Monthly Archives: April 2014

Guns or Money? A financial discussion of the Ukraine.

March 4th 2014 will perhaps be in the history books in the same way as October 24th 1962. In 1962 as the USA prepared for nuclear war fear was replaced by relief as Russian ships turned away and the Cuban missile crisis was defused. On March 4th this year the massed divisions of the Russian Army stopped their advance and the feared occupation of Eastern Ukraine was cancelled. Was it the diplomats or soldiers who achieved this? No, it was a new and powerful force for peace which blunted the charge; it was the fall in the value of the rouble, the collapsing stock market and the rising yields on government debt which resounded within the Kremlin’s walls. Militarily they could have been in Kiev by nightfall but at what cost?

The traditional direction of causality has always been that those who have money can afford guns, and therefore that the wealthiest world powers have often been the best armed. But the relationships between guns and money are neither constant nor simple and they seem to have entered a new phase on March 4th.

The old relationship has not always been that straightforward as there are stages of development and life cycles of empires to contend with, and as a wild simplification the key is to be found in the interplay between how well organised a government is and its stage of development with swift and relatively bloodless periods of expansion and bloody periods of disintegration. Often within a country it has been the bankers and industrialists who have tried to hold back wars but I argue below that the internationalisation of financial markets has now changed the game forever.

Any discussion of the Ukraine should start with geography. Indeed the clue in English is in the use of the definitive article. Why is it ‘The Ukraine’, not simply ‘Ukraine’ – for the same reason as it is ‘The United States’ or ‘The Nederlands’ – an adjective requires an article – because Ukraine means border land and so has a ‘the’ before the description. It lies at the border between North and South, of East and West and life on the borders of great civilisations and major empires will often be complicated. The sea and water ways are still today the principle trade routes and the Crimean peninsula is the closest opening to the open sea from the Russian hinterland. Recent history has, particularly from the British viewpoint, put Russia as an expansionist  aggressor. But actually, although Russian influence was expanding for much of history, the last 150 years are best seen not so much explained as Russian expansion as in the contraction of the Turkish and Austro Hungarian empires. The reason we, the British, went to war in Crimea last time we fought the Russians was to stop them inheriting the old Eastern Empire, which has stayed pretty well intact since the fall of Rome. The reason we then, exactly 100 years ago, joined them in the war which destroyed not only the Ottomans but the Hapsburgs and the Romanovs  was to stop the Kaiser taking over the remains of the Austro Hungarian Empire. And so the Ukraine today, 100 years on, is still remembering the shot that rang out in Sarajevo. Perhaps one hundred million people have died in the intervening century as the death throes of these great European empires continued, and the replacement nation states seek to find their various identities – and in the case of the Ukraine, its borders. The Ukraine has generally been fought over by the great powers as a side issue to their ownconflicts and its current borders are essentially those imposed on the defeated Russia by Germany in 1917 – the German motive being to establish a chain of border states it would use as a buffer to contain Russia. It was demilitarised manoeuvring space which was uppermost in design not national or ethnic identity.

So if history and geography have conspired to make the Ukraine a strategically important mixed up place pulled in all directions, what has changed and why do I feel rather hopeful that this time round local tensions will not lead to two world wars and death, dismemberment and impoverishment for almost every nation involved.

Finance and Economics

Among the dangerous fallacies put forward by an extremely insightful but disastrously erroneous Karl Marx was that the Capitalists wanted wars and prospered on the back of conflict. From the start of recorded history the enemy of enterprise has been governmental interference and in war governments have always felt free to intervene without limit. Confiscation of goods, land and workers were just as normal in Caesar’s time as today when a state went to war; disruption of markets and trade routes and misallocation of resources were just as much a feature of the crusades as religious fervour. Marx was right only in one respect – that in Victorian times the heavy engineering industry was prominent and profitable and the process of arming navies and land forces involved great expenditure on heavy metal. He confused this with a theorem that if you created a well- armed force that you would use it and certainly some of the explanation of some conflicts (including perhaps the first world war) depend on a fatal combination of strong armies and weak governments. The weight of history though is on the side of strong governments and strong armies being necessary and usually sufficient for prolonged periods of peace.

