Inflationary Proclivities of Central Banks

``Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency. . . Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose." John Maynard Keynes, The Economic Consequences of the Peace, 1920, pg 235.

As anticipated, Wall Street took the US Federal Reserve’s hiatus from its 2 year endeavor to normalize money policies as a reason to markdown equity prices, on the premise of a “slowdown-hurts-earnings” excuse, alongside with it, the Philippine Composite Index, which has closely tracked the movements of the US equity markets. The bizarre part came with Friday’s US strong retail sales figures, which had been imputed as a potential fulcrum for future Fed action on raising borrowing costs, as a reason to sell. Sell on Good news, Buy on negative news...this is today’s Wall Street mantra.

While the Phisix trailed Wall Street, this has not been the case with most emerging markets for last week. To wit, our ASEAN neighbors performed energetically on the broad financial markets, namely currencies, bonds and equities, which equally reflected the advances in other emerging markets of other regions, as shown in Figure 1.

Figure 1: Stockcharts.com: JP Morgan Emerging Market Index (black-red) JP Morgan Emerging Market Debt Fund (black)

Advances in bond prices (declining yields) have outperformed equities of late, as the chart above shows. These activities suggest that investors have been factoring in a slowdown in world economic growth. For the week, as the Phisix fell (-.89%), ASEAN markets were mostly on the upside, particularly Vietnam (+1.83%), Thailand (+.73%), Indonesia (+.92%) and Malaysia (+.46%).

In the light of moderating inflation indices, ASEAN central banks have either cut rate (Indonesia for the third time in four session for this year) or kept rates at unchanged (Philippines, Thailand and Malaysia) to spur economic growth. The “focus” on growth have led to an ardent rally in the region’s currencies as the Thai baht raced to a six year on a 1.3% jump to THB 37.26 over the week, while the Philippine Peso surged by .5% to a four month high at PHP 51.25, the Indonesian rupiah edged higher by .2% to 9,075, while Malaysia’s ringgit remained unchanged.

As of August 8^th, according to Bloomberg’s Yumi Kuramitsu and Jake Lee, ``The Indonesian currency has gained 8.1 percent this year, with the Thai baht rising 8.8 percent and the Philippine peso strengthening 3.4 percent over the same period.”

Figure2: Bloomberg: Relative Performances; Indonesia (orange), Phisix (blue), Thailand (green), Malaysia (light blue)

As shown in Figure 2: rising regional currencies has mostly been reflected in buoyant equity benchmarks (except Thailand) led by Indonesia (returns on a year-on- year basis), followed by the Phisix, Thailand and Malaysia. Following May’s dramatic selloff, the above equity benchmarks have been trading below May’s peak.

At the margins, I have noted in the past that the rising peso has been inspired or set by foreign portfolio flows buttressed by OFW remittances and trade receipts.

Figure3: Ascending Phisix (Red candle) on the backdrop of a falling US dollar/rising Peso (black candle)

As shown in Figure 3, the rising Peso has preceded a rally in local equities, manifesting a remarkable correlation, and should be further boosted as the Peso firms on the backstop of a prospective relaxation of monetary policies by global central banks and loose liquidity environment.

On the other hand, widely followed BCA Research admonishes that A Fed pause will do emerging equities more harm than expected (emphasis mine),

``A Fed pause typically does not help emerging market (EM) equities...EM equities have rebounded about 15% in the past two months, following the deep correction in May. There could be more upside in the near term in response to the Fed’s rate pause this week, but history suggests EM stocks will likely struggle if the Fed tightening cycle is over. EM stocks are growth sensitive and tend to advance when the Fed is hiking interest rates because the latter reflects improving U.S. economic conditions. While the structural story for EM stocks remains positive, the developing slowdown in the U.S. is a powerful headwind, especially since Chinese policymakers are also trying to cool their commodity-intensive economy. Bottom line: we recommend a neutral stance on EM stocks in global equity portfolios.”

It is rather odd where BCA views positive prospects on US stocks and bonds amidst the dour outlook they have publishing of late, yet maintains a neutral stance on emerging equities to which, according to them, is anchored to US economic conditions.

If the US bond markets are to continually rebound on the backdrop of a moderation economic growth (read: soft landing) and subdued inflation outlook, this indicates further loosening of the money policies ahead. As indicated last week, benchmark treasuries have mostly led Fed policies rather than the other way around.

Inflation as gauged by the activities in the bond markets appears to be indicative of a prospective meaningful reduction as shown in Figure 4.

According to the Bureau of Public Debt, TIPS or Treasury Inflation Protected Securities ``are securities whose principal is tied to the Consumer Price Index. With Inflation the principal increases. With deflation, it decreases.” In short, TIPS are sovereign debt instruments with yields computed based on activities of the Consumer Price Index as a measure of inflation.

Based on the yield differentials of long and short dated TIPS instruments, the bond market appears to be looking at deflationary conditions, according to the Gavekal Research team, ``The short dated bond, indexed on the short term cost of money has seen its yield move from 0% in 2003 to 3% today. Meanwhile, the long dated TIPS has been range trading between 1.5% and 3% since 2002, and we are basically smack in the middle of that trading range today. More interestingly, the difference between the two is almost at an all time high. So, in other words, the US bond market is positioning itself for deflation rather than for inflation. While, a few months ago, bond markets were by and large saying that inflation was a threat, this message has now reversed. This is an important development.”

Again, should the bond markets persist to manifest on the trends indicated by BCA and Gavekal corroborated by either economic data or significant deterioration in the equity markets then one can expect the US Federal Reserve to act on relaxing or reversing its present course to “stimulate” or “reflate” both the financial and economic settings.

Loose money and credit policies equate to abundant liquidity which is highly conducive for the leveraged speculative community. Under such circumstances, one should expect the indispensable participation of financial management entities (hedge, mutual, institutional funds, et. al.) to further adopt yield chasing strategies or finding returns in excess of cash or funding costs, even to the farthest and remotest corner of the most unstable areas of this world, as had been during the past three years.

