Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation

``Since the function of government in issuing money is no longer one of merely certifying the weight and fineness of a certain piece of metal, but involves a deliberate determination of the quantity of money to be issued, governments ..., it can be said without qualifications, have incessantly and everywhere abused their trust to defraud the people." Friedrich von Hayek, Denationalization of Money

The Philippines Phisix got afflicted with dengue fever even before the US caught cold.

Figure 6: courtesy of stockcharts.com: Phisix Underperforms The World!

Yes, world markets of late have been going down, but our Phisix have been totally battered or have underperformed relative to its peers see figure 6.

The Phisix is down against its neighbors as gauged by the Fidelity Southeast Asia fund (FSEA-at main window), it is also down against MIDDLE EAST and AFRICA (SPDR S&P Emerging Middle East And Africa-above pane), it is down against Asia ex-Japan (pane below main window) or relative to Emerging Markets (lowest pane)!

So what is going on?

As we previously discussed in Phisix: Domestic Participants Panic! Bottom Ahoy?!, the principal activities in the Philippine Stock Exchange has seen a marked shift from formerly massive foreign selling to an onslaught of impulsive retreat by undiscerning local players.

Yes, this time with foreign participants relegated to the sidelines, local investors continue to stampede out of the PSE!

Foreign participants constituted only 43% of the week’s transaction EXCLUSIVE of the Php 4.738 billion special block sales of Globe Telecoms with Net foreign selling amounting to a scanty Php 176 million.

If we include the special block sales of Globe Telecoms the net foreign buying balloons to P 4.49 billion but foreign trade as pc (%) of total trade increments to only 44%. On Wednesday the 25^th foreign trade accounted for only 30% of the overall trade. The seeming material reduction of foreign trade leaves the Phisix vulnerable to highly impetuous local players who don’t seem to know what is happening.

Reading the ASIAN Yield Curve, The Inflation Bogey

Figure 7 Asianbondsonline: ASEAN Yield Curve

Figure 7 courtesy of ADB’s Asianbondsonline.com depicts of the yield curve of ASEAN sovereign bonds.

For starters, on the Y-axis is the bond yield in %, while the tenor or the maturity in years is found on the X axis. The connected dots signify the yields of the sovereign bonds spread into years.

According to the Federal Reserve Bank of San Francisco, ``The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future. The shape of a yield curve also may provide clues to future interest rate movements—a humped curve indicating that short-term rates (over the next year) are expected to rise, but that over the long-run (several years) rates are expected to fall. The overall level of the yield curve also may shift up or down—at least in part because of changes in inflationary expectations over time.”

So by virtue of the yield curve, we can determine the market’s expectation of economic growth, prospective policy/-ies or inflation expectations that could ascertain the direction of the interest rate movement of a security or in this case of a particular country.

Unfortunately, while we can see the slope, shape and the steepness of the curve, we don’t see the shifts or movements of the curve from its previous position/s.

These are what we can deduce from the ADB yield curve picture.

One, the odd man out-Vietnam manifests of a significantly higher short term rates over long term rates. This implies that the market expects a tight monetary policy to be applied following a surge in inflation figures or expectations. Moreover, the humped or inverted curve also signifies the risks of a potential drastic economic slowdown or even a looming recession.

Two-Indonesia and the Philippines has a steeper sloping yield curve which is an example of how financial markets could be anticipating higher future interest rates arising from either higher inflation expectations or higher growth rates. Note that Indonesia has higher spreads and has a steeper slope which translates to even higher inflation expectations (or growth) relative to the Philippines.

Question is if the inflation has been the purported scourge to Asian markets why has Indonesia JKSE’s significantly outperformed the Phisix down only 15.06% (year to date) compared to the Phisix which has lost 31.90%? This week the Phisix lost 4.35% vis-à-vis JKSE’s -1.67%!

Three-the rest of the region shows of flat curves, which means a small premium in holding longer dated securities or possibly that the financial markets could be unsure of the risks of inflation as a major concern enough to impact the present economic growth.

Except for Vietnam, it seems that the Asian bond markets appear to be saying that inflation threat looks more of a bogey than a reality YET.

The Deflation Phantom, Real Risks Lies In Stagflation

Next, as we have repeatedly argued in Global Depression: A Theory Similar To A Horror Movie?, A Global Depression or Platonicity? II, A Global Depression or Platonicity?, the possibility of a deflation laced global depression on the Philippines or in much of Asia or emerging markets are significantly LESS likely.

Figure 8: ADB’s Managing Cities: Relative Size of Informal Economy

Why? A substantial segment of the emerging market economies thrives on the informal economy. For the Philippines, think of the ambulant vendors- Balut, cigarette or sampaguita; stall vendors- small eateries (carinderias or canteens); rolling store vendors-ukay ukay carts or fish ball or ice cream vendors and other home based business.

