A Deeply Embedded Inflation Psyche

``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.” –Murray Rothbard, Making Economic Sense

Many have touted today’s action in the marketplace as a manifestation of success from government intervention.

Given public’s predisposition to focus on the short-term and interpret heavily on current information, especially after repeatedly being seduced from the incentives provided for by inflationary policies, today’s appearance of success equals tomorrow’s seismic crisis.

Betting The House On Too Big To Fail

In the US, the “Too Big To Fail” syndrome is becoming deeply entrenched in the heavily regulated banking industry.

An article by Peter Eavis at the Wall Street Journal entitled “Uncle Sam Bets the House on Mortgages” gives as a stirring depiction of the growing intensity of systemic concentration risks.

(bold highlights mine)

``It is a stunning change, but is it good for the housing market, and to what extent will it boost profits over the long term for this elite trio: Wells Fargo, Bank of America and J.P. Morgan Chase?”

Graph 1: Wall Street Journal: Too Big To Fail Getting Bigger

``Right now, housing remains on government life support. Treasury-backed entities are guaranteeing about 85% of new mortgages, while the Fed buys 80% of the securities into which these taxpayer-backed mortgages are packaged.”

``The optimistic take is that this support, though large, will shrink when market forces regain confidence. But there is a darker possible outcome: The emergency assistance is entrenching a system in which the taxpayer takes the default risk on most mortgages, while a small number of large banks get a larger share of the fee revenue from originating and servicing mortgages.

``That is what is happening now. While big banks are originating lots of mortgages, they are selling nearly all of them to Fannie Mae and Freddie Mac. Indeed, combined single-family mortgages held on the balance sheets at J.P. Morgan, BofA and Wells actually fell 3.5% in the first half. Before the bust, these banks sold large amounts of loans to Fannie or Freddie, but they also held on to products like jumbo mortgages. The volumes for those large loans now have tumbled.”

What you have here is essentially the politicization of the US banking industry, where the top 3 banks have cornered the meat of the “economic rent” from mortgage servicing and issuance which it deals with the US government.

And this concurrently, becomes an issue of moral hazard, where these highly privileged banks, which operates on implied guarantees from US government that they are “too big to fail”, may indulge on more aggressive risk taking activities at the expense of US taxpayers.

Moreover, the US government stands as THE market for home mortgages.

Alternatively, this also posits that since the US government is a political entity and is less constrained by economic pressures, the pricing structure for transacting these mortgage securities have been above what the market is willing to pay for. Thus, government intervention translates to massive tax payer subsidies to cover losses meant to keep the banking system afloat.

Analyst Doug Noland in his Credit Bubble Bulletin recently dissected the Federal Reserves 2^nd Quarter Flow of Fund and construed that instead of targeting stabilization for conventional mortgages, the Fed has been propping up private label Mortgage Backed Securities.

He says (all bold emphasis mine), ``So, the Fed is amassing quite a stockpile of “conventional” GSE MBS, but often these are “private-label” mortgages recently “refinanced” into GSE securities. And as the Fed buys the new GSE MBS, newly created funds become available to flow back to reliquefy the formerly illiquid ABS marketplace (along with agencies, Treasuries, corporates, and equities). To be sure, placing essentially federal government backing upon previously “private-label” mortgages dramatically changes the market’s perception of these securities’ worth (“moneyness”) – especially with fed funds pegged for an extended period at near zero and the Fed in the midst of a $25bn weekly purchase program in order to fulfill it commitment to purchase $1.25 TN of mortgage securities….”

``Not only is the vast majority of new mortgage Credit this year government-backed, Washington guarantees are being slapped on hundreds of billions of existing “nonconventional” mortgages. This intrusion and transfer of (Credit and interest rate) risk has terrible long-term ramifications. Although in the near-term this mechanism provides a powerful stabilizing force for both the Credit system and real economy.”

Here is an example of the “privatization of profits and socialization of losses” from which would most likely exact a heavy toll on US productivity and which would likewise be reflected on the economy, as the productive segments will be penalized dearly for the subsidies or the losses incurred by the US banking system.

Nevertheless all these accounts for the priorities of the incumbent officials and their penchant to salvage a preferred industry via the inflation route, as we discussed in Governments Will Opt For The Inflation Route.

Bernanke’s Fascism Risks An Inflation Crisis

One would have to wonder whether Fed Chair Ben Bernanke is a chronic prevaricator or has been captured by the industry he regulates or operates with a tacit vested interest on the industry or has been fanatically blinded by ideology to declare that the Fed won’t monetize debt and likewise yearn for expanded powers or control over more parts of the economy including the proposed regulation of banker’s pay. Mr. Bernanke failed to predict, was in denial of the crisis and panicked in front of Congress to ask for bailout money.

To quote John H. Cochrane And Luigi Zingales who wrote on a Wall Street Op-ed on the Lehman anniversary, `` these speeches amounted to the financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.”

Yet the justification to “help the agency act more decisively to reduce the chances of a recurrence” would only entrench the growing politicization, reduce the systemic efficiency and transition the US market economy into fascist state.

In the definition of Sheldon Richman, Fascism is ``where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically. In doing all this, fascism denatured the marketplace.” (bold emphasis mine)

Yet, the diminishing role of institutional check and balances and an increasingly centralized flow of power would only amplify the systemic concentration risks that could spark a runaway inflation crisis (given Bernanke’s tendency to inflate).

