Global Markets: Signs of Emerging Deflation?

``Liquidity exists when there are counterparties available to trade at any moment in time. It follows that liquidity is both an expression and a consequence of the ability of market participants to take risks on each other. For liquidity to exist, therefore, there must be a general sense, in the market, that each participant (or, at least, most of them) are suitably equipped to face the risks they are taking. This is what we call confidence.” Jean-Pierre Landau, Deputy Governor of the Bank of France

We were supposed to deal with the aspects of “decoupling” but a seemingly more important development has come to fore; global financial markets appear to signal the emergence of deflation!

Financial markets rarely transmit messages in consonance, but when they do we ought to pay attention.

Over the last two weeks, such latent messages have become more apparent as shown in Figure 1. But again the caveat is that two weeks may not a trend make.

Figure 1: Stockcharts.com: Signs of Deflation?

On the topmost pane, Dow Jones world equity index (blue arrow) has fallen steeply, just as gold (pane below center window-blue arrow) plummeted over 5% this week. Moreover, we see broad based US Treasuries massively rallying, where in terms of the benchmark 10 year (lowest pane-blue circle) its yields have dropped abruptly. Bond prices move inversely relative to yields. When US bonds rallies markedly, this signifies investor’s “flight to safety” on fears of an economic recession.

Now this comes as the US dollar index appears to be consolidating or forming a bottom, see main window, albeit this is too premature yet to conclude.

Again the US dollar’s action could be in reaction to technical oversold levels or possibly a reflection of a narrowing current account deficit or due to expectations on narrowing interest rate spreads, where the recent financial market crisis could possibly impel the Euro zone and the Bank of England to equally cut rates.

Since we have observed that the world has been outrageously levered via different mechanisms such as the CARRY TRADE, one notices that today’s downside volatility has been coincident with meaningful rallies in currencies which had been utilized as funding sources for cross asset arbitrage trades as shown in Figure 2.

Figure 2: Carry Trade Unwind?

The Japanese Yen and the Swiss Franc has substantially gained during the past two weeks (bar chart and superimposed line chart at the main window, respectively) as markets resonated on the jitters from the unfolding credit crisis.

Notice that the Salomon Brothers Emerging Market Debt Index (pane below main window) appears to have peaked as the Yen-Franc tandem bottomed during early November. This could mean that levered arbitrage positions which were sourced from such currencies had been unwound.

Nonetheless if industrial metals are priced to reflect on global economic growth then the present streak of declines forebodes of decelerating trend of world growth as shown by the lowest pane in the chart via the Goldman Sachs Industrial Index.

Nevertheless, the issue revolves around the continuing saga of accelerating strains in the US credit markets which continues to ripple across the financial markets worldwide with some incipient signs of spillover to the real economy.

Aside, the US financial sector remains under severe pressure, compounded by the recent implementation of Statement 157, as required by the Financial Accounting Standards Board (FASB), a non-profit private organization, whose purpose is to standardize financial accounting and reporting guidance. The new reporting guidance requires firms to specifically disclose its assets into 3 three categories: Levels 1, 2 and 3 starting on the November 15^th. Recent moves to defer the implementation were rejected.

Under the FASB, Level 1 is defined as liquid assets or assets that can be assessed or priced from the market or “marked-to-market”. Level 2 are assets with less liquidity but could be assessed or priced based on estimates from “observable inputs” from similar assets or otherwise known as “marked-to-model”. Meanwhile Level 3 is classified as highly illiquid assets with no point of reference or “unobservable” inputs. Level 3 is basically a guess.

Analyst Nouriel Roubini points out that some major financial institutions in the US have enormous level 3 assets exposure relative to equity capital base, he cites Citigroup 105%, Goldman Sachs 185%, Morgan Stanley 251%, Bear Stearns 154%, Lehman Brothers 159% and Merrill Lynch 38%. While this does not suggest that all Level 3 assets will go kaput, this suggests of the risks of incurring more losses from these institutions which should eventually be reflected in the financial markets.

This also implies that these institutions would be hoarding money to defend or buttress its capital base such that lending activities would be stymied. Essentially contracting liquidity in the marketplace and in the economy translates to a phenomenon called as deflation.

As example, Goldman Sach’s Jan Hatzius recently forecasted that financial institutions such as banks, brokerages and hedge funds would see a cut of liquidity or lending by as much as $ 2 trillion which could result to hard landing in the US.

Bloomberg quotes Hatzius, ``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' Hatzius wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.

In addition there have been signs that the housing recession has now began to spillover to the Commercial Real Estate, where office buildings, shopping malls and construction for structures for manufacturing have likewise began to crack.

Quoting Nouriel Roubini (highlight mine), ``And indeed the boom in CRE investment – with excessive construction of commercial real estate is leading – like in the case of housing – to a glut of unsold or empty properties that is leading to a fall in prices. As reported by the FT: “Moody’s index of commercial real estate prices is expected to show that prices flattened or fell in September, after rising nearly 14 per cent in the 12 months to August. RBS Greenwich Capital predicts that US commercial property prices will fall 10-15 per cent next year.”

``The coming meltdown of commercial real estate is also evident by the sharp widening in credit spreads for CRE mortgages and commercial mortgage backed securities (CMBS). One of the most clear signals of this extreme stressed in the non residential MBS (CMBS) market is given by the CMBX index that is reported by Markit. The data are scary: for BB tranches the spread is now over 1500bps; for BBB- the spread is 1,100; for BBB is 965; even for A is 540; and 326 for AA tranches. All these spreads have sharply widened compared to their spring 2007 levels. At these spreads the ability to finance any new CRE investment – apart from those already committed and financed – is practically null. After the pipeline of already financed projects is finished the market for financing and securitizing CRE – apart from the highest rates projects – is practically frozen. Indeed, the issuance of CMBS fell to $6.3 billion in October, down 84% from a record $38.5 billion in March that finance about half of commercial property purchases. So the CRE market now behaves similarly to the sub-prime market; it is totally frozen.”

