Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline

As expected, Philippine inflation rates leaped to its highest level in 3 years according to the news wires.

Chart courtesy of abs-cbnnews.com: Soaring Philippine Inflation Rates!

The following quote from abs-cbnnews.com, ``The price of rice, a staple in the Philippines, soared in April by nearly 25 percent from a year ago. Overall food prices rose 12 percent, the National Statistics Office said on Tuesday.” (emphasis mine)

Earlier mainstream analysts primarily attributed the rise of our inflation index to higher oil prices from which refuted in our March 5 post, “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.”

And this was even prior to the emergence of the “rice crisis”. Now it appears that our view has been validated anew!

Remember the so-called inflation index is a LAGGING indicator, again to quote abs-cbnnews.com (highlight mine), “The Philippine’s annual inflation jumped to a near three-year high of 8.3 percent in APRIL, putting pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth”.

And implying stock market price movements based on a lagging indicator does not reflect the functionality of markets as forward discounting mechanism. Does the April data mean the same, better or worst for today?

In short, any attribution to inflation of the past as determinant of today’s market decline is all about “rationalization” or looking for a simplified explanation into today’s activities.

Notwithstanding, if inflation had been the “casual” agent responsible for today’s decline, why does it seem that even “inflation hedges” have been affected too?

The meat about the argument of inflation being a negative for the market is about pressures on corporate margins. Higher input costs and limited consumer pass through or pricing power crimps on corporate profitability. But this should not hold true for existing producers of commodities who are likely to benefit from rising values of “commodity products”.

It also means pressure on consumers in terms of declining standard of living.

An example would be this quote from Standard & Poors,

``In the world of higher commodity prices, corporate winners and losers fall into two distinct camps.

``Commodity producers are big beneficiaries. Their business outlooks appear generally strong and their ratings stable, in our view, as scarcity and worldwide demand affect everything from corn to copper. But companies that rely heavily on grains, oil, or other commodities to make finished goods face increasing costs, and thus weaker profits, if the slowing U.S. economy makes raising prices more difficult.

``The fallout from high commodity prices will be unequally distributed and determined by whether one is a buyer or seller of commodities. The level of commodity input into finished goods and the ability to raise prices will determine how serious the impact will be for commodity users. Low steel costs, for instance, are certainly better than higher costs for automakers. But steel is a relatively small part of a car's cost, and the woes of Detroit's Big Three (oil prices and labor costs, for example) go far beyond steel prices. Baked goods, cereals, meat, poultry, eggs, and dairy products all contain, directly or indirectly, large amounts of corn or wheat, so the impact of higher prices for those grains is widely felt among food processors. And the high price of oil will clearly be deleterious for industries like refiners or airlines, where oil is a major input.”

So when we see the market down with commodity producers similarly impacted, it is unlikely to be “caused by” inflation. Instead, it is likely caused by negative sentiment with all “excuses” lodged into it.

Moreover, if one notices the big drag to the sentiment today seems to emanate from the 8.28% decline of Meralco. While indeed Meralco stands only at 3.4% weighting of the Phisix, the purported action by the government to threaten a “takeover” if not a “change in management” is enough to create a pandemonium. Why? It is all about using populist politics as a cover to apply political vendetta or harassment. When government threatens (directly or indirectly) to “nationalize”, private ownership is compromised and thus, leads to destabilization.

Lastly, the world is into an inflationary boom. Inflation by the definition of a surfeit of money creation, massive credit expansion and re-intermediation, aside from spectacular speculative excesses.

The odd thing is that while we cheer the authorities to “save” the financial assets from being overwhelmed by market forces, paradoxically we jeer at the prospects of rising “product” prices when these systemic leveraging have mainly been responsible for the increased claims against limited resources, or too much money chasing too few goods.

No, product inflation will NOT move in a straight line. But for as long as people expect governments to provide more subsidies we should correspondingly expect such trend to be reflected in our way of living.

Further, on the account of the domestic scene, it will “pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth” as the report says.

This is what we wrote last April 6,

``As we have repeatedly said, negative real rates will likely trigger more speculative activities as the search for the alternative monetary function of “store of value” intensifies. This further reinforces more “inflation” within the domestic economic and financial system.

``So we may likewise expect the domestic central bank, the Bangko Sentral ng Pilipinas (BSP), to raise policy rates to keep up with rising treasury yields (falling bond prices)…

``Otherwise maintaining present rates amidst surging consumer price could lead to negative real rates across the entire yield curve, which should further aggravate the opportunity costs of holding cash.

``On the other hand, rising yields could lead to resurgent foreign capital portfolio flows predicated on currency yield spread arbitrages or carry trades."

So as the Philippines go deeper into NEGATIVE REAL RATES at the expense of savers and for added stimulus for borrowing and speculation, the BSP will be forced to raise rates. But contrary to expectations of further declines, rising yield spreads could as mentioned above entice foreign money into the markets which could increase inflation pressures.

Remember stock market investing cannot solely be explained by sheer earnings or economics (as previously explained), because it also reflects the function of money as a store of value.

chart courtesy of Wall Street Journal: OECD consumer prices

So even when the world (or OECD) has seen resurgent consumer price inflation…there seems to be no strong correlation about rising inflation and declining stocks yet.

chart courtesy of stock charts.com: Dow Jones Developed World Index

The Wall Street Journal Chart shows inflation accelerating in developed countries during the last semester of 2007 (red ellipse) even when the credit crisis was in the process of unraveling.

