What To Expect In 2011

We humans, facing limits of knowledge, and things we do not observe, the unseen and the unknown, resolve the tension by squeezing life and the world into crisp commoditized ideas, reductive categories, specific vocabularies, and prepackaged narratives, which, on the occasion, has explosive consequences- Nassim Nicolas Taleb, The Bed Of Procrustes

It’s crystal ball peeking time.

Much of what we’ve been saying here isn’t likely to change for 2011, except to say that perhaps most of what we have been predicting may accelerate or escalate.

Here are the factors, which I perceive, constitute as the major drivers of the global asset markets (this includes the Philippines):

1. Monetary authorities of developed economies will fight to sustain low interest rates.

This comes even amidst pressures on the bond markets (see figure 1)

Figure 1: Economagic: US Treasury Yields leads Fed Fund Rate

Rising treasury yields (see green line) almost always leads Fed interest rates (red line). Said differently, markets influence policies than the other way around.

In addition, the Fed’s rates only reveal the path dependency or the penchant to artificially keep down interest rates until forced by hand by the markets.

Yet, rising interest rates do not automatically equate to financial markets turmoil, as suggested by some perma bears, who desperately keeps looking for all sorts of excuses to pray for the markets to go lower. The US S&P 500 index (blue) shows how US equities had surfed the rising interest tide over the years, until they have reached some pivotal point.

Nevertheless, it is important to determine the genuine dynamics of the interest rate movements[1] rather than to impute personal bias-based conclusions that are largely unfounded.

And as we earlier pointed out[2],

Rising interest rates presuppose one of the following drivers: increased demand for credit, concerns over credit quality, emerging scarcity of capital or the deepening inflation expectations.

Figure 2: Rising Yields A Global Phenomenon (charts courtesy of Cumberland Advisors[3] and Danske Bank[4])

Let me further point out scarcity of capital can be a consequence of perceived insecurities from political environment or protectionism.

Yet, the fact that rising interest rate appears to be a global phenomenon (see figure 2-upper window) suggest that the current interest dynamics has been less about credit quality concerns (despite the ongoing PIIGs crisis) but more about emerging inflation expectations, and secondarily, rising demand for credit.

Even China, whom sporadically applied some brakes over her system’s rapidly growing credit due to bubble concerns this year, has also been vacillating to implement a tight monetary environment despite posting inflation rates at 28-month high[5]. China reportedly plans to allow some 7 trillion yuan ($1.1 trillion) in new loans for 2011[6].

So like any conventional approach, when caught between the bind of choosing between the proverbial devil (the temporal benefits from inflationism) and the deep blue sea (prospects of having to suffer from economic rebalancing). Authorities as will most likely choose the former.

2. More Inflationism: Bailouts and QEs To Continue

In spite of the rhetoric on austerity, authorities of major developed economies will likely engage in more inflationism, stealthily coursed through central banks or in central banking vernacular “quantitative easing” or “credit easing”.

At the start of the year, policymakers blabbered about ‘exit strategies’ which we accurately debunked and exposed as poker bluff[7].

Even if the US had been declared out of recession by the National Bureau of Economic Research (NBER) in June of 2009[8], a non profit group in charge of ascertaining recession and business cycles, the Federal Reserve have stubbornly persisted on using the printing press option.

Incidentally and ironically, popular economic experts have again failed miserably with their misguided forecasts, such as Keynesian high priest Paul Krugman[9] and populist Nouriel Roubini[10] both whom had predicted of a large probability a double-dip recession, which apparently did NOT materialize this year.

Just how could these so called experts be so frequently awfully wrong, yet get so much the public’s attention?! As Nassim Taleb rightfully dissects, economics cannot digest the idea that the collective (and the aggregate) are disproportionately less predictable than individuals[11]. Of course Mr. Taleb refers to mainstream economics which fixates on mathematical-empirical formalism rather than the study of people’s actions or conduct (praxeology).

This also demonstrates that the public has hardly been concerned about accuracy or about dealing with reality. Instead the public have been indulging or assimilating dogmatic ideas that confirms to their beliefs or which runs along with their line of thinking, regardless if they work in the real world.

Nonetheless, we further argued that such inflationist policies had been actually directed at the banking system, which actually operates as some form of cartel under the aegis of central banks. Officials have only used the economy, particularly the employment figures, as cover[12] in order to continue with the redistributive process of ‘privatizing profits and socializing losses’ in order to buttress the banking sector.

To add, if higher treasury yields will translate to higher mortgage rates and thereby put renewed pressure on the housing markets, then we can expect more versions of QE to be activated. QE 2.0 has barely waded into the water and now Fed officials as Bernanke appear to be telegraphing or conditioning the public for a QE 3.0[13].

And this isn’t going to change anytime soon. Not unless consumer inflation runs berserk and consequently weigh on the political dimensions that would affect policymaking.

Yet while I am very pleased that Congressman Ron Paul will take over as the chairman of the Domestic Monetary Policy Subcommittee of the House Financial Services Committee[14], it remains uncertain whether Congressman Paul can successfully overhaul, or diminish the role of, or dismember the deeply entrenched interest groups that constitute the banking cartel, or at the least make a dent on the making the Federal Reserve transparent. Subjecting monetary policies to free market forces should salvage the system from self-disintegration (read: sell gold).

