The Race To Currency Destruction (Hyperinflation): Want to be a billionaire?

Courtesy of the Economist

From the Economist (highlight mine), ``HYPERINFLATION requires a good head for figures and a sturdy wallet to hold wads of low-value paper money. Governments have attempted to keep pace with hyperinflation by issuing ever-higher denomination banknotes to replace worthless notes that might as well serve as wallpaper. Last week Zimbabwe's central bank unveiled a 100 billion dollar banknote to cope with inflation running at 2.2m%. On Sunday July 27th the bank changed tack and announced it would be lopping off a string of zeroes on replacement notes, in what passes for economic reform in stricken Zimbabwe. But Robert Mugabe has some way to go before he can claim for his country the accolade of printing the highest-denomination banknote. A note issued in post-war Hungary came with a mind-boggling 19 digits.”

Courtesy of Associated Press

Because Zimbabwe’s inflation is 2,000,000 % a month, the Zimbabwe central bank plans to reform the currency by removing “zeroes”.

This from the AP, ‘Zimbabwe's bank chief plans new currency reforms — removing "more zeros" from the plummeting Zimbabwe dollar and raising the limit on cash withdrawals — to tackle the country's runaway inflation and cash shortages, state media reported Sunday.

“Previous currency reforms have failed to tame Zimbabwe's inflation — officially pegged at 2.2 million percent a year but estimated by independent analysts to be closer to 12.5 million percent. It also has become virtually impossible to get access to cash as the country's economic collapse worsens.

“Authorities last week released a new 100 billion dollar bank note. By Sunday it was not enough even to buy a scarce loaf of bread in what has become one of the world's most expensive — and impoverished — countries.”

How much that this money buy? According to the CNN

``It said a 4-pound (2-kilogram) bag of sugar cost about 20 billion Zimbabwe dollars ($1) at the government's fixed price, and 90 billion on the black market ($1 at the black market exchange or $4.50 at the bank exchange rate.)”. 20 billion dollars for a bag of sugar! Amazing. Yes, you have a billion alright but it buys practically nothing.

As the Economist have noted we’ve got a history of countries literally printing money in order to politically survive its corrupt and incompetent leaders.

Chart from Cato Institute/Steve Hanke

If the idea is simply to throw money to our socio-economic problems as a political solution, as many have suggested, then we should keep in mind the experiences of Zimbabwe, Yugoslavia, Hungary and Weimar Germany.

There is no free lunch.

Politicking Weighs On Phisix, Inflation Problems Have Been Policy Induced

``For far too long, we have accepted the idea that government can and should take care of us. But that is not what a free society is all about. When government gives us something, it does two bad things. First it takes it from someone else; second, it causes dependency on government. A wealthy country can do this for long periods of time, but eventually the process collapses. Freedom is always sacrificed and eventually the victims rebel. As needs grow, the producers are unable or unwilling to provide the goods the government demands. Wealth then hides or escapes, going underground or overseas, prompting even more government intrusion to stop the exodus from the system. This only compounds the problem.” Congressman Ron Paul Challenge to America: A Current Assessment of Our Republic

The Phisix has been bedraggled by administration led politicking which has led to its recent rout (down 3.1% over the week). Yet, the efforts by the mainstream media have been to affix the culpability to inflation which recently rose to a 9 year high. This mindless penchant to attribute false causes has been misleading the public compounded by blabbermouth experts.

Attribution To Inflation Woes Don’t Add UP!

As we argued in my recent post, Phisix Breakdown: Politics Not Inflation Related, goods and services inflation means the loss of purchasing power by the domestic currency to mostly fuel and food (which is what the news report says). Alternatively, this means that rising fuel and food prices have been getting a far larger share of expenses out of household or business budgets from which comes at the expense of non-fuel and non-food items. In short, spending on food and fuel crowds out other items. This is called relative price adjustments.

So in the perspective of relative prices applied to the equity markets, share prices of energy issues should benefit from the expectations of rising share of fuel expenditures and so with food related firms at the expense of other issues if “inflation” is the concern. Relative to the performance of energy companies, except for Petron Corporation, which amazingly soared by 17.65%, the rest of issues slumped such as Aboitiz Power (-3.57% w-o-w), Aboitiz Equity Ventures (-1.39%), PNOC EDC (-5.36%), First Gen (-1.43%), First Philippine Holdings (-3.03%) and Meralco (-4.07%)! So the so called inflation woes don’t add up.

Yet, inflation figures reported in the news reckon of past performance-particularly of last May. This means markets acting as a forward discounting mechanism should have discounted the past and read into the future.

If in the past (say last month or in May which read on the April figures) the market believes food and fuel inflation will continue to impact spending patterns in the future (which is today) then share prices of these issues would have likewise adjusted. This means at this point, shares of energy and food issues should be on an uptrend. But this isn’t the case.