Respected independent Canadian research outfit BCA Research somewhat shares the deflation outlook given the present readings from economic indicators as shown in Figure 3…

Figure 3: BCA Research: US Inflation…or Deflation?

From BCA (highlight ours), ``Core CPI is just over 2% on an annual basis, and is set to decelerate. Earlier upward pressure from the shelter component of CPI is easing, while goods prices are already firmly in deflationary territory. Service sector inflation (outside of housing) failed to gain a head of steam during the economic boom, and is likely to drift lower with the economy growing at a sub-par pace. Retailers are back in aggressive price discounting mode. Inflation is not going to be a constraint on the Fed, and we expect further rate cuts ahead, especially with the credit crunch continuing to roll on.”

Remember, US equity markets have now begun to falter anew even after TWO rate cuts, which means that the equity markets are currently anticipating even more forthcoming weaknesses and thus the renewed selling pressures.

Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts

``A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.”- Ben S. Bernanke, The Financial Accelerator and the Credit Channel

So with financial markets and some economic indicators pointing towards emergent signs of deflation, this ultimately leads us to the probable responses of US monetary authorities from which the direction of global markets will be anchored.

The question remains: Will Mr. Bernanke & Co face the music and save the US dollar by allowing deflationary trends to permeate and segue into a full blown recession or will they undertake measures to prevent the economy from falling off the cliff by utilizing its monetary tools?

We have long argued that the US Federal Reserve is sensitive to financial markets more than the economy [see sensitive August 13 to 17 edition, US FEDERAL RESERVE Is Financial Markets Sensitive!].

Our thoughts has been that given the Paper Money US Dollar standard from which the world operates on, the US Federal Reserve will do everything it can to sustain the present monetary system, which has given Americans an undue advantage over the rest of the world by simply issuing promises to pay (dollar notes) in exchange for goods or services. Hence for us, the Fed’s unstated mandate is to forefend its main constituents (banking system) from a collapse. Forget moral hazard, it’s all about perpetuation of the system.

We have also shown in the past that since Central Banking has been introduced in the US in 1913, the Purchasing power of the US dollar continues to approach ZERO, a natural predisposition of all paper currencies, see August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The plight of the purchasing power of the US dollar not only reflects on the impact of the cumulative inflationary policies but also of the historical responses by the US Federal Reserve when confronted with a financial or economic crisis, where the tendency has been to sacrifice the US dollar at the altar of the Paper Money-US dollar Standard.

So aside from the need to rescue its major conduits to sustain the system, the Fed likewise recognizes the overwhelming dependence of US households on financial assets to sustain their consumption patterns, which further buttresses the case for more intervention.

We are here to discuss not on the merits but on the proposed action and potential effects to the markets. As we always say, markets reflect on policies imposed.

And this bailout would come in the form of various monetary tools that the FED possesses such as injecting liquidity or manipulating interest rates to possibly even intervening directly in the financial markets. And such is the reason why a contingent executive committee, commissioned by EO 12631 in March 18, 1988, called as the Working Group on Financial Markets exists, or otherwise known as the Plunge Protection Team.

“Helicopter Ben” was the moniker Mr. Bernanke garnered following his November 21, 2002 speech Deflation: Making Sure "It" Doesn't Happen Here advocating the use of unconventional tools to fight deflation at all costs.

In a recent speech (June 15, 2007) entitled “The Financial Accelerator and the Credit Channel” by Fed Chairman Ben Bernanke, it appears that our thesis has gotten even more validation.

From Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

Figure 4: St. Louis Federal Reserve: FED Funds Futures

In figure 4, from the Saint Louis Federal Reserve Fed futures have placed a rate cut of about 25 basis points this coming December.

So what this means?

Despite the hawkish tone of “no further cuts” from Fed Governor Randall Kroszner and St. Louis Fed President William Poole, the continuing stress in the financial markets will most likely spur the FED to cut in the next meeting (December 11) otherwise risk a meltdown in almost all asset classes.

Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.

Besides many of these FED officials had been talking incessantly about “inflation” even prior to the first rate cuts but suddenly voted in favor of cuts during the past FOMC meetings which goes to show how these officials lack the credibility by saying one thing and doing another.

Like any politicians or bureaucrats, the FED will protect its interests.

Loosening Correlations Between Asia and the US Markets

``Large diversification flows — other than the currency-rebalancing exercise undergone in some foreign central banks — have been powerful undercurrents in the currency world, forcing the dollar and the JPY below their values that are consistent with the economic fundamentals. We believe that, in the coming years, we will witness a similar trend in large EM economies that have accumulated enough wealth and attained adequate confidence and knowledge about the international capital markets. In other words, while many of these EM economies have been acquiring foreign assets through their central banks and SWFs, we believe that the private sectors of these economies will be major exporters of capital to both the developed markets and to other EM economies.”-Stephen Jen, Morgan Stanley

Over the interim, the US markets could go either way. This means the same with global equity markets including the Philippine Phisix.

Figure 5: Chartoftheday.com: Pre-Election Cycle

On the bear side, the continued dislocations in the credit market and renewed selling pressures in the US equity markets aside from deflationary signals across asset markets are likely the risks to reckon with as the market awaits action from US Monetary authorities.

We are inclined to believe that any material threat to US markets would likely manifest itself by next year.

On the other hand, the bullish premise is that major US equity benchmarks appear to be technically oversold and could rebound soon, before ascertaining its next major move. Aside, the seasonal Presidential Pre-Election cycle in the US could also be of help to the bulls as shown in Figure 5.

So far, the rendition of the average Pre-election cycle by the US markets today has been quite in precision as shown by chartoftheday.com. Of course, we understand that past performance does not guarantee future outcomes, which is why we think markets can go either way.

