Phisix-ASEAN Market Volatility: Politically Induced Boom Bust Cycles

It’s hard enough for politicians to face the music, to dispense bad news, to make hard choices, allocate pain to constituencies whether it’s spending cut or tax increase. But when the Fed destroys the bond market, which is the benchmark for the whole capital market, and tells the Congress that you can borrow money for two years at eighteen basis points, which is -- as far as Washington’s concerned -- that’s a rounding error. It’s the same as free. When you’re giving that kind of signal, then there is no incentive, there’s no motivation for people to walk the plank and face down this monster of a fiscal deficit and imbalance that we have. Washington thinks you can kick the can down the road, the debt is more or less free, and we’ll get around to solving the problem. But today, let’s not make any tough choices. That’s where we are. - David Stockman

It’s the Boom Bust Cycle, Stupid

Why would global markets fall in sync in September 22^nd?

It would appear an idiotic idea to suggest that most people woke up on the wrong side of the bed and thus abruptly decided to dump equity holdings en masse.

It would also seem myopic to suggest that this has been a byproduct of liquidity trap[1], where monetary stimulus—low interest rates and an increase in money supply—had been the cause of this.

The chart above of the ASEAN markets has been emblematic of what I have been repeatedly saying long ago—the message of which has been encapsulated from my earlier remarks[2] during the bear market embers of November 2008, (bold highlights original)

The other important matter is that of the understanding of the mutually reinforcing dynamics of inflation and deflation. Deflation and inflation is like assessing the virtues of right and wrong- an ex-post measure of a previous action taken. An action and an attendant reaction. Yet, you can’t have deflation when there have been no preceding inflation. At present times, the reason government has been massively inflating is because they have been attempting to combat perceived threats of equally intense debt deflation…

Thus, reading political tea leaves seem likely a better gauge in determining how to invest in the stock markets.

Since 2009, ASEAN markets had climbed on the back of the intensive inflationism employed by global central banks mostly led by the US Federal Reserve, through its zero bound rates and asset purchases or Quantitative Easing (see black arrow).

If this has been about a global liquidity trap then obviously there would have been no antecedent boom in ASEAN or global market equities during the stated period (2009-2010).

Yet during the past quarter where the Eurozone debt crisis has escalated, exacerbated by visible signs of an economic slowdown in the US and parts of the global economy, global financial markets has been strained.

Yet financial market expectations, whom have been deeply addicted towards bailout policies, have increasingly embedded expectations of another US Federal Reserve rescue.

Such expectation had not been realized.

The Liquidity Trap Canard

Before proceeding, it is important to point out that despite the current financial market turmoil, the Eurozone has not been suffering from ‘deflation’ as a result of lack of ‘aggregate demand’.

On the contrary, the EU has exhibited symptoms of stagflation[3].

In the US, aside from exploding money supply, consumer and business loans have been materially improving.

5 year chart of Business Loans from St. Louis Federal Reserve

5 year chart of Consumer Loans from St. Louis Federal Reserve

Both charts depict that the current problem or market meltdown hasn’t been about liquidity traps.

Importantly consumer spending in the US has remained robust.

To quote Angel Martin [4]

real personal consumption expenditures have recovered from pre-recession levels. This recovery can be clearly seen in this graph, which shows quarterly data from the first quarter of 2006 to the second quarter of 2011.

So the recent downdraft seen in the financial markets has NOT been about liquidity traps, which has been fallaciously and deceptively peddled by some.

Politically Induced Monetary Paralysis

So what has been the market ruckus all about?

In a September speech prior to the Federal Open Meeting Committee[5] (FOMC) meeting, which decides on the setting of monetary policy, Federal Reserve chief Ben Bernanke hinted that he would consider the lengthening the duration of bond purchases and possibly include further Quantitative Easing as part of the measures to further ease credit conditions[6].

Apparently going into the FOMC meeting on September 22^nd, opponents of Bernanke’s asset purchasing program mounted a publicity assault which included several Republican legislators[7], and most importantly, even Mr. Bernanke’s predecessor Mr. Paul Volker at the New York Times[8].

Even the outcome of the FOMC meeting, where Mr. Bernanke’s telegraphed policy of manipulating the yield curve via “Operation Twist” had been formalized or announced, the decision arrived at had not been unanimous and reflected internal political divisions.

Except for the inattentive or those blinded by bias, it has been obvious that only half of what had been impliedly promised by the Mr. Bernanke became a reality.

The net result has been a global financial market jilted by Mr. Bernanke[9].

Lately, even Federal Reserve of the Bank of Dallas President Richard Fisher acknowledged that their institution has been under siege “from both ends of the political spectrum”[10].

Such political impasse is not only seen in the US Federal Reserve, but also over fiscal policies in Washington, as well as, the schisms over prospective measures required to deal with debt crisis in the Eurozone. A good example has been the rebuff US Treasury Secretary Tim Geithner received from the German Finance Minister[11].

This has been coined by some as ‘political paralysis’ which continues to plague the markets[12].

As proof of politically driven markets, this week’s furious rally in global markets has been bolstered by renewed expectations of bailouts, as the German parliament overwhelmingly voted to beef up their contributions to the European Financial Stability Facility bailout fund. There are still 6 of the 17 euro zone countries[13] whom will need to pass the agreement reached in July 21^st.

Rumors have also floated that IMF might expand her exposure towards Euro’s bailout to a whopping tune of $3.5 trillion[14], which means the world, including the Philippines, will be part of the rescue team to uphold and preserve the privileged status of Euro and US bankers as well as the Euro and US political class.