And the same dynamics appears to take hold whether in the Eurozone or Japan or the United Kingdom. Every perceived crisis would be met by the same approach.

My point is: bailouts and flooding the world with liquidity would remain instrumental in determining the direction of asset prices in 2011.

3. Effects of Divergent Monetary Policies

Divergent monetary policies will impact emerging markets and developed markets distinctly, with the former benefiting from the transmission effects from the latter’s policies.

While most economic experts will talk about interrelationships of the output gap, economic growth and trilemma of international finance or the impossible trinity[15] of fixed exchange rate, free capital movement and independent monetary policies-where only two of the three conditions can be attained, we see current coordinated policies as no more than designed to artificially promote growth by inflating bubbles.

Artificial low interest rates, which punish savers and rewards borrowers, have been the conventional or the orthodox policy treatment to modern financial and economic maladies. Thus, suppressed interest rates are likely to impact both domestic and international reallocation of resources applied to nations under the rubric of emerging markets and of nations classified as developed.

For nations whose banking and financial system have not been directly affected or impaired by the recent financial crisis, and for economies that had been relatively unscathed and whose financial system have been less leveraged and has been marked by high rate of savings, the impact from such interest rate policies have been dramatically magnified.

And this appears to be case for ASEAN bourses (see figure 3).

Figure 3: Policy Divergences And ASEAN Bourses

With the exception of Malaysia (green), the bellwethers of major ASEAN bourses, namely Philippines (yellow), Indonesia (Orange), and Thailand (red) has broken above the pre-crisis highs largely driven by the above stated dynamics.

Local investors will likely continue to ramp up speculations on asset prices (stocks, real estate[16] and private sector bonds) which should give some semblance of or will likely be interpreted as an ongoing economic boom, where in truth, many will account for misdirected investments.

And this will be amplified by portfolio flows from foreign funds, whose incentives to arbitrage on global markets have been driven by home policies of similar depressed interest rates and the deliberate debasement of their currency.

Add to that would be pressures from resurgent domestic inflation that would force up rates or the appreciation of the domestic currency or both, whose yield spreads would equally attract foreign arbitrage. Thus, in cognizance of the volatility of policy induced portfolio flows, some emerging markets have either been contemplating on capital controls[17] or have begun implementing them, albeit largely in a benign scale.

Yet one can’t discount the role of momentum or the herd mentality in the bidding up of asset prices, where psychology fuelled by circulating credit would lead to irrationality or extreme valuations which would be justified as “new paradigm”.

4. The Globalization Factor

Aside from globalization of monetary and administrative-fiscal policies, globalization of trade, migration and finance similarly plays a significant role in shaping asset prices.

While inflationism does play a role in the allocation of resources, so does globalization. So in one way globalization somewhat offsets the malinvestments from inflationism. However it remains to be seen how much of malinvestments can be muted by globalization.

Nevertheless, mainstream economics not only to tend misread the effects of globalization for political ‘mercantilist’ purposes, but likewise underestimate on the role it plays on the economy, as well as the rapidly changing dynamics behind these[18].

For instance many perma bears have mainly used “lack of aggregate demand” from developed economies as the principal reason to argue for “depression economics”.

But this is false for the simple reason that it oversimplifies and underestimates the impact of trade and of people’s action and likewise sees past performance as a static trend going forward!

And this is why high profile experts have entirely missed out predicting the recent rally or the recent improvements in the global economy

A good example of sicj underestimation is the dynamics of Asia’s domestic consumption (see figure 4).

Figure 4: DBS Research: Asia 2011 How Scissors Cut

According to the DBS Group Research[19],

Remember all that talk about global imbalances and the worry that if the US did not consume then Asia, which purportedly lived off the US, could not grow? Oops. Since 3Q08, US consumption has grown by 1%, or by paltry $27 bn. Asia’s consumption has grown by 22%, or by $225 bn. That’s an expansion 8x bigger than in the US. With new consumption running 8:1 in Asia’s favor, it’s simply no longer credible to claim that Asia’s growth depends on the US or that failure to fix some ‘imbalance’ puts global growth in peril. It doesn’t. US growth maybe in peril...but that’s another kettle of fish: one that everything to do with explosive leverage and abysmal risk management and nothing to do with current account surpluses or deficits.

So aside the mainstream missing out the improvement of Asia’s domestic consumption, the DBS Research group goes on to argue that the region’s growth has been spurred mostly by the private sector in spite of the safety nets applied (bottom window).

And as we have long argued, trade openness and economic freedom lubricates demand, which serves as the ultimate end of production. And demand isn’t constructed based on circular flows but on people’s changing subjective value preferences.

And for as long people are allowed to openly engage in free markets, depression-deflation economics, which stems largely from government bubble and protectionist policies that induces such systemic distortions, is no more than a figment of a mercantilists imagination. Under free markets, greater output translates to growth deflation that increases the public purchasing power.

Besides, the aggregate demand deflation camp also tends to underestimate the fundamental function of why central banks ever exist at all: they exist not only as a lender of last resort, but as financer of government liabilities or the financier of political goals of the political leaders.

