On Target Newsletter
2022.04.24
In this issue:
- Global recession scare,
- Smart low-cost investing,
- War in Europe,
- Investing in diamonds,
- Australia,
- Russia’s rouble rebounds,
Props of the Global Asset Boom Are Crumbling
A classic global recession scare is gathering momentum.
Inflation in the major economies is the highest it has been for 40 years, and is still rising. Shortages of fossil fuels driven by “don’t invest” climate mania and spin-off of the Ukraine conflict have sent energy costs sky-high. Interest rates are rising – the yield on ten-year US Treasury bonds has climbed to 2.85 per cent. Technology stocks, long-time investors’ favourites, are under pressure, as are emerging markets. After-effects of the pandemic such as the destruction wrought to major industries linger on, with continuing shutdowns in China.
Yet stock markets on the whole remain remarkably resilient. What’s going on?
For decades central banks have pursued policies of easy money. Investors have become addicted to it. Giant businesses have been built on foundations of abundant credit, ignoring profits in a hunt for growth. Without facing any risk from inflation, central banks have been free to keep politicians, consumers, businesses and investors happy without needing to inflict the pain of cutbacks. When we were shocked by the surprise arrival of Covid-19, governments were able to react with countering stimulus measures on an unprecedented scale. No one objected.
Now things have started to change. Inflation has arrived. Central banks have awakened to the return… at last… of their traditional enemy of rising prices. The prevailing view is that they now must pick between poisons: either they let inflation become embedded in social psychology, and risk a self-feeding dynamic; or they take drastic action before matters get out of hand.
Although what they’re saying suggests their opinion is shifting towards the latter — earlier, more aggressive tightening, reversing bond buying and raising interest rates – it’s clear that investors on the whole don’t believe that central bankers will follow through. That when tightening starts hurting enough to pose significant risk of recessions, they’ll forget about fighting inflation and revert to easy money.
We shall see. Early signs are that policy is moving towards economic contraction. There is a sharp slowdown in money supply growth in America, with parallel moves in Europe. Slowing money growth implies that inflation will come down of its own accord gradually, without the need for a violent squeeze by central banks.
The Wu Xia shadow rate used by independent analysts to measure Federal Reserve
policy has signalled nine shifts towards tightening since November.
The University of Michigan’s consumer sentiment index has dropped as low as it has done at the onset of every recession for the last half-a-century. The New York Economic Cycle Research Institute’s leading indicator of economic growth has fallen below zero. These signals imply that the underlying props of the Wall Street boom are crumbling.
The Research Institute’s Lakshman Achuthan says the Fed is succumbing to the perennial mistake made by central banks – having let inflation run loose, it is now jamming on the brakes too hard… after the economic cycle has already turned down.
In previous episodes, the Fed blinked (reversed policy direction) whenever the S&P 500 index fell by 10 per cent or so. This time inflation is so high that it might not blink until equities have fallen by 20 per cent, even 25 per cent. It will stick to its script “until there is broken crockery everywhere, meaning either a stockmarket crash, or a recession, or both,” Achuthan says,
Smart, Low-Cost Investing for Non-US Expats
By Chad and Peggy Creveling
While Americans are taxed on worldwide income and assets and are actively discouraged from holding investments outside the United States, expats who aren’t Americans can often realize substantial tax benefits from investing in offshore markets.
They are typically not taxed by their country of citizenship on income and assets held outside their home country.
This creates a substantial benefit and a huge incentive for non-US expats to move their investments to one of the offshore centers. Doing so allows them to save tax and to potentially access a greater array of investment opportunities than exist in either their home country or the one where they work.
The Problem of “Cowboy” IFAs
Until relatively recently, the only way expats could gain access to the offshore markets was through armies of lightly regulated or unregulated independent financial advisors (IFAs). These IFAs, who had varying degrees of experience and professionalism, acted as a direct sales force for the various product providers located in the offshore markets.
