Emerging Markets and the Philippines: The Last Shoe to Drop?

``The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”-George Soros, The worst market crisis in 60 years

Global depression advocates were in boisterous gaiety following last week’s synchronized global equity carnage and used such occasion to pontificate and bash the topical “decoupling” paradigm as preposterous, a myth or a figment of imagination.

In our view, such “know-them-all” outlook ignores the general circumstances of the unfolding war of attrition between the forces of inflation and deflation, where the present episode of a battle won is unduly justified as equivalent to a final victory in war.

Yes, we agree that market forces will eventually undo every government induced imbalances, but the world is more complex than is commonly assumed even by these experts.

Austrian Economist and 1974 Nobel Laureate awardee Friedrich Hayek in Individualism and Economic Order explains of the dynamics of changes which emanates from the individual level, ``For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since only the tastes and not the actions of individuals can be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other peoples' actions, there is no reason why these processes of successive changes should ever come to an end.”

Put differently, an individual’s response to the conditions which one encounters differ from the response of other individuals, and these separate responses underpin such “change” dynamics which makes it hard to qualify and quantify. Thus, if a community of individuals has different reactions to variable conditions, could we be assured that the deduced proximate causal relationship based on the different levels of economic and financial interdependence as opined by experts lead to the same distribution outcome? Can we also expect of the same responses from government officials in the face of divergent political pressures?

In the recent past when developed economies as the US suffered from “shocks”, emerging markets bore the brunt of such radical adjustments, as shown in Figure 2, courtesy of IMF’s Global Financial Stability.

Figure 2: IMF Global Financial Stability Risk: Improving Performances of Emerging Market Assets

This is an important picture: notice that during the last 3 minor selloffs in the US markets prior to the July credit squeeze, which ranged around 5-7% (rightmost graph), namely in April-May 2004, May-June 2006 (Yen Carry Unwind) and February-March 2007 (Shanghai Surprise), the degree of the losses accounted for by emerging markets (leftmost graph) had been thrice as high at the start (2004 and 2006), but has considerably lessened (2007).

In short, the volatility trends in emerging markets has seen tremendous improvements relative to its Beta coefficient; the previously HIGH beta was cut by almost half in February 2007 when compared to the losses in the US S & P 500.

Today’s turbulent markets reflect the same improving dynamics. As earlier stated, the S & P 500 has lost 15% as of Friday’s close while the Phisix is down 16% from its peak and so with emerging markets (EEM) at 19%. If the same volatility had been applied relative to its 2004 and 2006 scale, then emerging market benchmarks and the Phisix would have caved in by about 45%!

Yes, we remain undoubtedly “coupled” to the US markets yet, but “recouplers” are “reading the tea leaves” from too much of only one facet of the “interrelated” global asset class.

Go back to figure 2 and I’ll show you more. In between the S & P 500 and the MSCI emerging market equity benchmark are three other benchmarks, respectively, external debt (EMBI Global), Local currency debt (GBI Emerging Market) and currency.

The same marvelous progression dynamics with the equity markets can be said of these asset classes except that…

Figure 3:asianbondsonline.com: Philippine Bond Yield on Major US Issues (left) and 2 year and 10 year Local Currency Yield (right)

…unlike in the past where emerging market equity volatility led to equivalent losses but at a very much mitigated degree, today’s volatility has even accounted for surprising gains (!), (read my lips G-A-I-N-S) -if one reads into the Philippine markets as a possible representative of the emerging markets.

Figure 3 courtesy of ADB’s asianbondsonline.com shows that bond yields of Philippine papers in both local currency issued sovereigns (left) and US dollar denominated sovereigns (right) are presently LOWER. Since bonds yields and prices are inverse, this means bond prices have been climbing HIGHER a year on year basis. In short, positive returns amidst a negative equity market landscape. The same holds true if compared with the JP Morgan Emerging Debt (JEMDX) funds on the same timescale.

Figure 4:asianbondsonline.com: Peso-US Dollar/ Peso Japanese Yen

Again if one looks at the Philippine Peso we see the same mechanics at work. The Philippine currency amidst the global turmoil continues with its winning streak, not only relative to the US dollar, in spite of the April-May 2004, May-June 2006 (Yen Carry Unwind), February-March 2007 (Shanghai Surprise), July-August 2007 (global credit squeeze) and today’s US recession concerns, but has also risen against the Japanese Yen as shown in Figure 4. This even comes in the face of a lower growth rate of the much ballyhooed Peso driven OFW remittances in November (inquirer.net).

Although we may not be bullish on the Peso relative to the Yen (global volatility should lead to possible repatriation Japanese money invested abroad which could mean rising Yen and a lower Peso), the point is global financial markets appear to be pricing in a market beta of “muted convergence” (a.k.a. recoupling) for the emerging markets ONLY in the dimensions of the equity markets!

Of course the markets may again rule against my outlook as in January 11, [see Windshield Outlook: NO Signs of Global Depression], but until we see these happen again, present trends appear to signal emerging market resiliency than weakness.

How can these not be, where US markets have been reeling from the heat of potential credit rating downgrades of key corporations, including major bond insurers as discussed last week (yes-more US taxpayers money coming- New York Insurance Superintendent Eric Dinallo to the rescue?) (cnnmoney.com), on capitalization, losses and lower earnings concerns, the Philippines has recently been stamped with good seal with an accompanying credit ratings upgrade from “stable” to “positive” from Moody’s (inquirer.net).

Further, recency bias had been exhibited by some ivory tower ensconced experts as highlighted by mainstream media, following the recent thrashing in the domestic equity markets. According to an alleged expert, one of the main risks of the local economy is that Business Process Outsourcing (BPO) will endure job retrenchment from a US slump. Huh? We don’t follow the logic.

The major reason, according to C/Net.com, why companies outsource some of their work is due to cost-cutting. A slump in the US will prompt for more cost-cutting measures, which possibly means more prospective outsourcing, not less. Remember the Y2K problem or the Millennium Bug Crisis of 2000 (news.com) in tandem with dot.com crash helped fueled the Indian-led outsourcing boom we are witnessing today.

Bottom Line: one of these markets will definitely be proven wrong soon. Will there be an emergent divergence in the global equity markets? Or, will emerging market bonds and currencies collapse under the weight of US-UK-EURO deflationary selling pressure?

The man who broke the Bank of England in the 1990s in the person of billionaire philanthropist George Soros (Financial Times) recently wrote, ``Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.” (highlight mine)

A bank analyst recently asked, ``will emerging markets be the last shoe to drop?”

