Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble

``No two economies are ever alike in details. The composition of the industries changes. The expectations of people change. The government changes. The international linkages and governments change. The monetary systems vary. The skills and composition of the labor force change. The technology changes. The knowledge changes. The goods being produced and consumed change. The institutions change. Need I go on? No one understands an economy, and no one can understand a business cycle in an economy. I mean really understand it. Sure, there is a broad understanding. There is a grasp of certain features. We are not bereft of knowledge. But we do not know the details. We do not understand the linkages or what goes through people’s minds and affects their behavior. All the models we use, including the Austrian models, are more or less broad-brush affairs.”-Michael S. Rozeff Fiscal and Monetary Policy Annoy Me

As of Friday’s close, the Philippine Phisix passed the 2,500 Rubicon.

And by doing so the Philippine benchmark has recovered some 48% of its losses from the 2007 pinnacle and is now about 52% away from a full recovery, see Figure 1.

Figure 1: Phisix: On A Halfway Mark To A Complete Recovery

To attain the present levels, the Phisix has tallied a blazing 6 consecutive weeks of gains.

The Predicament of Mechanical Chart Reading

A mechanical chart practitioner, without the understanding of the underlying fundamental dynamics, would have seen resistance after resistance being broken, and as consequence, would either have been left behind watching in ‘shock and awe’ and immersed in ‘regrets’ (constantly muttering “I should have…” or “I could have…”) or have been frantically chasing after adrenalin infused stock prices.

True, technically speaking, the run in the Phisix have been overextended but the hallmarks of major trends can translate to serial bouts of trend overreach.

Moreover, historical actions can’t serve as precise guide simply because the underlying circumstances between the points of comparison could be distinct; where possible incidences of parallelism would depend on the degrees of circumstantial similarities.

Minyanville’s James Kostohryz, an investment banker, hits the nail in the head in his Anatomy of a Losing Trade, ``There's no such thing as a market being “overdue” for a correction. This is pure nonsense. There's no reason why a market has to behave in a fashion that one is comfortable with. Past experiences are only relevant to the extent that current circumstances are analogous. In this case, they weren't. So leaning on past experience was a mistake.”

The lesson is that mechanical chart reading signifies as oversimplification of reading and analyzing markets which is an inferior way to generate outsized returns.

Market-Real Economy Divergences Underscore Reflexivity Theory At Work

Yes, markets can go anywhere over the interim. This means that profit taking could surface or that a countertrend cycle can emerge.

And markets could use divergences in current events relative to markets to justify such actions.

Figure 2: NSCB: Philippine GDP At The Edge of Recession

Take for instance the descending trend of economic growth as shown in Figure 2. 1^st quarter Philippine GDP growth surprised to the downside with a substantial slowdown (NSCB).

However this hasn’t been the case. On the contrary, the Phisix got fired up to account for a remarkable 5.83% gain week on week and for a cumulative 35.02% advance year to date!

Of course we expect the mainstream to read this as an “inflection point” so as to “rationalize” current market actions. And this is what we have been expecting for sometime.

Although, it would be a paradox to note that the Phisix had been stabilizing in the first quarter even as the economy had been undergoing a belated precipitate decline in economic activities, the operating fundamental dynamics underscores the reflexivity theory at work.

As we wrote in The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery, ``In short, the reflexivity theory -from fact to perception and now perception to facts-seems to be succeeding at recalibrating the market’s mood.” Rationalizations of market actions (perceptions) to the real economy may indeed translate to a turnaround (prospective fact).

We see the same divergent mechanisms or reflexivity theory operating even in our regional contemporaries.

Except for Indonesia whose economic growth clip over the same period has marginally slowed but remains substantially up at 4.4% (guardian.co.uk), Thailand and Malaysia recorded negative growth and could be in the threshold of a recession.

Yet, Indonesia’s bellwether the JKSE has on a year-to-date basis displayed the bulls’ overwhelming dominance to account for 54% of gains, while Thailand’s SETI has tabbed 34% and Malaysia’s KLSE 23%.

BSP Policies To Add To Inflation Woes

Going back to the Philippines, the substantial decline in growth has extrapolated to a hefty drop in inflation which has prompted the Philippine central bank the Bangko Sentral ng Pilipinas (BSP) to cut rates to a 17 year low, see Figure 3.

Figure 3 Reuters: Philippine Inflation

The Consumer Price Inflation has basically fallen below Bangko Sentral ng Pilipinas (BSP) policy interest rates.

I don’t know how accurate this inflation gauge is, but to my observation, commercial rice prices in our location have remained at the price levels near the peak of the inflation cycle and haven’t manifested any meaningful deviation as accounted for by the published official statistical account. Rice is a key component in the inflation index (see chart here).

Nonetheless, the steep fall in the domestic inflation index appears analogues to the Posttraumatic Stress Disorder (PTSD) impact on global trade last year. It most likely reflects on a lagged impact of the global financial and economic shock from the seizure in the US banking system on the real Philippine economy, which is likely to be a temporary phenomenon, especially that prices of commodities have returned with a vengeance.

