Minnesota a la Greece, Bill Gross says US Worst than Greece, PIIGS

If Greece has been one of Europe’s major headache, then the US has her counterpart, Minnesota.

From yahoo.com

Time is running out for Minnesota's parks, highway rest stops and public universities, not to mention 36,000 state employees.

If Gov. Mark Dayton and lawmakers don't agree on a budget by June 30, the state government is expected to shut down. The state moved one step closer to this outcome on Friday by sending layoff notices to much of the state workforce.

Should officials not resolve their differences in time, state parks and highway stops could be shuttered over the busy Fourth of July weekend. Forget about renewing a driver's license or taking classes at state colleges. Nonprofit agencies may have to suspend their social services if their state funding disappears.

As for the state workers, they'll have to wait to see who is deemed critical. The rest could lose their pay, and some their health benefits. The unions have already launched a campaign pressuring state officials to pass a budget.

At issue is whether to close a $3.6 billion budget shortfall by increasing taxes or making spending cuts. The decision must be made before the fiscal year ends on June 30.

I know Minnesota is small compared to Greece. But the point is both have been suffering from the same sin—profligate government spending—and now faces the consequences. Reality stares on them.

Yet seen from a relative standpoint, Pimco’s Bill Gross says that the US is in worst condition than Greece or the Eurozone.

Mr. Gross’ recent analysis or outlook squares with mine.

Incidentally Mr. Gross, formerly an apostle of Krugman, has reversed his position, since his uber-Keynesian partner Paul McCulley departed from (or kicked out of?) PIMCO in December 2010.

From CNBC, (bold emphasis mine)

When adding in all of the money owed to cover future liabilities in entitlement programs the US is actually in worse financial shape than Greece and other debt-laden European countries, Pimco's Bill Gross told CNBC Monday.

Much of the public focus is on the nation's public debt, which is $14.3 trillion. But that doesn't include money guaranteed for Medicare, Medicaid and Social Security, which comes to close to $50 trillion, according to government figures.

The government also is on the hook for other debts such as the programs related to the bailout of the financial system following the crisis of 2008 and 2009, government figures show.

Taken together, Gross puts the total at "nearly $100 trillion," that while perhaps a bit on the high side, places the country in a highly unenviable fiscal position that he said won't find a solution overnight.

"To think that we can reduce that within the space of a year or two is not a realistic assumption," Gross said in a live interview. "That's much more than Greece, that's much more than almost any other developed country. We've got a problem and we have to get after it quickly."

Politicians and their fanatic worshipers think that money printing measures will help solve such dilemma by kicking the proverbial can down the road. They’re dead wrong. [If they have strong enough convictions, they should put all their money in shorting gold]

If Mr. Gross analysis is accurate, then this only shows that socio-economic problem of the US is so remarkably huge. And that if the US obstinately pursues on the money printing path, the scale of such undertaking would equally be colossal. This brings to fore the risks of hyperinflation, which is what US presidential aspirant and candidate Ron Paul has recently warned of and which could also be read as his prediction.

This is also why I have been saying that the next crisis will be even more devastating than 2008, as both the banking system and governments have already been pushed wall. The next crisis will likely see what I call the Mises Moment: either massive defaults by governments and a possible collapse of the banking sector or the worst alternative—hyperinflation. I can't fathom yet how the technology driven globalization will be impacted.

Yet hyperinflation would likely mean the end of the de facto US dollar standard or even the closure of US Federal Reserve as Nassim Taleb predicts or even possibly the disintegration of the Euro too (if the Euro would hyperinflate along with the US).

Finally there are many speculations on the new terminology of money printing or currently known as Quantitative Easing.

Jim Rogers calls sarcastically his version as the ‘cupcake’. Bill Gross sees a price cap on 2-3 treasuries and David Rosenberg calls his the ‘Operation Twist’

At the end of the day, what faces the world is the risk of debt defaults or default by hyperinflation.

Ben Bernanke on Debt Ceiling: Only I am Allowed to Dabble with Politics!

US Federal Reserve chairman Ben Bernanke warns that the US debt ceiling should NOT be used as a bargaining chip.