Bernanke’s Financial Accelerator At Work, US Dollar As Lifeblood of Globalization

``There is no sign that underlying need to sell US assets to the Chinese government to finance the US current account deficit is about to go away. China’s government isn’t buying US assets to help finance a period of adjustment that will ultimately reduce the United States dependence on Chinese flows. It is buying US assets as a byproduct of a policy of trying to defer adjustment.”-Brad Setser

One of the main reasons we argue against the supposition of a global depression or even downplay the odds of a world recession in spite of a potential US hard landing is on the assumption that monetary policies from the US will have different impacts to different countries, especially to those whose currency regime remains tied to the US.

In a recent note to a favorite client, I wrote, ``If there is any one-single most important link to globalization, it is not exports, reserves, capital flows or remittances, it is the US dollar standard system. Since most of the trade or capital flows, which shapes trading patterns and cross border flows influences a nation's economic and monetary structure, are conducted still in the US dollar, US policies (fiscal and monetary) will continue to be asymmetrically transmitted to the rest of the world. As to its unintended effects is one matter to reckon with and speculate on.”

Why do we say so? Because the Paper money-Fractional Banking system which underpins the US dollar standard is the major artery network which serves as the lifeblood of today’s global economy. In the words of Friedrich A. Hayek in his “The Paradox of Saving,” (emphasis mine) `` So long as the volume of money in circulation is continually changing, we can not get rid of industrial fluctuations. In particular, every monetary policy which aims at stabilizing the value of money and involves, therefore, an increase of its supply with every increase of production, must bring about those very fluctuations which it is trying to prevent.”

So in effect, the manipulation of money and credit growth brings about distortions and imbalances in the real economy. But since today’s real economy involves the participation of most countries in the globalization phenomenon albeit at varying degrees, then the consequences of such imbalances will be reflected on a global scale but is whose to impact domestic economies would likely be at diverse levels.

Figure 5: Bank of International Settlements: Credit, Asset Prices and Monetary Policies

Figure 5 from the Bank of International Settlements (BIS) shows of the divergent scale and scope of the world’s regions relative to its exposure to credit, real policy interest rates, real property prices and consumer price inflation.

In other words, the chart zooms in on the vulnerability of each region to the risks of an asset busts which could influence their underlying real economies. Thus, we find the Industrial countries (upper left) followed by Central and Eastern Europe (upper right) as the most risk prone relative to the indicators: credit to GDP and property price trends. Notice too that real policy rates (green line) have been drifting on a downtrend to near zero levels for all regions which has underpinned growth in the asset markets (property prices).

Yet, following the emergency US Federal Reserves 75 basis point cut last Tuesday, the single biggest cut since 1982, and the first emergency cut since 2001 (cbsmarketwatch), these real policy rates are likely to plunge to negative levels and could possibly ignite further inflationary pressures in different areas not affected by the credit crisis.

For instance, countries whose monetary regimes that are tied to the US dollar via a currency peg like the oil revenue rich GCCs or China risks more inflation. And the speculative momentum brought about by expectations of a break in the currency regime or a substantial revaluation will likely attract more speculative influx into their assets.

Yes admittedly, GCC bourses have lately been affected by the turmoil in the equity markets pricing in the concerns of a US recession but it is too early to impute on the superiority of the transmission effects of a US slump over negative real rates brought about by the Bernanke Put. Zimbabwe should be a timely reminder of policies gone awry and whose unintended effects are reflected in the currency exchange value and the stock market.

As we always love to quote Ludwig von Mises (highlight mine), ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

To our mind, voluntary abandonment of credit expansion is unlikely the scenario given the existence of Central banks whose implied fundamental task is to inflate the money and credit system.

Further, any additional actions to reduce rates by the US Federal Reserve and other safety nets via fiscal response will give further emphasis to such glaring discrepancies in the global monetary system. This is likely lead to more boom-busts cycles.

Nonetheless, the urgency of action undertaken by the US Federal Reserve has prompted for a debate on Fed Chairman Bernanke’s alleged “undeserving” sensitivity to the predicament of Wall Street and thus being hoodwinked by a 31-year old rogue trader Jérôme Kerviel from Société Générale (newyorktimes), who reportedly burned $7.2 billion of the company’s capital from unauthorized trades, to unduly trigger an emergency response from the Ben Bernanke’s Fed.

Such assertion gives Mr. Kerviel undue credit for being able to force Chairman Bernanke’s hands.

We don’t know about the exact chronology of events but global markets have already been in a steep decline even before Monday’s selling pressure.

Besides, Asian markets opened the week with massive losses even prior to the opening of markets in Europe. Hence, while Société Générale unwinding of Mr. Kerviel’s losing illegitimate positions may have influenced the momentum for further selling, it is unlikely to have been the cause. In fact, the US markets, despite the emergency rate cuts and proposed policy responses over the week by the Fed, President Bush and the Congress combined, fell significantly on Friday.

Third, as discussed in November 12 to 16 edition, [see Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts], Bernanke’s speech last June 15 on the Financial Accelerator was a dead giveaway on his policy responses.

Again from Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

What we wrote then (emphasis mine),

``Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.”

Oops, looks like a bullsye for us.

From our point of view, Mr. Bernanke would have done the same even without Mr. Kerviel’s tomfoolery. It is thus far the fear over the unquantified degree of losses in the banking system spreading over to the real economy that is weighing on the financial markets, hence markets will respond accordingly.

Besides, if indeed Mr. Kerviel’s misdeeds did mistakenly trigger an undue reaction by the Fed, this should be revealed by the next FOMC meeting at the end of the month. The Federal Reserve is likely to hold rates under such circumstances, albeit we will go by Bernanke’s operating principle as basis for anticipating on his next policy response.

Phisix, Most Global Markets Enter Bear Territory

A Technical definition of a Bear Market is when benchmarks decline by 20% from its highs.

Today’s huge 5% decline brings the Phisix officially to bear territory.

We aren’t alone though. Half of the global markets are in bear territory following yesterday and today's carnage. According to Bloomberg,

"More than half of the world's biggest stock indexes fell into a bear market as mounting concern about a U.S. recession dragged down banking and retail shares across Asia, Europe and Latin America.

“The MSCI World Index's 3 percent decline yesterday, the steepest since 2002, left benchmarks in France, Mexico, Italy and 35 other countries at least 20 percent below their recent highs. Declines today turned Indonesia, India, the Philippines, Taiwan and Thailand into bear markets as well...

“Among 80 equity national equity benchmarks tracked by Bloomberg, indexes in Argentina, Australia, Austria, Belgium, Bulgaria, Chile, Colombia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland, Italy, Latvia, Lithuania, Luxembourg, Mexico, Namibia, the Netherlands, Norway, Peru, the Philippines, Poland, Portugal, Romania, Singapore, Spain, Sweden, Switzerland, Sri Lanka, Taiwan, Thailand, Turkey, Venezuela and Vietnam have also dropped at least 20 percent from recent highs.’…

“Fed funds futures show that 72 percent of traders expect the Federal Reserve to cut its benchmark rate to 3.5 percent from 4.25 percent on Jan. 30. Banks and consumer stocks have failed to recover even after policy makers lowered the target rate for overnight loans between banks three times since September from 5.25 percent."

