Tripoli Trip Up

One of the toughest jobs in journalism last year must have been that for the writers of "The Economist" magazine's "The World in 2011" edition, which was printed and written at the tail end of 2010.

The entry for Egypt reads "The presidential election is a contest between continuity (the long-term but ageing president, Hosni Mubarak, if he runs), dynasty (his son, Gamal, who may run instead) and improbability (victory goes to an opposition candidate...)".

The entry for Libya starts with: "Muammar Qadaffi has held power for 40 years and will certainly complete 41... he has removed all significant threats to his rule."

These entries merely serve to prove that the recent ructions in both countries, and elsewhere around the Middle East, blew up out of seemingly nowhere and were not predicted by anyone (viz. the CIA).

These events therefore come under the heading "exogenous shocks" which have an impact on markets and are rarely foreseen. Time will tell whether or not these ones in Libya and Egypt have a more than short-term effect (falling into the background on the seemingly inevitable departure of the odious madman in Libya), or have an effect which is longer lasting - most likely through a permanently higher oil price, should the country dissolve into civil war, or the Qadaffi faction reassert some form of bloody control.

Even in the depressing case of the latter, though, it should be borne in mind that although Libya produces a high quality and much demanded crude oil, it still only accounts for about 2% of global oil output.

On this issue of these types of "exogenous shocks", I went to a presentation this morning from BlackRock iShares, whose newly installed Chief Strategist was giving us his views on 2011.

In overall terms, these can be summarised as follows:

(1) Favour equity over fixed income,
(2) Tactically favour Developed Markets over Emerging Markets for 2/3rds of this year
(3) Favour corporate fixed income over sovereign
(4) Buy Gold on dips

Downside risks are seen as:

(a) Inflation (demand driven). Key things to watch for in this regard are:

• Chinese loan growth (if the government doesn't bring this under control inflationary pressures in China will accelerate),
  
• Indian industrial production (the RBI is seen as being behind the curve in draining excess liquidity from the banking system),
  
• Food prices in emerging markets where food accounts for between 1/3 of the CPI basket (China) and 1/2 (India).

(b) A double dip recession, most likely caused by:

• An unexpected "exogenous event" (see Libya), such as a permanent spike up in oil prices. Note that every $10 rise in the average price of oil trims US GDP growth by 0.25%,
• Too much austerity too soon (which makes the current deficit cutting plans in the UK an interesting case study). Note that the US consumer currently receives 20% of his/her disposable income from the US government (via social security or pension payments). So a big cut in government discretionary spending would hit these payments, and the consumer, hard. Even the tea partiers might have trouble voting for that one.
  

BlackRock notes that interest rates will remain low this year in the Developed world since at present, governments do not have to compete with the private sector for capital. Long term rates will only rise when private sector debt demand increases (the latter being a reflection of a stronger economy).

Most interesting, though is BlackRock's view on 2012 and beyond.

The key, in its view, are the bond markets.

At present, given the lack of competition for capital, the US government is able to fund its yawning deficits with little difficulty and no risk premium.

In reality though, BlackRock reckons that the US position looks worse than even the European basket cases of Greece and Ireland. Why? Because in Europe, 40% - 45% of GDP is subject to tax (OK - maybe not in Greece, where payment of tax is seen as an optional extra). In the US, the figure is supposedly less than 20% - with much resistance from voters when this number climbs above 20%.

By comparison therefore, the ratio of government debt to government revenue is approximately 360% in the USA vs. about 320% for Greece, 240% for Ireland and 150% for Italy (making Silvio the model of financial probity).

The fact that the US is currently able to fund its debt in US$, has helped postpone the day of reckoning (and a debt watch down grade by the rating agencies) but BlackRock reckons this will come at some point from 2012 onwards when markets will start demanding much higher bond yields. The necessary reforms to the bloated entitlements of Social Security (starting with an increase in the retirement age), Medicaid and Medicare will only come when a crisis of this type forces politicians of all stripes into a corner from which there is no escape.

The issue of course, on the latter, is when this crisis will occur.

So far, markets have been amazingly sanguine about the US deficit and the US debt. A key indicator on the continuing market tolerance of this, or otherwise, will come in negotiations over the Federal Budget which must be concluded by the end of June this year. Even the tea partiers are wary of causing a government shut-down for being too heavy handed on forcing spending cuts on the three big entitlements - the only places that cuts will make any substantive difference: everything else is so much window dressing.

The implication is therefore, that political courage will only rise to the surface when politicians are faced with the prospect of having to make changes no matter what the political consequences.

At that point, those in power will be turfed out no matter who they are and how secure they might seem in the months before - just ask Messrs. Mubarak, Qadaffi and that bloke in Tunisia...

Steve
e-mail: steve.davies@javelinwealth.com
contact: +65 65577185
website: http://www.javelinwealth.com
Javelin Wealth Management supports www.kiva.org, the global microfinance philanthropy initiative, and the Central Asia Institute (see www.ikat.org).