Phisix: Knocking At The Exit Gates of the Bear Market!

``A natural system has built-in redundancy. It manages and heals itself. The economic system is no exception…I argued against the idea that the economy is a "house of cards," susceptible to collapse as soon as a few cards are dislodged. We suggested that it's more like a beehive. The future of the hive does not depend on full employment for all the worker bees. In fact, an accident can put many bees out of action without compromising the hive as a whole.”-David Ranson, Economics as Metaphor, Wall Street Journal

Amidst the snowballing portrayal of gloom and doom, the Phisix once again appears to be playing our script to a tee.

Last week’s sizzling performance by the Phisix (up 2.85%) wasn’t much of the fanfare. That is, if we take into the account simply the nominal gains. Any market watcher could dismiss this rebound as simply a typical “dead cat’s bounce”.

However, unlike in the previous rallies, what deserves our attention is that the domestic benchmark appears to have reached a CRITICAL level enough to allow for a seismic shift AWAY from its present cycle.

As a reminder, like Mother Nature, financial markets always operate in cycles. This means that presently, the Phisix STILL is technically in a declining phase, otherwise known as a bear market. Segueing into the next cycle means undergoing a cycle shift to a market bottom.

Since market cycles constitute a process, a bottom can be characterized as a period of consolidation (sideways movement) and or incremental recovery. Again all these take time to unfold.

And a shift from the bottom to the next cycle means that as equilibrium has been attained where sellers have reached an optimal level or where they can’t drive down prices further (since they are equally met by buyers at a defined price level or range), investors will gradually develop confidence enough to start improving on pricing valuations.

Thus, from a bottom phase, once optimism starts to gain ground, we can expect the market to evolve into the advance or in the case of the Phisix the resumption of the secular bull market.

Since the Phisix appears to have reached the cusp of reestablishing a market bottom, the obverse side is that if it fails, this implies of the next round of declines or a series of losses to the level of testing the most recent lows.

However, considering that much of today’s rally have been VERY MUCH UNLIKE the past, this seems to present a fairly good chance for a successful breakaway!

Since our goal is to identify a market bottom going FORWARD, as discussed last week, I’ve drawn an outline of measures aimed at identifying the prospective reemergence of the cycle. Hence as previously enumerated:

1) mending MARKET INTERNALS,
2) improving TECHNICAL PICTURE,
3) reversal of FOREIGN FUND FLOWS,
4) possible SIGNS OF DIVERGENCES relative to US markets,
5) improving regional bourses performances and lastly
6), acceptable FUNDAMENTAL "story" for the investing public.

Market Internals Turns Significantly Positive

First we noted that one way to gauge a market bottom would be to assess investor sentiment through market internals as shown in Figure 6.

Figure 6: PSE: Advance-Decline Spread: Broad Based Improvement!

The Advance Decline Spread is a very significant market breadth indicator. It reveals whether rallies are based mainly from BLUE CHIP issues or importantly if the rallies are being reflected over the BROAD MARKET.

Since the start of the year the Phisix has had THREE bull market insurrections. In the three rallies we saw a weakening trend of the POSITIVE advance decline ratios whereas during the declines we saw LARGER negative ratios compared to the rallies, this gap signals the general bearishness of the marketplace. Effectively, we understand now WHY the previous rallies have failed. This seems not to be the case today.

Another, since the start of the year, the bandwith of advancing issues relative to declining issues had been shrinking (channel drawn by RED lines). This means that as the Phisix have declined, the selling pressures as reflected in the BROAD Market has been diminishing. The recent massive breakout on the POSITIVE side accentuated by the spikes (green circle) to the January highs lends credence to the strength of the recent rally!

A continuing rally accompanied by broad market gains ensures this shift away from the Bear Market Phase.

Next, we also noted that a transition to a bottom needs to be accompanied by improvement in the technical picture as shown in Figure 7.

Figure 7: stockcharts.com: Technical Picture and Divergences

The recent rally has brought the Phisix to touch the 50-day moving averages (blue line) similar to the rally in May (see green circles). Perched at 2,584, we need a breach from this level and also from the 2,650 level (minor resistance) to reinforce the confidence of a market bottom.

Of course, if the Phisix advances way beyond 2,900, the likelihood is that we have progressed into the next level, which should be a delight to local punters.

Of course, the local benchmark should also go beyond the variable 200 day moving average (red line) to likewise revalidate the return of the bullmarket.

Emerging Signs of “Uncoupling”; Ambiguous Regional Synchronicity

One of the MISSING puzzles during the former rallies had been SIGNS of DIVERGENCES, another variable which we identified as a potential support in the departure to the so-called “recoupling” thesis. Yes recoupling could happen to many markets, but we don’t share the view that it is going to be a “one size fits all” phenomenon (as argued above).

From the start of the year, most the bear market rallies seen in the Phisix had been accompanied by a corresponding rally in global bourses (near congruence in the blue line trends). This has been a continuing evidence of the high correlation among global equity markets.

Surprisingly, this week’s rallies apparently deviated from the norm and had been manifested over a much awaited development for us- a divergence or “decoupling”.

