Fitch Defies S&P on China’s Credit Bubble

Defying the consensus, US Credit rating agency Fitch ratings says China’s bubble is unsustainable.

From the Bloomberg: (bold mine)

Chinese banks are adding assets at the rate of an entire U.S. banking system in five years. To Charlene Chu of Fitch Ratings, that signals a crisis is brewing.

Total lending from banks and other financial institutions in China was 198 percent of gross domestic product last year, compared with 125 percent four years earlier, according to calculations by Chu, the company’s Beijing-based head of China financial institutions. Fitch cut the nation’s long-term local-currency debt rating last month, in the first downgrade by one of the top three rating companies in 14 years.

“There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast,” Chu, 41, said in an interview.

Usually I would take the opposite side of the fence vis-à-vis credit rating agencies, but in the case above, the Fitch analyst Ms. Charlene Chu resonates on my analytical methodology: She focuses on the trajectory.

China has implemented a massive RMB 4 trillion or $586 billion stimulus meant to shield against the US epicenter crisis in 2008. This serves as an aggravating or secondary cause. From the same article:

Amid the global credit crunch of 2008, China ramped up lending by state-controlled banks to prevent an economic slowdown. The assets of Chinese banks expanded by 71 trillion yuan ($11.2 trillion) in the four years through 2012, according to government data. They may increase by as much as 20 trillion yuan this year, Chu said April 23. That will exceed the $13.4 trillion of assets held by U.S. commercial banks at the end of last year, according to the Federal Deposit Insurance Corp.

Chu says companies’ ability to pay back what they owe is wearing away, as China gets less economic growth for every yuan of lending.

In short, the stimulus only created massive malinvestments or transfers of resources to wealth consuming activities. Thus the diminishing returns of credit. The payback from which is likely to come sooner than later.

The Chinese government’s denial:

China’s expansion of credit hasn’t caused a surge in the proportion of bad loans, data from the banking regulator show.

While loans overdue for at least three months have grown for six straight quarters to reach 526.5 billion yuan at the end of March, the ratio of nonperforming loans declined to 0.96 percent as of March 31 from 2.42 percent at the end of 2008, according to the China Banking Regulatory Commission.

As previously noted, Non Performing Loans (NPL) are coincidental or lagging indicators. They usually become apparent when the bubbles are in the process of reversing. 

Yet for as long as the bubble inflates, or for as long as housing prices moves up, the Ponzi financing scheme may continue to thrive.

When entities (private or public) can hardly finance principal and interests of outstanding loans from cash flows but increasingly depends on rising assets to cover funding requirements, through asset sales or as collateral for more borrowing such is called a Ponzi finance as postulated by economist Hyman Minsky.

China’s housing bubble continues to balloon even as the real economy has materially been slowing down, as shown in the chart from Wall Street Journal. Such is a sign of growing Ponzi finance.

In short, current inflationist policies by the Chinese government motivates the public to speculate on housing and other financial packages rather than invest on productive enterprises.

Such housing bubble has likewise drawn in hot money as shown by the chart from Zero Hedge

The Chinese government has recently moved to curtail hot money flows using copper imports to facilitate “carry trades” based on “interest rate arbitrages”.

Going back Fitch. Ms. Chu says China’s statistical data has been unreliable. Importantly she says that much of what I call Ponzi finance may have found a channel in the burgeoning “Shadow Banking Sector”

Chu, who has covered Chinese financial institutions at Fitch for seven years, says these figures are distorted. The ratio of nonperforming loans to total lending has declined mainly because credit has surged, she said. Moreover, the regulator’s data doesn’t reflect the real amount of debt because of the ways banks move loans off their books, Chu said.

Some loans, often for real estate, are bundled together and sold to savers as so-called wealth-management products, while other assets are sold to non-bank financial institutions, including trusts, to lower the lenders’ bad debt levels, according to Chu. Wealth management products and trusts are sold to investors eager to get more than the government-mandated benchmark of 3 percent annual interest on bank savings accounts.

“The data may be somewhat accurate for the on-balance-sheet loan portfolios of the banks, but banks have substantial off-balance-sheet positions for which there is no asset-quality information,” she said.

The Moody’s estimates that China’s Shadow Banking System have reached 29 trillion yuan or  $4.7 trillion  compared to 17.3 trillion yuan in 2010

Shadow banks are manifestations of regulatory arbitrages or the circumvention of regulations. China's shadow banks has been mainly through Wealth Management Products (WMP) which have mainly been about short term financing

Quoting Ms. Chu from another article:

WMPs are vehicles that can borrow/lend, and banks engage in transactions with their own and each other’s WMPs. This makes the pools of assets and liabilities tied to WMPs in effect second balance sheets, but with nothing but on-balance-sheet liquidity, reserves, and capital to meet payouts and absorb losses. These hidden balance sheets are beginning to undermine the integrity of banks’ published balance sheets.

