Asset Class: International Equities

A trade and a currency war? Not what the doctor ordered.

Mr. Trump never has a meeting that is anything but a “tremendous success.” Often he announces the success before the meeting takes place. As he jets around the world showcasing his unique brand of international diplomacy his definition of “success” is not necessarily shared by his global peers.

The G7 summit held in Quebec ended in farce and controversy when Mr. Trump rejected the text of the joint communiqué whilst taking very personal pot shots at the Canadian Prime Minister, Justin Trudeau. The Trump tirade was fired from Air Force One whilst en-route to his next summit – this time with North Korea’s Kim Jong-un – yet another “tremendous success.”

According to Mr. Trump he had “great chemistry” with the North Korean dictator, declaring that Kim Jong-un “…will turn that country into a great successful country.” He went further: “I learned he’s a very talented man. I also learned he loves his country very much.” Could he really be referring to one of the world’s legendary tyrants, a man who maintains his citizenry in abject poverty, sends thousands to gulags and orders the execution of countless others (including, allegedly, members of his own family)? Should we be pleased that Mr. Trump shares his chemistry?

At the same time Mr. Trump has commenced his promised assault on world trade by announcing a raft of protectionist measures which spares few countries – including his greatest trading partner, Canada.

Protectionism is bad policy. Period. It adds to costs, brings about a sub-optimal allocation of labor and capital, leads to inefficiencies and diminishes consumer choice. Feather-bedding industries has never proved a wise action in the history of economics. Perhaps Mr. Trump has read a different text book.

When American consumers start paying more for goods that contain steel or aluminium (most things) in addition to the huge range of goods imported from China will they call their President to offer their heartfelt thanks? As interest rates rise to combat higher inflation will they be secretly delighted? Who will benefit if China’s rate of growth slows dramatically thanks to the new tariffs?

We should of course endeavor to be fair – the reality is that there is no such thing as “free trade” in the modern world. Any country that provides subsidies to select industries or companies, offers preferential tax arrangements or other favored treatment is indulging in protectionism under a different name. We struggle to find any country that doesn’t engage in these and other practices that distort the economic trajectory. And of course the European Union, at the forefront of castigating Mr. Trump over his tariff initiatives, cowers within its own customs union – yet another protectionist body. Moves by the U.K. to exit the customs union at the same time as it formally leaves the EU are met with howls of protest by scores of politicians in the U.K. We despair.
Energy
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The latest annual BP review of global energy trends has hit the desk. It contains the usual excellent array of all manner of statistics relating to energy sources and applications.

For those who fret about rising carbon dioxide emissions there is both good and bad news.

The good news is that in the last 10 years carbon dioxide emissions emanating from North America have fallen at an annualized rate of 1.1% (all due to the U.S.); in Europe they have fallen at an annualized rate of 1.2% whilst in the Commonwealth of Independent States (dominated by Russia) they have fallen at an annualized rate of 0.4%. And the bad news? In South and Central America emissions have risen at an annualized rate of 1.7%; in the Middle East they are up at an annualized rate of 3.3%; in Africa up at an annualized rate of 2.2% and in Asia Pacific up at an annualized rate of 2.6%. In the world in the last 10 years emissions have risen at an annualized rate of 1.1%.

The elephant in the room is China. In 2017 it accounted for 27.6% of global carbon dioxide emissions and in the last 10 years the emissions growth rate has amounted to an annualized 2.5%. The slightly smaller but rapidly growing elephant is India which made up 7.0% of global emissions in 2017 but has experienced a 10 year annualized emissions growth rate of a sizeable 5.6%. There is no sign of it slowing down.

Assuming that the U.S., Europe and others continue to reduce their level of emissions it will have little overall impact unless China and India change their ways. To be fair to China its growth in emissions has slowed to an annualized rate of 0.6% over the last 5 years but India’s growth has remained rampant. The country with the fastest rate of emissions growth is Vietnam (over 10% annualized over 10 years) but it, fortunately, only accounts for 0.6% of the world’s total. At the other end of the scale the country experiencing the most rapid decline in CO2 emissions is, perhaps surprisingly, the Ukraine with a 10 year annualized reduction of 5.5%. However it only accounts for 0.5% of the world’s total.

If we stretch the measuring stick all the way back to 2001 it is impressive that the U.S. now has a lower level of CO2 emissions than in that year (down by 10%) whilst Europe, in aggregate, can make a similar boast (8% lower). The U.K. should receive a special gong for reducing its emissions by a massive 31% over the same period.

Turning to renewable energy it is apparent that solar and wind are experiencing astonishing growth. In the case of the former, data provided by BP indicates that since 2001 and through to the end of 2017 the annualized growth rate of cumulative installed photovoltaic (PV) power has amounted to 47%. In the case of wind, also since 2001, the annualized growth rate of installed wind turbine capacity has been only marginally less astonishing at 21%.

