Guggenheim's Scott Minerd has released a somewhat controversial piece looking at several steps forward in case the MENA crisis escalates to the point where dominoes start toppling each other. His conclusion: "After all these dominoes fall, global investors will likely find themselves in a world that looks like this: the Middle East is highly unstable, emerging market economies are slowing, and the crisis in Europe has been exasperated by shrinking exports, leading to a decline in the value of the euro. Against this landscape, the U.S. economy and dollar-denominated financial assets will look increasingly attractive on a relative value basis." Needless to say we disagree with this rather simplistic assessment, or rather, with a very large caveat: in nominal terms, Minerd may well be right, but the resultant surge in oil to well over $200 (should his thesis pan out) will cripple the US economy, force the Treasury to turn on the afterburner on debt issuance, and ultimately result in the biggest bout of monetization ever, resulting in the death of the US dollar (and thus, the resurgence of the gold standard). That said, it is a good piece, if one takes the conclusion with a big piece of salt. In our opinion, the only clear winners from the domino collapse will be oil as we have claimed since early January... and the PM complex of course.
The Economic Domino Effect, by Scott Minerd of Guggenheim Partners
The democratic movement erupting across the Middle East and North Africa (MENA) reminds me of the historic political changes that occurred the early 1990s when the Berlin Wall fell, the Cold War ended, and a series of revolutionary events led to the dissolution of the Soviet Empire.
When the populist revolution broke out in Egypt, I happened to be in Moscow speaking at the Troika Dialog Russia Forum. I must admit, being at the scene of the Russian revolution 20 years later made the events transpiring in Egypt feel all the more historic. One morning I watched images of Egyptian protestors standing on tanks in Tahrir square in Cairo, and at a dinner that evening I listened to first-hand accounts of when Boris Yeltzin stood on a tank outside the Russian White House during the 1991 revolution.
While my Russian colleagues recounted the winds of change that brought the collapse of communist regimes in the early 1990s, I could not help but reflect on how the political transformations of that period also precipitated turmoil in the financial markets and severe recessions.
The unification of Germany in late 1990, for instance, led to the European currency crisis in 1992-1993 and essentially plunged the entire continent into a deep recession.
This crisis was a particularly vivid experience for me because at the time I was running European fixed-income trading for Morgan Stanley. Similarly, the 1991 collapse of the Soviet Union was followed by a severe recession and hyperinflation.
History teaches us that the revolutionary road is lined by economic shocks and currency instability. As the events play out in the Middle East and North Africa, I believe the turmoil in the region will perpetuate an economic domino effect that may result in dramatic shifts across the investment landscape over the course of the next year.
The Global Cost of Turmoil: Higher Oil Prices
As we have already begun to see, the mere threat of a disruption to the world’s oil supply has caused the price of crude oil to spike. The extent and duration of the spike in oil prices will depend largely on whether the threat extends beyond smaller oil producers like Libya, Algeria, Yemen, and Bahrain, and into larger players like Saudi Arabia and Iran. Keep in mind that oil prices spiked 15 percent on the perceived threat that Libya’s production of 1.6 million barrels per day might be in jeopardy. Imagine what may happen to prices if investors perceive the possibility of an interruption to Iran’s production of 3.7 million barrels per day, or Saudi Arabia’s 8.6 million barrels per day.
In terms of how high crude oil prices may rise, the summer of 1990 may provide some perspective. During the early stages of Operation Desert Storm, crude oil prices rose 141 percent over a three-month span. It was another five months before prices
returned to pre-crisis levels, which meant that for more than eight months oil prices were, on average, 40 percent higher than pre-crisis levels.
If we apply a price appreciation experience similar to the Gulf War in 1990 to the average crude oil price one month prior to the protests in Egypt (approximately $90 per barrel for sweet crude oil futures on the NYMEX), we arrive at oil reaching as much as $215 per barrel. If we apply a lower percent increase, say the average increase of 40 percent during the 1990 conflict, crude oil would still exceed $125 per barrel. With crude oil futures currently trading around $98 per barrel, this means it would be possible to see oil prices rise another 25 percent increase from present levels.
Short of a threat to Iran or Saudi Arabia, oil at $200 per barrel is unlikely; however, as the democracy movement spreads across the MENA region, I believe there is a very real prospect that crude oil prices could hit $125 or higher.
