Supply and Demand

May 2016

 

Summary of contents

• Prices of assets should peak or trough near the highest or lowest point of excess supply or demand.

• We appear to have gone beyond the point of excess demand over supply (due to increased building) in the residential property market and prices should therefore fall, at least relative to incomes and inflation.

• The demand for government bonds has been artificially distorted by central bank purchases which in the UK account for 35% of those in issue. It is reasonable to assume that prices will fall substantially when central banks attempt to dispose of these bonds and/or interest rates rise.

• In the fourth quarter of 2015 US companies were paying out more in share buy backs and dividends than they generated in operating earnings. Expect stock markets to significantly fall in value.

• Due to a fall in oil exploration activity, explorers found the lowest level of annual volume recorded since 1954. Expect prices to rise.

• Committed copper mine supply (operating mines and firmly-committed projects) will be insufficient to meet primary demand by 2018. Expect prices to rise.

• The current investment allocation of world institutional portfolios to gold is a tiny 0.55%. Historically the average has been 2% and the peak 6%. Expect prices to rise.

• Given the current ratio of Fed gold to liabilities, the equivalent price today is $23200 per ounce.

• Based on the M1 money supplies of China, the Eurozone and the US and with 40% gold backing, the implied non-deflationary price of gold is $10000 an ounce.

• $2.3tn of excess reserves in the US banking system is capable of creating inflation of 1600 (one thousand six hundred) %.

• Interest rates are now around 4% behind the Taylor Rule, a situation that has historically led to much higher rates of inflation.

• An alternative and interesting way of looking at the savings glut is that it is deferred economic growth.

• Your perseverance will lead to great success and the rewards will be more than monetary because you will have learned what it takes to be a great investor and that is a lesson that will last a lifetime and a lesson only a small number ever attain.

 

Supply and Demand

As most investors should know a chief determinant of price is the balance between supply and demand. The elasticity of prices can also be important – the responsiveness of supply and demand to prices. In a world that has been artificially distorted by historically high levels of debt (i.e. money), huge supply and demand imbalances have been created. Some aspects of these imbalances and the manner in which they affect prices are I believe deceiving investors into believing that prices will continue in the same direction, purely because there continues to be an over/under supply or demand. What helps determine price direction is the extent of the over supply or demand – by this I mean that prices will peak close to the point at which demand most exceeds supply and as the balance is redressed (the excess of demand over supply reduces) prices will fall even though there continues to be an excess of demand. They will trough close to the point at which supply most exceeds demand and as the excess of supply over demand diminishes, prices will rise. So let’s consider each of the major asset classes using this simple supply/demand rule, beginning with the asset most widely considered to be in short supply – residential property. Just to keep the whole report compact, I will add into each category any other comments on current market conditions.

 

UK Residential Property

The UK population is currently growing at the rate of 0.6% per annum. Housebuilding in the UK has been steadily in decline since the 1970's levels of over 350000 per annum to around 120000 in 2008. Last year the figure had grown again to 190000. Whilst this figure is still short of the required level of growth for the size of our population, the trend is beginning to reverse and so therefore should prices. With a little help from rising interest rates which should occur over the next couple of years and continue for perhaps a couple of decades, house prices should fall – at least relative to incomes and perhaps inflation. Consequently, investors should not expect to make significant gains in this sector even if they are buy to let investors where legal, stamp duty, taxation and maintenance costs will eat into some of the gains from income.

 

Bonds

The counterpart of debt is credit and so the creditors of the world have been saving their credit and investing into supposedly safe bonds (loans made to both governments and corporations). Supply/demand ratios for this market are grossly distorted, for example, in the UK the Bank of England owns 35% of government debt through quantitative easing (QE). What will the price of these bonds be when central banks attempt to sell these bonds and/or interest rates rise? It is reasonable to assume that these bonds are significantly over priced. Indeed, considered as risk free assets, most other conventional assets are priced around these bonds (you can expect a higher yield for taking more risk in property and stock markets) and consequently as the bonds are repriced so should be property and stock markets.

 

Stock Markets

I have mentioned on several occasions that companies are borrowing money (that investors are lending to them) with which they are buying back their own shares. Thus investors are doubling up their leverage risk by investing into corporate bonds which are being used for buying back shares to pump up the share price. By the fourth quarter of 2015, companies in the S&P 500 Index were using more money than they were generating in operating earnings to pay dividends and buy back shares. Thus they were eating into capital in order to maintain this masquerade. When investors stop lending to companies and/or profits fall more than is being offset by the dividends and share buy backs, the circus should end and stock markets should collapse. Buying conventional shares today is not investing it is speculating.