Unfortunately, what expats saved on home country tax they typically more than paid away in fees on high-cost, complicated, non-transparent investment products. In some cases, they were subject to outright fraud and embezzlement by “cowboy” IFA outfits.
Fortunately, expats now have better options. The rise of global brokerage platforms such as Internaxx, Interactive Brokers, and Saxo Bank afford expats the opportunity to build low-cost, globally diversified investment portfolios in a highly regulated environment. Expats retain the tax benefits of investing outside their home countries without incurring excessive fees or enduring poorly regulated financial salespeople masquerading as advisors.
Here are some of the key benefits of using a global discount brokerage platform such as one of the above:
Lower product fees: The typical offshore mutual fund has high annual expenses running up to 2% and more. Additionally, there can be front-end fees of between 3% and 7%. Insurance-linked investment products can be even more expensive, with several layers of fees that can total 4% or 5% annually, not including front-end fees, which are often hidden in the bid-offer spread.
Using a global broker, expats can build diversified portfolios with exchange-traded funds (ETFs) and lower-cost mutual funds for fees that range from 0.15% to 0.25% on the lower end. These savings on product and portfolio fees go directly into your pocket.
Greater product choice: Global brokerage platforms provide an integrated platform that makes it easy to trade global investment products on multiple exchanges and assets denominated in multiple currencies from a single account. For example, Interactive Brokers allows you to trade on over 120 exchanges around the world, providing direct market access to stocks, options, futures, forex, bonds and ETFs from a single account that can be funded in multiple currencies.
In contrast, most IFAs provide access to the same high-cost funds and insurance-linked products from a relatively small number of offshore fund and insurance firms. It’s unlikely that you’ll ever see one of these product salespeople recommending a diversified portfolio allocated among low-cost ETFs.
No lock-in or surrender fees: Many insurance-linked investment products sold in the offshore market impose a surrender fee that can last five to seven years or, in the worst cases, many more. Lengthy lock-in periods are designed to ensure the product provider is reimbursed for the commission it paid to the IFA who sold you the product. This locks you into a high-cost product, and since the IFA has already been paid, there is little incentive for ongoing advice.
There are typically no surrender fees or lock-in periods with investments or portfolios designed with ETFs on global brokerage platforms.
Low trading/switching costs: With many offshore product providers, and particularly with insurance-linked products, there can be substantial costs or limitations on switching funds. This can be a significant impediment to rebalancing an investment portfolio. At a global broker, investments can be bought and sold cheaply with no restrictions, which greatly reduces portfolio management costs.
Easy to integrate with a true advisory service: The traditional IFA financial service model is really a sales-driven model where IFAs act as a direct sales force for a relatively limited number of product providers located in the offshore markets. Products are sold on a commission basis, which incentivizes the sale of high-commission products and provides little incentive for proper ongoing investment management and advice.
The more high-commission products sold, the more commission earned by the IFA. As a particularly unfortunate example, see the International Adviser magazine
article “Figures Reveal Huge Scale of LM Fund Sales,” which suggests that the brokers pushing the now failed LMIM fund received up to 4–5% in upfront commission on each sale.
A global brokerage platform provides an effective, low-cost alternative for those who want to build and manage their own portfolios, but it also provides a good alternative for those who don’t really have the time, knowledge, or inclination to do it themselves.
Rather than paying high fees to access products, you can focus on getting proper investment and financial advice geared to your long-term financial wellbeing. Portfolios can be built on a global brokerage platform for a fraction of the cost of portfolios constructed from the typical investment products sold in the offshore markets.
This low-cost access to products can be coupled with an advisory service that helps you devise and manage a globally diversified investment portfolio. The benefits of this approach are lower fees and ongoing advice aligned with your long-term interests.
The next time you receive a cold call or email from someone pitching an offshore product or financial service, consider your options.
The Crevelings are Thailand-based CFAs who advise expats on personal financial planning. To learn more, visit their website: www.crevelingandcreveling.com.
