DABERIAM XIX

October 2005

September was an extraordinary month; the two hurricanes being viewed in real time on the world’s television as they wrought havoc across the Gulf of Mexico was palpable. Real time genuine reality television generated a massive amount of smugness amongst the voyeurs in the rest of the world. To a frightening extent the reaction outside America and to a small extent in the liberal press in America, to the terribly human tragedy was viewed with little sympathy for the some million people who suffered. 

There seems to be growing evidence of extraordinary complacency in the political circles of Western countries. The disaster showed up the incompetence of the State Governments of the area whose long-term neglect contributed to the damage caused by the hurricanes, and the apparent breakdown of all the disaster planning, that now appears to be largely political rhetoric, that was supposed to have come out of the internal security budget post 9/11. The most worrying feature, however, is that I doubt whether any other country’s government response would have been any better. 

The economic fall-out of the two hurricanes has been a spiking in energy prices and a real awakening to the incredibly tight energy situation in the World. The good news is, the shock to the system has demonstrated in no uncertain terms the lack of capacity in the world’s energy supplies. Rita and Katrina destroyed 108 oil and natural gas platforms, and badly damaged a further 50 or so. The US Department of the Interior estimates that it is a negligible 0.5% of US oil production, and a somewhat higher percentage of refining capacity. The very tight supply situation has ricocheted around the world. American consumers are curtailing their fuel consumption, US vehicle miles travelled in July were already down dramatically year on year, the free market economy response but, most importantly, more recently Asian countries from China to Indonesia had to allow fuel prices to rise dramatically. 

In the UK the supply situation prompted the CBI to mount an attack on the Labour Government’s non-existent energy policy. The national grid which is responsible for operating the gas and electricity transmission network slipped out a forecast "that an average winter would require small cuts in supply to large gas users such as Gas Fired Power Stations, a really cold winter would face heavy energy users with substantial cuts". 

The Government response from Alan Johnston, the Trade and Industry Secretary has been that "domestic users will be protected!" so that’s all right! Industry does not matter. The Government’s longer term electricity generating policy predicts cutting Nuclear capacity from something over 20% down to something under 10%, roughly replacing it with renewables and an interesting category called ‘other’. At the same time the forecast shows a halving of coal generated electricity from over 30% to just over 15%, and the difference between being taken up by gas by 2020. 

I am not an expert on energy supply, but it is difficult to observe other than that this seems to be a very high-risk economic strategy. Apart from the fact that it will blow a hole in Mr Blair’s Kyoto promises. 

Apart from Britain, most other countries are beginning to take seriously increasing electricity generating capacity and endeavouring to diversity away from oil and gas. China, in particular, is building coal-fired power stations and upping its nuclear capacity, planning some thirteen new plants. The world, however, is facing and will continue to face a shortage of oil and gas and other commodities as industrialisation continues to grow at a fast rate in China and India. One of the perverse effects of the energy shortage is on agricultural products. Sugar, palm oil and other starchy product prices are being driven up dramatically as they are used to substitute the petroleum-based products. 

Inflation will inevitably pick up. Even China’s not-for-profit economy will have to pass on the increase in commodity prices to its customers in the rest of the world. The good news is, German and Japanese industries seem to be coming out of the doldrums. Painful corporate restructuring in the last five to ten years is bearing fruit. The US economy will receive a boost from the rebuilding required following the hurricanes and seems to remain hugely resilient. 

The building up of Government debt in the US and Europe, however, continues unabated. Twelve out of twenty-five EU countries are running deficits of over 3% of GDP, including the four biggest economies: Britain, France, Germany and Italy. Adding the EU deficits to the increased US borrowing will in the end push up interest rates. With commodity prices rising and Government borrowing rising, there is a certain inevitability that inflation will become an issue. The when will largely be, I believe, precipitated by some shock or tipping point in the trends. At the moment, the trends are relatively benign but something will come along to trigger a change of attitude. It’s anybody’s guess what the trigger will be, perhaps another hurricane, a major earthquake or, as interest rates rise the collapse of an international financial institution possibly in the early part of next year, 

In the meantime, let us enjoy a beautiful autumn.

