Myth of War as Political and Economic Solution

Some people here or abroad seem to be agitating for war.

In the Philippines, recent unfortunate incidents over at the Spratlys Islands have prompted some officials to call for increased military spending as countermeasure against alleged provocations by foreign marauders.

As earlier pointed out, suggestions of an ‘arms race’ are foolish because they are not only economically unfeasible but political brinkmanship risks escalation which might lead to undesired consequences that may be baneful for both parties. In addition war spending robs the local economy of productivity and resources which leads to poverty.

Since the Philippines have an existing Mutual Defense treaty with the US, which other nations recognize, then perhaps current incursions by China represents a test of this relationship or has been merely been flexing her brawn in order to flaunt her new hardwares of destruction.

Besides, China’s actions have not shown aggressiveness elsewhere, and to the contrary, has been more investment oriented.

This is unless China’s military and incumbent political leaders have different agendas.

In the US, experts like Dr. Paul Krugman seem to be arguing for increased war spending to bolster the economy. Professor William Anderson quotes Krugman

“If we had the threat of war, had a military buildup, you’d be amazed at how fast this economy would recover.”

For people who view the world in the context of dollar and cents, then this view would seem plausible.

Yet as rightly pointed out by Professor Anderson the US has been waging war on different fronts,

I'm not sure what we call Iraq, Afghanistan, Libya, and wherever else the U.S. Armed Forces are shooting people. I think I call it war, and we can see just how good it has been not only for our economy, but also the economies of the lands this government has attacked.

From Google’s Public Data

From Cato.org

In relative terms, the US has the largest share of military spending in the world and has continuously outspent the world. And this has been growing trend since 2000 (obviously post 9/11).

So has increased war spending or other forms of government spending been boosting the US economy? Unfortunately not.

From Dan Mitchell

War as a demand booster is a myth.

Henry Hazlitt in his must read classic Economics in One Lesson debunked this fallacious dollar and cents view based on ‘aggregates’.

The great Mr. Hazlitt, (italics original)

Now there is a half-truth in the "backed-up" demand fallacy, just as there was in the broken-window fallacy. The broken window did make more business for the glazier. The destruction of war will make more business for the producers of certain things. The destruction of houses and cities will make more business for the building and construction industries. The inability to produce automobiles, radios, and refrigerators during the war will bring about a cumulative post-war demand for those particular products.

To most people this will seem like an increase in total demand, as it may well be in terms of dollars of lower purchasing power. But what really takes place is a diversion of demand to these particular products from others

In wars, it is not just the diversion of resources from productive to consumptive activities, which brings about a lower standard of living, but the intangible costs from losses of human lives (capital)! Death from war or disasters or any form of destruction cannot serve as economic boosters.

Those who argue for war do so either because they know someone else will do the dying for them or have not envisioned of the brutalities of a real war.

Maybe this is part of what historian Arnold Toynbee calls as the “Generational Cycle in the transmission of a social heritage”.

Dr. Marc Faber quotes Toynbee,

The survivors of a generation that has been of military age during a bout of war will be shy, for the rest of their lives, of bringing a repetition of this tragic experience either upon themselves or upon their children, and... therefore the psychological resistance of any move towards the breaking of a peace ....is likely to be prohibitively strong until a new generation.... has had the time to grow up and to come into power. On the same showing, a bout of war, once precipitated, is likely to persist until the peace-bred generation that has been lightheartedly run into war has been replaced, in its turn, by a war-worn generation'

In short, the lack of exposure to war whets the desire for war.

Here is a suggestion: Dr. Krugman and all his ilk and his followers (including Filipino politicians and their adherents), who yearn for war for whatever reasons, should go to the front line, instead of getting ensconced in the proverbial ‘ivory towers’, and bring their family along with them.

If you want war, go fight them yourself!

Perma Bears Declare: Expect QE 3.0

Popular Perma Bears of different persuasions have jointly declared “QE3 is gonna happen!”

I am no perma bear, but a realist. Although this time I’m on their camp with regards to the prospects of QE 3.0. [pardon me for this seeming appeal to authority, my point is to show that even different ideologies or perspectives can come up with same conclusions]

From the Wall Street Journal, (bold emphasis original)

How’d you spend your weekend? Some of the biggest (and most bearish) guns in economic and market prognostication put their heads together at a small confab on Lake Winnipesaukee in New Hampshire this past weekend. In attendance: David Blanchflower, formerly of the Monetary Policy Committee of the Bank of England; Swiss doom-and-gloomer Marc Faber; Fred Hickey, the bearish editor of the High-Tech Strategist newsletter; Morgan Stanley exec Stephen Roach; and economic forecasters David Rosenberg, Nouriel Roubini and Gary Shilling.

