Should Filipinos Invest Abroad?

``No drug, not even alcohol, causes the fundamental ills of society. If we're looking for the source of our troubles, we shouldn't test people for drugs, we should test them for stupidity, ignorance, greed and love of power.”-P.J. O'Rourke, American Political Commentator, Journalist

In a recent discussion, a colleague raised the issue of whether locals should consider investing overseas given today’s financial globalization. My immediate reply was that there is no general answer to these concerns as this would depend on the distinct goals of each individual.

Some could see overseas investing as a way to tap overseas opportunities unavailable to the domestic market, others may contemplate on putting eggs into different markets or for portfolio diversification, some because of perceived higher returns or lower transaction costs, some for tax purposes or “recycling of funds” or some for just plain curiosity or even vanity (the need to feel sophisticated).

Nonetheless, global retail overseas investing has been a growing trend supported by the ongoing integration and the deepening of financial markets, technology advances such as real time online trading platforms, relaxation of capital flow regulations and the lowering of so-called Home Bias.

As an example, we previously mentioned of the metaphorical Mrs. Watanabes of Japan, an embodiment of retail investors who, because of their high savings and nearly zero interest rates, have used the international currency market to enhance returns, which became an important foundation of the global carry trade arbitrages.

According to the Economist, the ``Mr and Mrs Watanabe account for around 30% of the foreign-exchange market in Tokyo by value and volume of transactions, according to currency traders, double the share of a year ago. Meanwhile, the size of the retail market has more than doubled to about $15 billion a day.” (highlight mine)

For those who are contemplating to undertake offshore investments should consider the risk-reward tradeoffs than simply plunging into the pool without appropriately understanding the risks involved. As Warren Buffett cautioned, ``Risk comes from not knowing what you're doing.”

Risks From Direct Investing

Here is a rundown on some of the risks we need to consider when investing abroad:

1. Currency Risk-

As defined by Investopedia.com, ``A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.”

As an example, you may gain 10% from your equity investments abroad but a corresponding 10% loss in the currency from which your equity investments are denominated effectively offsets your gain. A worst case would be to see your equity investments values fall in a currency that is also losing- a double whammy!

The important point is that investing abroad requires the comprehension of the fundamental dynamics of the currency market.

This perhaps is the main reason why the Mr. and Mrs. Watanabes opted for the carry trade arbitrage in the currency market which has now evolved into a $3.2 trillion a day turnover than from equity investments, because currency trading signifies as the simplest route to access offshore opportunities.

In other words, you only have to deal with the currency equation without having to complicate your investing perspective with other risk concerns.

As an aside, this is where home bias has a defined advantage for equity investments, simply because you reduce the risk of currency volatility or your risk spectrum is mostly confined to domestic related influences or variables.

Hence, the optimum goal in investing overseas is to profit from investments on a market that has both an upside potential on the currency and the equity aspects.

2. Beta Risk-

As per Investopedia.com, ``Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.”

Essentially such risk measure is one of correlation of a market (or a benchmark) among other markets or of individual stock or sectoral benchmark relative to its operating market; see Figure 1 as our example.

Figure 1: Danske Bank: Correlation of EM Markets (left) and Global Equity-Financials (right)

In today’s generally deteriorating equity markets, we see the US markets, despite being the epicenter of the crisis, outperforming Emerging Markets (EM). Of course, the chart’s perspective comes from a one year period and doesn’t show the larger picture. Prior to the crisis EM benchmarks have markedly outperformed the US; where, in spite of the present losses, EM continues to outperform over the past 5 years (remember framing matters).

From here we can deduce that EM markets tend to outperform during better days and underperform during periods of stress. The broad implications to portfolio allocations would be to long EM once the recovery is in the horizon and long US markets when the world tilts to a crisis, although perhaps an alternative proposition would be to long Gold or traditional currency havens as Swiss Franc or Japanese Yen for the latter scenario. This also suggests that in order to distribute or dissipate risk requires the arbitrage of different asset classes in different markets around the world.

