As is our custom, we use this early July report to offer our outlook for the next six months.  In this issue, we will discuss what we see as the key geopolitical issues that will affect the markets for the rest of 2012.  This list is not exhaustive but highlights our greatest concerns. 

Issue #1:  The Eurozone

Europe remains the biggest geopolitical concern and has been regularly listed since 2010.  For the most part, we have treated the Eurozone in a similar way as a doctor addresses a patient with a chronic illness.  Sometimes the patient can lead what appears to be a normal life.  In other periods, the disease returns and brings crippling problems. 

Unfortunately, markets are forcing Eurozone policymakers to move towards resolution faster than the political system can handle.  The underlying and unresolved issue remains the fact that, for the past 60 years, the EU has been trying to create a political union via closer economic ties.  Essentially, the European elites want to ensure that another world war won’t be fought on their soil.  To attain this goal, these elites wanted to create a political union; however, pervasive nationalism is preventing this outcome.  Thus, EU leaders have tried to substitute economic links for political union.  The euro was the crowning achievement of this movement; there were great hopes that the development of the Eurozone would lead to something similar to a political union.

The current situation appears untenable.  Due to reforms that began after unification, the German economy has become much more productive than most other Eurozone nations.  If these other Eurozone nations had maintained their legacy currencies, this would not be a problem because the D-mark would have appreciated against the rest of the Eurozone, offsetting German productivity.  However, due to the single currency, this productivity difference must be offset through other means. 

The productivity difference allowed German goods to fall in price compared to other Eurozone products.  This led to a rise in German exports (other Eurozone nation imports) that was funded by German loans.  Germany has become a creditor to the rest of Europe and is at risk if the other countries can’t service the loans.

Germany wants to ensure these loans are paid by gaining control of the debt service process.  Essentially, Germany wants to gain fiscal control over other Eurozone nations to ensure it will be repaid.  In order to prevent future crises, Germany wants to build in increasing Eurozone unity.  The past two years have made it clear that the lack of fiscal unity hampers rescue efforts.  Germany and other northern European nations are uncomfortable engaging in serial bailouts of periphery nations without structures to ensure reform and repayment.  However, fiscal and banking system unity will violate individual nation sovereignty.

 

Currently, there is an element of bargaining underway.  This was evident in the Greek elections, when Syriza, the radical-left party, wanted to stay in the Eurozone but refused to participate in austerity.  The party wanted to force Germany to push Greece out and was gambling that Chancellor Merkel didn’t have the courage to do so.  Thus, it is difficult to know if the governments’ positions are posturing or represent their true policy stances. 

There are ample reasons to keep the single currency bloc together.  The combined economic power of the Eurozone is impressive; if it were a nation, its economy would be the world’s largest.  The European continent has been the venue for two awful world wars mostly because various European powers have been trying to dominate a geography that does not lend itself to unification.  The current situation is a facet of this geopolitical condition.  If economic unity would bring political unity (or at least a form of federalism), the odds of a conflict would decline even if Europe rearms. 

It appears that the best way for the Eurozone to address its situation would be for Germany to experience a boom, leading to a rise in imports and inflation.  This circumstance would allow the rest of the Eurozone to grow and service its debt; the rise in German inflation would allow inflation to rise in the rest of the Eurozone.  If wages in the periphery rise less than the increase in the inflation rate, real wages fall and make these nations’ labor markets more competitive.  If this condition is coupled with structural reforms (end the mandated 35-hour work-week, make it easy to hire and fire, etc.), the German boom essentially creates room for the rest of the Eurozone to adjust.

However, Germany rightly fears that such an exercise will simply lead to an unsustainable boom in Germany and the rest of the Eurozone won’t reform.  This stance is likely correct.  Thus, to prevent this outcome, Germany wants control.

The markets (and non-Europeans) want Europe to stabilize its financial system with unified banking regulation, a Eurobond, easier monetary policies, and support for growth.  To obtain these outcomes, Europe really needs a dominant power that is willing, at times, to sacrifice its national interests to achieve these goals.  The most obvious regional hegemon is Germany; however, the Germans are uncomfortable with this role as is the rest of Europe.  Without this hegemon, it is difficult to see how the Eurozone will be able to meet the goals of the market.

For the past two years, the Eurozone has consistently “muddled through.”  However, as noted above, this path may not be feasible much longer.  Thus, the risks of a severe crisis are growing and will require close monitoring for the rest of the year. 

