TSLF: Total Socialization Of Losses Of The Financials

``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”-Ludwig Von Mises, Human Action

As anticipated, the US Federal Reserve has undertaken drastic measures aimed at alleviating the present circumstances.

As credit markets remain under constant pressure, benchmark yields have continued to rise seemingly irresponsive to the monetary policy actions. Thus the Federal Reserve has opened another novel program called the Term Securities Lending Facility or TSLF.

The TSLF is supposedly a compliment to the existing Term Auction Facility. This allows financial companies to trade directly with the Fed which would lend up to $200 billion and accept a wider degree of collateral including “non-agency AAA/Aaa-rated private-label residential MBS" or papers impacted by the real estate bust.

The facility also allows for a swap lines arrangement with several central banks as European Central Bank (ECB) and the Swiss National Bank (SNB).

To top it all off, the Fed even invoked a Depression era law to facilitate for extending loans to non banks as Bear Sterns via JP Morgan.

Some argue that repos extended as loans against an eligible collateral do not signify as inflationary since they will be reacquired by the Fed and secondly, they are meant to repair the capital base of the debilitated financial institutions and not utilized for normal operations-where once a normalization takes place the added liquidity is withdrawn.

True enough the repos do not expand the Fed’s liability (base money) under the assumption that the collateral has value in it. However, by accepting papers which markets has refrained to put a price into or by putting a bid on an illiquid paper with unknown value or by acting as market maker of last resort exposes the Fed to credit risks. Insufficient collateral means losses for the Fed.

Yet there are some even calling for a greater degree of Fed exposure to the market risks…by directly buying up affected mortgages or outrightly subsidizing losses of the financial institutions, which means greater socialization or nationalization of losses and increased moral hazard. Thus our revised meaning for the acronym of TSLF: Total Socialization of Losses for the Financials

According to Frankfurt School of Finance & Management Honorary Professor Thorsten Polleit in his very instructive article, Inflation is a Policy that Cannot Last (emphasis mine),

``There are basically three strategies the government can pursue to prevent a contraction of the credit and money supply caused by a breakdown of the banking sector.

``The first strategy is to inject peoples' tax money into banks, thereby socializing (part of) the domestic banking industry. Under the second strategy, the government would simply buy banks' risky assets, thereby making available (what is left of) banks' equity capital for new lending.

``However, it does not take much to see that both strategies might be highly unpopular. In particular, to finance capital injections and/or purchases of banks' risky assets, the government would have to take recourse to tax financing — using either current taxpayer money or, in the case in which the government issues bonds, future taxpayer money.

``However, there is the third strategy available to the government, a much more subtle and very powerful way of redistributing peoples' resources through the hands of the state: increasing inflation by making the central bank buy banks' risky assets. In fact, such a strategy amounts to creating inflation via monetizing banks' risky assets.

``That said, surprise inflation can lower the real interest rate burden on outstanding loans only in the short term — at the expense of creditors. However, as long as the money system is based on a relentless increase in bank credit and money supply, it would take ongoing surprise inflation to lower the real debt burden, but such a monetary policy would ultimately lead to hyperinflation.”

All three strategies appear to be at work today.

Another, the program deals with the asset side of the Fed’s balance sheet. The Fed will be changing the composition of its $873 billion in total assets from around $700+billion in treasuries to mortgages, expanding its market and credit risk.

But since the Fed’s balance sheet is materially smaller compared to emerging markets as China, Brad Setser says that the Fed can expand its balance sheets…

``But what if the Fed changes its mind and decides that it needs to expand the amount of support it offers the market? Well, nothing precludes the Fed from following the lead of emerging market central banks and issuing short-term “sterilization bills” to offset the growth of the assets on its balance sheet.

``As around $900b, the fed’s balance sheet is something like 6-7% of US GDP. With $1600b in foreign assets, the PBoC’s external balance sheet alone is more like 50% of China’s GDP.

``In a world marked by unprecedented central bank intervention, the Fed’s balance sheet is still kind of small.

``Expanding the Fed’s balance sheet dramatically to offset a massive deleveraging of the private financial system – a deleveraging that has been compared to a bank run in reverse, with the banks withdrawing credit from hedge funds and broker dealers in much the same way that households withdraw credit from the banking sector in a bank run – would be a truly radical step.”

Yet inflation seems to be the preferred policy option for the US FED, as we have been saying all along, since that the US is a net debtor financed by foreigners who are likely to be the victims of its monetary policy given the urgency of the situation. Ever heard of a Beggar thy neighbor policy?

From Martin Wolf the Financial Times, ``There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.”

With the radical thrust towards increasing TSLF all these will eventually be reflected in the fate of the US dollar, as Mises prophetically observed.

Ergo, gold, oil, commodities and other hard assets are likely to serve as insurance from devaluing paper assets.

The Cost of Currency Intervention: BSP Recapitalization by Issuing Bonds

Everything action comes with a cost, and so it is with the currency intervention measures administered by the local authorities to restrain the Peso's appreciation.

According to the Philippine Daily Inquirer, ``In the period from January to November last year, the BSP incurred P84 billion in foreign exchange losses leading to a P62.5 billion in net loss. The amount was charged by the BSP against the capital accounts built over the years.”

The consequences…the domestic central bank, the Bangko Sentral ng Pilipinas (BSP) plans to recapitalize by issuing bonds, again from the Inquirer, ``Inquirer sources said the scheme would be announced in the next few days. They said the government recognized that the BSP recapitalization was an urgent matter now that the central bank was incurring huge foreign exchange losses. To avoid imposing heavy burden on the government’s finances, in view of its bid to wipe out fiscal deficits and achieve a balanced budget this year, the government is favoring the bond issuance scheme, proceeds of which would be used to recapitalize the BSP.”

