But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities. In short, I had learned that I had to work for my money. I was no longer betting blindly or concerned with mastering the technic of the game, but with earning my successes by hard study and clear thinking. I also had found out that nobody was immune from the danger of making sucker plays. And for a sucker play a man gets sucker pay; for the paymaster is on the job and never loses the pay envelope that is coming to you Edwin Lefevre REMINISCENCES OF A STOCK OPERATOR
In this issue:
Phisix: ASEAN Currencies Dive as the BIS, IMF, OECD Warns About Bubbles!
-ASEAN’s Ponzi Finance Model Exposed!
-Bank for International Settlements Warns Anew on Low Volatility, Emerging Markets Risks
-Markets are a Process, Changes Happen at the Margins
-IMF and OECD: Bubbles in Everything, Everywhere! RBA warns on Housing Prices
-The Obverse Side of Every Mania Has Been A Crash: Circa 1965-1985
-Three Generations of Bubbles Reveal How Bubble Cycles Are Products of Financial Repression
-Why Stocks are Hardly a Hedge against Inflation
-ASEAN Currencies Stumble!
Phisix: ASEAN Currencies Dive as the BIS, IMF, OECD Warns About Bubbles!
I have been saying that bubbles have become so so so very much visible such that the establishment can’t deny or dodge on them.
In an impromptu warning by the IMF, in August I noted that[1]: (bold original)
The point is the IMF, like many other global political or mainstream institutions or establishments, CANNOT deny the existence of bubbles anymore. So their recourse has been to either downplay on the risks or put an escape clause to exonerate them when risks transforms into reality which is the IMF position.
ASEAN’s Ponzi Finance Model Exposed!
It has been an entrenched topic here for me to discuss on the deepening reliance on debt in order to produce growth. Some call this “credit intensity”. I call this the “diminishing returns of debt”. In academic lingo this is mostly known as Hyman Minky’s “Ponzi financing scheme”.
I have been saying that in the Philippine setting, debt dynamics has evolved towards Ponzi finance. For instance as an obstacle to the stock market boom, I pointed to the credit cycle last week: “Companies like SMC practice what looks like a Hyman Minsky’s Ponzi financing scheme which the banking system continues to facilitate. SMC’s rolling debt in and debt out of mostly short term debt in 2013 has reached nearly 10% of the Philippine banking system’s total resources. Rising rates will magnify SMC’s debt burden and raise SMC’s portfolio’s risk with banks[2]”
And because only a select privileged segment of the Philippine political economy has access to the banking and capital markets, I raised the issue of the risks of systemic concentration of leverage from the growing use of debt IN debt OUT. Again from last week,
And since the current credit boom translates to intensive leveraging of the balance sheets of entities with access to the formal banking system and to the capital markets, the current BSP actions eventually shifts the risk equation from inflation to levered balance sheets…
In short, there is concentration of credit risk from mostly heavily levered firms.
Well I am not alone now! Stunningly the Bloomberg[3] and the S&P appear to have picked up on this.
Southeast Asia’s 100 largest publicly traded companies are becoming more vulnerable to default as their debt surges and profitability weakens. Debt-to-earnings ratios rose last year at the fastest pace since 2011, as average return on capital at the biggest firms by market value fell for the first time since 2008, according to data compiled by Bloomberg. In the past four years, their debt rose 89 percent to the equivalent of $501 billion. Average economic growth in Indonesia, Malaysia, Singapore, Philippines, Thailand and Vietnam fell to just under 5 percent last year from 8.5 percent in 2010, forcing companies to rely more on borrowing than earnings to finance their investments. Outbound acquisition activity from the Asean region has tripled in the past five years as companies sought growth abroad.
Here is how I defined Ponzi financing, last June[4] (bold original)
Ponzi financing is really about the inadequacy by an entity to service existing liabilities out of the regular or conventional business operations. It is a symptom of an ongoing deterioration in the existing business model as expressed through corporate financing. So companies operating under these circumstances use increasing degree of leverage complimented by arbitraging of assets to make up for the shortcomings in the financing of business operations. This represents THE substance.
Note of the falling return on capital being substituted with debt. This is a sign of an ongoing deterioration in the existing business models of many big publicly listed being enabled by zero bound rates.
The Bloomberg article quotes the S&P on ASEAN Ponzi finance (bold added): “More and more debt is financing less and less growth,” Singapore-based Xavier Jean, a director of corporate ratings for Standard & Poor’s, said in a Sept. 11 interview. “The only way for these companies to keep growing seems to be leveraging up.” S&P released a study last week that said the escalating debt levels among Asean’s blue-chip companies will increase vulnerability when interest rates start to rise. Internal cash flows and cash balances funded only about half of the $300 billion the region’s largest companies spent on expansion and acquisitions between 2008 and the first quarter of 2014, S&P said. About $150 billion of debt was issued to bridge the gap.”
The predicament now is that the incumbent business model has become acutely dependent on debt based on a zero bound environment which is irreconcilable with rising interest rates.
