The Philippine Story in 2011: Infrastructure Investment

February 8, 2011

Inflation in emerging markets is accelerating. Indonesia just raised its official interest rate by 25 basis points last week, the first time since August 2009. In the Philippines, the January inflation rate surprisingly rose to 3.54% from 3% in December.

The Philippines is one of the few economies in emerging Asia with a favorable demographic trend. Its youth dependency ratio is higher than 0.8 in 2010, one of the highest in the world. Youth dependency ratio is defined as the population aged 19 years and under, to the population age 20−65 years.

Philippine economy has been mostly relied on domestic consumption in the past two decades.  In 2008, private consumption accounted for 71% of Philippine GDP, while most other ASEAN countries relied more on export and investment as the engine of economic growth.

Table 1: Consumption in GDP

Household income in the Philippines grew by nearly 20% from 2006 to 2009.  More importantly, the income growth is faster in low income groups than that in high income groups in the Philippines. The lowest income group saw their household income increasing by more than 28% from 2006 to 2009, while the highest income group experienced a 17% income increase during the same period.

Table 2: Philippine Household Income Growth, 2006-2009

Going forward, the Philippines badly needs more investment to upgrade its poor infrastructure.  The current basic infrastructure in the Philippines is so insufficient that it ranked bottom among Asia-Pacific economies according to World Competitiveness Yearbook, 2009.  The Philippines clearly has realized this problem and explored their options.  In 2011, Philippine government plans to attract private investments to finance more than USD 3 billion of infrastructure projects, including several privatization projects. Transportation has been the dominate sector that received the bulk of the investment.  The Department of Public Works and Highways has decided to allocate USD 1.4 billion (67% of its annual budget) on road construction in 2011.

Two major IPOs related to infrastructure (Cebu Air, Inc. and Nickel Asia Corporation) in 2010 contributed significantly to the record portfolio investment inflow (USD 13 billion) to the Philippines.  The 2010 net inflow of portfolio investment also set the record: USD 4.6 billion.  Two-thirds of the net portfolio investment inflow happened in the fourth quarter of 2010, taking advantage of the infrastructure-oriented development strategy established by the new Philippine government.

Philippine stock market performance in 2010 surely showed that investors had noticed the government’s strategy on infrastructure investments. Upon President Benigno Aquino’s election at the end of June 2010, Philippine stock market index (PSE) had risen from 3321 to 4413 in early November, a 33% increase in five months. During the same period, USDPHP dropped from 46.56 to 42.27, the lowest level since June 2008.

Philippine stock market index hit its 2010 peak days after Philippine currency PHP reached its peak against USD in early November.  Since then, both PSE and PHP trended downward.  By the end of January 2011, PSE had dropped by 10% from its peak and USDPHP had risen by 5% from its peak in 2010. The correction of Philippine asset prices is not a surprise as the larger trends of emerging economies include rising inflation, tightening monetary policies, and risk aversion. “Hot money” had begun to reduce their holdings in broad emerging market assets.

The correction in emerging markets is unlikely to end any time soon. The Philippines has more room than many other emerging economies to maneuver and continue its growth. Even when Philippine January annual inflation rate is up to 3.54%, it still falls into the range of target inflation rates set by the central bank (3.5%-5.5%). Philippine finance secretary Cesar Purisima recently told reporters “I want to send a clear message that inflation fears at this point are unwarranted …When you look at the whole economy, we are in a sweet spot where interest rates are low and inflation manageable … Right now, there is no reason to adjust the policy rate…”

As the biggest rice importer in the world, the Philippines is always vulnerable to the food inflation.  The latest example was 2008, when local food price inflation surged to 12.8% from 3.3% in 2007 when world rice prices hit a record high. In 2010, the Philippines imported a record 2.4 million metric tons of rice and the official reserve had a huge stockpile of rice.  Right now, the annual food inflation is 3.06%, still lagging behind the overall inflation, though rising from last month.

Compared with the double digit food inflation in China and India, the Philippines right now is indeed in a good position. The investment led growth relies less on external demand.  The return of investment on infrastructure is still high in the Philippines as the fixed investment is severely undeveloped. Upgraded infrastructure will in turn improve the long term sustainability of Philippine economic growth.

 



Inflation and the Returning of Rising Borrowing Cost in Europe

January 31, 2011

German inflation rate (y-y change) is up to 1.9% in January 2011, the highest level in two years. Inflation in other European core economies, such as UK and France, also picked up significantly by the end of 2010.  December inflation (y-y change) in France is 1.8% and December inflation (y-y change) in UK is 3.7%.

