Phisix: Why the Contagion Risk Must Not be Discounted

Here is what I wrote last week[1]

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

So apparently correction of the Phisix materialized.

In line with the activities of the region’s bourses, the Phisix fell 2.76% this week.

For our ASEAN peers, the outcome had been mixed. Thailand and Malaysia was modestly higher while Indonesia joined the Phisix in a correction mode but had been down moderately.

The BRICs or Brazil, Russia, India and China continue to suffer from hefty losses.

Whatever bounce we have seen lately have mostly signified as deadcat’s bounce for the BRICs. So far only India (BSE) has shown a little bit of strength compared to her contemporaries; China (SSEC), Brazil (BVSP) and Russia (RTSI)

If you have noticed, events have become sooo incredibly short term oriented, exceedingly volatile, and at worst, complacency seems to have become a dominant feature, especially in the Philippine setting, where the current environment has largely been seen as hunky dory.

And part of my concern stems from idea that BAD news has been interpreted as GOOD news where many have come to believe that either local and regional markets have become immune to the external developments or that interventions has been seen as a sure thing and will always be successful.

And as I have pointed out during the past few weeks, my other concern is that perhaps the Philippine market may have been “jockeyed” to project political goals.

Bubble Cycles: This Time Will NOT be Different

“This time is different” are four words that I fret most. For the late investment legend Sir John Templeton these are the four most dangerous words in investing[2].

Such statement is symptomatic of overconfidence, a deeply ingrained euphoric sentiment or an embedded belief that a new paradigm has somewhat reconfigured how life would play out.

A classic example is when the late distinguished monetary economist Irving Fisher infamously declared that the US stock market, at the climax of the bullmarket in 1929, had reached “a permanently high plateau.”[3] What followed in the coming months were the gruesome Wall Street Crash and the Great Depression.

So when I stumble upon news which avers that “Southeast Asia is looking more a safe haven than a risky bet, with foreign investors souring on China and India and pouring money into markets proving resilient to the global gloom”[4] such assumptions gives me a creepy feeling.

That’s because such sentiment evokes of the memories of the excruciating Asian crisis which once was heralded as the “Asian Economic Miracle”[5] in 1994 and which ultimately turned out into a grand cataclysmic bubble bust in 1997.

Yet it took 3 years for the bust to occur.

But euphoria does seep through public’s consciousness even when bubble cycles have not been homemade.

Exactly during the pinnacle of the last boom phase of the Philippine stock market, a local news outfit featured the ‘basura queen’ in June of 2007[6]. Basura is a local term for garbage and a stock market colloquial or slang for high risk issues.

The ‘Basura’ Queen swaggered about her making millions out of ‘basura’ issues, or the penny stock equivalent of Wall Street.

Overconfidence and the increasingly desperate search for returns seem to be revving up the public’s appetite for gambling.

But the seeds of a homegrown bubble are also being sown.

The Fitch Rating, a US credit rating agency recently, seems to have echoed on what I have been repeatedly warning about: that the Philippines may be on the ‘brink’ of a domestic credit boom[7]. Not just on the brink, we are already having a domestic credit boom[8].

Of course, local officials will hardly do anything about this, since the credit boom will spruce up the economy over the short term and would thereby provide an image booster or political advertisement to the incumbent administration as their “major accomplishment”.

The boom will be seen as a feat, but the bust will be passed on like a hot potato. In politics, who cares about the future?

Besides, officials have limited knowledge of the unseen or undefined “equilibrium” levels from where or which point to put the policy brakes on.

In addition, since the Philippine political economy have been mostly state driven, chieftains of the industries involved in the boom, who are most likely allies of the administration, will exert their political capital to influence on the direction of policymaking thereby extending the boom to unsustainable levels.

Finally since policymakers have innate Keynesian leanings, who try to promote consumption as the main policy thrust, the policy of negative real rates will drive

1. consumer spending through acquisition of more debt via mortgages, credit cards, and other consumer loans,

2. encourage more government spending which will be financed by low interest rates from the private sector, particularly channelled through banks and other financial institutions, which again would add to systemic debt, and importantly leads to consumption at the expense of production, and lastly,

3. fuel capital intensive speculation which will likely be directed to real estate projects, manufacturing and mining, and which again leads to more systemic debt accrual. Such misdirection of allocations of resources eventually leads to the consumption of capital. A great bust.

Again all inflation is political, designed to push the interests of a few at the expense of the society

And I am talking here of a locally fuelled bubble which is aside from today’s present risk: contagion.

Europe’s Capital Flight Paradigm

In case of a full blown global recession, there has hardly been convincing evidence that ASEAN bourses will entirely decouple.

As I predicted Japanese foreign direct investments capital flows into ASEAN has currently been intensifying[9].

Since Japan’s capital flows into ASEAN have still been couched on the term ‘investments’ based on ‘growth’, this has yet to translate into a full capital flight dynamic where Japanese investors frantically stampede into ASEAN assets regardless of risk conditions.

Once Japan’s debt crisis reaches a ‘tipping point’[10], where in the face of the dearth of access to private capital and from external financing, and where the Bank of Japan (BoJ) will substitute as the buyer or financier of last resort of local sovereign papers in order to save the banking system, then this ‘growth’ dynamic will likely be substituted for ‘flight to safety’[11].

