An Avalanche of Positive Publicity for Philippine Assets Elicits Different Perspectives

``There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.” In memory of Milton Friedman July 31, 1912 to November 16, 2006

Suddenly there have been an avalanche of bullishness on the Philippines, an amazing turnabout from the past few years, here are some examples....

Eoin Tracey of Fullermoney.com quotes, UBS Investment Research, in their latest report, “Is the Philippines All Priced In”? (emphasis mine)...

``It's important to point out that domestic participation in the equity rally has been relatively minor to date; most of the action has come from foreign investors. From a stock market point of view, there are three potential catalysts next year: First, we expect a mild increase in real growth - and this is a significant achievement given the expected slowdown in the global economy, which should bring down growth numbers in other parts of Asia. Second, very benign inflation conditions, and finally, a cut in official short-term policy rates.

``Now, having real GDP growth accelerate from 5.2% to 5.8% is not really a barnstorming expansion by historical standards, but it does stand out in a regional context. More important, however, it's a potent signal to investors that the economy can hold water - and that domestic demand can take over the real cycle. Over the past two decades the Philippines suffered a decline in the investment to GDP ratio, from over 25% in the mid-1990s to 20% in 2000 to around 15% today. So the physical capital base has been eroded, and the government recognizes this and has been trying to open doors to investment in the infrastructure, mining and resources areas. Our view is that this is not going to reverse quickly; it's a slow process, there's a lot of bureaucratic grit in the wheels, and now there's an election coming next year.

``However, we have had a fundamental recognition of the problem, and have seen some underlying reforms last year in the resources part of the economy. Significantly, FDI has increased 60% to USD1.2bn this year to date - which is not very much in the Chinese context, perhaps, but a very big increase for the Philippines. We already noted that the government is likely to step up spending and investment a bit next year as well, and on top of that you have the new economic zones that give tax breaks to new services areas such as call centers, relocation of back office by major financial institutions, and these sectors are absolutely mushrooming. All in all, we are looking at a recovery in investment spending to around 9% y/y growth in 2007, and this is a major factor behind our favorable GDP call.

UBS likewise cited the Philippines’ outperformance (+38.2% year-to-date, local currency, based on Friday’s close) possibly due to “headline export/GDP ratio below 50%” or what they categorized as “big” countries [China (Shanghai +69.83% y-t-d, Shenzhen +62.62%), India (+42.89), Indonesia (+43.82%), Korea (+23.8%), Philippines) in the region that have been less reliant on exports.

Quoting anew UBS, ``this is likely a reflection of a rising large country "premium", as investors learn to differentiate between markets in the face of an expected US slowdown. But it's also true that large economies have grown somewhat faster than their smaller neighbors over the past five years - and more important still, large countries have a much higher domestic contribution to overall growth, more than twice the pace of the smaller group.”

In short, UBS thinks that the traits of economic independence and domestic demand strength have rewarded these markets compared to the “small” export dependent ones [Hong Kong (+28.95%), Malaysia (15.67%), Singapore (19.84%), Taiwan (10.86%) and Thailand (+2.08%)].

Figure 1: Bloomberg: Phisix treading on 9 year highs

This observation seems sensible considering how markets performed of late, see Figure 1, albeit, written obviously under the context of the recent past performance, or predicated upon the optimism etched from the current gains or the “rear-view mirror syndrome”.

Yet, it has been a long-time conviction of your analyst that as the region integrates economically and financially, to eventually decouple from its dependence on the US, such is where the meat of the advance of our economic and financial advance will be most pronounced.

This terse commentary from Gavekal Research, ``An upcoming large capital spending boom in the “third-tier” Asian countries (Thailand, Indonesia, Philippines, Vietnam…) fuelled by lower interest rates, higher currencies, cheaper machinery (often from China) and a clearer political situation.” Nothing new here, we’ve dealt with this since 2004, see November 29 to December 3, 2004 (Domestic Investment to Help Drive the Phisix?)

The Philippine investing theme has likewise hit mainstream media, Carl Delfeld, board representative of ADB and chief honcho of global investment advisory Chartwell Partners, writes about the Philippines and Indonesia in his “Two Surprising Markets” article in Forbes Magazine, excerpting Mr. Delfeld (emphasize mine)....

``Many would categorize Indonesia and the Philippines as relatively poor countries, but I beg to differ. Both countries have many assets and great promise. Indonesia is rich in natural resources, strategically positioned to benefit from Asian trade and economic growth, and it has a very young population, the fourth largest in the world. The Philippines' strength is its English-speaking population, giving it the potential to develop into a dynamic regional services hub....

``These markets can be volatile, so have in place some risk-management tools, such as a 10% trailing stop-loss order to lock in gains. Both Indonesia and the Philippines still have an upside, but the best time to score large gains is when investors are not showing the slightest interest in these markets.”

Sound advice from Mr. Delfeld. Nevertheless, he includes a buy recommendation on Manila Water Corporation [MWC].

Analyst Jim Jubak writing for thestreet.com, notes of the changing export patterns of the world plus growing domestic consumption ex-US, as primordial reasons for global portfolio diversification, and surprisingly in his 10 recommended blue chips stocks, he includes San Miguel Corporation [SMC]! The Philippine asset class appears to be hugging the today’s limelight!

Table1: ADB Bond Monitor: iBoxx ABF Family Returns Index

In addition, Table 1 from ADB shows that the Philippines have likewise outperformed the region’s bond markets in both the local currency and the US Denominated instruments category since 2005, with double digit returns. So it is not a surprise for investor sentiment to shift and be more vocal on their confidence on the Philippine assets as present gains have buttressed such outlook.

