Media Sentiment: The US is in a Depression! Warren Buffett Buys!

The US is in a DEPRESSION! That’s if we are to measure depression in the context of FEAR than the actual economic depression itself!

According to the Economist, ``MANY comparisons may be made between the devastation being wrought on America's financial system today and the Wall Street crash of 1929. One similarity that the world is desperate to avoid is a repeat of the depression of the 1930s. Hopes are pinned on the American bail-out plan that the House of Representatives is set to reconsider on Friday October 3rd. If the fear of depression is anything to go by, the future looks bleak. A survey of newspaper articles over the past two decades shows a sharp spike in mentions of the dreaded D-word, as commentators have started to think the worst. The prognostications may possibly turn out to be true, or perhaps the only thing we have to fear are the fears of journalists themselves.” (underscore mine)

Courtesy of the Economist

Growing fears of “A Mother of All Banking System Run” or its downright collapse emanating from the unresolved gridlocked in the global credit markets have aggravated such an outlook, compounded with the rapidly deteriorating economic environment.

Even Warren Buffett, the world’s most successful stock market investor, acknowledges part of this anxiety and analogizes the present conditions to one of the US Economy lying "flat on the floor” and undergoing a “Cardiac Arrest”.

In a recent CNBC interview with Charles Rose, Mr. Buffett said,

``Paramedics have arrived…and they shouldn't argue about whether to put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way, or they shouldn't start criticizing the patient because he didn't have blood-pressure tests.” In reference to his advancement of the bailout package, which was recently approved by the US Congress.

He relates the impact of the credit crunch as ``sucking the blood out of the economic body of the United States”.

Anyway, the Mr. Buffett in apparent empathy with the US, ``In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now….They are not wrong to be worried.''(highlight mine)

Plainly said, the fear the US faces from the present risks environment seems justified, although Mr. Buffett believes that these presents itself as opportunities from which to profit over the long term, ``The prices make a lot more sense now…You want to be greedy when others are fearful and you want to be fearful when others are greedy.''

A classical Mr. Buffett act.

From our end, we understand this as nothing really new.

Boom and Bust always bring about attitudinal change. Inflation is followed by deflation. Greed turns to Fear, Panic and ultimately to depression. Aggressive risk taking morphs into morbid aversion to risk. Generosity turns into frugality. Profits segue into losses. Debt level falls. Collateral values fall. The negative feedback loop of margin calls from reduced collateral values reinforces downward price spirals on asset values. Company Balance sheet shrinks. Unemployment rises. Conspicuous consumption shifts into consumption based on necessities. People’s time references are lowered. Real currency values rises as people and corporations hoard cash. Government fiscal deficits rise as rescue efforts mount or as contingent liabilities are realized as losses. Zero savings can mean more savings. Current account deficits could become surpluses. So what else is different?

Eventually most of the malinvestments and excess levels of gearing or leverage will be reduced to the point where the economy affords them. All these take time. But the adjustments won't be painless.

It’s what history has repeatedly shown. It’s what all cycles are all about. It’s the nature of human beings, especially when misdirected decisions have been impelled by policy incentives that lead to such behavior.

Besides, is this not the essence of capitalism: Profits and losses? We can't say capitalism is purely a one way street of profits, while loses need be socialized. That's the Keynesian brand of capitalism. And that's what has got us into this in the first place.

As US President Franklin D. Roosevelt in his First Inaugural Address on a Saturday of March 4, 1933 ``So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

While there is nothing to fear but fear itself, eventually there will be a resolution to the crisis as it always had been. It's not the end of the world as we know it. Although we are hopeful that in learning from history we could avoid taking on the similar paths that would risk actualizing these fears.

The Mises Moment In Pictures

In Global Markets: From “Minksy Moment” To The “Mises Moment” we characterized our Mises Moment as ``governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.”

We have long said that politicians REACT to developments than PREMPT them arising from populist political concerns whether real or imagined. The belief that authorities can “do something” basically means manipulating varied legal tools (fiscal or monetary) aimed at controlling market forces for political objectives.

The problem is that such intuitive attempt to defeat or suppress business cycles by perpetuating boom conditions has been the root of today’s crisis. In other words, deflating markets are a consequence of previous inflationary activities which has distorted price signals in the markets and has similarly led to capital misallocation in economies.

Yet, it appears that massive efforts are underway to reinflate, which risks intensifying or prolonging the crisis conditions.

To quote Friedrich Hayek in Monetary Theory and Trade Cycle, ``To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection -- a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.”

So even without the bailout package, the Federal Reserve has undertaken a massive campaign to flood the world with money.