To repeat, what generates market instability or what are called as “market failures” are fundamentally bubble policies and interventionism and not some random flux arisng from from the lack of confidence or “animal spirits”.

My Working Targets for 2011

So here is how I see 2011:

Unless inflation explodes to the upside and becomes totally unwieldy, overall, for ASEAN and for the Philippine Phisix we should see significant positive gains anywhere around 20-40% at the yearend of 2011 based on the close of 2010. Needless to say, the 5,000 level would seem like a highly achievable target. What the mainstream sees as an economic boom will signify a blossoming bubble cycle.

Of course my foremost barometer for the state of the global equity markets would be the price direction of gold, which I expect to continue to generate sustained gains and possibly clear out in a cinch the Roubini hurdle of $1,500[20].

To repeat, Gold hasn’t proven to be a deflation hedge as shown by its performance during the 2008 Lehman collapse. The performance of Gold during the Great Depression and today is different because gold served as a monetary anchor then. Today, gold prices act as a temperature that measures the conditions of the faith based paper money system.

In addition if inflation will become more widespread, then we should likewise see the oil jump above $100 per barrel and this will be accompanied by general increases in other commodity prices, particularly in food prices.

And in my opinion, while everyone likes to focus on what seems sensational, I’d focus on what I think is more important. I don’t expect the Euro to evaporate soon as some others suggest. I’d probably pay a closer look to China, whose yield curve appears to be flattening (see figure 5).

Figure 5 Asianbondsonline: China’s Flattening yield curve

And I will get to scream fire once the yield curve turns negative.

Finally, surging inflation may not be good for the stock market in the entirety but that would be conditional. It should be good for certain assets as commodities or real properties (see figure 6).

Figure 6: Stagflation’s Winners (courtesy of Dr. Marc Faber[21])

Based on a seemingly similar economic environment or during the stagflation days of 1970-1980, hard assets turned out to be the winner.

Of course, it would be a different picture once hyperinflation gets into play; equities became store of value in Weimar Germany (1921-1923) and in Zimbabwe (2000s-2009).

But this could be one of the two options that could likely happen once the next bubbles go bust. The other one is debt default.

For now, identifying the whereabouts of the bubble cycle is my primary concern. And it should be yours too.

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[1] see Rising US Treasury Yields: Credit Quality Concern or Symptoms of Bubble Cycles, December 14, 2010

[2] see Global Markets And The Phisix: New Year Rally Begins, December 6, 2010

[3] Kotok, David R. The Bond Herd, 6% and Gold, Financialsense.com December 16, 2010

[4] Danske Bank, Basel III impact study published, Fxstreet.com December 16, 2010

[5] BBC.co.uk China sees inflation jump to 5.1%, a 28-month high, December 11, 2010

[6] Bloomberg.com China Said to Aim for at Least 7 Trillion Yuan Loans, December 13, 2010

[7] See Poker Bluff: The Exit Strategy Theme For 2010, January 11, 2010

[8] Marketwatch.com U.S. recession ended June 2009, NBER finds September 10, 2010

[9] Bloomberg.com, Krugman Sees 30-40% Chance of U.S. Recession in 2010, January 4, 2010

[10] Reuters.com Roubini says U.S. economy may dip again next year, May 29, 2009, Roubini, Nouriel Beware Of A Double-Dip Recession, March 11, 2010 Forbes.com

[11] Taleb, Nassim Nicholas The Bed of Procrustes, Philosophical and Practical Aphorisms Random House

[12] See QE 2.0: It’s All About The US Banking System, November 18, 2010

[13] See QE 3.0: How Does Ben Bernanke Define Change, December 6, 2010

[14] Norris, Floyd, Ron Paul Appears Poised to Irk the Fed Chief, December 16, 2010

[15] Wikipedia.org Impossible trinity

[16] See The Upcoming Boom In The Philippine Property Sector, September 12, 2010

[17] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[18] See iPhone Shows Why Global Imbalances Will Remain, December 16, 2010

[19] DBS Research, Asia 2011: How Scissors Cut, Economics Markets Strategy, December 9, 2010

[20] In 2009 Jim Rogers and Nouriel Roubini went into a heated public debate, where celebrity guru Roubini predicted that gold won’t surpass $1,500. See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009

[21] Faber, Marc Tomorrow's Gold: Asia's Age of Discovery

Rising US Treasury Yields: Credit Quality Concern or Symptoms of Bubble Cycle?

The Wall Street Examiner writes,

For those who argue it does matter, one number being tossed around is the level at which debt service equals 30% of tax revenues. Once interest payments take 30% of tax revenues, a country has an out-of-control debt-trap issue. When you think clearly about it, this just makes sense as the ability to dodge, weave, and defer is pretty much removed, as is the logic that it will be repaid in a low-risk manner. The world is going to be a different place when the US is perceived to be in a debt trap.

