``And this is the problem with just about every lame speech, every overlooked memo, every worthless bit of boilerplate foisted on the world: you write and write and talk and talk and bullet and bullet but no, you're not really saying anything...Most people work hard to find artful ways to say very little. Instead of polishing that turd, why not work harder to think of something remarkable or important to say in the first place?” Seth Godin, But you're not saying anything
In this issue:
Why The Philippine Phisix Will Climb The Global Wall Of Worries
-The Variable Influences Of Markets On Profits
-The Relative Effects Of Inflation To Prices And Real Returns
-Inflationism Via Deficit Spending
-The Austrian Business Cycle Applied To The Philippine Economy and Markets
IT should come as no surprise to the readers of this post that the Philippine equity benchmark, the Phisix, recently smashed its barriers to set a new 29 month high.
Simply put, this has been part of the long cycle, which we have been pointing out since 2008[1]. And not only that, we made the case that the recovery of 2009 would be anchored on today’s events[2]. Apparently the markets have been steadily validating our views.
The Variable Influences Of Markets On Profits
But what has come as a big surprise is that the recently established milestone seems to be in defiance of the prevailing doldrums seen in the global markets.
Although we have repeatedly been asserting that “decoupling” or divergences would be hard to realize (see figure 1), considering the deepening instances of globalization- in terms of trade and investment flows, labor and migration and importantly, synchronization of monetary policies - any outperformance would likely emanate from parallel, or at least, near parallel circumstances.
And where today’s markets have seen a trend towards the deepening of interrelationships, there will be little instances of disregard when local markets will be confronted by adversarial forces such as recessions from major economies, another bout of paroxysm in the global banking system and or a bear market from tightened money conditions. Here, divergences in the marketplace will hallmark exceptions, rather than the rule.
Figure 1: stockcharts.com: Tidal Flows Of Asian-US Markets
As one would note from the chart, Asian markets (ex-Japan and China) have basically exercised synchronized actions, where the motions of ebbs and flows seems to be uniform. The difference is in the extent or the degree of the surges and or the depths of the retracements. And since I can’t seem to adjust the chart on a year-to-date basis, I have instead presented this based on the available node.
Nevertheless, on a year-to-date basis, you’d be surprised to learn that emerging frontier stocks[3] have vastly outperformed the region.
Here is the pecking order of Asia’s best performers based on Bloomberg’s Asia-World Index[4] as of Friday’s close: Mongolia’s MSE Top 20 (49.32%), Bangladesh’s DSE Gen (36.76%), Sri Lanka’s Colombo All Share (28.61%), Indonesia’s JKSE (11.4%), Philippine Phisix (9.97%), Thailand’s SETI (5.02%), Pakistan’s Karachi (2.66%) and Malaysia’s KLSE (1.7%). All the rest of MAJOR Asian markets are in red led by China’s Shanghai Index (-22%).
The outlier gains can be categorized into 2 classes: Frontier South Asian markets and emerging Asia or ASEAN markets.
As a reminder, I am categorically NOT saying that decoupling can’t or won’t ever occur; that would seem like anchoring too much onto current developments. As the ubiquitous axiom goes, ‘Past performance may not guarantee future outcome’ or whatever we see today may or may not be tomorrow’s dynamics or trends. Hence interpreting today’s market activities linearly and discounting randomness is likely to be highly flawed (this should apply to perma bears).
What I am saying is that decoupling may not be ripe yet. As evidences lucidly demonstrate developed Asian markets have had tight correlations with the S&P 500, except for frontier markets and partly developing Asia.
Thereby unless we see deepening signs of “divergences” it would seem foolhardy and reckless for anyone or for any experts to allege for a “decoupling”.
Yet in a world of relative returns, where asset classes ALL compete for your or everyone else’s “scarce” money and where globalization has naturally defined boundaries, theoretically, real returns should be distinct for every country.
Globalization has its natural limits predicated on the idiosyncrasies inherent in each nation such as cultural preferences, political economic structure, political trends, degree of economic freedom, depth and sophistication of markets, demographic trends, breadth of education, quality and quantity of, as well as, access to labor, tax, regulatory and legal framework, security, maturity and effectiveness of social institutions, level of infrastructure development and many more.
