Markets Abhor A Vacuum: Philippine Bonds and Peso Sees Daylight

``I’ve been dealing with these big mathematical models of forecasting the economy…I’ve been in the forecasting business for 50 years…I’m no better than I ever was, and nobody else is. Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed. We can’t improve ourselves.” Alan Greenspan

In the light of the recent global market volatility, we previously dealt with how the present actions in the marketplace impacted the Philippine asset classes. While the consensus in the investing community have now gravitated towards the “reconvergence” theme, covering Philippines assets, we noted how bonds and the Peso have deviated from the previous patterns where past global volatility resulted to a carnage in all domestic asset classes. Such perspective can be seen either as an anomaly or perhaps as an inchoate sign of divergence.

Barely has our ink dried commenting on such aberration and we found another test to our hypothesis. Just as the Philippine credit ratings were upgraded by Moody’s a week ago, the Philippines surprisingly went into a $500 million bond offering early this week, which astonishingly was avidly grabbed by investors.

``The government’s $500 million sovereign offering was more than eight times oversubscribed at the top end of its initial price guidance as investors bought into the country's rosier economic outlook. (highlight mine)” (Inquirer.net)

If this had been a stock market IPO, then the outsized demand could have perhaps resulted to a vigorous jump in its listing price. But of course bonds and stocks are distinct animals.

FinanceAsia labeled the Philippines as “masters of timing” for being able to take advantage of the timeliness of its offering (offering ahead of the US FOMC meeting, seizing the recent upgrade momentum) and for having squeezed out a good deal of short positions.

Nonetheless, much of the demand came from Asia and domestic investors (of the 44% allocated to Asia, 20% were subscribed by locals).

David Lai, portfolio manager at Aberdeen Asset Management observed (highlight mine) ``It reflects that liquidity in the market is still strong, it’s just that people don’t want to risk their money in markets that are this volatile. Right now, they want safer bets, not risky issuers, even if these do pay a high return. Therefore a Philippines sovereign is just the ticket, given the country's improved fundamentals, the modest issue size and strong support from onshore investors.” (FinanceAsia)

Philippine bonds as a safety bet? Who would have thought of this a few years back? Not especially with the politically obsessed populace. But today locals are clearly part of the anchor to Philippine assets. Here George Soros’ Reflexivity theory is clearly at work, market prices have reshaped the public’s perception of fundamentals.

Another interesting comment quoted by FinanceAsia (highlight mine)``This transaction shows that investors, despite their nervousness, are able to consider emerging market sovereigns rationally since this asset class has exhibited low correlation to the rest of the credit markets," says a market observer. "But it won't impact the $20 billion-worth of deals currently in the pipeline, waiting to come to market."

And this has not been an isolated event; earlier Indonesia and state-run Korea Development Bank likewise went into the bond market and successfully raised $3 billion last January. From the Philippine Daily Inquirer, ``Indonesia's $2-billion two-tranche bond issue early this month was about three to four times oversubscribed, traders said. (highlight mine)”

Meanwhile, the global credit market crisis has not deterred the Philippine Peso from reestablishing a new milestone high. The Philippine Peso closed at Php 40.50 a fresh 7 and a half year high (abroad it even closed at 40.325). Again this is not an insulated event as prices of regional currencies have responded to the recent actions of the US Federal Reserve.

``All 10 of the most-actively traded Asian currencies outside of Japan rose versus the U.S. currency in the week after the Fed lowered its benchmark rate to 3 percent and signaled it's ready to reduce it further to spur U.S. growth. Thailand's baht strengthened beyond 33 to the dollar in onshore trading for the first time since August 1997. (highlight mine)” (Bloomberg)

Moreover, even as gloom and doom analysts dominate the webspace today, as you probably read in newspapers the Philippine economy vaulted to its highest economic growth in 31 years at a time where concerns of a US recession are expected to drag global economies with it.

From the Economist, ``Despite the dark clouds gathering over the global economy, the Philippines has put in its best economic performance in over three decades. New data show that the economy grew by 7.4% year on year in the fourth quarter of 2007, as strong domestic demand and services growth more than offset weak exports. The fourth-quarter result brought full-year real GDP growth in 2007 to a 31-year high of 7.3%. The domestic economy's prospects will remain bright in 2008, although a sharp slowdown in the US, the Philippines' largest export market, will prevent GDP growth from maintaining quite such a rapid pace as last year.”