When the US markets yielded to substantial selling pressure by losing over 2% on Monday, the Phisix sympathized but only lost .5%. On Thursday, as the Dow Jones Industrials lost 1.7%, the Phisix became nonchalant enough to even generate slight gains! So in 3 occasions over the past two weeks, the Phisix seems to have virtually ignored the developments in the US markets.

Thus, Figure 7 exhibits what we’ve been rambling about: the relative DIVERGENCE from the lackluster environments of the US S&P 500 (above pane), Dow Asia ex Japan (pane below main window) and Emerging Market Indices (lowest pane) as denoted by the arrows.

Another minor factor has been regional recoveries. As identified last week in Phisix Best Week of the Year; Identifying A Market Bottom, The Phisix-Peso Tango, some potential bellwether candidates of a market bottom formation (based on charts in) have been in Vietnam, Singapore, Japan and China; although like the Phisix, these needs to be further corroborated by either reestablishing a series of higher lows or as mentioned above by EXTENDED consolidation.

Foreign Flows As Sufficient Support But Not A Necessary Condition

The only factor that seems to be out of our guideline at the moment is foreign fund inflows as shown in Figure 8.

Figure 8: PSE: Foreign Flows Remains On A Negative Bias

The recent spikes in the chart accounted for special block sales, thereby had been omitted from our analysis.

While the extent of the foreign selling has starkly been reduced, since the second bout of selling reappeared last October, as shown by the wedge formation (red lines), daily activities still manifests of continued but subdued net foreign selling.

This is understandable considering that the capital raising activities via forcible liquidation is still an ongoing process of deleveraging on a global scale.

However, it seems that the chunk of the foreign selling appears to have climaxed in Asia and maybe here too. According to a report from Reuters about 80% of the new money taken into Asia last year has already been redeemed.

This means that LOCALS and NOT foreign investors have spearheaded the recent rally. This also means that while foreign money can act as a sufficient pillar in support of the Phisix, it is NOT A NECESSARY CONDITION.

The underlying question is how enduring can local participants buoy the local markets; something which we think will be promptly addressed during the succeeding sessions.

Naturally, it would be a delight to see locals could come into the picture considering the present conditions. My suspicion is that most of these have been by institutions than from retail investors.

Moreover, locals have been the very important missing link into the domestic capital market development, so any signs of participation signify as a welcome development, aside from the relative proof that domestic factors can potentially outweigh external variables.

Fundamental Excuse: Reversing the “Rising Fuel=High Inflation=Lower Stocks” Causality

Finally, as for acceptable fundamentals for public consumption, the recent weakness in global energy prices has also been reflected in the streets through the rollbacks of local fuel prices.

Therefore, for publicity purposes, the popularly accepted oversimplified causality of “rising fuel=high inflation=lower stocks” has effectively been reversed lending to an impetus for the recent rally. Of course, the same cause-and-effect argument has not been validated in most of the world’s bourses debunking claims that “oil” has been the key variable responsible for the weakness in the financial markets.

Besides, much of the ignored factor is that rice and food prices (which accounts as the most critical variable for the inflation issue) have also began to scale back, even as the BSP continues to warn of the threat of rising inflation. This rhetoric of the BSP, I think, aims to communicate its policy actions (yes they are likely to increase rates again) which I believe is necessary to close the inflationary stimulus from negative real rates.

Again, a combination of variables which includes declining global commodity prices, the Philippine supply side responding to the market signals aside from political pressure induced policies aimed at bolstering investment and stimulus as discussed in Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso are likely to lower statistical inflation index over the next few months.

Alternatively, the investments in agriculture should enhance the development in the rural areas, which should compliment the consumer driven “multiplier” of consumption and investment from continued strong flows of remittances despite current global conditions. Another, investments in the mining and other resource oriented industries plus infrastructure development should also cushion whatever decrease from external trade and from other macro economic linkages affected by the slowdown in the global economy.

So with 4 of the 6 metrics strongly suggesting of a continuation of the present momentum-technical considerations, solid market internals or broad based buying, emerging signs of continuing divergences and fundamental excuse of “lower inflation expectations” via lower global oil prices-the likelihood is that we may see the Phisix EXIT the bear market phase sooner rather than later.

As for additional signs from regional recovery has yet been to be confirmed while a positive reversal for foreign money flows into Philippine assets could likely be a bonus.

Overall, the next sessions should determine if we should start to rejoice over the end of the bear market….or have I spoken so soon again?

The Controversy Over Oil VAT (Visceral and Astigmatic Thinking)

``No government ever wants less government — that is, less of itself." Garet Garrett (1878–1954), Insatiable Government, American journalist and author

Populism is anything panacean.

Popular political demand has it that the lifting VAT on oil prices will provide relief to consumers.

No quibble on that- yes “automatic and short term relief” that is.

But, alas the thinking STOPS here!

Look at the table provided by ADB above (shown this last week).