And such disparateness account for as “false prices” that convey profit opportunities for entrepreneurs. Since “false prices”, according to Israel M. Kirzner[5] ``reflect the decisions of entrepreneurs who have not yet understood the correct implications of consumer preferences (present or future) for the relative values of resources today. The way in which entrepreneurial activity tends to correct such false prices is through their realization of the profit possibilities inherent in such false prices.” (bold emphasis added)
In genuinely free markets, the profit gaps tend to converge or disappear, as Ludwig von Mises wrote[6], ``If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses. The prices of all the factors of production would already today be fully adjusted to tomorrow's prices of the products.” (bold emphasis added)
So while the proclivity of free markets has been to converge or narrow the differentials in entrepreneurial profits or as seen on real returns, the inherent obstacles to free markets function as divergent profit windows for opportunities which serve to distinguish the level of real returns.
And the variability in the performances of frontier and emerging markets vis-a-vis developed economies appear to be highly demonstrative of this phenomenon.
Since developed Asian economies have been more integrated with Western economies, the returns exhibit close correlations with the latter as compared to the less integrated economies as seen in emerging Asia and the Asian frontier markets.
The Relative Effects Of Inflation To Prices And Real Returns
Well globalization isn’t limited to only trade, finance or labor, but similarly to market’s response to the conduct of monetary policies as well (see figure 2).
Figure 2: MoneyWeekAsia[7] and ADB[8]: Annualized Total Return On Equity and Policy Rates
Yet it’s fundamentally naive to argue that markets solely reflect on the real returns from the real economy in a world of central banking or outside of politics.
As we have shown in the past, in 2007, the components of total nominal returns for the major US bellwether the S&P 500 can broken down into: 20.9% capital growth, 53.8% dividends and 25.29% inflation.
I wrote then[9],
``Notice that inflation had been a factor only since the US Federal Reserve was born in 1913. Prior to 1913, equity returns had been purely dividends and capital growth.
``And further notice that the share of inflation relative to total returns has rapidly accelerated since President Nixon ended the Bretton Woods standard by closing the gold window in August 1971 otherwise known as the Nixon Shock.
``To add, the share of inflation has virtually eclipsed the growth in real capital!!!”
And over the years, inflation as a share of equity returns has indeed been ballooning. Therefore to ignore the influence of inflation is to patently misread the markets, since inflation has been the fastest growing segment in the relative total real returns on equity markets.
And this hasn’t been a US phenomenon but a global phenomenon.
The chart in the left window of figure 3 illustrates of the contribution of inflation to the relative real returns on major global equity markets while the right window reveals of how Asian authorities responded by jointly slashing policy interest rates.
From 1900-2009, inflation composed over 50% of the annualized total returns on equity assets in Italy, Japan, Denmark and Finland, while the rest of the markets accounted for over 25%, this includes the US, except for Switzerland (CH).
Yet the mainstream misinterprets inflation as either having little effects on the real economy or having insignificant impact to earnings. This is patently false.
First of all, inflation is always political. It involves the redistribution of resources which stem from political preferences by the political instead of the consumer demands, and consequently creates favoured sectors or classes.
According to Henry Hazlitt[10], (bold emphasis mine)
``Inflation, in brief, essentially involves a redistribution of real incomes. Those who benefit by it do so, and must do so, at the expense of others. The total losses through inflation offset the total gains. This creates class or group divisions, in which the victims resent the profiteers from inflation, and in which even the moderate gainers from inflation envy the bigger gainers. There is general recognition that the new distribution of income and wealth that goes on during an inflation is not the result of merit, effort, or productiveness, but of luck, speculation, or political favoritism. It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”
Next, the impact of inflation isn’t absolute both in terms of degree and in time scale. Instead, the effects of inflation have always been relative or dissimilar.
In other words, since inflation is a redistributive political process, groups that directly benefits from government redistribution programs are bestowed with the privilege of acquiring goods and services from yesterday’s “cheaper” prices by bidding up resources which forces up prices at the expense of those that don’t benefit from such programs.
Again Henry Hazlitt[11], (bold highlights mine)
``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation”
And in contrast to mainstream expectations, inflation does not impact every aspects of society at the simultaneously.