My point is liquidity or the present inflationary biases, as manifested in the realm of global finance in its myriad forms, such as massive trade imbalances, explosive growth of structured finance or ubiquitous credit boom, frenzied worldwide M&As, petro revenue liquidity et. al. , has driven economic growth on a macro framework rather than the other way around, and would continue to do so unless interdicted by a financial accident. In the same context, we find that these inflationary biases would likely be channeled into various asset classes as we are witnessing today.

In the appearance of coordinated tightening by global central banks led by the US Federal Reserve, liquidity has apparently been persistently accommodative allowing for intermittent rallies as seen in diverse markets and asset classes geographically.

Although there could be indeed signs of softening of inflation expectations, yet on the premise where global central banks would like to be seen as “successfully managing” the financial system, they are likely to err on the side of tolerating inflationary biases than to allow deflationary forces to overwhelm and render their policies as inutile.

Who among the bureaucrats would like to be perceived as being ineffective or inept? You can just imagine how its Japanese counterparts threw every known textbook response from adopting Keynesians measures of massive deficit spending to the monetarist approach of slashing rates to Zero or flooding central banks with cash to stave off a deflating bubble in the 90s only to fail miserably. Japan’s failed policies could be freshly ingrained in the minds of every member of the US Federal Reserves.

Moreover, you have the present war policies, an extended military exposure worldwide, massive defense and homeland security spending, humongous future liabilities concentrated in welfare entitlement programs as medicare and healthcare and foreign holdings of US bonds. Likewise globally, trend towards increased globalization and the deflationary shocks from the emerging market crises, the tech bubble bust, China’s accession to the WTO and Japan’s banking reforms, which have previously contained the effects of inflation, has permitted central banks around the world to adopt loose money policies too. ``As the effects of these unique factors pass, the inflationary effect of the excess money supply is becoming apparent” notes Andy Xie of Morgan Stanley.

At the end of the day, Central banking is all about inflation. According to analyst Puru Saxena (emphasis mine), ``You must understand that the central banks don't raise interest-rates to fight inflation. After all, the modern-day central banking system IS inflation! Central banks raise or lower interest-rates in order to manage the public's inflation fears or expectations. During such times when the public wakes up to the inflation problem and starts losing faith in the world's paper currencies (present scenario), central banks raise interest-rates to show that they're fighting inflation. Interest-rates are pulled up in an effort to restore confidence in the world's currencies as a higher yield makes currencies more attractive. On the other hand, when the public's inflation fears are under control and confidence in the monetary system is high, central banks lower interest-rates to create even more inflation!”

August 8th is Crunch Time; Market Expectations Runs Against History!

``Short the industry which the majority of Harvard Business School want to join.” – Dr. Marc Faber

For most part of this year, global financial markets have played a ‘guessing game’ on the US Federal Reserves’ next move. Since the US is the world’s largest economy, the world’s most important consumer engine, the nucleus of today’s monetary structure, and houses the world’s most important capital markets, present capital flow dynamics have largely been dependent on its evolving developments.

Financial markets, on the other hand, have largely moved in a synchronized fashion based on its underlying economic, financial and political prospects and its projected ramifications to the world. As pointed out in the past editions, particularly with reference to the equities benchmarks, the Philippine Composite index (Phisix), emerging markets and industrialized economies equity bellwethers have acted in unison with special emphasis during the last quarter. For instance, last May’s simultaneous global cross-markets shakeout had been a virulent reaction to jitters of a liquidity crunch emanating from coordinated actions to raise interest rates by global central banks aside from the narrowing windows for arbitrage plays or “carry trades”. Analyses ignoring these underlying trends are missing out the genuine drivers of the present market dynamics.

Today, post-May’s shakeout, the global financial markets appear to be nearsighted if not encompassed by chronic myopia to bid up equity prices in the outlook of a “moderation” of equity markets. Global markets have recoiled back from May’s shakeout low in anticipation of the US Federal Reserves’ interest cycle peak. In other words, the global investing community, which have been addicted to a prolonged period of loose money environment, have come into conclusion that slower economic growth does equity markets well.

The assumption here is that the technology-inspired productivity growth, coupled with low inflation and loose liquidity would allow for higher market multiples, aside from the cash rich US corporate world to go into an investing spree in the near future. Moreover, reactions evinced by the market suggest that it presumes a “soft landing” scenario and discounts the possibilities of a recessionary risk. In short, the market is functioning on a “Goldilocks” environment. With the hope that these anthropomorphic bears won’t turn its beastly selves to devour on Goldilocks!

Of course, under ‘normal’ circumstances this would not have been the case. Slower growth translates in general to lower earnings and multiples, such that price values would adjust accordingly. In addition, under the circumstances where the cash flow abundant US corporate world have restrained themselves from expanding throughout the cyclical recovery period in 2003 to early 2006, what would motivate them to do so under the present milieu considering that the main driver of its economy appears to have stalled?

However, under the backstop of a tidal wave of liquidity or excess money sloshing around in search for marginal returns, signs of renewed stimulus in the form of a rate pause or rate cuts have driven global investors back into a rekindled vigor. Yes, addicts are hyperanimated when shown of the substance that feeds on their ephemeral ecstasy. They are restimulated.

Market consensus view that the “moderating” or an expected “orderly” growth slowdown would compel Bernanke to bring back the “stimulative” environment. I have quoted the world’s savviest Bond maven, Mr. Gross last week on his forecast of a “last Bond bullmarket” as the Fed goes “reflationary”. The view is that as aggregate demand is compressed on a slowdown, inflation will be subdued. The likely outcome based on the consensus view is that under the zenith of the present Fed interest cycle, bond markets will rally, the US dollar will fall, equities will be boosted and Gold and commodities will go on a full blast.

