Contingent Causes and Consequences of Human Action Should Underpin Decoupling Theme

``The only effective way to address corruption is to change the system itself, by radically down sizing the power of the federal government in the first place. Take away the politicians' power and you take away the very currency of corruption.”-Congressman Ron Paul

What was previously pronounced as the hottest emerging trend easily became an orphan overnight following the synchronous Jan 21^st global equity markets meltdown. Even some of the most revered advocates of the so-called Asian “century” went on air to debunk the so-called “Decoupling theory” as a myth or as the emperor with no clothes.

Ironically, it seems like logical fuzziness to claim that Asia will be the next economic powerhouse when supposedly its fate has been declared as being foreordained towards the growth trajectory of western nations due to its trade, economic and financial links.

In a positively correlated economic and financial sphere, does it imply that Asia would outperform only when global economies and markets are accelerating upwards?

Maybe, the difference lies in the definition from timeframe dimensions (not today but tomorrow or sometime in the future perhaps?). Maybe also, too much emphasis has been devoted to a singular event or analysis based on the rear view mirror or recency bias or past performance as guide to future events.

Again as a reminder, we do not deny that under globalization trends which means more heightened interconnectedness, linkages (trade, financial, labor) have been tightening and is likely to get tighter. And such dynamics are likely to be reflected on the markets as had been the case since 2000. But again the caveat is that there is no pure globalization or integration.

We argued the case of positive interrelationships since 2003, and in fact took on the prisms of a bear (last week) to show that under selective dimensions; particularly the induction premised from exports and remittances, a severe US slowdown will negatively impact the Philippine economy.

But unlike then, our idea today is that markets and economies could possibly be rediscovering its individualities due the different dimensions of exposures to what has weighed in on some economies or markets. Besides, under diverse conditions people, societies or even nations react divergently to changing conditions.

To quote Jörg Guido Hülsmann in his article “The Epistemological Case for Capitalism” published at the mises.org (highlight mine), ``The causal analysis of individual human behavior must take account of the fact that any human action has certain invariant consequences — that is, consequences that result from like action at any place and any time. For example, an increase of the quantity of money tends to entail an increase of the price level above the level it would otherwise have reached, irrespective of when and where the money supply is increased. The study of such consequences is the task of praxeology and economic science.

``But human action also has contingent causes and consequences. The very same action — increasing the quantity of money — can be inspired by very different ideas and value judgments. And the objective consequences resulting from any action can provoke very different individual reactions at different times and places. In other words, the causal chains through which ideas and value judgments are connected with human action are contingent. The elucidation of these contingent causal chains is the task of historical research.”

Recent examples, in the recent G7 finance ministers meeting, media asked if global central banks would concertedly lower interest rates to help stave off a world recession, here is the reply of Finance Minister Fukushiro Nukaga, ``Each country needs to take a step, and it is important to push that move based on its own economic and fiscal situation”. (highlight mine)

The interview best described by Japan Times, ``…the G7 had dashed any hopes of concerted international action, such as coordinated interest rate cuts and fiscal stimulus packages, because economic and fiscal conditions differ from country to country.” (emphasis mine)

So while global central banks would work to coordinate with each other, policy stimulus would have to be applied distinctly.

Oh, speaking of surprises, just when mainstream experts had been almost unanimously bearish brought upon by the “contagion” effects from the US mortgage crisis saga, Japan’s last quarter GDP unexpectedly soared.

From Bloomberg (highlight mine), ``Japan's economy grew 3.7 percent last quarter, twice the pace economists forecast, as business investment rose and exports to Asia helped companies weather the U.S. slowdown.” So contrary to most expectations capital expenditures (based on rising demand from Asia, Russia and the Middle East according to Bloomberg) and exports have remained resilient in the face of a US downturn during the last quarter of 2007.

We don’t like to read too much from a single event. Yet this imparts an important message- analysis based on “sterilized” conditions exhibits vulnerability. While some analysts call this a “blip”, one said that Japan’s GDP was not the appropriate indicator. A seeming case of denial?

Since a quarter does not imply a reinforced trend, it could be that the mainstream will be proven correct; as the downdraft in the US economy intensifies these positive variables could reverse. In the meantime some even assert that Japan will be the next country where the next wave of Pandora’s Box of toxic papers will surface, as measured by the recent spike in iTraxx Japan (a measure of default risks of Japan’s top 50 companies). So the global credit crisis is popularly expected to further curtail its economic activities. But on the other hand, again they could be wrong.

We read that Japan’s economic problems have been mostly about the unintended effects as a consequent to the recently imposed policies more than the ramifications from a global contagion, this from Takehiro Sato of Morgan Stanley (highlight mine),

``Japan’s “errant policy-induced slump” is already widely acknowledged among investors as “Kansei Fukyo”. The three main components are 1) heightened liquidity concerns for SMEs with de facto volume restrictions and caps on the loan interest rate for consumer financing and a shared responsibility program launched by the Credit Guarantee Corporations (CGCs) in October 2007, 2) a sharp downturn in residential investment under the revised Building Standards Law, and 3) diminished investment in risk assets following implementation of the Financial Products Transaction Law…”

``We think that liquidity restrictions from cutbacks in consumer credit and loans guaranteed by the CGCs, though for very different reasons than in the US and Europe, might be interfering with corporate activity in Japan as well. The scaled-back credit guarantee program is not having a major impact yet since the changes were accompanied by transition measures to cushion the blow.”

Of course, Mr. Sato like most of the mainstream believes that external conditions combined with internal forces are making Japan’s situation ``increasingly difficult to envision a convincing upside scenario for Japan.”