Yet he goes on to talk down on the supposed nasty implications of NOT raising the debt ceiling

From the UK’s Telegraph,

Federal Reserve Chairman Ben Bernanke said the US could lose its AAA credit rating and create a new crisis in the financial markets if it does not raise the cap on government debt.

Mr Bernanke warned that if the $14,300bn (£8,784bn) debt ceiling was not lifted quickly there could be disastrous consequences.

"Even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of US government debt, credit fundamental doubts about the creditworthiness of the United States, and damage the special role of the dollar and Treasury securities in global markets in the longer term," he said.

American journalist and libertarian H. L. Mencken once wrote,

The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary.

By putting pressure on the opponents to raising the debt ceiling, Mr. Ben Bernanke is essentially saying,

I am the only person entitled to do politics, because I am the expert and everybody else does not know what they are talking about.

Apparently Mr. Bernanke is using 'fear' from 'hobgoblins' as leverage to reach a political compromise.

Of course, we also know how much of an expert Mr. Bernanke is considering his highly inspirational track record.

Quantitative Easing and Shadow Banking Liabilities

I have repeatedly been arguing that the US banking system cannot last in an environment without inflationism or money printing or Quantitative Easing or “cupcakes” (as Jim Rogers would call it) unless the US government would allow for a violent deflationary unwind (yes another crisis of greater proportion compared to 2008).

The latter seem as a NO OPTION—for ideological and political reasons—or a Hobson’s choice.

Zero Hedge’s Tyler Durden points out that the collapsing liabilities of the shadow banking system have essentially been offset by the recent US Federal Reserve’s QE programs. In short, to stave off a continuing meltdown that would negatively affect the US banking system requires continued rounds of QEs.

Mr. Durden writes, (bold highlights mine)

And the most important chart: consolidated financial liabilities (total credit money) and the sequential change. Note that in Q1, courtesy of QE2, we have just experienced a jump in this series of a whopping $343 billion. Absent this jump the economy would have plunged into a deflationary collapse... And Ben Bernanke knows this...

Which leaves just one option: the Federal Reserve... Whose ongoing boost in excess reserves (its Liability) for the pendancy of any monetary easing episode, results in an increase in Reserve assets at Commercial Banks (their asset), but more importantly, a boost in Commercial bank liabilities, be they US (which is not the case) or (foreign) which we have now proven twice is what is happening. Simply said, absent the ongoing transfer of credit money liabilities, so critical to keep the economy growing, from the Fed to private institutions, there will be no marginal growth in the consolidate financial system's liabilities. Which in turn means outright deflation.

And you can bet your bottom fiat piece of linen and cotton that Ben Bernanke knows this all too well.

With QE2 ending just as Q2 ends, we are convinced that the next Z.1 report, due out in early September, will show another massive jump in liabilities... And that's it. It's all downhill from there. Unless, of course, the Fed comes up with another Fed to Commercial Bank liability transfer program, which the Fed can call it whatever it wants. The point is: it is critical for it to materialize soon or else, the economy, without a marginal source of new debt, will plunge in the deflationary abyss that the $5.1 trillion plunge in shadow liabilities would have created had it not been for Ben Bernanke.

Take away the money printing or the “cupcakes” and the entire house of cards collapses.

Ben Bernanke seems trapped from his own actions. And that’s unless one believes that a Deus ex machina (god out of the machine) would emerge to save the day.

Quote of the Day: Fatalities from Organic Farming

From a comment on an article (source: Matt Ridley)

One German organic farm has killed twice as many people as the Fukushima nuclear disaster and the Gulf Oil spill combined.

Evidence of the Distortive Effects of Government Policies on Financial Markets

Howard Simons at the Minyanville explains, (bold emphasis mine)

The Chicago Federal Reserve produces a personal consumption & housing (PCH) index dating back to March 1967; it has declined every month since January 2007. The duration and extent of this decline, 52 months and counting, is unprecedented in the series and most likely is the longest and deepest downturn since the Great Depression.

Note, however, what its relationship to the S&P 500’s year-over-year changes has been. It used to be the stock market led the PCH index by about three months. More important than the lead-time was the congruence of direction: If the stock market rose, so did the PCH and vice-versa.

