Phisix 7,800: The Earnings Growth Mirage

Unpopular ideas can be silenced, and inconvenient facts kept dark, without the need for any official ban. Anyone who has lived long in a foreign country will know of instances of sensational items of news — things which on their own merits would get the big headlines-being kept right out of the British press, not because the Government intervened but because of a general tacit agreement that ‘it wouldn’t do’ to mention that particular fact. So far as the daily newspapers go, this is easy to understand. The British press is extremely centralised, and most of it is owned by wealthy men who have every motive to be dishonest on certain important topics. But the same kind of veiled censorship also operates in books and periodicals, as well as in plays, films and radio. At any given moment there is an orthodoxy, a body of ideas which it is assumed that all right-thinking people will accept without question. It is not exactly forbidden to say this, that or the other, but it is ‘not done’ to say it, just as in mid-Victorian times it was ‘not done’ to mention trousers in the presence of a lady. Anyone who challenges the prevailing orthodoxy finds himself silenced with surprising effectiveness. A genuinely unfashionable opinion is almost never given a fair hearing, either in the popular press or in the highbrow periodicals.-George Orwell

In this issue

Phisix 7,800: The Earnings Growth Mirage

-Introduction: PSE Facts

-The Interaction between EPS Growth and Interest Rates

-Phisix Returns Careens Away From Reality

-Sectoral EPS Growth Have ALL Been Declining!

-PSE 30 EPS Growth Rates Reveals that This Time Has NOT Been Different!

-DEBT EQUITY RATIO as Barrier to Earnings Growth

-The Four Horsemen to Earnings Growth

-The Fourth Horseman: Soaring US Dollar

Phisix 7,800: The Earnings Growth Mirage

Introduction: PSE Facts

The markets have been absurdly consumed by misperceptions.

As I wrote last January[1],

When stock market returns outpace earnings or book value growth, the result is price multiple expansions. This is why current levels of PE ratios are at 30, 40, 50 and PBVs are at 4,5,6,7. This is NOT about G-R-O-W-T-H but about high roller gambling which relies on the greater fool theory or of fools buying overpriced securities in the hope to pass on to an even greater fool at even higher prices—all in the name of G-R-O-W-T-H!

In the following outlook, I use PSE’s empirical findings to establish the facts and trends of the earnings growth.

The same data provides us plenteous insights that would not only would layout the growth blueprint of the future, but importantly either affirm or falsify popularly embraced wisdom such as current record highs has been about G-R-O-W-T-H as seen by media’s growth projections for 2014 and for 2015, and the perception that structural changes in the economy would tolerate current valuations to significantly depart from historical norms or “this time is different”.

I culled and assembled from the PSE’s monthly January reports the financial valuation numbers for the month of December from 2007-2014 as shown from the table above. 

This would be the basis for my appraisal of the validity of popular perception.

The numbers have mostly been based on third quarter financial statements submitted by the listed firms to the PSE. The end of the year results will be out in the PSE’s April report. I include below the PERs of each members of the Phisix composite.

The table above consists of Price Earnings Ratio (PER) in yellow background, Book Value (BV), Debt Equity Ratio (DER) in green backdrop, annual returns of the benchmark in orange and the ratio of returns relative to earnings growth in blue.

From the numbers indicated, I derived the implied EPS and Book Value in order to generate their annual growth rates.

In this report we will not deal with the Book Value.

Some notes:

-While the starting point of the data set will be from the year end of 2007, annual changes will begin from 2008. In the occasion where I use compounded growth rates, since the above numbers are based from end of the year, the period used will be from the succeeding year until the last reference point. For instance, 2008-2014 will cover 6 years.

-The Phisix composite index has had marginal changes in the firms included in the basket over the stated period. Considering liquidity (market volume)—aside from free market float—as the two principal criteria for the inclusion of a firm to the elite basket, the composite indices of the major benchmark and of its subset, the different sectors, have represented the most popular issues. The PSE has announced changes in the composition of the sectoral indices to be implemented next week, March 16, 2015

Since 2008 serves as the nadir of the current cycle, the beginning reference point should magnify whatever numbers seen from the above. For instance, the Phisix posted a CAGR of 25.25% from yearend 2008 to yearend 2014. Over the same period, the equivalent EPS CAGR has been at 8.62%. This means that the market paid an astounding 193% premium on earnings growth each year! This explains how multiple expansions have been the key driver of the Phisix which is why the current levels of valuation.

Of course the numbers above shouldn’t be seen only from a single standpoint for the simple reason that annual changes and sectoral performances have been variable

So here I will adhere to the BSP chief’s gem of an advice to journalists as noted last week[2].

Economic numbers rarely tell the complete story when taken at face value. Therefore, a responsible journalist who seeks to offer readers a fuller appreciation of the information will examine the figures within a broader context or against an array of other relevant indicators.

The Interaction between EPS Growth and Interest Rates

Despite headline hallelujahs, the chart of the reported nominal EPS growth can easily be seen as refuting the vaunted G-R-O-W-T-H story. Since 2010, EPS growth rates have steadily been in a decline!

Here is a terse chronicle or historical narrative of the EPS’s history.

The Great Financial Recession took the sails out of the Phisix. While EPS growth remained positive its growth rate fell by 20.9% in 2008.

Then, the Philippine economy had a relatively clean balance sheet with debts at vastly lower levels than today. I’m not referring to Debt Equity Ratio but to aggregate debt.

Yet let me interject a short history on Philippine interest rates

Remember that the BSP embarked on a target to radically alter the structure of the Philippine economy through the monetary tool of ‘boosting aggregate domestic demand’ by easing through a series of rate cuts. The BSP slashed interest rates from 6% to 4% in 2009. 

