Category: Finance, Economics and Investing

Of all the interesting stuff to write about why on earth would I want to write something about tax?

Well I wouldn’t but this particular subject got my attention at a recent CPD update. I feel obligated to go on these things on a fairly regular basis to keep reasonably tuned-in to developments in the tax and accounting world. The last one, a Finance Act 2016 seminar, contained all the usual things that I would much rather not fill my head with plus something extra. At this point you can switch off if you are non-UK resident, this is a specially delightful set of proposals affecting the 50m or so tax-paying citizens of Her Majesty’s British Isles.

The presenter of the seminar introduced the topic of ‘digital tax accounts’ with a little anecdote. As a tax specialist he had recently attended a conference of….tax specialists…whereupon they covered HMRC’s December 2015 proposals on digital tax accounts. After covering the topic and enjoying an exploratory Q&A, a survey was conducted of the said tax specialists about their plans for tackling the consultation proposals. Apparently, 17 of the 73 attending put their hands up to indicate that they intended to retire before the full effects of this digital nightmare rolled out. Now these are some of the best tax experts in the UK, the ones who not only advise large corporations on their tax computations but who give seminars to the high street accountants and other generalists.

Suffice to say it got my attention.

The ‘Making Tax Digital’ surfaced as a consultation document in 2015 followed by an innocuous looking promotion outlining the benefits of a move to digital tax accounts. In essence it is about moving tax online which in an increasingly digital world makes a lot of sense. However, as ever, the devil is in the detail.

Personal tax accounts are already being rolled out with many people already having received notification from the HMRC that their digital tax account is now live. For those of us used to doing self-assessment it’s probably not a big deal but it could be a challenge for the millions who don’t have a computer or the skills, or who are limited by sub-standard broadband provision. All most individuals will have to do is check their account to ensure that HMRC have populated it with the right numbers. Easy for those who already self-assess but it could be an extra task for many who have never directly engaged with the Revenue. It is not clear at the moment but it could well be that you will be required to ‘digitally approve’ the numbers each year.

So, a little more work for each of us as individuals but generally not a major challenge for the majority of people.

That’s probably the extent of the good news, unless of course you are a fee-earning accountant or accounting software vendor. The rationale for that comment will soon become apparent.

The first and least welcome surprise in the business world is that small businesses will be required to move over to digital tax accounts before big ones, a break from tradition. As proposals presently stand all small non-VAT registered businesses and landlords will be required to start delivering QUARTERLY updates after April 2018.

‘QUARTERLY updates.’ What does that mean?

We have to speculate at this point as the proposals are still fairly opaque. What it seems to be suggesting is that Joe Plumber, Eddy Electrician and Lawrence Landlord will have to transmit some sort of income and expenditure or profit and loss account each quarter, probably using a piece of HMRC approved accounting software. In other words a ‘mini’ year-end every three months. So it’s a major admin burden for the smallest of businesses, and inevitably, extra cost. What the Revenue intend to do with this information is not totally clear but more regular tax payments ‘on account’ is no doubt pretty high on the list of applications. The fun of course will start when attempts are made to try and reconcile these quarterly ‘abbreviated’ accounts with final year end accounts, and taxation adjusted for capital allowances, private use, loss relief etc. etc. The smallest of businesses have a limited interest and expertise and will clearly resort to their accountants for some sort of help. It will no doubt increase accountancy fees once the challenge of whether there is enough accounting help in the system has been faced. I would not overestimate the ability of the high street accounting sector to cope with a broadly unexpected onslaught of extra work. In time it will absorb the work but the transitional years could be pretty difficult. Even accountants have home lives.

HMRC hope that imposing these additional requirements will in some way raise tax revenues. The evidence for this is at best anecdotal and the policy could actually reduce revenues as rules force small businesses to keep better records and ensure those receipts don’t get lost. Time will tell whether the brave new world of digital taxation will also invoke the law of unintended consequences.

The implementation timeline is aggressive. It is the smallest of businesses in 2018 but larger VAT registered businesses, contractors with PSCs etc. will follow very quickly afterwards. Larger entities are further down the road but in many cases they will already have the infrastructure capable of submitting quarterly accounts; in most cases these organisations already produce monthly statements. The only additional task would be formal quarterly HMRC submission. In a world where these companies are being encouraged to think strategically and plan long term we could see a renewed focus on quarterly market updates. I have not seen a lot of discussion on the implications for PLCs but this could be a topic of future interest.

By 2020 most companies will be updating HMRC quarterly for Corporation Tax purposes through approved accounting software. Investing in Sage and other accounting vendors might not be a bad idea as it looks like every business will be compelled to pay for software, most of which is likely to be updated at least annually. It looks like this could become an additional ongoing cost in addition to any supplemental accounting fees.

Digital tax accounts aside we are slowly moving towards a world where everything is becoming government controlled. The emerging discussion about a cashless society would quite easily interface with a ‘digital tax account’ environment. With every piece of expenditure digitised and an all-seeing government holding absolute control over your affairs we are increasingly reliant on the fact that its intentions are benign. While most of us still think we still have some control through the ballot box we ought to recall the words of Mark Twain on this subject: “If voting made any difference they wouldn’t let us do it.” With digitisation happening so quickly we should be very careful that we maintain oversight on who is the servant and who is the served, or we might all wake-up one day and find that we have sacrificed our freedom to the god of convenience.

There are two broad subjects that I like to research and occasionally write about. Both are very broad but perhaps surprising to a lot of people there are often cause and effect links between them. The first is change management and improving business performance, and the other is finance, economics and investing. Finance, economics and investing are indeed subjects in themselves but there are so many joins and overlaps between them that it’s often hard to cover one without referring in some way to the others.

