2008: A Challenging Year of Inflation versus Deflation

``You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of '02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive…My view, instead, is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right. The problem is that real risk and perceived risk are two different things. And that's where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That's the psychological problem that most people have.”-Bill Miller manager of Legg Mason Value Trust

At the start of this year we projected that the Phisix would range by (+/– 5%) in the light of a US economic downshift and based on the mean reverting tendencies of markets. Apparently while indeed the US has seen some semblance of a slowdown, the strong run-up until the third quarter by global equity markets has proved our projections as inaccurate (Phisix is presently up 18% year-to-date and most likely will end up during at the yearend-with a few sessions to go― unless another August like shock erupts; like all of our earlier projections we tend to be too early).

Nevertheless, such outlook should be carried over for next year, specifically the Phisix and the Peso could correct (the Phisix could retest the 2,800-3,000 before recovering at the close of the year as well as the USD-Peso could bounce to the 45 level before a resuming its strength), as the strains of credit turmoil remains unresolved coupled with heightened risks of a US recession spilling over to a downdraft in global economic growth. Remember, if remittances have underpinned the virility of the Peso, as mainstream experts suggests, then a US recession-global growth slowdown should affect employment and migration trends enough to ease or even reverse the tempo of the Peso’s rise.

By our own measure, capital flow trends into Asia should determine the fate of the Peso in 2008. A moderate slowdown could exacerbate capital flow trends into Asia while in contrast any shock (similar to August) could result to massive unwinding of leverage positions.

The ensuing uncertainty described above will likely be accompanied by a concerted easing by global central banks in spite of today’s backdrop of magnified inflation. The TAF and the recent easing by the Bank of England and the Bank of Canada alongside with the US Federal Reserve is a prologue to the next year’s activities.

Besides, given the mean reverting proclivities of the markets where no trend goes in a straight line, this means secular or long term cycles will always be interrupted by countercycles.

Yes, speaking of inflation in spite of the deflationary developments rapidly unfolding in the frontiers of the financials, the world appears to be experiencing an onslaught of rising inflation (as measured in producer/consumer prices), mostly seen in energy and agricultural or food prices. Doug Noland writes in his Credit Bubble Bulletin,

``U.S. Consumer Prices were up 4.3% y-o-y in November. Our Producer Price index registered a 7.2% y-o-y surge. November Import Prices were up 11.4% from a year earlier. Euro-zone inflation jumped to 3.1% y-o-y, the strongest rate since May, 2001. German consumer inflation rose to an 11-year high (3.3%). Chinese inflation was at an 11-year high of 6.9% in November. Score of countries and regions – including Australia, Russia, Eastern Europe, and the Middle East - now confront heightened inflationary pressures, in what has developed into a powerful global phenomenon.”

Mr. Noland is right when he says the inflation is ``in the process of significantly limiting the Fed’s flexibility and capacity to orchestrate another Wall Street bailout.” But as we have always argued, for as long as the menace of deflation deepens, the likely thrust by global central banks is to err on the side of inflation and work to defer on the day of reckoning. No central banker would like to have a recession in their résumé, hence the inflationary boom-bust cycles.

Yet while we remain bullish on the Phisix and the Peso over the long term, 2008 poses to be a year of significant challenge where we think the performances of Gold and Oil as best guide in the ongoing battle between the forces of deflation and inflation.

The recent strength of the US dollar could be indicative of emergent deflationary forces as shown in Figure 5.

Figure 5: Stockcharts.com: US Dollar Rallies Signals Deflation?

So with global indices including the Phisix (above), Dow Jones World (pane below main window) and the US S & P 500 (lowest pane) on a clear downtrend, marked by lower highs at the onset of a rallying US dollar (main window-circle) amidst modest actions by major Central Banks, we are looking at potentially more downside volatility as financial market losses make themselves more apparent. The blue vertical line shows how global equity markets have become “synchronized” anew.

We have seen how central banks have employed “creative” (FHLB, M-LEC, TAF) options to defuse the unraveling crisis. We should expect intensified activities from them for as long as markets persist to exhibit an enduring loss of confidence. Or as the losses percolate or worsen, their accompanying actions are most likely to culminate into more aggressive rescue packages or face the risk of a full-blown crisis.

2008 will likely hallmark a tug-of-war between inflation and deflation.

Philippine Peso And Remittances: The Unsecured Knot

``One of the greatest tragedies of life is the murder of a beautiful theory by a gang of brutal facts."-Benjamin Franklin

The US dollar-Philippine Peso recently broke into the 41 level, the highest level in more than 7 years. Nonetheless, the Philippine Peso has been the top performing currency in Asia with a year to date gain of about 17%.

Figure 1 Left: World Bank: Remittances Year-on-year Growth on 3 month moving averages,
Right: Philippine Peso-USD Price Rate of Change (Inverted Scale)

Anyway, we read that the Peso has been “driven” by overseas money again. While the fundamental ratiocination appears to have given such correlation a strong link, as we demonstrated in our November 5 to November 9 edition see What Media Didn’t Tell About the Peso, these have not been airtight. In fact, based on price actions, the correlations have been more of a recent phenomenon.

