Quote of the Day: This Time is Different: Sovereign Debt Crisis will Wipe Out Pensions

Why is this Sovereign Debt Crisis collapse different from 1931? When the governments of the world defaulted on their debts in 1931, there were no pension funds. Government has exempted itself from all prudent reason for you take the state operated pension funds, like Social Security in the USA, where 100% of the money is in government bonds. They may have no intention of defaulting, but very few government have ever paid off their debts in the end. 

Then there are states who regulate pension funds requiring more than 80% to be in government bonds. A Sovereign Debt Default this time around will wipe out socialism, yet the bulk of the people are clueless not merely about the risk, but the ramifications. Younger generations do not save to support their parents for that was government’s job post-Great Depression. Socialism has altered thousands of years of family structure following the ranting of Karl Marx. This has been one giant lab experiment that ended badly in China and Russia and is coming to a local government near you. 

So this time it is SUBSTANTIALLY DIFFERENT. Government is now on the hook, which is part of the reason why they are moving to eliminate cash to prevent bank runs and to force society to comply with their demands. This is why we have people like Gordon Brown, who sold Britain’s gold reserves in 1999 making the low, claiming now that eliminating cash will eliminate the boom and bust of the business cycle. Let’s face it, Gordon Brown has NEVER been right when it comes to politics, not even once, and he has been the worst manager of finance that Britain has ever known. He sold the low in gold and now he presumes he can fulfill Marxism by eliminating cash. He postulates ideas that are theory without any support whatsoever. We cannot afford more arrogant people like this in politics who believe they have a right to experiment with society. 

This time it is very different. They have wiped out society placing the entire scheme of socialism as a terrible nightmare that will end badly, and they have ruined the social family structure disarming people that for thousands of years was our very means of self-sufficient survival. These clown have set the tone for wiping out the dreams they sold the elderly, all while hunting taxes and causing job creation to implode as the youth has been converted into the lost generation. All this with pretend good intentions. Can you imagine the damage to society if they had actually intended this mess? They have lied to themselves and to the people. We have to crash and burn – that part is inevitable. Only when the economy turns down will we then argue over solutions.

(italics mine)

This is from economist Martin Armstrong from his website.

Related to  this, for all the economic 'boom' projected by record stocks, the Bloomberg recently reported that 32 out of 50 or 64% of US states have been faced with budget gaps and thus have been making cuts, tapping reserves or face higher budget shortfalls. And the same report says that state governments have only about half of reserves compared to the pre recession era.

And due to pension concerns Moody's recently downgraded Chicago. 

Puerto Rico which is categorized as Unincorporated territory of the US has  currently been enduring a debt crisis, that has put to risk social services provided by socialism.

Data on US State fiscal and debt conditions can be found here.

Additionally the pension warning doesn't just apply to the US but to many other developed economies as well (OECD data as % of GDP  here).

Graphic: A History of Sovereign Defaults

Just a reminder that there is no such thing as “risk free”, particularly on the popular impression that government debts are safe havens.

Below a historical roster of Sovereign debt defaults from Wikipedia.org

Africa:

Americas:

Even the US has had several instances of defaults.

John Chamberlain at the Mises Institutes explains some of in list: Continental Currency Default of 1779, Default on Continental Domestic Loans, Greenback Default of 1862, Continental Currency Default of 1779, Momentary Default of 1979

Asia:

Postbellum Japan has not been spared too.

So as with the Philippines whom restructured debt in 1983/1986 (World Bank)

Europe’s largest economies Germany, the United Kingdom, France has had their share of defaults or partial defaults (restructuring)

As per historian Edward Chancellor (also cited by the wikipedia.org) reasons for default consist of: A reversal of global capital flows, Unwise lending, Fraudulent lending, Excessive foreign debts, A poor credit history, Unproductive lending, Rollover risk, Weak revenues, Rising interest rates, Terminal debt.

All these are rather symptoms of political spending which has been unproductive and consumption based (e.g. welfare, wars, bailouts, bureaucracy, etc.) and which frequently leads to excesses.

