Will “Divergences” Be A Theme for 2009?

``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity."-President John F. Kennedy

Doug Noland of the Prudent Bear’s Credit Bubble Bulletin rightly describes today’s market activities as a “divergence”.

Where most global economies seem to be phasing into an excruciating and punishing downside adjustment, there seems to be some signs of ``unequivocal signs of life” in select debt markets as important credit spreads have somewhat materially eased.

Although the surface may yet conceal the ``acute stress out there not visible to the naked eye,” our ‘biased’ conjecture leads us to interpret that these could be possible incipient signs of our long awaited “divergent” responses to the “convergent” policy approaches because of the “divergent” structural frameworks of each of the national political economies. In short, our “spillage effect”.

True, while most of the major equity markets remain under significant pressure. These could have been prompted by the market’s ingestion of the onslaught of the negative news, yet even in this aspect we can also see some indications “divergences”.

Visible Acute Stress In US Banking System

Last week, the developments in the US banking sector unveiled the second chapter of the massive transformation of the US banking system. The erstwhile marquee banking behemoths in the name of Citibank and Bank of America, which have been enduring the US government’s surgical knife, will undergo another major operation.

Citibank [C], like a work of karma, which ‘danced’ to the tune of the “securitization” during the pop music days of the shadow banking system, will possibly end up being ‘securitized’ itself; sliced, diced and sold to investors or as this CNN Money report calls it: “divestiture”, e.g. Citibank’s brokerage unit the Smith Barney is reportedly in a deal to be merged with Morgan Stanley.

On the other hand, Bank of America [BoA] will need to enhance and facilitate its digestive juices to reluctantly swallow, under the behest of the US government, another former investment banking titan Merrill Lynch. This deal reportedly will be backstopped by a $20 billion capital infusion and a $118 billion guarantee on the outstanding liabilities from the US government (Bloomberg). And this comes already after previous injections of $15 billion to Bank of America and $10 billion to Merrill Lynch.

All these demonstrate how the government has been dealing with the conundrum of debt overhang as aptly described by this article from the New York Times, where ``any systemic solution has to deal with the bad assets, once and for all.”

And yet the problem of managing “bad assets” is fundamentally one of valuations and asset identification from which the US government won’t allow markets to determine. This signifies as the ultimate paradox; the US government has been earnestly trying to discover an acceptable substitute for market based pricing to no avail-without having to overpay for these ‘toxic’ financial instruments (these might not qualify for as an ‘asset’ since they can be priced at zero or have negative value) at the expense of their taxpayers and the perpetuation of the perils of the moral hazard.

Meanwhile, banks have been refusing to sell these instruments because of the consternation of recognizing added losses which would further impair their already ruptured balance sheets, and most importantly, in the hope that the US government will ultimately rescue them from their miseries.

Yet expectations and government responses have been “divergent”, decrying the BoA deal the Wall Street Journal editorial wrote, ``…the feds believe that the way to calm financial markets is to force the nation's largest, and a heretofore healthy, bank to swallow toxic assets it didn't want.”

At the end of day, the US government’s effort to subdue markets forces will mean a critical choice between saving the taxpayers or the banking system, where the endgame could be the outright nationalization of its banking system or yielding to debt deflation.

And the dominant view has been fittingly enunciated by the same New York Times article, ``That is why you would need to throw more capital into the banks as part of a systemic solution…In past financial crises, it has often been the bold and brilliant stroke that has restored confidence and revived the financial system. During the German hyperinflation of the 1920s, the government actually created a new currency. During the Latin American crisis of the late 1980s, the United States government created so-called Brady bonds, which cleverly allowed banks to get their Latin American debt off their balance sheets by turning it into tradable instruments. And here we are again, in need of bold action and strategic thinking and the restoration of confidence.” (bold highlight mine)

Therefore ‘bold and brilliant strategic thinking’ extrapolates to the creation of more of the same actions that brought us here in the first place. To paraphrase the famous US Senator Everett Dickson quote, ``A trillion here, a trillion there, and pretty soon you're talking about real money.” And the painful reality is that real money is being diluted with the wave of paper money issuance.

As we have repeatedly been saying political choices will ultimately shape the rapidly evolving markets, the economic environment and geopolitical landscape.

Divergences in Asia, Select Credit Markets?

In the context of the discussion about divergences, Asian debt offering last week has been tremendously received by the debt markets following the pace setting actions of the Philippines (see last week’s Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?).

According to Bloomberg (bold emphasis mine), ``Bond markets in the Asia-Pacific region are having their busiest January for at least a decade, with $32.3 billion in sales, as government guarantees and stimulus plans help boost investor appetite.

``New issues almost tripled compared with the first two weeks of last year, and more than doubled the $12.4 billion of January 2007, data compiled by Bloomberg show…

``All the bonds sold in Australia this year have sovereign backing, and all the bonds sold in Asia without government guarantees were denominated in local currencies, Bloomberg data show. Sales in Asian currencies including the Chinese yuan and Malaysian ringgit rose 41 percent this month to $4.6 billion compared to the same period a year earlier.”

Such overwhelming response to G3 denominated Asian debt issuance could possibly be construed as “knee jerk” reactions to the previous liquidity squeeze amidst the frenzied mayhem which effectively closed the global debt markets last October.