Figure 6: Stockcharts.com: Phsix-US-Asia

In figure 6, the Philippine Phisix (main window) has shown a remarkable correlation with the US S &P 500 (chart below main window) anew, where both indices peaked out almost synchronically (see vertical blue line).

The basic difference is that of the degree of the reaction. Last August, the S & P 500 fell by about 10% from its peak (based on closing prices) and the Phisix reacted with extraordinary haste and intensity, the latter crashed by some 24% to 2,884 (see blue circles).

Today, the S & P is about 8% down from the October acme whereas the Phisix is stunningly down by about the same proportion as the US benchmark!

And to consider, market internals tell us that foreigners have been in a heavy retreat for 5 successive weeks (by about Php 11 billion!), which means the market has been bolstered and cushioned by the local investors! Foreign money accounted for a net selling of Php 3 billion this week. This significant support from domestic investors is a fresh development in this advance cycle which began in 2003, and became evident only during this July’s selloffs. We are inclined to believe that the Peso’s strength has a hand in this.

In addition, one could notice that Asian markets have belatedly responded to the US decline, as shown by the arrows in the Dow Jones Asia ex-Japan Index (middle pane) and the Fidelity Southeast Asia Fund (lowest pane), which suggests that previous tight correlations have now eased or relaxed.

So while it is true that US markets have still material influence to Asian markets we are witnessing some loosening correlations which if the pattern sustains, eventually should lead to a decoupling.

What Media Didn’t Tell About the Peso

``If a man tries to question the doctrines of etatism or nationalism, hardly anyone ventures to weigh his arguments. The heretic is ridiculed, called names, ignored. It has come to be regarded as insolent or outrageous to criticize the views of powerful pressure groups or political parties, or to doubt the beneficial effects of state omnipotence. Public opinion has espoused a set of dogmas which there is less and less freedom to attack. In the name of progress and freedom both progress and freedom are being outlawed.”-Garet Garrett (1878-1954), American Journalist

Meanwhile, we are pleased to say that the first segment “Gold, US Dollar and Oil: Markets Simply REFLECT On Collective Policies Imposed!” has been featured at Canadian website Safehaven.com. http://safehaven.com/article-8759.htm

Oddball comment of the week, this from Bloomberg (emphasis mine),

``Mexico's central bank Governor Guillermo Ortiz said policy makers can do little to stem rising food prices, and future interest-rate decisions will focus on stopping the spread of inflation to wages and other costs.

``Increases in the price of wheat, milk and other food items pushed Mexico's inflation rate above the bank's 2 percent to 4 percent target band in eight of the past 12 months. The five- member board led by Ortiz unexpectedly raised the benchmark interest rate on Oct. 26 to 7.5 percent from 7.25 percent, the second increase this year.

``There's little central banks around the world can do to prevent food prices from rising,'' Ortiz, 59, said in an interview in Miami today. ``But we can react to avoid second- order effects.''

Since inflation is a product of government policies, then such statement is a practical admission of arrant incompetence. What good is it for central banks to exist when they can’t control the effects of their own policies?

What Media Didn’t Tell About the Peso

In an open forum of a recently hosted “market outlook” by an international bank, the company’s treasurer was asked by a client if the it was advisable to still hold the US dollar.

To our surprise the officer says that because the Philippines have been embroiled in too much politics, particularly tainted by “corruption”, the Peso’s strength was unlikely to last. Duh! This was the same line of reasoning we were confronted with when we audaciously took on the contrarian stand to forecast the Peso to strengthen at the end of 2004, (see November 29 to December 3, 2004 The Philippine Peso’s Epiphany?).

Yet the said official admitted that contrary to their head office which saw the Peso’s rising trend to continue, the advice had been a ‘personal opinion’.

The same perspective can be gleaned from the headlines. When the Peso goes to a milestone record we read economic “experts” instinctively denounce the Peso’s rise as “baneful” to the economy given the adverse implications to the “competitiveness” of our exports and the ramifications to the OFW’s “buying power”.

Nonetheless, the common denominators attributed to the Peso’s rise are the same grounds used for such criticisms and its implied course of action; primarily remittances and trade-economic linkages.

The Endogenous View and the Framing Effect

As a contrarian analyst we try to follow the principles of French liberal economist Frédéric Bastiat’s who wrote about the Parable of the Broken Window in the 1850 essay Ce qu'on voit et ce qu'on ne voit pas (That Which Is Seen and That Which Is Unseen). The precept, of which, centers on the hidden costs of every decisions or the law of unintended consequences (usually seen through the prisms of government interventions). For example, applied to our field, while contrarians tend to serendipitously make occasional major accurate forecasts, the hidden cost or side effect of going against the crowd or of espousing a radically unpopular theme have been ostracization.

Applied to the Peso, domestic experts tell us that exchange rates are determined by demand and supply. True enough. But when we are contented to look at remittances, trade balances or foreign direct investments, we are then vetting from THE INSIDE LOOKING OUT or these variables are seen only as a FUNCTION of the Philippine Economy. That is not the complete picture.

And quite importantly, when we become totally entranced with politics to the point of logical paralysis like a deer who freezes in front of the headlights, such is called obsession or fanaticism and not analysis.

Again while exchange rates are indeed a function of demand and supply, these views purposely limits the public’s perception to the dimension of the Philippine Peso relative to the US dollar ALONE. Since currency markets reflect a ZERO sum game, where one wins at the expense of the other then it is easy to build a case against the rising Peso.

In other words, such arguments facilely plays into the variant of an economic concept known as the Dutch Disease, (wikepidia.org), ``The theory is that an increase in revenues from natural resources will deindustrialise a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive”. In our case, it is not natural resource exports yet, but of HUMAN exports.

