Driver Of The Philippine Peso: Available Bias, Oil or the China’s Yuan?

``The problem is not that supply and demand is such a complex explanation. The problem is that supply and demand is not an emotionally satisfying explanation. For that, you need melodrama, heroes and villains.” - Thomas Sowell, Too "Complex"?
The Philippine Peso has lost 5.78% since it peaked at Php 40.33 (closing quote) against a US dollar in February 28^th of this year. Year to date the Peso is down 3.55%.

Falling Peso and Media’s Available Bias, What Happened To Remittances?

Yet mainstream analysis seems lost with what has been going on. We’ve heard all sorts of oversimplified explanations or narrative causations covering the rice crisis to fiscal imprudence to surging oil prices to high “inflation” to risk aversion or to political maelstrom. But these factors do not seem to add up.

Previously, the popular explanation was that the strength of the Peso has been driven primarily by remittances, with subsidiary (and belated) attributions to portfolio flows. We argued against this remittance prompted Peso-appreciation in Philippine Peso And Remittances: The Unsecured Knot and What Media Didn’t Tell About the Peso.

Nonetheless, growth from remittance inflows from OFWs continue to hit record breaking levels and remains as vigorous as ever- 16% February, 9.4% in March or 13.2% for the first quarter…yet the Peso fumbled! Overtime, false premises are eventually unmasked.

Today, high inflation or levitated oil prices appear to dominate the airspace look equally tenuous.

Way up until the end of February of 2008, oil-based on West Texas Intermediate Crude benchmark-had been drifting upwards at the $100 levels where simultaneously the Peso continued to firm. Does this imply that oil above $100 signifies as the “critical point” where the economy folds?

Such arguments have NOT been consistent with present economic data.

The country’s current account recorded a 1^st quarter surplus of $8.6 billion (manila standard) and $499 million in April (inquirer.net) despite the 106% year on year growth of crude oil imports or 960% leap of rice imports y-o-y based on February figures which led to a $379 million trade deficit (manila times).

The country’s foreign exchange reserves also reached a fresh record at $36.7 billion (inquirer.net) despite “suspicions” of the Philippine Central Bank, Bangko Sentral ng Pilipinas (BSP) intervening in the currency market (seller of US dollars) to “contain” the Peso’s depreciation.

Moreover, the nation’s economic growth should remain robust. The Agriculture sector remains buoyant higher by 4% (Reuters) while tourism growth jumped 8.5% (inquirer.net) both for the 1^st quarter.

True enough, while a global economic slowdown may have SOME impact to the Philippine economy, especially in today’s highly interconnected world (relative to the past), as we argued Is the Philippines Resilient Enough to Withstand A US Recession?, where remittances represents about 10% of GDP and foreign trade (exports and imports) accounts for about 40%, we have other highly unappreciated-underinvestment themes-that has tremendous growth potentials (which ironically constitutes as the majority of the economy) enough to offset a global slowdown such as agriculture, mining, tourism, infrastructure, business process outsourcing, real estate, finance (banking and non-banking) and other service sectors.

We presented this in many of our articles including The Philippine Mining Index Lags the World (featured at safehaven.com) in September 2003 and blog posts as A Prospective Boom in Philippine Agriculture!, Want a Stock Market tip? PGMA’s SONA was a Mouthful and Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist.

Has Outcomes Started to Impact Expectations?

Our belief is that the advancing phase of the global commodity cycle compounded by a deepening process of regionalization (economic, trade and financial integration) will benefit the Philippine economy and its financial markets despite the present exogenous (global credit crisis, US recession, global economic slowdown, high “inflation”) and endogenous (political, cultural and national balance sheet or fiscal) risks.

Remember there is NO such thing as a “perfect decoupling” or a “perfect integration”. Amidst today’s globalization trends, where integration and interrelation among economies has been increasing, there will always be some idiosyncrasies within a political economy relative to the world based on culture, population (demographic) construct, intrinsic policies, willingness to open for international or global interaction, political, economic and financial market framework and others. Said differently, there is no such thing as a “one-size-fits-all” paradigm. The distinction of the impact from globalization trends depends on the degree of the country’s exposure.

Take for instance proponents of the deflationary depression scenario have been forecasting of a global recession (if not a depression) arising from the global credit crisis, as we discussed in Global Depression: A Theory Similar To A Horror Movie?, yet 10 months into the credit crisis, global economies appears to remain unexpectedly strong!

Japan’s economy stunned the consensus with a 3.3% growth on “exports on to Asia and emerging markets” (Bloomberg) equally buttressed by resilient domestic demand. It’s the same story in Europe which grew by .7% in the 1^st quarter or 2.2% from a year earlier (Bloomberg), where the Germany (the “strongest growth in 12 years”) and France surprisingly compensated for the slowdowns of some countries (e.g. Spain, and Italy) within region coming in the face of a strong “euro”, rising “inflation”, US economic slowdown and other risk variables.

Assuming a lag period for the transmission of the Credit Crisis or a US economic slowdown, this suggests that economic data should begin to reflect on such slowdown. But this has yet to surface. Of course, we don’t discount that such lag period may take longer and might eventually weigh on Japan or Europe’s economic growth.

But the all important lesson here is that forecasting based on inductions similar to Dry Bone song (toe bone is connected to the ankle bone is connected to the knee bone, etc…) overestimates what is known, and at the same time, underestimates on what is unknown. That is why projections based on the extremes are likely to be exaggerated or highly erroneous and so with the self-righteous rigid convictions which underpin such views.

The Other Side of Oil

In the interim, claims that “decoupling is a myth” based on the initial reaction of forced liquidations seem to be vacillating. Some deflation proponents have now been arguing about the dissociation of stock markets and the economy.

As you know, we have long argued that the stock market performance doesn’t always account for the activities of economies or corporate earnings simply because the stock market (or other aspects of the financial markets) can also account for the function of money as a “store of value” or the opportunity cost of holding cash. (I have to keep repeating this because many people don’t seem to get it).

As a reminder, Zimbabwe has long been in a serial recession but whose stock market has continually soared amidst declining purchasing power (hyperinflation) manifested by its currency (massive devaluation). Economic health-unemployment (80%), manufacturing capacity (5%)-and corporate earnings have not been a factor for stock market performance, but the currency’s (Zimbabwe Dollar) purchasing power has.

