Obama's Green Promise

Democrat Presidential Nominee Barack Obama in this acceptance speech in Denver promised that he would rid America of her dependence on foreign oil within 10 years. He has obviously recognized that access to resources over the next few decades is going to be the main source of international conflict. Even many who disagree with him that about the whether it was wrong to Invade Iraq, would not argue that the reason America found it had a National Interest in that country was its petroleum resources and America’s dependence on foreign oil was the imperative that drove the decision making. But how realistic is it to think that America could achieve energy independence within 10 years?

America currently consumes 20.7 million barrels a day and meets 6.9 million barrels of that consumption through domestic production. The other 2 thirds come from foreign sources. America imports 2.4 million barrels from Canada and Mexico, with the rest coming from much more unstable sources such as West Africa, South America and the Persian Gulf. Regions where you either have to deal with endemic corruption, resource nationalization or Islamic fundamentalism as a by-product of your dependence. It is obvious that given a choice you would not want to depend on the stability of any of these regions for something as important as energy security.

So what are America’s alternatives?

T. Boone Pickens believes that Compressed Natural Gas may be a substitute for gasoline. It is relatively inexpensive to retrofit existing cars to run on natural gas. Natural gas has traditionally been used as a fuel source for heating as well as electricity generation, something that it is well suited too. If large numbers of vehicles were converted to burn Natural Gas it would push up prices and the cost of home heating and electricity generation would rise.

The US currently produces 546 Billion Cubic Meters and consumes 653 Billion Cubic Meters with the shortfall made up from imports from Canada, Mexico. Proven Reserves in North America are 7.98 Trillion Cubic Meters, enough to meet current energy usage patterns for the next 10.3 years. If you converted half the cars in America to run on Natural Gas that reserve would be depleted in 6.7 years. So while this may be a short term solution that can buy some time, it does not solve the problem.

America is abundant in Coal Reserves, enough to last 234 years at current production. Unfortunately coal does not lend itself to easy use as a clean transportation fuel. It has to be converted into something else. It can be turned it motive power either by converting it to a liquid which is a fairly expensive process or used to generate electricity which could be stored either as Hydrogen by releasing the Hydrogen in water or by storing it in a battery.

Most Hydrogen that is currently produced is done by “cracking” it out of Natural Gas. Cracking it out of water is a much more expensive proposition. The main obstacle to the widespread use of hydrogen as a fuel source whether in fuel cells or in internal combustion engines is that with currently available commercial technology it is a very expensive fuel. There is however new technologies that are under development that promise to produce greater volumes of Hydrogen for a given amount of electrical input. If these technologies realize their promise this may provide one of the long term solutions.

The other technology that shows a lot of promise is new Battery Technologies. The main drawback to the widespread adoption of electric vehicles has been that Batteries are heavy in relation to their storage capacity and that they take a long time to recharge. Though most Americans have a daily commute of less than 60 miles they have been reluctant to buy vehicles that need to be recharged for 5 hours after only covering 250 miles. The two problems are being solved by using nanotechnologies to make better Lithium Ion Batteries. The latest technologies promise batteries that can give vehicles a range of over 250 miles on a single charge and can be recharged in as little as 5 minutes. They also can be recharged over 50,000 cycles meaning that they will probably outlast the car itself.

The technologies needed to meet Barack Obama’s goal of energy independence in 10 years are either commercially available or in the development stage. Technologies such as “clean coal” as well as renewable technologies such as wind, solar, geothermal and wave are all viable solutions at the right price. When confronted by the Arab Oil embargo in the 70’s, President Ford, proposed that the solution to end America’s dependence was to keep fuel prices high. The high prices would lead to increased conservation and provide an incentive for the market to create solutions. But as oil prices declined in to the 80’s all worries about energy security where pushed down the political agenda. It is awfully difficult to get people to see the problem when they can fill up their tank on the cheap.

If the government put an import tax on oil imports from outside the NAFTA countries and gradually increased it in a predictable fashion in would have 2 very profound effects. It would make it more attractive for the major oil companies to explore for new oil and gas deposits in North America rather than spending money drilling in potential political hot spots. It would also provide clear guidance to the automotive and electricity generating industries that investing in new technologies, that will help America escape its transport fuels strait-jacket, will be rewarded. The key to making this all happen is maintaining the political will to stick to this goal even if oil prices should fall. That is the real question.