More from Henry Hazlitt[12], (bold highlights mine)
“What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money. Putting the matter another way, the value of the monetary unit, at the beginning of an inflation, commonly does not fall by as much as the increase in the quantity of money, whereas, in the late stage of inflation, the value of the monetary unit falls much faster than the increase in the quantity of money. As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a "shortage of money."
This uneven distributional dynamics of inflation as exhibited through the variable changes in pricing mechanism is mainly due to psychological factors based on the expectations ``concerning the future quantity as well as the future quality.”
In other words, the direction of political developments ultimately shapes social psychology which impacts inflation in the mainstream economic sense.
And this is why despite mainstream’s tautology about deflation, whether in Greece[13] or in Hungary[14] or the US[15], political economic events have been manifesting signs of emerging stagflation rather than Fisherian paradigm of debt deflation.
Inflationism Via Deficit Spending
And how has inflation been transmitted into equity assets?
We see such transmission in two major ways, one is deficit spending and the other is artificially suppressed interest rates.
Figure 3 Asian Development Bank: Fiscal Balance[16] and Yield Spread[17]
While most of the deficit spending has been attributable to infrastructure projects, perhaps some of them may have surfaced through the recently held elections, wherein part of these funds could have ended up in the local equity markets.
In the Philippine Stock Exchange, among the sectoral indices, it is the Holding index which has posted the most significant increase (up 40.49%) as of Friday’s close on a year-to-date basis, whereas the Phisix is up only by 9.97%.
And many of the component issues in the index are involved in infrastructure directly or indirectly, e.g. Aboitiz Equity Ventures (+122%), Ayala Corp (+7.44%), SM Investments (27.69%), DMC Holdings (72.68%), JG Summit (134.82%), Benpres Holdings (8.57%) and Metro Pacific (11.54%).
Nevertheless, for a local expert[18] to predict for an economic slump arising from the slack in deficit spending signifies as sheer nutcase. If printing money has been the solution to all social problems then people need NO reason to work, save and invest and Zimbabwe would have been the most prosperous in the world.
Yet such presumptuousness exhibits Kip’s Law where “Every advocate of central planning always — always — envisions himself as the central planner” and is symptomatic of the arrogance of omniscience. Friedrich A. Hayek demeans such haughtiness as “Fatal Conceit”, where he says, ``The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”
I find Hayek comments almost accurate, as most high profile liberals, seen in media foreign or local, can’t even predict the markets accurately or has used “fear” or “pessimism” to argue for more interventionism and inflationism in order to uphold their personal or their corporate interests.
The same holds true for bureaucrats, most of them can’t prosper through markets and instead opted to use pretentious expertise to get employed in governments and have their personal interests bankrolled by taxpayers, all in the name of public service.
The Austrian Business Cycle Applied To The Philippine Economy and Markets
Going back to the second channel where inflationism appears to be taking place is in the suppressed level of interest rate.
An artificially lowered interest rate regime is a policy that punishes savers and creditors in favour of debtors. Low interest rates essentially fuels boom bust cycles. By engendering false signals through makeshift appearance of a deluge of savings, artificially suppressed rates entices businessmen to undertake long range investments, but which are not aligned with consumer preferences. Hence, such undertaking would account for as “malinvestments”.
Under free markets conditions, where rates are determined by consumer preferences, such projects won’t emerge since they won’t be viable.
And such malinvestments would run in conflict with the consumers who would use false signals from low interest rates to expand consumption.
And the ensuing collision between short term oriented consumer preferences and long term investments leads to a race to consume resources which eventually results to higher prices, higher interest rates and an eventual bust.
Thomas E. Woods Jr. observed of the typical Austrian Business Cycle in the “Forgotten depression” of the 1920s[19], (bold highlights mine)
``When the market's freely established structure of interest rates is tampered with, this coordinating function is disrupted. Increased investment in higher-order stages of production is undertaken at a time when demand for consumer goods has not slackened. The time structure of production is distorted such that it no longer corresponds to the time pattern of consumer demand. Consumers are demanding goods in the present at a time when investment in future production is being disproportionately undertaken. Thus, when lower interest rates are the result of central bank policy rather than genuine saving, no letup in consumer demand has taken place. (If anything, the lower rates make people even more likely to spend than before.) In this case, resources have not been released for use in the higher-order stages. The economy instead finds itself in a tug-of-war over resources between the higher- and lower-order stages of production. With resources unexpectedly scarce, the resulting rise in costs threatens the profitability of the higher-order projects. The central bank can artificially expand credit still further in order to bolster the higher-order stages' position in the tug of war, but it merely postpones the inevitable.”
