Global Markets To A Rough Start, Phisix: Part of the Normal Corrective Phase

``It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.” --Gordon Gekko, fictional character from 1987 film Wall Street

2008 looks like a prelude to a very challenging year as global markets baptized the week with stinging losses as shown in figure 1.

In a single session for the week, Japan’s major benchmarks the Nikkei 225 and the TOPIX fell by a nasty 4% each. Meanwhile, the world’s inspirational leader, the major benchmarks of the US markets fumbled heftily for a worst 3 day start of any year since 1904 (Bloomberg). And this was likewise reflected in other key markets in Europe and in Emerging markets.

Figure 1: stockcharts.com: An ominous start for 2008?

Our own domestic bellwether the Phisix succumbed to its worst inaugural weekly decline since 1998. The 30-member composite yardstick fell 3.93% over the week and had been in a rolling decline marked by lower highs and lower lows seen in the main chart signified by the declining trend channel since October.

Moreover, the Phisix appears to be perched at its major support-200 day moving averages (red line) which is likely to be broken this week following the substantial losses in Wall Street last Friday. A meaningful breakdown underscores a transition towards a corrective phase.

The patent breakdown of the Japan’s Nikkei (upper pane below Phisix) could likewise be replicated in the S&P 500 (above pane). The US bellwether appears to have found some critical support at the 1,400 (in closing prices) area during the past few months. The recent lower highs should draw up a bearish declining triangle from which a breakdown could lead the S&P to the 1,300 zone. Otherwise, a bounce from this crucial support area could imply a bullish triple bottom but would need to be confirmed by a breach of the 1,525.

We see the same dynamics with Europe’s Stoxx 50, which appears to be testing its support.

All these tells us that global financial markets are presently adjusting to the unpleasant realities brought upon by the spillover of the US housing bubble meltdown, the global liquidity and credit crunch, the loss of trust on innovative financial products (securitization and derivatives), the return of risk aversion, the ramifications from a paradigm shift of monetarism (from banking to nonfinancial intermediaries or the “Shadow Banking System”-as labeled by PIMCO’s Paul McCulley) and the perceptible deceleration of economic growth previously stimulated by the “Ponzi” dynamics as seen through the massive speculative inflationary driven forces.

One important aspect overlooked by mainstream analysis is that today’s marketplace dislocation is a fundamental function of structural insolvency of the balance sheets by the US banking system (estimated at $12.7 trillion- Dr. John Hussman), rooted on borrowers who recklessly speculated on assets (in expectations of short-term gains and a perpetuation of jubilance) and who engaged in egregious consumption from whose debts have burgeoned to unwieldy magnitudes such that these have become unserviceable and have likewise been exacerbated by the collapse of assets from which such speculations were anchored to.

The continuing risks is that all these redounds to a monetary tightening as the banking system react defensively by hoarding capital via loss writeoffs and selling of assets or equities to boost reserves while simultaneously reducing money allocated for regular operations.

Needless to say, these implied tightening coupled with insolvent borrowers risks a potential contagion in consumer loans such as credit cards and auto loans (signs of rising delinquencies-Associated Press), or in other business aspects such as US commercial real estate or diminished capital expenditures.

Moreover, similar risk dynamics are seen affecting some major markets and economies in Europe which had similarly benefited from leveraged mortgage prompted property booms in UK, Spain, Ireland etc. (menafn.com), such that further afflictions of these markets may give rise to enhanced risks on state fiscal conditions (lower taxes on same level of expenditures leads to deficits) and heightens default risks on Credit Default Swaps, corporate High yield bonds and Derivatives Counterparties, aside from potential risks on residual losses from hedge funds and the nonfinancial banking system.

In effect, the financial sector which had served as a key backbone for the property boom in Anglo Saxon countries has now been suffering from the repercussions of its previous excesses.

In addition, recent economic data suggests that the US may already be in recession- “began a recession in December” as averred by PIMCO’s top honcho Bill Gross (nationalpost.com)-if not at the verge of recession, possibly evidenced by a sharp jump in unemployment to a 2 year high (Bloomberg) and a notable contraction in the manufacturing sector as measured in the ISM factory index-the most in 5 years (Bloomberg).

Now if past performance were to repeat itself, then the average losses as measured by the major equity benchmarks in the US from peak-to-trough during a recession is about 40%. This means that given today’s nearly 10% decline from the peak, major equity benchmarks could fall by another 30%. That is IF history will rhyme.

Yet, the present actions by central banks, such as the US Federal Reserve, mainly deal with the liquidity dimensions of the present problem. Some analysts opine that the recent actions of major central banks appear to be directed towards the “normalization” of LIBOR rates, aimed at stabilizing credit flows, which had earlier spiked relative to Fed rates, as discussed in December 10 to 14 edition, [see Market’s Response To The Fed’s 25 Basis Points: Sell The News] to evince of such tightened conditions. The LIBOR rate is a very significant reference rate used in the financial markets which are supposedly tied to some $150 TRILLION of derivative pricing (Jim Bianco as quoted by David Kotok of Cumberland Advisors).

While rate cuts cold help alleviate present circumstances it won’t sufficiently resolve the insolvency issues confronting both the borrower (general public) and the lender (balance sheets of the banking system) and the ensuing confidence crisis. With the current financial markets turmoil still persisting in spite of the recent activities by central banks to cushion its impact with the panoply of diversified measures, we can expect more intensified activities from monetary authorities going forward. So while financial compression in the private sector harries markets of western nations (deflation), global central banks are likely to concertedly exhaust their bandwith of arsenals to stave off a global recession (inflation). It is the appearance of “shocks” or black swans that risks destabilizing global markets.