Yet, even as the appearance of a “peak” in inflation (based on the chart-but I don’t believe it has peaked), stocks has apparently recovered (which for some, signifies as a relief rally) in the backdrop of a “normalizing” US 10 year Treasury Yield.

Phisix: No Bubble! Time for Greed Amidst Fear

``So much of what we hear and what we're taught turns out to be false on closer scrutiny. Whether it is expert advice, what you read in the paper, or what your mother told you, if it is important, take the time to figure out for yourself whether it is really true.”-Steven D. Levitt, Co-Author of Freakonomics, on Figuring Things Out for Yourself

True to the functional transitions of the psychological cycle underpinning the general market’s direction, emotions have been sweeping away rationality like clockwork.

Some Signs of Psychological Capitulation!

Where in a downside cycle, mid stage characteristics as “desperation” and “panic” segues into the finale phase of “capitulation” and “despondency”, some market participants seem to have evinced symptoms of outright dejection by undertaking redemptions, or have utterly avoided or have completely lost interest, while others have even resorted to faultfinding.

These in conjunction with inordinately depressed market sentiment indicators and fundamental developments seem to reinforce our view that Phisix is likely to be nearing a bottom or could be in the inchoate juncture of a bottom formation in contrast to the mainstream thinking.

The basic problem for any investor is forecasting the future accurately. In determining the potential outcome of the markets, if the experts are vulnerable enough to fall for cognitive biases (heuristics or mental shortcuts), thus, it is natural to expect the public (who do not apply rigorous analysis) to give weight to the present direction of the ticker tape activities as the future outcome (recency bias). Yet unknowingly to latter, such biases could be detrimental to the performance of one’s portfolio, if not one’s health (physical or mental) or to relationships.

For instance, when the trend is up, the proclivity is to plough into the market using ANY justifications (available bias) while ignoring risk factors. Peer pressures lend to “missing or chasing the rally” attitude and the need to be “IN” popular trades, all of which expands risk taking activities while reducing returns.

“Experts” are expected to possess the magical powers of the Talisman to predict the next market darling. With the use technical instruments, the public is lured to catch short term “tops and bottoms” from which the legendary Jesse Livermore cautioned everybody wants “to get something for nothing”.

And when the trend is down, the hope of recovery dims, risk aversion grows while the appetite for financial voodoo vanishes, condemnation and depression eventually governs. This is the unfortunate, unpalatable and revolting realism of the marketplace; people simply get what they deserve.

This is where we would like to differ. As we have repeatedly argued, our observation is that long term trends in every asset cycle are basically determined by the Inflating or Deflating of Bubble cycles, operating under today’s monetary “paper money” framework.

Yes, despite the realization of an unfolding bear market today, our belief is that the long term cycle remains grounded in the ADVANCE phase and today’s decline accounts for a cyclical speed bump on the following premises:

1. There are NO signs of a local bubble yet.

2. Every asset boom bust cycles are determined by expansive growth or reversals of frenetic speculation powered by an overdose of leverage from massive credit and or money expansion. We don’t see them yet in the Phisix or the Philippine Economy.

3. The long term risk reward tradeoffs in the markets greatly depends on understanding the dynamics of how the bubble cycle impacts our investments and correspondingly applying such knowledge to balancing our portfolio, profitably.

Parabolic Prices In My Dreams

Today’s bear market is likely to be a temporary phenomenon. Why? Because the Phisix has climbed only by 2.8x from trough to peak in FOUR years (June 2003-July 2007) as compared to the recent experiences of Saudi’s Tadawul and China’s Shanghai Composite (see linked charts) which has exploded by 5.7x and 5x in just TWO-THREE years.

Why the indices of China and Saudi you ask? Because these bourses have exhibited exemplary volatility, in terms of speed and velocity and the duration and scale of movements, which has almost replicated a bubble’s behavior.

Yes, while China’s bourses have suffered from a steep decline (have lost nearly 50%), it has made an astounding rebound over the past two weeks. Meanwhile, despite the abrupt drop of about 65% from its zenith in February 2006, Saudi’s Tadawul seems visibly bottoming out after more than a year of consolidation and looks forward to the next wave up.

What seems to be noteworthy in the activities of both bourses is Newton’s third law of Motion at work, ``Every action has an equal and opposite reaction”.

The lesson is pretty clear: the magnitude of volatility reflects the scale of momentum swings-SHARP SPIKES EQUAL DRAMATIC DECLINES!

However, if we are to examine the phenomenon of how a bubble evolves, we can discern that the action of these bourses as possibly still in a bullish phase over a long period.

Figure 1: Moneyweek.com: Stages In A Bubble

Figure 1 courtesy of Dominic Frisby of moneyweek.com depicts of how bubbles in asset classes develop and unravel.

As you can see from the above diagram, ALL bubbles undergo transitions from the STEALTH phase to the AWARENESS phase to the MANIA phase to the BLOWOFF phase.

This means that incipient trends are generally unrecognized or incubated in a “stealth” phase and are seen or engaged only by a few contrarians “smart money”. As the trend gets accepted or reinforced, this draws in more institutional participants or the awareness phase.

The trend eventually gets a wider audience, but gets tested (First sell off or the bear trap).

Following a successful test, the “tipping point” has now been attained as evidenced by deepening convictions which eventually leads to a broadening of the participation from the general public, bolstered by media as the market transits to the mania phase.

