Why Current Market Conditions Warrants a Defensive Stance

Here is what I wrote last week[1],

Also the Phisix is likely to surf on the global ‘EU Summit honeymoon’ sentiment, as well as on the momentum from an imminent RECORD breakout.

Whether this breakaway run will be sustainable remains unclear as global markets will remain volatile on both directions.

Indeed the jubilation from the EU Summit combined with momentum powered the major local equity benchmark, the Phisix, to a fresh record high.

Of course this breakaway run will be subject to the question of sustainability given the recent developments abroad.

Nevertheless after 3 successive weeks of advances which racked up 8.53% in returns, it would be normal to see some profit taking.

Nonetheless today’s exemplary standings have more stories to tell.

The ASEAN Standout

From my radar screen of 70+ international equity benchmarks, the Phisix only ranks fourth among the best performers based on a year-to-date returns.

But the Phisix is the ONLY bellwether among the elite contenders that has been trading at record highs.

Except for Venezuela which has been drifting close to the recently etched milestone highs established last May, it is only Thailand that comes close to having a superb feat.

All the rest are still way off from their apogees set during the last 3-5 years

I do not count Venezuela’s stock market as a real contender for the simple reason that the outperformance of the Venezuelan stock market could be a reaction to the amplified risks of hyperinflation.

Due to a combination of price controls and massive imports by the government, Venezuela’s inflation rate has been down reportedly to 21.3% last June[2]. But this is likely to be temporary and designed for the reelection of President Chavez this October

Combined with falling oil prices and massively expanding government expenditures, the Venezuelan government will likely run out of hard currency or of foreign exchange which may force them to ramp up on the printing presses for financing.

Stock markets have been functioned as safehaven during episodes of hyperinflation as people jettison currency for real assets. A good example is the recent bout of horrific hyperinflation[3] endured by Zimbabwe which culminated in 2008[4].

Surging stocks amidst hyperinflation has barely been about real (investment) returns but about people trying to preserve savings through acquisition of claims on real assets (insurance against monetary disorder).

And going back to the top 11, Thailand’s stock market as measured by the major bellwether the Stock Exchange of Thailand (SET) is second only to the Phisix to demonstrate remarkable gains.

While the SET is at a milestone multi-year high, the Thai bellwether is still about 30% off from the 1994 pre-Asian crisis record.

Yet the best annual performers masks or are framed to exclude the position of the others. This shows why the use of statistics can tricky and can be tailored to fit a predetermined conclusion.

Indonesia and Malaysia may have posted moderate year-to-date returns relative to the Phisix, up only 6.1% and 5.87% respectively, but Malaysia, like Philippines, trades at record HIGHs.

Meanwhile Indonesia trades a few percentages or (3.5%) off the recent record.

So ALL four major ASEAN bourses are AT or NEAR landmark highs but so far the Phisix leads the pack.

Outside the region, I have not encountered any national stock markets that have come close to beating their 3-5 year highs.

Growing Detachment between Stock Markets and Real Events

It is obvious that any economic or financial gains would be used as political advertisement.

For instance the recent S&P upgrade of the Philippine credit rating have been painted as a puffery of good governance. The fact is that whatever gains seen in the Philippines has been a regional dynamic. They are in reality symptoms of the boom phase of the business cycle that has mainly been driven by the domestic monetary policies through the negative real rate regime and supplemented by external monetary policies which has induced a search for yield dynamic from foreign investors in response to international easing policies. This ‘search-for-yield’ can also be interpreted as capital flight.

The current market conditions of the Phisix fit the inflationary boom scenario described by the late Austrian economist Fritz Machlup[5]

If, however, we inquire into the causes of the inflow of speculative capital from abroad which is so much objected to, we shall often find that it was the boom tendencies that were already present on the stock exchange which attracted the foreign funds. La hausse amene la hausse. The beginnings of the speculative boom originated in a flow of money from domestic sources. And as it is extremely difficult domestic to conceive of a sudden epidemic of saving, we are once again driven back to credit expansion by the banks. It is the "domestic" creation of credit which usually produces that sentiment on the stock exchange and that movement of stock prices, which act as an by foreign invitation to foreign funds.

