Here is an update on a theme I have been developing this year called The Four Horsemen of The Capital Markets. The Four Horsemen are represented by WAR, PLAGUE, DEFLATION and NATIONALISM. These are the four main risks to capital markets and I am attempting to track the changes in the probability in these risks. Generally, the risks for each continues to grow. More interestingly, the probability of all four risks impacting the capital markets at the same time is growing. The Perfect Storm …
WAR: Since my last article this risk has grown the most. Here is a quick update on developments since my last piece. North Korea has begun to rattle its sabre in a desperate bid to seek attention from the U.S. Like a spoiled child that has been ignored while its bigger brother (Iran) gets all the attention, the younger sibling in the " Axis of Evil " family attempts to draw attention to itself by screaming loud and throwing a tantrum in the form of launching several test missiles. Furthermore, the little brat threatens authority with nuclear anhilation. Nevermind the fact that the ballistic missile tests were a resounding failure and it does not appear to have the ability to deliver said threat. In fact, even the fish in the Sea of Japan are safe despite taking the full brunt of little Evil's misguided expressions of power. The U.S. is right to ignore his attention-grabbing antics. Furthermore, a pact with China may go someway to appease China's growing power and influence on the World stage. In fact, I would go so far as saying that the U.S. may be able to divert China's attention away from the Middle-East by agreeing to reduce the U.S.'s influence in Korean and Taiwanese affairs. In other words, "...don't get involved in the Middle-East and we will turn a blind eye to Korea and Taiwan". North Korea has been supporting its economy through the export of weapons. That's no secret. What many people don't realize is that North Korea is taking a calculated risk that it can fuel the war on terror by selling armaments to terrorists and then blackmail the U.S. to pay them to stop. The U.S. is not going to play this game….anymore. The largest customer for North Korean exports is Iran. In one form or another. Armaments that end up in Hezbollah's hands are financed by Iran. The ongoing conflict between Israel and the Palestinians continues to escalate and is once again drawing in neighbours. Hezbollah, a primarily Shiite fundamentalist group, operates in Lebanon and Syria. It is financially and ideologically supported by Iran. Iraq continues to implode as the civil war (really a tribal conflict permeating borders) spirals out of control. Much of the blood-shed is initiated by foreign Shiite insurgents. Many of these have come in directly from Iran or are being supported by Iran. No prizes for guessing the common denominator in these conflicts. Big brother and head of the "Axis of Evil" family is Iran. In order to eliminate the islamic fundamentalist beast one must cut off its head. If the U.S. is serious in its War on Terror it has little choice. The countdown to a first-strike against Iran by U.S./Israel continues and in my opinion, the probability is now greater than 50% that this will occur between Q4 2006 and Q1 2007. The markets have still not priced in this risk but may be beginning to do so.
PLAGUE: There is not much to add on this since my last article. Thank God for summer. However, with every new flu season this risk will rise. Furthermore, as previously mentioned the H5N1 virus, or Bird-Flu as it is commonly known, is mutating at an alarming rate and has recently mutated into a form that enables human-to-human transmission albeit in an extremely isolated case. We don't actually need a full-blown pandemic to cause an impact on the capital markets. All we need is the fear of a pandemic to cause a material impact on the economy and the capital markets. This fear will rise as flu season begins in Q4 this year and continues into Q1 2007. The markets have effectively put this risk on the back burner for now…however, it is simmering.
DEFLATION: Massive liquidity is being drained from the global banking system in a concerted effort to reduce inflation expectations and in some cases to help support flagging currencies. At the same time, huge imbalances in the global financial system are being tested. What the U.S. needs is a U.S. consumer that will increase savings slightly and reduce consumption of foreign goods and services. Furthermore, the U.S. needs a China to stop driving energy prices higher but to continue supporting U.S. debt and purchasing more American goods and services. U.S. business spending would have to increase to take the place of a slowing U.S. consumer. The Chinese should reduce business spending and consumer savings and increase personal consumption. This is ideal but in my opinion is not likely to happen. What is really going on right now is a transfer of wealth from the West to the East. At the same time, the West is in denial and attempting to maintain its standard of living (mostly through debt). Luckily, this illusion could be maintained with rising house prices and a strong stock market. The positive wealth effect only extended the party but won't prevent the hangover. Particularly, now that the stock market is in decline and housing is looking more and more like a bubble ready to burst. Therefore, the West is very interest-sensitive. As per previous articles, the rise in interest rates (with high debt levels) and energy costs while real wages are falling leaves little disposable income. In short the consumer is under a lot of pressure. The open global economy gives the consumer (worker) little pricing power to drive up wages and without a positive wealth effect from houses and stocks, the result is a consumer strike and a slowing economy with excess capacity. In short, a deflationary scenario. This risk is growing rapidly and the full effect is beginning to be absorbed by the markets. The ensuing flight-to-quality decreases lending further and raises the risk of a credit crunch. This will further remove liquidity and wealth from the system. This scenario is growing in probability and Q4 is historically a dangerous period for financial markets and risk-perceptions.