What happened after QE1 began? Let’s run a simple in-sample regression model with the PCH index as a function of the S&P 500’s year-over-year changes lagged three months over the June 1967 – February 2009 period and save the coefficients. The fitted values of that model are shown in red below. If we then apply those coefficients to the March 2009-forward out-of-sample period, we see the fitted values in green. They are, starting one year after the 2009 rally began, much higher than the actual PCH index in blue. For example, the actual value of the PCH index at the end of April was -0.39; the out-of-sample fitted value was 0.04.

This is equivalent to saying the change in policy produced a change in financial markets without producing a change in the underlying real economy. There is your circus; you are on your own for the bread part of the deal.

This shows of the distortive effects of government policies on financial markets.

Also this represents additional evidence where markets today don’t accurately signal the actual balance of demand and supply.

Government policies have been major (if not the primary) factors in determining asset values.

It also shows that government can rig the game to benefit specific interests (banking sector over the real economy)

Finally, that the correlation-causation dynamics can change depending on the underlying forces, which in this case has been government interference.

So looking solely at correlation would signify as a dicey and tenuous way to analyze events unless one understands the likely (causal) drivers behind the market's actions.

Video: Jim Rogers says QE 3.0 could be Disguised

Legendary investor Jim Rogers says in this interview that the US Federal Reserve will engage in QE 3.0 when events get worst but will likely disguised it;

They may disguise it, they may call it cupcakes

Since governments are political entities, then they employ politics even in the way they communicate to the public.

A good example is the political language called doublespeak which Wikipedia defines as

language that deliberately disguises, distorts, or reverses the meaning of words. Doublespeak may take the form of euphemisms (e.g., "downsizing" for layoffs), making the truth less unpleasant, without denying its nature. It may also be deployed as intentional ambiguity, or reversal of meaning (for example, naming a state of war "peace"). In such cases, doublespeak disguises the nature of the truth, producing a communication bypass.

Quantitative Easing or credit easing policies is essentially money printing which is an example of euphemism or doublespeak.

So yes we could expect another doublespeak in terminologies applied for the next round of money printing or inflationism.

Video: Cato and Fraser Institute on the Economic Freedom of The World Report

The Fraser Institute and Cato Institutes discusses the Economic Freedom of The World Report which shows the strong relationship between economic freedom and economic development

Another Endorsement for the Prudent Investor Newsletters

On my linkedin profile page, long time reader, Wharton grad, highly successful investment banker and corporate finance advisor and currently Managing Director, Corporate Finance & Consulting at the Center for Global Best Practices, Mr. Tony Herbosa posted this recommendation...

For anyone serious about investing in the Philippines, Benson's Prudent Investor Newsletters are a must read on a continual basis. I must say that the PI newsletters have helped me anticipate major turning points in the market.

My profuse thanks, Tony.

Incidentally, I found that one of my articles had been referenced in an article by a Mises.org contributor and author published at the top libertarian website (based on Alexas), Lew Rockwell.com.

Nothing to crow about, but such surprising discovery had been a delight for me, since I frequent the site.

Exposing Ben Bernanke’s Fatal Conceit

In Fatal Conceit : The Errors of Socialism, the great F.A. Hayek wrote the following:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. To the naive mind that can conceive of order only as the product of deliberate arrangement, it may seem absurd that in complex conditions order, and adaptation to the unknown, can be achieved more effectively by decentralizing decisions and that a division of authority will actually extend the possibility of overall order. Yet that decentralization actually leads to more information being taken into account.

Below is a collection of some of US Federal Reserve Chairman Ben Bernanke’s monumental blunders which essentially validates Hayek’s observations.

From Center for Economic Policy and Research (all bold highlights mine, italics original) [ht Bob Wenzel]. Behold the wonders of analysis derived from econometrics.

10/1/00 – Article published in Foreign Policy Magazine
A collapse in U.S. stock prices certainly would cause a lot of white knuckles on Wall Street. But what effect would it have on the broader U.S. economy? If Wall Street crashes, does Main Street follow? Not necessarily.