And signs have been all over…

In the monetary system (data from St. Louis Federal Reserve)…

Federal Reserve Lending…

Changing Fed Balance sheet composition…

Courtesy of Cumberland advisors

Aside, the recent enhancement on TAF and swaplines with global central bank as declared by the Fed,

``Actions by the Federal Reserve include: (1) an increase in the size of the 84-day maturity Term Auction Facility (TAF) auctions to $75 billion per auction from $25 billion beginning with the October 6 auction, (2) two forward TAF auctions totaling $150 billion that will be conducted in November to provide term funding over year-end, and (3) an increase in swap authorization limits with the Bank of Canada, Bank of England, Bank of Japan, Danmarks Nationalbank (National Bank of Denmark), European Central Bank (ECB), Norges Bank (Bank of Norway), Reserve Bank of Australia, Sveriges Riksbank (Bank of Sweden), and Swiss National Bank to a total of $620 billion, from $290 billion previously.”

So the US isn’t just inflating its own financial system. As we have been saying it has also been inflating the world.

Testing the Banking System’s Resilience: Deposit Insurance Coverage

Previously the conventional thinking was that the banking system signified as the ultimate bulwark of money. While people basically trusted banks because of their faith over governments (implied guarantees), many fail to realize that such government authored cartelized system, which centered on the powers emanating from central banks, are not foolproof and are likewise subject to incompetence or abuse-whose constant manipulations of the market can be equally disruptive-and thus, lead to a loss of faith or specifically a RUN.

BCA Research: Credit Markets Remain Jittery

The continuing tremors in the banking system, as indicated by the intensified stress in the credit markets (see BCA Research chart above), which has fundamentally emanated from the bubble bust in the US, has rippled almost internationally and has most importantly began to raise questions about the sanctity and integrity of the current operating monetary platform-the Paper money standard.

As the system remains besieged from its self-inflicted ordeal, it is everyone’s task to ensure of the security of their deposits via the institutionalized deposit insurance coverage or a safety net (guarantee) provided by government institutions to depositors in order to promote financial stability.

From the Economist

According to the Economist, ``AS BANKS tumble like skittles, customers across the world are eyeing their cash nervously. Savings are protected in around 100 countries, with varying degrees of generosity. Those spooked by a run on a bank in Hong Kong this month may have been particularly nervous because only HK$100,000 ($12,860) of their cash is protected, including interest. Ireland has recently extended its limit from €20,000 ($29,337) to €100,000, to reassure savers. In America the first $100,000 is guaranteed for each depositor at each bank, while Britain's savers are limited to £35,000 ($64,650) in one institution, although an increase is expected soon. It is not only a matter of how much is protected, of course, but also of how quickly and easily the savers would get it back.” (highlight mine)

Of course, the other alternative is to own precious metals.

Significance of the Prospective Sale of AIG’s Philippine Unit Philamlife

John F Kennedy once said, “When written in Chinese, the word "crisis" is composed of two characters-one represents danger, and the other represents opportunity.”

AIG’s predicament of shoring up its balance sheet will come into full test for the global markets as it is reportedly negotiating for sale 15 to 20 of its business units (thedeal.com)

One of which is its Philippine exposure…Philamlife.

According to the Reuters,

``The Philippine unit of American International Group (AIG), the country's biggest insurance company, has received takeover offers from several groups, including the Yuchengco business clan, a top company official said on Monday.

``…AIG had not finalised any decision on what it would do with its Philippine unit, which has total assets of 170 billion pesos ($3.6 billion). Philamlife also has interests in banking, asset management and outsourcing.”

What’s the significance?

1) If the buyers should come from the Philippines, this could reflect on the strength of the nation’s real pool of savings.

2) In a world seemingly starving for capital, this should also reflect the Philippine market’s ability to expedite and raise capital which could also translate to a test of the health conditions of our economy’s liquidity and the stability of our overall financial system.

Should Filipinos Invest Abroad?

``No drug, not even alcohol, causes the fundamental ills of society. If we're looking for the source of our troubles, we shouldn't test people for drugs, we should test them for stupidity, ignorance, greed and love of power.”-P.J. O'Rourke, American Political Commentator, Journalist

In a recent discussion, a colleague raised the issue of whether locals should consider investing overseas given today’s financial globalization. My immediate reply was that there is no general answer to these concerns as this would depend on the distinct goals of each individual.

Some could see overseas investing as a way to tap overseas opportunities unavailable to the domestic market, others may contemplate on putting eggs into different markets or for portfolio diversification, some because of perceived higher returns or lower transaction costs, some for tax purposes or “recycling of funds” or some for just plain curiosity or even vanity (the need to feel sophisticated).

