The Socialization of Global Financial Markets

``Where in capitalism is the idea that you can spend more than you earn? Where in the vision of Adam Smith is the idea that foreigners will subsidize your standard of living – indefinitely? Where in laissez-faire is the notion that central bankers will prevent corrections by controlling the price of money? What had happened to the old sturm and drang? Where was Schumpeter’s ‘creative destructive?’ The new capitalists offered creation without destruction... resurrection without crucifixion! They offered not only to hold harmless investors in the face of their own bad judgment...but to revive booms before they ever expired and to cut short corrections before anything has been corrected.” –Bill Bonner

Global equity markets cheered anew the “socialization” of the financial markets, as shown in Figure 2, as major central banks such as the Bank of England and the Bank of Canada trimmed interest rates in response to the worsening global credit crisis and over concerns that such dislocations would spillover to the global economy.

Meanwhile the Reserve bank of Australia and the European Central Bank kept rates unchanged regardless of the signs of incremental increases of inflation (by their definition-higher consumer prices).

Figure 2: stockcharts.com: Equity Markets Applauds Central Bank Bailout Packages

The buoyant markets have been apparent in the Philippine Phisix (main window) alongside the US S & P 500 (above pane), the Dow Jones Asia ex-Japan (pane below window) and Emerging Markets (lowest pane) which have simultaneously recoiled following the other week’s tests at near critical support levels.

This came about as dovish statements from key central bank officials as Chairman Bernanke and Vice Chairman Kohn indicated of concerns of heightened downside risks which possibly telegraphed messages of a forthcoming rate cut this December 11^th.

As we have noted, the global equity markets since August have been living off from government crutches, i.e. buying the hope that the attendant remedial policy measures will be effective enough to thwart the ongoing rapid adjustments in the highly leveraged financial sector.

Despite several initial stopgap measures to contain the recent stress, equity markets continued to show signs of strain as selling pressures reappeared last November.

Recently even as equity markets appear to have been pacified the credit markets continue to manifest signs of significant dislocations as shown in Figure 3.

Figure 3: Financial Armaggedon.com: Biggest Spread since 1986

The chart depicts of the spread between US Libor rates or lending rates on unsecured funds charged by banks to each other relative US Treasury bills of the same maturity, from which today’s ``conditions are more akin to the chaos that developed around the time of the 1987 stock market crash, (highlight ours)” observes Michael Panzer of the Financial Armaggedon.com.

Mr. Panzer adds, ``More ominous, perhaps, is the fact that banks have much less in the way of cheap and relatively immobile customer deposits backing their outstanding loans than in the past. That means they are more dependant than ever on other banks and the financial markets to meet their funding needs”

This just shows how leveraged the global financial system is, deposit reserves which used to serve as sound collateral for lending has essentially dissipated. These have been replaced by collaterals of questionable value. In good times nobody challenged the viability of such premises. Now that the going gets though, the massive spike on yield spreads reflect on their reluctance to lend to each other which could signal a potential disorderly unwind.

Of course, again the equity market is hoping that the plans to mitigate losses from the mortgage market will gain traction as Treasury Secretary Mr. Henry Paulson alongside with industry lenders set up guidelines to freeze interest rates by affected parties.

But the problem is that these plans would only help a marginal number; from New York Times, ``The Greenlining Institute, a housing advocacy group in California that began raising alarms about subprime loans nearly four years ago, estimated that only 12 percent of all subprime borrowers and only 5 percent of minority homeowners would benefit from the rate freeze. The Center for Responsible Lending, a nonprofit group that supports homeownership, said the freeze would help only about 145,000 people.” (emphasis mine)

Second, is the concern over the breach of private contracts, from the Economist (emphasis mine), ``Whatever else it may be, the Bush administration’s agreement is an extraordinary intrusion by the government into private mortgage contracts…Whatever the economic arguments for the Bush administration’s plan, it amounts to poor public policy. America’s unfettered brand of capitalism is one of its strengths; investors may be less likely to trust a government that manipulates private contracts when conditions deteriorate. At a time when the economy is already weak and the dollar is suffering from a crisis of confidence, Mr Paulson’s awkward intrusion into the mortgage market looks more like desperation than a hedge against further trouble.”

Third is the ambiguous procedural process, again from the Economist (highlight ours), ``But how the process will work is not clear. A national blueprint may make it easier to identify those who are eligible for relief, but the process of renegotiating the loan, or applying a rate freeze, must be done individually. Lenders will need to check borrowers’ incomes, debt levels and the current value of homes before they can agree to a change in the terms of the loan. Mr Paulson, in fact, acknowledges his plan’s limitations by saying that other relief measures are under discussion.”

Another is about the incentives and potential consequences, from Minyanville’s Mr. Practical, ``The biggest ramification is this. Those investors will have to decide whether or not to accept the new terms. If they accept lower interest payments because it is better than default, the value (price) of the CDO will go down to reflect the new present value of the payments. This is a big fact that I think everyone is missing: the price of CDOs will be marked down from current levels. Banks' desire to lend will go down as a result of this. As an illustration, the spread between libor and ECB funding rate (equivalent fed funds) rose again last night and is at a record 89 basis points.

