DABERIAM XLIX

June 2009

At the half year it’s worth having a quick look back and then forward. Last June we had seen the collapse of Northern Rock, a very uncomplicated Building Society/Bank, which we now know the FSA had ‘thought’ might happen three years before, but they had totally failed to draw any conclusion from the models they had been running. 

A year ago I had anticipated “a major downturn” but had not anticipated the economic heart attack caused by the collapse of Lehman Brothers. We had anticipated that forecasters would be “extrapolating endless gloom and disaster” in 2009. 

Today the gloom and disaster scenario continues and most predictions do not include the idea of a continuing recovery. The reality, however, seems to be that things are certainly not getting worse at the rate predicted and in many areas are showing considerable signs of life. Asia and the US have Governments that have put in place massive global fiscal stimulus. According to the IMF, China’s stimulus package is estimated to be equivalent to 12.1% of GDP in 2009, with the US at 5.6% and with Germany trailing at 3.4%. Britain, with an exchequer that run out of money before the crisis, and in spite of all the hyperbolic announcements, is implementing a package of only 1.8% of GDP. 

Global Economic Indicators

World Economic Growth (IMF Figures + Projection)	2009	0.50%	2008	3.40%	2007	5.20%
Base rates: 30 June 2009	USD	0.25%	EUR	1.00%	GBP	0.50%
MSCI World Equity Index	30/06/2009	190.833	31/12/2008	181.894	YTD %	4.91%
Gold (PM London Fix $ per  ounce)	30/06/2009	934.50	30/12/2008	869.75	YTD %	7.44%
Oil (WTI Crude $ per barrel)	30/06/2009	69.89	31/12/2008	44.60	YTD %	56.70%

US motorcar production is likely to restart in July and house prices seem to be stabilising. Inventories in the US are at rock bottom and most interestingly, US corporate productivity is running very much higher than anticipated as companies dramatically cut into payrolls and inventory going into the recession. As we go from a declining GDP in the US to flat and the likelihood of a rise in the 3rd or 4th quarter, corporate profitability will produce a lot of upside surprises. Couple this with the banking industry in the US which has basically unloaded pretty much all of its dirty washing and has had to massively write down a lot of its assets under the banking regulation that exacerbated the crisis and you have a scenario where bank profitability will also be dramatically improving in the second half year.

For many different reasons China is also rapidly turning round and will bring with it the rest of Asia, including Japan. Europe remains the black hole in the global economy. Germany, the key economic driver in Europe, is in serious trouble. German elections in September have meant an unwillingness of the government to address the banking crisis and the subsidy to German industry to avoid unemployment rising has meant that German industrial productivity has collapsed, producing a massive drop in gross profits and a draining of liquidity. By the same token, it is not at all clear that the banking system has been cleaned up to the same extent as the US. 

The UK, on the edge of Europe, could be on another planet. Again the prospect of elections means that fiscal imprudence is now the order of the day. None of the political parties dare address the truly extraordinary state of government finance. It is virtually impossible to comprehend the real size of the government deficit. As Martin Wolf pointed out so succinctly a week ago in the FT, “The British government is forecast to spend £4 for every £3 it receives.” Next year the government is forecasting spending over 48% of GDP, an economically suffocating number for the whole economy, and this ignores the fact that for the government to fund its own employees pension schemes, it would need to take 85% of the country’s GDP. For the time being no political party can address these problems and it is difficult to see, under a democratic system, how it can be addressed as 25% of the UK work force is in the public sector and they are unlikely to vote for a curtailment of their own special privileges. It’s difficult to comprehend how the special problems of the UK are going to work out without another crisis. 

On a global basis, however, it would seem the green shoots of a late Spring are coming on nicely. We just need to pray for a little rain!

Damon de Laszlo 
June 2009

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

DABERIAM XLVII

April 2009

Since putting pen to paper in February, Spring has arrived! The flow of events, announcements, actions, conferences and other motions - signifying action - has been a torrent. The global economic data has relentlessly kept to its downward path and the economic crisis grinds on and fear stalks the lives of millions of people around the world as job losses rise. The politicians are becoming complacent and they are also running out of new ‘new ideas’. 

The world’s economies are driving inexorably through the process of adjusting to the bursting of the financial bubble that has given the appearance of prosperity over the last five years. The asset price boom that enabled massive borrowing to take place has been well reported and blamed on those “greedy bankers”, the politicians have as usual avoided blame for their part. It is politicians and Government who failed in their job to manage the regulation and enforce the necessary disciplines in the financial systems of the world. There is much analysis and report on the breakdown of the financial system and much more to come. The question though is how the world’s economies will develop going forward. 