Figure 1 stockcharts.com: Japan’s Nikkei 225

We don’t know much about Japan except through the reports we read. So our outlook depends on the accuracy of the information we gather. From our perspective, many analysts have deduced Japan’s present woes as having been more internally generated, whereas the impact from external factors has yet to be actualized or has yet to surface on the economic data.

This means that if economic data continues to prove that the contagion impact from the US may have been exaggerated then Japan’s dramatic swan dive (a peak-to-trough decline of about 32%-see figure 1) could have been an overshoot.

In other words, Japan’s decline appears to have priced in more of the expected “global contagion related” bad news than is otherwise reflected in the present economic data. The major benchmark the Nikkei 225 is down about 11% year to date.

This implies for two scenario, one market is wrong (overshoot) and the Nikkei should start bottoming out 13,000-14,000 before recovering. Or two, Japan’s economic conditions will likely deteriorate further and may fall into a recession (from which the Nikkei could decline somewhere into 11,000 to 12,000).

We can’t say if the Nikkei has reached its bottom, time will make the cycle apparent but for the moment it looks like the major Japanese benchmark is poised to test its resistance level.

From the above examples (G7 and Japan), we can conclude that the battle between a globalized and a divergent outcome has yet to be resolved decisively.

Monetary Conditions Remain Supportive of Emerging Market Assets

``Inflation is a societal evil. It redistributes real wealth from creditors to debtors. It impairs the role of money as a means of exchange. The efficiency of the market's price mechanism is greatly reduced, encouraging bad decisions, which in turn harm peoples' economic well-being. At the end of the day, inflation is a serious threat to freedom. The majority of the people, suffering badly from inflation, would most likely blame the free market for their plight, rather than blame the central bank for the debasing of the currency.”- Dr. Thorsten Polleit, Honorary Professor at the Frankfurt School of Finance & Management

Last week I presented the idea that the Phisix would likely be cushioned by negative real interest rates. Negative real interest rates are essentially consequences of policy actions which is either deliberate (government taking up “pro-growth” stance to induce borrowing) or unintentional (outcomes from policies directed at a different agenda).

Since the Consumer Price Indices (note: I don’t use inflation) have been at record low levels in 2007, Philippine authorities have utilized such environment to slash interest rates in order to cut interest rate differentials between the US dollar to stem portfolio flows into the country, whose implicit aim is to curb the pace of the rising Peso. In short, the country’s central bank, the Bangko Sentral ng Pilipinas (BSP) has been acting to control the Peso’s appreciation by manipulating interest rates, among other policy tools.

And as we also noted last week, the BSP had been surprised by the sudden upsurge in the local CPI which appears to have limited its policy options in following the US Federal Reserves into similar policy measures aimed at providing stimulus to the economy in order to shield the economy from a potentially sharp downturn.

While the projections for domestic CPI remains moderate, my take is that the BSP will likely be “surprised” anew by the continued surge in commodity prices globally (this week: record high soybean, soybean oil, platinum).

This means that if the BSP opts to maintain rates at present levels despite a resurgent “sticky” CPI, then it is thus adopting a “pro-growth” stance, or attempting to expand credit to drive domestic consumption and investment. On the other hand, the BSP may move to increase rates as now reflected in the bond market (both dollar and peso denominated).

As we have said before, negative interest real rates relates to the function of money as a “store of value”. When inflation is higher than the income stream received via coupon yields of fixed income “risk free” investments then effectively the purchasing power of a currency erodes, thus the populace would find alternative means of maintaining the “store of value” in a currency by buying into other assets or by speculating in the expectations of returns above inflation rates.

If the BSP elects to maintain at these levels then we are likely to see expanded borrowings from domestic investors from which some assets may benefit. On the other hand, if the BSP raises policy rates, foreign portfolio inflows could be magnified.

As Ludwig von Mises wrote in Man, Economy, and State: A Treatise on Economic Principles,

``Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

Again boom bust cycles are essentially driven by incorrect signals sent by policy makers to the capital markets. If a boom will be triggered by a prolonged negative interest rate environment, then a bust in the future should likewise be expected.

Such is the dilemma facing the BSP, as the credit squeeze in the US and Europe continues to unfold (see figure 2), attendant policy measures by the US or Europe could be expected to target or address the ongoing tightness in these markets.

Figure 2: Danske Bank: Widening Spreads Indicate Monetary Tightness

Doug Noland from the Credit Bubble Bulletin (highlight mine) identifies the broad market tensions, ``In the markets, various indices of investment grade Credits widened sharply to record levels. The key “dollar swap” (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November).”

This means that as policy rates in the US become accommodative, the interest rate spread or differentials or “carry” widens in favor of the peso, coupled with stronger economic growth, these factors are likely to signify as strong incentives for foreign money to bid up on Philippine assets.

On the other hand, if the BSP moves to increase rates in the face of rising CPI, it would only add fuel to such motivations. So PSE President Francis Lim shouldn’t be “unhappy” because the evolving events are likely to turn the tide in his favor (a return to portfolio inflows) overtime. All he has to do is to wait for Chairman Bernanke to deliver his gift.

Again as a reminder, the problem of the Philippine markets is not due directly to the worldwide credit crunch or our banking system “infected” with toxic papers (according to BSP Governor Armando Tetangco and Fitch Ratings- Philippine bank exposure to the CDO market is only .2% to total banking assets or $180 million) or seizure in the Philippine credit system but one of forcible liquidations by foreign funds or institutions impacted by the mortgage securities crisis to raise capital, and subordinately, readjustments on economic growth expectations following a considerable downshift in the US.