According to Asian Development Bank, ``Asian countries and their cities, in particular, have large informal economies. The growth of the informal sector is a rational response to economic opportunities, given the factors limiting entry into the formal sector. Informal housing investment and the use of the home to generate income reflect market realities. Furthermore, the distinction between the formal and informal sectors is often blurred where, for example, householders can work in one sector but live in another. In economic terms, the informal sector is a competitively remunerated population that has decided to live outside of the regulations of the formal sector because of its high transaction costs. The informal sector is the lifeblood of many Asians. Statistics on the informal economy are difficult to obtain and often unreliable. Nevertheless, a recent report shows that in 26 Asian countries, the informal economy contributed an average of about 26% of gross national product (GNP) nationally. The study estimates that the Central Asian republics have the highest proportion of GNP generated by the informal sector, while Bangladesh, Nepal, Philippines, Pakistan, Sri Lanka, and Thailand have more than one third of their GNP produced by the informal sector.”

Much of these informal sectors do not depend on banks or capital markets for access to financing nor do they depend on assets for collateral. Economist Hernando de Soto even identifies the Philippines as one of the representative nations plagued with “dead capital” (Mystery of Capital), or the inability to securitize (property) assets for capital raising or as collateral purposes.

In fact, based on empirical evidence, most of my neighborhood enterprises today avail of the micro financing of “5-6” or 20% interest rates a month (!) from mostly local based ethnic Indians or through some Pinoy moneylenders, which I think is a very popular source of informal financing for micro enterprises (Kyotoreview).

In addition based on the last Asian Financial crisis, while the liquidity crunch in the domestic money system had some impact to the informal sector (e.g. rising inflation/loss of purchasing power from Peso devaluation, increased incidences of non payment, etc…), this was easily covered by overseas Indians who extended financing to the local affiliates or relatives who were engaged in microfinancing via “5-6 schemes”, the growth of alternative financing methods called “Paluwagan” (mutual scheme of rotating savings) or the “Hulugan” (selling based on installment payments) and from Local government units via livelihood linked lending schemes (iadb.org- Prof. Mari Kondo, Asian Institute of Management, The Preliminary Findings on the Impact of the Asian Financial Crisis on Microfinance Institutions:A Case on the Public Market in the Philippines).

So the risks for emerging market economies seem likely to come from a stagflationary environment than from a deflation contagion.

Stocks As Inflation Hedge

Finally while the external environment looks quite hostile at the moment, we should think of this as windows of opportunities than simply join the ranks of the lemmings to the tune of the fabled Pied Piper of Hamlin.

US money policies are being circulated worldwide via low nominal interest rates or negative real rates as espoused by many central banks, this ensure a loss of purchasing power for the currency holder under this regime. According to Joachim Fels of Morgan Stanley, around 50 countries or one in four countries in the world are plagued by double digit inflation! This means that many countries are behind the curve in neutralizing domestic inflation.

Under this environment, whether you are in cash, bonds or in stocks most of the public have been losing money, directly (stocks or bonds) or indirectly (cash). Because inflation is a stealth tax against the country’s productive capacity, this loss of purchasing power is seen and felt via rising prices of goods and services. The natural beneficiaries are those who inflate the system (government).

The best insurance is to partially diversify into stocks because equity investments can account for as a store of value since they mostly represent storehouse of assets. Of course, not all stocks are cut from the same cloth.

In Vietnam, because of high inflation rates and the government’s constant intervention in the stock market to prevent its fall (down 67% after skyrocketing by over 7 times!) the public has sought protection in gold making it the largest gold market in the world. Yet the Vietnamese government, in order to maintain the faith of the public to its currencies, has barred gold imports.

This from Professor Michael Pettis of Peking University's Guanghua School of Management,

``Apparently, and in order to protect themselves from inflation, so many Vietnamese are buying gold that Vietnam has suddenly overtaken China and India as the world’s largest market for gold bullion. This orgy of gold buying has, of course, worsened Vietnam’s trade deficit, although I would argue that gold imports for investment purposes should be seen more as a reduction of the capital account surplus than an increase in the current account deficit, but either way it represents a drain on reserves. Although gold imports are regulated, until the suspension Vietnamese gold imports had soared. Gold imports for the first quarter of 2008 were up 71% over the same period last year, and imports of gold bar (which of course is what gold investors typically buy) were up 110%. I have said many times in this blog that I suspect that if we see problems with inflation or capital flight in China, one form these are likely to take are through gold purchases.”

If the Vietnamese understands that the insurance to the loss of purchasing power can be hedged by gold purchases, what does Filipinos understand as an inflation hedge? Politicians? The US dollar?

You can just see how the US markets reacted to the recent downfall in its equity markets last week…a corresponding surge in gold, gold mining and general mining stocks (revert to table 1)!

In addition, what do you think would happen to gold prices if Prof. Pettis is right, where 1.3 billion Chinese flee to gold as an insurance against inflation?

Anyway, in this cyclical bear market period whose bottom I think should be nearing, the following companies account for the highest dividend yields based on PSE’s April closing (source PSE monthly).