Perhaps issuers sensing a positive aura have jumped into the bandwagon to immediately work on securing foreign currency financing requirements as insurance against the risks of potential recurrent bouts of volatility seen last semester of 2008 or from a possible drought of capital considering the prospective tsunami of issuers from a world obsessed with government sponsored guarantees and stimulus.

In addition, the successes of the early movers appear to have triggered renewed appetite or unlocked anxious capital to possibly capitalize on the revitalized vigor in Asian credit markets.

Next, perhaps too, there could have been more demand for less credit risk prone Asian securities.

And lastly, possibly interest rate policies could be seen as starting to get some traction within the region.

Remember, Asia’s only link to the present crisis has been the trade and capital factor, and not balance sheets problems similar to its contemporaries in the Anglo Saxon economies. And as we have long argued, under the Austrian school of economics, interest rates tend to have different impact to economies based on the capital structure.

We quoted Arthur Middleton Hughes in our past article (see Global Market Crash: Accelerating The Mises Moment!) as saying, ``What this tells us is that the market rate of interest means different things to different segments of the structure of production.”

Figure 1: Danske Bank: Asia’s Bleak Exports and Industrial Production

It’s all gloom and doom out there. Such sentiment has been exacerbated by the preaching of the high priests of doomsday and by the negative economic data. For example, dramatic fall in China’s exports, which fell at the “fastest rate in a decade”-AFP (see figure 1 right window), have been compounded by the collapse of Industrial production seen in major Asian economies (left window). Nonetheless, all of these have eclipsed a scintilla of positive developments as evidenced by a surprising jump in China’s bank lending-WSJ (see figure 2) and an unexpected surge in China’s money supply-Forbes.

Figure 2: US Global Investors: Jump In China’s Bank Lending

According to US Global Investor’s: ``A significant rebound in money supply growth and bank lending in China during December suggests that the government’s stimulating policies may have achieved some success. However, challenges for the economy are likely to be sustained in the foreseeable future.”

We agree. And it is not just in the economic data but likewise seen from the relative strength of the equity benchmarks where from the start of the year, China’s Shanghai Index and the Philippine Phisix appears to have outperformed the region and the S&P 500 as shown in figure 3.

Figure 3: stockcharts.com: Divergences of Shanghai, Phisix vis-à-vis Asia and S & P

Since the advent of 2009, the Phisix (pane below center) is still up 4.13% alongside with the Shanghai’s Index up 7.3% (main window) while contemporary bellwethers of Asia and the US S&P 500 are all in the red.

Of course, two weeks of exemplary equity activities may not a trend make or it is simply too premature to tell. Or possibly too, China’s bank lending revival or resurgent money supply growth could merely be an anomaly. Yet these conflicting developments should make 2009 interesting as the unprecedented scale of government actions, which reflects on the grand struggle between government instituted policies and recessionary forces, will likely produce some unforeseen ‘black swan’ reactions.

And speaking of Black Swan, could the widely discredited “decoupling” a euphemism for “divergences” be the name of the game for 2009?

It has been our belief that Asia will probably recover earlier and outgrow the Western world over the coming years. This should possibly become evident once the global nexus of the forcible selling of the debt deflation process decelerates and as domestic economies adjust to the realisms of a “demand” slowdown in the West.

Many institutional analysts have been asserting that the world’s recovery will depend on the US, based on the Keynesian premise that the US comprises as the world’s only aggregate demand. We doubt so. In contrast, we believe that Anglo Saxon economies will be sternly hobbled by the gross inefficiencies brought by the stifling government interventions.

The onus of recompense on the burdensome costs of these interventions, the “crowding out” effect of government interventions on the private sector, and the reduced purchasing power from the torrent of stealth taxation policies combined could severely undermine the economic growth output potentials of the Anglo Saxon economies led by the US.

And unlike the mainstream view fixated with the aggregate demand dynamics, we believe that “supply” side adjustments (we are dissenters of the excess capacity argument) and “politically” motivated government policies will likewise militate on the highly fluid environment.

And as discussed in Phisix and Asia: Watch The Fires Burning Across The River?, we think that this crisis should serve as Asia’s window of opportunity to amass economic, financial and geopolitical clout amidst its staggering competitors. But this will probably come gradually and develop overtime and possibly be manifested initially in the activities of the marketplace.

And this spillage effect doesn’t seem contained to Asia alone, some emerging signs could be seen in the Euro zone, see Figure 4.

Figure 4: WSJ: ECB Rate Packs A Punch

The interest rate guided policies from the European Central Bank could have begun to influence bank lending rates to consumers.

According to the Wall Street Journal blog reports (bold highlight mine) ``But new data on the interest rates euro-zone banks charged households and firms in November suggest lower ECB rates did, in fact, make a difference. On Oct. 8, the ECB delivered its first rate cut of the crisis, taking its key rate to 3.75% from 4.25%. In November, they followed up with another half percentage-point cut to 3.25%. Today, the ECB noted in a statement that “almost all” average rates in November for the real-economy loans the central bank tracks “were lower than in the preceding month… Businesses also got some relief, with rates on new loans to non-bank firms falling to 5.53% in November from 5.86% in October. One month’s data, clearly, doesn’t confirm a trend.”

Again “divergences” could both signal a trend anomaly or an emerging inflection point, the path of which is unclear for the moment.

Thus from where we stand we have observed that despite the grim bleak outlook, some signs of “divergences” in Asia’s bond market, in select Asian equity markets and in some global credit risk barometers could transition to be important themes for 2009.