Given that this is unsustainable, so what goes around will eventually come around.
Bank for International Settlements Warns Anew on Low Volatility, Emerging Markets Risks
Well, it’s not just Bloomberg and the S&P.
Even as stock markets continue to ramp to milestone highs, alarm bells over bubbles seems to be snowballing even from the most unexpected places.
For the third time this year, the central bank of central banks the Bank for International Settlements (BIS) pounds on the table the issue of heightening market risks from an extremely low volatile marketplace. From their Quarterly Review[5] (bold mine, footnotes omitted)
The exceptionally accommodative monetary policy of recent years is also likely to have played a key role in driving volatility to such exceptional lows. Policy has had a direct effect, by compressing volatility in fixed income markets. For example, the reduction of interest rates to the effective lower bound in all major currency areas has pinched down the amplitude of interest rate movements at the short end of the yield curve. More transparent central bank communication, forward guidance and asset purchases have also removed uncertainty about interest rate changes for medium- and longer-term maturities.
By fostering the search for yield and influencing risk appetite in the market, accommodative policies have also had an indirect effect on volatility. An environment of low yields on high-quality benchmark bonds - coupled with investor confidence in the continuation of favourable market conditions - is set to foster risk-taking behaviour. This then tends to be reflected in lower hedging costs via options, as well as a general narrowing of risk premia. In fact, the decline in volatility across asset classes since mid-2012 has gone hand in hand with rising asset valuations and collateral values more generally. As the capital constraints faced by financial intermediaries are alleviated, these institutions have an incentive to take on more risk, sending asset prices higher. This potentially creates additional feedback effects, since return volatility tends to be dampened when valuations rise. As market participants further revise down their perceptions of (market) risk, they may be inclined to take larger positions in risky assets, boosting prices and pushing volatility even lower.
Translation: Through zero bound, central banks have provided a massive subsidy to various debt financed carry trades that has burned shorts, thus the untenable Pavlovian one-way trade.
The BIS further notes of the yield chasing have prompted for a gravitation towards the use of derivatives “encouraged market participants to take increasingly speculative positions on volatility in derivatives markets”. So yield chasing has prompted many market participants to absorb more risks via financial engineering.
The meatier part of their foghorn has been their protracted disquisition on manifold risks facing emerging markets (EM).
The BIS elevates to the limelight EM risks from three dimensions: Asset Managers, Corporate leverage and Cross Border banking.
1. Asset Managers. Global investors on emerging markets mostly depend on “collective investment vehicles, managed by a small number of large asset management companies (AMCs)” or a simply a small band of large players.
In perspective, notes the BIS, “In 2012, the share of the largest 20 AMCs was about 40% of the total AUM of the largest 500 companies, or $28 billion (Graph 1, left-hand panel). Furthermore, the top five accounted for 18% of total AUM, with the largest player representing nearly 6% of the total.”
EM bond and equity Asset Under Management (AUM) bond and equity funds has bulged by 55% from the pre-Lehman peak of $900 billion to $1.4 trillion in May 2014. EM equity funds grew by less than double from $ 702 billion at the end of 2009 to $ 1.1 trillion as of the end of 2013. Meanwhile bond funds quadrupled, from $88 billion to $340 billion over the same period.
These small number of large AUM players have a tendency to bandwagon or “behave in a correlated manner”, where their actions tend to “amplify each other's fluctuations”. Likewise, these managers use “common/similar portfolio benchmarks” thereby generating “correlated investment decisions”
In short, concentration risks from a small number of big players highlights EM asset allocation.
The BIS thinks that EM Asset managers have been undiscerning such that they think, assess markets and act like. And since EM markets are essentially illiquid, market risk emerges out of the changes in portfolio allocation, so any abrupt shift in sentiment may prompt for massive capital flight thereby inciting market sharp volatilities.
This has been the risk dimension or scenario that the Philippine central bank, the Bangko Sentral ng Pilipinas (BSP) has been fixated on, thus the reiterative warnings of capital flight by the BSP chief.
Foreign trades account for more than half of the typical daily turnover of the Philippine equity markets. Outside the elites who control about 80+%, the foreign share of market cap has been at around 15-16%. Retail investors have been a speck in the Philippine Stock Exchange with less than 1% in direct exposure.
As of 2013, in one of their plethora of charts, the Institute of International Finance notes that foreign share of market cap in the PSE may have shrunk as domestic share of publicly listed market cap has ballooned to about 90%. If the assessment is accurate, then domestic plutocrats may have increased their exposure in order to help boost their asset inflated “wealth”. Nonetheless bigger exposure by domestic investors doesn’t make the domestic stock market immune to volatilities or a downturn.
