Reverse Coupling, Inflation From The Core and Current Account Deficits

``Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

Finger pointing on policymaking is easy to do. Yet many analysts seem to forget that the global monetary regime functions under the US dollar standard system which runs on the fractional banking reserve system platform, whose underlying principle basically stems from leverage (reserves as a fraction of deposits).

Because the logistical agencies of the US monetary system have presently been undergoing severe deleveraging pressure, this has been spilling over into the real economy and equally reflected in the underlying asset prices which is likewise being felt worldwide see figure 5.

Figure 5: The Economist: Sinking Global Equity Markets

The Economist cites Standard & Poor’s estimates of the losses for the month June as having wiped out $3 trillion in global capitalization, mostly due to the horrific 10% losses in emerging markets.

And as we have been saying along-it’s all not about oil but a combination of factors from the softening economic growth, deteriorating profit outlook, rising interest rates and higher incidences of consumer goods inflation.

“Reverse Coupling”

Thus given these aggravating circumstances, the US Federal Reserves policies have been designed to keep interest rates at negative real levels considering the staggering amount of leverage built onto the financial system under the abovementioned environment.

And as we discussed last week in Global Financial Markets: US Sneezes, World Catches Cold!, this evidently could be the continuing policy thrust since authorities have in their radar screen the magnified view of heightened systemic deflationary risk. Apparently the central bank of central banks the Bank of International Settlements (BIS), have echoed the same risk and sees “inflation is a more immediate threat than deflation” (The Economist).

Hence, the Bernanke-Paulson tandem appear to be banking on a lower dollar and lever its economy through exports by turbocharging the economic growth to emerging markets via the transmission mechanism of US dollar linked monetary regimes and the expansion of the current account deficit. Essentially lower US interest rates have been stimulating emerging markets.

This excerpt from the commentary of Fred Bergsten, director of the Peterson Institute for International Economics at the Financial Times appears to corroborate our view,

``The improved US trade performance of the past two years is due partly to the substantial, if lagged, restoration of the country’s price competitiveness as the dollar declined by a trade-weighted average of 25-30 per cent since early 2002, reversing most of its excessive run-up during the previous seven years that produced unsustainable current account deficits exceeding 6 per cent of GDP. Equally important, however, is the continued robust growth of the world economy. Every percentage point by which the rest of the world expands domestic demand faster than internal growth in the US produces gains of about $50bn (€32bn, £25bn) for the US external balance. Weighted by US exports, foreign growth exceeded US growth by about 2 percentage points in 2007 and will do so by an average of about 1.5 points this year and next as decoupling persists. Taken together, these currency and comparative growth factors have already improved the real US trade balance, and hence GDP, by almost $150bn since 2006, with gains of another $150bn or so likely through 2009. (The nominal US trade and current account deficits will not improve as much because of the sharp rise in the price of oil imports.)

``The Organisation for Economic Co-operation and Development’s new Economic Outlook projects that more than 80 per cent of all US growth in 2008-09 will derive from continued strengthening of its external position. Exports have been climbing at an annual rate of about 8 per cent, at least six times as fast as imports. Unless domestic demand takes an unexpected further fall in the quarters ahead, reverse coupling of the global economy will thus have prevented the US recession that was so widely predicted and feared.”

So what you have is the US trying to utilize emerging markets to cushion its economic decline hoping that the global inflationary process from emerging markets would keep the US-UK deflationary forces at bay. However, the unexpected repercussion of this exercise is the risk of emerging markets to overheat and exacerbate the “inflation” in commodity prices particularly of food and energy.

An example, if you think record levels of oil prices have climbed enough to “destroy demand” in emerging markets, it’s definitely not showing yet. Car sales in June remained robust in India (+8%) Brazil (+30%), Korea (+9.2%), New Zealand (+5.5%) and Australia (+1.4%).

Inflation From The Core

If markets have been reappraising financial assets through policy actions shouldn’t it be the US that needs to be penalized more for its influential grip over other economies?

Yes, if you ask Doug Noland in his Credit Bubble Bulletin (highilight), ``I find it rather incredible that U.S. and European policymakers are increasingly pointing blame and calling upon their emerging economy cohorts to aggressively combat inflation. With the U.S. today stuck with intractable $700bn Current Account Deficits and European Credit systems still churning out double-digit Credit growth, the Periphery is not the root cause of today’s escalating global inflationary pressures. The global Credit system has run amuck, a process that evolved from years of Credit and speculative excess generated by, and tolerated at, the Core. It is today unreasonable to expect the Chinese or Asians generally to bring their booming economies to their respective knees to fight global inflation anymore than we can expect the Fed to tighten the economic screws to the point of balancing our Current Account and punishing the destabilizing speculators.

``Today’s inflationary dynamics have been developing for decades. Only discipline and stability at the Core of the global financial system would have stemmed the strong inflationary bias of contemporary fiat “money” and Credit. But the Core was instead egregiously undisciplined and unstable, setting the stage for the type of runaway inflation we are now experiencing. The Core came to love and rationalize asset inflation and consumption. The Periphery was forced along for the ride and happy to oblige.”

Of course, to a lesser degree the US dollar linked monetary regimes in emerging markets should bear some of these responsibilities for tolerating the US policy induced global inflationary environment.

Emerging Market Turmoil: From Carry Trade To Current Account Deficits?

On the other hand, perhaps the turmoil in today’s marketplace exceptionally seen in some emerging markets could be as a result of the shifting focus of the markets as the distortions from the carry trade in the face of heightened risk aversion fades while the market prices on the state of current account balances as suggested by The Economist see figure 6.