The occasions when the short-term foreign funds flowing onto the stock exchange are to be regarded with real mistrust are when these funds owe their boom is existence to a credit inflation abroad. In this case foreign they bring the foreign “business cycle germ” into the home country

Yet the much ballyhooed upgrade has been based on superficial measures. They have most likely been influenced by surging prices in the asset markets (reflexivity theory), by political Public Relations campaign, particularly the phony war against corruption (where corruption is misleadingly portrayed as a function of ethical virtuosity rather than from real cause: arbitrary statutes and regulations[6]) and could even possibly be related to dwindling stock of “safe assets” for the global banking system than from real changes or market based economic reforms as I explained earlier[7]

What the credit upgrade does is to give license to the Philippine government to lavish on public expenditures. This would only promote crony capitalism, (yes guess which parties will be awarded with the proposed $16 billion of public work spending?) and that rewarding debt would work to the detriment of the economy over the long run through the adverse effects of the crowding out phenomenon[8], higher taxes and the serial blowing of the bubble cycles.

Grandiose skyscrapers (or the Skyscraper Index) have exhibited uncanny accuracy as harbingers of the bust phase of financial bubbles.

And believe it or not, 9 of the 10 of the world’s tallest building will rise in Asia and have been slated for completion from 2015 onwards—with China having four, South Korea three and one apiece for Indonesia (3^rd largest) and Malaysia[9].

So if the skyscraper index remains a functional indicator of financial excesses then we could or we may see a regional financial crisis anytime during the time window of 2015-2017.

Yet given the extreme fluidity of current conditions, such bubble conditions may be delayed or hastened depending on the direction of external and domestic social policies mostly channeled through monetary policies, particularly the complicit war by central bankers against interest rates (or the euthanasia of the rentier).

From the prescient admonitions of the great Ludwig von Mises[10]

Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation. In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy.

Of course, I see the soaring Phisix as effects of the bubbles parlayed as symptoms of Panglossian complacency (based on the belief that the Phisix or the region will decouple) or if not Pavlov’s classic mental conditioning (of the strongly held belief that central bankers will successfully bailout financial markets) or as effects of “jockeyed” markets.

As for the latter, aggressive buying in a landscape where global political authorities have been exhibiting anxieties over global economic conditions simply does not match with the current state of exuberance.

To give some examples.

The Bloomberg quotes IMF’s Christine Lagarde’s diagnosis of the world economy[11]

“Over the past few months, the outlook has regrettably become more worrisome,” Lagarde said. “Many indicators of economic activity -- investment, employment, manufacturing -- have deteriorated. And not just in Europe or the United States.”

Or how about the “45-minute salvo” fired by 3 central banks last Thursday as acts of desperation?

From another Bloomberg article[12]

Global central banks went on the offensive against the faltering world economy, cutting interest rates and increasing bond buying as a round of international stimulus gathers pace.

In a 45-minute span, the European Central Bank and People’s Bank of China cut their benchmark borrowing costs, while the Bank of England raised the size of its asset-purchase program. Two weeks ago, the Federal Reserve expanded a program lengthening the maturity of bonds it holds and Chairman Ben S. Bernanke indicated more measures will be taken if needed.

Many major global equity markets sagged following the news of the 45 minute interval coordinated easing from 3 major central banks.

The most curious response I saw came from China.

The Shanghai index remained wobbly and even traded on the negative for almost two thirds of Friday’s session which appeared to have discounted the interest rate cuts. The above chart from Bloomberg shows of the intraday actions. It took the last minute for the Shanghai index to surge, which according to news reports had been led by the property sector[13].

That last minute adrenalin shot may not persist as China’s Premier Wen Jiabao immediately shot down the notion of the lifting property controls in a comment today[14].

This is yet another example of the confounding stance by China’s political authorities.

The weaknesses in global markets following the reported near simultaneous interventions in the bourses of major economies could be deemed as “buy the rumor, sell on news” or of reality check relative to hope based expectations.

As I wrote a few weeks back[15],

One, if central bankers FAIL to deliver in accordance to market’s expectations, then we will likely see another huge bout of downside volatility in global equity markets….

On the other hand, if markets may be temporarily satisfied with REAL actions of central banks (e.g. $1 trillion bailout) then we should see a minor or a slight “sell on news”. But this should be seen as opportunities to RE-ENTER the markets incrementally.