Damon de Laszlo 
October 2005

DABERIAM XVIII

August 2005

The end of August brings the realisation that the days are getting shorter. Predictions of doom and economic disaster are now being postponed to 2006 and explanations are being thought of to justify why they didn’t happen in the first half of 2005. The problem with this method of predicting is that, like a stopped clock, they come right periodically. Secondly explanations for the lack of a predicted crisis start to generate in some quarters an air of complacency. 

I have a feeling the world is going to rock along nicely through ’05 and probably into the beginning of ’06 but imbalances are building that show little sign of being corrected fast enough not to cause a crisis. 

Economic systems work as price influences “decisions” and they work relatively smoothly provided there are no monopolies or Governments that stop the “decisions” being taken. Prices rise and fall influenced by fashion and perception as well as cost, for example house prices rise if there is full employment and rising income and/or falling interest rates, a point is reached where prices continue to rise through fashion even though economics would predict that people are getting out of their depth and then on the whole they will stabilise or drift downwards, as unemployment rises combined with falling incomes and/or rising interest rates. The market won’t collapse however, unless there are a lot of forced sellers. Most imbalances tend to correct roughly in the same way that they build up unless something inhibits the “decision” mechanism. 

Oil or, more generally, energy consumption is proving to be subject to forces outside the normal economic mechanism and a crisis point is being generated. Before the crisis is reached, however, inflation is likely to pick up dramatically, bringing rising interest rates and economic slow down along with a possible property crunch, all of which is likely, perversely, to postpone the energy crisis point. 

Present economic growth trends are outstripping the reliable supply of oil, added to this is a shortage of refining capacity, causing major bottlenecks. Refinery capacity is, by and large, in the hands of the major oil companies and Government regulation in the western world militates against building either refineries or LNG capacity. This same inhibition applies to the only other reliable source of energy, Nuclear Power. 

As an aside, while windmills and other alternatives are being heavily subsidised and make 
a contribution, they don’t solve the basic problem that people want to turn on the lights and industry wants to run even when there is no wind! 

While there are oil and gas prospects around the world, many of them are controlled by governments, which for political reasons or pure bureaucratic incompetence are inhibiting exploration. This applies to Russia, most of South America, Mexico and a great swathe of “...stans” in East Europe. China, faced with American protectionism and Congressional 

parochialism is pursuing a strategy of acquiring energy, raw material and food resources using its dollar resources, directed with a focussed Government strategy. They are negotiating with Governments or buy resources at a great rate in South American and the East Europe “..stans” that run along its border. 

The American political behaviour towards China is not improving the global situation. While China remains focussed and cool headed, congressional statements are feeding on themselves to create a potential hysteria that is dangerous to world economic stability. 

It is interesting that the Chinese responded to American hectoring on currency by revaluing, but by an amount which is basically irrelevant, making Treasury Secretary Snow’s pronouncements look rather lame. 

The rising oil prices have not yet had an impact on inflation, partly because a number of inflation indicators exclude energy and partly because Asian consumer goods are still depressing western prices. China’s ‘not for profit’ economy is shielded from rising oil and energy prices by Government regulation. The increase in the cost of plastics derived from oil has not yet fed through into prices. These two distortions apply to a greater or lesser extent to the rest of Asia and the Third World. The free market pricing of oil and energy is really only being felt in Western countries where it is a smaller percentage of the economy than in other parts of the world. 

Two consequences of this distortion are building up. The increases are not feeding through to either dampen demand in the Asian area for energy or increase prices of consumer goods in the West. Western inflation in services is being masked as demonstrated by some interesting statistics in the FT last week. In the period 1996-2005, UK incomes have risen 50%+, while items such as holidays and private education have risen between 50 and 60%. In the same period cars have effectively remained unchanged while items such as clothing have declined by approx. 40%, with electrical and electronic goods declining over 60%. 