Yet like all central bankers who believes they can control the economy “to avert recession” by adjusting knobs through monetary tools, our BSP has joined its global peers to impose Zero bound policy rates and has declared the possibility of more rate cuts. And in doing so, have revved up the business cycle which has been premised on the unsustainable highly flawed economic ideology of borrowing, speculating and spending policies to boost the economy.

As you will observe, policymakers everywhere are innately reactive than proactive. Current market prices have been signaling a return of inflation yet the focus by policymakers have been on past data. Commensurately, the policy response is to address the past concerns. Unfortunately, such responses would result to short term gains but with lasting damage far greater than any interim benefits.

Hence, Philippine policies have been contributing to the global “super” inflation dynamics.

While it had been a delight to read that our honored BSP Governor Amando Tetangco quote one of our inspirational economic icons in his speech at the Australian-New Zealand Chamber of Commerce Philippines Annual General Membership Meeting, Makati-City last 14 April 2009, where he said, ``Frederic Bastiat, a 19th century French economic journalist, once said, “there is only one difference between a bad economist and a good economist: the bad economist confines himself to the visible effect; the good economist takes into account the effects that can be seen and those effects that must be foreseen”, disappointingly the venerable Governor doesn’t seem to be practicing what he had preached. And quoting Mr. Bastiat looks more like an ornament to spice up a talk.

Policies Shape People’s Incentives, Foreign Funds Flows Recovering

Policies shape people’s incentives.

The low interest rate regime has begun to show signs of gaining traction. This has spurred a boom in domestic banking credit in April (BSP) and equally a hefty liquidity expansion as reflected by the domestic M3 which grew by 13.7% in April (BSP).

Of course while bank loans to industries may presuppose usage, we can’t say if the loans had actually been used as so designated. Possibly some of these could have been diverted to the stock market.

Figure 4: PSE: Percentage Share of Foreign Trade: Local Participants Dominates!

The present boom in the Philippine Stock Exchange (PSE) has been mostly due to local participants, see figure 4. This is in contrast to the previous cycle 2003-2007 where foreigners functioned as the market’s driver.

The share of foreign trade has hardly gone beyond the 50% threshold as exhibited by the black horizontal line, since the start of the year.

This local buying phenomenon has been a primary feature in the present epiphany of stock markets in Emerging Markets and in Asia.

To quote the high profile contrarian analyst from CLSA Mr. Chris Wood whose interview can be seen here, ``What is being positive there in the rally began in Asia in October-November last year, is that we've seen growing local investor participation in Asian market, so the people who bought earlier in this rally since late last year weren't foreign fund managers but local investors throughout the region. That growing local investor participation is a long term positive.” (bold highlight mine)

For us, it is likely that high savings rate combined with loose monetary policies to induce speculation, fiscal stimulus applied, largely unblemished banking system, and low systemic leverage that has impelled a bidding war in the stock markets and commodity markets.

Of course, for media and mainstream, it would prominently be the “high” economic growth story which we won’t disagree with.

Figure 5: PSE: Improving Foreign Trade

Notably, foreign trade on the account of the falling US dollar index has also been improving see figure 5. For most of the year, foreign trade has largely been a net selling.

I excluded from the chart the April 30 foreign trade data which incorporates the special block sale of San Miguel Brewery to Kirin, because it skews the chart by making little visibility to current market action. Nevertheless, the red line manifests the reemergence of foreign buying activities but has remained minor to local activities.

And this hasn’t been an insulated event. Fund flows to emerging markets have begun to pick up steam.

According to this report from Bloomberg (bold highlight mine), ``Emerging-market equity funds received $3.79 billion in net inflows for the week ended June 3, led by investments in Asia excluding Japan, EPFR Global said.

``Funds that invest in Asian stocks excluding Japan added $1.54 billion, the most in dollar terms, while global emerging- market equity funds attracted $1.07 billion, the Cambridge, Massachusetts-based research company said in a report dated yesterday. Latin America stock funds drew inflows of almost $1 billion, while funds investing in Europe, the Middle East and Africa gained $230 million.

``Emerging-market stock funds have taken in $26.1 billion of net inflows this year, following 13 straight weeks of gains.”

So renewed interests from foreign investors on emerging markets are likely to even propel stock prices to higher levels! We should see the same dynamics reinforced locally. This time it will probably be foreigners chasing stock prices.

The Peso Riddle

For me one of the current major puzzles has been the underperformance of the Philippine Peso, in spite of the spirited rally of the Phisix and in the face of the sagging US dollar.

While the Peso has been marginally up from the start of the year, it has underperformed most of its contemporaries.

My conjecture is that foreign portfolio flows could have had considerable influence to this and my suspicion is that since foreigners had been basically net sellers the Peso hasn’t responded positively.

However, if foreign flows into the Philippine Stock Exchange continue to improve then we might see a sizeable move in favor of the Peso.

The other possible factor is government intervention.

Officials could be intervening in the currency exchange markets so as to “contain” appreciation of the Philippine Peso relative to the US dollar.

Lately some accounts of such intrusions have been observed in the region, according to the Wall Street Journal, ``central banks in South Korea, Thailand, Taiwan, Singapore and India are believed to have sold their currencies”.