Figure 6: Economist: Current Account Balances Reshaping Asset Pricing In Emerging Markets?

From the Economist, ``ACCORDING to economic textbooks, the currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. This will stimulate their exports and curb imports, thereby helping to slim the trade gaps…Increased concern about current-account deficits is also causing investors to discriminate much more between emerging markets. A popular argument in recent years has been that developing economies are less risky because, unlike a decade ago, they are no longer dependent on foreign capital. It is true that emerging economies are forecast to have a combined current-account surplus of more than $800 billion this year, but this is more than accounted for by China, Russia and the Gulf oil exporters. In fact over half of the 25 biggest emerging economies now have deficits. South Korea is running a deficit after a decade of surpluses. Brazil has also moved back into the red, despite record high prices for its commodity exports. Others such as India, South Africa and Turkey have had external deficits for many years.”

While some of the performances in emerging markets appear to affirm such theory, it hasn’t been linear. For instance, the Philippines have severely underperformed South Africa and Turkey both of which have had deficits even during the heydays of the markets.

The Philippines isn’t about to turn into a current account deficit yet though. Current account surplus is expected to narrow to $4.2 billion from $6.9 billion (Reuters) despite the expected broadening of the trade deficit to about $11 billion-highest in 9 years on higher fuel and rice imports and weaker exports. So the recent underperformance of the Philippine asset class does not tally will or could be fully explained by this theory.

Thus, if we read by the activities in the market, such expectations are likely to be wrong (we will turn steeply into a deficit) or the market is inaccurately priced (market is wrong).

For the Philippine setting my conjecture is that the recent bear market has been exacerbated by internecine politicking see Philippine Politics: The Nationalist Hysteria Over Energy Issues.

Phisix: Too Much of Horror Movies

``In the sky, there is no distinction of east and west; people create distinctions out of their own minds and then believe them to be true." – Buddha

Local investors have been spooked by either inflation figures or elevated oil prices or both. The Phisix lost another 3.94% over the week to increase its year to date losses of 34.58%. From the Phisix peak in October 2007, the present bear market has accrued losses of about 39%.

Despite the net foreign selling this week, which was mostly due to the special block sales of San Miguel shares, board transactions reveal of a marginal net foreign buying. Again the rather slightly bearish bias to neutral outlook by foreign participants indicates of the locals at the driver’s seat.

The recent activities suggest that local participants continues indiscriminately sell the market in the assumption that the apocalypse is around the corner. This is a peculiarity though; retail investors hardly seem to know how to absorb losses which makes us suspect the ongoing selling pressures could possibly come from redemptions from indirect participants (e.g. bank UITFs, or Index funds or mutual funds).

Well we have been arguing that inflationary environments does not equate to financial Armageddon, there are industries that have been seen to benefit from the present environment see figure 7.

Figure 7 PIMCO: Winners and Losers

Pimco’s Mark Kiesel says that their company remains weighted in certain sectors (highlight mine), ``The energy, materials and metals and mining sectors remain areas we continue to favor in our credit selection process. In the case of energy, fundamentals tend to improve as price levels rise because higher inflationary periods typically result in strong top-line revenue growth for energy companies where demand is relatively inelastic. The industrialization of the emerging markets has led to significantly stronger demand growth for energy and put pressure on already tight resource supplies. Not surprisingly, gross margins for energy companies have expanded over the past several years as revenue has grown faster than costs.”

Why? See figure 7 again courtesy of PIMCO…

Figure 8: PIMCO: Who Has Pricing Power?

So inelastic demand, commodity pricing pass through, revenues growing faster than rising costs makes the aforementioned industries attractive.

Why have the local participants been selling? Because they’ve watched too much of horror movies.

Merrill Lynch Turns Bullish on Philippines

Investment banking heavyweight Merrill Lynch recently took a contrarian position by turning bullish on the Philippines according to the Finance Asia.

Merrill increased weightings on the country following the improvements in the company’s composite valuations which makes the Philippines the third most attractive market following Australia and Taiwan.

While Merrill sees rising oil prices as a challenge, ``Merrill Lynch notes that its new country allocation however appears to be in flagrant contrast to how a fund manager should be positioned, if the conviction is oil prices will keep rising. However, the firm notes that the impact of oil prices on a market is different from the overall call on that market,” notes Rita Raagas De Ramos for Finance Asia.

Read the rest here.

Denmark First European Country to Fall Into A Technical Recession; Many To Possibly Follow

This from Reuters: ``Europe got a first taste of recession on Tuesday when Denmark, a country that fronted the housing boom of the past decade, said economic output had shrunk for two quarters in a row.”

Courtesy of Danske Bank

This from Steen Bocian of Danske Bank, ``GDP actually fell by 0.6% q/q, or -0.7% y/y. The numbers were down right across the board . investments, private consumption and public spending all declined relative to Q4 07. The only bright spot was exports, which were up 1.1%.”

Courtesy of Elliott Wave

Other looming candidates: Spain, Ireland, UK, Netherlands and Portugal-following a bursting housing bubble whose magnitude to quote Susan Walker of Elliott Wave ``The surprise is the United States, which, when compared to Europe, looks like the epitome of fiscal conservatism.”

Odd Article of the Day: Dogs Inherit Billions!

Leona Helmsley’s favorite dog Trouble gets $12 million, while an estate worth $5 to $8 billion will be bequeathed to the welfare of dogs! Read here for the complete article from the New York Times.

Darned lucky Dogs!

Food and Oil markets: Market Signals Don’t Give The Right Incentives?

Recently we read from a prominent economist who argued that the reason markets don’t work in saving resources is that “market signals don’t give the right incentives”.

