Rallying US Bonds Lifts Phisix and ASEAN Markets

Mark Hanna:   The name of the game, move the money from your client’s pocket into your pocket.

Jordan Belfort:   But if you can make your clients money at the same time it’s advantageous to everyone, corrent?

Mark Hanna:   No

…

Mark Hanna:   Nobody knows if a stock is going to go up, down, sideways or in circles. You know what a fugasi is?

Jordan Belfort:   Fugazy, it’s a fake.

Mark Hanna:   Fugazy, fugasi, it’s a wazi it’s a woozy, it’s [makes a flittering sound] fairy dust.

The above quotes have been lifted from the 2013 movie “The Wolf of Wall Street”[1]. That’s the advice given by Wall Street veteran Mike Hanna (Matthew McConaughey), playing as mentor to neophyte Jordan “Wolf of Wall Street” Belfort (Leonardo DiCaprio).

The above quote is a wonderful example and or a great depiction of the conflict of interests involving market participants. This is known as the principal agent problem[2].

When people talk up their industry while at the same time ignoring or downplaying risks in their framing of their discussions, such could be symptoms of the agency problem at work.

Be careful of fugazies. They may come in the form of Hopium dealers or could be experts afflicted by the Aldous Huxley syndrome.

The Schadenfreude Rally

I noted last week that rallying US bonds (falling yields) could spark a rally on risk assets[3]

the dramatic fall on yields of US Treasuries last Friday due to lower than expected jobs, may buy some time and space or give breathing space for embattled markets. But I am in doubt if this US bond market rally will last.

So ASEAN markets rallied strongly on the prospects of a weak US economic performance. Indonesian stocks soared by 3.7% over the week, while Thailand and the Philippines surged by 3.18% and 2.47% respectively.

Here is an example of how mainstream media described of Monday’s risk ON in Asian markets “Asian stocks outside Japan rose the most in eight weeks after slower growth in U.S. payrolls eased concern the Federal Reserve will accelerate cuts to stimulus.”[4]

Shades of schadenfreude eh? ASEAN financial market speculators would need to wish or pray for sustained stagnation of the US economy in order to keep the bond vigilantes at bay or to prevent UST bond yields from rising in order to see another round of booming financial markets.

But ASEAN markets responded differently to declining UST yields.

Indonesia’s $4 billion global bond sale also played a big part in this week’s magical reversal where the USD-rupiah fell by .6% to 12,091. Indonesian bonds rallied vigorously too, yields of the 10 year local government bonds fell by about 39 bp. So Indonesia’s financial markets went into full risk ON mode.

Thailand’s currency via the USD-baht dropped also by .6% to close the week below 33, particularly 32.81. On the other hand USD-Malaysian ringgit rose sizeably by .8% to 3.2959 as Malaysian stocks as measured by the KLSE fell by .74%

Thailand’s bonds rallied modestly with yields of 10 year local currency government bonds lower by 10 bps, while the yield of 10 year LC Malaysian bonds has been little changed.

Again curiously the mystical effect from the success of Indonesia’s global bond float hardly inspired the Philippine counterpart which also raised $1.5 billion a week back[5].

True yields of one month Peso sovereign bond, which spiked by nearly 200 basis points, last week retraced 75% of the earlier gains. Nonetheless, yields of the short term (1 month) Philippine treasury at 1% have been up 4 times from the lows during October 2013 at .2%. Interestingly, while short term yields fell, yields of 5 year and 10 year (4.3% this week as against 4.24% last week) were modestly up over the week, while 20 and 25 year bonds were little changed.

The USD-Peso even climbed up .6% to 45 to the highest level since September 2010

The “breathing space for embattled markets”, has thus, benefited Indonesian and Thai financial markets most, but had a mixed picture for the Philippine and Malaysian financial assets.

Again I would note, “curiously” because the Philippine government which raised $ 1.5 billion from the global bond markets a few days ahead of Indonesia have shown divergent results from the latter.

It would serve as a convenient pretext to say that perhaps Indonesia might have ran far ahead or has been heavily oversold. Could be. Or the Philippines may have a belated response. Could be too.

But could the present actions in the peso and domestic bond markets been signalling either inflation or incipient signs of credit stress? We will see.

Signs of increasing fissures in the tightly controlled Philippine bond markets and the falling peso are hardly indicators in favor of a bullish case for the Phisix.

Rising rates here or abroad and the falling peso will have negative impact on highly levered companies that should likewise put a strain on loan and asset portfolios of the banking industry. The bulls will need to see a sharp decline of the USD vis-à-vis the Peso as well as lower bond yields for local bonds and the USTs

Whose Fund Flow Data is Correct the BSP or the PSE?

I would like to also raise another of what seems as discrepancy in government-private sector statistics. 

The BSP announced this week that foreign portfolio investments reached US$4.2 billion in 2013 which is 8% higher a year ago where 74.7% of inflows where had been funnelled into the PSE-listed securities[6].

I keep tab with the PSE daily quotes and I find that the net foreign inflow data by the PSE and the BSP for 2013 a galaxy apart. Whether I apply 75% on the net inflows or via applying 75% in both gross inflow-gross out outflow, BSP’s inflows would register to USD $3+ billion for 2013. This seems to contradict PSE’s data which shows inflows at a measly USD $ 585.5 million, based on the average end month quote of the Peso for 2013 at 42.65. 

This means that foreign inflows constitute only 18% based on PSE data compared to that of the BSP’s data. So what gives?

I hope the PSE will come up with its official figures. But if the PSE’s data remains far from the BSP then this should point to a credibility issue on which party has been reporting patently inaccurate data.