I hope they are right, because a segment of my portfolio has been constructed out of this scenario. However, the consensus is usually wrong during major turning points in the market.

As the Fed decides on August 8^th on where its policies are headed for, let us use history as a guide to vet on whether the premises of the consensus expectations are cogent or grounded on flawed apriori inferences.

Figure 1: Economagic: 10-year Treasury (blue) Fed Funds rate (red)

Relative to the bond markets, while in general the Fed funds rate tend to follow actions in the Treasury market rather than Fed funds rate determining the direction of the Bond markets, I have noted in four instances where at the peak of the cycle, the benchmark treasuries jumped over the short term (see arrows) in contrast to market expectations!

With the exception of 1970s, the bond markets mostly declined on recessions. However, under the present inflationary landscape, there is that risk that bond yields may, in contrast to Wall Street expectations, climb as it had in 70s!

Why? Let me quote Peter Schiff of Euro Pacific Capital (emphasis mine), ``Economists are also mistaken in their belief that a weakening economy will counteract inflationary pressures. This overlooks the fact that a weakening U.S. dollar will stimulate demand abroad at the same time it restrains it here at home. So even as Americans consume less, prices will continue to rise as they are forced to compete with wealthier foreigners for scarce consumer goods.”

Put differently, inflation is conventionally deemed as a product of economic growth, which is a misplaced view. Inflation is monetary phenomenon as argued by economist Milton Friedman, such that the expansionary environment of money and credit would find a transmission channels towards demand abroad. Further, the predilection towards the Keynesian fixation on the aggregate demand side of the equation misses out the possible impact on the supply side...a slowdown may induce a reduction of supplies too, which would offset any decline in demand!

Figure 2: Economagic: Tradeweighted US Dollar Index (blue) and Fed Fund Rate (red)

A correlation is a correlation until it isn’t. As shown in Figure 2, the previous peaks in the Fed fund rate had been corollary to vigorous rallies in the US dollar index, as shown by the three arrows. Furthermore, another notable observation is that, except for the 1990 recession, the previous records of growth contractions in the US (red shadow) have spurred a surge in the US dollar Index! This is contrary to market expectations!

Since the present drivers of the directional ebbs and flows of the US dollar index include its intrinsic cash yield premium and the structural deficits, I am inclined to view that the US dollar may continue its downdraft, as the US goes into an interest rate cyclical peak while global central banks maintain steps to close the yield premium spreads. Besides, out of fundamental considerations, imbalances have not been blown out to its present state relative to the past.

But again, the bearish overall sentiment, technical picture (you see a double bottom?) and historical precedence could pose as countervailing risks of a firming dollar. Seeing this broad picture allows me to understand the bet premises of the underrated US dollar bulls.

Again, we see market consensus operating on largely misplaced assumptions.

Figure 3 Economagic: S & P 500 (blue) and Fed Funds Rate (red)

In my May 29 to June 2 edition, (see US Epicenter of Global Market Volatilities), I quoted John P. Hussman, Ph.D. of the Hussman Funds who argued that investors had been sporting rose colored glasses (emphasis mine) in the expectations of high returns in spite of the culmination of the interest rate cycle, ``It doesn't help to argue that the Fed will stop tightening soon, because the end of a tightening cycle has historically been followed by below-average returns for about 18 months.”

The chart in figure 3 reinforces this perspective, the arrows above shows that each time in the past the Fed goes into a cyclical reversal for interest rates, the equity benchmark as measured by the S & P 500 has declined markedly. Again, we see history working opposite to the conventional market expectations. Could this time be “different”?

Figure 4 Economagic: CRB Precious Index (Blue) and Fed Fund Rate (Red)

One interesting insight I discovered is that as measure of trends for the Fed fund rate, over the past 35 years, the CRB Precious metal index appears to LEAD it. As shown in Figure 4, the ascension of the CRB precious metal index in the previous 3 cycles, including the present one (see arrows) spawned a hike in the Fed interest rate cycle by a lead time of about 2 years! On the other hand, the crest of the CRB precious metals index has likewise led to reversals in the Fed funds rate by over the same timeframe!

In other words, gold’s price direction could be a meaningful barometer in determining where the future Fed fund rates are headed for, and consequently the global interest rates under the aegis of the US dollar standard system.

For the moment the rallying gold prices could presage a further rise in interest rates over a two year span as Bernanke & Company have been painted to a corner. In the words of analyst Martin Weiss, ``But they're cornered between the unemployment and the inflation. They're fighting two tough wars on two opposite fronts. There's no way they can win both. If they decide to raise interest rates still further, it will be a disaster for the economy. But if they decide not to raise interest rates, it will be a disaster because of run-away inflation.”

In all, as shown in the charts above, the expectations of the market consensus have been mostly on the antipodal side of history. What we see depends on where we stand. While past performances are no guarantee of future outcomes, the present market climate appears to be operating under the predicate of ‘this time could just be different’. I wouldn’t entirely be optimistic on it, since the consensus has been usually wrong during critical junctures, and in most probability they could be wrong again. As German Philosopher Friedrich Hegel once said, ``The only thing men learn from history is that men learn nothing from history.”

Although, in paradox, I have to admit that I am as hopeful that they (consensus) are right this time, so that we won’t be in for nasty surprises. But keep tight those sell stops.

Phisix Looks Bullish, Eyes the FED

``My approach works not by making valid predictions but by allowing me to correct false ones." George Soros

Activities in the Phisix reflected the activities in most emerging market bourses; they were upbeat as the US markets remained buoyant. And this has been so with sovereign bonds as well as the Peso, which closed the week slightly higher at Php 51.52 to a US dollar as against last week’s Php 52.56.

While foreign money remains as the critical driver of the index, they had been liquidating over the broader market. This suggests that foreign money could be rotating from the broad market and into the blue chips (particularly the telecoms). Net foreign buying stood at about Php 630 million, while the locals seized the leadership relative to trading volume.

