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Vol. X No.14 - August 1 - August 31, 2011


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Stephen Tierney MBMG International Ltd.

 


Domino Effect, part 1

One of the key themes of our rather cheery Four Horsemen of the Apocalypse global outlook right now is that all Four Horsemen - EUR, USD, JPY & GBP - are in terminal trouble. All will suffer some sort of chronic failure. The failure of any one will trigger the ultimate collapse of the others (although Euro, Yen or Sterling going first will likely send the Dollar sky-rocketing - albeit not for long).

In the report, we repeatedly say that any of the four could go at any stage and trying to guess which could be the first to go is folly - but that does not stop us and when the report was written we had a slight hankering for it being the Euro. Recent events have, of course, now changed all that. We are certain it will be the Euro. The ECB (and by implication Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain) is living on borrowed time. The French smoke and mirrors re-fi plan (AKA when is a default not a default? When you can kick the can down the road!) contains more holes than a large wedge of French Gruyere - cf www.guardian.co.uk/world/2010/aug/16/swiss-win-the-gruyere-cheese-war.

These were so obvious that it made us realize that even EU finance ministers could not insult our intelligence so brazenly.

Do not be surprised if the EU decides that the GIPSIs must leave the single currency and re-introduce Drachma, Punts, Escudos, Pesetas and Lire - but with a difference. These meaningless second tier currencies could well be artificially pegged to the single currency meaning that the GIPSI banking system would be cut adrift and their new currencies would be traded more on street corner black markets than Manhattan's money markets.

Having previously focused on the problems facing debt-ravaged Japan, which by simple metrics is the most indebted of the Four Horsemen of the Economic Apocalypse, it is time to look at how the wedding between the Euro family and the GIPSI nations (Greece, Ireland, Portugal, Spain and Italy) is bringing about increased economic chaos in, arguably, what is the most complex of our horsemen, the Euro zone.

The Euro zone's fundamental flaw was the co-mingling of debt of lower risk nations such as Germany and France in the same credit risk pool as the GIPSIs. This disaster in the making is now entering the final sequence.

How were nations with such disparate risk profiles able to obtain similar credit ratings and interest costs on debt?

The answer lies in the determination of the European Central Bank, on behalf of the EU, to manipulate criteria that even the weaker economies could eventually achieve. However, it still required creative accounting, unfathomable derivative contracts and the financial engineering capabilities of Wall Street's sharpest minds before 17 members managed to gain entry into the monetary union club, thereby enjoying years of collective cheap funding. The periphery nations boomed as their lower cost bases and higher growth rates were combined with access to previously unimagined amounts of cheap credit.

In the cold light of day it does seem inconceivable that Greece, having spent around half of the last 200 years in default, was granted a credit rating comparable to Germany. However, once the credit ratings agencies swallowed the deception that the Euro zone was broadly homogenous, investors, including banks, followed. The GIPSIs are Europe's version of sub-prime, overwhelmed with debt they are unlikely to ever be able to repay. Greek borrowing costs, which had been running at well over 25 percent per year, virtually converged with German debt costs at well below 5 percent. Membership of the Euro for countries that had previously had difficulties raising capital and whose price of capital had reflected this was like giving membership of a candy shop to children with a sweet tooth.

The whole plan of the Euro was another example of the effects of the tidal wave of global liquidity that flooded markets in the 1980s and 1990s, flowing into the most immediately rewarding (and generally riskiest) asset classes. Asset bubbles grew and grew until 2008… when they started to burst.

To be continued…

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 Stephen Tierney on [email protected]

 



Investors urged to be patient during market turmoil

Investors should now be patient before making emotional financial decisions due to fear of loss.

This is according to MitonOptimal Multi Asset Management MD and fund manager, Scott Campbell, after the last few days sell-off locally and on international stock markets. From peaks just a month ago, markets are now down between 10% and 20%. When talking about South Africa, he went on, “We remain optimistic about the SA rand’s potential to remain attractive to yield-seeking global investors. Also, that local interest rates will stay lower for longer as this US and EU economic calamity plays itself out.

“We also remain in favour of global equities to generate long-term capital growth in local and offshore portfolios,” Campbell said.

The reasons for this dramatic collapse are mainly due to two causes:

The problems and consequences of the ever growing government debt in the US, Europe and Japan are now becoming clear in investor’s minds.

