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Graham Macdonald MBMG International Ltd.
Nominated for the Lorenzo Natali Prize


Inflation is a worry

As many readers will know, MitonOptimal are our preferred fund house. Their common sense approach beats all others as far as we are concerned. For example, their strategic inflation forecasts are based on the long term Kondratieff inflation / deflation / disinflation cycles. The developed world has been in the disinflationary and deflationary cycle since 1980 and is about to change to a vastly different long inflationary period. Most Emerging Markets are earlier in this cycle with some Asian countries ahead of the process.

MitonOptimal went out into the market to find what the experts thought. This is what they found, “With growth barely managing to keep pace with trend, underlying inflation should remain modest this year,” Michael Hanson, an economist at Bank of America Corp. in New York, said in a research note to clients. “The main risk to the inflation forecast remains a sharp increase in oil prices.”

Anatole Kolesky from Gavekal Research, however, is of the view that inflation is here and has said the following: “Inflation is now clearly above the Fed’s newly-announced 2% target and is heading higher, yet this seems to cause no concern among investors. Instead they prefer Bernanke’s standard reassurance, repeated recently: “As always, we have to look at inflation and be comfortable that price stability will be maintained and that inflation will be low and stable." But the fact is that inflation has already moved out of the “low and stable” range, as currently defined by most central bankers - and this is true in the Eurozone and Britain, as well as the US.”(See graph).

The Fed said after last Spring’s policy meeting that the jump in energy costs will probably be short-lived. “The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate,” the Federal Open Market Committee said in the minutes of its March 13 meeting.

RMB Asset Management Research Unit reports that under a worst case scenario, they forecast that the oil price will jump to a high of US$170/bbl if tensions escalate into an armed conflict. Depending on the length of this conflict, the economic damage caused by high oil prices would be extensive. Inflation would increase, disposable income would be driven lower and weigh on confidence. Given the fragile state of the economy, it may tip the globe into recession.

MitonOptimal has concluded that no one knows what the short term future holds - especially when politicians are in the mix! - However it is imperative to follow the price trend in oil (and food) to protect our portfolios against potential inflation shocks and benefit from the pricing power certain stocks hold in these sectors. But equally important to note, is that the developed world is trying to reflate whilst the emerging world is still fighting the evil of inflationary pressures. These are very different asset class environments and need to be played carefully if money is to be made.

It’s a mad, mad, mad, mad world, part 2

The Bank of International Settlements (BIS) analyses a country’s debt by three categories - corporate, government and household. The BIS did a report in September which showed that there were thirteen countries in the developed world whose debt was beyond the threshold in at least two of the aforementioned categories. Time was when markets could just worry about one or two countries. Unfortunately, with the world edging towards a financial precipice, those markets are now going to have to concentrate on many more nations than usual as the numbers are just too large to contemplate.
The refinancing of certain countries will be amongst the biggest the world has ever seen. Also, it should be remembered that this sum, whatever it ends up being, does not include having to recapitalise the banks or cover future payments such as pensions, etc.
Egan-Jones, a credit rating company, pointed out at the end of last year that Greece could not support more than EUR40 billion in taxes and that is “why debt holders are likely to face a 90% haircut… And unless trends reverse, Spain, Italy and Belgium will follow.”
When this happens we will have the ultimate Catch 22. Will Germany allow the ECB to print as much money as it likes thus allowing the weaker members of the eurozone to pay off their debts? If they do then they will go against the German Constitutional Court which will not allow it as it remembers the Weimar Republic and what happened then. Also, the Bundesbank would be very much against it as it does not think printing money is the solution as it would bring unwanted inflation to Germany - something which is anathema to that country.
Thus, the choice is staring Germany in the face. Either, in the words of Nike, “Just do it” and start printing money as fast as possible in the hope it can save the Euro or, as Liam Halligan wrote recently, accept the fact that the “Euro is an incoherent nonsense which, in its current form, is doing far more harm than good.”
Behind the scenes there have been signs that some EU officials are preparing the way for some of the weaker states to leave the eurozone and so reform the Euro around a small but healthier group of countries. Admittedly, this would be expensive but, in the long run, may be cheaper than trying to get the poorer EU nations to follow a stricter fiscal and monetary policy a la Germany.
It is difficult to forecast what is going to happen from here on as politicians are getting in the way of common sense. Given this, our best ‘guess-timate’ is that the problems that are going on in Spain at the moment, and have already happened elsewhere in Europe will only get worse and will occur in other European countries. There will have to be, at least, a large scale restructuring of the Eurozone based on Germany or preferably the complete dismantling of the Euro.
In summary, current indicators suggest that at the very best global growth will be slow this year. There is a risk that the Federal Reserve will have another drive to pour liquidity into the system to be followed by the ECB having to act as lender of last resort. If this does occur asset prices will rise, but the impact of such monetary ease on the real economy will be anaemic. It is likely to be followed by a crash in late in 2012 or in 2013.
The more likely outcome is that the ECB continues to operate under the Bundesbank mantra providing token relief to the weak members. Europe will remain in recession. The US economy, despite any action by the Federal Reserve (pushing on a string) will have very slow growth at best but will return to recession in 2013. Asia will be affected by banks in Europe having to raise capital together with much reduced exports outside the region. And in China growth will be slower so experiencing a reduction in exports. World industrial production will be very weak with a recession in 2013.
This period will be fraught with danger as the world de-leverages after a generation of governments promising more than they can pay for and in many countries households borrowing more than they can afford. This is a bad enough environment but it is made worse by society ageing in so many countries: there will be far fewer workers to support retirees.
Professors Reinhardt and Rogoff have well documented what happens to economic activity in their book, ‘This Time is Different: Eight Centuries of Financial Folly’: “The aftermath of systemic banking crises involves a protracted contraction in economic activity and puts significant strains on government resources.” More recently they add that you can’t get rid of debt quickly and you cannot get rid of it nicely. The bullet has to be bitten meaning that debt must be repaid rather than one institution lending to another so that the latter can repay its debt.
To be continued…