``A nuance of the above is that senior trauches of CDO now have a higher certainty of pay-outs while the junior trauches now may be worthless. These junior trauches will sue like crazy as this thing unfolds.”

``What will happen is that banks/other investors who own these will then take another write-down but then declare this is the end. This will not be true. A huge percent of all re-negotiated mortgages eventually still default. It just buys a little time for a few more interest payments. The bottom line is these folks bought houses they couldn’t afford when paying market interest rates. This is really a plan to help banks take one more write-down and declare all is well and then hope for some magic turnaround. But there won’t be a turnaround.”

Finally on the proposed government bailout, again Mr. Practical, ``So far Mr. Paulson is trying to make this look like a “voluntary” plan by lenders. We all know there is lots and lots of pressure being exerted by government to get them to volunteer. But I have a feeling Mr. Paulson’s plan does not end here. There is also talk of getting Congress to pass legislation to let states and municipalities issue tax-exempt debt to refinance loans for those who cannot keep their homes. This would be nothing more than a government led bailout of banks and large investors at the expense of taxpayers. ”

As we have long argued, the US government will protect the US dollar standard system with an attendant bailiout of its major conduits, even at the expense of the purchasing power of its currency. Yes, there could be some sacrificial lambs but the overall action appears to be pointing towards such direction.

Second like any governments, they tend to be reactionary in their approach to problem solving--responding mostly to short-term popular demands but whose actions are likely to benefit vested interest groups.

Third, it is the nature of governments, given the backdrop of today’s paper money system, to utilize manipulative (inflationary) policies to steer an economy towards a short-term boom then blame the markets for the ensuing bust from which they would find the necessary excuse, backed by socialist experts and grandstanding politicians, to justify for the next policy (inflationary) maneuvers.

Lastly, such rescue plan has yet to be implemented and we are already seeing some signs of a backlash, which means like most interventionist policies they tend to end up with long term unintended consequences.

Stock Markets: Monetary Policies Have Larger Impacts 2

``“Movie-plot threats”: the tendency of all of us to fixate on an elaborate and specific threat rather than the broad spectrum of possible threats. We see this all the time in our response to terrorism: terrorists with scuba gear, terrorists with crop dusters, terrorists with exploding baby carriages. It’s silly, really, but it’s human nature.’- Bruce Schneier, American Cryptographer and computer security expert, interview at Freakonomics

So where are we headed for?

Figure 4: Ratings and Investment Info: China’s Currency Reserves and the Shanghai Composite

First, we believe that monetary policies have very compelling influence on the directions of asset classes more than what the conventional wisdom leans on--predicated mostly on corporate earnings or on plain vanilla economic linkages as discussed last week.

Figure 4 from Ratings and Investments shows how China’s soaring foreign currency reserves have coincided with the spiraling Shanghai Composite Index. To fittingly quote Professor Michael Pettis of Peking University’s Guanghua School of Management, ``the root of China’s problem is the growth in the nation’s money supply caused by the currency regime.”

Second, the unfolding credit crisis which has been emblematic of the declining collateral values held by major financial institutions is about to test global central banks risk tolerance based on the prospects of deflation or of contracting liquidity.

As evidence, the rescue project by Secretary Paulson code named, “Hope Now Alliance” signifies the intent to slowdown the deterioration of the present financial conditions to the point of undeservingly manipulating contracts. In short, desperate times calls for desperate measures.

By our understanding of the ideological framework of Mr. Bernanke, based on his previous speeches Financial Accelerator and the Helicopter strategy, it is likely that the pursuit to preempt a deflationary outcome would be its principal policy activities. Hence, given such premise, it is our belief that the US Federal Reserve would cut no less than 25 basis points during the next FOMC meeting next week.

Nonetheless, there are other sources of potential risks, which we believe the authorities are well aware of, such as US commercial real estate, other asset backed assets as Auto Loans or Credit Cards, Credit Default Swaps, High Yield Bonds and Derivative Counterparty risks.

Third, with signs of decelerating economic growth becoming more apparent--OECD expects world growth in 2008 at 2.3% compared to 2.7% in 2007 (Canadian Press), global banks appear to be calibrating their policies with that of the US.

Hence, a prolonged turmoil in the credit markets, further downside volatility in asset prices and palpable signs of spillover to the real economy are likely to prompt for more liquidity spillage policies. The BoE and Bank of Canada’s actions are likely the first of a series of moves.

It takes only four central banks to make material impact on global liquidity at present; namely the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. Remember, as we mentioned in the past, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

While we expect the BoJ to remain on hold during this turbulent period, the rest including the hawkish ECB’s Jean Claude-Trichet, are likely to join the bandwagon once such dislocations become evident.

Figure 5: AMEINFO.com Arab General Index

Lastly, as we have been saying all along, we don’t claim to know or pretend to comprehend everything, because the world is too profound or complex to do a simple 1+1=2. There are simply too numerous variables to consider.