The leverage being accreted can be seen in the accelerating growth of China’s bank assets as shown from the chart by Northern Trust. Bank Assets in the official sector have now topped 250% of GDP and excludes the shadow banks. Bank assets has spiked since 2008. 

Every bubble culminates with a mania phase, characterized by a blow off in the build up of debt which ultimately implodes

A jump in the ratio of credit to GDP preceded banking crises in Japan, where the measure surged 45 percentage points from 1985 to 1990, and South Korea, where it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. In China, it has increased 73 percentage points in four years, according to Fitch’s estimates.

“You just don’t see that magnitude of increase” in the ratio of credit to GDP, Chu said. “It’s usually one of the most reliable predictors for a financial crisis.”

I have previously shown this chart from Harvard’s Reinhart-Rogoff where debt build up leading to every crisis intensifies until this hits a certain debt intolerance level which may triggered internally or externally.

Fitch versus S&P

The nation is in a better position now to tackle nonperforming loans, said Liao Qiang, a Beijing-based director at S&P. In the past decade, China’s economy has quadrupled, the number of urban residents surpassed those on farms and policy makers allowed freer flows of its currency in and out of the country. Its foreign-exchange reserves surged fivefold from 2004 to $3.3 trillion at the end of 2012.

“Given that China’s credit is mostly funded by its internally generated deposits, I don’t think a real financial crisis, which is normally manifested in a liquidity shortage, will happen anytime soon,” S&P’s Liao said by phone. Local-currency savings stood at 92 trillion yuan at the end of 2012, according to the National Bureau of Statistics.

Again we see the conflict between analysis based on statistics and with that of economic logic.

Bubbles are symptoms of savings being squandered for yield chasing speculative wealth consuming activities.

With underdeveloped capital markets and as the Chinese government uses financial repression via negative real rates to confiscate people’s savings, real savings by the average Chinese are being transferred (to the government) and consumed (through speculations—housing and Ponzi Shadow banks). The implication is that real savings are being depleted. 

China’s stock market continues to languish since the 2007 top. This provides scant returns for the public (tradingeconomics.com)

And that’s why many Chinese gravitate to gold. The state of the Chinese yuan, like other fiat currencies, reveals of the "inflation tax" and continues to depreciate against gold as shown by the chart from GoldMoney.com

Surging bank loans

Chinese banks extended 2.8 trillion yuan of loans in the first quarter, 12 percent more than a year earlier and the second-largest quarterly total on record, government data show. Economic growth in the period slowed to 7.7 percent from 7.9 percent in the fourth quarter.

Only 29 percent of last year’s aggregate financing translated into economic growth, the lowest rate on record, as borrowers use more resources to finance outstanding debt and less for investment, Sanford C. Bernstein & Co. analyst Michael Werner wrote in January.

The reality is that the Chinese government has already launched a stealth stimulus since last year. 

This can be seen in the continuing credit growth in the Chinese banking sector as seen from ‘the chart from Dr. Ed Yardeni.

Most of the pick up in credit growth I believe has been directed to State Owned Enterprises (SOE). One must realize that Chinese economy remains heavily politicized where many firms are wards of the government. So Chinese policies can be coursed through them without official admission. 

And as a final note, the covert stimulus being reflected as credit boom is likewise manifested on money supply as shown by the chart from Zero Hedge

Denials will not assume away the effects of unsound policies.

At the end of the day: bubbles (something out of nothing) and Ponzi schemes will reveal of their true nature. 

This means I will not bet on the China led “Asian century” until we see significant liberalization of her economy and monetary system.

Phisix: Choosing The Ideology behind Profitable Actions

We have been trained to look for godliness, virtue, direction, and truth outside ourselves, in some agency external to ourselves. Such beliefs have been generated largely by those who have either a religion or a political system to fasten upon the necks of their fellow beings. It is through such thinking that some have been able to control the thoughts and actions of others by attacking their victims' sense of self-capacity and worthiness to function in the world.-Butler Shaffer

There will be only 3 trading sessions in the coming week because of the extended holidays (on Monday Eidul Fitar and Tuesday Ninoy Aquino Day).

This means that the public will likely be in a vacation mode. So unless some externally driven event will incite unusual volatility that may trigger a local response, I expect the market’s mood to be largely lackadaisical. So whatever direction the Phisix closes the week, the average trading volume will likely be weaker.

Since momentum in the global markets appear sprightly; the odds for a shock seem unlikely.