War in Europe Hits Economies
The Ukraine war has sparked another global supply chain crisis just as pandemic-related disruptions had started to ease, says Rabobank.
► Large parts of the world depend on Russia, Ukraine and Belarus for basic necessities such as food, energy and metals. Europe for example not only depends on them for its energy imports, but also for chemicals, oilseeds, iron and steel, fertilizers, wood, palladium and nickel.
► Energy dependency is a particular vulnerability, now that Russia is demanding payment in its rouble currency for its exports. It is unlikely that Europe would be able to fully replace Russian gas in the short term, although most of the Russian oil and solid fossil fuels could be replaced.
► Besides energy goods, disrupted supply of pig iron and several other iron and steel products, nickel and palladium will probably have the largest impact on European industry.
► European supply chains could also be distorted via war-related production distributions in third countries. The European Union could face challenges in importing, for example, electronic circuits, from third countries requiring inputs such as nickel and neon gas sourced from the war zone.
► Germany and Italy are relatively vulnerable to the crisis because of their large industrial sectors, strong reliance on Russian energy, and in the case of Italy strong reliance on Russia for certain iron and steel imports, and gas.
Trade has come to a halt due to a wide range of sanctions, self-sanctioning (mainly by Western companies), and strongly-disrupted production and transport in Ukraine. Certain industries depend on the war zone for intermediate products. A striking example is the dependence of German car factories on parts produced in Ukraine, which has led to the closure of several of them.
Russia accounts for 37 per cent of the European Union’s imports of gas, 34 per cent of its solid fossil fuels, 28 per cent of chemicals, 21 per cent of oil, 18 per cent of fertilizers.
It is unlikely that Europe will be able to replace Russian gas with alternative supplies. There probably isn’t enough available in the short run, and there are technical constraints. Germany doesn’t have any LNG terminals to process arriving shipments from abroad, nor do landlocked countries such as Czechia. Switching to alternative fuels such as coal could be necessary next winter, but that will outrage the green lobby. Replacing Russian oil will raise costs and involve converting refineries to process replacement crudes.
Energy prices rose significantly even before the outbreak of the Ukraine war, which added to their burden and led to production cuts in energy-intensive industries, especially large gas consumers, such as those producing aluminium, zinc, steel, ceramics, concrete, bricks, glass, asphalt, paper and fertilizers.
Disruptions will certainly hit construction, a sector that has had to deal with lengthy delivery times for materials. Higher input prices can be expected to impact on margins of building companies and project developers, raising prices of projects and leading to delays and cancellations.
Other sectors that will see the costs of their non-energy inputs rise are machinery and equipment, consumer appliances and transportation, due to less steel and aluminium production.
Apart from energy commodities, the European Union depends on the war zone quite extensively for certain chemicals, fertilizers, timber, rubber and several metals. Chemicals include the carbon black used to strengthen the rubber in tyres and the ammonia used to make fertilizer. Russia is the world’s largest exporter of lumber.
The important metal at risk
There is large dependence on the war zone for different metals. It provides more than 50 per cent of EU imports of pig iron, 40 per cent of the world market share of semi-finished steel products, 90 per cent of EU imports of nickel mattes.
Nickel is an important metal at risk from the conflict. It is essential for rechargeable batteries, medical devices, automotive production, electrical and electronic equipment. It’s also used in construction and to make stainless steel. It will play an increasingly important role in the world’s electrification boom. Russia is one of the biggest exporters of nickel. Its world market has become very tight.
The world, but especially Europe, depends on Russia, Ukraine and Belarus for several key inputs to its industries and food supplies. Although they only account for 1 per cent of EU GDP, this understates their importance to value chains and food security. Apart from vulnerabilities due to direct trade between the EU and the war zone, there is the impact of trade involving third countries – particularly motorcycles, electronic circuits, batteries and electrical machines.
Motorcycle production is dependent on long, optimized supply chains and therefore vulnerable to any disruption. New machines are packed with chips and other electronics; built using steel, aluminium, plastics and rubber. Russia is a global player in production of those inputs.