Yet the variances in the above data exhibits two contrasting pictures; if the BSP data is correct, where during the latter half foreign money posted net inflows despite 2 months of Net outflows (August and December), then local selling not foreign selling brought the Phisix into the bear market territory. Could this be a case of Mike Hanna’s ‘Fugazis’ via pump and dump?

But if the PSE data is correct, where consistently every month from August until December showed net foreign selling, then this would be in sync with global trends where foreign funds yanked money out of emerging markets[7].

The Reasons Behind Rising Philippine Bond Yields and Falling Peso

BSP’s data on banking sector loans in November 2013 continues to exhibit the latter’s loan growth expanding faster than the statistical economy[8].

Much of the increase has emanated from the frothy construction and real estate industry which has served as the pillar to the Philippine statistical economic growth. This has been followed by manufacturing, which I don’t see as in a bubble.

An interesting picture is the negative credit growth posted by financial intermediation sector (pink ellipse), which has been the first since 2008. This negative credit growth came amidst the weakening of the Phisix and the Peso last November. It could mean some entities may have closed their credit positions possibly by selling stocks and possibly bought the US dollar out of the proceeds. They could be foreign entities.

Financial intermediation represents only about 9% of overall loans. This means that the credit contraction could easily be offset by gains in the real estate industry. The negative credit growth should also extrapolate to a marginal impact on domestic liquidity growth which has been running amuck. The BSP notes that last November M3 “increased by 36.5 percent year-on-year (y-o-y)…to reach P6.7 trillion”[9]. Gosh 36.5% against a statistical economy growing at 6-7%!

Domestic claims on private sector and other financial corporations constitute about 67.73% of M3.

This fantastic runaway growth in domestic liquidity fuelled by banking credit and the likely return of price inflation, which subsequently may lead to stagflation, is why emerging markets like the Philippines has been vulnerable to capital flow exodus from the so-called US Federal Reserve “tapering”.

And rising domestic bond yields mostly at the middle to the long end of the curve appear to be signalling the return of the risks of price inflation.

So rising rates, which has been signaling shortages of real resources, has been putting strains on an inflating bubble in the real economy. Such has likewise been signaling the possible return of the risks of price inflation. These factors are hardly conducive for bullmarkets

Yet we should expect sharp denial rallies to occur. Inflection points of any markets are typically characterized with high degree of volatility. Big denial rallies or relief rallies represent a common trait of bear markets. Yet a real recovery will only occur unless these factors will be addressed.

Moreover following a breach into the bear market, history doesn’t support a comeback for the Phisix. Since 1980, the best performance by the Phisix having endured a bear market strike following record highs has been denial rallies that recovered the previous highs but eventually faltered into a full bear market as in the case of 1994-97 and 2007[10].

As a Wall Street saw goes, “Bear market descends on the latter of hope”. And that hope is predicated on “this time is different”.

Of course I would not rule out a “this time is different” scenario, if the BSP decides to undertake the same measures as with her developed economy peers.

However the risk is that, unlike developed economies that has muted price inflation, any direct easing moves may spark a upside spiral in price inflation that may bring about political instability.

The Periphery to Core Dynamic

Let me repeat again, bubble cycles are market process induced by government interventions. Since they are a process they undergo distinct stages whether seen from the resource allocation/ production process or from the behavioral perspective. A usual symptom can be seen via the periphery to core dynamic.

Let us take the US crisis of 2008 as an example.

In response to the Greenspan Put[11] (Former Fed chair Alan Greenspan injected liquidity and lowered interest rates from 6.5% to 1%[12]), in 2003-6 real estate and stocks marched higher along with rising yields of US Treasury notes.

Underpinning this inflationary boom has been a massive ramping up of credit by US households, the real estate industry, the mortgage industry, US banks and the shadow banks (via various forms of financial engineering, particularly securitization[13] such as Mortgage Backed Securities, Asset Backed Securitization and various forms of derivatives).

The previously advancing US housing as measured by S&P Shiller 20 Index (upper window red line), peaked in early 2006 and began to decline. Yet US stocks as measured by the S&P 500 continued to climb ignoring the decline in the real estate even as the losses in the real estate and mortgage industry mounted and diffused into the financial system.

Almost a year and a half after the inflection point of the US housing industry, the ascendant stock market reached its inflection point and began its decline. Losses in the real economy from the hissing housing bubble became more apparent. Inflationary boom turned into a deflationary bust. The Wile E. Coyote moment arrived. Divergence became convergence as all assets swooned, except the US dollar and US treasuries. The US housing meltdown morphed into a banking and financial crisis which spread throughout the world.

The Wile E. Coyote moment culminated with the Lehman bankruptcy and the disappearance of the five largest investments banks of the US[14]

The ‘periphery’ then was the housing and mortgage markets and the stock markets. The ‘core’ was the banking and the shadow banking system and the real economy.

Hindsight is 20/20. Today’s dynamic may be different. It may be global. Current strains may be about emerging economies, functioning as the “periphery” with developed economies as the “core”.

The point is massive accumulation of debt in a system that has pillared rising asset prices amidst a vastly complacent “cheerleading” public would likely bring about a ‘periphery to core’ process that would redound to a Wile E Coyote moment elicited by rising rates.

The World Bank recently warned that should the Fed continue to taper or if advanced economies abruptly unwind central bank support then in their “disorderly adjustment scenario”, they see spiralling risks of sudden stops where capital flows to emerging markets may contract by “as much as 80%” which is likely to affect “nearly a quarter of developing countries”[15]

Again the question I will throw is that why should there be “sudden stops” or precipitate capital outflows if emerging market’s economic structures have been “sound”? 