Enthusiasm or cautious optimism then morphs into greed, excessive risk taking, feelings of infallibility or overconfidence and the delusions of permanent grandness or the proliferation of infamous equivalent phrases of “this time its different” or “new paradigm”, where deep-seated convictions clashes with realities. This represents as the Blow-off phase.

Eventually a climax is reached, reality pervades, the house of cards fall under its own weight (or prompted by policy shifts) and the bubble pops. The whole cycle goes into a full reverse.

So where is the Phisix today, according to the bubble cycle?

Figure 2: Phisix’s Monthly: First Major Test?

First, let us use the past cycle of the Phisix as an example as shown in Figure 2.

In the 1986 to 2003 cycle (blue frame), the Phisix entered into the awareness phase in 1986 and encountered its first major test which was apparently triggered by an aborted coup d'état attempt at Camp Aguinaldo in 1987. The next “test” came with another botched coup attempt in December 1989 at Makati. Both “tests” incurred losses of nearly 50% spread over 1-1/2 years before recovering.

What happened after the “tests”? The Phisix skyrocketed by 458% in three years (1991-1994)!

When the Asian Financial Crisis scourge hit the Phisix, we saw the same dynamics as seen in the Saudi-China’s model, Newton’s “Every action has an equal and opposite reaction” in motion. The Phisix lost more than two thirds of its gains, bounced back ex-post the Presidential elections and excruciatingly returned every gains it accrued during the bounce, over the next three years or until late 2002 to early 2003.

Today, following the completion of the full cycle, the Phisix appears to be in an awareness phase which seems to have met its first acid test or its baptismal resistance or its bear market trap after FOUR years, see again figure 2.

This means that if I am correct about the interpretation of the next phase of the Phisix, it is likely that once the recovery gets a firm footing, the next velocity of gains will eclipse the performance of 2003-2007. Think about it, if the Phisix should repeat its past 400% gains from present levels, this means that the Phisix should reach more than 13,000, way above my 10,000 forecast!

No Signs of Public Exuberance or Euphoria

Next, another prominent feature of a bubble is pubic exuberance.

As shown in our bubble diagram, each of the phases exhibits different types of investor involvement.

The stealth phase attracts SMART Money or the Contrarian players (remember our Phisix 2002, mining in 2003, Peso in 2004), the awareness part draws in INSTITUTIONAL money and lastly, RETAIL investors jump on the bandwagon in a MANIA which then leads to the final BLOW OFF phase.

We have seen this happen in China just recently before the “bubble popped”, where 250,000 new accounts were opened daily by retail investors including maids (estimated 99 million new accounts in 2007-sovereign society)!

Have we seen a profusion of public participation as manifested by a massive influx of retail players? I doubt so.

I have previously shown this chart in my outlook.

Figure 3: PSE Daily Trades: Best measure of Local Speculative Activity

We don’t have data on the opening of number of NEW accounts, but we can have a rough approximation of retail activities as signified by the number of trades.

Since retail investors tend to be short term players, my impression is that the rising trend of the daily trades reflects on the speculative activities of retail investors.

As shown in Figure 3, although yes, there had been some signs of a build up of speculative activities from mid 2006, the momentum was easily quashed triggered by the global credit crisis in 2007.

You have to remember that the Phisix climbed from 2003-2006 by about 127% with daily trades drifting within a range. This supports the view that the Phisix has been gradually wended from the stealth phase to the awareness phase where buyers were mostly from “smart” money camp.

Thus, this implies that even before the Phisix bubble took off, it popped! The Phisix Bubble has effectively been deferred! Seen in a different light, this process should even be more beneficial to us, since it gives “smart” money a second major opportunity to build up on our portfolio to take advantage of depressed retail sentiment which should lengthen the bubble cycle and proffer marvelous opportunities of outsized profit returns!

No Evidence of Excess Leverage

Third, ALL bubbles are driven by excessive leverage from massive credit and or monetary expansion.

Think of the Phisix and the Asian crisis in 1997, 2000 Nasdaq dotcom bust, 1990 Japan’s stock market and real estate bubble bust, the US housing bust in 2006 and the commodity bust in 1980 to name a few. The common denominator has been a pyramid built on the walls of leverage.

As previously pointed out, we have very miniscule exposure of US mortgage related tainted papers which according to reports figures to only about .2% of the total banking assets.

We also have not seen material signs of ballooning credit or leverage in any of our macro and micro statistics yet (e.g. Real estate loans, stock margins, current account deficits, corporate loans, etc.).

Figure 4: IMF: Asset Price Developments (left), External Liabilities (right)

For instance, external liabilities as % of GDP has been falling drastically (see figure 4 right window), which means Philippine credit risk relative to foreign debts have considerably declined, albeit it remains to be seen how the recent “politicized” policies on the rice crisis will impact this.

However based on past performance this excerpt from the IMF,

`` External liabilities by Philippine residents (as measured by FDI liabilities, gross portfolio liabilities, and other liabilities—currency and deposits, as well as loans) have fallen sharply since 2004. Starting from a level above 90 percent of GDP, which was raising serious sustainability concerns, external liabilities had declined by over 20 percentage points of GDP by 2006. This sharp decline reflects the significant debt prepayments of the general government and corporate sectors (including the highly indebted power sector).”

`` This reduction is particularly stark in comparison with other countries. The Philippines was a clear outlier at the start of the decade. Since then, the Philippines’ total gross foreign liabilities (as a share of GDP) have converged rapidly to the levels of emerging Asia and emerging Latin America., and by 2006 had actually fallen slightly below the averages of both regional groups.”