I recall a local analyst argue lately that domestic “fiscal reforms” have been the mainly responsible to the present wellbeing of the Philippine asset class and cited neighbors as Indonesia as an example.

While I do not dispute the fact, that reforms have been made enough to makeover our asset class or even Indonesia’s as more palatable for investors, I would dissent on this frame of argument such that with reference to the Phisix, please refer back to figure 1, our equity market have risen since mid-2003, even when reforms were yet on the drawing boards. In other words, reforms have not been the key drivers to our markets, in my view, excess liquidity has.

Figure 2: Bloomberg: Indonesia’s JKSE have risen in tandem with the Phisix

And the same goes with Indonesia, as shown in Figure 2. Even prior to any change of administration or purported reforms, Indonesia's JKSE has been an equal recipient of global diversification emanating from the chase for yields phenomenon and has risen almost in tandem with our Phisix over a similar timeframe.

Yes today’s market makes everyone inexorably a genius. Every “rationalization” or justification, especially one that’s been in congruence with the current affairs, no matter how specious, meets a round of applause especially by mainstream media.

However, I would accentuate that the present euphoric mode of global markets are a result from a significantly lesser degree to domestic developments, but on a larger premise from that of massive credit and money creation and intermediation on an international scale.

You have to look no further than the recent explosion of derivatives. Let me cite the recent press release from Bank for International Settlements (emphasis mine), ``The volumes outstanding of over-the-counter derivatives expanded at a brisk pace in the first half of 2006. Notional amounts of all types of OTC contracts stood at $370 trillion at the end of June, 24% higher than six months before. Growth was particularly strong in the credit segment, where the notional amounts of outstanding credit default swaps (CDS) increased by 46%. Rapid growth was also recorded in other market segments. Open positions in interest rate derivatives rose by 24%, while those in FX contracts expanded by 22%. Equity and commodity contracts grew at 17% and 18%, respectively. Gross market values, which measure the cost of replacing all existing contracts and thus represent a better measure of market risk at a given point in time than notional amounts, increased by 3% to $10 trillion at the end of June 2006.”

$370 trillion! That’s about 7.22 times the global GDP and about 2.14 times the estimated aggregate world financial stock components, i.e. sovereign and private debt, equity securities and bank deposits! And to consider, derivatives are supposedly instruments which derive their underlying value from a security, group of securities or an index, which to extrapolate, means that derivative contracts are disproportionately larger than the underlying values of the securities they represent. This simply implies that the world’s financial system keeps getting increasingly levered to the hilt. Until when the global financial system can accommodate these dynamics is one thing to behold, otherwise it poses no other than intensifying systemic risk!

The world central banks has tightened interest rates alright, but this has not been manifested in the rather buoyant financial markets as we have repeatedly asserted, according to Wall Street Journal’s Cynthia Koons and Michael Aneiro (emphasis mine), ``Global issuance of risky ‘high yield,’ or junk bonds -- which Wednesday surpassed the previous record for a single year -- surged further into uncharted territory following yesterday’s blockbuster sale of $5.7 billion in new debt by hospital operator HCA Inc.…Global high-yield issuance surged past the $210.8 billion mark set in 2004 to a record, according to Dealogic. By yesterday…total global junk issuance stood at $217.4 billion, with a month and a half to go until year end. October set a single-month record with $30.5 billion in new issuance… And a report issued this week by J.P. Morgan forecasts that this month could see as much as $25 billion in new issuance, which would be a record for November… Despite the surge in issuance, junk-bond yields have dropped to a 5½-month low of 8.15%...” To which we ask what tightening? And where?

This bring us to the logical explanation by Mr. Raghuram G. Rajan, Economic Counselor and Director of Research of IMF, ``The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a liquidity glut which has pushed long term real interest rates the world over lower. This has spilt over into markets for existing real and financial assets — real estate, high-risk credit, private equity, art, commodities, etc — pushing prices higher. Indeed, casual empiricism suggests that the most illiquid markets, where typically there are few transactions, and small infusions of liquidity can have substantial effect, have been pushed the highest.”

Which brings us back to the year-to-date performances of Asia as cited above; the most illiquid markets has apparently performed the best, namely the stellar gains of the Philippines, Indonesia, India and China or the UBS’ rubric of “Big” countries, which appears to also reinforce Mr. Rajan’s viewpoint.

Now given the three varying perspectives, to wit, the local analyst’s “domestic reforms”, UBS’ “economic independence/domestic demand theme” or IMF’s Rajan “liquidity glut”, which fits today’s dynamics better? Go figure.

Bullish Retail Investors Suggests of Signs of A Nearing Top?

``We just need to understand that no matter how much conviction we have, events may prove us wrong...After all, not long ago, the world believed all swans were white; then the world discovered Australia—and a black swan”- Jack Crooks, currency analyst

An online stockmarket forum http://www.tradercentral.ph/ held an assembly last Saturday at the PSE, where I was invited as one of the guest speakers on the topic of global market analysis, (Yes, It was my first speaking engagement and hopefully the last).

The amazing thing about the event was that the expected attendees had been somewhere about 100, when over 200 participants came. In other words, there was a flood of prospective, if not relatively “new” retail investors.

While the event was indeed a resounding success for the organizers, it sort of revealed of today’s market psychology where local retail investors have become also “bullish” with today’s market, who seem to be willing to “take the plunge”. (Of course, I’d like congratulate and thank the organizers, as well as Mr. Rapi Juvida, Jeff Siy, and Wilson Chong for the assisting me on my most challenging experience.)