It’s a mad, mad, mad, mad world, part 3

Anyone who had listened to what the Bank for International Settlements was saying since 2005 would have been well prepared for the shocks that began towards the end of 2007 and then blew up in 2008. They issued a new warning in their September 2011 report, The Real Effects of Debt. We should heed this warning.

They conclude, “Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth (in 1st qtr 2010 USA’s debt: GDP ratio was 117%)… A clear implication of these results is that debt problems facing advanced economies are even worse than we thought. Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may raise interest rates, further undermining debt sustainability.

“So, as public debt rises and populations age, growth will fall. As growth falls, debt rises even more, reinforcing the downward impact on an already low growth rate.”

They conclude, “In the end, the only way out is to increase saving.” This is part of the process of de-leveraging which is likely to take until around 2018 to run its course. These years will be characterised by rolling recessions and deflating asset prices interspaced by short periods of recovery.

The second dynamic which will help shape the world economy will be the demographic changes with so many countries’ population age profiles changing for the worse and far outnumbering those that will continue to have positive demographic profiles, India, Indonesia and Brazil to name just three.

Demographic change is not an abstract development; it will have serious consequences for future growth. The OECD, for instance, estimates that the impact of aging on GDP growth rates will be a decrease of growth in Europe to 0.5% a year, in Japan to 0.6% a year and in the USA to 1.5% a year in the period 2025-2050.

Demographic changes will impact household wealth creation. In their report, The Coming Demographic Deficit: How Aging Populations will Reduce Global Savings, they wrote: “Aging will cause growth in household financial wealth to slow by more than two-thirds across countries we studied (USA, Japan, and W Europe), from 4.5% historically to 1.2% going forward. The slowing growth will cause the level of household financial wealth in 2024 to fall some 36% or by $31 trillion, below what it would have been had the higher historical growth rates persisted.”

For Europe, the demographic profile is worrisome. According to data by Dr Clint Laurent and his team at Global Demographics, the number of 65+ aged group rises from around 19.6% of the population in 2011 to 29.1% in 2031 with the dependency ratio standing at just 2% by then.

A surprising development is that the demographic profile of the USA is so much better than that of China. Once the USA puts its financial house in better order, which it will if not willingly, its growth expectations will be better than China’s.

For China, based on simple fundamentals, growth has peaked. The years of circa 10% growth are over because such growth is unsustainable and brings in its wake a package of problems. “One approach to forecasting total real GDP of a country is to combine the projected trend in the number of persons employed with the projected trend in the gross productivity per worker,” writes Dr Laurent. He calculates that the trends in the education index of the country should give an expected productivity growth of 7.8% a year to 2016 and 5.8% a year to 2021.

This slowdown will have a huge impact on China’s future requirements of imported metals like copper. This trend is likely to be magnified also by US and other foreign companies vacating China and returning to their home bases - in the USA once the political system rolls back much of the red tape, health care costs and tax issues, etc. There is a fundamental reason for companies to return home: it is that multinationals want their supplier chains adjacent to the market, not on the other side of the world.

Thus, demographics and debt will be huge constraints on world growth. As I said at the start of this article, “It’s a mad, mad, mad, mad world” where there is more individual selfishness and greed rather than the collective good. Until this changes we will have to wait along time for the world to get it right.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]

HEADLINES [click on headline to view story]

Inflation is a worry

It’s a mad, mad, mad, mad world, part 2

It’s a mad, mad, mad, mad world, part 3