DABERIAM XIV

February 2005

My note last November ended with Russia as a question mark. It still is - Russia has never been a country where the “Rule of Law” applies, except for a short period at the end of the last Czar’s reign. Not unsurprisingly, this coincided with a huge burst in industrial innovation and middle class prosperity. 

Typically business in Russia has been conducted under bureaucratic fiefdoms with the Czar, or today the President, at the head. Putin is reverting to mean by effectively renationalising the major oil producer, YUKOS. Dictating the direction of oil and gas pipelines and negotiating what amounts to private contracts with the big oil companies for exploration. The sadness is that the Kremlin will not be able to manage these resources efficiently, and investment in other areas will be discouraged. We can expect political instability around the peripheries of Russia as improvements in the economy fail to materialise. 

Leaving Russia to its own devices, the rest of the world looks quite good. The Governments of the United States, China and India are steadily getting on with the business of encouraging enterprise and doing their primary job or running stable economies. Bush has said that he is going to address the Government deficit by curtailing expenditure and, if history is anything to go by, he will succeed. There are also signs that the Federal deficit is turning and it will decline steadily over the next few years. 

Law Reform is rising up the Agenda and will be addressed and there is an increasing understanding that personal savings and an ageing population, along with the health issues that they bring, are all needing attention. The argument is only in the detail. Consumer expenditure is likely to grow at a slower rate, if at all, but capital expenditure will take over as the engine of the US economy, fuelling GDP growth and productivity. Some three or four hundred billion of cash will be repatriated by Corporate America and turned into capital expenditure in the current year. 

The Iraq elections happened and, by all accounts, were popular and relatively fair to the disappointment of many who were hoping that it would turn into a shambles and discredit American policy. The elections will help the phased withdrawal of US troops from the front line of internal security to holding areas close to the Saudi and Iranian borders. 

The Fed continues its policy of ratcheting up interest rates to dampen the mortgage refinancing market and the housing boom. It seems that the Fed is fully aware of the enormous amount of liquidity in the system that needs to be slowly reduced. There is a danger here that they miscalculate and there could be a market accident in the debt area. There is a lot of paper in the system that is over-rated and, as interest rates rise, holders of heavily geared funds are likely to receive a “haircut”. 

The big worry, the US balance of trade, is likely to improve with a decline in retail growth, the impact of Chinese consumer goods will flatten out and, as China encourages its domestic consumption, the cost of these goods will tend to increase. This, as well as the global appetite for dollars, means that demand for the currency will continue. There is really no alternative to US Treasuries and Bonds for the World’s Central Banks, which is why US long yields remain stubbornly low. 

China and India are continuing to discover that economic growth and freer markets feel nice. Barring a political miscalculation leading to military threats, Asian economic growth is becoming the driver of the world economy. The good news is that China has slowed a little and this has brought relief to the commodity markets. However, there is a general global concern with the huge amounts of liquidity in the world system. Asset inflation is a problem. 

On a world basis surplus liquidity generated by Central Banks in 2001/02 has in turn driven up property prices in the US, UK and Europe. The same is happening with a vengeance in China where a seven to eight year building boom shows no sign of abating. The same liquidity has been pushing the trends in the commodity markets. 

Europe is another matter. While there are signs that Germany and France are trying to loosen up their labour markets, the process is painfully slow, and the bureaucratic restrictions on entrepreneurial activity are stifling. Both countries have huge unemployment, particularly among the young. Both countries make it difficult to start businesses, and both countries are running a huge Government deficit, as a percentage of GDP, similar to the US. 

Britain, by adopting European habits, is itself stifling entrepreneurial activity and the Government, in true Socialist fashion, is resorting to meddling with the official data. The revisions and rebasing of information from the Office of National Statistics makes year on year comparisons difficult, and in some areas impossible. The vast increase in resource directed to the government departments has been largely responsible for the declining unemployment in the UK, and a large amount of the economic growth. 

The robust and entrepreneurial economy that the Labour Government inherited is being stifled, with the result that national productivity is declining along with Government revenue, which will lead to massive Government deficits in the next year or so. 