In 2Q 2011, the BSP partly reversed course to raise rates by 50 basis points. So from 4% official rates went by 50 bps to 4.5%

However the BSP had an immediate change of mind and engaged into another succession rate slashing activities from yearend 2011 until the 3Q of 2012. In total, the BSP trimmed 100 basis points to from 4.5% to 3.5%.

The BSP maintained rates from 2012 until rampaging food prices and financial assets forced them to raise official policy rates twice during the third quarter of last year from 3.5% to 4%.

Now the link between interest rates and earnings growth

The frantic reduction of interest rates in 2009 apparently juiced up the Phisix earnings growth for two years. The rate of earnings growth registered a spectacular 26% and 28% in 2009 and 2010 respectively.

Apparently, the overheating of earning growth rates was unsustainable, so this came under pressure. The reversion to the mean flexed its muscle and evidently forced the downside adjustments.

So coming from two successive years of earnings growth juggernaut, earnings growth rate recoiled and stumbled by 20.24% at almost at the same scale with 2008. This coincided with the BSP’s rate increases in 2011.

So earnings growth backpedaled when the BSP slightly tightened.

However, the sharp downturn EPS growth had been reversed in conjunction with the BSP’s second wave of rate cuts from late 2011 to 3Q 2012.

In 2012, earnings growth jumped by another splendid 16.46%. But this has been far less than the pace of 2009 and 2010.

This shows that when the BSP eased earnings growth temporarily revived.

But from then, things turned downhill, EPS grew by less than half of 2012 levels or at 7.94% in 2013 and worst, in 2014 EPS growth eked out only 1.63%!

So despite the sustained easing mode by the BSP, the EPS growth momentum subsided. The downshift has been exacerbated by the BSP’s minor tightening in 2014.

In effect, the positive impact from interest rate manipulations has been subject to the law of diminishing returns. The tightening only compounded on this dynamic.

As a side note, again full year EPS will be revealed in the April report.

Yet to see a rebound in line with popular expectations means 4Q earnings will need to explode.

For instance media says that 2014 earnings will come at 6%. Given the 1.63% EPS growth for three quarters, for this to happen, 4Q earnings will have to explode by 19%!!!

This only demonstrates how EPS growth projections have been immensely overrated.

Phisix Returns Careens Away From Reality

Now that we have dealt with earnings and interest rates, we look at returns.

With the exception of 2014, in the past, and in general, Phisix returns largely tracked the earnings performance (see left window). In short, markets behaved relatively rationally.

The Phisix zoomed for two years, 63% in 2009 and 38% in 2010, in response to the fabulous rebound of earnings coming off the 2008 meltdown based on the relatively sound fundamentals and the BSP easing as noted above.

When earnings growth retrenched in 2011 in conjunction with the BSP hikes, the Phisix posted only a meager 4% return for the year. So the market’s priced in the EPS growth downturn.

Ironically, while the 2011 earnings growth performance was almost equal to 2008, with both scoring a significant retrenchment in growth rates, returns revealed immense disparity; the Phisix lost 48% in 2008 as against a positive 4% for 2011.

Aside from liquidity issues, the difference reflects on the prevailing sentiment where the former had been bogged down from an overseas contagion while the latter manifested a residual carryover of optimism from the previous 2009-2010 run. But still returns then somewhat reflected on earning activities.

The BSP easing in 2012 which again had been accompanied by an EPS growth rebound had the Phisix posting a magnificent 33% return.

The bullish sentiment spilled over to the first semester of 2013 but was truncated by the 2013 taper tantrum selloff.

Yet that 2H selloff brought Phisix valuations closer to earth. Valuations was high but not at outlandish levels.

In 2014, the wheels just came off.

The suppressed bullish sentiment from 2012 to 1H 2013 came back with fury.

In 2014, while EPS grew by a speck (1.63%), returns simply went off tangent and blasted away.

In the past, the return-EPS growth ratio, which reflected on market’s assessment on earnings or the premium or discount paid relative to earnings, hardly went beyond 100%.

That all changed in 2014 where the market paid an astronomical 13x earnings growth (left window)!!!

This is the reason why the Phisix PER in 2014 soared by 20% to 21.84 from 18.08 in 2013.

Yet the current departure between returns and valuation levels has been representative of this massive and still ballooning divergence!

Sectoral EPS Growth Have ALL Been Declining!

It would not do justice for us to look at the Phisix without examining the sectoral performance in the lens of earnings growth.

As of Friday’s close, the holding sector dominates the share of the Phisix with a 35.41% weighting. This is followed by Industrial 17.09%, property 16.04%, services 15.28% financial 14.88% and mining 1.3%.

So given that the holding and industrial sector plays the lead role as the major influencers of the Phisix, I show them first. 

Yet for both sectors, EPS growth apparently has moved in tandem with that of the major benchmark. They have all underperformed expectations.

The highly popular property sector, which has been sizzling hot today and outperforming the rest and responsible for much of the lifting of the Phisix to current record highs produced a surprisingly negative (-7.4%) growth in 2014!

The finance sector departed from the majors, posting two hefty EPS growth in 2012 and 2013, but this seem to have faded as the sector’s growth rate shrank to a paltry .8% in 2014.

On the other hand, the service sector, which has underperformed in 2010-2012, rebounded strongly in 2013 but gains appear to have been short-lived as EPS growth posted only 6.33% last year.

Yet the service sector had been the best performer in 2014 in terms of EPS growth compared to the rest including the most popular and most influential peers.

Unfortunately the service sector had been the industry laggard in terms of returns, posting only 13.94% in 2014 when the Phisix celebrated a 22.76% buoyed mostly by the biggest three sectors. So the present state of the domestic markets have been rewarding hype and at the same time punishing the real performer.