Unfortunately this form of presentation is called the Framing Effect or (wikepidia.org) ``the packaging of an element of rhetoric in such a way as to encourage certain interpretations and to discourage others.” (highlight mine).

Objective analysis attempts to look from a balanced angle against biased analysis whose views are directed by a certain desired outcome. In the markets, losses are usually suffered by those who are consumed by their biases. It certainly seems applicable to everything we do. Since extreme biases “tunnels” our vision to the point of absolute rigidity, we become less open and flexible and squarely insist on our perceived outcomes. We simply cannot move forward if we are drowned by false expectations.

Myths versus Observable Reality

Well in contrast to such views our thoughts is that the currency markets operate from three divergent angles; namely endogenous, exogenous and market expectations (speculative capital). Hence the domestic frame we presented above could be called as endogenous or internal view.

Initially to give us a broader perspective let us examine the historical performance of Philippine Peso from two horizons, a long term 62 year time frame and a medium term 7 year period, as shown in Figure 1.

Figure 1: Philippine Peso’s Long Term or 62 year (left) and Medium Term or 7 year Historical Performance (right)

Since 1945, the Peso (left chart) has experienced about 60 years of continued depreciation relative to the US dollar with only marginal stability attained during the early 1990s or when the Philippines and the PSE’s Phisix was buoyed by a REGIONAL boom. Most of the recent decline came in the wake of the Asian Crisis.

It is important to emphasize that the Philippines has NOT moved beyond what its neighbors have been, which means luck played a substantial role when we advanced (shown below), instead of policy choices.

In short, like today, the Philippine financial markets and its economy has been captive to external forces rather than internal driven factors, subjecting us to external risks more than the internally generated one in contrast to what the others say.

Under such premise it pays to understand how the Philippines have been latched to the global economy, its shifting role relative to regional and world dynamics and the underlying drivers that could hold sway to the direction of both its financial markets and economic path.

As you can further see in the long term chart, it is only during the present period where the Philippine Peso has made a meaningful advance, particularly during the inflection point in 2005.

One should note that in 2005, the Peso attempted to advance in January but was spurned by “politics”, remember the “Hello Garci” scandal? Yet by September, the markets have simply discounted the political window and went on to adjust materially (see left chart of Figure 1). Since then, all of the significant blips of the Peso had been due to external factors. Not even the recent Glorietta blast was enough to turn the Peso around.

Before we proceed, it is an important reminder that the charts of Figure 1 or the historical trend of the Philippine Peso would serve as an ANCHOR for comparison to the subsequent charts in our discussion.

Figure 2: IMF: Remittance Flows (left), Yardeni.com: Philippine Trade Balance (right)

Mainstream media and their attendant experts always impress upon us that the strength of the Peso has been primarily due to remittances, which has now comprises about 10% of the GDP.

While we do not deny the fact that remittances has immensely added to our foreign exchange reserves and has been an important contributor to our economy, as a market observer we find the correlation or the causation of the remittance driven Peso argument as quite doubtful.

The left pane of figure 2 from the IMF (2007 country report) shows of the remittance trends of the Philippines since 1995. What can be observed are as follows:

One, remittance trends has been on a 10 year uptrend and steadily growing since and

Second, the rate of remittances has accelerated since 2002.

Now revert to figure 1 or the peso’s 7 year chart (left); notice that since 2002 the Peso continued to decline in spite of the acceleration of remittances. Again the Peso made its successful turnaround only in September of 2005 a full three years after the quickening of the upside pace. Yet, the most notable part is that in all the years prior to or before 2005, even as remittances rose, the Peso continued to fall!

So the attribution of a causality relationship with its present action or otherwise stated as the rise of the Peso as due to the gains in remittances has NOT been DIRECT. The easy way to say this is that the rise of the Peso cannot be adequately explained by the remittance trends, or simply put, PRESENT correlation does not imply causation! It is a puzzle how so called experts appears to chime in on a supposed “cause and effect” when such has not been supported by price actions.

Of course there will always be some justifications for such incongruence or a simplified explanation for such outcomes such as a “lagged effect” or the Peso could have reacted only after it reached a certain unidentified level called as the “critical mass” level which ultimately served as a tipping point.

We do not argue against these premises (here we are preempting on possible responses), but our question remains which do we follow, a 10 year or 3 year lag? Or what then has been the pivotal measure for the “critical mass” of remittances, 8-10% GDP perhaps?

Then there is the argument that the state of the Peso could also reflect our trading patterns, which appears to be even more defective. Figure 2 courtesy of Yardeni.com tell us that the Philippines have been trading on a deficit (as of August)!

Figure 3: Deutsche Bank: FDI Flows (left), IMF: Net Portfolio flows ex-US dollar assets

On the other hand, others contend that Foreign Direct Investments may have spearheaded the Peso’s rise. Figure 3 from Deutsche Bank shows that FDI compared to our neighbors have severely lagged or has not shown any vital improvements as to equally reflect on the Peso!

Next, media tells us that stock market flows have been one of its factors behind it. While this could have been true in the past, data from the Phisix should tell us of the validity of such claims.

Since the week that ended September 7, the Peso has gained by about 8% or more than half of its year to date gains of about 14%.

The reason we chose the two months of time line is to smooth out away from the talks of the latest developments in the corporate world such as San Miguel’s recent divestment of Australian Dairy National foods and Australian Premier Brewer J Boag & Son (which for us is a questionable strategy in the bottomline enhancement issue; instead the company plans to emigrate to a divergent platform of unrelated interests such as mines, energy-which deserves another article) and the privatization of PNOC-Energy Development Corp, which is said to affect further the Peso’s firming trend.

Not that we disagree with these; we do subscribe to the grounds that these “corporate events” could further support gains of the Peso. But our point is, beyond all these chatters, the fact is since September 7^th the Phisix has accrued some Php 7.0356 billion of net foreign selling in contrast to what has been reported. This foreign selling occurred in 7 out of the 10 weeks, which suggests that this has not been a one-off event. Therefore, we have not seen inflows material enough to extrapolate that the Peso rose because of stock market activities.