It is a suspicion that needs further confirmation by trend reinforcement.

We’ll keep vigil.

Has Global Warming Phased Into The Return of The ICE Age?

We have been told that by mainstream that global warming is the new reality.

In fact, policymarkers worldwide have been instituting global warming as part of the economic equation (carbon taxes, cap and trade, etc…)

Yet, evidence seems to be turning otherwise as the weather seems to be abnormally cold today. (Even in the Philippines)

This from USA Today’s article “Arctic cold grips much of nation”…

``The cold wave that stunned the nation's midsection expanded into the Northeast on Wednesday with subzero temperatures and biting wind that kept even some winter sports fans at home. The wind chill hit 33 below zero during the night at Massena, N.Y., and the National Weather Service predicted actual temperatures nearly that low in parts of the region by Thursday night.”

And there have been claims that we could be transitioning into a new ice age…

See video…



(Hat Tip: Mark Perry)

Will the faddish "liberal" trends be eventually unmasked? Will the “new religion” eventually lose its tarnish?

Stay tuned

Sovereign Debts: Let the Downgrades Begin!

Making good its warning, the US credit rating agency Standard & Poor's downgraded the credit rating of Greece amidst a deteriorating economic environment and expanding debt.

According to the Wall Street Journal (bold highlight mine),

``The one-notch downgrade to A- comes as S&P has warned of ratings cuts for some of the European Union's weaker members. Spain and Ireland are also among those which have been threatened with downgrades.

``In Greece's case, S&P pointed to the need for "necessary reforms of public spending," noting the government's ability to improve its budget position through better tax collection and higher property or income taxes is offset by the rising cost of debt servicing and public pressure for additional social spending.

It’s not just Spain and Ireland under watch, but also Portugal.

Insuring sovereign debt via Credit Default Swaps (CDS) have been materially climbing for many developed countries. This reflects growing concerns about the possibility of countries to default. Yet as governments race to provide guarantees and stimulus support programs to cushion the impact of a downward spiral of their respective national economies, more economies may be put under the credit watch. See chart courtesy of FT Alphaville.

As we earlier dealt with in Sovereign Debt The New Ponzi Finance? and Government Guarantees And the US Dollar Standard, there is no free lunch.

Guarantees and all other government spending will have to come out of real resources or real capital.

As Richard M. Ebeling of American Institute for Economic Research wrote, ``Government deficit spending and the resulting debt is a burden on both current and future generations. Today’s deficits have to be paid for out of current production and output. Those who lend the money to the government forgo the private-sector uses for which that money could have been applied. Every dollar borrowed by the government means one less dollar that a private investor could have used to expand his business, or start up a new enterprise, or spend on research and development that would have introduced product innovations for the benefit of the consuming public.”

Nevertheless, with a barrage of proposed government spending (chart courtesy of Casey Research) intended to prop the US economy, the US risks endangering its AAA credit ratings status which at the same time jeopardize its currency reserve standings.

But bureaucrats remain confident of a government maneuvered turnaround.

Stay tuned.

Clean Air Basics: Carbon Capture and Storage

Learn Carbon Capture and Storage from this interactive presentation (McKinsey Quarterly)

First word from McKinsey, ``Climate change has businesses, governments, and nonprofits examining how to stabilize atmospheric greenhouse gases while still maintaining economic growth. In plotting the course to a low-carbon economy, they will weigh a number of methods for addressing the various risks and opportunities. Carbon capture and storage (CCS)—or more accurately, the sequestration of carbon dioxide—is an important topic in the emerging field of climate change. It represents one possible approach for stabilizing atmospheric greenhouse gases—although there are many economic, technical, and legal barriers to its implementation. As background for informed discussion, we offer this interactive depiction of the technologies involved in CCS."

Press on image to redirect link...

From Deloitte: 2009 World Largest Retailers

Here are the world's largest retailers according to the Deloitte's latest annual Global Powers of Retailing report.

Apparently the retailing businesses have capitalized from the recent crisis. As we pointed out in Industry Trends During Recessions, not all of the industries are affected in a recession.

According to the Research recap, ``A number of discount retailers were big movers on the Top 250 list as consumers cut back to deal with the economic downturn. Schwarz Unternehmens Treuhand KG (Schwarz) climbed three places from 10th to 7th. Aldi GmbH (Aldi) also climbed this year and was the only new entry in the Top 10, taking the place of Sears Holdings Corporation (Sears)."

Nevertheless, Russian, Chinese and South Korean retailers were among the fastest-growing.

Research Recap adds, ``In fact, two Russian and four Chinese retailers new to last year’s list have climbed significantly in this year’s rankings, with two of the Chinese companies breaking into the top 100. Gome Home Appliance Group is ranked 63rd and is the 8th highest ranked retailer in Asia/Pacific, the first Chinese retailer to break into the regional Top 10. Russian electronics retailer Euroset Group had a Compound Annual Growth Rate from 2002-2007 of 108.5 percent"

The moral: People go back to basics during difficult times, thus the retailing business could be considered as a defensive positioning. Another area to consider under present conditions: pawn brokering.

Web based Auction Markets: Virginity for Tuition

The sex trade is supposedly the oldest profession in the world. Nonetheless, today’s technology is giving the trade a facelift.

The web space has introduced a semblance of an auction market to those willing to offer their services. Not only that, services for niche market-virgins.

