Market Analysis – Monday, February 13, 2017


This market analysis examines the recent performance of global financial markets, the role of liquidity in supporting financial markets, and the prospect of currency wars from the viewpoint of an analyst-trader that utilizes fundamental, technical, quantitative, and big data analyses.

It’s All About Liquidity

20170213-chart1As discussed ad nauseam, governments relied on loose monetary policies in the aftermath of the 2007-2008 Financial Crises to prop up financial markets as exorbitant debt levels curtailed fiscal remedies and fear of political blame prevented necessary structural changes. Like passing the baton in a relay race (or a game of hot potato), monetary bodies took turns implementing different brands of QE. In approximate order: Fed (QE1, QE2, Op Twist, ZIRP, QE3), BoE (asset purchases), BOJ (asset purchases, ZIRP, NIRP), SNB (asset purchases), ECB (asset purchases, ZIRP, NIRP). But, despite the influx of paper money, developed and many developing economies failed to rise from the mat leading to the next phase of the Financial Crises: currency wars.

Currency Wars

Fear of a repeat of the 1989 Tiananmen Square protests, China unilaterally devalued the yuan twice in August (~2.9%) and December (~4.4%) 2015 in an effort to boost exports and jobs, resulting in a significant global sell-off each time (light blue boxes in Charts 1 and 2). Leaders from Washington to Brussels to Tokyo gasped and an undisclosed agreement was made at the Feb 2016 G20 finance ministers and central bankers meeting in Shanghai between the US, China, EU, and Japan (G4) to prevent a future financial market panic. As described by Jim Rickards, China would peg the renminbi to the USD (e.g. CNY6.50-6.30, Nov 2015 to Feb 2016 range) which would weaken, while the yen and euro would strengthen (Charts 2 and 3). But, a funny thing happened on the way to the pagoda. With the US presidential elections approaching and Donald Trump unseemingly holding steady, DXY drifted upwards starting in May 2016 as the markets factored in the remote possibility of a Trump win and a pro-growth platform. Not part of the agreement, China devalued in May-Jul (~3.4%) and again in Oct-Dec (~4.9%), contributing to a minor sell-off in stocks (green boxes in Charts 1 and 2). Now, with Trump in the White House, all bets are off as the greenback reached a 15-year high in Jan (black circle in Chart 2; DXY intraday high 103.82 on Jan 3).

Pushing an “America first agenda,” Pres Trump has threatened to institute import tariffs, declared China a currency manipulator, counteract China’s aggressive posture in the South China Sea, and has pivoted the US away from China and towards Russia. Many of his cabinet appointees support this view. Nevertheless, the Communist Party’s cling to power resides in its ability to provide jobs for the masses and keep the economy growing – no amount of antagonizing is going to change its stance. With problems of its own making, China must battle internal political unrest stemming from Pres Xi’s centralization of power, a massive credit bubble, and capital flight, to name a few. If push comes to shove, China may forego mini-devaluations and opt for a 20-30% maxi-devaluation, which some neocons would surely label as an act of war. The situation could go pear shape in the short future.

Coming Soon

My next post will examine the current state of financial markets in detail, discuss the role of complexity theory in analyzing the global financial markets, drawing reference to the Thai butterfly that caused the 1997 Asian Crisis (see Case Study: 1997 Asian Financial Crises, Parts I and II), and apply complexity theory and Bayesian statistics to today’s markets to determine the key drivers that could trigger a global market sell-off. My subsequent post will discuss the role of gold, SDRs, or eDollars in the event of a financial market meltdown that surpasses those of 1987, 1998, 2000, and 2007-2008 and the importance of China having a seat at the table of the next global financial system reset. Ultimately, I shall post on my results of using big data analysis, predictive analytics, and ensembles modeling techniques to produce leading drivers and their assigned probabilities of inducing a major market correction using the conclusions from my next post. Stay tuned!

Emerging Markets Analysis – Friday, May 13, 2016

Country Focus: Philippines


This emerging markets analysis examines the recent performance of Philippine equities and its outlook, with an emphasis on sector analysis, and provides some thoughts on stock selection from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Lastly, a Philippine Sector Dashboard is provided.

Philippine Presidential Election Results

After much anticipation, the Philippine presidential elections completed relatively smoothly. To be sure, reports of vote buying and voting equipment not working at some stations came in, but absent was Wild West, nation-wide violence that seems to mar some developing country democratic elections. By all accounts, Rodrigo Duterte, the seven-term mayor of Davao City (fourth most populace city in the Philippines), will be the 16th president-elect of the Republic of the Philippines. Running on a platform of zero tolerance, anti-corruption and anti-crime, Duterte, nicknamed “Digong”, “Duterte Harry”, and “The Punisher”, has vowed to eliminate drug traffickers, criminals, gang members and other perceived “lawless elements”. While crime reduction is always a positive, the former lawyer’s plans for the economy, fiscal policy, monetary policy, trade policy, diplomatic policy, and geopolitical policy are among the list of items that investors will be most focused on.

PSEi: Up, Up and Away!

As discussed previously, the blue-chip PSEi has formed a flag-pattern starting in March, trading in a band between 7376 and 7160 (Chart 2). As a continuing indicator, the flag suggests the PSEi would likely run to about 8600-8700 before the first significant correction. On May 11, two days after the election, price penetrated the upper resistance zone on the highest daily volume in over eight months to close at 7396 (also, an eight-month high), then fell back to 7325 on lighter volume the next day, only to jump to 7493 on May 13. If the flag/bullish trend-pattern setup holds up, price should continue its ascent, perhaps, re-testing the 7370-7380 former resistance (now support) level again, with an initial target of 7500 and a secondary target of 8000, once the 7910 May-18 2015 swing-high is taken out. Ultimately, an intermediate high of 8600-8700 would be expected, before a significant correction. Penetration of a significant swing-low would nullify the bullish trend…of course, a trailing stop loss at just below the significant swing-low would provide protection in the worst case. Unfortunately, no direct method of trading the PSEi exists, unless someone wants to buy or sell a free float market capitalization-weighted number of shares of the 30 stocks in the PSEi, cumbersome and costly (In Feb 2015, the Singapore Exchange (SGX) launched the SGX-PSE MSCI Index Futures, a USD-denominated contract which tracks the MSCI Philippines Index that includes 22 constituents representing roughly 85% of the PSE market cap). Luckily, there’s another way.

Sector Analysis and Sector Rotation Model

20160513 Chart 3
Chart 3. Sector Rotation Model. Source: John Murphy, Trading with Intermarket Analysis.

Normally, sector analysis provides a methodology to identify turns in the four-to-five year economic cycle, generally three to six months ex ante.  As a leading indicator, stocks tend to bottom and turn upwards while the economy is still struggling (and bonds usually turn several months ahead of stocks). By the time the economy enters recovery mode,  the general stock market is already racing northwards. In the sector rotation model in Chart 3, the stock market is represented by the red line, while the economy by the green line. Cyclical stocks, highly sensitive to  the economy, such as consumer discretionary and transportation shares, typically lead the recovery. This author likes to monitor selling volume of corrugated boxes (paper industry) to gauge when business activity is about to pickup (boxes are needed before any final products are actually sold and boxes for tools and heavy equipment often go first). Eventually, factories begin to turn out finished products that increases demand for intermediate goods, basic materials, and energy. However, as written ad nauseam in previous reports, continuous central bank intervention over the last decade has distorted the capital investment and business decision-making process to create a new normal environment. Nevertheless, sector rotation still does occur, but not necessarily in the neat order depicted in Chart 3.

Philippine Cyclicals Lead the Way

Difficult to tell, but cyclical stocks bottomed at the end of August (green circle in Chart 4), five months ahead of all other sectors, with the exception of utilities. Interestingly, the PSEi, property, services, industrials, mining, energy, and holding firms all reached their lows on Jan 21 (financials bottomed ten days earlier). Defensive utilities was the last sector to trough on Mar 9. As examined in a prior report (Emerging Market Analysis for April 28 2016), mining stocks (+31%) have put in a stellar performance, along with holding firms (+32%), property (+29%), and energy shares (+29%) over the last 16 weeks. In the 4-week lead up to the May 9 presidential elections, holding firms, property developers, miners, energy cos, and financials institutions bumped up 2-4% as a Duterte win seemed more probable. As several news outlets have reported, President-elect Duterte would likely entertain investments from China to help build up infrastructure. Again, stocks are the ultimate leading indicator and appear to be shouting that a construction boom is at hand.

