2009: Asian Markets Could OUTPERFORM

``Is Asia decoupled from the U.S. economy? Only partially. About 60% of Asean's and Northeast Asia's exports are ultimately consumed in the G3 countries (the U.S., the EU and Japan). A U.S. recession will slow growth in the EU and Japan. However, at least 60% of the shoes, textiles, garments and other essential consumer products these countries import will come from Asia, providing a buffer for Asian manufacturers. Those Asian economies that export commodities, oil and gas will also benefit if these resources continue to command high prices. India and China are set for rapid growth. Both have the resources to increase spending on infrastructure and to stimulate consumer spending. Only 35% of China's economy is consumer driven. This could be pushed up to 50% to 60%, which is also true for India. We'll soon know if China will be able to rely more on domestic consumption for its growth. Once the Chinese are accustomed to spending more of their disposable income, trade imbalances will decrease.- Lee Kuan Yew, China's Olympics Journey

One of the seemingly implausible observations is for experts to suggest that any global economic recovery would likely originate from the US.

Since the US had been the epicenter of the crisis, whose malaise belatedly spread to almost the entire world, the aggressive policy actions are deemed to have aptly settled most of the balance sheet impairments and should pave way for normalization of its economic cycle. For us, this is putting too much faith over the efficacies of the actions of policymakers.

While true enough, the world is momentarily feeling the brunt of the real economic impact of the downturn, many parts of the world remain affected because of trade and capital flow channels than from a debt overhang in their national balance sheets. In other words, the recent synchronization of markets had been mostly because of forcible liquidations from the debt deflation process and isn’t representative of the same disorder suffered by many OECD economies as compared to Asia or other select emerging markets.

What we’d like to point out is that many balance sheets of Asian economies for instance remain lightly leveraged, (as we discussed in Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?) such that if the US seems having a hard time normalizing credit flows, I would venture a guess that once the effects from the trade nexus subsides, credit take up will most likely be more apparent in economies unhampered by the debt.

Since there are more unknowns than what can be known, we’d be operating from the standpoint of what we know based on what’s happening with the US, the largest and most influential economy of the world today, and its possible influence to the world.

What we know:

1. Inflationary policies are laden with unintended consequences.

2. Applying greater degree of inflation means a further loss of purchasing power of the currency or a lower standard of living.

3. More government intervention means suboptimal resource allocation which also entails suboptimal economic growth.

4. The shift in the leverage to government involve a “too big to fail” paradigm which only increases systemic risks. Governments cannot be viewed as “risk free”. Iceland’s fall should be a reminder (see Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?)

5. The US economy and financial markets are now “Housed” by Ben Bernanke who is playing the financial game with a loaded dice. Meanwhile, the US government is also playing the economic god.

6. Because life and death of industries depend on Washington’s blessings, lobbying has turned into a sunrise industry.

7. Policymakers are still struggling to figure out how to deal with the crisis and thus exhausting all creative means for instantaneous results at the expense of the future.

8. The US will be operating from the perspective of government consumption as driver of the economy since private consumption, investment and exports will likely remain soft. Yet, government spending doesn’t create value or raise aggregate demand because it has to get money from somewhere from the economy mostly via redistribution.

This from Daniel J. Mitchell, Cato Institute, ``This is a debate about Keynesian economics, which is the theory that the economy can be boosted if the government borrows money and then gives it to people so they will spend it. This supposedly "primes the pump" as the money circulates through the economy. Keynesian theory sounds good, and it would be nice if it made sense, but it has a rather glaring logical fallacy. It overlooks the fact that, in the real world, government can't inject money into the economy without first taking money out of the economy. More specifically, the theory only looks at one-half of the equation — the part where government puts money in the economy's right pocket. But where does the government get that money? It borrows it, which means it comes out of the economy's left pocket. There is no increase in what Keynesians refer to as aggregate demand. Keynesianism doesn't boost national income, it merely redistributes it. The pie is sliced differently, but it's not any bigger.” (highlight mine)

Thus, government consumption as driver of the US economy will likely be a short term fix but isn’t likely to provide the much widely expected support over the long term.