The IMF in their April Staff report issued this statement (emphasis ours),

``There is no clear evidence of an emerging bubble. Partly reflecting developments in Asia, asset prices have bounced back. However, property prices are still below the 1997 level. Equity market prices have risen faster with the PE ratio reaching 15½ at end-2007. Equity prices have fallen by more than 10 percent during the first three weeks of 2008, now implying a PE ratio well below the worldwide average of 21 during 2001–06.”

So, there you have it…essentially for Philippine assets you have NO EUPHORIA, NO SPECULATIVE EXCESSES, NO OVERVALUATION and NO MASSIVE LEVERAGE! Ergo, NO BUBBLE!

The main market risk today comes mainly from domestic populist politics and from external variables or the transmission effects of a global economic slowdown which could lengthen the entire process but is unlikely reverse the present cycle unless a black swan occurs (possibly from US dollar crisis or global depression or world war).

Heeding Buffett’s Advise: Be Greedy When Others Are Fearful!

Thus we ask ourselves, how can we afford to be bearish when the cycle insinuates that we are still locked in a long term “advance” phase or a bullmarket? Not unless if our horizon is TOO SHORT, as to read in today’s action as an everlasting trend.

Dr. John P. Hussman, Ph.D. of the Hussman funds offers some sagacious advice, ``Good investments are those based not on hope, but on some foundation of evidence – either of reliable “investment merit” (based on properly normalized valuations), or of measurable “speculative merit” (based on the quality of market action). Taking a significant exposure to market risk without such foundations is like moving into a house built on sand.”

We should instead take a cue from the world’s best stock market investor and now the world wealthiest, billed as the sage of Omaha, Mr. Warren Buffett, who appears to have embarked on a buying spree following years of holding a war chest of over $40 billion.

In a lecture at Columbia University at age 21 Mr. Warren Buffett was quoted, ``I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."

Now that we have been seeing many worsening signs of fear, I think it is time to gradually take advantage of such opportunities.

Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited.”- George Soros

Activities in the financial markets can never be explained in a straightforward narrative manner.

You’d probably wonder why despite gloomy economic news in the US and in other major developed economies aside from declining corporate profits, global stock markets continue to remain elevated or are surprisingly even advancing.

Moreover, as commodities recently tanked some observers commented that the reason stocks are recovering could be due to falling inflation pressures which could likely improve corporate margins. Such argument appears unfounded.

If it is true that commodities prices have been boosted by soaring demand, then the present pace of decline should imply of contracting demand, which could be reflective of a meaningful downshift in global economic growth, see figure 5.

Figure 5: US Global Investors: Moderating Asian Exports

Asian exports are, as shown by US Global Investors, all rolling over led by a severe decline in US imports. Now the decline has been similarly seen with European imports but in a time lag. Imports of commodity producers have likewise “peaked”.

Thus, by sheer induction, equity asset prices should continue to face pressures from downside revaluation, unless the markets foresee a recovery over the near term (which is very unlikely).

In addition, if it is also true that the falling US dollar have prompted for a commodities “bubble” as argued by some then the recent US dollar rebound suggests of liquidity contraction or a monetary tightening which should also signify negatively for equities too.

Yet, stock markets continue to perform strongly even when seasonality factors such as “Sell in May and Go Away” say it shouldn’t.

Drooling Over US Financials

Meanwhile others have been drooling over at the gains accrued by the US financials following the recent bear market “reversal” marked by the buyout by JP Morgan of investment bank Bear Sterns under the facilitation of the US Federal Reserves. The impression etched by the rallying US financials is that it has bottomed or is on a path towards recovery.

We doubt such premise. To quote Mohamed El-Erian of PIMCO,

``Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.”

This means that even if the Fed have “successfully” patched some of the liquidity dislocations in the financial markets (as evidenced by some improvements or narrowing of credit spreads) by absorbing tainted assets as eligible collateral, recessionary pressures from the real economy could add to its portfolio (consumer) loan losses which are likely to require additional capital raising exercises given the delicately compressed capital ratios, as much it is likely to its impact business operations in an environment of slowing demand, tighter lending standards and reduced investments.

Nevertheless, the disruptions (unidentified losses) in asset securitization remain an unresolved problem aside from the onus of new government regulations.

Global Central Banks Inflating Away….

So, again why are the stock markets surging?

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

In contrast to mainstream analysis, our view on the stock market has always covered “inflationary” policies conducted by monetary authorities.

It is a reason why we believe stock markets don’t always relate to the oversimplified tale of micro/macro economics or corporate earnings and may diverge from “realities”. Because central banks can always excessively inflate the system, from which to serially “blow bubbles” in terms of assets or goods as the purchasing power of a currency erodes.

We always love to cite Zimbabwe as an example. The country has been suffering from successive years of chronic hyperinflationary depression whose inflation rate is 165,000%, has 80% unemployment rate and whose currency is traded at Zimbabwe $150 million per US dollar when officially pegged currency is at Zimbabwe $ 30,000 to a US dollar or 5,000x its official rates! You can just imagine the Philippine Peso pegged at 42 to a US dollar but whose black market rate is at P 210,000 to a US dollar.

Yet in spite of the depressed earnings (no earnings to talk about) and a recessionary economy, its stock market has soared by 360% in just three weeks! See the irreverence to mainstream analysis?

We seem to have the same dynamics today in global markets. What we could be witnessing is the impact of concerted REFLATIONARY policies by global central banks. And this has could have spurred the “rotation away” from commodities and into the general equity markets spearheaded by the financials (But this “rotation” isn’t likely to be a lasting trend).