One man’s error could lead to another global systemic mayhem.

The Fed didn’t monetize debt?

Again Doug Noland on the Fed Fund Flow, ``In total, Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR). Who were the other major purchasers? The Fed monetized $647bn SAAR, the Household Sector bought $343bn SAAR, and Broker/Dealers accumulated $404bn. And while it is positive that American households are buying Treasuries and saving more, this does not change the fact that this so called “savings” was bolstered by income effects from massive government spending increases.”

For us, the outcome of inflation or deflation is a result of a deliberate policy. It’s only the fat tails or the extreme outcomes that function as a form of unintended consequences, similar to the meltdown post Lehman bankruptcy in 2008.

Moreover we don’t believe that inflation can only occur via a revitalized US consumer.

Such view myopically underestimates the role of fiscal channels [Noland: “bolstered by income effects from massive government spending increases”] or an increasing concentration or centralization of power by central banking [Richman: “Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically”].

In addition, given today’s increased globalization or deepened integration by global economies and financial system, there are transmission mechanisms or interlinkages from global governments undertaking the same inflationary tools [Noland: “Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR)”].

Hence while the risks of debt deflation seem a concern for some parts of the world, it does not apply to all. Yet if debt deflation is premised from a monetary phenomenon perspective, based on country specific issues, then the argument crumbles especially when applied to countries that have been least leveraged.

Not even a “ghost fleet of recession” or massive number of ships idly anchored in Asia in the absence of international trades arising from the recession would be enough to circumvent a steadfastly determined central bank to inflate a system.

A central bank can simply print a dollar per every dollar of liability, even if it means hundreds of trillions, if it deems it as beneficial.

Zimbabwe’s recent example should be a reminder that no amount of capacity utilization, unemployment rate, velocity of money [see last week’s Velocity Of Money: A Flawed Model], consumer spending or consumer debt and other traditional econometrics used by mainstream experts deterred a tyrant (operating on centralized power and a politicized economy) and an inflation obsessed central banker in Dr. Gideon Gono from fanning 89,700,000,000,000,000,000,000% hyperinflation in 2008.

While the US or UK may not be the same as Zimbabwe, an increasing centralization of power and politicization of the economy could neutralize any inherent advantages thereof. As former Fed Chief Alan Greenspan quoted in Bloomberg commented, ``It’s the politics in the United States that worries me, whether the Congress will basically feel comfortable” with the Fed withdrawing its stimulus, Greenspan said in a broadcast to Tokyo clients of Deutsche Bank Securities Inc. today. He later said that “if inflation rears its head, it will swamp long-term markets,” referring to bonds.”

In short, Mr. Greenspan appears sardonically worried about the US government’s addiction to inflation, a policy which incidentally, he applied extensively throughout his tenure. One might say that he inured the world with the “Greenspan Put” or Mr. Greenspan’s repeated policy of rescuing or providing support for the markets with artificially lowered interest rates during the 1987 stock market crash, the Gulf War, the Mexican Tequila crisis, the 1997 Asian crisis, the LTCM debacle, Y2K, the burst of the internet bubble, and the 9/11 terror attack.

Not until a significant part of the world becomes as deeply indebted as those afflicted by the recent bubble, will deflation become a meaningful threat to the global banking system or perhaps not until the destruction of the present currency system.

Yet deflation is a natural and rightful antidote to the excesses of inflation.

Exploding Bond Markets, From Periphery To The Core

Moreover, while debt deflation advocates continue to tunnel onto the banking system as the key source for benchmarking credit market conditions, they seem to forget the existence of the bond market as an alternative venue for credit access.

However, the difference is that credit via the bond markets won’t trigger the fractional reserve nature of today’s banking platform that would expand monetary aggregates. Nonetheless it helps push up prices of securities.

This from the Financial Times, ``European bond issuance has hit $2,000bn so far this year, the fastest ever pace of issuance, as companies race to refinance in the bond markets and banks remain reluctant to lend.

``European sovereigns, agencies and companies have sold 38 per cent more than the $1,450bn issued in 2008 in the year to date, according to analysts at data provider Dealogic, who add that issuance has never previously stood at such a high level so early in the year.

``Non-financial companies accounted for a record $446.3bn so far this year, 55 per cent more than in all of 2008….

``Financial issuers have sold a record of $542.8bn year to date, 24 per cent more than issued in 2008.”

In Asia, a somewhat similar dynamics could be at work as bond market growth has also been robust see figure 2.

Figure 1: ADB Bond Monitor: Hefty Growth in Bond Markets

According Standard & Poors as quoted by Researchrecap ``Notwithstanding a near universal attempt by central banks to ease monetary conditions, bank lending—still the predominant source of funds in the emerging markets—has varied from country to country. China is a standout, having reportedly injected as much as $1.1 trillion in new lending during the first six months of 2009. For many other markets, however, credit growth is decelerating (and, in some cases, contracting) in comparison with a year ago. This suggests that banks, even those that were largely unscathed by the financial crisis, are remaining cautious to stave off a potential increase in nonperforming loans.” (bold highlights mine)

In short given the fresh memory of the 2008 setback, some banking system in the region has opted to remain conservative in their lending practice. Nonetheless, the other route has been through the debt markets.