Such dynamic appears as partially being played out in the Eurozone: government debts of Germany, Finland and Netherlands[12] (as well as Denmark[13]) have become lightning rods against the concerns of the Eurozone’s dismemberment and this dynamic has also began to diffuse into Belgium and France.

Yes, it is panic time in the Eurozone as expressed by the bond markets…

…but not in the equity markets

I think that the difference is that the European Central Bank (ECB) has yet to aggressively step up as the buyer and financier of the last resort which is why most of the capital flows have been absorbed into government bonds.

Nevertheless some of these safehaven flows may have already been rechanneled to the equity markets of Germany (DAX), Denmark (KFX), Netherland (AEX) and Belgium (BEDOW).

Meanwhile the Finnish and French bellwether has yet to ventilate similar ‘capital flight’ dynamics.

Remember if the risk conditions in the Eurozone stabilize, then these capital flight dynamics will likely be reversed as money flows back to their sources, and the current boom may turn out to another bust, which ironically may again fuel more destabilization.

Some bullish background, eh?

Contagion Risk Must Not be Discounted

We shouldn’t forget that the Asian Crisis proved that contagion risk was a real risk that spread throughout the region.

As the Reserve Bank of Australia noted[14],

One can then locate the onset of crisis in Korea, Indonesia, Malaysia, and the Philippines in a process of contagion: a flip to the bad equilibrium to which the economies were vulnerable, in response to the ‘wake-up call’ (i.e. signal) from Thailand that this was a possible outcome.

This was likewise true with the 2007-2008 meltdown of the US property and mortgage bubble.

Remember that the real effects of an external transmission of contagion were hardly felt since the Philippine economy escaped a recession and that the ensuing global slowdown hardly left an imprint to local corporate earnings, yet the Phisix lost over half of its value from peak to trough[15]!

So while it may be true that those years had different conditions from today, despite some of the real relatively positive changes on ASEAN economies, we must be reminded that globalization and dependence on the US dollar through international currency reserve accumulation via the global banking system has been the umbilical cord for global asset markets.

Merchandise trade as % of GDP remains as a significant factor to ASEAN economies particularly to the Malaysia and Thailand.

But the Philippines also depends on foreign remittances (10.73% of GDP 2010[16]) as well, and to the lesser extent Indonesia (>1% of GDP 2010[17])

While the Philippines and Indonesia may be less exposed, the question will be internal dynamics.

Dependence on government spending only provides temporary relief (benefits the cronies) at the expense of the future (higher taxes, higher debt levels, and higher inflation)[18].

Has the political, legal, tax and regulatory environment eased to incentivize entrepreneurs to take on more productive ventures?

Philippine economic growth has recently been powered by exports[19], most likely due to global restocking. But with a ongoing recession in the Eurozone, as well as, a pronounced slowdown China and other major emerging market economies, and importantly the US, expectations of robust “double digit” growth signifies as wishful thinking…unless major central banks come up with more aggressive short term palliatives.

And a slowdown in global merchandise trade has been prompting for a contraction on trade surpluses (perhaps partly due to increasing domestic demand) and a reduction of foreign currency reserves, as some emerging market central banks have attempted to stabilize exchange rate values with use of these surpluses and thus results to monetary tightening conditions that may not be conducive for equities[20].

In addition, the banking crisis at the Eurozone will prompt for major balance sheet adjustments in order to raise capital mostly through shrinkage, particularly banks are slated to reduce balance sheets by €2 trillion by dumping 7% of these assets by the end of 2013. This also means that supply of credit to the economy will contract.

Of course the real problem isn’t due to credit contraction which affects mostly the government and their protégé the banking system but of the failure to undertake real reforms focused on competitiveness and productivity[21].

Yet under the worse policy scenario arrived by IMF estimates according to DBS Research[22], a dramatic slowdown in the economy compounded by bank deleveraging (bursting bubble) will affect even the US and emerging markets will not be spared (most especially in Eastern Europe).

So we can hope for the best and prepare for the worst.

So underneath the headlines, ASEAN+3 (China Japan and South Korea) have doubled their Chiang Mai Initiative Multilateralism (CMIM) currency swap buffer to USD 240 billion which was a third funded by total foreign reserves accumulated by ASEAN 5 (US 765 billion as of April)[23][24].

So while Asian central bankers have been adding insurance against the risk of the aggravation of Europe’s banking crisis, domestic investors have been in a buying binge.

Yet the ongoing Euro-Brazil, Russia, India, China slowdown compounded by deleveraging within their respective economies has already affected Singapore whose economy suffered a contraction last quarter[25]

Yes China’s economy managed to post 7.6% growth last quarter, but many questioned on the validity of the statistics used to arrive at this output which for some have been overstated for political reasons[26]

And yet US and European markets rallied fiercely last Friday, which according to news drew on the conclusion that the recent conditions of China’s economy will lead to more monetary accommodation by policymakers[27]. Bad news again seen as good news.