Their conclusion: QE3 is gonna happen! Ed Yardeni, who was there, had this little insider snippet for readers of his daily newsletter (emphasis is MarketBeat’s):

“The conversations were spirited with lots of debates. The consensus was quite pessimistic about the outlook for the US and global economies.

“Everyone seemed to agree that the Fed would most likely leave the federal funds rate at zero for a long time and that a third round of quantitative easing is likely later this year. David Blanchflower, who is a former member of the MPC of the BoE, is in favor of QE-3.0. The rest of us were against it. Most agreed that it would probably boost stock and commodity prices again, though not as much as QE-2.0.

Not that I like it, I think QE is wrong and immoral.

But that’s the way the US political economy has been structured, and that’s how events will likely play out. As earlier pointed out, it’s not just the US but every developed nation’s political leader’s guiding principle or path dependency to policymaking.

The role of the prudent investor is to take advantage of this silliness. As investment guru Doug Casey writes of government interventions,

All such distortions have consequences, and one of them is to create opportunities for speculators.

Correlation isn’t Causation: Commodity Prices and Interest Rates

Correlations interpreted as causation.

This represents one of the most dangerous premises in making predictions.

An article in the Bloomberg suggests that the low interest rate environment may continue to fuel a rally in commodity prices.

From Bloomberg,

Commodities will resume a rally after their worst month in a year as the Federal Reserve keeps its benchmark interest rate at a record low following the end of a $600 billion asset-purchase program, said HSBC Holdings Plc.

The Standard & Poor’s GSCI Total Return Index of 24 commodities tumbled 6.9 percent last month, the first loss since August and the biggest drop in a year on concern growth may slow. The gauge rose 16 percent this year through April after rising 9 percent in 2010 and 13 percent in 2009 as output trailed demand.

Fed Chairman Ben S. Bernanke has indicated the bank won’t remove stimulus immediately after the second round of so-called quantitative easing concludes this month. The central bank will hold its policy rate in a range of zero to 0.25 percent until the year-end, a Bloomberg survey of 72 economists showed.

The CHART OF THE DAY tracks the S&P GSCI Total Return Index and the Federal Reserve’s target rates in the past three decades. Commodities typically move counter to borrowing costs and the GSCI index has advanced 33 percent since the end of December 2008, the month the Fed cut its benchmark rate amid recession.

Though I would agree that commodity prices could rally, partly coincidental to an artificially suppressed interest rates climate over the interim, I’d say that such correlation does not always hold.

Again reference point matters.

The framing of the Bloomberg chart begins in the 1980s and spans through 2010. This is the epoch of globalization.

However, prior to 80s, as the above chart from economagic.com shows, the correlation was much about rising commodity prices (CRB-Reuters-blue) along with rising interest rates (Fed Funds rate-red, 10 year Treasury yield-green), i.e. 1960s until 1980.

That’s because this era marked the ‘guns and butter’ policies of the US (Vietnam War and entitlement programs as Medicare and easy money policies of the US Federal Reserve).

In other words, this period characterized the economic environment known as stagflation (high inflation, high unemployment-which wasn’t incorporated in the traditional Keynesian model).

Bottom line: Correlations of variables highly depends on the underlying forces which drives them. Occasionally, some correlations reflect on the causal nexus, but for most instances they don't.

In my view, the current level of interest rates reflects on the du jour actions of monetary policies. And this seemingly benign trend may radically change, which subsequently, could upset the balance of the low interest rate-high commodity price correlation premise.

Spratlys Dispute: Why AFP’s Plan to Build Up Military Signifies War on the Filipinos

Governments always look for an excuse to expand power. And General Douglas MacArthur was right, government always try to keep “us in a continuous stampede of patriotic fervor -with the cry of grave national emergency” by conjuring “terrible evil at home, or some monstrous foreign power that was going to gobble us up if we did not blindly rally behind it”

The geopolitical tensions over Spratlys Island have prompted the Philippine government to shop for arms, according to yesterday’s news.

From the Philippine Daily Inquirer,

Amid increasing concern over renewed tensions in the South China Sea, the Philippine Embassy here is shopping for excess defense equipment from the United States under Washington’s Foreign Military Sales (FMS) program.

Jose L. Cuisia Jr., the Philippine ambassador to the US, said he has asked the Department of National Defense and Armed Forces back home to provide him with a wish list of military equipment they will need to shore up the country’s defense capability.

