Weekend Summary

Though I, and the average reader of this blog, is winding down a pleasant weekend of meeting friends, eating good food, complaining about the weather and the occasional discussion about how banks and politicians ruined the country, the reality is many today are suffering in a way our system has installed in peoples mind is not meant to occur. Too sophisticated is our society to allow suffering to have the basic needs of life– the problem is that with time this list got longer, rather than more necessary.

We shall now stop walking down this well trodden avenue before we enter into an anti consumerism tone and give a well detailed (though skewed) opinion on who is to blame (the answer is of course everybody, though some parties merit a higher coefficient of contribution).

We shall instead focus on our weekly review of movements in the business and financial world:-

Markets continue to rise and fall with large volatility and strong sensitivity to macro news items. Most recently, disappointing unemployment figures made markets drop 2% in the US. This highlights the uncertainty present in many investors’ minds.

Uncertainty is a big problem for many investors as old models/trends/systems are simply not working.

It is not a surprise; past numbers are no guide to the future!

To understand the future, you need to understand the drivers of the current state of affairs. When the economy is in a steady state or in a simple business cycle where interest rates determine economic activity in a dominant manner, than past numbers can be a good guide for the future.

However, one variable they should be looking out for is the debt load of almost all market participants in developed economies. This is simply not another statistic – it is reality! When leverage reaches a certain level it becomes THE statistic, not a statistic. It is the dominant variable that will ascertain the future of many economies. The longer this is ignored, the longer the problem lingers, like an unwanted smell that will not go away. Without the debt load in a country reaches a certain limit that a standard increase in interest rates leads to a large deficit to be continuously maintained to meet the debt load, at one point demand will decrease drastically. This will lead to rates increasing enhancing further the debt problem. Once in this situation there is only one way out – debt forgiveness to reduce the debt load and hence increase the potential return of capital in that country so new capital is attracted into the economy.

There is another way. And that is what is happening in Greece. The market structure is being aggressively changed by large market players been consolidated to ensure companies survive. These companies are becoming quasi monopolies. European competition authority is allowing this to ensure large service based companies survive and it will attract foreign investment because these companies will have stronger attributes to survive. Consolidation will mean job losses – but this will have to be achieved to reduce costs, increase margins and therefore attract new capital. Already in telecom and banking sector. Effectively the competition authority is being bypassed for the benefit of the survival of the economy. Ownership of assets being changed – restructuring of the economy is occurring. Waste will be removed – this means the middle and working class worker will pay as well as the previous owner of the company. Previous stakeholders lose capital or income to attract new capital – this is how it works. But here it is not the debt holder, it is equity capital and employees – the debt holder is being spared, no doubt because they want to tap further funds from the credit market.

With pasta models not working, investors will have to realize that uncertainty always exists! It is an uncomfortable thought, but it is reality. It is not removed by vast swarms of past data or even a deep understanding of history, though both can help interpret the present to assess what is likely to occur.

However, what is happening now does not happen in your average business cycle. Banks do not loss 90% of their market cap every business cycle, or the central bank prints such large amounts of currency every business cycle, or the housing market loss value for a number of consecutive years. We are in the midst of a large global transition initiated by globalization, and fueled by several components which were unsustainable. Politicians were unable to alter the courses of economies that were expanding in an unsustainable way, so the nature of markets will do the job for them…..

With past models not working, it is no surprise that markets react violently to new news. However, through a simple understanding of the main parameters that will change, one may not know the exact nature of the journey, but will have a good understanding of where we are going. Certain past trends that were strong components of recent economic history, which will not be to the same extent in the future are”-

Developed market middle class living beyond their means through increasing credit and asset prices. This will reduce consumer spending in these economies and lead to an increase in the saving rate

China will not invest so specifically in fixed investments for exports.

The international role of the USD as a reserve currency is likely to decrease over time

Greater political and fiscal union in Europe, or the return of individual currencies

Less welfare support for developed markets, higher retirement ages

Just these few changes, where there is little guess they will occur (only when), will make our future very different from our recent past. These are changes now being forced by the capital markets because politicians were unable to bring them to fruition. If you follow through the natural consequences of these changes, one can have an idea of what our future may look like, and then start asking who would benefit in this environment.

Though we have all heard of these stories, few are accepting them as the new reality. Instead, investors are caught in an “uncertain” world, frightened by the fact that old models don’t work, when it is really quite clear where we are going; only we don’t know how we will get there. One must be willing to forgive the details of the future to appreciate the bigger picture, which has such a powerful force leading it to this destination, that it is hard to think of an obstacle that can stop it.

A point on China not being able to continue with fixed investments to export. Look at the damage they have done on the margins of manufacturing photo voltaic modules. Prices have gone down so strongly that a number of US solar cell companies are going bankrupt every week. The Chinese companies are hardly making profit as they have developed such an overcapacity it would take years to allow demand to meet the supply – typical Chinese investment strategy that leads to a flooding of the market. If they finally end up as the only participants in the market it may be seen as a worthwhile strategy, but instead, it encourages protectionism. This is not clever. It also encourages more innovation in the USA to find new technology to generate solar energy, such as thin films (less labour intensive hence viable in higher cost locations).

We see Repsol and major shareholders getting concerned about Pemex and sacyr partnership. Always be aware of the shareholders of the company and what financial position they are in. Sacyr may want to sell, or get a larger dividend or force Repsol to sell assets so they get an extraordinary dividend as they own business is very weak at the moment. Pemex may want to buy those assets! Caixa worried. Especially as they hold assets like Fenosa where repsol is a large shareholder and they may be forced to sell that position!