There seems to be a bifurcation appearing in the world’s economy. On one side the USA and China appear to be stabilising, although there is still a lot of historical bad news to be reported, covering he first quarter of ’09 which will roll into the second quarter. By contrast Europe is in a much greater mess and has probably got another three or four quarters of horribly negative growth. 

Starting with the USA, the property crash looks as though it is starting to stabilise, the banking system and the Government’s actions to support it is beginning to function, industry has de-stocked and the public is starting to save and is repairing its balance sheet. The final problem to be addressed is the disaster called the motor car industry. In China the Government after considerable deliberation is now pouring huge resources into redirecting the economy from being export led towards internal consumption. The process will be painful but it appears to be beginning to work. The process will spill over into the rest of Asia and in all likelihood, we will see stability beginning to appear, albeit at a low or zero growth rate for the time being.

Global Economic Indicators

World Economic Growth (IMF Figures + Projection)	2009	0.50%	2008	3.40%	2007	5.20%
Base rates: 31 March 2009	USD	0.25%	EUR	1.25%	GBP	0.50%
MSCI World Equity Index	31/03/2009	166.12	31/12/2008	181.894	YTD %	-8.67%
Gold (PM London Fix $ per ounce)	31/03/2009	916.50	30/12/2008	869.75	YTD %	5.38%
Oil (WTI Crude $ per barrel)	31/03/2009	49.66	31/12/2008	44.60	YTD %	11.35%

Europe has the greatest structural problems in that it has an extraordinary and novel system of Government. The massive EU bureaucracy is politically unaccountable and basically insensitive to the plight of the constituent countries. Labour laws, environmental rules and gratuitous regulations continue to pour forth hampering the ability of business to adapt to the changing world. Unit labour costs continue to rise inexorably across Europe and the trend will increase as productivity declines draining corporate liquidity. Germany, the main motor of the European economy will continue to contract rapidly as its economic growth from export industries collapses further. Similarly, Britain’s economy that has been driven by its financial and property bubble, will continue to deteriorate with the added problem that it will be the first country to experience rising inflation as a result of the depreciation in its currency. UK is also likely to be the country that suffers the biggest Government deficit as a percentage of GDP, owing to the near complete loss of control of Government finance.

The simple problem facing the world is the asymmetric effect of borrowing to finance current expenditure by individuals and the corporate sector, and then repayment of the debt. Profligate lending enabled individuals to borrow money in increasing amounts every year enabling individuals to spend their income plus the extra borrowing. While borrowing is treated as tax free income and spent, its repayment has to be made out of after-tax income, i.e., A dollar or pound that is borrowed and spent costs approximately 1.35 dollars or pounds to repay, before even any interest has been paid. My calculation is obviously a generalisation but it indicates the cause of the huge reduction in retail sales that the indebted economies are having to adjust to. This is before the impact of the rise in unemployment is taken into account. 

At the moment there is considerable complacency regarding inflation. De-stocking of the retail and manufacturing sectors produce downward pressure on prices, not only of finished goods but also commodities. As industry adjusts to the lover level of sales, production capacity is reduced. The complex technology and supply chains of modern manufacturing means that once production has been shut down, it is very difficult to re-start in the short term. For example, the computer systems that run a modern factory are exceedingly difficult to re-start if it is closed, and the technical skills dissipated by redundancies. The same problems apply in the supply of raw materials and commodities. Mines and oil-wells can be closed down relatively quickly, but they take much longer to re-start. 

The world going forward is likely in the near future to become inflationary for the reasons described. Added to this, the same Governments that enjoyed the recent boom years will not be averse to a considerable amount of inflation which will help them avoid the consequences of the Government debt that is being piled up. 

While these observations predict a shift in the economic paradigm of recent years, it is not a prediction of doom and gloom; it is more the natural ebb and flow of economic trends. Growth and the appearance of prosperity will be more muted in the foreseeable future but that is not necessarily a bad thing.....

Damon de Laszlo 
April 2009

DABERIAM XLVI

February 2009

It is now clear from every piece of news that the world economy is up a creek without a paddle - or perhaps one should say, every country is at sea without a paddle! The bankers who were in charge in the last major credit crisis in the early ‘80s have all retired and the lessons learned forgotten. Added to this, the relatively benign economic climate of the last six or seven years has lulled governments and Central Banks into a complacent attitude towards debt. The economic models that are currently used have been created to fit recent economic history and modellers always forget that, when the fundamentals change, models cease to work. 

It is worth remembering that as late as the end of the 19th Century, with a belief in determination it was thought possible that a well-educated man could know everything. By the end of the 20th Century, these beliefs were still popularly held but were fatally challenged by evolutionary thinking and then quantum mechanics. Complexity in science and business grew rapidly, and even exponentially, as Moores Law took hold in computer technology at the end of the 20th Century. 