In essence, December 2014 underperformance had been broad based as it reflected on ALL the aforementioned major industries.

What media sells as G-R-O-W-T-H has really been a deviation from reality.

PSE 30 EPS Growth Rates Reveals that This Time Has NOT Been Different!

The above represents the Phisix composite members and their respective EPS from 2007 to 2014.

Given the facts that PSE’s EPS growth has been declining for the last three years, and where the decline has been a phenomenon that has been shared by three major sectors and lastly that in 2014 all sectors had performed dismally, my focus will be on the EPS growth performance during this period 2012-2014.

From the above table we get the following insights:

-There have been only SIX issues which has consistently delivered positive growth (blue font), specifically ALI, URC, JFC, ICT, RLC and MER. (blue font)

-There have been only FIVE issues, namely ALI, URC, JFC, ICT, and MER, which delivered an average growth of above 10% over the past 3 years!

-Last year, 10 issues, only one-third of the basket, posted growth of 10% see above yellow background.

-Last year, 13 issues posted NEGATIVE growth (red font).

-Most earnings of the individual firms has been very volatile.

So there had been more negative growth than positive growth with over 10%.

All these converge to demonstrate why the PSE’s EPS grew by only 1.63% in 2014.

Which is the exception and which is the rule, outperformance or mediocre earnings activities?

So has there been a structural change in earnings growth to warrant an alleged “new normal” of high valuations?

Based on the above, the answer is a clear NO.

Understanding Media’s Bubble Promotion; IIF’s Warning on Buyside Institutions

The above only reveals what media and their quoted experts/industry leaders see as “new normal” has actually been about survivorship bias—the error of focusing on the winners or the visible—in combination with fallacy of composition—what is true in some parts is interpreted as true for the whole.

Yet we have to understand where such sentiment has been coming from.

When buyside institutions declare “new normal” of high valuations they are most likely speaking to reflect on how they manage their balance sheets. I previously noted that this signifies a yellow flag. Remember[3]?

Finally I’d be very concern about buyside institutions selling products heavily based on expectations of beyond historical average returns. Those rose colored glasses may be a function of endowment effect—people value things highly because they own them. If the portfolio of buyside institutions have been largely weighted on such expectations, and if such expectations fail to take hold, a big mismatch in the asset—liability could result to a lot of pain for the clients.

The Institute of International Finance a consortium or a global association or trade group of financial institutions with nearly 500 members in 70 countries last week warned about the imbalances being accumulated on the asset-liability matching process by the buyside (pensions and insurance) industry due to the low interest rate regime.

Given that low interest rates have effectively increased present value of liabilities of such institutions, low interest rates effectively spurred the widening of the gap between assets and liabilities. Add to these, regulatory obstacles have created “shortages” of assets that these institutions are allowed to hold on their balance sheets.

So with the gulf between liabilities and assets, buyside institutions have resorted to incredibly perilous risk taking of using “various investment strategies” intended to “produce equity-like returns”. 

On a global scale, such institutions aside from boosting holdings of corporate and foreign bonds to record levels, have vastly increased exposure on ETFs, high dividend yield stocks, unhedged usually options based directional trading and carry trades. Worst, in order to produce equity like returns, buyside have used enormous amounts of leverage to finance such transactions.

Addressing buyside institutions, here is the IIF’s latest warning[4]: (bold mine)

The longer lower rates and net negative supply of high-quality government bonds persists, the more pressure is put on long-term investors to take on extra risk to generate income. These risk exposures would accumulate and render the financial system more fragile as long players become more exposed to a severe market downturn. Moreover, the phenomenon of “savings glut” chasing bonds could become endogenous, keeping bond yields low and requiring additional savings—thus prolonging the low-rate environment and supporting the buildup of even more risks.

The IIF essentially validates my yellow flag warning.

So when representatives of domestic buyside institutions declare that “this time is different”, they are symptomatic of the dynamic of “more pressure is put on long-term investors to take on extra risk to generate income”. It’s also sign of endowment bias—ascribing more value to things merely because they own them. In particular, they are expressive of their investment strategies employed for balance sheet matching.

In short, those “pressures” to match asset and liabilities have now been conveyed as rationalizing high valuations with “this time is different”.

Yellow flag it is for many financial institutions.

Of course the incentives of the buyside and the sellside industries are different.

Yet it would be really off the mark for anyone to say that media’s sentiment represents the consensus.

Take the stock market. There are only about 600,000+ invested directly at stocks or .6% of the population. If we add those indirect investors via mutual fund, UITFs and others this would be about 2-3% of the population. Even if we give the benefit of the doubt that there have been 5% directly or indirectly exposed to the market this means 95% have not been invested.

95% is THE consensus. But you don’t hear them. They are the silent majority. That’s because they are not organized. Also they don’t pay media advertising revenues.

Except for me, hardly anyone speaks in behalf of them. So for instance, when I get reprimanded by an industry leader for not towing the line, where the “consensus” (appeal to majority) has been used as a pretext to justify current mania, what has been talked about have really been about the sentiment of the consensus of the industry—again organized interest groups benefiting from the mania.

The organized interest groups are in control of communications in media. Media expresses on their sentiments and not of the silent majority. Even if many in the public shares media’s sentiment, for as long as they are not participants in the marketplace they remain uncommitted to such interest groups. Action speaks louder than words—demonstrated preference.

But again this would be an issue for another day.

DEBT EQUITY RATIO as Barrier to Earnings Growth

This leads to next ingredient to the stew of interest rates, earnings and growth; the role of debt as expressed in the PSE report as Debt Equity Ratio (DER).

From 2008 to 2014, the suppression of DER growth boosted EPS growth. On the other hand, a surge in DER growth has impeded EPS growth (see left window).