Chart 1: Inflation in UK, France and Germany

 

For European countries in the middle of the sovereign debt crisis, such as PIIGS countries, their fiscal austerity measures are supposed to cut the public spending, reduce the labor cost, and make their economies more competitive.  However, inflation in PIIGS countries rose even faster than these core economies in Europe, partly due to the consumption tax increases. These faster-rising inflation problems actually push business costs in PIIGS countries even higher, compared to core European economies.  Portugal inflation rate (y-y change) increased from 0.1% from January 2010 to 2.5% in December.  Spain inflation rate (y-y change) increased from 1.03% from January 2010 to 2.99% in December.

Chart 2: Inflation in PIIGS

 

Overall Eurozone inflation hit 2.2% in December, which compelled ECB President Jean-Claude Trichet to give a hawkish comment on inflation recently. However, ECB really does not have a lot of options.  Any rate raise obviously will further dampen the economic growth in PIIGS countries and negatively affect their fiscal revenues. These countries already depend on ECB funding mechanism to support their public finance. Their banking systems will be under more pressure if ECB ever lifts the interest rate to increase the borrowing costs.

So far, the fear of an immediate sovereign bailout for the rest of PIIGS countries (Portugal, Italy, and Spain) has been calmed since bond auctions at the beginning of the 2011 went pretty well. However, the yields of PIIGS government bonds were rising again in the past few days. The spiking January inflation in Germany is a warning signal. Inflation is likely to rise sharply in countries like Spain and Portugal as well.  The rising bond yields and increased inflation expectation will likely to push the yields of PIIGS government bond sales even higher next week.  The spiking borrowing costs will certainly put pressure back on the indebted PIIGS countries.  Right now, investors are focusing on the political turmoil in Egypt and uncertainty in the oil market.  Once the attention is shifted away from the event in the Mideast, the worry about the financing cost of PIIGS countries could return and contribute to the weakness in EUR.

Chart 3: Yields of Spain 10 yr Bond

 

 

Chart 4: Yields of Portugal 10 yr Bond

The Year-End Market and the China Interest Rate Raise

December 27, 2010

I hope that everyone has a great and happy holiday!

For those who are interested in the year-end thin markets, the following table presents the returns of S&P 500 index in the week between the Christmas and the New Year in the past 20 years.  The number of the positive returns is 12 and the number of the negative return is 8 for the last two decades, which give us little hint of direction in the final week this year.

But while most of Western countries were in vacation, PBOC raised interest rates by 0.25% in China due to rising inflation.  I looked at the most recent eight rate raises in China and the market reactions following the raises.  The following table illustrates the date of each recent rate raise, the 5-days return of related stock markets following the rate raise, the 5-days return of Dow Jones-UBS commodity index, and inflation rates at the time.

The Shanghai stock market had reacted positively toward rate raise announcements in the past.  The average rate of 5-days return following the rate raise is 4.93%.  Hang Seng index in Hong Kong had shown only an average 5-days return of 0.75%.  The Hong Kong market reacted negatively three times toward the rate raise decisions from PBOC in the last seven rate raises.  Impacts of China’s rate hiking announcements on commodities are also positive in the short term.  The average rate of 5-days return of Dow Jones-UBS commodity index following the rate raise is 0.56%, with only one negative return in seven rate raises. It is clear that markets had expected those rate raise decisions before PBOC made announcements in the past few years.  The latest raise is also not a surprise, since everyone was talking about it since the November CPI in China jumped to 5.1%.   When the uncertainty of rate raise is removed from the China stock market for now, it is likely that the history will repeat itself.

Is the Turning Point Upon Us?

December 16, 2010

Today the CPI for November 2010 is released. The headline CPI increases by 1.1% over November 2009.  The core CPI increases by 0.8% over the same month in 2009. Both readings are well below the Federal Reserve’s long term target inflation rate of 2%, reinforcing the Fed’s worrying about deflation rather than inflation.

 

Worry should Fed. QE2 has not shown its intended impacts of improving employment and lifting inflation in the US.  But China and a large part of emerging economies have already felt the heat. Nearly all commodities have seen their prices rising sharply in the past two months. The latest China’s CPI growth rate is 5.1%, the highest in over two years.

 

Fed might have this scenario in mind when the FOMC decided to implement QE2 last November.  In addition to stimulate business investment in the US, QE2 causes inflation to rise in emerging economies, which implicitly reduces the cost advantage enjoyed by those regions.  Then, the imbalance between the US and emerging economies could be somehow corrected. However, as the global supply chain is tightly integrated today, the US may have to bear the cost of QE2 before the benefit is felt.

 

The reason is simple. So far, commodity prices reacted much stronger to QE2 than CPI in the US.  The pace of commodity price appreciation is so fast that the adjustment in the global supply chain has not occurred yet.  US corporations have already seen their input price hiking. However, when the unemployment rate has stayed above 9% for nearly 20 months now, the consumer prices in the US have little room to increase further.