Bottom line: What we expected to happen in 2007 appears more likely to occur in 2008. As seen in last week’s selling pressure, global financial markets are likely to face trying times as downside volatility seems to have reasserted itself. If the US is indeed undergoing a recession or falls into one over the short run, then the Phisix in tandem with other markets would initially feel its immediate impact. One must remember that the peak of US mortgage resets is still in process (from October 2007 through April 2008).

In short, while we believe the Phisix and Asia is in a secular bullmarket, countercycles are a normal and healthy component of any long term trend.

Survey On Local Sentiment, Stock Market Cycles Based on Psychology

``The fact of storytelling hints at a fundamental human unease, hints at human imperfection. Where there is perfection there is no story to tell.”- Ben Okri, Nigerian Poet and Novelist

The Christmas holiday with its incidental social gatherings is one great opportunity to evaluate investor sentiment.

While of course, these occasions do not represent the entire constellation of investors in the Philippine stockmarket, we try to interpret the information we obtained from the ground level with that manifested by market internals.

Noticeably there seems to be a widespread enthusiasm for stock market. This is in stark contrast to 2002, where talk of the stock market was an anathema to any crowd. Today even some housewives appear to dabble or talk inspiringly of the “wonders” of the industry.

In fact, the mere mention of stock market triggered lengthy discussions of its myriad scope; from developments in companies, micro economics and or politics as influences, and rumored activities by insiders aside from recent “successful” exploits.

The levels of participants were of varying degrees- from fledging investors to finance professionals-where most appear to fall into the average category; whose decision making are prompted for by broker-reports or through mainstream media or via social networks.

Here are some points we gathered from them:

1. Feasible business opportunities seem limited.

2. Rising Peso reduces the incentive to invest in the US dollar.

3. Interest rates are so low that the market appears to be the only option to generate satisfactory returns.

4. Stock market returns have been strong relative to other businesses or money market instruments and is strongly expected to remain robust.

5. Stock market returns are driven by developments in individual companies or the economy or politics.

However, a friend pointed out to me that in online forums, participants have not been as sanguine. Some were said to have shown signs of anxiety or fear emanating from the recent bouts of volatility.

Figure 2: Stock Market’s Psychological Cycles

While it maybe true that some fears may have been exhibited by some participants due to the recent volatility (rear view mirror syndrome), the fact that they remained active online means that they are hopeful and in search for an opiate.

To our experience, as signified by Figure 2, the average investors typically abdicate on the market when they capitulate or has given up hope (but with long positions) and thus abandoned the market. Such is the reason why no one seems interested about the markets in 2002, where the opportunities for maximizing returns were at its greatest.

Yet in every stock market cycle these psychological shifts transpire.

Figure 3: PSE: Market Internals Number of Trades and Number of Issues Traded

Figure 3 from the Philippine Stock Exchange shows on the left pane the daily number of trades and at the right pane the daily number of issues traded.

Since the Phisix cycle reversed in 2002, both activities accounted for an ascending trend.

For the daily number trades at the left pane, trading activities jumped to the max in April of 2007 and has been on a decline since the credit crisis erupted. Today, the daily number of trades has fallen to the mid 2006 levels.

Essentially, the number of trades reflects on the trading sentiment for traders or punters to positively churn their positions. The fall in the number of trades depict of short term traders/punters caught into buying ‘market tops’ and have morphed into long-only investors (again see figure 2) or retreated to the sidelines (less likely scenario). This appears to be a confirmation of the sentiment visible on the online forums.

The right pane shows of the number of issues traded. This indicator signifies general investor sentiment. When market participants generally turn optimistic the tendency is to position over to the broader market. In the past, we have made the 120 line as a yardstick demarcating optimism from pessimism.

Today, the number of issues traded remains at the peak albeit with signs of tapering (red arrow). This suggests that the investors generally remain optimistic buying into the broader market but has been trading somewhat less. Such developments again appear to validate our views from the ground on investors still optimistic but on a denial phase.

While we do expect some material reduction of activities in the face of externally instigated selling pressures over the interim, we do not expect these indicators to return to the 2003 or 2004 levels considering our view of the present cycle as a normal countertrend amidst a secular trend development.

In a way, some of the issues raised by the participants whom I listened to had valid footings such as the firming Peso and the low interest rates. Thereby, the recent activities exhibited by local investors in shoring up the Phisix, which resulted to a slim majority in 2007 at 50.22% of total Peso trade) could likely be a trend well into 2008 (in the assumption that foreign investors remain net sellers- which is very unlikely; foreign investors are likely to resume their net buying as US markets probably turn lower).

China’s Rising Remimbi To Spur Continued Rise of the Peso

``When everybody knows that something is so, it means that nobody knows nothin’.” Andrew S. Grove, co-founder of Intel

Meanwhile the Philippine Peso which appreciated by about 18.77% in 2007 for its biggest annual gain and the best performer in Asia for 2007 (economictimes.indiatimes.com), should be expected to remain strong in line with other Asian currencies, albeit at a much subdued pace compared to 2007.

China’s rising inflation and geopolitical pressures latched on growing “protectionist sentiment” in the US may prompt Chinese authorities to accelerate the pace of appreciation or conduct a huge one off revaluation vis-à-vis the US dollar.

