The sky is falling

Back in September last year, the Wall Street Journal wrote an article about how low oil prices could lead to a global recession. An article by the Guardian last Friday repeated the sentiment with a suggestion that low oil prices could hurt the stock market.

Look out, Chicken Little, the sky is falling!

The doom and gloom argument appears to be based on two factors:

  1. Falling oil prices will hurt oil producers like Exxon and Chevron. Since these firms are large, falling profits will lead to lower share prices which in turn will pull down the market index and lead to a drop in the overall market. This would bad for shareholders;
  2. Secondly, the falling oil price will make it more difficult for oil companies to repay outstanding debts. When oil prices were high many Wall Street banks lent money to finance new drilling expeditions, and Dealogic estimates that the oil and gas industry has roughly $500 billion in outstanding debt. Increased levels of distressed debts could lead to stress in the banking sector.

Oil producers and the banks who backed their optimistic projects during the boom years will stand to lose in the new reality of low oil prices.

Luckily though the economy is composed of more than just banks and oil producers.

Richard Branson, the billionaire entrepreneur and philanthropist, provided some sound wisdom at Davos recently when he said that “oil prices are good for the consumer, they are good for most businesses. They are very good for the airline businesses. And obviously if you are an oil company they are not so good for you. But I think what the market has missed is that with oil below $30 a barrel and likely to stay there for a long time, that there is no need to try to make up a recession. This is going to be the greatest boost to the economy that you can imagine.”

In support of Branson’s view, The Economist reported on Saturday January 22nd that “the economies that have enjoyed the strongest GDP growth in the past year have .. been oil importers: India, Pakistan and countries in east Africa.” Similarly, in the IMF’s latest forecast, published on Tuesday January 19th, the economies that were spared a GDP growth downgrade — China, India, Germany, Britain, Spain and Italy — were all net oil importers.

While it is true that a slump in oil prices will produce winners and losers, and there are likely to be stormy waters ahead for countries like Brazil, Saudi Arabia, Russia and Nigeria, the good news is that the sky is not falling.

Hard economic times

When the economy slows, you’re likely to get RAPED, SHAFTED or SCREWED

Due to the current financial situation caused by the slowdown in the US economy, Congress has decided to implement a scheme to put workers of 50 years of age and above on early, mandatory retirement, thus creating jobs and reducing unemployment. This scheme will be known as RAPE (Retire Aged People Early).

Persons selected to be RAPED can apply to Congress to be considered for the SHAFT program (Special Help After Forced Termination).
Persons who have been RAPED and SHAFTED will be reviewed under the SCREW program (System Covering Retired-Early Workers).

A person may be RAPED once, SHAFTED twice and SCREWED as many times as Congress deems appropriate.

Persons who have been RAPED could get AIDS (Additional Income for Dependants & Spouse) or HERPES (Half Earnings for Retired Personnel Early Severance).

Obviously persons who have AIDS or HERPES will not be SHAFTED or SCREWED any further by Congress.

Persons who are not RAPED and are staying on will receive as much SHIT (Special High Intensity Training) as possible. Congress has always prided themselves on the amount of SHIT they give their citizens. Should you feel that you do not receive enough SHIT, please bring this to the attention of your Congressman, who has been trained to give you all the SHIT you can handle.

Sincerely,

The Committee for Economic Value of Individual Lives (EVIL)

PS – Due to recent budget cuts and the rising cost of electricity, gas and oil, as well as current market conditions, the Light at the End of the Tunnel has been turned off.

(source: unknown)

Building flexibility into business planning

ONE of the take away lessons from the CFA curriculum is that the conventional method of valuing an investment is to determine the present value of expected future cashflows.  One way of doing this would be to use the constant growth dividend discount model, which estimates the value of a stock by assuming that dividends grow at a constant rate … forever.  If the present value of expected cash inflows exceeds the cost of the investment, then we should invest.

I hope this model of investment valuation concerns you. It certainly concerns me. It basically tells us that we should make an investment decision based on the most likely expected future.

If we are happy to agree that (1) it is not possible to predict the future and (2) past performance does not guarantee future performance, then this colour by numbers method of investment valuation leaves much to be desired.