According to the ADB’s Bond Monitor, (bold underscore mine)

``Emerging East Asia’s bond market grew by 12.8% year-on-year (y-o-y) on an local currency (LCY) basis to USD3.94 trillion in the first half of 2009. The market also expanded by 5.2% quarter-on-quarter (q-o-q) in 2Q09 as financial markets showed signs of stabilization and the region’s growth showed signs of recovery. This lifted the growth rate for outstanding LCY bonds for the first half of the year…

``The strongest improvements in y-o-y bond market growth rates on an LCY basis in the first half of 2009 were in Hong Kong, China (19.4%); the People’s Republic of China (PRC) (14.8%); Republic of Korea (Korea) (13.1%); Indonesia (12.3%); and the Philippines (8.2%).”

Anyway, one of the publicly listed companies in the Philippines, the SM Investments, successfully sold $500 million worth of bonds from which two-thirds of the placements had been made local investors (FinanceAsia). This is a testament of the immense liquidity of the domestic system which had been reinforced by a faster growth clip in July (BSP).

In addition, domestic bank credit growth has remained vigorous in terms of trade and production, household consumption and bank repo lending activities (BSP).

And the growth in both the banking and bond markets have been indications of inflationary policies gaining continued traction in Asia. This as we repeatedly been saying is simply due to low systemic leverage, high savings rate, unimpaired banking system, current account surpluses and an apparent trend towards a deepening regionalization, and likewise, integration with the world economic system.

And as discussed in The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery, we proposed that growth dynamics would probably shift from the core (US consumers) to the periphery (emerging markets), ``money appears as being transmitted to support growth in the developing countries as part of the collaborative efforts to inflate the system.”

Morgan Stanley’s Joachim Fels, takes a parallel view in his recent outlook, ``near-zero interest rates in the US and Europe eased monetary conditions in those emerging market economies that peg to the dollar or the euro, adding to their domestic stimulus packages. Thus, it didn't come as a surprise that China was the first major economy to emerge from recession, given that it imports easy money from the US through the exchange rate link without having the US's financial sector problems.

``The point worth noting here is that we may all still be underestimating the effects of the stimulus that has already been put into place and is still playing out. If so, growth would not moderate from its current 4%+ global pace going into 2010 as in our base case, but accelerate further. The most plausible upside scenario, in our view, would be one where Asia keeps motoring ahead with domestic demand strengthening further in response to the stimulus, leading to a surprisingly strong revival of global trade.” (bold emphasis added)

Stages Of Inflation Redux

Instead of the deflation scenario, today’s sweet spot in inflation could actually signify as the initial phase of the three stages of inflation as also discussed in Warren Buffett’s Greenback Effect Weighs On Global Financial Markets.

To quote Henry Hazlitt, ``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." (bold emphasis mine)

What could be seen as some pockets of deflation today, could actually be the initial phases of inflation. And a continued rise in the commodities space even if it signifies as a currency “pass through” from the sagging US dollar would likely intensify the inflation expectations.

Then when the late stage of inflation have been reached, where the value of monetary unit falls faster (or consumer prices are rising faster) than the increase in the quantity of money which leads to the perception of “a shortage of money”, the central bank under the auspices of the government would either elect to print money at an ever accelerating “exponential” rate to meet such shortages-ergo the hyperinflation scenario, or opt to withhold feeding the boom (or by declaring a default) -the deflation scenario.

Again this will all be a result of policy choices.

So simply reading conventional metrics when governments have taken a lead role in the marketplace will lead to misdiagnosis and mass confusions on the disconnection between the market from economic reality. Analyzing how political trends will shape policy decision making will likely be a better alternative [see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?]

Anyway, a hyperinflation episode would also lead to deflation once the hyperinflated currency have been eschewed and replaced by another currency. The recent case of Zimbabwe which has abrogated its currency, the Zimbabwean Dollar, for the US dollar and South African Rand is a prime example.

At the end of the day, global policymakers will continue to bask on the triumphalism from present day policies and will most likely continue to keep the booze flowing.

Hence even if markets don’t move in a straight line they will likely respond positively to policy sustained policy accommodations over this early phase of the inflation cycle.

Not Just A Bear Market Rally For Philippine Phisix or Asia

``Key question then: why do smart people engage in negative thinking? Are they actually stupid? The reason, I think, is that negative thinking feels good. In its own way, we believe that negative thinking works. Negative thinking feels realistic, or soothes our pain, or eases our embarrassment. Negative thinking protects us and lowers expectations. In many ways, negative thinking is a lot more fun than positive thinking. So we do it. If positive thinking was easy, we'd do it all the time. Compounding this difficulty is our belief that the easy thing (negative thinking) is actually appropriate, it actually works for us. The data is irrelevant. We're the exception, so we say. Positive thinking is hard. Worth it, though.”- Seth Godin The problem with positive thinking

For many, the basic premise for today’s global market rebound has due to a “bear market rally”.

Dem Dry Bones

This especially holds true for the advocates of the global ‘deflation’ outcome and for those who interpret markets based on conventional methodology.

Nevertheless, predictions have underlying analytical foundations.