``The scheme will enable the BSP to get the money immediately this year while the cost burden on the government will be staggered over a 10-year period.”

Now this assumes that the Peso won’t have to be supported further…

Socialization of the US Markets Accelerates with the Fed's latest tool the TSLF!

TAF gets tougher as it is now supplemented with the Term Securities Lending Facility or TSLF- the latest instrument which allows the Federal Reserve to lend up to $200 billion and accept as collateral- agency and private residential securities or "non-agency AAA/Aaa-rated private-label residential MBS"!!! You read it right-garbage papers!

You can read more from Bloomberg the updates including the Fed’s Text on the novel “bridge” financing.

Crude Oil Surge Past US $109!

This from CNBC: "Oil rose to a record high for the fifth day in a row on Tuesday, boosted by investor flows into oil and other commodities partly to hedge against inflation and the weak dollar.

Chart courtesy of cnbc.com

"Concerns about inflation are very strong. Hedge funds are selling stocks and buying commodities, especially oil and gold, because the U.S. dollar is weakening," said Takeda Makoto, an analyst at Bansei Securities.

The Philippines Needs Economic Freedom More Than New Laws

``Excess and inequality of taxation, however disguised in the means, never fail to appear in their effect. As a great mass of the community are thrown thereby into poverty and discontent, they are constantly on the brink of commotion; and, deprived, as they unfortunately are, of the means of information, are easily heated to outrage. Whatever the apparent cause of any riots may be, the real one is always want of happiness. It shows that something is wrong in the system of government, which injures the felicity by which society is to be preserved.” Thomas Paine (1737–1809) was an English pamphleteer, revolutionary, radical, and classical liberal. Society Is a Blessing, but Government Is Evil

Recently I stumbled upon an article descriptive of the supposed excesses of the lower house of the Philippine Congress. While the general idea-the supposed extravagance from the enormous allocation of the pork barrel funds coming at expense of the economic development- seems accurate, what prompted this response is the seeming counterfactual projection of causation: the alleged inertia of the Philippine Congress to pass laws which has resulted to our economic plight. In short, the Philippine economic malaise has been imputed as an offshoot to a dearth of laws!

Of course, the narrative comes with a tacit political slant; its dubious silence on the performance of the Philippine Senate. This seems to imply that the lower house has been inadequately doing its job (yet undeservingly gets its disproportionate share of Development “Pork” funds) because it remains supportive of the administration, while the upper house which has been conducting a series of “trial by publicity” of the recent scandals by several key figures of the administration purportedly “in aid of legislation” appears deserving of their perquisites (thus the suspicious silence).

Nonetheless, such straw man argument ignores the fundamentals of why the Philippine legislative branch or other government agencies are allotted with such humongous discretionary funds for its elected officials. The problem with most politically colored analysis is that it mostly focuses on the symptoms while discounting the roots of the problem.

Let’s revert to government basics: Every enacted law requires attendant administration personnel, logistics and corresponding police power to effect its implementation or an organization called as a bureaucracy. This means that funding for this public hierarchical entity comes from you and me or the taxpayers. In essence, ceteris paribus or all things being equal, more laws equal to more taxes!

So by sheer logical deduction; if economic nirvana would be attained by paying more taxes via more regulations then why not simply tax 100% or all of our income by regulating each and every activity? Yet, would you be willing to work your guts off under such circumstances?

We have seen the failed experimentation of such model in the nomenclature of “communism”. But, history’s lesson tell us that such paradigms simply don’t work, otherwise Mao’s China or Stalin’s USSR would still be functional and stand as the most economically prosperous…but where?

Ironically, the only remarkable achievement communism has brought upon to this world is the undue death of 94 million people- estimated 20 million in USSR, 65 million in China, 1 million in Vietnam, 2 million in North Korea, etc… (Black Book of Communism) aside from amazing feat of equality-every one is poor (of course except the leadership)!

So the argument of absolute regulation is by itself impractical.

Costs of Laws: Compliance Costs

And since everything has a cost; laws have their own costs too.

One has to deal with compliance costs-directly or indirectly-which means aside from the direct costs of paying taxes, indirect costs implies costs from the loss of productive time, efforts, expenditures in manpower or resources used in conforming to government regulations or laws, as shown in Figure 1.

Figure 1: World Bank’s Paying Taxes: Compliance Costs

From World Bank’s report on Paying Taxes 2008, ``Making the tax rules for businesses complex is unlikely to generate more revenue – quite the opposite.”

So, essentially the more complicated the regulations in the form of ambiguous laws, many laws per tax and mandatory forms, the higher the costs of compliance.

The point is that the tax structure based on the underlying laws determines the cost of compliance. High compliance costs increases the cost of doing business which basically deters investments, the primordial reason for a nation’s economic development.

Regulations In A Complex Society Leads To The Law of Unintended Consequences

And importantly, the costs associated with the laws of unintended consequences or unforeseen consequences. Alex Tabarrok of Marginal Revolution has a splendid definition of this phenomenon (highlight mine),

``The law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple, it operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives. Society in contrast is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences.

``Unintended consequences are not restricted to government regulation of society but can also happen when government tries to regulate other complex systems such as the ecosystem (e.g. fire prevention policy that reduces forest diversity and increases mass fires, dam building that destroys wet lands and makes floods more likely etc.) Unintended consequences can even happen in the attempted regulation of complex physical systems (here is a classic example involving turbulence).

``The fact that unintended consequences of government regulation are usually (but not always or necessarily) negative is not an accident. A regulation requiring apartments to have air-conditioning, for example, pushes the rental contract against the landlord and in favor of the tenant but the landlord can easily push back by raising the rent and in so doing will create a situation where both the landlord and tenant are worse off.