The timely release of World Bank’s Remittance Trends 2007 as shown in Figure 1 (left window) exhibits the year-to-year growth of the remittances. This means that while nominal remittances have been growing, the rate of change on an annual basis have been on a decline since the last quarter of 2006 and bottomed out in July of 2007, only recently has this reversed to the upside.

In comparison with the Philippine Peso-USD (inverse scale: black line-right window) over a similar timeframe, we can identify some observable similarities and notable differences.

The peak of the October remittances coincided with the summit of the Peso last 2006, whereas the trough in the remittance this July was accompanied by a bottom in the Peso’s ROC last August.

Prior to these, the peaks and troughs have been rather distinct. As an aside, the degree of changes has been in stark contrast; for instance, the intensity of the latest ascent had been precipitate, even if we exclude the November performance, the ROCs would have been at the resistance levels relative to the benign reversal seen in the WB’s remittance chart.

Of course, one should be notified that due to the lack of breadth of our data on the Peso, the “apples-to-apples” or the equivalent year to year change has not been utilized. However, the overall trends should depict on these dynamics.

Our point is; relative price action, the Peso-remittance causality or correlation has been more of a recent phenomenon confirming our earlier views, but whose relationship cannot be reckoned as straightforward or infallible.

We are heartened by the news that new instruments (e.g. multi-currency Retail Treasury Bonds) have been designed by the Philippine Central Bank, the Bangko Sentral ng Pilipinas (BSP), aimed at our migrant workers, to hedge against the rising Peso.

But what seems to be amiss is a market based approach on these aspects. By introducing or adopting a franchise on alternative market platform/s, such as a domestic futures market (a genuine futures market-not the defunct MIFE model), which could allow more financial (non-banking) and nonfinancial institutions to even retailers to participate or access a wider range of hedging tools could spur the creation of varied hedging vehicles or instruments, such as indices like ETFs or Exchange Traded Funds, which could compete to offer better yields to OFWs or to the populace.

Remember, deeper and more sophisticated financial markets should reduce transaction costs thereby boosting efficiency and competitiveness in our domestic enterprises, as well as augment our economy’s capital formation channels. At the same time, by diminishing risks through hedging enhances returns potentials thereby attracting more participation from the populace.

This is one concrete way to yank out our inordinate dependence from politicians.

Open Market Economies or Che Guevarra’s Chimeras

``Ideologies are now served à la carte. Chávez makes common cause with the Cuban Revolution. But he parades under banners of Jesus Christ and calls Christ the “first revolutionary.” So much for Communism’s dismissal of the opium of the people. The Venezuelan leader talks a lot about women’s rights, but abortion remains illegal. Just as Chinese Communism can be capitalist, and Russian democracy look Leninist, Chávez’s Cuban-inspired socialism can be Catholic: what counts is power preservation.”-Roger Cohen, columnist International Herald Tribune

The public, impelled by mainstream media, has been made to believe that the success in a country’s political economy should be driven by “personality based” (rent seeking) politics or the “honesty-charity” model of “socialism”, or the belief that central planning should solve each and every of our daily problems.

This socialistic inclination appears to have diffused into the hoi polloi…do you see the proliferation of Che Guevarra T-shirts on the streets? (Gadzooks! Have mass murders or “democide” now become a paragon for economic salvation?!)

The irony is that while we opt for a political democratic form of government where we “elect” our leaders, we chose to subordinate our economic path to the whims of these leaders who eventually “fail” us by the “unwarranted” imposition of perceived popular themes of “injustice” and “corruption”.

When economic opportunities are determined by politicians then we subject ourselves to centrally planned governance-socialism. Bloated bureaucracy, surging government spending and soaring taxes are symptomatic of such dynamics. And so is the price of getting elected (see our November 18 discussion).

Yes, according to the recent World Bank’s Paying Taxes 2008 Report, the Philippines ranked 135^th of the 178 countries in terms of taxing businesses. This pales in comparison to our neighboring Malaysia, Indonesia, and Thailand which landed in 54^th, 63^rd, and 66^th spots, respectively (Businessworld). High tax rates equal to high costs of doing business. Should it be any wonder why we lack the required investments which contributes to the present economic plight?

Yet, the paradox is that we ask for more government. Why? Because many of our economic elites hide under the skirt of regulations to escape competition and even lobby for more laws to keep the statusquo or retain their competitive advantage.

On the other hand, most serving political officials, the wannabes (opposition) and their affiliates or associates-some in the media, some in the legal profession, and many in the church et. al. -advocate for bleeding heart or “doleout” economics or for more dependence on the government for a variety of purposes-anywhere from wielding the burgeoning public coffers for their self interests to the arrant lack of understanding of the implications thereof.

So in spite of all of the successive changes of leadership over the years, we continue to remonstrate on the actions of the incumbent leadership for exactly the same sins as the past administrations. And since we can’t comprehend on the true picture of what keeps us they way we are, we ask for the wrong cure-more government. As an old adage goes, ``Fool me once shame on you! Fool me twice, shame on me!”

Like a curse, hardly has it been known to us that our socialistic tendencies will continue to benight on us for as long as we chose to do so.

The fundamental problem with the ideals of socialism/communism is that its application has been incompatible with the universal laws of economics such as the law of scarcity, the individual’s sense of marginal utility and most especially economic calculation. Why do you think the USSR collapsed (lack of charity or honesty, perhaps-hahaha!)? Or communist China or statist India has now shifted their economic structures towards market-oriented economies?