Of course, alternatively, we do not know if the past selling activities by foreign money actually translated into outflows since the proceeds could have been used to either acquire other Peso denominated assets or remain liquid or deposited in some banks or financial institutions.

The point of all of these is to demonstrate what is reported in media which is supported by the mainstream “experts”, has less to do with the function of the Peso’s present conditions than commonly believed. In short, the Peso as a function of the Philippine economy, the ENDOGENOUS VIEW, is only one factor but has not been accurately the ENTIRE picture.

The Exogenous Perspective

Here are some empirical based analysis alluding to the themes which supports our second thesis of what drives the Peso; the EXOGENOUS perspective.

From the prolific Stephen Jen of Morgan Stanley (highlight mine), ``Exchange rates are no longer driven by trade or concerns about trade imbalances. We don’t remember the last time someone told us that they were selling the USD because of its C/A deficit. Rather, more than ever, exchange rates are driven by cross-border flows, e.g., diversification flows by central banks in Asia and the Middle East, and structural portfolio adjustments in the private sector, as ‘home bias’ declines worldwide. These flows are very powerful, and have little to do with where USD/CNY is.”

From another article “Global Official Reserves Just Breached US$6.0 Trillion” by the same author Stephen Jen (highlight mine), ``…while the depreciation of the dollar has led to some valuation gains of EUR, GBP and other currencies, in dollar terms, most of the increases in the official reserves reflected actual interventions. Thus, the dollar has indeed weakened this year, but the size of the interventions conducted by the emerging market central banks is rather extraordinary.”

From RGE Monitor’s astute Brad Setser, ``That story – when augmented with a story about rising oil savings and the investment of the oil surplus in (offshore) dollar assets – describes the world from 2001 to 2005 rather well. The US deficit rose from $385b to $755b (an increase of $370b). That increase offset a $127b increase in developing Asia’s surplus and a $263b increase in the surplus of the oil exporters.

``But as the dollar-RMB depreciated against Europe and oil-exporters started buying more European assets, the system evolved. China started to run large bilateral surpluses with Europe. And if 1/3 of the $1.2 trillion increase in official assets is invested in Europe, Europe is now receiving a $400b capital inflow from emerging market central banks and oil funds. That inflow seems to have induced a swing in Europe’s current account balance – This swing doesn’t show up in the data for the Eurozone as clearly as it shows up in the data for the European Union as a whole. That makes sense. Eurozone banks take the inflow from Asia and the oil states and lend it to Eastern Europe. But the overall result is clear: the IMF now forecasts that the rise in the emerging world’s surplus will be offset by a rise in Europe’s deficit.”

Notice some key words: “trade/current account imbalances”, “driven by cross-border flows”, “diversification flows by central banks”, “interventions of emerging markets” and “oil savings and the investment of the oil surplus”, where none of these delve with the issues of domestic currencies relative to its respective domestic economy but rather in the context of the currency’s relationship seen in the spectrum of global trade, savings, investments and/or finance flows.

Succinctly put, the Philippine Peso can be seen as a function of the global dynamics, particularly of the present Fiat Paper money standard.

Figure 4: RB of Australia/IMF: Regional Movement

To illustrate, since we have introduced the macro perspective in currency market dynamics, the left chart in Figure 4 shows to us how ASEAN countries have performed since 1985, courtesy of Glenn Stevens Governor of the Reserve Bank of Australia in his July 18^th speech.

Since 1997, ASEAN countries have moved almost uniformly in terms of the general trend, i.e. from crash to recovery, albeit, the distinguishing factor comes with the degree of relative price actions.

In the right side of the same chart, courtesy of IMF, shows of how Asian Currencies have generally appreciated in 2006. In pecking order, the Philippines ranked fifth following Thailand, South Korea, Indonesia and Singapore.

Again our point is, evidences point toward the Philippines’ predisposition to move along with the region, concomitantly or belatedly.

Figure 5: Yardeni.com: Philippine Foreign Exchange Reserves (left), Joey Salceda/PSE Economic Stock Briefing-Feb 21, 2005 right

The right frame of Figure 5, from a PSE presentation of Presidential Chief of Staff Joey Salceda shows how the Peso severely lagged the region in early 2005, hence its present outperformance could viewed from a perspective of a “catch-up mode”.

Nonetheless, the left frame of figure 5, again from yardeni.com manifests of the explosion of Philippine forex exchange reserves at the end of 2004. This forex trend appears to show of more correlation to the Peso than that of the others, but then again such correlation seems to have incepted only in 2005.

Like us, the IMF believes that portfolio flows have been a key variable in determining the Peso’s increase here is what they wrote (emphasis ours), ``There was also a pronounced acceleration in net portfolio inflows once global risk appetite resumed in Q3 following the sell-off in May-June, with net portfolio inflows from July through November of $1.3 billion, five times the level in the same period in 2005 (Chart 8) [figure 3-ours]. Against this backdrop, the peso appreciated by 7½ percent against the U.S. dollar during 2006, even as the Bangko Sentral ng Pilipinas (BSP) continued to build reserves, while using off-balance sheet currency swaps with local banks to reduce the impact on reserve money. The authorities also used the greater availability of foreign exchange to repay external debt, and to reduce their reliance on external borrowing."

So the IMF tells us that global dynamics have had a hand in influencing portfolio inflows which has coincided with the strength of the Peso.