However, what we understand is that despite claims that the world financial markets in unison would suffer miserably due to a US hard landing, our perspective is that they could be subject to functional randomness based on the possibility of diverse responses to collective policy activities by global central banks. This could be due to the different state of developments of domestic financial markets, the divergent currency regimes or policies involved or exposure to leverage, as well as the distinctive constructs of the domestic economies, financial globalization notwithstanding.

Figure 5 from the Ameinfo.com tells us that the Arab General Index has climbed this year, unfazed by the recent tumult last August and September similar to China. This goes to show that not every equity bourse have their destiny tied with the fate of US markets…yet. Yes, we understand that most of the bourses indicated have not been significantly open to foreign investors, but our point is with prospects of more inflationary actions, money would have to flow somewhere.

Gary Danelishen writing for Mises.org gives a good account of inflation process (underscore mine), ``New money that enters the economy does not affect all economic actors equally nor does new money influence all economic actors at the same time. Newly created money must enter into the economy at a specific point. Generally this monetary injection comes via credit expansion through the banking sector. Those who receive this new money first benefit at the expense of those who receive the money only after it has snaked through the economy and prices have had a chance to adjust.”

As a saying goes, Discretion is a better part of valor.

Some Memorable Quotes from Friday’s Manila Peninsula Debacle

``The main issue in present-day political struggles is whether society should be organized on the basis of private ownership of the means of production (capitalism, the market system) or on the basis of public control of the means of production (socialism, communism, planned economy). Capitalism means free enterprise, sovereignty of the consumers in economic matters, and sovereignty of the voters in political matters. Socialism means full government control of every sphere of the individual's life and the unrestricted supremacy of the government in its capacity as central board of production management. There is no compromise possible between these two systems. Contrary to a popular fallacy there is no middle way, no third system possible as a pattern of a permanent social order.”-Ludwig Von Mises

Quote:

From the Philippine Daily Inquirer, ``What we did was not only our duty but our moral obligation,” said Trillanes said in justifying his latest act of defiance, adding,“It is our duty as religious individuals to do what is right.”….“Dumaan tayo sa tamang pamamaraan [We passed through the right processes]. Elected pero wala ring nangyari [We were elected but nothing happens]. They voted for me so that I can speak up for their rights and our advocacies,” said Trillanes, referring to his election as senator last May. (highlight ours)

Possible Translation:

I got 11 million votes during the last elections; therefore I deserve my pork barrel!! Where the heck is my pork???!!!

Our comment:

Friday’s failed power grab simply highlighted mainstream media’s favorite theme of “Personality based rent seeking” politics or the misguided belief that our country’s success or failure depends on the proverbial “magic wand” by one great leader that has yet to emerge or that the present country’s ills will simply vanish by the ouster of the incumbent via another revolution.

After TWO (successful) EDSAs and several aborted coups since 1986, we never seem to grasp that the leadership game of musical chairs will not subject us to deliverance; not as long as we sustain the vicious cycle of the patronage system which is rooted on our unwarranted dependence on government or our platonic love affair with the “socialist paradigm”.

Statements like this simply reflect on the abject predicament of our deeply flawed political-economic structure. Yet, when parsed, they appear to be very revealing. As a prominent saying goes, the more things change, the more they remain the same.

Quote:

From Bloomberg, ``Like soldiers, we're going to face this, whatever they want to do with me,'' Trillanes said inside the hotel after the raid and before being arrested. ``This is not our loss. If there's a loser here it's the Filipino nation.'' (highlight ours)

Possible Translation:

Where are you, my 11 million @#$% voters when I needed you??!!

Our comment:

Obviously, there is a clear distinction between the mandated function of an elected official to fulfill one’s designated tasks and a naked power grab. Put into a math equation: 11 million votes ≠ a license to grab the political leadership.

But politics like the financial markets occasionally strips out one’s computational logic or rationality especially when overwhelmed by vanity, in this case prompted by an apparent miscalculation from the ramifications of popularity based political actions.

Again instructive political statements like this seem to give credence to English author Samuel Johnson’s ever noteworthy and applicable quote, ``Patriotism is the last refuge of a scoundrel”.

Reading Market Signals and Avoiding Logical Fallacies

``So we pour in data from the past to fuel the decision-making mechanism created by our models, be they linear or nonlinear. But therein lies the logician’s trap: past data from real life constitute a sequence of events rather than a set of independent observations, which is what the laws of probability demand.” Peter Bernstein

To our experience, there are two major common misperceptions of what drives the financial markets. In the case of the stockmarkets, the public generally believes that its directional path, in the absolute sense, is determined by either the conditions of the domestic economy or corporate earnings.

To question or to challenge such premises is almost equivalent to blasphemy; we get stared in the face with “shock and awe” kinesics with the implication that we either…come from another planet or…don’t know what we are talking about.

To be clear, like our contrarian view on the Peso, [see November 5 to November 9 edition What Media Didn’t Tell About the Peso], we do not dispute that the activities in the domestic economy and corporate earnings does somehow contribute to the pricing dynamics as evinced in the market ticker through the transmission of collective expectations, but our perspective is angled from the functions of correlation and causation in accordance to the conveyance of information from price signals.