I suspect the problem will rear its ugly head well before this 30% number is hit as markets start discounting the trajectory by hiking interest rates because of poor credit quality and/or inflation (or more accurately stranguflation). Naturally that question should be asked in terms of the recent and sudden uptick in Treasury note and bond rates that appeared strongly correlated to the latest round of tax “stimulus” and handouts, and the “unexpected” reaction to QE2. The latter is nothing more than a brazen, dangerous gamble to monetize the debt. Sure, one crowd is claiming economic growth is the causa proxima, but that feels like utter nonsense. Could it be that the markets at long last are anticipating a very bad result from QE2 and even more government largess? (emphasis added)

Although I sympathize with this observation, in my opinion, this looks more like a cart before the horse analysis when it comes to forecasting.

Two observations:

the analysis does not say how such mayhem would be triggered, except to presuppose intuitively that rising rates signifies implied doubts on on credit quality and

second it also does not say how authorities are likely to respond to such environment.

For instance, the claim that rising rates from economic growth feels like utter nonsense may not seem consistent with a seemingly tranquil credit environment in many parts of the world.

An environment manifesting concerns about of the credit quality would look like this…

In other words, the rising interest will be accompanied by turbulent credit markets (e.g. rising CDS) perhaps globally.

Yet we are not seeing this today YET (see below chart)

charts above courtesy of Danske Bank research

While the PIIGS episode today could likely foreshadow the milieu of tomorrow’s crisis, the difference is that the interest rate, credit and other financial markets have, for now, demonstrated benign reaction.

And this has allowed governments to continue with the current orthodox responses to the crisis—bailouts and the flooding of liquidity in the system.

A full blown crisis would likely occur when global government’s hands are tied.

And there are two likely series of events that would pose as trigger: accelerating inflation on a worldwide scale (symptoms-consumer, producer, commodity), and or another major bubble bust elsewhere around the globe (China?, Emerging markets?).

In my view: rising US treasury yields appear to be indicative of a brewing bubble cycle (in many parts of the globe) that is likely being transmitted from the disparities in monetary policies between developed economies and the emerging market economies.

The Possible Implications Of The Next Phase Of US Monetary Easing

``In a free economy the principal cause of a cumulative deficit in a country's international payments is to be found in inflation. Reference to it has been already made. A sustained policy of inflation leads a gold-standard country to a cumulative loss of gold and finally to the abandonment of that system; then the national currency can freely depreciate. In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies.” Michael A. Heilperin, International Monetary Economics

I have more proof that the next wave of inflationism will take place not because of the political exigencies to restore “export competitiveness” (a.k.a currency wars) or about the US unemployment woes, even if the latter has been used as justification for the coming actions, but to save the US banking system.

QE 2.0 And The Legal Face Of The US Mortgage Crisis

The US Federal Reserve through Mr. Bernanke in a recent speech said that “the risk of deflation is higher than desirable[1]” and that “Given the committee’s objectives, there would appear — all else being equal — to be a case for further action[2]”

So there seems to be a strong likelihood of Quantitative Easing (QE) 2.0 will take place during the next Fed meeting in November 2-3.

Yet, what’s wrong with the two illustrations? (see figure 1)

Figure 1: US Stocks Rallying Without Financials

Basically, the US stockmarket has been rallying absent the financials, the former leaders. The financials, as seen by S&P Financials (SPF: left window, bottom pane), have lagged and has been weighed by the banking index (BIX-left window, main chart)

The poor performance of the US banks can be traced to the next phase of the mortgage crisis.

Apparently the US mortgage mess has been transformed from a financial and economic issue into a major legal morass: The issue of property titles—where the complexities of the Mortgage Backed Securities (MBS), during the boom days, may have led to string of fraudulent actions which may have caused a “chain of broken titles”.

Gonzalo Lira has the details[3] but here is the kernel,

``A lot of the foreclosed properties might not have been foreclosed legally. The people evicted might still have a right to their old houses. The new buyers might not actually own the REO’s they bought off the banks. The banks could be on the hook for trillions of dollars, and in the sights of literally millions of lawsuits.”

The initial tremor has been a wave of foreclosure moratorium.

According to Chad Fisher of USA News[4],

``JPMorgan Chase has suspended foreclosures in 23 states while the company looks at 115,000 mortgage foreclosure files to find potential errors in its documentation. Ally Financial and Bank of America are looking for errors in files for all 50 states and suspending foreclosures. Goldman Sachs' Litton Loan Servicing, PNC Financial, and OneWest Bank began are checking their files, but Wells Fargo and Citigroup are holding their ground, stating that their affidavits are valid and sound...This time the states are banding together to stop foreclosures based on illegal affidavits submitted by mortgage companies in foreclosure proceedings.”

One risk is that banks may be required to buy back mortgage securities if they are the originators. This could put under further strain the banking industry’s capital position that could trigger another seizure in the banking system.

And perhaps QE 2.0 is meant to assume this role—to provide another subsidy to industry by acting as lender or buyer or guarantor of last resort.

Of course the foreclosure moratorium presents as another burden to the housing industry, which serves as another reason why QE 2.0 will, once again, be in operation.

As we have long said, this has much less been about the US economy, but about protecting the banking system, which has been the anchor to the de facto US dollar monetary system, from the risks of collapse.