All in all the investment prospects around the world look good and the stock markets, particularly in America, I believe are set to rise impressively as productivity and profits continue to beat expectations. 

There is a likelihood that the Euro has peaked. There is an old adage that, when a retail chain builds a flagship store, or a company builds a new HQ, it is often the ‘kiss of death’! As the famous Peter Drucker would say, “an excessive investment in managerial ego!” What does the building of a new massive Euro Central Bank HQ foretell?

Damon de Laszlo 
February 2005

DABERIAM XIII

November 2004

Since August large sections of the Wall of Fear that was confusing the Stock Market have crumbled. It would seem that we are left with the rubble of worry - perhaps a metaphor too far! 

The US elections have come and gone with President Bush greatly improving his electoral mandate to the huge disappointment of the Democrats, the legal fraternity, and the more intellectual pundits. There seemed before the election to be an implied desire in the press for a disputed outcome; the last thing columnists and experts seemed to want was a clear mandate. Luckily, middle-America voted for a man with clear ideas and principles and the world will now move forward. 

The US economy seems marginally to be slowing down but corporate America is continuing to turn in profits above expectation. Employment is rising at a slow but steady rate and even the budget deficit is starting to improve. Federal Tax receipts from an improved economy are growing and Federal Government outlays are slowing. The international deficit is a more difficult problem as the Chinese/US currency link means that the declining value of the dollar has no impact on the primary source of US imports, but even here there are encouraging signs. Chinese investment in Latin America, which is growing at a considerable rate, is likely to help US exports to that region. It is worth remembering that economic imbalances tend to revert to mean with or without Government intervention. 

The other market nightmare was oil. The tendency to project economic trends and graphs in straight lines showing an ever-increasing price of oil causes much “worry”. During the summer major sources of oil production were simultaneously curtailed: Nigeria with both strikes and civil strife, Russia, with the Government attack on YUKOS, the devastating hurricanes in the Gulf of Mexico and, of course, the war in Iraq. 

This, coupled with both US and Chinese reserve-building, meant that there was enormous pressure on oil prices. Saudi went into full production, the disruptions in the four other areas of oil supply have started to self-correct and the stock building seems to have abated a little. The linear extrapolation of increasing oil prices has turned down and we are likely to continue to see declining prices for the moment. Oil supplies, however, in general are getting tighter so there is no doubt that there is now potential for oil supply crises for some time to come. 

There are many other commodities, however, that are in short supply and will continue to be so as the Asian economy grows. Asia, with China at its core, is, I believe, taking on a life of its own. China’s growth, which would appear to have slowed a little, is fuelling Japan, Malaysia, Indonesia and the rest of the area. Foreign investment in China is still growing at a tremendous rate, some 23% in the first three-quarters of this year. The Chinese authorities are reforming the banking system at a faster rate than is generally appreciated and I believe the sophistication of the Chinese Government’s economic managers is not appreciated in the West. Chinese officials know they have to manage growth fast enough to mop up a huge labour force, possibly some 300 million people, that could be released from the land and Government industries as the country reforms. Labour unrest is the greatest fear of the Chinese Government. 

To fuel Chinese growth, and keep inflation down, the authorities seem to be shifting their focus to external sourcing of food and commodities. The Chinese President’s visits to Brazil and Argentina are the confirmation of a new policy direction. As Chinese prosperity grows and their farm production goes up-market, there is a need to import primary foodstuffs to keep domestic food prices down along with industrial commodities. 

There is probably a political dimension to these Chinese developments in Latin America. The US sabre-rattling with regard to Chinese imports along with periodic congressional attacks on the transfer of technology to China, is encouraging China to increase its political and trade muscle around the world. 

In general, the US economy is doing fine and will benefit from Chinese growth. In the US we are also likely to see an expansion in capital expenditure as US companies struggle to improve productivity and experience the supply-chain problems of bringing product from Asia. The demand for shipping and port facilities is outstripping supply. The US will extricate itself from the turmoil in Iraq, almost certainly within the next twelve months, but it will, under Bush, continue to exercise a global influence that will discourage pariah states. 