As noted last week, coincidental to the Peso’s advance, locals have shored up the broad market in the face of foreign liquidation. A firming peso could have inspired a rotation out of US dollar based assets and into equities by local investors. With this week’s advance the Phisix is up by about 12% year-to-date.

All eyes will be in the FED this time, as foreign buying of local equities would depend on the impetus inferred by overseas investors on ex-US assets. Bonds, equities and the Peso will flow alongside with the performances of its peers.

Figure 5: Stockcharts.com: Weekly Phisix

The technical picture, as shown by the one year weekly chart of the Phisix in Figure 5, looks likely tilted in favor of the bulls. Following the May selloff, the Phisix has gone into a V-shape recovery and has held strongly above its 50-day moving averages (blue) as critical support. There had been few instances where the support was breached albeit unsuccessfully. This suggests of the resiliency of the 50-day moving averages as support. Watch that support.

On the upside, as “officially” loose money conditions may see the light again, a decline in the US dollar may propel global investor activities in emerging market economies on the backdrop of higher “growth” prospects as cover, while chasing for yields as the real intent. With the current clip of recovery, the Phisix may test its previous high.

Finally, as global markets have build up expectations for a pause for the upcoming FOMC meeting at the 8^th of August, and if such expectations hold up as anticipated, there could be a “sell on news” reaction in the US markets which could spillover into the Phisix. Watch how the US dollar and gold responds. If the US dollar weakens amidst the selloff and gold rallies strongly, I think it would be time to add more positions in preparation for a possible yearend run.

FinanceAsia: Megaworld steps up with new high-yield debt deal

Megaworld breaks ice in the international high yield debt market! According to Finance Asia,

``Philippine real estate developer Megaworld on Friday (July 28) became the first high-yield issuer to take advantage of the positive sentiment left in the wake of last week’s hugely successful Philippine sovereign deal, pricing an un-rated $100 million Reg-S, five-year bond offering in line with guidance...

``The Megaworld deal was priced at 98.488% on a semi-annual coupon of 7.875% to yield 8.25%, which was spot on with the initial yield guidance provided by UBS. The yield is equivalent to 327.1bp over comparable US Treasuries.”

You may read on the entire article by clicking on this link

As Philippine companies get international exposure by tapping capital market abroad, so will its equities.

Liquidity Driven Rally Amidst A US led Slowdown?

``Fear not for the future, weep not for the past." - Percy Bysshe Shelley (1792-1822), English Poet

As mentioned during the last edition, the Philippine benchmark composite Index has basically shadowed the movements of the US equity benchmarks. This has not been an isolated motion but rather a global dynamic as shown in Figure 4.

Figure 4: Stockcharts.com MSCI Emerging Free (red line) and MSCI World Index (black line)

Both the MSCI World Index and MSCI emerging market Index had moved almost in lockstep over the past quarter.

With a significant rebound in global bond prices or a meaningful decline in yields, a rally in broad based commodities, lower oil prices and a broadmarket decline of the US dollar Index, it appears that the global financial markets have thus far, reflected for the US Federal Reserve to go on a pause this coming August 8^th, following evidences of a marked slowdown. The reappearance of stimulative conditions has temporarily provided global investors ammo to load up on diversified assets.

Figure 5: The Phisix (black candle) and the US/Philippine Peso (red line)

As shown in Figure 5, like clockwork, each time the Peso vis-à-vis the US dollar advances, the Phisix has been likewise buoyed. For the week, the Phisix stormed to a 3.94% advance following sizeable gains from Wall Street (Dow, Nasdaq and S&P 500 up over 3% a piece) to take the second spot behind India (+5.89%) as the best performing bourse for the week.

While foreign buying turned positive from last week, what bemuses your analyst is the extent of the exceptional signs of local bullishness as revealed by sentiment indicators, i.e. the wide gap between advancers and decliners (263 to 85) and the hefty jump in the number of issues traded over the week.

Meanwhile, alongside its ASEAN neighbors, the Peso climbed 1.16% to Php 51.56 against the US dollar in the backstop of the successful issuance of government debt instruments in the global financial bond markets last week. Financeasia.com brands the issuance as ``one of the largest order books ever seen in Asia.” Why? Because ``the final book closed massively oversubscribed, the 10-year tranche closed at 5.7 billion on 228 accounts, an over subscription of 19 times (emphasis mine), while the 25-year tranche closed at 6.5 million with 248 accounts, an oversubscription ratio of 15-times.” Very opportune indeed.

Again I find it truly bizarre for the financial markets to climb amidst the expected economic “moderation” in the US, except for the notion that these could have been so due to liquidity leakages within the financial system.

One of my favorite analyst Mr. Doug Noland in his Credit Bubble Bulletin rightly observes, ``second quarter financial sector earnings reports offer scant evidence of any significant slowing of system Credit growth. The major “banks” maintain an aggressive business posture, with robust growth in lending and capital market activities. The push to satisfy Wall Street earnings growth demands is intense, and the ongoing huge stock buybacks are as well indicative of more aggressive lending and market activities to come. Financial conditions remain extraordinarily loose; Credit Availability remains easy and marketplace liquidity abundant.”

So in spite of the Fed raising interest rates the liquidity backdrop remains essentially loose.

Still, a growth slowdown basically translates to weaker demand, limited pricing power and prospective declines in profit margins. Canadian Independent Research outfit BCA, sees an inflection point or a peak in global earnings power as shown in Figure 5. Quoting the widely followed BCA (emphasis mine),

Figure 6: BCA Research: Global Earnings Revised Down

``The path of least resistance for global earnings estimates is down until economic growth prospects turn-up anew.

``Analysts continue to rein-in earnings expectations after an impressive three year run of positive revisions. The de-rating will continue until signs emerge that global economic momentum is set improve. On this note, our proprietary Global Leading Economic indicator is still falling, and further weakness is likely as a cooling U.S. economy weighs on global growth. The offset for global stocks is that fund managers are already very bearish on both U.S. economic growth and earnings prospects over the next 12-months, as gauged by the latest Merrill Lynch fund manager survey. Accordingly, a weaker growth environment appears to have already been partially discounted. Bottom line: expect directional uncertainty in equities until yearend based on Q3 earnings results before prospects improve next year.”

