Sure the Dow took a bit of a beating last week, but then again the operative word here is ‘bit’. Okay, the Down Jones fell 217 points over the week, but that seems pretty trivial given the circumstances.

According to a Bloomberg survey among its investors, no less than 57 per cent think Greece will exit the euro this year. Not so long ago we were told that such an outcome is unthinkable: that a Greek exit from the euro would be an unmitigated disaster. But when the very thing that markets so feared seems to become pretty likely, they just shrug it off. The Hollande victory in France seems to create the conditions for a massive clash between the German Chancellor and the French President. Merkozy is dead, and Angele Hollande is unlikely to replace it. And the markets say they are not bothered.

Spain has now nationalised one of its banks: Bankia. But there is a growing feeling that Spanish house prices are set to fall much, much further. And if this happens, its consumers will become even more unsettled, mortgage defaults may surge, bank debts may rise even further, and Spain’s economy will look more precarious than ever. And yet, we are told the euro is safe.

All of a sudden the thinking seems to be that a Greek exit from the euro – a Grexit as it is being called – wouldn’t be so bad after all. We are told that Greece is a special case; that the euro can afford the departure of one of its smaller, less consequential members, situated on its periphery. Still, we are told the survival of the euro is assured.

But consider these words: “[The euro’s] defenders are right. The end of the euro would be disastrous.

“The trouble is that the continuation of the euro would also be a disaster. It seems hard to see how Greece, Ireland, Portugal and co can avoid a decade of wage deflation. Either that, or they will suffer sky high unemployment and the EU will have to fork out for their unemployment benefit. Or maybe both.

“If the euro stands as it is, the result will be that some of the region’s more indebted countries will end up suffering the economic fate of Detroit.”

Why quote that particular passage? After all, its conclusion seems pretty obvious. Well, it is quoted because it was written in ‘Investment and Business News’ on the 9 December 2010. The crisis in the euro has been plain for all to see for a very long time. By saying a continuation of the euro has led to economic depression across much of the region is not being wise in hindsight. This publication, along with many others, has been saying so for a long time now.

The euro defenders, who once said Greece will not leave the euro whatever happens, are now saying Greece is a special case. But we are seeing the rise of Far Right and Far Left parties across the region. Economic depression threatens to create a lost generation of workers in Spain. The supporters of the euro say it would be calamitous if the single currency is allowed to break apart. But the predictors of doom, those that said it will be a disaster if the euro is allowed to continue as it is, are the ones who seem to have the weight of evidence on their side. Articles on 14 May May Are markets riding into the valley of death? May Day celebrations Markets give thumbs up to George Osborne, but the economy stutters More QE?

Maybe the cause is different, perhaps it would be more apt to quote Tennyson and say that it is not ours ‘to reason why’. Instead we just need to ‘do and die’ with the demands of the markets.

But here is the puzzle. Yes, there is evidence to back up the idea of selling in May, and yes, there is a very good reason to think that markets are pretty much in perfect condition for a spring time sale. Yet the bulls seem to be able to shrug off the worse that the economy can throw at them. They charge as if they were the Light Brigade itself, although one can’t help but feel that they ride into the valley of death.

Since the end of the last World War, the S&P 500 has fallen by an average of 1 per cent between 1 May and 31 October. But between 1 November  and 30 April  it has risen by an average of 6 per cent. But when companies are valued by the markets, the market capitalisation is supposed to be based on a best guess of all future dividends, discounted by a guess of what the average rate of interest will be from now onwards. The resulting number gives us a net current value. So if shares all go up in tandem, those who believe the markets are rational would say there is one of two explanations. Either there has been some kind of deep rooted reason to believe the future has changed, that past estimates of what companies would make for the rest of eternity need to be revised dramatically, or alternatively, there has been a change in the future course of interest rates.

Any significant change in an index that cannot be put down to one of the two above explanations would rather suggest markets are not rational after all, and instead are determined  by such things as herd instinct and desire to conform to the crowd.

And right now, there is an awful lot of herd instinct and crowd conformity going on.

Take austerity. Things are looking nasty. Austerity, if applied by one country in isolation, can be just what is needed. But when we see a call for global austerity, we risk forcing the global economy into a very deep hole, but what do the markets do? Why they punish all those who question the need for austerity. If a country elects a leader who has doubts about the need for cut backs, for enforcing an economic depression on the electorate who invited him, or her, into office, the markets vent their venom.