When local retail investors become bullish, I become anxious. It is simply because the social dimensions of the market’s activities or the recent continuing gains have made the average investing public believe that returns from the financial markets have been easy to secure, notwithstanding, their apparent limited awareness of the risks prospects.

Noticeably too, their attention span have been intensely focused on the “short-term” trading aspects, particularly on the momentum side. This reminded me of children awed by magicians performing the sleight-of-hand tricks on stage.

Put bluntly, they are wont to see the plus side of the market, but gloss over the risks outlook. Besides, in the order of investors, retail investors are typically the last to enter.

Yes, arguably the low penetration level of local investors could translate to more upside for the market over the long run, as fundamentals such as the rising Peso coupled with higher yields may impel more local funds flow to the market. Let me repeat, over the long-term.

But, considering today’s palpable complacency, not only in the domestic arena, but as well as in the global arena, in the view of a prospective global economic growth slowdown led by the US, there could be meaningful bumps along the road. Yet, no one wants to hear of this.

Moreover, while it was my case to present the positive cyclicality of the Philippine stockmarket, I made a reminder that NO TREND goes in a straight line. And when countertrends do arise, they maybe as severe a headwind as to shakeout many investors and contemporaries, and likewise could prompt for a rethinking about the cycle.

The big guys have been sounding the alarm bells, PIMCO’s Paul McCulley (emphasis mine) in his latest outlook wrote, ``While the potential growth rate of GDP may have decreased over PIMCO’s secular horizon, the potential for a reflexive correction in GDP growth to outright recession has increased over PIMCO’s cyclical horizon. We sense volatility is creeping back into the business cycle, and the Federal Reserve’s “transparency” will be put to the test in the not-so-distant future.”

Or even the normally bullish BCA Research, thinks that a correction is due soon, see Figure 3.

Figure 3: BCA Research: Global Equities Are Due For Breather

According BCA Research (emphasis mine), ``The odds of a global equity market consolidation or correction are rising. Global equities have gained 16% since mid-June, and are now well above their May high. Stocks have benefited from a stream of positive economic surprises, including the sharp fall in oil prices and bond yields, among other things. It will be increasingly difficult to sustain this positive news flow in the short term. Moreover, this latest surge in stock prices is already comparable to the past three rally phases during the bull run that began in 2003, indicating that stocks are more vulnerable to any “bad” news. Bottom line: although market fundamentals on a 6-12 month horizon are still favorable, stocks look stretched from a short-term perspective.”

Two things of note: one, BCA comments of a world bull run that began in 2003, which prompts me to revert on the dimensions of what could have prompted a synchronous global bull run? Is it mainly Macroeconomics, Monetary Fund Flows or Domestic Reforms?

Secondly, I made my case on the Phisix stating that the “GIST of the gains of the Phisix has already been made” in my October 23 to 27^th edition, (see Should You Invest in the Phisix Today?), or in a different light, the Phisix could be near its cyclical top, eerily, almost in the same context of the above BCA’s analysis on the possibilities of a forthcoming correction.

In the said article, I mentioned that the Phisix could attempt to breach the 3,000 level by the yearend but in a larger probability could stay within its close ambit.

Yet, any further attempt to distance from the 3,000 mark by a significant margin, makes 2007 a likely candidate for an annual negative return following four years of consecutive gains. Remember, markets are basically mean reverting. 2007 or 2008 could be one of the odd-man out years in the ongoing advance cycle.

The prospects of a worldwide growth slowdown could be candidate for the trigger. And so as with the prospects of World Central banks to “continue raising interest rates” amidst a persistently high inflationary (consumer price inflation) environment, according to the latest G-20 outlook, or to even a combination of both (stagflation??)! There is also the risk outlook of rising protectionism.

Figure 4: Kitco.com: Collapsing Base metals signs of Shriveling Demand?

Last week, the base metal group led by DR. Copper, fell by a significant measure as shown in Figure 4. Over the past months, despite persistent calls for economic growth slowdown, base metals appear to have continually defied gravity to storm to new heights until last week.

Strangely too, the recent June rebound of base metals appears to have almost coincided with the rally in global equity markets. Does today’s correction imply or reflect on a genuine mark down in global demand? Does this represent merely a pause or a major inflection point? Will the decline in the base metals likewise lead to a cross-market liquidity squeeze? Or will it presage a corresponding decline in global equities?

As I’ve said in the past, the global financial markets have been sending asymmetric messages; the rallying bonds markets factors in a significant slowdown, while rising stockmarkets suggests of vibrant earnings and salutary economic outlook. With oil and metals down, the message appears tilted towards contracting demand.

In finale, let me repeat my October 23 outlook, ``Another not so bright scenario working against today’s high octane markets is that based on the charts, the Phisix has been quite overextended in terms of being overbought and is due bound for either a short-term pause or a natural corrective phase within its present momentum. I say present momentum with reference to the continuity of its interim uptrend, in contrast to a “major” corrective mode.

``Yet it is important to note that in bullmarkets, overbought conditions could go into the extremes, and vice versa for bearmarkets, which makes trading anticipation rather complex, if not abstruse.

``As mentioned above, patterns in markets are not something definite as to repeat exactly, but as Mark Twain puts it, it may “rhyme”. Prudent investing means measuring your potential gains against your potential losses and naturally, take on the appropriate action.”

US Politics: Market Reaction and Possible Ramifications

``The only conquests which are permanent and leave no regrets are our conquests over ourselves.”- Napoleon Bonaparte

JUDGING from the reactions of the global financial markets in general, the recently completed elections in the US had been essentially discounted, as markets have not revealed signs of any MAJOR twitch YET.

