DABERIAM XXIX

January 2007

Christmas is a time for reflection but December already seems a long time ago. At the end of December a number of economic statistics came out that indicate there could be a tipping point in 2007 that might disrupt the “more of the same” economic trends that carried us through 2006. 

The US economy seems to be slowing down gently; but the Fed looks poised to raise interest rates as the new Democrats are threatening to interfere with the Fed’s carefully balanced thought processes which are grappling with the problem that incipient and imported inflation is rising. 

In Europe and the UK money growth is still rising rapidly, compared with economic growth. Rising food costs, partly as a result of grain being diverted to alternative energy, the rise in German VAT and rising energy costs are creating inflationary pressure. Here again this must tilt the probability of the BoE and ECB increasing interest rates. 

Global Economic Indicators

World Economic Growth  (World Bank figures)	2005	4.00%	2004	3.40%	2003	2.90%
Base rates: 29 Dec 2006	USD	5.25%	EUR	3.50%	GBP	5.00%
MSCI World Equity Index	29/12/2006	235.243	31/12/2005	203.143	YTD %	15.80%
Gold (PM London Fix $ per ounce)	29/12/2006	635.70	31/12/2005	513.00	YTD %	23.92%
Oil (WTI Crude $ per barrel)	29/12/2006	61.06	31/12/2005	61.04	YTD %	0.03%

In China, financial managers of the economy are pushing up domestic costs at the same time as encouraging domestic consumption; the latter in order to try and rebalance the economy in favour of domestic rather than export driven growth. A series of policy straws indicate that quite significant changes that are taking place: big salary increases for some 120 million employees of state companies and civil servants; increasing prices for domestic oil, gas, electricity and water; further reductions in tax benefits to exporting companies; and measures to discourage exports of some raw materials. Fiscal measures to encourage state owned companies to pay Dividends will further encourage domestic consumption at the expense of capital investment. These various measures will push up the cost of Chinese consumer goods to the rest of the world with the related inflationary consequences. 

An interesting comment in the FT just before Christmas from a strategically minded Government:- China Curbs Corn Ethanol Production. The Government is worried about the effect of growing ethanol production on the price of food. To quote further from the FT: The growth in US Ethanol production is the key feature behind the 75% rise in US Corn Futures to a near 10-year high of $3.76 a bushel. 

There is also appearing a new wildcard in the global banking sector. While the general increasing concern about a financial crisis in the low grade bond sector gathers pace, pushing up interest rates and reducing liquidity, the possibly unintended consequences of Basle 2 could precipitate a credit crisis. 

The Bank of International Settlements, Basle 2 rules are a formulaic process for judging banks capital adequacy standards. The F.T. mentioned in December that Japanese banks as a consequence of the new rules coming into force in March ’07, were liquidating holdings in Hedge Funds and Funds of Funds as a consequence. The formulaic nature of the Rules could have other bizarre consequences on large sectors of industry. For example, in the materials processing industries, where raw materials are a high percentage of the cost of sales, companies’ turnover rise faster than profits as commodity prices rise. Under the Basle 2 rules this would make them less credit worthy and consequently less able to finance their turnover, creating a potential liquidity problem throughout the sector. The knock-on effect into manufacturing and food processing is difficult to anticipate. 

In 1994, a confluence of different phenomena created an unanticipated credit crisis. With the re-rating of low-grade debt, rising interest rates and Basle 2, a similar explosive mixture could be brewing. 

My apologies for casting a little cold water on the prospects of a benign year ahead.

Damon de Laszlo 
January 2007

DABERIAM XXVIII

December 2006

Since October we seem to have been living in a balmy world - the weather has been kind, hurricanes in America did not happen, commodity prices have declined including oil, and a feeling of happy complacency and general well-being has set-in in the run up to Christmas.