The markets are quite capable of self-defeating behaviour. That is clear. And we risk catastrophe as a result.

But that is not all, oil has fallen sharply too. The price of US sweet crude has dropped from $106 on May Day to $97 at the time of writing.

And finally, last week in the US the Dow Jones hit a four year high.

The rise of Hollande may explain why sterling had done so well, and indeed why the UK’s bonds have proven so popular. Will markets be so keen to lend to France? Well the next few weeks may reveal the answer to that one.

But why have equities done so well in the US? It is a well known saying: “Sell in May and go away.”  Maybe markets are pretty well placed for a fall.

Today’s articles:

Are the austerians on the retreat? 

Hollande leads the backlash 

Is common sense wrong? 

Sterling rises on Hollande victory 

The report is called The Future of Food and Farming, and was put together by the Government Office for Science in London. It pretty much said we need a new agrarian revolution, or else global starvation will become a major challenge in the decades ahead.

So who put the report together? Well, it involved 400 leading experts and stakeholders from about 35 low-, middle- and high-income countries across the world.

And these are the key conclusions.

“The global food system will experience an unprecedented confluence of pressures over the next 40 years. On the demand side, global population size will increase from nearly seven billion today to eight billion by 2030, and probably to over nine billion by 2050; many people are likely to be wealthier, creating demand for a more varied, high-quality diet requiring additional resources to produce. On the production side, competition for land, water and energy will intensify, while the effects of climate change will become increasingly apparent. The need to reduce greenhouse gas emissions and adapt to a changing climate will become imperative. Over this period globalisation will continue, exposing the food system to novel economic and political pressures.”

The report said that “hunger remains widespread, with 925 million people experiencing hunger. Perhaps another billion are thought to suffer from ‘hidden hunger’, in which important micronutrients (such as vitamins and minerals) are missing from their diet, with consequent risks of physical and mental impairment. In contrast, a billion people are substantially over-consuming, spawning a new public health epidemic involving chronic conditions such as type 2 diabetes and cardiovascular disease. Much of the responsibility for these three billion people having suboptimal diets lies within the global food system.”

The report then said: “Many systems of food production are unsustainable. Without change, the global food system will continue to degrade the environment and compromise the world’s capacity to produce food in the future, as well as contributing to climate change and the destruction of biodiversity. There are widespread problems with soil loss due to erosion, loss of soil fertility, salination and other forms of degradation; rates of water extraction for irrigation are exceeding rates of replenishment in many places; over-fishing is a widespread concern; and there is heavy reliance on fossil fuel-derived energy for synthesis of nitrogen fertilisers and pesticides. In addition, food production systems frequently emit significant quantities of greenhouse gases and release other pollutants that accumulate in the environment.”

So that’s pretty depressing stuff. What can be done?

The report said: “New technologies (such as the genetic modification of living organisms and the use of cloned livestock and nanotechnology) should not be excluded a priori on ethical or moral grounds, though there is a need to respect the views of people who take a contrary view. Investment in research on modern technologies is essential in light of the magnitude of the challenges for food security in the coming decades.”

And yet while it wants to see new technologies, it also warned of risk associated with that. It said: “The human and environmental safety of any new technology needs to be rigorously established before its deployment, with open and transparent decision-making.”

And that’s the problem. The world’s population is growing, and food needs to be produced in greater quantities. To do this, new technologies need to be developed, but there are risks associated with that.

We don’t want to be too dismissive of this report – we are sure it is broadly right. But scientists do have a tendency to fail to grasp how economies and businesses tend to react to changing conditions. The food challenge will inevitably to lead to new ways being found of producing food.

As for current levels of starvation. The problem here is not so much that not enough food is produced, rather it is the way the food that is produced is distributed.

 See: The Future of Food and Farming: Challenges and choices for global sustainability

The Guardian quoted Abdolreza Abbassian, an economist at the UN’s food and agriculture organisation, as saying: “We are entering a danger territory.” He warned: 2There is still room for prices to go up much higher, if for example the dry conditions in Argentina tend to become a drought, and if we start having problems with winterkill in the northern hemisphere for the wheat crops.”

