Practical analysis for investment professionals
30 December 2014

Best of 2014: Economics, Capital Flows, and Innovation

Posted In: Best Of

Every year at this time, we reflect back on the events of the last 12 months and take inventory. This year (2014) will likely go down in history as a pivotal transition year. The status quo is shifting. We are leaving behind the post-crisis global economic recovery, the resource shortages caused by the rise of emerging markets, as well as the policy aftermath of the financial crisis of 2008 (bailouts, zero interest-rate policy (ZIRP), negative interest-rate policy (NIRP), monetary stimulus, currency wars, and fiscal stimulus), and embracing something new. Enough time has passed and the telltale signs of change are all around us.

The story in oil: Marginal supplies are growing and marginal demand is declining. On the supply side, the US shale revolution is having a major impact. US production has ramped up from about five million barrels per day in 2008 to about nine million today. Also, fears or problems related to several recent disruptions in supply (e.g., ISIS in Iraq or civil unrest in Libya, Nigeria, and elsewhere) have largely subsided. And, of course, OPEC is caught flat-footed and voting to maintain current production quotas. On the demand side, China, Japan, and Europe are all showing significant fatigue with energy demand weakening.

Perhaps no country has been hit harder than Russia. The ruble is falling like a stone —down almost 50% vs. the US dollar in mid-December 2014. Ouch. Early on fear of war caused capital to flee Russia, then it was sanctions from the West, and then it was declining oil prices. The tipping point for Russia appeared to hit around 27 November, when Saudi Arabia announced its unwillingness to decrease OPEC oil production to offset the surge in output by the United States. Since that moment, oil prices have cratered and capital flight from Russia accelerated. The Central Bank of Russia hiked interest rates once in October and twice in December — from 8.0% to 17% in total. It seems Russia is in a “catch-22,” damned if they raise rates, and damned if they don’t. Sharply higher rates in Russia will throw them into recession. Even though the price of oil is falling in US dollar terms, the sharply declining ruble is raising the cost of energy in ruble terms — while also slowing the economy. If Russia maintains low rates, the exodus of capital from Russia could push the ruble even lower, creating massive inflation. A severe recession for Russia is in the offing.

The same factors that are hurting Russia — a stronger US dollar, hawkish US Federal Reserve, declining energy prices, declining global demand, declining commodity prices, and capital flight — are also wreaking havoc in other commodity-heavy emerging economies like Brazil, Thailand, Indonesia, Malaysia, etc. Brazil’s real plunged along with oil and the rubleSoutheast Asian markets are down as capital flight escalates there, too.

In Japan, Prime Minister Shinzo Abe came to power promising to rescue Japan from the desperate deflation of the past 20-plus years. Deploying all three arrows of the Abenomics strategy, Japan has now seen its economy shrink rather than grow. Japan’s revised numbers for Q3 2014 are now in and its recession is worse than initially reported. Japan is now printing 15% of GDP in new money each year. Two consecutive quarters of shrinking GDP cast doubt on Abenomics. Moreover, weakness in the global economy will likely erode Japanese exports, further offsetting any gains in trade a lower yen might have brought.

China continues to struggle with a mountain of bad debt, and the government seems intent on maintaining the status quo — albeit at a somewhat lower growth rate. This despite reports that the Chinese government has squandered almost $6.8 trillion in the five years since the financial crisis. And unless they attempt to rebalance their economy, they will likely experience steadily diminishing growth rates.

Europe continues to stumble along, desperately trying to maintain the status quo. Yet, recent signs suggest the status quo is yielding to recession. Moreover, connecting the dots, it seems that Europe’s notorious real estate bubbles in London, Paris, and Germany could all be impacted by the US shale revolution.

With all that crisis and confusion as a backdrop, we must remind ourselves that innovation flows like a river. 2014 was no different than the years before it as productivity advanced at a dizzying pace. In June, a supercomputer named Eugene managed to convince one third of a board of judges at the Royal Society in London that it was a 13-year-old boy — thereby becoming the first computer to meet the qualifications of the Turing Test. In the world of cryptocurrency, bitcoin has endured a wild ride, racing over $1,000 and then falling to about $315 today. But whether or not bitcoin itself succeeds misses the point. Bitcoin is not just a better PayPal . . . it has solved the fundamental problem of trust between two foreign parties in a transaction. Now the genie is out of the bottle and it can act as a platform to build an incredible array of things. In medical science, researchers have made profound advances in growing organs from stem cells. In energy innovation, scientists in Australia have reached an important new milestone by converting over 40% of the absorbed solar energy into electricity. Moreover, breakthroughs in battery technology are leading to a much more competitive profile for alternative energy. Researchers at Stanford have figured out how to extend lithium battery life by three to four times. Researchers at Harvard have developed an organic grid-scale battery. And lastly, Australia’s Commonwealth Scientific and Industrial Research Organisation (CSRIO) has created a supercritical solar steam engine that can compete with fossil fuel energy in terms of cost per megawatt. It seems, these innovations can radically change the long-term future for energy (and geopolitics for that matter), while shale oil and gas are reshaping the present.

In total, 2014 stands as a turning point. The status quo has changed. We are, it seems, embracing yet another brave new world. Have a safe and prosperous New Year!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

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