Excerpts of the new trade from the Telegraph…

``A student who is auctioning her virginity to pay for a masters degree in Family and Marriage therapy has seen bidding hit £2.5million ($3.7m)…

``Last September, when her auction came to light, she had received bids up to £162,000 ($243,000) but since then interest in her has rocketed.”…

``She said: "I get some men who are obviously looking for a girlfriend but I try and make it clear that this is a one-night-only offer…

``"I think me and the person I do it with will both profit greatly from the deal."…

$3.7 million for a ONE NIGHT STAND with a virgin! Wow. You can bet on a new market trend to emerge from this. And maybe this may expand to include other niches, especially with today's financial crisis. As an old saw goes, necessity is the mother of innovation.

2008 Global Meltdown: From Financial Markets To The Real Economy

The OECD recently published its global composite leading indicators (CLI) for major OECD nations and non OECD nations.

Below is the graphical depiction of the CLIs signifying the synchronized economic collapse in 2008....(charts from OECD)

Of course, all these economic indicators matches the actions in the financial markets…

Global equities (DJW), the Baltic Index (BDI) a barometer of global shipping rates and commodity prices (CRB) almost simultaneously a swan dive…

As the US dollar managed to surge…

The chronology of the above events from our perspective:

1. Building pressures of a financial collapse eventually found a release valve despite policies thrown to avert these.

2. The ensuing global financial markets meltdown led to a seizure in operations of the global banking sector.

3. The financial paralysis, which summed to shortage of available and accessible US dollars as the liquidation process snowballed, spurred the skyrocketing of the US dollar’s exchange value.

4. Lacking access to credit, Trade finance froze!

5. The banking sector’s inaccessibility and dearth of liquidity compounded crumbling assets led to the abrupt curtailment of orders across producers.

6. Reeling from the aftershocks of the seizure of the global banking sector, the real economy suffered from a spillover.

Sovereign Debt The New Ponzi Finance?

``I have no sympathy for Madoff. But the fact is his alleged Ponzi scheme was only slightly more outrageous than the 'legal' scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds, which Moody's or Standard & Poor's rate AAA, and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn't a pyramid scheme, what is?" Thomas Friedman, The Great Unraveling

As we have earlier exhorted, navigating the rough waters of 2009 markets will be challenging. It is because conventional analysis would have to be sidelined in exchange for the reading of political actions into the pricing system of the marketplace. The traditional scrutiny of earnings and GDP growth will have to pave way for the fundamentally altering risk reward environment motions of political preferences and the unforeseen reactions that such directives may engender.

As PIMCO’s Mohamed El-Erian recently wrote, ``Where does this leave investors? As my colleague Paul McCulley likes to say, only a thin line separates courage from stupidity. Investors should position their portfolios predominantly under the umbrella of government support rather than outside it; they should follow government actions rather than pre-empt them; and they should focus primarily on the senior parts of the capital structure.”

For starters, we understand that governments around the world will jointly be conducting monetary and fiscal programs to arrest the destructive impact of debt deflation and its aftermath. For instance in terms of fiscal measures, some of the reported expenditures earmarked for stimulus programs are (IIF.com): Japan $105 billion or 2% of GDP, European Union $254 billion (1.5% of GDP), Australia $7.4 billion (1% of GDP), China $586 billion (8.9% of GDP), India $4 billion (1.5% of GDP), South Korea $11.3 billion (1.1% of GDP), Chile $2 billion or (1.5% of GDP) and Mexico $5.8 bullion (.8% of GDP). Overall an estimated $3 trillion could be sourced from the markets this year three times that of 2008 (Financial Times).

Yet despite these immense allocations from the fiscal side, yield spreads in benchmark sovereigns of most OECD economies have been dramatically falling to reflect a “flight to safety” (see figure 1).

Figure 1: IIF.com: 10 Year Bonds

And this is not just reflected in nominal yields but likewise in real yields (or inflation adjusted). This means that based on market price signals from today’s bond market, interest rates of major economies are expected to remain low despite the proposed surge of issuance of government bank debt instruments.

To consider, bond yields play a very significant role in the economy as they signify ``an important transmission mechanism through which an easing in monetary policy affects the broader economy” to quote the Institute of International Finance (IIF), the world’s only global association of international financial institutions with some 375 members in 70 countries. Big segments of consumer credit are being benchmarked to these instruments. As the IIF further points out, `As low rates permeate down the yield curve, so they help support activity affected by longer-term rates”. For example, the US mortgage market used to be highly correlated or had been benchmarked from the 10 year bond yields until the emergence of this crisis.

While it is true that today’s bond market “flight to safety” boom favors government’s activities of providing cheaply funded fiscal programs, it is unlikely that the prevailing conditions could be sustained over the long term. As a caveat since we are not in the business of market timing, booms can last until it can’t.

Why? As we have previously stated, the fundamental problem is one of debt overload. Most of the major economies have absorbed far too much debt more than it can afford to sustain. And the subsequent debt deflation preceding the inflationary boom comes with the feedback loop dynamics of regressing and shriveling collateral values, funding or liquidity constraints and a paucity of capital.

With over $30 trillion of stock market capitalization vaporized in 2008, additional enormous losses in other markets (see 2008 Trivia: Lobby, Bailouts and Losses) and most importantly, losses in the financial institutions have now tallied over $1 trillion see figure 2.