Since the brunt of the global currency adjustments have been through the western managed free floats, Asian currencies, which had in the past maintained a mercantilist regime by subsidizing exports through currency manipulation and supporting US assets via investing its surpluses to US treasuries or other US assets known as the informal Bretton Woods 2, remain highly undervalued. Besides the continuation of a massive buildup of foreign reserves and strong capital flows are expected to remain vibrant. This runs under the assumption that the US economy and its financial markets won’t do a spectacular swan dive or the world won’t succumb to deflationary pressures.

As for the US dollar index, sentiment has been excessively against the US dollar such that Brazilian super model Gisele Bundchen, rapper Jay-Z and India’s tourist spots have eschewed the US dollar for other currencies for their revenues.

Meanwhile, a recession in the US which percolates to a slowdown elsewhere in the world is likely to prompt for monetary policies targeted on growth revival than inflation control, and thus, rate cut measures in offing for the Euro zone or in Canada or UK which means a stronger US dollar index for 2008 (most especially if the US capitulates to deflationary forces).

On the other hand, the Japanese Yen is likely to resume its uptrend as global markets remain under pressure as the carry trade unwinds (so with the Swiss Franc).

Nonetheless, as a side comment, talking of belated political reactions, the Philippine government recently responded to declining income from OFWs as a consequence of the rising Peso via the introduction of hedging facilities (pia.gov.ph). This is a clear example of government’s reactive nature. By liberalizing the markets, private initiatives would have addressed the issue earlier and have competed to provide the best programs for the benefit of OFWs, exporters and those affected by the rising Peso.

Negative Real Yields, Sovereign Wealth Funds and Back to the Future

``Do what you will, this world's a fiction and is made up of contradiction.”-William Blake (1757-1827), English Poet, Printer and Printmaker

True enough the uncertainties in the US financial system and its economy is duly a cause of concern which again is likely to impact the interim direction of our markets. However, we do not share the sudden resurgence of the “recoupling” argument.

In the world of financial globalization, integration is the byword, or in essence, markets and economies are expected to “couple” relative to cross border capital flows, trading and other economic activities and in the financial markets. But the diversity in the structures of the economies or the markets or of policies or a combination thereof is unlikely to produce a perfect integration. The “Dry Bone” inference of the foot bone is connected to the anklebone is connected to the leg bone is connected to the hipbone etc… signifies oversimplified thinking.

For instance we have long argued that monetary policies have had in the recent past served as an important influence to global asset classes. While it may be also accurate in the past that the “when the US sneezes the world catches cold”, past performance may not be an accurate indicator of the future.

This important quote from Dr. Marc Faber, ``Moreover, it would be wrong simply to assume that recession and slumping corporate profit will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed fund rate, a weak dollar, and “bubbly” emerging markets could make US equities a relatively attractive proposition compared to other financial assets.”

One can just take a glimpse of the bourses of the Gulf Cooperation Council which appears to have decoupled from most global equities in view of their exploding performances. Why? Because of the monetary regime -a US dollar peg, which has effectively tied their domestic policies with that of the US.

The declining US dollar have in essence imported inflation into these countries teeming with surplus foreign reserves which seems to be giving investors a one way bet in anticipation of a break of the currency peg. Where the underlying inflation rates are greater than nominal policy rates redound to negative real yields as described by Dr. Faber.

In short, central banks can control the money they print but they can’t control where it goes. This leads us to the recent breakaway run in gold prices amidst the deflationary backdrop in Anglo Saxon economies shown in Figure 4.

Figure 4: Prieur Du Plessis/Plexus Asset Management: Rampaging Gold Prices in Various Currencies

Gold has not been rising based on the US dollar alone, but against almost all major currencies as shown in the above chart courtesy of Prieur Du Plessis.

And you think oil’s $100 milestone high is all about demand and supply as academic “know them all” experts tell you. Check out Figure 5.

Figure 5: stockcharts.com: Falling US dollar Index and Rising Oil prices!

For over two years the peaks and troughs of the US dollar and the Oil prices appears to have been “perfectly” synchronized (green arrows); each time US dollar peaks oil bottoms and vice versa. This simply suggests that a decline in the value of US dollars, the currency from which oil is predominantly traded, has likewise prompted a rise in oil prices. In short, oil prices, aside from demand and supply, simply reflect on the relative declining value of the US dollar.

If gold, oil and the GCCs are manifesting a departure from the “recoupling” theme, why shouldn’t emerging markets?

Our views have almost been isolated given many apostasies among former decoupling advocates, except for one, incidentally a favorite…BCA Research,

Figure 6: BCA Research: Emerging Market Decoupling to Persist into 2008

According to BCA Research (our emphasis), ``The economic decoupling between emerging economies and the U.S. is attributable to underlying fundamentals and is therefore sustainable. Unlike in the 1990s when emerging economies relied on foreign capital to finance their expansion, many of these countries are now net creditors in global financial markets and are not vulnerable to a withdrawal of financing by G7 banks. Domestic interest rates are still very stimulative thanks to their strong currencies and vast savings, which will continue to underpin domestic demand growth. While exports to the U.S. have been slowing, trade among developing economies is booming. As a result, overall emerging market growth will not slow considerably, even if the U.S. economic slump continues. Bottom line: Our Emerging Markets Strategy service recommends that investors continue to overweight emerging equity markets within a global portfolio.”