Another, the left pane illustrates how Financials stocks have been tightly correlated with the general global equity bellwether. While Financial stocks have suffered more than the bellwether of global ex-financial stocks, the strains of the former has likewise generated a downside trajectory to the latter, the causality of which generally accounts for the function of macroeconomic links (see below).

It doesn’t make sense to invest in a market which is highly correlated to your base market unless your goal is to tap industries that are unavailable to the local market. Therefore, if the objective to invest abroad is to diversify, then the ideal approach would be to deal with markets that have either a low or negative correlation.

3. Macroeconomic risk-

Macroeconomic risk generally deals with the performance, structure, and behavior of a national or regional economy as a whole (wikepidia.org).

Figure 2: wikipedia.org: Macroeconomics Circulation

The fundamental reason why the world has been suffering from a growth slowdown or the financial markets agonizing from heavy losses is due to the fundamental impairment of the financial channels (market and banking) whose transmission mechanism is clearly demonstrated above in figure 2.

The tightening of credit conditions from the US led housing-securitization bubble bust have effectively been raising the cost of capital, eroding corporate profits, decreasing business expenditures, magnifying losses in asset holdings among public and private institutions, prompting for the balance sheet restructuring by reducing leverage in private institutions, contracting consumer demand, raising unemployment, lowering prices of commodities and increasing government intervention in markets. And this weakness has been spilling over to the world.

Thus, the recent liquidity contraction translates to a magnified purview of the financial and economic structure of each nation under present turbulent conditions.

Said differently, the performance of markets in reaction to the gummed or gridlocked credit markets and economic downdraft has probably been a reflection of: one) the depth of interconnectedness of a country to the world via trade/financial/political channel, or two) the overall vulnerability of a country’s economic framework.

In essence, macroeconomic risks deal with the risks of an investment theme relative to economic output, national income, inflation, interest rate, capital formation or savings and investment, consumption, fiscal conditions and international trade and finance.

Thus, investing abroad means understanding how economic, financial and political linkages could impact your portfolio.

3. Taxation and Transactional Cost Risk-

From Reuters financial glossary ``The risk that tax laws relating to dividend income and capital gains on shares might change, making stocks less attractive.”

Whereas transaction cost means ``cost incurred in making an economic exchange” (wikipedia.org) which involves the “search or information” cost (search for availability of goods or securities in a specific market), “contracting” cost (cost of negotiation or bargaining) and “coordination/policying and enforcement” costs (meshing of different products and process aside from cost of enforcing the terms of contract) [wikipedia/wikinomics].

This means that prospective investments in overseas market requires the understanding of risk dynamics from the underlying cost structure of the present taxation regime of the host market, aside from its potential changes.

Taxation is part of the transaction costs that could determine the viability of investing overseas. Lower cost of transactions could function as a critical variable if only to wring out additional profits or returns from an economies of scale standpoint.

4. Liquidity Risk-

As defined by investorwords.com, ``The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as a house).”

In short, liquidity risk can mean the tradeable-ness of a given security or market.

This is somewhat related to the transaction cost where the more liquid or scalable a market is translates to lesser transactional cost.

Example, the Philippine state pension fund Government Service Insurance System (GSIS) has allotted some $1 billion, which makes up around 12% of GSIS’s total loans and investment portfolio for its global investment programme.

This dynamic can be lucidly seen from the AsianInvestor.net article (highlight mine), ``The GSIS will have a tough time generating returns for its members if it continues to stick with Philippine shares because of limited choices and relatively low volume. Low interest rates and the absence of a strong secondary fixed-income market in the Philippines are also constraints.”

Thus, a prospective overseas investor needs to aware of the liquidity conditions of the market or of the specific issues which one intends to deal with.

5. Political and Regulatory risks-

Political risk is a broad definition which essentially encompasses the changing nature of a country’s political structure. This from investorwords.com ``The risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits. For example, a company may suffer from such loss in the case of expropriation or tightened foreign exchange repatriation rules, or from increased credit risk if the government changes policies to make it difficult for the company to pay creditors.”

