Market Talk on Select Philippine Energy issues: Refinancing Woes or Available Bias?

Recently because of the poor performance of some locally listed energy issues, we were asked of the opinion of why this has been so and if we agreed with a study of a domestic broker on the notion that the recent share price decline have been prompted by 1) the question of having to raise money in today's environment given the scale of the company's refinancing requirements and 2) the falling value of the equity collateral of its recently acquired subsidiary which mandates the said company to raise funds to cover such deficit.  

Some FACTS first:

1.    These issues have been on a downtrend since October last year, which basically reflects overall market decline. 

2.    Since the advent of the credit crisis, foreign selling has dominated the selling side 

Our observations:

One, the study has been ambiguous in the order of causality: have the decline of share values in the said issues been "causing" debt refinancing problem, or has debt refinancing woes "caused" the losses in its share prices? 

Two, given the "facts" above, we really doubt if the declining trend had been all about debt refinancing. The Phisix bear market has been due to net foreign selling which has been a broadmarket affair since the credit crisis surfaced. And as we have been saying it is the deleveraging dynamic that has been the vicious knot that ties the miseries of global markets. The debt refinancing issue has only been recently raised.  

On our end, the thesis of "debt refinancing woes" could be based on sheer speculation than of genuine concerns.

Three, while there has indeed been some spillover of the credit woes to Asia, this hasn't totally sucked liquidity out enough to squeeze the Asian or Emerging Market sovereign or corporate debt markets. 

According to Christian Monitor: "Dutch bank ING has calculated that $111 billion worth of emerging market bonds must be refinanced during the next year. But credit is tight. That's raising doubts about whether corporate borrowers will be able to refinance their loans.

"I don't think we'll see a sovereign debt default problem," when a country can't repay its loans, says Mr. Das. The focus will instead be on banks and "companies that have been major issuers into the credit bubble."

"He says, "Russia, Kazakhstan, and Ukraine had a number of banks issuing debt. They haven't all lost access [to credit], but if even Gazprom is having to pay higher [interest rate] spreads [on loans], you can be sure that the weaker names will continue to have a much harder time getting bond deals done.""

Another, it seems the loan market in Asian remains vibrant, click on FinanceAsia article.

Fourth, the underlying business models of these companies generate immense cash flows. Thus, the problem won't necessarily be about the access to debt but instead to the cost of debt.  This means the high cost of financing (assuming the tight credit environment) risks taking a bite out of the company's earnings or bottom line.

Having said so this bring us to perspective of the company's solvency; will the "high" cost of debt refinancing render the company insolvent? Unlikely in my view.  And since the problem is NOT one of INSOLVENCY, thus, the controversy over the company's refinancing could be seen as "rationalization" (looking for excuses to justify present market action) or Available Bias (the use of current events to explain market actions). We think that the company will easily find a lending window given its generally feasible business model.

Fifth if the company is faced with any risk, it could emanate from the political front (populist policies), as the owners of the said companies have been seen as political foes.

All told we adhere to Edwin Lefevre's advise (truism), "In a bear market all stocks go down and in a bull market they all go up...I speak in a general sense."  

CDS Market: Is the US Dollar Losing Its Safehaven Status?

In Global Markets: From “Minksy Moment” To The “Mises Moment” we pointed out that despite the massive “flight to safety” as seen by US Treasury bills which almost yielded to nothing during the recent riot in the global credit and equity markets, credit default swaps on US debt have reached record levels! 

From the Liam Halligan of Prosperity Capital published at the Telegraph “Financial crisis: Default by the US government is no longer unthinkable”

 

This is a very compelling picture which shows of the real emerging risks of a default by the US government on its snowballing debts as it is being compounded by the systemwide rescue of the financial sector.

 

Likewise it puts to question the foundations of the US Dollar as a “safehaven”.

Global Markets: From “Minksy Moment” To The “Mises Moment”

``In their haste to be wiser and nobler than others, the anointed have misconceived two basic issues. They seem to assume: (1) that they have more knowledge than the average member of the benighted, and (2) that this is the relevant comparison. The real comparison, however, is not between the knowledge possessed by the average member of the educated elite versus the average member of the general public, but rather the total direct knowledge brought to bear though social processes (the competition of the marketplace, social sorting, etc.), involving millions of people, versus the secondhand knowledge of generalities possessed by a smaller elite group.-Thomas Sowell, "The Vision Of The Anointed: Self-Congratulation as a Basis for Social Policy"

It has been a most eventful week! Looking at the end numbers won’t do justice to the drama that had unfolded. And we should expect this to continue. And for the first time, even Philippine broadsheets highlighted the ruckus in the global financial sphere on its headlines, giving the oblivious public the opportunity to attest of the ongoing dynamics at the “macro” framework of global finance. Unfortunately, many of these reports only focused on the “surface” than of the “genuine” pressures which has been rattling the “core” of the system.