Since the US markets today appear to be the inspirational leaders in the flow of funds activities across the world, there could be some repercussions to the recently concluded political exercise where the incumbents at the Legislative Chamber had been palpably dethroned.

Strangely enough, despite the so-called “economic recovery” in the light of largely buoyant financial markets, the setback by the ruling party [GOP] appears to reflect on heightened discontent with the present political policies. Stated differently, the economic and financial status of the voting population usually undergirds the satisfaction level with the political leadership, where the defeat by the incumbent could possibly signify inauspicious financial standings by the majority, or that the economic recovery had been largely imbalanced.

If history were to be used as basis for measuring performances of the financial markets under a political gridlock, based on a study by the Financial Analysts Journal (written by Scott B. Beyer, an assistant professor of finance at the University of Wisconsin-Oshkosh; Gerald R. Jensen, a professor of finance at Northern Illinois University; and Robert R. Johnson, a managing director at the CFA Institute.), Mark Hulbert founder of Hulbert Financial Digest and columnist for CBS Marketwatch observed that there had been little statistical impact on stockmarket performances. Mr. Hulbert wrote (emphasis mine), ``The researchers found no evidence that the stock market performed better during periods of gridlock. In fact, they found limited evidence to the contrary: The stock market actually performs slightly better during periods of harmony. However, in an interview, Jensen stressed that this finding in favor of harmony is of limited statistical significance. The most important takeaway from their research, according to Jensen, is not that harmony is particularly good for stocks; instead, the important lesson to draw is about gridlock: The markets do not perform any better when it exists than when there is harmony.” Mr. Hulbert concludes, ``Leave the political handicapping to others, and focus your investment energies on analyzing other factors more directly relevant to your portfolios.”

What doesn’t work for the stockmarkets works for bonds, a favorite straight shooting economic opinion writer, who incidentally is not a formally trained economist, Bloomberg’s Caroline Baum quotes Jim Bianco, ``Historically, gridlock is good for the bond market, according to Jim Bianco, president of Bianco Research in Chicago. ``It's not the composition of government per se but the pace of regulatory growth that affects financial-market performance,'' Bianco says. ``When the Federal government is divided, as it last was from 2001 through 2002, regulatory growth nearly grinds to a halt...The bond market does well in this environment'' -- which makes sense since regulation raises the cost of doing business -- and its returns are over twice the average of all periods.”

Legislative impasses lessen the odds for the imposition of more regulatory policies, which essentially allows, to quote Ms. Baum ``market's natural ability to provide the goods and services consumers want at prices they will pay”. Put differently, the lesser the economic meddling, the more favorable it is for the markets and for the economy.

At the end of week, we observe that US stocks across the board were sharply higher following last week’s reprieve, while the US bond markets rallied strongly to expunge most of its decline during the previous week, as shown in figure 1. It is the same story for the Philippine asset class.

Figure 1: US Government Securities (red line) and Emerging Market bonds (black line)

Also superimposed with the US Government Securities “bonds” Index [USGAX] is the JP Morgan Emerging Debt Funds [JEMDX] which has depicted an even better performance. This means that global bonds led by the US have rallied strongly since end-June (note of the synchronized bounce by both indices) or even prior to the culmination of US elections whose result was largely expected based on survey polls.

Come to think of it, the message of the markets has been diametrically opposed. The bond markets have been expecting or has priced in a SIGNIFICANT slowdown scenario, whereas the equity markets have been reflective of a NO LANDING/strong growth scenario. ONE of which could eventually be proven wrong.

Past performance do not signify future outlook, yet if the resiliency of the world’s economy were to be measured by exports alone, here is what Panglossian economist Dr. Ed Yardeni of Oak Associates has to say, ``A global boom in exports? You bet! Exports are on steep uptrends and at or near record highs in most major economies. Exports are growing above 20% y/y in Russia (29.9%), China (29.3), India (21.7), and Germany (21.0); above 15% in Argentina (18.2), Brazil (18.2), and Indonesia (16.7); above 10% in Mexico (13.3), France (11.5), South Korea (11.3), and Italy (11.1); and high single-digits in Japan (7.9), Turkey (7.7), and the UK (7.5). Canadian growth lowest at only 1.5%....Any good news in September's trade report? US exports and imports are at record highs, reflecting a global economic boom. September's merchandise exports rose twice as fast as imports, i.e., 20.0% y/y vs. 9.7%. Meanwhile, the politically sensitive US trade gap with China hit another one-month and 12-month record in September, and could come under renewed scrutiny given the new Democratic majority in both the House and Senate.”

Oops, politically sensitive trade gap. Let us leave that for a moment and proceed to a dissenter, the high profile chief economist of Morgan Stanley, Mr. Stephen Roach, who argues that the Political Gridlock today could be timed wrongly as the US economy is in a fragile state, he wrote, ``With a split Congress at worst and a Republican White House, such an outcome now seems quite possible — at least on paper. In my view, that would be tragic — gridlock is the last thing America needs. Granted, there are times when government can, indeed, get in the way. But there are also circumstances which demand leadership and decisive policy actions.”

Mr. Roach pinpoints three areas of concern for the need of political harmony, namely chronic savings problem, Federal government’s structural fiscal deficit and Trade policies.

In a political stalemate landscape, the “chronic savings problem” would be dealt with the status quo or to quote Mr. Roach ``rely increasingly on the Kindness of strangers” which essentially exacerbates the currency and real interests rate risks dimensions, if and when foreigners lose confidence on the stability of the present system.

