DABERIAM LIX

December 2010

Exciting things have happened since the beginning of November. President Obama has managed to get the Bush personal tax cuts extended for another year and has introduced 100% Capital allowances to encourage American industry to invest. He has also signalled a change of heart and started to engage with business, which he now regards as “a good thing” rather than “a bad thing”!

The economic numbers now clearly demonstrate that the American public is paying down mortgages and, where they are re-financing their mortgages for lower interest rates, the surplus appears to be being used to pay down debt rather than spent on consumer products. House prices are declining which will enable the market to clear slowly, but there is still a fundamental surplus of housing and shopping malls left over from the building boom. Corporate profits continue to rise along with corporate productivity, which will now be enhanced with a growth in capital expenditure. One can also expect to see a slow improvement in employment.

The good news is tempered by increased inflation, a global problem, as the surplus cash sloshing around the world drives up commodity prices which are further driven by ever-increasing Chinese demand. It is beginning to dawn on the consultants and large swathes of the investment community that interest rates are more likely to rise than fall. The Feds QE2, along with the US government deficit, is also causing the conventional wisdom of the last five years to be challenged. Meaning that, in general, investors are beginning to be less certain that Bonds are a safe haven. The switch of the popular trend out of equities into Bonds will, as it reverses, have a major upward impact on the equity markets. The equity markets will further benefit from the trend that is now developing from the re-industrialisation of the US where import substitution is growing and the return of production from Asia to the US is playing out. Companies like General Electric and Caterpillar are building new plants to take advantage of improved productivity and avoid the trend in increasing freight costs around the world. This will add impetus to the improving US/China balance of trade.

While the US government deficit is nothing other than frightening, it is likely to be ameliorated by increased corporate revenues and possibly an increase in tax revenue as individuals pay down debt and reduce their interest deductions.

The UK is starting to address with a vengeance its government deficit and it is clear that government action is speeding up, with the consequence that the first quarter of 2011 will be a painful but necessary adjustment with rising unemployment, business bankruptcies and falling house prices.

Against this, companies, excluding the building sector, that went into the recession well funded will be able to take advantage of the growth in Northern Europe and North and South America. They will also be facing less competition from Asia, and China in particular; the same trends that are appearing in the US also apply to the UK. The borrowing binge that was poured into wasteful consumption is going to take time to re-pay but it will nevertheless gradually pan out.

The more difficult problem for Europe is sorting out the sovereign debt crisis and the inter-European banking chaos. Beautifully highlighted in the Financial Times of 2nd December by a chart showing countries’ banks: cross border exposure(See attached) Incredible numbers appear as it is revealed that banks are holding masses of safe but now toxic sovereign debt in other EU countries. It is almost impossible to see a way for this to be unravelled without resort to rescheduling. Perhaps the ECB by being given the political support to embark on a system such as the US adopted with Brady Bonds.

China, the country most responsible for the lack of inflation in the west as it poured low cost manufactured goods into the western economies, is reversing trends. The 12th Chinese Government 5-Year plan, 2011-2015, aims at increasing domestic demand in both goods and services to sustain its country’s growth. The switch from export led growth to internal consumption will have a major impact on western prices. The belief that inflation is dead will be horribly shattered, along with the complacency of a lot of western Central Bank thinking that seems to be predominantly based on economic models. If a few of the Members of the Monetary Policy Committee of the Bank of England actually went shopping, they would discover that prices are rising, and might realise that their explanations that inflation is due to exceptional circumstances were hollow.

In the UK in particular, there is a shortage of industrial capacity and skilled labour, and government policy of increasing the tax on capital expenditure is not going to help this situation improve. Interestingly a policy diametrically opposite to US government policy.

In general, the financial bubble that caused the distortion of the last five years has burst and most of the western economies are on the mend. The hang-over after the binge is hurting but things will begin to improve. There is still possibly six months more of pain to be endured but by the end of 2011 things will look a great deal better than they did this time last year.

Damon de Laszlo
14 December 2010