True, as net creditors emerging markets via Sovereign Wealth Funds armed with an estimated $2.5 trillion of investible funds and assets, have been on a buying spree for distressed US assets and elsewhere around the globe…

From Bloomberg’s Zachary R. Mider (highlight mine), ``Foreign investors exploited the declining U.S. dollar during the past three months to snap up American companies at the fastest pace in at least a decade. Buyers from Dubai to the Netherlands accounted for 46% of the $230.5 billion of U.S. mergers and acquisitions announced in the fourth quarter, the biggest share since 1998 when Bloomberg started compiling the data. The total excludes $17.9 billion of so-called passive investments by state-run funds in Asia and the Middle East in U.S. banks, including New York-based Citigroup Inc.”

From Telegraph’s Ambrose Pritchard (highlight mine), ``Abu Dhabi's giant fund Adia ($875bn) rescued Citibank with a $7.5bn equity infusion, taking advantage of the US mortgage crisis to scoop up 4.9pc of the world's top bank for a pittance…

``The modus operandi of the funds is to dip their toe in the water, then build up a strategic stake gradually if all goes well. Temasek has taken a 2pc share in Barclays, while China's Development Bank holds 3.1pc - a stake that may be in doubt after Barclays' failed bid for ABN Amro.

``Dubai's various state-controlled bodies hold 2.2pc of Deutsche Bank, 3pc of HSBC, 3.5pc of Euronext, 2pc of Perella Weinberg Partners, 28pc of the London Stock Exchange, 20pc of Nasdaq and 68pc of Thomas Cook India.

``Abu Dhabi has pushed its stake in Mid-East banks to 30pc or 40pc, or even 97pc in the case of BLC Bank in Lebanon. Whether Western countries will tolerate strategic creep of this kind is another matter.

From S&P (highlight mine)…

``Temasek Holdings, based in Singapore, has equity in a range of banks, including Barclays, Standard Chartered, China Construction Bank, DBS Bank, ICICI Bank, and Sberbank.”

Thus would it be a wonder why perceptions on emerging markets have encountered a remarkable makeover?

This from Dow Jones’ Charles Roth and Claudia Assis (highlight mine)… ``Traditionally, investors would scramble from emerging markets at the first signs of trouble within the asset class or in response to global market volatility and tightening credit. But after four straight years of big annual gains, 2007 became not only the fifth year of clear outperformance but the first in which emerging markets became something of a safe haven from the implosion in the U.S. subprime mortgage market and the subsequent fallout…”

Deflation advocates claim that Sovereign wealth funds will simply deplete their surpluses by throwing money after bad assets. The assumption is that these state owned funds (state capitalism-Brad Setser) would function like unthinking zombie investors buying up US assets which will continue to collapse. Maybe, but seems quite unlikely if not outrageous.

From the Financial Times (highlight mine)… `` A secretive Hong Kong-based subsidiary of China’s State Administration of Foreign Exchange, manager of the world’s largest foreign exchange reserves, has bought stakes in three of Australia’s largest banks, raising fresh questions about transparency of China’s sovereign wealth investments in international markets.

``Australia and New Zealand Bank and Commonwealth Bank of Australia said Hong Kong-registered SAFE Investment Company had bought stakes of less than one per cent in each of the banks. An entity with the same name has taken a stake of about one-third of a per cent in National Australia Bank , people inside NAB reckon.”

It is no doubt why such level headed fund managers believe that emerging markets are still likely to outperform US markets despite the present juncture.

Lastly over the long term, the present divergence is likely to be a representation of a continuing transitional shift in market leadership, see Figure 7 courtesy of Chris Gilpin of Casey Research…

Figure 7 Resource Investor/Casey Research: Shifting Market Leadership

From the S & P 500, the market leaders had been energy and basic materials in late 70s to technology in the late 90s to financials into the new millennium… Are we seeing a shift back to energy and basic materials? Back to the Future?

Llewellyn H. Rockwell, Jr.: Why Don't People Get It?

This great New Year’s message from Mises.org’s Lew Rockwell should help enlighten our understanding about governance and reduce our vulnerabilities towards the illusion that “personality based politics” based on veiled socialism-is the path towards economic salvation. Quoting Lew Rockwell’s article in its entirety (highlight mine)...

Llewellyn H. Rockwell, Jr.: Why Don't People Get It?

Even now, people think nothing of professing their attachment to socialist ideology at cocktail parties, at restaurants serving abundant foods, and lounging in the fanciest apartments and homes that mankind has ever enjoyed. Yes, it is still fashionable to be a socialist, and—in some circles within the arts and academia—socially required. No one will recoil. Someone will openly congratulate you for your idealism. In the same way, you can always count on eliciting agreement by decrying the evils of Wal-Mart and Microsoft.

Isn't it remarkable? Socialism (the real-life version) collapsed nearly twenty years ago—vicious regimes founded on the principles of Marxism, overthrown by the will of the people. Following that event we've seen these once decrepit societies come back to life and become a major source for the world's prosperity. Trade has expanded. The technological revolution is achieving miracles by the day right under our noses. Millions have been made far better off, in ever-widening circles. The credit is wholly due to the free market, which possesses a creative power that has been underestimated by even its most passionate proponents.

What's more, it should not have required the collapse of socialism to demonstrate this. Socialism has been failing since the ancient world. And since Mises's book Socialism (1922) we have understood that the precise reason is due to the economic impossibility of the emergence of social order in the absence of private property in the means of production. No one has ever refuted him.