``More generally, when regulation pushes against incentives, incentives tend to push back creating unintended consequences. Not all regulation pushes against incentives, some regulations try to change incentives but incentives are complex and constraints change so even incentive-driven regulations can have unintended consequences.”

As you can see no matter how noble the intention of a law maybe, the laws of unintended consequences can negate whatever the anticipated positive outcome simply due to the unforeseen complexity of societal dynamics.

Simplified “moral” thinking as basis for regulation frequently backfires. Popularity does not automatically translate to righteousness. So the concept of plainly churning more laws as the magical formula to economic upliftment is grossly misguided, if not daft.

Applied to the present political scenario, what we are seeing is exactly a backlash (law of unintended consequences) on the structural strangulation of the economy by political forces operating on the platform of rent-seeking (patron-client) culture emanating from the pork barrel system of governance. Personality based politics as advocated by media ensures that the same dynamics will be repeated again and again for as long as the political structures are not overhauled.

In fact, it is more laws or regulations that have led to the intensified empowerment of the domestic political hierarchy. Going back to basics, more laws mean more financing requirements for implementation or a bigger bureaucracy, sustained by a bigger share of taxes.

The Vicious Feedback Loop

``Taxes do not result from a market process, nor do they reflect allocation decisions of resource owners . . . In other words, taxation is a method of intervening, not an alternative to intervention or nonmarket allocation” (emphasis mine), excerpted from O'Driscoll and Rizzo, cited in Efficiency and Externalities in an Open-Ended Universe.

As we previously discussed The Economics of Philippine Election Spending, the costs of winning elections have surged dramatically in line with the explosion of government spending. Everybody wants to have a piece of spending other people’s money by the very virtue of more “moralistic” government intervention! Joining politics becomes a privilege to determine where to spend taxpayer money.

Yet, unwittingly the public’s desire for increased “moral” wealth redistribution translates to this very perverted political cycle.

The vicious feedback loop as follows:

1. More clamors for “morality” equals more government meddling and thus, more Pork or government spending.

2. More Pork equals higher occurrences of abuse of power and increased degree of corruption which leads to high costs of business and more taxes.

3. High cost of business and more taxes translates to a loss of the currency’s purchasing power (via inflation), ergo more poverty and social inequality.

4. More poverty incidences and social inequality results to more political pressure for the leadership “do something” via more “Moral” redistribution.

5. Go back to step 1.

As a caveat, media, politicians and high profile experts does not even attempt to distinguish social inequality between those engendered by policies and the other shaped by productivity, e.g. some bakers will produce more output of bread than the others, some will produce better quality of bread at the expense of output, some will not produce better quality or will also be inferior in the production output.

Likewise, as previously argued, the surfeit of Countrywide Development Funds or Pork Barrel has overtly skewed the incentive structure by the voting populace and its leaders which have effectively legalized corruption via kickbacks seen from the entire level of the nation’s political structure which has concomitantly fostered a culture of dependency and deeply embedded sense of “entitlement”.

Figure 2: World Bank’s Paying Taxes: Higher Taxes Reduce Business Incentives, Broadens Informal Economy

Yet, again unknowingly to the public, a bigger share of taxes from greater government expenditures results to reduced attractiveness for investments relative to other countries, as the stratospheric costs structures require a high hurdle rate for the Return of Investments (ROI) as shown in Figure 2.

Higher taxes constitute as a major obstacle for capital investments, where it also reduces tax participation. Tax evasion, a large informal economy and tax leakages are simply symptoms of a big government-high taxation regime.

Thus, the lack of capital investments, and not the lack of laws, results to our economic woes.

This instructive quote from Stephanie Medina Cas and Rui Ota, a multilateral government institution known as the IMF in a research paper Big Government, High Debt, and Fiscal Adjustment in Small States (highlight mine), ``Controlling the size and cost of government can make government more efficient and more effective in achieving its principal functions in the delivery of goods and services.”

Economic Freedom Relative to Corruption and Wealth

Our excessive dependence on the political leadership for the economic path results to massive distortions and imbalances in the economy, the sensitivity to abuse of power, and the vulnerability to corruption. While we have a “quasi” political democracy, paradoxically we lack the economic freedom so required in today’s globalized playing field.

Figure 3: Heritage Foundation: Economic Freedom and Corruption

It is this lack of economic freedom that has been closely associated with everybody’s favorite “moral” theme of “corruption” as seen in Figure 3, courtesy of Heritage Foundation. Yet, interestingly none of our “experts” undergird its importance.

Economic freedom as defined by Heritage Foundation, ``A country’s level of economic freedom reflects the ability of ordinary citizens to make economic decisions on their own. It includes the freedom to choose a job, start a business, work where one chooses, borrow money, and use a credit card. It ranges from buying a house to having a choice in health care, from being fairly taxed to being treated justly by the courts. The higher the economic freedom in a country, the easier it is for its people to work, save, invest, and consume.

``Yet the struggle for economic freedom faces determined opposition. Tariffs are just one example of protectionism that never lacks champions, and those who want special privileges will always pressure societies to expand the size and weight of government intervention. Special privileges for the few mean less prosperity for the many.”

As we have mentioned in Philippine Politics: Systemic Defects of the Pork Barrel Political Economy, it is this special privilege acquired through as an inadvertent offshoot to the intricate “web of laws” (derivative of the law of unintended consequences) or through purposive passage of laws which has kept the competitive edge of “privileged groups” through a phenomenon called as a Regulatory capture (wikepedia.org), ``…in which a government regulatory agency which is supposed to be acting in the public interest becomes dominated by the vested interests of the existing incumbents in the industry that it oversees”, which has spawned the country’s quasi oligarchic structure and crony capitalist tendencies.