Banking System’s Conflict of Interest Should Underpin Gold’s Rise

``O gold! I still prefer thee unto paper which makes bank credit like a bank of vapour.”- Calvin Coolidge (1872-1933), Thirteenth President of the US (1923-29)

As we have earlier said, present market actions denote of ongoing deflation of several asset classes brought about by the massive deleveraging in the US banking system. For instance, the rapid decline of gold prices has been lauded by global depression proponents as working in favor of their cause, see figure 4.

Figure 4:stockcharts.com: Gold and Oil Still Intact, Yen and US dollar bottoms

Depression advocates argue that the prevailing deflation momentum in the US will overwhelm the world and set forth a chain of global financial market meltdown and economic reversals. We do not buy such apocalyptic theory (as discussed last week).

True enough, deflation is having its field day as the rising Japanese Yen (lowest pane) signifies the deleveraging of the global carry trades amidst last week’s carnage, while the bottoming signs of the US dollar index (upper pane below center window) possibly represents the stampede towards the hoarding US dollar and US dollar denominated-US treasuries.

Incidentally debt deflation is a manifestation of the painful adjustments by market forces on the massive imbalances imposed into the system by the accrued colossal distortions of inflationary activities shaped by government activities over an extended period of time. On the other hand, the inflationary forces are simply the redistributive policies enacted by policymakers to appease the voting public or special interest groups to perpetuate themselves in political power.

For us, while deflation seems to be at the edge today, the present turmoil signifies only an episode of an epic ongoing battle between market forces and government activities.

For instance Martin Wolf columnist for the Financial Times in an outstanding piece “Regulators should intervene in bankers’ pay”, wrote why bankers appear to be distinguished from the rest of the field we quote (highlight ours),

``No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble…

``It is the nature of limited liability businesses to create conflicts of interest – between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

``That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation.”

While Mr. Wolf believes that the solution to this is to regulate bankers pay in order to align it with their accompanying incentives, our thoughts is that the major culprit, aside from those indicated (which are more reflective of symptoms than causes for us), is the present monetary system-the US dollar standard operating under the Fractional Banking system-whereby the conflict of interest paradigm emanating from a “limited liability businesses” is best exemplified.

Central bankers are designated for social tasks; to ensure price stability and generate maximum employment (a.k.a. inflation). On the other hand private bankers undertake risks to generate profits. But since the underlying privilege of private bankers-as primary agents or conduits for Central Banks-hence the issue of limited liability businesses emerge out of divergent incentives.

To quote Ludwig von Mises in Human Action, ``Bureaucratic conduct of affairs is conduct bound to comply with detailed rules and regulations fixed by the authority of a superior body. It is the only alternative to profit management. . . . Whenever the operation of a system is not directed by the profit motive, it must be directed by bureaucratic rules.” (emphasis mine)

In essence, when you combine the role of private and public interests you have natural case of conflicting incentives, easily known as the agency problem or principal-agent problem.

Since our extant monetary system operates under the unique arrangement between Central banks and private bankers (Central banks cannot afford the banking system to go under hence the subsidy), the latter conducts risk-taking activities under the assumption of “limited liabilities” or implied “subsidies” or the knowledge “socialization of losses” from their political patron, given their indispensable role.

Notwithstanding, the worsening conditions in the US banking system today, such dynamics underpins the crucial relationship [as per Martin Wolf…only businesses able to devastate entire economies…no other industry is uncertainty so pervasive…no other industry is it as hard for outsiders to judge the quality of decision-making] from which should lead to more subsidies or “socialization of losses” disguised in variant forms, even when some of them declaim such as “Moral Hazard”-for us a PR stint. Under such premises, gold prices will likely continue to flourish as global policymakers continue their currency debasing activities.

Thus, we believe that gold’s recent decline is likely a countertrend reaction to its recent surge more than a sign of “depression”. By depression we mean a prolonged agonizing period of recession.

Figure 5: US Global/Moore Research: Seasonal Activities in Gold Prices

In addition, Figure 5 illustrate to us that the present actions of gold could also signify seasonality. Gold tends to peak during the first quarter, then tapers of until the third quarter before resuming its upside.

Third, following gold’s latest feat of achieving record nominal milestone highs, gold’s decline could also represent the issue of popular-crowded trades.

Since mainstream media has finally caught up with the gold fever with such commentary from Financial Times, “Gold is the new global currency”, momentum, speculative and retail investors tend to crowd in on fashionable themes.

Moreover, crowded trades appear to have piled in as shown in Figure 6.

Figure 6: Rude Awakening: Sell Gold!..or Buy it

This from Eric Fry from the Rude Awakening (underscore mine)

``Gold's price has been soaring recently, and so has its popularity, especially among the "Speculators" in gold commodity futures. According to the latest Commitment of Traders Report from the CFTC, the Speculators – also known as the "dumb money" – are holding a record-high, net-long position of 220,000 gold futures contracts. For perspective, that's double the position this group held six months ago and four times the position they held two years ago. For additional perspective, the Speculators held their record-high, net-short position on April 9, 1999, shortly before gold launched its dazzling run from $280 an ounce…

``It is worth noting, therefore, that while the Speculators are flowing into the gold market, the "smart money" Commercial traders are ebbing. The "Commercials" are holding their largest-ever net-short position in the gold market. In other words, they are betting heavily against rising gold prices. By contrast, back in 1999, the Commercials were taking the other side of the Speculator's big bet against gold. In April of 1999, the Commercials held their largest-ever long position in the gold market, just before the gold price took flight.

In short, technicalities, sentiment, overcrowded trades and seasonality factors could weigh against gold over the short term. But again we won’t count much on these as governments are likely to intercede and continue measures aimed at mitigating the circumstances of the public via “safety nets” (for political reasons) or to “socialize losses” for special interest groups even at the extent of some possible sacrifice among their constituents.

Bottom line: Today’s monetary standard depends on the operating principle of the privileged “Fractional Banking system: Central Bank-Private Bank” arrangement where authorities will likely fight to preserve the status quo, even if they require socializing more losses for its upkeep at the expense of the general public. This should be good for gold.

As an aside, depression advocates could end up being right for the wrong reasons: Collective Central bankers (mostly Keynesians) could proselytize into Austrian economists and allow for the maladjustments in the system to run its course without government interference despite the public’s outcry. Or perhaps war or protectionism overcomes globalization trends. The latter of which seems to be a more credible risk.