Experiences of Negative Real Yields

So how powerful does a negative interest rate impact asset prices?

According to Barry Ritholtz, ``In the United States, real interest rates were negative between 2002-03. The crisis hit five years later. (Real Interest rates just flipped negative again in 2008).” Ergo, negative interest rates have basically been a crucial variable in shaping the US real estate boom bust cycle.

Negative interest rates have also accelerated a boom in the Hong Kong property markets despite the swoon in the equity counterparts.

According to the Australiannews.com (highlight mine), ``The unintended result is that home loan rates are so cheap that they are throwing more fuel on a hot property market that looks set to get even hotter.

``A typical mortgage here now carries interest of about 3.1 per cent. But compared with Hong Kong's inflation rate of about 3.8per cent, which now hovers at a more than nine-year high, that looks inviting, creating a so-called negative real interest rate.

``For many potential home buyers in Hong Kong, mortgage payments are now effectively cheaper than rents, which are slower to adjust to rate changes.”

So if the Hong Kong property markets are the assets directly boosted by negative rates, we earlier said that Zimbabwe (hyperinflation-66,000% last December!) found its “store of value” in stocks and in Venezuela via “Cars”.

And so with China, see figure 3.

Figure 3, World Bank China Quarterly: Interest rate differential with the US has reversed (left), Interest rate increases lagged behind the rise in inflation (right)

This from the World Bank, ``With monetary policy remaining constrained by the exchange rate policy, administrative measures continue to play a role in monetary policy. High balance of payment surpluses put upward pressure on the RMB. Much of the surpluses are sterilized using open market operations and reserve rate increases. With the interest differential between China and the US having turned positive, policy makers are concerned that high interest rates would attract more portfolio flows (although it is not clear how high interest rate sensitive capital inflows are). This external constraint has kept domestic interest rates lower than they otherwise would be. Interest rates were increased during 2007, but these increases lagged behind the rise in inflation. Thus, on the metric of real interest rates (deflated by current inflation) there was no monetary tightening in 2007. As a result, administrative measures and window guidance are used to affect bank lending. The tightening of window guidance at the end of 2007 have been relatively successful in reducing credit expansion, although the success of such measures is difficult to maintain for long periods without economic costs.”

Monetary Policies As Leading Indicator

For us, monetary policies have served as marvelous reliable leading indicators in determining performances of asset classes, more than “micro” fundamentals or technicals.

In my January 21 to 25 outlook [see Bernanke’s Financial Accelerator At Work, US Dollar As Lifeblood of Globalization], 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.”

Well, David Kotok of the Cumberland Advisors (highlight mine) appears to corroborate our view, ``The power of the Fed projects globally because there are many jurisdictions which peg or manage their currency exchange rate against the dollar. China manages its currency and does not allow the market place to set the exchange rate. China was 31% of our trade deficit in 2007 and is 7.5% of the world’s non-US GDP. Saudi Arabia pegs its currency. It is 3% of the US trade deficit and 1% of the world’s non-US GDP. Tom Russo of the Group of Thirty estimated the world’s cumulative numbers on this issue…He sees more than half of the US trade deficit to countries that are either managed or pegged. They collectively represent about 16% of the world’s non-US GDP. The US is about 27% of world GDP.

``We must understand that a stimulative monetary policy in the US transfers stimulus to those countries as well as applying it here. That is why we are optimistic that the Fed’s power will reach beyond our borders and that the outlook for the growth of world economies is looking better because of it.”

Again, what we are trying to say is that policy responses from a financial architecture built around the US dollar standard system will likely be distinct across geography depending on the currency regime, the economic and capital structures aside from present policies and the prospective policies adopted in the face of changing conditions.

Because the linkages from the interest rate channel commands a significant heft, it has the potential to impact markets materially or offset the liquidity contraction experienced in some other parts of the world. Thus, the assumption of a “one-size-fits-all” argument is for us a logical fallacy of composition.

So like the BSP, China as shown above has been living through a negative interest rate environment, which has been an important contributor to the ongoing boom in its real estate industry, aside from the previous boom in stocks in 2007 (The Shanghai composite is down 14.5% year to date and down 26% from its peak in October 2007). Nonetheless, like all cycles greased by credit expansion, a bust in China is likely to follow its boom-at a yet to be defined timeframe-2010 or 2011, perhaps?

And importantly, as rate adjustments in the US have brought upon a “negative carry” this should reinforce the case of additional weakening of the US dollar relative to Asian currencies.

Respected fund manager John Hussman of the Hussman Funds, expects a dollar crisis arising out of the US-China negative carry (emphasis mine), ``Presently, the U.S. economy is running the deepest current account deficit in history, even as the Federal government has promised to run up another $150 billion in debt to run a “stimulus package.” At the same time, the carry between Chinese interest rates and U.S. Treasury yields has now turned negative, meaning that there is no longer a favorable interest rate differential to encourage Chinese investment in U.S. government debt. Moreover, the gradual appreciation of the yuan continues, meaning that the Chinese are also taking losses on their holdings of U.S. Treasuries due to dollar devaluation. The only remaining allure of Treasuries has been for capital gains due to investors' flight to safety, but with yields already compressed, it is increasingly risky to expect continued downward pressure on long-maturity interest rates. This places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains.

``My impression is that the markets will respond to this difficulty with what economist Rudiger Dornbusch referred to as “exchange rate overshooting.” In the present context, that means a dollar crisis.”

``Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

Proof of Liquidity: Soaring Emerging Market Reserves

So based on a returns perspective, such prospects may not be attractive for the Chinese (as losses on reserve holdings mount) as they could restrain their accumulation of US assets. But an important point to consider is that the Chinese buying of US assets have not been due to return basis but more for economic and political consideration, hence the “competitive depreciation” of currency.

The perceptive and very meticulous analyst Brad Setser makes a very important point (highlight mine), ``Central banks aren't building up dollar reserves because they want dollars. They are building up dollar reserves because they don't want their currencies to appreciate against the dollar. The dollar's fall against the euro and the growth in emerging economies dollar reserves are thus both manifestations of the same basic trend -- a lack of private demand for dollars, relative to the US current account deficit, and the resulting pressure for the dollar to fall.”

Yes, private sector investments could likely to veer away from US assets, as they have been. But it is unclear whether this should impact the emerging market governments from accruing US assets in order to control or manage their currency values. Based on recent performances this has not been the case.

Figure 4: Brad Setser: Surging Dollar and Total Reserves Amidst A Slowdown in US Current Accounts

Figure 4 courtesy of Brad Setser shows how Emerging markets continue to aggressively accumulate reserves in both US dollar (yellow) and total reserves (blue line) even in the light of an improvement in the US current account deficit (red line).

And for 2008, the pace of accumulation is likely to pick up. According to Brad Setser, ``And 2008? Well, the early data for January suggests that global reserve growth remains very, very strong. India, Singapore, Malaysia and Thailand combined to add over $30b to their reserves (counting the increase in Thailand's forward book). Japan chalked in another $20b, though its total was inflated by the impact of falling long-term rates on its long-term dollar portfolio (Japan marks its bond portfolio to market). Brazil is still intervening as well.

``Then throw in China. Or really through in China's reserves, the CIC and the state banks, as not all of China's foreign exchange is now showing up at the central bank.

``Then add in the oil exporters ...

``There is a reason why the Fed's custodial holdings rose so strongly in January.

``The scale of the increase in emerging market government assets right now is truly mind-blowing.”

This simply shows that even if the US current account has been improving substantially enough to raise the alarm bells from the depression advocates of a global liquidity crunch, the continued “massive” accumulation of surpluses evidenced by the rapid surge of emerging market (dollar and total) reserves spotlights on the liquidity dynamics generated elsewhere (euro zone, intraregion Asia?).

The surge of China’s January bank lending and money supply growth appears to validate this view. In short, some parts of the world have been experiencing credit deflation while in other parts of the world, liquidity remains abundant. Inflationary dynamics are likely to end up in assets or channels unspecified by the authorities.

Is it a wonder why commodities (agriculture, energy, precious metals) continue to surge in face of the gloom and doom scenario parlayed by depression advocates? This comes in stark contrast to the scenario where US money contraction is said to feed in through world prices (some of them hit mainstream press saying that the depression risks would prompt the US government to buy a broad range of assets to support the economy).

Projecting Oil Prices is Not All About Demand

Mainstream analysis also declares that as the US segues into a recession, world demand for oil would crimp and thus be reflected in its prices. Some have even argued for $70 oil by mid year. They could be right. But this has not yet been apparent.

Figure 6: Simmons and Company: Contracting World Oil Supplies

The problem with this view is that many high profile experts seem to focus on one side, the demand side (shows of their economic ideology-the Keynesian school). Rarely has there been an objective perspective dealing with the balance-such as ascertaining the actual state of the supply side as shown in Figure 6, courtesy of Matthew Simmons of Simmons and Company International.

The theory is if demand slows more than the supply then prices should go down. However what is greatly overlooked is that if supply declines faster than the decline in demand then prices will remain levitated. Now supply appears to be rapidly “peaking out” even when demand seems to stall (IEA-Forbes).

Moreover, if speculation is indeed responsible for oil at its current levels then depressionists will be proven right. However, we have read this oversimplified “speculation-driven” rationalization ever since oil prices hit $30, $40, $50, $60, $70, $80 and now $90 oil. Even at today’s seizure in auction rated securities as evidence of a spreading credit crisis we are seeing continued elevated oil prices.

In addition, global oil supply forecasts won’t be reliable for as long as there is a lack of transparency in terms of field audit, or checking on the validity of claims of real proven reserves by oil producers or exporters, aside from some government’s move to nationalize the industry, limit exploration access, increase tax revenues by arbitrary contract changes and containing private sector participation. In short, government’s restrictions to access oil have been contributing to the inefficient allocation of resources, distorting the marketplace and subsequently today’s high prices.

Besides it has been reported by U.K.-based Oil Depletion Analysis Centre that 60 of the world’s 98 oil producing countries have already hit peak oil production according to energy analyst Sean Brodrick. So as recent discoveries have not been enough to replace declining production wells, supply pressures will remain.

WTIC crude soared by 4% over the week to $95.5 per barrel, only $4.5 away from the psychological threshold high of $100. Rising crude oil adds to the pockets of OPEC and other oil producers, even as interest rates are likely to head lower especially for countries with its currency regime tied to the US dollar, as the US Federal Reserves adjusts its policies in order to provide enough cushion to its downshifting economy. In addition, a decline in the US dollar (prompted by China’s negative carry or as an offshoot to ‘stimulative’ policies) is negatively correlated to the price of oil or ensures higher oil prices.