Yet faced with every problem is the desire to use of the legitimate structural coercive machinery-government-as political mechanism for dispensation of fairness or justice. Do you ever think that government can ever be just, fair or honest? Our answer: No. Simply because “justice, fairness and or honesty” depends on how an incumbent defines these. Like market prices, which are subjectively valued, so as with the definition of one’s sense of fairness justice or honesty. Che Guevarra’s brand of justice was of public trial and mass execution…of the political opposition…should such be considered as one’s political model?

Anyway, since we are speaking of developmental issues, here is a recent pertinent narrative about Ireland’s transformation according to Dr. Steve Forbes of the eponymous Forbes magazine and his suggestions for Israel (emphasis ours),

``The dispute there between Protestants and Catholics has been bloody and has lasted for more than three centuries. Yet there now seems to be real progress toward peace. Why? Not because diplomats suddenly became more able but because of the profound changes to the south, in the Republic of Ireland, which for centuries had been one of the poorest economies in western Europe.

``Things started to change dramatically in the 1970s. Dublin aggressively courted foreign investment, using tax cuts and tax holidays as bait. Other tax and regulatory changes were made. Result: Ireland today is the most vigorous economy in western Europe. Its per capita income is now larger than that of Britain, France or Germany. The great boom in Ireland did not go unnoticed in the North, and in fact that region has benefited greatly from the Republic's prosperity. A vigorous, new middle class is rising in all of Ireland. As people become more prosperous they tend to focus on bettering their lives more than on blowing up their neighbors…

``Israel has made significant changes--especially under Benjamin Netanyahu, who was finance minister (2003--05)--but it could do a lot more, including instituting a low-rate flat tax. Until recent years, in fact, Israel's economy was grossly overregulated, overtaxed--hardly an inspiring free-enterprise model. The faster it can move to a Hong Kong/Estonia/Switzerland model, the better for its own well-being and security. A free-enterprise boom would be noticed by neighbors--and quietly emulated.”

The lessons are clear enough, the odds of successes for open market driven economies have conspicuously been lopsided than of any statist or socialist models, especially when in comparison to Che Guevarra’s revolutionary paradigm-Cuba. (Wasn’t he booted out by Fidel Castro for either incompetence or for conflict of ideals? And wasn’t all his revolutionary attempts in different countries-Panama, Dominican Republic, Bolivia, Congo-been a failure?).

The Socialization of Global Financial Markets

``Where in capitalism is the idea that you can spend more than you earn? Where in the vision of Adam Smith is the idea that foreigners will subsidize your standard of living – indefinitely? Where in laissez-faire is the notion that central bankers will prevent corrections by controlling the price of money? What had happened to the old sturm and drang? Where was Schumpeter’s ‘creative destructive?’ The new capitalists offered creation without destruction... resurrection without crucifixion! They offered not only to hold harmless investors in the face of their own bad judgment...but to revive booms before they ever expired and to cut short corrections before anything has been corrected.” –Bill Bonner

Global equity markets cheered anew the “socialization” of the financial markets, as shown in Figure 2, as major central banks such as the Bank of England and the Bank of Canada trimmed interest rates in response to the worsening global credit crisis and over concerns that such dislocations would spillover to the global economy.

Meanwhile the Reserve bank of Australia and the European Central Bank kept rates unchanged regardless of the signs of incremental increases of inflation (by their definition-higher consumer prices).

Figure 2: stockcharts.com: Equity Markets Applauds Central Bank Bailout Packages

The buoyant markets have been apparent in the Philippine Phisix (main window) alongside the US S & P 500 (above pane), the Dow Jones Asia ex-Japan (pane below window) and Emerging Markets (lowest pane) which have simultaneously recoiled following the other week’s tests at near critical support levels.

This came about as dovish statements from key central bank officials as Chairman Bernanke and Vice Chairman Kohn indicated of concerns of heightened downside risks which possibly telegraphed messages of a forthcoming rate cut this December 11^th.

As we have noted, the global equity markets since August have been living off from government crutches, i.e. buying the hope that the attendant remedial policy measures will be effective enough to thwart the ongoing rapid adjustments in the highly leveraged financial sector.

Despite several initial stopgap measures to contain the recent stress, equity markets continued to show signs of strain as selling pressures reappeared last November.

Recently even as equity markets appear to have been pacified the credit markets continue to manifest signs of significant dislocations as shown in Figure 3.

Figure 3: Financial Armaggedon.com: Biggest Spread since 1986

The chart depicts of the spread between US Libor rates or lending rates on unsecured funds charged by banks to each other relative US Treasury bills of the same maturity, from which today’s ``conditions are more akin to the chaos that developed around the time of the 1987 stock market crash, (highlight ours)” observes Michael Panzer of the Financial Armaggedon.com.

Mr. Panzer adds, ``More ominous, perhaps, is the fact that banks have much less in the way of cheap and relatively immobile customer deposits backing their outstanding loans than in the past. That means they are more dependant than ever on other banks and the financial markets to meet their funding needs”

This just shows how leveraged the global financial system is, deposit reserves which used to serve as sound collateral for lending has essentially dissipated. These have been replaced by collaterals of questionable value. In good times nobody challenged the viability of such premises. Now that the going gets though, the massive spike on yield spreads reflect on their reluctance to lend to each other which could signal a potential disorderly unwind.