On the other hand, the fiscal deficit dilemma in a slowing economic environment could exert revenue pressures on growth-sensitive areas which may lead to ``another round of cyclical deterioration in the federal budget deficit and renewed pressure on national saving and external financing” notes Mr. Roach.

And finally, the growing risks of protectionism in the light of present trade policies, or in his words, ``Washington in effect says no to globalization and threatens sanctions on offshoring.”

While both analysts belong to the opposite side of the fence in terms of confidence levels in view of the present financial and economic milieu, we can observe that both agreed on one issue, the trade issue.

Systemic Risk Posed by Democrat-led Congress?

``The difference between death and taxes is death doesn't get worse every time Congress meets." – Will Rogers

The election, which was coincidentally timed with the latest trade data, where US trade deficits with China have reached uncharted record highs, according to the LA Times, ``The deficit with China set a record of $23 billion in September. It is running at an annual rate of $228 billion this year, on pace to surpass last year's $202 billion, which was the all-time high for any U.S. trading partner” appears to have provoked an immediate response from the Chinese government as the Democrats dislodged the Republicans in both houses of Congress, ``Zhou Xiaochuan, governor of the People's Bank of China, said at a conference in Frankfurt that China has very clear plans to diversify its reserves, which now stand at more than $1 trillion. A wide range of instruments are under consideration, Zhou added” notes Wanfeng Zhou reporter for CBS Marketwatch.

One must not forget that a (Schumer-Graham) Bill filed in the US Congress by New York Senator Charles Schumer, a Democrat, and South Carolina Republican Lindsey Graham intends to slap 27.5% tariffs on imports from China, if China remains recalcitrant to allow its currency [Yuan] to appreciate, where Treasury Secretary Henry Paulson persuaded the senators to delay the vote which had been initially scheduled last September 27.

In essence, the bill is nothing but a political blackmail aimed at a wrong but highly popular target. Why? ``While the US imports lots of Chinese goods, China is not our biggest supplier of foreign goods. China soared past Japan in exports to the US in 2002 and surpassed the Eurozone last year, but the US still imports twice as much from Canada and Mexico than from China (emphasis mine)” notes Dr. Yardeni. Yes, another case of barking at the wrong tree.

Figure 2 US Dollar Index: Making Another Downside Breakdown Attempt on Diversification Talks

Let us put things in proper perspective; the US Dollar has been on a downtrend since 2002. Over the interim, following its short-term rebound or since its mid-October high, the US Dollar index has been on a decline. It has however formed a bearish Head and Shoulder pattern. Note too, that Friday’s test to break the neckline coincided with the aftermath of China’s Diversification Talks.

This is one highly trenchant comment from currency analyst Jack Crooks, whom has largely towed the line of the US Dollar bulls until Friday (emphasis mine)...

``Before US Senator and leading US-China trade/currency critic Chuck Schumer even finished his joyous celebration of Democrat victory in the Senate yesterday, Chinese central bank governor Zhou Xiaochuan launched the first salvo it what could be the upcoming US-Chinese currency battle.

``Effectively the diversification comment made by Zhou, and the dollar and metals market reaction, shows that China has some heavy artillery that it’s not afraid to use should Mr. Schumer turn his threats into legislation now that he and his party are in a position to do so.

``This is scary stuff for the dollar, and all financial assets in general, if indeed a real battle were to break out between the US and Chinese over trade and yuan.”

As I have argued in many instances, it is inherent in most politicians and their ilk (globally) to act on palliatives or motion on the whims of the popular, without giving second thoughts on the possible unintended consequences of their actuations.

This bill is ominously reminiscent of the Smoot-Hawley Act in 1933 which according to wikepedia.org, ``raised U.S. tariffs on over 20,000 imported goods to record levels, and, in the opinion of many economists, protracted or even initiated the Great Depression. U.S. President Herbert Hoover signed the act into law on June 17, 1930.” To paraphrase Spanish philosopher George Santayana, those who do not remember the past are condemned to repeat it.

The same interventionist fiasco is currently being exhibited by the Canadian government on its declared war via increased taxation against Income trusts leading to massive losses or exodus of capital. As always, politicians presume to know better even when they stake the least.

In my opinion, the Chinese government would unlikely be bullied into submission from a myopic suicidal bill which could do more harm to the US and to the world economy more than uplift its domestic [US] welfare.

Figure 3: Yardeni.com: China’s Foreign Currency Reserves tops $1 trillion!

Further, with China’s forex reserves believed to have topped the US 1 Trillion mark, USD 987.9 billion in September and growing by about USD 20 billion per month see Figure 3 courtesy of yardeni.com, gives them incredible amount of ammunition against any legislated blackmail.

In addition, China holds an estimated USD 339 billion in US Treasuries, as of August according to CNN, the second largest following Japan’s estimated $640 billion, which is in itself an economic and financial equivalent of a “nuclear bomb” that could force US interest rates to soar and the US dollar to crater, if and when they decide to retaliate against any trade sanctions. And to consider the US economy is heavily levered on a mountain of debt, and rapidly rising rates could simply be catastrophic.

Since China’s yuan has been allowed to be revalued last July 21, 2005 it has climbed by about 5.2%, which has also spearheaded the appreciation of most of the currencies in the Asian region (including our peso).

My view is that China could persist on appreciating its currency by a measured pace which they would be comfortable with. And these actions may be “timed” as part of their “compromise” or diplomatic efforts to stave off any potential conflicts.