Yet all these seem to have helped market sentiment and partly reversed earlier losses.

The point of all of the above is to exhibit in essence, how global financial markets have been substantially dependent on policy steroids. In other words, markets have been mainly driven by politics than by economic forces or that the current state of financial markets has been highly politicized and whose price signals has been vastly distorted.

And most importantly, the latest financial market meltdown represents as convulsions over failed embedded expectations from the apparent withholding of the expansion of rescue programs from which the financial markets have been operating on.

To analogize, today’s jittery volatile markets are manifestations of what is usually called as ‘withdrawal syndromes’ or symptoms of distress or discomfort from a discontinuation of a frequented or regularized activity.

In addition, financial markets appear to be blasé on merely promises, and seem to be craving for concrete actions accompanied by “big package approach[15]” from global policymakers. In short, policymakers will have to positively surprise the markets with even larger dosages of bailouts.

Non-Recession Bear Markets

I would like to further point out that it is not a necessary condition where recessions presage bear markets.

While some global equity indices have broken into bear market territory[16], the US and ASEAN markets have not yet reached the 20% loss threshold levels enough to be classified as bear markets.

Bear markets occur mainly because of political actions that creates boom bust conditions. This has been the case of China and Bangladesh[17].

The US has also experienced TWO non-recession bear markets.

The first instance was in 1962 which was known as the Kennedy Slide[18] where the S&P fell 22.5%.

Ironically the Kennedy Slide coincided with the failed original experiment of Operation Twist in 1961, as Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack wrote in a 2004 paper[19],

Operation Twist does not seem to provide strong evidence in either direction as to the possible effects of changes in the composition of the central bank’s balance sheet.

Except that the authors thought that the limits to the size had been responsible for this policy inadequacy, and Ben Bernanke today is conducting this experiment in a very large scale.

The Kennedy Slide’s boom phase appears to be triggered by the dramatic lowering of interest rates following the recession of 1960-61.

The bear market turned out to be short lived as the S & P 500 had fully recovered in a about a year later.

The second non-recession bear market is the notorious Black Monday Crash of October 1987.

The expansionary policies of the Plaza Accord[20] which represented coordinated moves by major developed economies to depreciate the US dollar, fuelled a boom bust cycle which eventually paved way for the lurid global one day crash.

As the great Murray N. Rothbard wrote[21],

To put it simply: the reason for the crash was the credit boom generated by the double-digit monetary expansion engineered by the Fed in the last several years. For a few years, as always happens in Phase I of an inflation, prices went up less than the monetary inflation. This, the typical euphoric phase of inflation, was the "Reagan miracle" of cheap and abundant money, accompanied by moderate price increases.

By 1986, the main factors that had offset the monetary inflation and kept prices relatively low (the unusually high dollar and the OPEC collapse) had worked their way through the price system and disappeared. The next inevitable step was the return and acceleration of price inflation; inflation rose from about 1% in 1986 to about 5 % in 1987.

As a result, with the market sensitive to and expecting eventual reacceleration of inflation, interest rates began to rise sharply in 1987. Once interest rates rose (which had little or nothing to do with the budget deficit), a stock market crash was inevitable. The previous stock market boom had been built on the shaky foundation of the low interest rates from 1982 on.

The crash had been a worldwide phenomenon according to the Wikipedia.org[22]

By the end of October, stock markets in Hong Kong had fallen 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.45%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover. (The terms Black Monday and Black Tuesday are also applied to October 28 and 29, 1929, which occurred after Black Thursday on October 24, which started the Stock Market Crash of 1929. In Australia and New Zealand the 1987 crash is also referred to as Black Tuesday because of the timezone difference.) The Black Monday decline was the largest one-day percentage decline in the Dow Jones. (Saturday, December 12, 1914, is sometimes erroneously cited as the largest one-day percentage decline of the DJIA. In reality, the ostensible decline of 24.39% was created retroactively by a redefinition of the DJIA in 1916.)

Yet many experts had been misled by the false signal from the flash crash to predict a recession, again from the same Wikipedia article,

Following the stock market crash, a group of 33 eminent economists from various nations met in Washington, D.C. in December 1987, and collectively predicted that “the next few years could be the most troubled since the 1930s”. However, the DJIA was positive for the 1987 calendar year. It opened on January 2, 1987, at 1,897 points and would close on December 31, 1987, at 1,939 points. The DJIA did not regain its August 25, 1987 closing high of 2,722 points until almost two years later.

And in typical fashion, central banks intuitively reacted to crash by pumping mass amounts of liquidity into the system[23].

It took 2 years for the S&P to return to its pre-crash level.

The non-recession bear markets reveal that in the case of the US, such an occurrence would likely be shallow and the recovery could be swift.

But it would different story in China as the Chinese government continues to battle with the unintended effects of their policies which has spilled over to the real estate or property markets. Apparently, China’s tightening policy drove money away from the stock market, which continues to drift near at September 2009 lows, but shifted them into the real estate sector.

In short, like the crisis afflicted West, the current depressed state of China’s stock market signifies as an extension of the bubble bust saga which crested in October 2007, a year ahead of the Lehman episode. China’s cycle remains unresolved.

Should the US equity markets suffer from a technical bear market arising from the current stalemate in Federal Reserve policies, but for as long as a recession won’t transpire from the current market distress, then the downside may be mitigated.

So far, the risk for a US recession has not been that strong and convincing as shown by the above recovery in lending.