So considering the economic ideological underpinnings by our officials, there is a good chance that government involvement to support “OFWs” which has been a popular cause, and exporters could have been a factor for the Peso’s inferior performance.

Conclusion

The flagrant disconnect between markets and the real economy has reached Philippine shores, where monetary forces seem to be the overwhelming driver of the rejuvenated Phisix.

While the Philippine economy has been less sensitive to exogenous bubble bursting woes abroad, local policies have now been contributing to the collective global efforts to “reflate” economies. And mounting evidence shows that markets have been increasingly responding to these policies.

The positive signs from current market actions are likely to have some influence to the real economy, which essentially validates the reflexivity theory. Although, present policies will likely fillip speculative spirits instead of promoting real investments.

Moreover, the resumption of the bear market in the US dollar has now widened the portal for foreign money flows into emerging market financial markets. As the initial thrust over the past months had been due to local money, foreign money could now function as the secondary engine to sustain the upswing in the domestic financial markets. This dynamic could also tilt the fate of the Peso which could have been hampered by previous accounts of net foreign selling or by government intervention in the currency markets.

With monetary forces clearly at the driver’s seat, the Phisix could be on its way to a full recovery and could even prompt for our target of Phisix 10,000 (perhaps sooner than later).

The unfortunate part is that we are clearly in an embryonic phase of the next bubble, thanks to policies that cater to economics of abundance in a world of scarcity.

And unlike the 2003-2007 cycle, which saw the Phisix as a victim of contagion, if present internal policies and external transmission persists to inflate the bubble, then the bubble dynamics will become structural for the Phisix and the Philippine economy.

Our Mises Moment Answers Mainstream’s Conundrum of Market-Fundamental Disconnect

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.”-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion

The mainstream is obviously very perplexed.

They can’t seem to figure what’s going on with market prices that can’t seem to match “fundamentals”.

Take this as an example. ``With oil inventories high and demand down year on year, yet prices surging, "fundamentalists" are puzzled” observes Liam Denning of the Wall street Journal.

Skeptical of the fundamental –market disconnect, the unconvinced Mr. Denning concludes his article with, `` Ultimately, however, the danger for China, and commodities bulls, is that Beijing's efforts fail to fully offset the harsh realities afflicting the world economy as a whole.” (bold highlight mine)

Figure 6: Wall Street Journal: China Watch The Body Language

Many have attributed the rise in oil or iron ore prices primarily to China see figure 6. But the unpleasant fact is that this isn’t just about oil or iron ore or China.

It’s about policy induced inflation whose growing influences are being ventilated on markets and which has been percolating and distorting the real economy.

And the primary mechanism for such release valve has been the US dollar.

As we wrote in last week’s Mainstream Denials And The Greenshoots of Inflation, a broadening category of the commodities have been experiencing price gains. So it’s not only oil or iron ore or gold but a whole range of commodities which includes food prices.

In addition, it isn’t just China or Sovereign Wealth Funds, but a broader spectrum of participants have joined the bandwagon as buyers of commodities. As we noted in Hedge Funds Pile Into Commodities, hedge funds have been growing exposure to commodities.

Even life insurance outfit as Northwestern Mutual Life Insurance Co. ``has bought gold for the first time the company’s 152-year history to hedge against further asset declines” (Bloomberg) could be signs of possible major reconfigurations of investments flows towards commodities.

My recent post which surprisingly turned out with a high number of hits, deals with Hedge Fund Ace John Paulson who made an amazing allotment of 46% of his portfolio into gold and gold related investments [see Hedge Fund Wizard John Paulson Loads Up On Gold]! He didn’t say why, but the message was loud and clear! What a statement.

Aside, Bond King and regulatory arbitrageur Bill Gross recently wrote to warn the public to diversify away from US dollar before ``central banks and sovereign wealth funds ultimately do the same amid concern about surging deficits” (Bloomberg)

He thinks that the US has reached a “point of no return”, again from the same Bloomberg article, ``“I think he’ll fail at pulling a balanced rabbit out of a hat,” Gross said from Pimco’s headquarters in Newport Beach, California. “They are talking about -- once the economy in the U.S. renormalizes -- the move back toward balance or much less of a deficit. I suspect that will be hard to do.”

Moreover, a public gold fever (not swine flu) appears to have infected ordinary Chinese sparked by the revelation of massive gold accumulations by the China’s government. According to the China Daily, ``Inspired by the increase in the government gold reserves, the more savvy investors are also buying shares of Chinese gold producers on the Shanghai Stock Exchange and the smaller Shenzhen Stock Exchange.”

Furthermore, drug trades have reportedly been reducing transactions based in the US dollar and could have possibly been replaced by trades in gold bullion (telegraph).

This Dollar based concerns won’t be complete without Russia’s continued outspoken campaign to replace the US dollar as the world’s international reserve currency, which apparently not only got support from major Emerging Markets as China and Brazil, but even the IMF has reportedly jumped on the bandwagon saying that replacing the US dollar is possible.

This from Bloomberg, ``The IMF’s so-called special drawing rights could be used as the basis for a new currency, First Deputy Managing Director John Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today.