Financial markets now are a better defence than the Maginot line

The Treaty of Brest-Litovsk created a line of buffer states to protect against Russian expansion and the armed response of NATO to the occupation of Crimea has been to extend air patrols over the border states, but not to garrison them. Why then did President Putin call off the massed invasion force that are ready to roll into the eastern part of the Ukraine and stop at occupying just the Crimean peninsula  which the whole world (probably including many Ukrainians) and most of its inhabitants are very happy to see re-united with Mother Russia? The answer is to be found in the development of financial markets. When the first world war broke out the Governor of the Bank of England briefed the government on the outflow of gold but the wealth of the governing classes was still based on land and the new wealth creators measured their success in factories, in ships, in plantations and their income and access to their assets was still close to home.  To the extent they had financial assets or used banks these would have a strong domestic bias, and although there were family links and international financial houses like Rothschild, and even international banks like Societé Generale, these were much smaller than the domestic enterprises outside Britain. The British Empire was international but it was in 1914 still essentially British and the levers of power were centred in London. Over the last century all of the major economies have become dominated by financial markets (China least so and most recently) and international capital controls have almost disappeared. The free flow of capital has produced unparalleled prosperity and growth across the world, and the creation of financial assets has proceeded faster than real economic growth in all developed nations. Financial markets allow pieces of paper (today actually assorted electrons) to represent future claims on output, future claims on assets and services and allow them to be exchanged, valued and to provide an easy way of satisfying the universal desire for security. As long as there is no war, as long as the financial markets which promise the future access to resources still exist, as long as the pieces of paper can one day be turned into travel, houses, food and warmth. And there you have the secret of why, on Tuesday 4th March 2014, President Putin postponed or cancelled his rescue mission for the denizens of Donetsk. His investment portfolio had just fallen by 20% – and worse – how will the Russian ruling classes enjoy their wealth if they cannot get dollars, visit London shops or send their children to western schools and universities?

But the most significant problem he faced was that the entire prosperity of modern day Russia has been based on turning real assets – commodities – into financial assets – and investing them in international markets. The three-fold threat of falling values, of denial of access and of an end to creation of new financial wealth was the world’s defence, and it worked.


Points of View: Pharmaceutical M&A

Pharmaceuticals have been at the forefront of investor news this week as mergers and acquisitions have dominated the sector.  The two largest UK pharmaceutical companies, GlaxoSmithKline and AstraZeneca have both been at the heart of these recent announcements.

First, GlaxoSmithKline (GSK) has announced a complex three-part deal with Swiss-based pharmaceutical company Novartis that will see it: a) assume control of Novartis’ over-the-counter business (in return for granting Novartis a 36.5% stake in the combined consumer health business); b) divest its oncology business to Novartis for up to $16bn; and c) acquire Novartis’ vaccine business (for up to $7.1bn plus milestones/royalties).  The market has thus far received this news positively as it cements GSK’s position as global leader in both over the counter medicines and vaccines whilst allowing it to exit its sub-scale oncology business for a reasonable price.  Following completion of the transaction, GSK has indicated that it will utilize the after-tax net proceeds to fund a £4bn return of cash to its shareholders via a tax-efficient B share scheme.

Second, US-based pharmaceuticals giant Pfizer has confirmed speculation that it approached AstraZeneca in January with a cash/share offer worth £46.61 per share.  This was rebuffed and the company confirmed that it made a second approach last week, which was again rebuffed.  Investors will be monitoring the situation closely as under takeover rules Pfizer now have until 26th May to decide whether to progress its interest further.

Points of View: UK Wage Growth

The Office of National Statistics (ONS) released some noteworthy data last week which suggested that earnings growth in Britain has risen to match inflation for the first time since 2010.  This is significant as it potentially signals the end of a wage squeeze which, apart from an upward blip for a couple of months in 2010, has broadly been in place since early 2008.  According to the Financial Times, real earnings have fallen more than 9% since March 2008 – the deepest and longest period of annual declines since reliable records began in the mid-19th century.