Nonetheless our self righteous expert didn’t say why the market signals have been behaving this way, but cited food and oil as an example.

To quote segments of this timely and incisive article from the liberal New York Times (Keith Bradsher and Andrew Martin)-accounts for the aberrations in food market dynamics (all highlights mine)…

Agriculture Trade Left Behind
Courtesy of NYT

``When it comes to rice, India, Vietnam, China and 11 other countries have limited or banned exports. Fifteen countries, including Pakistan and Bolivia, have capped or halted wheat exports. More than a dozen have limited corn exports. Kazakhstan has restricted exports of sunflower seeds.

``The restrictions are making it harder for impoverished importing countries to afford the food they need. The export limits are forcing some of the most vulnerable people, those who rely on relief agencies, to go hungry.

``“It’s obvious that these export restrictions fuel the fire of price increases,” said Pascal Lamy, the director general of the World Trade Organization.

``And by increasing perceptions of shortages, the restrictions have led to hoarding around the world, by farmers, traders and consumers.

``“People are in a panic, so they are buying more and more — at least, those who have money are buying,” said Conching Vasquez, a 56-year-old rice vendor who sat one recent morning among piles of rice at her large stall in Los Baños, in the Philippines, the world’s largest rice importer. Her customers buy 8,000 pounds of rice a day, up from 5,500 pounds a year ago.

``The new restrictions are just an acute symptom of a chronic condition. Since 1980, even as trade in services and in manufactured goods has tripled, adjusting for inflation, trade in food has barely increased. Instead, for decades, food has been a convoluted tangle of restrictive rules, in the form of tariffs, quotas and subsidies.

``Now, with Australia’s farm sector crippled by drought and Argentina suffering a series of strikes and other disruptions, the world is increasingly dependent on a handful of countries like Thailand, Brazil, Canada and the United States that are still exporting large quantities of food.

So EXPORT RESTRICTIONS imposed by national governments is one major factor…

World Tariffs Courtesy of New York Times

``Powerful lobbies in affluent countries across the northern hemisphere, from Japan to Western Europe to the United States, have long protected farmers in ways factory workers in Detroit could only dream of.

``The Japanese protect their rice industry by making it nearly impossible for imported rice to compete. The European Union severely limits beef and poultry imports, and Poland goes further, barring soybean imports as well.

``Negotiators have been working for years to free trade in farm goods, but today’s crisis actually makes that more difficult for them. Food protests in places like Haiti and Indonesia that rely heavily on imported food have convinced many nations that it is more important than ever that they grow, and keep, the food their citizens need…

So IMPORT RESTRICTIONS again by national governments likewise contribute as another major obstacle….

``In some of the nations concerned about shortages now, past policies have discouraged farming. From Indonesia to West Africa to the Caribbean and Central America, poor countries have frequently cut farm assistance programs and lowered tariffs to balance budgets and avoid charging high prices to urban consumers. But they have found that their farmers cannot compete with imports from rich countries — imports that are heavily subsidized.

``As a result, steps that could have taken place decades ago, resulting in more food for the world today, were abandoned. These included changes like irrigation schemes and new crop varieties.

``“The subsidies given by developed countries to their farmers have led to lack of investment in agriculture in developing countries” in Africa and elsewhere, Mr. Nath said.

``To make matters worse, the World Bank and the International Monetary Fund frequently pressured poor countries in the 1980s and 1990s to lower tariffs and to cut farm support programs, mostly to reduce budget deficits.

``Indeed, the World Bank concluded in 2006 that not enough attention had been paid to the negative effects of its policy prescriptions on farmers in developing countries.

``The current export restrictions, which mainly help urban consumers in poor countries, are the latest blow to farmers in the developing world.

``Arfa Tantaway Mohamed, who grows rice on three-quarters of an acre outside the bustling town of Aga in northern Egypt, is frustrated at Egypt’s export ban, which is suppressing rice prices."

Third and Fourth factors include, VACILLATING POLICY PRESCRIPTIONS and SUBSIDIES…again by national governments.

One of IMF’s proposed solution (ironically a multilateral “government of governments” organization) is…

``Trade polices. Global food markets need to be kept open, with restrictive policies, such as export taxes and bans, removed to maintain appropriate incentives for producers and consumers. Tariff reductions can help to reduce trade distortions and mitigate price increases.”

So none of the above looks like a malfunction caused by market forces, instead they come from distortive government policies.

As for oil we excerpted this article from Jim Mctague of Barrons online,

``Drilling in the Gulf has long been contentious. On one side are the tourism, real-estate and environmental industries. On the other are those dastardly oil men, the J.R. Ewings that everyone loves to hate. Five years after the 1973 Arab oil embargo, Congress amended the Outer Continental Shelf Lands Act to give states, local governments and environmental groups more leeway to challenge drilling in federal waters off their coasts, and they did just that with the enthusiasm of terriers chasing rats.

``James Watt, President Ronald Reagan's environmentally hostile, politically inept interior secretary, tried to reverse the restrictive trend in 1981. He proposed opening almost the entire Outer Continental Shelf to drilling. Coastal communities howled like injured coyotes. California's congressional delegation slipped a provision into an appropriations bill that year that placed a moratorium on drilling off that state's shores. Subsequently, Congress enacted separate moratoriums for Florida, New Jersey, California and North Carolina.

``Those bans didn't cover the Destin Dome, which went on the block in 1984. Chevron and partners Conoco and Murphy Exploration & Production drilled three exploratory wells there in 1987, 1989 and 1995 that found an estimated 2.6 trillion cubic feet of natural gas. But to actually produce gas, Chevron needed federal and state approval.