Of course, again the equity market is hoping that the plans to mitigate losses from the mortgage market will gain traction as Treasury Secretary Mr. Henry Paulson alongside with industry lenders set up guidelines to freeze interest rates by affected parties.

But the problem is that these plans would only help a marginal number; from New York Times, ``The Greenlining Institute, a housing advocacy group in California that began raising alarms about subprime loans nearly four years ago, estimated that only 12 percent of all subprime borrowers and only 5 percent of minority homeowners would benefit from the rate freeze. The Center for Responsible Lending, a nonprofit group that supports homeownership, said the freeze would help only about 145,000 people.” (emphasis mine)

Second, is the concern over the breach of private contracts, from the Economist (emphasis mine), ``Whatever else it may be, the Bush administration’s agreement is an extraordinary intrusion by the government into private mortgage contracts…Whatever the economic arguments for the Bush administration’s plan, it amounts to poor public policy. America’s unfettered brand of capitalism is one of its strengths; investors may be less likely to trust a government that manipulates private contracts when conditions deteriorate. At a time when the economy is already weak and the dollar is suffering from a crisis of confidence, Mr Paulson’s awkward intrusion into the mortgage market looks more like desperation than a hedge against further trouble.”

Third is the ambiguous procedural process, again from the Economist (highlight ours), ``But how the process will work is not clear. A national blueprint may make it easier to identify those who are eligible for relief, but the process of renegotiating the loan, or applying a rate freeze, must be done individually. Lenders will need to check borrowers’ incomes, debt levels and the current value of homes before they can agree to a change in the terms of the loan. Mr Paulson, in fact, acknowledges his plan’s limitations by saying that other relief measures are under discussion.”

Another is about the incentives and potential consequences, from Minyanville’s Mr. Practical, ``The biggest ramification is this. Those investors will have to decide whether or not to accept the new terms. If they accept lower interest payments because it is better than default, the value (price) of the CDO will go down to reflect the new present value of the payments. This is a big fact that I think everyone is missing: the price of CDOs will be marked down from current levels. Banks' desire to lend will go down as a result of this. As an illustration, the spread between libor and ECB funding rate (equivalent fed funds) rose again last night and is at a record 89 basis points.

``A nuance of the above is that senior trauches of CDO now have a higher certainty of pay-outs while the junior trauches now may be worthless. These junior trauches will sue like crazy as this thing unfolds.”

``What will happen is that banks/other investors who own these will then take another write-down but then declare this is the end. This will not be true. A huge percent of all re-negotiated mortgages eventually still default. It just buys a little time for a few more interest payments. The bottom line is these folks bought houses they couldn’t afford when paying market interest rates. This is really a plan to help banks take one more write-down and declare all is well and then hope for some magic turnaround. But there won’t be a turnaround.”

Finally on the proposed government bailout, again Mr. Practical, ``So far Mr. Paulson is trying to make this look like a “voluntary” plan by lenders. We all know there is lots and lots of pressure being exerted by government to get them to volunteer. But I have a feeling Mr. Paulson’s plan does not end here. There is also talk of getting Congress to pass legislation to let states and municipalities issue tax-exempt debt to refinance loans for those who cannot keep their homes. This would be nothing more than a government led bailout of banks and large investors at the expense of taxpayers. ”

As we have long argued, the US government will protect the US dollar standard system with an attendant bailiout of its major conduits, even at the expense of the purchasing power of its currency. Yes, there could be some sacrificial lambs but the overall action appears to be pointing towards such direction.

Second like any governments, they tend to be reactionary in their approach to problem solving--responding mostly to short-term popular demands but whose actions are likely to benefit vested interest groups.

Third, it is the nature of governments, given the backdrop of today’s paper money system, to utilize manipulative (inflationary) policies to steer an economy towards a short-term boom then blame the markets for the ensuing bust from which they would find the necessary excuse, backed by socialist experts and grandstanding politicians, to justify for the next policy (inflationary) maneuvers.

Lastly, such rescue plan has yet to be implemented and we are already seeing some signs of a backlash, which means like most interventionist policies they tend to end up with long term unintended consequences.

Stock Markets: Monetary Policies Have Larger Impacts 2

``“Movie-plot threats”: the tendency of all of us to fixate on an elaborate and specific threat rather than the broad spectrum of possible threats. We see this all the time in our response to terrorism: terrorists with scuba gear, terrorists with crop dusters, terrorists with exploding baby carriages. It’s silly, really, but it’s human nature.’- Bruce Schneier, American Cryptographer and computer security expert, interview at Freakonomics

So where are we headed for?

Figure 4: Ratings and Investment Info: China’s Currency Reserves and the Shanghai Composite

First, we believe that monetary policies have very compelling influence on the directions of asset classes more than what the conventional wisdom leans on--predicated mostly on corporate earnings or on plain vanilla economic linkages as discussed last week.

Figure 4 from Ratings and Investments shows how China’s soaring foreign currency reserves have coincided with the spiraling Shanghai Composite Index. To fittingly quote Professor Michael Pettis of Peking University’s Guanghua School of Management, ``the root of China’s problem is the growth in the nation’s money supply caused by the currency regime.”