 

While companies cannot pass the higher costs of raw materials to final consumers, in short term, there are two likely results. The first result is that corporations will have to cut their profit margins since they cannot fully pass their increased costs to consumers. Lower profit margin means less incentive to invest and expand.  Another result is to cut other costs (mainly labor cost) to offset the hiking material prices.  Cutting labor cost will reduce wage, increase unemployment, and then put more pressure on consumers. Both results spell trouble for the whole economy and the stock market.

 

Historical data has proved the above point.  The following chart presents the monthly S&P 500 Index and the growth rate of US core CPI minus the growth rate of Import Price Index from China to the US.  Since China is often the last step in the supply chain: assembling and shipping goods to the US, the growth rate of Import Price Index from China could measure the production cost of US companies (a better measurement than PPI in the US).

 

The chart shows that S&P 500 largely lagged the growth rate of core CPI ex the growth rate of import price from China.  More importantly, whenever core CPI ex import price moved across zero, the major turning point of the stock market happened in a very short period or even at the same time.  Import price index from China is only available since December 2003.  In the past seven years, the growth rate of core CPI ex import price from China only moved across zero twice.  It first fell below zero during the period between the end of 2007 and the beginning of 2008.  S&P 500 index reached its peak during that period.  Then, the rate rose above zero at the beginning of 2009.  One month later, S&P 500 index touched the bottom.

 

After the CPI release today, the growth rate of core CPI ex import price is at 0.4%, continuing its downward trend. Given the rising inflation expectation in China and the danger of deflation in the US right now, that rate is falling below zero again-companies will bear the increasing costs and see their profit falling.  Is the next turning point of the stock market right in front of us now?

How to Play a Potential Canadian Housing Bubble

December 14, 2010

A Canadian housing market could be the biggest source of its domestic economic uncertainties. Housing prices have been rising significantly in Canada since 2009. The residential average house price, according to the Canadian Real Estate Association (CREA), rose from about $200,000 in 2003 to above $340,000 now. This is a nearly 75 percent jump over seven years.

The average family income after tax only rose from $65,000 in 2003 to $71,900 in 2007, according to the latest publication of Statistics Canada. If the income continues to grow at the same rate until today, then the average housing price-to-income ratio in Canada is going to rise from 3.08 in 2003 to 4.38.

As a comparison, at the peak of this most recent US housing bubble, the price-to-income ratio in the US reached its highest level of 4.7 in 2005. If we assume that the average family income in Canada is at the same level today as 2007 due to the recession, then the price-to-income ratio would also be 4.7 in Canada. The mortgage delinquency rate in Canada is currently still well below 1 percent and remains stable. But remember, the mortgage delinquency rate in the US in 2005 was also quite stable and low, while the housing market was at its peak.

Another source of pressure is that the Bank of Canada became the first central bank in the Group of Seven to raise rates since the onset of the global recession. If it raises interest rates again in the near future, it will put more pressure on homeowners in Canada.

Source: CREA and Statistics Canada

If an investor believes that the Canadian housing market is vulnerable to a deep correction and wants to trade on this belief, there are some choices: RBC Royal Bank (NYSE: RY) and BMO Financial Group (NYSE: BMO). The Canadian dollar ETF, FXC, is another vehicle available for investors to trade this housing bubble in Canada.

The residential mortgage exposure ($126 billion) of RBC Royal Bank at the end of the second quarter in 2010 is 8.4% higher than the exposure ($116 billion) in the same quarter in 2009. That exposure is also 18% of the total risk exposure of RBC Royal Bank at the end of the second quarter in 2010. The stock price of RBC Royal Bank is currently near its pre-crisis high. Given that it expanded its residential mortgage business aggressively last year, when the housing market was developing the bubble, investors should keep a cautious eye on its performance.

On the other hand, the residential mortgage assets of BMO Financial Group have been reduced from $48.1 billion at the end of the second quarter in 2009 to $46.7 billion in the second quarter in 2010. However, in the past three quarters, the bank’s residential mortgage exposure has risen steadily. If BMO can keep its exposure to the housing market under check, then BMO Financial Group could be a good choice for investors who want to avoid the potential housing risks in Canada.

If the housing bubble in Canada does burst in the next few quarters, then I expect that many investors would want to leave Canada for safe assets such as US government bonds. As an ETF to track the Canadian currency value against the US dollar, FXC should be a potential target for shorts. However this FXC short play should be a long term strategy (1-2 years), since the value of Canadian dollar is closely linked to the commodity price and the stock market index.

Fed Rate Decision and Its Impact on Stock Markets

December 14, 2010

FOMC just ended its meeting on interest rate. Not surprisingly, the Fed rate is kept at 0.25%, given the recent wave of bad news on housing, retail, and employment. What does Fed have to say this time? In the FOMC statement from the April meeting, it said “…Growth in household spending has picked up recently…Housing starts have edged up…”. It is no longer the case. Since Fed had already have an extremely low interest rate, the main question before the meeting is what they can do to fuel the recovery. They just ended the asset purchasing program back in March. If they ever re-start the programs, it will send a powerful negative signal to markets that how bad things are and they are worried. And actually, the credit markets do not need more liquidity now, unlike September 2008.