When people fear the value of their currency is eroding, as seen through sharply higher prices of goods and services, they tend to seek refuge in asset prices which are scarce, liquid and represents “store of value” or whose value is expected to remain against a massively devaluing currency. Yes, central banks can simply print money for myriad political purposes and accrete humongous financial claims against a dearth of hard assets.

While the others see the rise of commodity prices as a relative shift from the absorption of credit creation and intermediation to financial assets into commodities or in short- NO problem of inflation, our view is that today’s rising markets could be a symptom of a Zimbabwe like disease in the markets.

The world’s current account imbalances, whose enormous surpluses are held by non-democratic emerging markets with underdeveloped financial markets, have equally been generating massive domestic liquidity through amassing foreign currency reserves transmitted by the monetary pegs to the US dollar. In effect, US dollar policies (such as today’s negative real yields) are being diffused to emerging markets via monetary mechanism where the latter’s surpluses are recycled into democratic industrialized economies with mature financial markets which may continue to incur current account deficits.

For instance, with Oil at $126; this means intensifying wealth transfer from oil exporters to oil importers, it also means higher surpluses for oil exporting countries, aside from more money for alternative non US dollar investments via Sovereign Wealth Funds by oil exporters and other surplus generating countries and structural adjustments in the balances of the current account surplus-deficit nations based on the changing dynamics of spending, investing and trading patterns.

A very perceptive commentary from Brad Setser (highlight mine),

``It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies

``Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters' current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And both are already on a sharply upward trajectory. Governments are spending more - and the oil-exporting economies are investing more, in part real interest rates in many oil-exporting economies are incredible low. Those crazy and wildly pro-cyclical dollar pegs. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.

``The Spring IMF World Economic Outlook assumed that oil would average $95 a barrel -- pushing the oil exporters current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters' current account surplus could approach $900 billion range.”

So with huge surpluses from emerging market oil exporters (GCC), aside from countries with surpluses from goods and services (Japan) and countries with surpluses from capital inflows (Brazil), which maybe finding their way into global financial (possibly through equity-via the Sovereign Wealth Fund route) markets coupled with excess liquidity arising from the lack of sterilization (mopping up of excess liquidity) due to the underdeveloped financial markets could have accounted for the spillage of such liquidity excesses over to the commodity markets, could have accounted for the rising price of goods and services around the world and the appearance of recovery in the global equity markets.

The point which requires emphasis is that the spending, investing and trading patterns by these current account surplus countries are likely to determine the asset or currency values of where these spare funds will eventually be parked.

Another aspect to stress is that these surpluses amount to an ocean of money being pumped into the system, aside from the equivalent strains being produced by such surplus-deficit asymmetries.

Baltic Dry Index, Commodity Cycle and the Flawed Populism Concepts

Figure 1: Investmenttools.com: Soaring Baltic Dry Index Amidst Recovering US S&P 500

Figure 1 from Investmenttools.com shows of the near record highs of the Baltic Dry Index overlapped by the main US equity benchmark the S & P 500.

The Baltic Dry Index an index which is representative of dry bulk shipping rates covering a range of raw materials or commodities including coal, iron ore and grain indicates that there is an ongoing shortage of shipping carriers which has prompted for shipping rates to climb back to its recent record highs.

While the correlation between the S&P and Baltic Index has not been entirely strong, we do see some firming interaction since the second round implosion of the credit crisis last October. This paved way for the fall in the Baltic rates coincident to the S&P. Recently the Baltic rates appears to have led the S&P.

This posits the scenario where Baltic shipping rates could have reacted to the supposition of a marked slowdown in commodity shipments (possibly expectations of a US recession), whereas today, the Baltic Index could be sounding off a “limited impact” scenario of an economic growth slowdown relative to the commodity markets.

Further, the fresh record high of the CRB Index supports the assumption of vigorous demand for commodities. But there is also another possible factor responsible for such upsurge-supply bottlenecks brought about by high financing charges and tight lending standards-have caused cancellation of orders for additional ships.

From Bloomberg’ Todd Zeranski, ``As much as $14 billion in ship orders is threatened by cancellations and delays, equal to 94 percent of annual revenue at Hyundai Heavy Industries Co., the largest shipbuilder. Tightening credit markets mean lenders demand a bigger deposit and shorter terms for financing, said Tobias Backer, the head of shipping for the Americas at Fortis, a merchant banker.

``The loss or delay in deliveries of about 250 cargo ships, or 10 percent of orders, will tighten the supply of vessels and support rates when demand from China and India for everything from soybeans to coal has never been greater. Based on the current orders for 2,561 new cargo ships, shipping rates are expected to decline 56 percent during the next three years, futures markets show.”

So even amidst a threat of a potential slowdown in demand for commodities for whatever reasons, the restricted access to financing extrapolates to diminished output for shipping, which means supply constrains or elevated prices for commodities and the Baltic Index.

Demand is a populist Keynesian framework peddled by mainstream media, however supply is another important variable frequently ignored.

The point being, a global economic slowdown isn’t a clear cut certainty that will cause a fall commodity prices, if supply falls faster than the decrease in demand then obviously prices will continue to rise.

Currency Basics

What has this got to do with the Peso?

A lot.

First things first, when we deal with currency markets, we deal with currency pairs or currency values measured against another currency. For instance when we quote the US dollar relative to the Philippine Peso USD/Php, the US dollar serves as the base currency while the Peso is the quoted or the secondary currency.

Second currency values are fundamentally driven by fund flows (capital and trading account), expected policy actions (monetary and fiscal), prospective interest rates and or yields, economic activities, political conditions, purchasing power and others. Traders and punters likewise apply sentiment and technical measures like in the stock market.

Third, since currency values are measured against another then it is a zero sum game, when one currency rise, the other declines. Hence, valuation of currencies shouldn’t be seen from a singular perspective but from dual ends. In other words, valuation is measured by relativity.

For example when one argues that rising oil prices hurt the Peso, it misses the perspective the US is likewise an oil importer, hence oil imports are likewise potentially harmful to the US dollar, so the question should be- higher oil prices should essentially impact which currency more?