Hence from an exogenous point of view, one has to factor in demand and supply relative to global monetary and fiscal policies (e.g. which countries are printing more money, forex reserves allocation and trends of sovereign wealth/pension funds), global trading patterns (e.g. growing regionalization trends), macro savings and investment dynamics (e.g. oil surpluses recycled into domestic real estate investments, Japan housewives “Mrs. Watanabes” into carry trades, and demographic trends), global financing and market trends (e.g. US-Asian/Petro Economies-Vendor Financing scheme or the “Bretton Woods 2”, McKinsey’s New Power Brokers-Petro dollars, Asian dollars, Hedge funds and Private equity), evolution of the financial markets (e.g. integration and consolidation of markets, innovative securitized or structured finance products), cross border capital flows, geopolitics and economic linkages.

In our point of view, the premier variable in today’s Peso is the state of the US dollar as a consequent to these agglomerated variables. The alternative aspect is that the Philippine Peso has not been rising but rather the US dollar has fallen against almost all currencies, given the US dollar’s de facto reserve currency status in today’s Paper Money system. Given the change of perspective the issues hinged from the domestic angle changes.

Market Expectations or Speculative Capital

Non market practitioner-experts usually view issues from the perspective of theories but usually base their analysis from select or preferred statistics. Some of such analysis most frequently discounts on the dynamism of market forces, where the nomenclature is that people act or behave like automatons; easy to diagnose, responds uniformly and actions easy to forecast. This resonates very rigid thinking.

In contrast, many market practitioners clearly understand that markets reflect on the psychological output from collective investors. As such, given that people are inherently emotionally driven, markets could occasionally mirror bouts of irrationality or undergo emotional vertigos at certain points of a trend.

Since the Peso, which is traded in the currency market, is rated by investors, speculators and other market participants who are responsible for setting a price for it, based on subjective opinions then they are equally subject to such volatilities and extremities.

Hence we will borrow from George Soros’ as our third view for the currency market, called the “Speculative Capital” or in our terminology the market’s expectations.

Speculative capital essential deals with returns expectations, where as George Soros wrote in his book the Alchemy of Finance (highlight ours), ``moves in search of the highest total return. Total Return has three elements: the interest rate differentials, the exchange rate differentials, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.”

The basic motive by any market participant is to seek the highest returns. And when a confirmatory trend is set, investors tend to pile in so as to reinforce the beliefs or convictions established by the nascent trend. Hence momentum sets in which allows for the trend to persist until a certain phase where the cycle turns or inflects.

Adds Mr. Soros (highlight ours), ``To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely. The situation is highly unstable: if the opposite bias prevailed, it could validate itself. The greater the relative importance of speculation, the more the unstable the system becomes: the total rate of return can flip-flop with every changes in the prevailing bias.”

So while “fundamental factors” such as Endogenous or Exogenous facets could be utilized to establish rational based valuations for investors in the currency market, cyclical factors based on price based expectations can thus lead investors to make fundamental justifications based on prevailing price actions, instead of the other way around.

Hence, under extreme ends experts are likely to be susceptible to justify or provide simplified explanations based on present prices even if the markets have been in essence prompted by unstable speculation. A view likely to be erroneous.

This is why in contrast to the “know-them-all experts” we can say through our experience that markets can in itself become inexplicable at certain times.

So as Mr. Soros implicitly warns, one must not always trust or depend on fundamental based views when markets could actually be swayed by sheer emotions, and thus lend to boom busts cycles.

We share such view.

The Politics Behind The Peso

``The moment we want to believe something, we suddenly see all the arguments for it, and become blind to the arguments against it."-George Bernard Shaw

Again we can’t help but emphasize on what the history says; in all 60 years where the Peso devalued from Php 2 to a US dollar until its peak of Php 56.4 (or about 96% loss) in 2005, our export industry has NOT gained a hefty market share enough to navigate or steer our economy into Nirvana, which has remained sluggish all throughout the past 6 decades, as we discussed in our August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The point being that the function of price as represented by currency changes alone has not been a beneficial factor to our export industry simply because OTHER variables has led to our lack of competitiveness, ergo the seeming price inelasticity of our exports.

Whereas even if the Peso falls to Php 100 to a US dollar, it is not guaranteed that our export industry will recover without adequate reforms in the areas which has impeded on our capacity to compete. Those arguing on the elasticity of our export industry are simply suggesting of short term solutions again, notably through government interventions-a cure worse than the disease-without asking how such wretched conditions emanated from in the first place.

This fallacious linear way of thinking, “falling peso is good for exports” can easily be debunked using with Zimbabwe as an example. Because of Zimbabwe’s hyperinflationary depression has resulted to an inflation rate of 6,598% in August 2007 (BBC), the value of its currency has dropped like a stone from a cliff, where its official rate is at Z$30,000 to a US dollar, but in the unofficial “black markets” are trading at (VOA) Z$1 Million to a US dollar! In effect, Zimbabwe, given such grotesquely skewed premise, should be the WORLD’S LEADING EXPORTER! Duh!

When reforms are made to reflect on the capacities to compete in the market, then prices come into play depending on the level of products produced and to which markets they are sold to, here the cost efficiency and productivity factors would play the leading roles. Hence, addressing these factors requires no short term solution where eventually currency markets should reflect on its true price levels.

As you have seen in Figure 4, the entire region has appreciated against the US dollar in relative terms. So if one argues about pricing in terms of currency adjustments, ALL Asian countries have generally seen their export pricing costs climb. This holds true for most of the rest of the world. So the argument of losing export market share is entirely out of context.

It is not the issue of the Philippines versus the US alone; in the global trade dynamics, it is the issue about the US dollar falling against most global currencies.

To likewise expose such misleading grounds, exporters can always hedge their exports via currency forwards, which if I am not mistaken are also offered by domestic banks. That is why financial markets need to generate more sophistication and deepening, so as to allow our investors alternative sources of financing or acquire additional capabilities to hedge their risks. A natural outcome of a well functioning market is for our industries to achieve increased efficiencies and heightened competitiveness.