Nonetheless, global retail overseas investing has been a growing trend supported by the ongoing integration and the deepening of financial markets, technology advances such as real time online trading platforms, relaxation of capital flow regulations and the lowering of so-called Home Bias.

As an example, we previously mentioned of the metaphorical Mrs. Watanabes of Japan, an embodiment of retail investors who, because of their high savings and nearly zero interest rates, have used the international currency market to enhance returns, which became an important foundation of the global carry trade arbitrages.

According to the Economist, the ``Mr and Mrs Watanabe account for around 30% of the foreign-exchange market in Tokyo by value and volume of transactions, according to currency traders, double the share of a year ago. Meanwhile, the size of the retail market has more than doubled to about $15 billion a day.” (highlight mine)

For those who are contemplating to undertake offshore investments should consider the risk-reward tradeoffs than simply plunging into the pool without appropriately understanding the risks involved. As Warren Buffett cautioned, ``Risk comes from not knowing what you're doing.”

Risks From Direct Investing

Here is a rundown on some of the risks we need to consider when investing abroad:

1. Currency Risk-

As defined by Investopedia.com, ``A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.”

As an example, you may gain 10% from your equity investments abroad but a corresponding 10% loss in the currency from which your equity investments are denominated effectively offsets your gain. A worst case would be to see your equity investments values fall in a currency that is also losing- a double whammy!

The important point is that investing abroad requires the comprehension of the fundamental dynamics of the currency market.

This perhaps is the main reason why the Mr. and Mrs. Watanabes opted for the carry trade arbitrage in the currency market which has now evolved into a $3.2 trillion a day turnover than from equity investments, because currency trading signifies as the simplest route to access offshore opportunities.

In other words, you only have to deal with the currency equation without having to complicate your investing perspective with other risk concerns.

As an aside, this is where home bias has a defined advantage for equity investments, simply because you reduce the risk of currency volatility or your risk spectrum is mostly confined to domestic related influences or variables.

Hence, the optimum goal in investing overseas is to profit from investments on a market that has both an upside potential on the currency and the equity aspects.

2. Beta Risk-

As per Investopedia.com, ``Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.”

Essentially such risk measure is one of correlation of a market (or a benchmark) among other markets or of individual stock or sectoral benchmark relative to its operating market; see Figure 1 as our example.

Figure 1: Danske Bank: Correlation of EM Markets (left) and Global Equity-Financials (right)

In today’s generally deteriorating equity markets, we see the US markets, despite being the epicenter of the crisis, outperforming Emerging Markets (EM). Of course, the chart’s perspective comes from a one year period and doesn’t show the larger picture. Prior to the crisis EM benchmarks have markedly outperformed the US; where, in spite of the present losses, EM continues to outperform over the past 5 years (remember framing matters).

From here we can deduce that EM markets tend to outperform during better days and underperform during periods of stress. The broad implications to portfolio allocations would be to long EM once the recovery is in the horizon and long US markets when the world tilts to a crisis, although perhaps an alternative proposition would be to long Gold or traditional currency havens as Swiss Franc or Japanese Yen for the latter scenario. This also suggests that in order to distribute or dissipate risk requires the arbitrage of different asset classes in different markets around the world.

Another, the left pane illustrates how Financials stocks have been tightly correlated with the general global equity bellwether. While Financial stocks have suffered more than the bellwether of global ex-financial stocks, the strains of the former has likewise generated a downside trajectory to the latter, the causality of which generally accounts for the function of macroeconomic links (see below).

It doesn’t make sense to invest in a market which is highly correlated to your base market unless your goal is to tap industries that are unavailable to the local market. Therefore, if the objective to invest abroad is to diversify, then the ideal approach would be to deal with markets that have either a low or negative correlation.

3. Macroeconomic risk-

Macroeconomic risk generally deals with the performance, structure, and behavior of a national or regional economy as a whole (wikepidia.org).

Figure 2: wikipedia.org: Macroeconomics Circulation

The fundamental reason why the world has been suffering from a growth slowdown or the financial markets agonizing from heavy losses is due to the fundamental impairment of the financial channels (market and banking) whose transmission mechanism is clearly demonstrated above in figure 2.

The tightening of credit conditions from the US led housing-securitization bubble bust have effectively been raising the cost of capital, eroding corporate profits, decreasing business expenditures, magnifying losses in asset holdings among public and private institutions, prompting for the balance sheet restructuring by reducing leverage in private institutions, contracting consumer demand, raising unemployment, lowering prices of commodities and increasing government intervention in markets. And this weakness has been spilling over to the world.

Thus, the recent liquidity contraction translates to a magnified purview of the financial and economic structure of each nation under present turbulent conditions.