The idea that government debt represents as safe haven is no less than political travesty meant to justify the current unsustainable debt based political economic institutions. 

Eventually, the naked will be exposed when the tide subsides.

The Euro Bailout And Market Pressures

``The problem is that the fundamentals of these economies are not right. People in those countries cannot maintain a decent standard of living because they are not producing enough in the private economy to keep the public-sector unions afloat. Unfortunately, these unions are so powerful that they can extort pay and work agreements that plunder the taxpayers, and now that the bailouts have arrived, look for the unions to be even more militant and violent. These countries don’t need more inflation, contra Keynesians. They need to stop feeding the monster of public-employee unions and permit business to operate without being smothered by rules and regulations. But after being bailed out, these governments will go back to doing things as they always have, and the malinvestment will continue.” William L. Anderson, Will the New Bailout Save Europe?

The ultimate question at present is whether the Greece crisis would escalate into a full-blown international sovereign debt crisis, in spite of the recent monster $1 trillion bailout[1] announced by an EU-IMF syndicate last Sunday or if the market stresses emanating from the Greece episode would lead to a cascading impact on the real economy. And for that matter the sequential question should be, what would be the attendant policy response if the markets continue to react negatively?

Bailouts Are Politically Motivated And Ballooning

It’s a silly notion to limit ourselves to only the economic aspects, when throughout the decade the policy response, when confronted with a crisis, has been mostly politically designed which eventually had political results, particularly boom bust cycles. And this is why political reactions[2] by global leaders have been like clockwork, which has seemingly validated us anew.

For instance, the nearly 10% plunge[3] in the US the other Friday, which was mostly pinned on computer error, has prompted authorities to conduct an investigation. Here is a very telling commentary, as quoted by the Financial Post[4], from a US lawmaker,

"We cannot allow a technological error to spook the markets and cause panic," Rep. Paul Kanjorski said late on Thursday. "This is unacceptable."

This only implies that US markets have been very much incorporated into the policy setting modules of US authorities, where falling stockmarkets for valid reasons or not, e.g. due to technological glitches, is like a taboo.

And there is little nuance when compared to the EU’s bailout of the Euro, where EU Commissioner Olli Rehn announced, ``We shall defend the euro whatever it takes”[5]

These are more than enough proofs that the guiding principle for global authorities is to shore up their markets as means to convey “confidence”. As we have been saying, the intuitive response by global governments has been to unceasingly throw money at the problem. And confidence in the market is likely to translate to financing for politicians running for elections, aside from a favourable image to the public.

And one would note that the cost of bailouts have been growing,

This from Bloomberg[6],

``The cost of saving the world from financial meltdown has been bloated by ‘hyperinflation’ since Long Term Capital Management LP’s rescue in 1998… rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia’s default, and the almost $1 trillion committed to halt the European Union’s sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. ‘We haven’t had any kind of normal inflation in the last decade, but we’ve had hyperinflation in writedowns and the magnitude of bailouts,’ said Jim Reid, head of fundamental strategy at Deutsche Bank… ‘You have to do more to get a similar effect every time.’”

As we earlier wrote[7], To paraphrase Senator Everett Dirksen ``A trillion here and a trillion there, and pretty soon you're talking real money; (gold as money)"

There seems to be no apparent end to the spate of bailouts.

QE In 4 Largest Economies And A Different Kind Of Carry Trade

Will global governments wake up to face reality recognizing the attendant risks by adapting policies that require stringent sacrifices to clear their respective markets of excesses or malinvestments? Or will they continue to flush the economic system by the massive use of their printing press as a short term fix or a nostrum?

For us, until they are faced with a crisis that forces their hands, the path dependency for authorities is for the latter.

Yet a genuine manifestation of an international sovereign crisis would be a surge in interest rates among nations afflicted by growing risks of debt default.

However this seems unlikely to occur yet, as governments would still be able to manipulate the bond markets for political expediency, particularly to finance existing deficit as incidences of inflation appear muted.