The basic pillar for such sponsorship is that the US will remain as the irreplaceable source of demand for the world. But laden with too much debt and hamstrung by a vastly impaired banking system, US consumers will be unable to take up the slack emerging from the recent bust, while the world will unlikely find a worthy substitute, and as consequence, suffer from the excruciating adjustments from the structural excesses built around them during the boom days.

Hence, the Dem Dry bones deduction-Toe bone connected to the foot bone, Foot bone connected to the leg bone, Leg bone connected to the knee bone. BOOO! We are faced with a Global Deflation menace.

We have spilled too much ink arguing against the seemingly plausible but fallacious argument simply because all these oversimplifies human action without taking into account how people will respond to altering conditions (creative destruction), overemphasis on the rear view mirror and importantly, such arguments tremendously underestimates the role money plays in a society (inflationary policies).

Moreover, the assumption that the world has been scourged with its arrant dependence on the US seems downright exaggerated as today’s market actions have shown.

In other words, yes while increased globalization trends has indeed integrated or has deepened the interlinkages of a large segment of global economies, particularly financial and labor markets and investment flows, it hasn’t entirely converged every aspect of the marketplace or the economy.

That’s because nations have their own cultural, religious and geographical traits that are unique to themselves that function as natural barriers.

Yet all these have significant impact on the motional profile of a country’s political economy. So every country (in terms of government and its constituents) will have to deal with its inherent domestic forces as much as it has to deal with fluctuating external factors, and all these dynamics will result to different or divergent responses.

Hence, national idiosyncrasies (or decoupling dynamics) will be retained and will continue to do so because of such intrinsic barriers. This, in spite of a prospective deepening globalization trends.

So individual values and actions will significantly matter more than perceived macro assumptions advanced by sanctimonious ivory tower experts.

This also means that the assumption that markets or economies will be totally convergent or “coupled” to each other is another false concept.

Four Stages of Bear Markets

Figure 1: US Global Funds: 4 Stages Of The Typical Secular Bear Market

Many have used this chart, the “four stages in the typical secular bear market”, which has floated around in the cyberspace, to justify the significance that today’s rising markets account for as a bear market rally (see figure1).

Right at the nadir of the market meltdown, triggered by the institutional bank run in the US [see October 26^th Phisix: Approaching Typical Bear Market Traits], we described how the Philippine Phisix reached the typical bear market levels in terms of depth or degree of losses and the timeframe covered, ``We are presently 15 months into the present bear market which begun in July of 2007. The last time the Phisix shadowed the US markets it took 28 months for the market to hit a bottom. I am not suggesting the same dynamics although, seen in terms of the US markets, the recent crash seems different from the slomo decline in 2000.”

From a hindsight view, we have been validated anew- we did not match the longest “slomo” decline of 28 months during the 1999-2001 cycle, but nevertheless clocked in as an extended cyclical bear market (15 months peak-to-trough), in terms of duration compared to 1987 (13 months) and 1989 (11 months).

Nonetheless the above chart of the 4 stages of a bear market has indeed traced out the bear market dynamics of the Phisix over the 1999-2002 period (see figure 2) but on a different timeframe scale relative to the US.

Figure 2: PSE Phisix: 4 Stages of Phisix Bearmarket

The Philippine market appears to have a slightly shorter cycle than its US counterpart if we are to base it on the first 3 stages (59 months US vis-à-vis 56 months). That is to repeat, in the context of a SECULAR bear market cycle.

But, I would caution you from interpreting the same operating dynamics today as that with 2001.

Besides, I would admonish any tautology that actions in the US markets should correlate with the Philippine markets-they shouldn’t. Not because of exports and not because of remittances.

Secular Bull-Cyclical Bear, Where The Rubber Meets The Road

The Philippines (Phisix and the economy) has essentially had some mixed blessings from its less globalized economy and market; she didn’t outperform during the boom days and conversely, didn’t fare as badly during the global recession.

But overall I don’t see this as being net beneficial for the country since trade openness and economic freedom is the source of capital accumulation. The semblance of any of today’s success could be attributed to more on luck than from any policy induced measures.

However, because boom bust or business cycles are fundamentally credit driven, then our eyes must focus on where the rubber meets the road.

The Philippine economy and its banking system have currently been operating from significantly reduced systemic leverage (in fact the private sector debt has been one of the lowest in Asia see Will Deglobalization Lead To Decoupling?).

Another, the crisis adjustment pressures or the market clearing process coming off the excesses from the pre-Asian crisis boom have had most of its imbalances ventilated during the 1997-2003 cycle. That’s the essence of bear markets-sanitizing excesses and balancing imbalances.

In addition, the Philippine banking system has been extremely liquid, where total resources in the banking system as of April 2009 at Php 5.8 trillion (BSP Tetangco speech August 11^th).

Domestic banking system’s Non Performing Loans (NPL) has returned to pre-Asian Crisis levels of around 4%, which serves as evidence of the market clearing process (BSP Tetangco).

Besides, because the domestic banking system’s balance sheets have been least impaired due to largely missing out on the highly levered securitization shindig, the Philippine banking system remains adequately capitalized, well above the risk ratios as per BSP regulations (10%) and Bank of International Settlement (8%) standards (BSP Tetangco).

This low systemic leverage reflects, as well as, on our emerging Asian market peers, in contrast to the US and European counterparts.