2. Corporate Leverage. Zero bound has prompted many corporations to ramp up on debt. Corporate indebtedness, according to the BIS, now hovers at around 100% of GDP for some EMEs (Graph 3, centre panel). Private sector non bank borrowing has more than doubled from 2009 to 2012 to almost $375 billion
The debt dynamic has been different across the EM space, although what seem to worry the BIS has been in the debt/earnings ratio. Like in the Bloomberg and S&P report above, debt accumulation has been growing faster than earnings, such that even at zero bound, debt burdens have been rising. Notes the BIS[6] (bold mine), “In many cases, the deterioration in debt servicing capacity reflects a combination of rising debt loads and slowing earnings growth. Furthermore, despite broadly stable and low interest rates over the past five years, many EMEs have encountered a sharp increase in interest expenses because of the larger debt loads (Graph 3, right-hand panel)”.
Some of those debts have been used to arbitrage on interest rate differentials which led to sizeable increases in foreign denominated liabilities. Increased debt loads denominated in foreign currency has created funding mismatches exposing many firms to currency risks, especially on firms that has been unhedged or has inadequate hedging exposures.
And some firms have used debt markets for “for purely financial (ie speculative) purposes”. Thus a return of market volatility would bring to fore credit risks, rollover risks and currency risks.
3. Cross-border bank lending. The BIS also elevate the issue of cross border banking claims which has inflated to “more than $3.6 trillion at the end of 2013 - roughly as large as the stock of all portfolio investment in EME”[7]. The BIS worries that exposure in cross border bank lending has been underappreciated, yet such are highly sensitive to contagion transmission. The cross border lending has been highly sensitive to “sudden stops” that “could still destabilise economies and, in the worst case, lead to a balance of payments crisis”.
Yet corporate leverage and cross border lending has been risk profiles which the BSP seem to keep their eyes closed on. Or maybe they are withholding such risks from the public. The panic tightening may be indicative of the latter.
Last March, the BIS fired the first salvo noting that changes in US monetary policies will make Emerging Markets vulnerable via “sudden stops” that may be triggered from liabilities by local banks, wholesale funding markets and or foreign exchange exposures[8].
The BIS issued a stern warning, in a follow up last July, of the brewing “disconnect between extraordinarily buoyant financial markets and weak investment”, where by current pace of accumulation of imbalances will “at some point, the current open global trade and financial order could be seriously threatened”[9].
I speculated then that the BIS may have had a hand with the BSP’s current panic tightening when the BSP governor said “The advice of some of the participants was that central banks should start raising interest rate”
The BIS, thus, has been warning of increasing risks of a global crisis and has been applying pressure on central banks to tighten.
The BSP may or may not have been influenced by the BIS. But the recent panic tightening by the BSP has been indicative of changes at the margins that have been happening in the domestic monetary landscape.
Markets are a Process, Changes Happen at the Margins
As I keep repeating here markets function as a process. This means that changes always happen at the margins over a period of time.
People’s actions are based on their subjective values and preferences. Yet these values and preferences are likewise influenced by motley forces of social, economic, environmental and political dimensions.
Applied to the marketplace, this means that unless dramatic changes occur to force participants to respond accordingly, entrenched trends don’t radically get altered instantaneously.
Trends are built or decayed over a period of time. Market cycles undergo transitional stages. Trends or cycles don’t happen just because. Trends or cycles happen because of the underlying incentives guiding the market participants to act. If the incentives guiding people’s actions changes, due to say social policies, then naturally, the market’s response will eventually reflect on such direction of changes.
Take zero bound rates for instance. Zero bound has oriented or programmed or hardwired the marketplace to jettison risk in the assumption that political subsidies will last until eternity, thus the Pavlovian response to chase the markets. The current chasing of markets has led to record debt levels, record stocks and record low volatility.
Did these just happen? No it didn’t. It took a transition, specifically about 5 years for the markets to reach the current state.
This can be seen in the context of psychological transition: From depression to optimism to irrational exuberance/mania.
In terms of finance and economics, encouraged by policies of financial repression for the market to use debt to jumpstart aggregate demand or to borrow and spend, the market response has been to use debt or leverage to arbitrage and speculate on risks assets whether in the financial markets or in the real economy. Such evolution has brought about the current state of overvaluations, overleverage and misallocation of resources.
Think in terms of politics. Through 2009-2013 have you heard of warnings from political authorities on valuations, complacency or low valuations? Hardly any warnings then. One can say Nada, zilch, zippo, nien, nyet.
But now things have been changing at the margins!
ASEAN leverage risks have surfaced to the mainstream.
The BIS has issued THREE warnings over a span of NINE months or ONCE every quarter!
The domestic central bank, the BSP, has acted to tighten SEVEN times in the PAST 6 MONTHS!
Just last July, the US Federal Reserve Chairwoman Janet Yellen warned of some equities being “substantially stretched”, in particular she referred to the valuation metrics of small tech caps and biotechnology[10]. She also observed that “risk spreads for corporate bonds have narrowed and yields have reached all-time lows” which perhaps has been influenced by ““reach for yield” behavior by some investors”
The US Federal Reserve officially denies a bubble, that’s because they don’t have a definition of a bubble in their dictionary. Therefore if bubbles are undefined then the Fed won’t have them in their econometric models.