7/1/05 – Interview on CNBC
INTERVIEWER: Ben, there's been a lot of talk about a housing bubble, particularly, you know [inaudible] from all sorts of places. Can you give us your view as to whether or not there is a housing bubble out there?

BERNANKE: Well, unquestionably, housing prices are up quite a bit; I think it's important to note that fundamentals are also very strong. We've got a growing economy, jobs, incomes. We've got very low mortgage rates. We've got demographics supporting housing growth. We've got restricted supply in some places. So it's certainly understandable that prices would go up some. I don't know whether prices are exactly where they should be, but I think it's fair to say that much of what's happened is supported by the strength of the economy.

7/1/05 – Interview on CNBC
INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

10/20/05 – Testimony before the Joint Economic Committee, Congress
House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.

11/15/05 – Confirmation Hearing before Senate Banking Committee
SEN. SARBANES: Warren Buffet has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?

BERNANKE: I am more sanguine about derivatives than the position you have just suggested. I think, generally speaking, they are very valuable… With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and do not create excessive risk in their institutions.

3/6/07 – At bankers’ conference in Honolulu, Hawaii… as delinquencies in the subprime mortgage sector rise
The credit risks associated with an affordable-housing portfolio need not be any greater than mortgage portfolios generally.

3/28/07 – Testimony before the Joint Economic Committee, Congress
Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear…At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.

5/17/07 – Remarks before the Federal Reserve Board of Chicago
...we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.

8/31/07 – Remarks at the Fed Economic Symposium in Jackson Hole
It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

1/10/08 – Response to a Question after Speech in Washington, D.C.
The Federal Reserve is not currently forecasting a recession.

2/27/08 – Testimony before the Senate Banking Committee
I expect there will be some failures [among smaller regional banks]… Among the largest banks, the capital ratios remain good and I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.

4/2/08 – New York Times article after the collapse of Bear Stearns
“In separate comments, Mr. Bernanke went further than he had in the past, suggesting that the Fed would remain aggressive and vigilant to prevent a repetition of a collapse like that of Bear Stearns, though he said he saw no such problems on the horizon.”

6/10/08 – Remarks before a bankers’ conference in Chatham, Massachusetts
The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.

7/16/08 – Testimony before House Financial Services Committee
[Fannie Mae and Freddie Mac are] adequately capitalized. They are in no danger of failing… [However,] the weakness in market confidence is having real effects as their stock prices fall, and it’s difficult for them to raise capital.

9/24/08 – Response to a question after JEC testimony… during the TARP debate, two weeks before the Fed initiates its liquidity facility for commercial paper markets
I see the financial markets as already quite fragile. The credit markets aren’t working. Corporations aren’t able to finance themselves through commercial paper. Even if the situation stayed as it did today, that would be a significant drag on the economy.

3/16/09 – Interview on CBS’s 60 Minutes
It’s absolutely unfair that taxpayer dollars are going to prop up a company (AIG) that made these terrible bets, that was operating out of the sight of regulators.

5/5/09 – Response to Questioning at Senate Joint Economic Committee Hearing
The forecast we have is for the economy, in terms of growth, to begin to turn up later this year, but initially not to grow at the rate of potential, which means that unemployment and resource slack will continue to rise into 2010. We think that the unemployment rate will probably peak early in 2010 and then come down relatively slowly after that. Um, currently, we don’t think it’s going to get to 10 percent, we’re somewhere in the 9’s, but clearly, that’s way too high.

7/21/09 – Testimony before the House Committee on Financial Services
A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability.

Falling Markets, QE 3.0 and Propaganda

The essence of the interventionist policy is to take from one group to give to another. It is confiscation and distribution.-Ludwig von Mises

Some say that falling markets won’t account for the imminence of QE 3.0.

That would signify a blatant misread.

For me, falling markets account as one of the two possible conditions for the re-institution of QE

As I previously wrote[1],

Although I expect that this extension won’t come automatically which I see as either tied to the US Congressional vote to raise debt limits or in reaction to growing pessimism in the some of the world’s economic environment due to a cyclical slowdown or to the accrued effects of signaling channels applied by governments or from mainstream’s addiction to inflationism. Besides if the debt ceiling will be raised this gives further excuse for the FED to activate QE 3.0.