Thus, Philippine economy and its financial markets appear to be coming off on a clean slate, enough to imbue additional leverage in the system to power the Philippine Phisix and the economy to another bubble.

Sorry to say, but central bankers, being legalized cartels, are innately enamored to blowing bubbles, due to the unlimited potentials to issue credits via the fractional reserve banking platform (or issuing of money more than bank holds in reserve) from which all global central banks operate on.

Lastly, the recent bear market cycle emanated from contagion effects than from internal adjustments from massive structural misallocations, which is what the US economy has presently been undergoing. This means that adjustments from the bust are likely to be minor.

So, distinctions matter.

In short, the last bear market cycle that the Philippine Phisix suffered WAS NOT a secular bear market but a cyclical one.

Inflation: Keys To Future Investment Returns

The same reasons are behind why the historically low interest rate regime pursued by the Bangko Sentral ng Pilipinas (BSP) has generated significant traction in the economy, as we have been anticipating.

Proof?

According to the BSP, Real estate loans have been picking up as of June 2009, so as with Automobile loans, credit card receivables and other consumer loans (appliance and other consumer durables and educational loans) over the same period.

And all these have likewise been reflected on the Phisix, which as of Friday’s close has been up 51.16% on a year to date basis, driven by local investors [as discussed in last week’s Situational Attribution Is All About Policy Induced Inflation].

This compared to the 2003-2007 cycle which had been foreign dominated. That’s another key point to reckon with.

Moreover, from a chartist viewpoint, not all the bearmarkets have the same patterns, (see figure 3)

Figure 3: Philippine PSE: 18 year Cycle

At over the 23 years from where the Philippine Phisix has undergone a full cycle (secular bull and secular bear market 1985-2003 or 18 years), the ‘cyclical’ bear market in 1987 (45% loss in 13 months) did show a short resemblance to the 4 stage bears, but the 1989 market had been a V-shaped recovery (62% loss in 11 months) [pls see blue ellipses].

The point is that there is a material difference in the performance of bear markets during secular and in cyclical trends.

In cyclical markets, while bear markets can be deep, they are likely to recover rapidly compared to secular bear markets, whose correction process takes awhile, for structural reasons stated above.

Apparently, the action in today’s market appears to account for such cyclical trend dynamics.

Because no trend moves linearly, we should expect bouts of interim weaknesses. However, this should serve, instead, as buying opportunities.

Moreover, I’d like to bring to your perspective the long term cycle of the Phisix as exhibited by the pink channels. You’d notice that the long term channel isn’t sideways or down BUT UP!!!

While other observers, especially those colored by political bias, could impute economic fortunes on this, my thesis is that the nominal long term price improvements reflect more on “inflation” than real output growth.

This is why the Phisix seems so highly sensitive to monetary fluxes. The lesser the efficient the market, the more sensitive to inflationary ebbs and flows.

And this long term chart has likewise been giving us a clue to where the Phisix is likely headed for-10,000, as emerging markets and Asia takes the centerstage of the bubble cycle.

But this inflation driven pricing isn’t relegated to the Phisix alone, but has been accelerating its influence over the world and even in the US markets.

Proof?

I am now really finding some “comfort with the crowds” (pardon me, I am also vulnerable to cognitive biases, but at least one that I am aware of) among big investing savants. Aside from Warren Buffett whom we featured in Warren Buffett’s Greenback Effect Weighs On Global Financial Markets, the world’s Bond King PIMCO’s top honcho, Mr. William Gross recently wrote about how asset pricing dynamics will be fueled by inflation.

These are the strategic scenarios which he enumerated as having a high probability of playing out:

(bold/underline highlights mine)

-Global policy rates will remain low for extended periods of time.

-The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.

-Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.

-Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.

-The dollar is vulnerable on a long-term basis.

In other words, US dollar vulnerability, QE and other monetary ‘bridge financing’ non interest rate tools, aside from fiscal policies and low interest rates are all inflationary policies that are “keys to future investment returns”.

Whereas Asia and Asian-connected economies, given their edge of low systemic leverage, unimpaired banking system and the thrust towards trade and financial integration with the world commerce, are likely to assimilate most of the circulation credit “inflation”, hence their likely dominance in terms of attaining the highest global economic “growth”.

I’m not suggesting that credit expansion equals sound economic growth. Instead what I am saying is that economic growth in Asia and emerging markets will be based on the public’s response to the incentives set forth by policies to sop up credit.

In short, conventional analysis will continue to find enormous disconnect as inflationary policies amalgamates its presence on the markets.

But at least Mr. Gross have been candid enough to unabashedly admit looking for opportunities to strike lucrative deals with the government based on special ‘privileges’, “shake hands with government policies, utilizing leverage and/or guarantees to their benefit”…or euphemistically this is called political entrepreneurship or economic rent seeking from the US government!

Well, more signs of the Philippinization of the America.

The Applause Goes To Inflation

I wouldn’t shudder at the thought of policy tightening given the near unison of voices from the global authorities to extend the party.

Since inflation is a political process, then let us tune in to the statements of the political authorities to get a feel on their pulse and the possible directions of the markets.