Such risks get accentuated when government becomes more adverse to private sector participation or to market oriented economic platforms (e.g. Venezuela and Bolivia) or when government policies run roughshod over its constituents (e.g. Zimbabwe) or with its neighbors (e.g. Russia).

As we have noted in Phisix: Learning From the Lessons of Financial History, trade, current account and fiscal surpluses, high forex reserves, low debt or favorable economic or market conditions can be radically overturned by 5 cardinal sins in policymaking; namely-protectionism (nationalism, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Whereas Regulatory risks are political risks applied more to specific sectors; from investopedia.com, ``The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Hence it is imperative for any overseas aspiring investor to anticipate risks of policy changes that could negatively impact an investing environment.

6. Other Risks

Of course there are other domestic risk issues to deal with such as valuation risks (financial valuation ratios), leverage risks (risks due to debt related exposure) or company specific risks (labor, management, etc.).

Risks From Indirect Investing

Nonetheless one may argue that you can deal with foreign markets through a variety of funds, such as Exchange Traded Funds, ADRs, Hedge funds, mutual funds or trust related funds sold by banks (UITFs) or insurance companies.

But as we previously noted there are issues like:

A. Principal-Agent Problem

This deals with the conflict of interest by investors when dealing with other market participants because of differing goals mostly due to the varied business models. For instance, investors would be mostly concerned about profits or returns on investment (ROI), whereas most brokers would be concerned with the commissions from client transactions while mainstream bankers or fund managers would be interested with the fees generated from the products they sell.

Thus, when bankers, fund managers or brokers issue their inhouse literatures they are mostly designed to sell the products or services they offer than to meet the investor’s objectives.

As Legg Mason’s Michael Maubossin writes in the Sociology of Markets, ``agency theory is relevant because agents now control the market. And, not surprisingly, agents have very different incentives than principals do. And this game is close to zero sum: The more the agents extract, the lower the returns for the principals.”

B. Asymmetric Information

``A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.” (investopedia.com)

Applied to the financial markets this means that sellers of financial products have more information than the buyer or clients. Thus, clients or investors are likely to submit to the whims of the finance manager, who are usually not invested. In other words, many people have committed their trust and money to fund managers or bankers who don’t even have much stakeholdings in the funds they manage except via fees or profits.

From Chuck Jaffe (marketwatch.com), ``In 46% of the domestic stock funds surveyed, the manager hadn't invested a dime. Other asset classes were far worse with nearly 60% of foreign stock funds reporting no manager ownership, two-thirds of taxable bond funds having no managers with money in the fund, up to 70% of balanced funds having no manager cash and some 78% of muni bond funds having shareholder cash only.”

Besides, investors who bought into funds are subject to information asymmetries on how fund managers or bankers allocate their portfolios. The risk strategies employed by fund managers may not square with the overall risk appetite of the investor or investment managers could be taking in more risks than would be tolerated by their clients.

How Distorted Incentives Contributed To The Mess

How does this relate to investing overseas?

First, no institutions are insuperable. The idea that funds are backed by big institutions should be questioned or scrutinized by every investor here and abroad.

As the lessons from Enron (formerly 7^th largest corporation in America) in 2001, the recent fall of the 158 year old Lehman Bros (formerly 4^th largest investment bank in the US) and American International Group (largest insurance in the US), fund managers and bankers are not immune to cognitive biases of the herd mentality whose agency problem, because of the desire for more share in the fees derived from profits piled into more leverage and momentum despite being aware of the unsustainable trend and compounded by guiding principle of implicit guarantees of government bailouts, helped triggered the colossal overspeculation fueled by monumental overleverage. It’s not their money anyway.

Evidence? Look at the performance of the $1.9 trillion hedge fund industry (Wall Street Journal), ``Nine out of every 10 of the 4,000 hedge funds surveyed globally by data provider Eurekahedge are performing insufficiently well to beat their high-water mark–the level at which they can charge performance fees, equivalent to a fifth of returns.