But given the fragility of current conditions, no one can really tell.

Update on Holiday Economics

As a side note, the string of political holidays only depletes productivity from the economy. The mainstream will argue that “holiday economics” promotes tourism and tourism related industries from which should support the economy. But again, costs are not benefits.

While holidays indeed promote tourism and allied industries, such thinking ignores the unseen costs borne by such political holiday statutes.

As I previously wrote[1],

local policies are counterproductive, privileges one sector (4% direct 10% indirect) over the entire economy, raises cost of doing business, reduces output, promotes idleness, hedonism and wrong virtues (spending instead of saving) and importantly the "elitist" tendencies of the powers that be.

For an update, according to World Travel & Tourism Council[2], the direct contribution of Travel & Tourism to GDP was PHP194.7bn (2.0% of total GDP) in 2011, the total contribution of Travel & Tourism (meaning tourism related industries) to GDP was PHP830.8bn (8.5% of GDP) in 2011. In terms of employment, direct employment from the industry accounted for 778,000 jobs or 2.1% of total employment and the total contribution of the industry to employment, including jobs indirectly was 9.6% of total employment (3,547,500 jobs).

Back of the napkin calculation tells us that ‘Holiday economics’ means supporting 8.5% (of GDP) against the 91.5% of the economy, and in terms of employment, 9.6% as against 90.4% of the labor force.

Holiday economics has been premised on promoting the interests of the elite at the expense of the underprivileged or the ‘poor’.

Market Internals Suggests of Healthy Correction Phase

In the Philippine equity markets, part of what I expected occurred last week.

The recent selloff in the mining sector seems to have percolated into the broader markets.

The Phisix languished, down 1.07% this week, weighed by all major sectoral indices except for the mining and oil which defied the broad market correction

As I wrote last week[3],

I lean on condition (B) or where the bear market of the mining sector will likely percolate into the general market, due to growing risks of contagion.

However everything really depends on how and what future policies will be conducted, especially in the US, as previously discussed.

So the correction phase appears to be another rotational process which essentially shifts the flow of sentiment from the mining sector to the general market and vice versa.

I seriously doubt that the domestic mining sector as having reached an inflection point or has “bottomed” out. I would like to be convinced based on evidences from internal and external forces. Instead I suspect that this week’s rally has been more of a dead cat’s bounce, from a vastly oversold position, than from a recovery.

The correction phase can be seen in the modest deterioration of the market breadth. The rotational process, as well as, the modest decline of the general market should be seen as a healthy profit taking process.

The continuity of the benign conditions, as I have repeatedly been pointing out, will depend on external developments.

Superstitious Beliefs versus Rigorous Analysis

Many have assigned the current weakness in the local equity market as having been influenced by the Chinese tradition of the “Ghost Month” (August 17 to September 15, 2012)[4]

The tradition suggests that many activities such as evening strolls, traveling, moving house, or starting a new business or even swimming can bring about bad luck, thus believers refrain from doing them.

People’s beliefs are acquired mostly through three ways[5], through tradition (handed down through generations), through persons of authority (whose opinions people take as truth and accept or assimilate them, e.g. parents, teachers, religious leaders, politicos, experts and etc…) and or from reason and evidence.

Based on reason, there has been little empirical evidence to support such claims.

While I don’t have the exact figures for the said periods, I used the annual % monthly returns of August (left window) and September (right window) of the Phisix since 1985 to see its validity.

As one would note that in the above chart, from both August and September windows, negative returns have not been a predominant feature. Instead we see sporadic fluctuations between positive and negative zones.

Examining further, one would note that the direction of returns have largely been driven by the dominant trend of the marketplace: Returns have either been negative or marginally positive during cyclical bear market periods, while in bull markets, returns have mostly been positive.

One interesting aspect is that sharp market volatilities has characterized September returns, where gains and losses have been magnified.

I think this seem to square with the seasonal activities in the US where September tends to be the worst month for stocks as exhibited by the Average Monthly gain by the Dow Jones Industrials since 1950[6].

And the sharp volatility compounded by negative returns could have been due to the simultaneous large liquidations of savings, which includes sales of stocks, to fund major consumption expenses by US households, particularly spending for new school clothes for children, winter clothes and other weather related consumption activities. Fueled by tight monetary conditions, the massive outlays for consumption may have served as catalyst for the notorious September-October window which has been seasonally prone to market crashes[7]

The lesson that can be gleaned from the above is that beliefs based on superstitions and or the tendency of many to employ the availability heuristics—mental shortcuts based on what we can remember rather than from complete data[8]—are hardly useful substitutes for thorough investigation and rigorous analysis of the marketplace from which to project the future or even explain markets on an ex-post basis.

