Global Markets: How Sustainable is the Recent Risk ON?

From Risk OFF suddenly to Risk ON. 

Most of global stock markets led by the US went into hyperdrive mode.

Some bulls have come out of their hibernation to aver “you see I told you, forex reserves, floating currency, low NPLs neatly did the trick. And this has been all about ‘irrationality’”. Of course, I will keep pointing out—the so-called financial market ‘irrationality’ represents a two way street, because such involves the base human impulses of both greed and fear. Bluntly put, fear can be irrational as much as greed. However, any idea of a one directional bias for irrationality signifies in and on itself “irrational” logic

A mainstream foreign report even implied that the “short-lived” emerging market woes have passed. I can’t agree to the notion that 7 ½ months of Emerging Market volatility represents a “short” time frame period. Neither can I reconcile how the repeated ON and OFF volatilities over the same period equals the conclusion that EM troubles have passed.

EM guru Franklin Templeton’s Mark Mobius, for instance, flip flopped for the second time in 2 weeks, earlier by noting how EM selloff will “deepen” to this week’s “probably nearing the end of this big rush out of emerging markets.”[1]

Such seeming state of confusion from the mainstream signifies desperation to resurrect the boom days underpinned by cheap money.

Yet has the current rally been really indicative of the end of the EM selloff? Or has this been the proverbial calm before the storm or the maxim “no trend goes in a straight line”? Or a stock market lingo—a dead cat’s bounce?

Nonetheless as I keep pounding on the table, we should expect “sharp volatility in the global financial markets (stocks, bonds, commodities and currencies) in the coming sessions. The volatility may likely be in both directions but with a downside bias”[2]

Acute market volatilities represent a normative character of major inflection points whether bottom or top. Incidentally since the present volatilities has been occurring at record or post-record highs of asset prices particularly for the stock market, then current volatility logically points to a ‘topping’ formation rather than to a ‘bottoming’ formation.

Severe gyrations tend to highlight the terminal phase of a bull market cycle. Again in whether in 1994-1997 or in 2007-2008, denial rallies can be ferocious to the point of expunging all early bear market losses but eventually capitulate to the full bear market cycle[3].

The bottom line is that stock markets operate in cycles and that the best way to play safe is to first understand the cycle and ride on the cyclical tide.

China: Stocks Soar as Default Risks Escalates

Let us examine why global stock markets resumed a risk ON scenario this week. 

Take China, the Shanghai Composite celebrated the first week of the year of the wooden horse with a blistering 3.5% run.

Monday’s ramp was allegedly prompted by the extension of subsidies by the Chinese government to automakers[4]. Incidentally one of the beneficiaries of the extended subsidies to automakers has been BYD Co., an automaker with investments from Warren Buffett’s Berkshire Hathaway. More signs that Mr. Buffett once a value investor has transformed into a political entrepreneur.

Moreover, this one week stock market blitzkrieg has partly been an offshoot to the Chinese government’s rescue of a troubled shadow banking wealth management ‘trust’ product worth 3 billion-yuan ($496 million) at the near eve of the New Year’s celebrations[5].

So prior to the New Year, the Chinese government conducted a bailout. After the New Year, the Chinese government extends a subsidy (another bailout?) to a politically privileged sector.

Yet will the two interventions be enough to stabilize China’s markets? Or will the Chinese government have to employ serial bailouts in increasing frequency in order to keep the China’s highly fragile financial markets and economic system from falling apart?

How about reports where six trust firms which has 5 billion ($826.6 million) loan portfolio to a delinquent coal company have been in danger of default[6]? The debt exposure by the six trust firms account for 67% more than the size of the one recently bailed out by the world’s largest China’s state owned bank, the Industrial & Commercial Bank of China Ltd (ICBC).

The Reuters’ report adds that another trust, Jilin Province Trust Co Ltd, with exposure to struggling coal company Shanxi Liansheng Energy Co Ltd have failed to pay off “763 million yuan in maturing high-yield investments it sold to wealthy clients of CCB (China Construction Bank)”.

Ironically this is the same coal company with which the ‘first’ bailed out trust firm has exposure to. Has Jilin Province Trust’s debt payment delinquency been in the hope for a bailout? Will other creditors with exposure to the same coal company follow suit?

So has the pre-New Year bailout of the ICBC sponsored Trust firm exposed to Shanxi Liansheng Energy, opened the Pandora’s box of the moral hazard of dependency on government life support system? Will shadow banks resort to defaults or threats of defaults in order to be bailed out? Should we expect a wave of bailouts? How will the Chinese government pay for all these?

Yes while foreign currency reserves of the Chinese government tabulates to a record high of $3.82 trillion at the close of December 2013, as proportion to shadow banking debt this represents only half of $7.5 trillion based on JP Morgan estimates[7] and one fourth if based on the estimates of the controversial former Fitch’s analyst Charlene Chu[8]

And this is just the shadow banks. Of course not every shadow banks will fail, but the point is how deep will a potential contagion be? This is some dynamic which I think no one has a clue.

Aside from tremors from the shadow banks, private Chinese companies who lack implicit guarantees from the government have either postponed or canceled debt issuance. The Zero hedge reports[9] 9 companies who recently backed down from raising $1 billion worth of debt.