Figure 7: Prieur Du Plessis/GaveKal: Gold’s Rise has been correlated with the China’s surging Purchasing Power

Finally the chart from Gavekal shows how the explosive growth of Chinese purchasing power (measured through wages) has been correlated to surging gold prices.

No, this is not to suggest that China’s buying patterns has been responsible for the recent surge in gold prices to record highs, but it does show how Chinese consumption as the fourth largest consuming country, which accounted for 9.2% of worldwide global consumption (Forbes) has played a modest role in its turbocharged performance.

It also implies that as the Chinese grows wealthier the likelihood is that gold consumption will likewise reflect the rise of its purchasing power.

Portfolio Management Under Today’s Stressful Market Environment

A Premature Call or One Week Does Not a Trend Make?

``The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”-Joan Robinson, Cambridge University (1903-1983)

Hardly has the ink dried from our last outlook, when financial markets across the globe started falling apart. Could we have spoken way too soon?

Worst of all, what we asserted as possible seminal evidence of financial market “decoupling” got slammed, as shown in Figure 1.

Figure 1:stockcharts.com: Global Markets Cracking UP?

The Philippine benchmark, the Phisix (center window) suffered its worst single week loss steeply down 9.57%, since the week that ended August 16 in 2007. Year to date the Phisix, prompted by a streak of intense foreign selling, has lost 12.52%, with barely a month into 2008!

Worldwide, most of the reactions have been the same, the Dow Jones World Index (above pane), the Fidelity Southeast Asian Fund (pane below center window) and the Templeton BRIC Fund (lowest pane) all showing a technical breakdown from critical support levels.

Again, with the exception of benchmarks Gulf Countries which continues to appear immune from the recent global pressures and some select bourses, such as Jamaica, Ukraine Taiwan (possibly for insulated reasons this week), and some others, it is broadly a sea of blood out there for last week.

Warren Buffett on Bond Insurers: Watching fires Burn Across The River

``The battlefield is a scene of constant chaos. The winner will be the one who controls that chaos, both his own and the enemies.” -- Napoleon Bonaparte

While in the past a misread on the reaction of local investors evoked a sense of panic on my part early August (discussed last week), most of what I have written then is coming into pass this time around.

In other words, this is sheer evidence of how attempting to “time markets” over the short term is almost an impossible task. Investing in the financial markets using ticker based assessments usually results to disastrous outcomes especially at critical turns and mostly when trading and or investing disciplines and money management are sacrificed at the altar of momentum or emotionally driven impulses. The previous pressure of “missing rallies” has now morphed into fear today for many market participants.

Again the formula of perceptive observation applied to judicious risk analysis combined with enduring patience and strict adherence to one’s investing discipline equals outsized returns through minimized risks. This can be epitomized by the latest activities of the world’s best stockmarket investor, the sage of Omaha, Mr. Warren Buffett.

In 2003, Warren Buffett vehemently argued against the use of derivatives, labeling it as a “Financial Weapon of Mass Destruction” (bbc.co.uk). This was publicly debated by with former Fed Chief Alan Greenspan (Forbes: The Great Derivatives Smackdown) and other financial experts and market participants who dismissed Mr. Buffett’s admonitions.

Four and a half years later, derivatives have been a key contributor in today’s financial turmoil and could likely be the epicenter of the next wave of leverage implosion via credit derivatives known as Credit Default Swaps or among counterparties in many suspect derivatives contract-known as Counterparty risks.

The Notional amount or Over-The-Counter Derivative contracts have grown to an astounding $516 trillion as of June 2007 (bis.org), with Credit derivatives expected to grow to some $33 trillion (bba.org.uk) or according to some estimates at $45 trillion (Forbes).

And for Mr. Buffett, a field littered with casualties from failed derivative gambits as seen in the Bond Insurance industry covering mainstays as ACA Financial Guarantee, AMBAC Financial Group Inc, MBIA Inc., Radian Group and others (money.cnn.com), becomes a timely opportunity for his entry, through his flagship Berkshire Hathaway, into the severely battered industry (ft.com).

Mr. Buffett appears to practice an age old Chinese proverb which deals with the warfare stratagem of “Watch the fire burning across the river”. The enemy dealing maneuver is part of the 36 collection of stratagems which advocates ``delay [in] entering the field of battle until all the other players have become exhausted fighting amongst themselves. Then go in full strength and pick up the pieces (wikipedia.org).”

With the industry mainstays running themselves aground through imprudent speculations, and neglectful evaluations of risks, Berkshire Hathaway is in the process of cornering the industry business from the fallen warriors.

So who among us can painstakingly wait for four-and-a-half years to seize an opportunity? Such is the redoubtable virtues Mr. Buffett seem to be preaching to us.

Selling Reaches Extreme Levels, Potential Bounce Soon?

That said, today’s selling pressures could likely be distinct from that in July-August of last year.

Our feedback is that some of the expectations seem geared towards the impression that the markets could deliver a similar reaction relative to last year. Hence, the assumption that today’s market ruckus is merely a short-term blip. Hopefully they are right. But for us, last year’s initial tremors seem to be more like a practice drill for today’s more earthshaking market action over the next months.

In July 2007, the violent gyrations in the global equity markets had been principally in response to the sudden seizure of credit access in US-Europe financial system. Following a rapid gamut of actions from global central banks, such tightness appears to have eased considerably since (Reuters).

Nonetheless, the distinguishing aspect from then is that markets appear to be pricing in an intense global slowdown possibly via the snowballing expectations of a US Recession…TODAY! Yes, that is according to Merrill Lynch, Goldman Sachs (telegraph) and others.

The sharp decline in commodities, equity markets and 40% collapse of the Baltic Dry Index, against a backdrop of a fierce rally US Treasuries (sharply falling yields), surging Japanese Yen (unwinding carry trades) and bottoming out of the US dollar Index have chimed in to emit a unified message.

True enough, brutal selloffs similar to last week may result to a sharp rebound as technical and sentiment indicators seem to have touched extreme levels, see Figure 2.

Figure 2: US Global Investors: Negative Two Standard Deviations

Mr. Frank Holmes of US Global Investors suggests that these areas of extremes are measured by a statistical tool called Standard deviations (SD) or a measure of statistical dispersion, which assess the spread of values in a data set. If many points in the data set are close to the mean then the SD is small, while if many points are far from the mean then the SD is large, whereas if all the data are equal then SD is zero (wikipedia.org).