Rising oil and commodity prices translate to more foreign exchange reserves for emerging markets central banks. This also means more money for placements by government owned sovereign wealth funds. This also suggests of abundant liquidity for the emerging economies marketplace. As well, negative interest rate environment could foster an environment that could absorb some of the excess liquidity. Or if Dr. Hussman is right, where China slows on buying US assets then a realignment of capital flows to within the region is a likely alternative.

Bottom line: Negative real yields, widening spreads between US dollar and Philippine Peso, negative carry between China and the US, growing foreign currency reserves in emerging countries and higher commodity prices should underpin emerging market assets as the Phisix.

Is the Philippines Resilient Enough to Withstand A US Recession?

``Do what you will, this world's a fiction and is made up of contradiction.” William Blake

We recently stumbled across a Pollyannaish article whereby a domestic broker boldly declared that the Phisix as still in a bullmarket and forecasted the Philippine benchmark to reach new record levels or gain some 25% from the current levels at the end of the year (I hope they are right, but bearmarkets descends on a ladder of hope).

The article cited a string of positive “micro” developments to justify its projections which was mostly buttressed by the assumption that US-Philippine linkages have shrunk in significance to meaningfully impact the domestic economy.

While we partially sympathize with such views, we think that such sanguinity is uncalled for simply because, for us, such outlook greatly underestimates the risks involved under today’s operating environment aside from overestimating the resiliency of the Philippines.

The fact is, given today’s highly correlated financial markets as shown in Figure 1, a bullish view on the Phisix basically requires either of the two outcomes—a mild or benign US recession which recovers swiftly OR that the Philippines and to some degree other ex-US financial markets or nomenclature asset classes “decouples”.

Figure 1: stockcharts.com: Still A Bullmarket?

As you can see, global equity markets reacted in near unison (vertical blue line) last October to the recent tremors which begun last July (look at the peaks and troughs of each benchmarks).

The Phisix (center window) peaked earlier compared to the synchronous decline of the Dow Jones World Index (topmost window), emerging markets (pane below the Phisix) and Asia (ex-Japan markets). But this dynamic of tight global correlation has been evident since 2000 and has even intensified during the latest bull run, as repeatedly discussed in the past. So basically, until a “decoupling” becomes manifest, the fate of global markets is significantly dependent on the developments in the US.

Besides, on a technical standpoint, none of the above markets looks like operating under bullish conditions. In fact, with over half of global markets touching the 20% loss threshold --which is a technical definition for a bearmarket--last January 21st, this means that the Phisix and the many global markets have transitioned to an interim bearmarket as discussed in our January 21 to 25 edition [see Phisix: On A Bear Market Template, Bear Market Rules Apply].

As you readers maybe familiar with, we have been a proponent of “past performance does not guarantee future outcome”. We argued about the bullish case of “decoupling” signals in our January 21 to 25 edition [see Emerging Markets and the Philippines: The Last Shoe to Drop?] where in the past selloffs, emerging market assets were dumped across the board, but today the degree of categorical selling has diminished. In fact, there had even been signs of divergences-recent selloffs were ONLY seen in the equity markets-not the bonds or the Peso (Ok, Philippine bonds declined this week-mostly on the account of inflation concerns; emerging bonds fell too so as with the Peso).

Philippine Exports Immune From US Recession?

Figure 2: Deustche Bank: Top 5 Export partners 2004

Ok, let’s us play the devil’s advocate and assume the bearish scenario.

We read many discussions asserting the premise of Philippine economic resiliency based on the diminished linkages between the US and the Philippines, where exports to the US formerly accounted for around 35% of total exports in 1995 to 16% in 2004 see Figure 2.

On the surface, indeed our exposure to the US has significantly declined, but what is thoroughly overlooked by such analysis is that the operating dynamics of the region’s trading patterns had a significant makeover.

The recent growth of intraregion trades had been a function of “vertical integration of production chains, whose final demand”, according to ADB “is outside the region” see Figure 3.

Figure 3: ADB: Regional Supply Chain Platform

What this means is that instead of direct shipments, regional trading dynamics have morphed or shifted into an interdependent network of supply chains where intraregion exports has mainly functioned as inputs to the production processes meant for reexports to major economies or outside the region.

Today’s trading dynamics operates like a regional outsourcing. As an example we’ll take the composition of a Dell laptop as described by Gavekal Research in Our Brave New World. ``The keyboard was made in China, the PCB made in Singapore and the motherboard was made in Malaysia. The flatscreen was made in South Korea. The semis were made in Taiwan, on US-owned design patent. Some of the software were compiled in the US, some in India, some in Sweden and some in Russia. The design of the notebook itself was done in Austin, Texas. Finally the laptop assembled in China.”

As you would have probably been aware of, China has operated as the quasi-final assembly line to the regionalization of the production process. That is why we are concerned more of the evolving risks in China than the US and or how a US downturn may impact China.

However as ADB’s notes (Uncoupling Asia Myth and Realities), ``more that 70% of intra-Asian trade consists of intermediate goods used in production, and half of this intraregional trade in intermediate goods is driven by final demand outside Asia. Consequently, about 61.3% of total Asian exports (instead of 43% of total exports) are eventually consumed in the G3 countries. Within Asia, the PRC is the largest driver of regional exports, but its final demand accounted for only 6.4% of total Asian trade, which was only half of the contribution from Japan and slightly below a quarter of that from the US. The results show that the G3 countries still remain as main export destinations for final goods departing from Asian ports, when taking into account the share of intermediate goods trade that is for assembly and production within the region but that is eventually shipped out of the region.”

What this means is that Asia is still heavily reliant to the consumers of US, Europe and Japan. This is where the depression advocates emphasize- a severe drop in consumer spending in the US which may ripple to the consumers in Europe and Japan-will depress the supply chain network of the region (yes including the Philippines).