Today we are faced with a scientific world where people at the top of different disciplines do not necessarily understand each other’s work. In industry, commerce and finance complexity is the rule. We have seen a massive break down in the global financial system, appearing first in London and New York and spreading out across the interconnected economic world. Starting in 2007 with the collapse of a bank in the UK and finally global trade coming to a virtual halt in October 2008 with the collapse of Lehman in the US. 

We know from evolutionary thinking that all systems need checking or they will spin out of control and collapse – examples in nature and engineering are abundant: rats arriving with ships on Pacific islands destroy ground nesting birds; diseases introduced by man into the Americas devastate the indigenous population, and steam engines need ‘regulators’. In commerce the use and control of monopolies is well understood and in banking regulation has always been needed to prevent bubbles and fraud. Unfortunately, as it is said of Generals, regulators are always fighting the last bubble or fraud, and if there has not been a problem for a long time, the regulators become intellectually lazy. 

Global Economic Indicators

World Economic Growth (IMF Figures + Projection)	2009	0.50%	2008	3.40%	2007	5.20%
Base rates: 30 January 2009	USD	0.25%	EUR	2.00%	GBP	1.50%
MSCI World Equity Index	30/01/2009	188.488	31/12/2008	181.894	YTD %	3.63%
Gold (PM London Fix $ per ounce)	30/01/2009	919.50	30/12/2008	869.75	YTD %	5.72%
Oil (WTI Crude $ per barrel)	30/01/2009	41.68	31/12/2008	44.60	YTD %	-6.55%

Today we are facing two simultaneous bubbles of global proportions. One, the East-West trade deficit. The US and the UK making up a large percentage of global GDP, were growing their economies on borrowed money. The Chinese and Asian industrialisation in general produced the money to lend to the West to buy their products. Western government and Central Banks were able to claim the end of inflation as imported goods were cheap and kept interest rates low, they enjoyed the increased revenue from GDP growth that was fuelled by borrowing. Everyone is happy except that economics 101 predicted it was going to end in a recession, but timing a bursting bubble is always a problem.

The second phenomenon has been a raft of new banking organisations and financial instruments that grew to facilitate the huge debt recycling that was financing global GDP growth - this second bubble is much more vicious and much less well understood. It was also the more dangerous as the regulators, even if concerned, were complacent and not expected to act as their masters in Government were reaping the benefits from the growth, and taking the credit. 

The growth in world trade started to stall, probably some two years ago as the price of commodities generally took off, from an already rising trend, in 2007, precipitating concern that inflation had risen from the dead. Added to this, Chinese labour costs started to rise, along with the currency, producing increasing costs for the debt laden buying public in the West. 

The Central Banks’ reaction to inflation is conventional and we saw rising interest rates and tightening of the money supply, causing stress in our stretched global banking system. The herald of the economic bubbles bursting was the collapse of Northern Rock, a savings and loan institution in the UK that had been generously given banking status by a regulatory change initiated by the UK’s Chancellor, now Prime Minister, Mr Brown. The public and the banking system started to panic, causing the tidal wave across the Anglo-Saxon system. 

Politicians inevitably became involved in an incredibly complicated domino effect that resulted in a basically political decision to allow Lehmans to collapse in September 2008. World trade came to a virtual halt as the global banking system froze. Ships could not be loaded as the systems of trade credit broke down. What was going to be a nasty recession, in the space of a few months turned into a potential global depression. Headlines reported the global shut-down of the motor car industry, oil prices declining by upwards of 70%, commodity prices in general collapsing, and unemployment rising at a phenomenal rate. The impact on China, where its export driven economy has laid off some twenty million people in the space of a few months, demonstrates an unprecedented global phenomenon. 

It is really unsurprising that Governments have been unable to react fast enough. The speed of change and its global nature is unprecedented and politics, by its very nature, is virtually unable to deal with a problem that is only anticipated. 

The question has to be, what next? In historical terms, the speed of the economic collapse on such a global scale is unprecedented. The speed of the reaction of national governments is also unprecedented. The massive stimulation to national economies will probably, sooner rather than later, have a dramatic effect. 

Debt is being transferred at an unprecedented scale on to the books of Western governments. The natural reaction of individuals is to save, but the consequences of the crisis and its economic solution will also be in the destruction of huge amounts of debt, the corollary being the destruction of the savings that supported that debt. In crude economics the unwinding of the debt instruments that have fuelled economic growth, can only be done at the expense of future economic growth, i.e., the banking spiral works in both directions. It’s difficult, however, to believe that politicians can resist the pressure to mitigate the pain so there is an inevitability that accumulated Government debts will be dissipated by the onset of inflation, perhaps in only two to three years time. 