I think that such knee jerk response represents more of a melt-up from “crowded short positions” rather than a major inflection point.

As Prudent Bear analyst Doug Noland rightly points out[28],

But the downside of the Credit cycle radically alters rules of the game. Over time, reality sinks in that the previous prosperity was in fact an unsustainable boom-time phenomenon. The downside of the Credit cycle ensures faltering asset prices, deflating household net worth and financial sector deficiencies, along with the revelation of problematic economic imbalances and maladjustment. It’s not long into the bust before many see themselves as losers – and to have lost unjustly at the hands of an unfair system. The growing ranks of losers become an increasingly powerful political force.

Nevertheless I expect Friday’s huge jump to filter into Asian markets including the Phisix at the start of the week.

My conclusion remains: for as long as political gridlock over policies persists (in the US, China and Eurozone) and central bankers of major economies remain rudderless, markets will remain subject to extreme volatility from the collision of hope (expectations of decoupling, deeply embedded Pavlovian expectations of major central bankers coming to the rescue and of the narcotic effects of inflationism) and reality (ramifications from deflating bubbles: economic slowdown and deleveraging). Not to discount of the possibility of major policy errors from too much focus on the short term fixes.

While I remain bullish over the Phisix over the long term, the short term horizon has been filled to the brim with uncertainties coming from almost every direction. This for me magnifies the tail event risks.

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[1] see Why Current Market Conditions Warrants a Defensive Stance July 9, 2012

[2] SirJohnTempleton.org Consider these 'words of wisdom' about investing September 20, 2006

[3] Wikipedia.org Irving Fisher

[4] Reuters.com Southeast is Asia safe haven as China, India stumble, July 14, 2012

[5] Wikipedia.org 1997 Asian financial crisis

[6] See Philippine Stock Exchange: The PUBLIC’s MILKING Cow???!!!, June 17, 2012

[7] Inquirer.net Philippines on the brink of a credit boom, must be wary of dangers—Fitch Rating, July 6, 2012

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

[9] See Japan’s Capital Flows to ASEAN Accelerates July 4, 2012

[10] See The Coming Global Debt Default Binge: Japan’s Government Under Financial Strains July 9, 2012

[11] See Will Japan’s Investments Drive the Phisix to the 10,000 levels? March 14, 2012

[12] Bloomberg.com AAA Yields At Zero Drive Investors To Belgian Debt: Euro Credit July 13, 2012

[13] See Denmark Cuts Interest Rates to Negative July 6, 2012

[14] Corbett Jenny, Irwin Gregor and Vines David From Asian Miracle to Asian Crisis: Why Vulnerability, Why Collapse? 1999 Reserve Bank of Australia

[15] See Dealing With Financial Market Information February 27, 2011

[16] Tradingeconomics.com Workers' remittances and compensation of employees; received (% of GDP) in Philippines

[17] Tradingeconomics.com Workers' Remittances And Compensation Of Employees; Received (% Of GDP) In Indonesia

[18] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 3, 2012

[19] ABS-CBNNews.com May exports growth at 17-month high, July 10, 2012

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

[21] See What to Expect from a Greece Moment June 17, 2012

[22] DBS Vickers Economics Markets Strategy 3Q 2012 June 14, 2012

[23] Ibid

[24] Wikipedia.org Chiang Mai Initiative

[25] See Contagion Risk: Singapore Economy Contracts, July 13, 2012

[26] See China’s Economic Growth Slows Anew, Economic Data Questioned July 13, 2012

[27] Bloomberg.com S&P 500 Erases Weekly Loss On JPMorgan Rally, China, July 13, 2012

[28] Noland Doug Game Theory And Crowded Trades Credit Bubble Bulletin, Prudent Bear.com July 13, 2012

Inflation’s Sweet Spot Augur For A Gold Breakout And Global Equity Market Rally

``When the government and the banking system begin inflating, the public will usually aid them unwittingly in this task. The public, not cognizant of the true nature of the process, believes that the rise in prices is transient and that prices will soon re­turn to “normal.” As we have noted above, people will there­fore hoard more money, i.e., keep a greater proportion of their income in the form of cash balances. The social demand for money, in short, increases. As a result, prices tend to increase less than proportionately to the increase in the quantity of money. The government obtains more real resources from the public than it had expected, since the public’s demand for these resources has declined. Eventually, the public begins to realize what is taking place. It seems that the government is attempting to use inflation as a permanent form of taxation. But the public has a weapon to combat this depredation. Once people realize that the govern­ment will continue to inflate, and therefore that prices will con­tinue to rise, they will step up their purchases of goods. For they will realize that they are gaining by buying now, instead of wait­ing until a future date when the value of the monetary unit will be lower and prices higher. In other words, the social demand for money falls, and prices now begin to rise more rapidly than the increase in the supply of money."-Murray N. Rothbard,The Economics of Violent Intervention in the Market

Speaking of benign inflation, the “sweet spot” of the inflation is the seductive phase where the financial and economic ambiance is characterized by an episode of rising asset prices which reinforces the perception of the strengthening of the economy’s recovery and vice versa.