True enough economic data are lagging indicators, and for us do not serve as key movers of the financial markets. Nonetheless, we concede that in a world of globalization of trade and finances, the conditions in the US will have SOME impact to different countries but on a varying scale.

For the Philippines, the transmission channel will probably be through trade (export and imports are equally about 40% of GDP) as noted above and remittances (52% of total are from US). But other variables such as domestic demand (private consumption accounts for 70% of GDP) can also have a material impact.

The point is if economies operate on complex and diversified moving parts in the face of perpetually changing conditions, then analysis based on straightforward classroom assumptions are likely to be misguided.

Yet, as to how external conditions could affect domestic demand remains unclear. Again from the Economist, ``the key question for the Philippines is whether domestic demand can continue to support growth if a US recession hits exports hard.”

Bottom line: Amidst the credit contraction in the US and some other parts of the world, liquidity appears to remain abundant in Asia and in the Philippines, such that Philippine bonds and the Peso seem impervious to the recent bouts of volatility and in fact got recently bid up. Either this signifies an anomaly that would adjust in the face of more external pressures (from the US) or this represents seminal sign of emergent decoupling--remains to be seen. If the latter emerges, then this should spillover to the equity markets.

Besides, markets like nature abhor a vacuum. As global central banks printing presses churn out paper and digital money, especially under today’s conditions to arrest signs of budding deflation haunting some major economies, they are likely to fill up on some assets markets and or filter into consumer prices.

Bernanke’s Crash Course for Central Bankers: Save the Stock Market!

``The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”- Ludwig von Mises, Human Action

While US markets (Dow Jones and S&P up over 4%, Nasdaq 3.75% week on week) responded gleefully to US Federal Reserve Chairman Bernanke’s move to slash 125 basis points in the span of about 8 days, the global response had been uneven-most Asian markets remain under continued selling pressure while in Europe the reaction was mixed (Eastern Europe mostly down, Continental Europe up).

Could it be the bottom for US markets? Maybe. Maybe not. We are inclined to think not. See Figure 1.

Figure 1: Economagic: Rate cuts and the S & P 500

Some hail Mr. Bernanke’s move as being a “proactive” or “activist” Central Banker. We don’t share that view. Mr. Bernanke started his rate cuts following pressures in the credit markets which percolated into the stock markets, it was not an ex ante but an ex post response. Therefore, like typical bureaucrats he was reactive and employed treatment based solutions. The fact that he assertively slashed rates in an unprecedented scale makes him more of an aggressive reacting Central Banker than a proactive one.

Yet the $64 trillion question is “will the aggressive treatment based actuations serve enough to plug the impairments in the US banking system?”

If one looks at history for guidance we see that rate cuts do not automatically cause a stock market recovery especially if indeed the US is undergoing or nears a recession.

The most pronounced example is during the dot.com bust in 2000, despite the FED serial actions of pruning the Fed fund rates from 6% in 2001 to 1% in 2003 (green rightmost line), what transpired was a secular decline interspersed with short but powerful clearing rallies. At the end of the cycle, from the peak to the through, the S & P lost more than 40%.

This is not to suggest that history will repeat or even rhyme. It could or it may not. While we are leaning on the view that US could or is likely suffering from a recession today, we do not discount the possibility that it may even head off a recession. Until the underlying problem of malinvestments in the banking system gets to be resolved, US markets are likely to remain under selling pressure despite the current intense rally. A recession would expose the US markets to even more downside volatility.

But there is an important difference between the dot.com bust and the housing bust today, the recession in the US then was prompted for by capital spending excesses in the corporate sector, while today’s proximate trigger comes from the housing bubble bust which has spread over to a wider sector of the economy exacerbating the recession risks.