From Caijingonline, ``China's economy is at a crucial juncture in its recovery and the government will not change its policy direction, Premier Wen Jiabao was cited as saying by Xinhua news agency September 1”…``China will stick to its moderately loose monetary policy as it strives to meet economic goals, Wen said during a meeting with visiting World Bank President Robert Zoellick.” (emphasis added)

From Bloomberg, ``China’s banking regulator said it will take years to implement stricter capital requirements for banks, seeking to assuage concerns the rules will cause a plunge in new lending.”

From Wall Street Journal, ``World Bank President Robert Zoellick said Wednesday it is too early for China to roll back its stimulus measures as the country's economic recovery could still falter.”

From Bloomberg, ``European Central Bank President Jean-Claude Trichet said the bank won’t necessarily raise interest rates when the time comes for it to start withdrawing other emergency stimulus measures. The term ‘exit strategy’ should be understood as the framework and set of principles guiding our approach to unwinding the various non-standard measures,” Trichet said at an event in Frankfurt today. “It does not include considerations about interest policy.”

From Wall Street Journal, ``Dominique Strauss-Kahn, managing director of the International Monetary Fund, warned world governments against “premature exits from monetary and fiscal policies” despite signs that “the global economy appears to be emerging at last from the worst economic downturn in our lifetimes.”

From Bloomberg, ``Federal Reserve officials in their August meeting discussed extending the end-date for purchases of mortgage bonds to minimize any market disruptions, and expressed concern about the pace of a likely economic recovery.”

As presciently predicted by Ludwig von Mises in Human Action, ``The favor of the masses and of the writers and politicians eager for applause goes to inflation.”

The global political leadership sensing short term triumph from current policies will continue to exercise the same “success formula” to limn on the illusion of prosperity.

Their actuations are so predictable.

The Deflation Bogeyman

I wouldn’t be a buyer of the global deflation thesis especially under the context that deflation is a monetary phenomenon.

That’s because the only transmission mechanism from so-called deflationary pressures, via the recession channel, would be from remittances and exports, which isn’t deflationary in terms of the potential to wreak havoc on the domestic banking system or even on the 40% informal cash based economy.

Said differently: Slower or negative exports or remittances will NOT contract the money supply and won’t be a hurdle from a Central Bank determined to inflate the system!

In the US, the fact that tuition fees from Ivy League Schools have been exploding to the upside, in spite of today’s crisis, dismisses the deflationary nature in the absolute sense for the US economy [see Black Swan Problem: Deflation? Not In Ivy League Schools].

What the US has been undergoing is a statistical deflation- a price based measure from the preferred numbers by the establishment.

In terms of political dimensions, scare tactics (deflation bogeyman) has been repeatedly used by authorities to justify inflationary policies to wangle out concessions aimed at rescuing select (political interest groups) entities or industries at the expense of the society.

And I think that the ultra low inflation (BSP) in the Philippines reflects on the same statistical mirage.

Just this week my favorite neighborhood sari-sari store (retail) hiked beer prices by 5%! While beer may not be everything (it may even be a store specific issue, which I have yet to investigate), looking at oil prices at $68 today from less than $40 per barrel in March signifies a price increase of 70%!

Seen from a lesser oil efficient use economy, the transmission mechanism, whose effect may have lagged, could be more elaborate than reflected on government based statistical figures.

To consider both the US and the Philippines will have national elections in 2010, senatorial and Presidential-senatorial respectively. So it wouldn’t be far fetched that the incentive for incumbent authorities from both countries to intervene (directly or indirectly) in order to create the impression of a strong economic recovery for the sole purpose of generating votes.

The fact the Philippine Peso continues to slide against the US dollar in the face of stronger regional currencies seems so politically suspicious.

The Peso’s woes can’t be about deficits (US has bigger deficits-nominally or as a % to GDP), or economic growth (we didn’t fall into recession, the US did), remittances (still net positive) or current account balances (forex reserves have topped $40 billion historic highs) or interest rates differentials (Philippines has higher rates).

In sum, when you factor in all the major variables that could influence the Phisix- local politics (national elections), geopolitics (such US elections), the “anxiety” from global central bankers which should translate to prolonged or extended monetary inflation, continued loose domestic monetary policies, long term technical trends, inflation sensitive fundamental issues (as systemic leverage, banking system) and the potential response from the public to loose monetary policies-it would seem highly probable that the domestic stock market is likely to continue with its long term ascent.

So I would NOT reckon this to be a bear market rally especially not from the flimsy excuse of global deflation.

Figure 4: Bloomberg: Possible Bear Market Rally

Bear market rally could be a US phenomenon (see figure 4), but is unlikely for Asia and Asian Emerging Markets.

Nevertheless, I would use the US dollar index, gold and oil as my main barometers for measuring liquidity conditions.

US Home Bubble Cycle: Upside Directly Proportional To Downside

Floyd Norris of the New York Times posted a chart in his most recent article which I think fittingly illuminates how the bubble (inflation) process works.

This from Mr. Norris, (all bold highlights mine)

``IN the last eight years, home prices in the United States have almost exactly kept up with inflation. But it has been a wild ride.

``During the period, the Standard & Poor’s Case-Shiller 20-city composite index of home prices rose almost 21 percent. The Consumer Price Index also rose almost 21 percent.

``The period, from June 2001 through the June 2009 figures that were reported this week, can be separated into two periods: the five-year boom and the three-year bust. There are limited indications that prices have started to rally in some areas, but the overall index’s move in June just kept up with inflation.

