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