None of these have been new to us. We’ve dealt with the risks of evolving finance (structured products, derivatives, etc…), since we became bullish in GOLD in 2003 (The Rip Van Winkle in Gold series.)

Warren Buffett’s Philosophical Victory

We even subscribed to the views of Mr. Warren Buffett, the world’s premier investor, on his advocacy against the menace of newfangled exotic financial products or as Mr. Buffett has repeatedly warned, the “financial weapons of mass destruction” (see Figure 1) and of the follies of “squanderville” economics or conspicuous debt driven consumption as manifested by US current account deficits in November 2003 Fortune Magazine “America's Growing Trade Deficit Is Selling the Nation Out From Under Us”.

Figure 1: US Global: Derivatives In Perspective

And as always and contrary to the mainstream, in the fullness of time, Mr. Buffett has once again been utterly validated. As a reminder, Mr. Buffett’s themes have almost always materialized from a LONG term and NOT ticker (short term) based perspectives, as commonly espoused by the public.

And recent events only have only reinforced such theme where market forces have been wracking at the pillars of the much maligned world’s monetary (financial) system.

And this has not just been foretold by Mr. Buffett but also by the Austrian School of Economics.

The “Minksy Moment” At its Finest

“Minsky Moment” has been coined by the distinguished UBS Economist George Magnus. It refers to the illustrious American economist Hyman Minsky (1919-1996) who is known as the father of Financial Instability Hypothesis, from which he gained popularity over the theory of “stability leads to instability”.

In our August 2007 article, Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?, we described Minsky’s credit cycle as,

``Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).”

Or said differently, complacency tends to foster greed, via the transition mechanisms of the credit cycle where people imbue more risks by adopting unsustainable arcane credit instruments, which eventually culminates to a break point known as the “Minsky Moment”.

So the perturbation you have been witnessing from today’s financial sphere is exactly how the late Minsky described all these to be; the diverse alphabet soups of highly leveraged complex instruments-slice, diced and repackaged, stamped with investment grade ratings by credit rating agencies and sold to investors all over the world.

Banks and Investment Banks which traditionally held on the mortgages they underwrote and took the underlying credit risks morphed into “originate and distribute” models from which disseminated credit risk to investors, who instead of conducting their own credit scrutiny to establish the viability of these products, almost entirely depended on the seal of approval from credit rating agencies. For global investors faced with a “savings glut” and institutional requirements to match investments with liabilities, in behaving like lemmings, it became an “in” thing to get into these papers on the assumption they were safe as determined by the Credit Rating Gods.

With capital freed up from warehousing credit risk, these institutions worked to assume more risk by the extension of credit facilities to a wider scope of the population who were less creditworthy or “subprime” on ultra-favorable loan terms in order to generate additional returns via the economies of scale.

Moreover, these institutions piled into more dubious loans from the real economy (real estate mortgages) which were recycled with more leverage and wrapped into complex financial labels into the financial economy underpinned by the creation of off balance sheets vehicles (SUV) from banking institutions from which emerged the Shadow Banking system. Aside, derivative instruments as credit default swaps (CDS), originally meant as an insurance against company defaults was likewise utilized as another tool for obtaining leverage (CDS issuance vastly greater than underlying bonds), whose mind boggling size further enhanced counterparty risks.

Thus, the full scale transition towards the Ponzi structure.

Who can forget the infamous quote from Citibank’s Charles Prince, ``But as long as the music is playing, you've got to get up and dance. We're still dancing.” Yes, almost every participant knew this was bound to happen, but assumed that they could get out ahead of the others. Unfortunately like cartoon character Wily E. Coyote, who runs off the cliff and keeps going on until he looks down and realizes that he’s been running on air, the industry plunges to the ground!

Nonetheless when the Minsky Moment emerged, the risk distribution on an international scale revealed that risk weren’t really reduced but instead, as vividly shown last week, had been spread and became the source of the tremors which rippled throughout global markets.

From the effects side, Minsky was absolutely correct. Stability created conditions for greed which allowed for more risk taking appetite backed by a pyramid of unsustainable gearing.

The Emergence of Mises Moment?