The answer is that they have hardly been “sound”. Since 2008, global governments have used interventions via monetary policies and by fiscal means to generate “growth”. And this applies as well to Emerging Asia.

Reports the Wall Street Journal[16]

An environment of falling productivity has arisen in which local authorities have had to plough ever-greater amounts of stimulus into their economies to support growth, amid a lack of concrete structural reforms.

Post crisis governments almost everywhere have used massive build-up of leverage to drive statistical growth, which in return has reduced productivity, and consequently increased the risks of imploding bubbles. The current environment has lead emerging markets to become heavily dependent on low interest rates, rising asset prices and foreign capital flows. Yet such intensive accumulation of debt and the possible adverse consequences from malinvestments has been ignored by the mainstream and in fact glorified as “new paradigms”.

Aside from a global dynamic I think that emerging markets will have their own unique versions of “periphery to core dynamic” where financial asset markets could represent one of the peripheral indicators.

Rising rates have gradually been exposing on such fragilities and frailities.

---

[1] ‘The Wolf of Wall Street’ Movie Quotes Quotereels.com

[2] Wikipedia.org Principal-Agent Problem

[3] See Phisix: Will a Black Swan Event Occur in 2014? January 13, 2014

[4] Bloomberg.com Asian Stocks Rise as U.S. Payrolls Ease Stimulus Concerns January 13, 2014

[5] See Will an ASEAN Black Swan Event Occur in 2014? January 13, 2014

[6] Bangko Sentral ng Pilipinas Record High Foreign Portfolio Investments Noted in 2013 January 16, 2013

[7] Barrons Blog Are Fund Flow Data From EPFR Global Reliable Readings Of Investor Sentiments? January 17, 2014

[8] Bangko Sentral ng Pilipinas Bank Lending Grows Further in November December 27, 2013

[9] Bangko Sentral ng Pilipinas Domestic Liquidity Rises Further in November December 27, 2013

[10] See Phisix: Don’t Ignore the Bear Market Warnings June 13, 2013

[11] Wikipedia.org Greenspan put

[12] Wikipedia.org Historically low interest rates Causes of the United States housing bubble

[13] Mark Fagan Tamar Frankel MBS, ABS, SPV, CDS, ARM, BBB+: Understanding the Alphabet Soup of Securitization Harvard Kennedy School October 2008

[14] Agora.com Poof! 5 Biggest Wall Street Investment Banks Gone In 6 Months September 29, 2008

[15] Financial Times World Bank warns of capital flow risk to emerging markets January 15, 2014

[16] Wall Street Journal Real Economics Blog Rapid Asian Growth Comes at a Cost January 17, 2014

How Western Environmentalism Shaped China’s One Child Policy

Ideas have consequences. 

China’s one child policy hasn’t been a communist idea, writes author Matthew Ridley. Instead this has emanated from western environmentalist ‘Malthusian’ concept, which had been embraced by a Chinese missile scientist who repackaged and pushed these to Chinese policymakers. The result from the adaption, as usual, has been unintended consequences

A slice from Mr. Ridley:

As China’s one-child policy comes officially to an end, it is time to write the epitaph on this horrible experiment — part of the blame for which lies, surprisingly, in the West and with green, rather than red, philosophy. The policy has left China with a demographic headache: in the mid-2020s its workforce will plummet by 10 million a year, while the number of the elderly rises at a similar rate.

The difficulty and cruelty of enforcing a one-child policy was borne out by two stories last week. The Chinese film director Zhang Yimou, who directed the Beijing Olympics’ opening ceremony in 2008, has been fined more than £700,000 for having three children, while another young woman has come forward with her story (from only two years ago) of being held down and forced to have an abortion at seven months when her second pregnancy was detected by the authorities.

It has been a crime in China to remove an intra-uterine device inserted at the behest of the authorities, and a village can be punished for not reporting an illegally pregnant inhabitant.

I used to assume unthinkingly that the one-child policy was a communist idea, just another instance of Mao’s brutality. But the facts clearly show that it was a green idea, taken almost directly from Malthusiasts in the West. Despite all his cruelty to adults, Mao generally left reproduction alone, confining himself to the family planning slogan “Later, longer, fewer”. After he died, this changed and we now know how.

Susan Greenhalgh, a professor of anthropology at Harvard, has uncovered the tale. In 1978, on his first visit to the West, Song Jian, a mathematician employed in calculating the trajectories of missiles, sat down for a beer with a Dutch professor, Geert Jan Olsder, at the Seventh Triennnial World Congress of the International Federation of Automatic Control in Helsinki to discuss “control theory”. Olsder told Song about the book The Limits to Growth, published by a fashionable think-tank called the Club of Rome, which had forecast the imminent collapse of civilisation under the pressure of expanding population and shrinking resources.

Read the rest here

Quote of the Day: The fear of missing out

There’s a nasty little parasite that exists in nature known as the nematomorph hairworm (Spinochordodes tellinii) which typically infects grasshoppers and crickets.

Once fully grown, the worm is able to profoundly affect the behavior of its host; most notably, the worm can actually compel a grasshopper to throw itself into water.

This is great for the worm as it needs the moisture to reproduce. But for the grasshopper, it’s deadly.

There’s another vile protozoan known as Toxoplasma gondii. According to a 2007 study, rats and mice who are infected with it demonstrate a marked reduction in natural defenses, making them far more susceptible to being eaten by cats.

Nature is full of these unpleasant parasites which cause their hosts to engage in irrational, destructive, or even suicidal behavior.

Of course, they exist for humans too… especially for investors. In fact probably the number one parasite which affects investors is a very peculiar emotion: fear.