Picking the Winners

Once desired sectors are identified, the next step is to select stocks to be added to your watchlist. As an aside, not all stocks are included, for obvious reasons, in a given sector index. Thus, often, small and medium-sized high beta stocks, not included in an index, could turn out to be multiple-baggers, high returners (5x or even 10x, to borrow a baseball analogy from Peter Lynch, the legendary manager of Fidelity’s Magellan Fund).

For each stock the fundamentals should be examined to avoid any potential landmines (senior management problems, multiple consecutive quarters of diminishing sales, declining capex to boost earnings, new reporting methodologies (especially, pertaining to revenues and inventory), new entrants and disruptive technologies, regulatory changes, supply chain problems, trade restrictions, auditor concerns, and foreign exchange rate impact, to name a few). After weeding-out the dogs, an investment/trading strategy and set-up needs to be executed that includes trade signal, confirmation, trade trigger, initial stop loss and trailing stop loss strategy, position sizing, money/risk management, exit strategy, and portfolio management (all of which, of course, is written down in your investment/trading plan and kept on your desk). Obviously, this author does not subscribe to a long-term buy-and-hope strategy, preferring a three-month to twelve-month investment horizon employing a strict, disciplined, and replicable rules-based investment/trading strategy with a library of bullish, bearish, and swing trading set-ups (and a handful of short-term quantitative momentum set-ups).

Very importantly, should new information counter the original premise for a given trade, it is imperative that risk be reduced by either exiting the trade completely (preferable for most) or partially exiting open positions and narrowing trailing stop loss orders. Also, position sizing may be the most critical feature of a well-honed trading plan – keeping loss-exposure of individual trades to 0.5%-2% of trading capital significantly reduces probability of catastrophic blow-ups (low maximum draw down), enabling you to remain in the game (all of which requires sufficient amount of initial trading capital). Finally, do not rely on specific recommendations without doing a proper investigation as risk appetite, investment horizons, and investment goals vary. Good skill!

Philippine Sector Dashboard

Property Sector

Cyclicals Sector

Services Sector

Industrials Sector

Mining Sector

Energy Sector

Utilities Sector

Financials Sector

Holding Firms Sector

Emerging Markets Analysis – Thursday, April 28, 2016

Country-Sector Focus: Philippines – Mining


This emerging markets analysis examines the primary external factors affecting commodities, Philippine mining sector with a closer look at Nickel Asia, and the outlook for Philippine equities and mining stocks from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Lastly, a Philippine Mining Sector Dashboard is provided.

The Party Ends When The Punch Bowl Is Removed

As the 2013 Taper Tantrum foretold, anticipation and the eventual ending of QE3 in Oct 2014 led to massive unwinding of leverage trades and re-assessment of yield-searching investments. As capital returned to the US, the greenback strengthened, boosting the USD Index from around 80 to over 100, or 25%, within eight months (Chart 1). Simultaneously, huge capital outflows from China resulted in the weakening of the renminbi as the PBOC side-stepped the dollar freight train (Chart 2). The Fed givenths and takeths away.

For the Middle Kingdom, its credit-fueled investment boom ground to a halt that, along with the appreciating USD, increased volatility, withdrawal of liquidity, excess capacity, and global slowdown in business investment, contributed to the bludgeoning of commodities. In the aftermath, China’s banking and financial system remains a major risk as rising NPLs and special mention loans (loans very likely to become non-performing) on normal on-balance sheet loans at commercial banks and imploding off-balance sheet/SIV high-interest paying wealth-management products  continue to be a prime drag on the economy as loan officers, rightly so, are hesitant to lend. China’s regulators seem to be buying time by forcing banks and financial institutions to equitize certain NPLs (swap NPLs for common stock). Should the underlying companies turn insolvent, the central government would most probably provide capital infusions to needy financial institutions and the more viable, troubled private companies become nationalized.

As discussed in previous reports, the Fed’s dovish shift in mid-Jan leads this author to believe that no interest rate hike is forthcoming in 2016 and that the next major move shall be a rate cut, ZIRP, NIRP, or QE4 (even, possibly, “helicopter money”), most likely occurring after the 2016 US presidential elections (Emerging Market Analysis for Apr 4 2016 and Market Analysis for Mar 29).

Philippine Mining Sector

Over the last 24 months Philippine miners get caught in the maelstrom, under-performing the blue chip PSEi by 30% through the recent Jan lows (black arrow, Chart 3). Those miners recognizing the global macroeconomic and monetary policy implications would have started serious hedging in Sep 2014, if not earlier, as the GreenMango PSE Mining Index penetrated below a previous swing-high in early-Sep and swing-low in late-Sep (horizontal green dashed lines, Chart 3).

Nevertheless, miners’ fortunes took a turn for the best when the Fed, after a widely anticipated rate hike in Dec, suddenly reversed stance just weeks later. The PSEi and mining stocks, after falling for eight months and upwards of twelve months, respectively, immediately bottomed-and-reversed in a “V”-shaped fashion (green dashed “V”, Chart 3). In the last 13 weeks Philippine mining stocks are up 21.8% vs PSEi 13.8% and in early Mar was outperforming blue chips by nearly 20% (Chart 4). A closer look shows that a handful of miners really attracted the eyes of investors: Global Ferronickel +78%, Nickel Asia +52%, Philex Mining +47%, Lepanto Consolidated Mining +46%, Century Peak Metals 45%, and Marcventures +45% (Chart 5, Chart 6, Chart 7).  The constituents and weightings of the GreenMango PSE Mining Index are provided at the end in DB Table 1 and DB Chart 1. Next, a glance at leading Philippine lateritic ore nickel producer Nickel Asia.

Nickel Asia

After a brisk run-up, Nickel Asia’s twin mountain top price formation in late-2014 / early 2015 gave way in the wake of the termination of QE3 (left side, Chart 8). Like all miners, Nickel Asia’s share price was hammered, falling from an intraday high of P16.11 in late-Dec 2014 to intraday low P3.30 in late-Jan 2016. For the last two months, NIKL has been range-bound between P5.85 and P5.10-P4.74 (Chart 9).

The bottoming formation currently taking place in Nickel Asia’s share price (green ellipse, Chart 8) could acquire legs as global investors once again hunt for yield and OFW remittances pick up steam following Feb’s 9% YoY rise (Emerging Market Analysis for Apr 4 2016). Furthermore, as China may likely re-peg the renminbi to the depreciating greenback to reinvigorate its exports, economy, and create inflation to give relief to its growing debt problem, commodities would get another boost.

20160428 Chart 11
Chart 10. Source: InfoMine.

For Nickel Asia, the global economic slowdown led to a glut of stainless steel (SS) product world-wide of which China has been trying to sell-off over the last 18 months, or so (upsetting local SS producers in some countries). Until the SS inventory overhang alleviates and/or SS production capacity reduces, sustainable increased demand for raw nickel will be slow to realize. Hence, LME warehouses remain flush with nickel at 415,075 MT (Chart 10), while spot nickel price sits at around $4.26 per pound (as of Apr 29), having traded above $9/lb in early 2014 and $13/lb in early 2011 (Chart 11). But, the tide seems to be turning as spot nickel is up 23% from its nearly 13-year low in early April.

Looking ahead, the LME 3-month nickel future price stands at $9180/MT, up +10% from early Apr (Chart 12), signifying increasing future demand. For China, rising demand may stem from abroad, from domestic consumption, or both. According to Stainless Steel World, China’s growing domestic consumption of SS shall outpace the country’s GDP rate of growth for years to come.

With Indonesia’s mineral export ban still in place (since Jan 2014, although some concession on nickel concentrates may be forthcoming in 2017), the Philippines and Nickel Asia, specifically, is well-positioned to pick-up any increased demand for nickel from China. Major potential competitors in New Caledonia have long-term supply contracts with South Korean and Japanese firms and South American and North American nickel miners would have additional logistics and transportation costs to contend with.