We have been saying for so long that the entire premise of today’s suspenseful episode has been centered on the structure of the prevailing monetary system- the Paper Money US dollar standard operating on the fractional banking reserve platform as defined by wikipedia.org as ``only a fraction of their deposits in reserve with the choice of lending out the remainder while maintaining the obligation to redeem all deposits upon demand.”

It means that it is the intrinsic nature of global central banks to foist boom conditions derived from leveraging (modeled after the banking system) or by means of expanding money and credit to the point that it becomes unsustainable. From which the ensuing bust will tend to prompt liberals or interventionists to unjustly brand such cyclical inflection as “market failure”, when market forces had been repeatedly tweaked and distorted to the extremes by constant policy based interventionism.

Besides, had there been automatic adjustment mechanisms meant to curb excesses by allowing market forces to determine the resource allocation process (e.g. gold standard), boom bust scenarios would have greatly been reduced.

Unfortunately while many articulate voices cite the lack of regulation or its ineffectualness, a large part of this laissez faire blaming has not been consistent with reality; this noteworthy quote from George Mason University Professor Tyler Cowen from the New York Times (highlight mine),

``But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That’s dysfunctional governance, not laissez-faire.

``When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act.

``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.”

We’d like to add the implicit guarantees of Fannie & Freddie Mac and Community Reinvestment Act of 1977-forcible lending to minorities as additional unintended consequences to the present boom bust scenario. Of course as we earlier brought up, the most compelling dynamics of the recent tragedy arose out of the policies to expand credit or money.

At this point, events are proving to be strongly in transition towards our “Mises moment”,

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

Our “Mises moment” assumes that governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.

Why?

Because for governments, credit is the only panacea for any economic or market ailment. This from Ludwig von Mises from Human Action, ``Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

“Too big to fail or too interconnected to fail” has been the overwhelming justification for recent government actions to inject massive doses of credit into the global financial system for the implicit aim to stave off a financial meltdown. Of course, with it comes the unintended consequences which will reveal itself overtime.

As for “inflationary” credit expansion, here is a list of the recent activities…

-The US took the Fannie Mae and Freddie Mac into conservatorship ($200 billion).

-The US rescued its largest insurer AIG with an $85 billion in loan package (three-month Libor plus 850bp) collateralized by its assets with the US government assuming 79.99% in equity through warrants and has the right to veto payment of dividends and preferred shareholders in condition that it pay the loans by orderly liquidation of its assets.

-The US through in coordination with global central banks have made available nearly $300 billion ($180 initial and $100 additional) for short term loans (New York Times) see figure 2.

Figure2: Wall Street Journal: US Running the Printing Press To Save the System

-U.S. will insure money-market funds from a backstop of $50 billion from an emergency pool (Exchange Stabilization Fund) against losses for the next year as it seeks to prevent a run on $3.35 trillion of assets that average investors and institutions rely on as a safe alternative to bank deposits. (Bloomberg and Wall Street Journal)

Other prospective courses of actions include the following (From Danske Bank):

“-Setting up an entity that would take bad assets off financial companies’ balance sheets: As in past financial crises the plan is to set up a fund that could take over troubled assets from the balance sheet of financial companies. This is in many ways similar to the RTC fund set up during the savings and loans crisis.

“Such fund would create an investor of last resort in troubled assets and remove the significant black box element from balance sheets of banks. In turn, this should increase downside visibility and thereby confidence among banks.

“-The creation of federal insurance for investors in money market mutual funds: As investors have become increasingly worried about money market mutual funds, otherwise thought off as one of the safest investments, insurance akin to the one currently safeguarding bank deposits could hinder a massive outflow from the money market funds currently under scrutiny

As of this writing, the US Treasury has appealed to its Congress to be granted with $700 billion to buy on a carte blanche basis ``bad mortgage investments from financial companies in what would be an unprecedented government intrusion into the markets.” (Bloomberg)

Will Systemic Socialization Be Successful?

With the US Federal Reserves finally opting to expand its balance sheets, the response from the gold market has been breathtaking as it has been with global equity markets, see figure 3, but to a lesser extent.

Figure3: stockcharts.com: Gold Smells Bloody Inflation!

The extraordinary run up in gold prices comes even in the face of the raising of margin requirements on Comex gold and contracts by 47% and 20% respectively. (Bloomberg) This is another sign of government intervention to halt spiraling precious metals. Notice that the turn in the US dollar index could mark an inflection point.

Again this hasn’t been unexpected since we noted in our June article, Global Financial Markets: US Sneezes, World Catches Cold!, “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!”