Figure 2: IIF: Losses and Capital Raised

According to IIF (bold highlight mine), ``Reported and potential losses have put pressure on bank capital, despite the fact that banks and other financial institutions have raised $930 billion of capital, more than a third of which represents government’s stakes. As a defensive response, banks have conserved their capital and liquidity to be in a position to absorb potential losses, thus reinforcing counterparty risk aversion in drying up interbank transactions. Investors have also pushed banks to raise their capital, not only as measured by their Tier 1 ratio but also the equity/asset ratio. Essentially, until asset markets settle down so that investors can form a clear assessment of potential losses, more capital injection including by governments will not be sufficient to stabilize the banking system.”

As noted by IIF, the mounting losses in asset values as reflected in the financial system losses will likely impel the industry to remain on the defensive by trying to remediate balance sheet impairments than to provide “normalized” business activities or rekindling risk activities. This essentially relegates the burden of providing support of collateral asset values, liquidity constraints and capital provision to the government which ironically depends on taxpayers, or borrowing capacity or the printing press. As clearly manifested in figure 2, the US government have substantially been replacing the private sector as purveyors of such capital.

Yet, in a recessionary environment, which technically means decreasing economic output but factually translates to the market clearing of malinvestments caused by previous inflationary policies, surviving private businesses will likely be safeguarding assets and also be conservative or scrimp on expansion plans while households will likely exercise austerity. Thus, the ability to save should essentially reflect the ability to refinance or reinvest.

But governments aren’t interested about savings. In fact governments are afraid of savings or the so-called misguided popular Keynesian concept of the “paradox of savings” or “paradox of thrift”. What is good for the individual is extrapolated to be bad for the economy, as we discussed in Consumer Deflation: The New Fashion. A weakening economy is always projected on the prism of the slackening of demand which necessitates government’s role to assimilate on such shortcomings. Thus, governments everywhere expect to takeover the role of “inflating” their national economy billed to the taxpayers of the next generation. It is a concept which relies on the principle of SOMETHING for NOTHING based on the virtue of consumption over production. (Why do you think central banks are adopting Zero Interest Rate-ZIRP regimes?)

Proof? From the incoming President Obama [CNNMoney], ``What's required for the economy right now [is] to put more money into the pockets of ordinary Americans who are more insecure about their jobs, who are continuing to see rising costs in an area like health care, who are struggling to make ends meet." Where does one source funding “to put money into the pockets of the masses”?

But if history should serve as guide, the performance of a command driven economy almost always underperforms and produces more dependence on inflationary actions which exacerbates the entire vicious process of inflation-deflation (boom-bust), market-socialism cycles.

As Ludwig von Mises presciently wrote (bold emphasis mine), ``“The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

This is unfortunately true today. As for our politicians and their lackeys, this addiction to spend using taxpayer’s resources, which is construed as an inexhaustible pool, is unsustainable. But like the recent real estate boom bust conditions, unsustainable [boom] trends can’t last, as the popular Herb Stein quote goes, ``If something cannot go on forever it will stop.”

Predicated on the surge of government rescue programs, the IIF views the onrush of government issuance and today’s market pricing as brewing pressure of destabilizing imbalances (bold highlight mine), `` It is hard to reconcile this bond market pricing with economic policies (both monetary and fiscal) designed to stimulate recovery. The inference, of course, is that G10 bond markets have become distorted by extreme conditions under which end investors and financial institutions are desperate for the apparent security offered by government bonds. As a result something of a bubble has developed in these debt markets. The problem with this flight to “quality”, however, is that G10 government bond yields are thus liable to upward correction at some point, either because of credit or inflation concerns (or a bit of both). This implies considerable downside price risk, which could be a new source of financial sector volatility at some point in the future.”

Nonetheless, the basic problem lies squarely with the patent building up of the mismatches between the supply side-availability and accessibility of capital-with the government’s demand for it.

Hence, if global economies recover and risk appetite regains ample groundswell then the safehaven pricing for treasuries will severely be reversed, as money flows will be redirected towards risk assets.

On the other hand, if the leverage absorbed and produced by the governments can’t be sustained or paid for by the revenues generated by the economy or its lack of ability to pay gets reinforced, then the sovereign risks of a credit default could become a reality.

This reminds us of Mr. William Gross’ outlook who recently discoursed about some of the intrinsic Ponzi structures in the US economy, `` Municipalities with begging bowls now extended for over a trillion of Federal taxpayer dollars, based their budgets and their own handouts on the perpetual rise in home prices, the inevitable upward slope of sales taxes, and the never-ending increase in employment and personal income taxes. To add injury to insult, they conveniently “balanced” their books with a host of accounting tricks that Bernie Madoff could never have come up with in his wildest imagination. Now, with cash flow insufficient to meet current outflows, they are proving my point that we have met Mr. Ponzi and he is us – all of us: auto companies that siphoned sales dollars to make labor peace instead of research and design expenditures; hedge funds that preposterously billed investors for 2% and 20% of nothing; a President and politicians who thought they could fight a phony war for free and distract the nation’s attention from $40 trillion of future social security and health care liabilities. Ponzi, Ponzi, Ponzi.”

Yes, sovereign debt has now assumed the new role of Hyman Minsky’s Ponzi financing.

Fundamentals of Credit Default Risks

So the credit default risks from sovereign debt emanates primarily from the debt issuance far outnumbering the pool of available capital, especially in a world where external trade has been shrinking and collateral has been losing value.

Another, any signs of the reemergence of inflation or of a global economic recovery may result to a stampede out of a one sided trade.