Considering that the Phisix has soared since, I don’t see today as a providing a buying window, unless global central bankers would bring on their vaunted bazookas or until there will be meaningful improvements in the global economic arena

When financial markets flows into the opposite direction from the economy sans support from central bankers then the risks of a crash becomes a factor to reckon with.

One thing that could be justify divergences or decoupling is the possibility of intensified capital flight. While there are little signs of these affecting ASEAN markets yet, as explained last week, Denmark’s case seems like a relevant model.

Denmark’s bond markets which earlier have exhibited negative yields have now been reinforced by Denmark’s central bank policy of negative interest rates. Capital flight from the Eurozone to Denmark has prompted for an outperformance of Denmark’s equity markets[16] and has been on my top 11 list.

However the same capital flight phenomenon has not boosted the Switzerland’s Swiss Market’s Index in the same degree as Denmark. So we need to observe this further.

Outside More Central Bank Intervention, Expect Downside Pressures

Current conditions could be ripe for a significant retrenchment for global equity markets based on ‘fundamentals’.

Nearly 80% of the world’s industrial activities have been contracting[17].

Compared to 2007-2008 which had the US property bust as the epicenter, today’s slowdown has been coming from different directions, particularly, the Euro area and the BRICs.

Even in the US, both the industrial activities[18] and non-industrial activities[19] have been exhibiting considerable signs of weakening.

These may not signal yet the imminence of recession, but the risk of recession grows if both domestic and international conditions deteriorate further.

And the global economic slowdown has shown incipient signs of filtering into US corporate profits[20].

While the distribution of revenues from S&P 500 member companies has marginally been tilted towards US, nonetheless revenues from abroad still accounts for a substantial 45% share[21].

This means that slowing global economic growth will pose as material drag to current “fundamentals”.

So in the absence of further interventions by central banks or when steroid dependent markets have been left to their own devices, broad based downturns on the world economy would hurt profits and will get reflected on the stock prices.

The alternative view is that since global weakness has been coming from different directions interventions will require global coordination similar to the 45 minutes salvo.

In addition, “liquidity” conditions in emerging markets have reportedly been faltering.

This essentially reflects on the ongoing monetary tightening or increasing manifestations of bubble bust conditions in major economies as the Eurozone and the BRICs to Emerging Markets.

The transmission mechanism of which can be seen through the deterioration in trade balances which has been exacerbated by falling commodity prices, declining foreign reserve accumulation as some EM authorities have used excess reserves to support their domestic currency and a slowdown in capital inflows (which even may risk a reversal, if current conditions worsen)[22].

I would further point out that easing through interest rate policies will have miniscule effects to economies laden with debt.

Demand for credit will be limited as hock to the eyeball indebted individuals, households or corporations will be working to pay off existing liabilities. Further, impaired credit ratings diminish access to debt. Also supply of credit will be limited as institutions whose balance sheets have been compromised by problematic assets will work on building up capital reserves. Also, slowing of economic conditions will also hamper debt activities.

This means that unless global central banks pull out another rabbit out of a hat trick of aggressive ‘delaying the day of reckoning’ interventions through money printing, money conditions will tighten, as the malinvestments from previously inflated activities will have to undergo price adjustments that would need re-coordination in the transfer of resources from non-productive to productive activities.

So debt acquired during the bubble heydays will have to be dealt with eventually through the laws of economics.

Aside from the ECB, all eyes will be on the US Federal Reserve FOMC’s meeting on July 31 to August 1, 2012[23]

It would be interesting to see how the Phisix and ASEAN bourses will react in the face of a more pronounced slowdown in the US

Stay Defensive

The principal reason why the Philippines and her ASEAN neighbors have been more receptive towards negative real rates policies is that these economies has been excised of leverage as a result of the Asian crisis as shown in the above chart[24].

But this does not mean that the Philippine and ASEAN economies will be immune from a global economic slowdown. Again the exceptionalism and resiliency of ASEAN markets will be tested with a US economic slowdown.

Again since negative real rates rewards debt and speculation, today’s low debt era may easily transform low debt ASEAN economies into speculative and consumption activities based on debt similar to conditions which plagues developed economies today.

That’s the nature of bubble cycles.

For now, unless the US Federal Reserve (and or the European Central Bank) brings out the BAZOOKA soon, expect the Phisix, ASEAN and global markets to retrench.

At record and near record highs for the Phisix and ASEAN markets, retracements should be seen as normal countercyclical process.