Moreover, Chinese non-performing loans (NPL) have been racing higher for the 9th consecutive quarter to the highest level since the 2008 crisis.

As you can see, the Chinese NPL experience demolishes the false notion that falling NPLs are free passes to bubbles. Credit bubbles implode from their own weight or from rising interest rates or from a reversal of confidence by lenders. In China’s case, rising NPLs are symptoms of the hissing overstretched credit bubble which has been transmitted via higher consumer price inflation and rising interest rates.

The growing risk of debt default, shrinking access to credit and rising NPLs are troubling signs of rapidly deteriorating China’s credit conditions. Yet these are signs of stability?

Even the China’s central bank, the People’s Bank of China, has been cognizant of the growing risks of debt defaults. As quoted by Bloomberg[10]:

China’s central bank signaled that volatility in money-market interest rates will persist and borrowing costs will rise, underscoring the risk of defaults that could weigh on confidence and drag down growth.

“When the valve of liquidity starts to tame and curb excessive credit expansion, money-market rates, or the cost of liquidity, will reflect that,” the People’s Bank of China said in a Feb. 8 report. “The market needs to tolerate reasonable rate changes so that rates can be effective in allocating resources and modifying the behavior of market players.”

Meanwhile China’s banking regulator, the China Banking Regulatory Commission, in the face of rising concerns of defaults has ordered some small financial institutions to “set aside more funds to avoid a cash shortfall” according to another Bloomberg report[11].

As you can clearly see, the Chinese government has been preparing for their financial Yolanda.

Moreover, the Chinese government dramatically infused money into the financial system last January based on the latest PBOC data where the Zero Hedge observed, “this month's broad liquidity creation was the largest monthly amount in China's history!”[12]

China’s infusion of a tsunami of liquidity, where China’s loan creation (left window) totalled $218 billion in January while total social financing (right window) spiked by $425 billion has essentially dwarfed the $75 billion by the US Federal Reserve and the $74 billion by the Bank of Japan.

Why the gush of government sponsored loan creation-total social financing in the face of rising risks of defaults? Has the Chinese government been forced to play the debt musical chairs in the recognition that a stoppage in credit inflation would extrapolate to a Black Swan event[13]? 

All these represents newfound stability and a conclusion to the EM sell off? All these are bullish reasons to bid up on stocks? Will ASEAN or the Philippines be immune to a potential debt implosion?

Or have the recent spurt in China’s stocks been signs of communications (public relations/ signalling channel in central bank gobbledygook) management by Chinese government aimed at creating a financial Potenkim Village in order to assuage creditors?

As risk analyst, I’d say good luck to all those who believe that “this time is different”.

US Stocks: Fed’s Janet Yellen Gives Go Signal for More Stock Market Bubble

How about US stocks?

US stocks sprinted for the two successive weeks expunging most if not all of the earlier losses. As of Friday, the S&P 500 knocks at the door of new record highs.

The melt up in US stocks began the previous week when the ECB made a “teaser” to further ease by suspending sterilization in March.

As a side note, this week the enticement for more easing came with a report the ECB has been “seriously considering” negative overnight bank deposit rates[14]. This may have also compounded on the frenzied charge by US-European stock market bulls.

Europe’s stocks have been on a blitz. But ECB’s overture for more easing reveals of the stagnation of Europe’s real economy. 

Europe’s economic stagnation has been reflected on corporate earnings. Forward revenues of European stocks have been in a steady decline since 2012.

Ironically, European stock markets seem to see heavenly bliss from such negative streak of earnings.

Such parallel universe exhibits why this has hardly been your granddaddy’s stock markets.

Central bank policies have transformed financial markets into a loaded casino (backed by central bank PUT or implicit guarantees) where people mindlessly chase yields with the singular aim of jumping on the stock market bandwagon financed with a deluge of credit money and rationalizing such actions by shouting statistics, regardless of their relevance.

Moreover, the unimpressive US job data whetted on the speculative appetite of the Pavlovian momentum chasing crowd. 

Bad news in the real economy has been good news for Wall Street. Why? Because Wall Street expects subsidies provided by the US Federal Reserve to them, via zero bound rates and asset purchases charged to the real economy, to continue.

In terms of present policies, this implies that the Fed’s “tapering” may be truncated.

Bad news in the real economy is good news for Wall Street has been one of this week’s main theme.

Retail sales fell most since June 2012 blamed mostly on the “bad weather”. Revised data showed that retail sales slumped also even in December but at a lesser degree[15]. So this has hardly been about bad weather or that bad weather represents a convenient rationalization for the stock market meltup.

The chart from Businessinsider reveals that core retail sales has been in a downtrend even as retail employment has been rising[16]. Yet how will a sustained fall in retail sales continue to finance retail employment?

Most importantly factory production dropped most since 2009[17] again blamed on the bad weather.

So the unexpected declines in factory output, jobs and retail sales, which not only translates to sluggish economic growth but may even reinforce on each other, have been seen as bullish for stocks by Wall Street.

This reveals how central banking policies have been driving a wedge or a gulf between the Main Street and Wall Street as evidenced by such seeming economic and social schadenfreude, where Wall Street benefit from the sufferings of the real economy. This also means more polarization or partisanship in the political sphere.