Correlation is not causation but there is a link. Debt is a liability. It is included in a company’s operating cost. If a company acquires debt and if such increase in costs will not be negated by an increase in revenues or in margins, then debt servicing will gnaw at the company’s earnings.

So the inverse fluctuations from DER and EPS seem like a manifestation of such dynamic.

The huge debt buildup has also been broad based in terms sectoral performance and a largely a 2013 origin dynamic.

DERs of all the major sectors have spiked in 2013. In 2014, DERs continued to rise in the holding industry, finance and service. The growth rates have declined in the industrials and the property sector.

I would guess that those numbers have been underrepresented. That’s because BSP’s bank loans to the general economy especially to the property sector have risen through 3Q 2014.

Also I believe that there has been a lot of off balance sheet loan transactions aside from the existence of the domestic shadow banking system as previously reported by the World Bank.

In addition I believe that balance sheets have been bloated from monetary inflation to possibly overstate equity values.

So add to the DER story the BSP interest rate history we get an idea how the Phisix EPS growth story has been shaped.

Those interest rate cuts of 2009 which ignited the magnificent EPS growth effectively reduced DERs. But again we see the law of diminishing at work. The succeeding rate cuts in 2012, not only reduced EPS growth trends, but likewise combusted the PSE’s DERs past 2008 highs since 2013!

So debt must have likely been a key factor in depressing EPS growth in the past and so will they affect EPS growth in the future.

Debt accounts for as just ONE of major barriers on why those high growth expectations from industry consensus will likely miss overstated targets by a galaxy.

The Four Horsemen to Earnings Growth

Yet I will add FOUR more obstacles that have not been included in the PSE report.

Three are domestic, which I have previously discussed, has been part of the Philippine government’s puffed up 6.9% 4Q GDP.

The fourth is exogenous.

Despite the panoply of media cheerleading on selective statistics, embedded in the government’s economic growth statistics has been substantial ongoing challenges in investments, household spending activities and even retail and wholesale trade as noted here.

If investments won’t pick up where will real economic growth come from that should filter into earnings? Why have households been pulling back? Why has growth in the retail industry plummeted in 4Q 2014?

If household spending remains lackluster where will malls, condos, casinos and hotels or the PSE’s top line come from and how will earnings growth be generated? How about the surge inventory from wholesale activities?

And how about those debt that has financed all these activities?

Also why does the BSP chief insist in his deflation spiel to even lecture journalists on how to see events in the framework of deflation?

The Fourth Horseman: Soaring US Dollar

Now the fourth factor: the USD-peso

Last week, Asian currencies had practically been hammered.

Against the USD, the South Korean won collapsed by about 2.7%, the Indonesian rupiah was smoked anew by about 1.7%, and the Singapore dollar got smashed 1.1%.

The most recent currency star of Asia, the Indian rupee was not invincible after all. The rupee was battered by 1.2%. This has reduced the rupee’s year-to-date gains which still remain positive. The rupees’ smashed up have likely been due to her ‘surprise’ interest rate cut along with South Korea.

As a side note, it’s a surprise to media but not a surprise for me as I expect Asian currencies, including the BSP to jump into the interest rate cutting bandwagon. 

The Thai baht lost 1.07%, the Malaysian ringgit fell .97%, the Taiwan dollar slipped .59% while the Philippine peso lost only .47%. The Chinese currency the yuan was the best performer to date to rise by .07%.

And speaking of central bank panics, add to this week’s rate cutting has been Russia and Serbia.

Year to date except again for the rupee, Taiwan dollar and the Philippine peso Asian currency has been substantially weaker. For now, the Philippine peso now takes on the leadership but for how long?

There are two major transmission mechanisms for currency weakness, one is through imports, and the other is through foreign denominated debt.

On a global scale, with the US dollar index hitting 100, a multiyear high, this bring into the light the $9 trillion US Dollar based credit to non banks OUTSIDE the US (see left), and the potential harbinger for a colossal event risk (right) which in the past has been “associated with major market events such as 1981 Volker shock, 1992 ERM crisis, Lehman in 2008 and so on” according to Bank of America Merrill Lynch/Business Insider.

Question now is what happens when one of these Asian nations suffer from a credit event? Will this be isolated or will history repeat?

It appears that the industry would like to anchor on the former, while the latter is the likely outcome.

A lot of people think in terms of satisfying present convenience. As Bill Bonner of Agora Publishing writes[5]:

People come to think what they must think when they must think it.

This time will NOT be different. The obverse side of every mania is a crash.

---

[1] See Phisix at Record 7,400: Be Fearful When Others Are Greedy January 12, 2015

[2] See Phisix 7,800: Record Phisix as the BSP Continues with Deflation Spiel! March 9, 2015

[3] See Phisix 7,800: Record Stocks, Incredible Misperceptions February 23, 2015

[4] Institute of International Finance, Capital Markets Monitor: A Fundamental “Asset-Liability Mismatch:” Investing in a Low-Rate Environment March 4, 2015

[5] Bill Bonner How This Great Race to Disaster Finally Ends January 9, 2015

More Central Bank Panic: Russia, Serbia Cuts Interest Rates

Central bankers around the world have been resorting to crisis resolution measures of aggressively slashing rates (and other easing measures)…

Last night Russia announced a 100 basis point cut

From Bloomberg: (bold mine)

Russia’s central bank lowered its main interest rate and signaled more policy easing ahead if inflation continues to ease as the economy buckles under low oil prices and sanctions over Ukraine.

The one-week auction rate was cut by one percentage point to 14 percent, the central bank said in a statement on its website Friday. Seventeen of 32 economists in a Bloomberg survey predicted the move, with nine seeing no change and five forecasting a bigger reduction. Another analyst predicted a half-point cut.