As an example, as we recently cited, the popular view of the Philippine Peso’s strength has been constantly attributed by mainstream media to the grounds that strong inflows from remittances have “caused” its present conditions. While from the fundamental perspective such argument appears incontrovertible, however if one looks at the price trends of remittances relative to that of the Peso, we would find some notable divergences and belated correlations, all of which does not appear to demonstrate the straightforward cogency of such assertion. This is what distinguishes us from mainstream experts.

In the news you’d frequently read experts as saying or writing in simplified gist…“the market (stocks, commodities, bonds, real estate, labor, et. al.) has been moved by so and so factors (usually event-driven)”…or the extensive use of logical fallacies of post hoc ergo propter hoc (after this therefore because of this) or cum hoc ergo propter hoc (correlation does not imply causation). There are even experts who generally draw “cause and effects” conclusions to market outcomes by interposing their underlying biases on what they believe the market should be.

Dr. John Hussman of the Hussman Funds describes this phenomenon best (highlight ours),

``Unfortunately, most economists have never fully internalized the “rational expectations” view that market prices convey information. Of course, accepting this view does not require one to believe that prices convey information perfectly (which is what the efficient markets hypothesis assumes). But where finance economists take this information concept too far, economic forecasters don't take it far enough. As a result, economic forecasts are generally based on coincident indicators such as GDP growth and industrial production, or pathetically lagging indicators. This tendency to gauge economic prospects by looking backward is why economists failed to foresee the Great Depression and every recession since.”

Since market prices are mainly shaped by psychology through expectations which are transmitted by value judgments, the myriad flow of information impacts rightly or wrongly the decision making processes of diverse market participants in different degrees. As Ludwig von Mises in Human Action says…

``It is ultimately always the subjective value judgments of individuals that determine the formation of prices…. The concept of a "just" or "fair" price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.”

For instance, similar sets of information can be construed contrastingly by market participants which could prompt for opposite market actions.

A “buy the rumor sell the news” is concrete example, once a news comes out to either confirm or deny the rumors that impelled for the recent price movements, traders usually sell (acknowledging the end of the play) while investors buy (in confirmation of expectations), ergo value judgments actively at work in the marketplace.

In short, most of the mainstream analysis which feeds on the public’s “simplified” knowledge is predicated upon the “rear view mirror” syndrome or on recent past performances. Sometimes they also reflect on the biases of these experts.

Bottom line: When analyzing markets our proclivity is to read market signals and interpret them objectively instead of imposing our biases on our perceived market realities or subjecting them to selective analysis.

Stock Markets: Monetary Policies Have Larger Impact Than Economic and Corporate Links

``This is the U.S. financial banking system and it will be defended. And if the U.S. cannot push through superconduits and rescue plans, foreign sponsorship will step up as it recently has. Whether they can pull the U.S. up or the U.S. pulls them down is another conversation altogether.”-Todd Harrison, founder CEO of Minyanville

Now going back to our original premise about “economy and corporate earnings” as drivers to the market, let us use the US equity markets as example.

Figure 1: Northern Trust: US Real GDP

Except for the recent perplexing third quarter surge in the face of a deepening housing recession and the worsening credit conditions, figure 1 from Northern Trust shows us that real seasonally adjusted GDP as measured by its percentage change since 2003 has been trending lower (superimposed blue arrow).

This means that while its economy has been growing in nominal terms, the speed of its variable changes relative to real economic growth had generally been slowing down post the dotcom bust.

Now if “economics-drives-stocks” then respectively, we should see some similarities in the price actions patterns of the S & P 500 as shown in Figure 3.

Figure 2: WSJ: Earnings Growth has been Slowing

But before we jump to the broad based index the S & P 500, a chart from an article in Wall Street Journal in Figure 2 likewise depicts of a slowdown in the year-to-year quarterly change in the earnings growth by the aggregate composite members of the major bellwether as indicated by the superimposed blue arrow over the left chart.

So again while earnings have been growing in nominal terms, the speed of its variable changes has notably been slackening since 2004.

Again if “earnings growth” equally drives stocks as commonly perceived by the public then respectively we should see some similarities in the price actions patterns in the S & P 500 as shown in Figure 3.

Figure 3: S & P 500: Quarterly Chart/Rate of Change

Figure 3 reveals of the quarterly chart of the major benchmark S & P 500 (black candle).

To compare with the performance relative to the economy in 2003, the major equity bellwether bottomed out then began its major turnaround to the upside.

In 2004 relative to earnings growth, the S&P continued with its vigorous ascent. This progressive advance has been strongly supported by the rate of change, manifested by the uptrend of the red line.

Thus, relative to price actions, the widely espoused view that “economic growth” or “earnings growth” drives the stock markets do not convincingly explain the performance of the S & P 500.

Instead, it does seem like a paradox: strong markets were coincident to slowing economic growth or deceleration of earnings growth. This inverse correlation could be described as “decoupling”, in contrast to commonly held popular views.