This from Morgan Stanley’s Joachim Fels, ``global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years.”

So essentially, the Fed has been injecting steroids into the financial markets, as much as other major global central have provided liquidity support to a distressed financial system, while emerging markets have long undertaken expansionary policies that has nurtured explosive demand growth in food and energy. In addition the recent spikes of food prices have further aggravated such these inflationary measures of instituting safety nets to buy off political stability.

Figure 6 US Global Investors: Asian Real Rates are Negative!

So circumstantial evidence suggest that the recent bounce in global equity markets could have been in response to the expansionary monetary policies whose real interest rates has somewhat turned negative, as shown in figure 6 courtesy of US Global Investors which accounts for the average real rates in Asia. The region holds about 70% of foreign exchange reserves. Negative real rates are likely to support more leverage driven speculative activities.

Dissent Over Subsidies, Risks of Heightened Inflation and Moral Hazards

And the efforts to subsidize the financial system has not ended in the US as the US Federal Reserves continues to expand the scope of its outreach “nationalization” programs to cover unconventional areas as student loans, credit card debts and car loans as collateral for financial institutions.

Some experts/authorities have expressed dismay over the seeming relentless use of taxpayers money to support the financial sector…this quote from Bloomberg, ``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Two more quotes from the same article,

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The point is that policy measures undertaken by the Bernanke leadership have clearly caused some vocal dissent over the risks of increased inflationary pressures.

Snippets

The snippet of my observations:

-Inflationary activities (marked by negative real rates) by global central banks could have been responsible for bloating global equity markets.

-The recent outperformance of the financials which took away the centerstage from commodities isn’t likely to be an incipient long term trend, as continued inflationary “nationalization” programs are unlikely drivers for such reversal. Moreover, recessionary pressures in the US economy are likely to limit any progress for US financials.

-The commodity cycle works best in a negative real rate environment. This could mean that the recent decline of commodities doesn’t account for a hissing bubble but possibly of a normal corrective phase following its near parabolic ascent.

-The expectation of a reversal of the US dollar long term downtrend coming off a Fed pause is likely to be too optimistic. Since the Fed keeps expanding the reach of its bridge financing bridge facilities, this seems enough evidence that its credit system has not yet normalized and could signify as a considerable obstacle to expectations of an earlier recovery by the US economy relative to the world. In short, the US dollar’s recent rally could be an oversold technical bounce.

-While activities in the US treasuries could imply the end of the Fed rate cycle, this would likely depend on the activities in the US stock market which evidently has been proven as a mainstay barometer of Mr. Bernanke.

-Back to the Philippine Stock Exchange. Against a backdrop of recovering world markets, the Phisix seems to be the only laggard for unclear reasons. Yet, as we mentioned before, excessive negative sentiment, negative yield environment, extremely oversold levels and favorable external developments have recently aligned to suggest of a looming noteworthy tradeable bounce if not a potential bottoming process.

Figure 7: ino.com: Rice Prices Off the Record Highs

If the excuse for this slump has been predicated on the rice crisis, then as figure 7 courtesy of ino.com suggests, such “rationalization” may not hold soon.

Noteworthy Insights on the Rice Crisis

Some important insights on the Rice Crisis…

All highlights mine

From Tyler Cowen published at the New York Times…

“Restrictions on the rice trade run the risk of making shortages and high prices permanent. Export restrictions treat rice trade and production as a zero- or negative-sum game where one country’s gain comes at the expense of another. That’s hardly the best way to move forward in a rapidly growing world economy.

“This lack of support for trade reflects a broader and disturbing trend. An increasing percentage of the world’s production, including that for agriculture, comes from poor countries. Over all, that’s good for rich countries, which can focus on creating other goods and services, and for the poor countries, which are producing more wealth. But it can slow the speed of adjustment to changing global conditions.

“For example, if demand for rice rises, Vietnamese farmers — who remain shackled by many longstanding regulations of communism — aren’t always able to respond quickly. They don’t even have complete freedom to ship and trade rice within their own country.

“Poorer countries also tend to be the most protectionist. To make matters worse, about half of the global rice trade is run by politicized state trading boards.

“The reality is that many of today’s commodity shortages, including that for oil, occur because ever more production and trade take place in relatively inefficient and inflexible countries. We’re accustomed to the response times of Silicon Valley, but when it comes to commodities production, many of the relevant institutions abroad have only one foot in the modern age. In other words, the world’s commodities table is very far from flat.

“Many poor countries, including some in Africa, could be growing much more rice than they do now. The major culprits include corruption in the rice supply chain, poorly conceived irrigation systems, terrible or even nonexistent roads, insecure property rights, ill-considered land reforms, and price controls on rice.

“The ability of a country to grow rice depends not just on its weather, but also on its institutions. Burma, now Myanmar, was once the world’s leading rice exporter, but it is now an economic basket case and many of its people go hungry.

“Of course, wealthy countries are partly at fault, too. Japan, South Korea and Taiwan all protect their native rice farmers; you’ll even see rice being grown in Spain and Italy, aided by European Union subsidies and protectionism. The United States spends billions subsidizing domestic rice farmers.

From Steve Hanke published at Cato.org...

“The economics of commodity markets provides the key to unlocking this mystery. The net cost of carrying inventories is equal to the interest rate, plus the cost of physical storage, minus the "convenience yield".