Essentially, laws have become the favorite tools of financial enrichment or economic empowerment by the political connected and by those in power and their associates or “special interest groups”.

As you can see from the chart from Heritage Foundation, countries which allow their citizens to determine their own economic destiny, who are free from choking regulations, openly embrace competition and rely more on trade and adopt an entrepreneurial culture are least likely prone to abuse of power and corruption compared to nations that are economically repressed or heavily overregulated.

To quote Ana Isabel Eiras of Heritage Foundation (highlight mine), `` To fight corruption and informality, it is essential to understand that corruption is a symptom—of overregulation, lack of rule of law, a large public sector— not the root of the problem. The perceived problem is unethical/corrupt behavior of the private sector, which leads the government to press more on private-sector activities. The real problem is the government action/regulations causing undesired behavior of the private sector. The optimal solution would be to eliminate burdensome regulations so that unethical behavior does not occur.”

This view runs starkly in contrast to mainstream spin where the conventional expectations for governance seem like a quasi socialist “be all end all” for our society whose mindset can be described as:

‘We want to be free to do what we want to do, but when faced with obstacles we want government to do it for us. Anything that evolves favorably to our convenience we ask to remain free but anything that runs against us we demand socialization.

‘Yet my barrier, your impediment and the other’s concerns are likely to be different and would most probably be in conflict with one another from which government will have to choose among us whom it would protect. Yet, whoever is accorded with government’s blessings is privileged while the rest of us cry “FOUL” (and all attendant labels-corrupt, inept, imperialists, etc. etc.)!

‘Oddly too, is that as much as we expect so much from government we are averse to pay more taxes (citing lame excuses as corruption as rationalization)!’

In essence, our expectations for freedom, government’s role in our lives and paying taxes have been entirely divergent. We don’t know exactly what we want. We expect sweeping changes by the fillip of a finger or a “quick fix” or “lotto” mentality, which we deal with under a pretentious and fallacious dissection, to our problems. Thus, the retrogression of our problems has become a frustrating illusion to many.

Figure 4: The Fraser Institute: Economic Freedom and Per Capita Income

Whereas when we are left to our own devices, we tend to act on what we perceive as the best path for us. In short, we tend to optimize our output given the conditions we are faced with if there would be less intervention from government.

Figure 4, from the Fraser Institute shows how countries which espouse economic free policies have higher per capita income relative to countries which are overregulated repressed or least free.

This goes to show that societies or nations tend to improve significantly when their constituents are allowed do their best, when they are least regulated and significantly less economically dependent on politicians.

Remember, economic freedom is a policy choice as much as it is a moral choice. It requires the realization that we can benefit if we trade competitively more than simply hide under the skirts of government. It requires us the right and the ability to fail. It requires the acceptance of income disparities. It also requires a reduction of power by the government and the accompanying cutback of government spending or Pork barrel discretionary funds through subsidies, doleouts and other welfare programs as well as greatly reduced tax rates and a simplified tax structure. It requires more private sector participation in the broader economy with a greatly diminished role for government. It requires for the development of a pervasive market oriented platform. It requires a legal protection of property and intellectual rights as well as the enforcement of contracts. It requires a streamlining of laws and the attendant pruning of the bureaucracy. Lastly, it requires a sound money policy independent of political influence.

Unfortunately, such premises for structural change signify a Sisyphean Challenge for our politicians who seem perpetually addicted to power and to our economic experts who seem obsessed with their apparent presumption of pedestal omniscience of how to infallibly manipulate the economy to meet their desired ends (Unfortunately since our independence they have been proven repeatedly wrong. Moreover, they can’t even accurately predict the markets with their supposed wisdom! It is a puzzle-if they can’t predict markets with lesser factors involved how much more can they precisely analyze a rapidly evolving highly complex society with a larger universe of moving variables and prescribe the required policy measures with less impact from the law of unintended effects?). As Albert Einstein warned, ``The attempt to combine wisdom and power has only rarely been successful and then only for a short while.”

Rising Yield Curve, Shift in Global Demand and the Gold Oil Ratio

``Everything is new if you are ignorant of history. That is why ideas that have failed repeatedly in centuries past reappear again, under the banner of ‘change,’ to dazzle people and sweep them off their feet." Thomas Sowell

As expected, we are witnessing anew the resurgence selling pressures in the financial markets as the global credit markets continue to manifest incredible strain of tightening liquidity signified by soaring interest rates of various benchmarks such as the credit default swaps of several US financial institutions trading at the highest level ever, yield spreads of US agency owned mortgaged backed securities at highest level since 1986, auction rate bond failures hit 70% as brokers and bankers withhold financing, distressed debt levels rose to its highest level since August 2003 as investor’s flee to safehaven assets, Euro zones interbank rate hit its highest since January 18 exceeding ECB’s policy rate, yield spread between 10 year German bunds and the Italian bond surged to a decade high, sales of emerging market bonds fell 65% and the a significant 21% decline in derivative trading the first time in 14 years.

This comes even prior to the US Federal Reserve’s meeting which is due on March 18, with market expectations of a Fed cut of possibly at least 50 basis points priced presently into the Fed futures market.

Nonetheless, the tensions in the credit market has successfully percolated into the equity markets as the turmoil in some hedge funds, asset liquidation by several companies aside from major repricing of companies experiencing mortgage problems, as the suspension of Carlye Capital Corp of its mortgage bond funds, suspension of investor redemption in several hedge funds, liquidation by mortgage lender Thornburg Mortgage of assets to raise capital, aside from a growing consensus of the US undergoing a recession prompted for massive liquidation across the board.