But since events have been so fluid, we cannot discount the risks of a global recession emanating from continuing political stalemate, dithering over monetary policies and from policy errors. Recessions can turn bullmarkets into bear markets.

Oppositely, powerful responses from central bankers may alter the risk scenario for the benefit of the bulls for another short period.

And this is why excessive volatility in both directions will continue to characterize the financial marketplace.

Yet if the Phisix continues to soar, alone or along with ASEAN, despite all the mounting risks, and without support by the FED and or by the ECB, and if they are not driven by capital flight, the tail risks of downside volatility may become magnified.

The current conditions of financial markets can be analogized to navigating in treacherous waters where one’s survival depends on skillful handling of the steep ebbs and flows of the tides, and of course guided too by lady luck. Yet chance according to Louis Pasteur favors the prepared mind.

So still, I would advise that prudence will remain a better part of valor in terms of portfolio management

---

[1] See Why has the Phisix Shined? July 2, 2012

[2] Businessweek/Bloomberg Venezuela Inflation Slows for Seventh Month on Import Surge, July 3, 2012

[3] See Zimbabwe's Hyperinflation February 25, 2009

[4] See Zimbabwe In The Aftermath Of Hyperinflation: Free Markets November 16, 2009

[5] Machlup Fritz A Digression On International Speculation Chapter 10, The Stock Market, Credit And Capital Formation William Hodge And Company, Limited p.163 Mises.org

[6] See Doug Casey On Corruption: Laws Create Corruption And Corruption Engenders Laws February 10, 2011

[7] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 5, 2012

[8] Wikipedia.org Crowding out (economics)

[9] See Does the Skyscrapers Curse Signal a coming Asian Crisis?, July 6, 2012

[10] Mises Ludwig von 8. The Monetary or Circulation Credit Theory of the Trade Cycle XX. INTEREST, CREDIT EXPANSION, AND THE TRADE CYCLE Human Action Mises.org

[11] Bloomberg.com Lagarde Says IMF To Cut Growth Outlook As Global Economy Weakens, July 5, 2011

[12] Bloomberg.com, Central Banks Deliver 45-Minute Salvo As Growth Weakens, July 5, 2012

[13] Reuters.com China bank shares pull down Hong Kong HSI, property lifts Shanghai, July 6, 2012

[14] See China’s Property Controls: Mistaking Forest for Trees July 8, 2012

[15] See Dealing with Today’s Uncertainty: Patience is the Better Part of Valor June 17, 2012

[16] See Denmark Cuts Interest Rates to Negative, July 4, 2012

[17] Zero Hedge 80% Of The World's Industrial Activity Is Now Contracting July 5, 2012

[18] Yardeni.com US Manufacturing Purchasing Managers Index July 3, 2012

[19] Wall Street Journal Blog Vital Signs: Slowing in Nonmanufacturing, July 6, 2012

[20] Wall Street Journal Blog, Number of the Week: Rest of World Pulls Down U.S. Profits June30, 2012

[21] Businessinsider.com CHART: A Breakdown Of Where S&P 500 Companies Get Overseas Business, June 27, 2012

[22] See Emerging Market “Liquidity” Conditions Deteriorate July 5, 2012

[23] US Federal Reserve Meeting calendars, statements, and minutes (2007-2013)

[24] Zero Hedge, Asia's Downside Risk And The Three Big Hopes June 21, 2012

Emerging Market “Liquidity” Conditions Deteriorate

Amidst all the external tumult, the Philippine stock market has amazingly defied the convention and continues to climb to new record highs. Because of this, many have come to believe of a ‘miracle’.

Yet the contagion from a global slowdown seems as being transmitted through deteriorating “liquidity” conditions in Emerging Markets which could pose as spoiler to the Phisix shindig.

Here are two views on the increasing risks of contagion through the “liquidity” channels

Canadian independent research outfit, the BCA Research seems bearish Emerging Market Stocks:

Recent data shows that the trade balance in emerging markets has continued deteriorating, a phenomenon that typically entails lower share prices. Falling commodity prices will support this negative trend for many EM countries.

One of the implications is that developing nations foreign reserves accumulation has slowed dramatically. In a number of countries, foreign reserves have in fact been depleted in the past year as authorities have sold international reserves to support their currencies, which, in turn, has squeezed domestic currency liquidity.

