DABERIAM LXXXI

February 2014

2013 turned out to be a remarkable year from the point of view of stock market recoveries. Nearly all markets rose, producing gains of between 20% and 30% in general: exceptional growth by any standard. January and February have, of course - and really inevitably - produced a nervous reaction. The fear that things have gone too far too fast, coupled with the gloomy weather conditions, has created a lot of volatility and the political worries in Europe and the Middle East have compounded this, with the addition of instability in Thailand etc. These are all issues that worry stock markets and generate noise which volatility feeds on. The underlying trends, however, seem to be holding relatively steadily, particularly in the face of exceptional weather conditions around the world.

It is, I think, weather conditions that should be of the greatest concern. The beginning of an El Niño is forecast which is likely to exacerbate the exceptional drought in Mid West and Western USA and Australia, with exceptional rainfalls in other parts of the world.

We have grown accustomed in the last year or so to declining commodity prices and low inflation; even the UK got down to 2% inflation, a first for many, many years. Inflation in the West has also been kept down by the enormous expansion in the Asian economies, particularly China, which have produced goods that affect all sectors of retail prices. Central banks’ actions on quantitative easing and flooding economies with liquidity in the aftermath of the financial crisis would probably have triggered inflation if it hadn’t been for these factors.

As the world economy stabilises and picks up in 2014, we are likely to see a change in the inflationary direction. China is rebalancing its economy towards internal consumption, rapidly pushing up minimum wages and the value of their currency. This will inevitably feed through into consumer prices around the world. The government is also, for good policy reasons, trying to damp down its property boom and its banking sector is going through a squeeze, which is forcing a growth in the alternative banking sector. I have no doubt the efforts to dampen the property bubble and speculation will work, but it is going to cause economic disruption and unhappiness in the burgeoning Chinese middle class.

On a fascinating visit to China in January, there was evidence of less happiness as middle class wages seemed to be being squeezed and the very effective clampdown on corruption, particularly at the wining, dining and gifting level, has taken a lot of the fun out of people’s lives.

The ramifications of the Chinese policies are impacting the western luxury goods industry and the slow down in a lot of Chinese infrastructure areas is affecting commodity producing countries. This has been the case for some time, which has also impacted commodity prices. The economic disruption in Africa, which seems to be increasing, is also likely to affect the production of raw materials. The governments of Latin America are also disrupting their raw material producing industries. On the oil and gas front, while the US heads towards self-sufficiency, the supply disruption in the Middle East is growing, keeping prices high. Food production is also being badly affected in California and Australia, and soft commodity prices could start to rise quite dramatically if weather conditions don’t improve.

However, the general trend in Europe is flat, but slow adjustments are taking place in spite of government! The US economy really seems to be well into recovery. The exceptional weather conditions will have had an impact in January and February but should not have any longer term effect. America is also benefitting enormously from its new internal energy resources which are a tail-wind for the repatriation of manufacturing, or “on-shoring”, as Asian prices rise.

US stock markets will tend to be more complicated as profits diverge. Large corporations, which have been indulging in manipulating their stock prices by borrowing money to buy back shares, may find their growth curtailed compared with the so-called Mid-Cap and Small-Cap companies who have the liquidity to invest to improve their productivity.

I had thought that the Fed would not start to reduce its quantitative easing until February/March, but it started in December. The reduction in cash generation by the Fed and the rapidly declining trade surpluses of the Chinese economy, which were invested in US Government Stock, are likely to produce upward pressure on US and world interest rates. If this is gradual, it is probably no bad thing, as the pensioners and savers will benefit.

Looking forward to the rest of the year, we should see improved economic conditions in Western countries, but I would be concerned for emerging markets and Asia. A major caveat to this is the political situation in Ukraine, which is exceedingly dangerous, and the continuing growth of instability in the Middle East which, if it spills over into Saudi Arabia, could cause enormous economic disruption.