``During the boom, home prices outpaced inflation by 10.7 percent a year for five years. During the bust, they plunged, trailing inflation by 13.6 percent a year."

The interesting observation isn't just "what comes up must go down", but instead "the degree of ascent is almost directly proportional to the scale of decline"...very much like Newton's third law of motion:

For every action, there is an equal and opposite reaction.

This "stages in a bubble" chart has been a frequent post here to underscore how the bubble cycle culminates...



Nevertheless Mr. Norris concludes, ``Now foreclosures are still rising, even as home sales and prices seem to have stabilized. If the worst is over, it will have been a wild ride that ended very close to where it began, but with many people much worse off for the experience."

Lessons:

1. Property prices fundamentally reflects on the degree of the impact from inflationary policies undertaken (extremely loose monetary policies, administrative policies promoting home ownership and tax policies encouraging debt or credit take up).

2. Bubble or inflation policies has had a net negative effect on society, (consumes capital), which requires a lengthy and painful period for healing or rebalancing.

To quote Stephen Cecchetti, Marion Kohler, Christian Upper of Bank for International Settlements in a recent paper Financial Crisis and Economic Activity

``By altering attitudes towards risk, as well as increasing the level of government debt and the size of central banks’ balance sheets, systemic crises have the potential to raise real and nominal interest rates and consequently depress investment and lower the productive capacity of the economy in the long run. We looked for evidence of these effects and found that a number of crises had lasting, negative impacts on GDP. In some countries this was a result of an immediate, crisis-induced drop in the level of real output combined with a permanent decline in trend growth. In other cases, we find that the growth trend increased following the crisis but that the immediate drop was severe enough that it took years for the economy to make up for the crisis-related output loss."

Unfortunately yet, policymakers never seem to learn and continue to adopt short term oriented bubble blowing policies. This would lead us from one crisis to the next but transitioning towards a bigger scale, as the imbalances which needs to be adjusted will have simply been postponed. However, these are accumulated until the laws of nature will ultimately force an adjustment.

In essence, bubble policies are best signified by the idiom jumping out of the frying pan and into the fire.

Asia: Policy Induced Decoupling, Currency Values Aren’t Everything

``The biggest lesson of the current crisis for Asian countries is that they can no longer depend on the West as a market for their exports, nor for reliable returns on their investment capital. To address the first issue, Asia has to cultivate its domestic consumer markets to sustain its growth. For the second, it faces a potentially more daunting challenge: to grow and strengthen its domestic capital markets, and stimulate Asian investment in Asia. Should Asia achieve these goals, it would mark a fundamental shift in the economic relationship between Asia and the West—and in particular between China and the U.S.” Matthews International Capital Management Asia Now, The Growth Issue

As we have been saying, inflationary policies are essentially vented on currencies which are instantaneously transmitted to the financial asset markets.

Besides, the impact of inflation has always been relative, since money enters the economy at specific points of the economy, and considering the distinct capital structure of national economies, the effects from these policies are likely to be divergent.

Take for instance, high savings, low systemic leverage, and an unimpaired banking system from the recent crisis [as we recently discussed in Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble] are likely to be more responsive to low interest rate policies regime implemented by domestic central banks. The massive outperformance of emerging markets relative to developed economies is a symptom of such response [see Global Stock Market Performance Update: Despite China's Decline, Emerging Markets Dominate]

It doesn’t stop here. This phenomenon has somewhat distilled also into national economies, see figure 5.

Figure 5: Divergent Impact On Industrial Production (Economist) and Car Sales (PIMCO)

Industrial production in the Emerging Asia has sharply been reinvigorated in contrast to the sluggish performance in the US.

The same divergent dynamics can also be seen in the comparative car sales between China and the US.

In short, what you are seeing is a clear manifestation of decoupling at work.

This from the Economist,

(bold highlights mine)

``Across the region, aggressive fiscal and monetary stimulus has helped revive domestic demand. Asia has had the biggest fiscal stimulus of any region of the world. China’s package grabbed the headlines, but South Korea, Singapore, Malaysia, Taiwan and Thailand have all had a government boost this year of at least 4% of GDP. Most Asian countries, with the notable exception of India, entered this downturn with sounder budget finances than their Western counterparts, so they had more room to spend. Bank of America Merrill Lynch forecasts that the region’s public debt will rise to a modest 45% of GDP at the end of 2009, only half of the average in OECD countries.

``Moreover, pump-priming has been more effective in Asia than in America or Europe, because Asian households are not burdened with huge debts, so tax cuts or cash handouts are more likely to be spent than saved. It is also easier in a poorer country to find worthwhile infrastructure projects—from railways to power grids—to spend money on.”

Mainstream analysts, whom mostly have been deflation advocates, jeered and hectored on the decoupling theme following the climax of the US banking seizure last September and October. Unfortunately, it appears that the deflationary episode signified as a fleeting moment of glory and as developments deepen things has once again been turning out to refute their highly flawed assumptions.

Importantly, we described in our February article Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?, that creative destruction, the role of real savings, supply side responses, and the role of Asia’s middleclass could act as possible channels for decoupling.