And part of such policies to suppress interest rates would be to buy government bonds from the financial markets or the banking system. And this apparently has been part of the measures that was packaged with the bailout of the Euro.

In essence, we have 4 of the world’s largest economies that have now engaged in “quantitative easing” (even if the ECB denies these, for the reasons that she would “sterilize” her purchases or offset bond purchases from banks/financial institutions with sale of EU bonds).

And these 4 economies constitute nearly 85% of the $83 trillion global bond markets as of 2009[8].

In short, world markets and the global economy would likely suffer from an unprecedented meltdown in a horrific scale, which would make 2008 a walk in the park, if any of the developed nation’s sovereign crisis transform into a full contagion.

However, I don’t believe that we have reached that point yet.

Figure 2: US Treasuries Index, EM Index, Yield Curve, US Dollar

The highly volatility in the markets have led a misimpression of a repeat scenario of carry trade circa 2008.

As we have pointed on last February, there is little evidence that a carry trade from the US dollar has been building among the global banking system[9].

Instead what the Euro crisis has been showing us is that the carry trade has been within the Eurozone system as seen by the interlocking[10] activities or the vastly intertwined network among private and national banks, EU member governments and the ECB. In short, it isn’t a foreign currency arbitrage, but a carry trade of government debts distributed among EU banks.

As we earlier quoted[11] Philipp Bagus[12],

(bold emphasis mine)

``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

And the existing regulations which mandate the banking system to hold government debt as a risk-free reserve has equally contributed to the current mess by introducing the moral hazard problem effectively channelled into subsidies to the subprime EU member states as Greece.

So the pressure seen in the Euro markets of late isn’t due to the unwinding of US dollar carry trades but a perceived rise in the default risks and possibly the consequent impact to the real economy from a perceived slowdown due to compliance to fiscal adjustments, or of the question of the European Union ability to survive the crisis without getting dismembered.

As shown above, US interest rates markets and the US dollar have been chief beneficiaries from the troubled Euro. The Morgan Stanley US Government Morgan Stanley Fund (USGAX), a fund where 80% of its assets are invested in Treasury bills, notes and bonds, has surged. Moreover, the US dollar Index where the Euro has the largest share of the basket, has continually spiked.

This, in essence, looks more of a rotation away from EU assets into US assets than a looming full blown international sovereign crisis.

In addition, we are seeing parts of that rotation away from the EU into Emerging Market Bonds as shown by rise in the Salomon Bros. Emerging Market Debt Funds (XESDX).

Likewise, the spread between the 3 month Bills and 30-year Bonds remains steep in spite of a relatively higher 3 month rates since the start of the year.

In a full scale sovereign crisis we are likely to see a faster surge of short term bills rather than bonds. And this will likely be triggered by a spike in inflation which sets about a self feeding mechanism that would force up rates. At this point, governments will have to choose to bring down interest rest rates by printing more money or by totally renouncing inflationism.

This Isn’t Lehman Of 2008; China’s Role And Slumping Commodities

Well obviously this isn’t 2008, where the disruptions in the interbank funding markets forced a seizure or a rapid system-wide contagion in the banking system.

Yes, we are seeing some volatility but this has been nowhere near the post Lehman episode as shown in the credit markets or in the interest spreads (see figure 3).

Figure 3 Danske Bank: Credit Markets Isn’t Manifesting Signs Anywhere Near 2008

The yields in US cash indices for different corporate bonds (left window) have largely been unscathed in spite of the current selling pressures.

And the 3 month Libor-OIS spread considered as a measure of the health of the banking system (in the US and Europe), hasn’t been suffering from the same degree of stress during the zenith of the Lehman days (right window).

And that’s also why EU officials have been quick to institute “buying of government bonds” or “quantitative easing” in response to signs of growing stress in Europe’s banking system.

By making sure of the ample liquidity of markets, these actions which work to suppress interest rates are meant to allow markets and the banking system continually finance EU’s bailout. In other words, the bailout is not only meant to politically uphold the Euro as the region’s currency, but to also keep intact the carry trade, unless overhauled by reforms-which appears to be nowhere in sight.