On the contrary, I would say that the recent weakness of the Phisix can be traced to a single axiom: NO Trend Moves in a Straight Line.

Given that the Philippine Phisix, which has outperformed most of the world’s equity benchmarks on a year to date basis, has shown signs of being overbought and overextended, then a salutary reprieve should be a natural state.

In short, profit taking is an inherent process of the financial markets.

Year-to-date, Thailand seems to have successfully passed the Philippines (19.37 versus 19.1% respectively) to take the region’s leadership. Yet both managed to keep some distance from last year’s leader Indonesia, as well as, Malaysia who remains the laggard among the ASEAN majors.

Meanwhile Malaysia’s year-to-date returns largely understates the real action—Malaysia has been the only bourse in the region (if not the world) trading at record highs.

I think that in as much as rotations occur within the domestic market, the same dynamic will likely influence activities of the region’s equity bourses.

As I previously noted[9],

given the rotational dynamics, we might see some “catch up” play or the narrowing of the recent wide variance between the laggards and leaders overtime. But this doesn’t intuitively mean that such gaps will close.

So far, only the Phisix has backtracked while Thailand’s SET has still been in high Octane. On the other hand, Indonesia has slightly narrowed the gap with the Phisix.

Risk ON Stands on Perpetual Promises of Rescues

The reason why the world’s bourses have turned conspicuously positive has been due to the recent return of the RISK ON environment.

The following represents mainstream media’s attribution of the strong performance of global equity markets for the week.

European stocks, from Businessweek/Bloomberg[10]

European stocks rose to the highest level since July 2011, extending gains for an 11th week, as investors anticipated policy makers will stimulate the euro-area economy and German growth retreated less than forecast.

Asian stocks, from another Businessweek/Bloomberg[11]

Asian stocks rose this week, with the benchmark index posting its longest weekly winning streak since March, after China’s Premier Wen Jiabao said there’s more room to adjust monetary policy and U.S. economic reports signaled strength in the world’s largest economy.

In spite of indefatigable pledges by Chinese authorities, China’s bellwether, the Shanghai index remains in doldrums seemingly unaffected by the global RISK ON landscape.

In fact, China’s authorities have admitted to recent signs of outflows of hot money[12] as domestic banks became net sellers of foreign exchange or 3.8 billion yuan ($597 million), which for me could be worrying signs of a popping bubble.

Meanwhile US stock markets according to the Reuters[13]

The S&P 500 held near a four-year high on Friday, and the market's key gauge of anxiety sank to its lowest since 2007, suggesting a belief that the problems stressing investors might be closer to a resolution…

The S&P 500 made a solid move above the closely watched 1,400 level in the last session, posting its biggest gain in two weeks. But trading volume remained low…

The S&P 500 has risen 2.8 percent in August and about 11 percent since a year low in June as traders eye some encouraging U.S. jobs data and highly anticipated policy meetings at the European Central Bank and the Federal Reserve in September.

In essence, the gist of today’s rally in the global stock markets has been galvanized around intensifying expectations that global central banks and governments will effectively rescue the markets.

And tidbits of good news are seen as signs of selective confirmation of a recovery. On the other hand, bad news have been interpreted as having to add pressure on governments to intervene, the result of which is to supposedly deliver good news—a recovery.

In other words, today’s global equity markets investors seem to have been strongly conditioned to carry expectations that markets can only move in one direction: UP. It can be said that the circularity of this logic entails a “heads I win, tails you lose” market environment from political guarantees. Such is the confirmation bias which intensely embodies the mainstream view.

Such has also been the reason why markets everywhere have increasingly been politicized as participants have been oriented to see rising markets as a form of political entitlement.

Divergences Aplenty

It has been interesting to note that, yes corporate fundamentals may have posted some positive signs but again everything depends on the reference points.

From the big picture, the positive signs emitted by the S&P 500 have not been convincing.

Aside from low volume, the divergences I previously mentioned, such as earnings, global economy, industrial and non-industrial activities[14], market internals, divergent signs on sub-sectors such as Transportation (Dow Theory)[15] or even the Russell 2000, have shown marginal and not substantial improvements, in spite of the near four year highs by the S&P 500.

A good example is the current divergence in the % of companies beating earnings and revenue estimates. While the above has shown positive results, it seems that US markets have been cheering what seems like diminishing returns or a decline in positive developments. (chart above from Bespoke Invest[16])

chart from Bespoke Invest

Again recent highs of the US markets have been accompanied by narrowing market breadth.

This means the drivers responsible for lifting the equity benchmarks have mainly been big cap issues. Yet the accounts of publicly listed companies at 52-week highs have also been diminishing. If such trend should continue then this entails limited upside for the S&P[17].