Widening Our Perspective On The Peso

Let’s us examine the Philippine Peso. As noted above the Peso continues to amass foreign exchange surpluses aside from recording current account surpluses mostly from remittances.

At the margins, the Peso’s prices have somewhat been set by foreign portfolio flows, aside from other additional minor factors as investment income or central bank forex operations. On the other hand, the US dollar is a net current account deficit currency despite its privilege as the world’s de facto currency reserve.

Figure 2: PSE: Foreign Activities: Declining Trend of Outflows?

Figure 2 exhibits the daily activities of foreign money in the Philippine Stock Exchange. It shows that foreign selling in the PSE has peaked sometime in December 2007, but seems to be gradually declining as shown by the red arrow.

By implication if the trends of foreign funds continue to improve then the Peso should strengthen. It could. But such analysis isn’t straightforward.

Figure 3: USD/Peso-Phisix relationship

Look at figure 3, the USD/Peso (black line chart), since the Peso began to appreciate in 2005 the Phisix seemed to track the USD/Peso’s performance on an inverse scale.

When the US Dollar rose, the Phisix declined, conversely when the Phisix peaked, the US dollar was in a trough (blue arrows). This relationship held until August of last year from where such correlation broke down. Bizarrely the Peso continued to appreciate even while the Phisix had been encountering a net outflow.

China’s Yuan Possible Influence On The Peso

Figure 4: Ino.com: Chinese Remimbi Resembles the Peso’s path

Figure 4 from Ino.com shows of the uncanny resemblance between the movements of the Peso and the Chinese remimbi.

Notice when the Remimbi spiked in August, the USD/Php bottomed. Over in August to September as the Remimbi weakened, the USD/PHP firmed. Next, as the remimbi soared from September until early March, so did the Peso until the last day of February.

So while correlation may not imply absolute causation, we think that the ongoing dynamics of increasing regionalization has had a hand in these. We have argued how trading structure of the region has been reconfigured into what Asian Development Bank describes as “vertical integration of production chains” or a regional outsourcing platform with China as the final assembly point.

The point is that since Asian countries have been engaged in some form of competitive devaluation or have manipulated their currencies to keep prices competitive, and since most of their exports have now shifted to within the region or to China, most of Asia’s emerging markets seem to have kept the dynamics of currency values within the parameters of Chinese remimbi as a bellwether.

And if we are correct with the analysis that the remimbi as the region’s leading benchmark, then it is likely that today’s correction will not last.

This excerpt from a speech of University of California, Berkeley’s Professor Barry Eichengreen, courtesy of RGE Global (highlight mine),

``If the U.S. is in for a long recession and serious credit problems are not over, then betting on dollar recovery would be premature. The problem is that the dollar has fallen dramatically against the euro but much less against the Asian currencies, because of the reluctance of governments and central banks there to let their currencies move against the greenback. It would be nice if those Asian governments and central banks let their currencies strengthen more against the dollar – both to make up lost ground and because Asia is the one part of the world that is growing strongly. The dollar could then recover a bit against the euro, which would take some pressure off of Europe, without appreciating on an effective basis. Indeed, if exchange rates were simply left to the markets, I would not be surprised to see the dollar fall further on an effective basis, given the weakness of the U.S. economy. That is, any recovery against the euro could be dominated by further depreciation against Asian currencies.

``But the reality is that exchange rates are not left to the markets. With inflation accelerating, Asian central banks are likely to countenance a bit more local-currency appreciation against the dollar, but only a bit. And if they limit the depreciation of the dollar against their currencies, there is not going to be much recovery of the dollar against the euro.”

So what can we learn from Prof. Eichengreen?

One growth differentials are likely to allow Asian currencies to appreciate. Two, faced with inflation pressures, given enough lever arising from strong economic growth (aside from the wide gaps of purchasing power) monetary policies will most likely adjust to present conditions. Either our BSP increase interest rates or allow for currency appreciation or a combination of both. If the BSP increases rates then yield differentials against the US dollar should widen which could attract back foreign capital.

This basically debunks arguments floated by mainstream analysts where rising oil prices or inflation is said to inhibit the Peso’s advance. This overlooks the perspective of policy maneuvers.

Next, considering that global risk taking conditions have been picking up of late, (yes we are seeing some major indices crossover the threshold away from bear markets territories) we are likely to see a reversal of portfolio outflows.

Lastly pricing in the foreign exchange markets are not entirely market-determined, hence the imbalances in the global monetary system will continue to mount.

We would further add that based on a probable shift in trade composition where eventually we should see commodity based exports (mining and agriculture) heftily contribute to our trade and current account surpluses (aside from investments and revenues from Tourism, energy and infrastructure) to compliment remittances and portfolio flows, provided the leadership maintain their fiscal discipline, the Peso’s long term path alongside its neighboring currencies is most likely to the upside! All these are also anchored on the underlying policies by the BSP (or the BSP’s tolerance for a market determined outcome).

For the meantime, while I can’t say when the USD/Php is likely to top, I would recommend using today’s rallying dollar as an opportunity for exit or to diversify.

Cheap Currency Not Always Equal To Undervalued Equity Assets

``A disordered currency is one of the greatest of evils. It wars against industry, frugality, and economy. And it fosters the evil spirits of extravagance and speculation. Of all the contrivances for cheating the laboring classes of mankind, none has been more effectual than that which deludes them with paper money. This is one of the most effectual of inventions to fertilize the rich man’s field by the sweat of the poor man’s brow. Ordinary tyranny, oppression, excessive taxation: These bear lightly the happiness of the mass of the community, compared with fraudulent currencies and robberies committed with depreciated paper.”-Sen. Daniel Webster, during the debate over the reauthorization of the Second National Bank of the U.S. in 1832

Attractiveness of corporate equity asset based on currency changes is relative. It doesn’t automatically mean that foreigners will be attracted to an asset simply because of the singular notion of a depreciating currency. If such is the case then foreign money should be stampeding into Zimbabwe since its currency is losing ground by the minute due to rampaging inflation. Maybe sometime in the future, but perhaps not under a Mugabe regime.