The major dilemma for US foreign policy in the next few years is likely to be Taiwan. If the Taiwanese Government decide to antagonise Beijing in the run up to the 2008 Olympics, America will have to decide how to react. The Chinese domestic politics will not allow the Government in Taiwan to publicly humiliate it by announcing “independence” moves. Conversely, the Taiwanese Government is tempted to wave the “independence” flag for its own domestic purposes. 

Europe seems to continue on its path of bureaucracy building. In spite of myriads of initiatives, governments in Britain, France and Germany continue to bury their industrial and entrepreneurial managements in red-tape and confused legislation. Companies are moving the hearts of their businesses to Eastern Europe and Asia. 

Russia is another question......................

Damon de Laszlo 
November 2004

DABERIAM XII

August 2004

June and July have continued to produce stock market confusion. There seems to be an aggregation of worries that don’t on the whole relate to underlying trends. 

In May I commented that the Fed’s long-expected indication that interest rates were going to rise sooner rather than later produced bizarre market gyrations. We also had the news that the Chinese Government was taking measures to restrain the unsustainable economic growth. This has since produced a rush of predictions about hard landings, crashes etc. Again these predictions seem to be based on nervousness or perhaps a desire for a crisis. 

The general good news is that a marginal slow down in global economic growth has stabilised most commodity prices, yet worries still remain. The US, in particular, seems to be beset by paralysis caused by the extraordinary polarisation of politics around an intense dislike or like of Bush. As a President he has managed to generate more odium than any other President in my living memory, both in the US and around the world. 

Further worries in the market about terrorist risk and the confusion generated by the reporting of Government warnings on terrorism add to the general market uncertainty in the short term, while the macro economic and global world seems to be on the whole good. Even the WTO has managed to get some sensible conclusions in the last round of meetings in Doha. Developed countries have for the first time agreed that subsidising their farmers and then subsidising the export of non-required product is extremely damaging to the developing world. 

Among the building blocks of the wall of worry that the markets are hung up on, perhaps oil is the most intriguing. It is probable that supply and demand is nearing balance, i.e., there is little surplus. The result of this is commodity traders, particularly in the hedge fund area, heavily influence market prices. While recent production figures are exceeding consumption, the price continues to rise on a fear of terrorist disruption. I suspect that if there were an oil related terrorist incident, there would, perversely, be a rapid drop in the price of oil as speculative positions were unwound and demand dropped. Rising oil consumption is a problem a few years out but at today’s prices it is not a significant drain on the world GDP. 

The good news, starting with China, is their economy is slowing, a bit, and is therefore probably now expanding at a sustainable rate without major dislocations. This growth is enormously helpful to the world economy, Asia in particular. It is also “a good thing” that Chinese poverty is diminishing and the country as a whole has an interest in world stability. As with oil, China raises some major problems for the West in perhaps four or five years’ time. Their rate of technological advance is prodigious and much of their industry is at the forefront of production techniques. Their manufacturing capability is likely to increase at a far faster rate than in the Western world, particularly (as reported in 13D Research) China will graduate 325,000 engineers in 2004, five times the number of the US! 

Virtually all global companies have manufacturing facilities in China and inevitably R & D will follow. In practice R & D can not for long be far away from production facilities in most manufacturing sectors. 

India too is broadening out its economic growth. The development of the Internet and the mobile telephone network is not only providing economic growth in the software industry, but also seems to be having an extraordinary political impact. India is a proud country with a great heritage and the Indian people have regarded themselves as a cut above the rest of Asia, if one is allowed to make this sort of comment in a Politically Correct world. The impact of greatly reduced cost of telephone communications and Internet facilities is bringing a realisation to middle class Indians that they are being overtaken by developments in China and Korea. This discovery seems to be galvanising political opinion into resisting bureaucracies that stifle economic and industrial growth. The globalisation effect at its best? 