Today’s financial markets have essentially been influenced by political forces more than economic developments. All the accounts of bailouts, rescues and assorted market interventions (quantitative easing, currency interventions, credit margin hikes on commodity markets) are part of the many examples. All these have effects on the marketplace[2].

Thereby, the state of the current sluggishness in the Philippine and global markets could likely be symptomatic of more of political design than merely reactions from economic forces.

Markets as Hostage to Politics

This week, we saw a political representative of China and one of the Fed officials jawbone on the possible adverse repercussions[3] from the palpable dabbling of a brief debt default by several Republican lawmakers as the debt ceiling is being deliberated.

This week, reports also say US President Obama pondered on using tax cuts as possible concession to the Republicans to reach a compromise[4].

Earlier both President Obama[5] and Treasury Secretary Tim Geithner[6] warned of a global recession if a settlement on raising the debt limits won’t be reached.

About a month ago a series of studies from the US Federal Reserve came out to state that commodity prices have not been tied with Quantitative Easing. Also during the same period commodity markets were slammed by the repeated increases of credit margins[7] of several commodities.

The point is the markets are seemingly being held hostage by politics. The idea is that markets can indeed go down, for the plain reason that the market is being used as leverage to secure political concessions.

Intervening and manipulating, directly or indirectly in the marketplace has been the du jour trend of today.

And what appears to be the imperative political tenet resonates in the famous statements of President Obama’s former Chief of Staff Rahm Emanuel[8]...

Never let a serious crisis go to waste. What I mean by that is it's an opportunity to do things you couldn't do before.

Don’t you see, the vehement aversion to crises has been the hallmark of today’s politicking?

This runs along with the prevailing economic ideology which guides on the directives of the political orthodoxy, where the prescription to supposed “market failures” would be through interventions channeled mainly through Keynesian concepts of ‘parting with liquidity’ (giving up liquid assets in exchange for employment-creating illiquid assets) ‘euthanizing the rentiers’ (low interest rates), and ‘socializing investment’ (public private partnership)[9].

Even Harvard Professor Carmen Reinhart along with her colleagues observes of the ongoing non-market features of today’s marketplace[10] characterizing an environment which they call as financial repression, (bold emphasis mine)

Undoubtedly, a critical factor explaining the high incidence of negative real interest rates was the aggressively expansive monetary policy (and, more broadly, official central bank intervention) in many advanced and emerging economies during the crisis. This raises the broad question of the extent to which current interest rates reflect the stance of official large players in financial markets rather than market conditions. A large role for nonmarket forces in interest rate determination is a key feature of financial repression.

In short, official players will likely manipulate markets to meet their ends.

Stoking Fear

And part of such tactical operations would probably mean instilling fear to paint an ambiance of urgency.

And speaking of fear, the current stock market declines seem to have twitched Wall Street’s fear measures higher.

Whether seen from original computation of volatility ($VXO), the current VIX ($VIX) and volatility applied to the CBOE S&P 500 3-Month ($VXV) signs of fear have emerged. The rallying US dollar appears to chime with such an environment.

This fear has been evident even seen Google Search trends (chart below).

Lately Google has shown increasing searches by the public for ‘double dip’. Meanwhile news and articles featuring double dip have also grown.

Given that Wall Street has been a politically privileged sector, with more fear comes the greater clamor for interventions.

Wall Street operates in an environment fostered by the moral hazard, which reveals on their sense of entitlement.

Rescues signify political events. Only in the pretext of growing risks of a crisis that would incur pernicious broad market and economy welfare implications will bailout measures be deemed as justifiable by politicians and the bureaucracy.

And along this line, it wouldn’t be farfetched to say today’s actions in the marketplace could be part of the effects of the conventional signaling channel tool used by central banks in preparation for the next set of rescue measures.

That’s why mainstream media seems to have misinterpreted Bernanke’s last comments as having ‘no QE 3.0’ when the fact is Bernanke’s statements prior to November 2010’s QE 2.0 resembled his latest comments[11].

