Tuesday, 3 March 2015

Investors: Financial and political risks you should know about, now.

As we enter the month of March 2015, with the world's stock markets once again reaching all-time record highs and with fear apparently having disappeared from investors' psyche (as evident by the VIX), there are many reasons to get cautious. Here are a few of the more important financial, economic and political risks that should be built into any 2015 investment decision.

1. The tech-heavy NASDAQ composite index has again breached the 5,000 mark, 15 years after it did so in March 2000. At that time, it collapsed and lost 78% of its value over the next two years and ended at 1,114. The 5,000 level is fraught with danger and the downside potential hugely outweighs possible further gains. The same holds for the S&P 500 and Dow Jones index, both which reached new all-time highs almost on a daily basis over the past two months. It might be wise at this point to ignore the 'market experts' who never tire of suggesting that "this time it is different" and that the markets are still "very undervalued". Big investors are shifting their money into cash -  it might be a good idea to do the same and wait for the inevitable crash or at least a substantial correction.  
2. Denmark's central bank bought a record amount of foreign currency over the past few weeks in order to keep the Danish currency pegged to the Euro, purchasing foreign exchange equal to 9% of Denmarks' GDP. This kind of currency manipulation by Denmark is in line with the 'beggar thy neighbour' policies implemented by central banks of Canada, Switzerland, the Euro Zone, Australia, Russia, India, Singapore, Sweden and soon, perhaps China. The year 2015 is going to be marked by currency wars, devaluation, negative interest rates and central government stimulus policies aimed at fighting deflation and creating competitive advantages of one country over the the next through fiscal engineering. It may provide short-term advantages, but it is logical that if all countries engage in this behaviour simultaneously, there can ultimately be no winner.

3. Apart from the Greek financial calamity which most likely will end up in Greece's exit from the Eurozone, other sovereign states such as Italy, Spain and Portugal are still facing severe economic difficulties, deflation and massive unemployment. Spain's unemployment rate is 24% and that of Portugal and Italy between 13 and 14% and Eurozone deflation is running on-off at almost 0.5%. But the risks appeared to be spreading to the sub-sovereign level, as pointed out by  Ambrose Evans-Pritchard in The Daily Telegraph. He is referring to the Austrian province of Carinthia, which faces probable bankruptcy after Austria’s central government refused to act as back-stop for debts which is a result of the province's exposure eastern Europe and the Balkans. The Austrian federal government refuse to cover more than €10bn in bond guarantees issued by the Carinthia for the failed lender Hypo Alpe Adria and bondholders may face a 50% hair-cut and the province a possible default and bankruptcy. This pattern could repeat itself throughout other regions, provinces, states and cities with exposure to the Ukraine and its flirtation with default. Belgium's Wallonia and the Italian region of Sicily are both mentioned a vulnerable by Evans-Pritchard.

4. But Europe is not alone in facing deflation, financial crisis and more importantly, DEBT. According to the McKinsey Global Institute global debt has increased to by 17% to $57 trillion since 2007, much of it in emerging economies, but even more so in the developed world (cited by Jeremy Warner in The Daily Telegraph). The combined public sector debt of the G7 countries has grown to about 120% of GDP and that of China to 282% of GDP ($28 trillion).  While governments traditionally have dealt with debt through inflation, low interest rates  and money printing, in today's deflationary environment this does not work at so well. Warner suggests that "as global debt rises off the scale, creditors stand to take a huge hit in a threatened tsunami of defaults...only a mass default will end the world's addiction to debt".

5.  The geopolitical risks posed by Russian neo-imperialism and the rise of the radical Islam in the Middle-East, Africa and South-east Asia, cannot be underestimated and could present a disaster to even the most meticulously-planned financial portfolio.  Putin's goal of re-uniting Russian-speaking territories in the former Soviet empire, reckless military adventurism and proxy wars are eerily similar to Hitler's goals and behaviour from 1935 to 1939.  Putin will probably not stop until either he has achieved his goals or until he is confronted by the possibility of actual conflict with the NATO alliance - even then he probably has calculated that the West will not risk Armageddon to protect Latvia, Estonia or Poland. The Islamic state and its franchise partners al-Qaeda, Boko Haram, Al-Shabaab, and many sympathizers already within the borders of Europe and North America, threaten with a third world war in all but name, spanning continents and lasting decades. Apart from the threat of concerted 9/11-style attacks on Western targets, smaller cells pose a more immediate and real threat to shopping malls, airports, train stations and sports stadiums in London, Paris, Sydney, Ottawa, Copenhagen and New York.

6. The decline in the price of oil might not be finished yet. While it has dropped from $147 at its peak five years ago to about $102 last year and to $51 today, supply is still far greater than demand. Currently, the U.S. is producing and importing one million barrels more per day than it is using, pushing oil inventories to the highest levels in 80 years. At this rate storage facilities could reach their maximum capacity by mid-April, causing another drop in oil prices, perhaps to $30 or even $20.

7. The Chinese economy is slowing down dramatically, opening the way for further declines in the prices of resources and possibly dragging the world economy down with it. China is facing growing budget deficits, production over-capacity, deflation, falling real estate prices and a major credit crunch. Total credit has increased from 100% to 250% of GDP since 2007, according to Ambrose Evans-Pritchard in The Daily Telegraph, equalling $26 trillion (the same number as the US and Japanese banking systems combined). In addition, China's official annual GDP has fallen from close to 15% in 2007 to about 7% in 2014. To make matters worse, the Chinese currency is pegged to the inflating U.S. Dollar and has similarly increased its value by 27% against
the Euro and by much more against most other currencies, making exports more difficult. China has now lowered interest rates from 7% to 5.5% in an attempt to address growing fiscal challenges, but ultimately it may have to pull out currency devaluation as its weapon of last resort, something which could severely damage the world economy and send panicked investors fleeing for the hills.