“The convenience yield is driven by the precautionary demand for the storage. When the convenience yield is zero, a market is in "full carry", future prices exceed spot prices and inventories are abundant.

“Alternatively, when the precautionary demand for a commodity is high, spot prices are strong and exceed future prices, and inventories are unusually low.

“As the term structure of rice prices makes clear (see chart), the precautionary demand in Thailand is not elevated and inventories are ample. Indeed, for the term structure of prices to be signaling unusually low inventories, the term structure would be negative in slope, not positive.

Chart courtesy of Cato.org

“In most countries, rice production and trade are subject to a plethora of laws and regulations. Subsidies to rice producers and consumers are widespread. Tariffs on imports and exports are common, as are import and export quotas.

“Many of these policies derive from a food security rationale and the desire to keep a large proportion of rice production at home. In consequence, rice markets are segmented, with wide differences in rice prices (adjusted for rice quality and transport costs) among countries.

“Not surprisingly, a relatively small proportion – only 6%-7% – of world production is exported.

From IMF’s Dominique Strauss-Kahn

“Although aid is the first step, we must be bolder in tackling the long-term challenges of food supply.

“Many farmers are not increasing output because they are not equipped to gear up production or because market distortions mean they do not benefit from higher food prices. So, just waiting for the market to self-correct is not a satisfactory option.

“We must not lose sight of longer-term solutions. This calls for a more global approach to policies. Agricultural policies must change. Higher food prices over the past few years in part reflect well-intentioned, yet misguided policies in advanced economies, which attempt to stimulate biofuels made from foodstuffs through subsidies and protectionist measures.

“High food prices also reflect imprudent agricultural pricing policies in some developing countries, and these too need to be improved.

“No one should forget that all countries rely on open trade to feed their populations. But we are already seeing actions at the national level, such as curbs on food exports, that have a damaging global impact. Completing the Doha round would play a critically helpful role in this regard, as it would reduce trade barriers and distortions and encourage agricultural trade.

“The International Monetary Fund and the World Bank are also engaged in discussions to improve both industrial and developing country policies. Multilateral agencies are stepping up lending to the agricultural sector in poorer and middle-income countries to encourage and support good policies. But there is more to do, and the World Bank's New Deal on Global Food Policy is a big step forward.

“We also need a new approach to risk mitigation and insurance at the level of both individual farmers and countries. Important steps are being made in this direction by aid donors with regard to catastrophe insurance and developing robust futures markets. This can greatly help assure farmers that, if they make investments, they will reap the rewards.

“We should consider adopting a similar philosophy to dealing with shocks - including, but not limited to, energy and food prices - at the macroeconomic level. Countries need to feel more assured that insurance-type financing will be available in times of need. The IMF will play its part in this regard.

From Martin Wolf of the Financial Times...

“Are prices going to remain high? Two opposing forces are at work. The first is the market, which will tend to bring prices back down as supplies expand and demand shrinks. But the latter is also what we want to avoid, at least in the case of the poor, since reducing their consumption is not so much a solution as a failure. The second force is the current intense pressure on the world's food system. This is true of both demand and costs of supply. Prices are likely to remain relatively elevated, by historical standards, unless (or until) energy prices tumble.

“This, then, brings us to the big question: what is to be done? The answers fall into three broad categories: humanitarian; trade and other policy interventions; and longer-term productivity and production.

“The important point on the first is that higher food prices have powerful distributional effects: they hurt the poorest the most. This is true both among countries and within them. The Food and Agricultural Organisation in Rome recently listed 37 countries in substantial need of food assistance. Moreover, according to the World Bank, soaring food prices threaten to make at least 100m more people hungry.

“Increases in aid to the vulnerable, either as food or as cash, are vital. Equally important, however, is ensuring that the additional supplies reach those in greatest difficulty. The options depend on the sophistication of a country's bureaucratic machinery. But they include work paid directly with food (which is a good way of screening out the better-off), a rationed supply of cheap food for the poor or cash vouchers. Those most in need will be the landless, both rural and urban, and marginal subsistence farmers.

“Now turn to the policy interventions. Protection, subsidies and other such follies distort agriculture more than any other sector. Alas, the opportunity to eliminate protection against imports offered by exceptionally high world prices is not being taken. A host of countries are imposing export taxes instead, thereby fragmenting the world market still more, reducing incentives for increased output and penalising poor net-importing countries. Meanwhile, rich countries are encouraging, or even forcing, their farmers to grow fuel instead of food.

“The present crisis is a golden opportunity to eliminate this plethora of damaging interventions. The political focus of the Doha round on lowering high levels of protection is largely irrelevant. The focus should, instead, be on shifting the farm sector towards the market, while cushioning the impact of high prices on the poor.

“Finally, far greater resources need to be devoted to expanding long-run supply. Increased spending on research will be essential, especially into farming in dry-land conditions. The move towards genetically modified food in developing countries is as inevitable as that of the high-income countries towards nuclear power. At least as important will be more efficient use of water, via pricing and additional investment. People will oppose some of these policies. But mass starvation is not a tolerable option.

From Caroline Baum of Bloomberg,

“Many Asian countries, including India and Vietnam, are banning rice exports to ensure adequate domestic supplies. Last week, Indonesia stepped up border patrols to guard against rice smuggling.

“By barring producers from selling overseas, demand for rice in any given country is lower than if the Asian food staple were freely traded internationally. The demand curve shifts back, the price and quantity demanded are reduced….