Looking at the context of statistics, our external trade has been a less significant factor if based on our 2^nd quarter GDP’s computation, by expenditure at current prices (NSCB). Private consumption accounts for about 70% of the GDP, followed by capital formation 15% and government consumption 11%. Net exports (Exports- Imports) account for only .1% of the GDP. This means that both exports and imports are almost at parity with the exports having a slight edge (both 42% of GDP), hence the net exports.

Of course, what the market critics wants to say is that the government needs to protect these groups by intervening in the markets. And the unseen part is that intervening eventually translates to balance sheet losses by our (BSP) Bangko Sentral ng Pilipinas which would imply to future actions of selling assets to cover deficits. Exhausting all available assets for sale extrapolates to either incurring more debts or printing more money or increasing taxes, whose side effects would mean losing purchasing power over the longer horizon aside from again the loss of competitiveness.

The desire to help a select group over a popularly themed perceived inequality over the short term means sacrificing the future for the benefit of a few.

The following excerpt reflects on the sentiment of domestic businessmen on the perceived factors which inhibits the country from attaining competitiveness (Businessworld), ``But from a list of 14 "factors for doing business," senior business executives in the poll selected corruption, inadequate supply of infrastructure, policy instability, an inefficient government bureaucracy, and "government instability/coups" as their five top concerns.

``Others include stiff taxes and complicated tax regulations, lack of access to financing, restrictive labor regulations, crime and theft, poor worker ethics, and inflation.” (highlight ours)

Our guess is that inflation which rank last seems so because it is the least understood among the lay people. However, generally stated, the frustrations emanate from again misdirected and distortive (inflationary) policies, which have been the main cause of our present plight. Yet ironically, these experts have been urging our officials to apply the same measures with which had caused them in the first place. It’s like giving an alcoholic his next bottle of gin.

Just take the account of remittances; bleeding hearts say that since remittances accounts for about 10% of the economy, it makes up a big portion of private consumption. And since it is a big part of our consumption it should be subsidized by a weak peso.

We wrote NSCB to ask for an estimated figure from which remittances contributes to this share. Apparently since I made the initial query two weeks ago and they have not responded, our guess is that they have no precise figure for such claims. Previously our requests were promptly responded for, not this one though.

The implication is while remittances do vastly help the GDP, rising currencies ex-Peso or a falling peso should help in the purchasing power of those who benefit or the supposed “majority”.

Again, the deceptive linear logic, “falling peso=greater purchasing power for OFWs=the better economy”, yet nobody says anything about higher future consumer prices, an offshoot to such policies.

First of all, if remittances account for 10% of GDP then apparently 90% of the other sectors are also there to deal with. When has the “popular” 10% been greater than the “unheralded” 90%?

Second, even assuming that the OFW’s beneficiaries constitute a big portion say a majority of our consumer spending power today, it is not spending that helps our economy but generating savings and channeling them into investments. The assumption that consumer spending has a multiplier effect is a dubious one. Even if we send half of our population abroad, if the country does not generate enough investments we are unlikely to improve and remain as we are today.

From Dr. Frank Shostak of the Ludwig von Mises Institute (emphasis ours),

``What gives rise to the expansion of real wealth is the expansion in the pool of real savings. It is real savings that funds the making of various capital goods i.e. tools and machinery. In short, it is real savings that sustain various individuals that are engaged in various stages of production. All that money does in all of this is to provide the facility of the medium of the exchange. It makes it possible for individuals to exchange goods and services. The services of money are not enhanced on account of its greater supply. If anything the increase in the supply undermines the services of money. After all when people’s demand for money rises they don’t want more money as such but rather more purchasing power, it is the increase in the purchasing power of money that makes goods and services more marketable. The increase in the supply of money only prevents an increase in the purchasing power of money from taking place.”

Third, all you have to do is look at the Peso for empirical evidence; has 60 years of devaluation and greater OFW exports resulted to a better economy??? I think the answer is quite evident for those who are wise enough to see the truth. Besides, OFW flows are likewise levered to global growth. In general, if global growth slows substantially so will the flow of OFWs and the remittances. Mexico’s remittance flows, which has been levered to the US economy, has started to slow (MSNBC).

Fourth, there is also the unseen implication of money flows, where under a falling peso, OFWs tended to delay remittances in the hope of garnering more “purchasing power”.

Investors are seen in the same light, under a falling peso, capital flight is the common option. People invest in the US dollar instead of the Peso investments. How can withholding money or investing in ex-Peso assets by resident investors benefit the economy?

If there is one domestic reason why we specialize in exporting labor, aside from globalization/demographic trends, is the belated effect of policy outcomes or the law of unintended consequences. It seems that we never learn.

Finally some pertinent quips from US presidential aspirant Ron Paul on currency manipulation (from Mish Shedlock),

``[The answer] is inflate the currency. They don't say inflate the currency, they don't say debase the currency, they don't say devalue the currency, they don't say cheat the people. They say lower the interest rates.'"

``And you never tell them 'the only way you can lower the interest rate is to create more money'. I see this as the problem we don't want to talk about…

``We ignore the fundamental flaw and that is not only have we had a subprime market in housing, the whole economic system is subprime in that we have artificially low interest rates. This has been going on for 10 years or longer and now we are bearing the fruits of that policy… The real deception is when we distort the value of money, when we create money out of thin air…. So my question boils down to this: 'How in the world can we expect to solve the problems of inflation, that is the increase in the supply of money, with more inflation.” (highlight ours)

In essence most of the policy makers, political demagogues and anti-market experts have the all same solution to the very problem from which was created; inflate the system, distort the markets, benefit from it (by being a part of the bureaucracy or the special interest/parallel groups), feed the public with the scraps of money and cry inequality! That is what personality based rent seeking politics is all about.

As they say in France, “plus ca change, plus c'est la meme chose” or in English, the more things change the more they remain the same.