And yet, even now, after all this, professors stand in front of their students and decry the evil of capitalism. Bestselling books make anticapitalism the theme. Politicians parade around telling us about the glorious things that the government will accomplish when they are in charge. And every evil of the day, even those directly caused by the government (airline delays, the housing crisis, the never-ending crisis in public schooling, the lack of health care for everyone) are blamed on the market economy.

As an example, the Bush administration nationalized airline security after 9-11, and hardly anyone even questioned that this was necessary. The result was an amazing mess that is visible to every traveler, as delays pile on delays and humiliation became part of the rubric of travel by flight. And yet who gets the blame? Read the letters to the editor. Read the mountains of copy written by journalists covering this issue. The blame is heaped on the private airlines. The solution follows: more regulation, more nationalization.

How can we account for this appalling display? There are two primary factors. The first is the failure of people to understand economics and its elucidation of cause and effect in society. The second is the absence of imagination that such ignorance reinforces. If you don't know what causes what in society, it is impossible to intellectually grasp the proper solutions or imagine how the world would work in the absence of the state.

The educational gap can be overcome. To think in economic terms is to realize that wealth is not a given or an accident of history. It is not bestowed on us like rain from above. It is the product of human creativity in an environment of freedom. The freedom to own, to make contracts, to save, to invest, to associate, and to trade: these are the key to prosperity.

Without them, where would we be? In a state of nature, which means a dramatically shrunken population hiding in caves and living off what we can hunt and gather. This is the world in which human beings found themselves until we made something of it, and it is the world we can slip back into should any government ever manage to take away freedom and private property rights completely.

This seems like a simple point but it is one that evades vast swaths of even the educated public. The problem comes down to a failure to understand that scarcity is a pervasive feature of the world and the need for a system that rationally allocates scarce resources to socially optimal ends. There is only one system for doing so, and it is not central planning but the free-market price system.

Government distorts the price system in myriad ways. Subsidies short circuit market judgments. Product bans cause the ascendance of less desirable goods and services over more desirable ones. Other regulations slow down the wheels of commerce, thwart the dreams of entrepreneurs, and foil the plans of consumers and investors. Then there is the most deceptive form of price manipulation: monetary management from the Federal Reserve.

The larger the government, the more our livings standards are reduced. We are fortunate as a civilization that the progress of free enterprise generally outpaces the regress of government growth, for, if that were not the case, we would be poorer each year — not just in relative terms, but absolutely poorer too. The market is smart and the government is dumb, and to these attributes do we owe the whole of our economic well-being.

The second part of our educational task — imaging how a market-run world would function — is much more difficult. Murray Rothbard once remarked that if the government were the only producer of shoes, most people would be unable to imagine how the market could possibly produce them. How could the market accommodate all sizes? Wouldn't it be wasteful to produce styles for every taste? What about fraudulent shoes and poor quality producers? And shoes are arguably too important a good to turn over to the vicissitudes of market anarchy.

Well, so it is with many issues today, such as welfare. Among the first objections to the idea of a market society is that the poor will suffer and have no one to care for them. One response is that private charity can handle it, and yet we look around and see private charities handling only comparatively small tasks. The sector just isn't big enough to pick up where government leaves off.

This is where imagination is required. The problem is that government services have crowded out private ones and reduced private-sector services beyond what they would be in a free market. Before the age of the welfare state, charities in the 19th century were a vast operation comparable in size to the largest industries. They expanded according to need. They were mostly provided by the churches through donations, and the ethic was there: everyone gave a portion of the family budget to the charitable sector. A nun like Mother Cabrini ran a charitable empire.

But then in the progressive era, ideology changed. Charity came to be considered a public good, something to be professionalized. The state began to encroach on territory once reserved to the private sector. And as the welfare state grew throughout the 20th century, the comparative size of the private sector shrank. As bad off as we are in the United States, it is nothing compared with Europe, the continent that gave birth to charitable services. Today, few Europeans donate a dime to charity, because everyone is of the belief that this is a government service. Moreover, after high taxes and high prices, there isn't much left over to donate.

It is the same in every area the government has monopolized. Until Fed-Ex and UPS came along to exploit a loophole in the letter of the law, people couldn't imagine how the private sector could deliver mail. There are many similar blind spots today in the area of justice provision, security, schooling, medical care, monetary policy, and coinage services. People are aghast at the suggestion that the market should provide all these, but only because it requires mental experiments and a bit of imagination to see how it is possible.

Once you understand economics, the reality that everyone sees takes on a new significance. Wal-Mart is not a pariah but a glorious achievement of civilization, an institution that has finally put to rest that great fear that has pervaded all of human history: the fear that the food will run out. In fact, even the smallest products dazzle the mind once you understand the incredible complexity of the production process and how the market manages to coordinate it all toward the end of human betterment. The achievements of the market suddenly appear in sharp relief all around you.

And then you begin to see the unseen: how much more secure we would be with private security, how much more just society would be if justice were privatized, how much more compassionate we would be if the human heart were trained by private experience rather than government bureaucracies.

And what makes the difference? The socialist and the advocate of free markets observe the same facts. But the person with economic knowledge understands their significance and implications. It is that bit of education that makes the difference. This is why we must never underestimate the central role of teaching about economics. Facts will always be with us. Wisdom, however, must be taught. Achieving a culture-wide understanding of liberty and its implications has never been more important.

Happy New Year!

