The following is an update on a theme I have been working on for some time. In my opinion, global capital markets face four major risks that are small but growing. Those risks are WAR, PLAGUE, DEFLATION and NATIONALISM. I seek to outline these growing risks and update with new info that may increase or decrease these risks. In my opinion, the risks for each one of these factors is steadily growing. Here is an update:
WAR: The U.S. has now exhausted diplomacy with Iran. The U.S. is currently strengthening its position in Afghanistan to contain rising Taliban forces. No coincidence that Afghanistan is on the border with Iran. Condoleezza Rice is currently visiting Pakistan to discuss the war on terror. It would be interesting to hear the discussions. Iraq is in a growing civil war which is spilling over borders. This is not the official line on Iraq but there is more than enough evidence to support this. The U.S. is effectively trapped. It can not retreat without severe consequences. If it does it will really look like the U.S. is a paper tiger and give a huge moral boost to North Korea, Iran and frankly any aspiring power or ideological group. This would, again in my opinion, send the Middle-East further into conflict. The likelihood of the civil war in Iraq dragging in other countries will increase and so will the continued rise of Islamic fundamentalism. Withdrawal could hardly be a feasible option. On the other hand the status quo is not effective. It has not solved any problems and in the short run at least has created more complex problems. This brings me to Iran. As you know, I fully believe the U.S. and/or Israel will hit Iran sometime between the end of 2006 and the beginning of 2007. This will be necessary to fulfill an earlier pledge with regards the war on terror. Namely to attack terrorists and nations that sponsor terror. The root of this single-minded focus following 9/11 is to eliminate Islamic Fundamentalism. If you look in the dictionary under "Islamic Fundamentalism" it says…see Iran. Iran is taunting the U.S. and counting on the U.S. Administration's failed Iraq campaign and waning public opinion, to back down. According to a recent Bloomberg article, a former U.N. inspector thinks Iran could have a nuclear weapon by 2009. The CIA is currently reviewing its best estimate for the development (by Iran) of a nuclear device. Currently, it is 5 years and if it were reduced to less than 3 years there may be an imperative for the U.S. Administration to act before Bush's term is up. There is growing evidence that a first strike by the U.S. is being prepared. A major defence supplier has revealed that sales to the U.S. of anti-missile flares have jumped. Chemring stated that sales for flares were 72% higher than in 2005. Following the supplemental budget vote, Chemring has just received a $75m order (1 250 000 flares approximately), corresponding to more than 20 months of production. Total order book for the specific flare is now $150m. In addition, Israel has made their largest purchase of bunker-busters bombs in the past year. Also, a source, I believe to be reliable, has said that Turkey has given permission for the U.S. to use its air-space in the event of any conflict. Of course, a first strike raises risks that the conflict spreads but in my opinion that risk is already in place and growing naturally. Russia is accusing the U.S. for its role in Iraq and has just sent in a hit team to track down and eliminate hostage-takers in Iraq. The Islamic fundamentalists are trying to create a global jihad and are focused on creating conflicts between different cultures, ideologies, etc. I really don't know what the outcome will be following a first strike but I think if the U.S. has three options: 1. withdraw, 2. status quo, 3. strike Iran, I believe that they will choose option 3. They are building the pre-text now and the propaganda machine is kicking into high gear. In my opinion, 9/11 was the trigger leading to the ultimate confrontation. I actually believe it is no coincidence that the U.S. is positioned on the Western and Eastern flanks of Iran. It is not directly about oil as conspiracy theorists love to say but more about two opposing ideologies that can not co-exist in this World. On the one hand is the U.S., bastion of modern western ideology and Iran, purveyor of Islamic Fundamentalism since 1979 (at least).
PLAGUE: It is now official. The first case of human-to-human transmission of the H5N1 virus has been confirmed in Indonesia. So far the H5N1 virus is 50% efficient. It is similar to the influenza strain that killed millions in the early part of the 20th century and known commonly as Spanish flu. While the H5N1 is extremely efficient at killing it is not easily transmitted. There is a trade-off in the efficacy/contagion relationship in that as the virus mutates to become more contagious it loses some of its efficacy. The reason for this is that the H5N1 is a deep lung virus and kills its victims by allowing them to drown in their own fluid. In order for it to become more contagious it must move up the respiratory system and this reduces the probability of the victim drowning. Nevertheless, it is of no great comfort to know that as the virus becomes more contagious its efficacy drops slightly. If it only killed 10% of victims it would not reduce the panic an outbreak would create. The impact on our modern society would be devastating. First of all, it is highly likely the news and the panic would travel faster than the virus itself. This might give us some warning to take preventative measures but the prevention may be worse than the epidemic itself. Why? Because it is likely people will stop travelling, reduce socializing and limit shopping trips. In short, it would have a measurable impact on the economy. Hopefully, an effective vaccine will be developed and distributed in time but this won't stop people taking preventative measures and that means it will have a negative impact on economic growth. The SARS outbreak a few years ago was limited but did have a short-term and noticeable economic impact. The reaction by capital markets would be swifter and, depending on the environment, may act as a catalyst to continued risk-aversion.