Electronics require inert gases for semiconductor manufacturing. Ukraine is the world’s largest producer of the purified form of neon gas, as well as a major supplier of krypton and xenon gas.
Out of the five largest member-nations of the European Union, the most exposed to the war zone through trade linkages is Italy. It depends on it heavily for imports of pig iron, steel, ferrous products, sunflower seeds and oil. Spain is also relatively dependent on it for agricultural commodities. The Netherlands buys half its animal fodder from the war zone. Germany’s biggest vulnerabilities are natural gas, oil, nickel and copper.
Member-states with a large share of gas in their energy consumption such as Italy and the Netherlands have seen their energy bills rise substantially even before the outbreak of war. If current prices are sustained until the end of this year, gas, coal and oil bills will be nine, four and 1.7 times on average than they were in 2019.
Rabobank says the world depends heavily on Russia, Ukraine and Belarus for several key industrial inputs. The economic fall-out of the war is being felt throughout Europe through higher volatility in commodity markets, lengthened delivery times and higher prices. Highly intertwined supply chains make outcomes difficult to predict. But “according to our analysis, the German economy is most at risk to face headwinds caused by the war.”
Getting Easier to Invest in Diamonds
The announcement of diamonds as a regulator-approved investment product in the US has resonated across the industry, says Cormac Kinney, chief executive of Diamond Standard. The anticipated 1 to 2 per cent annual growth in rough diamond production over the next five years will not keep up with accelerated demand, especially now that a much broader pool of investors are indirectly competing with the consumer jewellery market for diamonds.
At present fewer than 1 per cent of transactions of above-ground diamonds are allocated to investors. The equivalent ratio for precious metals is 15 per cent. There is more institutional investment in bitcoin than in diamonds.
Eoin Treacy says the primary obstacle to investing in diamonds has always been fungibility. No two stones are the same. The relative merits of colour, shape, size, cut, clarity and fluorescence mean pricing has always been inefficient and subject to interpretation. The inefficiency of the market has kept the market for stones opaque and deterred institutions from attempting to take positions.
Additionally, diamond mining companies have been terrible performers and historically have offered very little exposure to the capital appreciation of stones.
Diamond Standard has created a solution to this problem. They are in the process of launching a closed-end fund for qualified investors and over the next 12 months will launch, a physical ETF and a related asset-backed cryptocurrency.
They have become market makers in the sub-1 carat category. Making a market in over 10,000 stones a month has allowed them to create a value curve. By partnering with the GIA (Gemological Institute of America). they have created physical ‘coins’ (cryptocurrencies) which are fully fungible in value. Even though every coin has different diamonds inside it, the total value of the stones in each coin is the same.
For the first time a diamond product is fully fungible, which greatly facilitates trading. The coins are held in HSBC, JPMorgan and Brinks vaults, so custody is assured and every coin and bar has an embedded chip for authentication. Auditing holdings is an embedded feature of the products. The aim is to record custody and trading on an asset-backed blockchain via the Bitcarbon coin.
The 1-carat diamond price peaked in 2011 and trended lower for a decade. The commodity crash and Chinese campaign against corruption and conspicuous luxury took their toll. The price bottomed in 2020 and is now on a recovery trajectory. The Diamond Standard Trust (DIAM) is pending listing.
Modern Portfolio Theory creates demand for uncorrelated assets. Since early 2020, diamonds have a .013 correlation to gold, .082 correlation to the S&P500 and .053 correlation to oil.
The uptrend in pricing and the relative merits for inclusion in a diversified portfolio will create demand. That suggests there is clear potential for institutional demand to balloon over the coming years as diamonds take their deserved position as market traded hard assets.
Oz: Great Living Standards, But Narrowly Based
There are growing doubts about Australia’s excessive dependence on what has been called its “houses and holes” economy.