Said differently, the performance of markets in reaction to the gummed or gridlocked credit markets and economic downdraft has probably been a reflection of: one) the depth of interconnectedness of a country to the world via trade/financial/political channel, or two) the overall vulnerability of a country’s economic framework.

In essence, macroeconomic risks deal with the risks of an investment theme relative to economic output, national income, inflation, interest rate, capital formation or savings and investment, consumption, fiscal conditions and international trade and finance.

Thus, investing abroad means understanding how economic, financial and political linkages could impact your portfolio.

3. Taxation and Transactional Cost Risk-

From Reuters financial glossary ``The risk that tax laws relating to dividend income and capital gains on shares might change, making stocks less attractive.”

Whereas transaction cost means ``cost incurred in making an economic exchange” (wikipedia.org) which involves the “search or information” cost (search for availability of goods or securities in a specific market), “contracting” cost (cost of negotiation or bargaining) and “coordination/policying and enforcement” costs (meshing of different products and process aside from cost of enforcing the terms of contract) [wikipedia/wikinomics].

This means that prospective investments in overseas market requires the understanding of risk dynamics from the underlying cost structure of the present taxation regime of the host market, aside from its potential changes.

Taxation is part of the transaction costs that could determine the viability of investing overseas. Lower cost of transactions could function as a critical variable if only to wring out additional profits or returns from an economies of scale standpoint.

4. Liquidity Risk-

As defined by investorwords.com, ``The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as a house).”

In short, liquidity risk can mean the tradeable-ness of a given security or market.

This is somewhat related to the transaction cost where the more liquid or scalable a market is translates to lesser transactional cost.

Example, the Philippine state pension fund Government Service Insurance System (GSIS) has allotted some $1 billion, which makes up around 12% of GSIS’s total loans and investment portfolio for its global investment programme.

This dynamic can be lucidly seen from the AsianInvestor.net article (highlight mine), ``The GSIS will have a tough time generating returns for its members if it continues to stick with Philippine shares because of limited choices and relatively low volume. Low interest rates and the absence of a strong secondary fixed-income market in the Philippines are also constraints.”

Thus, a prospective overseas investor needs to aware of the liquidity conditions of the market or of the specific issues which one intends to deal with.

5. Political and Regulatory risks-

Political risk is a broad definition which essentially encompasses the changing nature of a country’s political structure. This from investorwords.com ``The risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits. For example, a company may suffer from such loss in the case of expropriation or tightened foreign exchange repatriation rules, or from increased credit risk if the government changes policies to make it difficult for the company to pay creditors.”

Such risks get accentuated when government becomes more adverse to private sector participation or to market oriented economic platforms (e.g. Venezuela and Bolivia) or when government policies run roughshod over its constituents (e.g. Zimbabwe) or with its neighbors (e.g. Russia).

As we have noted in Phisix: Learning From the Lessons of Financial History, trade, current account and fiscal surpluses, high forex reserves, low debt or favorable economic or market conditions can be radically overturned by 5 cardinal sins in policymaking; namely-protectionism (nationalism, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Whereas Regulatory risks are political risks applied more to specific sectors; from investopedia.com, ``The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Hence it is imperative for any overseas aspiring investor to anticipate risks of policy changes that could negatively impact an investing environment.

6. Other Risks

Of course there are other domestic risk issues to deal with such as valuation risks (financial valuation ratios), leverage risks (risks due to debt related exposure) or company specific risks (labor, management, etc.).

Risks From Indirect Investing

Nonetheless one may argue that you can deal with foreign markets through a variety of funds, such as Exchange Traded Funds, ADRs, Hedge funds, mutual funds or trust related funds sold by banks (UITFs) or insurance companies.

But as we previously noted there are issues like:

A. Principal-Agent Problem

This deals with the conflict of interest by investors when dealing with other market participants because of differing goals mostly due to the varied business models. For instance, investors would be mostly concerned about profits or returns on investment (ROI), whereas most brokers would be concerned with the commissions from client transactions while mainstream bankers or fund managers would be interested with the fees generated from the products they sell.

Thus, when bankers, fund managers or brokers issue their inhouse literatures they are mostly designed to sell the products or services they offer than to meet the investor’s objectives.

As Legg Mason’s Michael Maubossin writes in the Sociology of Markets, ``agency theory is relevant because agents now control the market. And, not surprisingly, agents have very different incentives than principals do. And this game is close to zero sum: The more the agents extract, the lower the returns for the principals.”