Economic data that is softening further, such as the Australian unemployment figures, and weakness emanating from the US consumer despite the better than expected unemployment figures.

Irrational market behaviour will start to settle when investors realise that more than 60% of the world’s population and consumer base (and therefore potential economic growth) is based outside the US and Europe.


The monetary, fiscal and economic stability offered by China, India and Asia is what will drive global economic growth of the future, expanding in a ‘two speed world.’ Emerging economies currently grow by 2% to 3% per annum faster than the developed world.

This is while US economic growth, its fiscal repair, EU debt, banking, and growth repair have still many years to run, with many episodes of market lapses and policy support actions likely to be encountered before these unstable conditions are left behind.

According to Campbell the US downgrade from AAA to AA+ by the rating agency Standard & Poor’s (S&P) is rather meaningless. A country that issues debt denominated solely in its own currency and which has control of its monetary policy, will not willingly default on its debt. Countries default because they run out of foreign currency to service their debt; but the US does not need foreign currency to service its debt.

S&P’s decision is an indicator of the degree of fiscal strain that the world’s largest economy is under. Although alarming, this may be the wake-up call the US needs to change its approach to the long-term difficulties. The same can be said of the European Union (EU), which needs to take far more decisive action in addressing the sovereign debt problems of its member states. Meaningful deficit reduction can only be achieved through a combination of revenue increases and carefully targeted spending cuts.

While steepening falls in equities reminded many of the shockwaves that swept through the markets in the wake of Lehman’s collapse, money and corporate credit markets are not yet seeing a repeat of the strains witnessed three years ago.

The Lehman event was based on a systemic risk to the banking sector. This is not related to bad assets in the banking sector’s books; it is related to the fact that the economic growth is not there to support the kind of national debt levels and benefits pay-out that politicians have promised its public.

Besides US rates staying lower for longer, the Fed will likely signal that its expanding balance sheet may be expanding even further with a form of quantitative easing. When announced, it may give renewed boosts to market perceptions, benefiting equities.

From an investment point of view, there are ironically two multi-national companies that have a better credit rating, growth prospects and management than the U.S government:

- Apple is still selling for less than 11 times forward earnings. It has no debt, almost $70 billion in cash and cash equivalents, top management, and a return-on-equity of nearly 42%, maybe they should be managing the federal government's budget?

- Microsoft is selling near the bottom of its five year valuation range based on Price Earnings, Price to Book ratios. Microsoft yields 2.6% (higher than US Treasury Bonds) and has increased its dividend pay-out by an average of over 11% annually over the previous five years. Microsoft has a AAA rated balance sheet, has about $40 billion in net cash on the balance sheet and sells at just 8 times operating cash flow.

You know there are problems afoot when certain countries have banned ‘shorting’. Whilst this might invoke the pretence of creating stability it is really only confirming no-one knows what is going on. With markets going up and down like an office lift it is vital to make rational decisions and not suffer potential losses that could be recouped if given a chance. Above all, don’t panic and remain liquid!

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 Stephen Tierney on [email protected]

 


Is this the final rate hike in China?

The Chinese recently raised rates again by 25bps to 6.65%, the fifth time since initially starting to raise rates in October of 2010. This has been as a result of rising inflationary pressures, with the whisper number that CPI for June will come in at 6.2%. Rising inflation has been a problem for a while now in China, with the graph on this page indicating that real rates are actually negative when one includes food prices.

Many now feel that the Chinese central bank has done enough and this will be the final rate increase for the year, but having now read copious views on the subject, it is not clear to me whether this is actually the final rate increase for the year or not. If I had to hazard a guess it would strike me that we are very near the end of interest rate tightening, if not the end itself. Why do I make this bold statement, given that most economists usually get these things wrong?

Firstly and most importantly, raising rates is not the only tool that the Chinese have in their arsenal when it comes to controlling the supply of money and what they seem to prefer to do is increase the required reserve ratio of the banks. Currently this sits at 21.5% for the big bank and 18% for the small banks, which effectively means that it has got a lot harder for banks to lend money. This difficulty in lending is seen in the amount of lending dropping from an official 7.95 trillion last year to current levels of 6.7 trillion. Couple this with evidence that the housing market appears to be rolling over, as seen by inventories in China’s biggest cities set to rise to over six months worth of supply by the end of 2011, and transaction volumes continue to tumble (down over 15 percent YTD in major cities such as Beijing).