This actually plays out in the manner introduced by market savant George Soros as the reflexivity theory- a self-reinforcing feedback loop mechanism where people interpret prices as signifying real events, and where real events reinforce these price signals.

In short, from our perspective, the sweet spot of inflation represents as a boom scenario for markets resulting from easy money policies.

However, since the interplay of perceptions which have been enhanced by price signals and statistical information on the real economy has been manipulated by the official policies, most people don’t recognize that price signals are manifestations of the deepening scale of malinvestments into the system. And as the boom phase draws in more of the crowd, the trend becomes entrenched until they become unsustainable...but we seem to be getting way too far.

A Global Rally Ahead?

Last week we said that equities are likely to be a “buy” once gold breaks above the 1,120-1,125 area[1]. And perhaps the sweetspot of inflation will become more conducive once it is supported by the concomitant rise of US and Chinese markets.

The reason we opted to use gold as a major key indicator for markets is because gold has not only decoupled from the US dollar and is likely to seek its own path overtime, but importantly gold has served as a significant lead indicator for equity and commodity prices. This is because Gold apparently reflects on the state of the global liquidity.

For now, even as gold hasn’t broken above the important threshold, the ancillary conditions appear to be suggestive of an upcoming breach (see figure 4)

Figure 4: stockcharts.com: Sweet spot of Inflation?

US equities as signified by the S & P 500 (SPX), while down for the week, has brushed off the recent accounts of the volatility from the ‘Greek tragedy’ and appears to be in an uptrend.

We also see China’s Shanghai index (SSEC) as striving to move higher (see middle minor window). China’s major bellwether have been in consolidation over the past two months, after being hammered repeatedly by the formal and informal arm twisting by her government in an attempt to squeeze bubbles out of her system late last year.

Next we have the JP Morgan Emerging Markets Debt fund (JEMDX) or a bond fund which is invested in sundry emerging market sovereign debt, as sharply moving higher. These could be signs that foreign money flows could be gathering steam into Emerging Markets anew.

Combined, these market signals could presage a vigorous resurgence of global equities out of “loose monetary conditions” and the reflexivity theory ahead.

And this is likely to also be reflected in gold’s next moves.

Gold’s ‘Fundamental Change In Sentiment’

Another reason why gold should be a good benchmark is that the varying interests of global central banks appear to have created a “neutral” zone for gold.

By neutral zone, we mean that gold is likely to reflect on market forces with reduced odds of manipulation. Many emerging market governments have been increasingly playing the role of “buyer” while former sellers seem to be downscaling sales activities.

Asian Investors quotes the World Gold Council on this noteworthy shift, ``After net-selling an average of 444 tonnes of gold in the five years to 2008, central banks only offloaded a net 44 tonnes last year. In fact, after 62 tonnes of net selling in the first quarter of 2009, central banks posted three quarters of net buying. This shift may signal a "fundamental change in sentiment", says the London-based World Gold Council (WGC).” (bold highlight mine)

In other words, the “fundamental change in sentiment” has transformed central bank officials’ view of gold from a “barbaric metal” to insurance, as previously discussed.[2]

I’d like to further add that gold prices have recently been weighed by the IMF’s proposed sale of the remaining 191.3 tons to the market.

While after a week of announcement, no nation has officially taken up the IMF’s offer, there are reports that India may suit up for IMF’s last batch of gold sales. This should stir up the gold market anew.

Many have expected China to take the counterpart of the IMF’s offer. But this may not happen. China’s gold procurement has been marked by inconspicuous domestic acquisitions since. As example, in April of last year, China surprised the market with the declaration that it had raised its gold reserves by “33.89 million ounces by the end of April” of 2009 since December 2002.

And since China is now the world’s largest gold producer, she isn’t likely to be pressured on overtly buying into IMF’s gold.

Albeit, we are quite sure that China’s interest in the precious metal remains unabated. Her huge sovereign wealth fund, China Investment Corporation (CID) had reportedly acquired an equivalent of 4.5 tonnes of SPDR Gold Trust ETF just recently, making the fund the largest holder, alongside with investing legends as John Paulson and George Soros.

Finally, should gold opt to somewhat mimic on the Euro’s moves anew, the prospects of a sharp rebound in a severely oversold Euro could also give the metallic money a boost (see figure 5)

Figure 5: Mineweb: Extremely Overbought US dollar and Severely Oversold Euro

Here we quote Mineweb’s Rhona O'Connell: (bold emphasis mine)

``The instrument shown here is the US Dollar Index position reported by the "I.C.E.", or IntercontinentalExchange, which turns over very heavy dollar trading, although the net speculative positions are comparatively low when compared with those in the euro on the CME or gold on COMEX. Nonetheless they reflect sentiment. The reported positions relate to contracts of $1,000 each, meaning that the largest recent net dollar short position, at 12,521 contracts, was equivalent to $12.5 million. The swing since then has been equivalent to $53.4 million to the long side and the latest position, a net long of $40.9 million, is almost 150 times the average since 2004.

``Meanwhile the net euro position on the CME is even more extreme. Taken over the same period, the net speculative euro position on the Chicago Mercantile Exchange has averaged a long of $4.8 billion euros. In mid-February the position was a net short of 8 billion euros; the outright long is at 71% of the average for the period, but the short is twice its average.”

