Relative Economic Growth, Lack of Access to Capital and Global Depression

``With greater wealth comes greater responsibility. This is inescapable. Wealth has a social function. If you own something, you must make decisions about how to use it. Consumers are always bidding for either ownership or the use of your assets. Ownership therefore has a price. If you do not respond to the offer, you are paying this price. You are paying the price in the form of forfeited opportunities. Whatever you do with the wealth, you could be doing something else with it. You cannot escape the responsibility of not doing something else with whatever you own.”-Professor Gary North, Honeymooner Politics

It can’t be an argument from the economic growth perspective too…

Figure 6: IMF: WEO Presentation: Economic growth decelerates Around the Globe

Even as global economic growth has moderated to 4 ½ in the first quarter of 2008 down from 5%, such growth clip is expected to decline further to 4.1% in 2008 and 3.9% in 2009, according to the IMF.

From the IMF’s World Economic Outlook update (emphasis mine),

``Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008.

``Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09.”

In short, despite the moderating pace, the economic growth differentials are still tilted towards in favor of emerging market economies (see left pane in Figure 6).

Moreover, we can hardly buy the arguments from the deflationist proponents of a world depression or near depression see figure 7.

Figure 7: ADB: Asia’s Household Indebtedness

ADB’s data shows of the dearth of leverage or indebtedness of the household sector, which reinforces our supposition of the insufficient access to the banking system by a large segment of the Philippine economy. Similarly this represents both as a shortcoming and as an opportunity (huge growth area).

If the banking system, the main conduit for finance intermediation, has relatively low exposure, it explains why the Philippine capital market likewise lags the region or for most of the world.

It also gives credence to the outlook that a large section of the economy is levered to informal financing channels.

Basically Indonesia and the Philippines could be deemed as primeval cash based society. It also demonstrates why both countries have lagged in the aspects of developments simply because of the lack of access to capital and to paucity of sophistication to lever and recycle capital.

Figure 8: ADB: Public Sector and External Debt as % of GDP

External and Public sector Debt for most of Asia has likewise been materially improving. But the Philippines has the worst position among the peers but has likewise shown significant progress.

Of course past performance may not repeat in the future given the deteriorating conditions abroad, but given the composite framework of the Philippine economy or financials, we need to be substantially convinced of how a depression in the US will result to a depression in the Philippine economy or in Asia. We have discussed in details such linkages in ‘Is the Philippines Resilient Enough to Withstand A US Recession?’.

We also don’t share the view that advanced economies will RECOVER first given the so-called belated effects of an economic growth slowdown contagion to Asia or to emerging markets.

The reason is that the US or UK or countries presently scourged with the deleveraging process is a systemic impairment which will take a longer period for convalescence or for market clearing. Whereas Asia or emerging market’s bear market comes about from the trade and financial nexus with these economies and has not yet been a structural problem (YET).

As a reminder, from every cycle emerges a new market leader, e.g. in the US, the technology sector 1990s-2000 and financials and housing in 2003-2007 (today the energy sector appears to be at the helm) and it is likely that once a recovery phases there will likewise be a new market leader (perhaps the next bubble). And our likely candidate emanates from Asia or emerging markets.

To elaborate further, monetary inflation has been a process INTRINSIC to the fiat paper money/currency standard. Since the impact of inflation is always never equal, it gets to be absorbed in different points of the economy at different times.

For instance in 2003-2007, most of the inflationary actions by global monetary authorities got absorbed in the real estate sector backed by financial securities (structured finance, derivatives, mortgages backed securities, etc…).

Aside, the spillover from these actions led to global arbitrages which spurred a phenomenon of price values of stocks, emerging market debts and commodities.

But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.

BSP’s Actions Should Reflect Sound Money Policies, Philippine Banks Can Afford Tightening

``The whole policy . . . must be looked upon as a case of price-fixing by which the rate of interest . . . was kept artificially lower through an unsound use of government control over banking policy. The results were speculation, inflation of prices, and eventual disillusionment and loss to investors and to large numbers of other citizens.”-Frank A. Fetter Modern Economic Problems, The Century Company

For us, the BSP should continue to raise its policy rates even if the statistical inflation index diminishes in the near term.