“It may be a noble idea for poor countries to transfer income from producers to consumers, but it's one that comes with a long history of unintended consequences.

“Governments continue to interfere with the law of supply and demand; that's to be expected. What's surprising is that so many practitioners of the dismal science can't seem to get it right either.

Does Declining Remittances By Latinos Bode Ill For The Philippines?

This is where it gets interesting.

chart courtesy from the New York Times

This from New York Times’ Julia Preston…

``In a sign that the economic downturn is hitting hard among Latino immigrants, more than three million of them stopped sending money to families in their home countries during the last two years, the Inter-American Development Bank said on Wednesday.

``With fewer people sending money home, money transfers to some Latin American countries have started to decline, reversing five years of often spectacular growth. In the first quarter of this year, transfers to Mexico dropped 2.9 percent from the first quarter of 2007, Mexico’s central bank reported on Wednesday, the first significant decline since Mexico began tracking the transfers in 1995.

``For Latin America as a whole, the amount of the money transfers, which are known as remittances, remained virtually flat over the last two years, the development bank reported. It estimated total remittances to the region at $45.9 billion in 2008, an increase of $500 million over 2006.

``That contrasts with the period from 2001 to 2006, when the amount of remittances to the region tripled, to $45 billion from $15 billion, according to figures from the development bank, a multilateral organization based in Washington that finances development projects in Latin America. Total remittances did not drop more sharply in the last two years because those immigrants who continued to send money sent larger amounts more frequently, the bank’s survey found…

***

The Philippine Peso has been on a decline following the revelation of the Rice Crisis.

Now that we see signs of declining remittance trends in Latin America, this should pose as a double whammy for the Peso IF we believe the “experts” are correct that remittances have principally driven the Peso’s appreciation.

Let us see.

Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom

``The collapse of the southwest real estate bubble in the United States didn't prevent investors from over-investing in Asia. The Asian crisis didn't prevent the Nasdaq bubble from developing. [I was] surprised by how rapidly the crisis mentality vanished. People can forget the lessons of a painful experience very quickly, and that can lead to poor decisions." Robert Rubin (Sep 2004)

Oops. Just as we thought we found the first clues of a bottom, the Phisix got whacked by almost 4.7% over the week on ferocious foreign selling.

This could probably be due to the downgrades slapped by some foreign institutions to emerging markets economies rocked by the present rice crisis such as the widely followed BCA Research whom recently wrote (highlight mine)…

``higher inflation and upward pressure on interest rates, rising social tensions could force policymakers to forgo proven market mechanisms, creating distortions that have long-lasting and harmful economic implications. In turn, this can lead to higher risk premiums on asset markets. The negative shock and risk of pass-through from skyrocketing food prices will be greater in the economies with a rigid supply side and low competition. Moreover, countries where the currency has been sliding will feel the effect of rising global food prices much more acutely. Bottom line: We are positive on emerging equity markets as a whole, but are concerned about the outlook for South Africa, Argentina, Indonesia, and the Philippines because of the lack of supply side reforms over the past several years and escalating threats from food inflation.”

Coincidentally, countries negatively rerated by the BCA Research likewise suffered from a severe thrashing this week as shown in Figure 1.

Figure 1: stockcharts.com: Possible Impact from Downgrades

And the losses were quite severe: for the week, Argentina’s Merval plunged 3.89% (mid pane), Indonesia’s JKSE plummeted 4.63% (pane below center window-Dow Jones Indonesia Stock), and least affected, South Africa FTSE/JSE Top 40 dropped 1.59% (bottom pane-South Africa iShares).

This is not to pin the responsibility on a single research entity for having to recommend an “underweight”, (although they indeed command a good following among international financial institutions), the point is, the continued hysteria over the rice crisis has been generating a bad image at a time when the sentiment for risk aversion is high enough to severely affect domestic asset prices as we see today.

Yet, with government continually throwing in more subsidies at the expense of the country’s fiscal conditions (more short term placebos for long term damage-our children pays for increased tax burdens), we can’t entirely fault them for such dire outlook; this seems more of a self-inflicted predicament. Yes, we simply love to shoot ourselves in the foot.

Rice Crisis: Distinguishing Noise From Facts, Transmission of Price Signals As A Cause

As we said last week, while yes, there is indeed a global food crisis; the “rice crisis” in the Philippines seems more noise than reality.

First we don’t see snaking queues for commercial rice. Those lines in TV and elsewhere in media are with subsidized NFA rice.

Second, evidence exhibits that it is largely a policy induced crisis. Subsidies have been providing incentives for arbitrage opportunities through price spreads from which some people have responded to, thus aggravating the demand supply imbalances.

Next, you have a central bank promoting more inflationary policies by keeping interest rates at present levels while consumer prices have been surging. This deepens the incentive to “hoard” tangible goods as the purchasing power or the “store of value” of the Peso diminishes.

Moreover, we have argued that price signals have not filtered to farmers enough for them to increase income or investments, as their output have long been constricted by traders and merchants and by price controls from the government purchases. An article from the Inquirer.net supports this premise,

From Philippine Senator Edgardo Angara, ``By the time the NFA comes in, the traders have already scooped up the entire harvest. They cannot even buy 10 percent. If you buy less than 10 percent, you're not going to influence the price movement.”

More again from the Inquirer (emphasis mine)…

``Maintaining stable prices all year round within reach of the poor and yet at the same time providing farmers with reasonable profit had been an NFA conundrum. NFA has suffered significant losses through the years as prices had been volatile and incomes of farmers have been low.