The Independent said: “As more Chinese enter the middle classes they tend to consume more poultry and meat, just as Westerners did at a similar stage in their economic progress. However, meat and poultry husbandry consumes at least three times the resources that grains do, while the drift towards the cities in China is reducing the yields of its farms.”

Yet, conversely, Capital Economics has argued meat consumption per head in China is already close to the levels seen in the West, and much higher than in Japan. People who warn that the rise in China will lead to a rise in meat consumption overlook this. Okay, as China develops we may see consumption of different meats – at the moment, pork accounts for the majority of China’s meat consumption. But it is hard to see how the development of China will lead to much more meat consumption overall.

As for the argument that the drift from the countryside to the cities is reducing yield from China’s farms, that’s a tricky one. It is true to say that China is running out of workers. As a consequence, we are likely to see wages rise in China over the next few years. But is that a good or a bad thing? If food is going up in price in China because Chinese workers are earning more, then isn’t that the very trend economists have been crying out for?

Some argue that higher food prices in China will lead to social unrest. Well, they might, but just bear in mind that a high proportion of China’s population produces food, so if the prices they receive go up, then they will be better off. Rising food prices in China may actually benefit a huge number of its populace. And for that matter, if food prices across the world are being driven up by demand as some countries get richer, then actually this may be a good thing, because the result will be improved income in countries that rely on farming, and quite often (although not always) these happen to be the world’s poorest countries. In other words, rising food costs could lead to redistribution of income from rich to poor.

It all depends on what’s causing the price rises. Rising demand may be one factor, but there are supply problems, too.

The worry relates to the possibility that there are deeper forces at work here.

You could say food prices have partially been pushed up by bad luck, a series of natural disasters ranging from drought to floods across the world. Bad luck won’t last for ever, so if this explanation is right, food supply should improve, helping to alleviate food inflation. Of course, if it isn’t bad luck, and we are seeing fundamental change in the global weather pattern, then that’s another matter entirely – and far more serious – but it is probably too soon to tell if that is what’s really happening.

This is what key indices, commodities and currencies did in 2010.

The truth is, gold is a classic bubble product. George Soros has said as much, calling the gold boom the “ultimate asset bubble”. It is a classic bubble commodity for the simple fact it goes up for no reason other than that it always does in times of insecurity.

Gold is not like oil, which is driven by economic fundamentals. Oil goes up in price because demand for energy rises while supply is limited. Gold rises because people believe in it, but they believe in it for no reason other than that people always have.

That’s why Keynes once called it a “barbarous relic”, and why Warren Buffett was once moved to say of gold: “It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

And for those reasons, economists have never been that fond of gold. Gold production does not help us produce more, it doesn’t make the world wealthier. As King Midas found out, you can’t eat gold, and you certainly don’t want to find that everything you touch turns to gold.

Peter Bernstein, the late economics historian, said in his book, The Power of Gold, that you can fit all of the world’s gold supply into an oil tanker.

Warren Buffett said that all that gold would fit into a container 67 feet or so across, and yet it would be enough to buy all the farm land in America, ten lots of Exxon Mobiles, and still leave you $1 trillion worth of change.
And what would you rather have, enough land and oil to supply the needs of a big chunk of the human race, or a pile of metal that isn’t good for much other than pretty jewellery?

Economists also don’t like gold because as a means of defining money, it has one fatal flaw. The supply of gold is entirely unrelated to the global economy’s productive capacity of goods and services. A global economy that links the money supply to the supply of gold, is one that can not realise the potential in new innovation. Unless, that is, by chance there is a new discovery of gold.
So the discovery of gold in the New World may have paved the way to the Industrial Revolution – although it created hyperinflation in Spain and Portugal during the hundred years or so after the conquistadores.

And yet gold rises because we have learnt in times of trouble it always does. Why buy gold? – because it is gold.

So the euro, dollar, pound and yen are in a race to the bottom. China doesn’t want to play ball. So gold rises.

Others fear that all this quantitative easing will lead to hyperinflation, so gold rises.

Others say we may get deflation, so gold rises.

In other words, a gold bull may say: “The answer is gold. Now, what’s the question.”