On the face of it LIBOR (Intercontinental London Interbank Offered Rate) appears irrelevant to most people and is often only vaguely understood by those outside of the financial services industry. Like the FED funds rate LIBOR is a global benchmark rate; in other words it is important.

I’ll resort to Investopedia for a full definition:

‘LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF), and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate.

LIBOR (or ICE LIBOR) is the world’s most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market…..’

What is slightly more interesting feature of LIBOR is that ‘…it helps to evaluate the current state of the world’s banking system as well as to set expectations for future central bank interest rates.’

It is this latter comment which is perhaps of more interest. With the notable exception of the Federal Reserve and, some would say, its quixotic notions of increasing interest rates, most of the world’s central banks are positioning lower or ‘low for longer’ interest rates. Dollar LIBOR seems to support this. If we look at a chart for the past few years there is a noticeable increase in rates. Each of the standard maturities are showing tangible increases with the trend starting somewhere towards the end of 2014. The Brexit vote in mid-2016 interrupted this trend but as you can see from the chart, within a week or two the earlier upward trend re-established itself rather quickly.

The FRED chart of U.S. bank excess reserves is also of interest. Peaking in August 2014 at $2.7 trillion it started a downtrend about the same time as Dollar LIBOR started to move upwards. Given the subject matter, availability of money, it seems reasonable to assume that the two things are connected. In other words demand for money has been increasing and it is being sourced from US bank excess reserves deposited at the FED. As of the end of July 2016 these reserves had dropped to $2.2 trillion, representing almost $500 billion only recently injected into the U.S. economy.

For information U.S. ‘excess reserves’ basically represent cash held at the Federal Reserve above the minimum the FED requires banks to hold on their balance sheets. It is a nuance of the U.S. banking system which is why you don’t see reference to it in UK discussions. Excess reserves rocketed upwards in alignment with the $4 trillion QE money printing exercise initiated in 2008 following the banking crisis. Starting in 2008 the FED used QE to buy assets from the private sector while at the same time announcing that interest would be paid on any private bank cash deposited back at the central bank. Given the waning appetite of business to borrow and a significantly increased reluctance by the banking system to lend, much of that QE cash swilling around the private banking system did not end up getting loaned out to business but was re-deposited with the FED. US banks took the view that low risk FED interest was a much better bet than lending to business in a shaky post-2008 business environment. Some QE did filter out into the real US economy but a massive amount ended up back with the FED. In other works the stimulus real economy effect of Dollar QE was muted at best.

Rolling forward to 2016 and demand for dollars has been slowly increasing, represented by Dollar LIBOR rates edging upwards. It is therefore moot as to whether we could see U.S. inflation also edge upwards. Much will depend on how fast this $2.2 trillion of excess reserves finds its way into the real U.S. economy. Currently ‘locked-up’, the money might as well not exist. But if hundreds of billions are released into the U.S. economy over a short period of time then there are bound to be consequences for the value of the U.S. dollar. More dollars chasing the same goods and services ultimately translates into inflation in one form or another, both in consumer prices and hard assets.

If U.S. inflation lurches upwards the FED may need to act to prevent a sharp fall in the value of the Dollar. At the moment the Dollar is regarded as ‘the cleanest dirty shirt in the laundry’ and remains the favoured currency in volatile and capricious markets. A Brexit vote and Cable moves in favour of the Dollar; a Eurozone crisis and the Euro falls and the U.S. Dollar increases. However, a sharp increase in U.S. money supply sourced from U.S. bank excess reserves and sentiment could well shift in favour of those other currencies, including of course gold. While the longer term goal of the FED is probably to help inflate away the ballooning U.S. debt (projected at $20 trillion by early 2017) short sharp drops are not usually regarded as desirable.

The FED is somewhat cornered. It needs a gradual drop in the value of the Dollar but would also like to increase rates in preparation for the next crisis. Notwithstanding the claims of the Democrats and the (allegedly) goal-seeked BLS economic statistics, outside of the large cities the US economy is not generally in a healthy state. A dose of inflation would probably help get things moving but the FED will not be able to achieve this if it starts putting rates up. Indeed, the opposite is a more likely result. For this reason there doesn’t appear to be much of an immediate case for increasing US rates in the foreseeable future, whatever the periodic ruminations of FED members. Nonetheless an increase in inflation above 5% and the FED could have its hand forced, whatever the longer term benefits of eroding the real value of US debt.

Back in the UK the BoE is still positioning a ‘low for longer’ policy, perhaps capping the current ‘crisis’ interest rates until 2020. Sterling LIBOR still supports these signals but a structural change in U.S. Dollar sentiment could well force a re-think of this intent. The current ‘Brexit bonus’ of a 10% drop in the value of the Pound could evaporate just at the time we need it most: during the uncertain two year countdown to formal exit from the EU.

In a world driven by central bank interventions forecasting is virtually impossible; even directional thinking is a tough challenge. Nonetheless herewith are some thoughts. If the US is about to experience higher inflation rather than the more widely assumed deflation there will be some consequences for Cable. Sterling could well increase against the Dollar which will put the BoE in an equally challenging situation. With Brexit fear and potential further EU referendums over the next couple of years the Euro could also drop in value against Sterling.

What short term strategy could the BoE deploy if faced with a currency increasing in strength against its major trading partners? How will the UK Treasury and BoE manage the UK’s own burgeoning national debt load, already exceeding £1.6 trillion? Faced with a shorter term challenge of a rising currency and the longer term problem of a growing national debt it really has few moves available. It no doubt feels that it must keep rates at low levels for as long as possible. Alas another 25 basis points fall in UK interest rates and the country risks entering the Twilight Zone world of negative interest rates.