``Chevron submitted a development plan to the state and the Interior Department for review in 1996 -- an inauspicious time for offshore drillers. George Bush I in 1990 had placed a temporary moratorium on new drilling off South Florida, fulfilling a campaign promise to Sunshine State voters. Then, in 1995, the Clinton administration came out against new lease sales, and Florida's congressional crew, both Republicans and Democrats, successfully supported another moratorium on new drilling to replace one that had expired.

``Chevron proposed drilling 12 to 21 gas wells. Florida bureaucrats took their sweet time before nixing the application two years later. Chevron appealed to the Department of Commerce, which can overturn state decisions. Reluctant to upset anyone, Commerce simply stalled. Under the law, there is no deadline on appeals. Chevron sued the federal government in 2000, claiming it had been denied a timely and fair review of its plans. Clinton stepped down, and Bush II was sworn in. His Commerce Department twiddled its thumbs, too. Meanwhile, Bush met secretly with Florida's then-governor -- his brother Jeb -- a foe of offshore drilling. They agreed to have the federal government buy back the leases for $115 million and place a moratorium on drilling at the Dome until 2011. There are now 140 actual leased tracts there that can't be drilled, reports Lisa Flavin, a senior policy adviser at the American Petroleum Institute in Washington.

``When President Bush suddenly flip-flopped this month and said he favored drilling on the Outer Continental shelf, Democrats accused him of wanting to give more land to Big Oil. Thundered Rep. Ed Markey of Massachusetts: "Oil companies already own 68 million acres of drillable land and sea, which is the size of Georgia and Illinois combined, but they're not producing there." They should use it or lose it, he added. But those acres include the Destin Dome!

`` Chevron took its lease refund to help finance a $12 billion project in Angola to produce liquefied natural gas for shipment here. Ironically, a major gas pipeline between Texas and Tampa runs right by the Destin Dome.

Again, populist and vacillating policies, regressive ideologies and environmental restrictions have kept supplies out of the market.

Overall, the problem of the inadequate diffusion of the incentives of market price signals basically stems from the mismatch between the incentives of LESS price sensitive economic agents who heavily regulates the supply side (government) and the price sensitive economic agents who accounts for the demand side (consumers).

Investments can’t happen when governments restrict them. Trade can’t happen when governments prohibit them. Prices surge when demand and supply imbalances are further aggravated by government hoarding! Thus, price signals don’t reflect efficient resource allocation because governments obscure them.

So it isn’t the problem of markets but one of government intervention.

Financial Globalization: PSE-NYSE Euronext ‘MOU Of Cooperation’ A Step Towards Future Integration?

In our January’s Unifying Global Stock Markets; Asia Looks Next!, we deduced (speculated) that Asia could the be next phase in the ongoing integration and consolidation of global capital markets.

Courtesy of Philippine Stock Exchange

Just recently the PSE and the NYSE Euronext signed a memorandum of understanding (MOU) for cooperation, to quote the PSE-

``To explore new opportunities in trading system architecture and technology, exchange traded products, market participant connectivity and market data management…

In addition, notes the PSE, ``The MOU also includes details on the PSE’s acquisition of a new trading system from NYSE Euronext and its affiliates, which was announced in April 2008. Under the terms of the NYX-PSE MOU signed today, areas of possible cooperation involve the sharing of information and experience on new stock markets products and services. The MOU also embodies the common goal of both companies to provide investors worldwide protection and operating fair, orderly and efficient markets. The MOU was drafted in the spirit that international cooperation between the two exchange companies will facilitate the development and efficient operation of all securities markets operated by the exchange groups.

So at a start what we could expect perhaps to see is the introduction of Exchange Traded Funds and (hopefully) expanded cross listings from listed companies at NYSE Euronext bourses.

Of course, the signing came with a photo-op as Philippine Stock Exchange officials rang the opening bell in one of the recent sessions in Wall Street. You can see the roster of officials at the PSE website.

Bottom line: once the infrastructure have been meshed (trading architecture), what’s to stop NYSE from reinforcing further “cooperation” by acquiring substantial stake at the PSE or a prospective merger and or acquisition.

Global Financial Markets: US Sneezes, World Catches Cold!

``So there is a connection between the ultra-expansionary monetary policies of Mr. Bernanke – I might add, an economist that is an academic and that has studied the Depression but doesn’t understand anything about international macroeconomic conditions. And the conditions that led to the Depression in 1929-32 are very different from what we are facing today because commodity prices at that time had been in an upward trend from 1890 to 1921, but throughout the 1920s, essentially in a downtrend. We are now in an uptrend, so the more money he prints, the higher commodity prices will go, and the lower the dollar will go and the more inflationary pressures the U.S. will face.”-Dr. Marc Faber on Global Inflation

The Dam finally broke.

The three major equity market bellwethers of the US are now knocking at the bear’s lair in the wake of the market’s carnage last week. Following the breakdown of Dow Jones Industrials, the 30 company price weighted average benchmark is now at the brink from the official technical description of a bear market or a loss of 20% from the peak.

The Industrials is down 19.89% from its zenith in October (based on closing prices), while the contemporary benchmarks of the S & P 500 and the Nasdaq are likewise nearing the technical breakdown and are down 18.32% and 19.01% from October, respectively.

And when the US sneezes, the world catches cold, as shown in Figure 1.

Figure 1: courtesy of stockcharts.com: The US Sneezes, The World Catches Cold

Like its US counterpart, the Euro Stoxx 50, a free float market cap weighted index of the 50 European blue chips is seen likewise attempting a technical breakdown (pane below main window) now perched at the critical support levels, while Asia and Emerging markets (center and lowest pane) have also been feeling the heat.