B. Asymmetric Information

``A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.” (investopedia.com)

Applied to the financial markets this means that sellers of financial products have more information than the buyer or clients. Thus, clients or investors are likely to submit to the whims of the finance manager, who are usually not invested. In other words, many people have committed their trust and money to fund managers or bankers who don’t even have much stakeholdings in the funds they manage except via fees or profits.

From Chuck Jaffe (marketwatch.com), ``In 46% of the domestic stock funds surveyed, the manager hadn't invested a dime. Other asset classes were far worse with nearly 60% of foreign stock funds reporting no manager ownership, two-thirds of taxable bond funds having no managers with money in the fund, up to 70% of balanced funds having no manager cash and some 78% of muni bond funds having shareholder cash only.”

Besides, investors who bought into funds are subject to information asymmetries on how fund managers or bankers allocate their portfolios. The risk strategies employed by fund managers may not square with the overall risk appetite of the investor or investment managers could be taking in more risks than would be tolerated by their clients.

How Distorted Incentives Contributed To The Mess

How does this relate to investing overseas?

First, no institutions are insuperable. The idea that funds are backed by big institutions should be questioned or scrutinized by every investor here and abroad.

As the lessons from Enron (formerly 7^th largest corporation in America) in 2001, the recent fall of the 158 year old Lehman Bros (formerly 4^th largest investment bank in the US) and American International Group (largest insurance in the US), fund managers and bankers are not immune to cognitive biases of the herd mentality whose agency problem, because of the desire for more share in the fees derived from profits piled into more leverage and momentum despite being aware of the unsustainable trend and compounded by guiding principle of implicit guarantees of government bailouts, helped triggered the colossal overspeculation fueled by monumental overleverage. It’s not their money anyway.

Evidence? Look at the performance of the $1.9 trillion hedge fund industry (Wall Street Journal), ``Nine out of every 10 of the 4,000 hedge funds surveyed globally by data provider Eurekahedge are performing insufficiently well to beat their high-water mark–the level at which they can charge performance fees, equivalent to a fifth of returns.

``All but 3% of funds of hedge funds were under the mark, according to the survey, as were 90.6% of equity long/short funds, 86% of portfolios focusing on market events, 85.4% of those investing in distressed securities, and 82.6% of futures managers. The picture was also bleak for long-only absolute return funds, 96.5% of which were below their high-water mark. The survey used figures compiled for July 31–the most recent available–and are likely to have worsened since then.”

To consider hedge funds have the ability to trade and profit even on when the market moves to the downside, except for the recent ban on short selling on 950 financial stocks which clearly handicapped their strategies.

Moreover, the agency problem and the information asymmetry dynamics had clearly been a functional component in the bubble formation when investment banks turned into the “originate and distribute models”-where they packaged and sold low quality or subprime mortgages or distributed credit risk, in complicity with the seal of goodstanding from credit rating agencies who ironically derive their revenues from the originators (effectively distorting the incentives to be objective appraisers), to equally unthinking clients or institutions worldwide. Thus, when the bubble imploded, the negative externalities caused by failed government policies espoused and profited by institutional oligopolies borne out of the cartelized financial system will once be folded into the arms of the US government whose concentration risks to the remaining institutions have equally been amplified.

Summary and Recommendations

To recap, to invest overseas isn’t the same as to invest locally primarily because of more risks concerns; particularly currency, beta, macroeconomic, taxation and transactional cost, liquidity, political and regulatory risks and other domestic related risks.

In addition, to rely on indirect exposure abroad via institutional products isn’t as risk free as portrayed by some, or impervious to the corrosive effects of principal-agent and the asymmetric information problem as recent events have clearly shown.

Big institutions have failed and will possibly go under the wringer as the world’s financial system adjust from taking up too much debt more than it can afford. The global credit crisis basically is a consequence of global financial institutions not knowing “who holds what” (similar to the Old maid game), thus we can’t really know who among the big financial players will remain standing or “strong” until the fog from the battlefield has lifted. What we understand is that Asian institutions are supposedly the least impacted compared to their counterparts because of the rear view mirror effects from the Asian Crisis.

The lesson for every investor is to increase their financial literacy and do their homework under some of the risk guidelines as presented above.

For beginners, before trying out overseas investment I suggest for you to get your hands dipped into the local market. Vanity won’t do you any good because tuition fees can be very costly and emotionally distressful. Once you gain experience via the learning curve, you can begin to dabble with markets abroad.

Refrain from the assumption that all markets operate similarly, as advocated by many hardcore technicians, because they aren’t. To analogize using George Orwell’s Animal Farm, ``All animals are equal, but some animals are more equal than others.” In addition, the supposition that markets contain all the information isn’t true as the information asymmetry dynamics above suggests.