According to Frank Holmes of US Global Investors (highlight ours): ``Over the past 60 trading days, the S&P 500 has dropped 14 percent. A decline of this magnitude last occurred about five years ago. As can be seen on the chart above [left pane-BT], this correction is approaching the same magnitude of other gut-wrenching events such as the collapse of Long Term Capital Management in 1998; Sept. 11, 2001; and the collapse of the technology bubble and the bear market that ensued in 2002.

Such high rarely occurring SDs, can also be seen in the histogram graph at the right pane, notes Mr. Holmes, ``The 60-day change on the S&P 500 has now fallen 2.18 standard deviations from the mean. There are very few periods with worse 60-day returns. In other words, odds favor a rebound from these levels.”

Why? Mr. Holmes adds, ``When markets fall for an extended period, or just have very sharp short-term corrections, fear begins to creep into investors’ psyches, and they begin to make irrational decisions. This becomes an opportunity for the investor who understands history and the math behind the market. These charts help us quantify the magnitude of the markets’ ups and downs and help us make better risk-adjusted decisions (emphasis mine).”

Given the technical oversold levels and the accelerating “fear” factor in the investing community, such extremes levels could trigger a ferocious short covering aside from potential short-term insurrection from the bulls.

But underlying question is will any forthcoming rally last?

Secular or Cyclical Trends, US Markets as Drivers and Opportunity Windows

The important thing to understand today is that since the market actions in the Phisix is STILL TIED to, or remains “COUPLED” to the activities in the US, the fate of the US markets remains of considerable influence to our forward direction over the interim. Hence the analysis of US markets, economy and forward policies are paramount.

Second is to identify and understand whether today’s declining phase comes out of a REVERSAL of the long term trend or simply a COUNTERCYCLICAL action, as we discussed in our October 23 to 27, 2006 edition, [see Should You Invest in the Phisix Today?].

If markets reveal that the secular trend has changed then necessary MAJOR actions need to be taken in one’s portfolio to adjust to the new conditions.

However, if markets merely suggests of transitional cyclical phases of mean reversion, or in the observation of legendary trader Jesse Livermore’s axiom, NO TREND goes in a STRAIGHT LINE, then it is normal to expect interim trends, such as a cyclical bear market phase amidst a secular bull market and vice versa, where slight portfolio adjustments could be made relative to one’s risk profile.

To consider, if sentiment reasons has purely weighed on the Philippine markets relative to a fundamental impacted credit-impaired US markets, essentially given Warren Buffett’s dictum where we have to be “greedy when everybody is fearful and fearful when everybody is greedy” then present opportunities poses as selective buying windows especially as prices are marked even lower out of plain investor psyche-fear. Yes, be reminded that ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised,” which is again another quote from Warren Buffett.

If it took the prescient Mr. Buffett more than 4 years to be proven right (again and again) with respect to derivatives (previously to the tech boom), then isn’t he now taking advantage of someone else’s or a majority’s folly or the present crisis as an opportunity to profit from? Why then fall for momentum or the bandwagon effect-which is after all another important psychological factor for underpinning today’s crash?

Again all these depends on one’s time frame and risks expectations; where participants has to reckon whether they are in the market for the punt or for momentum trades or for long term investing.

Measuring the Bad News

And since the US markets continue to serve as the world’s inspirational leader, persisting pressures emanating from the knock on effects of the imploding leverages within its financial system are taking its toll on global equity markets.

The contagion effect has been far reaching, from mortgages backed securities to Asset backed securities to Credit Debt Obligations and now to Bond Insurers, Credit default swaps on commercial property sector…as shown in Figure 3.

Figure 3: Danske Bank: More Bad News

The business of bond insurers is to underwrite insurance policies of bond issuers relative to missed payments or defaults. In the past, monolines (sole business is bond insurance) covered mostly municipal bonds. But the monumental bubble in the real estate sector induced a bandwagon effect of luring these insurers to expand its earnings by adopting complex risks models as mortgage backed securities and Credit Default Swaps in their portfolio.

The recent fallout from the collapsing mortgage backed securities have prompted a downgrade on several monoline insurers as MBIA, the largest bond insurer (wikipedia.org), which has lost about 85% of its share price (see topmost chart), as bond insurers are faced with huge payments on rising loan defaults. These companies have insufficient funding and/or capital to pay out on the insurance.

Further Chief Economist Steen Bocian of Danske Bank lists of the ramifications and other risks facing the US financial markets (emphasis ours), ``Bond insurers represent one of the systemic risks that have been a “ticking bomb” under the financial system. If the bond insurers get downgraded, their insurance will obviously lose value and the bonds they have insured will also likely be downgraded. This can trigger forced selling from investors that are holding the insured bonds if they are only allowed to invest in bonds with a high rating.

``Another risk at the moment comes from the commercial property sector. The activity in this sector has held up well but may start to be hit by the credit crisis and thus add to the woes in the construction sector. The Fed’s Beige Book reported that “reports on commercial real estate activity varied, with some reports noting signs of softening demand”.

Such far reaching contagion, which in essence signifies the question of the solvency of the US banking system, brings us to our earlier premise that global markets appear to be pricing in a recession scenario for the US economy.

Figure 3 from Northern Trust shows as how the S & P 500 performed from PEAK to TROUGH prior to and during a recession.

Figure 3 Northern Trust: The S&P 500 and Economic Recessions

Ms. Asha Bangalore of Northern Trust underscores two conclusions from the above, (highlight mine),

``(1). The S&P 500 is a leading indicator par excellence. Since the 1950s, the S&P 500 has always peaked before the peak of a business cycle, with one exception (1980 business cycle). The S&P 500 establishes a trough prior to the end of a recession without exception.

`` (2). The median percent decline of the S&P 500 from its peak to trough is 16.9%. In the first three business days of 2008, the S&P 500 is down nearly 7.0% from its peak in October 2007. If history is a guide, brace yourselves for a rough ride in the months ahead.”

From its peak in October 9 of 2007, the S & P 500 is about 15% down (Friday close) which is nearly within the median loss and 4% short of the average loss during the past cycles.

This isn’t to imply that we have reached the bottom; such would assume the average or median as the base. What we can say is that the path of least resistance is DOWN for the time being.

And that if a recession is truly underway or we are close to it, depending on the extent of impact on the economy- the degree or depth-and the response to the attendant policies aside from the duration-losses can go as high as 40% (1973-74) or 30% (2000-2001).

One must remember the meat of the losses occur during the transition towards a recession, as John Hussman wrote (emphasis ours), ``A large portion of bear market losses occur while investors are still denying the probability of a recession. By the time that a recession is well-recognized, significant damage has already been inflicted.

From which Mr. Hussman delivers a difficult poignant and pragmatic advice for the average market participant (highlight ours), `` For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy. It's likely that most investors who “caught” the rally in the stock market earlier this year never got out, because the features that would have prompted them to reduce risk (overvaluation, overbought conditions, overbullish sentiment) were the same conditions that would have prevented them from taking risk in the first place.”