And when the same deduction will be applied tomorrow or if once again the energy group is extrapolated to reflect on the continuing adjustments of consumption patterns then they should be expected to trend higher. This means prospective higher prices for energy issues!

But have we been seeing such dynamics? The reality is energy issues have either been consolidating (AEV, PCOR, AP and FGEN) or seem headed for the sewer (Meralco, FPH and EDC). Again, this inflation themed anguish doesn’t rhyme at all.

So why have energy issues (or the Phisix in general) been collapsing in the face of spending pattern adjustments arising from higher costs of fuel and food?

Because foreigners have been selling the Phisix! This week, foreign money has sold the most (Php 1.273 billion) since end of April. Coincidentally, the bulk or 68% of the foreign selling came at the time when the joint foreign chamber of commerce was being excoriated by our sanctimonious politicians.

A foreign chamber of commerce is a business organization representative of foreign owned enterprises in the Philippines. The benefits or costs accrued by their companies are transmitted to their countries which may induce or reduce incentives for future capital investments locally. Hence, any negative projection imparted by our leaders or by our political economy will negatively impact our image which may lead to foreign capital efflux aside from inhibiting future capital investments-our future jobs and taxes. So it becomes a paradox to brag about our “sovereignty”, especially under today’s “globalization” or increasing trends of cooperation and integration, when we can’t produce for ourselves enough capital to make enough jobs for our countrymen.

Besides, if as a foreigner you are invested in the country, having come to the realization that your equity ownership is at risk from political intervention, will you not sell and pull out? The answer is pretty obvious. Hence, the political risk arising from the administration’s continued assault on the private sector has been impairing the country’s attractiveness as a business destination. In effect, we have been shooting ourselves in the foot anew. We just hope and pray that sanity will be restored to our leadership.

Finally, the cause and effect between inflation and equities doesn’t necessarily have a linear correlation as we have always argued. To see an example, let us base it on recent global events-Kenya’s massive rise in its inflation data was equally met with a strong response in its stock market as shown in my post Kenya’s Mixed Message: Soaring Inflation Rates and Rising Stock Market.

Of course, Kenya is unlike Zimbabwe whose currency has practically collapsed down 84% since May and whose inflation rates is said to have vaulted to 1.8 MILLION PERCENT in May (Reuters). Of course, Zimbabwe’s hyperinflationary refuge has been its stock markets where its industrial index is up 261.15% in just ONE week while its mining index is also up 379.23% in just THREE days (allafrica.com)! In these we find that equity investments can become the corollary store of value when trust over a currency loses its foundation.

Yet, if there is any little trace of inflation based positioning in our domestic markets, well Figure 3 tells it best…

Figure 3 PSE data: Philippine Mining Index Diverges From the Phisix!

The Philippine Mining index (red line) has greatly outperformed the Phisix up 2.68% amidst the harrowing decline of the Phisix (black candle) over the week.

If inflation is defined as a loss of purchasing power against hard assets then naturally, resource based issues are likely to outperform under a massively devaluing currency reserve standard of the world, the US dollar.

Besides, since the Mining industry is the administration’s baby, (hopefully they won’t change minds), it is likely that there will be continued rotation towards such resource based sectors.

Figure 4 stockcharts.com: Resource based Assets Survive the US onslaught

And it’s not just here.

The major US benchmarks fell by about 3% last Friday, as the US dollar crumbled, to which some have associated the market’s reaction to the surprising stance by European Central Bank Jean Claude Trichet indicating the possibility of raising interest rates in July.

This unexpected declaration by Mr. Trichet allegedly prompted for a forced massive short covering across the Euro and commodities-particularly the oil benchmark which jumped by 8% the biggest increase since oil futures started trading in 1983 (NYT), aside from liquidation sales in the broad equity for margin calls. On the other hand, commodity related international stocks fell at a much subdued clip while mining and oil bellwethers in the US jumped (see figure 4)!

The Dow Jones Latin American Index (main window) slipped by 1.9% but still trades at near its recent highs, while the Dow Jones US mining index (pane below main window) shot to fresh record heights amidst the market turmoil.

Meanwhile, the Dow Jones Oil and Gas Services (middle pane) similarly leapt, as the Dow Jones Gold index (lowest pane) pivoted higher following the recent doldrums which has basically reflected the price action of gold.

As you would observe, except for the US Gold mining index which we think would follow suit higher, all three indices have been moving to the upside despite the increased volatility in the main US markets of late. This is “inflation” at its finest. In short, the loose correlation with the general market makes commodity based investments very attractive diversifiers.

