This report was originally published in 2007 as part of a broader paper on market opportunities. In this section we focused on macro economic influences.
Introduction
Knowing who is who within a market will save a great deal of heartache as orders become harder to secure. Knowing the competitors market and that of your clients is a core requirement. Technology can streamline a number of internal processes, however it is the people within the business that determine the final outcome of business success or failure.
To know that a new trend is emerging from the progressive Islamic States, namely that of state-owned acquisitions of Western companies may help understand the spheres of influence when talking to Volvo suppliers in the future. It is widely anticipated that a Chinese corporation will successfully buy the Volvo business from Ford.
However, the sovereign funds of Dubai, Brunei and Oman are also active. Who would have believed the rumour about Manchester City 12 months ago?
But the emergence of religious fundamentalism impacts on global economic certainty through increased terrorist activity and the use of insurgents in the Middle East battlefields of Iran and Afghanistan. Latterly pirates in the Indian Ocean have undermined confidence in those traditional trading routes.
In the West consumers are becoming aware of the environment, global warming and alternate energy sources, with the Government looking to introduce taxes for individual carbon performance. Increases in sales of the Toyota Prius and other hybrid vehicles are testament to this desire by the global consumer to put the environment on the political map.
Predictions that global oil reserves are becoming harder to source, as oil companies have explored extreme environments both physical and political, to release the oil, has led to alternate fuels being developed. The primary material used is wheat, which in turn has led to a price increase for all wheat-based products including pasta and bread. This has led to inflationary pressure for domestic economics as global wheat production is adjusted to meet demand.
Bio-fuels may not be the panacea to the solution for the discovery of a more environmentally friendly fuel. According to Volkswagen refining the diesel engine may generate less harmful CO2 emissions than that of bio-fuel, a belief that is gaining increasing support. Whilst no one argues that bio-fuels are more environmentally friendly than conventional fuels, the cost of production is increasing, as land is required, which in turn requires more machinery and transportation.
Energy Prices
In 2006 wholesale energy prices rose 27% on average, and gas bills escalated by 40%. This trend is continuing to fluctuate over the next several years, making short term energy prices volatile. This in turn will undermine the Stock Market returns and the global economy. Witness the latest Ofcom investigation into Energy companies pricing.
India’s economy has been growing by more than 8% a year over the past four years, while China’s annual growth rate has risen 7% in 1999 to 10.5% before the financial collapse, and that growth is set to return. Demand for oil is pushing the prices higher as speculators and production demands vie for global position.
However, the consumption per capita of the Asian markets is still low compared to the West. The average UK consumer consumes 10.4 barrels of oil per year and the average American uses 26, but the average Chinese uses only 1.5 barrels per person and the Indians use less than 1.
Improved Living Standards
Despite this recession the UK consumer has an increased standard of living today than at any other time in recent history. Some would argue that the definition of poverty has changed, but compared to 20 years ago every UK household has greater choice. However, household debt has increased to unprecedented levels to fuel this rise in the standard of living.
Asian and Chinese markets are continuing to show strong signs of growth even as markets contract. With the purchase of UK car manufacturer Rover and the redeployment of manufacturing to China, the demand for cars will continue, despite the downturn in the West. Increased sales in air-conditioning systems and fridges in India, confirm that further pressure on energy supply will increase over the following decade. China and India has a combined population of 4.4 billion people and the international Energy Agency expects demand to grow by 50% in the next decade.
Traditional Energy Supplies
Rising demand for oil presents a unique problem for world energy resources. Until recently no new oil fields had been discovered in the last decade. BP’s discovery off the Gulf of Mexico, along with negotiations with various hostile countries, ensures that access to energy by the UK is maintained for the present.
North Sea oil started dropping in 1999 and American oil production has been falling since 1970, partly due to the ‘petrol head’ culture and US domestic market quotas, which restrict US domestic market production. This allows the US to stockpile oil reserves from domestic wells and encourages overseas oil production. Oil production is now declining in Mexico, Kuwait, Russia and Venezuela. The Middle East is still the most productive oil region with Iran recently becoming the world’s 4th largest oil producer, but even this country has introduced petrol rationing to avoid becoming a net importer in future years. Nationalisation of the Venezuelan oil fields is being considered.
Ironically it is forcasted that Iraq is the only net supplier for oil and has sufficient oil reserves for decades to come. However oil production will not be on-line anytime soon.
Oil Reserves
As new oil becomes harder to find and excavated existing oil fields are much in demand, oil will continue to rise. However, increased oil prices do have one distinct advantage – the more inaccessible oil fields become the more economic they become to turn on. Hence the land grab going on for Alaska, the investment by global oil companies in Russia and the destabilisation of regional political systems are designed to drive an increase in oil production.
Russia is now leveraging its political stability to encourage infrastructure investment and technical know-how to develop the significant oil fields in some of the most inhospitable areas of the world, all under Russian rule. The political stability required by adjoining States to ensure consistent delivery is now the primary motivation of the G8 countries.