Accepting Risk That We Can Retain

So what to do?

Again under the present circumstances, the degree of decline in the US markets aside from the behavior of other asset classes appear to indicate that the US could be in a recession, where using historical performance could lead to more losses if not a prolonged period of rough sailing ahead.

The impact of the present adjustments will depend on the how the US economy and markets responds to the policies adopted by the US government in reaction to the present deteriorating circumstances.

President Bush recently pushed for a $145 billion plan as safety net, alongside Bernanke’s recent avowed support for fiscal stimulus, which could complement central bank actions. So far the markets seem to have discounted these and continue to stagger. According to Calculated Risk, market expectations are priced in for a 75 basis points cut with the odds of 100 basis points of implied probability rising further. This implies that the financial markets expect more aggressiveness in policy actions. Question is: will authorities oblige?

The path towards expansionary policies in the US and elsewhere will have different impacts to different asset classes and should be evident soon (maybe as new measures are implemented), but for the moment markets will remain synchronized as the focus remains on the potential bandwith of the credit-securitization-derivatives induced losses and its repercussions to the broader financial system and the economy.

If global markets have been driven by sentiments than of fundamentals, the likelihood is that “decoupling” will probably reappear in the form of earlier recovery than outright dissociation.

Because extreme situations suggest of a near occurrence of a countertrend (meaning a bounce soon), it would be reasonable to adjust portfolios according to one’s risk profile under a defensive stance. To paraphrase Mr. Hussman, to accept risk…that we can be reasonably expect to retain.

Global Depression: A Theory Similar To A Horror Movie?

``We citizens will remain pessimistic about the future. That’s our way. And that pessimism is exactly what we need to drive the technological advances that will bring the Golden Age. If we trusted the Golden Age to come on its own, it wouldn’t. It will take a lot of work. Luckily, that work is happening.”-Scott Adams, Dilbert

My daughter likes to watch horror movies. Her past problem was that each time she watches these, fear gets to overwhelm her such that she won’t be able to sleep or stay in a room by herself. This requires my presence at her side. Thus, each time I encounter her watching such genre of shows, I constantly remind her that “these are only movies” or that screenplays depict on the plots engendered by the film producers to entertain viewers.

Logical Fallacies and the Ludic Fallacy

Many analysts limn today’s investment landscape like a horror movie. They predict that the world will segue into a deflation induced global depression-your financial world Armageddon. Their simplified basic premise as follows:

The US is undergoing a “deflationary spiral”
Since the US functions as the most significant economic growth engine to the world
Hence the world will also fall into a US led-deflationary depression.

While their arguments or what we call as the Dry Bone deduction (toe bone is connected to the ankle bone is connected to knee bone…) presents a compelling case, we share Nassim Taleb’s dyspathy towards Mental Mapping. To quote Mr. Taleb from his magnum opus, The Black Swan (emphasis ours) ``We worry about those that happened, not those that may happen but did not. It is why we Platonify, liking known schemas and well-organized knowledge-to the point of blindness to reality. It is why we fall for the problem of induction, why we “confirm”. It is why those who “study” and fare well in school have a tendency to be suckers for the Ludic Fallacy.”

Further, such arguments seem to fall under logical fallacies of “begging the question” and the fallacy of “division”.

Begging the Question is (nizkor.org) `` a fallacy in which premises include the claim that the conclusion is true or (directly or indirectly) assume that the conclusion is true. This sort of "reasoning" typically has the following form”. Or essentially, an argument whose conclusion is its basic premise.

Meanwhile, the fallacy of Division (wikipedia.org) ``occurs when one reasons logically that something true of a thing must also be true of all or some of its parts.” Or the belief that the US equals or is the world- via the basis of tight interdependence.

The basic premise that the US financial system is presently undergoing a credit contraction, which is defined as deflation, is quite accurate. However, the assumption of the trajectory of its present activities will be transmitted to the world through the linkages of trade and finance is highly questionable in our view.

Moreover, depression advocates could be overestimating the inferred impacts of such linkages and at the same time underestimating the potential effects of government actions. This is not to suggest government actions will succeed which we think will not. Instead government actions out of the political demand to mitigate any crisis or dislocations could lead to unintended consequences.

While we fundamentally agree that every credit driven booms eventually result to catastrophic busts, we find the intense obsession towards the paradigm of Japan’s “lost decade” or the 1929 depression as undeserving.

Mistaking such maps or models for reality is what Mr. Taleb describes as the “Ludic Fallacy”.

Analyst Viewpoint: Rearview Mirror or Windshield Outlook?

The fact that the mortgaged induced securitization-derivative implosion has roiled some major developed markets and economies today should not extrapolate that the rest of the world will follow the same path.

For instance, as we pointed out in our previous issues the Philippines have little exposure to such toxic wastes; missed out entirely the recent global real estate boom (see Figure 1), have been reducing its debt levels (public and private), have seen its forex reserves surge in consonance with its Asian neighbors, a belated upsurge in the Peso and saw its stock market up by only about 260% during the past 4 years-which is hardly symptomatic of a bubble.

Figure 1: ADB Bond Monitor Real Estate Loans as % to Total loans

Besides, our belated reaction to the property boom appears to be cyclical; it took years to cleanse out the malinvestments in the system following the Asian Financial crisis.

Yes, a hard landing in the US will surely impact the world but to a different degree than the depression advocates have been projecting.

Next, previous crisis have shown different impacts to global markets.

Figure 2: Select Global Markets: A Rendition of Past Performance?

Figure 2 shows of the different equity benchmarks over a 20-year time frame. The Philippine Phisix (Green), US S & P 500 (black), Japan’s Nikkei 225 (blue), Hong Kong’s Hang Seng (violet) and Brazil’s Bovespa (red).

Our intention is to show how markets performed during the previous crisis in parts of the globe and its interrelation with other markets.

Depression advocates have been deeply enamored with Japan’s bust as a model, yet in 1990, the sharp drop in the Nikkei (blue top) has not impacted significantly much of global markets. In hindsight, one may argue that given the nascence of financial globalization and lesser trade or financial linkages by Japan’s economy relative to the world, a slump in Japan’s economy and markets had not meaningfully been transmitted to the world.

In fact, what transpired appears to be a shift-a boom in ASEAN markets and economies, represented by the Phisix and in Latin America, represented by Brazil.