Additionally, liquidity will be squeezed as capital inflows to both resource-producing and commodity-importing EM countries deteriorate. FDI inflows into EM have topped out and based on M&A activities, are set to fall drastically this year.

More troublesome news from Zero Hedge (bold cap and underline are original)

The growth in Emerging Market 'External Liquidity' recently was only ever slower in the quarters either side of the crash in 2008. This is a very worrying sign. EM nations are highly dependent on 'external' capital inflows (to smooth current account deficits) and have empirically been exposed to the 'sudden stop' nature of these inflows. It appears that Europe's banking crisis and deleveraging is indeed having a critical impact on EM nations - which may oddly mean domestic policy adjustments will be necessary (raising rates to encourage capital inflows) that will further exacerbate the problems as global growth slows. This brings to mind our recent comments on the shadow banking system and the drop in deposits among traditional risk-hungry EM funding banks - as we note that the more deposit-free the banking system, the slower the funds will flow. The newer the debt- and asset-inflation-based 'capitalism', the faster it is impacted at the margin - and it appears many EM nations are being affected rather rapidly.

Both seem to be singing the same song.

For as long as central bankers of developed economies continue to dilly dally on the policy directions and for as long political deadlock remains, the risk of an escalation of these downdraft grows.

Will the Phisix continue to defy the world? I can't say.

For how long will hope prevail over reality?

Be careful out there.

Global CDS Update: The Risk ON Environment

One substantial driver of the direction of interest rates would be the financial market’s perception of credit risks as measured on the credit standings of each nation.

The fierce start of the year rally seen in equity markets have likewise mirrored the actions in Credit Default Swap (CDS) markets

Writes Bespoke Invest (charts their too)

every country except one (Portugal) has seen its default risk decline in 2012. European countries have mostly seen the biggest drops in default risk, with Belgium leading the way with a drop of 31.6%. Greece -- while it still has by far the highest default risk -- has seen its default risk fall the third most in 2012 with a decline of 25.5%. (France ranks second at -25.7%.) The US currently has the lowest default risk out of all the countries shown by a wide margin.

Additional observations

The concerted accelerated massive credit easing programs undertaken by central banks of developed economies has so far soothed or bought off unsustainable debt concerns. Much of the deluge of liquidity apparently has diffused into the global equity and commodity markets through intensified yield chasing actions by market participants.

The easing environment has been complimented by central banks of emerging markets whom has been mostly slashing interest rates too.

The global financial markets have been heavily politicized and greatly relies on sustained central bank support. Given the heavy dependence on central bank steroids, we should expect sharp volatilities in both directions for the marketplace.

I wouldn’t read through the current façade as lasting. That’s because central banks would need further rationalization to pursue current policies. And the only pretext to do more of the same is to see markets undergo spasms anew.

I wouldn’t also interpret the low default risk of the US as sustainable. The US Federal Reserve has been expanding their balance sheet and has been running massive fiscal deficits which means current sanguine conditions are artificial and manipulated and most likely related to the coming US presidential elections.

One interesting observation is that ASEAN CDS are on the lower half of the table and has shown resiliency compared to many major emerging markets contemporaries and even to some developed economies (e.g. France).

If you are counting on a potential ‘decoupling’ by ASEAN relative to developed economies, the CDS markets will likely be the first area to emit such signals. So far, the CDS markets has been manifesting the same dynamics driving other financial markets--the rising tide lifts (almost) all boats.

Is this the End of the Gold Bull Market?

Over the past few days gold prices has been whacked.

Gold prices have breached the 200 day moving averages.

Immediately gold bears scream “This heralds the end of the gold bull market!”.

Not so fast.

As I earlier said, gold has been reflecting signs of global liquidity conditions which may have been affected by perceptions of inadequate actions by the global central bankers, a China slowdown (or perhaps a bubble bust?) and the MF Global fallout.

Heavily politicized and inflation addicted markets tend to selloff when policymakers declare “discipline”. For instance, last night Ben Bernanke said that the FED won’t be bailing out Euro banks.

From the Bloomberg,

Federal Reserve Chairman Ben S. Bernanke told Republican senators the Fed plans no additional aid to European banks amid the region’s sovereign debt crisis, according to two lawmakers who attended the meeting.