``“There are many, many attractions in the long run to such an outcome,” Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today. “But this is not a quick, short or easy decision,” he said, adding that it would be “quite revolutionary.” (bold highlight mine)

And worst of all, US dollar as a safehaven status has been scoffed at by Chinese students! Incredible.

This from Reuters, ``"Chinese assets are very safe," Geithner said in response to a question after a speech at Peking University, where he studied Chinese as a student in the 1980s.

``His answer drew loud laughter from his student audience, reflecting skepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.” (bold highlight mine)

It’s obviously a question of what degree of the Chinese population has been represented by the adverse reactions of Chinese students on Mr. Geithner’s statement. If these students account for a majority of China’s sentiment, then it is quite obvious that the public will likely be shunning the US dollar as mode of payment or as transactional currency or as medium of exchange (sooner than later) despite the Chinese policymakers’ avowed insistence to buy US dollar assets (but on a short term basis) which is no less than politically premised, as previously discussed here and here.

All these account for votes of displeasure over policies governing the US as reflected on its currency the US dollar, which mainstream can’t seem to comprehend.

As I wrote in my March outlook Expect A Different Inflationary Environment (emphasis added), ``This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

``And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

``In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.”

So far everything that we have said has turned out to be quite accurate.

But we seem to be transitioning to the next level.

This brings us to the question why the public seems to be gravitating towards commodities?

Ludwig von Mises has an explicit answer which I unearthed in Stabilization of the Monetary Unit? From the Viewpoint of Theory,

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.”

So let us break these down into stages:

First, the loss of the currency’s purchasing power.

Second, is the loss of a currency’s function as medium of exchange or the “demonetization process”.

Third, is the accelerating feedback loop between the first two stages which brings upon the irreversibility of the process and

Finally, the total collapse of the currency.

So there you have it. The public’s increasing exposure to commodities is fundamentally a question of the viability of the present monetary standards.

So far the political path and market responses have been behaving exactly as described by Prof. von Mises.

Hence, I call this the Mises Moment.

Hedge Fund Wizard John Paulson Loads Up On Gold

Interesting trivia on Hedge fund manager John Paulson.

According to Casey Research,

``Not familiar with Paulson & Company, or founder John Paulson? You should be, and here’s why:

Picture from Businessinsider.com

• Paulson’s bet on the subprime mortgage debacle earned $3.7 billion in 2007.

• The company made an estimated £606 million profit selling short British bank stocks in September 2008.

• John Paulson ranked #2 on Alpha’s Highest-Earning Hedge Fund Managers of 2008.

• Two of Paulson & Co.’s funds ranked #1 and #4 on Barron’s Top 100 Hedge Funds 2009 list."

So what has the top notch been loading up lately?


The answer is gold and gold mining stocks.

Again Casey Research, ``The privately owned hedge fund sponsor Paulson & Co. added over $3.7 billion in new gold positions during the first quarter of 2009, increasing its total investment to $4.3 billion. About 46% of the equity portfolio is now allocated towards gold and gold stocks."

Why?

Telegraph's Ambrose Pritchard thinks this has been due to reflation.

``The world's top hedge fund manager John Paulson has built a gold position of at least $5.5bn, the biggest such move since George Soros and Sir James Goldsmith bet on Newmont Mining in 1993...

``Paulson & Co has bought $2.9bn in SPDR Gold Trust, the biggest of the gold exchange traded funds (ETFs), which now holds 1106 tonnes − three times the Brown-gutted reserves of the United Kingdom.

``Mr Paulson has also built up a $2.3bn holding of Anglo Ashanti, Goldfields, Kinross Gold, and Market Vectors Gold Miners. The fact that he is launching a "Paulson Real Estate Recovery Fund", reversing the bet against sub-prime securities that made him rich, tells us all we need to know about his thinking. This is a liquidity-reflation play."

On the contrary having 46% of one's portfolio in gold suggests that it isn't just a liquidity reflation play, since reflation suggests of an economic recovery which should translate to a more diversified portfolio.

Instead it does seem to look more like a "super" or "hyper" inflation play.

CLSA's Chris Wood: Asia and Emerging Markets Are Undergoing An Incremental Decoupling Process

CLSA's popular contrarian analyst Chris Wood says that Asia and Emerging Markets are in process of incremental decoupling where Asia and EM are in a bull market while Western economies are on a countercyclical phase of a bear market.

Click on image for the interview or go to the transcript below (Hat Tip Prieur Du Plessis)

Q: What have you made of the markets’ move in the past few weeks?

A: I was expecting what I call a counter trend rally, driven by a counter trend rally in the S&P this year. The key point is that the S&P in the fourth quarter last calendar year went further below its 200 DMA, and at any point since 1932, in the midst of the great depression. So, it was almost inevitable that we were going to have a counter trend rally at some point in 2009. Actually, I thought it would start with the arrival of the new administration in January-February, but it didn't start so much. My guess as to how far this rally can go is 1000–1050 on the S&P, but in my view from the Western view, the S&P standpoint, I am viewing this as a counter trend rally in a secular bear market for the US. I have a different view for Asia and India. I believe Asia and India remain in a secular bull market. So I have a fundamentally different view for the Western world and Asia.