Another very significant catalyst for US stock market melt UP has been the debut testimony given by Fed Chairwoman, Ms. Janet Yellen, at the House Financial Services Committee hearing[18].

While Ms. Yellen admits that low interest rate can fuel asset bubbles, she denies that US stocks have been a bubble, where her personal sentiment sent a flurry of bid orders that powered stocks to a frenetic melt up mode.

Ms. Yellen’s admission that low interest rates serves fuel to bubbles…(bold mine)

We recognize that in an environment of low interest rates like we've had in the Unites States now for quite some time, there may be an incentive to reach for yield. We do have the potential to develop asset bubbles or a build up in leverage or rapid credit growth or other threats to financial stability. Especially given that our monetary policy is so accommodative, we are highly focused on trying to identify those threats.

Ms. Yellen’s grants a license to the US stock market bubble…

I think it's fair to say our monetary policy has had an effect of boosting asset prices. We have tried to look carefully at whether or not broad classes of asset prices suggest bubble-like activity. I have not seen that in stocks, generally speaking. Land prices, I would say, suggest a greater degree of overvaluation.

First, admit it and then deny it. Except for land prices, for Ms. Yellen “threats to financial stability” has been anything but relevant to the US. Does Ms. Yellen own a lot of stocks?

As another side note: Contra other central bankers like those from the Philippines, at least Ms Yellen acknowledges that low interest rates “may be an incentive to reach for yield” and thus “have the potential to develop asset bubbles”.

I don’t know which metrics Ms Yellen uses in valuing stocks or measuring credit growth. But the Russell 2000 at 81 price earnings ratio (!!!) as of Friday February 14^th close, certainly looks like a bubble from whatever angle.

And that “potential to develop asset bubbles or a build up in leverage or rapid credit growth or other threats to financial stability” has already been present via record net margin debt, and record issuance of various types of bonds e.g. junk bonds, corporate bonds that has been used to finance equity buybacks.

Perhaps the FED may be looking at solely the credit from the banking sector. If so, then such blinders will come at a great cost. Are bonds not financial assets held by US banks?

Yet systemic build up in leverage or rapid credit has been relentless.

The latest financial engineering has been to increasingly use shadow banks via “synthetic” derivatives based on corporate bonds in the face of shrinking liquidity in the bond markets. This novel approach has been meant to hedge on assets or to bet on their performance which according to the Financial Times represents a “dramatic shift in the nature of the corporate bond market”[19].

Moreover equities have increasingly played an important role as collateral for repo trades. From a Bloomberg report[20] “Repurchase agreements, known as repos, backed by equities rose 40 percent during the year ended Jan. 10, according to Federal Reserve data. Rising equity-collateral usage combined with a slide in repos backed by government securities pushed equities share to 9.6 percent of the $1.55 trillion tri-party repo market in January, up from 5.7 percent a year earlier, Fitch said in a report published yesterday.”

This growing moneyness or liquidity yield of equities seem to play right into Mr. George Soros’ reflexivity theory[21] in that “when people are eager to borrow and the banks are willing to lend, the value of the collateral rises in a self-reinforcing manner and vice versa.”

Hence soaring stocks, which leads to increasing values of equity based collateral, feeds on the borrowing appetite of stock market participants. The latter are likely to use proceeds from such borrowing to finance even more equity purchases that would be used to obtain more credit for speculation. Such collateral-lending-price feedback loop mechanism only serves as fodder to a deeper stock market Wile E. Coyote mania.

Manias may persist for as long as return on assets outpaces the cost of servicing debt or upon the sustained confidence of creditors on the capability and willingness of borrowers to fulfil their financial obligations.

If the cost of servicing debt is measured by the actions of the US treasury markets, then we should see how the latter has recently behaved.

Yet the dramatic melt UP in stocks have translated into wild swings in the yields of 10 year UST notes.

Why? Because rising stocks based on intensifying demand for credit tends to push up on yields, while adverse main stream economic data tend to push down yields as economic uncertainty spurs concern over asset selloffs or asset “deflation”.

Yet over the week, yields of 10 year notes climbed 7 bps to 2.75%. This means that the stock market melt UP seem to have bigger influence on the UST markets than the sluggish growth data.

This also means that regardless of what the Fed does (whether they persist on tapering or Untapers) for as long as, or in the condition that the stock market (and real estate) mania persists, yields of USTs are most likely to edge up.

This seems as signs that the US inflationary boom has reached a maturation phase where available resources have not been adequate to finance bubble projects on the pipeline. The entrepreneurial cluster of errors has been based on the misplaced belief of the abundance of savings from artificially lowered interest rates. Such errors are being reflected on rising interest rates and or an up creep of inflation.

Bernanke’s QE 3.0 in September 2012 had only a 3 month impact in the suppression of yields. Since July 2012, yields of USTs trekked higher, but the upside momentum accelerated when Abenomics and the Bernanke’s “taper” was announced in the second quarter of 2013.

This also is one reason why past data can hardly be relied on. That’s because central policies have so vastly distorted the pricing mechanism that has altered the traditional functional relationship of firms, markets and the economy.

What has driven yields of USTs down of late has been a pseudo meltdown in US stocks. While “bad news is good news” may hinder rising yields, strength in economic data will expedite the advance.