Overall, the operating environment of the post crisis US economy will be one with less degree of market openness, lesser productivity, greater regulation, higher taxes and lower leverage. Our view is similar to PIMCO’s top honcho Mr. William Gross where in his recent outlook wrote, ``My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”(bold highlight mine)

Thus the implied market and economic impact:

-This suggests that on the basis of recovery, Asian markets are likely to outperform the US markets if not recover earlier economically barring any further crisis.

-Asia’s economy or markets will not be immune to the volatility elsewhere especially from the US, as the recent events has shown. But over the long term it could be expected to build on its newfound “advantages” and would be perhaps less vulnerable.

-Over the short term, given the collective low interest inflation inducing environment worldwide, combined with the underperformance of Asian markets during the recent rout, any global market technical bounce should also likely reflect an outperformance of Asian markets relative to the US.

-Over the long term, the normalization of the economic cycle would translate to renewed appetite for risk taking, this means capital flows should revert to where economic growth remains least unimpeded by government instituted restrains. In addition, given the lack of leverage within Asia, our bet is that the next round of credit uptake will likely stem from the region.

Living In Interesting Times

Financial markets today have been experiencing bouts of irrationality if not plain insanity.

To consider, instead of getting compensated by loaning money to the US government via the purchase of US Treasuries, lenders LOSE money!

Chart from Bespoke Investment

Three month T-Bill yields have turned Negative!

And investors have been piling on, this from Marketwatch.com ``The Treasury Department sold $32 billion in four-week bills Tuesday at a yield of zero, implying investors purely wanted the assurance that they would get their principal back. Investors bid $128 billion at the auction, more than four times the amount available. Yields on one-month debt have plunged from about 1.80% in June. "I have never seen this before," said Michael Franzese, head of government bond trading at Standard Chartered. "It's all about capital preservation for the turn of the year, not capital appreciation.”

From our end, this remarkable development implies of a bubble at work.

Next, stock market volatility in the US is at record levels if one measures volatility from the perspective of absolute daily changes!

Chart from Bespoke

This from Bespoke Invest, ``Up until the start of 2008, a daily move of 4% in a 50-day period was noteworthy. From 1945 through 2007, the S&P 500 had 49 one-day moves of 4% or more, which is an average of less than one per year. This year we've had 28! For a market as big as the United States to average a 4.02% daily change over a 50-day period is truly astounding. This is the type of volatility that we see in frontier and emerging markets -- not the biggest, most developed market in the world. The volatility bubble won't last forever, and being long it at this stage of the game is a very risky bet.” (emphasis mine)

It’s been a wild rollercoaster ride out there.

Next, following the first official “rally” or “bounce” in US equities markets, Bespoke Invest says this had been the third worst bear market.

Chart from Bespoke

Again from Bespoke Invest, ``As shown, the bear market that ran from 10/9/07 to 11/20/08 is the third worst ever with a decline of 51.93%. The bears that ended in June of 1932 (-61.81%) and March of 1938 (-54.47%) are the only two that had bigger declines without a rally of 20%.”

All these seem to indicate that we are in some sort of a crossroad.

US Political Economy: History Repeats Itself

In our previous article Has The Barack Obama Presidency Been Driven By Market Dynamics?, we posited that activities in the marketplace, which has been reflective of present and future economic dimensions, may have served as an important psychological driving force to voter selection during elections.

Apparently, we learned that this hasn’t been the first time.

According to the Economist, ``ONLY twice since the 1920s has economic angst played such an important role in a presidential election—and both the previous occasions make imperfect templates. When Franklin Roosevelt defeated Herbert Hoover in 1932, the Depression had been going on for three years, thousands of banks had failed and unemployment was 25%. When Ronald Reagan beat Jimmy Carter in 1980, inflation had been high for years, hovering at 12% as voters headed to the polls. By contrast, the crisis facing Barack Obama has been underway for just over year, with unemployment standing at 6.5% according to figures published on November 7th.” (underscore mine)

Let us take a look at how the markets performed during the aforementioned periods.

The Dow Jones Industrials prior to the FDR-Hoover 1932 Presidential elections

Chart courtesy of Chartsrus.com

The S&P 500 prior to the Reagan-Carter 1980 Presidential Elections

Chart courtesy of chartrus.com

As Charles Kindleberger wrote in Manias, Panics and Crashes A History of Financial Crises ``For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."