BCA suggests that extensive bearishness could have been factored into the markets, or possibly, dominant negative sentiment could have fueled the recent rebound in the markets despite the lingering uncertainties. In short, investor sentiment swings and technical “chart” factors could have boosted equity prices abetted by liquidity leakages.

Furthermore, it is also important to mention that PIMCO’s Mr. William Gross, the “Warren Buffett” of Bonds, one of the most successful bond fund managers, if not the top-rated, in the investing world, have audaciously declared in his latest outlook that the bond bull market has began and would be the last, in his words, ``that this bond bull market will be the last; that history, as almost all active bond managers have known it since 1981, will come to an end a few years hence.” Mr. Gross attributes the rebound of bond prices to a significant slowdown in the US economy driven by an intense decline in the housing industry to be followed by possible money easing steps by the Fed.

Mr. Gross’ outlook is similar to my view that the bond markets are treading over to the bear territory over the long-term. The foundation to this outlook, according to Mr. Gross (emphasis mine), ``The important idea is that such a forecast speaks to eventual reflation, inflation, and declining bond prices sometime out there in 2009 and far beyond as the U.S. seeks to address its enormous future liabilities concentrated in social security, healthcare, and foreign holdings of U.S. bonds.” He also thinks the Dow Jones could possibly hit 5,000 in the distant future! My, my, my.

In contrast to the US markets which had undergone a bullrun from 1982 to the onset of the millennium, the Philippine market has basically risen from its nadir in 2002. Yes, today’s marketplace has been “globalized” in a sense that the activities have been running in almost parallel motions. But seen over the long run, both markets are coming from starkly divergent reference points and would, in high probability, remain divergent. In short, the cycles underpinning these markets are structurally dissimilar.

In a recent talkshow at Channel 27’s ANC channel, Rep. Joey Salceda of Albay raised as the “biggest risk” to the planned implementation of the grandiose projects enlisted by the PGMA at her SONA as a US slowdown. If I heard him right, he noted that for every 1% decline in US GDP, the Philippine growth clip would taper by an equivalent of 1.5%. That’s pretty significant. If the markets are all about economic growth then we should expect the domestic markets to consolidate or move rangebound as the US goes into a (hard or soft?) landing. I don’t expect our markets to fall off the cliff as a high probability event, even if the US goes into a recession.

If liquidity propulsion would still be the driver of world financial markets, then as the US Federal goes on a cyclical peak for its money policies, the domestic financial markets may in essence part ways from the directional path of the US markets. My bet is for this eventuality.

While I remain confident that the Philippine cycle remains on the upside over the longer period, the financial markets could be frayed by considerable headwinds caused by exogenous factors over the immediate term. One can take advantage of present swings or volatilities in the market to trade or to accumulate on dips.

Want a Stock Market tip? PGMA’s SONA was a Mouthful

``Men are more moral than they think and far more immoral than they can imagine.”-- Sigmund Freud

Any keen observer of President GMA’s State of the Nation Address (SONA) last week would have noted that the ambitiously grandiose programs enumerated were practically a dead giveaway in terms of stock investments for a serious investor over the long horizon.

These projects have been designed to mainly benefit several industries which we have dealt with as part of the unfolding global big picture trend (see November 29 to December 3, 2004 Domestic Investment to Help Drive the Phisix?), particularly domestic infrastructure, agriculture, tourism and energy. The SONA simply highlights the economic potentials of the Philippines and its crucial role to the region and the world, vicious politics aside(!).

Private Sector Initiatives

At an estimated humongous cost of P 290 billion, critics of these programs miss out the fact that, had the domestic financial markets been more developed and pervasive, e.g. bond (municipal or LGUs/Corporate) or commodities market, funding for these programs would have been complimented if not driven by private investments. PGMA herself appears to have overemphasized on the supply-side and glossed over the demand side, possibly espousing John Say’s Law of “Supply creates its own demand.” Knowing such opportunity I would have suggested to her to add infrastructure programs that would enhance the deepening of the domestic capital markets notwithstanding.

We should not forget that global liquidity has been a key driver of the world’s financial markets from which has propelled real economic growth, to quote a recent article from Joanna Chung of the Financial Times (emphasis mine), ``The sudden interest illustrates a broader theme in emerging markets over recent years: the constant hunt by bond investors for extra yield and their willingness to seek it in ever more far-flung locations”. One could expect the search for yields to spill over towards direct investments for as long as these projects are economically viable in an investor friendly environment (unencumbered by rent seeking politicians and the suffocating onus of regulatory tomes).

Regional Investment trends

Moreover, bilateral or regional investments can also help bolster these investments. Recall that Asia holds about $2trillion of surplus foreign exchange reserves, as shown in Figure 1.

Figure 1 IMF: Foreign Exchange Reserves and Share of Capital flows

China has, for one, financed the ongoing North Rail project in Central Luzon, and has aggressively been expanding its exposure worldwide to even remote distances, far flung and highly volatile areas, as Paul Mooney wrote for Yaleglobal, ``Chinese are busy developing much-needed African infrastructure: roads and rail lines in Ethiopia, Sudan, and Rwanda; a new hospital in Sudan; a farm and a bridge across the Nile; reclaiming thousands of hectares of farmland in Tanzania.”

Clearly, China’s foreign policy has been engineered to ensure a steady supply chain of raw materials and commodities for its rapidly growing resource-hungry economy by positioning and investing in resource-rich countries. Put differently, China’s national economic interests dictate a policy towards securing resources by investing in countries abundant with resources regardless of the underlying political conditions.