Shanghai Rules

When I first moved to Shanghai in 2004 I was told by a lot of old china hands that “Shanghai is not China”. That saying has been true for most of the 150 years that Shanghai has existed. She has always been China’s gateway to the rest of the World and was usually allowed to play by her own rules. The same can also be said about the Shanghai Stock Market, it too seems to play by its own set of rules, though these rules seem to be more about second guessing the intentions of the mandarins in Beijing.

When I first came to Shanghai the equity markets were in the doldrums after one of its typical boom bust cycles, the market had sat in a narrow trading range for many months, no economic news no matter how positive could seem to make the market move. The market had become weighed down by the overhang of millions of state owned shares. All most all the listed companies had at one time been a state owned entity. When they had gotten their initial listings they had issued freely tradable shares but had kept back the majority of shares in the government’s hands. These shares were not tradable, but the government had started to make noises about freeing these shares to trade.



This made investors very reluctant to buy shares even in companies that were showing very good revenue and earnings growth. The thought of having a wall of previously state owned share hit the market kept investors away. It took a couple of years of effort by the government such as cancelling some state owned shares as well as giving additional shares to private investors to sort this out. This exercise just reinforced in the minds of investors that the performance of their investment portfolio rested on the whims of the mandarins in Beijing.

The Shanghai Stock Market is once again waiting for the mandarins. This time investors are waiting for the government to intervene to prop up a falling market. Since it began its long decline in November last year, the rumor had gone around that the government would ride to the markets rescue because this was the year of the Olympics and the government would want to avoid any unrest. Many grimly hung on to their stock position as the market began its long decent, believing that the government would intervene. The Olympics are almost over and they are still waiting. Very soon, perhaps during the closing ceremonies, it will dawn on them that there will be no rescue this time. This will be when the market finally accepts reality and will reach its bottom.



At current valuations the Shanghai Composite index has an average P/E ratio of 19. Now this may not sound particularly high for an economy that is expected to grow at 8.6% this year. But you should bear in mind that between 2004 and 2006 when the Chinese economy was growing at 11% + the Shanghai Composites average P/E ration never exceeded 13 times earnings. It’s reasonable to assume that when this market does finally bottom it may well be trading at a low double or high single digit P/E. In the developed economies having growth rates of 8% would mean a stock market boom, but having growth slow this much in China is going to have a significant impact on many companies. Many firms operate their businesses on razor thin profit margins; they rely on constantly growing their top line to support their business model, with growth slowing from double digits many of these companies will no longer be able to maintain profitability and some will simply go out of business.

A period of consolidation is want this market requires. As a number of competitors fall by the way side the survivors will be rewarded with greater pricing power in a less cut throat competitive environment. This process will not happen overnight, in fact it may take a couple of years. So don’t expect the post Olympic capitulation to usher in a new bull market.

In Shanghai they play by their own rules, in all likelihood this market will sit range bound for sometime ignoring good economic news as it did in the past until the government changes the rules and sends it soaring again to unrealistic levels. Though this is the main market of the world’s second largest economy, it is still very unsophisticated. It is driven more by rumors of government interventions than it is by any economic fundamentals.

Pirate Bankers

Swiss Bankers over the years have built a reputation for probity, confidentiality and a conservative if not staid style for handling their client’s money. Recent events at UBS however have shattered that carefully crafted image and have lent an aura of swashbuckling to the pinstriped gnomes of Zurich.

After an utterly disastrous foray into Hedge Fund Management that culminated in the embarrassing closure of its Dillon Read Hedge Fund unit in May 2007. UBS has become a serial bleeder of red ink. Today’s Quarterly result are expected to be the 4th consecutive Quarter of Large write downs, after writing off $37 Billion in sub-prime assets in the last 3 Quarters, analysts are expecting additional write downs to bring the total to $43 Billion.

Desperate to recapitalize UBS accepted $11.5 Billion from Singapore’s Sovereign Wealth Fund and an unnamed Arab Sheik. This was done on very favorable terms for the investors, if UBS raised more money later in the year they would have their deal re-priced. When UBS subsequently was forced to go cap in hand to market again by doing a rights issue at a 30% discount to its stock price to raise an additional $15 Billion to shore up its dwindling cash-pot, this deal became very lucrative to the new investors to the detriment of existing shareholders. Not surprisingly this has led UBS shares to fall 53% this year the 4^th worst performance of any financial institution in Europe.

Not content with shedding money UBS has also been losing employees almost as quickly. In addition of planned headcount reduction of 7,000 employees, UBS has also been losing entire teams from its flagship wealth management franchise to its rivals. Bank Julies Baer, Sarasin and Cie and Vestra Wealth Management have been some of the beneficiaries.