``All but 3% of funds of hedge funds were under the mark, according to the survey, as were 90.6% of equity long/short funds, 86% of portfolios focusing on market events, 85.4% of those investing in distressed securities, and 82.6% of futures managers. The picture was also bleak for long-only absolute return funds, 96.5% of which were below their high-water mark. The survey used figures compiled for July 31–the most recent available–and are likely to have worsened since then.”

To consider hedge funds have the ability to trade and profit even on when the market moves to the downside, except for the recent ban on short selling on 950 financial stocks which clearly handicapped their strategies.

Moreover, the agency problem and the information asymmetry dynamics had clearly been a functional component in the bubble formation when investment banks turned into the “originate and distribute models”-where they packaged and sold low quality or subprime mortgages or distributed credit risk, in complicity with the seal of goodstanding from credit rating agencies who ironically derive their revenues from the originators (effectively distorting the incentives to be objective appraisers), to equally unthinking clients or institutions worldwide. Thus, when the bubble imploded, the negative externalities caused by failed government policies espoused and profited by institutional oligopolies borne out of the cartelized financial system will once be folded into the arms of the US government whose concentration risks to the remaining institutions have equally been amplified.

Summary and Recommendations

To recap, to invest overseas isn’t the same as to invest locally primarily because of more risks concerns; particularly currency, beta, macroeconomic, taxation and transactional cost, liquidity, political and regulatory risks and other domestic related risks.

In addition, to rely on indirect exposure abroad via institutional products isn’t as risk free as portrayed by some, or impervious to the corrosive effects of principal-agent and the asymmetric information problem as recent events have clearly shown.

Big institutions have failed and will possibly go under the wringer as the world’s financial system adjust from taking up too much debt more than it can afford. The global credit crisis basically is a consequence of global financial institutions not knowing “who holds what” (similar to the Old maid game), thus we can’t really know who among the big financial players will remain standing or “strong” until the fog from the battlefield has lifted. What we understand is that Asian institutions are supposedly the least impacted compared to their counterparts because of the rear view mirror effects from the Asian Crisis.

The lesson for every investor is to increase their financial literacy and do their homework under some of the risk guidelines as presented above.

For beginners, before trying out overseas investment I suggest for you to get your hands dipped into the local market. Vanity won’t do you any good because tuition fees can be very costly and emotionally distressful. Once you gain experience via the learning curve, you can begin to dabble with markets abroad.

Refrain from the assumption that all markets operate similarly, as advocated by many hardcore technicians, because they aren’t. To analogize using George Orwell’s Animal Farm, ``All animals are equal, but some animals are more equal than others.” In addition, the supposition that markets contain all the information isn’t true as the information asymmetry dynamics above suggests.

It would be recommended that you should use the international markets to compliment your overall portfolio strategy by either going for opportunities not accessible in the domestic markets or to diversify to less correlated markets or to hedge your portfolio using intermarket arbitrage.

Finally, be cognizant of the possible conflict of interest when dealing with institutions whose economic model and incentives are different than yours.

First Test of the Phisix Bottom Thesis: Passed With Flying Colors!

``The true prophet is not he who predicts the future, but he who reads history and reveals the present.”-Eric Hoffer, 1902-1983, American social writer

So far so good.

My suspicion that the Phisix could have probably entered into a bottoming phase encountered its first acid test and appears to have passed with flying colors. In the face of pervasive gloom and doom, the Phisix cautiously bounced back by 2% this week for the first week in five.

Interpretation of Initial Impact and Arguments For A Phisix Bottom Redux

Of course the market’s reaction can be interpreted in two ways;

one- a short term interim technical bounce amidst a persistent medium term bear market or

second- an interim bounce which paves way for a seminal bottom under the perspective of its long term underlying trend. Remember market cycles involves process transitions and is not merely event-driven as incredibly suggested by some “experts”, therefore, the Phisix would have to pass repeated tests in order to reconfirm the validity of the ongoing restoration of confidence process.