Outlook for Philippine Equities and Mining Sector Stocks

As discussed last week, since mid-Mar, a flag pattern has emerged in the PSEi signifying a rolling-stop as early-profit takers depart and new equity investors clamber aboard – note confirming volume slow down.  As a continuing indicator, the flag suggests the PSEi would likely run to about 8600-8700 before the first significant correction. Looking ahead, forceful penetration of the upper resistance zone of the flag at around 7370-7380 denotes resumption of the bullish trend. The trigger could emanate from any direction: poor Q1 US earnings announcements, more dovish Fed talk (next FOMC Meeting, Jun 14-15), major FDI announcement, strong OFW remittance inflows, relatively smooth Philippine presidential election (May 9). Two major risks facing Philippine equities and mining stocks are the perceived outcome of May’s elections and yet another flip-flop by the Fed. A down-break below 7180 on heavy volume nullifies the bullish trend set-up, requiring reassessment of the (then) current situation.

Mining companies face other factors, such as shifting USD, USDPHP exchange rate, demand for metal and mineral commodities, energy and transportation costs, and regulatory environment, to name a few. All told, should the Fed push through with an easing monetary policy, causing USD Index to break below its lower support level at 93-94 (lower green dashed line, Chart 1), that would set the stage for further greenback weakening, bringing respite to the mining sector.

So, what is the likelihood of a pick-up in natural resource commodity demand, specifically from China? According to Reuters, Chinese off-balance sheet local government financing vehicles (LGFVs) issued over 538 billion yuan ($83 billion) in bonds in Q1, including a record 287 billion yuan ($44.3 billion) in March. Much of this capital shall likely go to funding infrastructure projects as last year the government raised the debt-to-equity ratio for project financing. This can only help Philippine miners.

Nevertheless, sustainable demand for final products, consolidation or capacity reduction, and further cost reduction and inventory draw-down may still be needed to ensure that metal and mineral prices continue its recovery. Of course, should central banks lose control of the money printing apparatus to create not just moderate inflation, but high inflation, gold, silver, and other metals and minerals would truly show what a price recovery looks like. Presently, spot gold trades at around USD1250/oz  (as of Apr 27), up from USD1050/oz in Dec, or +19%, while silver has risen 25% over the same time frame to roughly USD17.25/oz.

Philippine Mining Sector Dashboard20160428 DB Table 1

DB Table 1. Source: Philippine Stock Exchange

20160428 DB Chart 1

Emerging Markets Analysis – Tuesday, April 19, 2016

Country Focus: Philippines


This emerging markets analysis examines Philippine portfolio capital flows, recent performance and outlook of Philippine bonds / yields, equities, and the Peso from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Lastly, some final thoughts are provided, as well as a Philippine Financials and Capital Flow Dashboard.

Philippine Capital Flows

The prospect of US normalization of interest rates led to net outflow of foreign portfolio investments of about  $310 mn and $600 mn in 2014 and 2015, respectively. However, the dovish-reversal of the Fed (see Emerging Market Analysis for Apr 4) in Jan has sent risk capital in search of yield as the likelihood of a rate rise diminishes. As discussed in previous reports, this author believes no rate rise will occur this (election) year and that the next major US monetary action shall be a rate cut, ZIRP or NIRP, and, possibly, QE4.

While more permanent-term capital started returning early in 2016, portfolio capital flows lagged slightly. FDI recorded $587 mn net inflow to start the year, a 123% increase from last Jan and represents the largest intake since Sep’s $1.519 bn haul. FDI flows targeted: $257 mn equity, $257 mn debt, and $73 mn reinvested earnings (Chart 1). After taking in $5.724 bn in net FDI inflows in 2015 versus $5.74 bn in 2014, the  government hopes to reach $6 bn this year.

Foreign portfolio investments continued cautiously in Jan, turning positive in Feb, before shedding the reins with a $482 mn net inflow in Mar, the biggest accrual in 13 months (Chart 2). According to the BSP, United Kingdom, US, Singapore, Luxembourg, and Hong Kong accounted for 80% of inflows in 2015, of which 78% were invested in PSE-securities and 22% in PH government securities.

20160419 Chart 3

Although not counted in capital flows, personal remittances (which is recorded in the current account balance) represents a major source of capital for the Philippines. Personal remittances from overseas increased 4.4% to $28.48 bn in 2015, representing roughly 10% of GDP. Foreign investors pondering a course of action for the Philippines may take a cue from what OFWs are currently thinking: Through the first two months of the year, personal remittances are up over 6% YoY, with Feb remittances jumping 9.0% from the prior year.

Steady private investment, construction, and infrastructure projects are expected to keep the Philippine economy humming (2016 GDP growth estimates range from 6% to 7%), negating the debilitating effect of a weaker external environment, increased financial market volatility, and potential havoc a weakening greenback (and strengthening local currency) can have on exports. Despite the difficult environment emerging economies faced last year, the Philippines GDP grew 5.8% and ended Q4 with a 6.3% annualized spurt. The current account surplus came in at 4.4% of GDP, sixth best out of twenty-eight emerging economies. Throughout, inflation remains subdued at around 1.4%. Thus, buoyed by solid economic fundamentals, the Philippines should expect increasing capital net inflows over the next 12 months, but risks remain. Next, a peak at bonds.

Philippine Bonds and Yields

The Philippine government remains active in the sovereign bond market. In Feb, the Philippine treasury department visited the international capital markets completing a 25Y USD 2 bn par issue with a 3.70% coupon, maturing in 2041, which improves on last year’s call (25Y USD 2 bn par issue with a 3.95% coupon, maturing in 2040). Similar to 2015, a portion of the proceeds went to buyback and retire higher-paying coupon bonds.

According to Reuters, Philippine companies are expected to raise over P100 bn ($2.1 bn) via the bond markets in 2016 as increased volatility last year kept many away. Much of the proceeds would be used for public-private partnership (PPP) projects, including toll roads, schools, an automated fare collection system, a railroad, a hospital and a bulk water project, as well as to pay-off retiring obligations. Corporates with an international investor following may take a looksy at the international bond market. Several weeks ago, Ireland successfully issued a 100-year (“century bond”) 2.35% coupon sovereign debt, just years after paying off its bailout loans from the European Debt Crisis in 2011. The Irish paper was priced to yield 31 bps below 30Y US Treasury bonds! Great timing or Luck ‘O The Irish?

Philippine Peso 10Y bond yields fell at the beginning of the year (first arrow in DB Chart 2). But, anticipation of the government’s jumbo USD sovereign bond offering sent yields sky-rocketing as investors positioned themselves (second arrow in DB Chart 2). Already, yields are drifting lower and should stabilize. A glance at the Philippine USD yield curve reveals that Philippine USD paper provides around 150 bps and 100 bps pick-up over US treasuries at 10-15 year and >15year maturities, respectively (DB Chart 4).

Recent Performance of Philippine Equities

Strong net foreign portfolio investment outflows last year led to a 3.9% drop in the PSEi Composite Index in 2015. But, the abrupt shift in sentiment starting in mid-Jan resulted in a “V” shaped reversal as foreigners plowed back in and locals piggy-backed for the ride (Chart 4). Since mid-Mar, a flag pattern has emerged signifying a rolling-stop as early-profit takers depart and new investors clamber aboard – note confirming volume slow down (Chart 5).  As a continuing indicator, the flag suggests the PSEi would likely run to about 8600-8700 before the first significant correction. Looking ahead, forceful penetration of the upper resistance zone of the flag at around 7370-7380 denotes resumption of the bullish trend. The trigger could emanate from any direction: poor Q1 US earnings announcements, more dovish Fed talk (next FOMC Meeting, Apr 26-27), major FDI announcement, strong OFW remittance inflows, relatively smooth Philippine presidential election (May 9). Two major risks facing the Philippines are the perceived outcome of May’s elections and yet another flip-flop by the Fed. A down-break below 7180 on heavy volume nullifies the bullish trend set-up, requiring reassessment of the (then) current situation. Next, let’s see what currency markets are saying.