But to point at “substantially stretched” and where risks spreads have “narrowed and yields have reached all-time lows” represents an indirect admission of the existence of such bubbles which again signifies as symptoms. Officials don’t like to ask how “substantially stretched” and “all time low spreads” has been obtained, as if they just fell out of the sky, yet they look at the symptoms and comment on them.
And the Fed’s response to bubble risks has been to set up a high level committee led by Vice Chair Stanley Fisher with the intent to “monitor potential threats to threats to financial stability”[11].
Would these actions have been formed if not out of response in marginal changes in current financial and economic conditions? Thus, the closing of the QE, Yellen’s irrational exuberance and the formation of a bubble committee (regardless of its usefulness) represent changes at the fringes of Fed policies.
The key question now is how will these changes affect the real economy and the financial assets?
And changes in policies and communications have been conspicuously happening around the world.
Last July, I pointed out that there has been a barrage of admonitions coming from authorities[12].
German Bundesbank President Jens Weidmann recently said that stimulus policies raises financial risk on the real estate markets. German Finance Minister Wolfgang Schaeuble warned the European Central Bank that its loose monetary policy risked inflating markets to dangerous levels with cheap money.
The Bank of England introduced measures to limit riskier mortgages, while the Swiss government in January forced banks to hold additional capital to protect them against a real estate crisis. In Denmark, the central bank has been pushing to reduce borrowers’ ability to defer principal repayments.
Monetary Authority of Singapore’s Lim Hng Kiang reportedly uttered “an uneasy calm seems to have settled in markets” as “we remain in uncharted waters”.
In Mid-August, India’s Central Bank Governor Raghuram Rajan cites of a 1929 scenario citing “greater chance of having another crash” from a sudden shift in asset prices”[13]
Most of these political words of caution have mostly been ad hoc.
It’s only the BIS and last July, the Institute of International Finance (IIF) whom has issued a formal caveat on the risks of global carry trade and risks on bond market liquidity
But notice in the July-August window, there has been a marked increase in political authorities exhibiting apprehensions on the state of the markets.
That’s a big number compared to practically zero in 2013.
IMF and OECD: Bubbles in Everything, Everywhere! RBA warns on Housing Prices
Yet the July-August window seems puny to what happened last week.
Again aside from the last week’s formal guidance on the escalating risk environment by the BIS, the International Monetary Fund (IMF), the Organization of Economic and Development (OECD) and the Reserve Bank of Australia (RBA) has jumped into the complacency—excessive valuations—high risk environment—warning chorus.
In a paper to the G-20, the IMF makes a shocking ominous assessment of global conditions[14] (bold mine):
Implied volatility measures fell to the very low levels prevailing before the May 2013 tapering remarks. This raises concerns that excessive risk taking may be building up, which could sharply reverse in the run-up to U.S. rate hikes or should geopolitical events trigger higher risk aversion…
Valuations in virtually all major asset classes are stretched relative to past norms. Long-term bond yields have declined further especially in the euro area but also in the United States and in most emerging economies… However, implied volatilities across asset classes have continued to decline, reaching levels prevailing before the Fed tapering talk. This raises concerns of a buildup of excessive leverage and under-pricing of credit risk which could be abruptly corrected in the run-up to U.S. rate hikes or because of higher global risk aversion.
“Valuations in virtually all major asset classes are stretched”???!!! That’s almost saying bubbles are in everything and in everywhere! Wow!
Yet this hasn’t been coming from me or from Dr. Marc Faber or from financial experts influenced by Austrian School of economics; instead, this comes from the IMF.
The IMF, according to iconoclast author Jim Rickards has been “the de facto secretariat and operating arm of the G20”, or as author and contributing editor to Casey Research Doug French says the latent central bank of the world[15]!
The BIS and now the IMF!!!
Echoing the BIS and the IMF, the Organization of Economic and Development (OECD) in their Interim Economic Assessment also divulge on their concerns[16]: (bold mine)
Even apart from the possibility that entrenched low inflation feeds further negative growth surprises in the euro area, there are many significant risks to the near-term outlook. Notably, geopolitical risks have grown in recent months, with an intensification of conflicts in Ukraine and the Middle East and increasing uncertainty about the outcome of the referendum on Scottish independence. Also, many emerging economies remain vulnerable to financial market shocks given the build-up of debt, particularly corporate debt, in recent years. The anticipated tightening of US monetary policy could lead to shifts in international financial flows and sharp exchange rate movements that would be disruptive, especially for some emerging economies. Of course, not all risks are on the downside. For example, successful implementation of the comprehensive assessment of banks in the euro area could be associated with faster-than-expected improvements in credit flows.
The bullishness of financial markets appears at odds with the intensification of several significant risks. A number of equity markets are reaching record highs, sovereign bond yields in several countries are near all-time lows and implied share price volatility in the United States and Europe is around pre-crisis levels. This highlights the possibility that risk is being mispriced and the attendant dangers of a sudden correction.
The OECD now sees what I have been saying along as the predominant forces underlying today’s economic and financial environment: Parallel universes or the patent disconnect between fundamentals, risk environment and market actions.