As one would note from the above overlapped charts of the yields of 10 year notes (TNX) and the S&P, over the last 9 months, there seems to be new correlation where yields of 10 year USTs decline ahead of the S&P (green rectangle). And the S&P rallies ahead of the bottoming TNX.

And rising UST yields (higher interest rates) amidst rising asset prices fuelled by massive debt expansion only exacerbates on the Wile E. Coyote momentum which eventually will lead to the Wile E. Coyote moment or what Ms. Yellen calls as “threats to financial stability”.

And all the RECORD credit inflation seems to escape the eyes of an econometric technician like Ms. Yellen who seems to think that all these operates in a vacuum.

Unfortunately blindness leads to Black Swans.

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[1] See EM Guru Mark Mobius Flip Flops Anew: EM Sell Off Nears End February 12, 2014

[2] See Phisix: Global Financial Volatility Intensifies February 10, 2014

[3] See Phisix: Don’t Ignore the Bear Market Warnings June 30, 2013

[4] Bloomberg.com China’s Stocks Rise to One-Month High as Consumer Companies Jump February 10, 2014

[5] See China Rescues Troubled Trust Product January 28, 2014

[6] Reuters.com Six China shadow banks threatened with default over coal firm exposure: paper, February 13, 2014

[7] Fox Business Shedding Light on China's Shadow Banking Industry February 11, 2014

[8] Telegraph The $15 trillion shadow over Chinese banks February 1 2014

[9] Zero Hedge Chinese Capital Markets Frozen As Bad Loans Soar To Highest Since Crisis February 14, 2014

[10] Bloomberg.com China Signals Volatility in Money Markets Will Persist February 10, 2014

[11] Bloomberg.com China Watchdog Said to Tell Small Banks to Set Aside Fund February 11, 2014

[12] Zero Hedge Spot The Real Liquidity Bubble February 15, 2014

[13] See Will China Trigger the Black Swan Event in 2014? January 20, 2014

[14] Wall Street Real Time Economic Blog ECB Considers Negative Deposit Rate February 12 2014,

[15] Bloomberg.com Retail Sales in U.S. Unexpectedly Fell 0.4% in January February 14, 2014

[16] Businessinsider.com Something Has To Give Here February 13, 2014

[17] Bloomberg.com Factory Production in U.S. Falls by Most Since 2009 February 14, 2014

[18] Reuters.com HIGHLIGHTS-Yellen's Q&A testimony to House panel February 11, 2014

[19] Financial Times Investors turn to ‘shadow’ bond market February 10, 2014

[20] Bloomberg.com Fire Sale Risk Climbs With Equity-Backed Repo Rise, Fitch Says February 13, 2014

[21] George Soros The Alchemy of Finance John Wiley & Sons p 23

Emerging Markets: Why Adjustments For Relative Yield Spreads has been Disorderly

Rising yields of USTs will have an impact on the policies of central banks whom has dovetailed their policies with that of the US Federal Reserve configured on zero bound rates

At the basic level, rising yields of USTs will compel for an adjustment in the respective contemporaneous ‘yield spread’ of domestic bond markets relative to the USTs that will get reflected on monetary policies.

What has made the adjustment disorderly, particularly for Emerging Markets has been the overdependence of specific economies on the zero bound regime, principally due to economic growth structured on credit expansion rather than economic reforms.

The relative yield spread adjustments has only exposed on the distinct vulnerabilities of these economies thereby leading to massive outflows.

The idea that the emerging market selloffs has passed days of turbulence neglects the importance of the fundamental relationship between respective pre-Taper/Abenomics ‘yield spreads’ of distinct EM nations with that of the USTs.

I pointed out last week how the direction of the Phisix seems to have found an anchor on the actions of USTs, where each time yields of 10 year USTs close in at 3% this seem to have spurred weakness or a spontaneous selloff in Philippine stocks.

It would seem that the same relationship holds true for ASEAN currencies. Since September 2013, where the yields of 10 year USTs (TNX, below chart) approached 3%, ASEAN currencies TWICE—particularly the USD-Philippine peso (red orange), US-Indonesian rupiah (orange), USD-Thai baht (green) and the USD-ringgit (red)—suffered convulsions from what should be normal yield spread adjustments.

Moreover, the second episode has led to greater (and not lesser) volatility where all four currencies broke beyond the September 2013 highs. So it would seem misguided to impulsively conclude that the emerging Asia’s woes have been short lived or has passed. Such assumption will have to be premised on a sustained decline of the TNX. However as pointed above, declining TNX has, of late, been accompanied by falling US stocks. And a steep drop in US stocks has likewise had a negative impact on local and regional stock market performance.

It is true that all of the region’s currencies have been rallying during the past two weeks. This has also been accompanied by buoyancy in the region’s equity markets. And again that has been largely because the TNX has dropped steeply. Nonetheless, the lull in ASEAN’s markets may be temporary as TNX has been climbing again (red ellipse). 

Notice that when the TNX peaked in September, the two month of tranquil space permitted the region’s financial markets to somewhat recover. However it is a question if the TNX has found a bottom. If it has, then it means a narrowing of the time span covering the previous peaks of September and December. This may imply that the ascent of the TNX may be accelerate or intensify. A fresh record breakout by US stocks can easily power the TNX to new highs.