The boom in ASEAN had been corollary to massive Japanese direct investments seeking out low cost production cost as an offshoot to the 1985 Plaza Accord, aside from hefty portfolio flows from US, first generation Newly Industrialized Countries of Asia (Taiwan, Korea, Hong Kong) and other foreign based funds in search for higher yields. As with all credit driven booms, following Latin America’s Tequila Crisis and the Asian Financial Crisis, ASEAN and Latin America equity benchmarks collapsed.

As Asian markets wobbled from the double whammy of Japan’s collapse and the ASEAN bubble implosion, what transitioned was a boom in the US led the technology sector or that global fund flows found its way into the US markets.

The dot.com bust in 2000 was the first concrete manifestation of synchronized markets (blue arrow and left light orange vertical line) as the Phisix, Bovespa, Hang Seng, Nikkei and the S&P all suffered declines but varied on the degree of losses.

Following the erstwhile Fed Chair Alan Greenspan’s drive to forestall the menace of “deflation”, the Federal Reserve slashed its rates to a 60-year low at 1%. Such policy actions stoked a reversal (blue arrow and rightmost light orange vertical line) in favor of the bulls, which saw diverse asset classes (bonds, stocks, commodities, collectibles-paintings stamps wines etc.., real estate) across the globe markets soar in near simultaneous fashion.

Thus, global depression advocates appears to have “anchored” their analysis using the recent past performance of tight correlation (in 2000-2006) as their basis for forecasting a global gloom and doom scenario. Such recency based analysis is called by Warren Buffett as the Rear View Mirror syndrome, to quote the Sage of Omaha, ``In the business world, the rearview mirror is always clearer than the windshield.”

Windshield Outlook: NO Signs of Global Depression Yet

Now looking at the windshield we ask, what has transpired so far over the decades was divergent markets which eventually evolved into convergent markets…our $64 trillion question is, will the past performance do a reprise?

As an aside, I am guilty of the same mistake of interpreting past performance for future outcome last year. When the first symptoms of the mortgage-securitization crisis appeared, I initially panicked out of the thought that local investors, who remained subordinate all throughout this cycle or since 2003 until mid-2007, would not provide for sufficient volume enough to match the equivalent intensity of foreign selling, hence increased the risks of a market collapse. Although, I expected local investors to pick up their volume eventually as we argued in 2006, the lack of consistent material evidence during the boom since 2003 rendered me a skeptic on the locals’ capability to shore up the market especially under duress, thus, the misread.

Nonetheless, 2007 proved to be the first instance where local investors proved their moxie, which again as discussed last week, should be a bullish underpinning. Once the sentiment of foreign returns in our favor, bullish locals plus bullish foreign money should propel the Phisix much higher! But, again, the ultimate question is one of timing-when will foreign money will reverse their sentiment?

As we all know, 2008 has started out negatively, with most major global equity markets suffering from the knock on effects of the credit triggered turmoil in the US financial markets.

While the impression portrayed is that the world is presently “recoupling” based on the woes of the US, we do not want to succumb to the fallacy of being blind to the “reality” that some markets appears to be in fact, “decoupling” from the US as shown in Figure 2. We will follow Warren Buffett’s advice of focusing at the windshield.

Figure 3: stockchart.com: BRIC countries Recoupling or Decoupling?

Figure 3 shows us that even while major developed markets have seen their equity benchmarks in a downdraft, contemporary benchmarks of major emerging market protagonists categorized as the BRIC or Brazil, Russia, India and China have still been ascendant if not remain at elevated levels in spite of the recent bouts of credit driven financial market tremors. This prompts us to ask; are the BRICs “recoupling” or “decoupling”?

As we have repeatedly mentioned, deepening financial globalization trends effectively works to integrate various economies through trade and financial mechanisms. Put differently, in today’s globalization trends markets and economies are likely to have greater degree of interdependence relative to the past, hence any shock could impact countries varying on the depth of their exposure to such trends.

But the important caveat is that countries are structured differently in terms of trade, financial markets, economies, fiscal and monetary policies and governance such that there is no such thing as a perfect correlation or integration. Such distinctions matter a great deal.

I have repeatedly used Zimbabwe as an example. Zimbabwe suffers from consecutive years of economic recession (unemployment rate at 80%, 30% contraction of GDP over the past seven years-voanews.com) which has resulted to a hyperinflationary depression-with present inflation raging at 24,000% (earthtimes.org), prompted by political repression. But guess what? Despite the standstill in its economy, where businesses appears to have grounded to a halt, its stock market soared by an astounding 300,000%, particularly 322,111% in 2007!

Why? Because of government policies. The argument is not about the size of its economy but rather how government policies influences markets or economies. It’s not your run-of-the-mill narratives impelled by economic or corporate forces as most analysts or experts suggest. It’s about the unintended consequences of government policies or activities on the marketplace and the economy. The shriveling value of the its currency, the Zimbabwe Dollar, effectively translates to a functional loss of its monetary role of “store of value”. Thus, the currency’s negative yield or the effective loss of purchasing power prompts for a substitute or a search of value greater than the currency-found in the form of company stocks.

As Ludwig von Mises in his Theory of Money and Credit observed (highlight mine), `` …a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time.”

This brings us back to our earlier assertion that monetary policies adopted by the US Federal Reserve pumped up prices of diverse asset prices across the continent; if monetary policies influenced global assets in the past can they not influence in the same manner global asset policies at a dissimilar scale?

Depression advocates insist that no, fiscal and monetary policies will end up in the same route as the Japan experience.

Here is a monumental quote from Treasury Henry M. Paulson, Jr. during a speech at the Asian Society last December 5 (highlight ours), ``Some in China are suspicious that the U.S. push for RMB appreciation and financial market liberalization is really an attempt to gain trade advantages and generate profits for American companies while slowing China’s economic expansion. They mistakenly believe that yen appreciation during the mid-1980s caused Japan’s weak economic performance in the 1990s. Rather, we now know that Japan’s economic difficulties were caused by the growth, and then collapse, of a huge stock and property price bubble, and the failure to use monetary policy to prevent the emergence of deflation after the bubble burst.”

Or how about this from Fed Chairman Ben Bernanke’s recent speech (New York Times), ``We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”. (highlight ours)

See what I mean? US authorities are in the belief that “appropriate” policy responses will serve as the much needed elixir to its present strains, and would act accordingly.

Now of course, the bag of tricks with which they intend to utilize could be expected to be far more than the traditional tools than we know of, given their understanding of the inadequacy of Japan’s policy responses (ZIRP, Quantitative Easing, massive pump priming).

Bernanke’s Helicopter speech is just a manifestation of the unconventionality of instruments they are willing to experiment with. Some of the recent examples of the new policy responses applications, the Term Auction Facility (TAF), Federal Home Loan Banks, aborted Super SIVs, swap agreements, changes in procedural rules and collateral and lending policies and others.