$140 Oil: The Last Nail In The Coffin

Again, mainstream media and their coterie of experts has fingered $140 oil as the culprit, but as we have been saying all along, $140 oil represents as only a contributory factor or the proverbial last “nail” in the coffin.

The recessionary pressures-from the ongoing credit turmoil, the housing meltdown, the market tightening of access to financing, the grand “deleveraging” in the financial sector, growing statistics of bankruptcies and foreclosures, mounting job losses, falling corporate profits, worsening balance sheets, consumer spending retrenchment, slowing capital investments and others, aside from higher “inflation” (high energy and food costs, rising prices of imports, rising costs of raw materials et. al.)-have combined to impact the real economy, which is now being reflected in the revaluation of the US equity markets.

Figure 2: courtesy of Bloomberg: Rising TED Spread: Credit Woes Not over!

Figure 2 from Bloomberg is just an example of the prevailing abnormalities and disruptions in the credit markets affecting both the financial sector and the real economy.

The TED spread-or “the difference between the interest rate for the three month US Treasuries contract and the three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another” (wikipedia.org)-continue to remain under severe strain and appears reaccelerating.

So as financial institutions remain reluctant to lend to each other, this suggests of the dearth of access to finance by many economic agents in the real economy, which essentially leads to an economic growth slowdown.

Figure 3: courtesy of Northern Trust: Falling Corporate Profits From the US

Such impact is becoming more evident in the performance of corporate profitability. This from Chief economist Paul Kasriel of Northern Trust (underscore mine),

``Along with its “final” estimate of first-quarter GDP, the BEA also reported its revised estimate of first-quarter corporate profits. Compared with the fourth quarter of 2007, corporate profits from current operations were estimated to have declined 0.3% in the first quarter of 2008 rather than the 0.3% increase originally reported. Looking at total profits on a year-over-year basis, they were up 1.0% in the first quarter. But, as shown in Chart 1, profits generated from domestic operations contracted 4.8% -- the third consecutive quarter in which year-over-year domestically-generated corporate profits contracted. If total profits are increasing year-over-year, but domestically-generated profits are contracting, then it must be that profits generated from overseas operations are increasing.”

So as shown above, this is not all about oil.

In Eyes Of Ben Bernanke: Systemic Deflation, Interest Rates and Petrol Deficits

There is an idea being floated that “frustrated expectations” over the policy actions of Fed controlled interest rates had been answerable for this week’s rout.

Since the prevailing belief is that oil prices have been “causing” the stress in the US economy and the financial markets, the expectations was for the Fed Chairman Bernanke to “raise rates” in order to combat rising oil prices. Since the Fed stayed on with the present rates, market’s expectations was unfulfilled, thus the attendant mayhem. How I wish it were so simple.

We don’t want to moralize about the principles of money “tightening” although it is a premise which we basically agree with. Yet it is one of the many things the world can do to ease the present strains but comes with a political cost.

The role of market participants is to anticipate on the prospective developments in the marketplace in order to profit from it. So we should instead attempt to understand the mindset of the leadership or those at the helm of the US Federal Reserve, particularly of Fed Chair Bernanke.

Second, it should be understood that the cyclical counterpart of a boom derived from credit inflation is an ensuing bust from debt deflation, which is what we are seeing in the US and parts of Europe today.

Indeed, the US government has reacted with a cocktail of countermeasures to cushion the aftermath of the housing, mortgage and structured finance bubble (deflation) bust with tax rebates, expanding the role of (Government Sponsored Enterprises) GSEs of Federal Home Loan Banks, Fannie Mae and Freddie Mac as mortgage “buyer of last resort”, sharp interest rates cuts, bridge financing via direct access by financial intermediaries to the Fed, currency swap with foreign central banks, the Fed engineered acquisition of investment bank Bear Stearns and the partial overhaul of the asset side of the Federal Reserve balance sheet replaced with collateral from various financial institutions that had been frozen or illiquid in the marketplace. But apparently, these actions have not resolved the liquidity or the solvency issues plaguing the financial sector-the epicenter of today’s debacle.

Thus, as stated in our latest blog post, Chairman Bernanke The Ideologue Probably Won’t Raise Anytime Soon, Mr. Bernanke’s premier concern is one of a systemic debt deflation (or a repeat of the Great Depression or Japan’s lost decade) and perhaps views the current inflation menace as a temporary phenomenon despite the recent verbal signaling to the opposite effect-“the upside risks to inflation and inflation expectations have increased” (Federal Reserves).

When action is measured against words, the point is, with nominal interest rates far below the official rate of “inflation”, which signifies a policy decision, this opines that Mr. Bernanke is indubitably concerned with the impact from the overleverage in the system- yes, as an example trading of enigmatic derivative instruments have now ballooned to $692 trillion (Bloomberg) or more than 10x the GDP of the global economy!

On the other hand, the issue of rising oil prices equals a US recession has been a causality embraced by mainstream thinking.

This quote from Stephen Leeb (Hat Tip Barry Ritholtz), ``Nothing has been a more reliable indicator for an upcoming recession as the price of Oil. Every major bear market, every major economic decline has been preceded by a large spike in oil prices. The 73-74 recession, recession of beginning 80's and the recession of 2000. Oil prices jumped 80% between 1999 and 2000. Oil prices have been the most important indicator of major economic disasters. Whenever Oil prices rise about 80% from year ago levels, a fair chance does exist that a recession/bear market will follow."

Figure 4: Courtesy of St. Louis Fed: Oil Is Not The Only Driver of Recession; Interest Rates too!

Figure 4 from the Federal Bank of St. Louis shows that rising oil prices and a US recession has not solely been the coincidental variables but interest rates too!