Gold, US Dollar and Oil: Markets Simply REFLECT On Collective Policies Imposed!

``I do not feel obliged to believe that the same God who has endowed us with sense, reason, and intellect has intended us to forgo their use.” -Galileo Galilei (1564-1642)

Another week, another record.

As the US dollar index fell to its lowest level ever, Crude oil and gold hit record milestones, a historical high and a new 27 year high, respectively.

While everybody can see prices, only a few realize that they have a common denominator and transmit a message.

The market for crude oil can’t be exactly characterized as FREE, as about 77% of the world’s 1.1 trillion barrels in proven oil reserves is controlled by governments (Washington post). And so as with the US dollar Index, where collective governments monopolize the role of money creation. In short, in a demand supply equation, the supply side of these markets is mostly controlled by governments, whereas the demand side is one that is being rated in the markets.

Take oil, the problem from the supply side stemmed from years of non-transparency practices, subsidies, nationalization, cheating among cartel members, environmental restrictions, fund diversion to social programs, underinvestment, and others-all of which has the distorted price signals in the marketplace which lent to complacency and therefore today’s massive disequilibrium which has now been reflected in prices.

On the demand side, both the currency market and oil markets reflect the effects of the inflationary policies (money and credit creation) instituted during the earlier years.

As for gold, which has served as a better part of global money for more than 2,500 years, the earliest coinage was said to have been in Lydia between 660 and 643 BC (wikipedia.org), it simply echoes on the collective malpractices of governments in inflating the system with excess money under today’s Paper Money standard.

Everybody sees gold rise in terms of US dollars, but this hasn’t been the case, gold has been rising against ALL currencies, including the best performing Canadian Loonie, as shown in Figure 1.

Figure 1: stockcharts.com: Gold’s Outperformance!

The US dollar index basket consists of 6 currencies which are weighted in different scales, namely the Euro (57.6%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%), and the Swiss Franc (3.6%).

With the Japanese Yen and the Swiss Franc functioning as funding currencies in today’s Carry Trade, it is obvious that gold’s rise has had far greater impact than the rest, so we purposely didn’t include them.

As you can see even against the Euro (lowest pane), which represents over half of the US dollar index, and has been gaining quite steeply vis-à-vis the US dollar, gold’s ascent has been conspicuous, and so with the British Pound (pane below main window).

Commodity currencies which benefit from the rise of exports of commodities such as the Australian dollar (middle pane) and the best performing Canadian Loonie (main window) are likewise underperforming gold.

Mind you, while the chart speaks of a one year frame, this phenomenon has been ongoing for several years.

Now instead of quoting other known figures, we purposely quote the favorite or the “idol” of Statist practitioners, the illustrious John Maynard Keynes, ``By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Our point is Mr. Keynes clearly understands the implications of inflation, why can’t their followers?

Yes, it’s funny how mainstream media including their cohorts of experts don’t tell you this. They focus on other aspects, the tangential aspects of economic ills…so as to generate support for MORE spending programs in the name of public welfare-hahaha! More inflation! Hahaha!...when in fact inflationary policies or the COST OF SOCIAL PROGRAMS or Government INTERVENTIONS have been basically the principal reason why our collective purchasing power has been eroding and widening the so-called “inequality” effect (which is actually a mirage since inequality is an undeniable fact of life!), a topic well-loved by demagogues and easily bought by the gullible public.

Look at these comments (telegraph) ``We are of course concerned about high oil prices, but the market is increasingly driven by forces beyond Opec's control.” Mohammed bin Dhaen al-Hamli, president of Opec and ``Please don't blame us for $93 oil... The market is out of control." He said that the oil market is "very confused", Qatar's Abdullah al-Attiyah oil minister. (highlight mine). How pathetic!

What this means? Governments have done ALL it can through the years to “manage” or “control” prices of oil, the issuance of paper money and even gold.

It is even alleged that the gold market has been sold short by western governments to limit the impact of the public’s inflation expectations, where a group called Gold Anti-Trust Committee (www.gata.org) has long spearheaded the campaign to expose the collective government’s manipulation.

Needless to say, despite all the “control and command features” imposed on the markets, these actions eventually BACKFIRE! The Law of Unintended Consequences, anyone?

If it is TRUE that gold has been shorted, then high 4-digit to even 5-digit gold is not improbable where $100+ fluctuations per day become a reality.

$150 oil backed by Peak oil syndrome is now clearly on horizon. Texas oilman T. Boone Pickens (hedgefund.net), whose streak has been on a roll, just recently predicted the price of oil will probably reach $100 before falling to $80 where he theorized ``that “peak oil,” the point at which oil production worldwide has reached its zenith, has arrived. After its peak, production will begin an unstoppable decline.” Looks like we are heading there!

As governments turn to rescue their factotums and conduits, watch the inflation genie morphs into a hideous Godzilla.

Because of the angst of the SYMPTOMS of inflation (high prices) more and more pressures will be applied to governments to undertake political “safety nets” programs to mitigate the impact on the populace. Argentina, Russia and China have initiated some semblance of price controls. Says Daniel Gross of Slate Magazine, ``If the price controls continue much longer, these economies could see the revival of another distressing factor that defined socialist economies in the 20^th century: rationing.” So aside from MORE price distortions we are seeing MORE inflationary policies again! Inflation in itself a self-reinforcing dynamic! Hahaha!

Alas, the world’s financial system is clearly undergoing an incredible stress. And the Austrians School have been dead on with their projections, either we see a destruction of the currency or face up to a Depression that would make the US 1930s and Japan’s lost decade look like a picnic.

Markets simply REFLECT on the collective policies imposed, or as the bible says what we sow, we reap. Markets don’t fail, Governments does.

People see what they want to see, but refuse to see what needs to be seen. In the end we all fall victim to our biases and blame others.