Second, the unfolding credit crisis which has been emblematic of the declining collateral values held by major financial institutions is about to test global central banks risk tolerance based on the prospects of deflation or of contracting liquidity.

As evidence, the rescue project by Secretary Paulson code named, “Hope Now Alliance” signifies the intent to slowdown the deterioration of the present financial conditions to the point of undeservingly manipulating contracts. In short, desperate times calls for desperate measures.

By our understanding of the ideological framework of Mr. Bernanke, based on his previous speeches Financial Accelerator and the Helicopter strategy, it is likely that the pursuit to preempt a deflationary outcome would be its principal policy activities. Hence, given such premise, it is our belief that the US Federal Reserve would cut no less than 25 basis points during the next FOMC meeting next week.

Nonetheless, there are other sources of potential risks, which we believe the authorities are well aware of, such as US commercial real estate, other asset backed assets as Auto Loans or Credit Cards, Credit Default Swaps, High Yield Bonds and Derivative Counterparty risks.

Third, with signs of decelerating economic growth becoming more apparent--OECD expects world growth in 2008 at 2.3% compared to 2.7% in 2007 (Canadian Press), global banks appear to be calibrating their policies with that of the US.

Hence, a prolonged turmoil in the credit markets, further downside volatility in asset prices and palpable signs of spillover to the real economy are likely to prompt for more liquidity spillage policies. The BoE and Bank of Canada’s actions are likely the first of a series of moves.

It takes only four central banks to make material impact on global liquidity at present; namely the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. Remember, as we mentioned in the past, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

While we expect the BoJ to remain on hold during this turbulent period, the rest including the hawkish ECB’s Jean Claude-Trichet, are likely to join the bandwagon once such dislocations become evident.

Figure 5: AMEINFO.com Arab General Index

Lastly, as we have been saying all along, we don’t claim to know or pretend to comprehend everything, because the world is too profound or complex to do a simple 1+1=2. There are simply too numerous variables to consider.

However, what we understand is that despite claims that the world financial markets in unison would suffer miserably due to a US hard landing, our perspective is that they could be subject to functional randomness based on the possibility of diverse responses to collective policy activities by global central banks. This could be due to the different state of developments of domestic financial markets, the divergent currency regimes or policies involved or exposure to leverage, as well as the distinctive constructs of the domestic economies, financial globalization notwithstanding.

Figure 5 from the Ameinfo.com tells us that the Arab General Index has climbed this year, unfazed by the recent tumult last August and September similar to China. This goes to show that not every equity bourse have their destiny tied with the fate of US markets…yet. Yes, we understand that most of the bourses indicated have not been significantly open to foreign investors, but our point is with prospects of more inflationary actions, money would have to flow somewhere.

Gary Danelishen writing for Mises.org gives a good account of inflation process (underscore mine), ``New money that enters the economy does not affect all economic actors equally nor does new money influence all economic actors at the same time. Newly created money must enter into the economy at a specific point. Generally this monetary injection comes via credit expansion through the banking sector. Those who receive this new money first benefit at the expense of those who receive the money only after it has snaked through the economy and prices have had a chance to adjust.”

As a saying goes, Discretion is a better part of valor.

Some Memorable Quotes from Friday’s Manila Peninsula Debacle

``The main issue in present-day political struggles is whether society should be organized on the basis of private ownership of the means of production (capitalism, the market system) or on the basis of public control of the means of production (socialism, communism, planned economy). Capitalism means free enterprise, sovereignty of the consumers in economic matters, and sovereignty of the voters in political matters. Socialism means full government control of every sphere of the individual's life and the unrestricted supremacy of the government in its capacity as central board of production management. There is no compromise possible between these two systems. Contrary to a popular fallacy there is no middle way, no third system possible as a pattern of a permanent social order.”-Ludwig Von Mises

Quote:

From the Philippine Daily Inquirer, ``What we did was not only our duty but our moral obligation,” said Trillanes said in justifying his latest act of defiance, adding,“It is our duty as religious individuals to do what is right.”….“Dumaan tayo sa tamang pamamaraan [We passed through the right processes]. Elected pero wala ring nangyari [We were elected but nothing happens]. They voted for me so that I can speak up for their rights and our advocacies,” said Trillanes, referring to his election as senator last May. (highlight ours)

Possible Translation:

I got 11 million votes during the last elections; therefore I deserve my pork barrel!! Where the heck is my pork???!!!

Our comment:

Friday’s failed power grab simply highlighted mainstream media’s favorite theme of “Personality based rent seeking” politics or the misguided belief that our country’s success or failure depends on the proverbial “magic wand” by one great leader that has yet to emerge or that the present country’s ills will simply vanish by the ouster of the incumbent via another revolution.

After TWO (successful) EDSAs and several aborted coups since 1986, we never seem to grasp that the leadership game of musical chairs will not subject us to deliverance; not as long as we sustain the vicious cycle of the patronage system which is rooted on our unwarranted dependence on government or our platonic love affair with the “socialist paradigm”.

Statements like this simply reflect on the abject predicament of our deeply flawed political-economic structure. Yet, when parsed, they appear to be very revealing. As a prominent saying goes, the more things change, the more they remain the same.