So the forces which heightens the odds for an upside breakout for gold prices looks firming up, and we should gold’s breakout to likely be accompanied by auspicious sentiment for the asset markets.

Positive Foreign Trade For The Philippine Stock Exchange

I’d like to conclude with a chart of the foreign flows into the Philippine Stock Exchange (PSE) (see figure 6)

Figure 6: PSE: Net Foreign Trades

Despite the marked selling in early February, we are generally seeing net foreign inflows into the PSE on a year to date basis.

This squares with our earlier observation that despite the diminishing share of foreign trade in the markets (about 37.7%), foreign trade has accounted for a net inflow to the tune of 5.2 billion pesos (about $110 million) for 2010.

Inflationism in developed economies is likely to spur more foreign fund inflows, which should support the domestic asset markets, particularly, the equity market, the real estate sector, corporate and sovereign bonds and the Philippine Peso.

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[1] See Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

[2] See Is Gold In A Bubble?

What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

``This pessimistic bias is a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.” Bryan Caplan The 4 Boneheaded Biases of Stupid Voters

What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

-The Pavlovian Response Stimulus Behavior
-Unlike The Bear Market Of 2007
-Posttraumatic Stress Disorder Revisited
-Economic Relativism And Zero Bound Rates
-Authorities Seem Clueless With Bubbles And Operate On Fear

Most of the global financial markets have ended the month mostly in the red. And with momentum appearing to falter, we are seeing marginally more price signal convergence than of a divergence over the past few weeks [both of the prospects we discussed in When Politics Ruled The Market: A Week Of Market Jitters]

By price signal convergence, I mean eerily somewhat similar shades that characterized the bear market of 2007-2008, namely, generally frail equity markets, feeble commodity markets, buoyant US dollar as foreign currencies fumble, lower treasury yields and rising credit default swap premiums, as shown in Figure 1, aside from a higher fear index.

Figure 1: Danske Bank: Negative Interest Rates In US and Resurgent CDS

US T-Bills turned negative for the first time since the Lehman episode in 2008 (left window). However, in spite of the spike in the credit default index of Europe’s most liquid investment grade companies, this has yet to even reach or top its most recent high in 2009 (about 75-right window).

The Pavlovian Response Stimulus Behavior

But does this mean a redux of bear market meltdown of 2007-2008? I don’t think so.

As we have earlier stated, markets appear to be acutely discordant or confused on what has truly been prompting for such apparent broad based weakness.

And as usual, media and mainstream analysts has repeatedly focused on any available current events to ascribe on the possible causal relations: the Chinese government enforcing a curb on bank credit, the Greece debt crisis and or the US proposed enhanced regulatory policies, aside from employment concerns.

Unfortunately, markets have not entirely been confirming such suppositions (see figure 2)

Figure 2: US Global Funds: S&P Weekly Performance

If read from the equity market activities in the US, aside from the Materials and Energy Index, which could be extrapolated as having been influenced by the China factor, it isn’t financials but the Info Tech index that has suffered the worst beating after the China factors this week.

Financials, consumer staples and consumer discretionary, or “economic sensitive” sectors declined marginally relative to its other contemporaries as the US economy registered a faster than expected 5.7% growth mainly due to inventory build up.

Yet following the outperformance of the Nasdaq (44%) and by the S&P 500 info tech (53%) in 2009, it should be natural that any correction should impact the biggest gainers most. The same force appears to have earlier influenced the financial sector, which accounted for last week’s biggest loser but this week’s least affected.

In other words, what we may have been witnessing could be an intrasector rotational profit taking process more than a rerun of the bear market.

And if we are to assess market sentiment (see figure 3) using the Fear index, following 3 successive weeks of decline, the financial markets doesn’t appear to be as apprehensive similar to the 2007-2008 experience…yet.

Figure 3: Fear Index: Not As Fearful

The Fear index has been on a relative downtrend compared to the 2007-2008 patterns where we saw massive contiguous spikes (blue ellipses).

While the surges in 2007 had little impact on the US dollar (USD) which then continued to decline, the recent upswing in the Fear index seems to somewhat replicate on the post Lehman syndrome October 2008 climatic drama, wherein the stock markets collapsed, the US dollar skyrocketed, US treasuries soared and commodities crumbled.

Like the famous experiment known as Pavlov’s dogs, where Nobel Laureate awardee Ivan Petrovich Pavlov successfully proved that dog’s behavior could be shaped by stimulus (ringing of bells)-response (bell ringing means food!), the markets appear to have assumed the same behavior by cognitively anchoring on the post Lehman syndrome as template for any correction: When the US dollar started edging up (or the perceived stimulus), markets have thus interpreted these as signals for “carry trade unwinds” and has equally responded by selling off in almost the same pattern as in the 2008.

In short, a morbid fear from the 2008 meltdown still seems fresh and deeply entrenched into the market’s mind. Yet with fear deeply-rooted into the market’s mindset (even policymakers are fretful of these), it is thus unlikely that the market should experience another bust, until complacency and overconfidence rules anew.

