DABERIAM XLVIII

May 2009

Today the newspapers are full of political trivia. The news that British Members of Parliament have been paying themselves huge sums of tax free money is not new, but the extent of these payments and the trivia for which payments have been claimed is truly extraordinary, leaving aside the further amounts claimed and not accounted for. While the ‘prudent’ ex-Chancellor, now Prime Minister, has bankrupted the country’s finances, virtually all Members of the Government and the rest of Parliament have become a disgrace to the integrity of the country. Britain is probably not even suitable as a candidate for Third World status. Of course, the machinations of Members of the European Parliament are a much more closely guarded secret! 

We are sure nothing like this goes on in the corridors of power in Washington. 

Back to more serious economic matters. The bottom of the cycle is more and more evident, the interbank market has improved enormously since the dark days of September/October last year, and the banking system is stabilising but general liquidity remains a problem as banks seek to improve their balance sheets and repay government debt. It is unlikely, in the near future, that we will see a rapid increase in bank lending, particularly to the private sector. Consumers in the US in particular are saving at an enormous rate, which is hardly surprising when it is estimated that consumer net worth in the last 18 months collapsed by an estimated $16.5 trillion. These figures make the likelihood of GDP driven growth for the rest of this year difficult to visualise. 

The recovery from the economic cycle is now in ‘alphabet-soup’ area: 
V - for a quick recovery;
U - for a slow recovery
W - for a quick recovery and then collapse and,
L - for no recovery at all. 

Global Economic Indicators

World Economic Growth (IMF Figures + Projection)	2009	0.50%	2008	3.40%	2007	5.20%
Base rates: 29 May 2009	USD	0.25%	EUR	1.00%	GBP	0.50%
MSCI World Equity Index	29/05/2009	201.542	31/12/2008	181.894	YTD %	10.80%
Gold (PM London Fix $ per ounce)	29/05/2009	975.50	30/12/2008	869.75	YTD %	12.16%
Oil (WTI Crude $ per barrel)	29/05/2009	66.31	31/12/2008	44.60	YTD %	48.68%

The good news is that there does not seem to be any prediction for a continuing downward slope. The forecasters of the various recovery patterns are, in some cases, discussing their own investment positions. The ‘W’ group, most interestingly, are those who feel that the recovery is here but they have missed the boat and are hoping for a dip to get into the market. The complexity of the various forces in the recovery pattern is such that predictions on a month to month basis are fairly unusable other than to say, looking back to this period from a few years hence, it is likely to be seen as the bottom. 

The stresses in the global trading system are going to be, to some extent, an extension of debates that were going on in 2006-7. Then the asset price boom was raising considerable debate about return on capital in large sectors of western industry. There was a lack of capital investment as management in many quoted companies were incentivised to produce short term returns. The best way to achieve this was to use spare cash to buy back equity. The process was encouraged by the private equity industry that was booming in the low interest rate environment. The private equity theory works when interest rates are low, bank lending criteria is lax, and asset prices are rising. In a nutshell, you raise a little equity, borrow a lot of money, buy a company, realise its assets and sell off its property to repay your debt, cut capital expenditure and R & D to the minimum to raise earnings and sell it on again in four or five years, then explain to the world what geniuses the private equity groups are, and proceed to do it again. 

The private equity/leverage buy-out phenomenon has left a lot of industry in US and UK, and to a lesser extent Europe, with out-of-date manufacturing capacity compared with Asia. 

Apart from private equity, etc. there were also considerable financial incentives for companies to outsource production to Asia as this did not tie up capital and could also produce greater margins owing to the lower labour costs. The question that arises from this shift in the manufacturing sector is complicated and has an important bearing on the potential for inflation in the next few years. Many economic models, and consequently the economists who run them, extrapolate from the numbers, that the slow down in the economy, the short-time working and shut-downs in the manufacturing sector leave capacity that can be started again when the economy picks up, therefore prices will not rise in the near future. As, however, a lot of the capacity that is being shut down is old, the likelihood of it being restarted is low. This applies not only in the manufacturing sector, but also in the commodity sector. For example, the average age of the stock of US on-shore drilling rigs and the men that operate them has been rising steadily for more than ten years. The shortage of rigs that was apparent two to three years ago will be even larger when drilling programmes start up again. 

It is quite possible that as the economy stabilises, we will see a very considerable recovery in Capital Expenditure as industry re-starts. Lending to the industrial sector will replace, but at a much slower rate, the recent lending to the private sector. Corporate profitability is likely to grow, driving stock markets, while the retail sector and personal expenditure stagnate for the time being. This is likely to produce a very different economic landscape to the one we have experienced in the last four to five years. 

The rebalancing of the economies of the US and China will continue, the big question marks will remain over Europe and, to a lesser extent, over Japan. 

If not sunny days ahead, at least the dark clouds are lifting. 

Damon de Laszlo 
May 2009