Conclusion: Navigating Turbulent Waters Prudently

And as I concluded two weeks ago[24],

I would certainly watch the US Federal Reserve’s announcement and the ensuing market response.

If team Bernake will commence on a third series of QE (dependent on the size) or a cut in the interest rate on excess reserves (IOER), I would be aggressively bullish with the equity markets, not because of conventional fundamentals, but because massive doses of money injections will have to flow somewhere. Equity markets—particulary in Asia and the commodity markets will likely be major beneficiaries.

As a caveat, with markets being sustained by policy steroids, expect sharp volatilities in both directions.

The point of the above was that my expectations had conditionally been aligned to the clues presented by Ben Bernanke of putting into action further bailouts which apparently did not occur.

And since Mr. Ben Bernanke appears to be politically constrained to institute his preferred policies, it is my impression that he would be holding the financial markets hostage until political opposition to his policies would diminish that should pave way for QE3.0. This means that the balance of risks, in my view, have now been tilted towards the downside unless proven otherwise.

Remember, it has been a dogma of his that the elixir to US economy emanates from asset value determined ‘wealth effect’ spending via the transmission mechanism which he calls the Financial Accelerator[25]

To quote the BCA Research[26],

But until QE3 is credibly articulated by Bernanke, there could be more downside for risky assets and further upside for the dollar.

And converse to my abovestated condition or premises, and because I practice what I preach, I materially decreased exposure in the local markets, as I await further guidance from the actions of policymakers.

Although I still maintain a bullish bias, in order to play safe, I would presume a worst case scenario—current global bear markets are signifying a recession—as the dominant forces in operation.

It’s easy to falsify the worst case scenario with incoming policy actions, data and unfolding market events.

Alternatively, this means that for as long as a non-recession scenario becomes evident then it would be easy to position incrementally, hopefully with limited downside risks.

In other words, for as long as there remains no clarity in the policy stance, I see heightened uncertainty as governing the markets. Thus I would need to see the blanc de l'oeil or the French idiom for seeing ‘the white of their eyes’ before taking my shots.

Bottom line: In the understanding that incumbent markets have been driven by politics, reading political tea leaves or the causal realist approach will remain as my principal fundamental analytical methodology in ascertaining my degree of market level risk-reward exposure.

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[1] Wikipedia.org Liquidity trap

[2] See Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?, November 30, 2008

[3] See Stagflation, NOT DEFLATION, in the Eurozone, October 1, 2011

[4] Martin Angel The Stagnant U.S. Economy: A Graphical Complement to Higgs’s Contributions, Independent.org, September 23, 2011

[5] US Federal Reserve Federal Open Market Committee

[6] See US Mulls ‘official’ QE 3.0, Operation Twist AND Fiscal Stimulus, September 9, 2011

[7] Yahoo News Republican lawmakers warn Federal Reserve against action on economy, September 21, 2011

[8] See Paul Volker Swings at Ben Bernanke on Inflationism, September 20, 2011

[9] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms, September 22, 2011

[10] Bloomberg.com Fisher Says Central Bank Is Under Attack From Ron Paul, Barney Frank, September 28, 2011

[11] See German Minister Calls Tim Geithner’s Bailout Plan ‘Stupid’, September 28, 2011

[12] New York Times, Stocks Decline a Day After Fed Sets Latest Stimulus Measure, September 23, 2011

[13] New York Times, Germany Approves Bailout Expansion, Leaving Slovakia as Main Hurdle, September 29, 2011

[14] See Will IMF’s bailout of Euro Reach $ 3.5 trillion? September 30, 2011

[15] Johnson Simon What Would It Take to Save Europe?, New York Times September 29, 2011

[16] Bloomberg.com Global Stocks Drop 20% Into Bear Market as Debt Crisis Outweighs Profits, September 23, 2011

[17] See Can Bear Markets happen outside a Recession? China’s Shanghai and Bangladesh’s Dhaka Indices October 1, 2011

[18] Wikipedia.org Kennedy Slide of 1962

[19]Bernanke Ben S., Reinhart Vincent R., and Sack Brian P. Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, 2004 US Federal Reserve

[20] Wikipedia.org Plaza Accord

[21] Rothbard, Murray N. Nine Myths About The Crash, Making Economic Sense Mises.org

[22] Wikipedia.org Black Monday (1987)

[23] Lyons Gerard, Discovering if we learnt the lessons of Black Monday, thetimesonline.co.uk, October 19, 2009

[24] See Definitely Not a Reprise of 2008, Phisix-ASEAN Equities Still in Consolidation, September 18, 2011

[25] Bernanke Ben S. The Financial Accelerator and the Credit Channel, June 15, 2007 US Federal Reserve

[26] BCA Research U.S. Dollar: Waiting For More Policy Action, September 27, 2011

Market Crash Confirms Some of My Thesis on Gold and Decoupling

The recent market meltdown confirmed many realities of the several thesis that I have been writing about.

Aside from the boom-bust cycles, the recent crisis debunks the decoupling theory.

When faced with the increased risks of a global liquidity contraction, market actions have converged to tighten correlations of the risk asset markets almost across the board.

As almost every markets fell, the US dollar and US treasuries became the temporary safehaven.

ASEAN markets, whom initially seemed defiant from the unfolding crisis in the West, has not been spared; even debt default risks, represented by prices of Credit Default Swaps (CDS), of ASEAN and Asian bond markets have begun to rise.