Furthermore, government debt will be competing with the private sector debt on a global scale for funding or capital raising, which is likely to lead to a “crowding out” effect. The crowding out effect as defined by wikipedia.org is ``when the government expands its borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit spending), crowding out private sector investment by way of higher interest rates.”

Of course, the “crowding out” phenomenon will only happen once the mechanism of the present global flow of funds diminishes. (We don’t believe that it will reverse because under a US dollar standard system, deficits are the inherent characteristic of the currency reserve economy.) Yet such phenomenon will likely occur as a result of governments working to strengthen their domestic economies, by utilizing their savings and or forex surpluses at home than by undertaking the previous global “vendor financing scheme”.

The crowding out effect, which gives priority to domestic government consumption than to private investment, therefore stifles economic growth. Therefore a world which engages in “nationalist” oriented policies would likely see repressed economic growth.

In addition, if the US Federal Reserve makes good of its threats to close the arbitrage gaps along the yield curve of US treasuries, by manipulating (buying) the long end, which is meant to reduce the incentives for the US banks to hold reserves and compel them to normalize operations (as we discussed in 2009: The Year of Surprises?), then such actions could possibly function as a window for the forex surplus rich major trading partners to “gracefully” exit US treasuries, while at the same time massively expand the balance sheet of the US Federal Reserve (possibly beyond the capacity for its citizenry to finance) and or serve as the bubble “blow-off” which could reintroduce substantial volatility back into the financial markets.

Remember, any drastic upsurge in the interest rates, as indicated by the activities in the US treasuries, will only serve to undo any incremental gains accrued from the recent activities.

Moreover, given the ginormous leverage built into the financial system, a sudden increase in US interest rates will mean higher cost of financing for the US government or for those institutions and virtually the economy on a lifeline which could further undermine its economic recovery path.

As we have earlier said, 2009 could likely be an exciting year, simply because government policy actions risks creating an environment where financial and economic conditions could swing from one extreme end to the other.

Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?

At the onset of 2009, so far there have been a few signs of troubles evident in the global bond markets.

If there is anything paramount, I should salute or commend the Philippine Central Bank, the Bangko Sentral ng Pilipinas (BSP), for their intrepid and swift actions as the “first mover” in tapping of the debt markets in the region, amidst a jittery backdrop.

You probably have read how the Philippines secured $1.5 billion in what was to be a remarkable FOUR times oversubscribed issuance (Businessworld) under a highly apprehensive atmosphere.

This comes even as the government’s budget deficit has reportedly increased to Php 102 billion from Php 75 billion which incorporates the Php 300 billion stimulus package (AFP). While a foreign institution have made a call to sell the Peso based on perils of “exploding” fiscal position, our view is that currency valuations are always relative, if paired with the conventional US dollar, fiscal cost of the latter will likely balloon more than the Philippines.

Anyway, the Philippines haven’t reportedly overpaid, in terms of high interest rates, in enticing investors though.

Besides, analyzing the buying composition of the deal gives us some clues of the potential flow of funds or source of future investments for Philippine assets.

According to the Finance Asia (bold emphasis mine),

``The 10-year bonds were priced at 99.158, which gives investors a yield of 8.5% – equivalent to a spread of 599.9bp over US Treasuries and 20bp over the implied 10-year curve. Investors paid a very tight new-issue concession of just 23-24bp, which compares very favourably with similarly sized 10-year offers by Brazil and Colombia on Tuesday, and a $2 billion 10-year offer by Mexico in December, all of which paid premiums of between 40bp and 50bp.

``This is partly explained by the strong Asian sponsorship of Philippine deals – 41% of the issue was picked up by regional investors, with 38% going to the US and 21% to Europe – because many of the region's investors are not heavily influenced by the premiums paid in international markets…

``In total, the lead banks – Credit Suisse, Deutsche Bank and HSBC – took $5.8 billion of orders from 281 investors. Funds dominated demand for the bonds, accounting for 58% of the orders, followed by: banks (20%); pension funds, insurers and government institutions (16%); and retail and corporates (6%).”

As you can see aside from the remarkable huge bid-to-cover spreads albeit slower than last year (Finance Asia), Asian buyers which may have comprised of regional financial institutions had been the primary buyers, although a significant chunk of the regional demand could have also been rooted from local institutions.

The point is Philippine bond deal may have reflected some improvement in investor’s sentiment, as we have seen positive uptake of emerging market issuance in Turkey for $1 billion, Brazil for $1 billion and Colombia for $1 billion (Financial Times) or even in France and Spain for a combined € 11.4 billion (guardian) or Austria € 3 billion and Ireland € 6 billion (Financial Times), this despite the seeming outlier or the poorly supported German bond auction which initially targeted € 6 billion but received only 87% bid for an issuance of € 5.24 billion (Financial Times). Incidentally, the dismal result of the German bond offering came almost a day ahead of the Philippine tender, which has shown little influence to the deal’s outcome.

Besides, despite the highly anxious global financial market conditions, the success of the Philippine bond deal could have indicated of the improving liquidity conditions in the region or locally, aside from the surprisingly strong appetite for its securities from the financially and economically besieged Anglo Saxon economies.

As for the demand from Western markets, perhaps the closing of year end related tax portfolio rebalancing (see Phisix: The Fantasy Of The 2008 "Window Dressing" Year End Rally) could have likewise enhanced the reception of Philippine bonds.