Moreover, we don’t share the mainstream view that curtailment of consumer spending is a prime reason why a recession could be triggered, as per John Hussman of Hussman Funds (highlight mine), ``recessions emerge not because of a general decline in the willingness to consume, but rather because a mismatch emerges between the mix of goods and services demanded in the economy, and the mix of goods and services that the economy has been supplying. Many industries experience continued growth during recessions (even if their stocks trade somewhat lower), while other industries experience profound demand shifts. In the late 1990's, there was clear overinvestment in telecom and information technology, and these sectors suffered disproportionately during the recession that followed. In the current cycle, the overexpansion has been in housing, debt origination, and leveraged finance, so a much different group of stocks will probably be hung out to dry this time.”

And because Chairman Bernanke believes that market actuations reflect the underlying economic conditions and its dislocations risks impacting the real economy, it has been a guiding economic principle for him to use aggressive monetary responses as revealed by his past speeches of the Financial Accelerator and Helicopter strategy. That is why we have been spot on in anticipating Bernanke’s policy approaches because he has been quite consistent with his views which have been translated into policy actions.

Lately we discovered in a past article (2000) that Mr. Bernanke even preached about rescuing the stock market as essential to protecting the economy. In an article entitled “A Crash Course for Central Bankers” published at the foreignpolicy.com he wrote to prove on the merits of subsidizing the stock market through aggressive policy responses (emphasize mine),

``Central bankers got it right in the United States in 1987 when they avoided deflationary pressures as well as serious trouble in the banking system. In the days immediately following the October 19th crash, Federal Reserve Chairman Alan Greenspan—in office a mere two months—focused his efforts on maintaining financial stability. For instance, he persuaded banks to extend credit to struggling brokerage houses, thus ensuring that the stock exchanges and futures markets would continue operating normally. (U.S. banks, which unlike their Japanese counterparts do not own stock, were never in any serious danger from the crash.) Subsequently, the Fed’s attention shifted from financial to macroeconomic stability, with the central bank cutting interest rates to offset any deflationary effects of declining stock prices. Reassured by policymakers’ determination to protect the economy, the markets calmed and economic growth resumed with barely a blip…

``History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

So given the accelerated activation of the Bernanke Put, it is of no surprise that like Pavlov’s dogs responding to a trained stimulus, investors ramped up on stocks, in the belief that the Fed’s implied subsidies as a guarantee for renewed risk taking. Talk about Moral Hazard.

One has to understand that policy actions such as interest rates adjustments operate on with a time lag, which means the impact is likely to be felt after a period of time and not immediately.

True, over the short run there are some benefits. The normalization of the yield curve (short term rates below long term rates) will help contribute to the banks profitability and possibly help rebuild its capital base. Mortgage borrowing costs will ease the burden for some borrowers as the reduced Fed rates affects the London Interbank Rates or LIBOR from which many mortgages are benchmarked. Home equity rates which are priced using prime rates follows the path of FED rates, are likely to also come down. Cost of funds for companies will similarly decline. A possible revival of “speculative spirits” on the backstop of expectations of a Bernanke Put or A FED subsidy. And negative real yields are likely to benefit stocks relative to competing assets as bonds, money market funds or certificate of deposits.

But it doesn’t bring back the heydays of loose borrowing standard. It won’t stop home prices from falling. It will punish savers where money market funds reached $3.3 trillion last week from $1.8 trillion in 2001 and where household deposits have reached $7.1 trillion during the third quarter of 2007 from $4.3 trillion in 2001. (Doug Noland). It will encourage further home equity extraction which will aggravate the highly indebted balance sheets of homeowners. It doesn’t take the risk away from bond insurers exposed to infected securities and from financial institutions loaded with leveraged debts.

Or said differently, FED action is actively working to defer on the day of reckoning or seems to be buying time in the hope that markets will self-heal without going through the required natural process of adjustments such as writing off losses, liquidating imbalances and recapitalization. The FED wants to recapitalize and leapfrog over other 2 processes.

Japan’s experience of market process denial- financing of companies with interlocking ownership, subsidizing of affiliated financial institutions and government forcing banks to make more loans to prop up insolvent institutions- resulted to a padding up of non-performing loans which magnified their imbalances that took over decade long to clean out.

MSN’s Jim Jubak has a good narrative on how failed policies caught up with Japan to essentially prolong the country’s economic agonies, from Mr. Jubak,

``Eventually, all this asset shuffling and all these accounting gimmicks couldn't hold off a final reckoning. Even a $70 billion bailout in 1999 wasn't enough to turn the tide. By 2000, a wave of 25,000 bankruptcies finally rippled through the Japanese economy.

