Scorecard From This Week's Global Equity Bloodbath

This chart from Bespoke presents a good coverage of this week's resurgent volatility. According to Bespoke,

``As shown, both the G-7 and BRIC countries sit at the top of the list of worst performers. The countries that have held up better are located mainly in the Middle East, Africa, and Eastern Europe.

``Combining the BRICs and the G-7, Russia has done the worst since Tuesday with a decline of 6.33%. But Brazil and the US are not far behind with declines of more than 5%. Italy, France, and Germany are all down around 4.75%, followed by Britain at -3.81%. There has been lots of talk about China partly at fault for the global sell-off, but the country itself is down just 3.64% since 1/19. Japan has by far done the best of the G-7 and BRIC countries over the last three days with a decline of just 1.62%."

While it is true that BRICs got equally hit as hard as the G-7, the picture isn't complete. In any comparison, points of references are important because they can tilt balance of presentation.

Remember, in 2009 the BRICs outperformed the G-7 by a wide wide wide margin hence it should be natural for them to bear the brunt of the recent carnage.

However, last week's selloff reveals that the damage hasn't been significantly different. And if the current correlation continue, one can expect the BRICs to materially outperform its G-7 counterparts anew.

Although as seen from a year to date (or on a 3-week) basis on the left column, the BRICs have marginally underperformed the G-7, however 3 weeks is too early to call.

Nevertheless the overall market conditions should give us some clues.

As mentioned by Bespoke some markets in former crisis plagued Eastern Europe and the Middle East have outperformed.

For instance, Estonia was up 7% on a week on week basis but is up 30% (!!!) on a year to date basis and so with her peers (also based on year to date) Latvia 15.04%, Lithuania 11.29%, Romania 7.2% and Ukraine 7.08 as well as Malta 13.27, Kenya 11.73%, Egypt 9.76% and so forth...

While everyone's focus (as indicated by Bespoke's article) has been on how the key markets got hammered (BRICs and G-7), what may have been ignored by the rest is how the broad periphery (emerging markets) had been vastly unfazed by the ruckus.

This for us, implies two significant messages:

First, that the periphery signifies delayed or belated reaction from the still to be felt ripples or

Second, that many emerging markets will likely show signs of meaningful divergences (decoupling), which could mark the theme for 2010.

And if it is the latter scenario, then this week's meltdown could be suggestive of a bear market trap.

Central Bank Policies: Action Speaks Louder Than Words, The Fallacies of US Dollar Carry Bubble

``The cause of waves of unemployment is not “capitalism” but governments denying enterprises the right to produce good money”-Friedrich August von Hayek

In last week’s outlook [5 Reasons Why The Recent Market Slump Is Not What Mainstream Expects], we proposed that the recent market volatility had most likely been a government mounted attempt to put a rein on “animal spirits” having gone berserk. We also posited that markets, having been overstretched, may have likely reached a snap back point or analogous to the breakage of the crosslinks elasticity as seen in the dynamics of a Rubber band.

In short, we argued that the recent downside volatility could have embodied a “bear trap”- a bearish signal that turns out to be false or a trap.

Market performance, this week, appears to have validated us anew. While short term direction is less of a concern to us as markets can go or gyrate bi-directionally, what matters most is the strategic context of the risk-reward or market analytical framework fused with a tactical approach in portfolio management.

And strategical analysis should consist of objective interpretations of all available facts, underpinned by appropriate definitions and realistically functional theories, and not the selective collection of facts (data mining) that are designed to fit (usually ideological) biases and stamped as “analysis”.

And from this standpoint, we argued that government’s present pronouncements, which recently spooked markets, will eventually be unmasked in the face of grinding realities from the cumulative and prospective political actions and from the prevailing economic and financial conditions.

As we previously said, ``So the Fed’s communiqué and the real risks appear to be antithetical. One will be proven wrong very soon.”

It would seem that this vindication partly happened so soon.

Policy Statements And Actions Diverge

The Fed declared last October 29^th, the end of its Treasury purchase program, ``The Federal Reserve completed its $300 billion Treasury purchase program today amid signs the seven-month buying spree helped stabilize the housing market and limited increases in borrowing costs” (Bloomberg).

I don’t know what the Federal Reserve’s definition of today is, but to my understanding the self-imposed limits of $300 billion and October 2009 has been met yet the Treasury purchase program seems ongoing (see Figure 1).

Figure 1: Federal Reserve of Cleveland: Credit Easing Policy Tools

The Federal Reserve bought nearly $2.8 billion of US treasuries by November 4^th!

So if there is any short term validation, it is that the political actions of the US government have been to continually undertake quantitative easing or further inflationary activities regardless of its official pronouncements.