Wishing you the best of 2008 (year of the "Brown Earth" rat)!

courtesy of Newyearjoys.com

courtesy of travelchina.com

Holiday Greetings

Happy Holidays to All!

Courtesy of stonehousecollection.com

Possible Demographic Distribution of Our Readership Base

Microsoft’s adlab suggests of the demographic breakdown of our readership base as found below…

Presently most of our readers are male, and belongs to the age group of 18-34 years of age. However, adlab suggest that the greatest potential growth for our readership base is at the 35-49 age bracket. I wonder how accurate this is.

Another interesting aspect is how Microsoft’s adlab came about with such stats. It implies that Microsoft can ascertain identities behind the IP addresses accessing our site. Hmmm.

Interesting stuff…

Market’s Response To The Fed’s 25 Basis Points: Sell The News

``For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy.”-John Hussman, Hussman Funds

We expected the US Federal Reserve to cut rates by 50 basis points. Instead they delivered 25. Thus, global equity markets responded with a dramatic selloff. Since, as we earlier mentioned, the markets have been founded on the expectations of the provision of “steroids” from government intervention, the lack of element of positive surprise resulted to a traditional “sell on news”.

Our initial impression was that the Chairman Bernanke of the US Federal Reserve could have underweighted the risks brought about by today’s credit logjam. But this doesn’t tally with the FOMC’s accompanying statement (highlight ours), ``Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

So, while the Fed recognizes the underlying dilemma, they opted to act moderately for unspecified reasons.

Some analysts suggested that the Fed’s ambivalence could have been due to external pressures particularly from Central Banks, such as China. From Reuters (highlight ours), ``What I'm worrying about now is the weakening dollar and its potential impact on global growth. The dollar is the major currency for trade and its continuous depreciation will push up prices of global strategic goods such as oil and gold and reduce the wealth of dollar-holding nations," Vice-Commerce Minister Chen Deming said.

``So I want to see a strong dollar," Chen told reporters during a break in a two-day "strategic economic dialogue" near Beijing with senior U.S. officials led by Treasury Secretary Henry Paulson.

Since the motion of continuously reducing interest rates have been detrimental to the US dollar holdings of global central banks, then such decrials seem understandable.

On the other hand, others suggest that the Fed’s actions appear to be reflective of the reduced policy traction as LIBOR rates continue to rise as shown in Figure 1.

Figure 1: Northern Trust: LIBOR Less Target Fed Rates

LIBOR or London Inter-Bank Offer Rate as defined by investorwords.com is the ``interest rate that the banks charge each other for loans (usually in Eurodollars). This rate is applicable to the short-term international interbank market, and applies to very large loans borrowed for anywhere from one day to five years.”

So aside from interbank borrowing, LIBOR is a widely used benchmark for ascertaining most adjustable mortgage rates to rates of corporate loans to even government borrowing. Yet LIBOR is not determined by the Federal Reserve.

In other words, to quote Martin Weiss from Money and Markets, ``LIBOR is easily the single most important interest rate in the world…Even if the Fed lowered its target for fed funds to zero ... if the LIBOR rate fails to decline in tandem, or worse, actually goes up, the Fed's power to avert an economic decline in the U.S. will be shot to pieces.”

Hence the Fed’s tentativeness could possibly be construed as a deflection of its policies growing impotence over the ongoing debt and capital destruction or “deflationary process” in the financial markets.

Bernanke’s “Rabbit Out Of The Hat” Trick; the TAF (Term Auction Facility)

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

Our notion of the US Federal Reserve’s seeming insouciance was nevertheless reversed…a day after it tepidly raised its interest rates. In an apparent orchestrated effort led by the US Federal Reserve to combat the global credit gridlock, major central banks which included the European Central Bank, Swiss National Bank and Bank of Canada agreed to auction credit at favorable rates and to implement swap arrangements. In short, the Fed pulled proverbial “rabbit out of the hat”.

From the Australianews, ``It is understood the joint effort will make available more than $US100 billion ($A114 billion) this month. The US Federal Reserve is injecting $US40 billion; the Bank of England $US46.4 billion, the European Central Bank (ECB) $US20 billion, the Swiss National Bank $US4 billion and the Bank of Canada is providing $US3 billion.”

The joint effort is called as the temporary Term Auction Facility (TAF). According to the Federal Reserve (underscore ours),

``Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress…

``The minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate corresponding to the maturity of the credit being auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over the relevant term…

``The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will provide dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. The FOMC approved these swap lines for a period of up to six months.”

These measures starkly reveals of the priorities of the US FEDERAL Reserve. It purportedly addresses the unraveling credit crunch or of the burgeoning illiquidity in the marketplace, whose aggravation could lead to a meaningful curtailment of the economic activities. So despite the meager amounts of the contingent liquidity provided for, relative to the total financial markets, such telegraphed actions have succeeded to temporarily narrow the spreads of the LIBOR rate from that of the target FED RATE as shown in Figure 1, courtesy of Northern Trust.

Second, the program deals with the stigma of banks borrowing from the discount window. Banks have been reluctant to borrow from the discount window because of the association of being “troubled” or “distressed”. So, under the new auction system, banks will be lent directly and quietly away from the prying eyes of the public.

Third, the measure aims to accept a much larger scope of collateral, which brings the question of the moral hazard of bailouts.

John Carney of dealbreaker.com says that the FED has announced that it will pay 85 cents on the dollar for CDO’s with no market price available. So effectively, the Fed under such circumstances will be providing cover or subsidies to distressed institutions holding “toxic wastes”.