The problem with mainstream media is that they have been focused on the aspects of currency wars, emanating from so-called imbalances, when the predicament is apparently internal: Incumbent unsustainable policies and their unintended consequences.

The Deadly Effects Of Competitive Devaluation

I’d like to add that the impact of the so-called “currency wars” will greatly depend on the degree of reaction by Emerging Market central banks relative to the inflationism applied by their contemporaries in the developed economies.

Since currency wars or “competitive devaluation” function as a subtle form of protectionism, which implies of multiple participants, the effect isn’t likely to be temporary or short term but a lasting one with disastrous results.

We are not new to this, according to Murray N. Rothbard[5], (bold highlights mine, italics original)

``Of course, the world had suffered mightily from fluctuating fiat money in the not too distant past: the 1930s, when every country had gone off gold (a phony gold standard preserved for foreign central banks by the United States). The problem is that each nation-state kept fixing its exchange rates, and the result was currency blocs, aggressive devaluations attempting to expand exports and restrict imports, and economic warfare culminating in World War II.”

The major difference is that countries then went off the gold standard and eventually returned to a modified US dollar-gold fix, known as the Bretton Woods system[6], while today we are operating plainly on a paper money US dollar standard. So essentially, the competitive devaluation being staged by today’s global central banks sails on unchartered waters.

Figure 2: Imports Then And Today

Besides unlike in the 30s, global trade was much less of a factor (see figure 2). And less global trade translated then to geopolitics that had been mainly based on nationalism.

Today, the world has been alot more trade oriented. And so far, the responses by emerging market monetary authorities have been benign, defensive and less confrontational.

For instance, Thailand reportedly will remove a 15% tax privilege accorded to foreigners on income from domestic bonds[7]. Also lately Brazil’s government will move to “to raise the country's Financial Operations Tax, known as IOF, on certain types of incoming foreign investment will be insufficient to resolve the country's problems with an appreciated local currency, Brazil's National Confederation of Industries, or CNI, said Tuesday[8].”

South Korea also joins the clamp down on foreign currency speculation by increasing probes on currency derivatives[9].

And to confirm our suspicions[10], Asian central banks have been heavily intervening on their respective markets to curb currency appreciation. According to a news report ``Authorities in the region were estimated to have bought a combined $23.2 billion via intervention from last week until Tuesday, according to traders estimated compiled by IFR Markets.[11]”

And signs are likely that reactive interventions also involves the domestic central bank (Bangko Sentral ng Pilipinas) in the slowing the appreciation of the Peso[12].

And of course the overall effect of competitive devaluation is to raise the price of commodities (see figure 3).

Figure 3: Stockcharts.com: Commodity Inflation

So whether it Gold (Gold), Agriculture commodities ($GKX-S&P GSCI Agricultural Index Spot Prices), industrial metals ($GYX S&P GSCI Industrial Metals Index - Spot Prices) or energy products ($GJX-S&P GSCI Energy Index Spot Prices) we seem to be witnessing broadening signs of commodity inflation emanating from these collective policies. This is aside from the financial asset inflation in Emerging Markets.

Author Judy Shelton quotes Euro currency founder Robert Mundell in an interview[13],

``'The price of gold is an index of inflation expectations," Mr. Mundell says without hesitation. "The rising price of gold shows that people see huge amounts of debt being accumulated and they expect more money to be pumped out."

In explaining the failure of the Bretton Woods system, Mr. Mundell again in the same interview says

"The system broke down," he hastens to explain, "not because of fixed rates. Fixed exchange rates operate between California and New York . . . the system broke down because there was no mechanism to keep the world price level in line with the price of gold." (emphasis added)

In other words, sustained interventions and inflationism deflected or distorted the exchange ratio between money relative to gold which induced huge unsustainable imbalances that caused the monetary system to disintegrate.

Applying this to competitive devaluation, this implies that protectionism via the currency valve will only risks leading the world to inimical trade wars or shifting bubble cycles or hyperinflation/breakdown of the currency system.

So for a full scale currency war to take place, the effects are certainly not negligible.

In A Currency War No Nation Wins

It’s even equally ridiculous to hear mainstream proponents advocate currency wars as solution to global imbalances such as “China wants to impose a deflationary adjustment on the US, just as Germany is doing to Greece”[14].

On the first place no one is trying to deflate other nations directly for their own benefit. Policies are most shaped to conform with perceived interests of local entities that takes external interests as secondary objectives.

For instance, QE 2.0 appears directed at the banking system rather than promoting demand via export competitiveness via the currency channel.

Next, people and not nations are the ones who conduct trade and trade balances likewise reflect on this.

Another, currency values are not the sole factor that determines trade balances, there are many issues such as scale of capital, technology, infrastructure, cost of doing business through tax and bureaucratic regime, legal institutions, property rights, state of the markets and labor and many others that influence the business environment.

Fourth, it isn’t true China or Greece has been deflating (see figure 4).

Figure 4: Tradingeconomics.com: Inflation in China and Greece

The problems of Greece, for instance, reflect more on the rigidity of a relatively closed economy[15] and the overdependence on a welfare state than from its Euro anchor. I’d suspect that even if Greece were to operate on its former currency, the drachma, and allowed to devalue; the internal rigidities won’t miraculously bring them to an export giant as misperceived by the mainstream.