He said he expected the defense department to “prioritize” its modernization goals, but was careful not to explicitly link the purchase of US excess defense articles to the Philippine military’s job of securing the territorial sovereignty of the country in the face of China’s alleged intrusions into the areas of the disputed Spratlys group claimed by the Philippines

The idea that the Philippines can resolve the current dispute with China over an ‘arms race’ or by brinkmanship is not only unfeasible and anachronistic but outright ridiculous.

Unfeasible because in almost every aspect, the Armed Forces of the Philippines cannot measure up to China’s People Liberation Army in terms of numbers and in technology.

In addition, China is by far wealthier (in terms of GDP per capital) than the Philippines and thus can afford to spend more for her military services. [Google Public Domain]

Chart from Tradingeconomics.com

Considering that China has unveiled its newest stealth warplane and aircraft carrier, it would seem that no amount of nonsensical ‘arms race’ will prevent a ‘determined’ China from encroaching on Spratlys.

But this isn’t to say that China will do so.

I say anachronism too because military engagement has not been the du jour foreign policy for China.

Had she assimilated an imperialist path, Taiwan, which China claims as part of her territorial sovereignty, would have been invaded. And so with the Japanese held Senkaku Islands, which China has claims too along with the Spratlys. A similar political friction arose in Senkaku Island in 2010 following a collision between Japan’s Patrol boats and a Chinese trawler.

Yet China’s geopolitical strategy has been to expand trade and investments around the world.

Derek Scissors of Forbes magazine writes,

China's hefty investments in sub-Saharan Africa have received deserved attention, but its investment in Latin America has been overblown by some. One reason is a common event in bilateral commercial transactions--grand announcements that never come to fruition. In mid-April Venezuela proclaimed a $20 billion oil-for-loans deal with China, but Caracas' track record in this area encourages skepticism. China has little investment in the Arab world, which is perhaps surprising in light of its focus on energy, but it has sizable engineering and construction contracts there. Australia, at $30 billion, is the single biggest draw for Chinese investment. The U.S. is second at $21 billion, Iran third at $11 billion.

The places where the Chinese have invested most often are also the places where their investments have been most often thwarted: Australia, the U.S. and Iran, in that order. Failures stem from a variety of causes, such as nationalist reactions in host countries, objections by Chinese regulators and mistakes by the Chinese firms themselves. According to the Heritage tracker, the value of failed investments from 2005 to 2009 is a staggering $130 billion. Chinese investment could have been a full 40% larger than it was had the failed deals closed.

So the more appropriate action to resolve any territorial dispute should be to actively increase trade with China.

As Frederic Bastiat once said,

When goods don't cross borders, armies will

Greater trade will likely ensure an amicable or diplomatic settlement because both China and the Philippines would like to see a continuity of this mutually beneficial relationship.

And this goes back to the reason why the call for more military spending represents a war against the citizenry.

As the great Ludwig von Mises wrote,

The adequate method of providing the funds the government needs for war is, of course, taxation. Part of the funds may also be provided by borrowing from the public, the citizens. But if the Treasury increases the amount of money in circulation or borrows from the commercial banks, it inflates. Inflation can do the job for a limited time. But it is the most expensive method of financing a war; it is socially disruptive and should be avoided.

More military spending means higher taxes and risks of higher inflation. It also means redistribution of wealth from the ‘productive’ private sector to government appointed intermediaries and suppliers or non-productive capital consuming activities.

Doing so leads to lower economic growth, higher unemployment, lower investments, higher risk premium and a lower standard of living. Also this amplifies the risks of corruption.

In addition a military build-up could also extrapolate to using newly acquired weapons against the citizenry to suppress political dissent or for repression or to expand in the engagement of military conflict with local subversives.

So instead of seeking diplomatic solutions, the likely path is to have more turmoil which heightens political instability which should further weaken the economy. It's another lesson we never seem to learn.

War on Commodities: UN Endorses Price Controls

UN endorses more price controls on commodities

Reports the Bloomberg,

Commodity markets need international oversight, more transparency and intervention to deflate bubbles because increasing speculation means prices are no longer driven by supply and demand, the United Nations said.

Increased investment in commodity markets has encouraged “herding behavior” and creates bubbles, the UN’s Conference on Trade and Development said in a report published today. Anticipation of the global economic recovery played a “disproportionate role” in higher commodity prices, it said.