The housing economy “consists of residents buying and selling property from and to each other for ever-higher prices using borrowed money in a surreal pyramid of paper wealth creation, which in 2021 hit A$9 trillion… more than four times GDP” says Satyajit Das, author of the new book Fortune’s Fool, Australia’s Choices. “This structure is narrow and risky, creating low-quality, fictional prosperity.”
The other pillar of the economy is mining wealth – non-renewable, finite resources exposed to volatile commodity prices. But fossil-fuel energy exports will be affected by emission reduction measures, for example the shift to renewables, proposed carbon taxes, and the European Union’s levy on carbon-intensive imports.
Miners already face funding pressures due to ESG investment guidelines. After the construction phase, mining creates little employment, directly accounting for only 2 to 3 per cent of total jobs.
Das says the resources sector “monopolizes capital and skilled workers, pushing up cost structures and the currency. That in turn affects Australia’s competitive position. It also creates excessive dependence on China, the major market for Australian exports. That trade relationship is increasingly fractious.”
Housing brings different risks. Astronomically high prices mask moribund wages and living standards but exaggerate housing unaffordability and inequality. Unlike business investments, capital tied up in homes does not generate income or jobs.
Australia’s household debt, primarily mortgages, is about 130 per cent of GDP – among the highest levels globally. Banks are heavily exposed, with residential mortgages constituting more than 60 per cent of their total loans… one of the highest levels in the world.
Economy diversification initiatives have had mixed results. Despite extensive government support, manufacturing has declined to about 6 per cent of the economy due to a small domestic market, locational disadvantages and high costs. Agricultural exports are victims of extreme weather and Chinese trade restrictions.
Services industries employ almost 90 per cent of the work force, with growing tourism and educational exports.
Australia is increasingly boxed in by its narrow economy. Necessary reform of the taxation system requires politically difficult decisions on expensive subsidies for the resources and housing sectors, Das says. Although houses and holes cannot sustain the country’s enviable living standards forever, they will not feature prominently in the coming federal election.
Russian Currency’s Strong Rebound
Russia has earned an additional $3.4 billion from rising prices of oil and gas sales since Ukraine invasion sanctions began.
Its currency, the rouble, has not collapsed, as some analysts predicted. In fact after losing 40 per cent of its value after invading Ukraine on February 24, it has bounced back to about the same as it was.
Countries such as India that refuse to join in the US-led sanctions policies are competing to buy large quantities of Russian crude oil at sharply discounted prices. Others such as Europeans may now be “unfriendly,” but continue to depend on Russia. The Kremlin is still earning about twice as much a barrel as prices have averaged over the past eight years. Goldman Sachs reckons its foreign trade surplus will exceed $200 billion this year.
The reason Russia doesn’t want to be paid in dollars or euros for the gas it’s selling to Europe is that it doesn’t want to be cheated — payments in those currencies are likely to be blocked under Ukraine sanctions. That cannot happen if payments are made in roubles.
Goldman Sachs forecasts that the Russian economy will contract by about 10 per cent – a bad recession, but not a collapse. Growth will recover next year. Goods no longer imported from the West will be replaced by domestic manufactures.
Putin has been building a fortress economy ever since the annexation of Crimea. Foreign funding has been negligible. Total public debt is only 18 per cent of GDP, one of the world’s lowest ratios. Over four-fifths of GDP comes from sectors that don’t require large imported contents.
LNG: The Biden administration’s announcement that it will ship an additional 15 billion cubic metres of liquified natural gas to Europe this year to replace imports of Russian gas doesn’t really amount to much. Currently Russia exports 155 billion cubic metres a year to the European Union. Europe doesn’t have the infrastructure to process the extra liquefied gas arriving by boat. Building it cannot be done in a hurry, and will cost plenty.
Where will it be sourced from? Major potential suppliers such as Qatar and Australia have long-term high-priced contracts with Asian buyers. They won’t be enthusiastic about commitments to European markets that hate fossil fuels, don’t believe in their future, and are hostile to long-term deals. Europeans will even find it difficult negotiating contracts with American suppliers, who are wary of their region’s woke obsessions.