On the contrary, a declining currency usually means higher prices of goods and services or consumer inflation which adversely impacts economic growth or corporate earnings. Perhaps foreigners could be attracted once they anticipate an inflection point following a massive devaluation and or a selloff or both. Think the Philippines in 1985/86, Argentina 1990, Peru and Brazil in 1990.

Dr. Marc Faber in Tomorrow’s Gold (highlight mine) makes an important case where falling currencies proffer great investment opportunities, ``Most investors believe that inflation is bad for financial assets and good for real assets such as gold, silver, diamonds and real estate. However what is usually overlooked is that, in very high inflation economies, at some point, stocks become ridiculously undervalued in real terms and therefore provide outstanding buying opportunities. I call this phenomenon the paradox of inflation: instead of producing high price levels, hyperinflation tend to create extremely low prices as currency depreciation (due to massive capital flight) over compensates for domestic inflation.”

Figure 5: Yardeni.com: Foreign Buying of US Equities

But out of the ordinary we don’t see any strong correlation of falling currencies and rising instances of foreign buying seen in the context of the US markets as an example.

The US dollar index strongly rose from 1995-2002, yet foreign purchases of corporate equities as shown in Figure 5 courtesy of Yardeni.com continued to rise. The US dollar likewise rallied in 2005, yet has seen positive inflows from overseas investors in corporate equities.

On the other hand, the declining US dollar has seen a mixed output. The initial phase consisted of a decline (2002-2004) while the succeeding phase has shown a reversal. In short, many other factors determine the attractiveness of an asset.

For the Philippines whose financials markets is hobbled by high transaction costs, high risk premium, low liquidity, unsophisticated and undeveloped market platforms as major disadvantages among other known risks, we have been quite fortunate –the emerging distaste for the US dollar has prompted for a worldwide search for alternative non-US dollar markets, diminishing global “home” bias supported by real time technological innovation and deepening trade and financial integration (a.k.a globalization), aside from the growing need to improve on the region’s financial markets as conduit to absorb savings and forex surpluses to mobilize capital-has buoyed the attraction of our assets to international investors.

We just hope we don’t shoot ourselves in the foot.

The Global Engineering Boom

The next career hotspot is evidently in engineering.

Major economies as Japan, Germany and Switzerland seem to be running short of Engineers.

This from the Financial Times (emphasis mine),

``Germany, a land renowned above all for its high standards of engineering, is facing an acute shortage of skilled engineers.

``Franz Fehrenbach, chief executive of Bosch, became the latest businessman to sound the alarm when he warned this week that the lack of engineers was “the key problem for the future”.

``VDI, the German association of engineers, believes the shortage is costing Europe's largest economy €7bn ($11bn, £5.5bn) a year and estimates that there are 95,000 unfilled posts, up from half that number two years ago.

``It is a similar situation in some neighbouring European countries such as Switzerland, where there are several thousand engineers lacking.

`` “Our shortage is not as serious as in Germany but it will get worse,” said Marina de Senarclens, head of Engineers Shape Our Future in Switzerland. “One reason is that new sectors such as financial services need engineers, meaning demand is ahead of supply.

`` “On the other hand, countries such as France and Italy are better at producing engineering students.”

``Mr Fehrenbach said for every 100 old engineers, only 90 young engineers were being trained in Germany, compared with an average of 190 in other western countries.

``Manfred Wittenstein, the founder of engineering company Wittenstein AG and the head of the VDMA engineering association, said: “It could act as a brake on our future growth.”

And so it is in Japan.

The ministry of internal affairs estimates that the digital technology industry alone is short by half a million engineers!

The fundamental problem is one of the declining interests by students in the field of science and engineering.

Courtesy of the New York Times

This from the New YorK Times, ``Universities call it “rikei banare,” or “flight from science.” The decline is growing so drastic that industry has begun advertising campaigns intended to make engineering look sexy and cool, and companies are slowly starting to import foreign workers, or sending jobs to where the engineers are, in Vietnam and India.”

In Japan, embracing foreign workers have been slowed by cultural rigidities.

``In the meantime, the country has slowly begun to accept more foreign engineers, but nowhere near the number that industry needs.

``While ingrained xenophobia is partly to blame, companies say Japan’s language and closed corporate culture also create barriers so high that many foreign engineers simply refuse to come, even when they are recruited.

``As a result, some companies are moving research jobs to India and Vietnam because they say it is easier than bringing non-Japanese employees here.” (NYT)

So aside from career opportunities, the obvious alternative is a potential boom in investments in engineering related business outsourcing here (IF we are able to generate enough quality graduates) and abroad.

Private Altriusm

The markets have been charged with many forms of atrocities such as greed, materialistism and uncharitableness and many others. In short, private altruism is not possible…

chart courtesy of the Economist

From the Economist (highlights mine), ``AMERICA'S government is frequently accused of stinginess when it comes to foreign aid: the official sort is just a TINY proportion of annual GDP. But donations from INDIVIDUALS and BUSINESSES are startlingly high. American private giving to poor countries amounted to $34.8 billion in 2006, dwarfing that of other rich nations, according to the Index of Global Philanthropy published on Monday May 12th by the Hudson Institute, a think-tank. An established culture of philanthropy and charity contributes to direct aid-giving, as does a generous tax regime.”

First Test of the Phisix Bottom Thesis: Passed With Flying Colors!

``The true prophet is not he who predicts the future, but he who reads history and reveals the present.”-Eric Hoffer, 1902-1983, American social writer

So far so good.

My suspicion that the Phisix could have probably entered into a bottoming phase encountered its first acid test and appears to have passed with flying colors. In the face of pervasive gloom and doom, the Phisix cautiously bounced back by 2% this week for the first week in five.

Interpretation of Initial Impact and Arguments For A Phisix Bottom Redux

Of course the market’s reaction can be interpreted in two ways;

one- a short term interim technical bounce amidst a persistent medium term bear market or

second- an interim bounce which paves way for a seminal bottom under the perspective of its long term underlying trend. Remember market cycles involves process transitions and is not merely event-driven as incredibly suggested by some “experts”, therefore, the Phisix would have to pass repeated tests in order to reconfirm the validity of the ongoing restoration of confidence process.

