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Quarterly Newsletter - Summer 2008

Markets, credit crunch, inflation, energy and food cost increases – problems galore!

As a result of the credit crisis, soaring oil prices and falling property values, stock markets the world over have performed poorly during the first six months of 2008.

As at the end of June, the UK’s FT-SE 100 and FT-SE 250 indices were down 13% and 14% respectively, by exactly the same margin as the American Dow Jones and the S&P 500.  The NASDAQ also is down 14%.  Germany’s DAX is down 20%, and France’s CAC managed a negative 21%.  Japan fared slightly better, down 12%, but the Chinese and Indian markets were the worst performers, down 48% and 34% respectively.  The only exception to this negative picture among the major markets was the Brazilian Bovespa index which recorded a positive 2%.  If you thought this general downward trend was limited to equities, fixed interest securities recently also have taken a hammering.

Against this background, our own globally invested equity unit trust, the CF Lacomp World Fund, has put in a creditable performance, down only 8%. In fact, a performance statistic published on 9th June in Professional Adviser showed the Lacomp fund in top position of all global fund-of-funds managers over one year and over three years, we were the fifth best performer!

The global economy looks set for a downturn, and arguments rage as to whether we will see a worldwiderecession or not.  Technically, a recession means two subsequent quarters with negative GDP growth, and many economies are already experiencing this, although the precise figures inevitably lag the actual events.  Take Ireland, for example, whose economy contracted by 1.5% in the first quarter of 2008.  The second quarter is unlikely to show an improvement, and investment in the economy has fallen by nearly 20%.  Add the fact that house prices have been falling each month for well over a year, and you can see that Ireland is facing a serious recession. 

In the UK, opinion about the possibility of a recession is divided.  Some commentators think that it would need a substantial rise in unemployment figures before a recession became inevitable.  Falling house prices, of course, do not help, and the recent trend is worrying, indeed. In June, prices fell by 2%, following a slide of 2.5% in May.  With the exception of 1931, when Britain abandoned the gold standard and the currency collapsed, house prices have never fallen by more than 10% in one year since records were kept.  According to Halifax, the UK’s largest mortgage lender, prices have fallen by over 8% in the first half of this year alone, suggesting that this is a worse housing crash than the one in the late 80s and early 90s.  Some analysts predict additional falls in values of 15 to 20% to come.  Of course, a lower property value, even if it entails negative equity, is not a problem in itself, but it becomes a huge headache if you either have to sell the house or have difficulty servicing the loan.  In other words, rising or falling unemployment will be crucially important in this respect. 

This potentially bad situation is compounded by the massive increases in everyday cost of living.  Rising petrol prices over the last year - diesel has gone up by 36%, unleaded petrol by 22% - and grocery bills that are up an average of 23%, not to mention direct and indirect taxation hikes (according to accountancy firm Smith & Williamson, the average family pays nearly 5% more income tax and more than 8.5% more National Insurance contributions in 2008 than in 2007!) all combine to make a mockery of the Government’s preferred measure of inflation, the Consumer Price Index, which claims that inflation is only 3%. 

Of course, both our Prime Minister and our Chancellor of the Exchequer have long been telling us that we are simply caught up in a global situation that initially had been caused by the American sub-prime crisis.  We have made it clear in previous Newsletters that we do not buy this simplistic view, but let us quote some of the statements contained in a recent report released by what we consider to be true experts in this field.  The Bank for International Settlements (BIS), the Swiss institution known as the “central bankers’ bank”, warned that the sub-prime crisis was merely a reflection of growing debt burdens in the developed world, and that it was a trigger, rather than the cause, of all the disruptive events that followed.  Of course, this is not something Gordon Brown likes to hear, seeing he was actively encouraging borrowing when living in No. 11, and Alistair Darling, the current occupier, has little option than to borrow even more heavily in an effort to sort out all kinds of problems.  Indeed, Britain’s indebtedness is now so great that our government has come in for heavy criticism from Brussels!