Higher Energy Prices Mean Pressure on Emerging Markets
If energy prices linger at such elevated levels, the next domino will be heightened inflationary pressures around the world, but particularly in the emerging markets. Central bankers in Brazil, Russia, India, and China (the “BRIC” countries) are already wrestling with runaway food prices. Surging energy prices are likely to trigger even tighter monetary policy decisions in the near term. The hawkish European Central Bank could even be convinced to move toward a rate hike as well.
But of all the economies impacted by higher energy prices, China may be in the worst position. Recently, China surpassed Japan as not only the second largest economy in the world, but also the second largest consumer of oil in the world. The possibility of a sustained, dramatic increase in energy prices should finally convince the People’s Bank of China that it has a significant inflation problem and is meaningfully behind the policy response curve. With inflation already at 4.9 percent but real interest rates at -1.9 percent, China is facing the triumvirate of price pressures: food, wages, and now energy.
But China is not alone. The other BRIC countries – Brazil, Russia, and India – also need to take dramatic policy measures to cool off overheating markets and fight inflation. We’ve already seen this in Russia, where a surprise rate increase was announced on February 25. This surprise move helped lift the ruble to its highest level in more than two years. Across the emerging markets, exchange rates (including the Chinese RMB) may be valued significantly higher to quash domestic inflation and calm the growing social unrest that has resulted from rising food prices.
Looking ahead, I believe restrictive monetary policy will lead to economic slowdown in the emerging markets in 2011. Since it’s seldom a good bet to fight against central banks, emerging market equities are not the place to be for the next few quarters. For investors looking at these markets, the next entry point should become apparent once there has been a material increase in interest rates and commodity prices begin to trend downward.
Cooling in the Emerging Markets Grinds on Europe
Any economic slowdown in the emerging markets will be especially painful for global economies that rely on exports to those markets for their livelihood in 2011. The prime example of this is Germany, the one economy that must remain strong for the sake of Europe.
Fueled by emerging market demand for autos, industrial products, and machinery, German exports to the BRICs rose 37 percent in 2010. This growth added as much as 1.1 percentage points to Germany’s remarkable 3.6 percent GDP growth for the year. If Germany isn’t able to expand its exports to the BRICs, which is entirely possible given last year’s robust output and the potential economic cooling of the emerging market economies, then Germany’s GDP could fall short of expectations by as much as a half of a percentage point.
Last year, when the German economy was humming along at 3.6 percent, Euro Area GDP was a scant 1.7 percent. In 2011, the economies of Greece and Portugal are projected to contract. Ireland and Spain teeter on the verge of recessions as well. The European Commission is already projecting German GDP to fall to 2.2 percent in 2011. If German GDP falls to below 2 percent, which I think is highly likely, economic growth for the Euro Area will likely dip below 1 percent, or possibly begin to contract. This means the Euro Area could find itself on the brink of another recession and the European Central Bank would be forced into accommodative monetary policy.
The Ultimate Beneficiary: U.S. Markets
After all these dominos fall, global investors will likely find themselves in a world that looks like this: the Middle East is highly unstable, emerging market economies are slowing, and the crisis in Europe has been exasperated by shrinking exports, leading to a decline in the value of the euro.
Against this landscape, the U.S. economy and dollar-denominated financial assets will look increasingly attractive on a relative value basis. By the second half of the year I expect to see a rebound in the dollar, lower bond yields, and the outperformance of U.S. equities relative to Europe and most of the emerging market countries, with the possible exception of Russia. The flight to safety play will also be good for gold prices, which continue to be in a generational bull market despite the recent consolidation (which I view as healthy).
Going Back to the First Domino
Looking back to the beginning of economic domino effect, it’s natural to think of the turmoil in the MENA region as the precipitating event – the hand that tipped over the first domino. But what may be most ironic about this entire scenario is that the dominos falling across the globe, from the Middle East to Asia and then Europe, ultimately end up back in the United States. I say “back” in the United States because the first domino that set these events in motion was actually the Federal Reserve’s policy of quantitative easing.
By printing almost $2 trillion dollars and using them to buy assets, the United States created a rising tide of liquidity that has lifted all asset prices, including commodities, and more specifically agricultural products. Just as chronic food shortages were a major catalyst in the 1991 revolution in the Soviet Union, rising food prices have been a catalyst for the social unrest in the Middle East and North Africa, and it even appears to be spilling over into China under the banner of the Jasmine Revolution.
Regardless of who’s to be blamed (or credited, depending on your perspective) for prompting the social unrest that has swelled into waves of democratic revolutions washing over the Middle East, the moral of the story for investors is that the U.S. financial markets should prove to be one of the most attractive places to invest in 2011.