Risk is being mispriced! Wow. It would seem as if the IMF and the OECD had been reading me.
The Reserve Bank of Australia (RBA) this week also counseled discreetly against domestic housing bubbles.
In a statement following the maintenance of interest rates at current level, the RBA noted[17]: “For investors in housing, the pick-up in housing credit growth had been more pronounced than for owner-occupiers, with investor demand particularly strong in Sydney and to a less extent in Melbourne," RBA said. "Members further observed that additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later”
In another article covering the same RBA caveat, the report says that “an investor-led surge in prices may amplify any subsequent fall and risk a drop in consumer spending, hurting the economy, the bank said yesterday in minutes from its Sept. 2 board meeting”[18]
The RBA Assistant Governor Christopher Kent was quoted (bold mine) “We’ve been at great pains to always tell people when you’re making investment decisions, make them with great care, don’t assume prices can always and will always go up,” Kent said. “And don’t always assume interest rates will stay low for the length of the loan.”
The mainstream article fantastically connects the dots to reveal how zero bound policy rates has been inflating Australia’s housing bubble (bold mine): The housing market has been pumped up by the RBA keeping its benchmark interest rate at a record-low 2.5 percent for more than a year, with investors accounting for a record 49 percent of new home loans in July. Demand for high-risk mortgages, including interest-only loans, is setting the stage for a jump in mortgage delinquencies when interest rates rise, Moody’s Investors Service said this month.
Austrian Business Cycle Theory (ABCT) has gone mainstream!
Unlike the BSP whom has “heroically” increased rates in a dramatic fashion, the RBA’s recent policies seem to reflect on my favorite central bank conundrum: I recognize the problem of addiction but a withdrawal syndrome would even be more cataclysmic.
So the RBA goes on to use a verbalized management of expectations rather than by actual tightening.
And here the Philippine BSP shows relatively more responsibility than her counterparts at the RBA.
Though having been forced to act, the BSP recent policies still represents a choice: a choice made that has partly reduced the risks of hyperinflation that would have crushed the informal economy, and importantly, the average citizenry.
The BSP’s recent actions merely transfers the burden of risks from inflation to credit risks on levered balance sheets, particularly shifting the burden back to those whom has benefited from this invisible redistribution. Thus, my comment of the seeming “heroic” nature of the BSP’s recent panic tightening policies.
Yet if the BSP really wants to become truly heroic, what they need to do is to squeeze out most, if not all, of the excess liquidity that has backed the illusionary boom! But can they afford it? There will be tremendous pressure against this from the influential plutocrats. But again, plutocrats can’t defeat the laws of economics. Again the BSP will be confronted with harsh choices as the consequences of their previous sins have emerged big time.
Going back to marginal changes, in a span of just a week, the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the Organization of Economic Cooperation and Development (OECD) have made their concerns—over speculative orgies backed by excessive build up on leverage—formal! Astounding.
Add to this the recent actions of the RBA.
That’s more than just changes on the margins. Rather this reveals of the radical changes in policy communications!! It’s a sign of growing desperation by the establishment!!!
Again this should NOT be construed as an “appeal to authority”. I have been saying this long long long long before these institutions have joined my camp.
Yet I even feel uncomfortable having them as ‘strange’ bedfellows. Not because these institutions have mostly failed to predict the last crisis*, as past performance is not a guarantee of future results, but rather these institutions have mostly advocated if not has been source of today’s problems.
*the BIS and the India’s RBI Governor Raghu Rajan had accurately predicted the last crisis.
The question now is how will these seemingly concerted communications undertaken by major international political institutions impact financial markets?
Given such signs of ‘desperation’, I now expect marginal erosion in the foundations of the bullmarkets.
Has developing divergences in market internals[19] in the US (e.g. 47% of Nasdaq companies has entered bear markets, the small cap Russell 2000 on a death cross) and in Europe (two-thirds of MSCI Europe has lost 10% or more from recent peaks) been indications of these?
We will see.
The Obverse Side of Every Mania Has Been A Crash: Circa 1965-1985
Last week, I presented here the 28 year perspective of the Phisix, which revealed that the obverse side of every mania has been a crash.
What makes the 28 year purview an interest is because this represented my generation.
Now I present to you my Daddy’s generation, 1965-1985.
My great and loving late Dad left me several stocks unfortunately whose only worth was as “wallpapers”. Stocks like PODCO (where I think he was once a director of), Acoje and others (mostly mining companies) which I lost overtime.
I recalled that at one point during my high school days, my Dad was so elated such that he intended to buy a new house in one of the plush villages in Greenhills, he brought me along with my mom to see this house. I never understood what happened or why he didn’t push through with it, and in the contrary, we even almost lost our family abode.
And as a spoiled one and only son, I used to have a driver who would wait for me until the day was through. By college I had to shuttle from home to school by jeepney. In short, I experienced a personal boom-bust life through my Dad’s finances.