Quote:

From Bloomberg, ``Like soldiers, we're going to face this, whatever they want to do with me,'' Trillanes said inside the hotel after the raid and before being arrested. ``This is not our loss. If there's a loser here it's the Filipino nation.'' (highlight ours)

Possible Translation:

Where are you, my 11 million @#$% voters when I needed you??!!

Our comment:

Obviously, there is a clear distinction between the mandated function of an elected official to fulfill one’s designated tasks and a naked power grab. Put into a math equation: 11 million votes ≠ a license to grab the political leadership.

But politics like the financial markets occasionally strips out one’s computational logic or rationality especially when overwhelmed by vanity, in this case prompted by an apparent miscalculation from the ramifications of popularity based political actions.

Again instructive political statements like this seem to give credence to English author Samuel Johnson’s ever noteworthy and applicable quote, ``Patriotism is the last refuge of a scoundrel”.

Reading Market Signals and Avoiding Logical Fallacies

``So we pour in data from the past to fuel the decision-making mechanism created by our models, be they linear or nonlinear. But therein lies the logician’s trap: past data from real life constitute a sequence of events rather than a set of independent observations, which is what the laws of probability demand.” Peter Bernstein

To our experience, there are two major common misperceptions of what drives the financial markets. In the case of the stockmarkets, the public generally believes that its directional path, in the absolute sense, is determined by either the conditions of the domestic economy or corporate earnings.

To question or to challenge such premises is almost equivalent to blasphemy; we get stared in the face with “shock and awe” kinesics with the implication that we either…come from another planet or…don’t know what we are talking about.

To be clear, like our contrarian view on the Peso, [see November 5 to November 9 edition What Media Didn’t Tell About the Peso], we do not dispute that the activities in the domestic economy and corporate earnings does somehow contribute to the pricing dynamics as evinced in the market ticker through the transmission of collective expectations, but our perspective is angled from the functions of correlation and causation in accordance to the conveyance of information from price signals.

As an example, as we recently cited, the popular view of the Philippine Peso’s strength has been constantly attributed by mainstream media to the grounds that strong inflows from remittances have “caused” its present conditions. While from the fundamental perspective such argument appears incontrovertible, however if one looks at the price trends of remittances relative to that of the Peso, we would find some notable divergences and belated correlations, all of which does not appear to demonstrate the straightforward cogency of such assertion. This is what distinguishes us from mainstream experts.

In the news you’d frequently read experts as saying or writing in simplified gist…“the market (stocks, commodities, bonds, real estate, labor, et. al.) has been moved by so and so factors (usually event-driven)”…or the extensive use of logical fallacies of post hoc ergo propter hoc (after this therefore because of this) or cum hoc ergo propter hoc (correlation does not imply causation). There are even experts who generally draw “cause and effects” conclusions to market outcomes by interposing their underlying biases on what they believe the market should be.

Dr. John Hussman of the Hussman Funds describes this phenomenon best (highlight ours),

``Unfortunately, most economists have never fully internalized the “rational expectations” view that market prices convey information. Of course, accepting this view does not require one to believe that prices convey information perfectly (which is what the efficient markets hypothesis assumes). But where finance economists take this information concept too far, economic forecasters don't take it far enough. As a result, economic forecasts are generally based on coincident indicators such as GDP growth and industrial production, or pathetically lagging indicators. This tendency to gauge economic prospects by looking backward is why economists failed to foresee the Great Depression and every recession since.”

Since market prices are mainly shaped by psychology through expectations which are transmitted by value judgments, the myriad flow of information impacts rightly or wrongly the decision making processes of diverse market participants in different degrees. As Ludwig von Mises in Human Action says…

``It is ultimately always the subjective value judgments of individuals that determine the formation of prices…. The concept of a "just" or "fair" price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.”

For instance, similar sets of information can be construed contrastingly by market participants which could prompt for opposite market actions.

A “buy the rumor sell the news” is concrete example, once a news comes out to either confirm or deny the rumors that impelled for the recent price movements, traders usually sell (acknowledging the end of the play) while investors buy (in confirmation of expectations), ergo value judgments actively at work in the marketplace.

In short, most of the mainstream analysis which feeds on the public’s “simplified” knowledge is predicated upon the “rear view mirror” syndrome or on recent past performances. Sometimes they also reflect on the biases of these experts.

Bottom line: When analyzing markets our proclivity is to read market signals and interpret them objectively instead of imposing our biases on our perceived market realities or subjecting them to selective analysis.

Stock Markets: Monetary Policies Have Larger Impact Than Economic and Corporate Links

``This is the U.S. financial banking system and it will be defended. And if the U.S. cannot push through superconduits and rescue plans, foreign sponsorship will step up as it recently has. Whether they can pull the U.S. up or the U.S. pulls them down is another conversation altogether.”-Todd Harrison, founder CEO of Minyanville

Now going back to our original premise about “economy and corporate earnings” as drivers to the market, let us use the US equity markets as example.

Figure 1: Northern Trust: US Real GDP

Except for the recent perplexing third quarter surge in the face of a deepening housing recession and the worsening credit conditions, figure 1 from Northern Trust shows us that real seasonally adjusted GDP as measured by its percentage change since 2003 has been trending lower (superimposed blue arrow).