NATIONALISM: This risk continues to rise as well. WTO discussions on farm subsidies have effectively failed. Cross-border takeovers are increasingly srutinized or blocked. Sentiment seems to be driven by ideological, racial, nationalistic and other divisional factors. The events of 9/11 seem to have created a polarization along primarily ideological lines but in fact race and other factors are increasingly being added to the mix. Outside the U.S. and the west in general, many don't differentiate between race, ideology, culture, nation but group them together. Liberalism and political correctness appear to be a fad going the way of the Dodo bird. Trade barriers may start increasing as economies slow in a futile attempt to address trade imbalances. Furthermore, the WTO and The United Nations are being tested and the pressure on these organizations can only grow in this environment.
CONCLUSION: The risks for each one of these factors continues to grow. Moreover, there is a small but growing probability of all four factors impacting the market at the same time….The Perfect Storm. I would be increasingly alert to this threat as Q4 unfolds. The weight of all four factors impacting investor perceptions at the same time would have a devastating effect on capital markets. If these risks continue to rise it may be wise to increase cash and gold holdings. I would continue to avoid cyclicals and look for opportunities in largecap pharma, defence stocks and good quality growth stocks (those whose fundamentals are solid) at lower valuations. Energy and energy related derivatives can be traded as they are likely to remain extremely volatile. I like NYMEX gas and its derivatives right now. Finally, I don't want to appear to be a doomsday monger with these comments. I am only observing the risks and trying to interpret the likely impact on capital markets. I sincerely hope that a Perfect Storm does not develop and in my opinion the risk is still small. However, I do think it is important to be aware of these risks and to monitor them.
WAR: Since my last article this risk has grown the most. Here is a quick update on developments since my last piece. North Korea has begun to rattle its sabre in a desperate bid to seek attention from the U.S. Like a spoiled child that has been ignored while its bigger brother (Iran) gets all the attention, the younger sibling in the " Axis of Evil " family attempts to draw attention to itself by screaming loud and throwing a tantrum in the form of launching several test missiles. Furthermore, the little brat threatens authority with nuclear anhilation. Nevermind the fact that the ballistic missile tests were a resounding failure and it does not appear to have the ability to deliver said threat. In fact, even the fish in the Sea of Japan are safe despite taking the full brunt of little Evil's misguided expressions of power. The U.S. is right to ignore his attention-grabbing antics. Furthermore, a pact with China may go someway to appease China's growing power and influence on the World stage. In fact, I would go so far as saying that the U.S. may be able to divert China's attention away from the Middle-East by agreeing to reduce the U.S.'s influence in Korean and Taiwanese affairs. In other words, "...don't get involved in the Middle-East and we will turn a blind eye to Korea and Taiwan". North Korea has been supporting its economy through the export of weapons. That's no secret. What many people don't realize is that North Korea is taking a calculated risk that it can fuel the war on terror by selling armaments to terrorists and then blackmail the U.S. to pay them to stop. The U.S. is not going to play this game….anymore. The largest customer for North Korean exports is Iran. In one form or another. Armaments that end up in Hezbollah's hands are financed by Iran. The ongoing conflict between Israel and the Palestinians continues to escalate and is once again drawing in neighbours. Hezbollah, a primarily Shiite fundamentalist group, operates in Lebanon and Syria. It is financially and ideologically supported by Iran. Iraq continues to implode as the civil war (really a tribal conflict permeating borders) spirals out of control. Much of the blood-shed is initiated by foreign Shiite insurgents. Many of these have come in directly from Iran or are being supported by Iran. No prizes for guessing the common denominator in these conflicts. Big brother and head of the "Axis of Evil" family is Iran. In order to eliminate the islamic fundamentalist beast one must cut off its head. If the U.S. is serious in its War on Terror it has little choice. The countdown to a first-strike against Iran by U.S./Israel continues and in my opinion, the probability is now greater than 50% that this will occur between Q4 2006 and Q1 2007. The markets have still not priced in this risk but may be beginning to do so.