We have premised the potential turnaround on a confluence of factors which involves the following:

1. Market volatility.

The recent gains of the Phisix (2.8 times) have not been steep and sharp enough as to merit a similar scale of descent. As an example, in 1986-1987 the Phisix climbed by about 10 TIMES which was correspondingly met by a nasty 50% correction. Similarly as mentioned last week, Saudi’s Tadawul and China’s Shanghai bourses flew by over 5 times in TWO to THREE years and has met by the same degree of volatility on its corrective phase, 65% and 50% respectively. Paraphrasing Newton’s Law, Every action has an almost equivalent and opposite degree of reaction.

2. Bubble cycle.

Every asset classes in today’s paper money driven world have been driven by varying stages of massive credit and monetary expansion. Based on public participation we have not seen evidence of such euphoria or investor irrationality.

Next, our asset markets have not reached extensively rich valuations levels. Lastly, the country’s macro or micro indicators have not signified signs of excessive leverage.

3. Encompassing Negative Sentiment.

Since market activities are driven by the investing or speculating public making decisions for whatsoever reasons- they involve psychology. Thus, market cycles are primarily underpinned by the psychological cycle.

Given today’s dire headlines from the domestic front (rice crisis, government threat of a utility takeover, etc.) to overseas (US recession, world economic slowdown, continuing credit crisis, surging “inflation” in food and energy, etc.), the degree of risk aversion has somewhat reached overshoot levels. Yet actions in the marketplace do not reflect or have not been congruent to the same degree of anxiety as shown in Figure 1.

Figure 1: stockcharts.com: PSE The Outlier!

As global markets have remained as closely correlated as in the past, most of these benchmarks imply that the underlying national indices under such rubric have rebounded since March of this year (vertical line).

The Dow Jones World Market at the top pane, the Dow Jones Asia Ex-Japan Index (below center window) and the iShares Emerging Markets (lowest pane) have recovered substantial losses since October.

Whether this recovery represents a “dead cat’s bounce” or a “bear market” rally is arguable and predicated on the caller’s bias. But the point is the Phisix (at center window) has missed the “gravy train”! Or…so it seems?

But compared to the past rallies which manifested of sharp V-shaped bounces, this time we are seeing some signs of consolidation (circle).

A prolonged consolidation or a gradual ascent should exhibit the recovery’s resilience, but again bottoming as a function of an evolving process within a cycle will mean repeated tests where investor patience and grit amidst prevailing fear should eventually be rewarded.

Yes, we were delighted to see that even as the US markets lost meaningful grounds last Wednesday (by about 2%), the Phisix “diverged” by recording moderate gains Thursday.

We have noted in the past that for the Phisix to reestablish strong indications of a recovery, (see Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom) durability in the form of less sensitivity to external variables should be seen as a guide, aside from progressive technical action, of which both signs seems to have been manifested this week.

Monday should be another test day since the US markets ended the week with moderate losses. Since Mondays are traditionally the weakest day of the week, the Phisix could be subject to some selling pressure following the weakness in the US markets. But for as long as the Phisix keeps the pace of its losses to within the range of losses in the US markets, we should remain in a consolidation phase with a recovery bias.

Dead Calm Waters Reveals Attribution Bias

One must be reminded that betting on future outcomes requires the understanding of risk and reward tradeoffs.

When we talk of a “bottom” we don’t even go near to the suggestion of a mystical formula or some alternative forms of voodoo rituality applied to the financial sphere but one where we distinguish the odds of the probability of incurring more losses against that of the odds of the prospective gains. In simple words, the bet of a bottom means the understanding that the room for further loss is significantly less than for future gains. But this, in contrast to the expectations of market punters, happens OVERTIME and requires PATIENCE.