Yet the current rally of domestic bonds of emerging Asia has hardly been impressive. Additionally, while regional currencies have bounced back, they are far from the lows of the post September levels. ASEAN currencies are rallying in lesser degree than during the post September lows.

The question now is if the TNX should continue to climb or spike, will the impact be devastatingly larger this time?

Presently even the mainstream has come to notice the recent bout of volatilities has exposed on the price inflation predicament of ASEAN[1]. But the emerging stagflation ogre has been seen as a supply side driven predicament rather than a credit inspired demand side imbalance. Debt exists nowhere in mainstream analysis.

Yet debt has been the anchor of any potential transmission mechanisms for a contagion

For instance, US and European banks have been found to have chased yield by having bigger exposure on EM’s the Fragile Five.

Philip Coggan of the Buttonwood Blog fame at the Economist quotes Erik Nielsen[2]

According to the BIS, US banks’ exposure to the “Fragile Five” increased by 37% to $212bn, while their exposure to the Eurozone periphery declined by 17% to $164bn. UK banks’ exposure to the Fragile Five increased by 29% to $291bn – while their exposure to the periphery declined by 30% to $277bn. German banks expanded their exposure to the Fragile Five by 34% to a relatively modest $69bn – while shrinking their exposure to the periphery by an eye-watering 50% to $354bn. French banks increased their Fragile Five exposure by a modest 15% (to $69bn) – while chopping their Eurozone peripheral exposure by 43% to $514bn. Italian banks doubled their exposure to the Fragile Five – but to a total of just $11bn, while cutting their exposure to the periphery (excluding Italy itself) by 46% to $33bn.  And Spanish banks increased their exposure to the Fragile Five by 26% to $185bn, while chopping their peripheral exposure (ex Spain) by 29% to $105bn.

So mainstream western banks flocked into the Fragile Five when the PIGS crisis surfaced.

And the powerful argument presented by Mr. Coggan has been to debunk the use of accounting identities in denying the above risk. Mr. Coggan writes, “the fragile five got that tag because they have current account deficits, but such deficits require, as an accounting identity, capital inflows. Someone had to lend these countries money so they could buy imports.”

In short behind all the smoke screens thrown by the consensus to defend the status quo via statistical figures and accounting identities, everything else will all boil down to sustainability or unsustainability of DEBT operating under the presence of the bond vigilantes.

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[1] Wall Street Journal Real Time Economics Blog, In Asia, Concerns About Inflation Re-Emerge, February 11, 2014

[2] Buttonwood, The money has to go somewhere February 10, 2014

Lessons from Kazakhstan’s currency Meltdown

I was surprised to see Kazakhstan’s stock market (KASE) zoom by 13.4% this week. And I found out that the rise has been due to a massive 19% devaluation imposed this week which mainstream attributes to “currency war”[1]. Yes stocks can serve as haven against hyperinflating governments.

Kazakhstan is basically a commodity (mostly energy) producing country[2],being the 9^th largest country in the world, whose geopolitical origins have been linked with Russia[3]. Nursultan Nazarbayev[4] has been Kazakhstan’s first and only president since the country gained independence from the Soviet Union. President Nazarbayev has been alleged as a dictator[5].

What interests me is that despite the supposed low consumer price inflation, low debt to gdp levels, current account and trade balance surpluses, it is ironic to see a country devalue quite so massively.

It turns out that some of the statistics stated may not be accurate or deliberately fudged.

Since the 2008 global crisis, Kazakhstan’s government has engaged in a spending binge that has resulted in sustained budget deficits where such has been financed with an explosive growth of external debt. This is in spite of the low debt to gdp ratio where the gdp numbers looks cosmetically embellished. 

Since attaining financing from external sources have been deficient, the government has tapped into the foreign currency reserves which has shrunk by nearly a third from the high of April 2011, as well as monetized her deficits as seen via a runaway M3. Kazakhstan has apparently adapted Argentina’s stylized policies of addressing internal imbalances[6].

Kazakhstan’s currency the tenga has endured almost a similar degree of sizeable devaluation in 2008. But recent financial pressures mostly on domestic financing may have forced the government to act. As one would realize, Kazakhstan’s dilemma has not been revealed by the current and trade balances but on her currency tenga, forex reserves, external debt and importantly M3. And another thing, given the 19% devaluation, this shows that the alleged low inflation figures have also been patently inaccurate.

The other lesson is that shouting “forex reserves!”, “forex reserves!”, “forex reserves!” or citing surpluses of trade and current accounts serves as no elixir against government rapacity (or from reckless bubble policies) as expressed via Kazakhstan’s financial markets.

While I am not certain that Kazakhstan’s policies would lead towards hyperinflation, exploding M3, unless curtailed, points towards this direction.

When stocks rise due to hyperinflationary policies, this isn’t about delivering real returns, but rather as signs of “flight to safety” (crack-up boom) where stocks as title to capital goods or real assets become a shock absorber from a collapsing currency.

However, the idea of thousands of % of gains in nominal domestic currency terms, under hyperinflation, may be equal to a buying power of just three eggs, as noted by fund manager Kyle Bass, on the Zimbabwe hyperinflationary experience[7].