Q: How would you describe what happened in 2008 then in India and other Asian markets like China? Deep cyclical correction? Over 10–15 months in an overall secular bull market?

A: I would describe that as a deep cyclical correction in Asia and EM driven by massive collective damage from what was going on in the Western financial system. That is why with my absolute return portfolio, I have been recommending investors from the middle of 2007 only to own my recommended portfolio, by hedging the Western financial risk by being short on western financial stocks. But in my view, the sell-off in Asian stocks last year was exacerbated by dramatic liquidation by foreign money particularly by hedge funds and so called fund of funds. What is being positive there in the rally began in Asia in October-November last year, is that we've seen growing local investor participation in Asian market, so the people who bought earlier in this rally since late last year weren't foreign fund managers but local investors throughout the region. That growing local investor participation is a long term positive.

Q: So are you saying that the secular bull market has commenced again in India and other Asian markets?

A: Yes, I think it has recommenced. It is two technical pieces of evidence that support that view. First, Asian markets and EMs have been leading this rally ever since they bottomed last October-November. Second, when the S&P made a new low in March, the Asian markets and EMs did not make a new low. That is technical evidence to me that Asian markets and EMs have become the asset class of choice in global equities. In the very short term because Asian markets and EMs have outperformed dramatically there is some short-term scope for the S&P to outperform. However, in the long run, in my view, the asset class of choice to remain fundamentally overweight is Asia and EMs. In my view, the biggest beneficiary of the dramatic monetary easing, quantitative easing undertaken by the Western central banks led by the Fed won’t be American/British consumers or American/British stock markets. The biggest beneficiaries will be Asia and EMs. In fact, the dramatic monetary easing could lead to massive asset bubbles in due course in Asia and EMs because the excess liquidity will flow to the best growth story and the best growth stories in the world are Asia and EMs. They have best demographic dynamics and have the healthiest economy because unlike the Western worlds, they do not have the structural leverage problems.

Q: Often, the measure of the restart of a bull market after a bear market is when the previous highs get taken out. How long is it before you think India and other Asian markets can take out their old bull market highs?

A: I don't assume that happens quickly, because I am bearish on the Western world. If I wasn't bearish on the Western world, then I would say very quickly, but I am. So in my view we are in a process here, we have commenced a process of incremental decoupling from Western markets. At the beginning of 2008, many investors in China and Indian equities believed in decoupling but by the end of 2008, after dramatic collapse in Asian stock markets after the Lehman bankruptcy, investors stopped believing in decoupling and started believing in the absolute opposite. The absolute opposite was a export-correlated train wreck with the US consumer. People became extremely negative on the most important EM story which was the not India but China. This year but the India and China economies have shown growth momentum; those very bearish concerns were misplaced. So we now have some empirical evidence that Chinese and Indian economies are able to decouple to a certain extent from the American economy, from the American consumer. The American economy is not growing, so that is building confidence in asset classes. We have begun the process of incremental decoupling. But I think unfortunately when the S&P turns down again when people realise that it is an L-shaped situation in the US, not an U-shaped or V-shaped recovery, you will get renewed correction. But my view is that next time the Western stock markets go down the Asian markets will prove much more resilient. But this process is incremental; it is not going to happen on a 12-month view.

Q: How bearish are you on the US markets?

A: I would expect a retest of 660 level in due course in the US if the equities correct and it coincides with the new dollar rally because the dollar rally is on deleveraging. But if the dollar keeps declining then the lows on the S&P need not be so large because some of the downside will be taken on the dollar.

Q: Even if the S&P were to go for a re-test you think none of the EMs, including India, will go for a test of their 2008 lows?

A: I don’t believe in a world where the S&P re-visits the lows of March. I don’t think the Asian equities markets, India will re-visit the lows because Indian economy has demonstrated its domestic demand driven resilience this year. We are now getting people talking of 5.5–6% growth, a few months back the RBI had come out with statements that growth was going to be much slower than expected and it said that growth was going to be 6%. Reality is at the beginning for this year, investors thought 6% was not attainable, but the data that has been coming out has been a positive surprise. The Indian economy is keeping its growth not by artificial stimulus measures by the government so basically the data has been a positive surprise this year and the government has been another positive surprise, which has been a clear mandate which should allow a more coherent policy which should allow for a renewed vigour in the infrastructure cycle now.

Q: How positive is the election?

A: I don’t want to over-dramatize it because of the Indian government history of disappointing on reform expectations. But I what I do think is positive is that most foreign investors who were on the sidelines before the election as they knew the situation is inherently unpredictable. So because of the clarity and because you don’t have a weak coalition government I think that was a major catalyst for foreigners to re-invest in India and logically the sector that should benefit is the infrastructure sector. The other point is that it has removed the risk that the fiscal deficit in India gets out of control.

Q: What are you overweight on in India, china and what sector in india?

A: I am overweight both on India and China but in the last quarter more India, because I was more overweight china in the first quarter. But in my long only portfolio, I am 33% in India and my biggest weight is in Indian banking though I did add a infra name after the election.