Morgan Stanley’s Joachim Fels sees the same view,

(bold highlights mine)

``More generally, with the establishment of a potentially large stabilisation fund, fiscal policy in the euro area is being effectively socialised. No country will be allowed to fail, and it seems that no country will be too big to bail. Ultimately, this creates an incentive for governments to run a looser policy than otherwise. If markets then refuse to fund a profligate government, it could turn to the fund, borrow at below-market interest rates and domestically blame the required fiscal tightening on the ‘diktat' from the euro area partners and the IMF. So, our bottom line on the implications of the European fiscal emergency plan is that, while it addresses the near-term liquidity problems, it does little to solve the underlying problem of fiscal sustainability and may even make things worse on this front over the medium term.”

Moreover, I’d like to add that while some have argued that the EU’s actions will not violate the principle of Maastricht treaty, which disallows for direct bailouts, the Special Purpose Vehicle (SPV) created to extend loans to troubled nations, for me, signifies as EU’s act to go around their self-imposed rule, or regulatory arbitrage, but this time by the EU government.

If governments would work to circumvent their rules in order to accommodate political expediency and likewise save particular interest groups in the context of the meme of saving the economy or the Union, then how else would this politically privileged group react when they knowingly feel protected? They are likely to engage in more reckless behaviour.

This reminds us of Hyman Minsky[13] who warned that bubbles emanate from government intervention, ``It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.”

So its more than just inflating, it’s also a burgeoning moral hazards problem.

In addition, considering that the US is directly and indirectly involved, through the Federal Reserve via the currency swap lines and the IMF respectively, this can’t be seen as “beggar thy neighbour” approach considering that the US Federal Reserve sees the spillover risks from a banking contagion as possibly harmful to the sensitive state of her counterparts. In other words, the Fed isn’t causing a higher a US dollar for trade purposes but to ring fence the US banking system from a Euro based contagion.

Instead, such policy is more of a “beggar thy economy” genre where resources are being marshalled to save the banking system in the US and in Europe, at the expense of the real economy.

It’s not clear that the recent spate of falling oil or commodity prices are materially connected to the events in Greece or Europe, as they seem more correlated to the developments in China (figure 8).

Figure 4: China and commodities

As you can see the sharp drop in China’s Shanghai index (SSEC), which has been under constant assault from her government in an attempt to quash formative bubbles, has nearly been concurrent with the drop in oil (WTIC) and general commodities (CRB). Albeit the SSEC’s recent steep decline has also coincided with the fall of global markets from the Greece crisis the other week.

However, one bizarre development which seems moving in contrast to the current tide has been the Baltic Dry Index (BDI). The BDI appears headed towards the opposite direction almost as markets have been falling.

And with reports that consumer price inflation has been accelerating, it is quite likely that the Chinese yuan, could be expected to appreciate soon. And possibly, the rising BDI could possibly mean two things: one, a rising renmimbi means cheaper imports, which could reflect on the possibility of China’s positioning, and second, the falling prices could also be another factor for increased demand.

Unlikely Slump For Global Markets

So what does this tell us of the global markets?

First I am doubtful if this is the “inflection point” as expected by the permabears.

I see this more of a reprieve than a reversal. As said earlier, for as long as consumer price inflation rates are low, governments can continue to flood the economic system with newly printed money that may artificially contain interest rates levels.

Since money isn’t neutral, the impact from bailouts will have uneven effects to countries or specific sectors in particular economies. Even those expecting a deflation in Greece seem gravely mistaken[14].

Second, aside from the liquidity enhancement programs, policy rates by developed economy central banks are likely to stay at present levels for a longer period of time.

We even think that EM economies are likely to maintain rates at current levels, given the current conditions. In addition, rate increases enhances the risks of attracting more foreign capital in search of higher yields. Policymakers in EM nations will be in a fix.