Finally the current rally in the US markets seems to have departed from the previous trend relative to gold.

In the past, rallying US markets (represented by the S&P 500) came at the heels of a more powerful run in gold (see lower window) and in other major commodities. So even as the S&P rose, gold climbed faster, thus the declining ratio between the S&P and gold.

The implication is that the RISK ON environment then had been broader which also meant that the rally had a firmer footing.

Today’s RISK ON environment seems to be concentrated on the equity markets and the junk bond markets where Gold and commodities has vastly underperformed, thus, the rising ratio between S&P and gold.

Junk bonds have been posting record issuance. Companies have been taking advantage of zero bound rates and strong demand which has brought down yields of speculative bonds to a few points away from the record lows reached during May of 2011[18]. Such yield chasing phenomenon exhibits the nature of today’s yield chasing rampant punting and speculations.

This means that gold’s modest rise has not been consistent with a strong RISK ON landscape.

The selective risk appetite and the apparent narrowing of asset selections mean that the markets could be highly susceptible to sudden changes of expectations or to mood swings: thus elevating the current risk profile of would be buyers.

Current Conditions Remain Highly Fragile

I have long been making this point: For as long as the US won’t fall into a recession or won’t suffer from a financial shock that could lead to a global recession, the recent decline in the Phisix extrapolates to a healthy profit taking process.

That said, a five to ten percent decline from the peak or the range at 4,825-5,080 could prove to be a spring board for the next record high. This is all conditional on the unfolding events abroad, and should not be read as one-size-fits all analysis.

Given the nature from which the recent global rally has been anchored, i.e. expectations from promises of rescues, I still remain highly apprehensive, or I will not write off the risks of possible sharp changes in expectations that may precipitate the current moderate RISK ON conditions to a swift and dramatic RISK OFF environment.

The contagion risks are real, which means current conditions remain highly fragile. Rising markets have not smoothened out all the underlying stresses.

Given the enormous distortions of the markets from repeated interventions, the best is to watch the interplay of stimulus-response between markets and policymakers.

To close, let us not forget our beliefs essentially drive our actions, rightly or wrongly. As the great Ludwig von Mises wrote[19],

In acting man is directed by ideologies. He chooses ends and means under the influence of ideologies. The might of an ideology is either direct or indirect. It is direct when the actor is convinced that the content of the ideology is correct and that he serves his own interests directly in complying with it. It is indirect when the actor rejects the content of the ideology as false, but is under the necessity of adjusting his actions to the fact that this ideology is endorsed by other people. The mores of their social environment are a power which people are forced to consider. Those recognizing the spuriousness of the generally accepted opinions and habits must in each instance choose between the advantages to be derived from resorting to a more efficient mode of acting and the disadvantages resulting from the contempt of popular prejudices, superstitions, and folkways.

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[1] See The Economics of Holidays, October 22, 2009

[2] World Travel & Tourism Council Travel & Tourism Economic Impact 2012 Philippines

[3] See Philippine Mining Index: Will The Divergences Last?, August 13, 2012

[4] Mandarin Language Ghost Month and Ghost Festival About.com

[5] Green Alexander, The Noblest Expression of the Human Spirit, Early To Rise, October 6, 2010

[6] Chart of the Day Dow-Average Monthly Gains

[7] See Austrian Business Cycle and September Market Crashes, June 27, 2012

[8] Changingofminds.org Availability Heuristic

[9] See Phisix and ASEAN Equities in the Shadow of Contagion Risks July 22, 2012

[10] Businessweek/Bloomberg, European Stocks Rise for 11th Week on Stimulus Bets, GDP August 17, 2012

[11] Businessweek/Bloomberg, Asia Stocks Rise for a Third Week on Wen Comments, U.S. Economy August 17, 2012

[12] Wall Street Journal Investors Shift Money Out of China August 14, 2012

[13] Reuters.com US STOCKS-S&P 500 up for 6th week; fear index hits 5 yr low, August 18, 2012

[14] See Why Current Market Conditions Warrants a Defensive Stance, July 9, 2012

[15] See Phisix: Managing Through Volatile Times, August 6, 2012

[16] Bespoke Invest Final Earnings and Revenue Beat Rates August 17, 2012

[17] Bespoke Invest Wanted: More New Highs August 17, 2012

[18] Bloomberg.com Junk-Bond Sales Soar To Record In August: Credit Markets, August 17, 2012

[19] Mises, Ludwig von 2. The Role of Power XXIII. THE DATA OF THE MARKET Human Action, Mises.org

Phisix and ASEAN Equities in the Shadow of Contagion Risks

The common feature for today’s global financial marketplace has been extreme volatility

Sharp price fluctuations are seen by scalpers and short term traders as wonderful opportunities. On the other hand, such landscape for me, exhibits signs of increasing market distress. From a trading perspective, this implies for a low profit-high risk engagement.