National Reinsurance 11.34%, PNOC-EDC 7.1%, Salcon power 20.5% First Gen 7%,Ginebra San Miguel 8%, Tanduay Holdings 7.45%, Holcim 6.18%, Anglo Phil 6.94%, Cebu Property Venture 6.25%, Polar property 6.35%, Aboitiz transport system 25% Republic Glass 8.82%, Pldt 8.74%, Globe Telecoms 8.86%, Asian terminals 7.27%, Far Eastern University 2.46% and Semirara Mining 8.16%.

Meanwhile, the Phisix has a dividend yield (annual dividend/ price per share) of 4.32% and 3.63% for the total market. Besides, April’s Price to Book Value for the Phisix is 1.77 while the Price Earnings Ratio is 12.29. With the Phisix down by over 10% as of Friday’s close relative to last April, this should pump up the figures of present dividend yield aside from depressing the PBV and PE ratios.

Many of the dividend yields have nearly caught up with present inflation rates (9.6% in May), or are nearly at par with benchmark 10 year Peso bonds (currently 9.496% as of June 27^th-asianbondsonline).

In short, the lower the Phisix goes the more attractive these yields offer relative to fixed income while the risks aspects into stocks diminishes.

Norway’s Krone: An Embodiment of A Reserve Currency?

Economist Paul Kasriel of Northern Trust recently opined that the Norwegian Krone could be the next currency reserve.

Courtesy of Northern Trust

Given that the Norwegian Central Bank recently continued with its monetary tightening measures by raising interest rates even amidst signs of an economic slowdown, ``That puts the Norges Bank’s policy rate 293 basis points over the May year-over-year CPI inflation rate on a harmonized basis. Notice that the Norges Bank was raising its policy rate in the first half of 2007 as the inflation rate was falling. The Norges Bank is offering savers an “honest” return on their funds. Isn’t this what you would look for in a reserve currency’s central bank?” remarks Mr. Kasriel.

What Mr. Kasriel means is that unlike the conventional practices of many global central banks including the de facto world reserve currency, the US dollar represented by the US Federal Reserve, Norway’s Krone offers positive real returns or a premium over inflation or the embodiment of an equivalent sound money policy in operating under today’s paper money standard landscape.

Well, the Norway Krone is likewise a bet on the natural resources like oil exports which accounts for about 51% share of total exports or 25% of the country’s GDP in 2006 (Norwegian Petroleum Directorate).

Anyway the Krone is up by about over 35% since 2003 see yahoo chart above.

With oil at trading at near $140 could we be seeing more upside for the Krone?

Interesting Trivia on Google

Here is an interesting article from my default search engine Google as excerpted from Askmen.com…

“5 Things You Didn't Know: Google

There is no other company more synonymous with the internet than Google. As the mother of all search engines (a legitimate title considering Google surpassed Yahoo! as the most visited website in the U.S. in 2008), Google has come a long way since its early beginnings. It is also ranked as the No. 1 company to work for, according to Fortune magazine. Its popularity has become so widespread that most think Google was born along with the internet. To others, however, Google is the pinnacle of all internet companies -- a multifaceted search engine extraordinaire.

Why such intrigue? Well, here are a just a few things you didn’t know about Google.

1- Google spends $72 million a year on employee meals

Seventy-two million dollars a year -- that works out to about $7,530 per Googler (a term Google uses to identify employees). While the exact details vary depending on location (the Google empire spans the globe), employees at Google's California headquarters, aptly entitled the Googleplex, are welcome to at least two free meals a day from 11 different gourmet cafeterias. As if that weren’t enough, another thing you didn’t know about Google is that in addition to the cafeterias, Google offers numerous snack bars that are chock-full of healthy morsels to munch on.

And that's certainly not all. Is your car in a bit of a rut? Not to worry; Google offers on-site car washes and oil changes. The list of perks for working at Google is never-ending, making it no surprise that it's considered the No. 1 place to work, offering: on-site haircuts, full athletic facilities, massage therapists, language classes, drop-off dry cleaning, day cares, and on-site doctors, just to name a few. Oh, and if your dog is stuck at home and feeling a little lonely, just bring him to work -- Google doesn't mind.

2- Google was originally called BackRub

Like many other booming internet companies, Google has an interesting upbringing, one that is marked by a lowly beginning. Google began as a research project in January 1996 by cofounder Larry Page, a 24-year-old Ph.D. student at Standford University. Page was soon joined by 23-year-old Sergey Brin, another Ph.D. student, forming a duo that seemed destined for failure. According to Google's own corporate information, Brin and Page argued about every single topic they discussed. This incessant arguing, however, may have been what spurred the duo to rethink web-searching and develop a novel strategy that ranked websites according to the number of backlinks (i.e., according to the number of web pages that linked back to a web page being searched), and not based on the number of times a specific search term appeared on a given web page, as was the norm.