Figure 3: Economagic: S & P 500 and Fed Fund Futures

This is why it is imperative for us to identify, understand and monitor the driver/s that has a commanding edge to the markets, simply because by associating with the wrong cause such analysis may result to inaccurate projections and costly actions. Or in medical analogy, misdiagnosis leads to wrong prescriptive cures.

Figure 4 courtesy of Economagic provides us a more compelling correlation…market action fueled by monetary policies!

The chronology of correlation: Since the 2000 peak, the S & P (blue line) has been on a downdraft reflecting the dotcom bust. This was followed by declining Fed fund futures (red line). The S&P bottomed out in late 2002, whereas Fed fund futures bottomed in mid 2003.

Subsequently, Fed Fund futures climbed following S & P’s recovery as Fed rates hit a 60 year low. However Fed rates peaked in 2006, while the S & P continued its ascent which presently drifts at the upper ranges.

The correlation looks seductively linear, DECLINING FED RATES EQUAL TO DECLINING S & P 500 or vice versa, but appearances do not reveal everything or the caveat here is that like the folly of many analysis “correlation does not imply causation”.

Instead one should keenly observe that the S & P leads the Fed Fund Rates at critical junctures in a majority of circumstances. This has been the case except in 2006 where Fed rates paused while S & P continued to trek higher.

The clear implication is that the market’s direction is followed by corresponding Fed actions or that the US Federal Reserve responds to the actions in the marketplace!

When the market is in trouble, the Fed reacts by corresponding action…interest rate cuts and other forms of inflationary policies, thereby flooding liquidity into the financial system. Conversely, when the market recovers, US monetary officials technically siphon liquidity off by raising interest rates.

So the recent rate cuts translate to extant pressures or reflect bouts of turmoil in the marketplace.

As expected, the latent intoned subsidies by the Fed had been recently borne by the statements of Federal Reserve Vice Chairman Donald Kohn-policy must be nimble, flexible and pragmatic (Reuters)-and by Chairman Bernanke- ``renewed turbulence'' in markets may have shifted risks between growth and inflation” (Bloomberg) and the “Hope Now Alliance” (Bloomberg) or a pact with financial institutions to freeze interest rates.

These bailout expectations appears to have helped fueled the recent astonishing gains by the equity markets which we think could be more of a technical bounce.

Bottom line: In the decoupling debate, in appreciation of how US markets, the world’s largest and most sophisticated markets, have been influenced by its domestic policies, and thus, under the same prism we dare not dismiss the potential impact on the global financial markets by the corresponding actions that could be taken by major central banks.

Not even under today’s deepening trend of “financial globalization” which tends to increase linkages and therefore heighten correlations, will probably be enough to prevent markets from “decoupling” -in the sense that markets may perform independently or attain very low levels of correlation or dependency variables over the longer horizon. The distinct conditions of the underlying structure of the financial markets as well as the variance in the domestic currency regimes are likely to be the conduction channels for such marketplace divergence.

A Global Depression or Platonicity? II

``Our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”-Nassim Nicolas Taleb

Projecting past performance into the future is a hazardous strategy. The recent fiasco in the US mortgage markets has been mostly due to such built in expectations of a perpetual boom.

Recalling ex-Citigroup CEO Chuck Prince’s infamous quip, ``When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing". That’s one pitfall which we stridently wish to avoid.

Thus, if a US hard landing scenario emerges where deflation or a severe credit “crunch” takes a firm grip on its markets and the economy, then the attendant monetary measures to be engaged by US authorities are likely to be aggressive (including the much ballyhooed Helicopter strategy by Ben Bernanke), considering their natural inclination to be averse to a Japan-like malaise.

As we earlier pointed out in our September 3 to 9 edition, [see A Global Depression or Platonicity?], the degree of exposure to tainted leveraged instruments in Asia has been limited.

And those advocating for a global meltdown could simply be overestimating on what they know and underestimating on what they don’t, and not giving enough room for randomness to operate, hence our tendency to “mistake the for territories” from which we cited Nassim Taleb definition of Platonicity.

As we also mentioned above, while financial globalization via integration of financial markets has the predisposition to increase correlations, different currency regimes aside from the divergent levels of development of the financial markets are likely to result to different outcomes in the face of such aggressive policy maneuvers.

For instance, considering that major currency reserve holders as China, GCC nations and Hong Kong, have effectively wrapped or surrendered their domestic monetary policies to that of the US by virtue of a US dollar peg, monetary policies are likely to have different impacts to their markets and economy compared to the US.

As Stephen Jen of Morgan Stanley splendidly wrote (highlight ours),

``The credit crunch we are witnessing is really a ‘rich’ countries’ problem. Much of EM (the GCC countries, China or Hong Kong) is unaffected and will not likely be directly infected by it. (We put ‘rich’ in quotes because on some measures some EM countries are richer in cash…) EM may eventually be adversely affected by an economic slowdown in the developed world, through trade, but not in terms of the credit cycle freezing up. In China, for example, the government has intentionally imposed a credit freeze, because it has too much liquidity. The same problem of excess liquidity is still faced by many other countries, such as Hong Kong, the GCC countries and some other EM economies.”