Interest rates have now been at these crisis levels for eight years. Failing banks have been protected but at the expense of current and future pensioners. Defined Benefit pension funds are mostly in deficit with bond yields at their lowest in hundreds of years and asset values in bubble territory. The economic infrastructure is creaking under the weight of systemic and polarised financial forces pulling in all sorts of directions. Add Brexit uncertainty and a global slowdown to this and the prognosis for the next few years looks less than healthy for the UK economy. Even if Brexit acts as a palliative factor the implications of continued lower interest rates look more likely to hinder economic progress rather than help it. The BoE looks like it is as cornered as the FED with many of its remaining ‘new normal’ economic manipulation tools now looking very blunt indeed. What exactly is the point of lowering interest rates even further and what evidence is there that this strategy still has any residual stimulative economic benefit, if indeed there ever was any?

Whatever the choices of the FED, BoE and ECB economic activity looks more likely to decline rather than increase. This of course suggests that businesses should be starting to look at 2017 and 2018 as revenue challenging and should thinking about paring costs to align with those less than stellar increases in income. The better companies undertake scenario analysis, plan and prepare in the good times rather than wait to see declining revenues on their profit and loss statements. Now is the time to think this through and take action rather than put your hands together and pray that the central banks, economists and political class know what they are doing.

The dénouement of the great monetary experiment could soon be upon us.

According to Goldman Sachs global oil supply went into deficit during May 2016 which probably explains the speculative behaviour on the paper derivatives markets. Oil prices in both WTI (West Texas Intermediate) and Brent rose during March, April and May, anticipating equilibrium later in the year. After an extended period of declining and low prices it looks like oil prices will lurch upwards, no doubt followed by prices at the pump.

During 2015 an unbelievable number of oil analysts were predicting many years of low prices, apparently confusing short term politically driven oil output policies with the fundamentals of the oil industry. They seemed to compound their errors by extrapolating US shale production forecasts using the sort of assumptions only appropriate to conventional onshore oil production. Anyone who knows anything about the economics of fracked oil knows that increasing or even maintaining production depends very much on establishing an increasing stream of new wells. Fracked wells typically peak in output in year two of production which is why we may well see some significant falls during 2017 and 2018. Even a significant increase in price may not be enough to stimulate the sort of production levels seen in recent years.

Short term it looks like oil prices will moderately increase but it’s the 2020s we ought to be preparing for. In true Spinal Tap fashion Saudi Arabia may have recently turned up the output dial to eleven in its strategy of containing Iran and hurting the US shale industry. But this policy can’t last given the unintended consequences of dismantling OPEC and depleting its foreign currency reserves at an alarming rate. It will need to scale output back not only for its own immediate domestic budget reasons but also because it doesn’t have infinite supply. Saudi has been increasing production in a world where current reserves are simply not being adequately replaced, not just in the Middle East but globally.

Peak conventional oil production is generally accepted as having occurred in 2006. Which is why there were many articles about Peak Oil during the 2006 – 2010 period. For a time it did look like all types oil, onshore, offshore, tar sands etc. might peak between 2012 and 2015. Oil market speculation pushed prices up to $140bbl in the period leading up to the global banking crisis in 2008 and the financial world took a breath. The US FED’s reaction to the credit issues in the banking sector had consequences for the oil industry. Trillions of US dollars were printed to bail out the banks but it was inevitable that some of this would find its way into the oil sector. An estimated $350bn helped finance the technology and infrastructure that made US shale happen. With prices between $80 and $120 hedge funds queued up to invest in aspirational US shale companies and an inevitable boom in output transpired. US shale has bought the world some time. A fortuitous set of circumstances and the profit motive added perhaps ten years to the Peak Oil window originally forecast for 2012 – 2015. Few are brave enough to forecast a new timeline but one thing for sure is that it will happen, and probably in our lifetimes.

Peak Oil is not about oil running out. There are billions and billions of barrels of the stuff all over the world, both discovered and undiscovered. Peak Oil is about output, price and EROI (Energy Return on Investment). Peak Oil is therefore about the affordability of oil in terms of its uses. We may have billions of barrels of oil offshore and in the Canadian tar sands but can we afford to extract it to run cars with? Can we afford the ongoing costs of cleaning the Canadian environment after the water and energy intensive process of converting it into usable energy? What is the point of having tens of billions of oil reserves if the energy we get from it equates to the energy we have to deploy to get the stuff out? This is what Peak Oil is really about. It’s not about running out of oil per se, but is about running out of affordable oil. Thus, as is suggested by recent price action we have probably already run out of oil at $30bbl. Even an artificially induced supply glut could not force the price below $30bbl for more than a few days.

A point also missed by the many oil analysts conditioned by the artificially induced supply glut of the last eighteen months is indeed whether we have actually run out of $60 or even $80 oil. If $60 to $65 is the break-even level for US shale then perhaps this this really the current Peak Oil price level. On the other hand most of OPEC oil producing nations and Russia need oil above $80bbl in order to meet their budget and social welfare commitments. Venezuela, for example, is generally recognised as having the largest oil reserves in the world and yet is edging perilously close to failed state status. While the nominal cost of actually producing oil in Venezuela is reputedly less than $15bbl, the implications of its social programmes suggest that ten times that amount is needed to keep its government and economy above water. Perversely its output has dropped by 300k – 400kbbls/day in the last twelve months, just at a time when it needed income the most. Theft, lack of maintenance and electricity problems have all contributed and are all aspects of an economy that doesn’t work when oil prices are too low.