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

In setting boundaries to Fed aid, Bernanke referred to steps beyond the currency-swap lines that were revived in May 2010 to help Europe alleviate its crisis, Corker said. Last month, the Fed led six central banks in announcing a half percentage-point cut in the cost of emergency dollar funding for financial companies overseas through the Fed’s swap lines.

Ben Bernanke has been under fire for having to bailout Euro banks, aside banks of other nations, in 2008. So the act to project an image of nonpartisanship is understandable.

Of course there are many ways to go about conducting a bailout…

The same Bloomberg article observed,

While the Fed may not be able to lend directly to banks outside the U.S., it can provide loans to their U.S. branches through the discount window. The Fed’s currency-swap lines also provide indirect dollar funding to overseas banks through the ECB and other central banks who assume the credit risk.

Lending through the swap lines peaked at $586 billion in December 2008. The swaps are separate from Fed emergency loans to banks and other businesses that peaked at $1.2 trillion the same month, including about $538 billion that European financial companies borrowed directly, according to a Bloomberg News examination of available data.

And once conditions worsens, you may expect the FED to reverse tune.

And paradoxically, Ben Bernanke’s has been signaling that the FED may ease further (QE 3.0) if contagion risks from the Europe escalates [Businessweek/Bloomberg]—a sign of ambiguity.

Besides, the EU has been preparing to mount another grand rescue scheme.

From the Economic Times.

Germany is reactivating its financial sector rescue fund as the eurozone debt crisis raises increasing questions about how banks can cover their capital needs.

Chancellor Angela Merkel's spokesman, Steffen Seibert, said the Cabinet decided Wednesday to reopen the (euro) 360 billion ($474 billion) fund, first established at the height of the 2008 financial crisis.

The fund closed to new applications at the end of 2010. But much of the money _ which totaled (euro) 60 billion for potential capital injections and (euro) 300 billion for loan guarantees _ remains untapped.

European authorities have determined that German banks require a total of (euro) 13.1 billion in new capital to comply with tougher new requirements. The country's second-biggest bank, Commerzbank AG, has been told it needs (euro) 5.3 billion.

And Japan and possibly ex-European nations will be part of the rescue operations. Reports the AFP

Japan has purchased 13 percent of the eurozone rescue fund's latest bond sale, a government official said Wednesday, as the region continues fundraising to help contain its sovereign debt crisis.

The Japanese government bought 260 million euros ($338 million) of the three-month bills, or 13 percent of the 1.972 billion euros raised by the bailout fund, the official said.

Data published by Germany's Bundesbank showed there was strong demand for the debt issued by the European Financial Stability Facility (EFSF).

The sale was oversubscribed by more than three times with investors bidding a total 6.286 billion euros, the German central bank said.

So as I have been saying, you can’t depend on reading current trends and use these to make forecasts. Policymakers will be responding to market developments which will have repercussions.

And I will like to further emphasize that the recent drop in gold is being accompanied by a slump in developed economy equity markets

Chart from Bespoke

Correlation between gold and stocks has intensively tightened.

This exhibits more evidence that in an environment faced by liquidations, margin calls and increased demand for money for safekeeping reasons, gold won’t likely function as refuge. This isn’t the Great Depression era of the 1930s where the gold was money.

In short, gold isn’t a refuge against deflation under a fiat paper money system

Here is a graph of the ECB’s deposits in relation to margin calls (from the Financial Times Blog) [hat tip Bob Wenzel]

We can expect that political authorities will continue to refuse adjustments from the markets, because these would imperil the interests or the beneficiaries of the incumbent political economic system—the political and banking class.

Thus, we will see them resort to accelerating inflationism or policies that will “extend and pretend” or “kick the can down the road” which only exacerbates the current problems. We can construe that most of the signals of “discipline” represent political posturing.

What will happen is that funds will be provided by political institutions (central banks or rescue funds) to allow banks to buy sovereign debt (to keep down yields) which will be used by banks as collateral for acquiring loans from the ECB. This will be like two drunks attempting to prop up one another. (to borrow the analogy from Professor Arnold Kling)

And banks will profit from arbitrages on the manipulated yield spreads.

So inflationism will be a policy that should be expected to continue.

For all of history commodities/gold has served as money or as refuge against inflationism. Thus we should expect gold to eventually find a bottom and begin to reverse the current downtrend once such policies are announced and triggered.