These unusually divergent statistics are masking what could turn into serious inflation and economic disruption if energy demand is not curtailed or new capacity brought on stream. Bearing in mind that new energy capacity, whether in the form of oil wells or generating plants, takes five to seven years to develop and, in the case of atomic energy, the only real source of non carbon-dioxide producing power, upwards of ten years to bring on stream. 

While I am not gloomy about the next six months to a year, there are some potentially serious economic dislocations that could occur from the lack of the surplus capacity that gives us fuel for cars and aeroplanes and electricity at the touch of a switch, which the West is so accustomed to. 

On a local front, it is interesting how little strategy there is in the thinking of Western Governments. The UK Government, for instance, is forcing BNFL to sell Westinghouse, a major builder of nuclear reactors, much to the glee of companies in the USA, Japan, France and South Korea who want to buy this technology.

Damon de Laszlo 
August 2005

DABERIAM XVII

July 2005

Before putting pen to paper, I sometimes read my previous report, although often I don’t, as it is difficult not to be influenced by one’s previous comments. 

However, since May not a great deal has happened to change my view of the world, except in my domestic life. The arrival of a grandson, Arthur, on the 19th June delightfully disrupted home life for a while. Further disruption was provided by my son’s epic return to London on the 4th of July, having spent 26 days 21 hours and 14 minutes rowing around Britain with three companions in a 23-foot boat. This has earned the four intrepid oarsmen a place in the Guinness Book of World Records as it is the first time anyone has been nutty enough to make an attempt - a task considered rather more difficult than rowing across the Atlantic. Do visit their website -www.gbrowchallenge.com 

The Federal Reserve Bank’s quarter point hike in interest rates last week was well trailed and will probably be followed by at least one more hike before the end of the year. 

The French rejection of the EU constitution, along with the Dutch, caught no one by surprise except apparently Brussels and the French Government. The relief from other Governments around Europe that they were not the ones to derail this venture was as interesting as the pronounced determination of the respective Heads of State to continue with the process anyway. While I am keen on the concept of a European free trade area, the political integration has always seemed to me to be an aberration and a dangerous bureaucratic dream that could lead to major instability in Europe. It’s difficult to see which way things will go but I fear that this incompetently managed piece of legislation will cause unnecessary instability in the EU and this is not good news economically. 

Back to the major world players, the US economy is going well, wages and 
employment are holding up and indeed increasing. Productivity is also improving and capital expenditure is going well. While I would expect pressure on margins, new capital expenditure is anecdotally improving productivity at a faster than expected rate. US inflation just seems to be creeping up and the Fed will continue to raise interest rates; from a stock market point of view this will be countered by the recent up-tick in M4. 

On the trade front, US exports are rising while the growth of imports is declining, implying a small move in the right direction vis-à-vis the US balance of trade. 

Asia seems to be moving along nicely with China apparently slowing. The increased US Government pressure on China to revalue is probably postponing the day on which they will act. In any event, it won’t make much difference to the US balance of trade. While the Chinese economy is growing, corporate profitably is negligible, it’s becoming a sort of “not for profit” economy! 

India, on the other hand, seems to be fulfilling an old promise of a genuine profitable economic expansion and, along with Japan, is beginning to add weight to the Asian economic growth. 

Europe shows no sign of being able to create a world-class institution. France, where in effect only half the population is in productive employment, is rudderless. The Government has lost control of the reform process and is unable to implement any reforms. 

Italy, running a deficit of 7% of GDP, is getting into deeper and deeper economic problems. The only bright spark is Germany, where its industry seems at last to be focussing on getting its own act together regardless of Government. 

This leaves the UK where economic growth is collapsing under the weight of “Government Initiatives”; bureaucracy strangles slowly but surely and as the proportion of the population that is working in the Government sector or on entitlements nears 50%, huge Government deficits and the inevitable tax increase will bring Britain into line with the rest of Europe.