Moreover, with its teeming foreign exchange reserves, China has embarked on acquiring over 100 oil fields and companies globally in the past 5 years, according to Bloomberg’s Asian analyst Andy Mukherjee.

In short, this ongoing trend to secure supplies to feed and sustain its prevailing economic growth dynamics is likely to continue for a foreseeable future and is likely to translate to more direct investments into the Philippines for similar motivations.

One must not forget that compared to Africa or Latin America, China has some shared history and culture and is geographically closer to the Philippines, hence, would perhaps merit more investment considerations, but with one possible drawback: our close political affinity with the United States (a topic for another time).

And this has not been limited to China, even other emerging countries as India has shown indications of expanding investments for similar incentives.

Figure 2 IMF: Asia Surpluses to Possibly Find its way back home

One development I am betting on is that once this “Bretton Woods II”, or the tacit or implicit “unofficial” US dollar peg adopted by many Asian nations in order to make their currencies cheap to drive on an export-driven economic growth, outlives its usefulness there is that big likelihood that the plethora of excess dollar reserves stacked up in Asian Central Banks would be channeled towards investments within the region as shown in Figure 2. Where instead of supporting the debt-driven US consumption growth engine through indirect subsidies via investments in US assets, mostly in treasuries, Japanese and Chinese reserves would flow as investments within Asia. Then, your great boom comes into being....the Phisix would cross over the 10,000 mark! But of course, such gradient would not come painless though.

And emerging signs of increasing regionalization that would pave way for such realization have been evident; for instance, leaders of the ASEAN community aims to draft a charter next year that would take initial steps to integrate economically ASEAN member countries, according to a report from the Associated Press (emphasis mine), ``A charter for the economic integration of the Association of Southeast Asian Nations, or ASEAN, is being drafted and may be ready by the time Singapore hosts regional heads of state next year, Singaporean Foreign Minister George Yeo said late Tuesday...The creation of a unified ASEAN bloc by 2015 would allow for a free flow of goods, services and human resources across the region, but will not include a single currency system, ASEAN officials say.”

Boom in Agriculture

As per the industries cited, since I have been bullish with gold in 2003 as I had been equally optimistic with soft commodities on the premise of supply inelasticity in the face of growing demand, but on a more subdued degree since agri-based companies make up a lean representation or inventory of publicly listed issues.

As an aside, I think that private sector investments will also continue to effuse towards agri-based industries, despite its endemic volatility, as growing demand may outpace present supplies borne out of a similar theme; the investment cycle~ underinvestments during the past two decade or so.

Future trend dynamics for agriculture will be levered on the growing financial empowerment of resource rich-emerging market population that would uplift consumption trends, unraveling trends of migration to cities or “urbanization”, the continued industrialization of emerging market economies, growing shortages of arable land due to desertification (expanding deserts) and a potential worldwide water crisis, competing demand for energy usage (raw materials inputs) and technological innovation that may spur yield productivity.

Tourism’s Rosy Prospects; Medical Tourism’s Solution to Migrating Professionals

Of course Asia’s vigorous economic growth performance has been a key factor in today’s tourism traffic dynamics. Increasing wealth, burgeoning middle class and growing access to credit has driven growth in the tourism industry.

Figure 3 Tourism & Travel Institute: 2004 Positive Growth Rate across all regions led by Asia

For instance, in 2004 around 30 million Chinese (again) took foreign vacations and is likely to reach 100 million in the coming years. According to the World Travel and Tourism Council (emphasis mine),

In terms of demand, growth will double in a decade, ``In World, in 2006, Travel & Tourism is expected to post US$6,477.2 bn of economic activity (Total Demand), growing to US$12,118.6 bn by 2016.”

In terms of growth, `` activity is expected to grow by 4.2% per annum in real terms between 2007 and 2016.”

In terms of capital investment, growth will be expected to also double in 10 years, ``Travel & Tourism is a catalyst for construction and manufacturing. In 2006, the public and private sectors combined are expected to spend US$1,010.7 bn on new Travel & Tourism capital investment worldwide - 9.3% of total investment - rising to US$2,059.8 bn, or 9.6% of the total, in 2016.”

Notwithstanding, the growth prospects of the highly underrated and unappreciated but very lucrative medical tourism industry which according to hotelmarketing.com, ``Medical tourism is growing rapidly, far outstripping the 4 to 6 per cent growth in general travel bookings predicted for 2006, with the number of medical tourist visits to many countries swelling by 20 to 30 per cent a year. The industry in Malaysia, Thailand, Singapore and India, currently worth around half a billion dollars a year in Asia, is projected to generate more than US$4.4 billion by 2012.”

So instead of hollering against medical professionals for leaving overseas over greener pastures and requiring big brother to inhibit or regulate these flows, the proliferation of this medical outsourcing trend should effectively stanch the tide of manpower outflows if given the appropriate incentives to thrive, expand and compete against, note, our very own neighbors. Medical professionals and investors should instead combine to utilize the financial and capital markets to take advantage of this embryonic “hot” growth trend and invest to compete, enrich and retain our workforce. It is savings and entrepreneurship that drives economic prosperity through free markets and not regulations.

In all, the programs cited by the President in her SONA, taken from an apolitical standpoint or perspective, appear to be achievable and come in the light of the present global macro trend dynamics. Under the auspices of a consistent and stable investor friendly regime and politically unfettered market oriented policies, it would seem that the private sector investments could compliment funding or even drive these investment programs. Growing trends of regionalization and economic integration could also be a platform for such investments. In addition, development of the nation’s juvenile capital market infrastructure would essentially buttress these programs.

You want a Stock Market tip? PGMA’s SONA just gave you that list!

Reuters: Big Oil renews Asian crude hunt as reserves dwindle

Some say there have been no short supply of oil, and that present prices of oil reflects “speculative or terror” premium.

Well, it looks like major oil companies have been sifting through even from the least prolific fields as signs of desperation to add up on their depleting reserves.

An excerpt from Reuters...