In short, when the risk is high or when uncertainty dominates, I opt to take a defensive posture. For me, it is better to lose opportunity than to lose capital.

The Philippine and ASEAN markets have not been spared of such volatility.

The local benchmark fell by a measly .07% this week. But this comes after the Phisix opened strongly on Monday, lifted by the late week rally of Wall Street from the other week. Unfortunately such one day rally failed to hold ground as the following sessions essentially more than erased Monday’s gains.

Global markets have closed mixed for the week.

Almost every major equity benchmark encountered a rollercoaster week. Like the Phisix most of the early gains came under pressure during the close of the week.

In the ASEAN region, there have been signs of rotation.

This year’s ASEAN laggards, Indonesia (+6.8% year-to-date) and Malaysia (+7.33% also y-t-d) ended the week strongly as ASEAN outperformers, the Philippines (+19.2%) and Thailand (+17.9%) retrenched.

This only goes to show that the destiny of the Phisix has been tied with that of the region. So any belief that the local benchmark may perform independently will likely be disproven.

Also given the rotational dynamics, we might see some “catch up” play or the narrowing of the recent wide variance between the laggards and leaders overtime. But this doesn’t intuitively mean that such gaps will close.

But the fate of ASEAN’s markets will ultimately depend on the unfolding events in the US.

US Markets and Economy as ASEAN’s Anchor

Yes there have occasional instances where the Phisix has diverged from US or world markets[1], but overtime, the mean reversion capabilities of the markets govern.

Thus, the exemplary performance of ASEAN markets can be traced to the buoyancy of the US markets.

For as long as the US remains firm, so will likely be the fortunes of ASEAN markets and vice versa.

The US markets has so far been resilient from the Europe’s crisis, partly due to the capital flight dynamics from the Euro into the US, and similarly from the slowdown from major emerging markets as the BRICs.

Nonetheless such sustainability must be questioned considering that much of the world’s major economies (developed and emerging markets) have been in a marked downtrend.

Unlike in 2008, there hardly will be any China and other major emerging markets to rely on to do much of the weightlifting. Many emerging markets, particularly the BRICs have been bogged down by their domestic quasi-bubble problems.

In addition, the US Federal Reserve continues to employ talk therapy (signaling channel or policy communications management) instead of undertaking real actions. Media continues to broadcast the prospects of a Bernanke Put (“bad news is good news”), as Fed officials continue to signal verbal support in projecting hope for the steroid addicted markets.

And importantly political gridlock and regime uncertainty has been worsening (taxmaggedon, fiscal cliff, debt ceiling, Dodd-Frank[2], Obamacare, the forthcoming national elections and lately even the controversial LIBOR[3] issue) will likely intensify the current business, economic and financial uncertainties.

And considering that the US markets and her economy has been bolstered by sustained injections of steroids, the lack of and the perceived dearth of policy palliatives, as evidenced by the decelerating money supply growth, will likely bring to the surface and expose most of the misallocated investments, which has been camouflaged by recent monetary policies.

Such dynamics will be manifested through an economic slowdown if not a recession—but again this would really depend on how Ben Bernanke and US Federal Reserve will react or respond to increasing evidences of a slowdown.

Lately even the New York Federal Reserve swaggered about having to boost to US stock markets[4], which they say without them would have been 50% lower!!!

Proof that low interest rates have hardly worked: record low mortgage interest rates[5] have been amiss in providing sustained recovery to US property markets[6].

Yet steroid addicted financial markets continue to look forward to the FOMC’s meeting during the end of July in the hope for another round of policy opiates.

Add to these the soaring costs of agricultural commodities (chart from US global investors)[7], which have been mostly attributed to weather or drought conditions.

This, I believe, has been exacerbated by easy money policies and other interventions (e.g. agricultural subsidies, tariffs and etc…) which should extrapolate to higher food prices.

So we seem to be witnessing incipient signs of stagflation as I have long been predicting.

[As a side note, a UBS analyst recently noted that the risks of hyperinflation has been greatest for the US and UK[8]. But he sees less than 10% chance for this to occur in the near future.

Yet he believes that hyperinflation results from “unsustainable deficits” which “occurs after central banks monetize a large amount of debt”. Thus hyperinflation is a fiscal phenomenon.

I’d still say that hyperinflation is a monetary phenomenon meant to address fiscal concerns. Yes hyperinflation signifies a means to an end approach.

In dire financial straits and in desperation due to the lack of access to domestic and overseas private sector financing, governments frenetically print money to preserve on their political entitlements and power.