Three, given the still steep yield curve, I have been expecting a pick-up in credit activities even in nations afflicted by over indebtedness. So far there have little signs of these (see figure 5)

Figure 5: St. Louis Federal Reserve: Consumer Loans at All Commercial Banks

Our basic premise has been that incentives provided for by the government to punish savers and reward debtors by suppressing rates will eventually force people to spend or speculate at the risk of blowing another bubble.

Besides, debt has been culturally ingrained in Western societies. It is an addiction problem[15] that will be hard to resist considering that the government itself is the main advocate of the use of addictive credit.

Fourth, economies of emerging markets have been performing strongly and are likely to maintain this momentum given the ultra loose liquidity backdrop.

Fifth, any slowdown or economic problems in any countries is likely to produce more bailouts from governments.

The trend has been set, therefore the chain of events are likely to follow. For instance, US participation in the bailout of Greece is likely to set a moral hazard precedent for financially troubled domestic states.

As Ganesh Rathnam argues[16], (bold highlights mine)

``The Federal Reserve's and IMF's participation in the eurozone bailout will not be lost on union members and politicians of heavily indebted US states such as California and Illinois. When the day of reckoning arrives for the US states who are unable to close their budget gaps and whose pension plans have huge funding gaps, they will be up in arms for their bailout as well. How could the US government politically defend its bailing out Greece via the IMF and the Federal Reserve and refusing the same for its own citizens? The idea that California would be allowed to default on its obligations when Greece wasn't is unthinkable. Therefore, the bailout of the PIIGS sets the stage for similar bailouts of bankrupt US states and cities.”

So governments worldwide will continuously pour freshly minted or digital money into the system. And yes this is going to be an ongoing battle between the markets and government armed with the printing presses.

Finally, Nassim Taleb in a recent interview[17] said, “No government wants solution to apply on themselves”.

And this only means that there will be even more government spending, bigger deficits and debts, higher inflation and missed fiscal targets or slippages from proposed austerity programs.

In the Eurozone, the EU circumvented existing rules to accommodate a bailout. These are signs that rules can flouted for political goals.

For the interim, this will all help. But at a heavy price in the future.

---

[1] see $1 Trillion Monster Bailout For The Euro!

[2] Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?

[3] See A Black Monday 1987 Redux?

[4] Financial Post, Obama says authorities probe cause of stock swoon

[5] see $1 Trillion Monster Bailout For The Euro!

[6] InvestorVillage/Bloomberg, Cost of Bailouts Keep on Rising

[7] See Are Record Gold Prices Signalling A Crack-Up Boom?

[8] The Asset Allocation Advisor, World Stock and Bond Markets and Portfolio Diversity; distribution share as follows US 37.9%, Euro 28.7%, Japan 13%, UK 4.9%

[9] See Does This Look Like A US Dollar Carry Bubble?

[10] See Was The Greece Bailout, A Bailout of The Euro System?

[11] See Why The Greece Episode Means More Inflationism

[12] Bagus, Philipp, The Bailout of Greece and the End of the Euro Mises.org

[13] Minsky, Hyman "Inflation, Recession and Economic Policy", 1982 (page 67) quoted earlier here More On Goldman Sachs: Moral Hazard And Regulatory Capture

[14] See Is Greece Suffering From Deflation?

[15] See Influences Of The Yield Curve On The Equity And Commodity Markets

[16] Rantham, Ganesh A Greek Tragedy in the Making

[17] See Nassim Taleb: Waking Up One Day To Perceptional Hyperinflation

Italy's Government Owned Cars And The Debt Crisis

This is one manifestation or symptom of why the PIIGS (Portugal, Italy, Ireland, and Greece) are in a crisis.

From the Economist, (bold highlights mine)

``RECKLESS, flashy and chaotic sums up the general view of Italian governments as well as the popular image of the country's drivers. It is hardly surprising that the two are so similar according to Renato Brunetta, Italy's minister for public administration. He reckons that the country runs a fleet of 629,000 official cars, ten times the number in similar European countries and 50,000 more than just a couple of years ago. The official fleet includes top-of-the-range Maseratis to ferry senior officials around Rome. Italy's domestic carmakers, which are starting to recover after a tough time, will be hoping that this particular government-efficiency drive goes no further."