Chart of the Day: US Dow Jones: Worst Annual Decline in History

From Chartoftheday.com:

``Continued concerns regarding the credit crisis, a slowdown in consumer spending, and a further weakening of the US economy sent the Dow down more than 7% on the day. Today also marks the one-year anniversary of the current correction. The Dow put in its record high of 14,164.53 back on October 9, 2007. Today, the Dow closed at 8,579.19 -- down 39.4% from its one year old peak. For some perspective on the magnitude of the current decline, today's chart illustrates how the Dow performed during the first year of all major corrections since 1900. As today's chart illustrates, the first year of the current correction has been more severe than the first year of any correction since 1900 -- and that includes the correction that began in 1929."

Two points of thought:

1. Could the collapse in US stocks signify more than just deleveraging and its economic spillover such that losses have topped 1929?

2. Relative to the Phisix which is down by 45% from the peak as of Friday's close, it used to be far worst, e.g. when US markets fell by 1% we dropped by 2-3%. Have we become low beta? Nonetheless despite the market's rout, the Phisix has held up well. So far so good.

Global Financial Markets: US Sneezes, World Catches Cold!

``So there is a connection between the ultra-expansionary monetary policies of Mr. Bernanke – I might add, an economist that is an academic and that has studied the Depression but doesn’t understand anything about international macroeconomic conditions. And the conditions that led to the Depression in 1929-32 are very different from what we are facing today because commodity prices at that time had been in an upward trend from 1890 to 1921, but throughout the 1920s, essentially in a downtrend. We are now in an uptrend, so the more money he prints, the higher commodity prices will go, and the lower the dollar will go and the more inflationary pressures the U.S. will face.”-Dr. Marc Faber on Global Inflation

The Dam finally broke.

The three major equity market bellwethers of the US are now knocking at the bear’s lair in the wake of the market’s carnage last week. Following the breakdown of Dow Jones Industrials, the 30 company price weighted average benchmark is now at the brink from the official technical description of a bear market or a loss of 20% from the peak.

The Industrials is down 19.89% from its zenith in October (based on closing prices), while the contemporary benchmarks of the S & P 500 and the Nasdaq are likewise nearing the technical breakdown and are down 18.32% and 19.01% from October, respectively.

And when the US sneezes, the world catches cold, as shown in Figure 1.

Figure 1: courtesy of stockcharts.com: The US Sneezes, The World Catches Cold

Like its US counterpart, the Euro Stoxx 50, a free float market cap weighted index of the 50 European blue chips is seen likewise attempting a technical breakdown (pane below main window) now perched at the critical support levels, while Asia and Emerging markets (center and lowest pane) have also been feeling the heat.

$140 Oil: The Last Nail In The Coffin

Again, mainstream media and their coterie of experts has fingered $140 oil as the culprit, but as we have been saying all along, $140 oil represents as only a contributory factor or the proverbial last “nail” in the coffin.

The recessionary pressures-from the ongoing credit turmoil, the housing meltdown, the market tightening of access to financing, the grand “deleveraging” in the financial sector, growing statistics of bankruptcies and foreclosures, mounting job losses, falling corporate profits, worsening balance sheets, consumer spending retrenchment, slowing capital investments and others, aside from higher “inflation” (high energy and food costs, rising prices of imports, rising costs of raw materials et. al.)-have combined to impact the real economy, which is now being reflected in the revaluation of the US equity markets.

Figure 2: courtesy of Bloomberg: Rising TED Spread: Credit Woes Not over!

Figure 2 from Bloomberg is just an example of the prevailing abnormalities and disruptions in the credit markets affecting both the financial sector and the real economy.

The TED spread-or “the difference between the interest rate for the three month US Treasuries contract and the three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another” (wikipedia.org)-continue to remain under severe strain and appears reaccelerating.

So as financial institutions remain reluctant to lend to each other, this suggests of the dearth of access to finance by many economic agents in the real economy, which essentially leads to an economic growth slowdown.