At the end of day, all these unwieldy or unsustainable levels of debt expansion will be defaulted upon directly through restructuring, or indirectly through inflation, where hyperinflation may arise as consequence to policy miscalculation, if not deliberately.

And this is why the risks of hyperinflation shouldn’t be discounted[9] despite today’s low interest rate environment]

Also, Spanish bonds at record highs are manifestations of persisting and growing financial and economic stress in the Eurozone and of the extreme fluidity of current conditions, which will have an impact to the US and to the world.

Markets have never really anticipated this.

As Doug Noland of the Credit Bubble Bulletin rightly observed[10],

It was not that many months ago that Spain was viewed as part of a financially stable European “core.” Indeed, Spain (5-yr) CDS ended Q1 2010 at about 100 bps. Spain commenced 2010 with government debt at a seemingly healthy 54% of GDP. Few anticipated the incredible pace of fiscal deterioration. With the federal government on the hook for the EU’s 100bn euro bank bailout package, the IMF now projects Spain will end 2012 with debt at about 90% of GDP – and poised for continued rapid growth.

Who would expect that French bonds to dramatically narrow against German bunds, where “spreads on French debt have narrowed by 16 bps in the last month and are currently at their lowest levels of 2012”[11] as French government paper morph into a ‘safe haven’ from the Euro crisis?

That’s how swift and powerful events have been moving.

To consider, people stampeding into French bonds seem to have overlooked the many sins underpinning the French sovereign paper.

As the BCA Research explains[12]

The French public sector is not in good financial health and is in worse condition than that of Italy in many respects. Italy has run large primary surpluses through much of the last two decades, while France has run large deficits. The Italian debt/GDP ratio was rather stable, while France’s has been rising sharply. In fact, France has accumulated 60% more debt than Italy since 1999, and its debt service costs are rising. More worrisome is that France’s combined private and public sector debt load is higher than that of Italy, putting the French economy in a perilous situation. The only variable where France looks better is economic growth, but even this has mostly come from larger government spending, and in turn at the cost of escalating debt.

And considering the incumbent socialist administration’s penchant for more government spending, taxes and regulations[13] which again will translate to more debt, reduction of productivity and competitiveness and potential exodus of investors, today’s safehaven may become tomorrow’s epicenter for the progressing crisis.

So we are seeing existing policy error compounded by more policy errors that only aggravates such crisis conditions, from which the sentiment of financial markets shifts violently from one end to another.

Hence, while earnings report of US publicly listed corporations may seem buoyant which has given the impetus for the bulls to provide the recent strength to the US equity markets[14], all the above compounds to signify substantial headwinds that US financial markets (equities, bonds, commodities) will be faced with.

And to add, it would be big mistake to read current market activities as tomorrow’s outcome given the huge swings happening in the financial markets around the world. That’s how unstable and mercurial current conditions are.

China’s “Good News” Ignored by the Markets

Such unpredictability has been no different for China.

This week, there has been a torrent of supposed good news that should have reanimated, if not fired up, China’s financial markets.

China’s banking system has reportedly posted a big jump in loan growth or bank lending rose by 16% to 919.8 billion yuan (US$144.3 billion) last June[15]

While news say that this signifies a positive sign from government efforts, this seems largely unclear. I am not even sure if these have been contracted by the private sector. As in the recent past, most of the so-called stimulus has been directed to the overleveraged and overindebted State Owned Enterprises (SoE)[16] which only adds to the current juncture.

The property sector likewise reported a significant surge in bank loans from April to June, up by 20% from last year to the tune of 322.6 billion yuan ($50.64 billion)[17].

Reports also say that China will ease restrictions on her shadow banking system, as well as, double up investments on railway projects[18].

This goes in contrast to previous reports where 70% of China’s railways projects recently has been suspended as a result of ballooning deficit financing, as well as last year’s deadly train crash which has brought upon safety concerns and exposed corruption at the highest levels of the ministry[19]

The confusing signals from supposed government stimulus and support, as well as, positive developments seems to have been discounted by the China’s financial markets as both the major equity market bellwether, the Shanghai Composite (SSEC-top pane), and China’s currency the Yuan (CNY/USD-bottom pane) have not demonstrated auspicious responsiveness to such developments.

Unlike at the end of the 2012 where the SSEC hit a low but the yuan remain lofty, this time both the SSEC and the yuan have been treading downwards.

These are hardly reactions that could be reckoned as bullish.

In contrast these could be symptoms of deeper underlying malaise—a bursting bubble, punctuated by intensifying hot money outflows[20].

With scarcely any household savings to tap, most of the increases in savings are from government and corporations[21] there seems little room for bailouts without incurring risks of inflation.