It would be recommended that you should use the international markets to compliment your overall portfolio strategy by either going for opportunities not accessible in the domestic markets or to diversify to less correlated markets or to hedge your portfolio using intermarket arbitrage.

Finally, be cognizant of the possible conflict of interest when dealing with institutions whose economic model and incentives are different than yours.

Phisix: Back To The Global Divergence Mode

``In the short run, the stock market is a voting machine and long run is a weighing machine. Five years from now and 10 years from now we will see that we could have made some extraordinary buys. I do know that the American economy will do well, and that people that own a piece of it will do well. But they shouldn't do it on leverage, and that's what people have learned in this period. "-Warren Buffett (at a CNBC interview with Becky Quick)

Following the bloody carnage in the global equity markets during the previous week, the Phisix reverted to its “divergent” mode by recovering most of its losses. The Philippine benchmark was up by 5.46% over the week, even amidst a mostly dreary global outlook and was one of rare bright spots in the Asian market alongside Vietnam (+10.19%) and China’s Shanghai (10.54%).

What seems to have driven the Phisix to stoically climb to the upside, amidst the interim weakness in most of the global markets, has been an erosion of foreign selling. Curiously enough, we even saw select blue chip buying by foreign money, albeit they were seen sporadically selling over the broad market to account for a minor net inflow of Php 188 million over the week.

Of course one week does not a trend make. But as what we have been saying before, if the estimates of foreign liquidation relative to the previous years of inflows have been accurate, then the pressure from another round of AIG-type of forcible liquidation has probably peaked and should be declining. And if we continue to see this trend reinforced, then the threat from any future selling pressures is likely to emanate from local retail investors who are the easiest to be swayed or spooked by media reports. Thus, perhaps the diminishing trend of foreign selling plus future risks of “contagion dynamic” from local retail investors are likely to be indicative of the bottoming process we have long talking about. And a bottom process entails rangebound trading or gradual confidence building recovery.

As we have repeatedly argued, the Phisix doesn’t share the same problem with most of the world. In fact, the Phisix sorely missed out (or is it serendipitously?) the real estate boom during the last few years. The contagion linkage the Philippine has with the world is through the trade, remittances, the booby traps from toxic US instruments held by some financial institutions and financial flows.

One year into the crisis we have yet to see any material deterioration from these external channels. Ironically, what has sharply impacted the local economic growth data has been the “rising food and fuel” component or imported “cost push” inflation. With food and fuel prices down, the risk towards the extended impact from the latter influences could be seen as likely to diminish which in essence should support “growth”.

Albeit, with the recent jump of oil to above $100 ($106 as of Friday) had been mainly on the account of the weakness of the US dollar rather than from demand recovery as industrial metals and the Baltic Index continue to soften see figure 3. In other words, oil and gold have been the beneficiaries (safe haven?) of the growing anxiety over a massive scale of US intervention to rescue its financial system.

As this Bloomberg report avers (highlight mine), ``Domestic banks are cutting trading with international firms in the interbank market, according to Zhuang Zhiqiang, a trader at Xiamen International Bank Co., which is partially owned by the Asian Development Bank. The move aims to control risks after the bankruptcy of Lehman Brothers Holdings Inc. stunned domestic investors, said Zhao Qingming, an analyst in Beijing at China Construction Bank Corp., the nation's second-largest lender. We've turned more cautious,'' said Zhuang, who is based in the southern Chinese city of Xiamen. ``Bank officials are worried about settlement risks as the ongoing crisis has weakened people's trust in U.S. banks.''

Figure 3: stockcharts.com: US Dollar Driven Oil Rebound!

Now with some Asian countries beginning to tow the line of monetary policies directed at resuscitating growth, where according to a Bloomberg report, ``Taiwan cut borrowing costs on Sept. 25, joining China, Australia and New Zealand in easing the price of money this month,” we are likely to see some of these effects via a recovery in the second quarter of 2009 barring a crash of the US economy.

We just hope that our central bank will not get cowed by pressures from our politicians and to remain focused on fighting the “ravages of residual inflation” by continuing to tighten.

Fiscal Bailout, US Monetary Policies To Ensure Inflation Transmission To Global Economies

``It seems clear that much of the current crisis has been exacerbated by mark-to-market accounting, which has created massive, and unnecessary, losses for financial firms. These losses, caused because the current price of many illiquid securities are well below the true hold-to-maturity value, could have been avoided. The current crisis is actually smaller than the 1980s and 1990s bank and savings and loan crisis, but is being made dramatically worse by the current accounting rules." Brian Wesbury, FT Advisors, Mark-to-Market Mayhem

As we have repeatedly been saying, the US Federal Reserve hopes to inflate the world through its currency pegs or dollar links in the hope that the monetary stimulus applied will revive global growth to support its export sector as the local economy is being battered by the deflating debt storm.