In the meantime there are signs that the rate of decline is slackening and will probably flatten out in the relatively near future. The now universal gloom and despondency, as with so many universal beliefs, is probably indicating that we are near the bottom of the trough. The question, therefore, is the shape of the trough! We could slide into economic oblivion or achieve a miserable economic climate for the foreseeable future. 

As an optimist, there is a high chance that the near vertical decline could reverse and the gloom turn to optimism by the end of the year. It’s worth remembering that, statistically, year on year comparisons will start to feel and look better even if economies just stabilise at a new lower level. The speed of change, because the world is so interconnected, is more than likely to surprise us on the upside, as it did on the way down. 

Damon de Laszlo 
February 2009

DABERIAM XLV

December 2008

In the last couple of weeks of 2008, it is worth remembering that the Western economic bubble plateaued in 2007; I was expecting it to deflate in 2008 (For those of you with time to read, attached are my comments from December 2007.) Unfortunately the economy in general continued to glow in 2008 - instead of deflating it burst in September/October with the total collapse of the banking system. To mix metaphors, the tide went out very suddenly leaving the banks, the private equity magicians, the hedge fund managers and financial markets in general, naked. The total breakdown of the banking system around the world brought global trade and industry to a juddering halt. 

The mountains of debt that fuelled the Western economies for the last five years collapsed, leaving a black hole in the world’s financial system. We now have the rapid appearance of deflation taking hold around the world. Prices and wages are being forced down and debt is being repaid or written off. On the other side of the balance sheet, asset values are being destroyed which in turn is wiping out people’s savings and pension schemes. This downward spiral will at some point stop, probably as suddenly as it appeared, but the global economy is in uncharted waters. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 28 November 2008	USD	1.00%	EUR	3.25%	GBP	3.00%
MSCI World Equity Index	28/11/2008	188.488	31/12/2007	299.916	YTD %	-37.15%
Gold (PM London Fix $ per ounce)	28/11/2008	814.50	28/12/2007	833.75	YTD %	-2.31%
Oil (WTI Crude $ per barrel)	28/11/2008	54.44	28/12/2007	96.01	YTD %	-43.30%

Around the world the Central Authorities are reacting in different ways depending on each country’s individual economic profile. The US started by throwing liquidity into the system but is now focussing on the real problem, dealing with a credit crisis. It is interesting that Treasury Bill rates have gone to zero or minus interest rates, that is lower than during the Depression of the 1930s. This coupled with the underwriting of the banking system will force the trillions of dollars in Money Market funds to place money back in the banking system. It is worth noting that the Government is effectively borrowing money at a minus interest rate and lending it out at 4 or 5% to the banks, making a huge profit in the process. As I mentioned, there are mountains of debt that have to be repaid or literally written off, in the early ‘80s bank crisis, this was called Debt destruction. 

On the other side of the world, China recovering from the Olympic Games and the industrial shutdown, as well as a massive earthquake, is grappling with the fact that a large percentage of its economic growth was export driven. The Chinese economy, which suffers from both the advantages and disadvantages of central planning, has to reverse its direction, from exporting consumer goods to internal consumption. It has the Central Government controls to do this as well as the reserves. The Chinese Government stimulus package, broken down roughly, is allocated 45% to railways, roads and airports; 25% to the earthquake recovery areas; 9% to rural infrastructure; 9% to energy efficiency and environment; 7% to low income housing and 4% to technology and R & D. This augers well for China’s future growth. 

By contrast, the UK’s reaction to the problem, apart from the necessary support for the banking system, was the announcement to bring forward infrastructure expenditure, which is unlikely to happen as they simultaneously announced the postponement of major industrial military expenditure on aircraft carriers and in any case most infrastructure projects are stalled in interminable planning enquiries and debates, eg. Runways at London Airport and Stansted. Along with this, a VAT reduction that will cost the Government billions and have no commercial impact apart from the huge bureaucratic burden it lays across industrial inter-company prices. In any event, private individuals should sensibly be paying down debt rather than being encouraged to spend. The UK Government debt going into the coming year of some £145 bn. is unlikely to be fundable and can only lead in due course to rising interest rates and devaluation. Not a recipe for an industrial renaissance.

Germany by contrast, has a less hysterical Government that is watching its banking system carefully and will probably support, where required, its industry so as to get the country on to a sustainable recovery path. 

While there are many, many anomalies and dangers in the fabric of the world’s economic systems, I take an optimistic view, rightly or wrongly, an entrepreneur has to deal with risk all the time, risk-taking is not compatible with pessimism. However, I am having a struggle remaining convinced that we will be over the worst by the 3rd / 4th quarter of 2009. Unless the banking system unglues itself very soon, the global network of interrelated industrial companies that support our modern lifestyle will start to break. Repairing the extraordinarily complex computer controlled industrial networks will take time and will add to the inflationary pressures that are being built into the system at the moment.

Damon de Laszlo 
December 2008