Looking at the above chart gives me an idea to what had happened then. An abbreviated segment of the chart on a log basis can be seen at Chartsrus.com
Over the twenty years, the Phisix has had four stupendous fluctuations. The 1965-1969 run returned a fantastic 31x. What followed was an incredible bear market marked first by a 47% decline and a sensational rebound but the completion of the bear market cycle which bottomed after a 67% loss from the 1969 peak.
This was the first of the major four cyclical boom bust episodes that undergirded the secular boom (1965-1979 or 13 years) bust (1979-85 or 6 years) cycle.
The succeeding years highlighted a wide trading range for the three following boom bust cycles. Notice that the second and third booms failed to reach the 1969 highs.
It was during the 1977-79 run where the previous 1969 high was broken and where the Phisix gained 10% more before the harrowing 81% collapse through 1985. If applied today the Phisix would rise to 8,100 before a collapse.
So in three generations or three major stock market cycles (1965-1985, 1986-2002, 2003 to date) spanning 49 years we see the same thing: all manias have been followed by a panic or a collapse.
That 1979-85 meltdown led to closures of some of the issues he owned which sadly he never took the option of selling at a loss, this apparently took a heavy toll on my Dad both financially and physically. I also have come to realize today that my Dad was a heavy stock market speculator.
And it is through the lens of my Dad from which I have learned to be a prudent investor.
Three Generations of Bubbles Reveal How Bubble Cycles Are Products of Financial Repression
If one would shrink the 1969-85 chart into 4 years it would have looked very much like the 1994-1997 mania where we see four major interim boom bust cycles that followed a great bear market.
Now if both the 1969-85 and the 1994-7 charts will be truncated to reflect on a one year plus pattern, today’s charts looks very much like a mini-replica of the two longer predecessors. You can see the comparative charts here.
Yet it would be inaccurate to say that this about fatalism (inevitable predetermination). This isn’t written in the constellations. Instead, bubble cycles are products of social policies. They don’t just happen, they are made.
The TWO previous generations has been pillared by the same political forces of Financial Repression. And the outcome of such financial repression has been to inflate bubbles and their eventual deflation.
So as with pre-Asian crisis environment which as described by a paper from Jetro (Japan External Trade Organization)[20] (bold mine): The Philippines manifested several symptoms of the crisis such as (a) the surge of short-term capital mostly in the form of portfolio investments relative to the flows of foreign direct investments, (b) a bubble in the economy shown by exuberance in the stock markets and price inflation of real estate and nontradables, (c) the rapid expansion of domestic credit extended by the commercial banking system, (d) a widening current account deficit, and (e) an overvaluation of the local currency. It will be recalled that these are also, but not exclusively, the same symptoms of the Mexican crisis in 1994
The current secular stock market and business cycle shares almost every single ingredient of the 1997 pre-crisis symptom EXCEPT the widening current account deficit. Yet a single difference will not neutralize the other sins.
The bottom line is that take away financial repression, part of which has been the manipulation of interest rates, and such bubble cycles won’t exist.
Why Stocks are Hardly a Hedge against Inflation
Yet a major differentiating factor between 1969-1985 and the current (2003-2014) and the mid (1986-1997) bullmarket have been in the financial and economic environment underlying the stock market actions.
The 1970s to the 1980s has been characterized by the era of stagflation.
Stagflation is an economic condition characterized by high inflation, stagnant economic growth and high unemployment.
The experience of the 60s-80s will debunk claims that stocks are a hedge against inflation.
Let me make a further clarification, since inflation represents an invisible redistribution process, then some companies or stocks and industries may indeed benefit, but generally stocks are hardly a hedge against inflation, unless we are talking of HYPERINFLATION.
A second clarification is that I am not aware of the distribution of industries and of companies comprising the Phisix composite index during my Dad’s generation. Although I suspect that they have been weighted towards the mining industry.
First we talk about the theory. When we talk about price inflation we are essentially discussing about unstable prices. If price inflation has been system wide, which implies price instability in the general economy then this means unstable prices upsetting the balance between supply and demand.
Unstable prices also means to blur the economic calculation process of entrepreneurs and capitalists thereby leading to the discoordination of the economic activities, and at worst, to malinvestments. From a cash flow perspective alone, how can an unstable economic environment and guarantee stable cash flows?
From the perspective of the economy, consumers are the biggest victims of price inflation. High price would mean changes in spending patterns which would translate to diminished spending power. As I recently wrote[21], “Sustained price pressures on basic goods would imply that the forces of the income and the substitution effects will increasingly come into play.”
The general impact from income and substitution effects will be to reduce consumer’s disposable income. I already wrote about this[22]: “The risks of higher inflation which reallocates consumer’s pattern of spending will essentially reduce disposable income and consequently depress demand. On the supply side, rising input prices will compress on business and commercial profits in the face of declining demand thus adding to supply side constraints”
For as long as incomes, profits and earnings don’t rise enough to offset the increasing costs of business then companies will suffer from a profit squeeze. Moreover, in the realization that consumers may reduce demand due to higher prices, some companies would instead opt to sacrifice earnings.