Damon de Laszlo 
July 2005

DABERIAM XVI

May 2005

As always it is interesting to sit and think about the direction of economies. On a global basis economic momentum is slowing. This is a good thing as the last eighteen months or two years’ growth rates have been well above a sustainable level. However, the statistics that show slowing economies cause alarm and despondency as a lot of them demonstrate changes in the rate of change. Couple this with the tendency of people to extrapolate in straight lines and you see there is a quick conclusion that disaster is around the corner. 

The rate of change of growth in the US from over 5% to probably just over 3% in the current year does not necessarily meant that next year will be only 1 or 2%. As things stand the US consumer driven growth appears to have slowed down which is excellent. This will probably have the effect of improving the US balance of trade and taking some of the inflationary pressures out of the economy. 

China’s rate of growth is also slowing from unsustainable levels, also good news, although some predict the slow down of growth will continue until there is an economic crisis. On the face of it this seems unlikely. 

The political climate, however, is less benign. The growth in democracy in various countries and the freedom that this brings is good news economically but as the more free countries appear, it leave the totalitarian states with fewer friends, and these cornered animals are more dangerous. North Korea is a case in point and sadly the activities of the communist government in Uzbekistan are only too clear a warning of this kind of danger. 

The political stability of the world over the last ten years has meant that many in Government have forgotten how rhetoric can get out of hand. Here again there are dangers, the Japanese/Chinese argument over the Japanese school textbooks’ reporting of history became over heated. There are many historical flashpoints and countervailing land claims, or should I say, island claims, between two countries. Taiwan’s provocative political stance on independence is also dangerous but that said, the Chinese Government is unusual in that many of the best brains in the country are in the Chinese Civil Service and their handling of the country’s economy and politics has been masterly in the last fifteen years or so. 

Europe as always is producing bizarre economic phenomena. The French Government is going through hoops trying to stop their people expressing their deep-felt negative views of the EU. The German Chancellor is lambasting investment institutions for assisting in the restructuring of the sclerotic German industrial structure. In the UK, the newly elected Government is endeavouring to paralyse the legislature with a huge programme of new laws, many announced “on the hoof”. The Prime Minister, we heard the other day, wants to prevent football clubs being taken over by “foreign investors”! Government by “sound bite” is the rule. A report comes out saying standards of literacy are declining; the next day an announcement that spelling will no longer be marked in English exam papers. An announcement that people can get burnt by hot water; Government response, every hot water tap (faucet) will have to have a thermostat restricting the temperature etc.! 

The election recently fought in the UK was depressing in the extreme. Labour policy by “sound bite”; Conservative policy criticised and then mimicked the same technique. By contrast, the Liberal Democrats excelled in what can only be described as high-waffle policies. While Mr Howard seemed to be bereft of policy or strategy, but at least did have only one Australian political sound bite advisor, Blair’s campaign suffered from interesting conflicting thoughts. Blair seems to be the epitome of US President Warren Harding, a President created at the beginning of the last Century by a lawyer lobbyist and a newspaper editor. 
The current worrying political phenomena are a product of global prosperity and a lack of real crisis issues. The danger is that we sleepwalk into some really nasty problems. The growth in the rhetoric of protectionism, if turned into legislation, will cause some nasty self-inflicted wounds on the EU and USA economies. 

The Green movement in Germany, while espousing concern for the environment and the virtues of Kyoto force the closedown of another Nuclear Reactor in Germany to be replaced by a coal-fire power station! 

Backing away from politics, and barring some unanticipated catastrophe, the major Western and Asian economies are set to grow comfortably. Before the end of this year I suspect many institutions, with their consultants in the lead, are going to have to consider buying equities as any pick-up in growth and/or inflation is going to leave Bonds very vulnerable. In these highly volatile markets with the huge weight of money in Hedge Funds and alternative investments, small movements in sentiment will cause the markets to move very rapidly. 

While I understand the Governments around the world wishing to issue very long Bonds, 30-year, and even 50 year, I cannot understand why anyone would buy them; the risk/reward ratio defies any logic for an investment of this duration.

Damon de Laszlo 
May 2005

DABERIAM XV

April 2005

“May you live in interesting times” is the Chinese curse. The simplicity of the debate and “worries” of the American election and Iraq have been replaced by a myriad of confusing discussions. 