As energy becomes more expensive, companies in the energy industry will see their profits increase.
Financial Markets
The UK economy relies on invisible earnings to deliver strong GDP figures. The majority of the UK’s invisible earnings are based on financial and legal services (3% of the UK GDP). The commissions made by financial institutions in loans, acquisitions and mergers and other financial instruments accumulate invisible earnings. Corporations pay tax which enables spending on various services the consumer require such as health, education, defence, law and order etc. A proportion of this is given to the Bank of England. The balance of funds available from the Bank of England determines how solvent the UK is. The Bank of England works with the Chancellor of the Exchequer to release funds for government requirements. However, the Government can arrange loans for other nations as well as borrow money for other countries.
The other responsibility the Bank of England has, is the liquidity of the domestic and global markets. The UK banking sector provides financial products to the consumer, corporate and institutional investors. Banks are able to do this because of deposits made by customers’ savings and interest payments on the financial products.
Banks loan cash to each other which is known as the LIBOR rate, this is lower than the rate the consumer pays which is where the High Street bank makes its profit.
The Bank of England sets the interest rate. The Bank of England Committee sets the rate at which consumers borrow from financial institutions. The interest rate is set after analysis of various data relating tot the economic development of UK Plc. The interest is reviewed once a month.
UK Debt Mountain
As oil prices rise, so will the cost of all the goods we take for granted. Our standard of living will start to fall. As petrol prices increase, so will our cost of getting to and from work, heating our homes and factories. The cost of a shopping basket will start to increase as the cost of transporting the goods we buy hits our pockets. Our social behaviour will start to change as we discuss openly the air miles our fruit has cost to reach our dinner tables. Food prices are soaring. Inflation will re-emerge its head again and we could experience the effects on our wallet and life-style not experienced since the 1970s.
The 1980s and early 1990s was the last time the UK economy had to deal with double digit inflation, with interest rates at 16%. This was brought on by a premature desire by the Major Government to join the EU on the back of a depressed UK housing market. Increased personal debt led to unprecedented business failures, repossessions and mortgage defaults.
Some of the same indicators are around today, whilst the base lending rate is at 0.1% the High Street mortgage rate is currently at 7% and rising depending on personal circumstances. It is anticipated that 8-10% will need to be sustained before UK Plc experiences a recession similar to the Major years.
Consumer Price Index
With food prices soaring, oil prices getting higher than most experts believed possible this time last year and with cheap supply of goods from India and China in decline, UK PLC will experience sharp inflation in the next period. As China’s economy grows so does China’s standard of living. There will be an increase in labour and transportation costs that will ensure cheap supply of goods to the West will decrease.
Food prices are increasing at a rate of 6% annually – the highest rate in a decade. Fish prices rose 12.6% in the past year. Vegetable prices are up by 10.2%.
The Consumer Price Index has already breached the Bank of England’s indexs several times recently and the household shopping basket is becoming more expensive due to inflationary pressures.
Several reasons are forcing this climb in prices including the rise of wealth in Asia and the climate change. A second indicator is the oil squeeze. This in turn promotes the use of alternate energy, including new fuels made from agricultural products. Europe wants bio- fuels to meet 10% of energy demand by 2020. By 2012, half the cars made in the US will be designed to run on 85% ethanol and bio-fuel made from corn.
An increase in US ethanol production will increase corn prices. As demand increases so will prices for other grains as consumers substitute wheat or rice for corn. Meat prices will also climb, since most corn has traditionally been used to feed livestock. Higher meat prices will in turn raise demand for fish. As land becomes devoted to growing corn, and other bio-fuel crops (such as rape seed and tropical oils) less will be available for food production, adding to supply/demand pressure, food prices and inflation.
Gold
Gold can give value in inflationary and recession times. If central banks allow inflation to rise by keeping interest rates low, currencies will lose value relative to gold. When banks raise interest rates too high, gold will retain value better than paper assets, so its price will still rise. Gold provides insurance against all economic woes.
Credit and Confidence
The free market demands that a financial institutions growth is centred on market expansion, either by geographical expansion or vertical market expansion. This can be summarised as new product development and/or entry into new territories.
In the mid 1990s banks took advantage of cheap money supply with a raft of consolidations and mergers, to leverage scale and influence over a larger global client base. Across wholesale, retail and business banking sectors, regional banks combined to form consolidated national operations and new financial products were issued to stimulate consumer growth. This ‘push’ coincided with de-regulation in the mortgage lending markets. Lending criteria was reduced to fuel the growth in housing. This was most keenly exercised in the US and UK property markets, which in turn stimulated growth in global property markets.
Again this stimulated growth in the emerging economies as we strived for cheaper products to satisfy domestic demand. With the easing of credit lending criteria the Western consumer was able to leverage the debt to stimulate profit and consumer spending. This helped fuel the expansion of industrial China and India.