 

Stanley Druckenmiller - the man who advised George Soros to sell the pound in 1992 and who achieved returns of 30% per annum before closing his funds to the public in 2010 and running them as a family trust – 'what part of 'get out of the stock market' don't you understand.'

 

Andrew Williams, Schroders – 'With today's valuations, the only way investors stand any chance of achieving portfolios that are attractively valued by historical standards is if they are willing to diverge significantly from benchmark indices. As the wider market continues its hunt for supposed safety and stability, that is where the real investment opportunities are now going to be found.

 

 

Albert Edwards, Societe Generale – 'The widening gulf between even 'moderately scrubbed' MSCI trailing operating earnings and 'heavily scrubbed' US GAAP (Generally Accepted Accountancy Principles) earnings shows that US corporates are increasingly trying to manipulate figures to camouflage the fact that they are suffering from earnings recession. This kind of gulf between unadjusted and adjusted earnings is typically seen before a recession. This trend can't last forever because 'the stock market eventually stops reacting to the manipulated pro forma earnings and slumps in line with what is really happening'. It ends with investors accepting that they can pretend no longer and profits are sliding into recession. It ends as the equity market spirals into a deep bear market as company management reach the end of the road in the face of the recessionary conditions and kitchen sink years of EPS (Earnings Per Share) manipulation ...It ends with investors losing faith with the Fed as the resumption of QE (Quantitative Earnings) proves ineffective in reviving the economy. It ends in deeply negative interest rates, currency and trade wars, helicopter money and ultimately inflation. In a nutshell, it ends badly.

 

Research shows that it is more important to miss the most volatile periods within stock markets - the days of the highest rises and falls – as it increases returns in the S&P 500 over 30 years by 43.2% rather than staying invested.

 

Energy

Every investor should know that currently oil supply exceeds demand. But that over supply is only around 1% and can be corrected very quickly. Oil explorers found 2.8bn barrels of crude and related liquids last year, according to IHS, a consultancy. This is the lowest annual volume recorded since 1954, reflecting a slowdown in exploration activity as hard-pressed oil companies seek to conserve cash. If the rate of oil discoveries does not improve, it will create a shortfall in global supplies of

about 4.5m barrels per day by 2035, Wood Mackenzie said. Paul Kibsgaard, chief executive of Schlumberger, the world's largest oil services company, told analysts last month: 'The magnitude of the exploration and production investment cuts are now so severe that it can only accelerate production decline and the consequent upward movement in the oil price. China is filling up new sites of its strategic petroleum reserves at a record pace. Its oil imports have jumped to 8m b/d this

year from 6.7m in 2015, soaking up a large part of the global glut. The international energy agency forecasts that Chinese petrol demand will jump by 8.8% this year and jet fuel by 7.5%.

 

Commodities

The bell weather of the global economy and all metals and one of those in most over supply has been copper. CRU’s long term market outlook finds that committed mine supply (operating mines and firmly-committed projects) will be insufficient to meet primary demand by 2018 and new projects needed before the end of the decade. Expect prices to rise before then.

 

Gold

According to the World Gold Council, the current investment allocation of world institutional portfolios to gold is a tiny 0.55%. Historically the average has been 2% and the peak 6%. New gold production amounts to around 2% per annum. So, despite a seventeen year bull market in gold (which we have fully participated in), I expect gold to rise considerably in value over the next five years due to a significant increase in investor demand and I am not the only one to think so:-

 

Stan Druckenmiller - 'Gold remains our largest currency allocation'.

 

 

 

 

Myrmikan Research – 'By the end of the Great Depression in 1941, the dollar was 84% backed by gold. Similarly, at the height of the Bretton Woods credit bubble in 1969 the ratio of Fed gold to Fed liabilities fell below 10%, but by 1981 the price of gold had risen to a level whereby the Fed's gold backed its liabilities by 135%. Given the current ratio of Fed gold to liabilities, the equivalent price today is $23200 per ounce. These figures are not an equilibrium value; they are the limits of how far

the dollar declined at the end of two massive credit bubbles. Our bubble is significantly larger, which is why when the market finally places a margin call on the Fed, gold will trade at these levels, perhaps higher, though only for a brief moment. The equilibrium price is anywhere from $5500 to $9000 per ounce.'

 

James Rickards – 'Based on the M1 money supplies of China, the Eurozone and the US and with 40% gold backing, the implied non-deflationary price of gold is $10000 an ounce.'