The US Dollar’s Temporary Role as Flight to Safety Haven

I’d like to further point out that the temporary status of the US dollar as refuge is largely due to the unraveling crisis of the Eurozone, or that the relative immediacy of the impact of the Euro debt crisis has been more than that of the US.

The US is NOT and will NOT be IMMUNE to the laws of economics as absurdly suggested by political zealots; the US also faces a prospective fiscal crisis from the continuing profligate ways of the welfare-warfare addicted government. The recent S&P downgrade[1] has been portentous of this.

The current record low or near zero rates almost across the yield curve, which for some represents as opportunity for the US government to further rack up expenditures, is not and will not be a permanent state. More welfare based extravagance ensures the erosion of the US dollar as safehaven status overtime.

Also since the US has largely been less reliant on cash transactions, thus US sovereign securities have temporarily assumed the role of moneyness or as an alter ego to cash.

Most importantly, the US dollar remains as the world’s premier foreign currency reserve as shown above where the US dollar represents about 60% of reserves held by governments and various institutions[2]. In addition, the US dollar represents 85% share of forex transaction in April 2010 down from a peak of 90% in 2001[3]. And of the $95 trillion size of global bond markets in 2010, the US accounted for the largest share at 39%[4].

This means that in a period of dramatic loan margin calls, redemptions or liquidations, and where most of the international payments and settlement system have been based on the US dollar, then it would be OBVIOUS that the US dollar becomes the de facto safe haven. The liquidations in the Eurozone only amplify on such dynamics.

It would be foolish to believe that the US is protected by some mantle of magical or supernatural powers. The only forces that has been giving the US dollar its current strength has mainly been the relatively worst current conditions of the Eurozone, global financial market’s perception of insufficient liquidity* and Ben Bernanke’s dithering on QE 3.0.

*Banking and state insolvencies are valid issues but central banks have been covering such shortcomings with the panacea of liquidity injections. Except that today, financial markets seem to discern that the current state of liquidity injections has not been enough.

Debunking Gold as Hedge Against Deflation and Fear

Another myth demolished by the present crisis is the assumed role of gold.

Many say that gold will function as hedge against deflation. Another camp says that gold functions as refuge against fear.

Both have been proven wrong.

The day Ben Bernanke inhibited the deployment of QE 3.0, gold prices along with the broad based commodity spectrum came crashing down together with global financial markets.

Where the perception that monetary expansion will not be applied, asset liquidation has dominated and gold prices had not been exempt.

So much for the deflation refuge. May I emphasize that asset deflation does not automatically suggest of consumer price deflation or an economic wide deflation-recession.

Also crashing equity markets around the world has been coincidental with falling gold prices. Essentially this discredits the idea that gold serves as refuge against fear.

True, many central banks will continue to inflate—such as the ECB, Swiss National Bank, National Bank of Denmark, Bank of Japan and others—but current state of markets suggest that their actions has not been satisfactory to warrant maintaining lofty record gold prices.

Either these central banks would have to inflate intensively, or more importantly, that team Bernanke joins the bandwagon to deliver the meat of what the market expects.

Also, while gold may be in a natural correction mode given its previously severely overbought conditions, I would think less about the importance of the technical conditions.

I believe that the Fed’s current inaction is temporary. Ben Bernanke would want to see more market pressures to justify QE in order to stave off deflation. In his recent public appearance he again raise the deflation bogeyman[5]

"If inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation"

And since price trend of gold seems correlated with the actions of ASEAN markets, a wobbly gold price trend would translate to an uneasy or apprehensive markets for the Phisix or ASEAN equities.

Thus, unless I see gold prices make a substantial recovery, I am predisposed to say that ASEAN equity markets could be susceptible or vulnerable to significant price retrenchments for the time being

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[1] See Misleading Discussion on US Debt Downgrade Crisis, August 9, 2011

[2] Wikipedia.org Reserve currency

[3] Marketwatch.com Daily foreign-exchange turnover hits $4 trillion, September 2001

[4] Wikipedia.org Bond Market Size Bond market

[5] See Ben Bernanke: Falling Markets will Justify QE 3.0, September 30, 2011

Phisix: Internal Market Actions Reflect on Boom Bust Conditions

Market internals reflect on the highly volatile bubble conditions.

The steep gyrations in both directions over the past two weeks had been equally reflected on market internals in the US or in the local markets.

Those stubbornly insisting that stock prices are about ‘earnings’ should explain the deepening unorthodoxy of the price actions in the equity markets or the growing discrepancy between price actions and ‘fundamentals’.

Current price actions in the local or in the US markets increasingly reflect on tidal flows[1] which are symptomatic of boom bust cycles.

Market breadth has been lopsided during downturns and in as much as in upturns.

Sectoral performances reflected on the same patterns. The meltdown a week ago which exhibited a broad based decline, had been reversed last week.

Bizarrely despite the furious volatility, foreign outflows remain limited.

Such dynamic appears to be reflected on the Philippine Peso which curiously still remains at the mid 43 levels despite the current turbulence. On Friday, the Philippine peso closed at 43.72 which was little change from last week’s 43.58.

Finally, there has been a huge spike in the weekly average of total number of issues traded even as markets moved sharply in both directions.

The extreme signs of volatility suggests of a very emotional state of the markets, which again highlights boom-bust conditions.