This means that while its economy has been growing in nominal terms, the speed of its variable changes relative to real economic growth had generally been slowing down post the dotcom bust.

Now if “economics-drives-stocks” then respectively, we should see some similarities in the price actions patterns of the S & P 500 as shown in Figure 3.

Figure 2: WSJ: Earnings Growth has been Slowing

But before we jump to the broad based index the S & P 500, a chart from an article in Wall Street Journal in Figure 2 likewise depicts of a slowdown in the year-to-year quarterly change in the earnings growth by the aggregate composite members of the major bellwether as indicated by the superimposed blue arrow over the left chart.

So again while earnings have been growing in nominal terms, the speed of its variable changes has notably been slackening since 2004.

Again if “earnings growth” equally drives stocks as commonly perceived by the public then respectively we should see some similarities in the price actions patterns in the S & P 500 as shown in Figure 3.

Figure 3: S & P 500: Quarterly Chart/Rate of Change

Figure 3 reveals of the quarterly chart of the major benchmark S & P 500 (black candle).

To compare with the performance relative to the economy in 2003, the major equity bellwether bottomed out then began its major turnaround to the upside.

In 2004 relative to earnings growth, the S&P continued with its vigorous ascent. This progressive advance has been strongly supported by the rate of change, manifested by the uptrend of the red line.

Thus, relative to price actions, the widely espoused view that “economic growth” or “earnings growth” drives the stock markets do not convincingly explain the performance of the S & P 500.

Instead, it does seem like a paradox: strong markets were coincident to slowing economic growth or deceleration of earnings growth. This inverse correlation could be described as “decoupling”, in contrast to commonly held popular views.

Figure 3: Economagic: S & P 500 and Fed Fund Futures

This is why it is imperative for us to identify, understand and monitor the driver/s that has a commanding edge to the markets, simply because by associating with the wrong cause such analysis may result to inaccurate projections and costly actions. Or in medical analogy, misdiagnosis leads to wrong prescriptive cures.

Figure 4 courtesy of Economagic provides us a more compelling correlation…market action fueled by monetary policies!

The chronology of correlation: Since the 2000 peak, the S & P (blue line) has been on a downdraft reflecting the dotcom bust. This was followed by declining Fed fund futures (red line). The S&P bottomed out in late 2002, whereas Fed fund futures bottomed in mid 2003.

Subsequently, Fed Fund futures climbed following S & P’s recovery as Fed rates hit a 60 year low. However Fed rates peaked in 2006, while the S & P continued its ascent which presently drifts at the upper ranges.

The correlation looks seductively linear, DECLINING FED RATES EQUAL TO DECLINING S & P 500 or vice versa, but appearances do not reveal everything or the caveat here is that like the folly of many analysis “correlation does not imply causation”.

Instead one should keenly observe that the S & P leads the Fed Fund Rates at critical junctures in a majority of circumstances. This has been the case except in 2006 where Fed rates paused while S & P continued to trek higher.

The clear implication is that the market’s direction is followed by corresponding Fed actions or that the US Federal Reserve responds to the actions in the marketplace!

When the market is in trouble, the Fed reacts by corresponding action…interest rate cuts and other forms of inflationary policies, thereby flooding liquidity into the financial system. Conversely, when the market recovers, US monetary officials technically siphon liquidity off by raising interest rates.

So the recent rate cuts translate to extant pressures or reflect bouts of turmoil in the marketplace.

As expected, the latent intoned subsidies by the Fed had been recently borne by the statements of Federal Reserve Vice Chairman Donald Kohn-policy must be nimble, flexible and pragmatic (Reuters)-and by Chairman Bernanke- ``renewed turbulence'' in markets may have shifted risks between growth and inflation” (Bloomberg) and the “Hope Now Alliance” (Bloomberg) or a pact with financial institutions to freeze interest rates.

These bailout expectations appears to have helped fueled the recent astonishing gains by the equity markets which we think could be more of a technical bounce.

Bottom line: In the decoupling debate, in appreciation of how US markets, the world’s largest and most sophisticated markets, have been influenced by its domestic policies, and thus, under the same prism we dare not dismiss the potential impact on the global financial markets by the corresponding actions that could be taken by major central banks.

Not even under today’s deepening trend of “financial globalization” which tends to increase linkages and therefore heighten correlations, will probably be enough to prevent markets from “decoupling” -in the sense that markets may perform independently or attain very low levels of correlation or dependency variables over the longer horizon. The distinct conditions of the underlying structure of the financial markets as well as the variance in the domestic currency regimes are likely to be the conduction channels for such marketplace divergence.

A Global Depression or Platonicity? II

``Our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”-Nassim Nicolas Taleb

Projecting past performance into the future is a hazardous strategy. The recent fiasco in the US mortgage markets has been mostly due to such built in expectations of a perpetual boom.

Recalling ex-Citigroup CEO Chuck Prince’s infamous quip, ``When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing". That’s one pitfall which we stridently wish to avoid.

Thus, if a US hard landing scenario emerges where deflation or a severe credit “crunch” takes a firm grip on its markets and the economy, then the attendant monetary measures to be engaged by US authorities are likely to be aggressive (including the much ballyhooed Helicopter strategy by Ben Bernanke), considering their natural inclination to be averse to a Japan-like malaise.