Thus, Paul Kasriel of Northern Trust (emphasis ours), brings to light the ramifications of TAF, ``A question arises as to whether the Fed will be taking a large enough “haircut” on some of the collateral being presented to it by successful TAF bidders. If the markets cannot price some of these securities, how does the Fed know what they are worth? If a TAF borrower were to become insolvent, the Fed might not be able to recover the full amount it had loaned the bank. In effect, the TAF program, as well as the regular discount window facility, transfers credit risk to the Fed, which means ultimately, to the taxpayer. Depending on how the Fed prices the collateral presented to it, the TAF program could be construed as a taxpayer subsidy to banks presenting “questionable” collateral. Remember, there is no such thing as a free bailout.”

Here, central banks are seen clearly fighting the onset of deflation with inflation and the consequent socialization of financial markets. The odd part is that markets always get the blame for a bust which has been created and fostered by preceding inflationary policies.

Lastly the swap arrangement deals with the proviso of extending standby US dollar supplies to the ex-US financial marketplace in the face of a liquidity crunch.

Prof. Willem Buiter calls such policies as meaningless or “a substitution of motion for action” since it does not deal with the underlying problem of general liquidity, from Financial Times (highlight ours),

``So talk of a US dollar scarcity in the euro area is hilariously silly. In 1947 there was a US dollar shortage in Europe. There was limited current account convertibility of the European currencies and effectively no capital account convertibility. This, however, is 2007. If commercial banks or other market participants want more US dollars, they can buy them in the foreign exchange market or borrow them. In the Eurozone, they would need liquid euro assets to buy US dollars, or they would have to borrow US dollars, secured or unsecured. Indeed they could borrow euros (secured or unsecured) and use these to buy US dollars. All these courses of action are problematic today because there is a shortage of liquidity in the Euro area, that is, a shortage of euro liquidity, US dollar liquidity, Swiss franc liquidity or indeed any kind of liquidity. If there were adequate euro liquidity, commercial banks or anyone else could use that euro liquidity to buy eminently convertible US dollars in the extremely liquid foreign exchange market. The ECB could choose to sterilise its loss of US dollar reserves or not; it could chose to restore its US dollar reserves, or not. End of story. Dollar shortage - my foot.”

Nonetheless, such concerted actions by the key central banks highlight on the severity of the stress envisaged by the global financial markets. In fact, the overcast of gloom and doom scenarios appear to be today’s du jour outlook.

Asian Banks Refrain From TAF, Another Evidence of Decoupling?

``The crisis signals a necessary re-rating of risk. It turns out that it also represents a move towards holding more transparent and liquid assets, as one would expect. This correction is altogether desirable. It has, moreover, been selective. It is a striking feature of what has happened that emerging markets have emerged as a safe haven as investors run away from US households. For those in emerging economies, this must be sweet revenge. They should not cheer too soon. Today's favourites may be brutally discarded tomorrow.”-Martin Wolf, Financial Times, columnist

Yet, despite the contingent actions by key western central banks, Asian Central banks refused to join their counterparts, from the Financial Times (highlight ours),

``Asian central banks on Thursday refrained from joining their North American and European counterparts in taking emergency action to boost market liquidity, underlining what economists dubbed a much healthier funding environment in the region.

``The contrast in responses “absolutely confirms how different the situation is in Asia,” said Glenn Maguire, Asia chief economist at Societe Generale. “There are some funding strains in Australia, Korea and China but nothing significant enough to warrant any change [in the stance of central banks].”

`` “If anything, [Asian] liquidity conditions are excessively high,” said Paul Schulte, chief regional equity strategist at Lehman Brothers. “While the West was trafficking these credit products over the past five years, Asia was, thankfully, in rehab.”

``The Bank of Japan took the lead among Asian central banks in expressing support for the US-led emergency steps to ease liquidity concerns, but said it had no plans at this time to take additional measures of its own. The BoJ has been supplying funds against pooled collateral since last year, allowing borrowers to access funds using a variety of collateral.”

Why is this important? Because it shows of the disparity of the immediate effects of the recent credit triggered turmoil to the region’s economy and financial marketplace. In the decoupling debate, these serve as empirical evidences in support of the pro-decoupling stance.

While we agree that most current account deficit countries (e.g. US Spain Italy Greece et. al) which have supplied the demand side of the equation are likely to suffer from a growth slowdown, if not a recession, and risk a spillover effect throughout the world, where we part is on the probable degree of its impact to Asia and to emerging economies.

Our point is that the structural construct of Asia’s financial market are less reliant on debt or leverage as shown in Figure 2, which makes the region less vulnerable relative to western economies or markets.

Figure 2: IMF: Wide Variety in Terms of Capital Market

In a recent speech by Takatoshi Kato, Deputy Managing Director of the International Monetary Fund (IMF), Mr. Kato notes,

``There is no doubt that the Asia-Pacific region contains countries that vary widely in terms of the level of depth, liquidity, and sophistication of their capital markets. Australia, Singapore, Hong Kong, and Japan already have advanced markets. But what is impressive is capital markets in Korea, Malaysia, China, Indonesia, the Philippines, and Thailand are also developing very rapidly as these countries reap the benefits of institutional capacity building and other structural reforms and international portfolio diversification.” (emphasis ours)

Following Asia’s financial crisis in 1997, the region has learned how to insure itself with a stockpile of forex reserves as well as the attendant reforms in its financial markets.