So I wouldn’t know what kind of world these analysts live in, but their narratives has been far from appropriate accounting for the facts. They would seem to be like snake-oil salesman.

Lastly, since inflationism is a subtle form of redistribution, i.e. from savers to spenders and from creditors to debtors, this will be beneficial only to a few but at the expense of society. Therefore, claims that the US will benefit from a currency war is unalloyed canard.

Doug Noland of the Credit Bubble Bulletin rightly observes[16],

``The U.S. cannot win the “currency war.” In reality, central bankers in China, Japan, Brazil, South Korea and elsewhere aren’t even battling against us. They have, instead, been waging war on the market. If foreign central bankers had not intervened and accumulated massive dollar holdings (international reserves up an incredible $1.5 TN in 12 months!) – in the process providing a “backstop bid” for both our currency and the Treasury market – it would be an altogether different market environment today.

``There will be no answer for global imbalances found by the U.S. “inflating the rest of the world.” The problem with inflationism is that one year of inflationary measures leads only to the next year of greater inflation.”

And I certainly agree that inflationism is an addictive agent. But like abuse of use of illegal substances, such actions will have long term deleterious implications.

QE 2.0 Should Boost Emerging Market and Asian Equity Assets

As we have long repeatedly argued, global policy divergences has been prompting for cross border capital flows that has been buoying emerging market assets including that of Asia (see figure 5).

Figure 5: US Global Funds: QE 2.0 Should Lift Asian Equities

And the transmission mechanism that would boost liquidity flows isn’t only from external sources but likewise reflected from domestic channels.

Some confirmation of our view from Morgan Stanley’s Joachim Fels and Manoj Pradhan[17]

``Economies with greater slack in their economies and less inflationary pressures will try to keep their currencies from appreciating, either through FX intervention or, to a lesser extent, via the use of capital controls. Intervention in FX markets will likely mean higher domestic liquidity (in the absence of tight credit controls like in China). In turn, the domestic economy is likely to expand and goods and risky asset prices are likely to be pushed higher. These EM economies should see a boom, and higher incomes, leading to an increase in the demand for US exports. Other EM economies, whose output gaps are too small for comfort or whose inflation is already a concern, could decide to let their currencies accelerate to a greater extent. Domestic expansion here would be more limited, so there would be not so much of an income effect; but US exports would still benefit again, this time from an improved price advantage thanks to EM currency appreciation.”

Figure 6: Tradingeconomics.com: Philippines Total Forex Reserves (ex-gold)

In the Philippines, as cross border capital flow surges, domestic liquidity has likewise been expanding, as the local central bank, the BSP, intervenes in the currency markets, aside from the ramifications of the artificially suppressed interest rates.

So in the environment of the alluring sweet spot of inflationism and concerted currency debasement, cash is likely the worst form of investment.

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[1] Businessweek.com Bernanke Ponders ‘Crapshoot’ Amid Deflation Risk, October 15, 2010

[2] New York Times, Bernanke Weighs Risks of New Action, October 15, 2010

[3] Lira, Gonzalo The Second Leg Down of America’s Death Spiral, October 12, 2010

[4] Fisher Chad, 5 Things You Should Know About the Foreclosure Moratorium, US News, October 15, 2010

[5] Rothbard, Murray N. The World Currency Crisis, Making Economic Sense

[6] Wikipedia.org Bretton Woods system

[7] Businessweek, Bloomberg Thailand to Levy 15% Tax on Foreigners’ Bond Income, October 12, 2010

[8] Wall Street Journal Brazil Industry: IOF Tax Not Enough To Resolve Forex Problems October 5, 2010

[9] Wall Street Journal, Korea to Inspect Forex Positions at Banks, October 5, 2010

[10] See Currency Wars And The Philippine Peso, October 10, 2010

[11] Business Recorder, Taiwan dollar at two-year high, October 6, 2010

[12] Inquirer.net, Jan.-Aug. BOP surplus rises by 25% to $3.48B, September 20, 2010

[13] Shelton, Judy, Currency Chaos: Where Do We Go From Here?, October 16, 2010

[14] Wolf, Martin Why America is going to win the global currency battle, Oct 12, 2010

[15] See Greece And Economic Freedom, October 16, 2010

[16] Noland, Doug Inflationary Biases And The U.S. Policy Dilemma, Credit Bubble Bulletin PrudentBear.com

[17] Fels Joachim and Pradhan Manoj, QE-20, Morgan Stanley October 15, 2010

Currency Wars And The Philippine Peso

``One cause for hope of an early agreement is that many of the illusions concerning the advantage of drifting currencies and competitive depreciation have been dissolving under the test of experience. Great increases in export trade have not followed depreciation; the usual result of anchorless currencies has been a shrinkage of both export and import trade. Again, the fallacy is beginning to be apparent of the idea that a currency allowed to drift would finally "seek its own natural level." It is becoming clear that the "natural" level of a currency is precisely what governmental policies in the long run tend to make it. There is no more a "natural value" for an irredeemable currency than there is for a promissory note of a person of uncertain intentions to pay an undisclosed sum at an unspecified date. Finally, it has been learned that competitive depreciation, unlike competitive armaments, is a game that no Government is too poor or too weak to play, and that it can lead to nothing but general demoralization.” Henry Hazlitt, From Bretton Woods To World Inflation

The Federal Reserve’s prospective Quantitative Easing 2.0 has now triggered an impassioned debate among international policymakers over the risks of currency wars.