In short, if there is no emergency, then there will be no rescue. Falling markets sow the seeds of alarmism, and thereby, setting in motion the conditions required for prospective rescues.

As previously noted, this has been the routine recourse by political leaders almost everywhere.

A Possible Growth Scare and Not a Crisis

Despite the recent signs of fear, credit markets in the US and in Euro seem to remain calm.

The above chart from Danske Bank[12] shows marginal signs of impact from the current equity-commodity downdraft on US bond markets and on interbank loans as represented by the LIBOR OIS spread.

But this has not been powerful enough to stir the proverbial hornet’s nest.

And the cyclical downturn of major economies following a vigorous upside could also be part of the story.

As the Danske Research writes[13],

Global leading indicators have suffered a setback recently, pointing to slower growth. The US ISM dropped considerably in May and European PMIs also fell faster than expected. China, on the other hand, seems to have stabilised, as the PMI dropped slightly in May and order-inventory bottomed.

The current declines could represent more of a growth scare instead of imminent risks of crisis or recession as presented by politicians.

Also, Danske Research[14] thinks that the dislocation from Japan’s recent disaster has partly been the culprit of the downturn of economies. But signs according to them are that Japan has been recovering fast.

The above evidences seem to show that the essence of fear being manifested by reports which highlights ‘double dip’ concerns may seem unwarranted.

A growth scare and not a crisis could be taking place.

Yet it is quite obvious that politics have been dominating feature of the marketplace.

---

[1] See ASEAN’s Equity Divergence, Foreign Fund Flows and Politically Driven Markets, June 5, 2011

[2] See Poker Bluff: No Quantitative Easing 3.0?, June 5, 2011

[3] See China Warns US on Debt Default as ‘Playing with Fire’, June 9, 2011

[4] See US President Obama Mulls Tax Cuts as Compromise for Raising Debt Limits June 9, 2011

[5] Huffington Post, Obama Debt Ceiling Warning: Raise Limit Or Risk Global Recession, April 15, 2011

[6] Wall Street Journal Geithner Issues Warning on Debt Ceiling, May 15, 2011

[7] See War on Commodities: Intervention Phase Worsens and Spreads With More Credit Margin Hikes! , May 14, 2011

[8] Wall Street Journal A 40-Year Wish List, January 28, 2009

[9] what-when-how.com SOCIALIZATION OF INVESTMENT

[10] Reinhart Carmen M., Kirkegaard Jacob F., Sbrancia M. Belen Financial Repression Redux, June 2011, IMF FINANCE & DEVELOPMENT

[11] See Bernanke’s Comments Mirror Those of Pre-QE 2.0 in 2010, June 8, 2011

[12] Danske Bank, Bad macro indicators and Greece weigh on market sentiment, Weekly Credit Market, June 10, 2011

[13] Danske Bank, Global: Business Cycle Monitor, June 6, 2011

[14] Danske Bank, ECB confirms July rate hike, Weekly Focus June 10, 2012

Phisix: Negative Real Interest Rate and Stagflation Risks

The real interest rate is not the difference between the nominal rate and the change in the CPI; it is actually the rate of exchange between present goods and future goods. Also, there is no such thing as the real interest rate — there are a multitude of real rates, which cannot be added to a total. -Frank Shostak

In sympathy with the actions in global markets, the Phisix declined 1.82% over the week which reduced year to date gains to .44%.

Negative Real Interest Rate and BSP’s Admission of External Influences

The Philippines and most of ASEAN have so far been less politically influenced relative to other markets.

But this doesn’t make us immune.

Proof?

From Bloomberg[1],

``Bangko Sentral will review inflation forecasts for this year and 2012 at the June 16 meeting, Tetangco said. An extension of the Federal Reserve’s so-called quantitative easing, “if it happens,” will tend to boost inflows to emerging- markets, bolster liquidity and strengthen currencies, he said.”

The good governor does not directly say it; but he implicitly acknowledges that there exists a strong transmission mechanism from US Federal Reserve policies, which have substantial effects on local assets, the local economy and inflation.

Governor Amando Tetangco thinks he has all the required tools to manage this.