Figure 3: courtesy of Northern Trust: Falling Corporate Profits From the US

Such impact is becoming more evident in the performance of corporate profitability. This from Chief economist Paul Kasriel of Northern Trust (underscore mine),

``Along with its “final” estimate of first-quarter GDP, the BEA also reported its revised estimate of first-quarter corporate profits. Compared with the fourth quarter of 2007, corporate profits from current operations were estimated to have declined 0.3% in the first quarter of 2008 rather than the 0.3% increase originally reported. Looking at total profits on a year-over-year basis, they were up 1.0% in the first quarter. But, as shown in Chart 1, profits generated from domestic operations contracted 4.8% -- the third consecutive quarter in which year-over-year domestically-generated corporate profits contracted. If total profits are increasing year-over-year, but domestically-generated profits are contracting, then it must be that profits generated from overseas operations are increasing.”

So as shown above, this is not all about oil.

In Eyes Of Ben Bernanke: Systemic Deflation, Interest Rates and Petrol Deficits

There is an idea being floated that “frustrated expectations” over the policy actions of Fed controlled interest rates had been answerable for this week’s rout.

Since the prevailing belief is that oil prices have been “causing” the stress in the US economy and the financial markets, the expectations was for the Fed Chairman Bernanke to “raise rates” in order to combat rising oil prices. Since the Fed stayed on with the present rates, market’s expectations was unfulfilled, thus the attendant mayhem. How I wish it were so simple.

We don’t want to moralize about the principles of money “tightening” although it is a premise which we basically agree with. Yet it is one of the many things the world can do to ease the present strains but comes with a political cost.

The role of market participants is to anticipate on the prospective developments in the marketplace in order to profit from it. So we should instead attempt to understand the mindset of the leadership or those at the helm of the US Federal Reserve, particularly of Fed Chair Bernanke.

Second, it should be understood that the cyclical counterpart of a boom derived from credit inflation is an ensuing bust from debt deflation, which is what we are seeing in the US and parts of Europe today.

Indeed, the US government has reacted with a cocktail of countermeasures to cushion the aftermath of the housing, mortgage and structured finance bubble (deflation) bust with tax rebates, expanding the role of (Government Sponsored Enterprises) GSEs of Federal Home Loan Banks, Fannie Mae and Freddie Mac as mortgage “buyer of last resort”, sharp interest rates cuts, bridge financing via direct access by financial intermediaries to the Fed, currency swap with foreign central banks, the Fed engineered acquisition of investment bank Bear Stearns and the partial overhaul of the asset side of the Federal Reserve balance sheet replaced with collateral from various financial institutions that had been frozen or illiquid in the marketplace. But apparently, these actions have not resolved the liquidity or the solvency issues plaguing the financial sector-the epicenter of today’s debacle.

Thus, as stated in our latest blog post, Chairman Bernanke The Ideologue Probably Won’t Raise Anytime Soon, Mr. Bernanke’s premier concern is one of a systemic debt deflation (or a repeat of the Great Depression or Japan’s lost decade) and perhaps views the current inflation menace as a temporary phenomenon despite the recent verbal signaling to the opposite effect-“the upside risks to inflation and inflation expectations have increased” (Federal Reserves).

When action is measured against words, the point is, with nominal interest rates far below the official rate of “inflation”, which signifies a policy decision, this opines that Mr. Bernanke is indubitably concerned with the impact from the overleverage in the system- yes, as an example trading of enigmatic derivative instruments have now ballooned to $692 trillion (Bloomberg) or more than 10x the GDP of the global economy!

On the other hand, the issue of rising oil prices equals a US recession has been a causality embraced by mainstream thinking.

This quote from Stephen Leeb (Hat Tip Barry Ritholtz), ``Nothing has been a more reliable indicator for an upcoming recession as the price of Oil. Every major bear market, every major economic decline has been preceded by a large spike in oil prices. The 73-74 recession, recession of beginning 80's and the recession of 2000. Oil prices jumped 80% between 1999 and 2000. Oil prices have been the most important indicator of major economic disasters. Whenever Oil prices rise about 80% from year ago levels, a fair chance does exist that a recession/bear market will follow."

Figure 4: Courtesy of St. Louis Fed: Oil Is Not The Only Driver of Recession; Interest Rates too!

Figure 4 from the Federal Bank of St. Louis shows that rising oil prices and a US recession has not solely been the coincidental variables but interest rates too!

Rising interest rates (red line) preceded ALL recession periods (gray area) in the US since 1954. Nonetheless, when oil prices came into the picture in about 1965 (blue line), all instances where oil price rose significantly and was met with an attendant recession, the interest rate cycles were seen either peaking out or rolling over.