Because of this unique strategy, another thing you didn't know about Google is that Page and Brin nicknamed the search engine BackRub. Thankfully, in 1998, Brin and Page dropped the sexually suggestive nickname, and came up with “Google,” a term originating from a common misspelling of the word "googol," which refers to 10¹⁰⁰.

The word “google” has become so common, it was entered into numerous dictionaries in 2006, referring to the act of using the Google search engine to retrieve information via the internet.

3- Google loses $110 million a year through "I'm Feeling Lucky"

There's not much to see on Google's main search page, and perhaps simplicity is one of the keys to Google's success. When searching Google, you are given two options: “Google Search” or “I'm Feeling Lucky.” By clicking the former, you are given that familiar list of search results; by clicking the latter, however, you are automatically redirected to the first search result, bypassing the search engine’s results page.

Besides the fun factor, the idea behind the “I'm Feeling Lucky” feature is to provide the user with instant connection to the precise page they are searching for, thus saving them time that would normally be spent perusing endless search results. Sounds harmless enough, right? Not so fast. Because “I'm Feeling Lucky” bypasses all advertising, it is estimated that Google loses about $110 million per year in advertising-generated revenue. So why in the world would any Fortune 500 company not patch such a gaping leak? "It's possible to become too dry, too corporate, too much about making money. I think what's delightful about 'I'm Feeling Lucky' is that it reminds you there are real people here," Google Executive Marissa Mayer told Valleywag, an online tech-blog.

4- Google has a sense of humor

Google also offers full language support for Pig Latin, Klingon and even Elmer Fudd. Anyone else still feeling lucky? Try typing, “French military victories” and clicking “I'm Feeling Lucky.” Behold the result.

Some might remember the “miserable failure” fiasco when one typed those words and clicked “I'm Feeling Lucky,” and they were instantly connected to a biography of President George W. Bush on the White House website. Now, before you jump to conclusions, this trick -- which no longer works -- was carried out by members of the online community through the art of “Google bombing.” Google bombing works because of Google's backlink search strategy.”

Read the rest at askmen.com

Chairman Bernanke The Ideologue Probably Won’t Raise Anytime Soon

``A believer is a bird in a cage, a freethinker is an eagle parting the clouds with tireless wing”- Robert Green Ingersoll (1833-1899) American Statesman and Orator.

The FOMC is slated to decide on US monetary policy rates today.

Federal Reserve Chairman Ben S. Bernanke recently voiced concerns over “rising inflation” following the unexpected stance taken by European Central Bank Jean Claude Trichet declaring that the ECB may raise rates by next month to combat accelerating inflation.

As per Fed Chair Bernanke (highlight mine) “Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.”

Thus, Bernanke’s statement prompted for a shift in investor expectations which increased the probability that the Fed would possibly be hiking interest rates in the near future. But with the recent signs of weakness in the many economic figures/stats, the unresolved credit crisis and the softening of the equity markets this expectation have been scaled downwards.

According to Barron’s Randall W. Forsyth ``The futures markets Friday put just a 43% probability on a 2.25% fed-funds rate, up a quarter-point, at the Aug. 5 FOMC meeting, down from 83% a week earlier. Fed-funds futures also Friday priced in an 84% chance of a 2.50% by the end of the Oct. 28-29 FOMC meeting. A week earlier, the futures market thought a 2.50% funds rate was a certainty by then, with 58% chance of 2.75%.

Of course, there are many fundamental “economic” justifications why probably the Fed won’t be hiking anytime soon…

So we will leave to the institutional economists like Ms. Asha Banglore of Northern Trust who recently argued, ``First, the labor market is under severe stress, firms have stopped expanding payrolls, no ambiguity here. Second, the National Bureau of Economic Research (NBER) could take several more months to declare an official onset of a recession, but there is no doubt the U.S. economy is experiencing one. Nonfarm payrolls, one of the measures the NBER uses to date business cycles, peaked in December 2007. Third and more importantly, if history is any guide, the Fed will not raise the federal funds rate until the unemployment rate falls.” (see chart above courtesy of Northern Trust).

It is instructive to know that “jawboning” is part of the policy tools utilized by monetary authorities to shape market expectations.

This from IMF’s Atish Ghosh ``Through the signaling channel, the central bank communicates to the markets its policy intentions or private information it may have concerning the future supply of or demand for the currency (or, equivalently, the path of interest rates). A virtuous expectational cycle can emerge: for instance, if the central bank credibly communicates its belief that the exchange rate is too strong—and would be willing to change policy interest rates if necessary—then market expectations will lead to sales of the currency, weakening it as intended.”