"It may have a long way to go before rivalling hotspots such as West Africa or Libya, but growing resource nationalism in the rest of the world -- from the Middle East to Russia to Latin America -- is giving Asia an edge, especially as Big Oil struggles to replace its dwindling reserves.

"Because there are opportunity constraints, companies are willing to look at areas that had not previously interested them," said Mark McCafferty, head of South East Asia research at energy consultants Wood Mackenzie.

"People are looking at the Philippines, for example, despite the fact there have been no recent successes. Companies are now willing to take a look to see if there is any potential."

Shell, which in 2004 opted not to develop a small oil reserves associated with the Philippines' biggest natural gas field, this year committed itself to exploring the country's East Palawan basin.

"Exploration activity in the Asia-Pacific region has increased significantly," a Shell spokesperson said.

Read more by clicking on this link

Phisix-US Correlation, Heightened Liquidity Risks Calls for Defensive Positioning

``The ladder of success is best climbed by stepping on the rungs of opportunity."- Ayn Rand

If there is any one factor that holds sway to the global financial markets of late, it is the speculations about the US Fed’s next moves. Last week, as Chairman Bernanke appeared on the US Congress for his Monetary Policy report, and the equity markets suddenly exploded to the upside on the view that Bernanke hinted for a pause. Global equity markets followed suit, US and global bonds rallied while the US dollar declined.

Figure 2 stockchart.com: Phisix (candlestick) and S & P 500 (line)

As shown in Figure 2, over the past three months, or since May, the Philippine Composite Index has largely shadowed the movements of the S & P 500 index of the US. Unlike my original expectations that the Phisix, which had previously ran the same course with that of Gold, would ply the same route or pattern, it now appears that investors have pinned the activities of the domestic market in line with the outlook in the US, which in my view, is not entirely promising.

The US Federal Reserve raised its overnight interbank lending rates for the 17^th time last June to normalize its money policies, load up on its monetary ammo against possible emergence of deflation, defend the US dollar (my view) and moderate the growth clip of its economy. Since the global financial system has been addicted to profuse liquidity injections which led to inflationary pressures worldwide, the prospects of a pause signifies of its continuity, hence the resonant jubilation at first instance.

Yet, the paradox here is that it comes in the face of an economic downturn, which makes the initial euphoria in the US markets unwarranted. Analyst Paul van Eeden warned (emphasis mine), ``On Wednesday the stock market in the US rallied because Ben Bernanke indicated that he might not push for higher interest rates. Two weeks ago the market rallied because of weak retail sales numbers. This market is dangerous: investors are desperately searching for good news.

``When weak retail sales figures and the Fed Chairman's comments that he sees the economy slowing are interpreted as good news for stocks, then you know it is time to get out of the market.”

As you know, I have been in the camp of those who think that the US Fed would embark on a gamut of rates cuts once signs of a downturn snowball. I mentioned that political expediency (election season, pressures from the public), inveterate fear of deflation, aside from ideological leanings by the Fed Chief, past actions undertaken by the Fed (see Figure 3) and the huge leverage in its system which translates to more money “created out of thin air” required to settle the chronically exploding liabilities as possible reasons why the Fed would likely accommodate more inflation risks and focus on sustaining asset-driven growth (see June 26 to June 30 Fed Dilemma: Too Much Pressure To Continue Hikes).

Figure 3: Ritholtz Research & Analytics: Liquidity Driven Banking Policy

Although over the long term, I think that accrued policy mistakes (out of the fixation towards short-term remedies) and rising default risks are likely to drive interest rates higher.

Another cause of concern is the continuing weaknesses conspicuous in the Arabian markets. The liquidity driven Arabian markets stumbled in December of last year and could have foreshadowed the inflection point of world equity markets last May (see Figure 4).

Figure 4: Ameinfo.com: SC Arab Index

Since the onset of the millennium, stocks have grown manifold and had been supported by abundant petro revenues, ``After growing at the average rate of 25.7 percent in 2005 to $597 billion, this year's nominal GDP for the six Gulf states could exceed $700 billion.” notes Henry Azzam founder and CEO of Amwal Investments.

After peaking last December, the SC Arab index has given back over 40% of its gains. It could be that the parabolic rise caused its market benchmarks to stumble under its own weight or that while liquidity continues to be strong; the explosive rise of its stocks was simply unsustainable or lacked the amount of liquidity growth to sustain its pace. It could also mean that Arab stocks have been responding to the liquidity withdrawal measures adopted by global central banks as shown in Figure 5.

Figure 5: Gavekal: Falling Velocity and Global Markets

According to the very perceptive team of Gavekal Research, ``Unsurprisingly, given the latest volatility on equity markets, the overall appetite for risk has fallen dramatically...Since velocity (the private sector’s propensity to multiply the liquidity provided by central banks) has been the primary source for liquidity and the most important driving force behind the rally of the riskier asset classes, this is a very important development. Indeed, with both M and V in negative territory, markets will now face serious headwinds.”

My concern is if Arab stocks buttressed by robust oil revenues continue founder, it could herald renewed softening in global equity markets as suggested by Gavekal over the interim. Until perhaps the Fed goes into an actual stop and global central banks plays follow the leader, then will we probably see a resurgence of global equities.

For the moment, the Phisix’s close correlation with the US markets represents inauspicious development. Until we see a lucid divergence (see June 12 to 16 Awaiting Asia’s Markets to Diverge from the US) of the Phisix or of the region’s activities relative to the US markets, then it would be recommended that one plays defensive and selectively trade or accumulate on opportunities.