As a final note, the US dollar is the world’s premier currency reserve, which means global banks, finance companies and governments hold as reserves [The US dollar and the Euro make up 90% of Allocated Reserves globally. Unallocated Reserves are not included in this graph, although they make up over 45% of total world foreign exchange holdings-Wikipedia.org] and comprises about 70% of the world trade/transactions [China Daily].

Thus, we shouldn’t be surprised, as this would be intuitive if not commonsense, that the US dollar will serve as temporary lightning rod against the current turbulence, in an environment where demand to hold money increases (again from liquidation, margin calls or safety reasons).

It will take the US Federal Reserve to hyperinflate to drastically reduce the role of US dollar, an event which has not been happening yet.

So I would rather use this opportunity to accumulate gold or gold related investments.

Global Equity Markets: Signs of Contracting Liquidity?

It’s the same politics-driving-markets story.

From the Bloomberg,

U.S. stocks retreated, reversing an earlier advance for the Standard & Poor’s 500 Index, after Federal Reserve policy makers refrained from taking new actions to bolster growth at the world’s largest economy.

While global central banks have been engaged in unprecedented acts of asset purchasing or quantitative easing (QE), the variances of the scale of applied QE will translate to differences in the impact on financial markets.

However, the continuing EU debt crisis, China’s ‘slowdown’ and liquidations from the MF Global fallout seem to be neutralizing whatever global central banks have been doing.

The Euro has broken down. Since the Euro has the largest share in the US dollar index basket then this means an upside breakout for the US dollar

Now if the US dollar’s rise has been signaling contracting liquidity in parts of the world, then this should be reflected on the price of gold.

And contracting liquidity could be also signal slower growth which should also reflect on prices of copper.

Copper indeed has been sluggish, but appears to have deviated from gold in terms of price trend. Copper still is consolidating while gold has broken down.

Nonetheless, part of such weakness could be percolating into equity markets.

The US S&P has languished but also remains on a consolidation mode. Since the degree of relative liquidity appears to be generating variable effects, then correlations will likewise manifest signs of divergence.

Chart from Bespoke

As with the US S&P 500, the lagging German DAX (relative to the S&P) seem to demonstrate such difference.

Finally to reemphasize, the breakdown of the Shanghai index continues to deepen.

Applied to the Phisix, which I think remains on the bullish phase of the current bubble cycle, the above signs or developments should keep us on our toes or should make us remain partly on the defensive.

However as caveat, we cannot simply read and project all these as the prospective trend.

Since the de rigueur trend in policymaking, which marks the difference from 2008 or anytime in history, has been a more activist approach where authorities have been quick to respond to the developments in the markets, any prospective actions will likely impact the markets anew (relatively depending on scale and in meeting with market's expectations).

The FOMC’s reluctance to undertake a direct QE is understandable. The FED may have observed that there has been an accelerating upside trend in US monetary aggregates. And more QE will only risk adding to inflationary pressures, so they may be reserving this option until (political and financial) conditions warrant.

Nevertheless the above quote from the Bloomberg only reveals how addicted financial markets have been to inflationism.

Rest assured that this political dynamic as major driver of the markets won’t fade away anytime soon and should continue to dominate the actions in the global marketplace.

Challenging times indeed.

Does Falling Gold Prices Put An End To The Global Liquidity Story?

``It is easy indeed to fall into the trap of phony economic growth; as long as capacity utilization is below the normal level, demand expansions fueled by monetary and fiscal impulses increase economic activity. But the more the economy approaches full capacity, the more the effect on the production of real goods gets weaker and the effect on prices gets stronger. Eventually, this reaches the point when the monetary expansion only has inflationary price effects, and its impact on real production becomes nil.”- Antony P. Mueller The Stimulus Scam

Part of our incomplete sweetspot of inflation scenario has been gold’s recent sluggishness.

One analyst even suggested that because gold isn’t rising, then it must be a return of “risk appetite” has been providing support to global equity markets.

One Week Does Not A Trend Make

But the weakness in the gold market alone is not sufficient to suggest that this isn’t about a global liquidity story (see figure 4).

Figure 4: stockcharts.com: Divergences in Gold, Silver, Copper and Oil

Gold has fallen quite steeply down 2.84% this week.

While it is true that we see gold as a superb indicator for global liquidity, it would be a mistake and even naive to interpret one week of price action as a continuing event.