``In the fiscal year that ended in March 2000, Tokyo's big banks sold $20 billion in stock from companies they had propped up, sending the Nikkei stock index down an additional 35% in the last nine months of 2000. That returned the stock market to the lows it had hit a decade ago.”

In short, while credit driven distortions could temporarily be patched up by the FED and the US government through present “reflationary activities”, odds for a massive unwind will continue to mount for as long as the market process to correct any mismatches in the mix of goods and services in the economy will be denied by procrastination.

After all has it not been the manipulation of interest rates that has been one of the major drivers of today’s US economic malaise?

As Professor Art Caden of Mises.org wrote (emphasis mine), ``incorrect interest rates create a tug-of-war between consumers, who now prefer present to future consumption, and investors, who are receiving the incorrect signal that consumers prefer future to present consumption. In the long run, this results in malinvestment as people attempt to undertake production plans that are inconsistent with the market interest rate; moreover, it reduces the net investment produced by the economy because people will only be able to invest the real resources available.”

So Bernanke’s advice to contemporary bankers-BUBBLE ON!

Pushing On A String or the Last Bubble?

``Thank goodness I have a lot of math, cause thru the clever use of differential equations, I can calculate that the Fed has only four more Shock and Awe 75 bps cuts, plus a Shock (but no Awe) 50 bp left.”-Barry Ritholtz, Is the Fed A Paper Tiger?

This leads us to our next observation: What if the Fed policy fails to stimulate the economy and the market?

Figure 2: contraryinvestor.com: Last Bubble Standing?

Contraryinvestor.com brings out an important point that long term yields see Figure 2, particularly 30 year (topmost) and 10 year yields (below 30 year) have almost reached levels when Fed rates were pegged to a 4 decades low in 2003-2004 (shaded area) signified by the short term yield at the lowest pane.

This shows how the treasury markets have priced in extensive fear or panic more than the underlying economic potentials. To add, treasuries have been behaving as alternative safehaven instruments arising from the lack of highly liquid instruments. Remember many AAA instruments have been impacted by the credit crisis due to financial engineering or packaging of AAA papers with garbage and got labeled as AAA by ratings agency, hence the recent downgrades and attendant losses.

Given the recent intense discounting action, yields of the treasuries appear unlikely to fall further unless markets will price in a massive recession or something equivalent to a depression.

From contraryinvestor.com (highlight ours) ``So as we move forward in time and surely in continued Fed response to our current circumstances, we have a really hard time believing the entirety of the curve is about to drop meaningfully further in yield level. THAT'S the big issue here. And if indeed we're even close in terms of correct interpretation of the current structure of the curve and how that curve might act ahead, then low yields are already heavily discounted in total broader financial market values as we speak. It may very well be the Fed is truly pushing on the proverbial string if further Fed actions cannot stimulate meaningful alternative yield level response to the downside. We'll just have to see how it all works out from here. And God forbid the equity markets were ever to come to the pushing on a string conclusion.”

In other words, the heavily overbought bond markets is in a critical crossroad, again either we see some form of mean reversion where Treasury yields will spike (meaning higher rates ahead)- possibly impelled by a breakdown in the US dollar/US averts a recession and sees inflation spike- or the US economy succumbs to a deflationary recession.

Thanks to the contraryinvestor.com, the treasury yield curve will surely be in our watch list.

Amusing Video From Slate Magazine: Buy America!

Amusing video from Slate Magazine...

Buy America!

The recent economic downturn may be bad news for Americans, but for foreigners with money to burn, editorial cartoonist Mark Fiore knows of a certain well-known superpower that's available for a song.