PLAGUE: There is not much to add on this since my last article. Thank God for summer. However, with every new flu season this risk will rise. Furthermore, as previously mentioned the H5N1 virus, or Bird-Flu as it is commonly known, is mutating at an alarming rate and has recently mutated into a form that enables human-to-human transmission albeit in an extremely isolated case. We don't actually need a full-blown pandemic to cause an impact on the capital markets. All we need is the fear of a pandemic to cause a material impact on the economy and the capital markets. This fear will rise as flu season begins in Q4 this year and continues into Q1 2007. The markets have effectively put this risk on the back burner for now…however, it is simmering.
DEFLATION: Massive liquidity is being drained from the global banking system in a concerted effort to reduce inflation expectations and in some cases to help support flagging currencies. At the same time, huge imbalances in the global financial system are being tested. What the U.S. needs is a U.S. consumer that will increase savings slightly and reduce consumption of foreign goods and services. Furthermore, the U.S. needs a China to stop driving energy prices higher but to continue supporting U.S. debt and purchasing more American goods and services. U.S. business spending would have to increase to take the place of a slowing U.S. consumer. The Chinese should reduce business spending and consumer savings and increase personal consumption. This is ideal but in my opinion is not likely to happen. What is really going on right now is a transfer of wealth from the West to the East. At the same time, the West is in denial and attempting to maintain its standard of living (mostly through debt). Luckily, this illusion could be maintained with rising house prices and a strong stock market. The positive wealth effect only extended the party but won't prevent the hangover. Particularly, now that the stock market is in decline and housing is looking more and more like a bubble ready to burst. Therefore, the West is very interest-sensitive. As per previous articles, the rise in interest rates (with high debt levels) and energy costs while real wages are falling leaves little disposable income. In short the consumer is under a lot of pressure. The open global economy gives the consumer (worker) little pricing power to drive up wages and without a positive wealth effect from houses and stocks, the result is a consumer strike and a slowing economy with excess capacity. In short, a deflationary scenario. This risk is growing rapidly and the full effect is beginning to be absorbed by the markets. The ensuing flight-to-quality decreases lending further and raises the risk of a credit crunch. This will further remove liquidity and wealth from the system. This scenario is growing in probability and Q4 is historically a dangerous period for financial markets and risk-perceptions.
NATIONALISM: This risk continues to rise as well. WTO discussions on farm subsidies have effectively failed. Cross-border takeovers are increasingly srutinized or blocked. Sentiment seems to be driven by ideological, racial, nationalistic and other divisional factors. The events of 9/11 seem to have created a polarization along primarily ideological lines but in fact race and other factors are increasingly being added to the mix. Outside the U.S. and the west in general, many don't differentiate between race, ideology, culture, nation but group them together. Liberalism and political correctness appear to be a fad going the way of the Dodo bird. Trade barriers may start increasing as economies slow in a futile attempt to address trade imbalances. Furthermore, the WTO and The United Nations are being tested and the pressure on these organizations can only grow in this environment.
CONCLUSION: The risks for each one of these factors continues to grow. Moreover, there is a small but growing probability of all four factors impacting the market at the same time….The Perfect Storm. I would be increasingly alert to this threat as Q4 unfolds. The weight of all four factors impacting investor perceptions at the same time would have a devastating effect on capital markets. If these risks continue to rise it may be wise to increase cash and gold holdings. I would continue to avoid cyclicals and look for opportunities in largecap pharma, defence stocks and good quality growth stocks (those whose fundamentals are solid) at lower valuations. Energy and energy related derivatives can be traded as they are likely to remain extremely volatile. I like NYMEX gas and its derivatives right now. Finally, I don't want to appear to be a doomsday monger with these comments. I am only observing the risks and trying to interpret the likely impact on capital markets. I sincerely hope that a Perfect Storm does not develop and in my opinion the risk is still small. However, I do think it is important to be aware of these risks and to monitor them.