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[1] Bloomberg.com Kazakh Devaluation Shows Currency War Stirring as Ruble Dips February 12,2014

[2] Wikipedia.org Economy of Kazakhstan

[3] Wikipedia.org Kazakhstan

[4] Wikipedia.org Nursultan Nazarbayev

[5] CBSNews.com The world's enduring dictators: Nursultan A. Nazarbayev, Kazakhstan, June 19, 2011

[6] See Emerging Market Turmoil: The Fallacy of Foreign Currency Reserves as Talisman February 3, 2014

[7] CNBC.com Why Inflation Could Eat Into Stock Gains: Kyle Bass February 1, 2013

Phisix: Stagflation is here, Expect a Weaker Peso

I have been saying that stagflation will be a force to reckon with given the easy money policies adapted by central banks of the Asia

Stagflation now a Reality

In September 2012 I pointed out that risks of stagflation or a bubble bust will become apparent in 2014 or 2015[1]

And one of the above risks (a bubble or stagflation) will become a force to reckon with in Asia, possibly in 2014 or 2015. All these will essentially depend on the feedback mechanism between the dynamics at the marketplace and policy responses on them.

The point is that inflationary policies results to different impact on the economy and the markets depending on the stage of the process. The boom phase appears to have ended. Now the backlash for promoting reckless policies has surfaced.

What’s stagflation? Wikipedia defines this[2] as “a situation where the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high.”

Based on official announcement where the Philippine economy continues to reveal strength, stagflation would not be an adequate characterization of the current conditions. 

But the recent shocking 27% quarter on quarter surge in unemployment survey figures defies whatsoever government claims about the robustness of the Philippine economy[3].

The survey essentially squares with two earlier surveys underscoring the equally stunning sharp deterioration in the general public’s opinion of their quality of life through 2013[4]

In addition, with the official admission that the current rate of inflation has been in the high end of estimates at 4.2% backed by a huge decline of the peso and stubbornly higher bond yields of 10 year Philippine treasuries considering that the domestic bond markets have been tightly controlled by both the government and the private sector banking system, the proverbial inflation genie has been unleashed from his lamp.

Moreover despite the 7.2% growth rate for 2013[5], based on the quarter year on year statistical growth rates, the Philippine economy from a high of 7.7% from the first quarter of 2013 dropped in the following quarters 7.6% (2^nd Q), 6.9% (3^rd Q) and 6.5% (4^th Q).

So if we go by the checklist

1) inflation rate is high—√

2) economic growth rate slows down—√

3) unemployment remains high—√

Stagflation has entrenched herself on the Philippine setting. Now the question is will stagflation prick the Philippine credit bubble?

Financial Repression as Key Culprit

The recent unemployment survey essentially validates my analysis that the representativeness of the Philippine statistical growth data has been inaccurate or suffers from large statistical errors.

This also reveals how the statistics of the Philippine government overestimates on the importance of the formal economy while understates the relevance of the informal economy.

Yes, as stated earlier, the swelling numbers of unemployment means that the informal economy has been in sick bed for quite sometime now.

The unemployment data essentially signifies a major pushback from the official downplaying of informal economy.

This also reveals how concentrated the statistical Philippine economy has been, which largely has been dependent on the households, whom has not only access to the banking sector but importantly access to credit.

The risks and benefits from present policies that has painted a robust statistical economy has been largely channelled through a few individuals whom has access to credit.

The unemployment data also exposes on the politicized nature of redistribution of resources channelled via central bank policies as part of the financial repression used by the government to lay claim on the resources of their non-political constituents.

It has been absurd for officials to raise strawmen by attributing Typhoon Yolanda and Moro rebels which are largely regional problems to a national problem.

I had been right about my reservations[6] of Typhoon Yolanda being unable to surpass Typhoon Pablo in terms of most destructive Typhoon. While Typhoon Yolanda may be one of the strongest ever to land on Philippine soil, the devastation covered one of the country’s most economically depressed region. The same premise can be used to dismiss official strawman arguments.

And it seems that experts sporting economic labels and political groups have grasping at the straws to explain why the surge in unemployment.

One says that investments have been in capital intensive and not in labor intensive projects. Such is a false choice fallacy. There is a third concept. Government via easy money policies has misallocated money flows towards credit intensive projects, regardless whether they are capital intensive or labor intensive. The fact is that in 2013, the real estate sector, construction and hotel industry borrowed Php 1.9, Php 3.25 and Php 2.7 for every Php 1 growth generated by these sectors[7]. The inefficiency of use of resources meant that this has displaced other market based investments in favor of yield chasing by those with access to the banking sector’s credit. Such deadweight loss are signs of declining productivity while at the same time increasing credit risks.

A nuisance political observer even was even quoted as pointing to liberalization as the culprit. These guys should move to North Korea, whose closed economy should give their fantasies a hard dose of reality.

North Korea is an example where in communism the joke parlance has been “the authorities pretend they are paying wages, workers pretend they are working”. Such also lies in the heart of the economic dogma where economic growth can supposedly occur when people just dig holes and fill them back in.