0718_pyrspectives_energy_consumption by source_500The big players in the solar game (in terms of the share of global capacity) are China, the U.S., Japan and Germany (in that order). In the wind game the major participants are again China, the U.S. and Germany.

Despite the growth of renewables the dominance of oil will continue for many years. The U.S. Energy Information Administration estimates that petroleum and other liquids will make up 31% of world energy consumption in 2040 followed by natural gas with a 25% share. Renewables are forecast to take a 17% share. Forecasts by the International Energy Agency vary slightly with oil at 27% by 2040, natural gas 24% and renewables 20%. The growth in energy consumption over the next 20 years will almost entirely be taken up by non-OECD countries – with China and India accounting for the lion’s share.

The oil supply interplay between OPEC, Russia and North America will continue to dominate world energy headlines. Predicting movements in the price of oil, short or long-term, has rarely been a profitable exercise. One thing however is clear; the Middle East will continue to hold most of the long-term cards whilst it dominates world oil reserves. And dominate it does.
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According to estimates by BP, North American oil reserves amount to 13.3% of the world total but the Middle East sits on 47.6% of total reserves. Saudi Arabia accounts for 15.7%. Interestingly, the largest single-country share of proven world reserves belongs to Venezuela at 17.9% of the total. This is “interesting” because Venezuela is in the midst of a classic emerging market debt crisis. Oil can’t save you if an economy is mismanaged.

The growth in the exploitation of non-conventional sources of oil in North America in recent years has been impressive and has thrown a spanner into the price control plans of Saudi Arabia (and friends). In 2017 the U.S. topped the world’s oil production table followed closely by Saudi Arabia and Russia. There is then a long gap to Iran, Canada and Iraq. U.S. production troughed in 2008 but has since climbed by an extraordinary 92%. Over the same time-frame U.S. demand has risen by a miniscule 2% – in fact it remains lower than in the five years to 2007. The U.S. demand/supply imbalance is therefore rapidly closing. The “frackers” continue to beaver away with steadily improving technology and techniques.

Each BP annual review includes a fascinating long-term price chart for oil expressed in real and nominal terms. The data stretches all the way back to 1861. In real terms the oil price has been higher than today’s price on many occasions, but most noticeably from 1864 to 1872; during the “oil crisis” from the mid-1970s to the early 1980s and then from 2006-2014. However a relatively “benign” period for the real price of oil ran for almost 100 years – from around 1878 to 1974.

Given the world’s ongoing dependence on this “black gold” and the never-ending geo-political tensions in key oil-producing countries we doubt that the word “benign” will be an appropriate moniker for extended periods in the future. We are happy to opt out of this particular forecasting game.

Chart: World Oil Production – by Country

Chart: Crude Oil Prices – U.S. dollars per barrel

Where Did All The Gold Go?

0718_pyrspectives_gold_russian reserves_500Simple answer – Russia has been buying it.

Global gold production (excluding recycled gold) currently runs around 3,200 tonnes each year and in each of the last three calendar years Russia’s central bank has hoovered up in excess of 200 tonnes. Its thirst for additional gold reserves started around 2006 and seems unquenchable.

Why is this happening? Unsurprisingly the central bank is not all that forthcoming but we can venture the guess that it is mainly about diversifying foreign currency reserves away from the U.S. dollar. Russia’s current gold reserves stand at around 17.6% of total reserves (see chart below) so potentially there is some distance to go if a more balanced distribution of reserves is desired.

0718_pyrspectives_gold_holdings_500Many will be surprised that Russia has the wherewithal to maintain gold purchases at this pace but the reality is that the country is running a healthy current account surplus and has a level of general government debt to GDP that is the envy of most western countries (17.4% of GDP according to the latest IMF data). For comparison: the U.S. sits at 107.8%; Japan 236.4%; U.K. 78.2% and eurozone 71.0% (IMF data as at the end of 2017).

Russia may be regarded as a one-trick pony when it comes to its principal exports (oil and gas) but it’s not a bad trick to have when prices are around current levels. The irony is that Putin’s Russia maintains most of its citizens in a relatively impoverished state. Per capita GDP puts it firmly in the “emerging market” category; it is considered one of the most corrupt countries in the world and, surprise, surprise, its select “elite” live in the most splendid luxury.

A more equitable distribution of the “spoils” is probably a forlorn hope.

The other country that emerges on the gold acquisition radar is China. Unlike Russia its declared purchases tend to come in lumps but when they occur they are sizeable. The last big lump was in 2015 when in excess of 600 tonnes new gold was declared. Since that leap a further 184 tonnes has been acquired (World Gold Council data). China’s central bank gold holdings only amount to 2.4% of foreign exchange reserves so there would appear plenty of margin for further increases.