Specifically, it’s the fear of missing out that drives so much irrational investment behavior. Nobody wants to miss a big boom, no matter how baseless the fundamentals.

It’s this fear of missing out that compels people to continue investing in stocks, even though they are near all-time highs and trading at Price/Earnings ratios that are historically dangerous.

Ironically, this fear of missing out is stronger than the fear of loss. But if everyone else is jumping in, it’s easier to ignore the obvious risks of losing our life’s savings investing in ridiculously overvalued stocks.

Following the crowd is a great way to lose a lot of money.

Some of the most successful investors in history have been those who had the courage to go against the investment herd mentality. They conquered the fear of missing out, and they bought what everyone else hated… or looked where nobody else was looking.

(italics original, bold mine)

 

This priceless wisdom is from Sovereign Man’s Simon Black.

Quote of the Day: The Biggest Insider Trading Perpetrator

We put in a good citizen call to the SEC yesterday.

“There’s a massive scheme to manipulate stock prices,” we told the friendly agent.

“I have to tell you that your call is being monitored so that we can better serve the public,” he replied.

“Oh, don’t worry about that. The NSA is tapping our call anyway.”

“Are you talking about a specific stock?”

“Oh no… I’m talking about all of them.”

“You mean a Madoff-style scandal?”

“No… no… This is much, much bigger than the Madoff scandal. We’re talking major manipulation. Intentional. Knowledge aforethought. Pumping up all stock prices. Trillions of dollars.”

“Who is doing this?” the agent asked… a certain tone creeping into his voice. He was starting to suspect he had a lunatic on the line.

“The Fed, of course.”

“Uh… thank you…”

“You gotta go after those bastards…”

“Uh… yes… we’ll look into it…”

“Okay… thanks… I just thought you should know.”

...

Without Fed support, the economy would probably be in recession. US GDP went up about $350 billion last year. The Fed offset it with $1.2 trillion worth of QE. Even so, the economy only limps along. Without it, the economy slumps. The Fed can’t tolerate a slump. So, it has to continue with QE.

Meanwhile, the federal government is absorbing $400 billion less capital this year than last as a result of lower budget deficits. This leaves a lot of excess stray kittens in need of adoption. Who will take them in?

Stocks! Real estate! Yes, dear reader, we will most likely see more gains in 2014.

This is blatant manipulation of the markets. The Fed is open about it. Even proud of it.

This is from Bill Bonner writing at the Bonner & Partners

Quote of the Day: From Socialism to Economic Fascism

The philosophy of socialism — in essence, the naked claim that one should have what another has produced — is as old as mankind. The societal implementation of this philosophy in the form of full-fledged state ownership and control of the major means of production and central planning of resource and output allocations, however, occupied only a brief historical span. Owing to its intrinsic inability to solve problems of calculation, knowledge, and motivation, socialism in practice consumed previously accumulated capital and impoverished billions of people caught up in the experiment, killing hundreds of millions in the process, and by now it has been abandoned almost everywhere it was tried. The underlying philosophy, however, has weakened not a whit. Now, in practically every country of any consequence, a system of economic fascism — a system with severely compromised private property rights, but some room for entrepreneurial maneuver — serves as a more viable replacement and as the context in which the age-old sin of envy drives politico-economic action as strongly as it ever did in the USSR and Maoist China.

This is from economist, author and Senior Fellow at the Independent Institute Robert Higgs (source Lew Rockwell Blog)

US Small Business Survey: One Data Source, Two Contrasting Sentiments

Former US President John F. Kennedy once asked two of his officials on the conflicting reports they issued on the political conditions of South Vietnam, “Did you two gentlemen visit the same country”?

The US National Federation of Independent Data (NFIB) recently released its small business survey.

The bullish view, from Dr. Ed Yardeni: (italics original)

The members of the FOMC might feel even better about the labor market and the economy if they look at December’s NFIB Small Business survey. Consider the following:

(1) More hiring and job openings. The survey shows that the outlook for the labor market is improving. The monthly data are very volatile, so I smooth them with 12-month averages. They show that the percent of firms expecting to increase employment rose to 6.3% in December. That may not seem like much, but it is the highest reading since October 2008.

Even more encouraging is that the percentage of firms with one or more job openings rose to 23%, the highest since January 2008. That’s up from the most recent cyclical low of 9% during November 2010.

(2) More capital-spending plans. Another upbeat reading from the survey is that 24% of firms have capital-spending plans over the next three to six months, the highest level since November 2008. Those capital-spending plans are highly correlated with the percent of firms reporting that earnings were higher minus those reporting that they were lower over the past three months. The up/down balance of earnings has recently rebounded back close to the June 2012 cyclical high, and is consistent with more upside to capital-spending plans by small businesses.

(3) Better sales, but too much government. From October 2008 through July 2012, the #1 problem reported by small business owners was poor sales. The percent reporting this as their #1 problem fell to 16.2% in December (based on the six-month average), the lowest reading since July 2008. Now the #1 problem according to the NFIB survey is government regulation (21.7%), followed by taxes (20.7%). In other words, the economy is improving for small businesses, but Big Government is a drag for them.

The uncertain view, from the source: the National Federation of Independent Business (bold mine)

Small-business optimism ended the year slightly up from November at 93.9, but below the previous 3 mid-year readings of over 94 and 6 points below the pre-recession average, according to the National Federation of Independent Business’ (NFIB’s) latest index. On the positive front, reports of capital spending rose significantly in December, increasing by 9 points from November and job creation among NFIB firms was the best since February 2006. Hopefully, the promising NFIB job creation and capital spending numbers for December forecast a better 2014.