The Bank of Russia is pressing ahead with monetary easing after a surprise 2 percentage-point cut at its January meeting as weekly inflation decelerated. Even with price growth more than fourfold its mid-term target, the regulator is responding to calls from business to unwind December’s emergency increase to 17 percent to buoy an economy entering its first recession in six years.

The first and second rate cut follows an earlier emergency rate hike last December intended to stanch capital flight out that has battered her currency the ruble. (chart from tradingeconomics.com)

The December sell-off or the ruble, see USD-RUB (from Google Finance) has apparently been in a hiatus.

As I explained here and here, despite relatively lower levels compared to developed  economy contemporaries, Russia has her own debt problems. And thus the central bank’s response “to calls from business to unwind December’s emergency increase” via rate cuts.

The problem has been that those rate cuts (with more to come) are likely to rekindle a weaker ruble and place the Russian economy in a indeterminate juncture.

Now Serbia's version. From another Bloomberg report: (bold mine)

Serbia’s central bank cut its benchmark interest rate for the first time since November as it fights a recession and the threat of deflation amid the government’s effort to tame the budget deficit.

The National Bank of Serbia lowered its one-week repurchase rate by half a point to 7.5 percent, it said in a statement on its website. Six of 23 economists surveyed by Bloomberg predicted a quarter-point reduction, eight forecast a half-point cut and nine expected no change.

Policy makers reduced the cost of borrowing amid “increased global liquidity as a result of the ECB’s quantitative easing” program, the bank said in a statement on its website. They also took into consideration “fiscal consolidation measures and structural reforms, as well as the conclusion of the International Monetary Fund program.”

With one of the highest benchmark rates in emerging Europe, Serbia’s central bank is caught between trying to help the economy emerge from its third recession since 2009 while also shoring up the dinar, which fell after the bank’s November move. Last week, non-executive central bank Chairman Nebojsa Savic said policy makers should hold rates at least until May, when the International Monetary Fund arrives to review Serbia’s compliance with conditions of a stand-by loan.

The following charts help explain the decision

Consumer credit has been exploding…

Meanwhile the spendthrift government has widened the fiscal deficit

And such reckless government spending financed by debt has helped increased the debt burden of the nation

Add to this the chronic deficit in her current account which means Serbia has been consuming more than producing

Unfortunately all those debt financed consumption spending has weighed on her annual gdp where Serbia’s economy has been mired in a twin recession of 2012 and 2014 (third or triple dip if to consider 2009)

Serbia’s stock market appears to ignore the 2014 recession because they have been in an uptrend since 2012

Yet part of the debt financing of consumption has been through external channels which has spiked over the past few years…

The problem with toying with money and credit is that there will be an outlet where accrued imbalances will be vented. And thus far this has been through a crashing currency the Serbian dinar via Google Finance USD-RSD.

And while rate cuts may temporarily ease the burden of domestic debt, this will likely put pressure on the dinar which will amplify pressures on her external liabilities.

So when media reports that Serbia has been "caught between trying to help the economy emerge from its third recession since 2009 while also shoring up the dinar"...this really is a symptom of a debt trap.

Debt is no free lunch.

As for why I believe central banks will be cutting rates I previously explained here.

This marks the 24th rate cuts by global central banks according to CBRates.com. 11 last January, 7 in February and 6 for March with more to come. The tally reflects only on official rate cuts and not other easing measures applied.

Record stocks in the face of record imbalances at the precipice.

Five Signs that Shows of the US Government's Rapidly Eroding Political Capital Base

The US government’s grip on domestic and international politics seem to be slipping fast.

First, the US financial imperialist plan to isolate and drop Russia from the global financial system has backfired.

From Sovereign Man’s Simon Black: (bold mine)

If Vladimir Putin is remotely capable of laughter (the jury is out on that one…) then he’s probably doing so right now.

Russia is once again Arch-Enemy of the United States. It’s like living through a really bad James Bond movie, complete with cartoonish villains.

And for the last several months, the US government has been doing everything it can to torpedo the Russian economy, as well as Vladimir Putin’s standing within his own country.

The economic nuclear option is to kick Russia out of the international banking system. And the US government has been vociferously pushing for this.

Specifically, the US government wants to kick Russia out of SWIFT, short for the Society of Worldwide Interbank Financial Telecommunications.

That’s a mouthful. But SWIFT is an important component in the global banking system because it lays the foundation for banks to communicate and transfer funds with one another.

It’s a network protocol of sorts. Whenever a bank in Pakistan does business with a bank in Portugal, the funds will clear through the SWIFT network.

According to the SWIFT itself, they link over 9,000 financial institutions worldwide in over 200 countries, which transact 15 million times per day.

Bottom line, being part of SWIFT is critical to conducting business with the rest of the world. And if Russia gets kicked out of SWIFT, it would be a disaster.

Now, SWIFT is technically organized as a ‘Cooperative Society’ and governed by a board of directors.

There are 25 available board seats, and each seat is allocated for a three-year term to a specific country.

The United States, Belgium, France, Germany, UK, and Switzerland each hold two seats. A handful of other countries hold just one seat. And of course, most countries don’t hold any seats at all.

Here’s what’s utterly hilarious—

On Monday afternoon, not only did SWIFT NOT kick Russia out… but they announced that they were actually giving a BOARD SEAT to Russia.

This is basically the exact opposite of what the US government was pushing for.

Awkward…

But this story is even bigger than that.

Because at the same time that the US government isn’t getting its way with SWIFT, the Chinese are busy putting together their own version of it called CIPS.