Markets have been revealing the cracks from the unsustainable lavish spending by governments of mostly developed nations. Yet, as shown by the recent spate of bailouts, governments will fight to retain these privileges.

As an old saw goes, What are we in power for?

Selling In May, The Greek "Contagion" Panic In Perspective

We will try to put into perspective last night's panic which was supposedly triggered by concerns over a Greek contagion.

The chart below from Bespoke shows of the Credit Default Swap (CDS) prices or the cost of insuring debt, as of last night.

Bespoke decries the exaggeration in the news, "While CDS prices are higher today for countries like Greece, Portugal, Spain, and Italy, they were just as high late last week prior to declining quite a bit yesterday on news of the Greek bailout. Basically default risk today is right back where it was late last week and not "blowing out" to higher levels."


It's true that the PIIGS led by Greece has seen a rebound in CDS prices to indicate renewed concerns over sovereign issues in spite of the bailout, but they remain below their previous highs and have NOT reached the level of Argentina and Venezuela levels for now.

Again from Bespoke, ``Greece 5-year CDS is at 737 basis points today. Prior to the bailout it was above 800 bps. Venezuela and Argentina still have higher default risk than Greece. Portugal CDS is at 355.4 bps today, up from 275 bps yesterday, but still below the 380 bps it was at last week. Spain is probably the most worrisome country on the list at 208 bps, since it has a much bigger economy than any of the other countries at similar default risk levels. And Italy has jumped up to 164 bps today, which is more than double the next closest G-7 country."

The interesting part is, despite the so-called contagion spurred selloffs, CDS prices in the US and the UK have barely budged! In short, the selling frenzy could be media "exaggerations" and market sentiment feeding into each other more than a real "contagion" related dynamic.


We see parallel developments in the US treasury market. US 10 year yields have fallen (alternatively bond prices rallied) as stock markets retrenched. This implies more of "fear" than sovereign related concerns as both the CDS and treasury markets suggests.

Yet despite the spike in the VIX "fear" index, the US S&P seems more resilient relative to the similar episode last February-meaning that while the VIX have climbed about three quarters of the VIX high in Feb, the decline in the S&P have been relatively less.

Importantly while both the Euro benchmark (STOX50E) and the S&P fell nearly by the same degree last February, today, the S&P appears to outperform the Eurozone by falling less.

So even if the month of May could be partially validating the maxim, sell in May and go away, it isn't clear that this is the start of THE major inflection point. It looks more like a reprieve following the string of gains with Greece as serving as a rallying point for the current market action- of course, until proven otherwise.

A Sweet Vindication And Validation As The Phisix Soar To A 25 Month High!

``Pharoah created jobs for us. Moses led us away from those jobs. Even though those jobs helped to complete public infrastructure. Even though they were green jobs, where we used our muscles and our backs instead of fossil fuels. Moses could have been part of the ruling class in Egypt. He chose freedom instead. Those of us who followed Moses also chose freedom. Freedom brings risks. But we preferred the risks of freedom to the security of bondage. Do not confuse government with G-d. Government cannot miraculously provide us with manna--or health care. When we look at government, we should not see G-d. We should see Pharoah. Government-worship is Pharoah-worship. Passover is known as the festival of freedom. To live in the Jerusalem of a free society, we have to leave the Egypt of the reach of government.”-Arnold Kling, If a Libertarian Gave a Sermon for Passover

We have pounded the table for reasons that the mainstream can’t or refuses to see.

For the local experts and media, Philippine equities simply cannot rise supposedly because of election risks[1].

Yet week after week, the momentum, market internals and the Peso has been suggesting an opposite perspective. Denial due to intense obsession over sensationalism and abstractionism seemed to have dislodged rationality from recognizing reality.