Issue #2:  The Issue of U.S. Global Dominance

For the past year, the concern about weakening U.S. global dominance has been growing.  It appears the Obama administration has decided to address this situation.  Over the past few months, an Obama Doctrine has started to emerge.  This issue was discussed in detail in the January 23^rd edition of the WGR (The Obama Doctrine).

The doctrine has three elements:

Terrorism will be addressed covertly: The terror attacks of 9/11 made it clear that the U.S. was vulnerable to attack.  The key issue surrounds the best strategy to protect Americans.  The Clinton administration tended to view terrorist actions as police matters.  His government tried to track down terrorists as criminals and “bring them to justice.”  The Bush administration rejected that model, arguing terrorist organizations were attacking the U.S., not robbing a bank.  Thus, they should be treated as enemy combatants and afforded the legal rights given to prisoners of war, not given the protections offered to criminals by the U.S. Constitution. 

Overall, neither approach was workable.  To treat a group attacking American landmarks as deserving of the protections offered by the American political system seems to unnecessarily put U.S. citizens at risk.  After all, it would be a problem if an al Qaeda terrorist was set free due to a Miranda warning omission.  However, the problem with the Bush administration’s approach is that invading nations is not an efficient way to deal with terrorists.  Innocent civilians are killed in the target nations, nation building is expensive and not always successful, and wars change geopolitical conditions in unexpected ways. 

Candidate Obama adopted President Clinton’s position.  He wanted to end the wars and close the detention center at Guantanamo Bay (which had the unusual circumstance of being controlled by the U.S. but not being within the country, allowing inmates to be held there without the benefits of U.S. criminal protections).  The problem with Clinton’s position is that it didn’t protect the country from terrorist attacks and for all the problems the Bush administration’s policy brought, repeat attacks by Islamic terrorists did not occur during his term.  It should be noted that most analysts (this one included) thought follow on attacks were likely after 9/11.

As president, Mr. Obama’s position has evolved.  He did not close Guantanamo Bay.  But, more importantly, he has adopted an aggressive covert strategy, deploying hit squads (to kill Osama bin Laden) and using drones to attack suspected terrorists.  This policy avoids the “messy” issues of invasions (cost, large collateral damage) and treats the terrorists as military threats to the U.S., avoiding the police policy issue.

Although cheaper than invasions, covert action is not without risks.  Collateral damage is common; perhaps it isn’t as widespread as with invasions, but it occurs nonetheless.  Such campaigns are intelligence intensive—they require both signal interception and human intelligence to acquire targets.  Although less expensive than conventional military action, they are not cheap.  Perhaps the most unsavory aspect is that it involves the president ordering “hits” on suspected enemies without any clear rules of engagement.  Assassinating an al Qaeda bombmaker seems acceptable; however, would assassinating Bashar Assad be ok as well?

Policy will be focused on Asia: The decision to focus on the Pacific Rim is clearly defensible.  After all, China is an emerging superpower, and influencing its development will be critical.  In addition, in a fiscally challenged America, prioritizing spending will be unavoidable.  The U.S. could continue to try to monitor the entire world and be stretched, or it can focus its efforts on a critical area and let the rest of the world sort itself out.

It’s already clear that the rest of the world is adjusting to this new policy.  Germany is having hegemon status thrust upon it.  Russia under Putin has been steadily trying to rebuild influence in its “near abroad,” taking advantage of America’s distraction in the Middle East and South Asia over the past decade.  The pivot to Asia will further facilitate this trend.  In the Middle East, Iran, the Gulf kingdoms, Turkey and Israel are all vying to become the regional hegemon. 

Although the U.S. is the global hegemon, the only nation on earth able to project power anywhere, America is not omnipotent.  Choosing how and where to exercise that power affects how other nations behave.  

The U.S. will tolerate the rise of regional hegemons: This position follows from the previous decision.  If the U.S. is willing to focus on one area of the world, other areas will face less attention.  This situation opens the door to the rise of regional powers.  We would expect the U.S. to try to determine the “winner” but it may not be possible in all circumstances to select the best leader.  As the administration is discovering in Europe, Germany manages its role as hegemon differently than we would like.  In the Middle East, we may need to tolerate an Iranian hegemon, at least for a while.  This may mean jettisoning former allies, e.g., Israel, the Kurds, etc.  This policy may also allow Russia to reconstruct a form of the former Soviet Union. 