The point here is that the current price of Peak Oil is not necessary set by a large volume producer such as US shale. Without an increase in prices Russia could be the next Venezuela, or perhaps even Saudi Arabia. Neither economy is working effectively at $40 to $50 oil; both are depleting reserves to keep their respective government and social programmes intact. Both need prices to rise before they effectively run out of reserves. With a prolonged period of low prices there is more than a chance that they will be forced to either borrow substantial amounts or face a Venezuela style meltdown which could have similar and concomitant impacts on oil output.

Where then is the actual 2016 Peak Oil equilibrium price? We know that it is above the $25 – £30bbl range; the market has already told us that. But when we factor-in all the political and economic dynamics of the oil market, is it actually $60, $80 or even above $100? Notwithstanding shale it is clear that the recent surplus is anomalous and artificial. Not only has output and pricing strategy created short term difficulties but it has also sown the seeds of a more structural supply deficit in the 2020s. The oil business appears to need prices in the $80 – $100 zone to justify ongoing investments in exploration and field development and to keep OPEC economies afloat in 2016. Unfortunately, not only have the low prices of the last eighteen months curtailed shale oil investment but conventional and offshore E&P (exploration and production) has also plummeted. This recent lack of investment in E&P will have consequences in the early 2020s and possibly even sooner. Watch for the headlines to switch from forecasts of oil at $25 (even $10bbl!) to oil at $150 or even $200bbl.

So why do I as a change and transformation specialist take such an interest in oil? I see the oil industry as something of a nexus point. Oil remains our most important commodity and still provides the energy that powers the world. Significant changes in the availability and price of oil have dramatic and often fairly immediate consequences for economies and organisations working within those economies. A global shortfall in output of a two or three million barrels of oil per day will have a major impact on its price and the price of everything that relies on oil for its production. A one to two million excess of supply over demand had the effect of reducing price from over $100bbl to nearly $25bbl at one point. A deficit will not only reverse this but when availability is an issue could well power the price way beyond that reversion point. Shale output may start-up again but the investors who recently lost money on their original investment are likely to be a lot more circumspect about pumping even more billions into such a volatile industry. Iran, seen as potentially a gap filler also needs billions of external investment before it could offer the sort of output extant before UN sanctions were imposed.

Thus it is not beyond the realms of possibility that prices will be back in three figures in the coming years and potentially higher than the $140 reached a few years ago. In the absence of a shale-like saviour these prices will have major implications for how organisations will operate. They will have transform themselves to work within a new oil energy restricted paradigm. Alternative energy investment will need to be accelerated, other operating costs reduced and alternative models of operating developed. Oil stands at the nexus of business strategy and change and will continue to do so until the world truly develops an alternative energy infrastructure that significantly reduces our reliance on this highly volatile energy source.

There are many Peak Oil sceptics around but I am obviously not one of them. Shale has bought the world some time and tens of billions of E&P investment might buy us some more but from where I am standing in 2016 that doesn’t look very likely. Peak Oil may not be a ‘now’ issue but I would be surprised if we get to 2025 without it hitting the financial headlines again.

I think it is fair to say that most people in the Western world don’t actually understand what gold is all about. Over the past fifty years we have been inculcated into believing that it is a material used for personal adornment or perhaps as a minor industrial application. Very few now think of it as money.

My own interest in gold started around the mid-2000s, a few years before the 2008 banking crisis. Ironically the article that actually piqued my interest was about silver rather than gold but the two are usually referenced as behaving in a similar manner. I had some funds to invest and had started to undertake some research into potential targets. My journey through various funds, investment trusts, equities, bonds and all the other potential resting places for a substantial but not life-changing pot was often punctuated, or perhaps diverted, by discussions about gold. And so it started.

When Nixon reneged on the U.S. commitment to maintaining a gold-backed currency in 1971 the West effectively entered the modern era of ‘fiat’ money:

https://www.youtube.com/watch?v=iRzr1QU6K1o

There are currently no currencies directly backed by gold which is one of the reasons why we often see some dramatic volatility in their relative values. What a currency is worth is driven by a whole host of factors, the sum of which equates to traders’ perception of its value. The US dollar (USD) has increased in value by 15 – 20% over the past eighteen months against a basket of currencies, while the GBP has dropped five or six percent against the USD in recent weeks. There are lots of reasons for these moves but they all add up to a view that the USD is a ‘safer’ store of value at the moment while the Great British Pound (GBP) is seen as a ‘risk’, partially down to Brexit nerves. Without gold as an anchor, a fiat currency can and often does go to zero. We have also yet to see the impacts of the estimated $13 – $15 trillion of ‘printing’ that has taken place since 2008. True, much has been offset by general shrinkage in the global credit markets but the fact remains that there are still trillions of freshly printed currency sitting as ‘excess reserves’ at the U.S. Fed or swilling around the financial system. In virtually every other instance of currency debasement, deflation precedes a period of inflation so we may yet see some turmoil of the inflationary kind.

Which brings me back to gold which is often seen as a bet against price inflation; Kyle Bass, a famous hedge fund manager, has also suggested that: “buying gold is just buying a put against the idiocy of the political cycle. It’s that simple!” Gold haters tend to draw attention to the fact that gold doesn’t usually pay any interest. This is true but has become a somewhat academic point in Japan and parts of Europe where ‘negative interest rates’ are paid. A bar of bullion is a far more attractive prospect than a commitment to pay the bank interest for holding your money. Thus the ‘war’ between the fiat ‘paper bugs’ and ‘gold bugs’ has started to switch direction.