CIPS stands for the China International Payment System; it’s intended to be a direct competitor to SWIFT, and a brand new way for global banks to communicate and transact with one another in a way that does NOT depend on the United States.

We’ll talk about CIPS in more details in a future letter. But in brief, it addresses some serious weaknesses, inefficiencies, and technological challenges of SWIFT.

And it should be ready to go later this year.

Make no mistake, this is the beginning of the end of the US dollar’s global hegemony. It’s time to stop hoping that it won’t happen and time to start preparing for it.

Second, against US wishes, UK decides to join China’s Asian Infrastructure Investment Bank

From the Financial Times (bold mine) 

The Obama administration accused the UK of a “constant accommodation” of China after Britain decided to join a new China-led financial institution that could rival the World Bank.

The rare rebuke of one of the US’s closest allies came as Britain prepared to announce that it will become a founding member of the $50bn Asian Infrastructure Investment Bank, making it the first country in the G7 group of leading economies to join an institution launched by China last October.

Thursday’s reprimand was a rare breach in the “special relationship” that has been a backbone of western policy for decades. It also underlined US concerns over China’s efforts to establish a new generation of international development banks that could challenge Washington-based global institutions. The US has been lobbying other allies not to join the AIIB.

Relations between Washington and David Cameron’s government have become strained, with senior US officials criticising Britain over falling defence spending, which could soon go below the Nato target of 2 per cent of gross domestic product.

Third, the first open spat over Ukraine between the US-NATO and Germany

From Sputnik International (bold mine) 

German Foreign Minister Frank-Walter Steinmeier has told his US counterpart John Kerry that it is too early to take any pride in the western strategy towards the Ukraine crisis, just days after accusing the US of "dangerous propaganda" over Ukraine.

Steinmeier, speaking on a visit to the US, said to Kerry at a joint press conference in Washington: "It is far too early to pat our shoulders and take pride in what we've achieved."

His comments come days after an official in German Chancellor Angela Merkel's offices had complained of US Air Force General Philip Breedlove's "dangerous propaganda" over Ukraine, and that Steinmeier had talked to the NATO Secretary General Jens Stoltenberg about him.

Fourth, the average Americans see the US government as the most important problem.

From Gallup.com

Americans continue to name the government (18%) as the most important U.S. problem, a distinction it has had for the past four months. Americans' mentions of the economy as the top problem (11%) dropped this month, leaving it tied with jobs (10%) for second place

Though issues such as terrorism, healthcare, race relations and immigration have emerged among the top problems in recent polls, government, the economy and unemployment have been the dominant problems listed by Americans for more than a year.

The latest results are from a March 5-8 Gallup poll of 1,025 American adults.

Finally, actions speak louder than words (demonstrated preference), record Americans have been ditching US passports.

From CNBC.com (bold mine)

According to the latest data from the Treasury Department, spotted by Andrew Mitchel at the International Tax Blog, a record 3,415 Americans renounced their citizenship in 2014. That was up from the 2,999 in 2013 and more than triple the number for 2012.

You can read the list of individuals who renounced here.

While some may see taxes as the main reason to flee, that's only part of the story. The big policy change that's causing people to give up their American citizenship is FATCA, the Foreign Account Tax Compliance Act.

It may sound wonky. But the act requires foreign banks to reveal any Americans with accounts over $50,000. Banks that don't comply could be frozen out of U.S. markets. And Americans overseas—even those who never lived in the U.S. or have a tangential connection here—are now under far more pressure to file detailed tax returns and pay U.S. taxes on their overseas income.

The program was designed to catch more wealthy overseas tax cheats. But one of its unintended consequences is that those Americans are simply giving up on being Americans.

And as part of this exodus, Americans in Asia have also been dumping their citizenship, from Asian Investor.net

A fast-rising number of Americans based in the region are disposing of their US citizenship, citing increasing difficulty of managing their financial affairs due to growing regulatory demands.

I have posted about FACTA here. 

So underneath those record stocks have been a progressing US political entropy. Yet what happens if the US suffers a recession or another financial crisis?

How the Bank of Japan Pushed Japanese Stocks to Milestone Highs

I have previously noted that the Bank of Japan has included stock markets as part of the assets on their QE program

Yet the brazenness of the distortions from the BOJ's stock market interventions has even prompted the mainstream to see and report them.

From the Wall Street Journal: (bold mine)

The Bank of Japan’s aggressive purchasing of stock funds has helped Japanese shares climb to multiyear highs in recent months. But some within the central bank are growing uncomfortable about the fast-paced rally and the bank’s own role in fueling it.

Since Gov. Haruhiko Kuroda took office in March 2013 and introduced monetary easing of what he called a “different dimension,” the central bank has sharply increased its buying of baskets of stocks known as exchange-traded funds. By directly underpinning the market, officials have tried to encourage private investors to follow suit and put more money in stocks in the hope of stimulating the economy and increasing inflation.

During the past two years, the central bank entered the stock market roughly once every three days, picking up a total of ¥2.8 trillion ($23 billion) of ETFs that track Japan’s major stock indexes, according to Bank of Japan records. That distinguishes it from the U.S. Federal Reserve and European Central Bank, both of which have bought bonds to pump up the economy but haven’t directly bought stocks.

Analysts say the bank’s action has been a significant driver of Japan’s stock-market rally in recent months, combined with hefty purchases by the $1.1 trillion Government Pension Investment Fund. Their buying has often countered selling pressure from individuals in the market and made up for a weaker appetite among foreign investors.

I wrote this last November 2014

This is how the Japanese government has perverted Japan’s stock market. The public now will buy stocks in the hope that the BoJ and the GPIF will buy from them at higher rather than base one’s allocation from the cap rate of stock market and property investments. The public has been buying stocks out of moral hazard, someone (Japan’s taxpayers) will pay the price for the recklessness of a few.