The release of cash from these emerging industrial nations to Western companies, released large cash deposits, which were channelled into bonuses, tax and profits. Western industrial expansion in turn drove demand pressure and, therefore increased value on global raw materials, such as, steel, lead and gold. This is exemplified by the 10 year high prices experienced in the global gold index.
Whilst there is growth all is well. If there is a whisper that growth may be reduced, stock prices fall to correct company values against a perceived reduction in demand, which in turn affects the value of raw materials. This puts inflationary pressure on the goods at the factory gates which in turn leads to wage inflation, as the goods we buy are more expensive.
Whilst times are good, like the consumer, the company hedges its profits at the factory gate on the future demand for the goods and services it produces. This takes the form of acquisition of competitors, complimentary suppliers, and even a move into different markets to maximise the production capability of plant machinery.
Companies on the acquisition trail will need to invest in the market to satisfy shareholder return. Shareholders power is held by two investing bodies, the pension fund and the hedge fund. These two entities hold the power in any boardroom should the stakeholder be strong enough.
Bank and hedge funds place the money for the acquiring company to use. The return on the investment is invariably based on cost reduction, be that in production costs, the wage bill or the supply chain. Owning the market is the aim of acquisitive companies. In the good times Mergers and Acquisitions can conceal poor trading, as well as injecting some much needed cash into the balance sheet. Therefore finding the true value of any operation requires detail, or risk money.
Corporate activity can translate itself into impressive GDP stats. Over the last 10 years many domestic markets have expanded quickly with individual Gross Domestic Product (GDP) increasing by 3-5 % as a minimum in the case of Western economies, with the emerging markets of Eastern Europe, growing at faster rates than in the case of Russia, Hungary and Poland.
Geo Politics
Politically the expansion of the EU has provided a feeling of goodwill, as countries previously considered predator nations, now become the workforce for the expanding European trade nation. In the future this may further complicate global economic growth as we evolve from a two tiered system in the 80s (with cold war determining global economic growth), to a 4-5 tiered system in the early part of the 21st Century.
Financial Syndication
To fuel this domestic expansion Western companies have taken advantage of Western lines of easy credit, which have been underwritten by syndicated banking vehicles. Western economies rely on the banking community to support companies who are developing new technology, new markets and new products. Banks need to have confidence in economic stability and market growth. The domestic banking system in any Western economy is underwritten by the Government’s bank, namely the Federal Exchange in the US, The Bank of England in the UK or the European Central Bank in the case of Europe.
Ironically the countries underwriting this confidence, syndicate this risk across themselves, leading to the unusual position of China owning a significant portion of the long term US bonds. Bonds are used by governments as financial certificates that can be sold to either institutions or other central banks to release cash for the issuing country.
Bonds are then traded across the global exchanges to increase value. The closer the bond is to the declaration date the more value the bond has, and when the bonds reaches maturity the US Treasury buys them back at the new market price.
Whilst global confidence remains positive economies remain buoyant. If there is a step change in global confidence, such as world war, raw material, inflation or market crash, global confidence is affected. The Sub Prime collapse inflated the global credit crunch we are experiencing today.
Currency Crunch
Here are some facts on the credit crunch:
· The US dollar has fallen by 20% in the last year. Global companies, many of whom are on the FTSE 100, earn a sizeable percentage of their revenues in dollars. Falling profits due to a falling dollar could eventually drag down the share price of many of these companies.
· The US has a large currency reserve to underpin the Chinese dollar bonds, but if there is a serious run on the dollar this could be a threat to the world’s financial system.
· Economic growth in the US appears to be stalling as noted by the IMF who expects the US to underperform Europe.
· Reflect on the fact that Germany is just coming out of recession after a 24 + month term.
· The recent budgetary measures introduced by the US administration, combined with radical cuts in the US domestic interest rate, signals that global forces are opposing economic expansion.
· The dollar is now less attractive for global currency investors.
· US inflation is the highest in 10 years, which further undermines dollar performance.
· US Government debt and public spending is at an all time high exceeding $8.6 trillion – the largest amassed anywhere in the world ever. Bond holders such as the Chinese will be trading US bonds over the next few years for something more secure which in turn puts a downturn pressure on the dollar.
· The US current account isn’t looking that healthy either. The US GDP stands at 6%, a trigger that normally invokes a run on currency. The rule of thumb is that it takes a 10% drop in a currency to cause a 1% drop in current account/GDP ratio. According to the European Policy Institute this implies the dollar needs to fall at least 30-40% to reach a sustainable level.
· When the dollar falls, other currencies go up. Given the scenario investment funds will move their investments from dollar business to non US dollar based businesses.
Financial Confidence
With the collapse of the global dollar, investors may lose confidence in the financial system and in all forms of paper wealth. No other currency can replace the dollar in the short term, with the most likely contender the Euro, having its own unique set of problems, including an out of control welfare state, a declining population and problems with immigration which brings on social unrest. However, in recent months the Euro has started to outperform the dollar.
The Bank of Japan has little credibility as a currency haven and China is not a mature currency. Sterling has rising government debt and a record high current account deficit.