The other point of note from last week’s data was that the jobless rate has fallen to 6.9% of the workforce, down 0.3 percentage points on the previous quarter and the lowest since February 2009.  Interestingly, this is now below the 7% threshold that the Bank of England originally set last August under its “forward guidance” policy for considering a potential rise in interest rates.  Whilst it has since changed this guidance to focus on a wider range of indicators, the decreasing unemployment figures and improving wages story suggest that the “slack” in the economy is shrinking. This will no doubt fuel the fire of those commentators who argue that the Bank of England should raise interest rates sooner rather than later.  For interest, the consensus view at present is that the base rate will be raised to 0.75% in early 2015.

Points of View: Greek bonds

Points of View: Greek bonds

Last week it was interesting to note that the Greek government has returned to the capital markets for the first time since 2010, raising 3bn Euros in a five-year deal just two years after unnerving global markets by defaulting on its debts.  At the time of this last default, talk of Greece’s departure from the Eurozone led to the country being shunned by investors and this in turn put pressure on the Euro. In such scenarios – when the market deems a particular type of investment to be high risk – investors require a higher rate of return to compensate them for the additional level of risk that they are taking on. Consequently, the yield on 10-year Greek bonds exceeded 30% at the height of the financial crisis and hence debt issuance was far too expensive a method for its government to raise funds.

Incredibly, despite still having a “junk” credit rating, Greece’s bond sale last week was heavily oversubscribed, allegedly attracting more than 20bn Euros in orders from global investors.  As a result it was able to sell at a yield of just 4.95%, having initially priced the bond to provide a return to investors of between 5% and 5.25%.

The country’s deputy Prime Minister Evangelos Venizelos has announced that this huge interest from investors proves that the country’s debt is sustainable. However, elsewhere, concerns remain about the long-term health of the country and whether the successful bond auction is simply a sign of investor over-exuberance.

Points of View: European Central Bank to embrace QE?

With Eurozone inflation remaining stubbornly low at around 0.5% (a four year low and a quarter of the 2% target), the European Central Bank (ECB) has given the strongest signal yet that it is prepared to embrace quantitative easing (QE) in order to prevent the Eurozone from sliding into deflation or even a prolonged period of low inflation.

Following the recent decision to keep interest rates at 0.25% for the fifth month in a row, ECB president Mario Draghi sought to address concerns the central bank is complacent about ultra-low inflation, clarifying that the ECB would be prepared to use unconventional instruments such as QE in combatting a period of low inflation which is “too prolonged”.

The threat of deflation in Europe is clearly a worry for investors; however, by the same token, the prospect of QE is an appealing one insofar as it would likely bolster markets.  Unlike other central banks, though, implementation of QE may be a problem for the ECB.  Indeed, the structure of the Eurozone’s economy means there are substantial obstacles to a euro-wide implementation of sovereign bond purchases. Discussions appear to centre on buying bank loans but this is fraught with political issues.   To date, Mr Draghi has played the waiting game, promising action without needing to deliver.  If the Eurozone continues to flirt with deflation, though, the market will expect actions sooner rather than later.

Points of View: UK Life Insurers

UK life insurers have had a tough time of it during the last couple of weeks. Firstly there was the Budget; George Osborne’s statement that ‘No one will have to buy an annuity’ hit the sector hard.  Whilst the larger, more diversified UK businesses such as Legal & General and Standard Life fell up to 8% on the day, the worst pain was reserved for the specialist annuity providers, with Partnership and Just Retirement falling and incredible 55% and 42% respectively.

Next came the news on Friday morning of an inquiry from the Financial Conduct Authority into 30m policies written as far back as the 1970s, wiping hundreds of millions of pounds off the market capitalisation of the sector.  Shares in Phoenix and Resolution, which specialise in pools of old policies known as “zombie” funds, fell by as much as 24 per cent and 16 per cent during the day.  There was however a substantial recovery later in the day as the regulator sought to clarify the scope of its probe.  It said it still planned to scrutinise customer service levels, transparency and whether investments were appropriate. Contrary to earlier press reports, though, it said it was not considering banning insurers from charging their customers fees to switch and would not apply current standards retrospectively.

The manner in which the matter was handled by the FCA (it waited until six hours after the stock market opened before clarifying the scope of its probe) has been heavily criticised by the insurance industry and institutional investors, leading to calls for Martin Wheatley, the head of the FCA, to resign.