Six Impossible Things Before Breakfast

For the foreign mainstream pessimists, this simply can’t be happening.

Rising equities on low sponsorship (in the US), falling bank credit, balance sheet problems of the consumers and the banking system and high unemployment (of bubble afflicted economies), the fiscal woes of Dubai, Greece and the PIIGS, and extended valuations as seen from conventional metrics has been cited as principal reasons equivalent to Lewis Carroll’s “Six Impossible Things Before Breakfast” in Alice In Wonderland.

Yet, as Alice would say, “there is a place called wonderland”, thus, global financial markets continue with their upwards spiral. (see figure 1)

Figure 1: stockcharts.com: “Six Impossible Things Before Breakfast”

Of course, the reason for the apparent realization of such “impossibility” isn’t because wonderland exists, but because many have been fixated over a few variables which appear to be less influential in dictating the course of events.

In behavioural finance, this cognitive bias is called the “focusing effect” or when people place “too much importance on one aspect of an event; causes error in accurately predicting the utility of a future outcome”[2].

As you will note, for the Phisix (main window), the bulls ensured that the resistance at the 3,120-3,125, which has proven to be a significant obstacle, was transgressed with a mighty push, using the actions in the US as catalyst, which generated a noticeably wide gap.

Considering that the gap was backed by substantial volume (volume in pesos jumped 18% this week), one may construe this gap, in technical or chart analysis parlance as a “breakaway gap”.

A breakaway gap, in essence, is a breakout from a trading range or congestion[3].

A breakaway gap implies that the low of the breakout point should hold and serve as critical support. Likewise, this could imply of a beginning of a significant upside move.

Although we are not avid fans of charts, as they are not infallible and are subservient to patterns from past or historical performance, which may or may not unfold, [an example is the 3,120-3,125 level which formed 2 tops that would have indicated of a ‘double top’ bearish formation; however the pattern didn’t pan out]; our view today is that charts have now been in relative consonance with the underlying actions that appear to drive the market. In short, chart actions seem merely validating what we have been saying for sometime.

The Global Reflation Process

If we are correct, then global markets should extend gains over the medium term as the “animal spirits” respond to suppressed low interest rates and a still steep yield curve on a worldwide scale, including the Philippines (see Figure 2).

Figure 2: Asian Development Bank: Steep Yield Curves

The Philippines along with the US has one of the sharpest sloping curve through February 2010, as measured by the spread between the 2 year and the 10 year yields, along with the US, the European Union and Indonesia[4].

Considering the dearth of leverage in the domestic system (as that of Indonesia) compared to the West, the “borrow short invest/lend long” is likely to prompt for significantly more arbitrages and money flows into financial assets (local equities, real estate, bonds and the Peso). And perhaps it is why like Indonesia whose JKSE is up 10% year to date, the Phisix appears to be coming on strongly.

Although since the Phisix scored its eight consecutive week of advances and given the largely overbought conditions, as manifested by the local index’s sharp pullaway from the 50-day moving averages (blue line), a correction should be expected anytime.

Albeit any retracement isn’t likely to be deep and should see the support levels, from the current breakout, to hold. Nevertheless, in bullmarkets overextended upswings may continue.

Besides, given the ongoing “rotational” activities among listed issues, a correction does not likely imply that all issues will go down in synchronicity, but instead what is likely to happen would be a shift in the attention (or crowd favourites) to non-Phisix composite or third tier issues.

In addition, the Phisix, as likewise argued before, has been influenced by external forces, as exhibited by its close correlation with the performance of global equities, more than local issues. And this comes even as local participants dominate the overall market activities.

One would notice that Europe, plagued by the ongoing debt issues of Greece, Portugal and the rest of the PIIGS, appear to be, at first glance, outperforming Asia ($DJP1) and Emerging Markets (EEM) as seen by the performance of the Dow Jones Stoxx 50 ($stox50).