It shows that Filipinos spends an insignificant 2.4% of their income on energy expenditures relative to the aggregate. This means food prices does more of the damage to household spending than energy/oil. It also means households are less sensitive (more inelastic) to price changes of fuel relative to food-and so is the reason why car sales remain buoyant instead of a retreat even under surging fuel costs.

In other words, given the accuracy of estimates in the table provided by ADB, what you see in the news reflects popular dissent over higher food prices than fuel. Thus, oil prices reflect more of the political dimensions (since it’s easy to pick on oil as a culprit knowing that this is PRIMARILY an external causality).

Will the magic wand of lifting VAT ease oil prices? Yes, as argued above-temporarily.

But economic logic tells us that lower prices INCREASES demand.

This means that if oil prices in the Philippines have not reached the threshold of “demand destruction”, increased demand will OFFSET any lowering of prices from the VAT suspension.

Essentially this brings us back to square one- High oil prices but with a gaping fiscal hole! What was deemed as a solution complicates the situation even more.

Hence, what then would be the next item to blame? Will the next political demand be "Nationalization"? (Hahaha!-Philippines import almost all of its crude oil requirements which should translate to a total havoc to the national balance sheets!)

One senator suggested that VAT be replaced with a hike in luxury items (particularly car sales). The honorable senator forgets the effects of high taxes on car sales: car smuggling or legal loopholes which has resulted to the recent brouhaha over “used” car imports from economic zones (see Diesel Roll Back For PGMA’s Sona, MV Princess of the Stars Tragedy, Economic Realities of Cagayan’s Used Car Trade).

Another venerable senator suggests "efficiency" in tax collection by curbing car smuggling. Wonderful, another ideal solution- yes (we agree)! But then again this is nothing new and has been a battlecry for almost every aspiring politician. Yet, such motherhood statements or grand nostrum of lack of “efficiency” goes back to the paradox of overregulation, legal loopholes and bureaucratic leakages and corruption.

So, in effect both Senators have been discussing solutions based on a chicken and egg perspective but don’t deal with the heart of the problem!

The principle of taxation basically is the funding of government expenditures (for whatever programs) derived from revenues levied from its constituents, us the taxpayers.

Rising government expenditures without the necessary funding will compel government to borrow and or print money which results to the deterioration of the national balance sheet or the fiscal deficit.

When government competes with or “crowds out” the private sector in raising money this raises the cost of money while at the same time reducing productivity which derails investments.

Over the longer horizon, if alternative options of borrowing and printing money under degenerating deficits become unsustainable, the government will again be forced to raise taxes furthering our economic agony of rising unemployment, lack of investments, higher cost of living and depreciating currency.

Yet beyond the public’s knowledge; the demand for “reckless” spending to accommodate populist causes could entail the risks of hyperinflation! You should look at the classic hyperinflation paradigm unfolding in Zimbabwe see The Race To Currency Destruction (Hyperinflation): Want to be a billionaire?

Tersely said, short term popular elixirs will only lead to longer term pain. A cure worse than the disease.

While everyone wants to be relieved of high oil prices and the burden of taxation, what people should realize is that cuts in taxes NEEDS TO BE ACCOMPANIED BY A CORRESPONDING DECREASE IN GOVERNMENT SPENDING.

What I am trying to say is that an abolition/suspension/moratorium of VAT should come with DECREASED spending and not shifting of burdens by imposing other taxes, which lead to more inefficiencies in the economy and avenues for more corruption.

None of our political officials have proffered such option because it takes away their inherent privileges of constituent dependency or the basic premise for their existence.

That’s why populism is almost always about intuition, vacuousness and immediate pacification instead of sound policies that ensures productive economic growth by accumulating capital.

The Race To Currency Destruction (Hyperinflation): Want to be a billionaire?

Courtesy of the Economist

From the Economist (highlight mine), ``HYPERINFLATION requires a good head for figures and a sturdy wallet to hold wads of low-value paper money. Governments have attempted to keep pace with hyperinflation by issuing ever-higher denomination banknotes to replace worthless notes that might as well serve as wallpaper. Last week Zimbabwe's central bank unveiled a 100 billion dollar banknote to cope with inflation running at 2.2m%. On Sunday July 27th the bank changed tack and announced it would be lopping off a string of zeroes on replacement notes, in what passes for economic reform in stricken Zimbabwe. But Robert Mugabe has some way to go before he can claim for his country the accolade of printing the highest-denomination banknote. A note issued in post-war Hungary came with a mind-boggling 19 digits.”

Courtesy of Associated Press

Because Zimbabwe’s inflation is 2,000,000 % a month, the Zimbabwe central bank plans to reform the currency by removing “zeroes”.

This from the AP, ‘Zimbabwe's bank chief plans new currency reforms — removing "more zeros" from the plummeting Zimbabwe dollar and raising the limit on cash withdrawals — to tackle the country's runaway inflation and cash shortages, state media reported Sunday.

“Previous currency reforms have failed to tame Zimbabwe's inflation — officially pegged at 2.2 million percent a year but estimated by independent analysts to be closer to 12.5 million percent. It also has become virtually impossible to get access to cash as the country's economic collapse worsens.