“While there has been no sign that a real recovery has begun, we can be encouraged that the economy is at least crawling forward and not heading in reverse,” said NFIB chief economist Bill Dunkelberg. “Some segments of the economy are showing improvement (manufacturing, construction, professional services), but consumer spending, especially on services (70 percent of consumption), has lagged. Spending on items such as automobiles has certainly increased, however a corresponding rise in hiring has not yet materialized.

“Two monthly advances could be the start of a more positive trend, but there are many threats to improvement, including the majority of respondents feeling the current climate is not “a good time to expand substantially” blaming the political climate, something that may not improve in an election year. Obamacare will continue to generate issues for small business owners as well as individual consumers. And the national debt continues to rise with another fight to increase the debt ceiling looming once again. The uncertainty that has contributed to our slow recovery is clearly still present – making any advances shaky at best.”

What you see depends on where you stand.

 

It's also a wonder how current valuations of the small cap Russell 2000 at 87.65 as of Friday's closing prices is justified given the above, whether optimistic or uncertain

How Hyperinflationary Policies Ushered in China’s Communist Rule

Austrian economist and professor at Northwest University Richard M. Ebeling in a recent article articulates how the Chinese government’s hyperinflationary policies, which financed her war with Japan 1937-1945 and the civil war compounded by the “dictatorial” Nationalist government, ushered in the communist tyrannical rule.

Here is a slice. From Epic Times (hat tip Bob Wenzel) (italics original)

Inflations have undermined the cultural and economic fabric of society, bringing about social chaos and revolution. Inflation is the enemy of social order and economic stability. Inflation can destroy accumulated wealth, ruin the entire well being of broad sections of a country’s population, and sometimes bring about radical change in a nation’s political system. When combined with war, inflations tear apart the human community.

One example is the Great Chinese Inflation of the 1930s and 1940s. Indeed, the destruction of the Chinese monetary system during this period helped Mao Zedong’s communist movement come to power on the Chinese mainland in 1949.

In the nineteenth and early twentieth centuries, Imperial and then Republican China had no central bank. The monetary system was based on a diverse network of private banks operating in the various regions of the country. While copper was widely used in coins, the primary medium of exchange was silver, and the entire Chinese economy functioned on an informal silver standard for most of this time. A year after Chiang Kai-shek’s Nationalist (or Kuomintang) Party came to power in Nanking in 1927, the Central Bank of China was established with its headquarters in Shanghai, and the country was formally put on a Chinese silver-dollar standard.

Read the details here

 

The real effects of inflationary policies to the Chinese political economy. Again Professor Ebeling

But it is nonetheless true that whatever basis of popular support Chiang’s government might have had against the communists at the end of the Second World War, especially among the country’s middle class, was undermined by the inflation. It destroyed the wealth and savings of the Chinese middle class, and created chaos in virtually all commercial dealings due to the loss of a reliable and stable medium of exchange for purposes of rational economic calculation and business planning.

In addition, the inflation and its effects drove some segments of the rural population into a more severe poverty than even the war had generated. Thus, whatever support the Nationalist government may have had in the countryside soon withered away, as well.

Also, during and after the war, the Nationalist government imposed unworkable price and wage controls as a supposed tool to “fight” price inflation that only succeeded in creating even more distortions and imbalances throughout the Chinese economy due to shortages, black markets, and mounting corruption.

Its policies produced the social and economic unrest that played right into the hands of the communists, as Mao’s revolutionary government promised to do away with the corruption and abuse of Chiang’s Nationalist government.

The hyperinflationary policy followed by the Nationalist Chinese government, therefore, helped bring about more than half a century of Marxist tyranny on the mainland of China, a communist tyranny under Mao Zedong that historians have estimated cost the lives of at least 80 million innocent men, women and children in the name of building the “bright socialist future.”

I find some relevance with China’s inflationary policies of 1930-40s with current stylized policies and politics. Except that the sequence appears to be backwards.

Then inflationary policies had been designed to finance China’s war economy. However today, both China and Japan have been inflating bubbles with the aim of generating economic growth (really—statistical growth, and really—subsidies to the cronies of the Chinese government and State Owned Enterprises (SOE) as well as Japan’s Wall Street) and the ensuring of the tenures of their respective political leaders. 

[Note I included Japan in the above commentary due to the recent controversy which has historical significance.]

However, slowing growth even from statistical measures from the intensifying embrace of bubble policies have placed increased political pressure on both governments. And instead, the current bubble (inflationist) policies have amplified on the credit risks (and other associated risks) for both economies amidst an environment of slowing growth.

So to divert the public’s attention from the real problems, both governments has resorted to diversionary tactic of brinkmanship politics via territorial disputes aimed at the incitement of nationalist sentiment to generate popular support for their respective governments. 

This has also been impliedly contrived to further justify their current inflationary policies with even bigger defense spending. Both China and Japan, a staunch US ally, will raise their defense budget this year.

The peculiarity is that despite the hullabaloo over Senkaku Islands and so the so-called “China threat’ as portrayed by western media, the Chinese government as well as partly Chinese investors continue to indirectly finance the US war machine via record acquisition of US Treasuries. 

The danger of inflationism has been its relationship with wars. The next question is what happens when all these seeming theatrics risks becoming real even by accident? Will massive inflationism lead to World War III or even a nuclear Armageddon?

Or will communism and its close sibling socialism rear its ugly head again, not just in China but to practitioners of inflationism elsewhere?  

Recently Adolf Hitler’s anti-semitic book 'Mien kampf' has seen a surge in sales.

Signs of things to come?

Phisix: Will a Black Swan Event Occur in 2014?

