Not since the peak of the tech bubble in 2000 has the market been so complacent about growing risks. There are a number of factors that are converging and in my opinion we are closer to a significant adjustment of risk-perceptions than we have been since 1987. Let’s look at the evidence:
1. WAR: This risk continues to rise and in my opinion is still not reflected in the markets. The equity premium appears too low under the circumstances. The majority view seems to be that the current Israel/Lebanon conflict will be short-term in nature and diplomacy will intervene to calm things down. I don’t believe it. In an interview with the father of one of the Israeli hostages (aired on British television), he expressed his surprise that Israel would go to war over a kidnapping. In his opinion, kidnappings like this have happened in the past without such a military response. The U.N. and Europe express alarm at Israel’s disproportionate response to the kidnappings. The U.S. does not, but rather points the finger at Syria and Iran. Why? Because the U.S. needs a pre-text to strike Iran and this action by Israel is meant to draw out the extremists in Syria and Iran. The so-called War on Terror, which is a politically correct term for War on Islamic Fundamentalism, names and shames Iran and Syria as the bastions of this extreme view of Islam. It would appear that Israel is trying to draw the Syrians into a fight. As Iraq is the front-line against the Iranians (for the U.S.), so Lebanon is now a front-line against the Syrians (for Israel). The conflict, far from being nearly over, is just beginning. UN peacekeepers will not be effective as there is no peace to keep. Tribal conflict will not be eliminated. A cease-fire will not establish longer-term peace as it only allows for the extreme ideologies to re-group. The conflict has only widened the gulf between ideologies and both sides cannot co-exist. There is a small but growing realization that there can only be one victor, achieved by the complete elimination of the other. The conflict is not really Jews vs. Arabs. It is not even a religious conflict because the extremists do not represent the vast majority of Muslim thinking. The extremists are attempting to turn it into such by hijacking religion as their cause. It is extreme fundamentalist ideology along broadly cultural and tribal lines vs. the democratic ideology of advanced societies.
2. PLAGUE: Not a major factor now and certainly not in share prices. This issue percolates on the back burner but has not gone away. It may rear its ugly head at the most inopportune time.
3. DEFLATION: Central banks are focused on inflation which means deflation is the risk. For the uninitiated, the majority of central bankers have been schooled during the inflation era of the 70’s and their over-whelming focus on preventing a recurrence is risking the opposite. Inflation in the 70’s was double digit. Commodity price rises this time around may even be more pronounced and yet inflation rises are measured in basis points. Meanwhile, Bernanke and Co. continue to be vigilant against perceived increases in inflation expectations. This ghost of economies-past continues to haunt central bankers who were schooled in historical battles with the long vanquished phantom. Sure, consumers see evidence of inflation as costs of energy, soft commodities and services continue to rise. But, the real price of manufactured goods and labour continues to decline. Furthermore, there is evidence of wealth concentration as the middle-classes get squeezed. Up until now, this trend has been disguised by rising asset prices (houses/shares) supported by debt contributing to a positive wealth-effect and productivity gains masking a decline in real wages. The cloak is being removed and there before us stands the naked consumer. The trend in productivity gains is being reduced and the wealth effect is going into reverse. With low unemployment, slowing productivity gains and rising costs for energy and services, you might ask if wage gains can be far behind. Bernanke and Co. are somewhat surprised that wage inflation has been muted at best. For an answer, he might wish to look at the transfer of jobs that the open global economy is providing. Namely, the U.S. is exporting jobs. This is probably the biggest U.S. export but does not show up as a debit on the balance sheet (tongue in cheek please). Rather than expecting an increase in labour costs, a decline in productivity gains will exacerbate this export of jobs as manufacturers (and increasingly service providers) attempt to balance the difficulty in passing-on rising costs (eg. Ford, GM) onto an indebted consumer with limited negotiating power. In an open global economy, a transfer of wealth from the U.S. middle-classes to Asia accelerates. Recent economic stats from the U.S. indicate that business spending is picking up the slack in consumer weakness. This is not much comfort when you realize that the consumer represents roughly 65% of U.S. GDP and 20% of global GDP. U.S. consumer stocks have been hard hit this year with sell-offs accelerating recently. There have been profit warnings as well. These stock prices are leading indicators for the economy. It is no surprise that calls for an increase in protectionism, from the U.S., will only get louder.