Outlook for the Peso

For all the money printing and expanding Fed balance sheet, USD reigns supreme in the currency waters and when it decides its time to change direction, like an EEE-Class container ship, best to stand clear as all currencies feel the impact. As laid out in the previous report (Emerging Markets Analysis for Apr 4), with interest-rate hikes on hold, the USD Index, which has been trading in a consolidation zone since early 2015, will test its lower support level at 93-94 (far right DB Chart 9). As USD weakens, the PBOC will likely re-peg the renminbi to the greenback to help Chinese exporters and, hopefully, stabilize the weakening Chinese economy. Of course, other exporting countries may further loosen monetary policies and lower interest rates to defend their exports. On Apr 14, Singapore’s MAS switched to a neutral stance (by pegging SGD to a currency basket) to keep the SGD from strengthening against the depreciating greenback. The currency wars continue.

Meanwhile, the Peso will likely go with the flow, moving in between large waves like an agile cutter, with the BSP tweaking monetary policy here and there. After reaching its weakest point in six years on Jan 26 at P48.15/USD, the Peso has strengthened to about P46/USD on the back of steady capital inflows.

Final Thoughts

The Fed is unlikely to raise interest rates this year. Chair Yellen and other FOMC members have all but shouted this. Already, capital searches for higher yielding opportunities, including emerging economies and financial markets. Philippine equity performance over the last three months sits at the midpoint for emerging equities, despite a compelling economic story (DB Chart 8). To be sure, the Philippines has righted its economic house during the last six years and appears as one of the most attractive participants in the on-going foreign investor beauty pageant. With presidential elections less than three weeks away, a smooth outcome and hand-over would pave the way (hopefully) for continued economic, monetary, and structural progress made by the out-going Aquino administration. And, with a little good fortune, the Pearl of the Orient may yet be crowned belle of the ball and receive an allocation upgrade from investors.

Philippine Financials and Cash Flow Dashboard

Interest Rates / Bonds



Emerging Countries’ Capital Flow Dashboard20160419 Table 1.jpg

Emerging Markets Analysis – Monday, April 4, 2016


This emerging markets analysis examines the outlook for capital flows into emerging economies and its impact on emerging equities over the next twelve months and the outlook for the US dollar from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

A Lull in Fed Activity

20160404 Chart 1

After a false start in Dec (perhaps, planned), the Fed all but rescinds its hawkish interest-rate normalizing strategy as conveyed via recent dovish FOMC meeting decisions, released FOMC meeting minutes, and speeches. Not only would the Fed not be implementing its original three hikes this year (300 bps over the next several years was the original plan) but, perhaps, none at all, depending on the “data” (Chart 1). With the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the Fed will likely hold-off until early 2017, after the energy sector completes its current round of capital raisings, lenders off-load much of their exposed risk, and the new president swears in before making any major decisions. As discussed in the Market Analysis Reports for March 11 and March 29, this author believes NIRP (plus, possibly, QE4) constitutes the next weighty move by the Fed. Thus, this lull in Fed activity presents opportunities for emerging market equity investors.

Emerging Countries’ Capital Flows

20160404 Table 1

As noted by many analysts, in the wake of the 2007-2008 Global Financial Crisis, capital flow between advanced and emerging economies has become sensitive to monetary policies and its effect on interest rates and central bank balance sheets of developed economies. When considering heightened geopolitical and terrorist tension, lackluster economies, and the uncertainty of monetary policies, capital flows, understandably, have grown volatile. The current abatement in Fed action entices global investors to venture abroad in search of yield.

Some emerging economies will attract a relatively larger share of short-term (and even long-term) capital flows over the next twelve months. Countries with a high dependence on foreign capital that experienced large foreign capital withdrawals over the last eighteen to twenty-four months could expect an influx. During the 2013 Taper Tantrum, the so-called “Fragile Five” (Brazil, India, Indonesia, South Africa, and Turkey) experienced heavy portfolio outflows only to see much return in months. Some countries to watch include Turkey, South Africa, Colombia, Brazil, Peru, and Indonesia – all with high current account deficits that rely copiously on external debt and portfolio equity flow (positive net debt and portfolio equity flows) for financing. To a lesser extent, Poland and Chile could also see strong capital inflows. Interestingly, Argentina, under new President Mauricio Macri, recently settled its dispute with hold-out foreign bond investors and has taken aggressive steps to tackle the country’s problems and seeks to raise up to $15bn in international debt markets in April to settle the bill with holdouts – upon success, more capital raisings would follow to fund government expenditures and to boost depleted foreign currency reserves (Table 1). Also, India could see healthy capital inflows as it weathers the global economic storm better than most, expecting its economy to grow by 7.5% this year– a tad optimistic, perhaps, but significantly better than other economies. And, of course, Mexico, with its close proximity and integrated economy (to the US) could expect a rush of incoming capital. Furthermore, smaller developing economies sporting higher current account surpluses could see a bump up in allocation that would launch local equities: Vietnam, Philippines, and Thailand. Malaysia could be included in this last group, however some money managers still hold concerns over the 1MDB scandal. Another faction that could benefit are emerging commodity-producing countries.

Relief for Commodity-Producers

Since the start of the 2007-2008 Global Financial Crisis, commodities get hammered. But, the widely-broadcasted ending of QE3 creates a massive “risk-off” environment, commencing the summer of 2014, that sends USD parabolic and commodities on its next downleg (Chart 2). The recent dovish stance of the Fed enables commodities to finally form a bottom (Chart 3). Will it stick? Commodity fundamentals remain horrid, but as the adage goes: “Don’t fight the Fed.” And, the corollary: “Especially during a presidential election year.”

Emerging commodity-producing country equities bottom and track commodity prices upward in near lockstep, from mid-Jan 2016 (immediately after NY Fed Pres Dudley speech). As expected, high net commodity-to-GDP economies lead the way. The steep rise in UAE equities suggest the market expects bullish oil prices to continue, which Russia and Indonesia certainly cheer. Even problem-riddled Nigeria is forming a trough (Chart 4). For moderately high net commodity-to-GDP economies, Brazil and Colombia stage a remarkable turnaround zooming from group laggards to top of the class in several months (Chart 5). The prospect of Macri winning the presidency helps push the Merval to an all-time high. And, the long-awaited settlement with foreign bold holdouts and a state visit by Pres Obama solidifies Argentina’s planned return to the international debt markets (Chart 6). Argentina’s return is timely as the USD Index nears completion of a one-year topping formation (green circle in Chart 2 and Chart 7) that would lead to USD weakening for the indefinite future (USD Index next probable target: 85, a 10% depreciation), thereby making future repayments in relatively stronger pesos more attractive.

The Weakening US Dollar20160404 Chart 7

Emerging economies benefit from a softer dollar in several ways. China gains as pressure lessens on the PBOC, which removed its peg to the dollar and allowed the renminbi to weaken against the strengthening greenback (Chart 7).  Thus, watch for the PBOC to “re-peg” to the weakening USD, thereby helping exports. But, pressure increases on other emerging exporters, who may further loosen monetary policies and lower interest rates to defend its exports – the currency wars continue.

As already mentioned, commodity-producers enjoy a fillip and capital inflows into emerging economies could pick-up significantly that would boost local equities and bump up local and international bond prices, jump-start FDI and M&A activity, replenish depleted foreign exchange reserves and help finance current account deficits, and should local currencies strengthen vis-a-vis the dollar, imports of raw materials, natural resources, and machinery and equipment become attractive. Also, a weaker dollar brings relief to US dollar international bond holders as underlying names get a credit rating pop due to improving emerging economies and repayment spur, as mentioned for Argentina.

As business activity springs to life, local consumption rallies, particularly for discretionary spending; the lending cycle swings upwards to reinvigorate whole swaths of industries: banking, brokering, insurance, residential and commercial construction, existing  home selling, appliances, home furnishing and fixtures, houseware and accessories, office supplies, packaging and containers, paper and paper products, textiles, auto and trucks, construction equipment, business equipment, electronic equipment, computer equipment and software, communication systems, foods, cement, farm and construction machinery, building materials, industrial electrical equipment, industrial equipment, lumber and wood, machine tools and accessories, tools and accessories, waste management, and all types of consumer and business services. For emerging market investors, all this adds up to finance, cyclical, and technology stocks advancing first, closely followed by industrials.