2013 turned out to be a very interestingly volatile and surprising year. It was a year of marked by illusions and false hope.

Mainstream’s Aldous Huxley Syndrome

The Philippine Phisix appears to be playing out what I had expected: the business cycle, or the boom-bust cycle. Business cycles are highly sensitive to interest rate movements.

At the start of 2013 I wrote[1],

the direction of the Phisix and the Peso will ultimately be determined by the direction of domestic interest rates which will likewise reflect on global trends.

Global central banks have been tweaking the interest rate channel in order to subsidize the unsustainable record levels of government debts, recapitalize and bridge-finance the embattled and highly fragile banking industry, and subordinately, to rekindle a credit fueled boom.

Yet interest rates will ultimately be determined by market forces influenced from one or a combination of the following factors as I wrote one year back: the balance of demand and supply of credit, inflation expectations, perceptions of credit quality and of the scarcity or availability of capital.

The Philippine Phisix skyrocketed to new record highs during the first semester of the year only to see those gains vaporized by the year end.

During the first half of the year, I documented on how Philippine stocks has segued into the mania phase of the bubble cycle backed by parabolic rise by the Phisix index (for the first four months the local benchmark rose by over 5% each month!) and the feting or glorification of the inflationary boom via soaring prices of stocks and properties by the mainstream on a supposed miraculous “transformation[2]” of the Philippine economy backed by new paradigm hallelujahs such as the “Rising Star of Asia”[3], “We have the kind of economy that every country dreams of”[4], underpinned by credit rating upgrades, which behind the scenes were being inflated by a credit boom. This romanticization of inflationary boom is what George Soros calls in his ‘reflexivity theory’ as the stage of the flaw in perceptions and the climax[5].

While I discussed the possibility of a Phisix 10,000 as part of the inflationary boom process, all this depended on low interest rates.

But when US Federal Reserve chairman suddenly floated the idea of the ‘tapering’ or reduction of Large Scale Asset Purchases (LSAP) global equity markets shuddered as yields of US treasuries soared. Yields of US treasuries have already been creeping higher since July 2012 although the ‘taper talk’ accelerated such trend.

Since June 2013, ASEAN equity markets have struggled and diverged from developing markets as the latter went into a melt-up mode.

Just a week before the June meltdown I warned of the escalating risk environment due to the rising yields of Japanese Government Bonds (JGB) and US treasuries[6].

However, if the bond vigilantes continue to reassert their presence and spread, then this should put increasing pressure on risk assets around the world.

Essentially, the risk environment looks to be worsening. If interest rates continue with their uptrend then global bubbles may soon reach their maximum point of elasticity.

We are navigating in treacherous waters.

In early April precious metals and commodities felt the heat. Last week that role has been assumed by Japan’s financial markets. Which asset class or whose markets will be next?

Anyone from the mainstream has seen this?

Since the June meltdown, instead of examining their premises, the consensus has spent literally all their efforts relentlessly denying in media the existence of bear market which they see as an “anomaly” and from “irrational behavior”. 

They continue to ‘shout’ statistics, as if activities of the past signify a guaranteed outcome of the future, and as if the statistical data they use are incontrovertible. They ignore what prices have been signaling.

My favorite iconoclast and polemicist Nassim Nicolas Taleb calls this mainstream devotion on statistical numbers as the ‘Soviet-Harvard delusion’ or the unscientific overestimation of the reach scientific knowledge.

He writes[7], (bold mine)

Our idea is to avoid interference with things we don’t understand. Well, some people are prone to the opposite. The fragilista belongs to that category of persons who are usually in suit and tie, often on Fridays; he faces your jokes with icy solemnity, and tends to develop back problems early in life from sitting at a desk, riding airplanes, and studying newspapers. He is often involved in a strange ritual, something commonly called “a meeting.” Now, in addition to these traits, he defaults to thinking that what he doesn’t see is not there, or what he does not understand does not exist. At the core, he tends to mistake the unknown for the nonexistent.

English writer Aldous Huxley once admonished “Facts do not cease to exist because they are ignored.” Thus I would call mainstream’s rabid denial of reality the Aldous Huxley syndrome

Mainstream pundits like to dismiss the massive increase in debt which had supported the current boom. They use superficial comparisons (as debt to GDP) to justify current debt levels. They don’t seem to understand that debt tolerance function like individual thumbprints and thus are unique. They treat statistical data with unquestioning reverence.

I’ll point out one government statistical data which I recently discovered as fundamentally impaired. What I question here is not the premise, but the representativeness of the data.

The Philippine Bangko Sentral ng Pilipinas (BSP) recently came out with 2012 Flow of Funds report noting that the households had been key provider of savings for the fifth year[8].

Going through the BSP’s “technical notes”[9] or the methodology for construction of the flow of funds for the households, the BSP uses deposits based on the banking sector, loans provided by life insurances, GSIS, SSS, Philippine Crop Insurance and Home Development Mutual Fund, Small Business Guarantee and Finance Corporation and National Home Mortgage and Finance Corporation. They also include “Net equity of households in life insurances reserves and in pension funds”, “Currency holdings of the household” and estimated accounts payable by households, as well as “entrepreneurial activities of households” and “other unaccounted transactions in the domestic economy”[10]

But the BSP in her annual report covering the same year says that only 21.5 households are ‘banked’[11]. Penetration level of life insurance, according to the Philam Life, accounts for only 1.1% of the population[12]. SSS membership is about 30 million[13] or only about a third of the population. GSIS has only 1.1 million members[14]. These select institutions comprise the meat of formal system’s savings institutions from which most of the BSP’s data have been based.