Additional interesting insights from the recent offerings:

One, the yields were significantly higher than the previous, for the Philippines 6.5% in January 2008 while 8.5% for last week. Austria and Ireland were likewise “forced to pay higher yields than existing bonds to issue debt”. This gives credence to our belief that funding cost will climb over time, especially as governments actualize their purported programs.

Finally, while the drab results of the German bond auction could be construed as a market anomaly, on the obverse side, it could likewise signal an incipient crack in the bond auction markets as ‘bond vigilantes’ stage a reawakening.

Bond vigilantes, by the way, are fixed income investors who, according to the illustrious Forbes analyst James Grant, “took a pledge: Never again would they be the dupes of a central bank. They would henceforth sell at the first sign of inflation.”

Thus, the latest offering secures the Philippines and the other early birds, who availed of the seemingly improved market sentiment and conditions, the trouble of a probable “buyers strike” or the return of the bond vigilantes possibly anytime within the year.

Government Guarantees And the US Dollar Standard

``At some point, it will become necessary to guarantee failing pension plans, income, Medicare payments, mortgage payments, bank deposits, student loans, commercial paper, insurance policies, jobs, unemployment payments, old age payments, and much else, all at the same time. People will question the worth of shifting massive resources from one set of pockets to another set of pockets. They will see that the government guarantees nothing. It recycles resources it extracts from us back to us. This realization will mark the sunset of belief in federal guarantees.”-Professor Michael Rozeff, The Sunset of Federal Government Guarantees

One of the main objections to the risks of sovereign credit default is the purported faith on government guarantees.

Such belief is representative of unremitting and inexorable dependence in governments as drivers of the economic and financial prosperity. Yet bereft of the lessons of history and the basic principles of economics, never have these people realized that governments EVERYWHERE through the years and through their coercive police and military powers almost always change the rules in the middle of the game, or in accordance to leader’s whims or to fungible political priorities or imposed policies with short term noble sounding relief programs at the expense of negative long term costs or protected a few interest groups in the “name of the patriotism” or have robbed people of their property rights through unjust distributive inflationary policies.

In short, despite the repeated failures to achieve major societal goals, people have come to believe government guarantees mean something.

Yet believing in governments as solution to society’s upliftment could be fatal. What people haven’t realized is that guarantees require real capital or real resources for it to be dependable. Running huge deficits and paying them off with printing press money which can’t be backed by real capital means government guarantees “are not worth the paper they’re printed on” to quote Professor Michael Rozeff.

As we pointed out in It’s a Banking Meltdown More Than A Stock Market Collapse!, Iceland for instance, just last year used to be among the world’s wealthiest economies with a per capita income which was the 6^th highest. As the recent crisis unfolded, the Icelandic government guaranteed the deposits of its financial system and nationalized its overleveraged major banks in the hope to apply the magic wonders of the government wand. Unfortunately, due to the lack of real capital, the country of 320,000 went bankrupt.

Iceland’s banking system which operated like a national hedge fund during the heydays will be paying a pretty stiff price for its misadventures and policy blunders, according to Economist (bold emphasis mine), ``Gross government debt is forecast by the IMF to increase from 29% of GDP at the end of 2007 to 109% of GDP in 2009. Apart from the widening deficit, the increase in debt will result from three main causes: first, the recapitalisation of the failed commercial banks now under public ownership will cost around Ikr385bn, or 25% of GDP; second, the costs of recapitalising the Central Bank will be close to 10% of GDP; and third, meeting the extensive obligations of the failed banks (that is, compensating depositors and other creditors) will cost around 47% of GDP. A sizeable portion of this should, however, be recovered over the coming years as the banks' assets are sold. Nevertheless, there will a large debt-servicing burden on the central government that will have to be met by extensive cuts in government spending or through higher taxes.” Ouch.

The lesson here is that paper guarantees from any government may not even be worth anything unless they are backed by real resources or real capital. The same applies with the US dollar, the world’s preeminent currency backed by full faith and credit by the US government.

The belief that the US dollar is insuperable and is unlikely to seriously suffer from negative repercussions from its accrued reckless and imprudent past and present policies could signify as perilous complacency.

The fact that the recent crisis has its epicenter in the US and has rattled the foundations of the global banking system aside from disrupting the world trade financing have prompted some governments to explore alternative means of conducting trade outside the US dollar system such as:

1. The recent case of rice for oil barter between Thailand and Iran (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?),

2. Mounting talks about the resurrection of a modern form of Bretton Woods Standard (as previously discussed in Bretton Woods II: Asia Weighing In Too? and in Bretton Woods II: Bringing Back Gold To Our Financial Architecture?),

3. Utilization of a new payment system which uses local currency for trade as in Brazil and Argentina’s Local Currency Payment system. China and Russia has likewise been reportedly mulling to engage in a similar domestic currency based bilateral trade and

4. A pilot form of regional currency standard such as China’s recent proposal to expand the use of its currency as a medium of trade for China, Hong Kong Macau and ASEAN countries (BBC)

So aside from policy induced fundamental deterioration, all these exogenous events serve as ample evidence of the growing vulnerability of the US government guaranteed US dollar standard system.

Mike Hewitt of Dollardaze.org has made a splendid study on currencies where he observes that some 173 currencies are in circulation in the world today.

Yet not all of the existing currencies are widely used or circulated. Mr. Hewitt gives some examples as the “unofficial banknotes of the crown dependencies (Isle of Man and the Balliwicks of Jersey and Guernsey).”