Currency Values Aren’t Everything

The Economist highlights another point we’ve been making,

``The basic problem is that although the Asian economies have decoupled from America, their monetary policies have not. In a world of mobile capital, an economy cannot both manage its exchange rate and control domestic liquidity. By trying to hold their currencies down against the dollar Asian economies are, in effect, being forced to shadow the Fed’s monetary policy even though their economies are much stronger. Foreign-exchange intervention to hold down their currencies causes domestic liquidity to swell. Consumer-price inflation is not an imminent threat, because prices are falling in most Asian countries. Chinese consumer prices fell by 1.8% in the year to July. But asset prices look dangerously frothy. The obvious solution is to let exchange rates rise, but with exports still well below last year’s level, governments are reluctant to set their currencies free.” (bold emphasis mine)

What we are in agreement is here is that of the US Fed policy transmission to the Asian markets and economy.

Although it would be ideal that Asian currencies be allowed to rise to reflect some of these adjustments, the idea that currencies are the only major factor for adjustments represent as logical fallacies of hasty generalizations based on unfounded assumptions or Ipse Dixitism.

To consider, the Philippines saw its currency the Peso depreciate from Php 2 to a US dollar in 1960s to Php 55 pesos to a US dollar in 2005 (or 96% devaluation!).

Considering the macro assumptions that such magnitude of adjustments ought to reflect on its products, this implies that the Philippines should have been an export giant by now.

Unfortunately this hasn’t been the case. Instead, we became a giant of labor exports, as an aftereffect of a vastly lowered standard of living out of the inflationary policies accrued from present and the previous administrations.

Unfortunately, such simpleminded fallacy of composition by experts deals with the assumption of an economy producing a single good from a single type of labor funded by a single type of capital.

I’ll further the example; San Miguel Beer which cost Php 19 per bottle in a local sari sari store (informal retail outlet), costs Php 50 in local B rated bars, and Php 200 in 5-star hotels. This is known as Price Discrimination, which basically means the selling of identical products to different markets through market segmentation.

In other words, depending on the markets, some products are more price sensitive (price elastic) than the others. In practice, a product that caters to the lower income class of the society is more price sensitive compared to a product marketed to the high end income segment.

So markets, not only prices (through currencies), are the more important qualifying variables for any required economic adjustments.(yet, high profile local experts continue to call for inane Peso depreciation!)

The fundamental reason why the Philippines haven’t benefited from a depreciated currency is because the local political economy has a limited and underdeveloped market due to an unfree economic rent seeking crony capitalist structure which has remained in place until today.

Besides, if currency value is the sole determinant of economic growth then Zimbabwe should be the biggest exporter or the wealthiest nation today!!!

The Japan Experience

More example; if rising currency translates to “greater domestic demand” then why has the Japan’s economy remained an export dependent economy despite the huge (threefold) appreciation of the yen? (see figure 6)

Figure 6:Gold News: Soaring Japanese Yen

Nathan Lewis for the Daily Reckoning says that aside from the deflation in the banking system what mattered most had been the series of tax hikes that has kept Japan’s economy in the doldrums, 20 years from the bubble bust.

This from Mr. Lewis (bold highlights mine) , ``They began with a series of tax measures on January 1, 1990 - the first day of the bear market - which eliminated certain preferential capital gains tax treatments for property. To take a few of a great many such steps which followed: In 1992, the tax rate on short-term capital gains (under 2 years) on property was raised to 90%. Long-term gains were taxed at 60%. A 0.3% National property tax was introduced (this was several multiples greater than existing property taxes). A City Planning Tax of 0.3%. A Registration and License Tax of 5% of the sale value of a property. A Real Estate Acquisition Tax of 4%. An Office Tax of 0.25%. A Land Ownership Tax of 1.4%. Even the regular property tax, the Fixed Assets Tax, was effectively raised by several multiples. From 1990 to 1996, Japanese property values imploded by as much as 70%. However, the revenues from this tax rose by 46%. You can do the math…

``Already there is an annual rise in payroll taxes, scheduled for every year between 2004 and 2017, which will eventually take the payroll tax rate from 13.6% to 18.3%. (Employers match this, and there is no maximum income to which it applies.) And what about the increase in taxes on dividends from 10% to 20%? Or the introduction of a brand-new capital gains tax on equities of 20%, which had effectively been tax-free before? Or the effective 25% increase in personal income taxes, the result of the elimination of a 20% tax cut introduced in 1998? On top of all that, politicians are talking about increasing the consumption tax (similar to a sales tax) from 5% presently to 10% or higher. Until a 3% consumption tax was introduced in 1989, there was no consumption tax at all in Japan, not even at the prefectural or municipal level.”

In addition, John Hempton of Bronte Capital says the legacy of zombie corporations has consumed capital resources which was otherwise meant for other productive investments, ``the problem in Japan was their ability to keep zombie corporations (not zombie banks) alive for decades. Japan has a “Rip-Van-Winkle” industrial legacy to go along with its absolutely brilliant modern technology industries. This old industry sucks resources which would better be used by the modern industry.” (emphasis added)

In short, like the Philippines, domestic policies have been responsible for restricting the required adjustments to expand the marketplace in spite of the currency adjustments. So calling for adjustments of imbalances via the currency route is no less than a fantasy.

Therefore, I’d avoid listening to “expert” economists who would reason along logical fallacies and prescribe snake oil medicines.