A few years ago Ben Bernanke, the former U.S. Fed Chairman, was asked by libertarian congressman Ron Paul whether gold was money:

https://www.youtube.com/watch?v=2NJnL10vZ1Y

His response was both entertaining and illuminating. Entertaining in the fact that the subject of gold is taboo in central banker circles and illuminating in the bizarre nature of the response. Bernanke did not believe that gold was money and yet admitted that the 8,000 tons or more held at Fort Knox and West Point is held as a matter of ‘tradition’. This tradition has been more than kept alive in recent years by central banks in Russia, China and other Asian states who seem more than happy to exchange their US dollar treasuries for a ‘harder’ asset like gold. On a net basis since 2008 central banks have actually increased their gold reserves with China reputedly acquiring multiples of the amounts they have actually declared. So although ‘officially’ the USD remains the most liquid and ‘hardest’ of fiat currencies if you want to preserve wealth and value for the longer term then gold would seem to be the only option, especially in a world where a few billion Indian and Chinese people hold a slightly more traditional view. Paper currency may be OK to buy the groceries but if you want to preserve wealth for the next generation, gold is the only game in town, even land and property is secondary.

Whatever its appeal fully investing in gold is just as much of a risk as going ‘all-in’ to any asset class. The better known investors will usually suggest that a proportion of your portfolio should be invested in gold. This proportion seems to vary from around 5% to a maximum of 20 – 25% at the more extreme end. None suggest anywhere near 100%. The gold element of my own retirement fund is a fund itself, investing in the ‘majors’ (mining companies) in the gold sector. Since reinvesting my portfolio in the latter half of 2015 it has outperformed all of my others (up 27% in six months) and forms a disproportionate element of the overall fund, which now requires some realignment. After 3 – 4 years of appalling performance we seem to be seeing a new bull market, at least in the mining stocks themselves. Nonetheless you have to look at it in context. Gold increased more than six fold between the early 2000s and 2011 but then dropped by over 40% subsequently. Even today it is still 36% below its 2011 peak.

As with most other major commodities gold is priced in US dollars. Thus a miner operating in South America will substantially benefit if the USD moves up against a local currency. For example, a producer in Chile incurs costs in Pesos but will benefit from gold revenues priced in USD. In recent years the Peso has decreased in value from around 450 to 730 to the USD.

http://www.xe.com/currencycharts/?from=USD&to=CLP&view=5Y

Furthermore, the price of oil has decreased from over $100 to around $40bbl. It is not therefore surprising to see the large gold miners show some dramatic increases in prices over the last six months, despite the fact that gold still languishes in the $1200 – $1300 band. The ‘smart money’, the early movers, have already identified the potential and have taken positions; the institutions are no doubt checking the sector out and a year or so from now perhaps the ‘retail’ investor will take notice. Even now the gold sector is still down about 80% from the highs of a few years ago, when gold hit $1900/oz; it trades at around $1220 as I write this.

One aspect of gold that causes considerable distress to the ardent gold bug is that COMEX, and to some extent the LBM paper markets. Most gold today is traded as a contract rather than as a physical transaction. What this means is that ‘paper gold’ can be created at will to meet market demand. The market seems to work on a fractional basis or leverage. So long as there is enough physical gold to meet the claims of those actually wanting physical, the market can continue without any significant disruption. In the past year the ratio of claims to actual physical has been in the 350 – 400 region which obviously creates a certain amount of risk for participants. Commercial traders appear to remain unconcerned about this situation and continue to take short or long positions in the commodity, mostly rolling over these contract positions like clockwork on a monthly basis. It is entirely possible that this situation could be maintained for months or even years, that is until some extraneous instability elsewhere in the financial system ripples through to the gold market. In which case all bets could be off and a rather dramatic re-pricing could be in order.

I don’t expect drama during 2016 but it does look like the four year bear market in gold has ended. There will be ‘ticks’ both up and down during 2016 but it does look like the theme of an increasing price is slowly taking hold. As at the end of March / early April 2016 the gold buying season is still some months away and yet the ‘correction’ after the Chinese New Year celebrations has been muted compared with the last few years. There will be some volatility as speculation increases on whether the FED will add another 25 basis points its rate in June although beyond that it looks unlikely that there will be any more tinkering prior to the US presidential election. A combination of a new gold buying season starting in August and a few speculation free months on the US FED funds rate should translate into a fairly robust performance in gold in the latter part of the year.

Whatever your views on gold, both on its status as a currency and on its expected performance over the next year or two, it remains unwise to ‘over-invest’, whatever the prospects. It may also help to regard of it as a form of money, whatever Ben Bernanke declares in public, rather than as simply another asset. An ounce of gold will still pretty much buy what it could in Roman times. You can’t say that for either a USD or a GBP which have both depreciated by well over 90% in the last century.

The gentleman pictured is called Datta Phuge. In 2013 he was reported as ‘splashing out on a £14,000 gold shirt in the hope that it would attract female attention’.

http://www.dailymail.co.uk/news/article-2257209/Wealthy-Indian-Datta-Phuge-spends-14-000-shirt-GOLD-impress-ladies.html

 

Not sure if it worked…..

I have recently seen a number of articles suggesting that 2016 could in fact be a re-run of 2008. In other words a financial storm is brewing but most of us just don’t realise it, or maybe don’t see it yet. As a manager of my own SIPP (Self Invested Pension Plan – a bit like a 401k if US based) it matters to me. It does to you as well although the distance between you and retirement and the distance between you and your ‘managed’ pension plan probably makes it feel somewhat remote.