Q: Public sector units or private sector?

A: Both, but if I were making a new allocation it would be to a private sector bank.

Q: This trait to tanking up to defensives, you think that trend is over?

A: Tactically, Asian markets have had a big rally and people were fortunate in to be in the high beta names and they should be thinking of moving to less high beta names now, 70-80 on the oil price, you should reduce the beta names. But I would reduce in the commodity driven stocks, not banks.

Q: Do you find any discomfort with regard to valuations in India?

A: PEs look scary in India especially infra, but India is genuine domestic demand driven growth story. So it deserves a high PE premium, on a price to book basis, India looks undemanding. The whole risk in Asian valuations is in the potential negative correlation to the western world.

Chinese Are Fishing in Troubled Waters

In every crisis there are always opportunities.

And Chinese companies have made good use of this truism to snare iconic landmarks in the US amidst today's crisis.

Last night news wires reported that a Chinese company was reportedly buying into GM's Hummer lines...

Picture from New York Times

According to the New York Times (bold highlight mine), ``General Motors has reached a preliminary agreement for the sale of its Hummer brand of large sport utility vehicles and pickup trucks to a machinery company in western China with ambitions to become a carmaker.

``The buyer is the Sichuan Tengzhong Heavy Industrial Machinery Company, based in Chengdu, G.M. said Tuesday. The price was not disclosed, but industry analysts had estimated that the Hummer division would sell for less than $500 million.

``The deal, expected to close in the third quarter, would make Tengzhong the first Chinese company to sell vehicles in North America, though Hummer’s operations would remain in the United States.

``“The Hummer brand is synonymous with adventure, freedom and exhilaration, and we plan to continue that heritage by investing in the business, allowing Hummer to innovate and grow in exciting new ways under the leadership and continuity of its current management team,” Yang Yi, the chief executive of Tengzhong, said in a statement released by G.M. “We will be investing in the Hummer brand and its research and development capabilities, which will allow Hummer to better meet demand for new products such as more fuel-efficient vehicles in the U.S.”

``Hummer is one of four brands that G.M., which filed for bankruptcy protection Monday, plans to drop. The company also plans to close or sell Saturn and Saab later this year and to eliminate Pontiac in 2010. G.M. revealed Tuesday that it had 16 bidders for Saturn and three for Saab."

Last week, the NBA team Cleveland Cavaliers also sold a minority stake to Chinese investors.

Picture From New York Times

Again according to the New York Times (emphasis mine), ``The deal that may give a group of Chinese investors a minority stake in the Cleveland Cavaliers and its arena signals the first significant investment in a major American sports franchise by investors from China.

``The Cavaliers, who are led by LeBron James, the N.B.A.’s most valuable player this season and perhaps its biggest star, said they agreed over the weekend to sell a 15 percent stake in the franchise and its Quicken Loans Arena to the group, which is led by Kenny Huang, a Chinese-born investor who has also brokered marketing deals with the Yankees and the Houston Rockets, and a Hong Kong conglomerate.

``The deal must be approved by the league’s board of governors.

``If the sale is approved, it may be the most ambitious move yet in an American sports landscape full of leagues, teams and players striving for a foothold in the expansive and largely untapped Chinese marketplace. The N.B.A. has been aggressively expanding its presence in China with exhibition games and a joint venture that aims to develop a Chinese basketball league and professional arenas.

``Major League Baseball and the National Football League have also been seeking talent and business prospects in China. Nike and Adidas are doing the same. Prominent athletes like Kobe Bryant and Serena Williams have tried to capture part of the Chinese audience with endorsement deals.

``The N.B.A. is already enormously popular in China. N.B.A. games are telecast here and there are at least a half-dozen magazines devoted to the N.B.A. and its stars. Part of the popularity is attributed to the Rockets’ Yao Ming. Last summer, James and Yao appeared in an advertisement for Coke that ran on Chinese television during the Olympics. But other players, like the Los Angeles Lakers' Bryant, are just as popular among Chinese youngsters"

My comment:

Aside from US treasuries, here we see that the Chinese aren't just buying conventional companies, they are buying into hallmark American brands.

They are buying into America's pride and prestige.

And they are buying at the most opportune moment when Americans are direly in need of moolah.

In a classic Chinese military handbook depicting the 36 strategems of war, one of the recommended tactic to achieve superiority against the adversary is to employ maneuvers for confused situations or To Fish In Troubled Waters. These actions exemplify the execution of such maneuvers.

Nonetheless the Chinese has been steadily working to expand their influence overseas.

Chart from Heritage Foundation

Although, officially the Chinese government has done more political and economic deals with Africa and Arab compared to the rest, including East Asia.

But this could change-depending on the political winds.

3 Decades of Boom-Bust Cycles From The Greenspan Put

Professor Antony Mueller, in his blog, enumerates the litany of events which had been supported by the "Greenspan Put" or the monetary policy of lowering of interest rates to provide for liquidity injections in order to support asset markets.

This became a permanent feature in today's financial world and had been deeply embedded to the public's psyche almost similar to the conditioning effects of Pavlov's Dogs.