Figure 5 from Prieur Du Plessis’ Investment postcard emphasizes on the steepening of the yield curve which has exhibited a strong historical inverse correlation with the directional activities of the S & P 500.

Figure 5: Prieur Du Plessis/Stockcharts.com: Inverse Correlation of S&P 500 and the 10-year/2 year yield curve

A steepening of the yield curve has coincided with downside volatility in the S&P 500. Notes Mr. Plessis, ``The above analysis is merely one cog of the wheel, but seems to point to more downside for US stocks. However, be cognizant of the fact that the stock market is a discounting mechanism and often starts moving higher before a reversal of the yield curve (see 2002/2003). It may still be a while before we reach this stage, and investment portfolios should in the meantime emphasize capital preservation rather than opportunistic trades.” (highlight mine)

But of course even as the financial markets remain under renewed pressure of heightened volatility, commodities continue to march upwards mainly in the face of a record breaking decline of the US dollar, signs of growing emerging market domestic demand and redistribution of wealth.

Yet we gathered some important insights of how rising commodities could affect different regions of the world aside from the subtle changes in the way trade and wealth redistribution has been conducted of late as shown in Figure 6.

Figure 6 Danske Bank: Soaring Commodity prices bring shift in global demand

Danske Bank’s Chief Economist Steen Bocian observes that while stagflationary (stagnant growth and rising inflation) tendencies are being reinforced in the euro zone, there are important implications for global trade (underscore mine), ``For countries that export commodities and energy, rising commodity and energy prices are synonymous with rising real income. What we see in the global economy is not just higher inflation, but also a marked redistribution of purchasing power as expressed by movements in the terms of trade.

``The Middle East, Africa, CIS countries and Latin America have seen massive improvements in their terms of trade at the expense of the EU, the US and Asia. To some extent this is also reflected in global demand. Take Japanese exports, for example. The EU and the US together are no longer contributing to Japanese export growth. While Asia is still making a healthy contribution, the big change is that the rest of the world is carrying more and more of the load. This group consists mainly of countries which have seen improvements in their terms of trade. In January these countries accounted for almost half of Japanese export growth.”

Aside from the empirical evidence shown by the shift in trading composition of Japan’s trading partners, this redistribution of purchasing power tilted towards emerging market commodity producers seems to be a fitting explanation or perhaps a proximate reason why, despite the present pressures in the global financial markets, some equity markets appears to have ‘decoupled’ especially seen in Middle East and African equity benchmarks as Oman, Nigeria, Bahrain, Morocco Egypt and Kuwait which are trading at fresh record highs unaffected by the global tensions, while Jordan, Qatar, United Arab Emirates, Kenya, Tunisia and Namibia are at spitting distance from new record highs.

We notice the same phenomenon in some of Latin American bourses such as fresh record territory of Costa Rica’s benchmark and near record highs too in commodities heavy exports of Brazil, Bermuda and Jamaica.

The decline in Asian markets likewise appears to validate this stagflation view of rising commodity prices negatively affecting some of the region’s economy, if we base this on the recent performances of its benchmark. But our guess is that this should apply mostly to countries with insignificant natural resources exports. Indonesia among all of Asia appears to be least impacted by the recent tensions as its bellwether the Jakarta Stock Exchange remains at striking distance from its previously established highs.

So for the moment it simply isn’t true (yet) that the ongoing deflation in some vital parts of the world is likely to drag the whole globe into a deflationary morass as some depression advocates argue. For as long as commodity prices persist to benefit from the falling dollar, growing emerging market domestic demand and the redistribution of purchasing power from commodity importing countries to commodity suppliers we are likely to see the same phenomenon continue if not accelerate.

The same argument should likewise keep the Philippine Phisix from suffering a similar fate. As investments pile on into our resource industries, e.g. mines expects some $892 million from last year’s $605 million (inquirer.net) agriculture based biofuel investments from Spain Php 16.2 billion (inquirer.net) and from some companies in the US worth $55 million and $200 million (inquirer.net, manilastandard.com) or agriculture investments by China for food exports (chosun.com) and investments from UAE meant for Halal food for exports to the Middle East (khaleejtimes.com), commodity exports are likely to gain substantial market share relative to total exports and provide the unexpected support to our GDP. (Our agriculture experts can’t even seem to even make this call or perhaps are not yet convinced of these developments.)

That is why we remain long term bullish with resources related companies, simply because resource based industries are likely to benefit from the purchasing power shift which has been benefiting commodity exporters around the world.

Finally, we recently got a comment concerning which among the two major commodity bellwethers (gold or oil) appears to be more “pricier” relative to current prices.

I guess the gold oil ratio should determine this as shown in Figure 7.

Figure 7: US Global Investors: Gold Oil Ratio at Critical lows

With oil trading at inflation adjusted record high at over $105 and gold at just under $974, the 36 year chart gold-oil courtesy of US Global Investors posits that gold today buys 9.6 barrels of oil compared to its long term average of 15 barrels. This suggests that gold is relatively undervalued when compared to oil.

But as a caveat, John Derrick of Global Investors notes that gold has risen by 2 standard deviations during the last two months which has reflected similarities to the present performance of the yen relative to the US dollar.

What it means? From John Derrick (highlight mine), ``The dollar has fallen against other major world currencies and is nearing an extreme low condition, which historically suggests that a bottom could come soon. If the dollar bottoms out and then starts rising, a reversal for gold will likely follow given that these currencies tend to move in opposite directions.”

Well such is premised upon the condition that gold follows the inverse trajectory of the US dollar. But this correlation has not been strong or has not always worked under the same pattern; in 2005 both gold and the US dollar rose.