Of course, alternatively, a bust may occur only if the 2006 US housing mortgage crisis meltdown is seen as a continuous process extending until today, where the recent improvements in the markets and economies signify as merely bear market rallies or countercyclical trends.

Well our argument is if this should apply to the US then why should it also plague Asia or the rest of the world? Because the US is the world’s ONLY consumer and Asia is the world’s manufacturer? What nonsense.

Unless the global markets are inferred as sooooo hopelessly and incorrigibly stupid, static and rigid enough to fail to respond to the drastic and dramatic changes in the economic sphere, then this scenario should apply.

But in reality, the only thing rigid is NOT the market but the economic dogma espoused by mainstream analysts whose idée fixee is to resurrect past models and whose prisms of reality is as prisoners of the past. This month we discussed some of these subtle but highly material changes: Asia Goes For Free Trade, Asian Companies Go For Value Added Risk Ventures, Global Science and R&D: Asia Chips Away At US Edge, and Japan Exporters Rediscovers Evolving Market Realities.

The intense fixation on aggregates and on quantitative models which simultaneously ignores the human dimension to adapt to changes and respond to stimulus is the basic flaw for analysts who presuppose omniscience.

Unlike The Bear Market Of 2007

Well, sorry, but it’s not entirely like 2007-2008. Going back to the VIX and the European iTraxx index, both of the current surges haven’t undermined the dominant downtrend trends, and could reflect instead on normal countertrend cycles.

Moreover, while short term yields have admittedly shown some strains, these have not been reflected on the broad yield curve spectrum in the US and abroad.

Figure 4: stockcharts.com: US Yield Curve

The short term rates have indeed been falling but long term rates have held ground in spite of the recent pressures in the market. In short, it seems hardly like the 2007-8 chapter where yields have synchronically fallen.

True, the massive interventions of the US government has helped, but over the past 3 weeks the Federal Reserve has offloaded US treasuries in what some experts see as an experiment to rollback liquidity, aside from some FED activities that may have resulted to negative adjustments in November-December in US money supply (M1) and Adjusted Monetary Base.

But from our standpoint these actions could also be construed as insurance Ben Bernanke underwrote to extend his term [as discussed in Federal Reserve Tightening: Exit Experiment or Bernanke's Confirmation Insurance?].

Think of it, a market meltdown amidst the wrangling over Bernanke’s extended mandate would likely influence positively lawmakers to approve of his stay. That’s because the recent ‘successful’ market actions (money printing) have been correctly attributed to him. Yes, policymakers are not transcendental entities and are also human beings whom are subject to cognitive biases.

Yet, Mr. Bernanke epitomizes the public’s desire for inflationism, as Ludwig von Mises has been validated anew, ``In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

So in effect, the US yield curve appears to have steepened and should incentivize the maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).

In addition, Asian sovereign yields have not substantially appreciated amidst the recent turmoil. In 2008, except for US treasuries all assets including sovereign debt yields of Asia fell.

Posttraumatic Stress Disorder Revisited

It would also be similarly foolish to assume that following a bust cycle or a recession, especially in the aftermath of a banking crisis, markets would automatically respond to a renewed borrowing spree or rapid revival of confidence, even if they have been supported by governments. (On the contrary, government support could even be the cause of uncertainty, since expectations would have been built on the continual dependency of the markets from government crutches)

Blind believers of the theory that markets operate on “animal spirits” think that this can happen, we don’t. It would take a bevy of spirits to bodily possess a significant segment of the population to enable these to happen. Unfortunately, the concept of animal spirits escapes the fact that people react based on incentives and NOT on some senseless randomness or mood based decisions.

So aside from the hackneyed arguments of overleveraged consumers and capital scarce banking system, the credit markets is likewise subject to Pavlov’s doggy experiment; children burned from touching a hot stove will refuse to touch it anew. Again it is a stimulus-response dynamic.

Airplane traffic fell (response) post 9/11 (stimulus) as people opted to travel in cars even if the latter mode of transportation has been statistically proven to be more fatal. In short, a person traumatized by a specific action (e.g. flying or swimming) due to a certain set of circumstances will most likely refrain from engaging the same activity, even if the circumstances that generated the trauma is absent.

Since markets are primarily psychologically driven then obviously prices reflects on human action based on people’s varied expectations.

So unless people buy or sell financial securities because their “dream” or a “fairy godmother” or their nanny instructs them to get ‘confident’ and buy up the market, we expect people to act on the markets with the expectations to profit or to hedge or to get entertained or to study or to get some needs or wants to be fulfilled from rationally related goals.

We have said this before and we’re saying it again-it’s called Posttraumatic Stress Disorder syndrome (PSTD). [we brought this up last February and has been validated, it’s time to refresh on the idea What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis]

Figure 5: IMF GFSR: Bank Credit to Private Sector In OECD and Emerging Markets

So it would be natural for markets to react negatively to the credit process, in the aftermath of a bust, which had been preceded by an inflationary boom, because the environment turned into a “proverbial hot stove”.