Today, policy divergences among developed and emerging markets, which have been spurring capital flows that has boosted asset markets of emerging markets, has prompted for such worries.

Brazil’s minister Guido Mantega fired the first salvo[1] to accuse advanced economies of adapting “beggar-thy-neighbour” policies that could harm international trade.

Currency wars or competitive devaluation simply implies inflationism applied by governments in order to “boost jobs by bolstering exports”. This has been a long held mercantilist-protectionist approach, which had been debunked[2] by classical economist as Adam Smith, but seemingly being adapted by today’s leading authorities, perhaps out of desperation.

As the Wall Street Journal editorial writes[3],

``The growing danger today is currency protectionism—what students of the 1930s will remember as competitive devaluation or "beggar-thy-neighbor" policies. As economic historian Charles Kindleberger describes in his classic "The World in Depression," nations under domestic political pressure sought economic advantage by devaluing their national currency to improve their terms of trade.

``But that advantage came at the expense of everyone else. "As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

Here is my take on the currency episode:

First, I don’t see the Federal Reserve as attempting to attain “export competitiveness” by taking on the currency devaluation path.

The Federal Reserve’s action, as well as the Bank of England, seems to be more directed at surviving the balance sheets of their respective banking systems which has been buoyed by earlier dosages of QE.

Therefore, as said above, dodgy assets that are still held by the banks would need further infusion of credit to maintain their subsidized price levels.

Second, it is political season in the US with mid-term elections coming this November. Hence, political talking points have been directed against free trade to signify attempts to shore up votes by appealing to nationalism and to economic illiterates, following the growing unpopularity with Obama administration and the Democratic Party.

This has been underscored by the recent passage of the China currency sanction bill[4] at the US House. Yet this bill isn’t certain to be passed by the Senate, which will most likely be after elections.

Third, while the currency bill has been seen as directed towards “forcing” China to revalue what most don’t know is that technicalities matters. As lawyer Scott Lincicome writes[5],

``But none of that changes the fact that, if it became law, this particular legislation probably won't have a big effect on things, at least in the near term.”

Why?

Because, according to Mr. Lincicome, ``The change in language... gives the administration 'a way to say no' to U.S. industries and could signal to China that Washington isn't looking to declare a trade war over currency practices."

In politics, it is usually a smoke and mirrors game.

Lastly, global policymakers appear to be cognizant of the dangers of applying protectionism and the nonsensical approach by mercantilist policies.

The IMF has cautioned against currency friction and has volunteered to act as a “referee”[6] to settle trade disputes emerging from such strains.

Importantly, emerging market authorities have been quite sensitive into maintaining open trade channels.

Poland’s central bank governor Marek Belka in an interview with Wall Street Journal[7] delivers a jarring statement against mercantilism.

From Mr. Belka, (bold emphasis mine)

``All those wars produce a lack of stability, and the warring parties forget the basic point. The bottom line is devaluations and appreciations change your competitive position temporarily but they don’t change your competitive position for good. If you want to strengthen your competitiveness by devaluing your currency, this is a sign of despair, this isn’t a policy. I am worried because this destabilizes the global economy and it does not lead to rebalancing, something we all long for.”

We just hope that global policymakers remain steadfast in support of freer trade than engage in inflationism which is no less than veiled protectionism.

Nonetheless, as far as the subtle competitive devaluation has been an ongoing concern, we should expect the local currency, the Philippine Peso to benefit from a far larger scale of interventionism from advanced economies as United Kingdom and Japan, whom like the US, has been engaged in “quantitative easing”.

Figure 5: Yahoo Finance: Philippine Peso Versus Quantitative Easing Economies (ex-US)

This means that the Peso is likely to appreciate against the British Pound and could likely reverse its long term decline against the Japanese Yen as Japan expands her battle against alleged deflation, which for me is no more than promoting the nation’s export sector at the expense of the rest.

Relatively speaking, the Peso is in a far better position than both of the above and most especially against the US dollar given the current conditions.

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[1] BBC.co.uk Currency 'war' warning from Brazil's finance minister, September 28, 2010

[2] See Does Importation Drain The Wealth Of A Nation?, September 13, 2010

[3] Wall Street Journal, Beggar the World Monetary instability is a threat to the global recovery October 1, 2010.

[4] BBC.co.uk US House passes China currency sanctions bill, September 30, 2010

[5] Linicome Scott, House Passes Currency Legislation; Whoop-Dee-Freakin-Doo, September 29, 2010

[6] Marketwatch.com, IMF moves to referee currency debate, October 9, 2010

[7] Wall Street Journal, Poland’s Central Bank Governor Belka on Currency Wars, October 9, 2010

Stock Market Investing: The Search For The Mythical Holy Grail

“A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.” -Fritz Machlup, The Stock Market, Credit And Capital Formation

If you think that the bullmarket in the Philippine Phisix is an isolated ‘special’ affair and has been exhibiting signs of economic or corporate (micro fundamental) improvements or political endorsements, then you would be wrong (see Figure 3).