The most fascinating recent development in Europe was the announcement some two months ago that two Siemens factories in Germany had agreed to extend their working hours from 35 to 40 hours a week for no extra pay. This is deeply significant as it must be the beginning of the new trend in both Germany and France. Both countries’ Governments have failed to sort out their labour problems and at last companies are beginning to take the matter into their own hands. The alternative for European corporations is either to move manufacturing to Eastern Europe or Asia, which would be an economic disaster for Central Europe. The introduction of the ten new member States is producing huge strains as the regulatory burden in “Old Europe” greatly encourages companies to relocate to take advantage of more sensible labour regulations and, as importantly, lower tax rates. Economic performance in Europe will pick up and the renegotiation of working hours could have a dramatic effect on corporate profitability, as the efficiency of European manufacturing is by and large competitive, particularly with the US. The major worry in Europe, apart from the bureaucratic overload, is the potential political instability caused by the disparities in the Euro zone and the inability of the Commission to enforce its own rules on national Governments. 

Britain is still marching somewhat out of step with Europe and it is unfortunate that one has to observe that, the Government in Britain is doing its best to create the equivalent bureaucratic burden that hampers European industry. 

More worrying is the propensity for British Ministers to undermine the legal system. Complex modern economies require certainty that their actions comply with the law and that the law doesn’t change arbitrarily. Last month the Treasury announced that ‘in their opinion’ companies were not paying enough tax. There is a blurring by the Treasury between tax avoidance, which is legal, and tax evasion. This blurring makes long term capital investment and planning more uncertain which is not good for economic growth. 

In the same vein, the Department of Transport has decided that the Banks made too much profit financing the railway companies that were set up after privatisation. The new train operators had to raise huge amounts to replace the rolling-stock that the Department of Transport had failed to do prior to privatisation; this funding was provided by the big banks at relatively high rates of return, as the risk of this finance was high. The problem was exacerbated by the short duration of the train operators’ franchises - seven years against the economic life of the rolling-stock of some thirty years. Contracts entered into by sophisticated lenders and borrowers are now, many years later, being challenged by the Government, who of course can make up the rules as they go along! 

Having started with the peculiarities of the US market and its present bizarre behaviour, it is worth reviewing the good news. Corporate earnings continue to grow at a good rate. The corporate sector is very liquid. Employment is rising. The institutions appear to be underweight in Equities, and the Hedge Funds appear statistically to be heavily short. While interest rates are likely to rise rather than fall, which may slow down consumer expenditure a bit, the economy as a whole looks very solid. It seems that the general nervousness is being sustained on a relatively rickety wall of worry. As every month goes by with earnings rising and the market going nowhere, the stock market looks a better and better bet. 

The risk, I believe, is the market could move rapidly upwards and in quite a short period, leaving little opportunity to buy into the rise. Funds that are short or in cash or bonds are far more risky today than being in the equity market.

Damon de Laszlo 
August 2004

DABERIAM XI

May 2004

Since March the world economies ex-Europe have continued to grow but the economic statistics are, in the short term, pointing all over the place. The US indicators continued to show good economic growth with employment now beginning to show a rapid upturn, however the stock market has got itself into a panic over the Fed’s indication that interest rates are probably going to rise soon rather than in the distant future! 

The markets have risen rapidly over the last twelve months so the change of direction is not surprising. What is surprising is the nervousness the Fed’s predictable statements have caused. Companies’ profits continue to rise, the lack of capacity in the semi-conductor industry created by an enormous increase in corporate expenditure on IT plus the increase of use of computers in the automotive and telecommunications industries is driving US technology. The demand for commodities, from oil to aluminium, is going to precipitate a boom in investment in exploration and this in turn will drive the need for capacity for mining and drilling equipment through to processing equipment. 