 

Inflation

Nomura Economist – Richard Koo - '$2.3tn of excess reserves in the US banking system is capable of creating inflation of 1600% (one thousand six hundred)’. Assuming that this happens over a full cycle (in my opinion, 26 years) and that the monetary base does not increase any further, inflation should average 10% per annum. That would be higher than any 26 year period including the 1970s. Liquidity is 16 x statutory reserves. Both money supply and inflation could increase 16 fold. The contradiction is that the NYU Stern business school suggest that banks are weaker. In a recession bank capital can be eroded very quickly. Whilst they have excess reserves, either the reserve requirement is too low and/or the quality of those reserves is questionable – This leads to the trap of loose policy. Any sign of interest rates higher than inflation would cause a recession because such a large amount of economies are exposed to record amounts of debt. That is why many economists are predicting significantly higher inflation – the only way of controlling inflation is higher interest rates.

 

The Taylor Rule is a monetary policy rule which stipulates the interest rate that is required in response to inflation, output and other economic statistics. Since 1990 in the United States, interest rates have closely matched the Taylor Rule until 2010. Interest rates are now around 4% behind the Taylor Rule, a situation that has historically led to much higher rates of inflation. Wage growth is also ahead of inflation around the globe and that should also lead to higher inflation – wages are ahead of inflation by 4.2% in the US, 1.8% in the Euro area, 5.8% in China, 1.5% in Japan and 1.75% in the UK.

 

The latest Credit Suisse Global Investment Returns Yearbook looks at periods of rising and falling interest rates since 1913 and reaches the following conclusions around rising interest rates. Inflation tends to be 2.1% per annum higher than during periods of falling interest rates; US real equity returns are 7% per annum lower, US real bond returns are 3.3% per annum lower and the US currency 2.3% per annum lower.

 

The Savings Glut

An alternative and interesting way of looking at the savings glut is that it is deferred economic growth. There are currently global net savings of $400bn (mainly in Japan, Germany and China). China is rebalancing towards consumption, Germany is not but it may be forced to save its banks and Japan is desperately attempting to create inflation which would normally create a general propensity to spend rather than save. The US is the world's largest consumer and a lower dollar should increase inflation. Collapsing roads, crumbling bridges and poisoned water systems globally have created $4tn of lost output. Expect an improvement and if not by governments then by central banks investing directly into infrastructure projects. The ECB could use QE to buy bonds issued by the European Investment Bank for infrastructure spending.

 

 

 

Behavioural Finance – Fred Hickey, The High Tech Strategist – an email sent to his son via his wife who had received an email from their son in January expressing concern that he had been pouring his savings into gold shares with little to show for it other than losses – 'Dad says the kind of pressure you are feeling is the same pressure that forces people to make mistakes and sell low – typically at the bottom – and that includes many professional investors. He is constantly reminding people they should divert their attention from the temporarily low prices and not to be looking back at portfolio values. So much investing is psychological – knowing how to handle your emotions. Everyone knows ultimate success in investing is buying low and selling high. In reality it is nearly impossible in practice to do. The smartest people in the investing world are on our side. They are patient investors, but they are few in number. Dad has been through these periods before so it is easier for him because he knows what is on the other side of the rainbow. For newer investors like

yourself, who have not yet experienced such a gruelling, grinding process, it is very difficult. Ultimately, your perseverance will lead to great success and the rewards will be more than monetary because you will have learned what it takes to be a great investor and that is a lesson that will last a lifetime and a lesson only a small number ever attain.'

 

Jim Rogers – Such is the energy of the man that one former colleague suggested that by the time Mr Rogers decided to retire in 1980 aged 37, leaving the Quantum fund he had founded with George Soros in 1973, he had done the work of six people. Part of his success is that early into his career he recognised that conventional wisdom was nearly always wrong. 'When I went to Wall Street I saw

all these people who were older and more experienced and I assumed they had to be smarter than me. I quickly learned, however, that they knew no more than I did. Moreover, many of them were wrong.'

 

 

The views reflected herein are those of Vertis Private Wealth Management Limited and should not be regarded as a recommendation to invest in any one product or service; before investing you should always consider personal investment advice.

 

Where you seek the advice of Vertis Private Wealth Management Limited we continually monitor markets and will advise you where there is a change in the findings of our research and provide advice and guidance on any alterations that may be required to the investment strategy that we have previously recommended.

 

Vertis Private Wealth Management Limited does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.

 

Vertis Private Wealth Management Limited – May 2016