Nonetheless on our part, we vividly remember four occasions where Chairman Bernanke defended the financial markets, particularly the stock market, as some sort of policy catechism or guideline (all highlights mine):

1. A Crash Course for Central Bankers published at foreignpolicy.com (September/October 2000)…

``There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

2. “Never Again” speech at Milton Friedman’s 90^th birthday (November 8, 2002),

``For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

``Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

3. The celebrated Helicopter speech, ``Deflation: Making Sure "It" Doesn't Happen Here” (November 21,2002 )

``But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

4. The Financial Accelerator speech, ``The Financial Accelerator and the Credit Channel” (June 15, 2007)

``As the topic of this conference reminds us, financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission. In fact, as I will discuss, these two ideas are essentially related. As someone who (in a former life) did research on both of these topics, I thought it might be useful for me to provide a somewhat personal overview of the financial accelerator and credit channel ideas and their common underlying logic. Along the way I will offer a few thoughts on where future research might be most productive…

``The critical idea is that the cost of funds to borrowers depends inversely on their creditworthiness, as measured by indicators such as net worth and liquidity. Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces.

The interesting chart courtesy of Elliott Wave’s Euan Wilson shows of how Bernanke’s recent policies seems to have been directed towards the weakness of the stock market (represented by the Dow Jones Industrials) – with most of the recent initiatives coincidentally implemented at market troughs!

To sum it up, my view is that the imperative of the Bernanke doctrine calls for the principal support of the financial markets, with all other issues being secondary.

Thus, instead of an interest rate hike which signifies the conventional thinking, the likelihood- given the continuing infirmities in the equity markets- is that we may see Chairman Bernanke cutting rates instead!

Phisix: Domestic Participants Panic! Bottom Ahoy?!

``Time is what matters most. Just as time is the friend of the great business and the enemy of the not-so great business, so to time, like volatility, makes friends with the long-term investor and antagonizes the short-term one.” –Josh Wolfe Timeless Space & the Mismeasure of Risk

Post Holy week of 2008, we noted of an article by a high profile domestic analyst in a business broadsheet satirically provoking local stock market participants to “panic” so as to “end” the anguish of the present bear market.

The article appeared to be a “reverse psychology”, as we wrote in In A Crisis, Be Aware Of The Danger But Recognize The Opportunity, ``which was meant to do otherwise, it signifies pretty much of a deeply entrenched state of denial-the inability to accept the persistence of the present conditions. This seems to reflect signs of impatience and deepening frustration from a supposed market expert. As German-Swiss author poet Hermann Hesse in his novel Steppenwolf wrote, ``All interpretation, all psychology, all attempts to make things comprehensible, require the medium of theories, mythologies and lies."

Instead we suggested that prudent investors ought to understand the global credit-equity cycle, which appears to be of more impact to our equity market more than simply reading too much of sentiment as a potential indicator of the direction of our market.

Let us see why…

Figure 1: stockcharts.com: World Equity Markets Have Basically Tracked US Financials

Figure 1 courtesy of stockcharts.com depicts of the Dow Jones World Index (main window), whose peak seems to resemble the local Phisix (not shown), has been winding down since the US General Financial Services (lowest pane) has broken down in July of 2007. In short, global equity markets have been heavily correlated with the performance of US financial stocks and apparently have signified as a drag.

However, in contrast to the Dow Jones World index, which remains above its recent low, the local benchmark the Phisix has severely underperformed by successively carving out new lows despite this week’s technical rally.

Will Global Financial Markets Survive High Oil Prices?

In addition, we hear many of today’s pains pinned on oil prices. However, such causality seems specious. The same chart shows oil prices (pane below main window-$WTIC) and global equities have not been strongly associated. On the contrary, the recent rally of oil prices coincided with the rebound of global equity markets.

When oil prices pinnacled at nearly $140, global equity markets were already rolling over concomitantly alongside with the US financials. Thus, the pain from high oil prices is clearly a subordinate source of concern relative to the headwinds from the US financials.

On a positive note, $135 oil today also translates to strong demand from emerging countries, which is a peculiarity or an unprecedented characteristic given today's environment see Figure 2.

Figure 2: British Petroleum: World Oil Consumption: Signs of Decoupling?

British Petroleum notes that ``world consumption rose by about 1 million barrels in 2007, just below the 10 year average. OECD consumption declined nearly 400,000 barrels per day. China accounted fro the largest increment to consumption even though growth rate was below average. Consumption in oil exporting regions was robust.” (BP)

Essentially with oil at $135, the outperformance of emerging markets relative to advanced economies in terms of oil consumption could also be seen as another sign of "decoupling".

Yes, China surprisingly raised energy prices this week-18% diesel, 16% gasoline (NYT) and electricity prices nearly 5%-which means easing of subsidies to alleviate the growing incidences of crippling shortages arising from losses of petrol refineries, whom have been curbing production, aside from the prospects of power failure (as the Olympic season nears), as power companies have become reluctant to operate oil fired power stations for the lack of revenues to cover oil costs. Anyway, despite such increases, refined crude oil prices are still about 30% BELOW world market prices!