“Prices can move far from levels justified by the fundamentals for extended periods, leading to an increasing risk of price bubbles,” the UN said in the report. “Due to these distortions, commodity prices do not always provide correct signals about the relative scarcity of commodities.”

By how exactly does the UN determine “prices are no longer driven by supply and demand”? Their math models?

It’s an irony because earlier they had been warning about a US dollar collapse

From the IBTimes FX

Rob Vos, a senior UN economist involved with the report, said if emerging markets "massively start selling off dollars, then you can have this risk of a slide in the dollar."

Are they assuming that “selling off dollars” and “prices are no longer driven by supply and demand” are not at all connected?

Put differently, that there is absolutely no connection between debasing one’s currency and rising prices?

Maybe Zimbabwe did not experience a socio-economic depression from hyperinflation (2004-2009).

Instead Zimbabwe could have suffered from the herding effects of speculators. Speculators cratered the Zimbabwe dollar and caused consumer prices to double every day

Such is UN's prism of economics.

In the real world, rising commodity prices in response to government’s continued debasing of a currency is a symptom known as the “Flight to Real Values”.

From Mises.org

The frantic rush to spend all monetary savings and other available cash, buying goods, whether needed or not, in order to avoid holding, even for a short time, any rapidly depreciating monetary units. This occurs at that point in the development of inflation when the public is convinced that prices will continue to rise endlessly and at an accelerated pace. The flight into goods or real values is also known as a "Crack-up boom" (q.v.) and marks the complete breakdown of a monetary system.

The UN can only pretend. But they will not succeed in controlling prices if they do not treat the root of the problem—government’s inflationism.

As Ludwig von Mises warned in Planning for Freedom

those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation-the rise in prices-are masquerading their endeavors as a fight against inflation. While fighting the symptoms, they pretend to fight the root causes of the evil. And because they do not comprehend the causal relation-between the increase in money in circulation and credit expansion on the one hand and the rise in prices on the other, they practically make things worse.

Poker Bluff: No Quantitative Easing 3.0?

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of the fiduciary medium must necessarily lead to its breakdown. Once common principles for their circulation-credit policy are agreed to by the different credit-issuing banks, or once the multiplicity of credit-issuing banks is replaced by a single world bank, there will no longer be any limit to the issue of fiduciary media.-Ludwig von Mises

The US Federal Reserve’s Quantitative Easing programs will be terminated at the end of this month and some have suggested that this program will be discontinued for good.

I’ll say they’re dead wrong.

Same Old Song

I have heard this music before. In late 2009 going into 2010, as the markets recovered the mainstream blabbered about “exit strategies”.

I called this Bernanke’s poker bluff[1].

Bottom line: Interest Rate Derivatives, Expanding GSE Operations, Economic Ideology Record Debt Issuance, Rollover and Interest Payments, Devaluation as an unofficial policy, Political Influences On Policy Making and the Question Of Having To Conduct Successful Policy Withdrawals all poses as huge factors or incentives that would drive any material changes in the Federal Reserve and or the US government policies.

In knowing the above, I wouldn’t dare call on their bluffs.

In November or 10 months later, Bernanke’s Fed unraveled the QE 2.0[2].

Have any of the above variables changed for the better?

The short answer is NO.

All of the above factors seem in play and some may have turned for the worst.

One, while growth of derivatives (see right window) have slowed they remain sizeable. Importantly growth in interest rate contracts has reached pre-crisis highs.

Reports the Economist[3],

Interest-rate contracts, which make up the bulk of the market, reached $465 trillion in December 2010, exceeding their pre-financial-crisis level. While notional amounts are one measure of market size, the BIS says that gross market values, which measure the cost of replacing all existing contracts, more accurately assess the amounts that are actually at risk. The gross market values fell by 13% in the six months to December 2010, to $24.5 trillion.

So even if growth in gross market values of derivatives has been slightly reduced, an environment of higher interest rates will still risk unsettling the derivatives markets for its sheer size and complexity. That’s the reason why investment guru Mark Mobius currently warned that derivatives may trigger the next financial crisis[4]. For me, derivatives as shown by the sensitivity to interest rates movements represent a symptom rather than the cause.

Second, the average maturity holdings of US treasuries has declined to all time lows, which according to Zero Hedge’s Tyler Durden, just hit 62 months[5] (see left window)

This only means that aside from financing the current fiscal record[6] deficits, the shorter maturities adds to the financial burdens of rolling over of some of these old debts. In short, the US treasury will deal with new debts as well as old ones.

