DABERIAM XXVII

October 2006

The summer holidays have come and gone but for the moment the weather is still warm and there have been no serious hurricanes in the Gulf of Mexico. The result of this weather pattern is that many geniuses in the Hedge Fund and derivatives industry have been caught holding long positions of oil and gas while the price has plummeted. 

One Hedge Fund managed to lose $6 bn. in September on positions in gas. While the event only just made the headlines, it is indicative of an investment environment that is unusual. There is a huge amount of liquidity in the global economy. This is being generated by enormous savings in Asia and industrial and commercial corporate cash generation in the West. The liquidity is being mopped up by Government deficits in the West and the purchase of derivative debt instruments that are fanning the flames of the IPO and M&A Market. 

We are definitely not running into a bubble in the Equity Market and while the world’s economy remains stable, there may be a bulge, but not a bubble, in the property market. However, there is a hugely increasing amount of money chasing more and more complex debt instruments. Four years of low interest rates, high global liquidity and nervous institutions are creating an environment where funds are being poured into the debt and derivatives market on the basis that this is “safer” than equities.

Global Economic Indicators

World Economic Growth  (World Bank figures)	2005 (est.)	3.20%	2004	3.40%	2003	2.90%
Base rates: 30 Nov 2006	USD	5.25%	EUR	3.00%	GBP	4.75%
MSCI World Equity Index	29/09/2006	216.808	31/12/2005	203.143	YTD %	6.73%
Gold (PM London Fix $ per ounce)	29/09/2006	599.25	31/12/2005	513.00	YTD %	16.81%
Oil (WTI Crude $ per barrel)	29/09/2006	62.92	31/12/2005	61.04	YTD %	3.08%

There has always been a thought in the back of my mind that buying a Triple A Bond with a low yield is a high-risk strategy, as there is little chance of appreciation and a high chance of depreciation when interest rates can rise more easily than fall. In other words, an asymmetric risk/reward ratio. Couple this with the flight from equity into all forms of debt on the basis that it is “safer” and the focus of the doomsters should be here, not the equity market. 

Today we have a world where inflation has been low for goods, courtesy of Asia, and corporate profits in the West have never been higher, the continuing by-product of the application of modern technology, so what can go wrong? 

We have a shortage of spare capacity in raw material production. Asia and India are economic powerhouses and they are building infrastructure, which is putting pressure on the supply of most raw materials. Their billions of people also want heat, light and power, this is mopping up spare capacity for oil and gas. When the supply and demand is in balance and demand keeps growing while supply takes a long time to bring on-stream, that is when markets get volatile. Add to this the world liquidity mentioned above, which means all kinds of funds are entering the market, then expect wild gyrations. This is a market for traders, not investors. 

Another new element in markets is the growing fashion for ‘bio-fuels’. While the greenhouse effect is a great concern and generating ever increasing quantities of carbon dioxide is not a good thing, there is a somewhat misguided lobby pushing for bio-fuels which, in short, means turning food, in the form of sugar and grain, into liquid energy for cars. This is pushing up the world price of these and related commodities. 

We are in a long-term trend of increasing commodity prices and Asian domestic consumption, along with US Government pressure, will in the next year or two start to push up the price of Asian sourced products. Central Bank’s reaction to this is to raise interest rates, but hopefully they will soon start to worry about the effect on their domestic economies. When there is a feeling that interest rates are not likely to rise further and there have been a few more accidents in the derivative markets, there is likely to be a return to broad based equity investing. 

Generally speaking, the outlook for the global economy is benign, if you look through the noise of day-to-day headlines.

Damon de Laszlo 
October 2006