Secondly, if inflation does continue to rise, then the central bank can increase the RRR again, given that the central bank is loathe to raise high interest rates, because this attracts hot money as investors await the inevitable Reminbi appreciation.

Does that mean, with the latest rate increase, we are worried about a hard landing in China? We do not believe another 25bps is the tipping point, but on balance this cannot be good for economic growth. However, with GDP growth rates still much higher than nominal interest rates it is hard to believe this latest rate hike will make much of a difference.

It’s how much the banks are able to lend, rather than the cost of that debt that matters and in that respect this latest interest rate hike does not make much difference.

For now we remain sanguine about China’s growth rates, but should we see a further increase in reserve requirements, we will start to get a little more cautious about global growth and start to get a lot more nervous about commodities and commodity currencies.

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 Stephen Tierney on [email protected]


Land of the Rising Sun

Today the focus will be on the Land of the Rising Sun, where earlier this year a 9.0-magnitude undersea earthquake occurred some 72 kilometres off the coast of north-eastern Japan, triggering a devastating tsunami almost 40 metres high which travelled up to 10 kilometres inland. The confirmed death toll still continues to rise and thousands of people remain missing. The ensuing nuclear disaster has been ranked equal to that at Chernobyl, Russia in 1986.

The tragedy could barely have happened at a worse time for the Japanese economy. After many years of economic stagnation and a stock market which has struggled to retrace back towards its 1989 high of 38,957, the global liquidity surge had seen even Japan exhibit some signs of GDP growth and stock market rebound. All of this was derailed at 2.46pm, local time, on March 11. The financial implications of the crisis are only now starting to become clear as business operations and supply chains still struggle to cope with the challenges of rolling power outages and disrupted communications.

Just three weeks before the earthquake the Nikkei had almost broken through the 11,000 level, although it had then been struggling to hold that level as liquidity began to dry up in the global economy. The impact of the natural disaster saw a plunge to 8,227. Although the market briefly broke back above 10,000, it fell back into a holding pattern around the 9,500 level. The Yen, which had been edging gently higher prior to the tsunami was buoyed further by international intervention in the immediate aftermath to a strongest point for the year, before falling back again as the effect of the support efforts wore off. But the Yen has subsequently gradually strengthened back towards the March peak.

The Bank of Japan's response has been to turn on the liquidity taps in an attempt to kick-start reconstruction efforts. However, in a world where liquidity has been drying up and where ratings agencies doubt Japan's ability to continue borrowing, this move has been met with scepticism by the markets. Although Japan is both printing and borrowing money right now, comparisons with the stimulatory effect on the Japanese economy of the aftermath of the 1994 Kobe earthquake are misplaced. Japan's net sovereign debt 17 years ago was only a quarter of today's level. Gross government debt then stood at a high, but manageable, 80 percent. Today it has breached 200 percent - more than twice the accepted sustainable maximum.

In other words, Japan's problems following the natural disaster coincide with domestic debt that is reaching its natural limit, and a dramatically worsening global liquidity environment. That is not to say that there will not be further attempts to provide stimulus to the markets - there almost certainly will. However, the risk that these attempts will fail increases every day.

Even now, we continue to see more and more symptoms of this, such as economic growth forecast revisions, rating agency outlook downgrades and reduced guidance by major Japanese corporations such as Toyota. These all point to the underlying disease of an economy mired in debt which is now also burdened with huge rebuilding and social costs in the midst of commercial and economic disruption.

The three month anniversary of the tragedy was marked by protests in Japan. People are not happy at the extent of policy response to the devastation caused. The Japanese government is being blamed in some quarters for failing to take adequate care of tens of thousands of victims. There is also a real danger that, as more time elapses, the extremely positive initial reactions of support by individuals, governments and businesses outside Japan will lose steam as we gradually forget the horrors of 11th March, 2011.

The dignified suffering of the Japanese people along with the selfless response of many volunteers should embarrass all of us, individuals, companies or governments, who have taken our eyes off this particular ball.

The economic can that Japan has kicked down the road for the last 22 years is looking like it will have to be faced up to before too much longer. The human losses in Japan are a tragedy that will be remembered for many years to come. The social and financial impact of Japan finally being forced to take all the unpleasant decisions that it has managed to put off for the last 22 years will also be very hard to forget.

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 Stephen Tierney on [email protected]


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