So like the US, we have the same ingredients contributing to the current highly uncertain climate, ambivalent central bank (PBoC) and political stalemate which has been prompting for increasing manifestations of the unraveling of malinvestments that has been the driving force of the current slowdown.

The Asian Electronic Export Nexus

Many seem to have developed the hardened belief that domestic (or regional) markets have been made invincible by the recent events, particularly record high equities.

As I have been saying, today’s globalization has made the world much deeply interconnected through trade, capital, labor and even through the US dollar standard based banking system.

Embracing the idea of decoupling can be hazardous to one’s portfolio and detrimental to one’s emotions and ego.

In terms of trade, a slowdown in world growth will have impact negatively on Asia’s electronic exports.

As The Economist recently commented[22]

THE electronics industry accounts for two-fifths of manufacturing output in Asia, according to calculations by HSBC. So when electronics grows quickly, Asia's GDP tends to speed up too, to the tune of almost 0.2 percentage points for each full-point increase in the electronics sector. Unfortunately this correlation also applies when things slow down (see left-hand chart). And recent signs are that Asia’s electronics industry is doing just that: HSBC’s lead indicator, which gives a rough two-month preview of future production, has slowed sharply in recent months, in contrast to the latest available output figures. One bright side, given the economic woes of Europe and America, is that Asian manufacturing is no longer as closely tied to Western markets as it was. Three of the five components that comprise HSBC's lead indicator measure conditions within Asia. So when the next rebound occurs, it is likely to be home-grown.

Again while it is true that Asia has been less dependent on the West, there is no guarantee that other sectors will not be affected from slomo diffusing or spreading of the global debt crisis.

A slowdown in electronic exports incidentally constitutes about half of Philippine exports[23]

So those dreaming of immunity from a global slowdown will likely be refuted.

Bottom line: The contagion risk is real.

Unless we see aggressive collaborative actions from major central banks (which may place a temporary patch or booster to the markets), or signs of economic stabilization from developed nations or from major emerging economies (whom are experiencing market clearing liquidations from domestic bubbles), we should expect global markets to remain sharply volatile and erratic in both directions but faced with greater probabilities of “fat tail” risks.

As a final note: I don’t expect the coming State of the Nation Address by the Philippine President to have lasting effects. They are likely to be meaningless feel good political rhetoric whose goals are for his party to seize the majority in the coming congressional elections in 2013.

Bubble policies and the effects thereof will continue to be main drivers of the asset markets.

Approach the equity markets with caution.

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[1] See Phisix: Will the Risk ON Environment be Sustainable? June 24, 2012

[2] See Infographic: Dodd Frank-enstein, July 21,2012

[3] See Barclay’s LIBOR Scandal: Self Fulfilling Turmoil July 19, 2012

[4] See Bernanke Doctrine: New York Fed Boasts of Pushing Up the US Stock Markets, July 14, 2012

[5] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[6] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[7] US Global Investors America’s Competitive Spirit, July 20, 2012

[8] BusinessInsider.com UBS: The Risk Of Hyperinflation Is Largest In The US And The UK, July 17, 2012

[9] See Taking The Hyperinflation Risk With A Grain Of Salt?

[10] Noland Doug Risk On, Risk Off And The Spanish/Chinese Tug Of War, Credit Bubble Bulletin PrudentBearcom July 20, 2012

[11] Bespoke Investment Group EU Sovereign Spreads, July 20, 2012

[12] BCA Research, Watching France, July 10, 2012

[13] See Quote of Day: The Last Hurrah of Socialist Welfare States May 8, 2012

[14] See US Stocks Markets: Earnings Trump Economic Data, Leading Economic Indicators Fall, July 20, 2012

[15] Channelnewsasia.com China bank loans rise in June, July 12, 2012

[16] See China’s New Loans Unexpectedly Surged in May June 12, 2012

[17] Reuters.com China Q2 property loans rebound with sales, July 19, 2012

[18] See Will China Ease Banking Curbs? Has the Railway Stimulus been Launched?, July 17 2012

[19] Payne Amy Morning Bell: Transportation Secretary Wants Us to Be Like Communist China, Heritage Network, July 9, 2012

[20] Zero Hedge, Forget China's Goal-Seeked GDP Tonight; This Is The Chart That Keeps The PBOC Up At Night, July 12, 2012

[21] See Contagion Risk: Watch for China’s Catastrophic Deleveraging, July 16, 2012

[22] Graphic Details Chips are down, The Economist July 18, 2012

[23] RGE Analyst Blog Philippines: Reconciling Short-Circuiting Electronic Exports, Economonitor, February 17, 2012