Nevertheless, emerging exporters require a destination for their goods and services. Is China’s economy large enough and ready to sufficiently supply demand for final goods? What about India? Surely, rich or large commodity economies, like a rejuvenated Canada, Australia, Russia, Indonesia, Brazil, Nigeria, and Mexico would draw-in products. Little help from Continental Europe, which remains weighed down by a horrendous banking situation, a swarm of refugees, terrorist attacks, and a populace that grows more scared by the day. Also, the UK is not in the buying mood as it contemplates Brexit and economic life thereafter (what happens to existing EU trade, banking, and financial agreements), while staring at a current account deficit-to-GDP of 5.2% (2015), total official national debt-to-GDP of 81% (2015), and total external debt-to-GDP of 569% (2014). So, who does that leave?

Final Thoughts

How long this downleg in the USD lasts is anybodies guess. But, as previously examined, a US move to NIRP could cause economic and financial market linkages to eventually unhinge as the dreaded “Doom Loop” (see Market Analysis for Mar 11 2016) becomes reality to create a self-inflicted implosion and strong inflation (and, even possibly, hyperinflation). In the most extreme case, USD Index approaches the zero limit and some form of SDRs takes over (most likely backed by some portion of gold), but not before global economies and financial markets are thrown into disarray. No wonder China tried so hard to get the renminbi added (effective Oct 1 2016) to the IMF SDR basket (and a seat at the next global financial system re-set). That would also help explain China, Russia, and other nations’ obsession with gathering gold.

Until that event occurs (Japan remains upright after two and half decades of deflation), however, America awash in liquidity, albeit tied up in the financial markets, could overturn its pessimistic posture with a new president at the helm to get businesses to invest, expand, and hire again (fast-food and temporary teaching jobs don’t count) so that consumers feel stable enough to start spending once more to keep the global economic ball rolling. Combine that thought with the prospect of the strengthening (after three years of free-fall) of the world’s third largest economic currency (which, of course, helps its consumers and boost imports; Chart 8) and the posed paradox is solved: US and Japan to the rescue with back-up support from the OECD (many of whose currencies shall appreciate vis-à-vis USD by default, with the Brexit exception of the UK and GBP; Chart 9). Thus, watch for emerging market stocks (and emerging domestic and international bonds) to put in a relatively decent performance over the next twelve months, or so. And, should the Fed decide to buttress its dovish talk with action (ZIRP, NIRP, QE4) before then, back-up the truck.  Or, at least, that seems to be Plan A. Of course, Plan B could always be dusted-off and enacted: War.

Market Analysis – Tuesday, March 29, 2016


This market analysis examines recent actions by the Federal Reserve and its impact on financial markets, with a focus on emerging equity markets, and the outlook for Fed activity from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

All Eyes On The Fed

Fed actions continue to act as the primary driver of developing economies and financial markets. The mere suggestion of liquidity tightening by Fed Chair Bernanke in May 2013 sets off the Taper Tantrum that sucks capital out of risky assets, propelling emerging equity and debt markets downward in weeks (far left, Chart 1). This leads directly to QE3 and a resurgence in risky assets, including emerging equities, which reaches a 3-year high to form the peak in a HS pattern (center, Chart 1). But, stoppage of US liquidity injections (end of QE3), results in emerging markets exit, despite liquidity infusions from BOJ, ECB, BOE, Riksbank, SNB, and DNB (right, Chart 1).

China’s credit-fueled investment expansion grinds to a halt that, combined with a strengthening USD, sends commodity prices plummeting (Chart 2).

In Dec 2015, the Fed finally raises the target Fed funds rate (and indicates a total increase of 300 bps over the next several years), after threatening to do so for two and half years, despite signs of a slowing US economy, shattering US energy companies, lackluster Europe, and imploding China, shoving emerging equity (and debt) markets into freefall (first green down leg, Chart 3). By mid-Feb 2016, the Fed, once again, reverses course to deliver a dovish spin, halting the equity correction in a near perfect “W” bottom reversal. At the widely anticipated Mar 15-16 FOMC meeting, the Fed confirms no raise and then Chair Yellen, at a speech at the Economic Club of New York on Mar 29, implies that not only would the Fed not be implementing its original three hikes this year but, perhaps, none at all, depending on the “data” (Chart 3).  What the heck is happening?

Set-Up for NIRP

The BIS and major CBs coordinate monetary actions since the 2007-2008 Financial Crisis to prevent a meltdown in global financial markets. Eight years later, and after rounds of traditional monetary policy, quantitative easing, qualitative easing, and ZIRP, global financial systems remain on life support. Now, European CBs and BOJ are employing NIRP to support the Fed’s effort to strengthen the greenback and normalize interest rates as official US national debt soars over $19.2 trn, or 102% of GDP. But, with the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the likelihood of a rate hike diminishes by the day. The pretend wealth effect must continue for a little while longer.

By early 2017, once the energy sector has completed its current round of capital raisings, lenders off-loaded much of their exposed risk, and the new president sworn in, the Fed and banks may likely stand aside and let markets re-price. Would this be the ultimate cleansing discussed in earlier reports? Unlikely. More probably, similar to the 2008-2009 equity sell-off, after a 50%, or so, drop, the Fed would enact NIRP and, even, QE4, in a final (hopefully) effort to let the new administration and Congress find a solution to the financial morass.

Obviously, monetary actions have proven ineffective, so political leadership and regulatory, legislative, and structural changes are required to normalize the banking and financial systems and labor markets so that the real economy can grow, once again. If the actual problem of excess debt is not directly addressed, the US faces lost decades of fudged numbers and economic decline, just like Japan. But, under NIRP (see Market Analysis for Mar 11 2016), the unraveling may come much sooner. Throughout, of course, savers suffer and receive the blame for the ineptitude of borrowers.

Market Analysis – Friday, March 11, 2016


This market analysis examines the current economic environment, global monetary policy, and the outlook for global financial markets from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

Aftermath of QE3

Anticipation of the “official” ending of QE3 in Oct 2014, monetary easing at the BOJ, and easing rumors at ECB and Riksbank propels USD higher, starting in July 2014 (circle in Chart 1). Correspondingly, commodities plunge, dragging emerging markets along two months later (dashed vertical line in Chart1 and circle in Chart 2). Meanwhile, US equities, partially thanks to brethren central bank liquidity injections (see Market Analysis for July 27 2015), remain resilient, albeit volatile (first half of Chart 3). But, by mid-2015, Fed Chair Yellen’s talk about a rate hike finally takes hold as US equities breakdown through uptrend support (circle in Chart 3). Chair Yellen promises three rate hikes in 2016 and to raise Fed funds rate 300 bps by 2017. Despite intermittent rallies, equities face a decidedly downward journey…or, do they?

Energy Sector Gets Decimated

If a stronger dollar wasn’t bad enough, a slowing Chinese economy, prospect of new energy supplies from Iran, and highly-levered shale oil companies makes shorting energy a trade of a lifetime as crude oil trades below $30/bbl. With bank loans in dire straits (Citigroup $58bn, BoA $43bn, JPMorgan Chase $42bn, Wells Fargo $42bn exposures), energy companies manage to unload new equity offerings despite collapsing oil and share prices. According to Bloomberg, another $9.2bn share offerings have been announced YTD (as of Mar 1). With this as background, beware of bear market rallies…that knife is still falling! But…

The Fed to the Rescue

Despite the rhetoric out of the Eccles Building and deeply-massaged and contorted official unemployment figures, the facts are that oil prices are under $40/bbl. (not good for Russia nor US banks), US equities are trending down and volatile, and a lot of angry American voters are attending Trump rallies. At a 0.25%-0.50% target rate, the Fed is out of traditional ammunition to fight the next economic downturn, which is imminent. Any delay in a rate rise now means that the eventual hike arrives during a weaker economy, thereby triggering recession. With remaining FOMC meetings slated for Apr, Jun, Jul, Sep, and Nov 1 prior to the Nov 8 elections, perhaps, as NY Fed Pres Dudley’s speech on Jan 15 suggests, it’s too late to raise them at all. Like Pavlov’s dog sensing a free meal, financial markets make a swing-low in early Feb as the S&P 500 bounces from 1864 and WTI Futures Apr 16 from around 29.00. So, what next?