The latest statement acknowledged the weakness in the housing market and retail, but reiterate Fed’s belief of “a gradual return to higher levels of resource utilization in a context of price stability”. Thomas M. Hoenig is again the only member voting against the low interest rate. Overall, this statement is very moderate. It is very modest and gives out nothing unexpected. Basically it means that Fed is now taking a “wait and see” attitude. This hand-off approach should have little impact on stock markets. (un 23, 2010)

Short term market direction regarding Chinese Yuan appreciation

December 14, 2010

Markets have been quite confused to many recently. Economic data from U.S. last week have shown that there are still many challenges in economic recovery. Housing starts, building permits, retail, unemployment claims, and Philadelphia Fed Survey all were very disappointed. However, markets around the world shrugged off the negative news and rallied ahead.

There were several reasons that markets ignored the bad news. For one Spanish bond auction enjoyed the better demand than expectation, despite that the yield is much higher than the last auction. Then, Fed hinted that deflation is still its enemy No. 1. This means that Fed won’t exit the monetary stimulus status anytime soon. Over the weekend, China suggested that it will resume the gradual appreciation of its currency soon. This is another piece of good news for markets. Other Asian exporters’ currencies should follow China and appreciate as well. Hot money will flow into Asia to take advantage of the stronger currencies there. Asian assets should then experience a wave of rally as the result.

The next step, I suggest everyone to watch Chinese trade balance closely. The negative economic news in U.S. and the fiscal cuts in EU countries all imply that demands in the developed countries will drop in the second half of 2010. China also saw that its workers want to enjoy higher wages in the recent weeks. Adding the appreciating currency, Chinese trade surplus could disappear very quickly just like March. Then, it may well spell the end of this appreciation process. (Jun 20, 2010)

Fed Statement

June 23, 2010

FOMC just ended its meeting on interest rate.  Not surprisingly, the Fed rate is kept at 0.25%, given the recent wave of bad news on housing, retail, and employment.  What does Fed have to say this time?  In the FOMC statement from the April meeting, it said “…Growth in household spending has picked up recently…Housing starts have edged up…”.   It is no longer the case.  Since Fed had already have an extremely low interest rate, the main question before the meeting is what they can do to fuel the recovery.  They just ended the asset purchasing program back in March.  If they ever re-start the programs, it will send a powerful negative signal to markets that how bad things are and they are worried.  And actually, the credit markets do not need more liquidity now, unlike September 2008. 

The latest statement acknowledged the weakness in the housing market and retail, but reiterate Fed’s belief of “a gradual return to higher levels of resource utilization in a context of price stability”.  Thomas M. Hoenig is again the only member voting against the low interest rate.  Overall, this statement is very moderate.  It is very modest and gives out nothing unexpected.  Basically it means that Fed is now taking a “wait and see” attitude.  This hand-off approach should have little impact on stock markets.

Chinese Yuan and Markets

June 21, 2010

Markets have been quite confused to many recently.  Economic data from U.S. last week have shown that there are still many challenges in economic recovery.  Housing starts, building permits, retail, unemployment claims, and Philadelphia Fed Survey all were very disappointed.  However, markets around the world shrugged off the negative news and rallied ahead.

There were several reasons that markets ignored the bad news.  For one Spanish bond auction enjoyed the better demand than expectation, despite that the yield is much higher than the last auction.  Then, Fed hinted that deflation is still its enemy No. 1.  This means that Fed won’t exit the monetary stimulus status anytime soon.  Over the weekend, China suggested that it will resume the gradual appreciation of its currency soon. This is another piece of good news for markets.  Other Asian exporters’ currencies should follow China and appreciate as well.  Hot money will flow into Asia to take advantage of the stronger currencies there.  Asian assets should then experience a wave of rally as the result.

The next step,  I suggest everyone to watch Chinese trade balance closely.  The negative economic news in U.S. and the fiscal cuts in EU countries all imply that demands in the developed countries will drop in the second half of 2010.  China also saw that its workers want to enjoy higher wages in the recent weeks.  Adding the appreciating currency, Chinese trade surplus could disappear very quickly just like March.  Then,  it may well spell the end of this appreciation process.

I Am There

May 6, 2010

Whooh, 5/6/2010, a fun afternoon, isn’t it?

A huge swing in almost all assets and there is going to be some sort of short cover and re-position in the next few days, I hope. Otherwise my fresh long position today is going to be in trouble.

I do not know the reason of this 30 minutes crush and I will not add to the crowds that gave explanations. Just need a glass of whisky and enjoy a day that makes history.


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