I started taking a far greater interest in the movements in world markets about ten years ago. With a background in accountancy I have never really been uncomfortable with numbers, and PE ratios, EPS and dividend cover have been familiar concepts for many years. Alas it’s not really enough if you are going to directly control your own financial health, you really need to gain an understanding of the fundamentals of investing and the dynamics of markets, and possible even an insight into technical trading. I have also found it useful to try and better understand the movements of financial markets work and revisit a number of basic economic theories. On this latter point most economists have been trained in the Keynesian paradigm so the views you tend to get are filtered through Keynes economic theory. Our global banking system is also pretty much managed by Keynes followers so if you can get your head around some basic Keynes principles it is far easier to take a guess at the sort of policies they will follow when conditions change.

Central bankers were mentioned deliberately. In recent years it has become obvious that the markets have reacted, Pavlov style, not just to their policies but even to their ‘jawboning’. A newspaper article by Jim Bullard, a US FED president (St. Louis) can move markets. When the US markets react they frequently influence the European markets, sometimes even more than our own indigenous British or European central bankers. In other words there is a fairly tangible link between a US FED member opining on a local US issue and the value of my SIPP. It therefore makes sense to keep an eye on what is taking place outside the UK, in Europe, China, Japan and US.

The theme of this blog is 2016 vs. 2008. ‘History doesn’t repeat itself, but it does rhyme’ as Mark Twain is often purported to have said. This is also true of 2016 in that the US sub-prime derivative catalyst is unlikely to be the source of any problems later this year. In 2008 many of the US banks had miniscule capital ratios and the regulatory framework severely weakened. This is not the case today in that the US banks are far better capitalised, regulation is somewhat improved and the world of MBSs (Mortgage Backed Securities) is far more controlled. I would also like to think that there have been some cultural improvements in the banking system, although that of course we can’t really know until the next crisis emerges.

I do think that we have to look outside the United States for a catalyst. There are many potential candidates ranging from stability in the Eurozone banking system to Japan or China’s lacklustre economic growth story. It could be one or all of these things interacting with each other or perhaps it will be something taking place in the sovereign bond markets or instability in currencies.

Many of the change, transformation or performance improvement projects and programmes I get involved in involve identifying or improving KPIs (Key Performance Indicators) or what I call OPIs (Operational Performance Indicators), the latter being important but not key indicators. I like to apply this analytical framework to economic conditions and the markets as an aid to helping make decisions on what and where to invest.

The markets are not the economy but there is obviously a link between the two. When you get central banks interfering with markets the link is weakened but not eliminated, a good example being the QE (Quantitative Easing) fuelled extended bull cycle the US S&P has experienced until recent months. Irrespective of these interventions the bankers cannot delay the influence of fundamental economic conditions forever, so it’s useful to work through a number of global indicators to get a sense of context.

World GDP (Gross Domestic Product) is obviously a good ‘world KPI’ but it is limited in that it’s a lag indicator. It is a reasonable measure of what happened last year. More useful KPIs are those that track current activity, and two that I occasionally take a look at are the ‘Baltic Dry’ and the global PMIs (Purchase Managers’ Index).

The Baltic Dry provides a sense of world trade which is something of an analogue for global economic activity. It is not entirely reliable on a historical sense in that the boom years of the early 2000s resulted in an increase in shipping tonnage; in other words an increased supply of ships. Nonetheless, despite this distortion acting as a drag on freight pricing the index is trading at historically low levels. At its peak in 2008 the index exceeded 11,500 while today it has struggled to stay above 350.

Notwithstanding additional capacity, there has still been a massive drop in world trade, particularly in East –West import and exports.

The Markit PMI Index tracks PMI in 30 countries. It tracks output, orders prices and employment metrics and is closely watched as an indicator of forthcoming economic conditions. 50 is set as the benchmark with anything above this level suggesting better times ahead while results below indicates potential recessionary conditions. January 2016 data confirms the bear market in basic materials but still suggests that world financials and technology are still in positive territory. However, performance in in consumer services are showing signs of decline, particularly in the US:

https://www.markiteconomics.com/Survey/PressRelease.mvc/dff621d8de6144f189ab901ce430c809

Which brings me to the US. The US is still the largest economy in the world despite the economic assault of China. Whatever happens in the US economy has set the tone for world activity for decades so it’s a good idea to be knowledgeable about what is happening ‘over there’. There have been some improvements in US conditions in last few years, particularly in U3 unemployment numbers and growth. This could be changing. Notwithstanding retail, housing and car sales holding up there clouds are starting to appear on the horizon.

The US dollar may be (very slowly) fading as the premier currency in the world but it still remains the only option as world reserve and the size of its bond markets underpins its role as a safe harbour in a sea of volatile currencies. The enthusiasm for US dollar in the last couple of years can be seen in the DXY, a measure that tracks its performance against a basket of other currencies. The DXY has rocketed from 80 in 2014 to nearly 100 today:

In other words it has increased in value by almost 25% in a very short space of time. This looks like it may be beneficial to the US but it has a cost. Most of the larger US companies trade overseas and have experienced a drop in earnings as a result of local currency translation into USD. Central banks like to use the currency devaluation tool so the US FED are not likely to be particularly pleased with this situation. Import prices have dropped which means price deflation, another frustration in that the rationale for increasing interest rates is undermined. Long term it’s even worse. US debt is not only heading for $20 trillion but the value of that debt (purchasing power) is not eroding – most central bankers like to increase inflation to 2% or more as a contribution towards reducing its purchasing power. Its nominal value may be increasing but its buying power reduces if you can create ‘healthy’ inflation.

China’s growth is slowly reverting to the lower more ‘normal’ levels experienced by developed economies. It really is too large to generate the double digit growth of the past, especially when the structural impetus is to migrate from a manufacturing into a service based economy. It will be spending less on ghost cities and extravagant infrastructure but there still major initiatives such as the new ‘Silk Road’ which is attracting spend. It needs to eliminate surplus manufacturing capacity but it can’t achieve this overnight, the political risks of a social reaction to industry closures mean that it will take time to restructure.