Obviously with the recent accentuated downside volatility in the equity markets, aside from the freezing of the credit markets, Mr. Bernanke’s (aside from Treasury Secretary Paulson) actions reflected the aura of desperation enough to utilize their last ace; the shifting role of the US Federal Reserve from a lender of last resort to a BUYER of last resort or the socialization of the important aspects of the US financial markets, which was once the embodiment of modern capitalism!

Many have argued that the socialization of the financial sector is needed to save the system. We aren’t so sure.

Why?

-Prohibition of short sales has temporal effects. As we argued in our recent post Will The Proposed Ban of Short Sales Support Global Markets?, a ban of short sales is a form of price control which inhibits price discovery and leads to even more inefficient and volatile markets. Instead, since socialization seems to be the thrust why not simply ban the stock market altogether?

-It is unlikely for the US to save the entire banking industry or let alone the $47 trillion debt markets.

-Government will essentially compete with private funds for financing affected or bailed out or “nationalized” institutions. Aside from the risk of driving up interest rates, it could lead to more inefficiency in capital allocation within the economy resulting to a loss of productivity.

-Since the US government is entirely reliant on foreign financing (about $2 billion per day), it may be at the risk of having difficulty to borrow or raise money for its funding requirements.

As an example, just last week even when US treasury yields where at historic lows from the credit seizure, credit default swaps (CDS) on US treasuries rose to its highest level! From Reuters, ``Credit default swaps on 10-year Treasury debt widened to a fresh high of 27.9 basis points from 27.7 basis points late on Thursday, according to CMA, a specialised data provider.”

Figure 4: Casey Research: Foreigners Pull Plug on Dollar Recycling?

The Fannie and Freddie debacle led to an outflow or significant sales in agency holdings by major foreign public and private institutions last July (CBS marketwatch). Although some portion of the sales had been offset by inflows into US treasuries, which seemed as the only asset the foreigners were willing to buy, aside from the reduced net purchases of foreign assets by US residents, which equally reflected the forcible liquidations abroad, it wasn’t enough to account for to reverse the net outflows.

Overall, in times of heightened risk aversion, state owned Sovereign Wealth Funds or central banks don’t seem to be totally immune to the previous conventional pursuit of the acquiring US dollar assets (or recycling dollars) for political objectives as seen in Figure 4.

What this means?

It raises the risk of the skepticism over the viability of the “full faith and credit” upon which the US dollar and the world’s monetary system has been founded upon.

While we are seeing some participation of forex currency reserve rich countries as China in the ongoing negotiation to acquire distressed US financial companies as the brewing CIC-Wachovia- Morgan Stanley deal (newsdaily.com), it isn’t clear that the previous incentives for foreign financing will always remain the same.

Besides, it would necessitate a substantial portion of the US assets to be acquired by foreign investors, if the present system is to be maintained, which implies a shift in the balance of geopolitical power.

Yet, we appear to be seeing some signs of cracks on the seemingly inexorable faith over the US dollar system…

From the New York Times (highlight mine),

``The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia.

“I do not believe in U.S. financial institutions anymore; I don’t think any U.S. bank is safe anymore,” said Wang Xiao-ning, a Hong Kong homemaker. Even after the Federal Reserve had taken control of A.I.G., she waited in line with dozens of other anxious policyholders at one of the insurer’s customer service centers for the chance to close her investment account….

``Changing Asian sentiments have not yet eroded the value of the dollar — although market reaction to the A.I.G. bailout seemed to be doing that Wednesday. Asian skittishness has coincided with heavy selling by Americans of their holdings of stocks and bonds in foreign markets.

``“It’s almost a case of everyone bringing money back home,” Americans and Asians, said Ben Simpfendorfer, an economist in the Hong Kong office of Royal Bank of Scotland.”

This implies that the US has been more at the urgency to bring home its currency enough to have prompted for the recent US dollar rally, which evidently had been indications of the deleveraging process.

However, as Asians may become more skeptical, they could begin entertain the idea of possibly reallocating more of their investments to ex-US dollar denominated investments or tangible assets, albeit the alternatives aren’t large and liquid enough.

For Asians to withhold if not abandon the US markets in exchange for other potential markets would be a disaster for the US.

And it is not just in the financial world but also seen in migration flows.

From AsianInvestor.net, “We are seeing not only ethnic Asians seeking to return to Asia from Europe and the US, but also professionals without any personal link to Asia,” says Executive Access’ Eisenbeiss. “Asian markets still offer more opportunities than elsewhere for selected, experienced professionals.”