Unfortunately, unsustainable booms eventually transitions into nasty busts.

From Professor Mueller:

Bailout economics – three decades of monetary excesses

1987 Stock market crash
1988-90 Savings and Loan crisis
1990 Stock market “mini-crash”
1990-91 Gulf War I
1990-91 US mini-recession
1994 Mexican peso crisis
1997 Asian financial crisis
1998 Russian debt crisis
1998 Long-term Capital Management collapse
1999 Y2K liquidity crisis
2000 NASDAQ collapse (dot.com bubble)
2001 US recession
2001 9/11 terrorist attacks
2003 Gulf War II
2003-2004 Deflation scare
2005 Housing froth
2007 Beginning of housing crash
2007 Financial market “freeze”
2008 Stock market crash
2008 Year of the mega bailouts
2009 Financial crisis turns into economic crisis

In addition to Professor Mueller, the chart below is an illustration of the above (I forgot the source of this-my apologies)

And the boom bust cycle as aptly described by Roger Garrison is a constant of the Austrian Business Cycle Theory. Mr. Garrison explains (all highlights mine),

``The Austrian theory is not a theory of recessions per se; it is a theory of the unsustainable boom. As such, it has a much stronger link to the underlying microeconomics than does much of today's mainstream theorizing. The Austrians focus broadly on credit markets and ask what happens when the price of credit, i.e., the interest rate, is held below its market-clearing level. If interest rates were held too low by legislation (interest-rate caps), there would follow an immediate credit crunch. This "if-then" proposition is a direct analogue to the proposition that rent control causes a housing shortage and, more generally, that price ceilings cause quantities demanded to exceed quantities supplied.

``But what if the central bank papers over the shortage with newly created money? Would this way of bridging the gap between credit supplied and credit demanded transform the would-be credit crunch into sustainable economic growth? Hardly. It would simply insert a time delay between the "if" and the "then." In effect, the credit crunch is transformed into a boom and then a bust. The extent of the resource misallocations during the boom have a direct bearing on one aspect of the downturn. The necessary reallocations are roughly proportional to the prior misallocations. It is in this context that we can say, "the bigger the boom, the bigger the bust." But for both theoretical reasons and historical reasons, busts can and often do dwarf the preceding boom."

Bond Vigilantes Are Waiting At The Corner!

``Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession. The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.”- John Taylor Exploding debt threatens America

The Bonds Vigilantes are back! That’s according to the newswires and the opinion pages.

Bond vigilantes are supposedly a class of bond investors who serve as disciplinarians against government overspending. Sensing the perpetuation of profligacy, these market enforcers would sell sovereigns which would translate to rising interest rates and which effectively functions as a kibosh on the extravagancies of government.

The recent volatility in the long dated US treasuries markets (see figure 1) apparently breathed life on such market persona after more than two decades long of hibernation.

Figure 1: Bloomberg: UST 10 year yields (orange), Freddie Mac Mortgage Rates (green), Bankrate 30 year mortgages (yellow)

The recent surge in yields has prompted for concerns on the marketplace over the sustainability of stock market gains. Rising interest rates, as interpreted by the mainstream, may yet foil government measures to resuscitate the housing market and US consumers. As you will notice in the chart above, long dated treasuries often serve as benchmark to bank lending rates-so rising Treasury yields means higher mortgage rates.

But often doesn’t mean always. And with US government’s severe scale of marketplace interventions, mortgage rates and treasury yields departed earlier, as we noted in early May, see US Mortgage Rates versus Treasury Yields: Does Divergence Signal An Anomaly or A New Trend?

Yet the dynamics of the bond markets of the yesteryears haven’t been the same as today; foreigners have been pinpointed as the potential source of rising yields, through liquidations.

According to this report from Bloomberg, ``The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.”

Unfortunately, the classic definition of the bond vigilantes doesn’t hold true today, because rising long dated yields doesn’t automatically equate to investor selling YET see figure 2.

Figure 2: Yardeni.com: Foreign Buying of US Treasury Bills Have Surged!

As noted in last week’s $200 Per Barrel Oil, Here We Come!, the composition of the ownership of US treasuries held by foreigners, mostly by China, has dramatically shifted. In the face of declining foreign currency surpluses, foreigners have sold US agencies and reallocated their holdings mostly into short term bills.

This, we argued, has been primarily politically motivated. China doesn’t want to seen as ruffling the feathers of the US leadership and instead would like to be perceived as in “cooperation” and “collaboration” with them, despite expressing displeasure over the direction of present policies. This essentially places the responsibility of the repercussions from US policies entirely on US policymakers. So in contrast to bond vigilante actions of liquidations, foreigners have continued to buttress the US treasuries market, however yields continue to climb.

As example, Thursday’s US Treasury issuance of $26 billion in 7 year notes had been fully subscribed and this adds to the week’s total of $101 billion. While demand for the 7 year notes have been ample, ``the Treasury was forced to raise the yield by nearly 0.03 percentage points to entice buyers” reports the Associated Press.