4. NATIONALISM: The transfer of wealth from West to East, massive global trade imbalances and a polarization of ideologies combine in an open global economy to raise protectionist sentiment. Furthermore, growing geopolitical tensions continue to show the massive gulf in ideologies. Even amongst traditional allies who share a common ideology (Europe and U.S.A.) there is evidence of significant differences. For example, it would appear that America’s opinion of global organizations such as WTO and United Nations continues to dwindle. Evidence of this can be seen, not only in the very public display over the Iraq conflict, but recently with the Israel/Lebanon conflict. The G8 summit in Russia highlighted this division. These organizations are under threat and the G8 or G7 as it is sometimes called, has become an obsolete elitist’s club.
CONCLUSION: The risks continue to grow. The biggest risk in the short run is WAR. In my opinion, we are approaching a probability of 70% likelihood of a wider Middle-East conflict. This is important as any probability greater than 70% must be considered 100% for investment purposes. In other words, one must plan for the certainty of the event occurring and orient oneself accordingly. The market is currently beginning to price in this risk but probably no more than 20%. Therefore, followers of this newsletter have an advantage. The TED spread (a measure of global financial risk) is widening indicating a growing flight-to-quality and increased risk-aversion. It is by no means anywhere near panic levels. It should be a leading indicator to any major market turmoil. The next biggest risk is DEFLATION as central banks are attempting to rein in perceived inflation threats at a time when liquidity is rapidly drying up and there is a growing negative wealth effect. The FED, in particular, is walking a tightrope and will have a challenge maintaining price stability and confidence in the financial system in the unfolding environment. So far the U.S.$ seems to be enjoying its traditional role as safe-harbour in times of crisis. The recent strengthening of the US$ has more to do with flight-to-quality as the fundamentals do not support a strong U.S.$. Investors should now start positioning themselves for these risks if they have not already done so. First of all, de-leverage. Secondly, raise hard currency holdings (i.e. SFr, U.S.$, EUR, GBP). Finally, add gold and NYMEX natural gas and their derivatives to your portfolio. As mentioned in previous articles, you can play oil, but it is likely to remain extremely volatile. If you must own shares, the large cap pharma such as Roche and Novartis should provide defensive qualities with growth. Defence stocks such as Ultra-Electronics and Raytheon should do well in this environment. Finally, I would avoid the cyclicals. In general, my opinions have not changed much, but the growing risks make my recommendations more convincing.
1. WAR: This risk continues to rise and in my opinion is still not reflected in the markets. The equity premium appears too low under the circumstances. The majority view seems to be that the current Israel/Lebanon conflict will be short-term in nature and diplomacy will intervene to calm things down. I don’t believe it. In an interview with the father of one of the Israeli hostages (aired on British television), he expressed his surprise that Israel would go to war over a kidnapping. In his opinion, kidnappings like this have happened in the past without such a military response. The U.N. and Europe express alarm at Israel’s disproportionate response to the kidnappings. The U.S. does not, but rather points the finger at Syria and Iran. Why? Because the U.S. needs a pre-text to strike Iran and this action by Israel is meant to draw out the extremists in Syria and Iran. The so-called War on Terror, which is a politically correct term for War on Islamic Fundamentalism, names and shames Iran and Syria as the bastions of this extreme view of Islam. It would appear that Israel is trying to draw the Syrians into a fight. As Iraq is the front-line against the Iranians (for the U.S.), so Lebanon is now a front-line against the Syrians (for Israel). The conflict, far from being nearly over, is just beginning. UN peacekeepers will not be effective as there is no peace to keep. Tribal conflict will not be eliminated. A cease-fire will not establish longer-term peace as it only allows for the extreme ideologies to re-group. The conflict has only widened the gulf between ideologies and both sides cannot co-exist. There is a small but growing realization that there can only be one victor, achieved by the complete elimination of the other. The conflict is not really Jews vs. Arabs. It is not even a religious conflict because the extremists do not represent the vast majority of Muslim thinking. The extremists are attempting to turn it into such by hijacking religion as their cause. It is extreme fundamentalist ideology along broadly cultural and tribal lines vs. the democratic ideology of advanced societies.
2. PLAGUE: Not a major factor now and certainly not in share prices. This issue percolates on the back burner but has not gone away. It may rear its ugly head at the most inopportune time.