Research Process, Value of Time and Probabilities are Key to Outperformance

``Imitation in markets often gets a bad name, but it's important to recognize how vital imitation is in our day-to-day lives. We imitate each other all the time, primarily because other people often have better information than we do. It becomes a problem in markets when everyone starts to imitate one another, and they forget about what they're doing in the first place. It leads to excesses.”- Michael Mauboussin

Rather focusing on tangential issues, I’d like to impart to you some pointers on how to improve your portfolio returns from Michael Mauboussin, chief investment strategist at Legg Mason, an $850 billion highly acclaimed global asset management company in the US and author of the new book More Than You Know. In an interview with David Meier of Fool.com, Mr. Mauboussin cites three critical factors to concentrate on (emphasis mine)...

``The first thing, I would say, is to focus on process versus outcome. So process means understanding the research process, trying to understand specifically if expectations in the prevailing stock are too high or too low, and recognizing that even if you have a good process, periodically things will not turn out as you had hoped. [However,] a good, quality process will lead to good long-term results.

``The second thing I would say is recognize the role of time. In the very short term, it is almost impossible to discern between luck and skill, because there is just simply too much noise in the system. But over the long haul, certainly a good process will prevail. So [recognize] that it is important to be patient, and often, as you said before, to do absolutely nothing. This is not a business where more activity leads to better results. I think, in general, people perceive that. And certainly in America, there is an idea that doing more work is better. That simply does not hold for the stock market.

``The third thing is to recognize that markets are fundamentally probabilistic, and because they are probabilistic, it requires a certain psychological approach and psychological mindset. By the way, in Robert Rubin's wonderful book, In an Uncertain World, he talks a lot about the probabilistic mindset. He says many people believe they are [taking such an approach,] but very few people have the disposition or time or training to do it properly. So when you have a probabilistic mindset, you are constantly thinking about different alternatives. You are constantly taking information and updating your probabilities and outcome assessments and recognizing, again, that there are many psychological biases that can come into your doing that properly.

Of course you don’t normally obtain such judicious advice from the investing business, such as conventional brokers or some domestic financial institutions alike, as they are hardwired to think and impress upon their clients that returns from the markets entail frequent churning activities. As I’ve said before, it’s mainly because of their revenue models; in contrast to the investing profession, like Mr. Mauboussin of Legg Mason, which focuses on generating “Alphas” or above benchmark returns.

And neither would you hear from investing business community the probabilistic approach towards investing. Probability of outcome is the primer for risk management and essentially differentiates gambling from calculated risk taking ventures. By determining the odds, or the ratio of favorable outcomes to unfavorable outcomes, one could act to reduce or limit risk exposure and optimize on returns.

In my case, the investing-research process, as you probably all figured out, has been largely an amalgam of the Big Picture (particularly capital flows dynamics and monetary and cross market analysis), behavioral finance/economics (understanding the thought process to limit heuristics and mental shortcuts or biases) and a combo of sentiment and the technical picture with occasional dabbles on valuations. In short, I try to be as methodical and systematic as what Mr. Mauboussin suggests and recommend that you do as well.

Domestic Political Developments Unlikely to Drive Markets

I read from some ad hoc commentaries that the direction of the domestic financial markets for the coming week would find bearing from the Philippine president’s State Of the Nation’s Address (SONA). I find this attribution to be ludicrous. Unless of course, draconian policy changes would be endorsed to either choke or liberalize business conditions, the most one can expect from these events would simply be vainglorious political rhetoric and counter demagoguery from the political opposition.

If the previous market’s reaction to past political conditions were to be a gauge (e.g. aborted coup, heated elections, garci scandal, etc...) then the market could be expected to discount this as a nonevent. And as for these forecasters groping for any variables to associate to the market’s behavior, Robert Prechter of the Elliot Wave Theory describes them best, ``Those who regard the news as the cause of market trends would probably have better luck gambling at race tracks than relying on their ability to guess correctly the significance of outstanding news items.”

I would view developments in Lebanon as having more potential significance than local politics. The present military engagement has the open-ended possibility to escalate and diffuse as to drag the entire region into conflagration. With the world’s oil supplies, about three-fifths of the world’s proven oil reserves (see Figure 1), heavily dependent on the region, an expanded theater of war would bring the world to its knees with a supply shock. Think oil at $100 per barrel at least! That is the reason why we have to keep our eyes on the unfolding geopolitics rather than be transfixed on vapid and toxic domestic “personality based” politics.

Figure 1 Moneyandmarkets.com: Commanding Share of Middle East Oil

CBS Marketwatch Mark Hulbert: Explanations R US

The gullible investing public have been regularly inured to believe, especially by mainstream media and their coterie of analysts, that non-economic events (wars, natural calamities & etc.) have significant impacts in the activities in the financial markets. But do such events really move markets?

CBS Marketwatch Mark Hulbert in his latest article “Explanations R Us” cites a study (emphasis mine)...

``A comprehensive analysis of the impact on the market of non-economic events, which despite being nearly 20 years old remains one of the standard academic works on the subject, appeared in the Journal of Portfolio Management in 1989. It was written by economics professors David Cutler, Lawrence Summers, and James Poterba (Cutler and Summers are at Harvard; Poterba is at MIT).

``The professors designed their study to find evidence that non-economic news regularly has a big impact on stocks. They focused on all entries in the "Chronology of Important World Events" from the World Almanac for the period beginning with Pearl Harbor and ending with the 1987 Crash, and then eliminated from their list any events that the New York Times did not carry as a lead story and that the Times' Business Section did not report as having affected investors.

``The result was a list of 49 distinct events, such as Pearl Harbor, the Korean War, Kennedy's assassination, and so forth. The professors then measured the average absolute return of the S&P 500 index on these days.

``The professors came up with little evidence that non-economics events had a big effect on the stock market. On average, across all 49 events on their list, the S&P 500 moved just 1.46%, less than one percentage point more than the 0.56% that prevailed on all other days. Because of this small difference, the professors concluded that there is "a surprisingly small effect of non-economic news" on the stock market.

The lesson here is not to simply to adhere to superficial clues or heuristics or mental short cuts. Sensationalism can divert you to wrong causes and lead your portfolio astray. The financial markets are more abstract, complex and multi-dimensional than commonly thought.