The businesses that will prosper in the Global Financial Crisis are the ones that have flexible business plans. These are the businesses that looked into the future and saw uncertainty. These businesses understood that the state of the world in ten or even one years time is not only uncertain, but unknowable, and planned accordingly.

One company that comes to mind is Microsoft, which has a cash stockpile of some US$25 billion.  In the past, Microsoft has received considerable criticism for failing to either invest its vast cash reserves, or distribute them to shareholders.  Microsoft’s “conservative” approach now puts it in a strong position to acquire competitors who “strategically invested” their cash reserves in more prosperous times.

To quote the McKinsey Quarterly:

Corporate leaders might consider [using] robust business models incorporating some slack and flexibility instead of the models most common today, which aim to optimise value in the most likely future scenario and thus leave companies exposed when conditions change dramatically.

Weakness in the economy? An insight from two taxi driver economists

THIS article is intended to be pretty light-hearted. It provides an insight into the strengths of the current Australian economy after talking with two aspiring amateur economist taxi drivers.

Taxi driver 1

I was chatting with the taxi driver on the way home from work last week, and he was complaining to me that, despite talk of a “resources boom” and a resilient Australian economy, he felt that the economy is weak because he has been experiencing a significant reduction in business over the last little while.

My taxi driver turned out to be quite an economist and inspired this article and my last one, Economic recession 2008: measuring the strength of the economy.

Australia has been negatively affected by the sub-prime mortgage crisis in a similar way to most other countries. At the same time, however, Australia is benefiting from a resources boom. High commodity prices and strong demand for raw materials from countries like China has seen large amounts of money flow into Australia.

As my taxi driver made me realise, however, it’s all very well to be told about a “resources boom” and a record Federal Government surpluses, if the tell tale signs are painting a different picture. A company might appreciate that the economy is weakening when its inventory levels start to rise above expected levels. The government might appreciate that the economy is weakening when tax revenues start to decline or grow more slowly. But how does the common man, how do you and I, appreciate that the economy is weakening?

Obviously, if your wage isn’t rising and the price of things like food and oil rise, then you will have less money to spend on other things. However, this tells you nothing about the strength of the economy over all.

Here is a list of four tell tale signs, from day to day life, that might indicate the economy is weakening (some of these ideas are borrowed from a discussion on James Valentine’s program on 702 ABC radio last week):

  1. The length of the cab rank: The theory goes like this. When the economy weakens and people are put under financial strain, they cut spending. Expenditure on necessary things like food and accommodation are the last things that people cut out of their budget. The first thing that people do away with is entertainment. If people are not attending concerts and not staying out late, then they are not using taxis, and consequently there will be an oversupply of taxis. So, when the cab ranks become inexplicably longer than normal, or taxis become easier to catch on a Friday night, it might be a sign that the economy is weakening.
  2. The length of the queues in Aldi: For those of you who are unaware, Aldi is a discount supermarket chain that is slowly but surely taking the world by storm. In Sydney at least, Aldi stores are not always so conveniently located. Increased queues in Aldi might indicate that people are tightening their budgets due to weaker economic conditions.
  3. The length of Tuesday petrol queue: In Sydney, the cheapest day for petrol is, for some unexplained reason, Tuesday.
  4. The number of new Aston Martins on the road: Flashy sports cars are a luxury good, when the economy weakens there is less disposable income available and you would expect to see less new luxury cars on the streets.

Taxi driver 2

I had another encounter last night with an aspiring amateur economist taxi driver on my way home from work (my taxi drivers are such a source of inspiration). Having discussed the economy with the other taxi driver last week, I was intrigued to find out whether this driver also thought that business was slow at the moment, and why he thought that might be.

He informed me that business had been a little slower than normal, but nothing out of the ordinary. Unlike my first taxi driver, he didn’t attribute this to a slowing economy. “The weather has been cloudy and wet lately, and people don’t like to go out in this weather. Winter is coming. This means that it gets dark earlier, it’s colder at night and less people are out in the city. There are also less tourists in the winter. I make more money when it is sunny.”

