27 Oct 2023
Global Macro-economic and Geo-political Update
On the geo-political front there have been significant developments in the Middle East since our last newsletter. These developments are starting to be reflected in the global economy and are adding to the difficulty of interpreting the impact of changes in fiscal and monetary settings on macro-economic world.
Gaza/Israel and Ukraine/Russia Conflicts
As outlined in newsletter dated 11 August 2023, world wars are stumbled into, countries do not start a war and expect it to conflagrate further, rather they believe it will be contained as they misinterpret the reaction of other actors. Before folks realise it has spread out of control. This stumbling can be seen in the multi-polar world split that is occurring and we have mentioned many times in newsletters. The “West” (democracies) are lining up against the “East” (autocrats) and the autocrats’ alliances are growing out of necessity rather than because of common values. Iran and Russia being the prime examples with China being opacity.
The possible spread of the Israeli/Gaza war into a regional war will impact on the price of oil, particularly if Iran becomes involved and they severely disrupt the shipment of oil through the Straits of Hormuz which is what they can do easily. It’s the West’s weakest spot and Iran’s greatest geographical strength. A wider regional conflict will draw America back into another Middle East war which will strain their resources, as they will be involved in 2 wars in separate areas of the world. It will further cement the Russian/Iranian Pact in a critical geographical area of the world. It also means that NATO will have to increase their support to Ukraine in the Ukraine/Russian war more than they are currently doing.
Russia has stopped shipments of grain through the Black Sea, and this is impacting poorer countries that rely on this grain. Food shortages are occurring even though Russia has said it will assist those countries that rely on Ukraine grain. Regardless prices are increasing and are contributing to global inflation.
The BRICS meeting in Pretoria, South Africa had several important outcomes. The final communique highlighted:
The global momentum to increase local currency use and alternative financial arrangements, alternative payment instruments and platforms. At the next summit the central banks are to report back on progress in these key initiatives. It is important to note the use of the words – “alternate financial arrangements, alternative payment instruments and platforms”. This reflects the desire of BRICs countries to de-dollarise which we have written about in earlier newsletters.
The need to improve the fairness or the global financial architecture. Again, this reflects one objective of BRICS being de-dollarisation.
The importance of expanding its membership. New members were admitted. These being Argentina, Egypt, Ethiopia, Iran, Saudi and UAE who will become full members from 1 January 2024. It is likely the BRICS name will change to accommodate the new members and those likely to join in the future.
That it did not see BRICS as a competitor to the G20, although at the G20 meeting which followed the BRICS summit about a month later took the unexpected step of inviting the African Union, not a specific country to join the G20. This appears to be a response to BRICs regardless of how it may be “sold” by the G20 members.
We need to continue watching developments as they will impact on global trade and global economic growth.
Energy is life! This is an expression we use a lot because our standard of living is tied to the availability of energy (including food), at reasonable prices. With the price of petrol in Australia consistently around AUD2.20 per litre or more, along with price increases of staple products means folks are struggling to make ends meet. Higher petrol prices also reflect OPEC’s reduced production by 2million barrels per day and the stronger US dollar. A wider Middle East conflict will further restrict supply driving up the oil price, with flow through impacts on gas and coal prices.
It is likely there will be energy blackouts in Australia in the coming months as coal burning power stations are shut without a timely base load transition plan. The media rarely report on the 99% correlation between Gross Domestic Product (GDP) growth and energy. Small blackouts or power shedding have significant impact on GDP growth, and South Africa is a good example, as power shedding occurs twice per day. Major corporations, e.g., Mercedes Benz that has a large factory in East London, South Africa is exempt from the power shedding, while their smaller part suppliers are not, resulting in production delays. Energy and materials constraints will result in lower living standards.
The discussion around peak oil is a long standing and complicated one. The debate is about technological innovation although it is simply put as a supply/demand one. In the 1980/90s, the world thought that supply had peaked; then the innovation of horizontal drilling and shale oil opened new supplies, and importantly paved the way for the US to reduce its dependency on Middle East oil. The shale revolution made energy cheap again after the petro crisis of the 1970s which was linked to the breakdown of the Bretton Woods Agreement in August 1971.
The USA burns 8,000 kilowatt hours per capita, whereas, Brazil, Bangladesh, Indonesia, Pakistan, China, India use 5,000 kilowatt per capita. If these countries were to increase their energy use by 16 times to achieve energy usage parity with the USA, i.e., 5 billion more people on the planet using 8,000 kilowatts per annum, it makes what Ireland is doing with its cow culling program as totally irrelevant in the scheme of things.
There appears to be a renewed global interest in nuclear energy as more countries are either re-starting mothballed power plants or building new ones. Both full size nuclear reactors and the Small Modular Reactor (SMR) are seen as the most cost effective and cleanest solutions to climate change for a variety of reasons.
As you will be aware back in March/April, we took the view that equity markets were overvalued and that the best strategy was to stand back from the markets, except for some specific areas, e.g., uranium and given the disruption in the bond markets it was best to invest in short term debt/deposits.