Today, the artificially low interest rates in the region, has prompted the Philippines to account for the steepest yield curve (chart 3 right window). The Philippines has been followed by Indonesia in 2009 and by Hong Kong, India and Singapore in 2010.
A steep yield curve usually prompts for financial institutions to engage in maturity transformation where they “borrow short-lend or invest long” or the conversion of short term liabilities into long term assets[20].
And it is no coincident that Indonesia has outperformed the region followed by the Philippines in terms of today’s stock market performances while there have been ongoing concerns over brewing property bubble risks in Hong Kong[21] and Singapore[22].
Meanwhile, India has raised interest rates for the second time[23] along with China and Brazil as Indian authorities have been fretful of economic overheating as credit growth[24] has accelerated.
One very important distinction why credit response have been gaining traction in Asia compared to her contemporaries in developed economies has been due to numerous factors, which as we have previously mentioned[25], consists of “low systemic leverage, high savings rate, unimpaired banking system, current account surpluses, a trend towards deepening regionalization and integration with the world economy.”
In the Philippines, I have been receiving loan offers via text or via call center agents in countless times over a given week. This anecdotal evidence perhaps could be representative of the (yield curve) incentives guiding the domestic banking industry today.
Nevertheless, the impact of low interest rates have been almost clinically precise, according to how the Austrian Business cycle model should operate, credit growth is seen widespread, in domestic consumer loans[26] (+8%), automobile loans[27] (22.1%!), real estate loans[28] (+4.9%), credit card receivables[29] (+4%), the banking industry’s exposure to real estate[30] (+9%) and other consumer related loans[31] (+5.9%) have been variably higher on a year to date basis.
All these seem to exhibit incremental growth in long term investments (via housing or the property sector) and simultaneously an increase in consumer durable consumption via bank loans.
So credit growth alone seems more than enough to provide “traction” into the economic growth cycle which doesn’t merit more fiscal spending. Yet if a full blown bubble cycle occurs sometime in the future, where a bust is the endgame, the country will be out of ammunition to conduct policy based “automatic stabilizers” if government spending continues to swell today.
Let me further drive the point that one possible reason why the Phisix appear to be resilient is that the trend of foreign uptake has been diminishing.
In the recent past, I have demonstrated[32] how the share of foreign trade have diminished from more than 50% in (2003-2007) to about 30-40% today.
Yet in contrast to claims where foreign houses have been bullish and where foreign money are expected to balloon, the fact is, we seem to be seeing little participation from foreigners during this run (see figure 4), except for some occasions.
Figure 4: PSE: Year To Date Net Foreign Trade In (Thousands)
My guess is that foreign appetite for Philippine stocks will become apparent when the US dollar index starts to decline. And once foreign money comes in this will be a huge boost to the domestic market.
So streams of evidences suggest to us that locals have been very responsive to the monetary stimulus from an artificially low interest rate regime.
Of course the icing to the cake will always be psychology.
And people subliminally entranced by a low interest rate regime will always look for rationalization or resort to assorted cognitive biases to justify their actions, whether it is politics—“hallelujah a New incorruptible regime!!!” or through attractive valuations (see figure 5).
Figure 5: Money Week Asia[33] and ADB: P/Book Ratio (ex-Japan) and PER (Asia)
Experts may argue that low price to book ratio and modest Price Earnings Ratio for Asia would make her a buy.
The point is inflationism creates an illusion of prosperity by inflating asset bubbles in domestic market such as in the Philippines or in the Asian region, which eventually would exact toll on the society. The normative outcome of any bubble bust would be high rate of unemployment, output and capital losses, political turmoil, aside from a lowered standard of living via more incidences of poverty.
Yet many will be unaware of how these dynamics influence the real economy via market price signals and distortions in the economic structure.