Yet considering that the foreign official sector represents as the only parties (aside from the Fed) that have significant control on the supply holdings of US treasuries to materially influence prices, their recent actions does not indicate continued support to finance of US spending programs.

Foreign buying of US treasuries have been on a decline based on yearly change basis and as % of overall ownership (chart from yardeni.com[7]).

Faced with the risk of bond auction failure, the US government will likely try to avert this or get some insurance by having another round of QE.

Proof of this, as I presented last week, exhibits that nearly 100%[8] of US treasury issuance has been presently financed by the US Federal Reserve.

Morgan Stanley’s David Greenlaw estimates FED buying has accounted for 88% during the first quarter of 2011[9]. He also mentions that QE 1 reduced interest rates by 50 basis points on longer maturity securities, according to a Fed study which has on their calculation.

There seems to be a deepening relationship of dependency taking hold. And this certainly is not an auspicious sign.

The private sector as I earlier mentioned have accounted for as a marginal buyer. In addition, new regulations have financially repressed these institutions which compels them to finance (or acquire) government debts to comply with capital adequacy ratios that would meet with the Basel standards[10].

The record debt levels should also mean higher interest rate payments which should place additional burden on the economy.

Thus, the existence of the central bank has been to manipulate rates to benefit the government, aside from the banking sector, which intermediates such financing in behalf of the government.

More Rationalization and Signaling channel

Of course, I have also pointed out that the US housing appears to have regressed to a recession[11]

And all these are being vented on the equity prices of banking and financial sector.

As the US property sector staggers, such dynamic impairs or adds pressures to the values of the banking system’s balance sheets. The S&P Bank Index (BIX), the Dow Jones Mortgage Finance Index (DJUSMF), S&P 500 Financials (SPF) and the (XLF) Financial Select Sector have all been rolling over.

To say that NO quantitative easing would be in the pipeline would either mean an apostasy in economic ideology or the recognition of the mistakes from the past policies.

This also means disregarding the trillions thrown to support the banking sector during the last crisis (Neil Barofsky, special inspector general for the Treasury’s Troubled Asset Relief Program says $23.7 trillion[12] or CNN says $11 trillion committed and $3 trillion invested[13])

The fact that the Fed has been obstinately denying the causal linkages between QE and the commodity price increases coupled with patent serial interventions in the commodity marketplace by private regulators (most likely from indirect political pressures applied) via continuous increases in credit margins further suggests that part of the pre-deployment of QE 3.0 has been to condition or rationalize to the public of its necessity[14].

That’s hardly signs of conversion.

Furthermore, political authorities have been addicted to inflationism, which I have argued as signifying economic ideology and path dependency. This seems not only confined to the Fed but likewise to every major governments around the world.

Proof of this is the second round of bailouts being worked out for Greece[15].

And perhaps in anticipation of this cyclical slowdown, China has been in the process of threshing out a new massive bailout scheme[16] for local governments and their banking system, as well as, partially implementing new stimulus measures aimed at boosting the economy with large scale low cost housing projects[17]. Combined, these two grand projects could even surpass in scale, the 2008-9 $586 billion stimulus[18].

Adding to such bailout fad has been Russia and IMF’s rescue of Belarus[19] which appears to be on the brink of hyperinflation[20].

To top it all, the current signs of weakness in the US[21] or in China[22] or in the Eurozone[23] appear to be changing market’s sentiment everywhere.

Like addicts to illegal substance, even a local (Philippine) broadsheet carried a foreign report which appears to be subtly arguing for the rational of QE 3.0[24].

Meanwhile even the commodity marketplace, which has been under duress from the recent spate of interventions, doesn’t seem to be suggesting of the end of QE.

Gold continues to swiftly recover lost ground, while silver appears to be consolidating. The Reuters CRB (CCI[25] is an equal weighted index representing 17 commodities) seems to chime with gold but to a lesser degree. Importantly, natural gas which has been the perpetual laggard among the commodity spectrum seems likewise in an ascendant mode.

Gold Says QE 3.0

Rallying gold prices are not emblematic of desistance of QE, but rather a continuity of currency debasement activities conducted by global governments especially by the country which holds the principal privilege of seignorage—the US dollar.

We are not in a gold standard. While gold has shown incredible improvement in its reception as part of the financial system, where gold has recently been reckoned as collateral eligible[26], it is not money yet. Not yet anyway. We don’t use gold in payment and in settlement transactions.

Having said so, a disinflationary environment from a cessation of QE will lead to its price decline. Since markets operate as information discounting mechanism, then gold prices should not be rallying.