If the powers that be that run the global economy have any sense, then they absolutely will not enter into a new gold-based currency standard. We suspect the fears of both hyperinflation and deflation are overdone.

Capital Economics argues that in real terms gold is still below its all-time high, that the price of gold in ounces is approximately 15 times greater than the price of oil in barrels. But the average since 1970 has been 16.

But so what. Why has the average gold-oil ratio been 16 since 1970? There is no good reason. Besides, the gold-oil ratio could equally be implying that oil is too expensive.

Economists put too much emphasis on the relationship between prices in the past. They don’t take into account the forces of randomness, and how we can then be influenced by random forces to think we have seen a relationship, which in turn influences our behaviour and for a while can indeed create a relationship between two indices. Until, that is, fundamentals come into play and we see a crash.

To our way of thinking, gold has bubble written all over it, and the boom in gold is irrational. But then so too was the last gold boom, and yet it made a lot of people very rich. And as Keynes once said: “The markets will remain irrational longer than you can stay solvent.”

Mr Oldham said: “2011 will be the first for 12 years during which the FTSE 100 breaks into new ground, finishing the year at or above 6,750. As businesses look forward to a leaner, more efficient post credit-crunch world, investment and earnings will rise on the back of continued low interest rates. However, the year will not be without serious volatility, particularly due to successive crises in the Eurozone leading ultimately to some disorderly restructuring.”

He also predicted rises in sterling, which could threaten the UK recovery, but said: “The UK market performed well in the 1980s with a strengthening pound and we think it may repeat this experience.” Finally, Mr Oldham predicted “a good recovery” for BP, that the service sector and mid/small caps will continue to do well on the back of potential merger and acquisitions activity, and said: “We favour Carillion, Centrica, Prudential and CPP. Our two favoured stocks for 2011 are Experian and, as our shortest term high risk play, Churchill Mining.” But said that fears over Eurozone debts will hit the banking sector, and that Lloyds Banking Group will probably be the first of the government-supported banks to be ready for a part flotation in 2012. He also expects another good year for Germany.

So much for equities and bonds.

What about the UK property market? Well, this grid pretty much sums up what CML reckons:

CML concludes that: “Activity in housing and mortgage markets is set to remain broadly flat in 2011 and we do not envisage a return to the lending levels that characterised the middle of the last decade for many years to come.”

CML may be right, but next year will almost certainly see average households become worse off as wage inflation lags behind retail price inflation. If the forecast from McKinsey Global is right, and global real interest rates are set to rise over the next few years, then beyond 2012 the outlook for UK house prices is very ropey. See: Interest rates set to rise as economic tectonic plates shift – is this good or bad news?

Well, just a few hours later another story emerged, this time from the International Energy Agency, which said we have in fact already passed peak oil; that global oil output peaked in 2006. It said that the onset of global recession, leading to a fall in demand, was the only reason why oil did not carry on rising once it passed $140 back in the summer of 2008.

To see a more comprehensive analysis of peak oil and the arguments for and against, see yesterday’s piece: Peak oil is less than a decade away

It seems there are two theories on oil. One theory says that oil goes up and down in price following a regular cycle. This theory looks at what economists call elasticity of demand, and the idea goes like this. In the short run, oil is something we just must have. So, as price goes up, demand is barely affected – or, if you will, we have inelastic demand. But, the theory continues, in the long run, demand is actually quite elastic. If oil stays high in price, we change our habits. We buy more fuel-efficient cars, for example, or insulate our lofts.

And this is how the theory pans out. Oil goes up in price – the reason does not matter, just take this one as a given. To begin with, we all suffer, and recession may even be the result. But over time we learn to adjust, and bit by bit demand starts to fall. But oil companies, being run by people who have no understanding of economic cycles, don’t realise this. They can see price is high, then their finance directors enjoy something of a high from counting all the profits, and so they engage in an orgy of exploration.

A few years pass. Thanks to the oil exploration splurge, supply of oil is up. Thanks to the way we changed our habits and learnt how to be more economical with our use of oil, demand was lower. And all of a sudden price crashes. By the late 1990s, oil was around $10 a barrel, having fallen dramatically from its price of a few years earlier.