The BIS report also draws interesting comparisons between the current crisis and others in the past: ”Historians would recall the long recession beginning in 1873, the global downturn that began in the late 1920s, and the Japanese and Asian crises of the early and late 1990s respectively.  In each episode, a long period of strong credit growth coincided with an increasingly euphoric upturn in both the real economy and financial markets, followed by an unexpected crisis and extended downturn.  In virtually every instance, some form of new economic discovery or new financial development provided a further ‘new era’ justification for rapid credit expansion, and predictably became a focus for blame in the downturn.”

It is worth remembering that BIS was one of the earliest major financial institutions that pointed out that the world could face a credit crisis and a financial slump.  Sadly, few banks and other financial institutions, let alone governments, took heed. 

The central banks now face a real dilemma: do they ease interest rates to stimulate economic growth, or do they tighten their stance to stave off inflation? Stagflation - rising inflation combined with a downturn in economic activity - has always proved a challenge to whomever was in charge of interest rate policy, and it is a particularly pertinent problem right now.  America simply cannot raise rates to defend the weakening dollar.  Such a move would be disastrous for their economy.  The European Central Bank (ECB), on the other hand, saw fit to raise rates by a quarter-point to 4.25%, thus further widening the gulf in rates between Europe and America.  The Americans are not the only ones to be infuriated by this move. We already touched on the problems Ireland faces, and they need a hike in interest rates like a hole in the head. Italy and Spain have joined the chorus of disapproval, and even the Germans and the French, usually supporters of the ECB, have questioned the rationale behind the move. 

One school of thought argues that the current inflation problem is largely due to the much higher price of oil and food, that this issue will prove to be relatively short-lived and that focusing purely on staving off inflation is misguided.  However, ECB president Jean-Claude Trichet clearly sees inflation as the overall key risk and believes monetary tightening to be of overriding importance.  As a result, the euro has strengthened considerably against the dollar, sterling, the yen and the Chinese yuan.  And that, argue Trichet’s critics, presents its own problems which could make the ECB’s tighter stance become counter-productive.  A weaker dollar pushes the oil price even higher, and it is universally agreed that the high oil price is one of the main contributors for the high inflation figures.  Interestingly enough, the oil price jumped by $16 dollars in the two days afterMonsieur Trichet signalled the ECB rate rise! The situation is exacerbated by hedge fund operators who spotted the recent “see-saw” relationship between the oil price and the dollar and now aggressively use oil futures – heavily leveraged at that! – as quasi “anti-dollar” instruments.  

At Lacomp, we are firmly in the critics’ camp and consider the ECB’s action wrong.  With money supply already very short, a tighter monetary policy is highly risky.  Aggressively tackling inflation now could lead to a longer and more pronounced than anticipated slowdown in the global economy, potentially pushing us onto the slippery slope towards deflation, and that really would be scary!

Since the oil price is now such a big issue, let us look in some detail at the cause, and the potential solution, of this quandary. 

Energy is a major contributor to the global economy, currently estimated to be worth $6 trillion a year, which equates to 10% of world GDP! Current world energy consumption is estimated to be 15 terawatts (a terawatt is equivalent to 1,000 gigawatts, and each gigawatt represents the output of the largest coal fired power station).  This demand is predicted to double by 2050, and much of this additional demand is due to the increased industrialisation occurring in China and India.

Given the surge in oil prices and issues over new sources of supply, there is a clear ‘capacity gap’ opening up. This ultimately will enable energy production based around wind and solar power, traditionally a fringe activity, to become more mainstream.  However, unlike new IT products for example, solar and wind power are not really considered to be “disruptive technology” and therefore will not displace incumbent methods in the short term.  Whilst they, along with ethanol and a rehabilitated nuclear industry, will gradually expand in significance, the process is likely to be relatively slow, and the short term issues centre on oil.