Alice in Wonderland Time

Picking up the QE mantle from the Fed, the BOJ (see Market Analysis for Jan 12 and Jul 27 2015), following the election of Prime Minister Shinzo Abe in 2012, unleases its own version of liquidity infusion, triggering the Yen Carry Trade. ..and, just to be sure, officially enacts NIRP on excess bank reserves last month. The ECB, for its part, announces in early 2015 an “expanded asset purchase program” of Euro 60 bn per month, expected to total at least Euro 1.1 trn. On Mar 10, the ECB increases monthly purchases to Euro 80bn, cuts interest rates (including the deposit rate to -0.40%), re-declares inflation target of 2% (despite ECB projections showing sub-2% inflation for next 5 years), and announces a scheme to pay banks to lend. On the latter, don’t be surprised if European banks use this opportunity (gift seems more like it) to generate some lending and broking fees to help eurozone corporates engage in some good ol’ American-style share buybacks to give European equities a boost. Remarkably, in his speech, Pres Draghi all but rules out further interest rate cuts…er, get it while it’s hot?  With traditional monetary policy, Quantitative Easing, Qualitative Easing, and ZIRP all failures, global CB focus now rests on NIRP to inflate government and bank debt away. And into the rabbit hole we go…

NIRP: What Could Possibly Go Wrong?

By taking the NIRP route, CBs gamble that banks can withstand the hit on their income as lending rates move below deposit rates. For US banks, not as much a problem as not as relient on deposits for funding, but elsewhere it could cause major dislocations. Judging by collapsing European bank share prices, the gamble is not paying off (Chart 6). Making less money, weak banks cut-back on lending, weakening economies and driving CBs to take rates even lower, thereby inducing a self-inflicted death spiral. A WSJ diagram succinctly sums up the situation (Diagram 1).

Deflation-Led Implosion

As discussed in the previous report, economies currently running into strong deflationary headwinds. To be sure, these headwinds stem from underlying problems from the 2007-2008 Financial Crisis and before (see Case Study: US Bear Market of 2007-2009, Case Study: Dot-Com Bubble, and Case Studies: 1997 Asian Financial Crisis, Part I and Part II)*, which never went away: Too much sovereign, corporate, and mortgage-related/asset-backed debt. Keeping debt off-balance sheet, changing accounting rules, or re-classifying debt did not make the debt disappear. Unable to create gentle, steady inflation with the blunt tools at hand, CBs seem determined to pursue NIRP. But, as shown, secondary and tertiary effects can wreck havoc on NIRP.

20160311 Chart 7

Again, as discussed in an earlier report, the markets show early signs of deflation in Sep 2014 (Chart 7), while many pundits and economists focus on lagging indicators that suggest all-is-well. In Jul 2015, markets give another emphatic shout that deflation is now a significant problem. Further incongruous actions of monetary officials and politicians perpetuates extremely loose money policies that will likely push economies past the event horizon and into a deflationary-spiral with a nasty terminus: Hyperinflation. Thus, economies and financial markets find themselves today.

Probability of Hyperinflation?

So, assuming NIRP is enacted on a global scale (BOJ, ECB, Riksbank, DNB, SNB, and, possibly, Fed), the chance that monetary and political authorities can withdraw monies from the banking system before inflation takes-off is exactly nil. Hence, expect double-digit inflation as a result of NIRP. As for hyperinflation (+50% general rise in prices), those economies unable to remove liquidity in rapid order would be staring directly at a Zimbabwe or Weimar Republic hyperinflationary environment. How long do global economies have until the SHTF?


As suspected, this story does not have a happy ending. The CBs, led by the Fed, determine the duration and magnitude of the outcome. Out of traditional bullets, fanciful methods are tried to inject liquidity into economies that simply, like gigantic and tiny Alice, effectively inflate financial market prices temporarily before prices deflate once again, thereby inducing another round of the latest monetary potion – NIRP for now. So, how long does this go on for? Japan has managed to remain whole for two and half decades, while caught in its deflationary spiral. But, as explained, NIRP may change this.

If “The Doom Loop” proves to be moderately accurate, NIRP shall likely be the last kick-of-the-can and weak banks and financial institutions (e.g. insurers and pensions with 6-8% real long-term actuarial investment return assumptions are deluding themselves) will eventually be taken-over by relatively stronger ones, while the weakest, facing bankruptcy, split into “good” and “bad” entities, with “good” ones acquired by the strong and “bad” ones run-off. Of course, major unhinging in economies and financial markets occur, including forceful inflation and, possibly, hyperinflation. But, economists already know the solution: Stop printing money. Hopefully, politicians force the purging of putrid debt, letting several major financial institutions and corporates to go the way of the dodo bird, and, with any luck, setting an example for others, before declaring any moratorium on the painful cleansing.  Once again, that barbarous relic gold (silver as well) will prove its usefulness, as it has done, time after time throughout history, as the ultimate safe haven store of value.

*  Forthcoming Case Study: 1971-1973 End of Bretton Woods System examines, among others, the role that a reserve currency plays in abetting an economy and local borrowing and the massive build-up of debt (sovereign, corporate, mortgage-related/asset-backed, and personal debt) in the US after the US transitioned to a pure fiat monetary system.

Market Analysis – Monday, July 27, 2015

This market analysis examines the current economic environment, the recent performance of U.S. financial markets in relation to the 2007-2008 Financial Crisis, and the scenario for hyperinflation from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. With U.S. presidential elections less than 16 months away, will the government (The Fed) really raise short-term interest rates before then, the occurrence of which, many market participants agree, would lead to a major, and possible historical, sell-off in the financial markets?

Inflation or Deflation: The Market has Already Spoken
20150727 Chart1 20150727 Chart2
20150727 Chart3 20150727 Chart4
The market prices in deflation. The battle between inflationary and deflationary forces following the 2007-2008 Financial Crisis, at an initial glance, appears to be nearing a climax. Each time an equity market meltdown seemed imminent, causing investor flight to safety that boosted US bonds relative to stocks, the Fed rolled out, yet, another unconventional monetary program to inject money and credit into the economy, leading to a recovery in stock prices and a fall in the US bond-stock ratio (Chart 1; also, Market Analysis for January 12).

Despite the “official” ending of QE in October 2014, the S&P 500 has risen 6.7% (as of July 20) since the end of January, all while Fed Chairwomen Yellen insists that she would raise rates soon. Worrisomely, US bond yields have recoupled with stock prices, signaling that deflation shall dominate the economy in the foreseeable future (Charts 2 and 3). A re-examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 4). Again, while many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back. So, where’s the liquidity that continues to drive US equities higher coming from?

The Yen Carry Trade
20150727 Chart5 20150727 Chart6
The monetary liquidity baton has passed to the Bank of Japan. As discussed in the previous edition of Market Analysis (January 12 2015), the BOJ has initiated its own version of QE that dwarfs that of the Fed in relative terms. The Yen Carry Trade, running since rumors first surfaced that Shinzo Abe would vie for the prime minister role of Japan back in September 2012, kicked into high gear as the yen depreciated over 20% against US dollar during the last ten months (Chart 5). Since mid-October 2014, the S&P 500 has tracked USDJPY nearly step-for-step (Chart 6).

The ECB and SNB Quantitative Easing
On January 22, ECB President Mario Draghi announced a dramatic boost in ECB asset purchases to Euro 60 billion per month of euro-area bonds from central governments, agencies and European institutions, totaling at least Euro 1.1 trillion by September 2016. Several weeks later, the Riksbank launched its own bond purchase program (roughly $10 billion in total) in hopes of driving Swedish yields and the krona lower. While the krona has depreciated 4.3% against the greenback and remains virtually unchanged against the euro since the beginning of February, Swedish 10-year bond yields have actually risen slightly (up 2 bps to 0.72%), not what officials expected.

