July 2014

Since May we have seen little change in the trends around the world – more of the same.

The Middle East continues to polarise along sectarian lines with Isis’s announcement of the establishment of a caliphate – or new Islamic State. The leadership of this organisation appears to be highly sophisticated and a lot more commercial than the fundamentalist leadership of al-Qaeda. It is interesting to see that they have so far not destroyed oil resources or pipe lines. The effect of Isis has been to paralyse western interventions in the region and we may be seeing the development of a new country that, while it is Islamic and fundamentalist, is commercially realistic. It would also seem that the major beneficiaries in the region will be the Kurdish population who at least now have a chance of gaining their own independent state. Still the situation should be regarded with some trepidation, particularly by Europe as western oil supplies remain in danger.

The elections in Europe and the appointment of Jean-Claude Juncker are now history. It is to be hoped however that the protest votes in Europe will have some impact on policy going forward. While Mr Juncker is an avowed Federalist, he is also a pragmatist. Europe’s major problems are the lack of cohesive policy regarding finance. The European banking system is still awash with debt of which a large percentage is potentially bad. Private sector debt is still intolerably high and European government debt is hardly on a downward trajectory. With regulation squeezing the banking system’s ability to lend, Europe remains stuck in a zero or minimal growth trajectory for a long time to come. So called Zombie banks and Zombie companies, those that cannot expand and therefore cannot repay debt, have to be restructured and the debt has to be written down or written off. Otherwise resources are glued up and any progress is halted. It is a phenomenon of the current financial crisis that bad debt has not been written off; “debt destruction” was not an uncommon phenomenon in the middle and early part of the last century. Without it, economic paralysis sets in.

Britain is escaping the worst problems of Europe as it has much lower taxes on employment and much more flexible employment laws, enabling companies to reorganise and resource to flow to where it is needed. Britain also has an advantage in that its banks, while suffering the same regulatory burden as their European competitors, have to a greater extent taken write offs of bad debt, although there is still a long way to go. Outside the private sector, the UK government has still failed to reduce its borrowing and by and large has failed to address any of the infrastructure issues that have developed over the last ten years or so. Europe has built rail and airport facilities that have leapfrogged the UK and this is becoming a major headwind for British industry. The most worrying aspect in the lack of British government policy on infrastructure is the misdirection of huge resources towards subsidising inadequate and unreliable alternative energy to the point that there is serious contemplation by the government to pay industrial users to shut down in order to avoid power shortages that would affect the public. It is quite extraordinary that a country’s government can be so lacking in strategic competence that it fails to ensure that power supplies for a modern economy are

adequate. The inability of UK Ministers to address strategic issues of infrastructure and their inability to run the services and organisations that they are responsible for leaves one with some despair.

Even in Defence, a policy of vastly reducing the numbers in the army and making it up with reservists has turned into a fiasco, with the Prime Minister urging Civil Servants to join the Reserves to make up numbers. To achieve this, it seems to be seriously proposed that 1% of Civil Servants should join up, and be given extra paid leave and other incentives in return. When one reads on the same day that the Serious Fraud office has been fined by the Inland Revenue for apparently “wrongly reclaiming Value Added Tax”, one has to seriously wonder whether there are any Ministers who are competent and are even prepared to take responsibility for anything. Our system of government is being undermined.

Back to more macro issues. While Europe is pretty flat, the UK private sector is recovering slowly but steadily and the US economy is picking up speed. The US has enormous advantages, firstly its government takes a much lower percentage of GDP than European countries, and of course energy at one-third of the typical European price is a huge help.

While US corporate taxes are higher than Europe, their tax on labour is much lower and their labour laws far more flexible. Among the worries about energy and potential major corporate defaults in Europe, there is a chance that one of the south American countries – from Puerto Rico and south – could default, causing shockwaves in the market for sovereign debt. As well as this, the US Federal Reserve has a major problem weaning the markets off ultra-low interest rates which have encouraged greater and greater risk taking and the purchase of low quality paper by pension funds, insurance companies and very large institutions. While the stock markets are reaching historic highs, earnings and corporate liquidity have risen making equities much less risky.

Bonds, from AAA to the lowest quality, are guaranteed to lose capital value as interest rates rise and I think there is a serious risk that this rise could be precipitous if there was a stampede out of bonds as it really comes home to investors that they will go down in value. In this event, it is unlikely that the Fed would be able to manage the slow rise in interest rates as it has insufficient resources to be a buyer of last resort.

A short thought on China – Mr Xi ‘s government is doing exactly what it has told everyone it is going to do and is so far being very successful. On the corruption front, a very senior general has been sacked to everyone’s surprise. On the property front prices are declining; the currency has depressed, and there is some improvement coming through in its manufacturing base. All good news.

In general, while western governments are depressing, the world looks relatively steady.

Damon de Laszlo 2nd July 2014