At this point we enter the next stage in the cycle. Oil is cheap, and bit by bit we become more careless in the way we consume it. Fuel efficiency goes out of fashion. We yearn for Ferraris, or other fuel-guzzling beasts. Meanwhile, oil companies suffer from cheap oil and they slash their exploration budgets.
And so the cycle turns again, and oil shoots up in price like it did during the second half of the noughties.

Those who sign up to this theory tend to laugh off the idea of peak oil. It is not that they don’t believe a permanent decline in the supply of oil would be dangerous, they just don’t see it as very likely.

The peak-oilers, on the other hand, reckon we are running out. And some then go on to argue that black gold, or oil as some people call it, is the lynchpin of the modern economy. Within a few years of peak oil, we will see an irreversible descent into a new Stone Age.

Their critics see this as ridiculous. They point towards the tar sands of Alberta, Canada, for example, and say there is plenty of oil out there, just begging to be drilled into.

Two other developments make the issue more complex.

First there’s the credit crunch. It seems this may have had a twofold effect. As recession descended upon the world, demand for oil fell, and therefore so did its price, with a barrel of oil falling from around $145 in the summer of 2008, to less than $40 six months or so later. So the credit crunch pushed down on demand. But maybe the lack of credit also meant less money was available to fund further oil exploration. So in the short run, the effect of the global economic crisis was less demand for oil. But in the longer term, the effect may be less supply. So the anti peak-oilers can argue that the fall and rise in oil can still be explained by their economic cycle theory.

The second development relates to a certain Deepwater Horizon oil rig. The peak-oilers see this disaster as evidence of how oil is becoming harder to reach. Most people probably agree by now that BP has applied quite breathtaking technology in dealing with this disaster, but the fact remains that despite this, oil is becoming so hard to get at that disasters such as this increasingly are inevitable.
Those who dismiss peak oil simply argue that the BP oil spillage is a blip. And furthermore, a blip that is being compounded by the US. They argue that our expertise in learning how to tap into oil lurking in the deep places of this planet is improving. And that if we see an oil drilling ban in the Gulf of Mexico leading to a fall in supply, then this is not evidence of peak oil, merely evidence to show the US is a fickle beast.

It seems that the UK Industry Taskforce on Peak Oil and Energy Security (ITPOES) falls into the peak oil camp. Well, frankly, judging by its name, you would expect that. It warns of the “increasing importance of deepwater drilling to global oil supply,” which it says is “expected to constitute 29 per cent of new capacity by 2015, up from only 5 per cent today.” And argues that “the result is that any future delays or problems associated with deepwater drilling will have much greater impact on supply than is the case today.”

The taskforce has been set up by various businesses, and counts Sir Richard Branson, among others, as a patron.

In a report out earlier this year it said: “Having assessed the systemic changes caused by the global economic recession, coupled with the projected growth from non-OECD countries, ITPOES predicts Peak Oil will occur within the next decade, potentially by 2015 … The study finds that the recession has delayed the oil crunch by two years.”

The taskforce reckons peak oil will occur at around 95 million barrels per day, against production levels of 85 million barrels per day in 2008. In other words, demand only needs to increase by just over 10 per cent, and wham, oil goes shooting up.

The report’s authors may or may not be right, but there is one respect in which we agree with them.

Peak oil does not have to be the disaster some say it will be. The problem with oil is that trillions of dollars have been invested into it. But there are alternatives out there. Critics of wind and solar say they are nowhere near as efficient as means for generating our energy needs as oil, but can we really say that. If wind and solar power had a fraction of the money spent on them that has been thrown at oil, it seems pretty reasonable to argue they would become far more efficient.

In some ways peak oil may prove to be a good thing. If we turned out attention to other, renewable, forms of energy, or maybe heaped resources on genetics research, so that the maverick geneticist Craig Venter faced competition in his efforts to turn algae into a cheap form of energy, then in the long term we may end up with a source of energy that is much cheaper than oil is at the present, and which would not be subject to the vagaries of the economic cycles based around the folly of human nature.

The taskforce says that more urgent action is needed from government to address the threat of peak oil following the Gulf of Mexico oil spill. It urges the UK coalition government to take action to reduce the impact of the oil crunch by 2015.

See Peak Oil – Implications of the Gulf of Mexico oil spill, for the ITPOES report and see click here  for Investment and Business News articles on the alternatives to oil