We have a real time example of this. Last week, business leaders of Western Japan publicly appealed to PM Shinzo Abe for stable prices as profit margins have been deteriorating since “they can’t pass along the higher costs even as sales rise”[23]. This is a fundamental example of how inflation disrupts economic coordination and the illustrative effects of the Money Illusion (via rising sales).
So Japanese stocks may be rising due to expectations of more monetary steroids, but the real economy and real earnings of many firms have been suffering.
Under an inflationary environment rising stocks then haven’t about inflation hedges but about boom-bust cycles.
Moreover, inflation does initially balloon profits. Initial receivers of monetary inflation (usually loans from banks or government welfare/ subsidies) who are able to buy goods or services when inflation has not yet taken hold and sell them as inflation rises tends to profit from regular margins PLUS margins from inflated prices. I have shown this as the Money Illusion.
But the problem is that the higher prices entail higher cost of restocking or even replacement. So unless as incomes, profits and earnings rise to adjust to the higher business and replacement costs, there will hardly be any gains.
So any gains from price inflation essentially would signify an illusion as gains depend on sustained increases on prices, for profits to be sustained. In stocks, this would be like momentum chasing, where speculator buy high in order to sell higher. So for one to be able to profit sustainably means stocks should rise forever!
The problem is that bursting bubbles should expose on should absurdity.
Let us go back to the stock market cycle during the stagflation generation.
Time reference matters. I chose 1965, not because it is a special year for me, but because it is from this point where the Phisix began to creep higher.
Let us say an investor bought the Phisix and held it through 1985. From the 1965 to 1985 the Phisix returned 8.84x or 11.52% cagr. [PSE 1965: 11.3; 1985 100]. Over the same period, Philippine CPI index in nominal terms yielded 12.2x or a cagr of 13.3%. [CPI 1965 1.8; 1985 22]. So the real rate of return would be a NEGATIVE 1.6% cagr as inflation ate up all of the gains.
Let us say the speculator bought at the peak of the market in 1979 and held it through 1985. Nominal returns would be a HUGE -81% loss. Inflation adjusted returns should make the losses even deeper.
So I am referring here to two extreme points. So anyone who invested in between the lows and the highs and held them through 1985 would post NEGATIVE real returns—where 1965 would represent the minimum losses while 1979 would highlight the biggest loss potential.
The opportunity cost of the investing in the Phisix can be seen via the US dollar Peso exchange rate. If the resident sold his Phisix in 1965 and bought US Dollars instead (3.901 peso per US dollar) and held them through 1985 (18.61 peso per US dollar), the resident would have been spared of a 79% loss of the Peso.
Notice too of the volatility of the Phisix and the annual inflation rate. Annual inflation rate vacillated from 0 to 40%. The Philippines suffered a very short bout of hyperinflation in the second half of 1984 where inflation rates when soared past 50%.
In three occasions a spike in inflation rate coincided with the soaring stocks. But this relationship didn’t hold even during the hyperinflation stint. Yet the aftermath of the hyperinflation fit paved way for one of the greatest buying opportunity in stocks.
The Philippine experience shows why stocks are hardly a good hedge against inflation. So as with the US experience, during the same period.
The McKinsey Quarterly explains[24] (bold mine)
Yet a closer analysis reveals that to fend off inflation’s value-destroying effects, earnings must grow much faster than inflation—a target that companies typically don’t hit, as history shows. In the mid-1970s to the 1980s, for instance, US companies managed to increase their earnings per share at a rate roughly equal to that of inflation, around 10 percent. But to preserve shareholder value, our analysis finds, they would actually have had to increase their earnings growth by around 20 percent. This shortfall was one of the main reasons for poor stock market returns in those years.
Inflation makes it harder to create value for several reasons, especially when its annual growth rate exceeds long-term average levels—2 to 3 percent—and becomes unpredictable for managers and investors. When that happens, it can push up the cost of capital in real terms and lead to losses on net asset positions that are fixed in nominal terms. But inflation’s biggest threat to shareholder value lies in the inability of most companies to pass on cost increases to their customers fully without losing sales volumes. When they don’t pass on all of their rising costs, they fail to maintain their cash flows in real terms.
When prices are unstable the business environment becomes unpredictable. Unpredictability spreads to affect corporate health. So how will increased uncertainty and unpredictability serve as a hedge against inflation?
Finally, theoretically it is true that properties can serve as a hedge against inflation. But this is no carte blanche theory as one must understand the SOURCE of inflation.
If inflation has been the result of government’s deficit monetization then properties would indeed serve as a good inflation hedge.
In the current Philippine setting, all one needs to do is to look at where the bulk of the growth of money supply has been. About 70% of money supply growth comes from banking loans see BSP’s July data. Yet a big segment of banking loans has been to the property and property related sector see BSP’s July data. July’s data for both money supply growth and banking sector loans has been an ongoing trend since 2009.
This means that the origins of domestic inflation have been from credit expansion that has been spent to boost a property and property related bubble.