I don’t really think that the catalyst for the next crisis will be in changing economic conditions, my guess is that it will occur in the markets. Deutche Bank’s $60 trillion derivatives book combined with its low capitalisation rate has recently been cited as a major risk to the European and therefore world banking system. Its president recently had to reassure markets about the robustness of its balance sheet while at the same time going back to the market to raise more capital. Deutche may be a risk but it’s a known risk and doesn’t yet look like the next Lehman. The markets move quickly but it probably deserves a pass at this stage.

It is the unknown or little publicised risks that are the real concern. Credit spreads, the difference between any bond and a sovereign treasury have widened over the past year. This is a concern. Wider spreads mean growing risk and they are on the rise. We are not yet at 2008 levels but we are close to dotcom bubble levels and seem to be on a clear trajectory upwards. The US FRED charts are a useful tracker, using the benchmark 10 year bond as a reference point:

Liquidity is also an issue in the sovereign bond markets in that the central banks have been buying up government debt across the world at an unparalleled rate. Perversely, the policy of central banks buying up sovereign debt and sucking liquidity out of global markets may in fact become a catalyst for a crisis. Japan’s bond market is one to watch with this in mind.

I believe that gold is really a currency despite the PR of the last forty or fifty years. It still trades as a currency pair and is still stored in the vaults of most central banks as part of a country’s currency reserves. In recent years most central banks outside of the West have been buyers of gold, particularly China, whose gold reserves are officially less than 2000 tons but unofficially estimated at anything up to 30,000 tons.
It is not the price of gold that I track as an indicator but the gold/silver ratio. In the past when the gold/silver ratio has got to 80 or more we have had some form of crisis. In 2008 the ratio hit 83, in other words one ounce of gold bought 83 ounces of silver. Panic in the markets drove investors into gold so its value relative to other commodities rapidly increased to crisis levels. Silver is a form of money as well but it also has an industrial aspect and it’s this aspect that manifests itself when crisis conditions are apparent; gold is the behavioural driver of the ratio.

The worrying point at the moment is that the gold/silver ratio is almost at the 2008 peak:

It closed on Friday at 83.04 vs. the 2008 high of 83.86. If it were the only indicator of stress on the credit markets we would already be in a crisis situation. Fortunately, it is not a widely used indicator and is usually reactive to conditions rather than a driver of behaviour. At the moment I see it as a fear indicator, and perhaps the reaction of disaffected currency holders in nations where negative interest rates reign. Gold is often cited as not paying any interest but it’s a far better investment than a bank account in a world where you have to pay a bank to hold your cash.

So, in summary I don’t see an imminent Lehman type moment but there are concerns both in the fundamentals of economic activity and in some of the market indicators.

2016 may not be 2008 just yet but then again we are only two months into the year, and there is that small matter of a Brexit vote which could make things very interesting in May and June. Volatile markets look like a certainty this year, whether or not associated with a true crisis.

From June 26th 2012)

Rob Kirkby’s June 2012 blog article, ‘The Greatest Hoax Ever Perpetrated on Mankind’, recently caught my eye:

http://news.goldseek.com/GoldSeek/1339766400.php

It is one of those arcane areas of Finance that really ought to have a little more light shed on it, and probably should be written about much more than it has been. It may be a complex subject and prone to ‘buzzword bingo’ but we ought to persevere. Most people will be out of their comfort zone when exploring the ramifications of derivative trading and I am no exception. However, we should never be afraid to learn or ask questions.

So here goes.

The BIS (Bank of International Settlements) produces a half yearly report of the total number of global derivatives believed to be in existence at the end of a reporting period. The report dated 9^th May 2012 had the following comments on ‘key developments in the second half of 2011’:

‘Notwithstanding the increase in the reporting population, total notional amounts outstanding of OTC derivatives declined between end-June and end-December 2011, to $648 trillion. At the same time, gross market values, which measure the cost of replacing existing contracts, increased to $27 trillion, driven mainly by an increase in the market value of interest rate contracts.’

http://www.bis.org/publ/otc_hy1205.htm

So it would appear that we had $648 trillion of derivatives in place at the end of 2011.

Drilling further into the detail we find that of this $648 trillion, the largest element is that of interest rate derivatives, and of those nearly $403 trillion are ‘Interest rate swaps’:

http://www.bis.org/statistics/otcder/dt07.pdf

My feeble and amateur understanding of a credit interest swap is basically that of an exchange of cash flows between two parties. It might be to change a flow based on a fixed rate of interest to a variable rate, perhaps to exploit arbitrage opportunities, or maybe hedge risk in currency based transactions. The purpose and variety of these instruments appears to be almost limitless; each derivative being created pretty much on a bespoke basis to address a specific financial objective.

It stands to reason that as they are ‘binary’ on an individual basis then one of the two parties will be ‘in the money’; one wins, the other loses. Somebody has to take the other side of the trade.

Now this is where I start to have a bit of a problem. Either I need to better understand these things, or something about the whole derivative construct does not add up.

Let’s move on to the banking system, the ‘Big 5’ U.S. banks. I am not comparing ‘like with like’ from a definition perspective in switching from BIS tracking to OCC tracking but that is not really germane to the point I want to make. Limitations and inconsistencies acknowledged, let’s move on.

At the end of March 2012 the total notional amount of derivative contracts for the top five U.S. banks stood at $292.4 trillion:

http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq112.pdf

This is an aggregate amount and includes those defined as ‘interest rate swaps’ by the BIS. ‘Swaps’ remain the largest category within the OCC data definition at $168 trillion.