Raising interest rates to positive real levels will relieve policymakers of the blame of unbecoming conduct and inducing an inflationary regime, aside from reducing imported inflationary pressures via currency appreciation.

Besides, we believe that the banking sector and the Philippine economy are resilient enough to withstand further tightening.

The pervasiveness of the informal economy stresses the point that LIQUIDITY is the more important variable, since informal financing has made the sector inured to high interest rates or “5-6” microlending schemes as discussed in Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation.

Next is ACCESS TO FINANCING. As testament to the low penetration level of the banking sector, according to BSP chief Amando Tetangco Jr., ``Rural banks alone cover around 80% of the total municipalities in the Philippines with nearly 730 banks and over 2,000 branches nationwide.”

But of course, with the composition of investment patterns that are likely to shift towards resource or commodity oriented industries in the rural areas, the growth of rural banks according to our BSP chief has been ``faring equally or even better than its universal, commercial and thrift bank counterparts while remaining true to its core mission of serving the needs of the countryside.” And this trend is likely to get better.

Another, mainstream bank financing growth has improved modestly but has been concentrated to mostly consumer lending. The Philippine Daily Inquirer quotes BSP Deputy Governor for bank supervision BSP Deputy Governor for bank supervision Nestor Espenilla Jr. ``Loans to the corporate sector haven’t been growing too much. What’s driving growth is consumer loan and basically this mirrors the vibrance of the consumer sector of the economy. This has something to do with the [overseas Filipino] remittance story,” he said."

In short, the expanded rural income will probably be helped by remittances and will continue to find financial intermediation support from the banking sector, most especially from the rural areas.

Finally, in consideration of overall bank intermediation, this statement from the IMF ``Despite substantial progress in reducing NPAs, they remain large and depress bank profits. Bank lending remains low, well below funds raised in the capital market in 2007, as banks are willing to lend to only their best clients. The credit reporting system is poor, only 5½ percent of adults are currently covered, and an inefficient bankruptcy code extends recovery time to 5¾ years and reduces recovery rates to 4¼ percent.”

In other words, bank lending remains highly conservative, given the shortcomings of credit reporting or bankruptcy code as the IMF cites which indicates need for administrative reforms.

Moreover, the anguish from the Asian Financial crisis probably remains impressed on our bankers, hence the functioning hindrance in the access to credit.

These are some other banking highlights from researchandmarkets.com, which suggests of the vitality of our banking sector (highlight ours)

- Deposit mobilization is concentrated with universal and commercial banks, which account for the majority of the Philippine banking industry deposit.

- Financial Intermediation was the largest shareholder of the loan disbursal by banks during 2004-2007.

- Bancassurance will account for 65% of the total sales of insurance products by 2011.

- Increasing at a CAGR of 69.78%, microfinancing in the Philippines is expected to reach 56.5 Billion Pesos.

- Increasing mobile penetration will expand the mobile banking user base to more than 11 Million by 2011.

With reference to the Philippine Stock Exchange, some suggested that increasing rates will reduce the public’s incentive to invest in the stock exchange.

This premise will probably hold true if local participants dominate the trading activities. The fact is that only a scant segment of the Philippine society of approximately 1% has invested in the PSE directly and indirectly, which means that foreigners are likely to remain as main navigators of the Phisix. And our guess is appreciating currencies, controlled “inflation”, and improving balance sheets are more of an attraction once the financial chaos in the system settles than simply rising interest rates.

Bottom line: Interest rates are not the only variable that will determine capital flows. The BSP can afford to raise rates by responsibly closing the gap of the real interest rates and at the same time addressing regulatory reform issues, while the Philippine banking system given the present economic conditions can afford to withstand such tightening measures.