Of course the European Stoxx 50 is up by a measly 1.8% on a year to date basis and has been vastly outclassed by US markets (up over 4%). Incidentally, Asia (inclusive of Japan) is up 5% because it is started the year on a much lower point and has seen a more volatile ride, hence the appearance of lagging performance relative to the Stoxx 50.

In other words, what we are seeing is a global reflation process.

And this has been the core underlying dominant theme in the markets today, which has significantly been overlooked and underestimated by the mainstream pessimists.

Liquidity Seepage, Inflation Ahoy!

And where have most of the analytical loopholes by the pessimists can be found?

In the transmission effects of the collective zero bound interest rates, the lagged effects of yield curves, the idiosyncrasy of “habits” of every society[5], the impact from concerted fiscal policies or “automatic stabilizers” used [in the case of the US over $10 trillion in guarantees and spending on the banking system and other government spending on parts of the economy], the incentives from the potential impact from a stronger yuan, the varied effects of such policies to the distinct economic and capital structure of global economies, the Bernanke Put or the assurance to the financial markets of government’s continued inflationary support, which signifies as a ‘competitive advantage’ for the US in her nonpareil ability to underwrite reflationary policies through the issuance of liabilities with her own currency, and therefore provide a guarantee of liquidity to a highly complex global system vastly dependent on the US dollar.

As Doug Noland aptly observes,

``U.S. financial assets – hence the dollar – are perceived to benefit from a relative advantage versus other major currencies based upon, on the one hand, the virtual unlimited capacity for the Treasury to run massive deficits and, on the other, the Fed’s seemingly endless capacity to purchase (monetize) U.S. debt instruments and essentially peg interest-rates (short-term, and only to a lesser extent longer-term market yields). This extraordinary capacity and willingness by U.S. fiscal and monetary policymakers to inflate Credit and meddle (in the markets and economy) today bolsters marketplace confidence in the sustainability of economic recovery. As importantly, it cements the view that the soundness of Credit instruments throughout the entire system – Treasuries, mortgages, financial sector debt, corporates, munis, etc. – is underpinned by current and prospective reflationary policymaking.”[6] [bold emphasis mine]

And signs that credit takeup, even in balance sheet constrained economies as the US, seem to be gaining traction as this account from Bloomberg reveals[7],

``Investors are withdrawing from money-market funds at the fastest pace in at least two decades, reducing holdings that peaked at $3.9 trillion in January 2009… ‘The draining of cash from money-market funds shows people are becoming more comfortable taking risk, so equities are going up and bonds are also being well supported and the yield curve is flattening,’ said Christian Carrillo, a senior interest-rate strategist…at Societe Generale SA. ‘Such behavior can give some comfort to the Fed that it’s okay to reduce the size of its balance sheet, which is a pre-requisite for rate hikes.’” [emphasis added]

Rising markets are likely to spur a bandwagon effect, as these would exhibit on the reflexive nature of self-reinforcing mechanism between price signals and real events or the reflexivity theory. This means that bubbles are likely to continue to inflate and would only be compelled upon to reverse by the hands of nature. One sure sign of this would be the rising cost of inputs, higher consumer prices and increasing interest rates.

And as the report says, the hoarded liquidity in the US banking system is starting to find some leakage, as short term money market funds are regaining more confidence or “animal spirits” to redeploy cash into other asset markets in search of higher returns.

And once this seepage turns into a flood, that’s where we should start to worry. But this should take more time, and possibly, based on the cyclical effect of yield curves, inflationary pressures is likely to be more apparent by the last quarter of the year.

Hence, the idea that the current “bubble” will bust soon is likely to be inaccurate.

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[1] See Why The Presidential Elections Will Have Little Impact On Philippine Markets and Philippine Markets And Elections: What People Do Against What People Say

[2] See Anchoring, Focusing Effect, Wikipedia.org

[3] Stockcharts.com Chart School, Gaps and Gap Analysis

[4] ADB, Asian Bond Monitor, March 2010

[5] See Influences Of The Yield Curve On The Equity And Commodity Markets

[6] Noland, Doug; The Restoration of King Dollar?

[7] Ibid