Bubbles usually evolve around properties/real estate. The reason for this is because in the face of monetary easing, long horizon capital intensive projects would look increasingly profitable. Add to this the function of collateral, where inflated properties/real estate can become a major source of financing for future projects.
As I previously wrote[25],
The easiest way to generate an artificial credit fueled boom is via the property sector. This is because land supply is fixed. In response to artificially lowering of the interest rate (negative real rates), when the banking sector expands credit relative to the land supply, the value of land increases. And increases in the value of land likewise increases assets of companies backed by land. Aside from the normal course of commercial activities, higher asset values encourage manifold transactions such as mergers and acquisitions, capex expansions and various arbitraging activities. Thus amidst an easy money landscape, higher asset values promotes borrowing and lending in support of these activities.
If the source of inflation has been from a property bubble financed by debt then why should properties serve as a hedge when inflation (via interest rates or via reduction in disposable income) or the degree of debt burden itself would undermine the property bubble?
ASEAN Currencies Stumble!
Despite rising stocks, ASEAN currencies suffered a meltdown this week.
Depending on where one looks at, the Philippine peso slumped by over 1% along with the most of the neighbors most especially the Indonesian rupiah and Malaysian ringgit, but also the South Korean won, Taiwan Dollar and even the Singapore dollar.
In short, much of the region’s weakness has been due to the strong US dollar.
Despite the shortened trading week due to Typhoon Mario, the peso was traded in the international markets. The closing price of the peso at 44.52, based on Google Finance chart as of Friday has now erased the earlier gains during the year. The peso has posted marginal losses year to date.
I have said last February[26] that given the inflationary pressures (or stagflationary environment), the peso should have been weak: “the surge in inflation would also mean a dramatic decrease in disposable incomes of the residents, soaring interest rates, declining peso, and importantly, puts to the forefront the excessive credit conditions, as well as, over expansions of projects that had been financed by debt”.
Unfortunately the risk ON environment PLUS government massaging of peso and statistics seem to have defied such an outlook.
To estimate if there has government massaging of the peso, all one has to do is to match the fund “flows” with actual US Dollar “stocks” held by the BSP.
As I previously wrote[27] (bold original), GIRs consist of money or asset “stocks”, particularly Reserve Position in the Fund, Gold, SDRs, Foreign Investments and Foreign Exchange. The fact that foreign money “flows” continue to post positive balances, particularly OFW remittances, BPO foreign revenues, FDIs and portfolio flows means these should have flowed into the GIR as money or asset “stocks”. But they haven’t. So a fall in GIR reserves implies that GIR money and asset “stocks” PLUS foreign money flows from the current-capital account balances have been used to manage the Peso. Thus the BSP interventions in support of the peso have been far larger than what is seen by looking solely from the GIR data.
I find it pretty much curious, why imports have fallen in the face of the upper bound range of official inflation, if indeed the supply side has been the culprit as so alleged by the BSP.
Yet BSP’s actions have been directed to tighten money which is hardly about the supply side but about credit flows which means that current policies have been meant to address the banking system’s leverage.
A further implication is that the steadying official inflation numbers suggest that domestic production has filled the gap. This is something which I am not persuaded, as increase in manufacturing mostly on food may likely highlight the Money Illusion.
Nonetheless the current strength in the US dollar has been powerful enough to unmask some of the recent cosmetic embellishments.
The strong US dollar could likewise become a trigger for a risk OFF environment as it had been in the past. These are the dynamics which have presently been used by the BIS, the IMF and the OECD, as well as the BSP in their risk assessment.
And this has been what I warned of in 2013[28]: Let me repeat: the direction of the Phisix and the Peso will ultimately be determined by the direction of domestic interest rates which will likewise reflect on global trends.
This means that the peso is vulnerable from two fronts, one domestic inflation and second capital flight. So even if domestic inflation falls, a risk OFF environment could unnerve foreign money and cause a stampede out of peso based assets.
Yet should the peso continue to fall this will not only add to inflationary pressures, they are going to impact foreign currency denominated debts.
Nonetheless the pesos’ fall seem as in consonant with pressures on 10 Year bond Philippine bond yields to delineate the stagflationary dynamics as I indicated last February.
I estimate that the weighted average for yield Philippine government 10 year bonds has been at 3.71% for 2013. Current yield as of Friday at 4.375% implies 66 bps of potential interest rate spread (market rate increase).
Although I expect inflation pressures to eventually abate, as signified by declining money supply growth, over the interim it could remain high as money supply growth remains above 10% and this will likely be exacerbated by a weak peso.
Aside from the economic negatives from an inflationary environment, a lower peso and higher rates will serve as a one-two punch against earnings by heavily levered publicly listed companies.
Additionally higher bond yields means falling bond prices. This should affect balance sheets of financial institutions holding onto these bonds.
Notice too that peso and bonds have been under pressure while stocks continue to levitate.
Such contradictions will eventually be resolved.
Yet this has not been about destiny, this about consequences of previous actions.