I might like to add that the negative sentiment have truly reached extremes seen in the ground levels. In a recent social function which I regularly attend, where early this year participants seem agog over the market despite the decline (the assumption is that the market’s decline was short and shallow), today almost everyone seem to shun the topic of the stock market, which for me appears to uncannily resemble the investing atmosphere in 2002, a great window for grabbing outsized returns.

Nonetheless, I gathered that losses for some have been staggering enough to dismiss the existence of the stock market. And some have even fostered acerbity towards the financial intermediary agents (bankers, stock brokers and analysts).

Of course I might be accused of reading the sentiment of a group into the whole (fallacy of composition) but as we previously pointed out market internals, as seen by declining daily trades, have depicted the same picture where speculative froth engaged by mostly retail market participants have substantially ebbed. Since speculators have been caught in long positions due to their inability to accept losses or have been immobilized, trading activities have been restrained.

The lesson here is one of the Attribution Bias, where people tend to take credit on successful endeavors to inherent skills but deny responsibility for failures by imputing situational variables either by “randomness” or by the influences of others to their decision making.

Thus, when the market is buoyant everyone seems to know of the “whys” and the “whats” and the “who-drives-what” in the marketplace, and conversely when the market is dreary, the atmosphere seems like dead calm waters.

Negative Real Interest Rates and Emerging Market Bubbles

4. Negative Real Interest Rates.

Mainstream analysts or experts impute stock market investing to micro or macro events, some deal with the technical aspects. As a contrarian, we see the market as mainly the alternative function of money: a medium of exchange, a unit of account (means for economic calculation) and a store of value.

Not everything can be explained by micro or macro factors. Yet mainstream analysis insists on such lockstep correlation. We beg to differ.

Policies administered by government/s have manifested significant impact to asset prices. That is the reason for the phenomenon of bubbles. Investor irrationality is only an aggravating circumstance to a bubble in formation, because this cannot thrive without the principle of leverage (margin trades or credit expansion).

Following years of monetary accommodation and extensive growth of credit intermediaries of all sorts-derivatives to margin trades to alphabet soup of securitization, the implosion of the housing bubble in the US and other Anglo Saxon Economies has left central banks apprehensive of the negative economic growth impact from declining asset prices. As such, monetary authorities have mostly left policy rates lower than instituted “inflation” benchmarks hence negative real rates. Aside, they have been conducting massive liquidity bridging operations and applying fiscal subsidies in support of consumers suffering from the string of recent losses. We have explained most of these in Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

In addition, monetary pegs and mercantilist trading structures of key emerging markets have apparently resulted to a globalized mechanism for transmission of inflationary activities whose effects are now ostensibly rechanneled from Wall Street securities into commodities and emerging markets.

This insightful excerpt from Prudent Bear’s Doug Noland in his Credit Bubble Bulletin (highlights mine),

``prevailing inflationary pressures are global in nature. Wall Street finance is the source fueling the boom, and it’s running outside the Fed’s control. American asset inflation and resulting wealth effects are minimal, while price effects for food, energy, and commodities are extreme. In contrast to previous inflationary booms, while some selected groups benefit, the vast majority of people today recognize they are being hurt by rising prices. This hurt comes concurrently with atypical housing price declines. Today’s price effects pummel already weakened consumer sentiment, as opposed to previous effects that tended (through asset inflation) to bolster confidence. Furthermore, current inflationary forces are destabilizing and even destructive to many businesses, while playing havoc with the fiscal standing of federal, state and municipal governments.

``Revolving around booming Wall Street finance, previous inflationary booms naturally fueled surges in securities issuance and speculation. These Bubble Effects worked as powerful magnets in attracting foreign financial institutions, foreign-sourced speculators, and cheap foreign-sourced borrowings (i.e. yen borrowings financing higher-yielding U.S. securities) that all worked in concert to “recycle” our Current Account Deficits (“Bubble dollars”) directly back to our securities markets.