Because of the informal adoption of Bretton Woods 2, or a monetary regime of competitive managed devaluations by most Asian economies in the past, this signifies as subsidies to the production aspects of the region’s economy at the expense of the consumption side. Hence we have seen in the recent past, the soaring economic growth of emerging Asia, the migration of industries from the US to Asia, the proliferation of outsourcing, the massive accumulation of foreign currency reserves, the emergence of sovereign wealth funds and Asia’s vendor financing scheme with the west.

On the obverse side, this monetary paradigm represents subsidies to the consumers at the expense of the production side for the consumption based Western economies. Hence, the explosion of debt driven asset markets (real estate and stocks) supported by financial innovations (derivatives, structured finance, originate and distribute models) and the massive current account deficits.

Since currency adjustments are just beginning to impact Asian consumers, global depressionists say this would not be enough to stimulate Asian consumers to pick up or fill the slack from the retrenching Western consumers.

And worse, because of the huge global current account imbalances, past improvements in the current account balances of deficit countries as in the US have coincided with previous financial crisis, as global liquidity is drained or siphoned off the markets, as shown in Figure 4.

Figure 4: Black Swan Capital: Money Back to the Center?

The narrowing of US current account imbalances have in the past been associated with either US recession (1990, 2000) or a crash in the US markets (1987) as systemic deleveraging unravels. And it seems that we are feeling similar pressures today.

Money back to the center means that under a debt driven deflation scenario or contracting global liquidity, which global depression advocates predict, money dynamics will evolve from centrifugal (flowing outward from the center) to centripetal (flowing towards the center) or money will seek refuge in the US dollar, the de facto reserve currency of the world.

So by virtue of induction in the context of exports, a severe recession in the US will be transmitted throughout the world or to Asia and the Philippines. The bullish house of cards scenario based on an export-only analysis falls. Depression looms.

Will Remittances Save the Day?

Or how about remittances, many have argued that the Philippines’ resilience will be buttressed by continued flow from our “heroes” overseas workers…

Figure 5: DBS Bank: Falling overseas deployment (left pane), Falling Remittances (Peso)

Media accompanied by their coterie experts always pontificate that the Peso’s rise had been “caused” by the surging remittances. As we have pointed out in the past What Media Didn’t Tell About the Peso, and Philippine Peso And Remittances: The Unsecured Knot the correlation of the Peso and remittance growth has been more of a recent experience, in other words, causal relationship is tenuous.

Remittance growth has been exploding since 1990s yet the Peso soared only in 2005. As we have noted, analysis using remittance driven Peso dynamics suggests either a “tipping point” or “critical mass” has been reached enough to tilt the balance in favor of the peso to reverse in 2005 from its 45+ years of depreciation or there had been a tremendous “lag” time for remittances to be reflected in the Peso. For us, it is partially about remittances, and mostly about regional currency regime, the US dollar standard and regional capital flows.

Here is the comment from DBS bank on their first quarter outlook (highlight mine),

``This is the math: in the year-to-3Q07, US dollar-denominated remittances were up almost 15% compared to a year ago. In peso terms, however, this gain translated to just 4.4% YoY - only moderately faster than the 3.2% YoY pace of inflation at home. As is evident from the chart, the damage was most acute in 3Q07, when peso appreciation accelerated as remittances growth slowed. No wonder then that consumer spending, which has come to be so dependent on the income that overseas Filipinos send home, slowed noticeably in 3Q07, to 5.6% YoY from a three-year high of 6.0% in 2Q07.

``Looking ahead, consumer spending in 2008 looks set to, at best, only match the 5.7% rise we expect for this year, assuming that monetary policy will be supportive. Remittance growth is likely to slow, on a combination of a stronger peso and slower deployment of overseas workers. The government, in wanting to improve the quality of the workers it sends overseas, has been placing more stringent conditions on deployment, including the lifting of minimum wages. Foreign countries can also be partisan in their labour policies, such as the UK’s recent move to hike salaries for workers from non- European Community members.”

In the right chart of Figure 5, DBS Bank notes of how the Peso has appreciated more than the pace of growth for remittances. Here we raise some questions; why has the Peso continued to rise in the face of declining growth rate of remittances? How valid is the conventional “cause-and-effects” view of the rising Peso?

Another important variable is the question of remittance contribution to personal consumption. The highly popular explanation is that remittances have been a major contributor to personal consumption and thus has served as a major fuel for our domestic economic growth. But like the analysis above, they seem to be more of logical deduction than of analysis based on statistical estimates or figures.

In short, until we see some figures, we remain unconvinced of the so-called “multiplier effect” of remittance spending, which I believe is highly overrated (a justification used by experts to call for more Central Bank intervention). Since I wrote the National Statistical Coordination Board, to request for this info last October we have not received a reply (we wrote them again this week).

As proof again look at the analysis above, it says that because of the declining growth of remittances (using 3^rd quarter stats), personal consumption should slow. Yet recent consumption data during the 4^th quarter shows of a substantial rise as our domestic GDP soared to decade year highs. According to NSCB.gov, ``consumer spending grew by 6.3 percent from 5.8 percent a year ago.” So essentially, the impact of a strengthening Peso to overall consumption (aside from the purchasing power) has been less than what is accepted wisdom.