Regular readers will be aware of our fondness for the yellow metal. Nothing that has occurred in recent times has diminished our enthusiasm.
Aussie House Prices

The bubble in Australian housing may finally be at or near its end. Latest official data indicates that in the March quarter the weighted average of the 8 capital cities saw prices fall by 0.7%. In the 12 months to March the fall was 2.0%.

0718_pyrspectives_australia housing_index_500Significantly it is Sydney prices that are very much off the boil. The March quarter fall was 1.2%. Bank lending standards are tightening whilst foreign buying is waning thanks to government restrictions. Australia’s central bank is yet to increase its official interest rate but with rates continuing to move up in the U.S. it seems inevitable that an increase is in the medium-term wings.

On any international scale Australian house prices (Sydney in particular) are nothing short of extravagant. Whether you gauge it using price to income, price to rent or real house price movement over time the equation provides the same answer – yeek! The other scary part is that household debt (largely mortgage debt) relative to personal disposable income is at a record high and makes the other key housing-centric economies – Canada, the U.S. and U.K. – appear as if they are not really trying.

Around one-third of existing mortgages in Australia are interest-only but according to Reserve Bank data in the next four years almost half a trillion dollars in interest-only mortgages will convert to principal and interest increasing monthly repayments for almost 1.5 million borrowers by as much as 40%.

You have been warned.
Italy

Italy has its new populist government, the 66th change of government in 70 years. Not a record to encourage boasting. The new Prime Minister is Giuseppe Conte, a compromise candidate who has never before held public office. He is a law professor by profession.

The government is a complex coalition with ministers drawn from both the anti-establishment Five Star (M5S) Party and the far- right League. The latter party draws most of its supporters from the North and the former from the South. They do not have particularly warm feelings towards each other! It is still early days and the government is finding its feet whilst various key members of the eurozone endeavor to exert their early influence over this unpredictable assemblage.

Italy’s problems are well known: In the almost 20 years since the commencement of the eurozone real GDP growth has amounted to only 8.6% – or an annualized rate of a miniscule 0.4%. Among eurozone countries only Greece has fared worse. Youth unemployment (aged 25 and under) is around 33% (source: Thomson Reuters Datastream). The country has run-up a suffocating level of public debt – at the end of 2017 IMF data indicates it has reached 131.5% of GDP. The banking system is in disarray. According to the OECD, non-performing loans amounted to 178.8 billion euros at the end of the third quarter of 2017. This is by far the highest total within the eurozone.

In common with many other eurozone countries Italian workers leapt aboard the gravy train after joining the currency union and bid wages to uncompetitive levels. Between the beginning of 2001 and the end of 2009 unit wage costs rose by a meaty 32.7% yet productivity growth was negligible. Over the same period German unit wage costs rose by only 7%. Needless to say Germany stayed competitive and Italy didn’t. The intra-eurozone wage adjustment process has been ongoing since the end of the financial crisis.

0718_pyrspectives_italy_labor costs_500It is clear that Italy needs strong growth whilst being granted tangible relief from its public debt burden. The latter is unlikely under present eurozone arrangements whilst the former demands a heroic degree of optimism. Italy’s pre-eurozone history doesn’t inspire confidence – high inflation, frequent devaluations, low productivity growth, low output growth, inflexible labor markets.

The other issue which beleaguers Italy, and which it can do nothing about, is its demographic profile. According to the United Nations Italy has the second oldest median-age
population in the world (nudged out of top place by Japan), whilst a forecast by the OECD reveals that in the next few decades Italy’s ratio of the population aged over 65 relative to the labor force (dependency ratio) will be second to none. In other words, Italy’s work-force will have a bigger relative financial burden to carry than the work-force in any other country.

So what can the new “populist” leadership do? Their pre-election proposals of a flat tax and minimum “citizen’s salary” of 780 euros a month would shred the budget in the near term and do nothing to address the structural issues. The initiative to deport several hundred thousand migrants may be popular with the voters but again will do little to help.

In the current year Italy has to refinance debt equivalent to 22.2% of GDP whilst in 2019 the figure is similar at 22.1% (IMF data). This is a mammoth task for a country in such a precarious financial situation. Non-residents own around a third of the sovereign debt. Convincing them to pony up again will be a herculean task for the debt marketing folks.

The European Union/eurozone straightjacket gives any Italian government limited freedom of movement. Our guess is that another political crisis will develop when it is apparent few advances are being made and the specter of EU and eurozone withdrawal will again rear its head. This will be no trifling issue as the Italian economy is ten-times the size of Greece – the last country to threaten the eurozone hegemony.
Central Banks

0718_pyrspectives_central banks_balance sheet assets_500The U.S. Federal Reserve balance sheet shrinkage continues whilst another two interest rate increases are mooted for the balance of 2018. The European Central Bank has stated it will end bond purchases by the end of this year whilst the Bank of England has spoken of raising its benchmark rate three times over the next three years. Japan, however, is holding out – not yet indicating an end to its extraordinary bond-buying program or its negative deposit rate of interest.