This lack of confidence has also been affecting clients; UBS is expected to report today a net loss of $4.6 Billion in client funds. This is the first such loss in 8 years. UBS the World’s largest manger of client money with over $2 Trillion in assets must be unnerved by what, in private banking circles, is considered a lead indicator on future performance. The clients only started to shift their assets relatively recently and this may indicate that they are more unnerved by the accusations of criminality at UBS than they are about its lack of apparent investment management skills.

UBS has been sued by the Massachusetts and New York Attorney Generals who are accusing the Swiss bank of committing a "multi-billion dollar fraud" by steering broker clients into auction-rate securities that became impossible to sell once the credit market tightened. It has since had to agree to return $18 Billion in client’s money.

UBS has also been accused of helping US clients to commit tax fraud. A federal judge in Miami has authorized U.S. officials to seek information from UBS AG about U.S. taxpayers suspected of using Swiss bank accounts to evade income taxes, part of a probe that could crack open Switzerland's tradition of bank secrecy. The order issued gives the Internal Revenue Service permission to serve a summons on UBS to obtain information about possible fraud by people whose identities are unknown. The court granted the so-called "John Doe" summons, a day after the Justice Department made what it called an unprecedented request for the records, part of an IRS investigation into services UBS provided to U.S. clients from 2000 to 2007. Nothing seems to scare Private Banking clients like a tax department fishing expedition.

Tax Reformasi

In an effort to increase revenue and broaden the tax base the Government of Indonesia is proposing a number of reforms. When the House of Representatives returns from its recess it will be asked to vote on a reform bill that includes:

• The top corporate rate being cut to 28% in 2009 and 25% in 2010.

• For public companies rates would be 23% in 2009 and 20% in 2010.

• Companies with below 50 Billion in revenue would see rates fall to 14% in 2009 and 12.5% in 2010.

• Maximum dividend tax rate cut to 10% from the current 20%.

The government hopes to increase its collection of tax by making the tax rates more competitive with its neighbors such as Singapore. Currently government tax revenue amounts to Rp 580 Trillion which is 11.4% of GDP. Though the reforms proposed could see a Rp 40 Trillion fall in tax revenue, the government expects to see revenue rise in 2009 to Rp 702 Trillion, through greater tax compliance from the lowering of the tax rates. The biggest barrier is corruption by the tax department which typically sees bribes of 40% of the tax owed being paid tax department officials.

Another measure in the reform package that may help broaden the tax base is the gradual phasing out of the hated Fiscal Tax. Currently all Indonesian nationals and all foreigners working in Indonesia are required to pay a 1 Million Rp Fiscal Tax every time they leave the country. In theory you are able to claim this back when you file your taxes but in practice most people do not seek the refund as it is a sure method to bring about a tax audit and the subsequent bribes that will need to be paid.

As proposed in the bill, the Fiscal Tax will be eliminated for all registered taxpayers in 2009 and for everyone else in 2011. This measure, along with fines of 20% of the tax owed for people who do not register as taxpayers by the end of this year, is expected to increase the appeal of registering and broaden the tax base. Indonesia, a country of 225 million people has its budget supported by only 6 million registered taxpayers of whom only 2 million actually pay their taxes. The reforms are expected to increase the tax base to 10 million people by 2010.

Also in Indonesia.

In an effort to deal with growing inflationary pressure, Bank Indonesia has raised its policy rate by 25 basis points to 9%. This increase is part of continued rate rise that have seen the benchmark rate rise a full percentage point since may this year.

These efforts are to combat inflation which was reported as a rise in consumer prices by 11.9% in July. Food costs alone are running at 19.9%, the most in a decade.

Producer costs as measured by wholesale price inflation was running at 34.7% in June which suggest that there is greater inflationary pressure that has yet to work its way through the system. This could push inflation by the end of the year above the government’s 12.7% forecast for this year.

This rate rise would have been greater if the central bank had not benefited from the rise in the value of the Rupiah. In the last 10 months the Rupiah has been the second best performing of the major Asian currencies. The central bank hopes to get inflation under control and forecasts inflation at 6.5% to 7.5% in 2009.

Is this the Bottom?

The well worn saying that it is always darkest before the dawn also holds true for the stock market. Stock markets, by their very nature, are often driven more by sentiment than pure logic. When the majority of investors have thrown up their hands in frustration, it is usually an indication that a bottom is being reached. Investment market prices are based on forward looking sentiment. Investors make buying or selling decisions based on where they think the market will be in 6 months to a year in the future. In this way they are leading indicators.

So what signs do you look for to try and differentiate between a dead cat bounce and a real change in direction? In a word, capitulation.