Our assumption is for as long as major central banks conducts efforts to “socialize” losses, we are likely to see rising gold relative to all currencies But we should give Mr. Derrick’s insight the benefit of the doubt since overbought levels are likely to result to cyclical profit-taking.

Remember, no trend goes in a straight line.

Pentagon’s Active Denial System: Goodbye to People Power?

Pentagon has a new weapon…a ray gun (like in the sci-fi movies!) that can stop a person in his tracks (but) without injuring or killing him.

CBS News correspondent David Martin experienced it first hand, and gives this account. The weapon is likely to be used as a crowd buster. Watch the fascinating video from CBS.

What this could mean? If our government obtains this kind of crowd dispersal arsenal it could easily disband rallies at greatly reduced risk of violence.

BUT as caveat- it doesn’t deal with why people rally in the first place, which posits of the possibly that a new form of “demonstration” could likely be hatched. I hope that this would not be of the violent strain.

Philipppine Inflation Rate Surge on Soaring Commodities!

This from the Philippine Daily Inquirer,

"Annual inflation jumped to 5.4 percent in February, the highest since October 2006 and near the top end of forecasts, dimming prospects for a further cut in key interest rates when the central bank reviews its monetary policy next week.

"Government data released Wednesday show that inflation rose last month from 4.9 percent in January, rising for the fourth straight month. Inflation in October 2006 was also 5.4 percent.

"The central bank was projecting February inflation of 4.8-5.5 percent.

Chart courtesy of the Philippine Daily Inquirer

Many experts continue to impute the recent developments to oil prices.

The peculiar part is that oil has been on an upside streak since 2000, yet our consumer price index-oil price correlation has been tenuous. (see chart above: cpi begun its ascent in October when Oil had been trading above $85!)

What we have been saying is that the surge in global commodity prices, which appears to be reflected in food prices, is likely to be more strongly associated with the recent uptick in our price index data than oil alone.

Well guess what, the same article says that the BSP seem to confirm our view; again from the Philippine Daily Inquirer,

"Tetangco said elevated prices of main food items such as rice, meat, corn and flour, which comprise around 13.5 percent of the consumer price basket, likely pushed up inflation last month."

Philippine Politics In the Prism of the Peso

``I'm in favor of achievements - degrees and wealth and that sort of thing. Still, those achievements convey formal authority but not always moral authority. The only way to acquire moral authority is through your character and contribution, to live in such a way as to merit the confidence and the trust of other people.”- Stephen Covey

Allergy to Politics and the Focusing Illusion

The most difficult position for one to take today is to be apolitical. To my experience, in almost every discussion which deals with current events seem to require the domestic political equation as an indispensable theme.

Worst, it would appear that our world has been reduced to an argument of tangibles or absolutes (sometimes known as the fallacy of the False Dilemma) - where one’s choice is confined to ONLY black or white, good or evil or pro or against.

Yet, the arguments as we presented last week is one of the abstract phenomenon. It deals with intangibles or theoretical suppositions or even metaphysical concepts- where judgments are mostly based on the perceived values of individuals or are very subjective in nature.

So when words such as “Honesty, Morality, Truth, Altruism, Compassion, Justice etc.” are used and floated in the political sphere, beyond the public’s comprehension these words basically become expediencies or “slogans” meant to achieve a goal. Unfortunately once these are met, we see the cycle repeat over and over again, hence the never ending issue of street politics.

In behavioral finance, such cognitive distortion or bias can be identified as the Focusing Effect or Focusing illusion which is, according to wikipedia.org, ``when people place too much importance on one aspect of an event, causing an error in accurately predicting the utility of a future outcome.” The underlying belief that a personality change in the present leadership will automatically result to national salvation exemplifies this premise. This represent as the “lotto” or "quick fix" mentality. Again, we said the same in 1986 and 2001 only to find ourselves repeating the same mantra.

Yet, without structural reforms in our defective system, which is based on a pork barrel rent seeking “culture” grounded on excessive dependence on government and a dysfunctional market system controlled by politicians and their associates, all this beliefs are likely to signify another illusion-as in the past, we are likely to see the same dynamics in the future (even under new leadership).

The Abstraction of Action Speaks Louder

Abstraction, seen in the present day developments in our local financial markets, can be related to one’s perception of reality.

Because of the onslaught of controversies encompassing media space, the atmosphere depicted is of a country teetering on a verge of chaos. Thus, we are told that the Philippines as having been mired in a deep crisis which requires “urgent solution to a desperate situation”. This reverberating clamor for “change” has today become a fashionable social theme. Unfortunately, this fad has yet to reach a “critical mass” or to the same level of political fervor that has successfully ousted incumbents in the past.

Nonetheless, as a market observer, we are aware of the distinction between what is bruited about in the media-conventional thinking and how the market responds to what is the perceived as the risk environment.

The normal or conventional behavior is; the general public is unlikely to invest in a marketplace whose environment is perceived as highly risky. For example in 2002-3, hardly any local investor wanted to even talk about investments in the Philippine Stock Exchange following its deep cyclical funk because it was perceived as “highly risky”. This signifies extreme levels of risk aversion, yet, the public’s “Focusing Effect” led them to miscalculate and miss out the greatest buying opportunity which marked the secular bottom of the Phisix for this cycle.

If I ask you to invest in the sub-Saharan African states, would you? How about in the previously war torn areas of Mindanao? The most likely response would be a NO, especially if one is not acquainted with the area or is not from the area. Because people tend to operate merely on impressions, the conventional perception of such risk environment is likely to be based on negative reports depicting anarchy or violence.

But can a perceived high risk environment receive ample investments? Yes, perhaps depending on the social mood and or on the risk appetites of investors. So when social mood is optimistic or rather risk appetite is more tolerant regardless of the stream of bad news, then markets may not exactly reflect today’s headline sentiments and vice versa. In other words, ACTION speaks LOUDER than words! Financial markets may translate to votes of actual money placements by the investing public than mere “verbal” sentiment.