Does this represent an unwarranted concern? Not if you ask New York Mayor Michael Bloomberg, from Hedgeco.net, ``"Who’s buying our debt? It’s these overseas funds, these sovereign-wealth funds, these overseas hedge funds. They are in trouble now. So it’s not clear who is going to be buying" US Treasury bills, he said.”

Some Mises Moment Scenario

So what do we see from the Mises moment?

More US assets will probably be acquired by foreign institutions unless the US government resorts to increased financial protectionism. Yet there is could be a political policy dilemma over the prospective crossborder acquisitions of key US industries, as Brad Setser rightly points out ``Bailing out US banks is one thing. Bailout out a Chinese-government-owned US bank is another.” With more of the foreign buying of US distressed assets, the balance of geopolitical power would have clearly shifted. Yet if state owned institutions were to take such a lead role then, we could be seeing nationalization of US assets from governments abroad.

It is likely too that on the account of massive dosages of central bank money for rescue programs, the prospects of “higher inflation” could be signaled by the continued rise in gold and precious metals.

Furthermore, the US dollar may be pressured from government instituted policies that is likely to weigh on the fiscal equation. We cannot compare the past experience of nationalizations simply because the scale of government intervention will likely be the largest the world has ever seen.

With government weighing in heavily on the markets, the rules have been changing almost daily to the point of triggering credit events for CDS, which means even more losses.

Now, if the degree of US financials systemic losses are much more than anticipated by the regulators, then I think the appropriate question to ask is, who will then bail out the US treasury and the US Federal Reserve?

Phisix: Throwing The Baby Out of the Water

``An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.”-Winston Churchill

The recent selloff in most of the global equity markets has led some doomsday proponents to pronounce the toxicity of the emerging asset class as evidence by a drop in global forex reserves. They believe that a paucity of liquidity compounded by a US recession would lead to collapsing asset classes or some form of a crisis in emerging markets.

Unfortunately we can’t be convinced by such deflationary recoupling scenario promoted by perma bears simply because such argument has been predicated on the “fallacy of composition” or the generalization of the whole when it is only true for some its parts.

For instance, in the case of Russia which had been used as an example, which we recently also posted in An Epitome of A Full Scale Bear Market:: Russia, the country’s problem has been mostly from the political imbroglio where it got into a military engagement with neighboring Georgia. A compounding factor had been the liquidity crunch and falling commodity prices.

We aren’t seeing the same dynamics here in the Philippines.

Emerging Markets Are Not The Same

As we have repeatedly been arguing, for the Philippines it has not been about the question of risks from a recession, overleverage, oversupply, overvaluation, excessive speculation, stifling new government regulations or taxes, war, or even insolvency as seen in the case of the US or other developed economies.

Nor is it in Brazil whose housing or property industry remains sizzling hot according to the Business.view of the Economist.

For the Philippines despite the announcement of several banks with exposures to the Lehman bankruptcy, we had been right to say that the potential loses from these ‘toxic’ US instruments had been inconsequential relative to the banking industry’s capitalization or assets.

This from the inquirer.net (highlight mine),

``Seven banks in the Philippines have a total of $386 million in exposure to bankrupt US investment banking giant Lehman Brothers, according to the central bank’s estimates, but the banking system is widely believed to be in a good position to withstand the world’s worst financial shake-out.

``Even assuming zero recovery of their exposure to Lehman, the fallout for the seven banks is not expected to exceed one percent of their total assets.

``According to estimates by the central bank, Bangko Sentral ng Pilipinas (BSP), obtained by the Philippine Daily Inquirer, the retail tycoon Henry Sy’s Banco de Oro Unibank has the biggest exposure to Lehman at $134 million, followed by state-owned Development Bank of the Philippines (DBP) at $90 million.

``The BSP data show Metropolitan Bank and Trust Co. (Metrobank) has an exposure of $71 million, Rizal Commercial Banking Corp. (RCBC) $40 million, Standard Chartered Bank’s Manila branch $26 million, Bank of Commerce $15 million, and United Coconut Planters Bank (UCPB) $10 million.

``As a percentage of total assets of the individual banks, the exposures are as low as 0.5 percent and as high as 1.7 percent, according to the estimates, which were discussed at a meeting of the BSP policymaking body, the Monetary Board, on Thursday.”

As we have pointed out the main risk from the external link would come from the extent of foreign selling of domestic assets on the account of today’s mostly US based ‘deleveraging’ process. While there could still be some exposures to ‘tainted’ US financial instruments that may implode in the future, our idea is that this is likely to be material to impact normal business operations of the local banking industry.