Chairman Ben Bernanke understands that without exports the US economy would even be more vulnerable. Thus, the United States’ over reliance on foreign trade underscores the need for such stimulus transmission. It had been an unintended consequence before it looks like an unstated policy goal today.

Of course, another reason for passing the inflation buck is that EM countries have been more than willing to take on the real currency and interest rate risk-which means EM economies can afford to suffer from real value losses (via inflation) of their US portfolio holdings.

Since the Bretton Woods II framework has been driven by political objectives-for EM countries keeping currency undervalued for mercantilist goals- than by economic ones, as EM economies continue to support the US economy by buying into US treasuries despite the extremely low yields or expensive bonds, the risk is that perhaps the changing political objectives might lead to a shift in the global currency framework and consequently a US dollar crisis.

In the same plane, the fundamental reason why the US financial markets are being rescued is probably because Chairman Ben Bernanke understands that the current account deficit has been continuously plugged by foreign financing via the acquisition of paper claims on US assets. First it was Fannie and Freddie. Next it was AIG.

Now signs of growing political heft by foreigners into shaping domestic US policies, from an article in the New York Times,

``Foreign banks, which were initially excluded from the plan, lobbied successfully over the weekend to be able to sell the toxic American mortgage debt owned by their American units to the Treasury, getting the same treatment as United States banks.”

Another reason why? Because Chairman Bernanke understands that the US needs to get its feet back on the ground by having foreigners to provide the much required recapitalization of its severely impaired banking system aside from its present actions to cobble enough resources for a system wide bailout long enough to buy time for the world to recover.

From Kenichi Amaki of Matthews Asia, ``This week, two Japanese financial institutions stepped out of the shadows of the past to pick up stakes in some of their more recognized competitors. Japan's largest securities firm and investment bank announced the acquisition of Lehman Brothers' Asia Pacific, European and Middle Eastern businesses, including Lehman’s 5,500 employees in those regions, for an undisclosed amount. At the same time, Japan’s largest bank, announced that it had agreed to take an equity stake of up to 20% in Morgan Stanley for roughly $8.5 billion. These deals are expected to significantly boost both firms’ investment banking capabilities in geographic regions traditionally weak for them.”

Think of it this way, if the overall outstanding mortgage debt on non farm homes is $11.2 trillion where Fannie and Freddie holds $5.4 trillion, a 10% loss is easily equivalent to $1.12 trillion. This does not include the $2.4 trillion of “other mortgage debt” (corporate farms et. al.) and the $2.5 trillion outstanding consumer credit, which could likewise be impacted by a slowing economy and the ongoing credit crunch (hat tip: Brad Setser). So the proposed $700 billion package for the bailout will probably be insufficient.

Figure 4: The Economist: Cost of Previous Bailouts

Anyway, there had been greater amounts of bailouts as measured by the fiscal cost in % the GDP. According to the Economist,

``CONGRESS is under pressure to approve the Treasury's proposed $700 billion rescue package. Lawmakers, however, are conscious of the cost to the taxpayer: together with loans to AIG and Bear Stearns, public backing so far approaches 6% of GDP. This is well above the 3.7% of GDP of the savings-and-loan bail-out in the late 1980s and early 1990s. But some 6% of GDP is still much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%.”

In nominal terms the present bailout would be gargantuan but the justifications using historical average cost of 16% could mean there might be more in store in the future as the weakness in US economy spreads.

Thus, my view is slanted towards the idea that any possible rescue package will tacitly be directed to stimulate global economies to enable them to fund the US current account deficit by buying into US financial claims on a guarantee aside from attracting potential financing flows from overseas state and private institutions to recapitalize the floundering US banking system.

There has been a barrage of thoughtful solutions on how to go about the bailout scheme some of which had been suggested by noteworthy figures as Raghuram Rajan suspend dividends and rights offering on solvent banks, Nouriel Roubini New HOLC, Luigi Zingales Debt for equity swap and debt forgiveness, Charles Calomiris Preferred stock assistance, Steve Waldman nationalization, Brian Wesbury temporary suspension of FAS 157 mark-to-market rules and Bill King create a new system parallel with the existing dysfunctional system and decentralization of liquidity (hat tip: Barry Ritholz) among the others.

It’s a wild guess on how the US Congress will go about configuring this package.

Nonetheless, it does seem that most of the world markets have been anxiously awaiting for the details of the US Congress led fiscal bailout of the US banking system.