The problem is that even pretending to work and pretending to get paid doesn’t work. Reason? In the case of North Korea, the country has run out of hard currency or real resources to pay for her pretentious employer-employee relations, so unemployment has been increasing[8]. Yes NK officials want the scarce resources for themselves than distribute to the others

The ADB comes up with their techno gibberish citing “low investment are reflections of the sluggish industrialization”[9]. Of course the ADB doesn’t say why there has been low investment except to utter the banalities about the symptoms.

None has been there to say that the banking system and capital markets have been soooo inadequately utilized for people to transpose savings into investments. So with low access to savings equally there will be low investments from residents. Add to this the stringent regulatory hurdles in doing business.

Besides given the low access to the formal system, this means high transaction costs, high cost of capital and equally inefficient means to accumulate real savings and capital.

Also for foreign money to deploy savings into the country means liberalization of capital flows something which monetary officials have been reluctant to do. Why? It’s called financial repression or the various political measures adapted to capture resources of the constituents of a country for the benefit of politicians and their cronies.

Based on Investopedia’s more benign terminology, financial repression are “measures by which governments channel funds to themselves as a form of debt reduction. This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression can include such measures as directed lending to the government, caps on interest rates, regulation of capital movement between countries and a tighter association between government and banks.”[10]

So naturally no country will have a great deal of investments when the government vacuums the resources of the people and restricts savings from efficient allocations in the marketplace.

How about zero bound rates (negative real rates) as part of the repression?

Let us hear from Harvard’s Carmen Reinhart[11].

One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things being equal, reduces governments’ interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates and reduces or liquidates existing debts, it is a transfer from creditors (savers) to borrowers and, in some cases, governments.

While the supposed aim of financial repression has been to reduce debt, the free lunch access by politicians to savings ironically whets their appetite to add more debt.

Moreover based on the above the Philippine president will hardly make such statements: “I am sorry I kept interest rates lower than should be, so I can fund my pet projects. Anyway these are meant to benefit you like infrastructure, cash transfers, military budget, other welfare programs and before I forget my political constituent’s pork barrel. You see I have to get these politicians to agree with my spending plans. So the need for pork barrel. Anyway you will be financing this via low interest rate that should subsidize our spending. The good news is that you will not feel directly the pain from such transfers. This will be done by the loss of peso’s purchasing power which we will blame on producers and entrepreneurs for their greed. Also I am sorry that I didn’t realize that savers will be penalized in favor of borrowers who incidentally are mostly in the list of my network.”

So you expect real economic growth from a government who punishes savers by reducing their purchasing power and diverting these to political boondoggles and asset bubbles at the same time unwilling to dismantle legal barriers to economic activities?

Peso as main Victim of Stagflation

I would predict that a stagflationary environment will be baneful for Philippine assets, particularly for the peso.

I expect the Peso to further weaken for one basic reason: The BSP seem to adapt policies that has been meant to erode dramatically the peso’s purchasing power at the rate faster than the US, Japan or even China.

Even with the Fed’s aggressive QE and Bank of Japan’s even bolder Abenomics year on year change of M2 has been at 5% for the Fed and 4.5% for the BoJ. China’s M2 comes at 13.2% in 2013 according to the People’s Bank of China

The above M2 and quasi money growth data for Turkey (upper pane) and for Argentina, Philippines, Indonesia and Thailand (lower pane) reveals how and why emerging markets have been enduring inflation pressures. Note I updated the World Bank chart[12] to include updates for Argentina[13] and the Philippines (based on latest BSP figures[14])

The green threshold line is the 10% about twice the level of my estimates of the average growth for these economies. Of course there is no line in the sand for M2 to generate X inflation number as different countries have different tolerance for inflation or debt accumulation.

Yet these economies have been pumping money at far more than the rate of statistical economic growth. For the Philippines the 30+% levels have practically reached Argentina’s fantastic rate levels. This is four times statistical economic growth.

The difference is that: Argentina, hobbled by the lack of access to credit markets, has long been using monetization of deficits as seen via the soaring of M2 whereas the recent 2013 spike in Philippines M2 has largely been from the domestic credit bubble.

The Philippine dilemma has been that current statistical economic growth rates have been dependent on a credit boom. This means that a reduction in M2 would extrapolate to a significant slowdown or a contraction of the high growth areas as credit growth slows or screech to a halt.

The recent decline of forex reserves serve as evidence that in the impossible trinity[15], where government can only use two of the three factors: free movement of capital, exchange rate and domestic policy targets, the BSP intends to keep the credit boom alive in the hope that EM storm will breeze over. I hope they are right because the alternative would be worse.

This also means that M2 will remain elevated and sometime in the future. This means that unless these are restrained, the Philippines will likely suffer from a serious inflation problem ahead (10% or more??).

Be reminded again that every economy has distinct sensitivity to inflation risks. 

In the Philippines, in the assumption that there has been little change in the above spending distribution or that the data above has some relevance to current conditions, the Filipino consumer has been highly sensitive to food, housing and transport[16].

For a country with $ 2,600 nominal gdp (IMF 2012) or $2,587 (world bank 2012) and who are price sensitive to basic goods, an explosion of price inflation would translate to severe social dislocations via increased poverty levels and increased likelihood for social and political instability.