This will even be more pronounced if debt deflation does occur. Gold is unlikely a debt deflation hedge[27] as demand for cash would vastly increase under such conditions. Such dynamic was clearly evident in 2008[28] until the US Federal Reserve began its QE operations.

I’d further add that surging natural gas prices would imply as the deepening of inflation cycle. As I wrote in November 2010[29]

I’d be convinced of the deepening risks of the inflation cycle, when Natural Gas chimes in. So far, this hasn’t been so.

Well, the bull market in natural gas prices could have just begun.

It’s important to point out that many people, as the great Ludwig von Mises said[30],

think that there are higher and more important aims of economic policy than a sound monetary system. They hold that although inflation may be a great evil, yet it is not the greatest evil, and that the state might under certain circumstances find itself in a position where it would do well to oppose greater evils with the lesser evil of inflation. When the defense of the fatherland against enemies, or the rescue of the hungry from starvation is at stake, then, it is said, let the currency go to ruin whatever the cost.

This has also been manifested by the mainstream doctrine, which mistakenly believes that currency devaluation signify as an important tool to solve the economic problems. QEs has, thereby, worked as part of this measure to devalue the US dollar for purported economic ends.

Thus, the current lust for inflation signifies as a severe misunderstanding of the economic phenomenon which the mainstream mistakenly sees politics as a facile means to attain an economic end, from which usually backfires.

One should not also forget that in the US, policymakers are biased towards rising stock markets which for them serves as the trickle down multiplier from the “wealth effect” that works to boost spending and likewise triggers the “animal spirits” of the marketplace.

Thus the US stock markets constitute part of the coverage of the Fed’s policies[31]. To end the QE would extrapolate to the end of the support on the confidence transmission mechanism and to severe what they see as an important wealth effect multiplier.

Bottom line: NONE of the premises I wrote about in 2010, where I accurately predicted QE 2.0, has improved or has been resolved. In some instances they have worsened.

Thus for many reasons, especially applied to the US—the risk of bond auction failure, risk of imploding derivatives from higher interest rates, debt rollover risks and higher interest payments on sovereign liabilities, the implied policy of devaluation, risks of deterioration of the balance sheets of the major banking institutions, dogged refusal to instill fiscal discipline, ideological leanings and the path dependency of central bankers, risks of a downturn in the stock markets, rallying gold prices—all of which are strongly suggestive that there will be QE 3.0, 4.0, 5.0 until the nth.

It would take another monumental catastrophic crisis or a major transformation of people’s belief to embrace sound money and eschew the principle of inflationism for such policies to end.

And this won’t be happening anytime soon.

Lastly never trust government’s words, they always seem mellifluous but are usually laced.

---

[1] See Poker Bluff: The Exit Strategy Theme For 2010, January 11, 2010

[2] CNN Money QE2: Fed pulls the trigger, November 3, 2010

[3] Economist.com Global OTC derivatives, May 31, 2011

[4] See Will Derivatives Cause the Next Financial Crisis? May 31, 2011

[5] Durden, Tyler Fed Balance Sheet And Monetary Base Update - New Records All Around, Zero Hedge, June 2, 2011

[6] Financial Times, Record US budget deficit projected, January 26, 2011

[7] Yardeni.com, US Government Finance

[8] See How External Forces Influence Activities of the Phisix, May 29, 2011

[9] Greenlaw David Who Will Be the Marginal Buyer of Treasuries Post-QE2?, Morgan Stanley June 2, 2011

[10] See Financial Repression Drives The Bond Markets, May 23, 2011

[11] See How could the Euro be so strong? June 1, 2011

[12] See $23.7 Trillion Worth Of Bailouts?, July 29, 2010

[13] CNNMoney.com CNNMoney.com's bailout tracker

[14] See War on Commodities: Intervention Phase Worsens and Spreads With More Credit Margin Hikes!, May 14, 2011

[15] See Serial Bailouts For Greece (and for PIIGS), June 4, 2011

[16] See China Prepares For Massive Bailout!, June 1, 2011

[17] See China’s Bubble Cycle Deepens with More Grand Inflation Based Projects, June 2, 2011

[18] Wikipedia.org Chinese economic stimulus program

[19] Bloomberg.com Belarus to Receive $3 Billion Russian-Led Loan, Kudrin Says (1), June 4, 2011

[20] See A Crack-up Boom in Belarus, May 26, 2011

[21] Businessinsider.com United States: Brace For The Slowdown, June 1, 2011

[22] Wall Street Journal, China Shares End At 4-Month Low; Slowdown Concerns Dominate, June 2, 2011