And with the equally “saturated levels” of foreign exchange reserves in Asia, the region’s central banks may be least motivated to intervene in the markets and be impelled to keep the pace of its respective domestic currencies’ appreciation at acceptable or modest levels in line with China.

However one must be reminded that any belligerent approach by the incoming leadership in dealing with the controversial trade or currency aspects essentially translates to systemic risks. This leads your analyst to even be more bullish on gold and on Asian currencies.

Pat-on-the Back Rallies of Gold and Philippine Mines

``The power of accurate observation is commonly called cynicism by those who have not got it.” - George Bernard Shaw

The only representative of sound money is no less than a genuine gold standard, something despised by most bankers and politicians, because they inhibit manipulation or inflation or the debasing of currencies to suit the whims of a selected few.

Figure 4: stockcharts.com: Pat in the back chart for gold?

While it may be too premature to declare triumph, the gold chart in Figure 3 appears to be a “pat-in-the-back” chart analysis as presented in my October 23 to 27^th edition (see Excess Liquidity: Finding a Home in Assets Despite A Looming Slowdown) following its reverse-head and shoulder breakout, see Figure 4.

We should note that gold’s recent rise has been possibly due to the following factors: one, the end of the political season, two, banked by seasonal strength and three, a bullish technical picture.

A break above the $640 level reinforces my belief that gold will challenge its May 12^th high of $730 either at the end of the year or by early next quarter. In addition, the risk presented by the potential political conflicts in the trade and financial arena as presented above has added positive sentiment to gold’s advance.

Figure 5: Silver Breaking Out in Tandem with Gold

There are those who have argued that Gold’s rise must be supported by its sibling metal to confirm both their advances (ala Dow Theory).

The recent advances in Gold have likewise buttressed a major breakout move by silver now primed to test its May high of $15.21, see Figure 5. If this Gold-Silver correlation is accurate then we could expect both metals to advance further and confirm each other’s moves.

To put you in a rightful perspective; It is also important to note that both gold and silver have been advancing even PRIOR TO the recent breakout which appears to have been aggravated and NOT CAUSED by China’s diversification chatter. Any furtherance of such diversification threats which translates to actual actions (selling) would definitely enhance the price value positions of the said precious metals’.

By and large, we have noted of the rotational activities in the Phisix. Because sentiments dictate on the subject of pricing “value”, which have been obviously on the positive end, I inferred...or presupposed in my October 16 to 20 edition, (see Lagging Mines: Not For Long I Suppose), that mines would find its way to the limelight following its lagged performance.

I guess, it could be another “pat-in-the back” if my projections hold. The Mining Index delivered their marvelous overture last week up 14.88% as its underlying precious metal products broke out of consolidation ranges to reinforce their long term trends.

Figure 6: Another Pat-in-the- back chart of Mining Doing A Catchup?

In figure 6, the lagging mines (orange) have initiated its advance with oomph (!), in the shadows of the hefty moves of its peers: Banking (red), Property (candlestick), Services (Green) and Holdings (violet).

Considering that its peers have broken mostly from their May highs to establish new highs in the present cycle, then one can deduce that the Phimin index could likewise do the same rendition. To reach its May 12^th high of 6,283 translates to a gain of about 24% from the present levels. And that should be a conservative estimate if based on the similar patterns made by its contemporaries.

My outlook in the mines is as PROXY to actual precious metal holdings, since my thoughts of gold and silver are as genuine money/alternative currency, rather than simply commodity issues.

I am not in the camp of the “production=revenues=profits=higher share prices” because since I’ve been writing about the mining industry in 2003, when no one was looking, I have come to understand that the fate of the micro-themed outlook DEPENDS on the whereabouts of the MACRO based commodity cycle.

The micro theme has come about only WHEN the Mines have made a significant upside headway. In short, those espousing the micro theme will be surprised when the macro cycle turns upside down, their investments to will also reverse...since what has bolstered their bullish rationalities for the mines have been based on the rearview mirror syndrome (projecting the recent past linearly to the future).

Well for the moment, I join the ranks of the micro-theme bulls, as the cycle remains favorable for the “rejuvenated” industry.

And one last thought, it must be remembered that except for one profitable mine ALL other mines require massive financing to either rehabilitate or operate on their existing fields (brownfields) or undergo exploration to expand reserves (greenfields). This, in my view, is the principal reason WHY the Supreme Court ratified the Mining Act of 1995, to allow foreigners to provide capital and share their expertise to tap our greenfields with its multiplier economic effects to the upliftment of the country.

As such, one can EXPECT to have a spate of JOINT VENTURE and FINANCING deals, Mergers and Acquisitions, IPOs, or backdoor listing of mining issues in general because the cycle remains favorable for the mines. You do not need analysts, like me, or anyone else to tell you of these, simply because this is what to expect coming from decades long of underinvestment underpinned by a favorable cycle! You are simply witnessing a transitional shift from the past to the present cycle.

As an example, remember, during the last decade we saw mining companies being converted to either holding companies or technology companies. Today, we are seeing signs of the reverse; non-mining companies being converted into mining companies! All these are symptomatic of the growing acceptance by the investing public of the renascence of the mining industry.

However, one last very important reminder, All bull markets end in a MANIA.

Firm Peso Reflects Flood of Foreign Capital into Philippine Assets

``There is a tendency for things to right themselves." - Ralph Waldo Emerson

Similar to the previous weeks, Philippine assets have been on a roll!