“Authorities last week released a new 100 billion dollar bank note. By Sunday it was not enough even to buy a scarce loaf of bread in what has become one of the world's most expensive — and impoverished — countries.”

How much that this money buy? According to the CNN

``It said a 4-pound (2-kilogram) bag of sugar cost about 20 billion Zimbabwe dollars ($1) at the government's fixed price, and 90 billion on the black market ($1 at the black market exchange or $4.50 at the bank exchange rate.)”. 20 billion dollars for a bag of sugar! Amazing. Yes, you have a billion alright but it buys practically nothing.

As the Economist have noted we’ve got a history of countries literally printing money in order to politically survive its corrupt and incompetent leaders.

Chart from Cato Institute/Steve Hanke

If the idea is simply to throw money to our socio-economic problems as a political solution, as many have suggested, then we should keep in mind the experiences of Zimbabwe, Yugoslavia, Hungary and Weimar Germany.

There is no free lunch.

Tidal Power As Alternative Energy

Biofuels, Wind or solar power are the popularly known alternative energy.

What is least known is the recent commercialization of tidal power or tidal energy-(wikipedia) “form of hydropower that converts the energy of tides into electricity or other useful forms of power.”

A schematic of how tidal power runs looks like this…

from technologystudent.com

What we’d like to emphasis is-innovation is a natural product of the markets- where rising energy prices has opened the avenues for (substitutes) alternative energy sourced from mother earth.

You can read about the entire article of the first commercial tidal power system in Northern Island here.

courtesy of technologyreview

A short excerpt…

``The world's first commercial tidal-power system has been connected to the National Grid in Northern Ireland. Built by the British tidal-energy company Marine Current Technologies (MCT), the 1.2-megawatt system consists of two submerged turbines that are harvesting energy from Strangford Lough's tidal currents. The company expects that once the system, called SeaGen, is fully operational, it will be able to provide electricity to approximately one thousand homes.

``The system is currently being tested and has briefly generated 150 kilowatts of power into the grid. But it has also damaged one of its rotors due to a failure in the control system when the rotor began turning too fast. Although the problem was a minor setback, the unit is not expected to start running continuously and at full capacity until November, says Peter Fraenkel, the technical director at MCT.

``The technology works like a wind turbine, but instead of wind, the turbines are driven by the flow of tidal currents. It offers a significant advantage over wind because currents are predictable, says James Taylor, the general manager of environmental planning and monitoring at Nova Scotia Power, a company that also has plans for a one-megawatt tidal-power project. "Wind is intermittent and, because of that, is much more difficult and expensive to integrate in a power system," he says.

Diesel Roll Back For PGMA’s Sona, MV Princess of the Stars Tragedy, Economic Realities of Cagayan’s Used Car Trade

``Beliefs have a social as well as an inferential function: they reflect commitments of loyalty and solidarity to ones coalition. People are embraced or condemned according to their beliefs, so one function of the mind may be to hold beliefs that bring the belief-holder the greatest number of allies, protectors, or disciples, rather than beliefs that are most likely to be true. Ideological beliefs are obvious examples.”- Steven Pinker, Department of Psychology of Harvard University

Some political economy notes and observations.

1. Diesel Roll Back For PGMA’s Sona.

Political accommodation feeds on the dangerous impression that oil companies have been “obscenely” profiting at the expense of the people.

Since almost all of the oil requirements of the Philippines are imported, this means that domestic oil companies essentially import all crude oil for domestic refining taking with it the risk of inventory storage, currency, political pricing aside from other risks relevant to the industry. Thus, profits are realized because of successful risk taking endeavors and not from price gouging as peddled by some politicians.

Refining companies earn from crack spreads (wikipedia.org)-“differential between the price of crude oil and petroleum products extracted from it - that is, the profit margin that an oil refinery can expect to make by "cracking" crude oil (breaking its long-chain hydrocarbons into useful shorter-chain petroleum products)”, which means profit can only materialize if they are able to passthrough their products to the consumers tacked with some margins. If oil companies are not able to do so they will incur losses. Vested interests see only the profits (survivorship bias) and not the risks or the potential losses.

The basic reason why oil companies can afford to roll back prices is mainly due to the significant fall in world crude oil prices. This essentially allows oil companies larger margins if sales are to be maintained based on present retail prices. Present retail prices covers inventory accumulated from recent crude purchases. However, a sustained decline in world oil prices should also translate to more rollbacks in the future.

Those arguing that the country’s oil deregulation as the main culprit to high oil prices should look at the Vietnam and China experience.

Both countries whose oil companies are state owned increased prices significantly (Vietnam 30% and China 18%) primarily not because of fiscal problems (although it has an influence) but mainly because losses in state owned firms have reduced or lessened supply output which has led to rampant smuggling, vast shortages and rationing.

Given the precarious state of the Philippine fiscal position, the idea of nationalized oil companies will only placate near term desires but at the expense of greatly higher prices in the future. The fundamental problem of oil prices comes from sustained government intervention around the world.

Oil companies ought to be more transparent with the public by communicating on the risk-reward aspects than simply accommodating politicians.