Importantly Mr. Hewitt provides us some very important facts from today paper currency regime (all bold highlights mine):

-The median age for all existing currencies in circulation is only 39 years and at least one, the Zimbabwe dollar, is in the throes of hyperinflation.

-Excluding the early paper currencies of medieval China (and India, Japan and Persia) as well as the majority of paper currencies that existed in China until 1935, there are 612 currencies no longer in circulation. The median age for these currencies is only seventeen years.

Figure 3: DollarDaze.org: Fates of Currencies

-Both war and hyperinflation have each been responsible for the demise of 145 currencies. The Second World War saw at least 80 currencies vanish as nations were conquered and liberated.

-Second only to war, hyperinflation is the greatest calamity to strike a nation. This devastating process has destroyed currencies in the United States, France, Germany, and many others.

As one can observe, paper currencies tend to be generally short lived. Importantly, the fact that war and hyperinflation have been the main proximate factors which has caused most of the world’s currencies to disintegrate depicts that both are related.

To quote Ludwig von Mises in Nation State and Economy,

``One can say without exaggeration that inflation is an indispensable means of militarism. Without it, the repercussions of war on welfare become obvious much more quickly and penetratingly; war weariness would set in much earlier.”

Markets and Inequality: What Goes Up Must Come Down?

In our October’s Spreading the Wealth? Market IS Doing It! we averred that falling markets have been reducing the net worth of the richest. This has possibly been closing much of the controversial “inequality” gap.

We’ve got some interesting charts from the Economist….

Fabulous "inflationary" driven booms almost equal horrendous "deflationary" bust.

According to the Economist, ``INVESTORS are told that the value of their shares may go down as well as up. Rarely, however, do they plummet as far as they did in 2008. The total return of the S&P 500 index fell by nearly 40% last year, the second-worst performance by America's stockmarket since 1825, according to calculations by Value Square, a Belgian asset-management firm. Comparisons to the Depression are clear: only in 1931 and 1937 were there similarly abysmal losses. The firm looked at various predecessors of the S&P 500 from 1923 onwards, and for earlier years took data from a working paper by Yale Management School on the returns of companies listed on the New York Stock Exchange. Since 1825, 129 years saw rising returns, whereas 55 suffered falls—four of them in this century.”

And since stock market exposure is highest with those from the upper income strata….

Courtesy of Investment Company Institute

Apparently falling markets hurt them more, where according to the Economist,

``Over a third of American millionaire households said they lost at least 30% of their net worth since September, according to a new report by Spectrem Group, a financial consultancy. Property, mutual funds, shares and annuities took the biggest knocks. Unsurprisingly, financial advisors are under more scrutiny, with satisfaction levels falling from 60% earlier in the year to 40%. A majority of the wealthy say they may not be able to support their lifestyles and nearly 20% will delay retirement.”

Liberals must be enjoying these…

Black Swan Problem: Not All Markets Are Down in 2008!

As we noted in our November post Black Swan Problem: Not All Markets Are Down!, hasty generalizations won’t do any good. Despite the recent squall in the global financial markets there are still some countries that have managed to end up in green or have not fallen below the 20% threshold which technically delineates what is known as a bear market.

Bespoke Invest provides the annual performance of stock markets of 84 countries in 2008…

According to Bespoke, ``32 of the 84 countries were down more than 50% in 2008, while just three countries finished in the green -- Ghana, Tunisia, and Ecuador. Iceland was down by far the most, losing nearly all of its value at with a decline of 94.43%. Of the G-7 countries, the UK did the best with a loss of 31.33%, followed by Canada (-35%), and the US (-38.5%). With a decline of 48.4%, Italy was the weakest of the G-7 countries. At the start of 2008, the decoupling trade was all the rage, as emerging markets such as Brazil, Russia, India, and China (BRIC) were supposed to hang in there much better due to continued growth prospects. When all was said and done though, of the BRIC countries, only Brazil did better than any of the G-7 countries, while India, China, and Russia were all down more than 50%.”

Some added observations:

-Including the 3 ‘advancers’, there are 9 national benchmarks that have not fallen below the bear market threshold of 20% in losses. Of course this is based on domestic currency metrics and is likely to smaller when adjusted for US Dollars.

Said differently, the 9 benchmarks have decoupled from most of the global markets.

As we earlier quoted, ``No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion," wrote philosopher David Hume in his Treatise on Human Nature, which is a rephrase of the black swan problem posed by John Stuart Mill [Nassim Nicolas Taleb: Fooled By Randomness p.117]

Thus, decoupling then a myth? (Decoupling for us is a semantic argument; our point is in a world of globalization which is another word for more integration, the greater interconnectedness of markets and economies are likely to reflect more “synchronization”, but integration won’t be perfect. Besides, it our suspicion that forcible liquidations due to debt deflation have been the unseen knot responsible for the near simultaneous reaction of markets.)

-Asian Markets have been significantly hit compared to its European counterparts or even the source of the troubles…the US.

To consider it has been the US and Europe suffering from a combined debt deflation, economic slowdown and balance sheet impairments.

Courtesy of ADB’s December Asian Bond Monitor

Meanwhile Asia’s link has been through mainly through trade, liquidity and capital flows. Thus, it is my hunch that Asian markets could outperform as previously discussed 2009: Asian Markets Could OUTPERFORM