Now, DBS suggests that the slowing overseas deployment (leftmost chart) could serve as a probable indicator or precursor to the slowing of remittance trends. Notably this comes in the light of the economic conditions PRIOR to the global credit crisis which may evolve into a meaningful global economic slowdown. This means that wildly optimistic analysis based on recent “strong” trends will get likely get slammed if declining overseas deployment trends conspires with a US recession-global economic slowdown scenario.

Conclusion: Discretion Is The Better Part of Valor

So in the context of exports and remittances, global depressionists have valid arguments which should not be discounted. But the global financial markets and the economy is not just all about exports or remittances, there are other factors at play such as government policies, technological breakthroughs, globalization (finance, trade and labor)/protectionism, geopolitics, demographic trends, monetary dynamics and others.

Let us put into the place an objective perspective, in the context of the Philippine economy, if the highly popular remittances signify 10% of GDP then there is the other unpopular 90% of which is of more significance. Using common sense, I wonder when the popular 10% has surpassed the unpopular 90% in real life importance.

Also, if exports and imports contribute 40% each to the GDP then there is the other 60% to reckon with. Unlike mainstream experts who believe that they are uniquely armed and equipped with sophisticated analysis using modern statistical data which presumably captures the entire spectrum of variable working parts of the economy….we don’t. We don’t pretend to know everything. We even don't know much of anything that's why we question. Hence, we respect randomness or the influences of unknown variables.

Bottom line: Avoid looking for reasons to rationalize one’s biases (confirmation bias). Avoid also from falling into “conflict-of-interest” traps (agency problem). In matter of portfolio risks deployment, as a saying goes, discretion is the better part of valor.

Phisix: With A Little Help from Negative Real Rates

``All panics, manias and crises of a financial nature, have their roots in an abuse of credit.” Hyman Minsky

Because we believe in business and market cycles, our objective is to viably apply market cycle timing, where we try to identify which stage of the cycle we are in and allocate portfolio accordingly, instead of short-term technical “timing” the markets.

As for the current conditions, our view is that the Phisix like most global markets could possibly be undergoing a countercyclical interim bearmarket which could last anywhere from 3 months to over one year (hopefully I am proven wrong, so good times will continue-its bad enough to see 6 months of drought). As we have discussed in the past, we saw the same pattern during the last secular bull cycle in 1986-1996. There were two bearmarket cycles interspersed within the secular trend, particularly in 1987 and 1989 where the Phisix fell by over 40% on each occasion. Yet the Phisix rose by some 22 times from trough to peak in 10 years.

We see no difference today. Following the string of successes since the cycle turned bullish anew in 2003, one should expect normal countercycles or negative returns even during a secular bullmarket. One has to understand that “No trend goes in a straight line” as the legendary trader Jesse Livermore used to say and we have also been saying this since 2006.

More Decoupling Signs

Yet, we have been watching for signs of probable reversals. As earlier indicated, by measure of bonds and the Peso, the Philippines have gradually manifested incipient signs of “decoupling”. As to whether this is simply an anomaly-which will readjust or “normalize” when countenanced with more selling pressure from external sources or signifies seminal divergence-remains to be seen. The vitality of new trends needs to be successfully tested for several times, get entrenched over a longer period enough to draw in material following, otherwise the trend fails.

Earlier in the week, we were elated to see the Phisix impacted less significantly by the decline in the US. Last February 5, as the Dow Jones Industrials fell by 2.9%, the Phisix fell by only 1.2%! For the week, the Phisix was down a measly 1.6% when compared to the major US benchmarks which slumped by over 4.5%. One week does not a trend make though, but we could be seeing some signs.

Nonetheless this is not a one country event. Our neighbors also reflected the same dynamics, Indonesia recorded marginal losses of .29% and so as with Thailand .55%. On the contrary Malaysia even rose by a hefty 1.63%.

Moreover, the decline by the Phisix had been accompanied by subdued volume, implying a considerable moderation of selling pressure from foreign money. Could it be a bottom for the Phisix and Southeast Asian markets? Too early to tell, but under current global conditions our expectations is for the Phisix to form a more stable U-shaped recovery than an outright resurgence or recovery.

Remember, global markets are still reeling from the forcible selling from institutions holding toxic papers. Global markets are still repricing the readjustments of the balance sheets by major financial institutions as well as repricing of earnings to account for the economic slowdown, aside from repricing expectations from one that is risk tolerant to one of rising risk aversion.

As previously noted, this isn’t limited to the subprime space as the crisis has started to spillover to other facets of the US financial markets and to the real economy as seen in LBOs/junk bonds, Commercial Real Estate, bond insurers, municipal bonds, credit card and auto loans, etc. The economic slowdown emanating from the credit crisis is starting to impact other major economies. Many losses have yet to be identified, booked and priced in, so the risks of more selling pressures is still material.

Now of course, vexatious domestic politics has always been an obstacle to our domestic equity markets but this has largely been discounted. For as long as there won’t be a major political upheaval enough to destabilize and dislocate capital flows, the Philippine financial markets are likely to reflect global or regional sentiments.

Setting Up the Inflationary Credit Supply

However, an important thing to remember is that all major market/economic cycle reversals are characterized by one common variable: excessive leverage. Of course, excess leverage or rampant credit growth are essentially triggered by loose monetary conditions which is exacerbated by investor’s irrationality.

To quote Fritz Machlup in Essays on Hayek ``. . . monetary factors cause the [business] cycle but real phenomena constitute it.”

Or as in the case of stock market again as Fritz Machlup in The Stock Market, Credit and Capital Formation wrote ``... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.” (highlight ours)

Since the Philippine financial markets have not reached such euphoric levels as to allow its domestic market participants to recklessly leverage and speculate, we believe that the recent US led volatility will impact our markets at the start of the global cycle (today) and eventually “decouple”-seen through either an earlier recovery or via monetary/ inflationary prompted “decoupling”.