International politics have become rather surreal. Bush’s drubbing in the American elections had made him appear powerless, to the glee of Liberals and countries unfriendly to the West. In Britain, Prime Minister Blair is more and more seen as an invention of public relations and media management. Photo calls, word bites, posed appearances, and managed events wear thin as the infrastructure of the State deteriorates; education produces a rising level of illiteracy and the health service spins inexorably out of control, the military is underpaid and ill equipped. Worst of all the Attorney General, the supposedly independent head of the judiciary, now appears to take orders from Downing Street - the list is endless. In Europe, the small rise in growth rate looks destined to decline as the Central Bank ratchets up interest rates and Germany raises taxes. The Governments of Europe and America react to events and lack cohesion or the mechanism to create strategy.

The rest of the world, however, paints a more optimistic picture. China and India continue their dramatic growth with governments, particularly in the case of China, focussing on the long-term process required to improve the lot of their population. China’s development is clear and fascinating. The current five-year plan has the strategies and the processes in place to deal with environmental pollution, health and education and includes the staggering proposition that industrial jobs in modern factories with equivalent housing will get three hundred million people into the earning economy and out of the abject poverty and the short life expectancy in farming. China seems to be inspiring the rest of Asia and India to raise their game. It is also beginning to intervene in the management of the dysfunctional countries of Africa. While this is motivated by the need for oil and other commodities, it will almost certainly be a good thing for the people of these countries, compared with the state of chaos now prevalent. 

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	3.25%	GBP	5.00%
MSCI World Equity Index	30/11/2006	239.636	31/12/2005	203.143	YTD %	17.96%
Gold (PM London Fix $ per ounce)	30/11/2006	646.70	31/12/2005	513.00	YTD %	26.06%
Oil (WTI Crude $ per barrel)	30/11/2006	63.14	31/12/2005	61.04	YTD %	3.44%

The wildcard in international terms is, of course, Russia. This one-man Government with old-fashioned views of the world, smarting under the humiliation of its collapse in power that brought the end of the Cold War, has found a new weapon. The rise in the price of oil and gas that is funding terrorism in the Middle East and around the world, is also giving Russia for the first time a weapon more effective than the bomb.

In economic market terms, it is the marginal supply or demand that moves prices in the market. The Russian Government policy of taking direct control of its gas assets and intelligently using that supply to negotiate with each State in Europe has been the most fascinating exercise in political economic domination, possibly ever seen since the granting of monopolies by European Monarchs. In the space of little more than a year, Russia has gained economic control over the supply of gas and the pipelines of greater Europe, all achieved without causing even a ripple in the political consciousness of the countries it can now disrupt. In a word, if Mr Putin wishes to influence policy of any or all countries in wider Europe he can, by waving his hand over the gas tap. 

None of these observations should be regarded as pessimistic, other than that current Western event-driven governments are proving no match for the countries with governments that understand process and strategy. Luckily China and Russia are, by and large, primarily motivated by the need, at least in the short term, to improve the lot of their people. 

The conclusion, therefore, from the analysis is that 2007 will probably be as benign as 2006, with clouds perhaps gathering in 2008 - election years in USA and Russia. 

My very best wishes to you for Christmas and a very happy new year.

Damon de Laszlo 
December 2006

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

DABERIAM XXVI

June 2006

What has changed since May, other than the Stock Market bloodbath, or I think more appropriately, mudbath, that continued into June and the beginning of July, which is really no change. 

While it is the most popular job of the journalist and the pundit to issue dire warnings of doom and gloom on a daily basis, those that have to manage businesses and take decisions about investing in the future can only be successful if they consider and analyse information and look for signs of changing trends. This is the difference between noise and information. 

Around the world there seems to be a marginal slowing of economies in Asia but nothing that could be called significant, and the same goes for the USA. Russia and Japan continue to pick up their pace of activity, and Europe remains as a unit a sort of quagmire of conflicting trends producing virtually no direction of any kind. 

The biggest trend seems to be the world’s Central Banks’ feeling that they need to raise interest rates. A sort of Central Banks’ herd instinct that once they have got to the bottom they have to climb back up the hill. This movement in itself is slow and as long as the rate of change remains slow, it should not derail the world’s economy. 