Politically Induced Policy Measures Assures Of Prolonged Inflation Pains

All these market signals indicates too that the commodity and the “goods and services” inflation pressures being generated by the massive imbalances imposed upon by collective governments in skewing the global marketplace will continue to persist and risks even exacerbating. It is unhealthy to discount the possibility of a US dollar crisis.

In fact, our local politicos and the administration’s actions will likely compound on their dilemma with a slew of unintended consequences arising from their growing hostility towards the market instead of utilizing them for efficient allocation.

To give you an example the recent land conversion ban of agricultural properties ensures of the rising values of real estate which will likewise be reflected on rising rental prices as the supply of non-agricultural properties gets restricted in the face of growing urbanization and expanding population growth.

Figure 5: ADB’s Hyon H Son: Has Inflation Hurt the Poor?

As shown in Figure 5 courtesy of Hyon H. Son of ADB, rental comprises the largest of the non food expenditures for the Philippine poor and also for the non-poor.

So essentially, our government is simply shifting from one form of “popular” burden to another form of “unpopular” burden which eventually will get us slammed overtime anyway. Of course, the trick here is to understand how to cash in from the opportunities presented by the government’s populist impulsive driven policy gaffes.

Government’s Time For Self Introspection

And like all trends, commodities and good and services inflation doesn’t move in a straight line.

And as we also expected, inflationary pressures abroad has filtered to the domestic scene and will continue to do so until perhaps a global stagflationary recession occurs or a policy induced slowdown (tightening) by key Central Banks or nations collectively drop policy distorting measures (quite an impossibility).

Yes, another fulfilled expectations too is our (Bangko Sentral ng Pilipinas) BSP’s tepid response to rising “inflation” by increasing its headline borrowing and lending rates by a measly 25 basis points.

The unfortunate part is that increasing policy rates will do little good because-ONE, our inflation is basically imported, as University of Columbia’s Joseph Stiglitz recently wrote against inflation targeting, ``Inflation in these countries is, for the most part, imported . Raising interest rates won’t have much impact on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, not those in developing countries, should be raised” and-SECOND, raising rates on baby steps doesn’t remove the accommodativeness of the Philippine monetary landscape.

Come to think of it even after raising rates, the margin of our inflation index has been growing wider compared to 1) the country’s economic growth rate or 2) the nominal rates set by the central bank or 3) the yields of our treasury bills, which means like many other central banks around the world, the BSP seems to be fostering an “inflation friendly” negative real rate environment, again another policy induced problem.

Of course not to mention that March money supply growth rate is nearly double or 9.6% of the recent economic growth clip-another prospective contributor to domestic inflation.

So essentially the problem with our government is that they have been looking for scapegoats at the wrong places and have been caviling on the private sector’s contribution to our economic woes, when in fact, it is time for them to do some self-introspection.

Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited.”- George Soros

Activities in the financial markets can never be explained in a straightforward narrative manner.

You’d probably wonder why despite gloomy economic news in the US and in other major developed economies aside from declining corporate profits, global stock markets continue to remain elevated or are surprisingly even advancing.

Moreover, as commodities recently tanked some observers commented that the reason stocks are recovering could be due to falling inflation pressures which could likely improve corporate margins. Such argument appears unfounded.

If it is true that commodities prices have been boosted by soaring demand, then the present pace of decline should imply of contracting demand, which could be reflective of a meaningful downshift in global economic growth, see figure 5.

Figure 5: US Global Investors: Moderating Asian Exports

Asian exports are, as shown by US Global Investors, all rolling over led by a severe decline in US imports. Now the decline has been similarly seen with European imports but in a time lag. Imports of commodity producers have likewise “peaked”.

Thus, by sheer induction, equity asset prices should continue to face pressures from downside revaluation, unless the markets foresee a recovery over the near term (which is very unlikely).

In addition, if it is also true that the falling US dollar have prompted for a commodities “bubble” as argued by some then the recent US dollar rebound suggests of liquidity contraction or a monetary tightening which should also signify negatively for equities too.

Yet, stock markets continue to perform strongly even when seasonality factors such as “Sell in May and Go Away” say it shouldn’t.

Drooling Over US Financials

Meanwhile others have been drooling over at the gains accrued by the US financials following the recent bear market “reversal” marked by the buyout by JP Morgan of investment bank Bear Sterns under the facilitation of the US Federal Reserves. The impression etched by the rallying US financials is that it has bottomed or is on a path towards recovery.

We doubt such premise. To quote Mohamed El-Erian of PIMCO,

``Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.”

This means that even if the Fed have “successfully” patched some of the liquidity dislocations in the financial markets (as evidenced by some improvements or narrowing of credit spreads) by absorbing tainted assets as eligible collateral, recessionary pressures from the real economy could add to its portfolio (consumer) loan losses which are likely to require additional capital raising exercises given the delicately compressed capital ratios, as much it is likely to its impact business operations in an environment of slowing demand, tighter lending standards and reduced investments.