Moreover, if some of the estimates are correct that over 50% of portfolio flows to Asia has been redeemed (as pointed out last week) then we are most likely to have seen the worst of the depressed foreign sentiment which leaves us with sympathy selling.

Figure 5: PSE Net Foreign Selling

The Phisix suffered its second worst week of the year which lost 6.93% compared to the week that ended January 18^th which accounted for a 9.57% loss. But relative to the degree of foreign selling, (see figure 5 orange arrows) the amount has been less intense compared to the similar circumstances when the Phisix had been subjected to the same fate.

In fact, last Thursday, which likewise accounted for a 4% drop following a similar decline in the US markets, the Phisix saw significant reduction of foreign selling to the tune of only Php 256 million compared to the daily range of Php 500-950 million a day during the past 2 weeks. This leaves us to hypothesize that mostly momentum driven domestic retail investors “threw out the baby with the bath water” in panic!

Of course, we are not saying the Phisix is riskfree or immune. Any risk from the Phisix would likely come from the political spectrum, if not from inflation or higher food prices, which so far have begun to decline. Of course, the recent concerted central bank pumping of liquidity into the global markets may reverse this decline. But if the global equity asset classes manage to absorb these injections, then the increase in consumer inflation could likely be gradual.

Debating Keynesian Concepts

Besides, we don’t buy into the Keynesian connection that consumer spending drives the economy which leads to the myth that the wilting US consumers will automatically lead to a bust in the emerging markets. As Gerard Jackson of Brookesnews explains, ``consumer demand springs from production, meaning you cannot consume what has not been produced. Therefore when consumers demand goods they are in effect exchanging what they produced for the products of other consumers. This is why the classical school considered money to be a veil that concealed the process of production and exchange from the public eye.”

The notion of a consumer driven economy actually stems from monetary inflation which has a detrimental effect in shaping an economy’s capital structure, to quote Gerard Jackson anew, ``Monetary manipulation not only severely distorts a country’s capital structure by misdirecting production it can also lead to the currency being overvalued which in turn could induce some manufacturers to shift operations offshore when undistorted marketed conditions would have persuaded them to remain in the US”.

And if trade or current account balances signified of the symptom of inflationary monetary policies, then the Phisix hasn’t been in the same shape or conditions as the US enough to unjustly merit a “toxic” grade. Moreover, based on the account of real savings or savings from the actual stuff we produce, the Philippines with its large informal economy equates to a cash based society with minuscule leverage applied, meaning much of our economy has been based real output than from the influences of distortive monetary policies.

Besides, much of the angst from the past Asian financial crisis still lingers, as evidenced by the minimal exposure of the banking system to rubbish US papers and conservative lending schemes by the banking system.

Moreover, valuations in Asia ex-Japan have nearly fallen to its multi-year “floor levels” which may translate to a looming bottom, see figure 6.

Figure 6: Matthews Asia: Asia’s Valuations Near Extreme Lows

To quote Robert J. Horrocks, PhD of Matthews Asia, ``the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.” (highlight mine)

Like Mr Robert J. Horrocks, we have often stated that the decoupling recoupling debate is nothing but an invalid abstraction detached from the reality of the globalization process. And that from a valuations viewpoint, Asia has reached extreme lows and apparently has become detached from the real economy.

So while there might be additional sympathy selling pressures arising from the impact of the US financial crisis, this could be seen as opportunities from the facets of margin of safety to accumulate than to join the bandwagon of running for cover. Because markets are emotionally driven over the short term, they can always overshoot to the upside or the downside.

Recommendation: A Tradeable Rally Ahead?

Finally, some indicators suggest that we could have likewise bottomed out over the interim and a tradeable rally could be in the offing.

One, the restrictions on short selling of 799 financial stocks in the US and also adopted in the UK has moved the equity markets in seismic proportions last Friday. This should translate to a strong open in the PSE at the start of the week. However the effects from restriction curbs tend to be short term.

Two, as pointed out in my recent blog, Fear Index Pointing To Tradeable Rally Ahead?, each time the VIX or Fear Index peaks at above 30 it is usually followed by a bearmarket rally. The VIX or fear index hit a record high last week signifying outsized fear.

Three, the Phisix is coming from an oversold level, which means there could be more room for more upside traction.

So far, the recent lows have held its ground, giving us a clue of the possible strength of the aforementioned support level. The longer the Phisix maintains such support level the stronger it becomes.