You want to see that things have become so negative that the majority of the investors are just giving up and putting their money somewhere safe, like cash.

We saw signs of that kind of capitulation last week by Merrill Lynch. Merrill Lynch cleared all of their CDO’s off their books for 5 cents on the dollar. They agreed to unload their entire tranche to the fund Lone Star for 5 cents on the dollar in cash, with the chance to get up to a total of 22 cents on the dollar if the CDO’s recover. Anything beyond the 22 cents goes to Lone Star. This will allow John Thain, their CEO, to draw a line under the Credit Derivative debacle that cost Thain’s predecessor his job back in December.

Another sign that markets are reaching their bottom is when investors throw in the towel and sell stocks regardless of their value. You want to see a sharp rise in the number of shares hitting new lows. We saw this last month with 1304 new lows on the NYSE. This was coincident to the Dow hitting a closing low not equaled since July 2006

Market bottoms are periods of great volatility, you want to see the Volatility Index (VIX) going over 30, which it did on July 15th.

Another index which has been a very good indicator of when to buy is the American Association of Individual Investors (AAII) Sentiment Index. It is based on a survey of investors as to whether they are Bullish, Bearish or Neutral on the Stock Market. Historically, when it goes below 25% Bullish, that has indicated a market bottom. It hit 25% in the 2nd week of June and has since risen to where Bulls and Bears are just about even.

The professionals are also showing a great deal of pessimism, the Merrill Lynch Global Fund Manager Survey which measures the positions and sentiment of Fund Managers, shows that only a net 4% of managers where optimistic. It also indicated that 40% of managers said they were underweight in equities and 53% said they were overweight in cash.

Finally you want the last shoe to drop. Shares of companies in natural resources have traditionally been that last shoe. We have seen a sharp decline in Brazil, Russia, Canada and Australia, markets that have up to now weathered the crisis fairly well because of their exposure to resource extraction and basic materials.

Whether this is a rally within a bear market, or if market direction has already changed, will be decided over the next two weeks. It could be just an uptick caused by changes to the rules on shorting financial stocks in the US gaining some additional leverage on a drop in Oil Prices. Only time will tell. Either way, if this is a dead cat bounce, it is the bounce that foretold the final plunge that brought the market to its bottom.

Stagflation Dilemma

By Callum Roxburgh

Central Bankers in the developed economies are faced with a dilemma, while economic growth is slowing and their economies are slipping into a recession, energy and food driven inflation is preventing them from cutting rates. The worry is that this inflation will lead to wage increases that will then drive a self sustaining inflationary cycle. While they may be handcuffed by inflation in terms of using Monetary Policy to stimulate growth, the prudent use of Fiscal Policy could increase consumer spending and at the same time reduce demands by workers for outsized wage increases.

The current inflation is being driven by demand in the developing world; the voracious Chinese economy in particular has increased competition for the world’s finite supply of basic materials. As the average Chinese worker has seen his spending power grow he has increased his consumption of meat. Since it takes 10 kilos of grains to produce 1 kilo of meat we have seen an increase in grain prices. As his wages have increased further he has traded in his bicycle for a Motor Scooter or Automobile, thereby increasing demand for hydrocarbons. This demand growth has been outstripping the rate at which supply has been able to catch up. Since this is a demand driven inflationary cycle, as opposed to the supply driven cycle we saw in the 70’s, it is unlikely that we will see a significant decrease in prices in the short term.

Increasing the spending power of consumers in developed economies will not have a significant impact on basic materials inflation. Faced with increased costs every time they fuel their vehicle, they are not going to stop driving and walk to work. They are going to compensate by reducing spending in other areas. They may chose to spend less money on holiday travel or eat less in restaurants or forgo their White Chocolate Mocha Frappuccino, evidenced by Starbucks reporting its first quarterly loss in Corporate History.(1) These activities are not resource intensive so reducing them will have little impact on resource demand.

The impact of the US stimulus checks allowed the US economy to achieve 1.9% annualized growth in the second quarter compared to 0.9% in the previous quarter. (2) I was quite critical of this approach when it was announced and I still am. While the supporters of this kind of stimulus will use the increased growth in the second quarter as evidence of its effectiveness, what happens next quarter? Will we see economic growth fall?

A much better approach would be to deliver a permanent tax cut that was targeted at all taxpayers. This could be done by lowering the percentage of the lowest tax band or increasing the basic exemption that allows income to go untaxed. This would be stimulating to the economy and at the same time would head off outsized wage demands by workers who would feel less pressured by rising food and energy prices.