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[1] See US Equity Markets: More Signs of Tidal Flows, September 29, 2011

Celebrating Unsung Heroes of Capitalism: Wilson Greatbatch

From analyst Andy Kessler at the Wall Street Journal (emphasis added)

Wilson Greatbatch, 92, died this week a wealthy man. Investing $2,000 of his own money way back in 1958 and tending a garden to feed his family, Greatbatch invented the pacemaker. He licensed it to Medtronic, a company now valued at $36 billion that sells and continues to improve pacemakers and defibrillators. Greatbatch did his part to improve society, create wealth and increase, quite literally, our standard of living. But apparently that's not enough. President Obama suggested under a Cincinnati bridge this month that "if you've done well . . . then you should do a little something to give something back."

Give something back? Greatbatch did well specifically because he provided something that society needed. His and Medtronic's profits are what you and I are willing to pay above costs for these life-enhancing devices. This is true of Apple iPhones and Genentech Herceptin and Google Maps and Facebook Likes.

Ever since the mid-19th-century era of so-called Robber Barons, this country has had a philosophical divide over the role of business in a democracy. It's time to set the record straight.

History has proven that the road to increased standards of living and wealth was built on productivity—doing more with less. It was the Industrial Revolution that got us out of the growing fields and into factories, which allowed us to pay for roads and teachers and civil servants. And now the move out of factories into air-conditioned offices is creating anxiety. It shouldn't. Labor replacement is productivity. James Spangler's vacuum cleaner. The Walker brothers' dishwasher. Clarence Birdseye's flash freezing. DuPont's Kevlar. And John Simpson's guidewire catheter for angioplasty and heart stents—the list goes on. Each invention generated wealth because it improved our lives, not because someone "gave back."

Thanks Mr. Greatbatch, RIP.

I hope that people will learn to treasure those whom have truly contributed to our wellbeing through the markets.

Can Bear Markets happen outside a Recession? China’s Shanghai and Bangladesh’s Dhaka Indices

While bear markets usually accompany economic recessions, the cause and effect does not always hold.

Proof?

The following is China’s Shanghai Index (Bloomberg)

The Shanghai composite melted away nearly one year ahead of the global collapse brought about by the Lehman bankruptcy.

Since October the peak of 2007, today, the SHCOMP still is about 60% off the peak.

Peak to trough, from October 2007 to October 2008, the major Chinese composite lost 70.6% in one year, which means that from 2008-2011, only 10% of the accrued losses had been recovered.

However, the resultant world economic slowdown from the Lehman episode only diminished China’s economic growth rate (tradingeconomics.com) but did not lead to a technical recession.

China’s economic growth rate peaked in 2007 at around 13% and bottomed at 6% in 2009.

That’s partly because of China’s humongous $586 billion stimulus program which temporarily shielded the economy but has led to massive malinvestments.

One would note that money supply incrementally grew (red lines) from 2005-2007, but accelerated when the enormous stimulus packaged had been unleashed.

What has been palpable was the growth had been in new loans (chart Guinness Atkinson), which seemed unaffected by the stock market crash.

However, the Shanghai Composite bear market began or coincided with the regime's monetary tightening.

Bank reserve ratios had been serially increased, aside from interest rates which rose in 2007 until February of 2008. (chart from IMF)

However as noted above, the stimulus only prompted speculation to shift money from the stock market towards real estate (see below)

Yet the Chinese government has been attempting to contain the ballooning bubble via the same tools it used against the stock market plus some additional features as financial markets worked around government regulations.

Again from the IMF, (bold emphasis mine)

The central bank has used both reserve requirements and higher interest rates to slow credit but still relies heavily on direct administrative limits on loan growth. The central bank has also introduced a supplemental “dynamically differentiated reserve requirement,” which varies across banks and through time based upon the pace of credit growth at the bank, the capital adequacy ratio, and other factors. Staff argued that this focus on quantity limits has limited the supply of bank credit but with little impact on the cost of capital or demand for new loans.

In addition, with guaranteed loan deposit rate margins, the banks still have strong incentives to expand lending. As a result, the control of monetary aggregates through direct limits on bank lending is already being disintermediated. There has been a significant rise in off-balance sheet provision of loans (e.g. through trust funds, leasing, bankers’ acceptances, inter-corporate lending, and other means) and a growing intermediation of credit through nonbanks and fixed income markets. In addition, over the past several months, there have been large loan inflows from offshore entities recorded in the balance of payments (as Chinese companies go abroad to offset credit restrictions at home). Such avenues were already partially counteracting the impact and effectiveness of monetary tightening and that tendency was likely to increase in the coming years.

The central bank indicated that it was committed to moving gradually to more price based tools of monetary policy, noting that loan and deposit rates had been increased four times since October. The central bank was also now monitoring a broader measure of “social financing”—which includes bank loans, off balance sheet lending, as well as funds raised in the equity and bond markets—in order to better judge financial conditions. They felt that the existing array of tools and the expanded scope of their surveillance would be sufficient to contain disintermediation risks. They also indicated that, to some degree, lending limits could be viewed as an effective microprudential device in a system where risk management and risk monitoring were still insufficiently developed.

The rise of off balance sheet financing would be symptomatic of what Hyman Minky’s would call as speculative financing of a credit cycle. This would somewhat replicate the role of the shadow banking system during the US mortgage crisis.

Bottom line: China’s continuing bear market has been a product of her government’s boom-bust policies.

One more example:Bangladesh

Bangladesh recently experienced a stock market crash that seems detached with the actions of global markets.

The Dhaka index still remains in a bear market since its apex in December of 2010… (Bloomberg)

…but there has been no signs of economic recession (tradingeconomics.com) accompanying the bear market

The apparent reason seems to be same: The reversal of the Bangladesh government’s previously induced boom policies with policy tightening that resulted to a stock market bust.