Local sovereign bonds continued with its upward march, which brought down yields, as the Bangko Sentral ng Pilipinas (BSP) restructured its lending rates, notes Clarissa Batino of Bloomberg, ``The central bank yesterday introduced three rate levels for bank deposits, maintaining a 7.5 percent payment on amounts of up to 5 billion pesos. Interest on deposits of up to 10 billion pesos was cut to 5.5 percent, while sums in excess of 10 billion pesos will get a 3.5 percent rate.”

In the meantime, the Phisix was equally in a bedazzling motion to post another exceptional week up 2.39%. However, despite its outstanding performance, the Phisix landed only fourth in the region, following the phenomenal advances of China’s Shanghai composite (+3.27%), Indonesia’s JKSE (+2.55%) and Hong Kong’s Hang Seng (+2.47%).

And in contrast to country-specific vainglories attributed by our local “experts”, our position has been that these unfolding developments has been a global phenomenon with the Philippines benefiting from the flux of excessive creation and intermediation of money and credit on an international scale, as shown in Figure1.

Figure 1: stockcharts.com: Dow Jones Asia Ex-Japan (candle), and Dow Jones World (black line)

Like our Phisix, global markets have been on a tear. Albeit, the Dow Jones World Index appears to phase in an incipient correction mode as US markets take a breather. Notice too that like our Phisix, at the lower pane, technical indicators as the Relative Strength Index (RSI) have been drifting in the highly overbought zone.

Of course, we do not discount local developments as possible variables that could HELP influence present market psychology or sentiment, as the recent upgrade of the international rating agency, Moody’s Investors Services, on our credit rating outlook. Although, my view that is that the Moody’s upgrade has been simply a consequence to the gains of Philippine assets or that they have positively reacted to the snowballing trend of portfolio money flooding into Philippine and emerging market assets, which prompted such upgrade. Just consider, over the past three weeks, the Phisix recorded an accrued gain of 8.2%, which means even without the latest Moody’s edict issued last Thursday, the Phisix has been on a winning streak.

Naturally, the tidal wave of foreign money flows into Philippine assets reflects on our local currency, the Peso (up 6.4% year-to-date), as shown in Figure 2.

Figure 2: Rising Peso Correlates to an Ascending Phisix

In the previous rising stockmarket cycle during 1986-1997, I do not recall (sorry, no data on this, although I’ll try to work this one out with the BSP/PSE) the Peso as having been a significant factor in buttressing its past ascent. This makes the recent developments of rising currencies in the region a structural factor which should further boost the region’s financial markets over the LONG RUN. According to Denise Kee and Wes Goodman of Bloomberg (emphasis mine), ``The Asian bond market outside Japan will grow 10 percent to 15 percent a year to $10 trillion by 2015, said Heng Swee Keat, managing director of the Monetary Authority of Singapore. The market has grown to $2.7 trillion this year, making up 45 percent of Asia’s gross domestic product excluding Japan…That’s up from $600 billion in 1997, when the bond market made up 20 percent of GDP, he said.” If such projection materializes for the bond markets you can likewise expect the region’s stockmarket to likewise flourish. Since markets are mainly about expectations, I’d like to reemphasize the phrase, OVER THE LONG RUN, as to clear myself.

Over the short-term, I have made my case on the Phisix last week, having said that the GIST of the GAINS have had already been made, or to put bluntly, the Phisix nears its interim zenith. Yes, all these DEPEND on the external activities or conditions thereof which are centered mainly in the US.

I do not dispute that the Philippine benchmark may be headed for 3,000, if the momentum continues, despite its strenuously overbought conditions. Because markets are mainly psychological based, emotional rapt may bring market levels to the extremes, which may be described as parabolic movements. There could be short-term pullbacks though, as we have seen in the Dow Jones World Index led by the US over the week, which could also inspire a related retreat in the domestic arena, but what concerns your analyst is the major one, one that could see the Phisix drop by as much as 10-15% as discussed last week.

Figure 3: Number of Trades per Day

For the moment, we can expect the Phisix even amidst any minor correction to be engaged in sector rotational plays. While the locals have been as bullish as overseas investors, as measured in the number of trades, we have yet to attain the height of overconfidence similar to early May of this year, where the number of trades hit 9,000 to 11,000 per day, as shown in Figure 3 to signify a TOP! The momentum appears to be building for another spike ~of investor overconfidence (see red arrow and take note of the twin spikes).

And to remind you that markets operate under mean reverting tendencies, such that any further outperformance by the PHISIX, which is up 32% year-to-date on its 4^th year of consecutive advances, enlarges our risk factor of having a negative annual return for the Phisix in either 2007/2008.

On the other hand, a bullish trend of the local currency or peso may yet underpin the persistent vim in the Phisix if one would consider the outlook of Morgan Stanley’s chief currency analyst Stephen Jen (emphasis mine), ``In recent weeks the CNY (China’s Yuan), the SGD (Singapore Dollar), the THB (Thai Baht), the KRW (Korean Won) and the INR have outperformed the IDR (Indonesia’s Rupiah), the MYR (Malaysian Ringgit), the PHP and the TWD (Taiwan Dollar). I expect the latter four to gradually catch up: There is no reason why the still high-yielding IDR should not benefit from the normalizing risk pattern, and the MYR should rise with the SGD.” What Mr. Jen suggests as driver to the prospects of the firming four currencies is of the underlying currency’s yield premium/spread, or interest rates on the respective local currencies relative to the US Dollar or to the other ascribed pairs.

Of course, Mr. Jen’s forecast are predicated on the following conditions: US having a soft-landing, ``benign rotation of growth away from the US to the rest of the world” or essentially a decoupling, continued net equity inflows to the region, USD/CNY steady but orderly decline, continued retention of the Hong Kong Dollar’s peg and lastly, due to saturated levels of US dollar reserves, Asia ex-Japan Central Bank’s lesser degree of intervention.