Despite Japan’s intransigence it is clear the worm is turning. The growing gap between the Fed Funds rate in the U.S. and that of other central banks will inevitably suck them into its wake.

Unwinding just some of the U.S. $11.5 trillion pumped into the markets by the central banks since 2005 cannot be expected to pass without some financial wrinkles. It’s the size of the wrinkles that is the big unknown.
Fast Cars and Boats

In case you missed it a 1963 Ferrari 250 GTO sold for approximately U.S. $70 million in June. It is one of 36 250 GTO’s produced and is kitted out in silver and yellow livery. Apparently this particular vehicle finished fourth in the 1963 Le Mans 24-hours race and competed in many other prestigious international events.

The car was purchased by a U.S.-based collector who commenced his business importing rubber car mats from Britain in 1989 and then gradually branched into a wider range of vehicle accessories. Reportedly he owns an additional eight Ferraris as well as a couple of Porsches and an AMG Mercedes – oh, and a superyacht and a Gulfstream aircraft.

There are now quite a few examples of Ferraris selling for more than U.S. $20 million as well as the occasional Mercedes, Alfa, Aston Martin and Jaguar.

In August R M Sotheby’s will be selling at auction a 1962 Ferrari 250 GTO and it is expected to fetch a price similar to the 1963 Ferrari – so if you are that way inclined there is your opportunity.

Clearly the luxury car market is in over-rude health – usually a good test of just where in the economic cycle the world economy sits. Those who follow such things will remember spectacular crashes in the past (no pun intended). The other test we enjoy applying relates to the superyacht industry. This is also in rude health.

According to the latest edition of Boat International (the superyacht bible) 112 superyachts changed hands in the first quarter of this year with a combined asking price of U.S. $1.1 billion (an average of almost U.S. $10 million apiece). In the same quarter last year “only” 100 yachts changed hands with an average asking price of U.S. $9 million. In 2016 the figures were 75 yachts and an average asking price of U.S. $8.7 million. The market is dominated by U.S. owners – particularly Californians, New Yorkers and Floridians.

The trend is definitely up so the cash to splash is obviously out there. A far cry from the days of the financial crisis when sales of such yachts plunged (or should we say sank?). If you’re feeling particularly flush could we recommend a Burgess 2012 motor yacht named Excellence V which at 200 ft. can be purchased for only 425,000 euros a foot (or 85 million euros if you insist on having all of the 200 feet). If, on the other hand, you are feeling slightly less flush and would appreciate a bargain following a recent price reduction, a 183 ft. Benetti, launched 2007, is a snip at a mere 15.9 million euros. Before you proceed we should caution that fuel, crew, insurance and all the extras usually add an annual outgo that is equivalent to around 20% of the capital cost. But then if you have to worry about such trivialities we guess you can’t afford it in the first place.
The Final Word

Markets are being rattled by the growing trade skirmish. As well they should as it is not good news. There is no winner in this game – everyone loses. In China the benchmark Shanghai composite index is down 20% from its January peak.

The American President is keen to blame everyone else for the U.S. trade deficit but the reality is that America under-saves and over-consumes. The personal savings ratio in the U.S. is around 3% – close to the post-WW2 low it achieved immediately prior to the global financial crisis. Personal consumption relative to GDP is almost 70% – placing it at the top of the world’s developed-market ranking (Bureau of Economic Analysis and OECD data). Add in the expanding U.S. budget deficit and the growing level of public debt and it becomes clear that the U.S. needs to suck in significant savings from the rest of the world.

Earlier we referred to the difficult financing needs of Italy in the current year and the next but the U.S. is in no better financing shape. In both this year and in 2019 the combination of the budget deficit and maturing debt will demand refinancing equivalent to 24% of GDP (IMF forecast). The U.S. will, of course, easily attract the funding whereas Italy may not find it quite so easy.

The vibrant level of domestic demand means that the U.S. economy is bustling along with full employment but with mounting inflationary pressures. Like a pressure cooker the excesses will at some point blow off. The cycle is very mature.

Elsewhere we note that Chinese growth appears to be slowing and it would not come as a surprise if the administration resorts to currency depreciation as a weapon against U.S. trade disruption. A trade and a currency war? Not what the doctor ordered.

In the calendar year-to-date most developed and emerging market equity indices are in negative territory. Countries such as Argentina, Brazil, South Africa, Indonesia and Turkey are also suffering from marked currency weakness. The firming U.S. dollar and the steady increase in official U.S. interest rates are having a predictable and inevitable impact.

Markets don’t like uncertainty and it seems to us there is more than a fair share about at the moment. Equity valuations are, for the most part, robust and interest rates remain too skinny. We remain firmly on the side of caution.

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