Conventional wisdom would argue that higher oil prices will inevitably squeeze consumers in the world’s biggest economy and that recession will follow.  Actions by the Federal Reserve to counteract the impending slowdown have further weakened the attractiveness of the dollar which, amongst other things and as already mentioned above, has added to the upward movement in the oil price. 

The significance of recent price movements has been exaggerated somewhat in the popular perception – a $5 increase in the price of oil occasions much press comment but, in percentage terms, this equates to a less spectacular 75 cents per barrel in the 1990s – and the volatility of recent oil price movements is actually lower than the average level experienced since 1988.  This apparently “stable” situation suggests that it is demand that is driving the price rather than supply shocks (which do trigger volatility) although these are never far away, as evidenced by past hurricanes or the recent bomb attacks on Nigerian pipelines.  In addition, it is difficult to gauge to what extent speculators, particularly in the form of the earlier mentioned hedge funds, have affected oil price movements. 

Having said that, it is wrong to assume that high oil and commodity prices are all bad for the global economy. Yes, higher prices slow down spending and economic growth, but they also create huge wealth, which in turn is able to finance new projects and industries. 

Furthermore, things are very different from the 1970s when the tripling of oil prices (occasioned by reaction to the Yom Kippur war) last caused major economic dislocation.  Whilst the high oil price is still perceived as a major issue for the broader global economy, it is a fact that oil is not as economically important now as it was in the 1970s – witness the energy sector of the S&P 500 which was 27% of the index in 1970 but is now 11.75%.  Nevertheless, the issue remains crucial because of political and strategic considerations over and above pure economic factors.

With over 60% of the proven reserves of traditional oil in the Middle East, and a further 14% in Russia and Venezuela, the strategic implications for the US are clear.  Unlike some members of OPEC (which produces more than a third of global oil), Saudi Arabia is trying to avoid the backlash which accompanied the 1974 crisis and wishes to remain on good terms with consumers, particularly in the US.  Iran, on the other hand, is able to use the oil price as a line of defence in any stand-off with the US, threatening to cut supplies and prompt a global economic crisis if tensions rise. 


Indeed, last year saw Russia’s then President Putin engage in a bit of sabre-rattling by threatening to cut off gas supplies to other countries, so it is becoming increasingly clear that energy, and oil and gas in particular, now must be viewed as a strategic resource rather than a mere commodity, even in times of relative peace.

Saudi Arabia epitomises the short term problem.  As the supplier of  an eighth of global  oil and with the largest proven reserves, Saudi Arabia would appear to be in an enviable position as prices climb above $140 per barrel.  However, much of the reserves are of heavy oil that requires additional refining capacity.  The investment programme intended to raise capacity from 11.3m barrels per day  to 12.5m is at least a year from completion and short term output increases by the Saudis (up from 9.0m to 9.5m in May) have had little impact on the oil price.

The concentration of the remaining proven reserves in the Middle East, Russia and Venezuela, areas that America traditionally viewed as “unstable” or “unreliable”, means that much effort is being devoted to severing this energy dependence both by innovation and more efficient exploitation of the remaining domestic reserves, and it is precisely for those reasons that Lacomp, wearing its EIS fund manager hat, decided to invest in a company called Artificial Lift.  The attractiveness of Artificial Lift is in its potential to provide massive cost savings and improved access to these reserves through its innovative electric submersible pumps.  It is estimated that there are potentially 500,000 wells in North America alone for which the new submersible pump would be suitable.

As a director of Artificial Lift commented, there is a shortage of oil at a given price rather than a physical shortage.  There is plentiful supply in non-traditional tar sands and liquefied coal deposits, but these have historically been ignored because of prohibitive production costs, as was the case with deep sea oil drilling.  Tapping these new sources will gradually ease the supply issues but would not appear to offer a low-cost alternative. 

In other words, the days of cheap oil are probably gone forever.

In summing up, although the general outlook is not a happy one, we did anticipate some of these problems and have adopted a more defensive stance some time ago, as evidenced in the above average performance of the Lacomp World Fund, which is largely mirrored in our clients’ individual portfolios.


14th July 2008