As we earlier pointed out in our September 3 to 9 edition, [see A Global Depression or Platonicity?], the degree of exposure to tainted leveraged instruments in Asia has been limited.

And those advocating for a global meltdown could simply be overestimating on what they know and underestimating on what they don’t, and not giving enough room for randomness to operate, hence our tendency to “mistake the for territories” from which we cited Nassim Taleb definition of Platonicity.

As we also mentioned above, while financial globalization via integration of financial markets has the predisposition to increase correlations, different currency regimes aside from the divergent levels of development of the financial markets are likely to result to different outcomes in the face of such aggressive policy maneuvers.

For instance, considering that major currency reserve holders as China, GCC nations and Hong Kong, have effectively wrapped or surrendered their domestic monetary policies to that of the US by virtue of a US dollar peg, monetary policies are likely to have different impacts to their markets and economy compared to the US.

As Stephen Jen of Morgan Stanley splendidly wrote (highlight ours),

``The credit crunch we are witnessing is really a ‘rich’ countries’ problem. Much of EM (the GCC countries, China or Hong Kong) is unaffected and will not likely be directly infected by it. (We put ‘rich’ in quotes because on some measures some EM countries are richer in cash…) EM may eventually be adversely affected by an economic slowdown in the developed world, through trade, but not in terms of the credit cycle freezing up. In China, for example, the government has intentionally imposed a credit freeze, because it has too much liquidity. The same problem of excess liquidity is still faced by many other countries, such as Hong Kong, the GCC countries and some other EM economies.”

If the recent credit triggered market mayhem should serve as the proverbial canary in the coal mine then figure 4 courtesy of Rating and Investment Information shows how ASEAN Credit Default Swaps performed under the recent duress.

Figure 4: Rating and Investment Information: Narrowing ASEAN Spreads Indicator of Strength?

The cost of Credit-default swaps or contracts designed to protect investors against default has steadily narrowed since 2005 for ASEAN countries including the Philippines and Indonesia, the most vulnerable member countries of the region.

Yes, while there had indeed been a spike in CDS spreads during the August turmoil (encircled), it appears that these spikes can be discerned or construed as more of an “aberration” than of a reversal as the spreads appear to “normalize” or narrow anew.

Figure 5: IMF GFSR Report: Buyers of CDO (In percent, delta-adjusted basis)

As to further examine on the potential impact from the risks of the recent credit crisis turning into a full scale credit seizure, we can further estimate on the portfolio holdings by Asia of infected instruments as previously done.

Collateralized Debt Obligations (CDO) are investment grade structured finance products that are collateralized by asset backed securities, including subprime mortgages. The markets for these credit products have been heavily distressed following the string of losses brought about by the recent credit maelstrom, where estimated losses according to some analysts for the world’s biggest banks are at $77 billion with a potential to reach $260 billion (Bloomberg).

IMF’s latest Global Financial Stability Report as shown in figure 5 estimates that the bulk of the losses or those affected by these “toxic waste” products has been mostly from to the US.

According to the IMF (highlight ours),

``Direct exposure extends beyond the United States, with European and Asian investors active in the ABS and related markets. A handful of European institutions have already reported difficulties or closed owing to their exposure to U.S. mortgage markets and the withdrawal of their short-term funding, and still more are believed to be exposed to indirect mark-to-market losses stemming from their credit lines to conduits and structured investment vehicles. Within the Asia Pacific region, various market analyses suggest that exposure to mortgage-related products is concentrated in Japan, Australia, Taiwan Province of China, and Korea, but their overall exposure has been characterized as manageable and that region appears to be insulated from default risk.”

Figure 6: IMF GFSR :Probability of Multiple Defaults in Select Portfolios (In percent)

Figure 6 from the IMF’s GFSR likewise shows that among financial institutions large complex financial institutions (LCFIs) have been largely prone to losses reflecting extensive exposures to credit derivatives, whereas among emerging markets the estimated default risks remain “benign” with emerging Asia having the least risk.

From the IMF,

``Reflecting a weakening in credit discipline that has emerged along with the growth in credit, private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing, often embedding exchange rate risk or options and thus increasing their exposure to volatility. Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital market financing to help finance credit growth. Nevertheless, generally benign emerging market banking system default risk indicators continue to reflect market perceptions of healthy capitalization and profitability, as well as diverse earnings sources and sound asset quality. These trends warrant increased surveillance, as circumstances vary considerably across countries. Authorities in some emerging markets need to ensure that vulnerabilities do not build to more systemic levels. Across all emerging market countries, policies that support continued resilience should help, as global market conditions are likely to remain volatile.”

All of this simply reflects on the divergent exposures of different regions to the recent turmoil.

While we agree with the hard landing camp that trade or economic linkages are likely to affect global markets, where we part is the degree of impact. We don’t share the view of a global financial or economic meltdown.

Monetary policies even if even if they are to be ineffectual in the US are likely to impact the financial markets of different regions at varying degrees.

Given the inflationary tendencies of central banks, under the present Paper money standard, the most likely scenario will be a shift of bubble from one asset class to another, either to commodities or to Asian markets or both.