Yet even if we look at the capital markets, the numbers resonate on the small inclusion of participants—the Phisix has 525,085 accounts as of 2012[15] or less than 1% of the population even if we include bank based UITFs or mutual funds and a very minute bond markets composed mainly of publicly listed entities.

So no matter how you dissect these figures, the reality is that much of the savings by local households have been kept in jars, cans or bottles or the proverbial “stashed under one's mattress”.

In the same way, credit has mostly been provided via the shadow banking sector particularly through “loan sharks”, “paluwagan” or pooled money, “hulugan” instalment credit or personal credit[16].

In short, the BSP cherry picks on their data to support a tenuous claim.

In fairness, the BSP has been candid enough to say, at their footnotes, that the database for the non-financial private sector covers only “the Top 8000 corporations” and that for the “lack of necessary details” their “framework may have resulted to misclassification of some transactions”.

But who reads footnotes or even technical notes?

The Secret of the Philippine Credit Bubble

This selective data mining has very significant implications on economic interpretation and analysis.

This only means that many parts of the informal economy (labor, banking and financial system, remittances[17]) has been almost as large as or are even bigger than their formal counterparts.

We can therefore extrapolate that the statistical economy has not been accurately representative of the real economy.

Yet the mainstream has been obsessed with statistical data which covers only the formal economy.

And in theory, the still largely untapped domestic banking system and capital markets by most of the citizenry hardly represents a sign of real economic growth for one principal reason: The major role of banks and capital markets is to intermediate savings and channel them into investments. With lack of savings, there will be a paucity of investments and subsequently real economic growth.

In short, the dearth of participation by a large segment of the Philippine society on formal financial institutions represents a structural deficiency for the domestic political economy.

Any wonder why the mainstream pundits with their abstruse econometric models can’t capture or can’t explain why Philippine investments[18] have remained sluggish despite a supposed ‘transformational’ boom today?

This also puts to the limelight questionable efforts or policies by the government to generate growth via “domestic demand”.

Yet the mainstream hardly explains where “demand” emanates from? Demand may come from the following factors: productivity growth, foreign money, savings, borrowing and the BSP’s printing money.

With hardly significant savings to tap, and with foreign flows hobbled by rigid capital controls, the corollary—shortage of investments can hardly extrapolate to a meaningful productivity growth or real economic growth.

So in recognition of such shortcoming, the BSP has piggybacked on the global central bank trend in using low interest rates (then the Greenspan Put) to generate ‘aggregate demand’.

As a side note; to my experience, a foreign individual bank account holder can barely make a direct transfer from his/her peso savings account to a US dollar account and vice versa without manually converting peso to foreign exchange and vice versa due to BSP regulations.

The BSP anticipated this credit boom and consequently concocted a policy called the Special Deposit Accounts (SDA) in 2006, which has been aimed at siphoning liquidity[19]. Eventually the SDA backfired via financial losses on the BSP books even as the credit boom intensified.

The BSP imposed a partial unwinding of the SDA which today has only exacerbated the credit boom.

Given the insufficient level of participation by residents in the banking sector and the capital markets, thus the major beneficiaries and risks from the zero bound rate impelled domestic credit boom meant to generate statistical growth have been concentrated to a few bank account owners, whom has accessed the credit markets. This in particular is weighted on the supply side, e.g. San Miguel

The credit boom thus spurred a domestic stock market and property bubble.

This has been the secret recipe of the so –called transformational booming economy.

Yet, the large unbanked sector now suffers from the consequences of a credit boom—rising price inflation.

Well didn’t I predict in 2010 for this property bubble to occur?

Here is what wrote in September 2010[20]

The current “boom” phase will not be limited to the stock market but will likely spread across domestic assets.

This means that over the coming years, the domestic property sector will likewise experience euphoria.

For all of the reasons mentioned above, external and internal liquidity, policy divergences between domestic and global economies, policy traction amplified by savings, suppressed real interest rate, the dearth of systemic leverage, the unimpaired banking system and underdeveloped markets—could underpin such dynamics.

My point is that these bubbles have been a product of the policy induced business cycle.

Also these can hardly represent real economic growth without structural improvements in the financial system via a financial deepening or increased participation by the population in the banking sector and in the capital markets. 

The chart from a recent World Bank report[21] represents a wonderful depiction of the distinctiveness of the distribution credit risks of ASEAN and China.

From the Philippine perspective, households indeed have very small debt exposure basically because of low penetration levels in the Philippine financial system. Whereas most of the insidious and covert debt build up has been in the financial, nonfinancial corporations and the government.

Ironically, Indonesia whom has very low debt levels has been one of the focal point of today’s financial market stresses which I discuss in details below.

This only shows that there are many complex variables that can serve as trigger/s to a potential credit event. Debt level is just one of them.

Why a Possible Black Swan Event in 2014?

I say that I expect a black swan event to occur that will affect the Phisix-ASEAN and perhaps or most likely the world markets and economies.

The black swan theory as conceived by Mr. Taleb has been founded on the idea that a low probability or an ‘outlier’ event largely unexpected by the public which ‘carries an extreme impact’ from which people “concoct explanations for its occurrence after the fact”[22]

The Turkey Problem signifies the simplified narrative of the black swan theory[23]. 

A Turkey is bought by the butcher who is fed and pampered from day 1 to day 1000. The Turkey gains weight through the feeding and nurturing process as time goes by.

From the Turkey’s point of view, the good days will be an everlasting thing. From the mainstream’s point of view “Every day” writes Mr. Taleb “confirms to its staff of analysts that Butchers love turkeys “with increased statistical confidence.””[24]

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table.