Now this is where my brain starts to seize. The total capital base of these same banks amounts to $8.2 trillion, and this plays an aggregate $292.4 trillion derivative book. Irrespective of whether we are looking at an element of this total or the total itself I cannot believe that the total net exposure between all the banks within the global derivatives market is zero, even less the case for the five largest banks. Are we to believe that the collective banking mind is coincidentally split 50/50 on its global perspective on future interest rates and future FX trading conditions?

The question for me is really one of how much the net exposure of these banks exceeds their aggregate capital base. Is this now the real role of the Exchange Stabilisation Fund, to act as an amelioration element within the global derivatives market?

As implied by Rob Kirby you either believe:

a)    That everything eventually nets out to zero.

b)    There is an unseen force acting to maintain long term stability.

His ESF argument is starting look plausible.

Far smaller in size but perhaps of more interest to those of us interested in gold and silver is the value of the notional amounts of gold and precious metal contracts at the end of March 2012. According to ‘Graph 8’ this totalled around $153bn for gold and $33bn for other precious metals. However, care is needed in recognising the note: ‘Figures above exclude foreign exchange contracts with an original maturity of 14 days or less, futures contracts, written options, basis swaps, and any other contracts not subject to risk-based capital requirements.’ Refer also to ‘Table 9’ which provides a breakdown by the ‘Big 4’ banks. With $117.4bn in gold and $18.5bn in ‘precious metals’ it will not be a surprise to find that JPM is by far the largest derivatives player in the PM space.

I don’t draw any new conclusions from this other than that it is a confirmation of what we already know: JPM’s PM derivative positions are extraordinarily large and they don’t seem to have any obvious counterparties. Are they supposed to be hedging against themselves, other market derivatives, or is someone else pulling the strings for purposes we can only speculate upon?

The more I learn, the less I seem to understand.

From June 8th 2012

I recently tripped over the almost-forgotten story of the September 1931 Invergordon Mutiny. As part of a government austerity drive, to deal with the effects of the Great Depression, the British Government instructed the Navy to impose a pay cut of 10% across the board, and 25% on certain junior ratings. It was poorly communicated and naturally provoked a reaction, which itself wasn’t particularly well handled.

Mutinies had always been very rare events within British naval history, and so it came as something as a shock to the wider community when news finally filtered through. Indeed, by the time it hit an already unsettled Stock Exchange it caused a panic, which of course rapidly rippled through into the currency markets. Despite an ultimately successful imposition of a flat 10% cut, confidence in Great Britain, its government and currency had been irreparably damaged; it caused a run on the Pound. On September 20^th 1931, less than ten days after sailors had read about their pay cut in newspapers, Great Britain was forced off the gold standard.

An apparently minor event geographically remote from our centre of finance acted as a catalyst for a tectonic shift in global power. Fast forward to 2012 and we have a level of interconnectedness exponentially greater than that of 1931. News, action and reactions are almost instantaneous; perceptions are reality and markets can be moved with a carefully worded phrase.

We are overwhelmed with an almost infinite universe of choices for what might be the actual catalyst for systemic collapse, some more obvious than others. It is as likely to be the less obvious as the obvious. After all the obvious are being managed, those ‘known knowns and known unknowns’ are almost certainly being choreographed towards what they hope will be a least-worst outcome. The lack of action from the ECB, MPC and FED this week is more likely to be part of an ongoing crisis management strategy, than an attempt to telegraph an air of confidence in global recovery. ‘Not now, maybe later’; ‘it’s too early to tell’. All focused on economic recovery elements, rather than the real issue; a debt laden and failing Europe, the herald of global failure. The trigger may not have been pressed but the bullet is in its chamber.

Spain the state may be bailed out, and the associated austerity imposed may well guarantee negative growth for a number of years, perhaps a decade. As with Greece, Ireland and Portugal, the credit markets will effectively close to them, rendering an indeterminate reliance on the Eurostate. It will be managed; it’s a known unknown, unknown only at the quantum level. ‘Experts’ may guess at €400bn but the Eurostate propaganda will ensure that the amount will be significantly less. Perception is reality.

It’s the stuff not being talked and reported about that we should be worrying about. It suits many in the City and on the other side of the pond to maintain focus on Spain, Greece, Ireland, Portugal and next on the block, Italy.

Meanwhile, other financial cancers eat away at the integrity of the system. The masses are not aware of the problem, and those that are think they are in remission. The collapse of credit within the shadow banking system never made it beyond the secondary media, out of sight but continuing to shrink. A lack of transparency in the $600 trillion global derivative market remains unreported. Four years after Lehman CDS’s remain un-backed by capital and continue to be traded opaquely, off any recognisable exchange on the planet. Commercial bullion banks, having negotiated extension after extension see the ever-closing threat of Eastern demand for physical bullion heading straight for their overexposed short positions. The widely presaged volatility is already starting to occur. We were warned to expect $100 moves in gold in a single day as the systemic spinning top gyrated in ever wider movements towards its inevitable fall; we saw $66 last week. A failure in any one of these areas could unexpectedly cascade through into the global arena.

Then there is Iran, away from the headlines at the moment.

Would it suit Israel to attempt a strike coincidental with the Euro break-up dominating the media? Few nations in the Middle East want nuclear armed Iran and the patience of the Israelis in the EU brokered negotiations is not infinite. It is a known unknown that could surprise at any time with a predictable impact on oil prices and gold.

And of course we have the unknown unknowns, the ‘black swans’ ready to take flight.

What will be the Invergordon Mutiny of 2012?