We have premised the potential turnaround on a confluence of factors which involves the following:

1. Market volatility.

The recent gains of the Phisix (2.8 times) have not been steep and sharp enough as to merit a similar scale of descent. As an example, in 1986-1987 the Phisix climbed by about 10 TIMES which was correspondingly met by a nasty 50% correction. Similarly as mentioned last week, Saudi’s Tadawul and China’s Shanghai bourses flew by over 5 times in TWO to THREE years and has met by the same degree of volatility on its corrective phase, 65% and 50% respectively. Paraphrasing Newton’s Law, Every action has an almost equivalent and opposite degree of reaction.

2. Bubble cycle.

Every asset classes in today’s paper money driven world have been driven by varying stages of massive credit and monetary expansion. Based on public participation we have not seen evidence of such euphoria or investor irrationality.

Next, our asset markets have not reached extensively rich valuations levels. Lastly, the country’s macro or micro indicators have not signified signs of excessive leverage.

3. Encompassing Negative Sentiment.

Since market activities are driven by the investing or speculating public making decisions for whatsoever reasons- they involve psychology. Thus, market cycles are primarily underpinned by the psychological cycle.

Given today’s dire headlines from the domestic front (rice crisis, government threat of a utility takeover, etc.) to overseas (US recession, world economic slowdown, continuing credit crisis, surging “inflation” in food and energy, etc.), the degree of risk aversion has somewhat reached overshoot levels. Yet actions in the marketplace do not reflect or have not been congruent to the same degree of anxiety as shown in Figure 1.

Figure 1: stockcharts.com: PSE The Outlier!

As global markets have remained as closely correlated as in the past, most of these benchmarks imply that the underlying national indices under such rubric have rebounded since March of this year (vertical line).

The Dow Jones World Market at the top pane, the Dow Jones Asia Ex-Japan Index (below center window) and the iShares Emerging Markets (lowest pane) have recovered substantial losses since October.

Whether this recovery represents a “dead cat’s bounce” or a “bear market” rally is arguable and predicated on the caller’s bias. But the point is the Phisix (at center window) has missed the “gravy train”! Or…so it seems?

But compared to the past rallies which manifested of sharp V-shaped bounces, this time we are seeing some signs of consolidation (circle).

A prolonged consolidation or a gradual ascent should exhibit the recovery’s resilience, but again bottoming as a function of an evolving process within a cycle will mean repeated tests where investor patience and grit amidst prevailing fear should eventually be rewarded.

Yes, we were delighted to see that even as the US markets lost meaningful grounds last Wednesday (by about 2%), the Phisix “diverged” by recording moderate gains Thursday.

We have noted in the past that for the Phisix to reestablish strong indications of a recovery, (see Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom) durability in the form of less sensitivity to external variables should be seen as a guide, aside from progressive technical action, of which both signs seems to have been manifested this week.

Monday should be another test day since the US markets ended the week with moderate losses. Since Mondays are traditionally the weakest day of the week, the Phisix could be subject to some selling pressure following the weakness in the US markets. But for as long as the Phisix keeps the pace of its losses to within the range of losses in the US markets, we should remain in a consolidation phase with a recovery bias.

Dead Calm Waters Reveals Attribution Bias

One must be reminded that betting on future outcomes requires the understanding of risk and reward tradeoffs.

When we talk of a “bottom” we don’t even go near to the suggestion of a mystical formula or some alternative forms of voodoo rituality applied to the financial sphere but one where we distinguish the odds of the probability of incurring more losses against that of the odds of the prospective gains. In simple words, the bet of a bottom means the understanding that the room for further loss is significantly less than for future gains. But this, in contrast to the expectations of market punters, happens OVERTIME and requires PATIENCE.

I might like to add that the negative sentiment have truly reached extremes seen in the ground levels. In a recent social function which I regularly attend, where early this year participants seem agog over the market despite the decline (the assumption is that the market’s decline was short and shallow), today almost everyone seem to shun the topic of the stock market, which for me appears to uncannily resemble the investing atmosphere in 2002, a great window for grabbing outsized returns.

Nonetheless, I gathered that losses for some have been staggering enough to dismiss the existence of the stock market. And some have even fostered acerbity towards the financial intermediary agents (bankers, stock brokers and analysts).

Of course I might be accused of reading the sentiment of a group into the whole (fallacy of composition) but as we previously pointed out market internals, as seen by declining daily trades, have depicted the same picture where speculative froth engaged by mostly retail market participants have substantially ebbed. Since speculators have been caught in long positions due to their inability to accept losses or have been immobilized, trading activities have been restrained.

The lesson here is one of the Attribution Bias, where people tend to take credit on successful endeavors to inherent skills but deny responsibility for failures by imputing situational variables either by “randomness” or by the influences of others to their decision making.

Thus, when the market is buoyant everyone seems to know of the “whys” and the “whats” and the “who-drives-what” in the marketplace, and conversely when the market is dreary, the atmosphere seems like dead calm waters.

Negative Real Interest Rates and Emerging Market Bubbles

4. Negative Real Interest Rates.

Mainstream analysts or experts impute stock market investing to micro or macro events, some deal with the technical aspects. As a contrarian, we see the market as mainly the alternative function of money: a medium of exchange, a unit of account (means for economic calculation) and a store of value.

Not everything can be explained by micro or macro factors. Yet mainstream analysis insists on such lockstep correlation. We beg to differ.

Policies administered by government/s have manifested significant impact to asset prices. That is the reason for the phenomenon of bubbles. Investor irrationality is only an aggravating circumstance to a bubble in formation, because this cannot thrive without the principle of leverage (margin trades or credit expansion).

Following years of monetary accommodation and extensive growth of credit intermediaries of all sorts-derivatives to margin trades to alphabet soup of securitization, the implosion of the housing bubble in the US and other Anglo Saxon Economies has left central banks apprehensive of the negative economic growth impact from declining asset prices. As such, monetary authorities have mostly left policy rates lower than instituted “inflation” benchmarks hence negative real rates. Aside, they have been conducting massive liquidity bridging operations and applying fiscal subsidies in support of consumers suffering from the string of recent losses. We have explained most of these in Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

In addition, monetary pegs and mercantilist trading structures of key emerging markets have apparently resulted to a globalized mechanism for transmission of inflationary activities whose effects are now ostensibly rechanneled from Wall Street securities into commodities and emerging markets.