2. The MV Princess of the Stars Tragedy

It is a peculiar development why despite the repeated accidents by the same shipping company, consumers continue to patronize such private entity. The answer is the lack of choice.

None in the media has brought out the fact that the domestic shipping industry is a very tightly regulated industry.

Imagine, aside from 5 agencies that directly supervise the industry; namely, Maritime Industry Authority, Philippine Ports Authority, Bureau of Customs Bangko Sentral ng Pilipinas and the Philippine Shippers Bureau, there are another twenty six (26) other agencies directly or indirectly regulate the inter-island freight shipping industry (NEDA’s Philippine Institute for Development Studies). Incredible red tape!

With all these bureaucracy given the prevailing idea that government knows best, it is an oddity why the seemingly regular recurrence of the undeserving life losing tragedy.

Yet, media and the political circus continue to feed on the masses for more government intervention. Are 31 agencies not enough? Maybe Pagcor should be included as a regulating agency to allow bets on the next mishap? Why not nationalize? Hahaha.

It is quite evident that such choking bureaucratic entanglements represents by itself a significant barrier to entry which would naturally discourage potential rivals and limits challengers to the stalwarts, thus, the oligopoly or economic rents concentrated to a few inefficient sellers or providers.

Myrna S. Austria’s observation in her paper “Liberalization and Deregulation in the Domestic Shipping Industry: Effects on Competition and Market Structure captures the essence of the inefficiencies in the sector, ``Nonetheless, substantial competition exists in only a small percentage of the routes. A greater majority of the routes are still effectively monopolized, or experienced only mild competition. The top three or five companies in the industry effectively dominate the different routes. What is more striking is the large increase in cargo and passenger rates after the implementation of the reforms. The cartel-like arrangement that is observed to exist in the industry may have contributed to this.”

As we discussed in It’s Less About Oligarchy and More About Bureaucratic Crony Capitalism or in Philippine Politics: Systemic Defects of the Pork Barrel Political Economy, the major defects of the present economic system lies in the web of laws that shields competition on the turfs of the oligarchs. These oligarchic structure breeds inefficiency and continues to add up statistical fatalities in the domestic shipping industry, yet we never seem to learn.

3. Economic Realities over the Controversial Cagayan’s Used Car Trade

The recent ruckus over the used car imports gives some important economic realities.

One, imported used car has a thriving market, probably due to lower costs (reduced taxes due to export zone privilege?).

Two, laws meant to protect certain industries or interests have unduly created market inefficiencies resulting to higher domestic car prices. Thus, the price gap between the foreign owned local manufacturers and the imported used cars in the Cagayan Export zone has resulted to the underlying demand for the imported used car market.

Three, legal loopholes creates economic opportunities especially for those in power. The Cagayan Export Zone has used its privilege to go around the Executive Order (156) banning the importation of used car vehicles for resale in the country.

Fourth, politicians advance and protect their self interests and or vested interest groups other than those of the public.

In this case, it isn’t hard to qualify.

One, trade restrictions benefits car manufacturers at the expense of consumers, through higher prices caused by high taxes (seems like a modus operandi- taxes in exchange for protection from competition). Thus, the national government’s Executive Order is meant to “protect” the narrow interest groups allegedly for the benefit of the economy.

Some would probably argue that taxes serve the interest of the people. No, taxes pay for politician’s boondoggles and some of the people and NOT for the majority of the people (think Pork Barrel). People pay for the politician’s boondoggles directly through higher taxes and indirectly through higher cost of living, lower capital investments and unemployment.

Two, the key proponent of the Cagayan Export Zone (CEZ) has been an important ally of PGMA in the Senate hence the moxie to defy the law; another case of patronage politics.

Besides, here it is evident that politicians make their hometowns as “turfs” or “little kingdoms/dynasties” which make use of laws for the perpetuation of their political and economic regimes…hence more signs of oligarchy.

Another, the recent pieces of the political puzzles are falling into place…the motives behind the excoriation of the foreign chamber of commerce in early June has apparently been made evident. Aside, we now sympathize with our Supreme Chief Justice’s remonstration of "economic colonizers".

The Philippines needs to understand the functional benefits of well developed markets than relying on politicians for advancement. We need more economic freedom and less government intervention.

Phisix Best Week of the Year; Identifying A Market Bottom, The Phisix-Peso Tango

``In these circumstances, I wouldn't try to be too clever. You don't see market timers who own yachts. If you pack up now, chances are you'll miss a good part of the next bull market. A large part of the gains are always made in the first few months of one, when market-timing investors are still on the sidelines… Bear markets are the hardest kind to invest in. But they can also be the most rewarding.”-David Dreman, chairman of Dreman Value Management of Jersey City, N.J.

The Phisix had its best weekly performance, up 5.16%, for the year and since the first week of October 2007.

It’s been a while since we have seen this kind of positive market action. And this has pleasantly brought some smile on the faces of those enduring the agony of the present bear market cycle. But of course, the harsh reality is that one week does not a trend make. And it will take awhile for us to establish the much awaited recovery.