Rising interest rates (red line) preceded ALL recession periods (gray area) in the US since 1954. Nonetheless, when oil prices came into the picture in about 1965 (blue line), all instances where oil price rose significantly and was met with an attendant recession, the interest rate cycles were seen either peaking out or rolling over.

What this could suggest is that policy measures (mostly in response to the bond market via rising treasury yields) to wring out “inflation” in the system as signified by high oil prices could have led to the “recession or bear market” indicated by Mr. Leeb.

Put bluntly, it is not oil prices but a tightening environment to squeeze out “inflation” that resulted to these periods of recession. Oil prices again, served as the most convenient scapegoat.

And Mr. Bernanke, whom have exhaustively been trying to avert a recession, could have probably seen this picture and has purposely moved against such tightening in the belief that economic growth guided by the Fed’s monetary and fiscal policies, could help patch up these deflationary bottlenecks overtime while “inflation” symptoms of high oil prices could perhaps bow or vanish amidst these deflationary headwinds.

Another factor perhaps, is that the realization by Mr. Bernanke & co. of the nature of today’s monetary inflation as being transmitted through mainly the US current account deficit and secondarily monetary pegs or dollar linked currency framework adopted by about 45 countries.

Figure 5: courtesy of Brad Sester: US Petroleum Deficit Already Exceeds the Non-Petroleum Deficits

The idea is that since US monetary aggregates and bank credit (loans or investments of commercial banks) have NOT been expanding, petroleum imports- to quote our favorite keen eyed fund flow analyst Council on Foreign Relation’s Brad Setser, ``The petroleum deficit – over the last three months – already exceeds the non-petroleum deficit” -has now become the dominant variable of the US current account deficit which effectively becomes the primary source of monetary lubricant for the economic growth engines of emerging markets economies.

In figure 5 courtesy of Brad Setser, Petroleum imports have been expanding to the degree more than enough to offset the decline in non petrol imports. Said differently, US consumers have been materially buying less of foreign goods and have been paying more for oil products!

Remember, US export growth has been relatively strong in the face of today’s tribulations and has cushioned its economy from massive deterioration. And the continuity of such conditions requires a robust pace of export growth which emanates from a vigorous clip of external demand expansion.

Perhaps Mr. Bernanke thinks that if a decline in the Petrol deficits without the accompanying improvement in non-petroleum deficits translates to a slowdown of global demand for US products then the US economy faces the risks of a deflationary collapse! Put differently the US is in a life support system presently sustained by its monetary policy induced externally generated inflation process!

And this could be the reason why US Treasury Secretary Henry Paulson recently made rounds to the Gulf states telling them that abandoning the (currency) pegs “will not solve their inflation problems” (CBSMarketwatch).

Of course, the mirror view is that a US deflationary bust will extrapolate to a global depression (as repeatedly advocated by some)!

In effect, the implicit impact from the policies assumed (or of keeping rates on hold) by Mr. Bernanke & co. is to maintain a weak dollar, high oil price, and continued monetary inflation from the world feeding into the US economy by shoring up its exports in the hope that the latter will offset it from a deflationary collapse.

Maybe if all the above measures cease to work then the last ace for Mr. Bernanke would be to expand the Fed’s balance sheets by printing money or otherwise the US economy could succumb to deflationary recession!

Bernanke In Hot Seat, Imbalances As An Offshoot To Consenting Nations

Yes, Mr. Bernanke is in hot seat as the Federal Reserve for the first time in US history is due to undergo scrutiny from the IMF. According to Der Spiegel’s Gabor Steingart (highlight ours),

``Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF's board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

``As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests -- worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

``Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members -- but never the United States -- have already endured this painful procedure.”

It is likely that many countries have seen how US policies have unduly been impacting the world (through higher consumer goods and services inflation), thus the IMF could be applying pressures to the US to adopt a more global centric policies (speculation for me here). Of course, adopting currency pegs is a national determined policy, which means today’s imbalances is a product of “consenting states” or playing within the unwritten guidelines of the US dollar standard.

In finality, Mr. Bernanke’s recent policies have resulted to a general market tumult: a big decline in global equity markets, a rally in US Treasuries, a fall in global sovereign bonds, a retreat in US dollar index, and a massive rally in major commodities. Mixed signal in all.

No, this week’s decline isn’t all deflationary...

Table 1: Bigcharts.com: Commodity Indices Outperforms!

Not for the moment in the US anyway…

Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation

``Since the function of government in issuing money is no longer one of merely certifying the weight and fineness of a certain piece of metal, but involves a deliberate determination of the quantity of money to be issued, governments ..., it can be said without qualifications, have incessantly and everywhere abused their trust to defraud the people." Friedrich von Hayek, Denationalization of Money

The Philippines Phisix got afflicted with dengue fever even before the US caught cold.

Figure 6: courtesy of stockcharts.com: Phisix Underperforms The World!

Yes, world markets of late have been going down, but our Phisix have been totally battered or have underperformed relative to its peers see figure 6.

The Phisix is down against its neighbors as gauged by the Fidelity Southeast Asia fund (FSEA-at main window), it is also down against MIDDLE EAST and AFRICA (SPDR S&P Emerging Middle East And Africa-above pane), it is down against Asia ex-Japan (pane below main window) or relative to Emerging Markets (lowest pane)!

So what is going on?

As we previously discussed in Phisix: Domestic Participants Panic! Bottom Ahoy?!, the principal activities in the Philippine Stock Exchange has seen a marked shift from formerly massive foreign selling to an onslaught of impulsive retreat by undiscerning local players.