For the Turkey and the clueless mainstream, this serves as a black swan event, but not for the Butcher.

For me, the role of the butcher will be played by rising interest rates amidst soaring record debt levels.

Global public and private sector debt from both advanced economies and emerging has reached $223 trillion or 313% of the world’s gdp as of the end of 2012[25]. This must be far bigger today given the string of record borrowings in the capital markets for 2013, especially in the US (see below).

Moreover, recent reports say that there will be about $7.43 trillion of sovereign debt from developed economies and from the BRICs that will need to be refinanced in 2014. Such ‘refinancing needs’ account for about 10% of the global economy which comes amidst rising bond yields or interest rates[26].

While I believe that the latest Fed tapering has most likely been symbolical as the outgoing Fed Chair’s Ben Bernanke may desire to leave a legacy of initiating ‘exit strategy’ by tapering[27], the substantially narrowing trade and budget deficits and the deepening exposure by the Fed on US treasuries (the FED now holds 33.18% of all Ten Year Equivalents according to the Zero Hedge[28]) may compel the FED to do even more ‘tapering’. 

Such in essence may drain more liquidity from global financial system thereby magnifying the current landscape’s sensitivity to the risks of a major credit event.

And unlike 2009-2011 where monetary easing spiked commodities, bonds, stocks of advanced and emerging markets, today we seem to be witnessing a narrowing breadth of advancing financial securities. Only stock markets of developed economies and of the Europe’s crisis afflicted PIGS and a few frontier economies appear to be rising in face of slumping commodities, sovereign debt, BRICs and many major emerging markets equities. This narrowing of breadth appears to be a periphery-to-core dynamic inherent in a bubble cycle thus could be seen as a topping process.

Meanwhile the Turkey’s role will be played by momentum or yield chasers, punters and speculators egged by the mainstream worshippers of bubbles and political propagandists who will continue to ignore and dismiss present risks and advocate for more catching of falling knives for emerging markets securities.

And the melt-up phase of developed economy stock markets will be interpreted by mainstream cheerleaders with “increased statistical confidence”.

The potential trigger for a black swan event for 2014 may come from various sources, in no pecking order; China, ASEAN, the US, EU (France and the PIGs), Japan and other emerging markets (India, Brazil, Turkey, South Africa). Possibly a trigger will enough to provoke a domino effect.

I will not be discussing all of them here due to time constraints

Bottom line: the sustained and or increasing presence of the bond vigilantes will serve as key to the appearance or non-appearance of a Black Swan event in 2014.

As a side note: the dramatic fall on yields of US Treasuries last Friday due to lower than expected jobs, may buy some time and space or give breathing space for embattled markets. But I am in doubt if this US bond market rally will last.

[update: I adjusted for the font size]

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[1] See What to Expect in 2013 January 7, 2013

[2] See More Media Spin on the Philippine Statistical Bubble Economy December 5, 2013

[3] See Phisix 7,000: Why Asia’s Rising Star is a Symptom of Mania April 29, 2013

[4] See Phisix: The Myth of the Consumer ‘Dream’ Economy July 22, 2013

[5] George Soros The Alchemy of Finance John Wiley & Sons page 58, Google Books

[6] See Phisix: Will Abenomics trigger a “Sell in May”? May 27, 2013

[7] Nassim Nicolas Taleb Antifragile: Things That Gain from Disorder Random House New York, p.9 Google Books

[8] Bangko Sentral ng Pilipinas 2012 Flow of Funds Reports Savings Across Sectors; Household Sector Remains as Top Net Funds Provider January 3, 2014

[9] Bangko Sentral ng Pilipinas Revised Technical Notes on the Philippine Flow of Funds

[10] Bangko Sentral ng Pilipinas FLOW OF FUNDS SUMMARY MATRIX, BY SECTOR 2012

[11] Bangko Sentral ng Pilipinas Annual Report 2012 p.50

[12] Yahoo.com Philippines Has The Least Insurance Penetration In Asia – Philam Survey, January 3, 2013

[13] Domini M. Torrevillas Garbage collectors are now SSS members Philstar.com October 17, 2013

[14] Government Service Insurance System GSIS prepares for UMID-compliant eCard enrollment

[15] see Phisix: Will the Fed’s Spiking of the Punchbowl Party Be Sustainable? September 23, 2013

[16] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20, 2013

[17] See Shopping Mall Bubble: Will Remittances, BPOs and the Informal Economy Save the Day?, January 21, 2013

[18]Agnes Isnawangsih, Vladimir Klyuev, Longmei Zhang The Big Split: Why Did Output Trajectories in the ASEAN-4 Diverge after the Global Financial Crisis? October 2013

[19] See Phisix: Escalating Risks from the Region and from Internal Bubbles December 9, 2013

[20] See The Upcoming Boom In The Philippine Property Sector September 12, 2010

[21] World Bank EAST ASIA AND PACIFIC ECONOMIC UPDATE Rebuilding Policy Buffers, Reinvigorating Growth October 2013 p.46

[22] Wikipedia.org Black Swan Theory Background

[23] See Dealing With Financial Market Information February 27, 2011

[24] Nassim Nicolas Taleb Op. cit p93

[25] Wall Street Real Time Economics Blog Number of the Week: Total World Debt Load at 313% of GDP May 11, 2013

[26] Bloomberg.com Bond Tab for Biggest Economies Seen at $7.43 Trillion in ’14 January 6, 2014

[27] See The Fed Tapers, Tremors on China’s Debt Market December 20, 2013

[28] Zero Hedge Chart Of The Day: The Fed Now Owns One Third Of The Entire US Bond Market December 3, 2013