Phisix: Learning From the Lessons of Financial History

``Here’s the thing: When you get diversity breakdowns in markets, you get bubbles and crashes. When you get diversity breakdowns in societies, it’s ideologically similar. As Scott Page has shown, diversity (markets, ideas, ecologies) is a key to stability and growth.”-Josh Wolfe, Forbes Nanotech

In loving memory of my uncle Marciano U. Te (January 2, 1926-July 7, 2008)

``“The mistakes of a sanguine manager are far more to be dreaded than the theft of a dishonest manager," wrote Walter Bagehot. The best protection against excessively sanguine beliefs is the study of financial history, with its many examples of how easy it is to be plausible, but wrong, both as financial actors and as policy makers. Perhaps we need a required course in the recurring bubbles, busts, foibles and disasters of financial history for anyone to qualify as a government financial official. I have the same recommendation for management development in every financial firm.” Thus wrote veteran banker Alex Pollock, a resident fellow of the American Enterprise Institute, in advocating that the lessons from Financial History represents as the paramount guide into shaping of regulations-where history manifests of a slew of policy actions in reaction to market developments and their unintended backlashes-or for financial actors when divining portfolio strategies.

The most common problem we observe is that the public loves to adhere to simplified understanding of a complex problem, usually sourced from mainstream news, and apply nostrums as solutions. Whether it is the rice crisis, stratospheric oil or energy prices, or Phisix bear market it is basically all the same, we find a culprit, pin the blame on them without examining in depth why all these came about and worst, proffer solutions that are usually knee jerk responses bereft of historical morals which usually gets us mired into more trouble in the future.

Understanding the Phisix Bear Market

The Phisix, like most of the major equity benchmarks in the world including the US, is in a technical bear market, down by nearly 40% (37% to be exact based on Friday’s close). Since mainstream media is so fixated with oil and food, thus accordingly our market is likewise allegedly bogged by such issues.

We hardly hear any voice including from our so-called high profile experts in dealing with other pertinent issues: the continuing gridlock in the global credit market, the worsening economic slowdown in major developed worlds as a result of the deflating housing bubbles and attendant signs of contracting liquidity or monetary tightening in the global marketplace which has now become discriminate.

Of course, we do not share with depression advocates the view that the world is headed for Armageddon or that global financial “decoupling” is a fiction. As we mentioned, shrinking liquidity has made investment destinations become rather choosy or discriminate and our observation of Africa (see Recoupling and Inflation Doesn’t Explain Everything…) as benefiting from the present environment has been corroborated by the Economist magazine (emphasis ours),

``At the start of this year, some 15 sub-Saharan African countries had stockmarkets, listing some 500 companies with tradable shares and a combined market capitalisation–excluding relatively mighty South Africa's–of $100 billion, according to a report from Goldman Sachs, “Africa Rising”. Since then, these markets have mostly soared ever higher, even as shares everywhere else have plunged to earth. The best performing stockmarket among this impressive bunch is Ghana's, up by one-third so far this year.”

If this isn’t “decoupling” then I don’t know what this is suppose to represent.

Is it not a wonder why Africa seems immune to the same problem we or the world have been suffering from? Is it not the Philippines an “economically” better positioned compared to these states? So what’s the difference?

Honestly speaking, we don’t have an answer to everything although we do have some suspicions (prolonged years of underinvestment, prevailing commodity resource boom, probable portfolio rotations and China’s growing role in financing Africa’s infrastructure investments).

But there is one thing we can be sure of; if the premises cited by our financial experts do not seem to be applicable to African states, whom are supposedly in a far inferior position relative to us (based from the standpoint of economic statistics) or to most of our neighbors, then the likelihood is that the same conventional justifications used at our end stands from tenuous grounds.

Financial History And The Phases of Bear Markets

Figure 1: Phisix: History Shows 4 Bear Market Cycles

This brings us to financial history.

Financial markets are basically characterized by market trends borne out of the transitions of overinvestment-underinvestment cycles or commonly known as the Boom-Bust cycles.

Bear markets functioning as the other major market trend (other one being the Bullmarket) may constitute as either primary/structural/secular or secondary/cyclical/countertrend.

Primary-secular-structural bear market usually signifies the unwinding of previous excesses built up within the marketplace- as seen by massive overvaluation, speculative excesses (proliferation of margin trading) and “this time is different” euphoric attitudes- financed by too much debt or leverage in the banking system and or capital markets to the point of massive asset-liabilities mismatches which likewise reflects on major imbalances within an economy.

It may also represent fatalistic or defeatist government policies; remember the 5 cardinal sins-protectionism (nationalism, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Overall, structural or secular bear markets reflect internal or endogenous adjustments as a result from these malinvestments or bungled policies.