Yes, this time with foreign participants relegated to the sidelines, local investors continue to stampede out of the PSE!

Foreign participants constituted only 43% of the week’s transaction EXCLUSIVE of the Php 4.738 billion special block sales of Globe Telecoms with Net foreign selling amounting to a scanty Php 176 million.

If we include the special block sales of Globe Telecoms the net foreign buying balloons to P 4.49 billion but foreign trade as pc (%) of total trade increments to only 44%. On Wednesday the 25^th foreign trade accounted for only 30% of the overall trade. The seeming material reduction of foreign trade leaves the Phisix vulnerable to highly impetuous local players who don’t seem to know what is happening.

Reading the ASIAN Yield Curve, The Inflation Bogey

Figure 7 Asianbondsonline: ASEAN Yield Curve

Figure 7 courtesy of ADB’s Asianbondsonline.com depicts of the yield curve of ASEAN sovereign bonds.

For starters, on the Y-axis is the bond yield in %, while the tenor or the maturity in years is found on the X axis. The connected dots signify the yields of the sovereign bonds spread into years.

According to the Federal Reserve Bank of San Francisco, ``The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future. The shape of a yield curve also may provide clues to future interest rate movements—a humped curve indicating that short-term rates (over the next year) are expected to rise, but that over the long-run (several years) rates are expected to fall. The overall level of the yield curve also may shift up or down—at least in part because of changes in inflationary expectations over time.”

So by virtue of the yield curve, we can determine the market’s expectation of economic growth, prospective policy/-ies or inflation expectations that could ascertain the direction of the interest rate movement of a security or in this case of a particular country.

Unfortunately, while we can see the slope, shape and the steepness of the curve, we don’t see the shifts or movements of the curve from its previous position/s.

These are what we can deduce from the ADB yield curve picture.

One, the odd man out-Vietnam manifests of a significantly higher short term rates over long term rates. This implies that the market expects a tight monetary policy to be applied following a surge in inflation figures or expectations. Moreover, the humped or inverted curve also signifies the risks of a potential drastic economic slowdown or even a looming recession.

Two-Indonesia and the Philippines has a steeper sloping yield curve which is an example of how financial markets could be anticipating higher future interest rates arising from either higher inflation expectations or higher growth rates. Note that Indonesia has higher spreads and has a steeper slope which translates to even higher inflation expectations (or growth) relative to the Philippines.

Question is if the inflation has been the purported scourge to Asian markets why has Indonesia JKSE’s significantly outperformed the Phisix down only 15.06% (year to date) compared to the Phisix which has lost 31.90%? This week the Phisix lost 4.35% vis-à-vis JKSE’s -1.67%!

Three-the rest of the region shows of flat curves, which means a small premium in holding longer dated securities or possibly that the financial markets could be unsure of the risks of inflation as a major concern enough to impact the present economic growth.

Except for Vietnam, it seems that the Asian bond markets appear to be saying that inflation threat looks more of a bogey than a reality YET.

The Deflation Phantom, Real Risks Lies In Stagflation

Next, as we have repeatedly argued in Global Depression: A Theory Similar To A Horror Movie?, A Global Depression or Platonicity? II, A Global Depression or Platonicity?, the possibility of a deflation laced global depression on the Philippines or in much of Asia or emerging markets are significantly LESS likely.

Figure 8: ADB’s Managing Cities: Relative Size of Informal Economy

Why? A substantial segment of the emerging market economies thrives on the informal economy. For the Philippines, think of the ambulant vendors- Balut, cigarette or sampaguita; stall vendors- small eateries (carinderias or canteens); rolling store vendors-ukay ukay carts or fish ball or ice cream vendors and other home based business.

According to Asian Development Bank, ``Asian countries and their cities, in particular, have large informal economies. The growth of the informal sector is a rational response to economic opportunities, given the factors limiting entry into the formal sector. Informal housing investment and the use of the home to generate income reflect market realities. Furthermore, the distinction between the formal and informal sectors is often blurred where, for example, householders can work in one sector but live in another. In economic terms, the informal sector is a competitively remunerated population that has decided to live outside of the regulations of the formal sector because of its high transaction costs. The informal sector is the lifeblood of many Asians. Statistics on the informal economy are difficult to obtain and often unreliable. Nevertheless, a recent report shows that in 26 Asian countries, the informal economy contributed an average of about 26% of gross national product (GNP) nationally. The study estimates that the Central Asian republics have the highest proportion of GNP generated by the informal sector, while Bangladesh, Nepal, Philippines, Pakistan, Sri Lanka, and Thailand have more than one third of their GNP produced by the informal sector.”

Much of these informal sectors do not depend on banks or capital markets for access to financing nor do they depend on assets for collateral. Economist Hernando de Soto even identifies the Philippines as one of the representative nations plagued with “dead capital” (Mystery of Capital), or the inability to securitize (property) assets for capital raising or as collateral purposes.

In fact, based on empirical evidence, most of my neighborhood enterprises today avail of the micro financing of “5-6” or 20% interest rates a month (!) from mostly local based ethnic Indians or through some Pinoy moneylenders, which I think is a very popular source of informal financing for micro enterprises (Kyotoreview).

In addition based on the last Asian Financial crisis, while the liquidity crunch in the domestic money system had some impact to the informal sector (e.g. rising inflation/loss of purchasing power from Peso devaluation, increased incidences of non payment, etc…), this was easily covered by overseas Indians who extended financing to the local affiliates or relatives who were engaged in microfinancing via “5-6 schemes”, the growth of alternative financing methods called “Paluwagan” (mutual scheme of rotating savings) or the “Hulugan” (selling based on installment payments) and from Local government units via livelihood linked lending schemes (iadb.org- Prof. Mari Kondo, Asian Institute of Management, The Preliminary Findings on the Impact of the Asian Financial Crisis on Microfinance Institutions:A Case on the Public Market in the Philippines).