The point being that the future actions by US authorities will depend on its tolerance to meet the political demands of the whimsical voting public. In an election season, the inclination is to be more accommodative. However if conditions turn for the worst, where authorities will reactively pan to the public’s outcry for the mitigation of their economic or financial woes, then Bernanke’s hyperbole expression of turning to “helicopters” may be realized but in different forms, possibly through a cocktail of policy responses such as outright subsidies or bailouts, nationalization, price controls, capital controls, increase in borrowings to fund more welfare projects, increase government hiring, taxes etc.. Desperate measures for desperate times.

And upon such actions will correspond to the unintended consequences in the US and elsewhere abroad, where the transmission channel should mainly be through the US dollar- as the world’s reserve currency. Thus, the impact from such policy responses is likely to be divergent.

In the ASEAN region its equity markets have responded divergently too, as shown in Figure 4.

Figure 4: stockcharts.com: ASEAN Markets: Recoupling or Decoupling?

While the Philippine Phisix and the Thailand’s SETI appears to follow the actions in the developed world which means that they have been falling too, Indonesia and Malaysia’s markets have amazingly turned higher. In fact, Malaysia’s stocks, signified by Dow Jones Malaysia Stock Index (upper pane) appear to have shifted into an overdrive following its significant breakout last week on the account of heavy foreign buying (Reuters).

Don’t ask me for particulars why foreign money has started to prop up these benchmarks, I have nary an idea. Nonetheless, what we understand is if ASEAN is “recoupling” with the US then eventually the outliers or the present winners will reverse to reflect the path of the US markets, but if the present “decoupling” trend will be reinforced then we think that the Phisix and Thailand’s SET will likely follow the direction of this year’s leaders. As you know a decoupling strengthens our outlook for a Phisix 10,000 on a backdrop of surging Asian markets.

More to the point, if one looks at equity flows during the 2007 financial maelstrom, data from emergingmarketportfolio.com tells us why ASEAN or BRIC countries remain at lofty levels as shown in Figure 4.

Figure 5: courtesy of EPFR Global: Emerging markets as Safe haven?

In the past, we have shown you how some emerging market debt instrument have shown lower yields (priced on the basis of lesser risks) compared to that of US financials where the implication is that emerging markets have now become some sort of a “safe haven” [see November 19 to 23 edition, Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?]

Figure 5 from EPFR shows (right pane) how Dedicated Emerging Market Funds and International Global Markets have attracted capital flows at the expense of the US, Japan and Western Europe, despite the recent volatility.

In addition, on a sectoral basis, commodities/basic materials (right pane) continue to attract capital investments again despite the recent storm. The former laggards seen in the technology sector following the bust in 2000, appears to have shown signs of a steady recovery, while financials and real estate continues to cascade. On the other hand investment flows to the energy sector looks sluggish.

For the week ended January 9, AMG Data says that the inflows towards emerging markets continues to validate the present “decoupling” trends in BRIC and ASEAN markets, this from AMG, ``Excluding ETF activity International funds report net inflows of $396 million as net inflows are reported in all Emerging and Developed regions except Latin America (-$10 Mil) and Europe (-$41 Mil)”

Meanwhile the Institute for International Finance (IIF) a financial outfit consisting of 370+ members in 65 countries projects capital flows towards emerging markets to moderate but remain vigorous (Morningstar.com), ``The IIF expects the volume of net private capital flows to emerging markets in 2008 to reach $670 billion, which represents only a modest dip in capital compared to the record $681 billion reached in 2007. The IIF estimates that the volume of net private capital flows to emerging markets in 2006 totaled $560 billion.”

To consider, as the world continues to massively print or generate money or liquidity as shown in Figure 6, these are likely to find a home.

Figure 6: courtesy of Richard Karn’s Emergingtrendsreport.com: Sampling of M3 growth

So indeed while the US has been encountering some signs of “credit contraction” via its dysfunctional financial system, other parts of the world are still massively producing liquidity and perhaps could be the reason why we are seeing signs of divergences.

Not My Grandpa’s Deflation

Besides, Peter Schiff of Euro Capital provides an important insight why such horror stories are likely to be a US centric problem than a world problem. Quoting at length Mr. Schiff from his trenchant article Not Your Father's Deflation (emphasis ours),

``However there are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing…

``Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.

``In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege…

``The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors. Since American debtors can vote in U.S. elections and foreign creditors can not, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage.”

Prediction Dilemma: The Fox versus Hedgehog

Could the depression advocates be correct? Of course they could, although we assign a smaller probability to such scenario. That is why it is highly recommended for an investor to stay defensive during these turbulent periods, which means investing only the amount of risk that one can afford (by position sizing), even if we are long term bullish over Philippine or Asian stocks.

At present, in the battle between inflation and deflation markets appear to be signaling another form of ‘flation’…stagflation. Eventually the markets will tell which among these scenarios will dominate.

You see the debate about the merits of an inflationary or deflationary outcome is basically a problem of making predictions.

Another favorite analyst of ours Josh Wolfe of Forbes Nanotech identifies two types of prognosticators, a Fox and a Hedgehog, where according to Mr. Wolfe, ``Foxes are skeptics and less confident in making predictions and build a latticework of mental models. Hedgehogs are more enthusiastic (especially about what they know) and more confident in making predictions and then pushing those predictions into all domains. As you’ll see, the quick brown renaissance Fox jumps over the staunchly opinionated Hedgehog…”

Hedgehogs tend to be radical theorists in terms of forecasting and are frequently wrong than right, which today we find relevant in the advocacy for a global depression, quoting anew Mr. Wolfe (highlight ours)…

``Some hedgehogs are often seen to predict big extreme changes. Not because they are more prescient, but they are tend to be in a minority of opinion holders for an outlandish outcome. But those outlandish outcomes are important to have out there. Hedgehogs cling to very extreme assignment of odds to something: i.e. it absolutely will never happen: 0% or it is certain to happen: 100%. As the saying goes, even a broken clock is right twice a day. The cost of being a hedgehog is a lot of false positives. They constantly predict some certain outcomes, but they are more often wrong as most do not ever occur: (remember Dow 36,000?). Hedgehogs are also more likely to be on TV as talking heads because they are more confident, more assertive and assign higher probabilities to low frequency events—which also make them more interesting to watch than someone who is more reserved.”

In our case, we’d like to emulate the fox, always studying the different scenarios or models advocated by different hedgehogs and parlay our risk according to the probability of its occurrence. The bottom line is while extreme events or “black swans” may indeed occur, the odds are stacked against such scenarios, and most especially when the scenarios projected seem to be grounded on logical fallacies.

So when we hear or read depression proponents preach about the collapse of the world, until now, it remains to be just that…a movie plot.