The same applies to the mainstream permabears who can’t seem to get their focus away from the debt problem angle or the supposed “lack of aggregate demand” in major economies.

The US Dollar Story

Figure 3 Bloomberg: Exploding MSCI Emerging Market and Asian Currencies

As one would note, emerging markets stocks, as represented by the MSCI Emerging Market index (upper window), have been exploding of late. But still has some distance from reaching the 2008 highs.

And this has not just been a dynamic in the Emerging market stock markets, but also in the currencies of Emerging markets and their Asian contemporaries.

This is best represented by the Asian currency index, the Bloomberg-JPMorgan Asia Dollar Index (ADXY) which have similarly spiked (lower window)!

With Asian currencies surging, I would assume that in spite of the recent appreciation of the Philippine Peso, the relative performance of the Peso has been lagging, considering that foreign money flows have been quite active. Nevertheless, despite my suspicion of the repeated intervention by the local central bank, the Bangko Sentral ng Pilipinas (BSP), the Peso should follow her neighbours and appreciate going into the yearend.

So domestic assets are evidently being juiced up by foreign and local money flows.

And as further proof that past performance can’t serve as reliable indicator of the future, even the ongoing troubles in Ireland hasn’t prevented the Euro from appreciating against the US dollar.

And more on more mainstream analysts appear to be getting it.

This from the BCA Research[1], (bold emphasis mine)

``Four currencies – dollar, euro, sterling and yen – currently account for the vast majority of reserve holdings. All of these four major reserve currencies have their own fundamental weaknesses. At the margin, this will force reserve managers to look for alternatives. Indeed, according to the IMF, there is already a sharp spike in holdings of “other” currencies, to 3.6% of total reserves...

``Bottom line: Reserve diversification away from the U.S. dollar remains an ongoing structural theme in the foreign exchange market and commodity currencies will be a main beneficiary.”

It has been an open theme for us here that the so-called policy divergences between the major economies led by the US and emerging market economies, which can be likewise as the called the US dollar carry trade, has underpinned the actions in today’s financial markets.

And the telegraphed actions by the US Federal Reserve in support of a weaker dollar have been causing a flood of liquidity flowing into emerging markets, gold and other commodities.

The Holy Grail Is The Rising Tide

However in the domestic front, I sense alot of psychological changes as some people seem to get aggressive over their expectations of stock market returns.

Some seem to think that the role of the analysts is to provide them optimal returns by capturing the trajectory of price actions via market timing of every issue.

They desire to be in every security that are rapidly going up and expect analysts to be able to identify and predict them.

Yet they read momentum as a way to generate outsized returns and seek all sorts of information (earnings, economic growth and etc...) to confirm on such biases in order to justify their participation. They seem to be seeking the elusive Holy Grail of investing. Unfortunately, either they are being misled or are being overwhelmed by emotions.

Let me reiterate, this isn’t about special events surrounding particular issues. This is about the rising tide lifting all, if not most boats. (see figure 4)

Figure 4: PSE: Number of Traded Issues (Daily)

It’s been happening across emerging markets, where many EM bourses appear to be reacting “positively” to the “leash effects” of the falling dollar-policy divergence trade.

And the same phenomenon seems underway in the local stock exchange where the massive liquidity spillover has been generating a broader interest on publicly listed issues.

The underlying bullmarket has drawn market participants to trade on more issues, where an increasing number of formerly illiquid issues have now become “liquid”. The search for yield has been expanding and lifting prices across the most issues.

This only goes to show how an inflation driven bullmarket has relative effects on prices of securities even when the general level is likewise being lifted overtime.

The other way to say it is that rotational price actions of publicly listed issues is a general feature of a blossoming boom-bust cycle. As for which issues becomes tomorrow’s darling is a phenomenon that can be divined by Lady Luck and not any mortal analysts. Yet to narrow one’s timeframe is to unnecessarily increase risk tolerance and very dicey gambit.

So those who pin their analysis on a variety of non-essentials will certainly get the surprise of their lives when such dynamics reverses. For the meantime, as price levels go up, everyone’s a genius.

Interest Rates As Key

And it is equally important to remember that should there be any pin that may pop this liquidity driven activities (bubble) in the marketplace, it would be due to rising interest rates.

Figure 5: Casey Research[2]: Inflation Is The Biggest Driver of Interest Rate

And the benign levels of interest rates, which have been mainly due to manipulations by the governments will eventually succumb to one of the following factors:

-greater demand for credit or

-deterioration in the expectations of governments’ ability to settle existing liabilities, or

-most importantly, rising consumer price inflation which in the past have been the most pivotal factor in the determining interest rate levels (see figure 5).

As a final note, let me add to Warren Buffett’s advise, “The dumbest reason in the world to buy a stock is because it's going up”, and use all sorts of justifications to do so.

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[1] BCA Research, Prospects For FX Diversification September 28, 2010

[2] CaseyResearch.com Debtflation, September 13, 2010