Global Economic Indicators

World Economic Growth  (World Bank figures)	2005 (est.)	3.20%	2004	3.40%	2003	2.90%
Base rates: 30 June 2006	USD	5.25%	EUR	2.75%	GBP	4.50%
MSCI World Equity Index	30/06/2006	216.621	31/12/2005	203.143	YTD %	11.56%
Gold (PM London Fix $ per ounce)	30/06/2006	613.50	31/12/2005	513.00	YTD %	19.59%
Oil (WTI Crude $ per barrel)	30/06/2006	73.98	31/12/2005	61.04	YTD %	21.20%

In the macro sense, there seems to be a continuing integration of the world’s economies, talked about as ‘globalisation’. It is this globalisation that is stabilising individual economies as the actions of even the largest economy in the world, USA, has less impact on global trade than it used to. It is global trade that is going to be the overriding phenomenon of the still-new millennium. The extraordinary rise in the movement of commodities and goods from one market to another across the Atlantic and the Pacific can be measured most simply by noting the bottlenecks in shipping in the major ports of the world.

The other major change that slots into the new millennium and gathers pace is the incredible increase in productivity in all forms of production. The application of electronics and computers by engineers who started senior school in the ‘80s, who regard the computer as the core of any system and the impact of this on machinery is so ubiquitous that it is difficult to quantify. 

The manifestation of this in America is the continuing extraordinary increase in productivity, output per unit of labour, which in this flexible economy is generating all kinds of jobs and the country maintains its low unemployment record. The same effect in Germany is showing increased industrial production alongside high unemployment as the lack of flexibility in the country’s employment rules and regulations in general make it difficult for the development of new businesses. Thus increasingly flexible equipment is starting to have some interesting side effects. Small amounts of production are moving back from the cheap labour areas of China to the West, as the improved productivity enables hugely increased flexibility in production, shorter lead times and shorter runs. In some areas this has advantages over the long lead times required to manage the long supply chains and shipping costs of manufactured product, and shipping it half way around the world from Asia to the West. 

On a completely different front, another interesting trend in the financial markets has been over the last few years the phenomenal growth in, so-called, Hedge Funds. This growth has been encouraged by regulation in the main financial centres that restrict the flexibility of a manager to manage money. The Hedge Fund today is in reality any fund that is unregulated. By contract the regulated funds are managed within the financial centre rules and while they are typically long only, do indulge in buying so-called structured products and indexes. 

The distinction, apart from fees, between Hedge Funds and Long Only investment management is becoming rather like the distinction between hardwood and softwood. Many people think that this description describes the texture of the wood, while in fact softwood is a tree that has needles and cones, whereas a hardwood is a tree with leaves. Some hardwoods are very soft, and some softwoods are very hard! 

Hedge Funds today control such vast amounts of money that they do affect not only the stock market but also the commodity markets. In the last few months, we have seen commodity prices falling, possibly having been too high, but the underlying shortages have not changed. 

In the Stock Markets, the malaise seems to be due partly to the liquidation of stocks by pension funds where government and regulators have for some years now been confusing investment decisions, and Hedge Funds who are unconstrained by consideration of Capital Gains Tax or any regulation, and tend to follow each other in and out of the market. 

I am optimistic that by the time we get to the end of the year there will be a point at 
which the market will have started to move higher and then suddenly there will be a rush to be invested, driving it up again possibly to above trend heights. 

As a simple observation, it’s worth noting that the PE ratio of the S&P 500 has not been down at its present levels since 1995, and before that 1990. 

Hot off the Press, the British Government, in the form of Mr Blair, has just discovered that the country cannot survive without Nuclear Power. In the last ten years the Government has prevaricated and delayed critical decisions on keeping the country’s power generation stable and has successfully disposed of most of Britain’s nuclear expertise. This sudden enlightenment demonstrates the inability of the present Government to come to any serious strategic conclusion on any subject, let alone anything as basic as electricity generation. 