The conclusion

So, all things considered, perhaps these aspiring economist taxi drivers haven’t really been able to give me any insights on the current strength of the Australian economy. But at least they got me thinking.

Economic recession 2008: measuring the strength of the economy

It’s the economy, stupid

IT’S THE economy, stupid” is a well known phrase that was widely used during Bill Clinton‘s 1992 presidential campaign against George Bush senior. The phrase was coined by Clinton campaign strategist James Carville and refers to the notion that Clinton was a better choice because Bush had not adequately addressed the economy, which had recently headed into a recession. Clinton went on to win a decisive victory.

Having entered the second quarter of 2008, the American economy may be heading towards a recession once again.

What is a recession?

Broadly speaking, a recession is a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists have other more precise definitions of a recession, the easiest of which to understand is “two consecutive quarters of falling GDP”.

This definition was borrowed from the Economist A-Z, which is a really useful resource for understanding economic terms. I have added it to my list of useful links.

Strength of the US economy

A key contributor to the current weakness of the US economy is the sub-prime mortgage crisis. To indicate the magnitude of the losses suffered from the crisis, it is useful to note that the largest US bank, Citigroup Inc., has alone incurred more than US$45 billion of write-downs and credit losses since 30 June 2007.

In order to stimulate the American economy, the Federal Reserve has slashed the Federal Funds Rate by 2.75% between 18 September 2007 and 30 April 2008.

Gordon Brown, George Soros and Warren Buffett are all of the opinion that America, and the world at large, is currently facing its worst financial crisis since the 1930s. In particular, Warren Buffet was quoted by the LA Times on May 5 saying, “I would say that we’re in a recession, clearly”.

In the first three months of 2008, the US economy managed to achieve a modest annual growth rate of 0.6%. So, at least according to the precise Economists’ definition provided above, the US is not yet in a recession.

However, things are far from in the clear. Reuters reports that Scotia Capital senior currency strategist Camilla Sutton outlined that there are some very negative indicators for the strength of the US economy in the short term,

[T]he housing market has yet to bottom, consumer confidence is at multi-decade lows, employment growth has evaporated and high commodity prices are … exacerbating an already weak economic backdrop.

Bearing all of this in mind, concern about the short term strength of the US economy was sparked yesterday, May 6, when US crude oil prices hit a record high of US$120.36 a barrel. The rising price of oil (and food) is contributing to a higher US inflation rate. The US inflation rate, for the 12 months ending March 2008, was 4.0%. This compares with an inflation rate for the same period last year of 2.8%. Inflation is a procyclical coincident economic indicator because price levels tend to rise when the economy is booming. However, the rising price of oil is being driven by booming developing economies, in particular India and China, and not from growth in the US economy. Higher oil prices are also being driven by the uncertainty of oil supply resulting from political unrest in certain oil producing countries and interruptions in supply due to extreme weather conditions, leading to higher prices and slower growth in the US economy.

There is some cause for optimism however. According to the Times Online, recent economic data on the American economy (measuring things like jobs, GDP, business confidence, industrial orders and consumer spending) indicates that, although the US economy weakened abruptly in the final quarter of 2007 (October to December), the US economy is not nearly as weak as it has been at the start of previous recessions.

Strength of the world economy

According to the IMF, the growth prospects for the world economy in 2008 appear to be strong.

In the IMF’s World Economic Outlook, published in October 2007, the IMF indicates that global economic growth is predicted to be 4.75% in 2008. Interestingly, this prediction is made in light of the fact that financial market strains might trigger a more pronounced slowdown in the world economy.

Growth in developing countries appears to be the main driver for the expected strong global economic growth in 2008. In 2007, economic growth in China, Russia and India accounted for half of global economic growth. The IMF indicates that in 2008, the Chinese economy is expected to grow by 10% and the Indian economy by 8.4%. This is an extremely fast rate of economic growth, which would see the size of the Chinese economy double in less than 8 years.

If you enjoyed this article, you may want to read about The benefits of an economic recession and how to prepare for one, on the James Cox finance blog.