This only validates our postulation that the US banking system represents as the first order of priority among the many issues of concern by the incumbent US political and non-political leadership. Hence, the massive redistribution of wealth from the real economy to the financial sector and the corollary of accruing of structural imbalances in the pursuit of immediate resolution from short term oriented policies.

The same goes with the Bank of England, which recently declared a continuation of its own version of quantitative easing but at a “slower” pace (Telegraph).

Moreover one shouldn’t forget that equities have also been qualified as an eligible collateral as part of the TARP program.

To quote Mr. Practical of Minyanville (bold highlights mine), ``Under TARP, the fine print allows dealers to REPO stocks to the Fed as collateral (holy cow is right).

``What if there were an arrangement where large dealers buy stocks and stock futures through the day and REPO them to the Fed at the high closing prices? The dealer would book the profits derived from the difference at no risk.

``If you look at the trading patterns of the largest dealers, one in particular lost money trading in only one day last quarter. Statistically that's like finding a needle at the bottom of the ocean.”

What this implies is that the TARP program could be one of the many instruments used to prop up the equity markets.

As we have long been argued, markets today don’t act on the norm or as “traditional” forward indicators, which has essentially flummoxed the mainstream, but as policy instruments engineered primarily to keep the banking system afloat and secondarily to manage the “animal spirits” in order to jumpstart the economy.

As we noted last week, ``The underlying fundamental malaise is that the ‘bank as trader model’ has been a product of the collusion between the banking system and the US government to inflate the economy to the benefit of the elite bankers!”

So if market response this week appears favorable, that’s basically because money isn’t neutral- or money from these governments actions have filtered into equity and commodity assets-regardless of what has been happening in the real economy.

The Fallacies Of The US dollar As The Mother Of All Bubbles

This similarly shows that the allegations that the US dollar carry trade is now the “mother of bubble” isn’t generally true.

That’s because it hasn’t been the carry trade, but direct government liability accumulation via the quantitative easing aside from other government programs designed to reinforce the banking system that has kept the global financial markets at hyper-animated conditions.

Moreover, we take on the cudgels for investment guru Jim Rogers, in his debate with celebrity guru Mr. Roubini over the latter’s thesis that the US dollar signifies as the “Mother of ALL Bubbles” [see Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble].

We argue that the fundamental premise behind the falling US dollar hasn’t been the arbitrage leverage amassing within the private sector financial system especially in the US, which continues to reel from the lackadaisical credit growth amidst signs of surging reserves, but from global governments’ balance sheets.

Mr. Roubini oversimplistically attaches every asset class to the currency leverage, which he extrapolates as having an inverse direct causal relationship: a prospective bust in global assets as a result of delevaraging which should propel for massive rebound in the US dollar. This view has been anchored on (anchoring bias) virtually the same dynamics which made his celebrity “rock and roll star” status during the 2008 meltdown-(letting go of a success identity seems so hard to do!)

Moreover, the surge in commodity prices hasn’t just been a private sector dynamic, instead emerging market governments have played a pivotal role in the elevated state of commodity prices.

India’s recent surprise $6.7 billion purchase of half IMF’s gold’s reserves for sale serve as a major proof.

Figure 2: US Global Investors: China’s Impact On Metals

As one can observe in Figure 2, Chinese imports of metals and steel have exploded!

In addition, in 2009 China’s predominantly state owned enterprises has acquired $21.9 billion of privately owned resourced based companies (80% of which have been oil or energy while 20% have been in metals). Three more acquisitions are still in the process- Nigeria (offshore oil fields), Russia (stake at UC Rusal) and Norway’s Statoil (20 of the 451 drilling leases) [World Bank].

Emerging markets governments’ acquisition of commodities hasn’t entirely been for economic and monetary interests, but likewise has geopolitical dimensions into it. In short, the incentives that drives governments are likely political more than economical.

So it would be plain naïve to lump private sector speculation with government purchases and make a generalized conclusion based on unfounded one size fits all hypothesis.

I would like to further add that the degree of state buying advances our view that markets have been severely distorted by government interventions.

Moreover, unless one views the world as falling into an abyss from globalized deflation (which seems as a near impossibility given the fundamental nature of the paper money standard from today’s central banking and the diversified capital structure of each nation), today’s risk takers including that of governments/ government enterprises seem widely apprised of the risks from high inflation and the accompanying high interest rate regime, which could destabilize or cause heightened volatility in such arbitrages.

These have been evident from

-the numerous and growing clamor (including the United Nations) to replace the US dollar as reserve currency possibly with the Special Drawing Rights-SDR (a controversial rumor was recently publicized by the Independent which alleged that several key emerging markets and developed economies could have been attempting to a form coalition to conduct trade in oil in a basket of currencies outside the US dollar),

-increasing arrangements to conduct bilateral trade away from the US dollar (Argentina-Brazil, Russia-China, a Latin American Bloc),

-expanded currency swap arrangements in Asia, and

-importantly the proposed expanded use of the Chinese remimbi or the Yuan as the ASEAN’s currency standard [see The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency].