What this could suggest is that policy measures (mostly in response to the bond market via rising treasury yields) to wring out “inflation” in the system as signified by high oil prices could have led to the “recession or bear market” indicated by Mr. Leeb.

Put bluntly, it is not oil prices but a tightening environment to squeeze out “inflation” that resulted to these periods of recession. Oil prices again, served as the most convenient scapegoat.

And Mr. Bernanke, whom have exhaustively been trying to avert a recession, could have probably seen this picture and has purposely moved against such tightening in the belief that economic growth guided by the Fed’s monetary and fiscal policies, could help patch up these deflationary bottlenecks overtime while “inflation” symptoms of high oil prices could perhaps bow or vanish amidst these deflationary headwinds.

Another factor perhaps, is that the realization by Mr. Bernanke & co. of the nature of today’s monetary inflation as being transmitted through mainly the US current account deficit and secondarily monetary pegs or dollar linked currency framework adopted by about 45 countries.

Figure 5: courtesy of Brad Sester: US Petroleum Deficit Already Exceeds the Non-Petroleum Deficits

The idea is that since US monetary aggregates and bank credit (loans or investments of commercial banks) have NOT been expanding, petroleum imports- to quote our favorite keen eyed fund flow analyst Council on Foreign Relation’s Brad Setser, ``The petroleum deficit – over the last three months – already exceeds the non-petroleum deficit” -has now become the dominant variable of the US current account deficit which effectively becomes the primary source of monetary lubricant for the economic growth engines of emerging markets economies.

In figure 5 courtesy of Brad Setser, Petroleum imports have been expanding to the degree more than enough to offset the decline in non petrol imports. Said differently, US consumers have been materially buying less of foreign goods and have been paying more for oil products!

Remember, US export growth has been relatively strong in the face of today’s tribulations and has cushioned its economy from massive deterioration. And the continuity of such conditions requires a robust pace of export growth which emanates from a vigorous clip of external demand expansion.

Perhaps Mr. Bernanke thinks that if a decline in the Petrol deficits without the accompanying improvement in non-petroleum deficits translates to a slowdown of global demand for US products then the US economy faces the risks of a deflationary collapse! Put differently the US is in a life support system presently sustained by its monetary policy induced externally generated inflation process!

And this could be the reason why US Treasury Secretary Henry Paulson recently made rounds to the Gulf states telling them that abandoning the (currency) pegs “will not solve their inflation problems” (CBSMarketwatch).

Of course, the mirror view is that a US deflationary bust will extrapolate to a global depression (as repeatedly advocated by some)!

In effect, the implicit impact from the policies assumed (or of keeping rates on hold) by Mr. Bernanke & co. is to maintain a weak dollar, high oil price, and continued monetary inflation from the world feeding into the US economy by shoring up its exports in the hope that the latter will offset it from a deflationary collapse.

Maybe if all the above measures cease to work then the last ace for Mr. Bernanke would be to expand the Fed’s balance sheets by printing money or otherwise the US economy could succumb to deflationary recession!

Bernanke In Hot Seat, Imbalances As An Offshoot To Consenting Nations

Yes, Mr. Bernanke is in hot seat as the Federal Reserve for the first time in US history is due to undergo scrutiny from the IMF. According to Der Spiegel’s Gabor Steingart (highlight ours),

``Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF's board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

``As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests -- worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

``Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members -- but never the United States -- have already endured this painful procedure.”

It is likely that many countries have seen how US policies have unduly been impacting the world (through higher consumer goods and services inflation), thus the IMF could be applying pressures to the US to adopt a more global centric policies (speculation for me here). Of course, adopting currency pegs is a national determined policy, which means today’s imbalances is a product of “consenting states” or playing within the unwritten guidelines of the US dollar standard.

In finality, Mr. Bernanke’s recent policies have resulted to a general market tumult: a big decline in global equity markets, a rally in US Treasuries, a fall in global sovereign bonds, a retreat in US dollar index, and a massive rally in major commodities. Mixed signal in all.

No, this week’s decline isn’t all deflationary...

Table 1: Bigcharts.com: Commodity Indices Outperforms!

Not for the moment in the US anyway…