Fourth, massive injections of bridge financing by global central banks tend to induce a period of lull following the recent turbulence. In addition, the proposed resurrection of the Resolution Trust Company RTC type of rescue package will entail a huge cost to US taxpayers. Over the longer perspective, this could lead to some capital reallocation of Asian capital to within the region and,

Lastly, any forthcoming rally, which would probably coincide with the closing of the seasonally weak September, may strengthen our case for a yearend rally.

Inflation-Deflation Tug of War

Amidst the conservatorship of Fannie and Freddie, the rescue of Bear Stearns AIG and the bankruptcy filing of Lehman Brothers, credit markets continue to seize up on a global scale in manifestation of the rapid tightening credit conditions, aside from mounting loss recognition and forcible “deleveraging” liquidation as part of capital raising and shrinking of balance sheets by affected financial institutions which has resulted to the current downside volatility and staggering losses in global equity markets.

Courtesy of Danske Bank

A symptom of credit shortage can be found in the chart above courtesy of Danske Bank, one of the interbank rates used for stress testing (the Euribor-Overnight Indexed Swap). Importantly, the problems are obviously manifest in US Dollar denominated money markets, which of course, has been the epicenter of today’s crisis episode. Such dearth of “US dollars” available for credit have lent to the recent spike of the US dollar’s value which deflation proponents label as funneling to the “center”, aside from of course, the repatriation of US dollars to shore up foundering balance sheets of US financial institutions.

This very fitting quote from Bloomberg, ``“There’s a complete lack of faith in the markets,” said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.”

Such activities characterize deflation.

So on one hand you’ve got market forces unraveling the malinvestment from the previous credit bubble, which left leaning ideologues describe as “market failure” (which has actually been more government induced-via monetary policy and special privileges; besides capitalism includes profits and losses and not only profits).

On the other hand, global governments fearing a collapse to outright deflation have worked double time to reflate the world markets.

First, by massive bailouts-despite the overextended balance sheets of the US Federal Reserve.

courtesy of the New York Times

According to the New York Times (highlight mine),

``The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.

``By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

``In a sign of how short the Fed’s available reserves had become, the Treasury Department sold tens of billions of dollars of special “supplementary” Treasury bills on Wednesday to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities on Wednesday morning and will sell $60 billion more on Thursday. More money-raising is sure to follow.’

Harvard Professor and former IMF Chief Economist Kenneth Rogoff estimates that the US would need $1 trillion in rescue package (some say more).

And next, by the unprecedented concerted global central bank actions to provide humungous liquidity to the marketplace in order to hold down interest rates.

courtesy of the Wall Street Journal

This from the Wall Street Journal, ``The Fed boosted its currency-swap lines -- through which it gives foreign central banks access to U.S. dollars -- by $180 billion, to allow central banks to meet fierce dollar demand from commercial banks outside the U.S.

``The Fed added a record daily total of $105 billion in temporary reserves into U.S. money markets, while the European Central Bank injected an extra €25 billion ($35.88 billion) in one-day funds. The Bank of Japan injected the equivalent of $24 billion into the local yen money market, and the Bank of England offered an extra £25 billion ($45.54 billion) in short-term funds. Monetary authorities in Hong Kong, India and Australia also stepped in with cash injections.”

So global central banks are today creating a tsunami of “money from thin air” to keep afloat the global asset markets from their natural reaction to overleverage, oversupply, overspeculation and massive malinvestments.

Of course, treating insolvency with massive liquidity ain’t likely gonna solve the problem as this has not been the first time global central banks have injected liquidity ever since the credit bubble crisis surfaced last July of 2007.

And worst, it could lead to a next problem. The unintended consequences of generating the next bout of inflation.

Quoting CLSA’s Russell Napier (source fullermoney.com),

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks? (emphasis mine)

Will The Proposed Ban of Short Sales Support Global Markets?

The US SEC is said to be contemplating to impose a temporary ban on short selling (CBS).

A ban on short selling is another form of price control. How? Because short selling to quote Gary Galles of Mises.org, “increases the number of people with an incentive to discover valuable information about firms' prospects, by providing an added mechanism to benefit from information that turns out to be negative. When someone's research or information leads them to negative conclusions about a firm, short selling allows them to communicate their less optimistic expectations to others and make a profit if they anticipate the direction the market will later come to agree with. That is, they profit only if they come to "correct" conclusions before others. In the process, they benefit others by revealing accurate information sooner than would otherwise be the case, reducing the mistakes people would have made from relying on the less accurate prices that would otherwise exist.” In short, a ban on short selling, attempts to inhibit price discovery.