How does one maintain stable prices and reasonable profit for farmers when the market is controlled by select interest groups and by the government? The problem is essentially one of effective transmission of price signals to the farmers arising from misdirected government intervention.

When rice prices are capped and manipulated by certain interests groups aside from the lack of alternative markets (commodity spot and futures) which restricts output, financing access, hedging options and insurance coverage the result is the above “conundrum”; imbalances whose pressures have been building eventually reaches a culmination point-today’s crisis.

You don’t solve the problem of price signals with more price distorting interventions. Not even with absurd populist solutions as the so-called “genuine land reform” with poor international track record or more “distribution” centers which do nothing but increase taxpayer’s burden and resource allocation inefficiencies.

Again to quote Senator Angara (emphasis mine), ``If we let go of the NFA and give it full rein subsidizing and importing rice, then we will have a bottomless pit that will be hard to fill because it will consume so much of our taxpayers' money."

If a full subsidy to the NFA, whose institution has been reckoned as ineffectual and a source of corruption, consumes much of our taxpayers’ money, in the words of the good senator (at least we are delighted to see a politician display a good deal of common sense!), what do you think goes with land reform or more government distribution centers? You only throw the public’s money to address the symptoms and not the cause. Moreover, an unthought-of reactionary response tend to have unexpected consequences at the expense of the general public via direct or indirect taxation (higher prices) or other future crisis! In addition, you don’t get increased productivity by edict (Stalin and Mao tried it and failed miserably); it is done via the transmission effects of prices through profits.

Third, the fact that 1 million hectares of fallow agricultural properties had been reportedly leased to China is circumstantial proof that there are large scales of “unproductive” and “uncultivated” lands which simply needs to activate in order to contribute to the supply factors.

Market directed or government instituted, these idle lands will come into play as the global commodity cycle will induce more investments in response to supply demand asymmetries as reflected by market prices.

Notwithstanding, technological advances will certainly usher in the next wave of Green Revolution, an era marked by surging agricultural yields (1940-1960s) powered by product innovation.

We are not only blessed with vast amounts of agricultural lands, we are also fortunate enough to have the world’s major rice institute the International Rice Research Institute (Irri) headquartered in the Philippines. Reports say that the IRRI are in the final stages of introducing a new biotech hybrid variety (Aerobic and Submarine) which have the potentials to increase harvest yields by reducing sensitivity to drought, flooding or salinity.

Of course, there is always opposition to anything, this time the issue centers on compelling our farmers through taxpayer funds to adapt to this hybrid. If the new product has the potentials as advertised, it won’t need government’s money to get accepted and become a standard.

The point is that higher prices are forcing new investments into the industry as well as in the technology frontier which eventually translates to more supplies.

That’s why we’ve been bullish with agriculture all along. Have we not been right with this cycle?

Rice Crisis and Political Survival

Of course another dimension or ingredient to this problem is one of politics; the need by the incumbent to be seen by the public as doing something or what I call the Superman effect. People are wired to see images of heroes in action, thus the natural predisposition towards publicity stunts.

With a politically embattled administration coming off from a slew of scandals, such crisis provides the opportunities for diversionary PR stratagem, which perhaps is part of the theatrical plot, at the expense of our financial markets. What more attraction than to throw the public’s money to the “poor”! As a neighbor quipped, for “Pogi” points.

Everybody bleeds for the poor, the problem is more solutions via inflationary policies and price distorting laws or policies addressed to the “poor” increases the numbers and plight of the “poor”. People can’t seem to differentiate the trade off between today and tomorrow.

And this also why much of the world is turning into “socialism” via inflationary policies which will certainly keep the tabs of rising consumer prices until eventually either prices will be so burdensome enough to choke off demand where any government stimulus won’t work (“pushing on a string”) or provoke wars or prop more dictatorial regimes (furthers inflation) or that people would come to the realization of governments’ pretensions via the collapse of the present money standard or until a new “Paul Volker” appears.

Phisix: Still In Search For A Bottom

Nevertheless, with respect to the Phisix as we noted last week, while sentiment has produced some signs of a potential bottom, we further commented that this has to be backed or confirmed with positive technical action coupled with DURABILITY from external factors. This week’s action proved otherwise.

The intense selling produced a divergence with most international stock market benchmarks effectively decoupling from us as we turned lower.

Meanwhile, technical actions dramatically deteriorated as the Phisix fell to its major support level (again see Figure 1) where it is presently perched with the likelihood of a potential breakdown test given the intensity of the latest shakeout.

There are two likely scenarios here, one is that a successful breakdown means that a Phisix floor has yet to be established which means there could be more downside market actions.

The other is that the Phisix bounces from the present levels or from its 2,773 lows which could carve out a bullish double bottom pattern. Yet even if a double bottom does emerge it could take probably take sometime before the Phisix recovers meaningfully and exit from its declining phase reinforced by improving market action, sentiment, fundamentals and decreased sensitivity to external variables (or improvements abroad).

To be sure, we are still in a bear market until clearer signs of the bottoming phase sets in. Here is what we wrote, during the latest bounce last March in Missing Rallies or Catching A Falling Knife?

``Remember, bearmarkets draws in hopes of investors until they capitulate. If a decision has been made to enter the market today, then the expectation should be geared towards the longer horizon since the risks is likely tilted towards more potential downside actions or the risks of a portfolio going underwater. For me, trying to bottom fish or picking market tops is a game of vanity.”

So again have we been wrong with the cycle?