So the risks for emerging market economies seem likely to come from a stagflationary environment than from a deflation contagion.

Stocks As Inflation Hedge

Finally while the external environment looks quite hostile at the moment, we should think of this as windows of opportunities than simply join the ranks of the lemmings to the tune of the fabled Pied Piper of Hamlin.

US money policies are being circulated worldwide via low nominal interest rates or negative real rates as espoused by many central banks, this ensure a loss of purchasing power for the currency holder under this regime. According to Joachim Fels of Morgan Stanley, around 50 countries or one in four countries in the world are plagued by double digit inflation! This means that many countries are behind the curve in neutralizing domestic inflation.

Under this environment, whether you are in cash, bonds or in stocks most of the public have been losing money, directly (stocks or bonds) or indirectly (cash). Because inflation is a stealth tax against the country’s productive capacity, this loss of purchasing power is seen and felt via rising prices of goods and services. The natural beneficiaries are those who inflate the system (government).

The best insurance is to partially diversify into stocks because equity investments can account for as a store of value since they mostly represent storehouse of assets. Of course, not all stocks are cut from the same cloth.

In Vietnam, because of high inflation rates and the government’s constant intervention in the stock market to prevent its fall (down 67% after skyrocketing by over 7 times!) the public has sought protection in gold making it the largest gold market in the world. Yet the Vietnamese government, in order to maintain the faith of the public to its currencies, has barred gold imports.

This from Professor Michael Pettis of Peking University's Guanghua School of Management,

``Apparently, and in order to protect themselves from inflation, so many Vietnamese are buying gold that Vietnam has suddenly overtaken China and India as the world’s largest market for gold bullion. This orgy of gold buying has, of course, worsened Vietnam’s trade deficit, although I would argue that gold imports for investment purposes should be seen more as a reduction of the capital account surplus than an increase in the current account deficit, but either way it represents a drain on reserves. Although gold imports are regulated, until the suspension Vietnamese gold imports had soared. Gold imports for the first quarter of 2008 were up 71% over the same period last year, and imports of gold bar (which of course is what gold investors typically buy) were up 110%. I have said many times in this blog that I suspect that if we see problems with inflation or capital flight in China, one form these are likely to take are through gold purchases.”

If the Vietnamese understands that the insurance to the loss of purchasing power can be hedged by gold purchases, what does Filipinos understand as an inflation hedge? Politicians? The US dollar?

You can just see how the US markets reacted to the recent downfall in its equity markets last week…a corresponding surge in gold, gold mining and general mining stocks (revert to table 1)!

In addition, what do you think would happen to gold prices if Prof. Pettis is right, where 1.3 billion Chinese flee to gold as an insurance against inflation?

Anyway, in this cyclical bear market period whose bottom I think should be nearing, the following companies account for the highest dividend yields based on PSE’s April closing (source PSE monthly).

National Reinsurance 11.34%, PNOC-EDC 7.1%, Salcon power 20.5% First Gen 7%,Ginebra San Miguel 8%, Tanduay Holdings 7.45%, Holcim 6.18%, Anglo Phil 6.94%, Cebu Property Venture 6.25%, Polar property 6.35%, Aboitiz transport system 25% Republic Glass 8.82%, Pldt 8.74%, Globe Telecoms 8.86%, Asian terminals 7.27%, Far Eastern University 2.46% and Semirara Mining 8.16%.

Meanwhile, the Phisix has a dividend yield (annual dividend/ price per share) of 4.32% and 3.63% for the total market. Besides, April’s Price to Book Value for the Phisix is 1.77 while the Price Earnings Ratio is 12.29. With the Phisix down by over 10% as of Friday’s close relative to last April, this should pump up the figures of present dividend yield aside from depressing the PBV and PE ratios.

Many of the dividend yields have nearly caught up with present inflation rates (9.6% in May), or are nearly at par with benchmark 10 year Peso bonds (currently 9.496% as of June 27^th-asianbondsonline).

In short, the lower the Phisix goes the more attractive these yields offer relative to fixed income while the risks aspects into stocks diminishes.

Norway’s Krone: An Embodiment of A Reserve Currency?

Economist Paul Kasriel of Northern Trust recently opined that the Norwegian Krone could be the next currency reserve.

Courtesy of Northern Trust

Given that the Norwegian Central Bank recently continued with its monetary tightening measures by raising interest rates even amidst signs of an economic slowdown, ``That puts the Norges Bank’s policy rate 293 basis points over the May year-over-year CPI inflation rate on a harmonized basis. Notice that the Norges Bank was raising its policy rate in the first half of 2007 as the inflation rate was falling. The Norges Bank is offering savers an “honest” return on their funds. Isn’t this what you would look for in a reserve currency’s central bank?” remarks Mr. Kasriel.

What Mr. Kasriel means is that unlike the conventional practices of many global central banks including the de facto world reserve currency, the US dollar represented by the US Federal Reserve, Norway’s Krone offers positive real returns or a premium over inflation or the embodiment of an equivalent sound money policy in operating under today’s paper money standard landscape.

Well, the Norway Krone is likewise a bet on the natural resources like oil exports which accounts for about 51% share of total exports or 25% of the country’s GDP in 2006 (Norwegian Petroleum Directorate).

Anyway the Krone is up by about over 35% since 2003 see yahoo chart above.

With oil at trading at near $140 could we be seeing more upside for the Krone?