The three biggest threats for 2014-15

The Middle East, China and the insatiable appetite for higher dividends are all looming dangers for investors.

Summary: The rising tensions in the Middle East, particularly across Iraq and its neighbours, represents the greatest hazard on the global stage at this point. But also be tuned in to the health of the Chinese economy, and to how our companies balance out the conflicting demands for higher dividend payouts from investors versus meeting their capital expenditure needs.
Key take-out: Australia’s major banks will be under increasing pressure, with shareholders expecting high dividends. At the same time, thanks will need to spend enormous sums top update their technology networks in the face of increased competition across the payments system.
Key beneficiaries: General investors. Category: Economics and investment strategy.

As we start 2014-15 we could not have a more pleasant sharemarket experience, helped by the realisation that the US is truly recovering in a time of enormous excess liquidity and low interest rates, that is driving a yield boom.

As I have written before this is a boom that could extend for a while, but it has its dangers. The three biggest threats looming for the financial year ahead are first, the Iraq war, the instability of the Chinese banking system and, thirdly, the effect of the yield boom on many of our big companies, led by our banks.

The American recovery is proceeding on track, but the flood of liquidity in the world means the gradual taper of American money printing is not affecting bond prices and yields. In time it will. China continues in its zig-zag economic pattern and it looks like there is a period of ‘ups’ before the next ‘down’.

The Middle East powder keg

But as I look forward clearly the greatest hazard we have on the global stage is the Middle East. At the moment oil prices are slipping back because, so far, oil production has not been seriously affected by the intense fighting in Iraq. Most of the oil is in the south of the country, which has so far been insulated from the fighting. And, of course, the US is now emerging as a major oil producer with less dependence on the Middle East. But China is in a different situation. The Chinese are major investors in Iraq and looked to provide the money to lift Iraqi oil production from 3 million barrels a day to 6 or 7 million barrels a day by 2016.

China saw Iraq as a major source of its need for increased oil, and probably is more tense about what is taking place in the Middle East than any other country.

On my reading of the play the two major branches of Islam, the Sunnis and the Shiites, have been spoiling for a ‘decent’ fight for a long time. For all his terrible actions, Saddam Hussein kept the peace in Iraq and when America took its troops away an all-out fight between Sunnis and the Shiites was made much more likely.

What we are looking at is not just an Iraqi civil war but Iran, on the Shiites’ side (and possibly Russia), and Saudi Arabia on the Sunnis, will fund the fight. In many ways what has taken place in Syria is a foretaste of what might take place in Iraq. The way human beings will be treated will further shock the world.

In any elongated fight the first target will be the oil wells, which provide the wealth to fight your opponent. I hope I am wrong and that some formula is found to avoid and all-out war, but all the signs are there and when you look around other OPEC oil-producing nations there are problems wherever you look . For example, in Libya there is a form of anarchy with high ethnic tension; Sudan has been a mess for a long time; Angola has technical issues; the Saudi fields are becoming old; and Egypt has moved back to a dictatorship.

Given the US and Europe have retreated from the Middle East, these are all dangerous situations that could explode very easily. If that happened it would mean that oil prices would rise, which would lessen the amount of global growth that we otherwise would enjoy. In some ways it would actually benefit Australia, because most of our gas prices are linked to the oil price. It is highly likely that if the global economies slow in the wake of higher oil prices, central banks will re-ink the printing presses to keep their recoveries going.

The Australian dollar could rise quite sharply if the global mix goes that way.

The Chinese banking system

The stimulus that China undertook during the global crisis was the biggest in the world, and a large part was due to bad banking practices. As a result, there is a large amount of bad debt on Chinese banks’ balance sheets.

That means that China’s real growth is going to be less than the official number of 7.5%, even though China might fudge the figures. As 2014-15 proceeds, Chinese banking will emerge as a very large issue.

Yields and the major banks

As far as the yield boom is concerned, my great fear is the thirst for dividends will suffocate investment; and nothing illustrates this better than the banks, which are currently the darlings of the market because of their high yields.

Yet, at least three of the banks are in desperate need of major investment in the technology. Westpac and ANZ have old base systems that are unlikely to be able to compete in the modern world and leave the banks vulnerable to new competitors. NAB has undertaken the mammoth task of rewriting its systems, but the project is going over budget and is behind schedule.

But all the banks are going to be affected by the encroachment of major internet groups into parts of the payments system. Macquarie research says that initially 10% of bank revenues can be attacked, but as the decade proceeds another 20% will be put under threat. If the banks don’t bring their systems up to date, then then market share losses will be big. That will affect dividends. Yet shareholders are blindly unaware of this problem and are demanding bigger and bigger dividends, which are simply unrealistic.

And, again, I think this will become much more apparent as 2014-15 proceeds. Bank shares are going to rise further as part of the yield boom but at some point it will be necessary for those investors with too much reliance on high-yielding banks to lighten their load because of the new risk profile.