Damon de Laszlo 
June 2006

DABERIAM XXV

May 2006

March, when I last put pen to paper, seems a long time ago. While April was quiet, May has turned into a market bloodbath. The complacency of the markets as we came out of April has been rudely shaken for no reason that has not been apparent for some considerable time. Governments around the world, along with the Central Banks, have been tightening money supplies and raising interest rates. The economic growth in Asia has been driving up all commodity prices but the downward pressure on consumer prices indexes through Chinese industrialisation has kept inflation figures low. This last trend is beginning to change as the Chinese Government reduces the export incentives of its industrial base, and allows its currency to creep up against the dollar, increases the domestic prices of commodities, particularly oil, and is increasing its industrial rates of pay. This inevitably will lead to a rise in prices in the West. Again all fairly predictable. While we seem to be at the low water mark for inflation, the tide is coming in and the pressure on prices that will feed through into the indexes is growing steadily. 

While all the above is not new, perhaps the sub-conscious realisation that Western Governments are losing their credibility is really what is spooking the market. The Russian government seems to have a clear strategy of using its huge energy reserves as a political weapon against the West. The West continues to build gas-fired power stations as its primary new source of energy and replacement source for ageing nuclear and coal fired stations, further increasing dependency on Russian supplies. Another new development in the Russian economic power game is an effort to dominate Europe’s steel industry, an industry dependent on energy. 

China pursues a global strategy of buying and financing commodity resources around the world, gathering up assets in Latin America and Africa, it is also becoming the major customer for Australian raw materials and New Zealand agriculture. 

Global Economic Indicators

World Economic Growth  (World Bank figures)	2005 (est.)	3.20%	2004	3.40%	2003	2.90%
Base rates: 31 May 2006	USD	5.00%	EUR	2.50%	GBP	4.50%
MSCI World Equity Index	31/05/2006	219.319	31/12/2005	203.143	YTD %	7.96%
Gold (PM London Fix $ per ounce)	31/05/2006	653.00	31/12/2005	513.00	YTD %	27.29%
Oil (WTI Crude $ per barrel)	31/05/2006	71.29	31/12/2005	61.04	YTD %	16.79%

Policies that are entirely logical, bearing in mind that China now represents some 15% of world GDP on PPP basis, larger than the Euro zone, and is growing at around 10% per annum. These figures are inevitably having an enormous impact on world raw material resources and will continue to do so for some time to come. It is worth remembering that China represented less than 5% of World GDP, again on a PPP basis, just twenty years ago. 

The two elephants in the room of World economics, Russia and China, are largely ignored in the debates of the European and US politicians. Europe bickers incessantly and is almost wholly distracted by domestic politics and interstate political rivalries, while the government of the USA, distracted by Iraq and Iran, is failing to grapple with the problems of Latin America and other geo-political issues. The failure of Western Governments to produce any strategy to deal with the looming energy shortfall is extraordinary. The USA’s dependence on imported energy has been growing for over forty years; today some 40% of oil and gas has to be imported. Europe’s energy supply situation has been deteriorating rapidly over the last ten years and this deterioration will increase even faster as North Sea production declines.

The rapidly rising prices of commodities are the natural consequence of some twenty years of surplus, which resulted in low prices discouraging exploration. The rapid growth of China and India has absorbed these surpluses and industry and economics will work to correct the situation as higher prices slow down demand and encourage exploration. The economics can only work, however, if Government does not intervene. In the case of energy markets, there is heavy Government intervention and regulation. It has been fascinating to watch the last ten years of UK Government’s energy policy go from an opinion that the solution can be found in windmills, through the confusion of Kyoto, to the shock of realisation of Europe’s dependence on Russian Gas, to the announcement by the Prime Minister that nuclear energy needs revisiting - having previously decreed that nuclear power should be phased out and that the country should sell off its nuclear technology. 

Having said all that, for the near future world industry continues to produce huge productivity improvements that are leading to increased business profitability and prosperity in the West and Asia. Markets are never rational and pessimism is not a profitable strategy.

Damon de Laszlo 
May 2006