See my earlier explanation here

Depending on some other factors such as depth or penetration level of local investors on the domestic stock market or for other more reasons, actions in the stock markets can occasionally be detached from the real economy.

Self-Promotion: Prudent Investment Newsletters at the Wall Street Journal

I was surprised to see this…

My article featured in the Onespot section of the Wall Street Journal; click on the image to go to the link or this link.

Another shameless self-promotion for the Prudent Investor Newsletters

Stagflation, NOT DEFLATION, in the Eurozone

Some Keynesian diehards reach a state of egotistical orgasm, when they see the financial markets crashing, accompanied by record low interest rates.

They extrapolate these selective events as having to prove their point that today’s environment has been enveloped by a deflation induced liquidity trap- or the economic conditions, which according to Wikipedia.org, when monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply.

Let’s see how valid this is.

The Dow Jones Euro Stoxx 50 or an equity index representing 50 blue chip companies within the Eurozone is down by about 28% as of yesterday’s close from its peak in mid-February.

For the month of August, the Stoxx 50 fell by a dreadful 16%.

Yet according to the Bloomberg the Eurozone’s inflation has raced to the highest level in 3 years.

European inflation unexpectedly accelerated to the fastest in almost three years in September, complicating the European Central Bank’s task as it fights the region’s worsening sovereign-debt crisis.

The euro-area inflation rate jumped to 3 percent this month from 2.5 percent in August, the European Union’s statistics office in Luxembourg said today in an initial estimate. That’s the biggest annual increase in consumer prices since October 2008. Economists had projected inflation to hold at 2.5 percent, according to the median of 38 estimates in a Bloomberg survey.

Chart above and below from tradingeconomics.com

So low growth, high unemployment and elevated inflation in the Eurozone characterizes a stagflation climate and NOT deflation, in spite of the stock market meltdown.

While it is true given that commodity prices have crashed lately, which should temper on or affect consumer price inflation levels downwards, this is no guarantee that deflation in consumer prices will be reached. Perhaps not unless we see a nasty recession or another bout of a funding crunch. So far global central banks continue to apply patches in the fervid attempt to contain funding pressures.

Besides, contra-liquidity trap advocates, everything will depend on how monetary policies will be conducted in the face of unfolding events.

The ECB has actively been purchasing bonds (Danske Bank).

Yet despite these actions, the ECB has adapted a relatively less aggressive stance compared to the US in 2008. This implies that the policy response has continually lagged market expectations, and importantly, has been continually hobbled by political divisions, which has led to the ensuing turmoil.

This is not to say that aggressive responses by political authorities would solve the problem, but as in the US, they could serve as a balm. These are the “extend and pretend” actions that eventually will implode. For me, it’s better to have the painful market adjustments now, than increasingly built on systemic fragility which eventually would mean more pain.

Yet, despite current hurdles central bankers have not given up.

Denmark will unleash the same inflationism to bailout her banks. According to this report from Bloomberg,

Denmark’s central bank said it will provide as much as 400 billion kroner ($72.6 billion) as part of an extended collateral program to provide emergency liquidity to the country’s banks.

Lenders will also be able to borrow liquidity for six months, alongside the central bank’s existing seven-day facility, at a rate that tracks the benchmark lending rate, currently 1.55 percent, the bank said in a statement today.

The country’s lenders face a deepening crisis that threatens to stall a recovery in Scandinavia’s worst-performing economy. Two Danish bank failures this year triggered senior creditor losses, leaving international funding markets closed to all but the largest banks. Lawmaker efforts to spur a wave of consolidation and help banks sidestep Denmark’s bail-in rules have so far failed.

For as long as central bankers fight to preserve the political status quo by using expansionary credit easing tools or inflationism, deflation remains a less likely outcome.

Will IMF’s bailout of Euro Reach $ 3.5 trillion?

From the Daily Mail,

Christine Lagarde, the managing director of the IMF, said the current war chest of around £250billion ‘pales in comparison with the potential financing needs of vulnerable countries’ and needs to be expanded to deal with ‘worst-case scenarios’.

Sources in Washington said the IMF’s pot of cash could be expanded to £2.6trillion although officials in London said that figure looked ‘incredibly high’.

Mrs Lagarde’s warning came as U.S. President Barack Obama said the debt crisis in Europe was ‘scaring the world’ and that eurozone leaders were not dealing with the issue quickly enough.

And a top Bank of England economist urged leaders around the world to stop the world plunging back into recession. ‘It’s doing something rather than just saying something that counts,’ said Ben Broadbent, a member of the Bank of England’s Monetary Policy Committee charged with setting UK interest rates.

Danger: U.S. President Barack Obama said the debt crisis in Europe was 'scaring the world'

Britain is liable for 4.5 per cent of IMF funding – meaning it would have to contribute around £115billion to an enlarged bailout fund, or £4,600 per household.

It is conceivable that figure may turn out to be slightly lower because Britain’s share is falling as rapidly growing economies such as China contribute more.

Britain has already handed over £12.5billion in emergency loans to Greece, Ireland and Portugal to help prop up the euro.

The staggering rescue package proposed by the IMF signify that the rest of the world will be included. This would be led by the United States which reinforces their backdoor participation (aside from the monetary channels).

(Wikipedia.org: IMF)

And the proposed bailout implies of the inclusion of ASEAN and the Philippines with 3.94% voting share.