Phisix: On A Bear Market Template, Bear Market Rules Apply

``The failure to understand the dynamics of market cycles is a major reason why investors repeatedly overextend their risk near market peaks, hold onto their stocks over the full course of a bear market, and finally abandon stocks near market troughs. Though less than half of a typical bull market's gains typically remain by the end of a bear market, those bear markets rarely move in a straight line. Instead, they typically include several declines of 10-20%, punctuated by very hard rallies. As I've noted before, the 2000-2002 decline, which took the S&P 500 down by nearly half, included three separate advances of about 20% each (measured from intra-day low to intra-day high). These advances serve to keep investors “holding and hoping,” as Richard Russell would say.”-John Hussman

It is rare to have our projections (namely, oversold bounce, a rush of government policies, record high gold) come to pass immediately, as most of the time they take “eons” to transpire. But we won’t have to “pat ourselves in the back” over these short-term favorable outcomes because events may turn out to be fleeting.

In the ongoing epic struggle between market forces, manifested today by the adjustments brought about by debt induced deflation, and inflationary government intervention, signified by “safety net” policies aimed at cushioning its impact, the convulsive tensions from such conflict could be clearly felt in the markets. Tuesday headlines “Stock Market Plunges Worldwide” (Associated Press) was a clear depiction of such phenomenon.

As I have posted in my blogspot last Monday, “Phisix, Most Global Markets Enter Bear Territory” over HALF of the world’s indices has transitioned into bear markets as identified by Bloomberg, which included our own Phisix, shown in Figure 1.

Figure 1: stockcharts.com: Global Markets: Transition To A Cyclical Bear Market?

Technically, a bear market is defined as a drop of 20% from the top. And the underlying characteristic of bear markets is it “descends upon a ladder of hope” or that momentum implies the path of least resistance is likely to be a downward path. In short, expect negative returns. The paramount question is how deep and for how long?

For the Phisix, which as of Friday’s close is down 16.4% from its pinnacle last October, this highlights the second attempt to breach the psychological barrier of 3,000, but again due to oversold levels, the Philippine benchmark has violently recoiled and erased some of its losses (see Figure 1 main window). Again, data from PSE indicates that these intense selling could be attributed to the streak of massive net foreign selling since the advent of 2008.

Of course, we don’t deny that domestic dynamics has been tied to the events around the world, as we have been one of the “rare” contrarian iconoclast preachers of globalized correlation since 2003-when everyone was talking “micro”, although again we think that market dynamics could be shifting to “regional” than “global” in the near future (again another of our contrarian theme).

One remarkable observation today is that the Phisix has performed almost at par with US markets instead of suffering from severe drubbings of a far greater degree as seen in the past.

For the US markets which has served as an instrumental leader for global markets, 2 of its major indices like the Phisix crossed over into bear territories during the last week’s carnage but have regained some of its losses, namely the technology rich Nasdaq (down about 18% from its peak as of Friday) and small cap Russell 2000 (down 19%). On the other hand, the Dow Jones Industrials is down close to 14% and for the S & P 500 nearly 15% (upper pane in Figure 1).

All this implies is that our Phisix has now been transformed into a relative Beta play or near equal volatility with that of the US markets. Of course we expect this to change which we will elaborate later.

For the moment, the reappearance of risk aversion in the form of bear markets hound even emerging market stocks as represented by Asia ex-Japan (upper pane below center window) down about 17% and iShares Emerging Markets (lowest pane) down 19%-as of Friday’s close.

But with the realization that the direction of equity markets seems to have gradated into a bear market requires a new template for one’s portfolio management. In other words, some trading rules for surviving bear markets, Carl Swenlin of DecisionPoint.com gives us some great clues (emphasis mine),

``Oversold conditions should be viewed as extremely dangerous. Whereas in bull markets oversold lows usually present buying opportunities, in bear markets they can often resolve into more heavy selling.

``Overbought conditions in a bear market are most likely to signal that a trading top is at hand.

``While bear market rallies present great profit opportunities, long positions should be managed as short-term only.”

To translate for market participants of the Philippine Stock Exchange: The next attempt to successfully infringe on Phisix 3,000 could lead to a test on the next critical support at 2,550 possibly over the medium term (perhaps 3 months to one year).

Albeit, we don’t want to be too mechanical about this or depend stringently on such rigid technical outlook, because, it is of my view, that fundamentals will dictate on the markets in the succeeding events where the next series of downturns in Anglo Saxon markets will be met with lesser degree of declines in the Phisix or even a potential divergence.

But again under present conditions bear market trading rules should apply unless the Phisix reveals of prominent signs of divergences.

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.