Hypothetical Scenario for Hyperinflation
For hyperinflation to occur requires a fiat monetary system and a large and growing budget deficit. In his book The Monetary Dynamics of Hyperinflation (1956), Columbia University economics professor Phillip Cagan defined hyperinflation as a price-level increase of at least 50% per month. A study by John Hopkins University economics professor Steve Hanke and economics researcher Nicholas Krus, World Hyperinflations (2012), discusses 56 episodes of hyperinflation, dating back to France 1795-1796. Some people argue that Hanke and Krus’s strict adherence to Cagan’s definition (e.g. if the price-level falls below 50% after twelve months, only to rise back above the next month would be considered a new episode) overstates the number of cases. Thus, Peter Bernholz, Professor Emeritus of Economics at the University of Basle, puts the number of bouts of hyperinflation over the same time frame at 30 (Monetary Regimes and Inflation (2003)).

So, what causes hyperinflation? Hanke and Krus name war, political mismanagement, and transition from a command to a market-based economy as some reasons. The debasement of currency traces back to antiquity. For example, Roman emperors to pay for their wars and global expansion would reduce the size of coins or lower the amount of silver contained within denarius coins, thereby increasing the supply of money relative to the supply of available goods and services; inflation, but not hyperinflation, soon followed. Today, fiat monetary regimes resort to the virtual printing press to digitally expand the monetary base, while the corresponding governments issue more debt for which it exchanges with the monetary bodies. Thanks to modern financial-banking systems, the money supply expands as the velocity of money multiplies the effect of each economic transaction. For now, the multiplier effect has been muted by a sluggish economy, but should expectations return to normal and the monetary base remain at its historical lofty level ($3.9 trillion as of June 30, 2015, Board of Governors of the Federal Reserve System) inflation would likely take-off in short order. As long as existing holders of government debt and beneficiaries of government obligations (public pensioners, social security, medicare/medicaid, food stamp, and unemployment benefit recipients, etc.) remain confident that they will be paid in full and that others will accept the currency, the system holds. As the level of public debt and future obligations rises relative to collected taxes (not GDP), investors and government obligation recipients start to get nervous.

As of July 24, 2015, total U.S. public debt outstanding stood at $18.1 trillion; federal tax revenue $3.1 trillion; federal spending $3.6 trillion; and federal budget deficit $497 billion (TreasuryDirect and U.S. National Debt Clock). According to Bernholz, all cases of recorded hyperinflation experienced government borrowing as a percent of government spending of over 40% at one time. Even, if an attempted recovery managed to push borrowing back below 40%, hyperinflation eventually overwhelmed the economy. When a government needs to borrow to pay back its interest and principal, it enters a debt spiral from which escape is difficult. Inasmuch as a deficit remains, new debt continues to be added on which interest must be paid. Thus, the U.S. finds itself today.

As deflation takes hold, and, probably, spreads abroad (Case Study: 1997 Asian Financial Crisis: Parts I and II), government officials are likely to aggressively step-up quantitative easing efforts to generate counter-balancing inflation. To be sure, deflation is not necessarily a pernicious phenomenon; during the gold standard, monetary authorities kept prices stable by routinely allowing slight deflation following a burst of inflationary, economic euphoria. Unfortunately, recent history is littered with examples of countries that tried to deliberately inflate their way out of a financial problem. In 2009, the U.S. government borrowed 40.2 cents for every dollar it spent. The total U.S. public debt outstanding listed above excludes unfunded government liabilities; some put the total at over $60 trillion and, possibly, $100 trillion. With all that in mind, notwithstanding the effect on equity markets, would the Fed really hike interest rates before elections?

Market Analysis – Monday, January 12, 2015

This market analysis examines the performance of U.S. financial markets since the 2007-2008 Financial Crisis to provide an outlook for economic conditions from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Central bank activity carries on to drive the markets. Meanwhile, the tug-o’-war between deflation and inflation continues for supremacy of the U.S. economy. Altogether, this impacts the prospect for financial markets over the next 18 months.

Trading Ahead of the Fed
20150112 Chart1 20150112 Chart2
The market anticipates Fed monetary actions to get a jump on investing. As the 2007-2008 Financial Crisis develops, a flight-to-safety drives bonds skyward as stocks tumble, sending the bond-to-stock price ratio parabolic. Following Lehman Brother’s bankruptcy filing (Sep 15 2008), the Fed announces QE1, providing a reprieve to the markets. Bonds sell-off (yields rise) immediately, while stock investors digest what occurs; stocks eventually rebound strongly, after a final cleansing of weak holders, in March 2009. Going forward, each time bonds are heavily bid to catapult the bond-to-stock ratio up, the Fed rolls-out yet another unconventional monetary program. Astute investors trade ahead of the Fed, boosting stocks several months before a Fed announcement (Charts 1, 2).

Liquidity, Liquidity, Liquidity
20150112 Chart3
Liquidity continues to drive the markets. Fed intervention keeps a constant bid on bonds as liquidity seeps (flows) into the financial markets, collapsing bond yields, while lifting stocks and bonds. Each time bond yields bounce off the down trendlines reinforces the uptrend in stocks (Chart 3).

Other major central banks contribute to the liquidity influx. To combat the UK’s economic crisis, the Bank of England undertakes four rounds of QE (Mar 2009, Oct 2011, Feb 2012, Jul 2012) and maintains a near zero-interest rate policy. In Japan, suffering a long recession-depression since 1989, the government relies primarily on fiscal stimulus and ZIRP, with miniscule QE efforts. But, with the election of Prime Minister Shinzo Abe in December 2012, and subsequent appointment of Haruhiko Kuroda as governor of the Bank of Japan, the BOJ pledges a money-printing program that is, relative to the size of the US economy, twice the size of the Fed’s QE3. Some of this foreign money flow finds its way into the US financial markets, helping to drive up stocks and bonds.

The Deflation-Inflation Battle
20150112 Chart4 20150112 Chart5 20150112 Chart6
Deflationary and inflationary forces struggle for control of the U.S. economy. Following the 2001 Dot-com Bubble burst, deflationary effects dominate monetary inflationary counter-action. Increasing positive correlation between stocks and bond yields represents a tell-tale sign of deflationary conditions (red shaded region of Chart 4 and first arrow in Chart 5). Then, starting in 2012, the link between stocks and bond yields starts to weaken, turning negative in Q4 2013, hinting that deflation may finally be whipped. But, after bottoming in May 2014, positive correlation comes back with a vengeance as the market shouts deflation (second arrow in Chart 5).

From an economic analysis perspective, the Personal Consumer Expenditure inflation rate (Trimmed Mean version, which excludes high and low data points), the Fed’s preferred measure of inflation, shows 6-month and 12-month annualized inflation stabilizing between 1.25% and 2.00% over the last 3 years (Chart 6). But, with 1-year certificate of deposit rates at around 1.15%, savers continue to suffer drops in spending power, as banks and financial institutions leverage up on near zero financing while assuming riskier bets in a low-yield environment. Next, several scenarios for deflation-inflation are examined.

Three Hypothetical Scenarios for Deflation-Inflation
Scenario 1 (Deflationary Escape): Since December 2013, stocks and bonds appear to have re-coupled, returning to an inflationary / disinflationary relationship (arrows in Chart 4). Under this scenario, the U.S. economy has reached break-away velocity and escapes deflation’s crippling grip. Nevertheless, with U.S. government total debt at $17.8 trillion (as of September 30, 2014), or 101.3% of GDP, an inflation-bias will dominate for years to come. But, even moderate interest rate hikes in 2015 would surely spell the doom for the current stock and bond bull (bubble) market. With banks and financial institutions leveraged up, a rush to the exit would not be unexpected.

Scenario 2 (Return to Deflation): Should economic conditions continue to deteriorate, and/or another major financial institution run into trouble following the official ending of QE in October 2014, new liquidity injections (QE4?) could alter the financial market landscape, yet, once again. In which case, falling bond yields since December 2013, act as an early signal of a flight-to-safety and continued deflation, leading, most probably, to a major sell-off in stocks and clearing of the decks, before new Fed monetary easing re-ignites parts of the financial markets.