Nevertheless, the disruptions (unidentified losses) in asset securitization remain an unresolved problem aside from the onus of new government regulations.

Global Central Banks Inflating Away….

So, again why are the stock markets surging?

Quoting Fritz Machlup in The Stock Market, Credit and Capital Formation ``... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.”

In contrast to mainstream analysis, our view on the stock market has always covered “inflationary” policies conducted by monetary authorities.

It is a reason why we believe stock markets don’t always relate to the oversimplified tale of micro/macro economics or corporate earnings and may diverge from “realities”. Because central banks can always excessively inflate the system, from which to serially “blow bubbles” in terms of assets or goods as the purchasing power of a currency erodes.

We always love to cite Zimbabwe as an example. The country has been suffering from successive years of chronic hyperinflationary depression whose inflation rate is 165,000%, has 80% unemployment rate and whose currency is traded at Zimbabwe $150 million per US dollar when officially pegged currency is at Zimbabwe $ 30,000 to a US dollar or 5,000x its official rates! You can just imagine the Philippine Peso pegged at 42 to a US dollar but whose black market rate is at P 210,000 to a US dollar.

Yet in spite of the depressed earnings (no earnings to talk about) and a recessionary economy, its stock market has soared by 360% in just three weeks! See the irreverence to mainstream analysis?

We seem to have the same dynamics today in global markets. What we could be witnessing is the impact of concerted REFLATIONARY policies by global central banks. And this has could have spurred the “rotation away” from commodities and into the general equity markets spearheaded by the financials (But this “rotation” isn’t likely to be a lasting trend).

This from Morgan Stanley’s Joachim Fels, ``global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years.”

So essentially, the Fed has been injecting steroids into the financial markets, as much as other major global central have provided liquidity support to a distressed financial system, while emerging markets have long undertaken expansionary policies that has nurtured explosive demand growth in food and energy. In addition the recent spikes of food prices have further aggravated such these inflationary measures of instituting safety nets to buy off political stability.

Figure 6 US Global Investors: Asian Real Rates are Negative!

So circumstantial evidence suggest that the recent bounce in global equity markets could have been in response to the expansionary monetary policies whose real interest rates has somewhat turned negative, as shown in figure 6 courtesy of US Global Investors which accounts for the average real rates in Asia. The region holds about 70% of foreign exchange reserves. Negative real rates are likely to support more leverage driven speculative activities.

Dissent Over Subsidies, Risks of Heightened Inflation and Moral Hazards

And the efforts to subsidize the financial system has not ended in the US as the US Federal Reserves continues to expand the scope of its outreach “nationalization” programs to cover unconventional areas as student loans, credit card debts and car loans as collateral for financial institutions.

Some experts/authorities have expressed dismay over the seeming relentless use of taxpayers money to support the financial sector…this quote from Bloomberg, ``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Two more quotes from the same article,

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The point is that policy measures undertaken by the Bernanke leadership have clearly caused some vocal dissent over the risks of increased inflationary pressures.

Snippets

The snippet of my observations:

-Inflationary activities (marked by negative real rates) by global central banks could have been responsible for bloating global equity markets.

-The recent outperformance of the financials which took away the centerstage from commodities isn’t likely to be an incipient long term trend, as continued inflationary “nationalization” programs are unlikely drivers for such reversal. Moreover, recessionary pressures in the US economy are likely to limit any progress for US financials.

-The commodity cycle works best in a negative real rate environment. This could mean that the recent decline of commodities doesn’t account for a hissing bubble but possibly of a normal corrective phase following its near parabolic ascent.

-The expectation of a reversal of the US dollar long term downtrend coming off a Fed pause is likely to be too optimistic. Since the Fed keeps expanding the reach of its bridge financing bridge facilities, this seems enough evidence that its credit system has not yet normalized and could signify as a considerable obstacle to expectations of an earlier recovery by the US economy relative to the world. In short, the US dollar’s recent rally could be an oversold technical bounce.

-While activities in the US treasuries could imply the end of the Fed rate cycle, this would likely depend on the activities in the US stock market which evidently has been proven as a mainstay barometer of Mr. Bernanke.

-Back to the Philippine Stock Exchange. Against a backdrop of recovering world markets, the Phisix seems to be the only laggard for unclear reasons. Yet, as we mentioned before, excessive negative sentiment, negative yield environment, extremely oversold levels and favorable external developments have recently aligned to suggest of a looming noteworthy tradeable bounce if not a potential bottoming process.

Figure 7: ino.com: Rice Prices Off the Record Highs

If the excuse for this slump has been predicated on the rice crisis, then as figure 7 courtesy of ino.com suggests, such “rationalization” may not hold soon.