This insightful excerpt from Prudent Bear’s Doug Noland in his Credit Bubble Bulletin (highlights mine),

``prevailing inflationary pressures are global in nature. Wall Street finance is the source fueling the boom, and it’s running outside the Fed’s control. American asset inflation and resulting wealth effects are minimal, while price effects for food, energy, and commodities are extreme. In contrast to previous inflationary booms, while some selected groups benefit, the vast majority of people today recognize they are being hurt by rising prices. This hurt comes concurrently with atypical housing price declines. Today’s price effects pummel already weakened consumer sentiment, as opposed to previous effects that tended (through asset inflation) to bolster confidence. Furthermore, current inflationary forces are destabilizing and even destructive to many businesses, while playing havoc with the fiscal standing of federal, state and municipal governments.

``Revolving around booming Wall Street finance, previous inflationary booms naturally fueled surges in securities issuance and speculation. These Bubble Effects worked as powerful magnets in attracting foreign financial institutions, foreign-sourced speculators, and cheap foreign-sourced borrowings (i.e. yen borrowings financing higher-yielding U.S. securities) that all worked in concert to “recycle” our Current Account Deficits (“Bubble dollars”) directly back to our securities markets.

``In contrast, today inflationary forces largely bypass U.S. securities to play global energy, commodities, and hard assets. Foreign financial institutions are fleeing the U.S. risk intermediation business, while “Bubble dollars” are chiefly recycled back into Treasury and agency securities (where they now have minimal effect on U.S. home and asset prices). Meanwhile, the massive global pool of speculative finance is today focused on energy, commodities and the “emerging” economies.”

In short, what you are witnessing today is an ongoing massive shift in the inflation bias or bubble progression on a global scale from securities to commodities and to emerging economies.

Figure 2: stockcharts.com: Soaring Commodities and Latam Bourses!

Look at today’s commodity and commodity affiliated markets (see figure 2): Oil at an ALL time high $126 per barrel! The CRB Index is also at a Fresh record high! And commodity heavy benchmark of Latin American bourses (Dow Jones Latin America) also on record!

A world of negative real rates is likely to buttress such powerful dynamic. What you will likely have is a phenomenon of funds chasing winners which should spillover to a broader spectrum of commodity associated assets (yes we are seeing signs of the emergence of Ponzi financing in commodities), hence the bandwagon effect in motion!

While the impact of such inflation bias will always be unequally distributed between producers, sellers and buyers of commodities as discussed in my previous blog, Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline, the Philippine economy as an erstwhile major commodity exporter is a strong contender to be a beneficiary from the globalized inflation machinery.

Figure 3: PSE subindices: Recent Recovery Primarily Driven By the Mining Sector

Incipient signs of such rotation have already surfaced.

While the Phisix remain depressed down 23.25% year to date as of Friday’s close, the mining index (equally down 16.5%. y-t-d) has seemingly bottomed since March and has gradually been in consolidation and now seen moving higher-see figure 3 (Japanese Candlestick). This comes after a 6% jump this week, mostly from Atlas Consolidated which has soared by 25%! You don’t normally see a 25% run over a week from an index heavyweight (second largest weighting in the mining index at 16% after Philex) especially in a BEAR market! This only strengthens our case that the Phisix will likely recover soon.

And given that both the above technical picture plus the developments in the world market strengthened by a negative real rate environment, it is likely that the mining and oil sector will lead the Phisix’s recovery over the coming sessions.

All other indices in the chart are underwater on a year-to-date basis, this includes Banking (blue) down 19.75%, Commercial Industrial (violet) 20.59%, Property (red) 29.95%, Holding (green) 27.62% and Services (orange) 19.82%.

Moreover, investors will always find justification for an investment theme. Economic growth supported by capital investments over a dominant asset class is likely to become a feedback loop in a self reinforcing bubble cycle.

Figure 4 GMO: “They have the growth. We don’t. What’s to discuss?”

As the sagacious fund manager Jeremy Grantham of GMO (Jeremy Grantham, Richard Mayo and Eyk Van Otterloo) recently argued in his outlook, historically bubbles would need a strong underlying fundamental case from which the bubble is anchors upon.

In terms of emerging markets as shown in Figure 4 it is likely to be found in the consistent outperformance of economic growth. In the poignant words of Mr. Grantham, ``They have the growth. We don’t. What’s to discuss?”

Like us, Mr. Grantham believes that the next bubble will be on emerging markets. Quoting at length Mr. Grantham (all highlights mine),

``For one, emerging will increasingly be seen on a country-by-country basis. Nevertheless, the second wave of let’s-look-like-Yale money from state plans is still in its early stages and looking to invest overwhelmingly in emerging market funds, not in the specific country funds of the Yales and Princetons.

``For another caveat, the GDP growth rate of a country does not in the very long term necessarily determine how much money a country’s stock market will make. Long-term market return may depend more on profit margins. But investors believe GDP growth really matters, and Japan went to 65x earnings despite average or lower corporate profit margins.

``But the third caveat is the most serious; this emerging bubble can easily be postponed or even stopped before it really begins by the current financial problems and the slowing growth rates of the developed world that are likely to follow.

``My own view is that our credit problems will impact and interrupt the recently sustained outperformance of emerging in the intermediate term, say, the next 3 years, even as the acceptance of this emerging bubble case grows. Such interruptions may be quite violent but, despite them, at the next low point for the U.S. market the emerging markets are quite likely to do no worse and in the recovery they will go to a very large premium. And if, just if, the U.S. gets very lucky indeed and muddles through without serious market and economic problems, then the emerging bubble will of course occur more quickly and smoothly.”

Phisix: Political and External Risk Variables

So yes, allied with the views of Mr. Grantham as we have previously mentioned, the Phisix is envisaged by two major risk factors; one is domestic political risk and the other is the transmission factors of the external risk environment.

Political risk could be associated with the risk of destabilizing markets through populist policies such as overextending subsidies to reverse the gains or improvements of the country’s fiscal position and balance sheet, combined with threats to the sanctity of private property ownership via “nationalization” or management “take over”.