The Weakest Link: The Phisix

The Phisix today seems most susceptible to the present political drama than in any part of the current cycle (since 2003) because foreign money which had underpinned the run up of the entire cycle has now turned to negative (since the late semester of 2007).

In contrast, the local participants apparently have traded places with their foreign counterparts, whereby the former have been providing the backbone to the Phisix during the recent market turmoil as the former drivers exited.

Yes, as you well know, external developments have dragged foreign sentiment away from local equities which is most likely due to the ongoing liquidation dynamics as a result to the implosion of the house of cards built from highly leveraged mortgage securities and other derivatives papers in the US and in some other parts of the world.

Since many institutions had been caught holding into these papers with unrecognized value, raising funds meant selling of the most liquid holdings of their portfolio, hence the contagion effect (selling across the globe). Some financial institutions and lenders have been estimated to shrink capital assets by about $2 trillion (Greg Ip- WSJ).

Aside, this also mean adjustments in the economic and asset valuation expectations from the perceived impact of a meaningful downshift from the US economy as an offshoot to the tightening credit environment- where the same estimates say that about 1.5% percentage points would be knocked off the US economy- brought upon by the ongoing global credit crisis and the contraction of leveraged securities markets.

So with hiatus of foreign money serving as principal support for the Phisix, this leaves local participants as its major drivers. True enough, we have seen SOME impact of the political drama manifest in the Phisix as shown in Figure 1.

Figure 1: stockcharts.com: Phisix “Decouples” on Political Drama

The vertical line represents the “short-term” bottom from which Emerging market Economies (lowest pane), the US S&P 500 (above pane) and the Dow Jones ex-Japan index (behind-center window) has indicated partial recoveries or consolidation. On the other hand, over a similar timeframe, the Phisix has missed the recovery train and remained sluggish. Hence, the Phisix has partially "decoupled" from world markets which implies clues of negative impact from domestic politics.

Notably, in spite of this the net foreign selling has been greatly reduced and in fact these turned positive last week, as our market belatedly recovered (see circle).

Of course, hefty fall by the major benchmarks in the US markets last Friday are likely to exacerbate the negative conditions in the Phisix at the outset of this week.

So yes, admittedly over the short period the lack of foreign support has exposed the Phisix to some degree of political risks.

The Peso As The Strongest Measure of Sentiment

But, this is not entirely the same tune we hear if measured relative to our currency.

The Philippine Peso is likely to be a more accurate pulse of investor sentiment since they reflect capital flows across asset classes within our domain, aside from other factors such as remittances or trade surpluses or deficits.

Figure 2: Philippine Peso: No Crisis so Far

As a reminder, net selling in the Phisix does not automatically reflect capital exodus as it may imply asset shifts (from stocks to bonds or short-term cds).

Figure 2 shows of the historical significance of political tensions to the Peso. Tremors from major scandals, which rocked the political landscape in the Estrada Impeachment to the culmination of the People Power 2001, caused a significant drop in the US dollar-Philippine Peso exchange rate (see red arrow leftmost side).

Following the Estrada ouster in 2001, the Peso appreciated over a short period but resumed its long-term downward path.

It is the same story in 2005. The Peso which has greatly lagged the region relative to currency appreciation found itself attempting to firm up during early 2005 [as explained at What Media Didn’t Tell About the Peso]. However, as the HELLO GARCI scandal erupted- where almost the same intensity for the quest of “truth” was advocated-the Peso lost its upside momentum and consequently fell back to the 56 level (middle red arrow).

Meanwhile, the Phisix lagged the world by trading sideways then. It must not be forgotten that operating underneath the dynamics of 2003 to 2007 had been sizable foreign portfolio flows. Such that even during the outbreak of the Garci Scandal, foreign funds accounted for “net buying” even at greatly reduced scale.

Essentially, the public’s impulse of scampering for cover in response to the political scandals has been demonstrated by a loss of value of the Peso relative to the US dollar-where political anxieties has even overwhelmed foreign money flows. Or simply said the resident public exited the Philippine Peso on political antsy and sought the US dollar as safehaven.

Today we see almost the same extent of political drama but under a different set of circumstances. Yet as opposed to the past - the Peso is seen breaking into NEW highs…in fact is in a fresh EIGHT year high! Nonetheless, this comes in the light of a streak of net foreign selling in the Phisix since the advent of 2008!

This development thus leads us to several intriguing questions:

1. If the Public is seen selling from the perceived “crisis” then who is on the other side of the trade…buying? This is a big curiosity. Yet, market reaction does not suggest of high volatility or wild gyrations (just look at the chart) to indicate strains of “panic” or “fear”, accompanied by a “forcible” containment (yet!).

2. Has the public been immune to the political risks such that all the brouhaha for change could possibly translate to an “All bark no bite” scenario?

The fragmented elite, many of whom have joined the caravan to the supposed “path of enlightenment”, seem to have been jaded by the political stress as they appear to remain calmly invested! There has been NO substantial evidence of panic selling from locals in the Phisix or in the Peso. In fact, the main support in the Phisix has been from the local participants since the July 2007 credit crisis exploded or even since the start of the year! Can we deduce their actions as merely rhetoric in a political sense?

3. Has the negative real rates impelled the local investors to turn a blindeye to political risks (despite the social chatters) given the opportunity cost of holding US dollar assets? The thinking goes, “I’d like to flee but where to go? The US dollar keeps falling! Besides, inflation is eating up my peso.” (Still this does not represent a sign of panic…since they’re still thinking!)