``In contrast, today inflationary forces largely bypass U.S. securities to play global energy, commodities, and hard assets. Foreign financial institutions are fleeing the U.S. risk intermediation business, while “Bubble dollars” are chiefly recycled back into Treasury and agency securities (where they now have minimal effect on U.S. home and asset prices). Meanwhile, the massive global pool of speculative finance is today focused on energy, commodities and the “emerging” economies.”

In short, what you are witnessing today is an ongoing massive shift in the inflation bias or bubble progression on a global scale from securities to commodities and to emerging economies.

Figure 2: stockcharts.com: Soaring Commodities and Latam Bourses!

Look at today’s commodity and commodity affiliated markets (see figure 2): Oil at an ALL time high $126 per barrel! The CRB Index is also at a Fresh record high! And commodity heavy benchmark of Latin American bourses (Dow Jones Latin America) also on record!

A world of negative real rates is likely to buttress such powerful dynamic. What you will likely have is a phenomenon of funds chasing winners which should spillover to a broader spectrum of commodity associated assets (yes we are seeing signs of the emergence of Ponzi financing in commodities), hence the bandwagon effect in motion!

While the impact of such inflation bias will always be unequally distributed between producers, sellers and buyers of commodities as discussed in my previous blog, Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline, the Philippine economy as an erstwhile major commodity exporter is a strong contender to be a beneficiary from the globalized inflation machinery.

Figure 3: PSE subindices: Recent Recovery Primarily Driven By the Mining Sector

Incipient signs of such rotation have already surfaced.

While the Phisix remain depressed down 23.25% year to date as of Friday’s close, the mining index (equally down 16.5%. y-t-d) has seemingly bottomed since March and has gradually been in consolidation and now seen moving higher-see figure 3 (Japanese Candlestick). This comes after a 6% jump this week, mostly from Atlas Consolidated which has soared by 25%! You don’t normally see a 25% run over a week from an index heavyweight (second largest weighting in the mining index at 16% after Philex) especially in a BEAR market! This only strengthens our case that the Phisix will likely recover soon.

And given that both the above technical picture plus the developments in the world market strengthened by a negative real rate environment, it is likely that the mining and oil sector will lead the Phisix’s recovery over the coming sessions.

All other indices in the chart are underwater on a year-to-date basis, this includes Banking (blue) down 19.75%, Commercial Industrial (violet) 20.59%, Property (red) 29.95%, Holding (green) 27.62% and Services (orange) 19.82%.

Moreover, investors will always find justification for an investment theme. Economic growth supported by capital investments over a dominant asset class is likely to become a feedback loop in a self reinforcing bubble cycle.

Figure 4 GMO: “They have the growth. We don’t. What’s to discuss?”

As the sagacious fund manager Jeremy Grantham of GMO (Jeremy Grantham, Richard Mayo and Eyk Van Otterloo) recently argued in his outlook, historically bubbles would need a strong underlying fundamental case from which the bubble is anchors upon.

In terms of emerging markets as shown in Figure 4 it is likely to be found in the consistent outperformance of economic growth. In the poignant words of Mr. Grantham, ``They have the growth. We don’t. What’s to discuss?”

Like us, Mr. Grantham believes that the next bubble will be on emerging markets. Quoting at length Mr. Grantham (all highlights mine),

``For one, emerging will increasingly be seen on a country-by-country basis. Nevertheless, the second wave of let’s-look-like-Yale money from state plans is still in its early stages and looking to invest overwhelmingly in emerging market funds, not in the specific country funds of the Yales and Princetons.

``For another caveat, the GDP growth rate of a country does not in the very long term necessarily determine how much money a country’s stock market will make. Long-term market return may depend more on profit margins. But investors believe GDP growth really matters, and Japan went to 65x earnings despite average or lower corporate profit margins.

``But the third caveat is the most serious; this emerging bubble can easily be postponed or even stopped before it really begins by the current financial problems and the slowing growth rates of the developed world that are likely to follow.