Apparently those from within the central bank whom has been “growing uncomfortable”, realize how this absurd dynamic has been in place.

And the above confirms my presentation that it hasn’t been the households whom has been benefiting from milestone highs but foreigners and a few privileged domestic financial institutions.

Here is an update of foreign speculators dominating the record ramp of Japanese stocks which Tradingeconomics.com reports that “Stock investment by foreigners in Japan increased by 290 JPY Billion in the week ended March 7th, 2015.”

In short, current policies have yet "to encourage private investors" to jump into stocks.

 

The BoJ as index manager:

The central bank has stepped in mostly when market sentiment was weak. Three-quarters of the central bank’s buying occurred on days when the benchmark Topix index opened lower, according to a Wall Street Journal analysis of BOJ data.

The index has gained more than 50% since the start of Mr. Kuroda’s policy…

The stock buying, which began on a small scale under Mr. Kuroda’s predecessor in 2010, has intensified since Oct. 31 last year, when the central bank expanded its annual asset-purchase program by up to 33%. The annual goal for its purchases of ETFs was tripled to ¥3 trillion.

Because the Bank of Japan is unlikely to reach its goal of boosting the annual rate of inflation to 2% anytime soon, doing away with the deflation that has intermittently plagued Japan, speculation about possible further intervention is growing.

The book value of the bank’s ETF holdings stood at ¥4.323 trillion as of the end of February, according to Bank of Japan data, and the market value is likely higher because of recent rises. The bank estimates the book value will reach about ¥6.8 trillion by the end of this year.

For comparison, Nippon Life Insurance Co. is the single biggest private institutional investor in Japanese shares, with ¥8.2 trillion in Japanese stock assets as of last December. Stocks listed on the first section of the Tokyo Stock Exchange have a total market value of about ¥550 trillion.

Political barriers to the stock market intervention intensifies…

BOJ officials are divided over the wisdom of its growing activity in financial markets. Four of the nine board members opposed the October decision, citing, among other reasons, the fear of undermining market functions.

While the dissenters’ main concern was the bond market, Takahide Kiuchi, one of the dissenters, expressed concerns over surging stock prices at a news conference on March 5. “I don’t think there have been any dramatic changes in fundamentals,” he said.

Some within the BOJ think it may need to consider reducing its ETF purchases if the stock market keeps rising, according to a person familiar with the matter.

Those in the mainstream group within the bank, officials who supported the aggressive easing measures last October, have interpreted the bull market as evidence that their efforts to eliminate a “deflationary mindset” in Japan are bearing fruit. They shrug off the suggestion that the bank itself could cause overheating of the Tokyo stock market, people close to the BOJ said.

Some economists criticize the central bank’s stock purchases as another form of “price-keeping operations,” referring to a largely unsuccessful attempt by Tokyo in the 1990s to support a falling stock market by funneling savings in accounts at post offices and public insurance money into stocks.

BOJ officials used to be cautious about purchasing ETFs, worried that it could distort market activities and put the central bank’s own financial health at risk. But under pressure from politicians following the global financial crisis, the bank changed its stance in late 2010.

“We led the cows to water, but they didn’t drink it, even though we told them it tasted good,” Miyako Suda, who was a board member then, wrote in a 2014 book discussing monetary easing at that time. “So we thought we should drink it ourselves, showing them it was tasty.”

Doing the same things over and over again and expecting different results.

This simply shows how stock markets have become politicized and been used as instruments for political agenda thus impairing its price discovery and discounting mechanism. As I previously pointed out, this has not just been a Japan dynamic, as of early 2014 global government intervention in stocks has reached $29 trillion since 2009.

As history shows, such booms will be fleeting.

Central Bank Panic: South Korea and Thailand 'Unexpectedly' Cuts Interest Rates!

As I have been saying here global central banks appear to be in a state of panic for them to aggressively slash interest rates. And curiously too these rate cuts appear synchronized. 

I have been projecting central banks around the world to cut rates for the following reasons:

Political agenda will dictate on monetary policies. Incumbent political leaders would not want to see volatilities happen during their tenure, so they are likely to pressure monetary authorities to resort to actions that will kick the can down the road…

In short, authorities are likely to be concerned with short term developments. And political agenda will most likely revolve around popularity ratings and or the next election—or simply preserving or expanding political power.

Next, there is the social desirability bias factor. Monetary authorities won’t also want to be seen as “responsible” for a volatile environment. They don’t like to be subject to public lynching from market volatilities.

Third, there is the appeal to majority and path dependency. Since every central banker has been doing it and have long been doing it, they think that they might as well do it and blame external factors for any untoward outcomes…

Asian central bankers are likely to embrace the “sound banker” escape hatchet as propagated by their political economic icon—JM Keynes:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

In Asia, aside from India, Thailand and South Korea just confirmed these views.

Moments ago, the South Korean central bank, the Bank of Korea, just cut rates. 

From Bloomberg: (bold mine)

South Korea’s central bank unexpectedly lowered its key interest rate to an all-time low to prevent the nation from falling into deflation and support economic growth.

The Bank of Korea lowered the seven-day repurchase rate to 1.75 percent, as forecast by two of 17 economists surveyed by Bloomberg. The rest predicted no change. The central bank lowered the rate by 50 basis points in two steps in 2014.

With South Korea’s inflation at slowest pace since 1999 and exports falling, the BOK joins more than 20 other central banks in loosening policy this year, including its Thai counterpart, which unexpectedly cut rates Wednesday. Governor Lee Ju Yeol told parliament on Feb. 23 that the central bank would probably have to respond through interest rates if the economic situation deteriorated.