It could be also seen as a form of “market manipulation” except that it is done by governments.

Of course, because curbing short selling means covering all existing short positions, the initial impact would be for the markets to soar. However, like in the recent example, where the US SEC banned short selling on 19 financial stocks last July 21^st,(but announced on July 16^th)…

Short term gain-long term woes

...the "soothing" effects proved to be temporary- for the Dow Jones Industrials, bank, financial and broker indices. Eventually market forces reasserted themselves by exposing the fallacies of camouflaging inherent weaknesses of why these stocks /market have been falling in the first place.

We never seem to learn.

The issue here is about financial system “insolvency” in the US and a ban on short sales will be a quick fix which is likely to only prolong the agony.

Incredible Pictures: The World In A State of Panic!

September 17-18 should be a milestone of sorts as world markets freezes in panic.

This From Bloomberg,

``U.S. Treasury three-month bill rates dropped to the lowest since at least 1954 on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc.

``Investors pushed the rate as low as 0.233 percent as the loss of confidence in credit markets deepened. Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman.

3 month US Treasury Bill

Everyone (public and private entities) seem to be scampering for the exit doors to the point of buying short term treasuries that almost yield nothing.

Yet, one sided trades like this are vulnerable to sudden sharp reversals.

London-Interbank Offered Rate - British Bankers Association Fixing for US Dollar.

Bank Lending in terms of Libor. Again from Bloomberg, ``Money-market rates jumped this week as lending between banks seized up. The London interbank offered rate, or Libor, that banks charge each for three-month loans rose the most since 1999, to 3.06 percent, the British Bankers' Association said.”TED Spread

Seen from spread of Treasuries relative to bank lending rates, another quote from Bloomberg, ``The difference between what the U.S. government and banks pay to borrow in dollars for three months, the so-called TED spread, widened to the most since the October 1987 stock-market crash as bill yields tumbled. The spread widened as much as 64 basis points to 283 basis points. It was as low as 75 basis points on May 27.” Awesome.

This credit seizure episode has now spilled over to Asia!

Again from Bloomberg,

``Credit-default swap indexes in Australia and Asia outside Japan traded at all-time highs after the cost to protect against a default by Morgan Stanley and Goldman Sachs Group Inc. rose to records in New York yesterday. Default swaps rise as perceptions of credit quality deteriorate…

``The Markit iTraxx Australia Series 9 credit-default swap index traded 40 basis points higher at a record 235 basis points today and was at 225 basis points at 12:15 in Sydney, JPMorgan Chase & Co. prices show…

``The Asian benchmark that tracks 50 investment-grade borrowers outside Japan jumped as much as 30 basis points to a record 240, ICAP Plc prices show. The Markit iTraxx Japan index increased 31 basis points to 200 according to prices from Morgan Stanley…

MSCI Asia Pacific Index

So it does not put a doubt that credit woes have likewise tainted other assets as Asian equities seen above.

The MSCI Asia Pacific Index have fallen to a three year low!

An Epitome of A Full Scale Bear Market:: Russia

Russia's financial market seems to exhibit what we might call a full scale bear market.

chart courtesy of Danske Bank

We previously featured part of this in our previous post " A Government Cardinal Sin That Results To A Bear Market? War!"

Collapsing equity and currency markets, soaring interest rates as funds flee, and declining currency reserves hallmark a true bear market. Major contributing variables: Russia's recent military activities in Georgia, falling oil/energy/commodity prices, global deleveraging and rising risk aversion.

Fear Index Pointing To Tradeable Rally Ahead?

Markets are being whacked globally in the aftermath of the combined troubles plaguing the US financial industry, particularly Lehman bankruptcy, Bank of America’s buyout of Merrill Lynch, aside from the capital raising and credit rating of insurer AIG.

There seems to be so much fear in today’s market climate.

One of the popular measure of Fear is the VIX index as defined by Wikipedia, ``VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.”

During the past year each time the VIX spiked beyond 30, the markets tend to temporarily bottom and usher in some short term “rebound” as shown below…

The blue vertical lines point to the historical “peaking” activities of the VIX index.

The temporary bottoms which it coincides with have been followed by rallies as shown by the trend lines of the S&P and the Phisix. But the important point is that the scale of past rallies have differed, of which is a very important determinant of the viability of the trade proposition.

Bottom Line: Further selling pressures could translate to “short term trading windows” for the Phisix. At the risk end, these may seem like "catching falling knives"; but given a longer term perspective, opportunities seem to present itself as buying at fire sale levels.