With global equity markets still under duress, despite the aggressive monetary policy actions undertaken by the US Federal Reserve, one can expect global central banks to act in concert to avoid the furthering the risks of financial crisis by keep monetary conditions loose even when faced with signs of heightened inflation.

Recently the Bank of England followed the US with its own version of rate cut while speculations that ECB’s Jean-Claude Trichet has opened doors to follow suit caused the euro to tumble fiercely as we predicted at the start of the year.

In the Philippines the consumer price index soared to 4.9% in January largely on the account of rising food prices see figure 6. While local authorities as well as local experts attribute these to domestic factors, we think these is a global phenomenon. Others say it is due to climate change, growing wealth from emerging markets, rapid industrialization, surging oil prices and etc. While we agree that such could be part of the overall range of proximate causes, we believe that these are largely unintended effects from loose monetary policies, aside from distortions brought about by subsidies in the biofuel industry.

Figure 6: DBS Bank: Rising CPI, Declining Money supply

Figure 6 from DBS bank shows how Consumer Price Index has trended lower since the Peso began its rebound in 2005 and has contributed immensely in containing higher consumer prices. Talk about unsung heroes. However the spike in domestic money supply signified by the M3 (red line) in early 2007 may have contributed to the belated rise in the CPI.

Nevertheless, today’s sharp decline of the M3 has been due to the significant liquidity-absorbing effects of the Special Deposit Account (SDA) or a special facility accorded by the Bangko Sentral ng Pilipinas (BSP) to enable banks and Government Owned Companies to avail of higher rates compared to yields from government securities. If consumer prices continue to tread higher in spite of this, then it is likely that we are “importing inflation” via the commodity, oil and food channels.

Will Negative Real Rates Spur A Boom?

Since our 91 day Tbill yield stands at 3.673% according to the BSP, this brings about real interest rates to negative territory which means that holding onto cash or fixed income investments would bring about real losses in terms of purchasing power.

Negative real interest rates will compel the public to find an alternative ‘store of value’ as the Peso’s real purchasing power erodes. In Zimbabwe it is stock market, in Venezuela…it is cars?! From Boris Segura of Morgan Stanley, ``Another reason for the pent-up demand for cars is that they are increasingly being perceived as a store of value in an economy where there are few investment alternatives.”

Further, the public may be induced to pile into more debts for speculative purposes. It may even spawn an economic boom which will eventually turn to a future bust. Aside, negative real rates punish savers and subsidize debtors which will lead to propagation of malinvestments and eventually aggravate social inequality.

Negative real rates are likely to lend support to the Phisix, as Fritz Machlup said above, inflationary credit supply explains a rising stock market.

Figure 7 stockcharts.com: Inflation Paradox?

Talk of negative real interest rates, as major developed global central banks and policymakers work on to alleviate the woes in the financial sphere, we are seeing a resurgence in commodity indices as gold (pane below main window), food, oil (lowest pane) and surprisingly even the metal with a PHD….copper (center window) amidst chatters of a US recession-global slowdown or even a rising US dollar index (above window).

Is Dr. Copper’s present action a revelation of a resurgent global economic activity? Or is this merely a head fake? Or is Dr. Copper insinuating that the commodity inflation spectrum has just gotten wider?

Was JDV’s Ouster cause of today’s decline in the Phisix?

We heard a comment that today’s market decline had been due to Philippine Congress House Speaker Joe De Venecia’s ouster.

While such reasoning looks plausible at the surface and likely fits a media news script, this seems more of an “after the fact rationalization” than a strong evidence of causal relationship. Why?

One, the Philippine market have been largely driven by foreign investors, whose concerns are on the political risks that may influence capital flows, think 2006 Thailand Capital Controls as an example.

Two, as shown recently, our markets has depicted a strong correlation with the activities in global markets (January 21 global stock market meltdown).

Lastly, past domestic political predicaments (Oakwood Mutiny, Hello Garci Scandal, Peninsula debacle etc.) have largely been discounted by the market.

Nonetheless, the interim trend indicates global equity markets have been on a downturn since its peak last October. The past two weeks of market clearing or technically driven rallies both in the US and the Philippines are likely to suggest of renewed test downwards. And yesterday’s decline in the US markets appears to impact the region anew.

This headline from Bloomberg “Asian Stocks Fall on Earnings Concern; Yamaha, Posco Decline” shows of today’s regional performance. So evidence is not ample to suggest of a domestic politics prompted performance.

Our view is that the macro trend has been a far larger determinant to the direction of the markets although domestic issues could serve as an aggravating circumstance.

Besides, event driven market actions are likely to be knee jerk in nature or don’t endure. Ask yourself, will you sell the market because JDV was ousted? Your answer will be self explanatory.

As for political risks, it would seem to me that JDV’s ouster was a calculated move in the part of PGMA. Why?

Signs of shifting winds of loyalty or its erosion as evidenced by the Speaker’s inability to contain his loose cannon son from implicating the First Gentleman in the ZTE scandal.

Maybe PGMA fears of a reprise of a Manny Villar scenario where the former speaker suddenly turned around and stealthily passed on an impeachment bill against former ousted President Joseph Estrada that triggered EDSA 2. So, in my view, the ouster was a preemptive strike to ensure her position.

Again, this is all about preservation of power based on personality based politics.

As a saying goes in politics there are no permanent allies or friends only permanent interests.