Of course while we may expect price increases to somewhat dampen demand for energy usage (it is expected to hurt mostly countries that don’t use subsidies), this won’t be enough to curtail overall demand as evidenced by some countries who recently undertook measures to lift subsidies as Indonesia-recently hiked oil prices last May (Reuters), saw vehicle sales 24.4% year on year but 1.8% down from April (automotive world).

Besides, the market have learned how to adjust to the recent high oil price landscape by introducing fuel efficient yet affordable motor vehicles, as shown in Figure3.

Figure 3: Economist: Where low-cost car sales are set to grow

From the Economist, ``WITH one eye on emerging markets and another on fuel restrictions more carmakers are entering the low-cost car market. Renault, which already manufactures the €7,600 ($12,000) Logan, recently announced a venture with Nissan and an Indian carmaker, Bajaj Auto, to develop a car that will compete with Tata's Nano, which goes on sale in India in October for a tiny $2,400. Sales of basic and small low-cost cars are predicted to leap by nearly 4m cars a year to 17.7m by 2012, according to Roland Berger, a consultancy. Growth is set to be highest in the emerging economies of Asia and Eastern Europe, but sales in America, home of the big gas-guzzler, will also grow by an average of 8.7% a year.”

Figure 4: Economist: Falling US Light Truck Sales

So yes, while SUVs and Hummers (figure 4) are on the decline in the US, we don’t see the same with China which has a black market for Hummers and some growing variants-Beijing Auto’s Trojan and Dongfeng Auto’s HanMa (Financial Times).

The world has survived high oil prices. And is likely to get over high oil prices provided the world can adapt to the changes brought forth in time.

In fact, as seen in above, it is not high oil prices per se that has been contributing to the angst of the financial markets and the real economy, but the rate of change of oil prices, given that oil has doubled year on year. But then again the world markets seem to be finding ways and means to adjust to a given environment.

The point is that high oil prices reflect the reality of distortive government policies on one hand, and the seismic shift in the sphere of global economic progress on the other.

Short Credit-Short Equity In The Face of Global Monetary Inflation

Next, as we further commented, the pang of the recent bear market here and abroad looks likely one which tracks the cyclical credit-equity cycle. As we earlier quoted Citibank’s Mark King’s credit-equity cycle, it looks likely that we have segued into the fourth phase, where…

``Phase 4: Short credit, Short equity

``This is the classic bear market, when equity and credit prices re-couple and fall together. It is usually associated with falling profits and worsening balance sheets. Concerns about insolvency plague the credit market, while broad profit concerns plague the equity market. A defensive strategy is most appropriate - cash and government bonds are the best performing asset classes.”

Going back to figure 1 shows that LIBOR rates have remained high signifying continuing stress in the credit markets.

The London Interbank Offered Rate (wikipedia.org) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). To quote David Kotok of Cumberland Advisors, ``LIBOR is perhaps the most important interest rate in the world, in US dollar terms. It’s the pricing reference for probably $150 trillion. Trillion with a T. That number includes lots of derivatives.”

While falling credit and falling equities seem to be the classic bear market which we envisage today, we are faced with an environment where rising goods and services inflation makes the classic defensive strategy (cash and bonds) as an unlikely viable option.

Why? Because the inflation phenomenon has been transformed into a global affair. To aptly quote Doug Noland, in his Credit Bubble Bulletin (emphasis mine),

``First, there is the massive flow of dollar liquidity inundating the world. Despite huge dollar devaluation, a major Credit crisis, and economic downturn, our system is on track for yet another year of $700bn plus Current Account Deficits (and this doesn’t include the massive speculative outflows to participate in the global inflation). Global economies, especially booming Asia, are awash in dollar liquidity to use to bid up the prices of oil and other strategic resources.

``Second, today’s massive dollar flows have increasingly gravitating to speculative endeavors (hedge funds, sovereign wealth funds, commodities speculation, etc.) – each year ballooning the “global pool of speculative finance” that by its very nature chases rising prices (“liquidity loves inflation”).

``Third, the confluence of the flood of global liquidity and unfettered domestic Credit systems has exerted its greatest stimulatory effect upon the highly populated countries of China, India, and Asia generally. This, then, has created a historic inflationary bias throughout the energy, food and commodities complexes.-Doug Noland Good Inflation?

Figure 5: Brad Setser: US Exports More Financial Assets

Proof? Figure 5 courtesy of the Brad Setser of the Council of Foreign Relations shows that the US exports TWICE more Financial Assets than its exports of goods and services.

To quote the meticulous Brad Setser, ``No one has argued that the main benefit of globalization is that it allows America’s bankers to sell US debt – and increasingly shares of American companies – to governments in the emerging world. But that is a fairly accurate description of current trade and financial flows.”

This is the epitome of the US dollar standard- the US sells promises to pay (sovereign debt or treasuries/agencies) in exchange for goods and services, aside from selling equity ownership in the US to foreigners (mostly emerging markets).

Thus, the ongoing wealth transfer and inflationary pass through from the US to world which has begun to boomerang back to the US.

Local Investors Gripped By Panic! Bottom Ahoy?