This poignant New York Times quote from an anonymous Wall Street broker seems to have captured the essence of the markets abroad (highlight mine), ``People have definitely been saying that this is no longer an investor’s market, nor even really a trader’s market — it’s all entirely speculation on what the government is going to be doing next…Anyone who thinks they have a handle on where things are going is deluding themselves.” Indeed, since the credit crisis surfaced last year, the market has been living off from the onslaught of speculations to what government actions would be to done to stave off to magically vanquish the crisis.

Unfortunately, after over a year and upon waves after waves of government actions through assorted means of bridge financing and rescue takeovers this hasn’t prevented its financial markets or of most of the world markets from falling.

However, I think that as the contagion selling should eventually wear off despite the continued pressures in the US markets, aside from the indirect policy stimulus applied to foreign economies, which might give rise to a recovery of ex-US markets first in 2009.

Besides, the streak of selling has been ferocious enough to bring valuations to extremely oversold levels, see our last chart figure 5 from Daily Wealth,

Figure 5: Daily Wealth: Markdown on Emerging Market Valuations In Overshoot Mode!

From Chris Mayer ``The selloff is making things striking on the valuation front... which makes me bullish here. As you can see from the chart below, emerging markets haven't looked this cheap on a forward earnings basis in 20 years...”

First Test On Asia’s Banking System? Hong Kong’s Foiled BEA Bank Run

It was bound to happen.

The most recent spike in of LIBOR rates (courtesy of Bloomberg) in the international money markets (IHT) sparked rumors through a barrage of panicky text messages that suggested of a Hong Kong bank that had become vulnerable due to the recent losses in Lehman Brothers.

Depositors then thronged to the branches of the Bank of East Asia-founded in 1918, which makes it the oldest bank in the city-triggering a 2 day bank run.

Courtesy of BBC

But unlike the counterparts in the US or in UK, newswires reported that a combination of massive injection of funds to its system- about HK$3.9bn/$500m/£269m (BBC) by the Hong Kong Central Bank, plus domestic tycoon Li Ka-shing’s reported massive buying of the bank’s shares, which earned him the moniker of the “superman” by the local media (NYT), eased depositors’ concerns.

The overall damage, according to Timesonline, ``Total withdrawals from BEA on Wednesday were estimated at HK$2 billion by analysts at DBS Vickers Securities – a manageable 0.7 per-cent of the bank’s HK$300 billion deposit base.

``Some of those queueing to withdraw their money cited fears that BEA had not properly assessed its exposure to the unwinding of Lehman Brothers’ huge positions, which the bank puts at about $54 million. Many savers took to the streets in protest after discovering that HK$13 billion of minibonds guaranteed by Lehman Brothers that they had bought were rendered worthless after the bank’s collapse. Some pointed to the suddenness of Lehman’s demise, saying that in the days before the Wall Street giant went bankrupt it was issuing assurances of its stability, in similar terms to those used on Wednesday by BEA.”

From our understanding, the strongest possible reason why BEA survived the ordeal was PROBABLY because it wasn’t insolvent unlike its contemporaries in the US (IndyMac) or UK (Northern Rock). Liquidity injections can do some temporal patch up work, but can’t hide the company’s structural infirmities. The equity support provided by tycoon Li Ka-Shing signified as a vote of confidence or opportunity to profit than from altruism.

Second, in a world where people are anxious about the stability of the world’s financial system, the flow of information has been real time and powerful enough to trigger an unwarranted stress or panic.

Lastly, while this will NOT be the last of the systemic tests for Asian banks, they are likely to be better conditioned to weather the storm of panics.

The differences in the outcome of how an Asian bank and US banks reacted to Bank Runs clearly demonstrates signs of brewing divergences.

The Green Religion: Do As They Say and Not As They Do

Interesting article from the Guardian on the political rhetoric of environmentalism....

``People who believe they have the greenest lifestyles can be seen as some of the main culprits behind global warming, says a team of researchers, who claim that many ideas about sustainable living are a myth.

``According to the researchers, people who regularly recycle rubbish and save energy at home are also the most likely to take frequent long-haul flights abroad. The carbon emissions from such flights can swamp the green savings made at home, the researchers claim.

``Stewart Barr, of Exeter University, who led the research, said: "Green living is largely something of a myth. There is this middle class environmentalism where being green is part of the desired image. But another part of the desired image is to fly off skiing twice a year. And the carbon savings they make by not driving their kids to school will be obliterated by the pollution from their flights."

``Some people even said they deserved such flights as a reward for their green efforts, he added.

Read the rest here

Lesson: Be wary of holier than thou preaching. They may be sounding noble, but the preachers themselves don't practice what they advocate.

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."