[23] Reuters.com GLOBAL ECONOMY-Asia's factories feel the chill as U.S., Europe cool, June 1, 2011

[24] Businessworldonline.com US Federal Reserve mulling third QE?, June 2, 2011

[25] Wikipedia.org Continuous Commodity Index (CCI)

[26] See Two Ways to Interpret Gold’s Acceptance as Collateral to the Global Financial Community, May 27, 2011

[27] See Gold Unlikely A Deflation Hedge, June 28, 2010

[28] See Gold Fundamentals Remain Positive, January 31, 2011

[29] See Oil Markets: Inflation is Dead, Long Live Inflation, November 4, 2010

[30] Mises, Ludwig von Monetary Policy Defined, Part 2 Chapter 13 The Theory of Money and Credit, Mises.org

[31] See The US Stock Markets As Target of US Federal Reserve Policies, May 12, 2011

ASEAN’s Equity Divergence, Foreign Fund Flows and Politically Driven Markets

Trading is a psychological game. Most people think that they’re playing against the market, but the market doesn’t care. You’re really playing against yourself. You have to stop trying to will things to happen in order to prove that you’re right. Listen only to what the market is telling you now. Forget what you thought it was telling you five minutes ago. The sole objective of trading is not to prove you’re right, but to hear the cash register ring. Martin Schwartz

Divergence.

The week had been marked by divergences, where the ASEAN equity bellwether appears to have defied the performances of her contemporaries around the world.

The FTSE-ASEAN[1] (AWASEAN, yellow) scaled higher as the region’s index MSCI AC ASIA Pacific[2] (MXAP, red), the S & P Euro[3] (SPEURO, green) and the US S & P 500 seem to have rolled over on a year to date basis.

One would further note that except for the Eurozone, Asia, ASEAN and the S&P 500 came off from their recent highs.

It is an important reminder that any divergences should not be interpreted as representative of decoupling. Signs of decoupling will be manifested once the next crisis emerges. Yet given the depth or scale of today’s globalization or social interconnectedness which has not been limited to trade, labor, capital flows or to even monetary policies, I strongly doubt that this should transpire.

In addition I pointed out the commodities have been rallying in the face of an enfeebled global equity markets. We seem to be seeing some rotation from financial assets towards the commodity sphere as markets await political developments abroad.

And another significant point to consider is that given the variance in the political economic construct of each nation, the global transmission of credit easing policies and artificially suppressed interest rates everywhere would have different impacts on different asset classes.

Nations that had been least affected by the last bubble bust should outperform. And this perhaps explains the ASEAN divergence.

Yet this has been an important theme for us for the longest time.

Transmission Mechanisms from Policies Abroad

I have been saying that policies abroad are being transmitted to the Peso and the Phisix.

Interest rate spreads, devaluation policies, real economic growth rate differentials, degree of economic freedom and political, regulatory and tax costs and risks among the many other variables serve as major inducements to foreign money flows into the emerging markets.

Under current conditions, emerging markets are expected to receive fund flows to the tune of slightly $1 trillion for 2011.

Reports the Bloomberg[4],

Net private capital inflows to emerging market economies will keep growing this year and next to reach $1.1 trillion in 2012, attracted by economic growth above 6 percent in those countries, a banking industry group said.

The Washington-based Institute of International Finance today also raised its estimates for 2011 inflows by $81 billion to $1 trillion to reflect higher forecasts for Brazil and China. That more than offset lower flows to the Middle East and North Africa as a result of political turmoil there.

“The strength of capital flows is still presenting policy challenges in a number of emerging economies, especially those already facing pressures from rising inflation, strong credit and asset price growth and rising exchange rates,” the IIF wrote in its research note. Monetary policy in these countries is “generally too accommodative, in large part because policy makers are so focused on limiting capital inflows.”

Countries from Indonesia to South Africa are striving to manage inflows of overseas capital that put upward pressure on their currencies, making exports less competitive, and threaten to inflate asset-price bubbles. Nations including China and South Korea have argued that U.S. monetary easing has added to cross-border money flows in pursuit of higher returns.

The accompanying chart is from the IIF[5]

The Philippines is part of the EM rubric, thus should be one of the recipients of these fund flows.

Foreign trade has supported the current recovery, from the November 2010 consolidation or the profit taking phase, in the Philippine Stock Exchange.

Net foreign inflows, as of the end of May, tallied 14.3 billion php [US $324.127 million]. This accounted for about 40% of daily trade. Above chart shows of the weekly trend.