I quote Governor Tetangco anew from the same article,

“If you look at the May figure, inflation pressures still exist,” Tetangco told reporters in Manila today. “We will look at the options available, the instruments included in the toolkit including the policy rate, reserve requirement and macro prudential measures.”

And I have been saying that local media and the BSP have not been forthright[2] and will miscalculate on estimating inflation trends.

This has been happening.

Nevertheless, the Philippines still operates on an accommodative monetary policy.

Previously, the Philippine (CPI) inflation rate, as shown in the chart from tradingeconomics.com[3], has been slightly above interest rates which make for a negative real interest rate environment[4], where inflation is greater than interest rates. In this article, I will be wearing on the mainstream’s thinking cap on interest rates.

So accounting gains from fixed income investments on a nominal basis could likely be overestimated unless adjusted for by inflation.

The Bangko Sentral ng Pilipinas (BSP) increased its policy interest rates twice this year but so far, the level of rates are just about the level of BSP’s statistical inflation.

Yet given the public’s outcry over price hikes in energy and food, I think that the mathematical construct of the BSP’s CPI basket seems to underreport real CPI inflation.

This only means that the current operating conditions imply that negative interest rate environment could be alot greater than what can be gleaned seen using BSP computations.

The overall implication, according to Wikipedia.org[5], is that negative real interest rates leads

to commodity speculation and business cycles, as the borrower can profit from a negative real interest rate

Also, given the combination of the current level of economic growth rate, which remains far above the interest rate, coupled with the negative real interest rate outlook, suggests that the Philippines continues to operate on a loose monetary inflation stoking environment.

Easy money policies which favor debtors also mean favoring speculators. Thus, current environment remains supportive of an upbeat Phisix, despite a current slowdown elsewhere.

So both external and internal forces in fusion points towards higher inflation which will go beyond the expectations and the statistical estimates of the BSP.

The Peso yield curve seems to be indicating the same inflation outlook (chart from ADB’s Asian Bonds Online[6])

Our current yield curve (red) has further steepened from last year (yellow) implying higher future inflation.

To add, going back to the economic growth, inflation and interest rate chart, despite the slowing growth momentum (measured in quarterly changes upper window), which is signified by the red arrow, the above dynamics seems representative of symptoms known as stagflation—high inflation accompanied by high unemployment and slower economic growth[7].

So this could be a preview of what’s going to happen once inflation intensifies.

Stagflation and the EPIRA law

Aside from local and foreign monetary policies, part of the worsening of domestic inflation has recently been seeded.

The passage or the extension of the politically correct but economically unfeasible decree signified by the massive electricity subsidies based on the Electric Power Industry Reform Act [EPIRA] law[8] will be part of such force. In 2010[9], I have previously discussed on how this would contribute to today’s inflation. Apparently we see signs of price pressures[10] part of which has been due to this.

These subsidies would intensify demand for electricity consumption, where the benefits of political free lunches aimed at acquiring votes, will only be passed and added to the burdens of all productive enterprises.

The outcome will reminisce the past where increasing costs of energy will translate to higher cost of doing business, elevated risk premiums and high hurdle rates that would imply fewer investments, higher levels of unemployment, lower growth rate and importantly lower standards of living.

Moreover, this law impels for the growing risk of power supplies shortages.

Eventually socialist type of free lunches runs dry. As former UK Prime Minister Margaret Thatcher says[11], Socialism

always run out of other people's money. It's quite a characteristic of them

Proof?

Venezuelan President Hugo Chavez claims that energy is a “birthright” for Venezuelans[12]. The result has been a massive rolling blackout, a model we should look forward to especially in the face of the continued uptrend in commodity and energy prices.

In addition, like Venezuela[13], we can expect more smuggling or black market or illegal connections to take place.

Indonesia has learned from such unviable and absurd policies and has begun dismantling subsidies to all sectors.

As the Jakarta Post reports[14],

The government expects to remove the electricity subsidy completely by as early as 2014 so that it will have more funds available to fight poverty and improve healthcare directly for the poor, a minister has said..

Unfortunately we have taken the opposite route.