And as a reminder, market bottoms are cyclical phases always seen from the privilege of the hindsight. Yet in anticipating such a cyclical transition means understanding probabilities- that the prospects of further losses is much less than the prospects of further gains. But the underlying lesson brought forth by today’s market condition is all about patience, discipline and comprehending the risk-reward tradeoffs. To quote again Roman poet and author Ovid, ``Everything comes gradually and its appointed hour.”

As we repeatedly have been saying, our thought is that a market bottom would perhaps manifest itself through a combination of several indicators:

1. mending MARKET INTERNALS,
2. improving TECHNICAL PICTURE,
3. reversal of FOREIGN FUND FLOWS,
4. possible SIGNS OF DIVERGENCES relative to US markets, and lastly,
5. an acceptable FUNDAMENTAL “story” for the investing public.

It seems we are seeing some of these happening today.

In addition, of course, the Phisix won’t be a standalone when a full recovery becomes evident. This week’s bullish rendition was equally reflected in a majority of Asia’s market, although perhaps the most valid interpretation could be that these reactions mainly reflect a technical rebound from severely oversold conditions unless proven otherwise.

Nonetheless, optimistically we are seeing some bottoming ‘characteristics’ in the markets of Vietnam, China (Shenzhen & Shanghai), Singapore and Japan (Nikkei 225 & Topix), where base formation- “consolidations” or higher lows are the common traits in the technical picture of these benchmarks. We need to see further sustainability of such trends.

On the other hand, we are leery of V-shaped bounces as they are commonly features for ‘bull traps’.

If we use the ‘appeal to authority’ as an argument for a bottom, then the buying activities of guru George Soros in India, the bullish “calls” of Templeton Asset Management’s Mark Mobius, the legendary Jim Rogers and of the US key investment bank Merrill Lynch of Asia could be seen in the light of “positive” indicators.

Moreover, one of the idiosyncrasies seen in the Phisix is that the recent actions have once again coincided with the turning point of the Philippine Peso as shown in Figure 1.

Figure 1: Phisix-USD/Peso Correlation: Surging Peso Equals Rising Phisix?

Since the US Dollar/Philippine Peso (green line) began to converge with its neighbors in 2005, the Phisix (black candle) has shown some interesting correlations. The red block arrows points to major inflection points: when the Phisix troughs, the USD/Peso peaks and vice versa. Although this correlation hasn’t been in lockstep or 100%, we appear to be seeing the same dynamics occurring all over again!

This could be due to foreign capital determined Peso dynamics. It has been our thought that foreign money has driven the Peso at the margins more than much ballyhooed remittances. This is not to suggest that remittances have no contribution, of course they have, but foreign capital (portfolio and direct investments) could have functioned as more of the impetus in the pricing of the Peso than other factors.

For instance, the rally seen this week alone was not entirely a Phisix-Peso interplay but likewise seen in the sovereign debt market. Philippine 10-year Peso and US dollar denominated yields fell significantly by 46 and 47.2 basis points respectively, based on ADB’s AsianBond Online. This means that the Philippine bonds staged massive rallies (which I suspect comes mostly from foreign capital).

Although such foreign inflows hasn’t been reflected in the Phisix yet-if we consider board trades or foreign trade NET of special block sales. Yes, special block sales from Petron (from the tender offer) altered this picture on the aggregate.

But, overall if the financial picture continues to show improvement we will eventually see foreign inflows back in spite of (or probably due to-aside from other variables) Bangko Sentral’s Rate policy actions. As the Economist pointed out, which we had a cursory explanation in our recent post Burgernomics: Where is the world’s most Expensive and Cheapest Big Mac? Peso one of the world’s cheapest., high interest rate emerging market currencies have remained largely unscathed (Brazil’s real and Turkey’s Lira) despite the present “risk averse” conditions.

Tale of The Tape: The Philippine Peso Versus The US Dollar

``It requires very unusual mind to make an analysis of the obvious."-Alfred North Whitehead

It has also been our exposition that the recent rally of the US dollar relative to the Philippine Peso, which has been popularly imputed to rampant “inflation”, had been based on a false premise, see Figure 2.

Figure 2: ADB Bond Monitor: Fiscal balance as % of GDP (left), Net food and petroleum exports in 2007 in $ billions (right)

In my view, the markets simply looked for an excuse (available bias) to sell down the Peso and Philippine asset classes, when it had been mostly a combination of the phenomenon of a natural countertrend cycle, the lowering of world economic growth expectations and forced liquidations from capital raising financial institutions abroad.

Although the so called food and energy driven “Inflation” (defined by mainstream as rising prices-which is not the true definition) had been somewhat a contributor, as a market driver, it signified a minor role relative to the above, but had immense political coverage or impact. Thus, in terms of easy to sell explanations for a consuming public that buys on the appeal of oversimplified information, the mainstream news accounted for what is popular backed by experts who fed on such fallacious biases (confirmation bias).