In other words, rising yields hasn’t been due to foreign investor liquidations YET, but from oversupply or overissuance of US sovereigns relative to available capital, where the markets has been pricing a premium (through higher yields) for scarce capital to fund US government expenditures.

Nevertheless, events seem to be unfolding in an extremely fluid mode, such that we can’t count on the persistence of foreign support on US treasuries, especially if markets do turn disorderly.

Although the news report cited above, didn’t account for the category of buyers of the recently issued 7 year treasury notes, the US Federal Reserve can pose as the “buyer of last resort” as it can simply “monetize” debts through its digital or printing presses, since an “auction failure” can be highly disruptive to the financial markets, especially to the US dollar.

Bond Vigilantes Ahoy!

Nonetheless the bond vigilantes appear to have indeed surfaced in select US debt markets, concentrating on areas where governments have intervened to favor “political classes”. Here, comparable spreads have ostensibly widened between companies or industries affected by state intrusion relative to those without.

According to the Reuters (bold emphasis mine), ``To gauge whether those cases have made debtholders wary of other companies with so-called favored political classes, Garman compared spreads, or bonds' extra yields over U.S. Treasury yields, for companies with collective bargaining agreements with the high-yield bond market as a whole…

``Apart from automakers, sectors heavily influenced by collective bargaining agreements include supermarkets, construction, wired telecommunications, delivery and healthcare, Garman found. Gaming, select media and publishing companies and paper and textile companies also made his list.”

Uncertainty over the arbitrary selection of winners by the US government, the clash of objectives or priorities between management and government and the fickleness, changeability or instability of policies has translated to investor aversion or bond vigilantism.

Decoupling In Global Bond Markets?, Monetary Forces Gains Momentum

And as almost every government in the world have massively applied “stimulus” to their respective economies to provide for “cushion” from recession and to “jumpstart” economic growth, as discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, they will be competing with the private sector for access to funding in the capital markets which implies for “higher yields”.

Moreover, the capital markets will likely be the primary conduit for these fund raising activities as the banking system remains substantially dysfunctional, particularly in the bubble bust affected areas.

Evidences of such dynamics have begun to emerge, according to this Wall Street Journal report (all bold highlights mine),

``In the first quarter of the year, the value of corporate investment-grade bond issuance globally rocketed to $875.1 billion -- a 124% increase from the same period last year. That boom stands in sharp relief to a fall in the market for syndicated loans, in which a syndicate of banks makes a loan to a corporation, spreading the risk of the corporation's default between them.

``The value of banks' new corporate investment-grade lending fell 40% to $349.3 billion compared to the same period last year, according to financial data from Dealogic….

``There are two main reasons why loans from banks are stuttering: banks' available capital and banks' cost of funding. Both have made the interest terms that banks are offering corporations relatively high, making the bond market a preferable route to financing…

``Bank lending to the corporate sector has shrunk dramatically. In the nine months to December last year, global cross-border bank lending shrank almost $5 trillion -- the sharpest fall on record -- according to research out this month by the Bank for International Settlements.”

In other words, the current operating dynamics as seen in the US treasury markets will likely be applied elsewhere, but to a lesser degree on Emerging Markets and in Asia as the latter’s banking system have largely been unimpaired.

Proof?

The US bond market volatility in conjunction with a falling US dollar have prompted for a divergence or “decoupling” in bond activities see Figure 3.

Figure 3: stockcharts.com: Emerging Market-US Sovereigns “decouple”

The Morgan Stanley’s fund of investment in US treasuries as represented by the USGAX (red-black line), which according to Google, “normally invests at least 80% of net assets in U.S. government securities, which may include U.S. treasury bills, notes and bonds as well as securities issued by agencies and instrumentalities of the U.S. government” has been diverging with the JP Morgan’s benchmark for Emerging Debt JEMDX (black line) which according to Google invests in ``a portfolio of fixed-income securities of emerging-markets issuers. The fund normally invests at least 80% of assets in emerging-market debt investments. These emerging-market securities may be denominated in foreign currencies or the U.S. dollar.”

Last week, emerging market bonds posted their best week since 2002 (Bloomberg) in spite of the turmoil in the US sovereign markets as US bond yields rose to nearly a 6 year high (Bloomberg). If this isn’t decoupling, I don’t know what is.

Yet the falling US dollar (USD- lower window in the chart) has easily been made as a scapegoat for the actions in the volatility in the US treasury markets. The simplified explanation is this- a weaker US dollar extrapolates to higher value of emerging market currencies, ergo high bond prices for Emerging Market Bonds.

But this dynamic hasn’t been in place when the US dollar index fell from its peak in 2002 until its trough in early 2008!

In other words, the languid performance of US dollar index and the divergences in emerging markets sovereign relative to the US sovereign hasn’t likely been the underlying cause and effect. Instead, we suggest that it has been monetary forces that has accounted for as the principal driver of this rapidly evolving phenomenon-globally.

In short, monetary inflation has been getting a far bigger pie of the activities in the financial markets as well as in the real economy.

All told, as capital markets takes on a bigger role in the distribution of limited capital over banking system, in the choice of either funding government expenditures or private investment, the resurgent function of bond vigilantism will likely be accentuated as time goes by.