governments suffer from falling tax revenues and increased spending to fight off recession. On the average, real public debts ballooned by 86%.

Applying Past Lessons Today

So where are we today?

Figure 2: US Housing Prices (researchrecap) Japan Housing Prices (J. Quinn: Financial Sense)

If we are to base our analysis on the epicenter of today’s crisis which is the US, then housing prices based on the Case-Shiller index has lost 30% (see figure 2, left window), and is almost near the average loss of 35% during similar crises. Peaking in 2005, the housing bear market is now on its 4th year which is also approaching the average of 6 years.

In terms of the bear market cycle in equities, the major US bellwether as signified by the S&P 500 has lost over 50% and is now 16 months old or 1.3 years. Compared to the average of 3.4 years, the equity bear market cycle suggests of a transition for about two years more.

So simplistically speaking 2011 should be a turning point for the US real estate and US equities…if we are to base it on the average.

But as our earlier caveat, all crises aren’t the same.

Further, the average alludes to the typical. Since today’s landscape is global in scope compared against a regional or national phenomenon in the past, it is likely that the disposition of today’s crisis will be distinct.

Besides, the collective global government response has been unprecedented in scale. Importantly, today’s crisis jolts the foundations of the world’s monetary architecture. Hence, today’s crisis may not be the archetype.

What seems to be relevant is that the US government has been implementing almost similar policy responses as with Japan in the 1990s following its bubble bust.

The Keynesian approach of Zero Interest Rate, government infrastructure spending, tax cuts and rebates and monetary manipulations via the purchase of commercial paper, shares of public companies and provision of bailout funds for bailouts only resulted to a prolonged era of distress from which Japan’s real estate fell by over 15 years (see right window) and whose stock market went nowhere from 1990s until today.

Just recently, Japan’s key benchmark, the Nikkei 225 crashed below its support level shaped during the trough of 2003 to register a NEW low. The Nikkei which presently drifts near the 2003 lows reflects a loss of over 80% from the peak in 1990, nearly 20 years ago!

Of course some may argue that the rapid fire response by the US government may do the magic trick. Well, for us, the fundamental defiance of nature’s economic laws will either bring short term panacea with long lasting torment similar to Japan or precipitate another set of collapse.

Conclusion

Nonetheless, in our opinion, the US won’t probably see a bullmarket for years to come, even if the economy manages to emerge out of the recession. The indemnity from the recent crisis will be scathingly enormous and will contribute heftily to the suboptimal growth outlook. Besides, the intensity of government interventions seems likely to create substantial inefficiencies in the economy that should weigh on its productivity. Moreover, the US will have to deal with its ballooning unfunded entitlement liabilities.

Remember, it took almost 25 years for the Dow Jones Industrial to breach its 1929 peak. In the same vein, US benchmarks haven’t successfully broken through the dot.com pinnacle set in 2000, which makes today’s bear market nearly 10 years old! Hence it is likely that the US could be rangebound or muddle through over the next few years or even in the next decade.

Of course, we’d argue otherwise that if the Obama-Bernanke tandem prints an ocean of money similar to Dr. Gideon Gono’s policy approach in Zimbabwe. While this may boost share prices, not out of earnings, but because people may shun the destruction of its currency and seek sanctuary in hard assets or in stocks as ‘stores of values’, the net effect is that any nominal gains will be offset by currency losses.

Thus, the lesson we can get from the Rogoff-Reinhart study may possibly apply NOT to the US or the credit bubble infected economies. But as possible beacon to the performances of economies or markets untainted by the credit bubble structure but had been affected by the contagion from the implosion of the proximate epicenters of the bubbles.

While 2008 had been a year of convergence as we discussed in Will “Divergences” Be A Theme for 2009?, we’d probably see the resurrection of an unpopular discarded theory.