Since currency valuation comes in “pairs” or is a zero sum pricing dynamic (one advances, the other declines), the proper approach should be to cover similar variables of the nations being compared with, in assessing currency or asset pricing. You cannot deal with one factor without assessing the other because pricing comes in “pairs”.

Recently the easy and popular explanation had been- fiscal prudence relative to national balance sheets are likely to be sacrificed in order to mitigate social and political pressures arising from high food and energy costs. Thus, the fiscal costs amounts to balance sheet expansions which means rising interest rates at the expense of economic growth and the corresponding deterioration of asset valuations.

The ADB July Bond Monitor shows of the Asia’s net food and petroleum trade (right) and importantly the fiscal balance in % of GDP on the account of today’s “inflation” (see left).

The chart shows of the deterioration of fiscal balance even with the recent government actions of targeted subsidies for the Philippines as only 1% of the GDP even in the environment where the country would have to import more petroleum and food at the expense of its trade account.

But the US budget deficit projections calculated on February alone had been $410 billion for 2008 or 2.7% of GDP due to increased federal spending (yahoo).

Notwithstanding, the recent deterioration in tax revenues or collections has been putting a strain on financing the present government expenditures which has also been exacerbating the pressures of additional budget deficits especially under today’s recessionary environment. As discussed in our previous article Has The Underperformance of Philippine Markets Been Due To Policy Credibility?, the Nelson Rockefeller Institute has identified 36 states undergoing recession, which has been contributing to state budget deficits.

In addition, the present structure of US government debts have been mostly in short term instruments. Rising yields are likely to increase the costs of financing of its domestic spending requirements. Thus, the cost of financing is likewise a potential added burden for US taxpayers.

Moreover, the fiscal and monetary costs of nationalization of financial institutions, e.g. IndyMac- where the estimated costs of the Federal Deposit Insurance Corp (FDIC) takeover is $4-$8 billion (latimes) while 2 more banks were recently added to that casualty list (more of bank takeovers risks depleting the $53 billion insurance fund of the FDIC), the recent $168 billion national stimulus (with prospects of possibly more stimulus-William Gross of PIMCO is asking for $500 billion more!) and the provision of bridge financing to key financial institutions (recently including Fannie Mae and Freddie Mac) suffering from both an illiquid environment and potential insolvency.

Figure 3: Heritage Foundry: A Nation of Entitlements

It doesn’t end here. The US also bears the costs of its exploding unfunded entitlement programs which seem to likewise jeopardize the balance sheets of the Federal Government, see Figure 3.

According to the Heritage Foundry (highlight mine), ``The U.S. spends a total $1.2 trillion on the Big Three entitlement programs ($581.4 billion on Social Security, $370.8 billion on Medicare, $291.2 billion on Medicaid).”

So it isn’t as simple as inflation here should weigh on the Peso and financial assets-blah blah, because all the abovementioned costs have been a huge onus to the US economy relative to the problems in the Philippine setting.

Even in the spectrum of purchasing power, the Economist’s Big Mac Index (discussed on my recent post) shows that Asian currencies are terribly undervalued relative to the US dollar, which means that the prospects for the Peso to advance alongside its neighbors is quite compelling.

Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso

``Thinking is the hardest work there is, which is probably the reason why so few engage in it."-Henry Ford

Perhaps Stephen Jen of Morgan Stanley has read our arguments and has written an article providing an academic cover for our view. He says which I quote,

``whether inflation is positive or negative for long-term economic growth depends on whether money is a substitute (a store of value) or a complement (a medium of exchange) for physical capital.

``This theoretical debate can only be settled by statistics. Here are some key statistical facts about this relationship:

``-No clear systematic relationship between inflation and long-term growth. Unlike the Phillips Curve relationship, and contrary to popular presumption, the long-term statistical relationship between inflation and growth has been rather unstable and inconsistent, over the past decades, and across countries. There were episodes of high inflation and high growth, as well as high inflation and low growth.

``-High inflation (15-30%) was often accompanied by high economic growth. When inflation rates breach 40% or so, inflation is almost always bad for growth. However, inflation of around 15% has historically not been particularly problematic for economic growth. In the 1960s, Asia and Latin America experienced high growth-high inflation phases. Per capita income growth in these countries actually accelerated when inflation rose from single-digit to double-digit levels. Further, such a state had been sustained for a long time without major disruptions. Even now, China and India’s rapid economic growth rates are accompanied by rising and high inflation, with no apparent extreme tensions in the economies.

``-Inflation reduction has output costs. Stabilisation of hyper-inflation has had no major output losses. But reducing inflation from ‘high’ to ‘moderate’ has led to costly output losses. The experience of the US under Fed Chairman Volker – with the US economy going through a recession and a period of high unemployment to bring down inflation – is particularly representative of this process.

So in effect, the impact of inflation depends on the policies of balancing the economic growth aspects relative to the risks of inflation and can be assessed only from a micro angle or from a case to case basis and not from wholesale assumptions, see figure 4.

Figure 4: ADB Change in Inflation and Output growth (in basis point)

The ADB chart exhibits the trade-offs between more inflation and less output across the region’s economies. Each country has different impacts to the problem of inflation.