Scenario 3 (Keynesian Deflation Paradise): Similar to Scenario 2, except that the Fed announces a new round of QE before any panic selling occurs (perhaps, preempting a major bank failure). Thus, no major sell-off in equities takes place and prices actually jump upwards from today’s lofty level. Of course, this only delays the inevitable correction, which would occur from a greater height, producing a more pernicious psychological effect over all, perhaps, leading to the dreaded deflation spiral. How long politicians continue to kick the can down the road would, likely, be determined by the financial markets willingness to hold government debt.

Economic Outlook
So, what is the most likely outcome for the economy? From an intermarket analysis perspective, returning to Chart 1, the bond-to-stock ratio forms a large right triangle dating back to the start of the 2007-2008 Financial Crisis. As the ratio approaches the apex, a break below support, where the relative strength of stocks overwhelms that of bonds, would suggest a return to normalcy – inflation/ disinflation. However, the more likely bet is for a break above resistance, with bond relative strength dominating, to deflation, and the requisite Fed monetary easing (QE4?).

20150112 Chart7
Equity markets give a strong deflationary signal. An examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 7). While many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back.

The underlying causes of deflation never actually went away. Banks and financial institutions still hold huge amounts of non-performing property loans and other credit-related assets and associated derivatives via off-balance sheet vehicles. Accounting and legal gimmicks to hide these do not make them go-away. Furthermore, China, India, and the rest of the developing world possess a plethora of untapped labor that continues to exert downward pressure on prices. As advanced technology and processes roll-out in developing countries (albeit, requiring education and training of the workforce, and additional capital), prices would be suppressed even further. Also, the energy revolution in deep-sea drilling for oil and gas, shale oil, fracking, long distance pipelines, and LNG terminals and tankers raises energy supplies. For the developed world, aging demographics in Japan, Western Europe, and, to a lesser degree, in the U.S., lessens demand over time, depressing prices. To combat ongoing deflationary pressures and high government and corporate debt levels, developed countries would, most probably, continue to try to inflate via money printing and loose monetary policies and increased spending programs. The alternative, of course, would be to restructure the entire financial system, representing enormous losses and layoffs, and even a sharp recession. But, once a bottom is found, investors would return with capital, as they have throughout history, to enable economies to grow once again.

Case Study: 1997 Asian Financial Crisis: Part II

This case study examines the 1997 Asian Financial Crisis from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Part II investigates the phenomenon of deflation and how it impacts economies and financial markets worldwide. Part I focuses on the events leading up to the crisis and its effect on emerging market economies and financial markets. What condition pressures bonds and stocks to decouple? Can a butterfly flapping its wings in Bangkok lead to trillion dollar losses in Internet stocks?

Commodities Go Ugly Early
Chart 1 Chart 2
The 1985 Plaza Accord to weaken the greenback boosts commodities and emerging market stocks, particularly in Asia, through the 1990s. In August 1995, the U.S. dollar starts to strengthen once again, placing downward pressure on commodities and Asian commodity producers, such as Indonesia, Malaysia, Philippines, and, to a lesser extent, Thailand. As many Asian central banks peg their currencies to the dollar, strengthening local currencies also builds up pressure on exports. And, as Part I discusses, Asian governments and local companies increasingly rely on USD loan and bond financing – as long as the peg holds, all seems well (Charts 1, 2).

Asian Contagion
Chart 3
With downward pressure building on the baht, Thailand’s central bank intervenes in the currency market to support its currency. But, as foreign reserves (U.S. dollars) rapidly diminish, the central bank throws in the towel and lets the baht float in early July 1997. The baht devalues from THB25 to THB54 per USD over the next seven months. Soon, contagion spreads throughout the region as foreign investors exit Asian financial markets and currencies. A sample of stock market losses recorded from peak to trough follows: Bangkok SET -86%, Seoul KOSPI -81%, Kuala Lumpur Composite -80%, Philippine Composite -68%, Singapore Strait Times -67%, Jakarta JCI -64%, HK Hang Seng -58%, and Taiwan TWSE -45% (Chart 3).

Deflation in Asia
Chart 4 Chart 5
While equity markets crumble throughout Asia, deflation as defined by economists (a decrease in the general price level of goods and services) takes hold in only a handful of countries. Regardless, the deflationary effects are felt throughout the region and all countries enter recession or an economic slowdown. As deflation favors hording of currency and liquid assets, while punishing borrowers and holders of illiquid assets, under-investment tends to occur that impacts the economy. For society, the gap between wealthy and poor can widen dramatically. In severe cases, a deflationary spiral leads to a decrease in prices, which in turn causes lower production that places downward pressure on wages and demand, resulting in further lower prices, and so on. For Asia, without a doubt, three countries that maintain their currency pegs to the U.S. dollar suffer the worst effects of deflation: Hong Kong, China, Singapore. Hong Kong does not emerge from deflation until Q4 2004 (Chart 4, 5).

Deflation Arrives in the U.S….
Chart 6 Chart 7
The U.S. bond market feels the effect of Asia’s meltdown next. As the Asian Financial Crisis unfolds, capital returning from Asia bids up bonds, collapsing yields (Chart 6). Although U.S. stocks dip in August and October 1997, equities quickly regain its legs to rocket to new highs. Nothing out of the ordinary, bonds and stocks continue to track one another, typical relationship under benign disinflationary conditions. Then, in July 1998, the correlation between bonds and stocks changes from positive to negative (ellipse in Chart 7). Now, rather than stocks trading in sync with bond prices, stocks are following bond yields – stocks and bonds decouple. This is a tell-tale sign of deflation. Furthermore, exacerbating the situation, supply-side deflation creeps into the U.S. via low-cost goods from China and the rest of Asia. Advancement in technology and, to a lesser extent, an aging U.S. population also places downward pressure on prices. While the 4-5 year business cycle continues, under deflationary conditions, the tendency is for bond yields to peak (or trough) first, followed by stocks, and then commodities.

…But Deflation Goes Unnoticed
Unfortunately, this early indication of deflation washing up on the shores of the U.S. goes unnoticed. In March 2000, when the Dot-com Bubble finally bursts in spectacular fashion, pundits and mass media low-play the threat of deflation (circle in Chart 7). By October 2002, the NASDAQ Composite falls 78% from its peak, wiping out over $5 trillion in share holdings. Nevertheless, as late as December 20, 2002, in a speech to the Economic Club of New York, Fed Chairman Greenspan states that the U.S. is “nowhere near” falling into deflation, which, by this time, only strengthens belief that deflation is a serious threat.

Deflationary effects emanating from Asia spreads to Russia in 1998, Argentina in 2000, and contributes to the bursting of the Dot-com Bubble and collapse of European stock markets in 2000. Deflation last reared its ugly head in the U.S. during the Great Depression of the 1930s. Once entrenched deflation becomes difficult to eradicate.The 2007-2009 U.S. Bear Market and this century’s European economic meltdown stems from deflation. While this case study focuses on the 1997 Asian Financial Crisis, the 1991 Japanese Asset Bubble burst, arguably, initiated the deflationary effects that eventually encircled the globe in the 21st century.

In today’s interconnected world, inflation, disinflation, and deflation can be transmitted across the globe in short order. Intermarket, technical, and quantitative analyses serve as tools to identifying when economic conditions change before traditional economic and fundamental analyses foresee a shift. Commodities impact developing markets via the producer and consumer links; the latter will play an increasing role as middle classes continues to expand. A weakening U.S. dollar tends to boost commodity prices, while strengthening curtails prices. Developing countries that peg their currencies, whether to the U.S. dollar, euro, or, even, gold, run the risk of building up pressure on exports (or imports) and on financial stability, should governments and local companies rely too heavily on external financing. Bonds and stocks decoupling over an extended period of time signals deflation. Once established, deflation is difficult to eradicate and leads to under-investment that impacts the growth of an economy. For society, the gap between wealthy and poor can widen dramatically, which can lead to the social unrest witnessed in parts of Europe and some urban areas of the U.S. since 2007. In severe cases, a deflationary spiral as occurred during the Great Depression can devastate a country. Even the most senior economists do not always spot deflation before it is too late.