And importantly, any markets, including gold, can be affected by short term quirks or market specific events. For instance, the unresolved gold sales of the remaining allotment of the IMF can be a factor.

Yet, gold’s alter ego, silver has not shared the same quandary.

Also the strength in copper and oil, even if they are partly underpinned by the emerging market story, has also been a story of liquidity.

Proof?

According to Bloomberg, ``Emerging-market and high-yield bond funds each took in more than $1 billion in the week ended March 10, EPFR Global said, the most since the research firm began publishing weekly data on the sectors a decade ago.

``The inflows helped reduce the yield premium investors demand to hold emerging-market debt rather than U.S. Treasuries by 25 basis points in the period to 259 basis points, according to JPMorgan Chase & Co.’s Emerging Market Bond Index Plus. The gap was 258 basis points at yesterday’s close, the least since June 2008. A basis point is 0.01 percentage point.

``Developing nations have raised $28.9 billion from global bond sales so far this year, the busiest start to a year since 2005, according to data compiled by Bloomberg.”

Major emerging markets as Indonesia, India, China and Brazil has seen turbocharged money supplies (see figure 5)

Figure 5: News N Economics: Expansionary Monetary Policies in BIICs

And it does not stop here.

Global Liquidity Story Continues

We’ve been repeatedly saying that the record steep yield curves across the globe are likely to jumpstart the credit process, even in nations beset by credit woes. However the impact will always be uneven. And as we also been repeatedly saying these are the seeds to the next bubble.

Ignore the meme about falling “money velocity” as a reason for the alleged failure to restore the credit process out of the “liquidity trap”. Aside from being a flawed model[1], these experts disregard the incentives brought about by the “profit spread” of interest rates.

Of course we can add that they have been erroneously interpreting the neutrality of money from government expenditures, as well as, underestimating the increasing share of governments’ contribution to the economy.

Murray N. Rothbard explains the profit spread[2], (bold emphasis mine)

``In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate.”

We believe that the profit spread dynamics is beginning to kick in.

This from the Wall Street Journal[3], (bold emphasis mine)

``Companies are aggressively borrowing in the debt markets once again—a sign of renewed confidence in the world economy following recent fears that struggling European countries could have difficulty financing their budget deficits.

``In the U.S., bond sales by companies such as Bank of America Corp. and GMAC Financial Services are on pace to conclude their busiest week since the beginning of the year. In Europe, borrowing by companies so far in March is already more than 60% of February's totals.

"It tells us that financial liquidity is very much on the rise," said John Lonski, chief economist at Moody's Investors Service. "No longer do corporations suffer from a dearth of liquidity. This puts them in a better position to take advantage of opportunities that arise."

``So far in 2010, U.S. corporations have issued $195.2 billion of debt, excluding government-guaranteed bonds, according to data provider Dealogic, up from $166.8 billion during the same period in 2009. The resurgence of the corporate debt markets comes after a shaky February, when several companies were forced to delay bond sales as worries about Greece's problems sent investors fleeing to safer assets such as U.S. Treasurys. Those concerns have subsided and money is again flowing into corporate bond funds, giving managers cash to invest.”

And this can likewise be seen in Canada “on pace to issue the most debt”, in Asia “lowest relative borrowing costs in more than two years and demand from international investors is driving Asian companies to sell record amounts of dollar- denominated bonds”, in Russia “Yields on Russian dollar bonds fell to less than 5 percent for the first time as rising oil prices boosted investor confidence”, in Turkey, and even in the PIIGS “Portuguese, Italian and Spanish companies are rushing to sell bonds, taking advantage of investors’ demand for corporate debt after Greece’s budget crisis froze issuance”. [Hat tip: Doug Noland]

In short, to attribute improving financial markets plainly to restored confidence is missing out the bigger picture. Money is needed to bid up asset prices, which accounts for as increased confidence levels or what the mainstream calls as the “animal spirits”. And the steep yield curve from zero bound rates, quantitative easing and massive deficit spending have all contributing to global reflation.

Nevertheless present activities do not suggest that gold has lost its efficacy as indicator for global liquidity.

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[1] See Velocity Of Money: A Flawed Model

[2] Rothbard, Murray N. America's Great Depression p.41

[3] Wall Street Journal Credit Market Springs to Life