If the recent credit triggered market mayhem should serve as the proverbial canary in the coal mine then figure 4 courtesy of Rating and Investment Information shows how ASEAN Credit Default Swaps performed under the recent duress.

Figure 4: Rating and Investment Information: Narrowing ASEAN Spreads Indicator of Strength?

The cost of Credit-default swaps or contracts designed to protect investors against default has steadily narrowed since 2005 for ASEAN countries including the Philippines and Indonesia, the most vulnerable member countries of the region.

Yes, while there had indeed been a spike in CDS spreads during the August turmoil (encircled), it appears that these spikes can be discerned or construed as more of an “aberration” than of a reversal as the spreads appear to “normalize” or narrow anew.

Figure 5: IMF GFSR Report: Buyers of CDO (In percent, delta-adjusted basis)

As to further examine on the potential impact from the risks of the recent credit crisis turning into a full scale credit seizure, we can further estimate on the portfolio holdings by Asia of infected instruments as previously done.

Collateralized Debt Obligations (CDO) are investment grade structured finance products that are collateralized by asset backed securities, including subprime mortgages. The markets for these credit products have been heavily distressed following the string of losses brought about by the recent credit maelstrom, where estimated losses according to some analysts for the world’s biggest banks are at $77 billion with a potential to reach $260 billion (Bloomberg).

IMF’s latest Global Financial Stability Report as shown in figure 5 estimates that the bulk of the losses or those affected by these “toxic waste” products has been mostly from to the US.

According to the IMF (highlight ours),

``Direct exposure extends beyond the United States, with European and Asian investors active in the ABS and related markets. A handful of European institutions have already reported difficulties or closed owing to their exposure to U.S. mortgage markets and the withdrawal of their short-term funding, and still more are believed to be exposed to indirect mark-to-market losses stemming from their credit lines to conduits and structured investment vehicles. Within the Asia Pacific region, various market analyses suggest that exposure to mortgage-related products is concentrated in Japan, Australia, Taiwan Province of China, and Korea, but their overall exposure has been characterized as manageable and that region appears to be insulated from default risk.”

Figure 6: IMF GFSR :Probability of Multiple Defaults in Select Portfolios (In percent)

Figure 6 from the IMF’s GFSR likewise shows that among financial institutions large complex financial institutions (LCFIs) have been largely prone to losses reflecting extensive exposures to credit derivatives, whereas among emerging markets the estimated default risks remain “benign” with emerging Asia having the least risk.

From the IMF,

``Reflecting a weakening in credit discipline that has emerged along with the growth in credit, private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing, often embedding exchange rate risk or options and thus increasing their exposure to volatility. Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital market financing to help finance credit growth. Nevertheless, generally benign emerging market banking system default risk indicators continue to reflect market perceptions of healthy capitalization and profitability, as well as diverse earnings sources and sound asset quality. These trends warrant increased surveillance, as circumstances vary considerably across countries. Authorities in some emerging markets need to ensure that vulnerabilities do not build to more systemic levels. Across all emerging market countries, policies that support continued resilience should help, as global market conditions are likely to remain volatile.”

All of this simply reflects on the divergent exposures of different regions to the recent turmoil.

While we agree with the hard landing camp that trade or economic linkages are likely to affect global markets, where we part is the degree of impact. We don’t share the view of a global financial or economic meltdown.

Monetary policies even if even if they are to be ineffectual in the US are likely to impact the financial markets of different regions at varying degrees.

Given the inflationary tendencies of central banks, under the present Paper money standard, the most likely scenario will be a shift of bubble from one asset class to another, either to commodities or to Asian markets or both.

US Markets: Counting the Chickens Before They Hatch

This from CBSMarketwatch, ``U.S. stocks climbed for a second day Wednesday, with the Dow scoring its largest percentage leap so far this year, and a revived financial sector paving the way after a Federal Reserve official bolstered hopes for additional interest-rate cuts ahead.” (highlight ours)

This from New York Times, ``Stocks soared on Wall Street today after a top Federal Reserve official appeared to open the door for additional interest rate cuts, pledging to follow “flexible and pragmatic policy making” as the central bank decides how to cope with the current financial upheaval.” (highlight ours)

So aside from being oversold, obviously the US markets has been building its “bullish” foundations from expectations of further Fed Steroids or as they say "counting chickens before they hatch", this from Fed Governor Donald Kohn (emphasis ours)…

`` An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago. In general, nonfinancial businesses have been in very good financial condition; outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels. Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.”

…while ignoring hawkish comments from Philadelphia Federal Reserve Bank President Charles Plosser and Chicago Fed President Charles Evans or a case of "selective perception".

This only means that the FED has its hands tied, where it would need to appropriately respond to market’s expectations on December 11^th else risks a collapse. A confirmation from Bernanke’s speech tonight could add to these expectations.