Well going back to the local analyst who called for the domestic participants to panic, the Philippine stock market appears to be accommodating his wishes.

Market internals suggests, despite the rally in the Phisix last week, of panic stricken activities led by local mostly retail investors.

Let us look at some of the evidences:

Figure 6: PSE: Net Foreign Trade

Figure 6 accounts for the year to date representation of net foreign trade. The chart shows that despite the most recent burst of foreign selling largely brought upon by the intense politicking amidst a drab global equity market sentiment, the intensity of foreign selling seems to have been thawing (red arrow) compared to the earlier bouts of liquidation.

In fact, for this week, foreign trade accounted for a marginal net buying of Php 152 million. But, this came amidst a negative net foreign trade breadth or the number of companies with positive foreign trade minus number of companies with negative foreign trade.

For the Phisix to bottom, foreign trade needs to revert to both a positive net Peso value and positive market breadth. We anticipate improvements on the said variables as the BSP raises interest rates in the face of high goods and services inflation, provided the politicking will abate.

However, market breadth persisted to decline despite the modest rally posted by the Phisix this week.

Figure 7: PSE data: Deteriorating Advance-Decline Spread

As can be seen in Figure 7, market breadth has turned deeply negative, but this has been smaller compared again to the earlier bouts of selling seen last January or March.

A bottoming phase would likely show lesser degree (smaller incidences of declining companies) and intensity (smaller number of declining companies during down days) of negative market breadth coupled with stability or improvement in the technical picture.

Figure 8: PSE: Collapsing Average Peso Trade Amidst Rising No. of Trades

And the kicker, as shown in Figure 8, is the surging number of trades (violet) amidst a materially diminishing Peso volume per trade (maroon).

During the earlier bouts of selling (since the second round of credit driven fears emerged in October 2007), the number of trades had been declining as the Phisix headed lower. This basically reflected a retreat of buyers.

However during the past two months we can see a reversal of this pattern, the Phisix persisted towards its downdraft but the number of trades amplified. This apparently reflects FEAR.

In addition, the latest episode of selling shows that the average Peso volume per trade has dramatically weakened. Again the lower volume plus heightened trading activity could possibly indicate fear among small accounts or retail investors!

Usually, the inflection point of any cycle is marked by a shift in ownership. In a bullmarket cycle, the strong hands give way to the weak hands who pushes the market to its maturity or until the pivotal turning point. On the other hand, we should expect the same but an antipodal ownership shift in a bearmarket, where weak hands are expected to give way to the strong hands.

So for our analyst whose wishes appear to have come in full circle, perhaps this could be indicative of the nearing culmination of the bearmarket.

Foreign Money Governs PSE; Value Investing Amidst Fear

``The farther backward you can look, the farther forward you are likely to see." Winston Churchill

The PSE Playing Field

Retail investors according to the PSE registered only a scant 430,681 accounts for Filipino investors in 2007. This signifies less than 1% of the total population, something we talked about as early as 2004. Yet, of the total, only 103,412 have been active or involved in a trade in a year, which represents a grotesquely small figure even considering the run up over the past 4 years.

Of course, the PSE didn’t include those indirectly involved in the trade, which should have accounted for mutual funds and trusts funds offered by banking institutions such as Unit Investment Trust Funds (UITF) or by Life insurance companies such as Index Funds.

Even so, this implies that a reasonable ball park figure should account to some 1% of the population which means the Philippines remains one of the least exposed to the capital markets, which is one reason the Philippines remain poor.

Capital markets, as we have so frequently stated, function as an alternative source of financing next to banking.

Aside, they operate like money- they serve as a platform for conducting exchanges of financial instruments (medium of exchange), they are avenues for valuation and liquidity generation (unit of account) and are repository of assets (store of value), thus contribute to the mobilization of savings, the channeling of investments and help determine consumption patterns.

For instance, when an economy grows with an attendant rise in corporate profitability, if these companies are predominantly not publicly listed, then corporate profits contributes less to the consumption patterns because they don’t pay dividends or offer capital appreciation to a wider scope of ownership but the profits stay within the companies that generate or produce them.

However in countries with mature and deep capital markets, when profits rise, stock prices and dividends also tend to rise. Shareholders can easily sell or use their stockholdings as collateral to finance consumption or for reinvestment. They may also choose to use value added dividends to do the same. In essence, capital markets allows for a wider option for individuals or enterprises to access capital increase savings and investment returns or to even act as a hedge to an investment (for sophisticated markets).

Unfortunately most of the participants misunderstand this and sordidly treats the capital markets as some sort of an alternative avenue for gambling or a casino.

Of course, this is abetted by the woeful quality of information dissemination by the key participants themselves who engage the public into a short term perspective or to the allure or promise of easy money with a dearth of understanding between the tradeoff of risk and returns or of cost and benefits.

Half Full or Half Empty?