Let’s get some clues from the IMF on its latest Global Financial Stability Report on the state of bank credit to developed economies, ``Bank credit growth has yet to recover in mature markets, despite the recent improvement in the economic outlook. Bank lending officer surveys show that lending conditions continue to tighten in the euro area and the United States, though the extent of tightening has moderated substantially. Although credit supply factors play a role, presently weak credit demand appears to be the main factor in constraining overall lending activity.” (emphasis added)

Again the IMF on Emerging Markets, ``Outside of China, credit growth in many emerging markets has yet to recover appreciably. This suggests that leverage is not yet a key driver of the rise in asset prices. That said, policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.” (emphasis added)

We see TWO very important messages from the IMF outlook: one Asset Markets have NOT been supported by credit growth and most importantly FEAR.

This brings to my mind some questions:

If global asset prices haven’t been pushed up by the global credit expansion then how can asset prices materially fall (assuming they’ve been pushed up by savings)? Or how can a bust happen when there has been no preceding boom? Unless the global stock markets are ALL being manipulated by developed governments, which have taken most of the balance sheet expansion these days!

Another way to look at this is from the time delayed impact of the steep global yield curve which obviously hasn’t taken a footing yet.

As we have argued in What’s The Yield Curve Saying About Asia And The Bubble Cycle?, it takes some 2-3 years as in the case of 2003 to generate traction in the credit markets.

``Credit growth can be a powerful accelerator in expansions and usually kicks in strongly in later phases of upswing, but it rarely leads markets or real economy on the way up. Put simply, we do not need a pickup in bank lending to see an economic recovery or pickup in asset prices” comments Morgan Stanley’s Joachim Fels and Manoj Pradhan.

In short, the focus on credit, which is predicated on mainstream ideology, is actually a lagging indicator. Credit lags and not lead the economic cycle. This is perhaps due to the median expectations to see more concrete signs of stability, since everyone’s risk profile isn’t the same.

So while mainstream seems unduly focuses on the state of credit, little attention has been given to market’s ability to adjust based on existing the stock of savings, aside from the repercussions of money printing to the asset markets.

Hence if we go by the feedback mechanism from the previous credit cycle (2002-2006) then a more meaningful improvement could probably be expected by late this year and well into 2011. Yet the impact will be dissimilar.

Economic Relativism And Zero Bound Rates

But the mainstream would object, how about the overindebted consumers and the overleveraged banking and financial system, will they not affect the credit process?

Again the problem is to engage in heuristics or parse from angle of aggregates or oversimplifying problems or issues. For even in the economies that have seen the absorption of extraordinary or excessive leverage, debt assumption is largely a relative sectoral issue. Not all the industries have over expanded by taking up too much debt.

In the US, the technology and communications sectors bore the brunt of the dot.com boom bust cycle during the new millennium which spent the entire decade cleaning up their mess. The recent US boom bust phenomenon was largely a banking-real estate crisis and would likely spend years doing the same, unless government continues to socialize the losses, whereby taxpayers will shoulder the burden.

A similar relative effect should apply to the US households or even on the highly politicized issue of employment (By the way, the employment issue is being politicized as a way to shore up lost political capital following the electoral setbacks by the President and his party. On the other hand the pandering to the masses could also mean a diversionary strategy from a beleaguered political party whose goal is to secure the Senate majority this year).

Yet even if unemployment rate is at 10% or 17% on a broader scale last September, then still some 90% and 83% are presently employed and could possibly take up some form of credit but maybe to a lesser degree.

So the issue of absolutism is totally out of whack. So we may yet see some credit improvements in the future from the current levels (see chart again above) even if they are muted relative to the height of the previous boom.

The same dynamics should be applied to the world, where only some nations engorged on excessive credit. Many haven’t, such as Asians and the BRICs.

Figure 6: CLSA/Zero Hedge: Asia’s Loan To Deposit Ratio

In most of East and Southeast Asia bank loan to deposit ratios are under 100% which translates to generally underleverage in the system (more deposits than lending) except for Korea, Australia and India whose ratios are marginally above 100%.

Thus it would be foolhardy to argue that these economies won’t generate credit improvements when there is low systemic leverage, high savings rate, unimpaired banking system, current account surpluses, a trend towards deepening regionalization and integration with the world economy.

So the low leverage figures as shown by the IMF in figure 5 will likely see major improvements for as long as current policies are skewed towards favoring debtors at the expense of creditors.

Moreover I just can’t foresee a market meltdown given interest rates have been zero bound in major economies.

Figure 7: Japan’s Interest Rate and the Nikkei 225

Japan is a favorite for the mainstream peddling the deflation theme (which implies that money printing has no effect on consumer prices or the ‘liquidity trap’ which is disputed by the Austrian school as the money is neutral fallacy).

Although we believe that present conditions DON’T MEET anywhere near a Japan scenario, there seems no example of markets operating on near ZERO rates for comparison. So even if it is an apples to oranges comparison the point is to prove that a meltdown is unlikely at Zero bound, at current levels.

As you can see in figure 7, Japan’s stock market has basically shadowed the actions of its interest rate. In 2003, Japan’s zero bound rates hit the lowest level which apparently had been in coordination with the US, and these has been followed by a stock market rally. Interest rates then chimed, it moved higher. Today, Japan’s rates remain at near the lowest or near zero even while the Nikkei has modestly advanced. The interest rate chart in the lower window is only until 2005.