UK to Develop a Green Energy Surplus
If Britain increases its output of offshore wind energy fivefold to 50 gigawatts by 2030, and nuclear and solar power almost fourfold thereafter, as the government has announced, it will eventually have a very large surplus of “clean” energy available for export to Europe, Ambrose Evans-Pritchard says in The Telegraph.
Currently nearly all hydrogen is “dirty” because it’s sourced from natural gas. So-called green hydrogen is made from hydrolysis of water using electricity from renewable sources such as wind, solar. It’s still very expensive, but the cost is coming down fast. Graham Cooley of ITM Power says: “We have halved our cost of production over the last three years, and we expect to halve it again over the next three or four years.”
Clean hydrogen is expected to replace the 75 million tonnes of fossil-based “grey” hydrogen made from natural gas that is used in refineries and industry. It can be stored in salt caverns to provide a back-up for renewables when there’s little wind; turned into liquid fuel for ships, trucks and aircraft; used to make steel, cement, fertilizers.
Tailpieces
Shortages: The UN Food & Agricultural Organization’s index of food prices is 34 per cent higher than a year ago following the war shutdown of supplies from Ukraine and Russia. Poor countries in the Mideast and Africa have been hit particularly hard. And the outlook is for things to get worse. 20 to 30 per cent of land in Ukraine producing grains and sunflower oil will remain unplanted this spring or be unharvested in July and August.
Food accounts for about 17 per cent of consumer spending in advanced economies, but a much higher proportion in developing countries. In sub-Saharan Africa it accounts for 40 per cent. Food price inflation is being blamed on Ukraine/Russian disruption, but it was well under way before the war thanks to poor harvests, bad weather and the pandemic.
Inflation: America’s March report — the annual figure of 8.5 per cent — was probably the peak, provided there are no more Ukraine-related shocks. However underlying inflation continues to run at above 4 per cent.
If the March figure was the peak, and if the Federal Reserve is serious about tightening monetary policy, it makes sense for fixed-income investors to buy some ten-year Treasury bonds. It Europe hawks are gaining leverage for their view that intensifying inflation suggests that the central bank’s asset buying programme should end in the third quarter, to be followed by a rise in interest rates.
Electric trucks: The cost of manufacturing a battery-powered truck will always be higher than a combustion-engine equivalent, says Martin Daum, head of Daimler Truck, the world’s largest manufacturer. Even if the price of batteries falls to €60 per kilowatt/hour, their materials alone will cost as much as all the components of a diesel-engined model. Battery packs fell last year, but still averaged €132 per kilowatt/hour. The cost of key raw materials used in modern batteries such as lithium and cobalt have more than doubled over the past year. Daimler’s long-haul electric model, the eActros, costs three times as much as its conventional vehicle.
Renewables: The key consideration emerging from the current energy crisis and consequent price shock is the immense importance of a supply which is balanced, secure and economic – and the peril in dreaming rather than facing reality, says the well-known commentator Charles Moore.
“It is not true, for example, that wind power is cheap,” he says. “If it is, why do we still subsidize it so heavily? Capital and operating expenses are high, as are the costs of system balancing and grid construction/maintenance. Nor is it true that we can rely on renewables – wind fails, the sun doesn’t shine.”
Coal: Russia is seeking alternative markets in Asia following Europe’s Ukraine-related sanctions. Although Europe is hostile to the stuff because of the campaign against fossil fuels, it imports 43 million tons a year from Russia to drive power stations. It faces international competition from Colombia, Indonesia, the US, South Africa and Australia.
Migration: The European Union plans to punish countries that refuse to accept their citizens sent back to them after illegal entry by suspending duty-free access for their exports and levying punitive tariffs. It’s a political reaction to rising anti-immigrant feeling.
Investing in land: The commodities boom, partly driven by the Ukraine war, has triggered a boom in American farmland. Values in the Midwest grain belt have risen 25 to 30 per cent in the past year.
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