IMF: IMF Executive Directors and Voting Power

Yet such humongous bailout scheme, if it does become a reality, would adversely impact global economic growth as resources are shifted from productive use towards saving the skins of Euro bankers and the political class. Filipinos will pay for this with higher taxes or inflation.

Moreover, there are no guarantees that shock and awe bailout tactics will work over the medium term or the long term. Just look at what has been happening to the US, whose economy continues to flag despite the trillions of dollars expended by the US Federal Reserve and the US government.

Also, by funneling large amounts of resources to current rescue programs, the world would have depleted or drained their resources should another crisis arise anytime.

Lastly, the use of scare tactics to secure political deals, seem to be acknowledged by politicians. Except that for some, they pretend to fight them, when they in truth—they have impliedly been promoting them.

Ben Bernanke: Falling Markets will Justify QE 3.0

From Ben Bernanke’s public appearance last night [source: Reuters] (bold highlights added)

Federal Reserve Chairman Ben Bernanke said on Wednesday the central bank might need to ease monetary policy further if inflation or inflation expectations fall significantly.

In his first public remarks since the Fed launched a fresh measure aimed at keeping down long-term borrowing costs, Bernanke indicated a willingness to push deeper into the realm of unconventional policy if economic growth remains anemic.

"It is something that we're going to be watching very carefully," Bernanke said in response to questions from the audience at a forum sponsored by the Cleveland Fed.

"If inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation," Bernanke said.

My deciphering or translation of the above: ‘Despite the vocal protestations of my critics, a continuous decline of markets should validate my imposition of QE 3.0, which will absolve my position.’

The above statements serve as more evidence that Mr. Bernanke’s current policy actions appear to be constrained by politics. Global markets have already substantially fallen, with MSCI All- Country World Index of 45 nations breaking into the bear market territory last week, yet Chairman Bernanke’s favorite instrument has been in absentia.

Additionally, these statements can be construed as more indications that markets are being used as negotiation leverage or manipulated for political goals.

Could Mr. Bernanke, then, be wishing for the markets to endure further strains?

Has Germany and Ireland been printing their own Currencies?

I have seen some unconfirmed reports or rumors where EU member states as Ireland and Germany have been re-issuing their native currencies prior to joining the EU, particularly the Irish pound and the German deutschmark

From Moneynews.com

Ireland's central bank reportedly is printing Ireland's old currency in case the country leaves the eurozone. At least that's the rumor circulating in Dublin, notes Alan McQuaid, chief economist at Bloxham stockbrokers in that city.

McQuaid, writing a guest commentary for The Guardian, says he's not sure if the rumor is true. But he does hope Ireland has contingency plans in case the euro disintegrates.

Then again, given the record of European leaders, a lack of backup plan wouldn’t be surprising.
As Greece struggles to remain solvent, the European monetary union is scrambling to stop the debt crisis from spreading. If the crisis does spread, Ireland might be next in line.

Some pundits say Ireland should drop the euro.

Being master of your own destiny does have appeal, McQuaid admits. If it returned to the punt, Ireland could boost exports by devaluing the currency and reduce its debt burden.

Also, a known political insider Philippa Malmgren, special assistant to Special Assistant to the President for Economic Policy on the National Economic Council for ex-President Bush and was also a member of the President's Working Group on Financial Markets, aka, the Plunge Protection Team, at Sweden's largest business paper, Dagens Industri says that she expects Germans to return to the Deutschemark and have already ordered its re-issuance (hat tip: Bob Wenzel)

Germany refuses more emergency loans and prepares the reintroduction of the D-mark. They have already ordered the new currency and excites the printers to rush. It says the U.S. economy Doctor Philippa Malmgren.

"My impression is that the German Government sent us a number of signals that, from their perspective there is no other solution (than to leave the euro)," writes Philippa Malmgren, formerly an advisor to former U.S. President George W. Bush and global strategy director the banking giant UBS in his blog.

The validity of these reports are unclear.

Nevertheless, when markets are usually exhibiting signs of depression as this, they could signal a bounce or an important inflection point.

Otherwise if these reports are true, then a realization of Euro’s disintegration would likely mean intensely turbulent times for the financial markets—as the “newly” independent European central banks would likely embark on saving their respective national banking system by printing tsunami of money to counter waves of deflationary defaults.

In this case, we should expect even more massive gyrations both on the upside and downside that could make hearts palpitate rapidly.

Fasten your seat-belts.

Global Wealth Convergence

Economist Timothy Taylor writes, (bold emphasis mine)

It is possible that although inequality within many countries is rising, global inequality is actually falling. After all, a number of countries with lower levels of per capita income, like China and India, have been experiencing rapid growth. Perhaps from a global viewpoint, the gap between high and low incomes is diminishing even though within countries, that gap has been rising.

What looks more like Aristotle’s the “whole is greater than the sum of its parts” is what I call as the global wealth convergence dynamic

Mr. Taylor quotes an IMF study suggesting that China and India has been key factors that have been led to this,

What is the evidence on global inequality? Branko Milanovic offers a useful figure, where inequality is measured by the Gini coefficient. For those not familiar with this term, the quick intuition is that it is a measure of inequality where 0 represents complete equality of income and 100 represents complete inequality (one person has all the resources). Here is a figure showing Gini coefficients for relatively equal Sweden, the less equal U.S. economy, the still-less-equal Brazilian economy, and the world economy.