A surge in inflation would also mean a dramatic decrease in disposable incomes of the residents, soaring interest rates, declining peso, and importantly, puts to the forefront the excessive credit conditions, as well as, over expansions of projects that had been financed by debt.

When the great Austrian Ludwig von Mises warned that the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money[17], this also puts into the spotlight imbalances brought about by massive issuance of quantity of money by domestic authorities that erodes the valuation of a currency unit, the peso.

---

[1] See The Impact of Open Ended QEs on Asia: Bubbles or Stagflation September 15, 2012

[2] Wikipedia.org Stagflation

[3] See Behind the 27.5% (Q-on-Q) Surge in Philippine Unemployment Rate February 11, 2013

[4] See Phisix: Will the Global Risk OFF Environment Intensify? February 3, 2013

[5] See Behind the 2013 Philippine Statistical Economic Growth of 7.2% January 30, 2013

[6] See Typhoon Yolanda: From Natural to Man-Made Calamity; Spontaneous Order Thrives! November 18, 2013

[7] See Phisix: Global Financial Volatility Intensifies February 10, 2014

[8] Daily NK In the So-called Socialist Country, North Korea, the Number of Unemployment Is Increasing October 16, 2007

[9] Inquirer.net Aquino on rise in joblessness: What went wrong? February 12, 2014

[10] Investopedia.com Financial Repression

[11] Carmen Reinhart Financial Repression Back to Stay: Carmen M. Reinhart, March 12, 2012

[12] World Bank Money and quasi money growth (annual %)

[13] Wall Street Journal Argentine Central Banker Says He Aims to Slow Money Growth December 24, 2013

[14] Bangko Sentral ng Pilipinas Domestic Liquidity Growth Slows Down in December January 30, 2014

[15] Wikipedia.org Impossible trinity

[16] Hyun H. Sun Has Inflation Hurt the Poor? Regional Analysis in the Philippines in the Philippines Asian Development Bank

[17] Ludwig von Mises II: The Emancipation of Monetary Value from the Influence of Government - On the Manipulation of Money and Credit: Three Treatises on Trade-Cycle Theory [1978] onlinelibertyfund.org

Quote of the Day: Traits of Sociopaths and Psychopaths

When you look at Obamacare and the destruction it has caused in so many people’s lives, it’s just more of the same.  Whether it’s spying on us, or wars around the world, when you put it all together, the people in charge fall into two categories:  sociopaths and psychopaths.

Did you hear our secretary of state saying that ‘The US will defend Japan against China.’  Who is he speaking for?  Is he speaking for me?  Is he speaking for you?  We’re going to defend Japan against China?  This guy is a madman.  These are the characteristics and the traits of sociopaths and psychopaths.

This quote is from quoted business consultant and Trend forecaster Gerald Celente in an interview with Eric King at KingWorldnews.com (hat tip Lew Rockwell.com)

Quote of the Day: Defense of Liberty Must Emphasize on Principle versus Expediency

What must be developed is a case for freedom that starts with a better demonstration and defense of the nature of man in the world and what is necessary for his survival and improvement. In an age in which religion has lost it hold and appeal for many, such a defense of freedom must have its basis in reason, logic and objective reality.

Central to such a new defense of liberty must be its emphasis on principle versus expediency; that freedom is a tightly woven tapestry of principles that when compromised “at the margin” between individual liberty and political paternalism has the risk of incremental loses of freedom that cumulatively run the danger of an unplanned but no less serious “road to serfdom.”

As Friedrich Hayek argued, minor or marginal “exceptions” to advance seemingly “good causes” through government regulation, redistribution, or planning, always threaten to become a slippery slope:

“The preservation of a free system is so difficult precisely because it requires a constant rejection of measures which appear to be required to secure particular results, on no stronger grounds than that they conflict with a general rule [of non-government intervention], and frequently without our knowing what will be the costs of not observing the rule in the particular instance. A successful defense of freedom must therefore be dogmatic and make no concessions to expediency, even where it is not possible to show that, besides the known beneficial effects, some particular harmful result would also follow from its infringement. Freedom will prevail only if it is accepted as a general principle whose application to particular instances requires no justification. It is thus a misunderstanding to blame classical liberalism for having been too doctrinaire. Its defect was not that it adhered too stubbornly to principles, but rather that it lacked principles sufficiently definite to provide clear guidance . . .

“People will not refrain from those restrictions on individual liberty that appear to them the simplest and most direct remedy of a recognized evil, if there does not prevail a strong belief in definite principles. The loss of such belief and the preference for expediency is no part the result of the fact that we no longer have any principles that can be rationally defended.”

As Hayek argued on another occasion, if the cause of liberty is to prevail once again, it is necessary for friends of freedom to not be afraid of being radical in their case for classical liberalism – even “utopian” in a right meaning of the term. To once more make it a shining and attractive ideal to imagine a world of free men who are no longer slaves to others, whether they be monarchs or majorities.

It would be a world of sovereign individuals who respect each other, who treat each other with dignity and who view each other as an end in himself, rather than one of those pawns to be moved and sacrificed on that chessboard of society to serve the ends of another who presumes to impose coercive control over his fellow human beings.

This is an excerpt from a speech by American libertarian author and Northwood University economics professor Dr. Richard Ebeling published at the Northwood Blog (hat tip Bob Wenzel)