On the sidelines I’d like to add that once the new Philippine President assumes office, my bet is that popularity ratings will decline as people’s “sanguine” expectations will be envisaged with political reality. However the rate of decline is something we can’t foretell.
We seem to be seeing this today in the US, and an even worst episode recently just took place in Japan, where Yukio Hatoyama[34] the former Prime Minister (PM), because of an astounding nine month collapse in popularity ratings, was forced out and had been replaced by newly elected Naoto Kan[35], who now serves as the 5th PM in about three years!
None the less, declining popularity ratings of political leaders and stock market performances have had little correlations. Although, a seemingly attractive subject, this would make for a good discussion sometime in the future.
Figure 7: Cleveland Federal Reserve: Credit Easing Tools
[1] See Focusing On The Future: the Phisix and the Philippine Presidential Cycle
[2] See 2009: Phisix and Peso Will Advance!
[3] Frontier markets are a subset of emerging markets, where the difference compared with developed emerging markets lies in the liquidity market depth or market depth, market capitalization and lower correlation. See Wikipedia, Frontier Markets
[4] Bloomberg World Index, Asia
[5] Kirzner, Israel M. Reflections on the Misesian Legacy in Economics, Mises.org
[6] Mises, Ludwig von, Entrepreneurial Profit and Loss, Chapter 15 Section 8 Human Action
[7] MoneyWeekAsia, Why Asian currencies will keep going up Interest rates will have to rise in Asia
[8] Asian Development Bank, Capital Markets Monitor, May 2010
[9] See Worth Doing: Inflation Analytics Over Traditional Fundamentalism
[10] Hazlitt, Henry Hazlitt, What You Should Know About Inflation p.130
[11] Ibid
[12] Hazlitt, Henry The Velocity of Circulation
[13] See Is Greece Suffering From Deflation?
[14] See Is Hungary Suffering From Debt Deflation?
[16] Asian Development Bank, Bond Monitor March 2010
[17] Asian Development Bank, Capital Markets Monitor, May 2010
[18] Inquirer.net, RP economy headed for slump, says former national treasurer
[19] Woods, Jr. Thomas E., The Forgotten Depression of 1920
[20] Wikipedia.org, Financial Intermediary
[21] Marketwatch.com, Is Hong Kong ready for reverse property bubble?, February 28, 2010
[22] The Temaske Review When will Singapore’s public housing bubble burst?, February 28, 2010
[23] Investors.com, Money Policy Tightens In Brazil, India, China, June 1, 2010
[24] Business Standard, Bank credit up 18%; infra sector gets lion's share June 3, 2010
[25] See What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?
[26] Bangko Sentral ng Pilipinas, Consumer Loans Reach P417 Billion in First Quarter 2010, June 4,2010
[27] Bangko Sentral ng Pilipinas, Automobile Loans Up by 5.5 percent From Last Quarter, June 4,2010
[28] Bangko Sentral ng Pilipinas, Residential Real Estate Loans Up By 3.5 Percent From Last Quarter, June 4,2010
[29] Bangko Sentral ng Pilipinas, Credit Card Receivables Stand at P130.7 Billion in First Quarter of 2010, June 4,2010
[30] Bangko Sentral ng Pilipinas, Exposure to Real Estate Sector Up 1.8 Percent in 1st Quarter, June 4,2010
[31] Other CLs refer to loans granted to individuals to finance other personal and household needs such as purchase of household appliances, furniture and fixtures and/or to pay taxes, hospital and educational bills. Bangko Sentral ng Pilipinas, Other Consumer Loans Stand at P39.2 Billion in First Quarter 2010, June 4,2010
[32] See External Developments Are Prime Movers of Philippine Markets
[33] Money Week Asia, Why Asian currencies will keep going up Interest rates will have to rise in Asia
[34] See How Populist Leadership Goes Kaput: Japan Edition
[35] Reuters, Obama calls to congratulate Japan's PM-elect Kan, June 5, 2010
[36] Businessweek, South Korea Urges Central Bank Currency-Swap System, May 30, 2010
[39] Danske Bank, Weekly Credit Update, June 4, 2010
[40] Danske Bank, Global: Business Cycle Monitor, June 2, 2010