Remember, two rate cuts of 75 basis points and a bunch of policy palliatives have recently failed to boost the markets, hence yesterday’s dovish statements from Governor Kohn. This could simply be a clearing rally from technically oversold levels and is no guarantee that markets would resume their uptrend over the interim.

Pervasive Losses In Global Financial Markets, US Treasuries Signal Rising Risk of Recession

``How, exactly, is enslavement won? Through a combination of fabricated “crises” and an insidious phenomenon known as “gradualism.” Create the crisis of your choice — global warming, education, Big Oil price gouging, home foreclosures … ad nauseam — then milk that fabricated crisis nonstop until gradualism is able to take hold and convince the brain dead that the only solution to the crisis is for government to step in and pass more laws to save us from imminent peril.” –Robert Ringer

AFTER two rate cuts (75 basis points), the opening of the discount window (including lowering of its rates), changing of some lending rules such as exempting banks to lend to broker subsidiaries and the widening of the eligibility of collateral acceptance and the injection of liquidity via repos and Federal Home Banks, where the US Federal Reserve appears to have utilized a panoply of monetary tools, including the unconventional ones, to cushion the impact of the housing recession triggered credit crisis, yet such dislocation continues to ricochet throughout the global financial markets.

Interest rates alone reflects on the recent stains where the “TED” spread or the difference between three-month US Treasury bill yields and Libor, the London interbank offered rate soared to record levels! We are thus witnessing a frenetic “flight to quality” in terms of a massive rally in US Treasuries, as shown in Figure 1.

Figure 1: stockcharts.com/ Ivan Martchev: Collapsing Yields of 10 Year Notes!

The last time US treasuries encountered such a colossal move was during the Nasdaq bubble implosion in 2000 that ushered in an economic recession. The blue horizontal arrow points to the closing prices of US the T-Note yields last Friday.

Don’t forget during this period, the US Federal Reserve slashed its Fed rates from 6% to 1% until mid 2003 in order to mitigate the economy’s deterioration but to no avail. Instead the ocean of US dollars generated consequent to such intervention has spawned a new monster; a US housing bubble buttressed by exploding leverage in terms of new financial instruments. Derivatives have now reached $516 trillion during the first half of 2007 (Bloomberg). And some of these are seen unraveling today.

Hence, the behavior of the US Treasury markets, relative to the speed and degree of its decline, suggests to us that a US recession is either imminent or now unfolding!

The impact of the credit crisis has apparently permeated to different sectors of the US economy from what we previously mentioned as signs of contamination in the commercial real estate to rising delinquencies in credit card, now globally to bond insurers (e.g Ambac Financials, FGIC Group, ACA Capital, French Natixis SA), reinsurers (e.g Europe’s Swiss Re), major mortgage lenders or “Government Sponsored Enterprises” (GSE’s) in Freddie Mac and Fannie Mae, Municipal Bonds (e.g. California’s downgrade) and even to rising incidences of default in US auto loans.

Mounting risks of losses from Australian and Japanese corporations loom on CDO downgrades, where recently major Japanese banks were reported to have accounted for ¥ 1.3 trillion yen or US $12 billion in US subprime exposure.

Even European banks have agreed to temporarily desist or suspend from trading on so-called “covered bonds”, or securities backed by mortgage or loans to public sector institutions (Bloomberg) `` to halt a slump that has closed the region's main source of financing for home lenders”.

Meanwhile, three month deposit yields in some Asian countries fell on contagion fears. This excerpt from Telegraph’s Ambrose Evans Pritchard (highlight mine),

`` The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety as investors across the region pull out of risky assets.

`` Yields on three-month deposits in China and Korea have plummeted to near 1pc in a spectacular fall over recent days, caused by panic withdrawals from money market funds and credit derivatives…

`` Korean and Chinese three-month yields have fallen from 4pc to 1pc in a matter of days in an eerie replay of events on Wall Street in late August when flight from banks and the US commercial paper markets caused yields on three-month Treasuries to falls at the fastest rate ever recorded. Asian investors appear to be opting for deposit accounts with government guarantees.

`` It is unclear what prompted this latest "heart attack" in the credit system, though rumours abound that Asian banks have yet to own up to their share of the expected $400bn to $500bn losses from the US mortgage debacle.”

Even sovereign debts appear to be stomped by the ongoing stampede out of risk assets, from Financial Times (highlight ours),

``Investors are shunning European government debt issued by countries other than Germany as worries about a global economic slowdown prompt a flight to safety within Europe.

``There is a strong sell-off in sovereign debt relative to [German] bunds, ranging from top-rated Spain to eastern Europe,” said Ciaran O’Hagan, strategist at SG CIB.

``Credit spreads, derivatives, and currencies are all taking a whack as part of the flight to quality.”

These developments include emerging market debts which this week suffered quite heavily. Curiously, while most of the damages to emerging Asian debt had been relative to domestic currency denominated issues, the Philippines appears to have been the least affected in both local and US dollar issues, based on the data from Asianbondsonline.org. Of course this is not to suggest that we are “better off” than the rest of the pack, as one week does not a trend make.