Yet this is an example of redistributive tax scheme, where publicly listed Meralco, a legally franchised monopoly, would serve as the conduit for such mandate. This validates only my observation about Meralco’s status as a pet company for politicians[15].

The good news is that stagflation does not automatically translate to wreckage for the stock markets. Not if we use Venezuela as a model.

Venezuela has had an amazing stock market run this year[16] despite inflation tipping towards hyperinflation earlier, along with high unemployment and a two year economic slump which she has reportedly emerged from[17].

This is not to say that stagflation is good for the stock market, instead the returns of Venezuela’s stock markets remains negative when computed for inflation.

Put differently Venezuela’s stock market could have functioned as a defensive store of value from her rapidly devaluing currency.

The other point is that Venezuela’s dynamic may or may not apply elsewhere because of every nation’s idiosyncrasy or structural uniqueness.

For most, the current state of boom bust cycles, which drives global stock markets evinces that meltdowns are a mostly result of liquidity contraction from a previous inflationary environment such as the recent cases of Bangladesh[18] and Vietnam[19] or the global 2008 crisis.

PSE: It’s a Correction Phase

Last week’s correction seem as broadmarket based.

All sectors endured losses. Even the mining sector which has sizzled for 10 consecutive weeks finally relented.

The good news is that despite the losses, market breadth hasn’t been as dire as declining issues led advancing issues moderately.

Even net foreign trade posted slightly negative.

The Peso declined along with the local benchmark market, albeit only marginally lower from php 43.205 to a US Dollar last week to php 43.28 at Friday’s close.

Market internals and the Peso’s actions have not yet been manifesting signs of sharp deterioration.

Thus, I’d read the actions in the Phisix as a consolidation phase awaiting a trigger for a next run.

One would further note that the last time the Phisix collapsed was in an environment of higher rate of inflation and higher level of interest rates than today. Of course the 2008 episode accounted for as contagion which whose origins were from external forces.

The point is I don’t see substantial signs of severe corrosion of financial and economic conditions yet.

Finally, we should expect the continuance of current global volatility until political issues abroad would get threshed out.

As for the timing of when this resolution will happen is beyond my capabilities as analyst, I can only speculate.

As Ludwig von Mises wrote[20], (bold emphasis mine)

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people's actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety.

And since I expect the current market actions to represent more of a countercyclical reprieve than a major inflection point, then it should be considered as windows of opportunities to accumulate or for trade.

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[1] Bloomberg.com Philippines’ Tetangco Says Inflation Pressures ‘Still Exist’ (1), June 10, 2012

[2] See The Code of Silence On Philippine Inflation, January 16, 2011

[3] Tradingeconomics.com Philippine Indicators

[4] Investorglossary.com Real Interest Rates

[5] Wikipedia.org Negative Real Interest Rates

[6] Asianbondsonline.adb.org Philippines

[7] Wikipedia.org, Stagflation

[8] Businessworldonline.com Legislators OK extension of lifeline subsidy scheme, June 7, 2011

[9] See Earth Hour In The Philippines: Rotational Brownouts! The Revenge Of Economics, April 09, 2010

[10] Philstar.com Power, fuel rates up, April 6, 2011

[11] Thatcher Margaret TV Interview for Thames TV This Week 1976 Feb 5 Th

[12] Yahoo.com Hugo Chávez challenges Venezuelan 'birthright' to cheap gas, March 4, 2011

[13] Reuters Africa, World's lowest gas prices fuel Andean smuggling, June 10, 2011

[14] Jakarta Post, Govt expects to remove electricity subsidy by 2014, March 23, 2010

[15] See Meralco’s Run Reflects On The Philippine Political Economy, July 12, 2009

[16] See Global Equity Markets: Signs of Exhaustion; What US Outperformance Means, May 17, 2011

[17] Wall Street Journal 2nd UPDATE: Venezuela 1Q GDP Up 4.5% Vs Previous Year, May 17, 2011

[18] See Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets, January 11, 2011

[19] See Vietnam Stock Market Plunges on Monetary Tightening, May 24, 2011

[20] Mises, Ludwig von UNCERTAINTY: Case Probability, Chapter 6 Section 4 Human Action