Raging stocks in the face of economic situation deterioration that prompts for a monetary policy response via interest rate cuts?! This has been du jour reward-risk environment: parallel universes, bad news is good news.

Well that’s South Korea’s policy rate trend from tradingeconomics.com

And that’s South Korea’s statistical GDP annualized.

Note that BoK has been cutting rates even as statistical gdp continues with its downshift.

It’s basically doing the same thing all over again expecting different results.

And here is the kernel of the policy decision from the same article:

Governor Lee said after holding the key interest rate on Feb. 17 that the “sharp increase” in household debt was one of the reasons for the decision. Government’s efforts to curb household debt could give more “leeway” for BOK to lower rates, according to Samsung Securities Co.

The Financial Services Commission said Feb. 26 that it planned to convert 20 trillion won of household debt this year to fixed-rate, amortized loans. Data released the same day showed South Korea’s household debt rose to a record 1,089 trillion won at the end of last year.

“A rate cut can lead to more household debt, and policy measures to reduce risks from higher debt offers room for monetary policy,” Stephen Lee, a Seoul-based economist at Samsung Securities, said before the decision.

Like anywhere else, the general idea of the present day dynamic of serial rate cuts have been to lessen the debt burden. At the same time while cost of servicing debt goes down, demand for debt may go up. So the unfortunate result for such engagement would be a “debt trap”.

That’s the US Dollar South Korean won based on Google Finance

Since the BoK has opted to subsidize the domestic debt, her choice would most likely extrapolate to an even weaker won, thereby shifting the vulnerability of her debt burden to overseas exposure.

All these actions are just signs of kick the proverbial can down the road. But the road has a dead end. 

Now the Bank of Thailand’s announcement: (bold mine)

The Bank of Thailand’s Monetary Policy Committee has decided to reduce the policy rate by 0.25 percent from 2.00 to 1.75 percent per annum with immediate effect.

Mr. Mathee Supapongse, Secretary of the Monetary Policy Committee, said that the decision was made on 11 March 2015 at a meeting of the committee, which voted 4 to 3 to reduce the policy rate. Three members voted to maintain the policy rate at 2.00 percent per annum.

He explained key considerations for policy deliberation, saying that in the fourth quarter of 2014 and January 2015, the Thai economy continued to recover slowly, as the economic momentum from private consumption and investment was softer than expected owing in part to weaker private sector’s confidence.

In the periods ahead, the economy is projected to recover at a slower pace than formerly assessed. Exports of goods are expected to recover at a rate close to the previous projection, but with higher downside risks from a slowdown in trading partners’ economies, notably China. Meanwhile, tourism is projected to recover steadily, partially offsetting the weaker domestic demand.

In the first two months of 2015, headline inflation declined and turned negative due to low global oil prices. Nonetheless, the prices of most goods and services continued to rise, reflected by positive core inflation. Looking ahead, inflationary pressure is forecasted to remain at a low level, close to the committee’s assessment at the last meeting. Overall financial stability remains sound, but there is a need to closely monitor the potential risk build-up associated with search-for-yield behavior, amid an extended period of low domestic interest rate environment.

“In the policy deliberation, the committee judged that the outlook of the Thai economic recovery is weaker than previously assessed. Fiscal stimulus will take time to materialize, while headline inflation is projected to remain low for a certain period of time. Against this backdrop, four members judged that monetary policy should be eased further to provide more support to economic recovery, and help shore up private sector’s confidence. Nevertheless, three members deemed the current policy rate as still being sufficiently supportive of economic recovery, while the policy space should be preserved as a shock absorber, to be used when more necessary and when policy transmission is more effective. Fiscal stimulus, especially the implementation of planned public investment, should be a key growth driver at this juncture.

“Going forward, the Monetary Policy Committee will closely monitor developments of the Thai economy, and will pursue appropriate policy to sustain the ongoing economic recovery, as well as to maintain financial stability in the long term.”

This is Thailand’s official policy rate trend since 2011

Those rate cuts have done little to support even the statistical economy over the same period

What those actions have done has been to swell Thailand’s credit markets…

...as well as inflate the balance sheet of Thailand’s banks.

A lot of those loans appears to have been channeled into speculative activities

Housing prices have been on wild ride up! (The data above is from Global Property Guide as of May 2014)

Others have been channeled to stocks where like everywhere else, Thailand’s stock market via the SET has been sizzling…

Coming off the jitters from October lows, the Thai SET appears to be inflecting again. 

And I believe that the decline in stocks which the BoT fears could amplify “part to weaker private sector’s confidence” could be a reason for last night’s divisive decision to cut rates in support of the speculative markets.

Yet subsidizing domestic debt will mean a weaker baht (USD-THB), which again like in South Korea’s dilemma will mean placing bigger weight on foreign debt exposures.

It’s odd how the BoT can claim “financial stability remains sound,” when they are in fact major force behind the “potential risk build-up associated with search-for-yield behavior, amid an extended period of low domestic interest rate environment”

BoT’s statements echo the Philippine BSP

Meanwhile despite the BSP’s stance, which has been to keep at current levels, those reiterative deflation risk spiel by the BSP chief have most likely been meant to condition of the public to the eventual lowering of rates. 

The problem is that lowering rates need to be justified. And since everything has been a showbiz, the BSP has been in a predicament to look for one. The BSP chief has even lectured financial journalists on how to write their articles by focusing on deflation.

The BSP cannot be seen as upsetting the boom image.

Anyway, Thailand and South Korea’s rate cut marks the 21st and 22nd rate cuts for 2015 according to CBrates.com. That’s aside from all other non-interest rate easing channel.

At the end of the day, there is a price to pay for all these debts, and this has been why central banks have been in panic. Extend and pretend.