4. Or how about this naughty thought of mine…could it be that some political entities been “manipulating” public sentiment to do a “poop and scoop” or spread bad news in order to buy assets in the hope that they fall?

With Philippine trade account registering a deficit for 2007 of $5.04 billion (forbes.com), this leaves remittances and portfolio flows as possible major contenders for the vitality of the Peso.

Yes, remittances have remained strong- as they had been during the Estrada impeachment to the People power 2001 and during the 2005 outbreak of Garci Scandal…yet the Peso fell! But it would seem dubious if they signified as the sole variable responsible for the levitated state of the Peso.

This most likely posits that the combined forces of unseen portfolio flows, the “no panic” attitude (yet) among local investors (instead of capital flight maybe a capital repatriation!) compounded by continuing of remittances may have buoyed the Peso. (Of course, this has shadowed the region's performance).

Foreign Money Are Not Zombie Investors!

It is also awkward or a cockamamie to suggest that foreign money is inured to political risks.

Figure 3: Bloomberg: Thailand’s SETI

While there are still substantial signs of copious liquidity in the world’s financial system, the market tensions evident in the global credit markets as well as in the structured finance securities and derivatives markets spilling over to global equities signify traces of discriminatory flows of liquidity. Ostensibly, these “surpluses” have been flowing into the commodity markets. Hence, the attendant risk taking posture by international fund managers are likely to be more discerning than during the previous pre-July 2007 Credit crisis era.

Yet, even then, political risks did matter. When the military successfully unseated the incumbent Thaksin Government of Thailand via a coup d'état, a financial market carnage ensued in September 2006 as seen in Thailand’s premier benchmark, the SETI, in Figure 3 courtesy of Bloomberg.

This was further exacerbated when Thailand’s central bank instituted capital controls from which they have partially reversed following a fierce backlash from investors. Incidentally, Thai’s Central Bank has reportedly been scheduled to lift all controls this week (Reuters).

So, foreign investors are not zombie buyers who acquire assets regardless of risks. Since they are profit oriented enterprises (unless they are Sovereign Wealth Funds SWFs), their positions are based on estimates of a risk-reward tradeoff.

Likewise, foreign money have not been acquiring assets out of political considerations; again unlike central banks who continue to amass US dollar instruments (mostly agencies today) despite the steep losses of the US dollar or like select Sovereign Wealth Funds (e.g. China’s CIC or SAFE). So it would be a huge mistake to presume foreign money flows as entirely impervious to political risks.

Encore: Believing In Six Impossible Things Before Breakfast

All this goes to show that words can be different from actions. One can say a mouthful of things yet act on the contrary. Politicians are the ultimate practitioners of this, they are devout followers to Napoleon Bonaparte’s advice, ``If you want to be a success in the world, promise everything and deliver nothing.”

Such abstract disparities have been equally conspicuous under today’s setting; reality according to the Philippine financial markets is starkly different from the reality as limned by the media, the politicians and their followers.

In a perspective, yes there is a crisis- but this has been limited to the political spectrum, the media space, and to social circles.

No, there is no crisis (yet) in the financial sphere or the economic front as signified by performances of the Peso or other financial markets; for whatever reasons possibly higher risk tolerance, negative real yields or buoyant social mood.

To argue otherwise is to see our reasons BLINDED by extreme fixation on politics. Besides, the generalization that Philippines in a crisis falls under a logical fallacy- the fallacy of composition, which is, according to wikipedia.org, the inference of ``something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).” As you can see, sensationalism will bring us nowhere.

To paraphrase Mr. Warren Buffett in his latest Berkshire annual letter, many of those suggesting for a crisis seems to direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.”

So until we see this “crisis” rear its ugly head possibly through further deterioration in the political arena which may diffuse into the real economy and most likely felt first in the markets, like the global depression tales, they belong to the genre of horror movies.

A Week of Milestones

``Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.”- Ludwig von Mises, from Lord Keynes and Say's Law, The Critics of Keynesian Economics, edited by Henry Hazlitt, University Press of America 1983

Figure 4: stockcharts.com: Milestone Highs in Commodities!

Last week was a week of milestones.

One, crude oil crossed the all important psychological threshold of $100 barrel (lowest pane), two, gold is only a breath away from another landmark $1,000 and copper nears its all time high at $3.95 a lb.

The CRB index too a composite featuring a basket of different commodities likewise is on a record run (pane below main window) as shown in Figure 4.

Of course, all this comes in the light of a US dollar index that has etched a lifetime low.

Meanwhile, Gold priced in the US dollar index (main window) - meaning against the Euro, Japanese yen, the Canadian Dollar, the British Pound, Swedish Krona and the Swiss Franc-which means not only has gold risen to a milestone high in US dollars terms but likewise against a basket of currencies represented by the US dollar index.

Of course, the burst of activities maybe interrupted by interim corrections.

Again others say that the next wave of credit derivatives implosion will sink these lofty gainers. This maybe true in the equities market but we aren’t convinced with regards to commodities. Others also say that inflation is a lagging indicator and would eventually fall as credit driven woes escalate. As we have noted before, monetary policies will have divergent impact to different countries. In addition, yes while demand maybe impacted by a slowdown but what of supplies?

Besides, as collective government attempts to socialize losses and increase interventions in the marketplace in the challenge to stabilize prices, we are likely to see even more distortions, more liquidity generation and more currency debasement activities—or your “moralistic” inflationary activities.

Figure 5: Comex Gold to the Philippine Mining Index: A clue of Future Prices?

In figure 5 we see the US comex gold shares take a spike, whereas local mining issues have not responded similarly. Is the COMEX gold sending us a signal of the prospective direction of our domestic Mining issues?

As a reminder, not all mining issues are cut from the same cloth.