DEFLATION: As I have stated many times, I do not believe inflation is a threat. As far as the U.S. is concerned one has to wonder if FED policy is more about supporting the currency and weening the consumer off his binging. Central Banks are tightening monetary policy in what appears to be a co-ordinated effort to dampen rising inflation expectations. I am no conspiracy theorist but I don't see the makings of an inflationary spiral developing for the reasons I have stated in previous commentaries. There is more than enough anecdotal evidence to suggest that global labour has little pricing power and that there is excess manufacturing capacity (particularly if you look at it throughout a business cycle). Unlike the 70's, rising commodity prices are acting more like a deflationary force. Manufacturers are having little success in passing on rising costs and consumers are unable to raise their disposable incomes. More importantly, the western consumer and the U.S. consumer in particular is very interest-sensitive. Rising energy costs and rising interest rates when wage growth is anemic and debt levels are high does not a pretty picture make. The result is a consumer that is forced to reduce spending and increase savings. In the short run, this strengthens the U.S. $ and may go someway to re-align financial imbalances. The U.S.$ may be losing its role as global reserve currency. Recent comments made by Korea, China, OPEC and several Middle-East states to diversify away from the US$ may be just the beginning. This will have significant implications as the supply of U.S. $ in circulation exceeds demand. Of course this is primarily an M1/M2 problem but I think ripples through the overall supply/demand balance of the US$. The FED may find it necessary to keep rates higher and longer than it otherwise would want to. However, this process is rarely smooth and the risk of getting it wrong are high. The U.S. consumer is still the hero in the global growth story and he is under attack. The risk of a consumer-led slowdown is growing rapidly. This will have an obvious knock-on impact to the global economy. At this point excess labour and manufacturing capacity will become apparent and this is deflationary in a global economy. I am aware that inflation is a monetary phenomenon but I am also aware that monetary policy has not prevented periods of deflation and inflation throughout the past 100 years. The track record of central banks maintaining price stability is at best weak.
NATIONALISM: The best selling book in the U.S. right now is " GODLESS, the Church of Liberalism " by Ann Coulter. Basically, the book centers around the notion that the U.S. is too liberal. Perhaps, I should say it again. This is the best selling book and not because people are questioning her rationale but because a large number of Americans actually support her view. For anyone outside the U.S. this is alarming because most non-Americans feel the U.S. is sliding further to the right. I have not read the book but I have read the first chapter and that is enough for me. You can find the first chapter on www.townhall.com. I would not recommend buying the book and supporting her cause. The events of 9/11 have contributed to a polarization of cultures and ideologies, and this has continued to the present day. The U.N. itself is under threat as it has been seriously tested as a viable forum for dialogue between countries. It risks going the way of the League of Nations before it. As Americans feel under threat culturally, economically and physically they turn inward for protection and outward with aggression. Witness the single-minded pursuit against terrorist threats and the willingness to effectively ignore and manipulate the democratic process of the U.N.. There has been an increase in trade barriers in recent years and the prevention of takeovers of U.S. firms by foreign interests. There seems to be a growing xenophobia by the U.S. administration and the American people. The U.S. is not the only country descending into nationalism (as opposed to rising), however it is the most important and a leader. The trouble with nationalism is that it easily spreads internationally (a bit ironic I suppose). The current WTO meetings are an attempt to deal primarily with farming subsidies. Developed countries subsidize their agricultural industries which impede the natural competitive advantage of developing countries. It is unfair and adds greatly to global imbalances but farmers are a militant lot and this grass roots issue is sensitive. A collapse of these trade talks could set the stage for an increase in protectionism. There are many who consider these issues to be unresolved.
CONCLUSION: The risks continue to grow and the capital markets may be beginning to factor in some of these risks. At the moment, cash is king (which currency?). Gold should benefit. Energy and energy related investments will likely increase in volatility as demand erosion from a slowing economy fight with supply constraints from geopolitical factors. Largecap pharma should hold up well and good quality growth stocks that have sustainable fundamentals but reduced valuations. Other than playing the volatility in energy/gold I would avoid the cyclicals.
About the author:---------------------
Stephen L. Martin is an independent advisor. He has published articles, studies and research on investments over 20 years and has appeared on national television and radio. The views expressed are his own.