Global Macro Notes: Deeper Implications of Middle East Turmoil

February 1, 2011
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Thanks to the many narratives and themes competing for dominance, Mr. Market often behaves like a child with ADD (Attention Deficit Disorder).

Some breaking piece of news or shiny data point will grab his attention for the pulse of a few trading sessions — then the focus switches elsewhere.

So it seems, as of this writing, with the unfolding situation in the Middle East.

As soon as investors realized the Suez Canal is not going to be shut down — the Egyptian government has no interest in losing billions of dollars in revenue — it became “game on” for broader risk assets, the market focus shifting back to positive U.S. economic data.

But it would be foolish to view Egypt’s uprising through a short-term lens only. There are deeper implications here, some of them quite serious…

So here are a few of those “deeper implications” for Middle East turmoil, all with potentially powerful impact on trading and investing decisions moving forward:

  • A rise in the geopolitical “fear premium.” At any given time, X dollars per barrel are added to the cost of oil as a risk component for disruption or supply shock. We are likely to see a structural shift higher in the fear premium moving forward, with many long-standing relationships in the Middle East (going back decades) now destabilized.
  • A permanent rise in tensions beyond Egypt. Saudi Arabia, the “swing producer” of OPEC, is deeply alarmed by the goings on in Egypt. Saudi Arabia hosts an angry and marginalized Shia population, and also has an unemployment rate of 42 percent for youth ages 20-24. The Saudis, who are Sunni, are terrified that Iran, which is Shia, will quietly instigate a new uprising among Saudi Shias, who represent 10% of the population and are concentrated in key oil producing regions.
  • A growing rift between Israel, the United States, and the rest of the world. The overwhelming response to what’s happening in Egypt is a sort of rally cry for freedom. Most global observers, and perhaps even most Americans, see the birth of a democratic process as a 30-year dictatorship topples. Israel sees things very differently, with Israeli pundits professing to be “shocked” at the potential “betrayal” of Mubarak. United States V.P. Joe Biden further did the White House no favors in trying to argue Mubarak is not a dictator and shouldn’t step down. The “realpolitik” stance embraced by Israel and the United States, tied as it is to the repressive Mubarak regime, has become a hypocrisy millstone around the neck of the West.
  • Increased pressure on China and inflation-challenged emerging markets. The “E.M. Hiking Cycle” theme was already prevalent before the revolution in Egypt. Now, with Brent crude surpassing $100 a barrel and West Texas Intermediate above $90, those inflationary pressures will only increase. Having embraced the money-pumping Greenspan playbook and fueled a massive real estate boom that has led to wrenching inequality gaps in the populace, China is already a bubble waiting for a pin
  • Increased political risk for emerging markets in general. As we touched on in Twelve Major Risks for 2011 and further underscored in Pondering the High Cost of Food, the Federal Reserve has been foolish, and perhaps criminally negligent, in ignoring the impact of its blithely inflationary monetary policies on the rest of the world. The cost may now be manifesting in the form of rising political risk across the board, as concerned emerging market leaders are forced to stockpile food and energy, re-embrace subsidies, and potentially crack down with tighter protest controls — all of which add a resurgent fiscal and political risk premium to E.M. investing overall.
  • Increased pressure on U.S. consumer discretionary income. Higher food and energy prices act like a regressive consumption tax, taking money from consumer wallets and hitting lower income spenders the hardest (as food and energy is a higher proportion of total budgets). The frightening possibility here is that the recent uptick in consumer spending, a possible “wealth effect” brought about by QE2 and rising markets, could dissipate just as the real pain of rising gas and grocery costs begins to bite.
  • Increased pressure on corporate profit margins. There are certain industries and sectors that do quite well against a backdrop of rising food and energy prices. Unfortunately, most do not. Investors conveniently forget it was inflation that Businessweek blamed for “The Death of Equities” when the famous cover ran in the late 70s. (The 1979 subtitle: “How Inflation is Destroying the Market.”) We are in the early stages of a potential new inflation cycle with profit expectations unduly optimistic. Rising input costs on the food, energy and materials side could hit corporate margins just as the long stretch of productivity gains from cost-cuts peters out.
  • Increased attractiveness of crude oil alternatives. This one seems obvious, given the action of the past few days, but is still worth noting for its powerful longer-term context. We bought uranium producers in the aftermath of the Egypt uprising and almost immediately saw partial profit targets hit (holding the balance as a trend management position). Meanwhile, our oldest and most profitable trade as of this writing is a nine-week position in FCG, the Revere Natural Gas ETF. (All activity documented in the Live Feed archives.)
  • Increased risk of recession via deflationary shock. As we noted in Deflationists Still In It To Win It, a key argument of those still bearish is that the anemic U.S. recovery, driven as it is by stimulus drugs and thinly justified hopes, is still vulnerable to exogenous shock. Along with multiple other candidates, a further surge in oil prices could be that shock. As James Hamilton of Econbrowser notes in respect to oil market disruptions and economic downturns since WWII, “Every recession (with one exception) was preceded by an increase in oil prices, and every oil market disruption (with one exception) was followed by an economic recession.”

In the Mercenary portfolios we are oriented to the above-listed factors on both the long and short side. Our long positions are concentrated in energy and crude-alternative related names, while the short side remains focused on restaurants, retail, and other overvalued areas of the market subject to discretionary income compression and the threat of a U.S. economy stumble.

JS

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