3. DEFLATION: Central banks are focused on inflation which means deflation is the risk. For the uninitiated, the majority of central bankers have been schooled during the inflation era of the 70’s and their over-whelming focus on preventing a recurrence is risking the opposite. Inflation in the 70’s was double digit. Commodity price rises this time around may even be more pronounced and yet inflation rises are measured in basis points. Meanwhile, Bernanke and Co. continue to be vigilant against perceived increases in inflation expectations. This ghost of economies-past continues to haunt central bankers who were schooled in historical battles with the long vanquished phantom. Sure, consumers see evidence of inflation as costs of energy, soft commodities and services continue to rise. But, the real price of manufactured goods and labour continues to decline. Furthermore, there is evidence of wealth concentration as the middle-classes get squeezed. Up until now, this trend has been disguised by rising asset prices (houses/shares) supported by debt contributing to a positive wealth-effect and productivity gains masking a decline in real wages. The cloak is being removed and there before us stands the naked consumer. The trend in productivity gains is being reduced and the wealth effect is going into reverse. With low unemployment, slowing productivity gains and rising costs for energy and services, you might ask if wage gains can be far behind. Bernanke and Co. are somewhat surprised that wage inflation has been muted at best. For an answer, he might wish to look at the transfer of jobs that the open global economy is providing. Namely, the U.S. is exporting jobs. This is probably the biggest U.S. export but does not show up as a debit on the balance sheet (tongue in cheek please). Rather than expecting an increase in labour costs, a decline in productivity gains will exacerbate this export of jobs as manufacturers (and increasingly service providers) attempt to balance the difficulty in passing-on rising costs (eg. Ford, GM) onto an indebted consumer with limited negotiating power. In an open global economy, a transfer of wealth from the U.S. middle-classes to Asia accelerates. Recent economic stats from the U.S. indicate that business spending is picking up the slack in consumer weakness. This is not much comfort when you realize that the consumer represents roughly 65% of U.S. GDP and 20% of global GDP. U.S. consumer stocks have been hard hit this year with sell-offs accelerating recently. There have been profit warnings as well. These stock prices are leading indicators for the economy. It is no surprise that calls for an increase in protectionism, from the U.S., will only get louder.
4. NATIONALISM: The transfer of wealth from West to East, massive global trade imbalances and a polarization of ideologies combine in an open global economy to raise protectionist sentiment. Furthermore, growing geopolitical tensions continue to show the massive gulf in ideologies. Even amongst traditional allies who share a common ideology (Europe and U.S.A.) there is evidence of significant differences. For example, it would appear that America’s opinion of global organizations such as WTO and United Nations continues to dwindle. Evidence of this can be seen, not only in the very public display over the Iraq conflict, but recently with the Israel/Lebanon conflict. The G8 summit in Russia highlighted this division. These organizations are under threat and the G8 or G7 as it is sometimes called, has become an obsolete elitist’s club.
CONCLUSION: The risks continue to grow. The biggest risk in the short run is WAR. In my opinion, we are approaching a probability of 70% likelihood of a wider Middle-East conflict. This is important as any probability greater than 70% must be considered 100% for investment purposes. In other words, one must plan for the certainty of the event occurring and orient oneself accordingly. The market is currently beginning to price in this risk but probably no more than 20%. Therefore, followers of this newsletter have an advantage. The TED spread (a measure of global financial risk) is widening indicating a growing flight-to-quality and increased risk-aversion. It is by no means anywhere near panic levels. It should be a leading indicator to any major market turmoil. The next biggest risk is DEFLATION as central banks are attempting to rein in perceived inflation threats at a time when liquidity is rapidly drying up and there is a growing negative wealth effect. The FED, in particular, is walking a tightrope and will have a challenge maintaining price stability and confidence in the financial system in the unfolding environment. So far the U.S.$ seems to be enjoying its traditional role as safe-harbour in times of crisis. The recent strengthening of the US$ has more to do with flight-to-quality as the fundamentals do not support a strong U.S.$. Investors should now start positioning themselves for these risks if they have not already done so. First of all, de-leverage. Secondly, raise hard currency holdings (i.e. SFr, U.S.$, EUR, GBP). Finally, add gold and NYMEX natural gas and their derivatives to your portfolio. As mentioned in previous articles, you can play oil, but it is likely to remain extremely volatile. If you must own shares, the large cap pharma such as Roche and Novartis should provide defensive qualities with growth. Defence stocks such as Ultra-Electronics and Raytheon should do well in this environment. Finally, I would avoid the cyclicals. In general, my opinions have not changed much, but the growing risks make my recommendations more convincing.