There is also an enormous shortage of shipping and port facilities around the world need refurbishing. Shipping shortages are being caused by Chinese growth in raw material imports, coupled with the increased use of coal and oil for power generation. This latter point is partly a perverse result of the green movement’s success in shutting down nuclear capacity, e.g. Tokyo Electric Power’s decision to shut fourteen nuclear stations, largely as a result of green political pressure, is producing an enormous increase in the demand for coal and oil. The delays in ports around the world are also greatly exacerbating shipping demand. The demand for shipping is far greater than supply and will be for the foreseeable future. In general, it is easy to predict that capital expenditure on shipping and the engineering industries that support it, mining, oil drilling and everything related to infrastructure, is going to grow for the foreseeable future. This in turn will have a knock on effect in all industrialised countries. 

Power consumption is also rising around the world and no country is likely to get near to Kyoto’s commitment of reducing CO2 emissions. In the UK alone coal and oil consumption was up by 7.1% in 2003 bringing a reported 1% increase in CO2 emissions. No amount of wistful thinking about wind is realistically going to change this picture. 

Luckily, from a global warming point of view, the French have announced plans to build a new generation of pressure water reactors; Finland is following suit; and even Sweden is coming around to the idea of expanding its nuclear capacity. Russia and China are building nuclear capacity and even Belgium is thinking about it. Interestingly, Britain and the new Socialist Government in Spain are the only major countries now still committed to phasing out nuclear energy. 

China’s recent announcement that firmer measures will be taken to restrain credit is good news. Chinese capital expenditure has been running out of control and a great deal of uneconomic investment has inevitably been made. The Government in China is well aware of the boom and bust cycles of capital expenditure and interestingly seems to be using the political party system to dampen down bank lending, which means it is likely to be effective. A slow down in the Chinese economy will dampen down the rapid rise in commodities experienced over the last two years. It will also tend to discourage the flow of capital into China, which has greatly contributed to the GDP growth of 17 - 18% in the last 12 months. If the Government gets its balancing act right, it will not precipitate a property crash in Shanghai and other over-built areas. China’s balance of payments and trade surpluses are declining fast and the Government’s desire to keep down inflation will encourage them to import food, particularly wheat, from the USA, helping to improve trade relations. 

A controlled slow down in the rate of growth in China will not have a harsh impact on the rest of Asia, indeed the likely reduction in commodity prices will help everybody. 

India is something of a wild card as for the first time it is experiencing economic growth that the bureaucracy has as yet not been able to stifle. Services provided by cable and telephone lines are difficult to intercept compared with goods and therefore difficult to “licence”.

The US economy is going well and, as predicted, State Governments’ incomes are rising fast and their budget shortfalls of last year are being covered. Rising Federal income will reduce the fiscal ’04 deficit forecast of some $520 bn. dramatically. To the extent that consumer expenditure slows this is being covered by a considerable increase in business capital expenditure. 

American industry is short of capacity and the productivity increases gained from equipment design in the last five years make it uneconomic to restart plant that was shut down 99/00. This observation applies to virtually all sectors of manufacturing. Corporate borrowing is also likely to pick up as inventory building spirals from a very low base. The increase in corporate profits and optimism will also fuel merger and acquisition activity. All this activity will in due course lead to a considerable recovery in the stock market after it has got over its current jitters. Inflation, of course, will rear its ugly head and is already apparent in the “benefit costs” related to employment. 

The UK is in a similar position, except that the Bank of England, unlike the Fed, has acknowledged that there is insufficient spare capacity in the economy to sustain the current rate of growth without inflation. The major difference in the UK is, however, Government action. Patricia Hewitt, the Trade and Industry Secretary’s overweening desire to “help” produces a stream of legislation that creates legal confusion for corporate management. One of the principal requirements of an efficient economy is the ability of people to know what the law is and how they can operate within it. Current proposed legislation such as the requirement for Directors under risk from unlimited fines to file an operating and financial review is a case in point. Quoted companies will have to give details of factors affecting future and past performance. It sounds simple but the Company has to decide what is relevant information in this context and they will be judged in retrospect. This will inevitably lead to masses of fun for DTI Inspectors! 

In another area a proposed equality regulator to promote human rights and back legal cases against companies sounds wonderful but is an open invitation for lawyers and pressure groups to attack the corporate sector. Patricia Hewitt’s apparent observation is that it will be helpful to companies as a single point of contact for advice on “the increased volume of equality legislation”. How helpful! 