Japan In “Bear Market”, Will Global Equities Follow?

``The ultimate driver of Japan’s adaptation today is globalization. In short, the world changed while Japan slept, as more and more developing countries became participants in the world’s economy and the old patterns of trade and capital flow went by the wayside. Now, as Japan reawakens, its challenge is to find a place in this different world, starting with its own backyard: Asia.”-Matthews Asian Fund

Figure 2: Stockcharts.com: Are Global Markets Headed Lower?

Major equity markets continues to be in a funk with Japan’s 39-year old broadest benchmark, the Topix, technically entering into a “bear market” when it declined below the yardstick of 20% from its 2007 peak last week. The Topix is down by over 21% as of Friday’s close. (Thursday to be exact-Friday was Labor Thanksgiving “kinro kansha no hi” holiday)

Another major Japanese equity bellwether, the Nikkei 225, a price weighted index of Japan’s top 225 blue chip stocks, as shown in the main window of Figure 2 courtesy of stockcharts.com, has been down by nearly 19% and is clearly approaching its pivotal support level at 14,000.

Meanwhile, Europe’s Dow Jones Stoxx 50 or (stoxx.com) a ``leading Blue-chip index for the Eurozone, provides a Blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain” have lost about 9.5% from its peak (shown in the upper pane below main window) and like the Nikkei 225 seems to be testing its critical support level at around 3,500.

The broad based S & P 500 (pane above main window), a major US bellwether, is down by about 8.6% from its peak, relieved from its recent lows by a stern rally last Friday, but on lean volume, on an abbreviated trading day following the Thanksgiving Holiday. Incidentally, the Dow Jones Industrials has touched the 10% loss trigger point which should activate the next phase of the “Bernanke Put” this December 11^th.

Like the Nikkei and the Dow Stoxx 50, the S & P 500 is nearly at the cusp of the crucial threshold level at 1,400.

On the other hand, the Dow Jones Asia Pacific ex-Japan stocks (lowest pane) surrendered about 14% of its gains from the recent highs and appear to be in a pronounced decline reflecting the same activities in the major markets.

From Bloomberg (emphasis ours), ``Global stock markets have lost $2.9 trillion since Oct. 31 and the collapse of the subprime market in the U.S. has triggered about $50 billion in writedowns among the world's largest banks.”

So, in a break from last week’s seeming indecision, global markets appear to be signaling in unison a forthcoming test of the respective critical support levels, which may determine the direction and returns for 2008.

With the recent performances of the US treasury markets indicative of an approaching US economic recession, plus Japan’s likely transition towards an interim bear market, the likelihood is that once these levels have been cleared, a “bear market” could be the hallmark of global equities in 2008, unless of course we see an elaborate turnaround soon.

A US Recession Will Initially Drag Global Equities Lower

``Recessions are not caused by a general shortfall in spending, but instead by a mismatch between the mix of goods and services supplied by the economy and the mix of goods and services demanded. Though demand shifts away from some kinds of output that the economy produced in the prior expansion (as we saw with tech and telecom in 2000-2002 and are seeing in housing today), we often see continued demand in other sectors, but the mismatch takes time to correct, and output and employment suffer as a result. Most job losses during a recession are typically concentrated in a small number of industries, while other industries experience growth and even growing backlogs and rising employment. So the next recession, whenever it occurs, will probably feature a good amount of dispersion. Most likely, we'll observe particular weakness in housing-related industries (and associated finance sectors), while a variety of sectors including technology, oil services, broadband telecommunications, and consumer staples may be better situated (though such stability still may not prevent stock price weakness).”- John Hussman, Hussman Funds

How does a US recession affect world equity markets?

Learning from the past using the 2000 model we can take note that global equity markets echoed the directional path of the US markets as shown in figure 3.

Figure 3: US 2000 Bubble Implosion Reverberated in Asian Markets

Where the US Tech bubble crashed in 2000 as shown in Figure 3 (see red line), the plight of the Philippine benchmark, the Phisix (shown by the black candle), which was in a bear market in the aftermath of the 1997 Asian Crisis, was further aggravated until it reached its trough in 2002.

The 1998-1999 cyclical rally amidst a secular bear market was mostly due to the reaction as a natural consequence to the violent 1997 selloff and in confluence to the seasonal “New President’s stockmarket honeymoon” following the Presidential election victory of Joseph E. Estrada.

As you can see, no trend goes in a straight line. And secular trends are usually pockmarked by intermittent cyclical countertrend movements or plainly said, a cyclical bear market amidst a bullmarket or a cyclical bullmarket amidst a bearmarket. 1998-1999 signified the latter.

Notice too, that Asian markets represented by Japan’s Nikkei (green line), Hong Kong’s Hang Seng (gold line) and Singapore’s Strait Times (blue line) all turned lower or inflected by 2000, stayed on a general declining trend for more than a year then bottomed out synchronically by 2002.

So if the past were to do an asymmetric reprise, then a US recession could likely lead to a similar decline in Asian markets, including our Phisix…initially.