So when we read of canards repeatedly circulating in the emails of “why the Philippines is poor?” we understand that it is the fundamental aspect of principally NOT having ENOUGH capital investments in the country and NOT because of lack of “moral” leadership why the Philippines is “poor” (yea ironically the Philippines is “poor” but home to 3 of the 10 world’s largest malls and growing!).

It is because of the lack of appreciation of the markets through property ownership and the enforcement of contracts, the lack of savings, a dearth of platform or infrastructure for establishing pricing efficiency, the lack of competitive environment, a politically dependent society or culture and importantly the high costs of political intervention and bureaucracy.

Remember the popular personality based politics theme of corruption represents a symptom and NOT the disease. Corruption basically is an offshoot to suffocating network of bloated bureaucracy as a result of overregulation and inordinately high taxation due to huge liabilities accrued from failed policies and deep dependence on political gratuity (a.k.a. pork barrel).

Economics 101 tells us that the more you want of something you LOWER the costs, in contrast, the less you want of something you INCREASE the cost. If you want to lessen the incidences of corruption you increase the cost of committing corruption. If corruption is an offshoot to overregulation then streamlining of laws, reduced bureaucracy and lower taxation should be encouraged aside from strictly enforcing laws.

In addition it is NOT governments that drive the wealth of economies or responsible for the upgrading of the standard of living of societies, otherwise communism (Stalin’s USSR, Mao’s China, Kim’s North Korea, Castro’s Cuba) would have succeeded; it is the people!

If governments empower its people to conduct trade openly with LESS political intervention thereby strengthening the division of labor within its economy then it reduces the country’s risk premium, lowers the hurdle rate, reduces the cost of doing business and thus becomes competitively attractive for capital investments.

Governance permissive of a market economy or an entrepreneurship culture and less dependence on the political leadership is the common denominator of successful economies. Because it is a governing policy to limit government’s intervention then the issue of “moral” becomes moot.

But when you see the leadership use its coercive power of its legally clothed leviathan to conduct political harassment or render vindictive actuations on presumed political opponents in the name of public services then it raises questions among potential investors about the sacredness of equity ownership.

This in itself increases the cost or barriers of doing business. Hence capital would seek a hefty premium in terms of higher rate of return or yields for it to consider deploying them into the country. The higher the costs the lower rate of investments.

These incessant political interventions is the reason why the Philippines will remain politically and economically disadvantaged and will thus depend on the global or regional cycle for its upliftment than from intrinsic factors such as the popularly demanded (but largely ineffective) “government driven” initiatives instead of the unpopular market oriented reforms. To quote Ludwig von Mises, ``The effect of its interference is that people are prevented from using their knowledge and abilities, their labor and their material means of production in the way in which they would earn the highest returns and satisfy their needs as much as possible. Such interference makes people poorer and less satisfied.”

As for external risk variables, the country is faced with the same macro risks as the others, a sharp US recession, a steep global economic slowdown, accelerating inflationary policies which could fuel the intensity of the present bubbles and or goods and services inflation, geopolitical risks of public upheavals (triggered by food crisis) or potential military conflicts (over resources), a US dollar crash, global depression and other fat tails.

Phisix, Inflation and the Available Bias

``While inflation is a growing problem for Asia's developing countries, it is not necessarily the region's biggest threat. Rather, the looming risk is the potential for governments to react poorly to inflationary conditions in a bid to quell popular dissatisfaction. In the process, poorly construed policies may actually exacerbate, rather than alleviate, inflationary conditions.”-Matthews Asian Fund

And another thing, one of the factors attributed to Tuesday’s decline in the Phisix was due to “rising inflation”.

For us, this serves a vivid example of the application of the available bias to stock analysis or news reporting.

The inflation figures reported by the newswires dealt with April figures. Why should a market react to past records, unless they think “goods and services” inflation figures will worsen now?

One must be reminded that the market functions as a forward discounting mechanism. Hence estimated actions are based on potential outcomes and not on past records.

Second, “inflation” data always lags. Inflation data captures “lag” responses to government policies or to shocks in an economy.

Third, there is no strong correlation between the performance of stocks and inflation as shown in figure 5.

Figure 5: IMF Staff: PSE and Inflation Over 6 Years, Correlation Where?

Courtesy of IMF’s April Consultation Staff Report the chart shows that over 6 years there has been NO direct correlation between the performance of the Phisix and Philippine “inflation” benchmarks.

Soaring inflation in 2003-2005 did not stop the Phisix from doubling, whereas the declining “inflation” coincided with a steepening of the Phisix gains of 2007. The operative word is “coincided”.

Our idea is that stock markets serve as a repository of company assets (tangible and intangibles) which accounts for potential diversity of treatment by investors given the current “goods and services” inflation landscape.

Since there is no firm correlation to “inflation” and the “Phisix”, hence ascribing “inflation” as deterrent to advancing stocks is simply an excuse or justification based on available news used to explain unrelated events. Thus, the available bias. The fact that the Phisix climbed by 2% over the week debunks such imputation.

Maybe journalists and mainstream analysts should explain why and how hyperinflation (165,000%) in Zimbabwe has been “beneficial” to stocks (360% in Three weeks or 4,000 % from January to April 28^th)?

$200 oil?

This from the Economist,

“OIL briefly reached another record on Tuesday May 6th as West Texas Intermediate traded at over $122 a barrel for the first time. Ten years ago a barrel fetched around $15. The feeble dollar, soaring demand and supply constraints have all helped to push up prices by 25% in the past four months alone. And there is little sign of respite for worried governments and consumers. This week Goldman Sachs, a bank, predicted that oil could reach $200 a barrel before the end of the year.”

Chart courtesy of the Economist

Oil just recently set a new record at $123.93.

For as long as government intrusions seen in many faces (price subsidies, supply “geographic” restrictions, nationalizations, massive credit expansions, currency debasement policies, high taxes, “strategic petroleum reserves”, et. al.), persist to distort market mechanisms, oil prices will continue to ascend (perhaps even more than $200) until demand crumbles. Eventually the market determines the outcome.

Will Internet TV Be A Dominant Trend?

Internet protocol television (IPTV) seems to be gaining ground worldwide.

chart courtesy of the Economist

This from the Economist...