Even the House of Lords is becoming concerned. In a Select Committee Report it warns against the danger of regulatory creep caused by an increasing number of industry watchdogs and Quangos. These are largely unaccountable and their powers to impose penalties and fines and create secondary legislation mean an increasing burden on industry. Is this part of bringing us into line with Europe? 

In another vein, the Government’s success in holding down unemployment has largely come from Government recruiting itself. Of some 480,000 net jobs created in 02/03, 360,000 were public administration etc. This statistic does not auger well for wage inflation in the near future. 

Germany is still in the doldrums with its industry in a regulatory straightjacket and its policy of raising taxes to meet the ever-growing deficit is not a pretty picture. 

But interestingly, France’s fiscal laxness and disregard for European fiscal rules is beginning to show results.

Italy would appear to be following suit and looks as though it is going to ignore the European Council’s famous 3% deficit ceiling. 

In general, the outlook remains good except for the confused stock markets and this confusion is likely to continue for a while as Hedge Funds and others sell stocks in order to unwind their borrowing position in the face of rising interest rates. This unwinding process may also cause an overshoot in the decline of commodity prices. The other area that could unnerve the markets for a longer period would be the collapse of a major financial institution that is imprudently over-geared and cannot cope with the rising interest rates, but even an event of this kind would probably not derail general economic growth over the next one to two years.

Damon de Laszlo 
May 2004

DABERIAM X

March 2004

The world economy continues to grow apace except in Europe. The US looks as though it is going to clock up a third consecutive quarter of above trend growth with no sign of the growth abating. Capital expenditure is up and employment is picking up as companies see continuing full order books. Shortage of capacity is appearing in the IT industry and in particular in the semi-conductor sector. The demand for commodities is exceeding supply at a time of low stocks and the Central Bank in the run up to the November election has avowed to err on the side of inflation rather than deflation. 

China is experiencing growth at an even faster rate than the US but the major difference is there is no shortage of labour or capital. 

Japan, for the first time in ten years, is going into growth mode. Consumer expenditure is showing the first signs of life, and export sales are growing rapidly driven by China. Japan, like China, has no shortage of labour or capital. 

The UK economy, like the US economy has very little real labour capacity and very little useable manufacturing capacity. More importantly, it also suffers the same constraint as the US as far as financial capital is concerned. Both countries’ Government borrowing leaves little room for industrial borrowing for capital expenditure without pushing up interest rates. 

Commodity prices have risen considerably and are likely to continue along with freight rates. Container ship capacity is at the limit having grown some 34+% in the last twelve months. 

In economic cycle terms, we are at the end of the deflationary cycle and it is likely, bearing in mind the US - UK deficits that the economies are going to overheat rapidly.

China’s inflation rate has gone 3%+ positive in January after five years of deflation and the Chinese domestic demand for consumer goods now not being ‘discouraged’ by the Government means that cheap goods from China to America and Europe will start to disappear, driving consumer inflation. 

From a stock market point of view, company earnings are going to grow more rapidly than consensus and the enormous institutional underweighting in equities in the US, UK and Japan is going to drive markets, certainly for the next eighteen months. 

Interest rates are, however, likely to rise as competition for capital between industry and Government heats up and interest rates could rise very rapidly if Japan and China start to sell US Treasuries for their own capital investment needs. The rise in interest rates at some point will precipitate a financial crisis as those holding long term low yielding bonds experience the inevitable depreciation. 

Will the pension and insurance industry get caught again? Having moved out of equities at the bottom of the market into bonds; they will start moving back into equities as the bond market starts to crater next year. This will drive equities in ’05. 

These problems along with those created by rapidly rising commodity and oil and gas prices are more than likely not going to appear as serious constraints until we get to the end of 2004, beginning of 2005 when I think inflation will be back with a vengeance. 

In the meantime, barring the normal desire to look for disaster, the outlook is rosy.

Damon de Laszlo 
March 2004