Market Review 12 April 2011

Last week was a positive one for equity markets, although Japanese equities crumbled further. The MST Resources fund, however, rose significantly as did its sister fund, the Melchior Exploration fund. North American equity markets were sluggish ahead of the US first quarter earnings reporting season, which begins tonight with the results from Alcoa.

Markets have been watching with some fascination the political disputes in the US over budget cuts, which ran on until within an hour of the deadline on Friday night. Both the yen and the US dollar weakened against their European and Canadian counterparts last week. In the month-to-date, the euro is up 2.3% against the US dollar, sterling up 2.2% and the Canadian dollar 1.6% against the US dollar.

The volatility of the Japanese equity market seems to be both awkward and uncomfortable. Attention has clearly shifted from Japanese equities back to Asia ex-Japan and the Melchior Asian Opportunities fund is up quite sharply this month, at least in US dollar terms. The key themes for the balance of the month are likely to be earnings, oil and inflation – the last two are clearly related.

In the fourth quarter of 2010, S&P 500 earnings ex-financials rose 19.3%. Analysts were surprised by the strength. They went into the earnings reporting season expecting earnings to grow by 13%-14%. In our view, they are likely to be surprised on the upside again in the first quarter of this year. Currently the expectation from analysts is that earnings will rise by 13.3% compared with a record rise in the first quarter of 2010.

US analysts are still around 5% adrift and next three weeks may, therefore, provide some reassurance and comfort on the earnings front. The areas of strongest growth, once again, are likely to be in the energy and materials sectors followed by industrials and technology companies. The laggards are likely to be utilities and telecommunications.

Continuing conflict in the Middle East has provided underpinning for the oil price. Brent oil futures broke out to a new 30-month high last week as the Libyan conflict, Gabon oil strike and fears over Nigeria’s upcoming election dominated headlines. Postponed elections never sound good and as all recent Nigerian elections have featured violence and conflict, loss of production from that quarter is a real risk.

According to the IEA, Nigeria produced 2.26 million barrels per day in December, production was effectively unchanged in January at 2.24 million barrels per day but, if Bloomberg is right, production dropped to 1.92 million barrels per day in March.

Former Saudi oil minister, Sheikh Zaki Yamani, issued a warning about Saudi Arabia last week claiming that apparent civil calm is only masking underlying discontent. He commented to Reuters: “If something happens in Saudi Arabia oil will go to $200 to $300. I don’t expect this for the time being but who would have expected Tunisia? The political events that took place are there and we don’t expect them to finish. I think there are some surprises on the horizon.”

It is not surprising that the leadership in long-established oil producing Arab states should be jittery. Money, of course, is a help if political unrest becomes too threatening. The IEA recently suggested that OPEC stands to earn over $1 trillion a year in oil export earnings if oil prices remain above $100 a barrel.

In Saudi Arabia, the government’s initiatives to increase wages and provide for housing and unemployment benefit are expected to increase government spending by over 30% this year. This means that the Saudi budget breakeven price for oil will rise from $68 last year to $88 this year. It also means that the beneficiaries of this spending will have an even greater propensity to consumer more energy.

The question of inflation is important. It is important in the short run, given Dr Bernanke’s belief that currently commodity price inflation is essentially a temporary phenomenon. It is a problem in the longer term, however, because of concerns that the period of benign inflation prompted by the entry of China, India and others into the real world 25 years ago with all their underused resources, may be coming to an end.

The authorities in western developed nations have, of course, been massaging nominal rates of CPI inflation downwards for some time, introducing various statistical refinements designed to reduce the nominal rate of inflation. The issue of inflation is a challenge too for the money management industry. Managing money in an era of rising inflation would be more complicated than it has been in the last 25 years of disinflation.

For years, western countries have manipulated consumer price indexes to show a lower rate of inflation than might otherwise have been the case. The reasons have been various but must principally be seen as an attempt to contain social security, pension and other social benefit payments that are indexed to national inflation rates. John Williams of Shadow Government Statistics has studied US CPI and has created his own index designed to show where CPI would be if no changes had been made to the method of calculation since 1980.

In the last several decades, the US Bureau of Labour Statistics has introduced a variety of changed methodologies into the calculation of US CPI to reduce the level of reported US inflation. The general approach has been to move the CPI away from its traditional job of measuring of the cost of maintaining a constant standard of living. The lower the rate of inflation that is used, the stronger will be the resulting inflation-adjusted level of growth – easily spun as an added benefit.

Had these adjustments not taken place, it has been calculated that inflation in the US would currently be above 9%. If the global inflation rate were to turn out, on average, to be, say, 8% in the years ahead, money managers would have to exceed an 8% annual return simply to preserve current purchasing power.

In future, money may have to be managed with the primary focus of beating inflation. This implies an intensely global perspective with a heavy emphasis on currencies and focus on companies that can preserve value through pricing power.

The issue of currency is important. Since the beginning of this year, the euro has risen by 8.21% against the US dollar. In part, this is because the Europeans are at their old game of tightening Eurozone monetary policy. The European Central Bank raised its bank rate by 0.25% last week to 1.25%.

Eurozone M3, which saw a resumption of growth in the summer and autumn 2010, has stagnated again in the last few months. The official pressures on banks in the peripheral countries of Portugal, Ireland, Greece and Spain to raise capital and sell off loan portfolios are clearly a major factor behind this latest money slowdown.

Because of the recent oil and commodity price surge, real money balances have been falling since autumn 2010. This fall has been most pronounced in the peripheral countries and has negative implications for demand and output in those economies this year. The risk of a pause in the Eurozone’s recovery, of course, has been increased by the fall in the US dollar against the euro.

Short-term interest rates may have been virtually zero but the growth in bank balance sheets and in the quantity of money in the healthier Eurozone economies has not been sufficient to outweigh the money contractions in the peripheral countries and, therefore, to deliver a healthily positive rate of money growth. Since November, Eurozone M3 has been static. Or to be precise, the annualised three-month growth rate in February has been minus 0.1%.

The immediate money growth situation has been worsened by regulatory demands for banks to back their operations with more capital and to rid themselves of risky assets. Both new capital issuance and asset sales cause the quantity of money to fall in the first instance. Meanwhile, the euro has strengthened.

One ought to spare some sympathy for the regulators. The UK’s Independent Commission on Banking has reported that UK bank assets are more than four times the size of the UK economy making the largest lenders too big for the UK government to save. As the head of bank credit research at Société Générale pointed out “This shows that the UK and several other countries are just too small to save their banking systems.”

When the US rescued Citigroup in 2008, its assets equated to 16% of US GDP. However, the Royal Bank of Scotland’s assets were worth 99% of UK output when it was bailed out the same year. German banks’ assets equal about three times the size of the German economy, a similar comparison to the Irish.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.