Mr. Jen concludes (highlight mine), ``The role of fiat money is key in determining whether this relationship is positive or negative. For some EM economies, this relationship could be positive, justifying central banks protecting growth and allowing inflation to rise. Investors should be aware of the risk of EM central banks having a moratorium on inflation-targeting.”

As we commented last week in Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation where popular inflation indicators seem to be on the mend as declining food and oil prices across the board signifies a decline in global economic growth than from government policies, the recent substantial broad based food and energy declines abroad confirm these trends as recently posted Why Food Inflation Will Ease Over The Interim (in pictures).

Moreover, market signals combined with political pressures have been putting the lid on these pressures too. We are seeing more and more efforts from the private sector in response to market signals to increase supply as the “Adopt a Farmer” by some business and socio civic groups.

Figure 5 ADB: Updated Food and Energy Weightings in CPI basket

Remember principally it is rising food prices creating the inflation hysteria, see figure 5. The pain comes from food (46.6% of CPI) and not much from fuel (2.4%). This explains why car sales remain firm despite the rising cost of fuel contrary to popular wisdom as projected by media.

The Bangko Sentral ng Pilipinas (BSP) also holds sway on the direction of the Peso and financial markets. If the BSP manages to increase rates enough to close the real rates gap, then it is likely that the currency yield arbitrage, aside from reducing imported inflationary pressures are likely to attract foreign investors back to the market.

Relative Economic Growth, Lack of Access to Capital and Global Depression

``With greater wealth comes greater responsibility. This is inescapable. Wealth has a social function. If you own something, you must make decisions about how to use it. Consumers are always bidding for either ownership or the use of your assets. Ownership therefore has a price. If you do not respond to the offer, you are paying this price. You are paying the price in the form of forfeited opportunities. Whatever you do with the wealth, you could be doing something else with it. You cannot escape the responsibility of not doing something else with whatever you own.”-Professor Gary North, Honeymooner Politics

It can’t be an argument from the economic growth perspective too…

Figure 6: IMF: WEO Presentation: Economic growth decelerates Around the Globe

Even as global economic growth has moderated to 4 ½ in the first quarter of 2008 down from 5%, such growth clip is expected to decline further to 4.1% in 2008 and 3.9% in 2009, according to the IMF.

From the IMF’s World Economic Outlook update (emphasis mine),

``Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008.

``Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09.”

In short, despite the moderating pace, the economic growth differentials are still tilted towards in favor of emerging market economies (see left pane in Figure 6).

Moreover, we can hardly buy the arguments from the deflationist proponents of a world depression or near depression see figure 7.

Figure 7: ADB: Asia’s Household Indebtedness

ADB’s data shows of the dearth of leverage or indebtedness of the household sector, which reinforces our supposition of the insufficient access to the banking system by a large segment of the Philippine economy. Similarly this represents both as a shortcoming and as an opportunity (huge growth area).

If the banking system, the main conduit for finance intermediation, has relatively low exposure, it explains why the Philippine capital market likewise lags the region or for most of the world.

It also gives credence to the outlook that a large section of the economy is levered to informal financing channels.

Basically Indonesia and the Philippines could be deemed as primeval cash based society. It also demonstrates why both countries have lagged in the aspects of developments simply because of the lack of access to capital and to paucity of sophistication to lever and recycle capital.

Figure 8: ADB: Public Sector and External Debt as % of GDP

External and Public sector Debt for most of Asia has likewise been materially improving. But the Philippines has the worst position among the peers but has likewise shown significant progress.

Of course past performance may not repeat in the future given the deteriorating conditions abroad, but given the composite framework of the Philippine economy or financials, we need to be substantially convinced of how a depression in the US will result to a depression in the Philippine economy or in Asia. We have discussed in details such linkages in ‘Is the Philippines Resilient Enough to Withstand A US Recession?’.

We also don’t share the view that advanced economies will RECOVER first given the so-called belated effects of an economic growth slowdown contagion to Asia or to emerging markets.

The reason is that the US or UK or countries presently scourged with the deleveraging process is a systemic impairment which will take a longer period for convalescence or for market clearing. Whereas Asia or emerging market’s bear market comes about from the trade and financial nexus with these economies and has not yet been a structural problem (YET).

As a reminder, from every cycle emerges a new market leader, e.g. in the US, the technology sector 1990s-2000 and financials and housing in 2003-2007 (today the energy sector appears to be at the helm) and it is likely that once a recovery phases there will likewise be a new market leader (perhaps the next bubble). And our likely candidate emanates from Asia or emerging markets.

To elaborate further, monetary inflation has been a process INTRINSIC to the fiat paper money/currency standard. Since the impact of inflation is always never equal, it gets to be absorbed in different points of the economy at different times.

For instance in 2003-2007, most of the inflationary actions by global monetary authorities got absorbed in the real estate sector backed by financial securities (structured finance, derivatives, mortgages backed securities, etc…).

Aside, the spillover from these actions led to global arbitrages which spurred a phenomenon of price values of stocks, emerging market debts and commodities.

But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.