``My own view is that our credit problems will impact and interrupt the recently sustained outperformance of emerging in the intermediate term, say, the next 3 years, even as the acceptance of this emerging bubble case grows. Such interruptions may be quite violent but, despite them, at the next low point for the U.S. market the emerging markets are quite likely to do no worse and in the recovery they will go to a very large premium. And if, just if, the U.S. gets very lucky indeed and muddles through without serious market and economic problems, then the emerging bubble will of course occur more quickly and smoothly.”

Phisix: Political and External Risk Variables

So yes, allied with the views of Mr. Grantham as we have previously mentioned, the Phisix is envisaged by two major risk factors; one is domestic political risk and the other is the transmission factors of the external risk environment.

Political risk could be associated with the risk of destabilizing markets through populist policies such as overextending subsidies to reverse the gains or improvements of the country’s fiscal position and balance sheet, combined with threats to the sanctity of private property ownership via “nationalization” or management “take over”.

So when we read of canards repeatedly circulating in the emails of “why the Philippines is poor?” we understand that it is the fundamental aspect of principally NOT having ENOUGH capital investments in the country and NOT because of lack of “moral” leadership why the Philippines is “poor” (yea ironically the Philippines is “poor” but home to 3 of the 10 world’s largest malls and growing!).

It is because of the lack of appreciation of the markets through property ownership and the enforcement of contracts, the lack of savings, a dearth of platform or infrastructure for establishing pricing efficiency, the lack of competitive environment, a politically dependent society or culture and importantly the high costs of political intervention and bureaucracy.

Remember the popular personality based politics theme of corruption represents a symptom and NOT the disease. Corruption basically is an offshoot to suffocating network of bloated bureaucracy as a result of overregulation and inordinately high taxation due to huge liabilities accrued from failed policies and deep dependence on political gratuity (a.k.a. pork barrel).

Economics 101 tells us that the more you want of something you LOWER the costs, in contrast, the less you want of something you INCREASE the cost. If you want to lessen the incidences of corruption you increase the cost of committing corruption. If corruption is an offshoot to overregulation then streamlining of laws, reduced bureaucracy and lower taxation should be encouraged aside from strictly enforcing laws.

In addition it is NOT governments that drive the wealth of economies or responsible for the upgrading of the standard of living of societies, otherwise communism (Stalin’s USSR, Mao’s China, Kim’s North Korea, Castro’s Cuba) would have succeeded; it is the people!

If governments empower its people to conduct trade openly with LESS political intervention thereby strengthening the division of labor within its economy then it reduces the country’s risk premium, lowers the hurdle rate, reduces the cost of doing business and thus becomes competitively attractive for capital investments.

Governance permissive of a market economy or an entrepreneurship culture and less dependence on the political leadership is the common denominator of successful economies. Because it is a governing policy to limit government’s intervention then the issue of “moral” becomes moot.

But when you see the leadership use its coercive power of its legally clothed leviathan to conduct political harassment or render vindictive actuations on presumed political opponents in the name of public services then it raises questions among potential investors about the sacredness of equity ownership.

This in itself increases the cost or barriers of doing business. Hence capital would seek a hefty premium in terms of higher rate of return or yields for it to consider deploying them into the country. The higher the costs the lower rate of investments.

These incessant political interventions is the reason why the Philippines will remain politically and economically disadvantaged and will thus depend on the global or regional cycle for its upliftment than from intrinsic factors such as the popularly demanded (but largely ineffective) “government driven” initiatives instead of the unpopular market oriented reforms. To quote Ludwig von Mises, ``The effect of its interference is that people are prevented from using their knowledge and abilities, their labor and their material means of production in the way in which they would earn the highest returns and satisfy their needs as much as possible. Such interference makes people poorer and less satisfied.”

As for external risk variables, the country is faced with the same macro risks as the others, a sharp US recession, a steep global economic slowdown, accelerating inflationary policies which could fuel the intensity of the present bubbles and or goods and services inflation, geopolitical risks of public upheavals (triggered by food crisis) or potential military conflicts (over resources), a US dollar crash, global depression and other fat tails.