In other words, interest rates are pivotal factors in determining relative asset pricing, resource distribution and risk considerations.

In a bubble cycle, a credit boom will force interest rate higher as demand for resources will be artificially buttressed as investors compete with each other to invest in projects with long time horizon and also with consumers, whose consumption patterns will focus on the present. This hasn’t been the case yet.

Hence, ZERO bound interest rates amidst comparable yet depressed treasury yields or even cash will likely favor riskier assets as stocks and commodities.

In addition, major economies have been growing national leverage as the crisis erupted. National leverage comes in the form of government spending. And government spending has been backed by the issuance of these sovereign paper receipts, from which spending results to relative scarcity of goods and services. Hence the relative abundance of government paper receipts over goods and services implies prospective inflation.

And an upsurge of inflation likewise implies that given the loftily priced levels of sovereign instruments or paper receipts, risks appears titled more towards “risk free” instruments, particularly from nations which PIMCO’s Bill Gross calls the Ring of Fire [see Bill Gross: Beware The Ring Of (DEBT) Fire!]

So the risk reward tradeoff should benefit equity and commodity assets more than the conventional “risk free” instruments.

Authorities Seem Clueless With Bubbles And Operate On Fear

The second most important message conveyed by the IMF is Fear.

Again according to the IMF on emerging markets, ``policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.”

Even if the stock and commodity markets have gone substantially up, as we earlier pointed out, fear remains a dominant feature in the landscape.

Again the PTSD and or the Pavlov’s stimulus response behavior exhibits that not only many investors but most officials and policymakers have bubbles chronically embedded on their mindsets. The wound is apparently still fresh.

Yet this is one of a policy paradox, policymakers create bubbles by artificially lowering rates in order to boost the credit cycle, aside from other policies as manipulating the treasury and mortgage market via quantitative easing or providing assorted Fed as THE market via an alphabet soup of programs and other forms of fiscal or government spending.

Another implied goal is to see higher asset prices with the implicit aim to recharge confidence or the “animal spirits”.

However, rising asset prices is likewise seen as a bogeyman arising from the previous experience (anchoring) where such officials have excruciatingly learned that a bust follows a boom, ergo a bubble.

Yet, we’re quite sure authorities won’t be able to determine how to distinguish when high prices redound to a bubble. Why? Based on what metric? Who determines when it is a bubble? Since prices are subjective they will always arguable or debatable by some other officials. Besides market based politics will likely influence policymakers. Regulatory capture anyone?

We are seeing signs of such ambiguity or confusion today.

Here is International Monetary Fund chief Dominique Strauss-Kahn who recently warned against ``easing their stimulus programs "too early" before private demand becomes strong enough.”

From the Japan Times, ``"If countries exit too early (from stimulus), and if we have a new downturn in growth, then really I don't know what we can do," the IMF managing director said at the Foreign Correspondents' Club of Japan.

``Although the IMF does not forecast a double-dip recession, he said, "You never know. It may happen."

So the IMF chief wants easy policy to remain, while their GSFR is cautioning against higher asset prices (implying an intervention is required). Are they simply pretending caution? Or are they merely playing safe by offering a contingent clause?

Here is another contradiction, this time from a Chinese official who rebukes US authorities for low interest rates which he believes risks exacerbating a US dollar carry trade bubble. This was when the US dollar was falling last November.

From Marketnews.com ``Liu Mingkang, the director of the China Banking Regulatory Commission, warned a forum here at the weekend that a falling dollar and low U.S. interest rates are providing a vehicle for speculation worldwide, and are exposing risks for the emerging markets in particular as asset prices soar.

"The carry trade in U.S. dollars is huge because of U.S. dollar depreciation and the U.S. government's policy to keep interest rates unchanged and that has had a big impact on global asset prices, encouraging speculation in stock and property markets," he said. (emphasis added)

With the US dollar apparently rising today and where outflows from China’s swooning stock market reached an 18-week high, we see a reversal of sentiment.

From the Telegraph, ``China's deputy central bank chief Zhu Min warned that tighter US monetary policy could spark a sudden outflow of capital from emerging markets, evoking the 1990s Asian financial crisis.”

So China initially smacks the US for low interest rates, easy policies and a weak dollar policy and then currently China censures the US for tightening, which is which?

Have authorities been seeing their shadows (policies) as if it have been chasing them (boom bust cycles)? Or is it a case of a tail (policy errors) that wags the dog (unintended consequences vented on the marketplaces)?

Given the prevailing undertones which reflect on the heightened apprehensions of policymakers, it is doubtful if true tightening would ever take place in the near future. Instead, what would force up interest rates would be the same dynamics that haunt China now, market based inflation from a boom bust process.

At present, global stock markets don’t seem to clearly manifest signals on these yet. Moreover, the dissonance or the incoherence of the opinions of the experts appear to demonstrate a market undergoing a reprieve more than one suffering from a bout of depression based meltdown as alleged by some grizzly bears.

As we have been saying it’s seems mostly about poker bluffing.