Overall there are two dimensions that can be gleaned from this-

One there is a commodious growth for the capital markets over the long term, especially if Asian markets will continue to outperform the world or converge with developed countries in terms of scalability, depth and sophistication.

As an example, despite the global credit crisis and stock market infirmities in the region, Asian merger and acquisitions continue to proliferate and outperform the world, this from the Financial Times (Sundeep Tucker),

``The aggregate value of announced cross-border deals between Asia-Pacific companies has totalled $54bn in the year to date, according to figures from Dealogic, the data provider. This compares to $25.7bn during the corresponding period last year.

``Bankers report that deals currently in the pipeline should mean 2008 will be a record year for intra-Asian deals, eclipsing last year's mark of $76.2bn. The value of intra-Asian deals has risen steadily since 2004, when combined deal activity totalled $35.2bn…

``Regional consolidation has been led by outbound Chinese investment into the financial services and resource sectors. There has also been strong cross-border activity across south-east Asia.

``Bankers attribute the growth in Asian M&A to strong economic growth, increasing scale and financial capabilities of the region's corporations and rising confidence among senior management ranks to execute overseas deals.” (underscore mine)

Second, presently given the size and breadth of domestic investor’s participation, they seem serve as subaltern to foreign money. Although of course, we have noted that local participants have occasionally functioned as the alternative cushion to the market especially during the recent foreign driven selling, the dominance of foreign money is the explicit reason why our performance has been closely tied with activities abroad.

Yet, with a general negative sentiment (initially due to forced liquidation abroad for capital raising purposes) towards equity markets which resulted to a net foreign selling here, politicking has compounded on the domestic arena which persisted to weigh on the market, this time with local participants largely contributing to the selloff.

Of course, the idea that recoupling due to the gathering storm of deflationary forces or from the inflation contagion as the reason why global stock markets are being sold down the sewer can easily be rebuffed.

In my recent post Recoupling and Inflation Doesn’t Explain Everything…, we showed how bourses of some countries have defied gravity (uncannily some in Africa!) and continue to drift at record highs.

The point is that markets can act distinctly from the general observation for one reason or another.

Asia’s Leverage of More Policy Options

As for Asia, we think that the region’s Central Banks have more policy options compared to its counterparts in Europe or in the US which should allow Asian markets to recover rapidly.

Like us, University of California Berkeley Professor Barry Eichengreen believes that aggressively raising rates should be an instrument to consider,

To quote Prof. Eichengreen (RGE Asian),

``These negative interest rates and their artificial stimulus to consumption and investment are also why we haven’t seen more of a slowdown in Asia – why we haven’t seen more recoupling. But now that Asian central banks are being forced to tighten, we will see more evidence of their economies slowing down. Asian currencies will appreciate against both the dollar and the euro. Although the Fed and the ECB may raise rates as well, both inflation and growth are weaker than in Asia, so they will have reason to respond more moderately…

``Fortunately, there is another instrument for sustaining demand in these circumstances, namely fiscal policy. Higher interest rates will push up the exchange rate and damp down inflation. Tax cuts and increases in public spending on locally-produced goods will limit the contraction of aggregate demand. Insofar as these fiscal actions stimulate the demand for locally-produced goods, they will push up the exchange rate still further, which will moderate the rise in import prices and further contain inflationary pressure.” (highlight mine)

This means that public investments on infrastructure, as an example, may help offset (by lowering cost of transactions) any decline in the economic growth arising from the costs of higher interest rates. Besides, being a major commodity producer, expediting investments within or related to this field could help rebalance our economy aside from boosting foreign exchange revenues.

Yet, higher interest rates could induce for a firmer peso and could lure foreign money back to the Philippines and into local assets.

Remember, if you are concerned that local money will be diverted away from equities, just refer to the data from PSE and realize that foreign money and not local investors have been the key drivers of the financial markets (for the time being until perhaps certain higher levels of the Phisix would be attained).

Value Investing Amidst Fear

Figure 8 Phisix: Quarterly Chart

Yes, the bearmarkets (see figure 8) of the past whether as a countercycle of a bullmarket or during the main bearmarket cycle have shown the Phisix to have lost 50-60% before recovering.

While of course we can’t discount this to reoccur, we doubt this premise simply because the past conditions do not represent the same as today as we laboriously argued in Phisix: No Bubble! Time for Greed Amidst Fear.

Anyway as a matter of technicals, a 50% retracement should imply the Phisix at 2,450, otherwise if the market should fall further then a 61.8% retracement should imply the Phisix at 2,100.

But as Michael Maubossin of Legg Mason wrote in The Failure of Arbitrage, ``Trend followers, as emotion riders, are not concerned with price-to-value discrepancies. Price alone indicates whether a momentum investor is right or wrong. So while trend followers care only about price, value investors care about the discrepancy between price and value. The distinction in the perceived source of edge in the strategies is crucial because it implies very different roles in the market ecosystem.”

So at this point the investing perspective shifts from that of momentum (fear) to that of Value.