On the other hand secondary-cyclical-countertrends are simply trends that correct temporarily against a major trend. Remember since no trend goes in a straight line major trends are likewise confronted with major corrections, and this could be triggered by many superficial factors.

The Phisix has not been a stranger to bear markets. In the past twenty two years we have seen four bear markets which equally reflect both cyclical and secular or structural (see figure 1) phases.

The Cyclical Phases (as measured by peak to trough)

Following EDSA I, the Phisix soared by TEN times before:

1. August 1987 to October 1988- the Phisix lost about 45% and consolidated for 13 months before recovering and resuming another attempt to the upside. The trigger for the bear market in 1987 – ex-Col. Honasan’s August 28^th Black Friday’s botched coup d'état against erstwhile President Cory Aquino.

2. November 1989 to October 1990- the Phisix lost about 62% in about 11 months before convalescing. The trigger for the bear market of 1989 -November 30^th Makati coup again by ex-Col. Honasan.

The aftermath to the last cyclical bear market saw the Phisix soar by over 5 times to its 1997 high of 3,447.

As you can see, political upheavals such as the past aborted coup attempts could serve as triggers to bear markets.

The Structural/Secular Phase (as measured by peak to trough)

Figure 2: IMF: Asia: A Perspective on the Subprime Crisis

Figure 2 from IMF’s Khor Hoe Ee and Kee Rui Xiong reveals of the similarity between today’s subprime debacle in the US and the 1997 Asian experience.

Abundant liquidity, massive capital inflows, overcapacity from overinvestments, loose credit standards, soaring assets fueled by leverage, inordinate foreign currency debts, conflicting interests from participants (agency problem) and moral hazard among others have been enumerated as main contributors to these pair of boom bust cycles.

In the Philippine financial markets, the angst from the fundamental adjustments of the 1997 crisis was mainly expressed via massive price revaluations as the sharp depreciation of the Peso, the collapse in real estate prices and the initial collapse of the Phisix.

Again what must be remembered was that even if the bubble popping contagion was seen from a regional perspective, the imbalances brought about by the above factors was seen in the construct of the domestic economy and in the local financial markets. In short, the bubble was internally generated as much as it reflected the region’s activities.

This leads us back to figure 1, the secular bear market of the Phisix…

3. February 1997 to October 1998-the Phisix lost 66% in about 20 months. But following the election of President Joseph Estrada, the cyclical Presidential honeymoon period led to the Phisix rebound of 120%. This could be interpreted as the cyclical bullmarket within the secular bear market.

4. July 1999 to November 2001- the Phisix lost 62% in about 28 months for the culmination of the secular bear market cycle. Oddly, the Phisix appear to trace the developments in the US markets or when the Nasdaq dot.com bubble imploded in 2000, for a huge chunk of this cycle.

From the above we learned that it is very important to distinguish between the basic compositions of market trends. Why? Because, the torment from a secular bear market relative to the cyclical bear market is far worse in terms of depth (longer duration for adjustments) and scale (larger degree of losses). Thus you can make your portfolio adjustments to reflect on the risks involved once you can categorize which part of the cycle we are into.

In general, the internal market configurations and domestic economic structural dynamics determine the adjustments reflected in the financial markets from which demarcates the cyclicality or secularity of a given trend.

Alternatively, this means that if today’s problems emanates from exogenous factors then unless it becomes severe enough to fundamentally alter the present economic and financial landscape, we should expect the present bear market to represent the cyclical nature of today’s underlying market trends.

No Bubble: A Reprise!

Have we been in a structural bubble? No, as we scrupulously argued in Phisix: No Bubble! Time for Greed Amidst Fear.

Figure 3: IMF: Improving Balance Sheets and No Property Bubble

Even IMF’s Khor Hoe Ee and Kee Rui Xiong argues in their piece that balance sheets of corporate debt levels have been markedly improving in Asia, aside from modest property appreciation seen relative to the advances in Europe and the US see figure 3.

But there are always exist some form of risks most likely coming from a contagion, quoting Mr. Khor and Mr. Kee (highlight mine),

``Even so, Asian policymakers must watch for remaining risks from the subprime crisis that could pose problems for Asia. These include what a Standard & Poor's report called a possible "triple whammy" on banks: more subprime-related losses, an adverse impact on Asian financial markets that affects banks, and an adverse impact on Asian economies that affects banks.