The big drop in foreign trade during the other week had been due to 2 special block sales in Meralco [PSE: MER] and San Miguel [PSE:SMC].

There is a strong correlation between foreign flows and the Peso. The vertical line from the Peso chart partitions the year-to-date performance.

The foreign volume inflow spikes in April and May appear to be reflected on the Peso (see two red arrows) with two concomitant surges over the same period.

Meanwhile the recent outflows seen from the special block sales have coincided with the recent price sluggishness of the Peso.

So even at 40% share of daily trades, foreign flows account for as a major determinant to the price activities in the Phisix and importantly the Peso.

And as I have long been saying the correlation between the Peso and other popular metrics as remittance or exports have been tenuous[6].

Foreign flows are representative of the degree of demand for a currency.

Hence, currency traders must take heed of the activities in the PSE as part of their studies from which to derive their predictions

Another aspect is that the above estimates made by the IIF, I think, largely depends on current conditions which seem to presuppose the QE in play.

Thus a furtherance of the QE should translate to more capital flows into emerging markets including the Philippines. This means buoyant stocks and a stronger peso.

QE’s basically connect the Emerging Markets by transmitting bubble conditions. Some countries appear to be aware of this, as the Bloomberg report says, “China and South Korea have argued that U.S. monetary easing has added to cross-border money flows in pursuit of higher returns”

So while some reads this as somewhat positive, this represents a bubble process at work. Boom days will be met by a greater bust. The success of a prudent investor would be how one negotiates the boom bust cycle.

Rotational Process Continues, Politics as Main Driver

Rotational activities continue to dominate the activities within the Philippine Stock Exchange.

The industrials spearheaded the gains of the Phisix. This was largely due to the upsurge in Meralco (6.35%) [PSE: MER], Energy Development Corporation (4.09%) [PSE: EDC] and San Miguel Corp (6.27%) [PSE: SMC].

The financial industry, which I earlier said could be a candidate likely to help buoy the Phisix[7], has taken the second place. Meanwhile the mining sector continues to bedazzle with the 10^th consecutive week of advances which has been defying my expectations[8]. In a bullmarket, overbought conditions can remain extended.

The Phisix continues to consolidate amidst signs of emerging weakness in the global markets. It is unclear if such divergences will hold or persist.

Although for as long as there would be no recession in the horizon, and where monetary conditions remain easy or accommodative as today, such variability in price actions remains a possibility.

True, there have been signs of economic slowdown in many parts of the world, but a downshift does not mechanically imply a collapse or a recession.

Seasonality can also be a factor. But this factor would come into play if other forces are restrained.

Yet barring any black swan or high sigma events, I don’t foresee any signs of an impending recession yet. So, over the short term, the Phisix or even global equity markets may just vacillate and look for direction.

Finally my expectations have largely been shaped by the prospective political actions by the political leadership, particularly by the US Federal Reserve on extending the QE program which is slated to end this month.

Although I expect that this extension won’t come automatically which I see as either tied to the US Congressional vote to raise debt limits or in reaction to growing pessimism in the some of the world’s economic environment due to a cyclical slowdown or to the accrued effects of signaling channels applied by governments or from mainstream’s addiction to inflationism. Besides if the debt ceiling will be raised this gives further excuse for the FED to activate QE 3.0.

However as clearly outlined, politics largely determines the outcome of the marketplace.

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[1] Bloomberg.com The FTSE Asean Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid capitalization universe for Developed and Emerging Market (Advanced Emerging and Secondary Emerging) segments. Base Value 100 as at December 31, 1986.

[2] Bloomberg.com The MSCI AC Asia Pacific Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1987.

[3] Bloomberg.com The S&P Europe 350 Index is a free float market cap weighted index that measuresthe performance of equities in 17 Pan-European markets, covering approximately 70% of the total market cap. It offers an effective balance between broad market representation and liquidity. The S&P Europe 350 is part of the S&P Global 1200. It has a base date of Dec. 31, 1997 with a base value of 1000.

[4] Bloomberg.com Capital Flows to Emerging Markets Seen Surpassing $1 Trillion, June 1, 2011

[5] Institute of International Finance Capital Flows to Emerging Market Economies, June 1, 2011

[6] See How The Surging Philippine Peso Reflects On Global Inflationism, December 6, 2009

[7] See A Bullish Financial Sector Equals A Bullish Phisix?, May 22, 2011

[8] See Phisix: Why I Expect A Rotation Out of The Mining Sector May 15, 2011