Ergo, the accumulation of commodities by emerging markets could function as an insurance against currency volatility, in view of a heightened inflationary environment, as consequence to spendthrift and reckless US national policies that could incite systemic global instability. Effectively, this demolishes the core premise of the “US dollar carry trade mother of all bubble”.

True, there are maybe some parts of the marketplace that has engaged in the carry trade but the overall climate departs from the 2008 environment depicted upon by Mr. Roubini.

``A fiat-money inflation can be carried on only as long as the masses do not become aware of the fact that the government is committed to such a policy. Once the common man finds out that the quantity of circulating money will be increased more and more, and that consequently its purchasing power will continually drop and prices will rise to ever higher peaks, he begins to realize that the money in his pocket is melting away. Then he adopts the conduct previously practiced only by those smeared as profiteers; he "flees into real values." He buys commodities, not for the sake of enjoying them, but in order to avoid the losses involved in holding cash. The knell of the inflated monetary system sounds” admonished Ludwig von Mises. (bold underscore mine)

Put differently, as the public loses trust of the functionality of the prevailing money standard they either look for substitute/s (in the past-resort to barter or a foreign currency-but in this case a new currency standard) or a return to basics…commodities.

Fancy But Unrealistic Models

Of course, one can’t help but point out on the foibles of the highly mechanical traits of analyzing markets from presumptive models utilized by the mainstream that frequently leads to severe misdiagnosis and the subsequent maligned therapeutical prescriptions or perversely flawed actions in managing a portfolio.

Figure 3: Wall Street Journal: U.S. Factories Are ‘Grossly Underutilized’

Low capacity utilization is one of the most frequently used justifications by the mainstream to argue for “low” inflation which is blamed on the deficiency in demand as responsible for “idle” resources. The fundamentally flawed premise of mainstream’s concept of inflation is due to its definition-inflation is seen as rising prices instead of as emanating from money supply growth. Secondly, capacity is viewed in the context where capital is homogeneous.

In the Wall Street Journal article we note of such differences (bold highlights mine),

``Looking beyond the headline number points to another sobering reality: Some industries were hit much harder than others — and therefore have further to go to get back to more normal utilization. Capacity utilization in primary metals plunged from 86% in December 2007 to 55% currently, mainly because of collapsing demand for some types of steel, while the utilization rate in the computer and peripherals industry fell to 58%, down from 83% in December 2007.

``Each industry got hammered by its own mix of headwinds. Computer sales suffered as businesses postponed information technology upgrades and laid off white-collar workers, while makers of big ticket items such as furniture and cars suffered because consumer financing dried up even for those still eager to buy.

``Only a few industries avoided going off the cliff. Capacity usage in the petroleum refining and coal industries fell only 1 percentage point over the last 21 months, while in the food industry, usage declined only 2 percentage points.”

The performances of capacity utilization vary across industries. This extrapolates that the current monetary policies will likely influence relative “overinvestment/s” on specificity basis on a relative circumstances or that over investments will happen in some areas more than the others.

For instance, the implosion of the dot.com bubble in 2000 didn’t put a check on the 2003-2007 US housing bubble cycle from inflating. Moreover, in the recent case of Iceland, both rising unemployment and falling output didn’t forestall inflation, which had been a consequence of the currency’s or the krona’s devaluation [see Iceland's Devaluation Toll: McDonald's].

As Brookesnew’s Gerard Jackson explains, ``Sufficient monetary growth reduces excess capacity by raising the value of the product relative to production costs. (It should be noted that this does not always mean a general increase in prices). However, where inflation is already a force and there is a great deal misallocated capital then a loose monetary policy can bring about accelerating inflation before full operating capacity has been reached and full employment restored.”

Not to mention that the massive interventions put forth by the US Federal Reserve on the banking system combined with fiscal policies aimed at propping up select industries at the expense of the rest of society or as Mr. Jackson avers, ``inflation is already a force and there is a great deal misallocated capital then a loose monetary policy can bring about accelerating inflation”, ergo, the seeds of inflation has been planted, hence inflation is what we will be harvesting.

It’s just the “degree” of inflation that will likely be debated.

In short, mainstream can’t fathom the prospects of a stagflationary environment (at the very least) because of the continued reliance on popular but fallacious models.

Overall, for as long as global political and bureaucratic authorities continue to mount a massive campaign to fillip their respective economies with reflation steroids, we should expect the “Frankenstein” market to respond accordingly. So far the favorable responses will arise from Asia and emerging markets, until the systemic leverage renders them unsustainable.