The Chinese Government is talking down the Chinese economy to try and reduce the building bubble and state sector industry capital expenditure, without destabilising the private sector. 

On the other side of the Pacific, the Fed. is tightening the money supply, trying to deflate the property bubble without upsetting the rest of the economy. While the recent rapid dollar decline is, in conventional terms, likely to produce retail inflation in the US, the globalisation of production means that US retail prices are not rising as expected. The economic pressures in the world are, while keeping retail prices down, pushing up commodity prices which must be curtailing Chinese and other Asian manufacturers profitability. 

Globalisation of industry is keeping retail prices steady, a phenomenon that has not really been experienced since the end of the 19th Century. 

One can make a rather generalised observation that Pax Britannica created a free trade world at the end of the 19th/beginning of the 20th Century, we are seeing Pax Americana having the same effect. 

With the globalisation of trade also comes the globalisation of liquidity. The movement of funds around the world is today creating similar financial bubbles to those that were seen in the late 19th , early 20th Centuries. The difference today is the speed of communication, along with the increased financial sophistication of markets, creating faster market gyrations, and this confuses the analysis of the major underlying trends. 

On a world basis, the Chinese economy is slowing a little, which is a good thing. The Japanese economy is slowly reorganising itself after a long period in the doldrums and I believe will join the Asian growth phenomenon. India is also, for the first time, likely to really break out of its bureaucratic bonds as the Government is finally starting to build the infrastructure for the movement of goods and the e-communication is raising expectations. Europe has managed to create a straightjacket which is probably the dark spot of the world and the US seems to be doing fine, but is suffering from being the depository of the world’s surplus cash. 

Moving from general observations to particular issues, I am always looking for events that could upset the general market. Oil is one obvious area. It is in a tight supply situation which is unlikely to be corrected for the next ten or fifteen years. The world economy will continue to grow and the world economy will continue to waste this scarce resource by burning it in power stations, unnecessarily contributing to the CO2 overload. 

It is gradually dawning on countries that the only viable alternative is Nuclear Power. At an OECD meeting in France in March, most countries came to this conclusion. To get significant new Nuclear capacity on stream is going to take ten years plus. So for the foreseeable future a major disruption of supply would push oil prices much higher and disrupt the world economy. 

It is worth noting in passing that Nuclear Power is one of the bright spots of the French economy, generating approx. 80% of its electricity, saving the country the equivalent of 10 billion Euros over the cost of power from natural gas and delivering 25 bn. Euros p.a. in export sales. 

In America while the economy is intrinsically sound, the excesses in the financial markets could produce a crisis as interest rates rise. Startlingly the great GM is possibly an economic iceberg. In March, G E Capital withdrew a $ 2 bn. Loan Facility as GM’s credit rate fell to BBB- and GM’s market capitalisation also fell below that of Harley Davidson, a company making some 317,000 motorbikes a year, compared with GM’s 9,000,000 vehicles! 

GM, facing global competition, probably cannot trade its way out of these problems. None of its competitors has to support the incredible health care and pension costs of its ex-employees. Each GM worker must produce enough profit to support 2.5 pensioners before the company makes a profit. In reality, the story of GM is getting to Chapter 11. 

While there always are dangers, I feel basically optimistic about the US economy. The Sarbanes Oxley legislation is having an interesting and perverse effect. Companies are in a hurry to publish bad news and are more and more nervous about publishing good news. Also many companies are still grappling with publishing any information owing to the complexity of the act. We can expect the first quarter reporting season to start with depressing reports and it won’t be until we get into the third quarter that everybody will wake up to the fact that earnings are much higher than forecast. I still think there is going to be a boom in the S&P at the end of the year as it dawns on the institutions that corporate earnings growth is still outstripping economic growth and is not reflected in the indexes. Interest rates are also rising which is going to make institutional holders of Bonds wake up one day and realise that their assets are in the wrong place.

Damon de Laszlo 
April 2005