While I am acquiescent with most of the conditions, the US soft-landing side is a continuing concern where because of the past occurrences, probabilities makes a soft landing a very unlikely scenario, in my view, in contrast to the consensus. In the invaluable words of Bond Guru Pimco’s William Gross (emphasis mine), ``Financial innovation, central bank transparency, and even globalization’s great moderation of economic volatility are powerful arguments suggesting the old days of copious Alpha and Beta are over because 5% GDP growth and compressed risk spreads are not likely to permanently return to historic levels. Yet we have a collective sense that risk spreads will not remain so low over the next 12-24 months, and that instability – whether it be sparked by U.S. housing, global overinvestment, or geopolitical events – will one day temporarily resurface.” Mr. Gross’ 12-24 months probability of a volatility spike resonates with my risk factor of a negative annual return for the Phisix in 2007/2008.

Figure 4: Chartoftheday.com: Breakdown by US Single-Family Home Prices

As we have previously noted, loose money and credit conditions still overwhelm any weaknesses seen in the US real estate sector that has prompted significant “rotational” activities such as a boom in US equities, corporate M&As, commercial real estate, etc. The full impact of an economic slowdown brought about by the retreat of the US real estate industry, which is already in a recession, has yet to be felt (with the consensus largely dismissing the prospects of a recession). Figure 4, courtesy of chartoftheday.com shows of the breakdown of the US Single-home prices.

Figure 5: stockcharts.com: Bottoming out of Treasury yields?

Yet, if expectations for a continued loose credit and money conditions or Fed rate cuts have been the impetus for the recent explosion in equities, then Friday’s activities in the bond markets as signified by 10 US Treasury year yields could possibly be ominous or the proverbial “taking away of the party’s punchbowl” as shown in Figure 5, where US T-yields (red candle) have declined (red arrow) in conjunction with the a Dow Jones Industrial Averages (black line; blue arrow). The yield spike was mainly a reaction to the declining unemployment rate.

While of course, we know that one day does not a trend make, what is notable in the chart is that the benchmark yields appears to form a double bottom pattern which could mark an important inflection point, if the succeeding price actions will affirm such behavior.

Notice too that the recent bottom has also coincided with the peak in the main Dow Jones equities bellwether.

This leads us to assess and/or project that a breakout of the Treasury yield at 48.5 (resistance level) would imply a confirmed reversal of the bond rally, heightened inflation expectations, an increased possibility of the US Federal Reserve to take additional action or increase its short-term rates and increased pressure on equities. Until then, I think, the Dow’s recent decline has been mainly due to technical factors.

Asia’s Micro Bullish Case: Dividend Yields and RoE

``ASEAN is something of the forgotten entity in Asia these days as investors obsess over China and India. Still it is a very large region with many unique strengths and we remain focused on its long-term potential as a home to many excellent Asian companies. Thailand is one of the world’s great tourist destinations and one of the largest agricultural exporters. It has quietly built a significant automotive industry in recent years. Singapore has come out of a long slump and is enjoying the lowest unemployment rate in over a decade. Indonesia has been a darling of global investors and its very young democracy continues to make progress against a host of challenges. The region is finding a way to provide goods and services to China, Japan and India, with entrepreneurs as the real driving force, not the politicians or generals.”- Mark W. Headley, President and Portfolio Manager, Matthews International Capital Management, LLC

Finally, going back to Asian markets, the bullish case for investing in equity markets in Asia aside from the macro prospects are also due to the corporate fundamentals, i.e. steady improvements on Return on Equities (RoE) and above par dividend yields

Figure 6: Guinness Atkinson Funds: Steady Improving Returns on Equity

According to the latest Asian Brief by Guinness Atkinson Funds (emphasis mine), ``Over the last eight years attitudes in Asia have changed; markets and customers have grown more sophisticated as have the companies that serve them. Asia is still a high growth area and there are young and high growth companies emerging all the time. But there are now many more established businesses operating in this high growth region. These businesses now focus more on their main activities, have divested non-core divisions and are concerned more with profitability than empire-building.

``This has led to a big increase in the number of dividend paying companies in Asia and has also led to Asia becoming one of the highest yielding regions in the world…It stands in marked contrast to stocks in developed markets such as the US where the dividend yield is hovering around 2% and where the payout ratio has declined over the past 10 years.”

	Dividend Yield 2006E (%)	Dividend Yield 2007E (%)	Payout Ratio 2007E (%)
China	3.17	3.83	41.86
Hong Kong	3.64	3.99	52.97
Indonesia	3.52	4.50	49.10
Korea	2.23	2.54	23.63
Malaysia	4.62	4.62	57.85
Philippines	3.89	3.38	45.60
Singapore	4.58	4.11	58.88
Taiwan	3.95	4.48	55.45
Thailand	4.83	4.92	44.82
India	1.70	1.89	20.94
Asia ex Japan	3.29	3.65	41.43

Table 1: Guinness Atkinson Funds: Asian Dividend yield

Corporate fundamentals, aside from the hunt for yields, have been the flanking support drivers for the Asian Markets, backed by many high growth areas/opportunities, improving returns on equities and rising dividend yields in general (except the Philippines, Singapore and Malaysia), as shown in Figures 6 and Table 1, courtesy of Guinness Atkinson Funds.

This should enlighten us why the region has become a magnet for cross-border capital flows and reinforces my belief that the secular advance phase of the Philippine financial markets has an ocean of expanse for growth OVER THE LONG TERM HORIZON.