This has been the correct call as the S&P 500 and the ASX 200 have fallen 5.35% and 5.5% from 3 July 2023 to 23 October 2023 respectively. Short term interest rates have continued to rise while the yield curves remain inverted. With the Israeli/Hamas war we have seen the MOVE index (a measure of bond market volatility) reach its 3rd highest level on record. This last week the 10 year US treasury yield broke through 5%, the highest its been since 2007.
Of course, it is important to understand it is impossible to time entry/exit from markets and as the old saying goes it is time in the markets that matter, so as noted above we have been investing selectively and applying dollar down averaging when possible while being cognizant of the many other factors at play, e.g., weight of money that impact on values.
A positive that is in the wings is China lifting its sanctions on some of Australia’s export products, e.g., wine, although this will not spur the overall share market which takes its lead from the US.
For many years now we have warned investors about industry funds over valuing closed end funds and unlisted assets, and therefore overstating their overall returns. This week the Australian Financial Review reported that:
“Industry super fund QSuper handed back the keys to a prime New York City midtown office tower after its investment went under water just 2½ years after valuing the asset at $US540 million ($855 million) on its books. The decision to appoint a so-called special servicer to a $US399 million loan that backed its commercial real estate bet means QSuper faces a total loss on its position.” The article goes on to say “ART has among the highest exposures to so-called unlisted or illiquid assets with a 34 per cent exposure in its $49 billion Lifecycle Balanced Pool option, according to Morningstar research. About 9 per cent, or $4.3 billion, of the balanced option was invested in unlisted property at the end of 2022, according to Morningstar.”
One important take away that we have stated many times is liquidity is king when investing and unlisted and closed end funds are generally illiquid, and if you are going to invest in them the returns must be commensurate with the risk.
Even though equity markets are down, and bond markets are showing increased levels of volatility, the gold price has recovered to USD1980 per ounce since the start of the Israeli/Hamas war. This reflects the flight to safety in uncertain times.
We are confident that folks have noticed supply shortages for food items when shopping and visiting coffee/sandwich shops. At the Wagga Wagga sheep sales about a month ago prices of a whole sheep were less than a dollar, so a farmer rather than incur the costs of carting the sheep back to the property shot the sheep. This type of drastic action has not been seen since the early 1980s. The beef industry is similarly affected as prices have halved in 12 months even though farmers are de-stocking as drought conditions caused by the approaching El Nino take hold. The lower prices are not yet reflected in supermarket prices for lamb and steak. Of course, in the rural communities when farmers are doing well, the town does well as the farmers spend, and of course vice versa.
Monetary and fiscal policy are not aligned as the Reserve Bank of Australia (RBA) are trying to reduce demand and the Federal Government continue to spend even though the budget is heading toward a surplus from increasing export prices (because of strong US dollar), tax bracket creep and low levels of unemployment. Baby Boomers are retiring and there is not enough of the Millennials/Generation Xs to fill the employment void. There is no simple answer to this problem other than for those proposing to retire to delay it, and those that have retired to rejoin the work force which the Federal Government is encouraging along with increasing immigration which is one cause of the housing shortage.
Inflation continues to hold as it is in the US with further interest rate rises a possibility.
The strong US dollar globally tells you that the global economy is struggling although not simultaneously across sectors. Folks are going on holidays and still spending on entertainment. The strong US dollar reflects the increasing cost of debt capital as the US Federal Reserve increases the Feds Funds rate and the contraction in money supply as banks pull back on lending which creates a shortage of US dollars. This forces the price (exchange rate) to increase (devaluation in the local currency). Whereas, when banks are expanding their lending, the US dollar falls because there is an increase in the supply of US dollars. In the 5 years to 2022 debt capital was cheaper, than equity capital. This has now changed, and this is in part reflected in the continuing strong equity prices along with the continuous and regular flow of monies into pension funds.
Having visited the US recently, the mortgage industry is rapidly adjusting to higher interest rates as companies in this industry downsize. Their focus is on getting through the next 12 plus months with a catch cry of “survive to 25” often heard. Market participants are waiting on the US Federal Reserve to start dropping interest rates to kick start the housing market again which like Australia plays an important part in economic growth. The challenges of home shortages, high levels of immigration, skilled staff shortages and people wanting to work from home are also evident in the US, as they are in Australia.
In the US, the working from home 2-3 days a week seems to be a permanent outcome of Covid, despite companies telling staff they must come back fulltime. Ironically, Zoom that really made a name for itself from the Covid lockdowns has instructed its staff to come back full-time. It will be interesting to see what happens, because one of the reasons for the great resistance by staff to returning full-time in the US is because employees only get 2 weeks annual leave per year, and most employees have a reasonably long commute each way to and from the office. Employees value the time to be able to household chores while working and the extra free time because they are not commuting, They are also saving money ordinarily spent on commuting costs, e.g., bus/train/ferry fares and petrol/toll costs. There are substantial unquantifiable lifestyle benefits, such as positive impacts on relationships as both parties are not tied from long days in the office and commuting. Has the life work balance arrived?
As always, we are available to discuss investment and debt strategies, so please feel free to reach out.
General Advice Warning: Any advice or information provided is general advice only and has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any General Advice provided, you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. If you wish to discuss the contents of this newsletter, please do not hesitate to contact us.