“NEARLY a third of Hong Kong's households watch television via the internet, according to a new report from Telecommunications Management group, a consultancy. Because internet protocol television (IPTV) uses the same technology as that which links computer networks, smaller countries with high broadband penetration tend to have more subscribers. As well as plain old programmes, viewers can also enjoy other services such as on-demand video. So far, Europe accounts for over half of the world's subscribers.”

Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline

As expected, Philippine inflation rates leaped to its highest level in 3 years according to the news wires.

Chart courtesy of abs-cbnnews.com: Soaring Philippine Inflation Rates!

The following quote from abs-cbnnews.com, ``The price of rice, a staple in the Philippines, soared in April by nearly 25 percent from a year ago. Overall food prices rose 12 percent, the National Statistics Office said on Tuesday.” (emphasis mine)

Earlier mainstream analysts primarily attributed the rise of our inflation index to higher oil prices from which refuted in our March 5 post, “What we have been saying is that the surge in global commodity prices, which appears to be reflected in food prices, is likely to be more strongly associated with the recent uptick in our price index data than oil alone.”

And this was even prior to the emergence of the “rice crisis”. Now it appears that our view has been validated anew!

Remember the so-called inflation index is a LAGGING indicator, again to quote abs-cbnnews.com (highlight mine), “The Philippine’s annual inflation jumped to a near three-year high of 8.3 percent in APRIL, putting pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth”.

And implying stock market price movements based on a lagging indicator does not reflect the functionality of markets as forward discounting mechanism. Does the April data mean the same, better or worst for today?

In short, any attribution to inflation of the past as determinant of today’s market decline is all about “rationalization” or looking for a simplified explanation into today’s activities.

Notwithstanding, if inflation had been the “casual” agent responsible for today’s decline, why does it seem that even “inflation hedges” have been affected too?

The meat about the argument of inflation being a negative for the market is about pressures on corporate margins. Higher input costs and limited consumer pass through or pricing power crimps on corporate profitability. But this should not hold true for existing producers of commodities who are likely to benefit from rising values of “commodity products”.

It also means pressure on consumers in terms of declining standard of living.

An example would be this quote from Standard & Poors,

``In the world of higher commodity prices, corporate winners and losers fall into two distinct camps.

``Commodity producers are big beneficiaries. Their business outlooks appear generally strong and their ratings stable, in our view, as scarcity and worldwide demand affect everything from corn to copper. But companies that rely heavily on grains, oil, or other commodities to make finished goods face increasing costs, and thus weaker profits, if the slowing U.S. economy makes raising prices more difficult.

``The fallout from high commodity prices will be unequally distributed and determined by whether one is a buyer or seller of commodities. The level of commodity input into finished goods and the ability to raise prices will determine how serious the impact will be for commodity users. Low steel costs, for instance, are certainly better than higher costs for automakers. But steel is a relatively small part of a car's cost, and the woes of Detroit's Big Three (oil prices and labor costs, for example) go far beyond steel prices. Baked goods, cereals, meat, poultry, eggs, and dairy products all contain, directly or indirectly, large amounts of corn or wheat, so the impact of higher prices for those grains is widely felt among food processors. And the high price of oil will clearly be deleterious for industries like refiners or airlines, where oil is a major input.”

So when we see the market down with commodity producers similarly impacted, it is unlikely to be “caused by” inflation. Instead, it is likely caused by negative sentiment with all “excuses” lodged into it.

Moreover, if one notices the big drag to the sentiment today seems to emanate from the 8.28% decline of Meralco. While indeed Meralco stands only at 3.4% weighting of the Phisix, the purported action by the government to threaten a “takeover” if not a “change in management” is enough to create a pandemonium. Why? It is all about using populist politics as a cover to apply political vendetta or harassment. When government threatens (directly or indirectly) to “nationalize”, private ownership is compromised and thus, leads to destabilization.

Lastly, the world is into an inflationary boom. Inflation by the definition of a surfeit of money creation, massive credit expansion and re-intermediation, aside from spectacular speculative excesses.

The odd thing is that while we cheer the authorities to “save” the financial assets from being overwhelmed by market forces, paradoxically we jeer at the prospects of rising “product” prices when these systemic leveraging have mainly been responsible for the increased claims against limited resources, or too much money chasing too few goods.

No, product inflation will NOT move in a straight line. But for as long as people expect governments to provide more subsidies we should correspondingly expect such trend to be reflected in our way of living.

Further, on the account of the domestic scene, it will “pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth” as the report says.

This is what we wrote last April 6,

``As we have repeatedly said, negative real rates will likely trigger more speculative activities as the search for the alternative monetary function of “store of value” intensifies. This further reinforces more “inflation” within the domestic economic and financial system.

``So we may likewise expect the domestic central bank, the Bangko Sentral ng Pilipinas (BSP), to raise policy rates to keep up with rising treasury yields (falling bond prices)…

``Otherwise maintaining present rates amidst surging consumer price could lead to negative real rates across the entire yield curve, which should further aggravate the opportunity costs of holding cash.

``On the other hand, rising yields could lead to resurgent foreign capital portfolio flows predicated on currency yield spread arbitrages or carry trades."

So as the Philippines go deeper into NEGATIVE REAL RATES at the expense of savers and for added stimulus for borrowing and speculation, the BSP will be forced to raise rates. But contrary to expectations of further declines, rising yield spreads could as mentioned above entice foreign money into the markets which could increase inflation pressures.

Remember stock market investing cannot solely be explained by sheer earnings or economics (as previously explained), because it also reflects the function of money as a store of value.

chart courtesy of Wall Street Journal: OECD consumer prices

So even when the world (or OECD) has seen resurgent consumer price inflation…there seems to be no strong correlation about rising inflation and declining stocks yet.

chart courtesy of stock charts.com: Dow Jones Developed World Index

The Wall Street Journal Chart shows inflation accelerating in developed countries during the last semester of 2007 (red ellipse) even when the credit crisis was in the process of unraveling.

Yet, even as the appearance of a “peak” in inflation (based on the chart-but I don’t believe it has peaked), stocks has apparently recovered (which for some, signifies as a relief rally) in the backdrop of a “normalizing” US 10 year Treasury Yield.