``But to date, such impacts seem muted. Asian banks are engaged in traditional bank lending and are not heavily exposed to the more sophisticated types of financial products that have hurt financial sectors in many industrial countries. However, a decline in the real economy as a result of economic declines in the United States and Europe could cause a significant deterioration in the quality of bank loans.”

Since the banking system has been the foremost conduit for the financing of most the Asian economies, all eyes should now focus on how banks will adjust to the ensuing downdraft in the economic growth of developed countries or from the junctures of rising “inflation”.

This I think is what the global financial market has thus far priced in, aside from the ongoing delevaraging process that has fomented the forcible selling of most liquid asset classes by institutions caught in the web of illiquidity stasis.

And if Asia is not a bubble then the likelihood is that the bear market arising from the present contagion conditions as mentioned above could be likewise be cyclical and temporary in nature. If our analysis is correct then we should see the rendition of the same patterns even amongst our neighbors.

Vietnam climbed about EIGHT times from late 2003 and has corrected 66% over the past 8 months. Today, the much ballyhooed “next China” seems to be healing (but needs further confirmation) and is up 20% from its most recent lows.

India likewise soared nearly FIVE times over the past four years and is down nearly 40% from the peak and could see still some selling pressures. Whereas China’s Shanghai index skyrocketed 4.5 times since only 2005 (or a bullmarket of about 2 years old!) and has surrendered 57% of those gains (based from its recent peak prices).

Meanwhile, our neighbor Indonesia has climbed about 4.5 times also since 2003 and has contracted by 32% during the first panic in August of 2007, but interestingly remains above this level. The JKSE is also presently above its April lows (-23% from peak) and is today down by about 20%.

On the other hand, our Phisix has trailed all of them up by only 280% from June 2003 to October 2007 and has touched the 40% threshold of losses just the other week.

Another, in a structural bear market practically all issues are supposedly headed for the gutters, but this isn’t the case today. In fact some issues have been trading within their 2007 highs: namely, Pilipino Telephone (PLTL), Petron Corp (PCOR) and Oriental Petroleum (OPM), or at near historical highs Manila Water (MWC), Philodrill (OV) and Semirara Corp (SCC).

Again these are empirical evidences that today’s bear market is cyclical in nature.

The point of this exercise is to show you the following:

1. Relativity of the performance of the previous upside and the present downturn matters. Market trends are generally determined by the longer term trends and are usually impeded by intermittent secondary or cyclical-counter trends.

2. Experts usually use existing headline information to account for present market actions but whose analysis can be shown NOT TO BE CONSISTENT with the broader market picture or if taken from a macro perspective. To quote self development author Robert Ringer, ``A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

3. Since people by nature are hurt by the prospects of pain more than the delight from future gains-this accounts for a cognitive bias called LOSS AVERSION- thus, losses tend to be fast and furious, even during cyclical markets due to the impulsive nature of investors.

4. If the recent losses signify cyclicality and not structural impairments then the gist of the losses appear to have been priced in for many of Asian markets (Barring any massive shocks from external channels, e.g. stock market crash in the US or UK). This is not to imply that they can’t go lower. What we mean is that the scale of losses will probably be much lesser from this point on or the degree of losses could be in the process of culminating.

5. The cyclicality, tendency to overshoot, false premises and relative performance combines to reinforce the likelihood of a faster than expected recovery.

6. Finally we are not in the practice of financial voodooism to suggest when exactly the turning point will be. From our perspective, using the lessons of the financial history, we should use the present crisis as an opportunity to grab worthwhile investment themes which are likely to be selective given the present character of heightened risk aversion.

To quote PIMCO’s co CEO Mohamed El-Erian (emphasis mine),

``Today's markets are particularly tricky as they provide the duality of both great opportunity and enormous risk. And in contrast to recent years, investors will not be able to appeal to a few macro themes; be they bullish ("the great moderation" and "goldilocks") or bearish ("debt exhaustion" and the collapse of structured finance). Instead of the phase of highly correlated market moves, up and then down, we will witness the gradual assertion of fundamental differentiation between market segments and for instruments in the capital structures…

``This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion.”