Milanovic writes: "Global inequality seems to have declined from its high plateau of about 70 Gini points in 1990–2005 to about 67–68 points today. This is still much higher than inequality in any single country, and much higher than global inequality was 50 or 100 years ago. But the likely downward kink in 2008—it is probably too early to speak of a slide—is an extremely welcome sign. If sustained (and much will depend on China’s future rate of growth), this would be the first decline in global inequality since the mid-19th century and the Industrial Revolution.

One could thus regard the Industrial Revolution as a “Big Bang” that set some countries on a path to higher income, and left others at very low income levels. But as the two giants—India and China—move far above their past income levels, the mean income of the world increases and global inequality begins to decline."

My intuition is that globalization has functioned as one of the most critical variable contributing to the global wealth convergence.

China and India’s merchandise trade has ballooned from 10% in 1976 to over 50% and 30% respectively even after the 2008 crisis. That’s because trade is a mutually beneficial action which leads to prosperity.

From Ludwig von Mises, (Nation, State and Economy p.165)

Economic history is the development of the division of labor. It starts with the self-contained household economy of the family, which is self-sufficient, which itself produces everything that it uses or consumes. The individual households are not economically differentiated. Each one serves only itself. No economic contact, no exchange of economic goods, occurs.

Recognition that work performed under the division of labor is more productive than work performed without the division of labor puts an end to the isolation of the individual economies. The trade principle, exchange, links the individual proprietors together. From a concern of individuals, the economy becomes a social matter. The division of labor advances step by step. First limited to only a narrow sphere, it extends itself more and more. The age of liberalism brought the greatest advances of this sort.

Commemorating the 130th Birthday of Ludwig von Mises

Today is the 130th birthday of one of my inspiration and role model: the great Ludwig Heinrich Edler von Mises…

Asia’s Demographic Inequality

Demography isn’t destiny, so argues the Economist, (bold emphasis added)

INVESTORS are often lured to countries like India and Vietnam by their demographic promise—by their fast-growing population of workers and consumers. Likewise, investors in China often worry that it “will grow old before it grows rich”. Demographics are not destiny, but they are a noteworthy determinant of economic potential. Youngsters and retirees do not work, which harms growth directly. And because these dependants make a claim on a country’s income without adding to it, they also depress savings, thereby slowing the accumulation of capital and the growth of productivity. In its latest Asian Development Outlook, the Asian Development Bank calculates the contribution of Asia’s youthful demographics to its economic success over the past decade. The bank also projects the impact of a greying population on Asia’s growth from now until 2030.

I concur that demographics represent only part of destiny. The economic destiny of every nation depends on the extent where people are allowed to accumulate and use capital efficiently (via economic freedom and free trade).

The Fallacy of Luddite Economics

We are told that by this Wall Street Journal article that business spending on machines than labor is bad news for the US economy. (bold emphasis added)

The man-vs-machine situation, however, presents a huge negative to the outlook. In an economy based on consumer spending, the lack of jobs and income growth means consumers can’t spend.

Businesses’ preference for equipment — while understandable from a cost perspective — is also a big reason why policymakers are stymied to find ways to ignite job creation.

Indeed, the Federal Reserve‘s pursuit of low interest rates only widens the cost gap. That’s because it cheapens the borrowing costs for capital projects while doing little to hold down payroll expenses.

The reasons cited why businesses spending have been substantially tilted towards machinery have rightly been attributed to political factors:

Aside from the Fed’s policies, again from the same article, (bold added)

You can’t fault companies for investing in new machinery rather than hiring new workers. As two news reports detail, labor costs are rising, a function of both private and public pressures.

First, employers face a jump in health insurance costs. The Kaiser Family Foundation reported a 9% average increase in the premiums paid by employers this year. The average yearly cost to cover a family hit a record $15,073, up sharply from $13,770 in 2010.

Second, companies must deal with higher taxes to replenish state unemployment-benefit coffers. According to Wednesday’s Wall Street Journal, employers will get hit by higher tax bills as many states have to pay back Washington for benefit money borrowed during the recession.

So while politics has been a factor, this misses out the more important factor: Investments in machines are about added productivity and a higher standard of living, which eventually brings about more jobs.

The great Henry Hazlitt demolishes this myth in the must read classic Economics in One Lesson p.41-42. Here is an excerpt: [bold emphasis added, italics original]

it is a misconception to think of the function or result of machines as primarily one of creating jobs. The real result of the machine is to increase production, to raise the standard of living, to increase economic welfare. It is no trick to employ everybody, even (or especially) in the most primitive economy. Full employment—very full employment; long, weary, back-breaking employment—is characteristic of precisely the nations that are most retarded industrially. Where full employment already exists, new machines, inventions, and discoveries cannot—until there has been time for an increase in population—bring more employment. They are likely to bring more unemployment (but this time I am speaking of voluntary and not involuntary unemployment) because people can now afford to work fewer hours, while children and the overaged no longer need to work.

What machines do, to repeat, is to bring an increase in production and an increase in the standard of living. They may do this in either of two ways. They do it by making goods cheaper for consumers (as in our illustration of the overcoats), or they do it by increasing wages because they increase the productivity of the workers. In other words, they either increase money wages or, by reducing prices, they increase the goods and services that the same money wages will buy. Sometimes they do both. What actually happens will depend in large part upon the monetary policy pursued in a country. But in any case, machines, inventions, and discoveries increase real wages.

By the article’s main premises—where consumption drives the economy and where machines signify a threat to consumption—then we must conclude that the medieval era or even the stone age would be a much wealthier and ideal society than today.