As we have earlier said, we don’t deny the initial impact of a US led slowdown to the Philippine or Asia’s financial markets as discussed in November 19 to 25 [see A US Recession Will Initially Drag Global Equities Lower], but what we see as potentially divergent is the impact of global monetary policies [see November 19 to 25 Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?] to individual or importantly to regional financial markets.

The same article from Financial Times underscores the risk that matters most for us (highlight ours)…

`` Despite limited spillover into emerging East Asia from the US subprime turmoil, there are several signs of financial vulnerability related to sharp gains in equity and real estate prices [within the region],” the ADB said.

``Part of that slowdown is likely to stem from China, where “a series of tightening measures has been introduced to curb rapid investment growth and asset-price inflation since mid-2006, but the full effect has yet to be seen,” the ADB said.

``The ADB forecast that Chinese economic growth would slow next year to 10.5 per cent from 11.4 per cent this year. In September, the ADB had forecast that China’s economy would expand 10.8 per cent next year.

`` “The liquidity issue is not really concerning this region,” said Lee Jong-Wha, author of the ADB report. “Inflationary pressure is clearly the main concern, so central banks will become more cautious about that. The issue is monetary instability rather than financial problems.”

Simply put, in contrast to the Armageddon scenario proposed by some, the risks for Asia lies squarely in the hands of China’s reaction to a US-led global slowdown instead of the credit crisis.

Philippine Stocks and Peso Hinges On Asia’s Direction

``If demand in the US drops further, Chinese exporters will be devastated by a rapid and continuous fall in orders.”-China's commerce ministry

For us, the seeming resiliency of the Philippine equity market has been backstopped by a firming Peso and a steepened yield curve.

Since the August “credit turbulence” set in, domestic investors for the first time in the present cycle (since 2003) have lent massive support to keep index above its previous resistance level and now support at 3,400.

The Philippine Stock Exchange registered a net selling of Php 20.318 billion since the week ending August 2 or representing 75% or 15 out of 20 weeks. In short, in contrast to the past four years where foreign investors have propelled the local market, today, local investors have been weightlifting the Phisix amidst the credit crisis.

Figure 3: ADB Bond Monitor: Philippine Benchmark yields

Moreover, the yield curve of Philippine bonds has steepened as shown in Figure 3. According to the ADB’s December Bond Monitor, ``Yield curves in most economies also steepened this year, mirroring the trend in world markets. In Indonesia, Philippines, and Thailand, curves steepened as loose monetary policy pushed down yields on shorter maturities, while rising inflation pushed the yields higher on bonds with longer maturities.” (emphasis ours)

As the ADB mentioned, the steepening of our yield curve implies loose financial conditions which could have prompted for local investors to sustain the PSE at present levels, aside from the firming Peso. This comes in the face of a spurt of foreign selling following the advent of the credit crisis.

This brings us to the next level of risks…a China slowdown.

Asia’s firming currencies have been mostly symptomatic of its balance of payments or capital and/or current accounts surpluses due to the de facto “Bretton Woods 2”, or an informal “US dollar standard” arrangement where Asian currencies have been purposely kept low, as a subsidy to its producers to increase its export market share (at the expense of domestic consumption). As a corollary of trade, the surpluses of US dollars generated are either hoarded or mostly recycled into US assets e.g. treasuries, agencies, real estate or equities.

On the obverse side or viewed from the context of US or current account deficit countries, this phenomenon can contrastingly be extrapolated as a subsidy to its consumers at the expense of their domestic producers.

Where in relation to China’s currency regime as the world’s final assembly line, to quote Professor Michael Pettis, `` Rising industrial production is central to the monetary trap in which China is stuck. As production surges ahead of consumption, the trade surplus must also grow (since the excess must be exported), and as it does it forces the PBoC to expand domestic money supply in a way that then reinforces fixed asset investment and future growth in industrial production. A reduction in the rate of growth would imply a future reduction in the growth rate of the country’s trade surplus.”

In other words, should a US-Eurozone downturn meaningfully impact China’s trading activities, we could possibly see a diminishing rate of growth of its industrial production (see Figure 4), which could translate to lower trade surplus, reduced money growth or subdued rate of appreciation of the remimbi relative to the US dollar…unless increased domestic consumption fully substitutes for such weaknesses…which is quite unlikely.

Nevertheless a disorderly adjustment in China could result to the unexpected, massive outflows of speculative money which could reverse the trend of its currency’s appreciation.

Figure 4: Danske Bank: Slowing Industrial Growth

China’s Industrial production recently slowed to 17.3% (Chinaview.com), where according to Flemming J. Nielsen of Danske Bank (highlight ours), ``The most likely explanation for the recent weakness is the government’s intensified crackdown on inefficient steel producers for environmental reasons. China has recently reduced tax rebates on exports of high-energy and resource-intensive industries including steel and export of steel has plummeted by about 40% since April 2007.” Simply said, the recent slowdown can be seen in the light of domestic policies aimed at tempering industrial production growth, rather than emanating from external activities. Our fears have not yet been evident.

So if China’s currency regime as signified by its “borrowed” monetary policies from the US will be affected by the impairment in the financial flow linkages then its “expected” rate of currency appreciation could diminish or even possibly reverse. Obviously this will sap into the Philippine Peso’s recent strength, which should also risk being echoed in the activities of the Phisix.

Such is the reason why we should remain cautious until a clear trend becomes manifest.