It is important to note that elections do matter.  A new president can change policy.  However, a President Romney will find himself facing similar constraints as the current president and so major adjustments may be difficult.  Candidate Romney has already indicated that he views Russia as a significant threat.  A change in the White House may lead to a moderation of focus.  For the rest of the world, this instability of direction remains a problem as the U.S. tries to adjust to the post-Cold War era.  As the U.S. struggles with this role, worries about a non-polar world will arise that could affect how nations deal with each other and how trade is conducted.  This issue will be ongoing for the next several years.

Issue #3:  Cyberwarfare

Leaks from the Obama administration confirmed that the U.S. was involved with the creation and deployment of Stuxnet, the computer weapon that attacked Iran’s nuclear program.  At least two other weapons have been deployed, Duqu and Flame.

The Stuxnet virus clearly slowed Iran’s nuclear development by sabotaging industrial processes designed to enrich uranium.  In many respects, it was a nearly perfect weapon.  It was deployed without the target’s knowledge.  When it began to affect industrial machinery, the initial explanation was user error.  As the problem spread, it took several weeks for Iran to eliminate the virus.  Until the White House leaks, both Israel and the U.S. enjoyed plausible deniability on this issue.

In the history of warfare, technological breakthroughs offer promises of dominance.  From fluted armor, the longbow, gunpowder, rifles, poison gas, tanks, the machine gun, ironclad ships, submarines, air power, nuclear weapons, stealth technology and missile delivery systems, nations have tried to use new military technologies to overwhelm their enemies.  History also shows the edge gained tends to be ephemeral.  Enemies either copy the technology or develop countermeasures to render the new technology less effective. 

It would be reasonable to expect that other nations will develop these weapons along with countermeasures.  Unfortunately, the West, especially the U.S., is probably more dependent on information technology and the internet in economic activity.  The possibility that a foreign enemy could use a virus to disrupt electricity production, traffic flow, the financial markets, etc. is a frightening prospect.  The U.S. is responding to the threat; the military has a cyberwarfare command and the U.S. has a well-developed private sector industry designed to counter viruses and other such threats.  However, America is a target-rich environment and, at some point, an unfriendly power or terrorist group will likely try to exploit a vulnerability to attack the U.S.

Issue #4:  Iran

Some of the issues with Iran were addressed above.  Iran is vying with Israel, Saudi Arabia and Turkey to become the Middle East hegemon as the U.S. shifts its focus to Asia.  In addition, Iran’s nuclear program has raised fears that the country is trying to develop nuclear weapons.  The U.S. and Israel both oppose this development although the degree of concern between the two nations is quite different.  Iran with nukes is a major threat to Israel, whereas it isn’t nearly as big of a problem for the U.S.  Israel wants to ensure Iran doesn’t obtain nuclear weapons and is willing to consider military action to prevent that development. The U.S. would also prefer that Iran doesn’t acquire a bomb, but is less open to the military option.

For Israeli PM Netanyahu, his period of greatest leverage is between now and the presidential elections.  Many Americans favor Israel; in an election year, not supporting Israel will damage any candidate’s chances.  Israel probably does not have the military capability to destroy Iran’s nuclear facilities, short of deploying nuclear weapons themselves.  Thus, Israel would prefer the U.S. conduct the attack. 

Given these conditions, it makes sense for Israel to vocally press the U.S. to engage Iran militarily before the elections.  Once the elections are over, any president can more easily ignore Israel’s calls for action. 

For President Obama, if a war is inevitable, it is better if it occurs in the autumn.  A president never appears to have more authority than when he is acting as Commander-in-Chief.  It would be very hard to campaign against a president in the middle of a successful military operation.  However, history also shows the “good feelings” that come from a war pass quickly, so a war that occurs too far away from the election isn’t useful. 

Overall, the U.S. would prefer to avoid another Middle East war.  If Israel precipitates a conflict, it does risk a permanent rupture of relations with the U.S.  Threatening comments will likely continue but it would probably take a belligerent act by Iran to spark a conflict. It would be reasonable to assume that Iran understands the U.S./Israeli dynamic and will put off making such actions until after the elections.   

Issue #5:  Saudi Royal Succession

Saudi Arabia recently named the second crown prince in a year as the current generation of leaders age.  King Abdullah has been naming his successors as has been the custom for the past several decades. However, Abdullah and his kin have been working to create a succession committee to move the leadership to the next generation.  The problem is that this committee has never been used to name the crown prince.  Thus, it is unknown if it will work in practice. 

The Saudis remain a major global oil producer; even more critical, it is the largest holder of excess productive capacity.  When the world needs additional oil supplies, Saudi Arabia has the largest idle capacity.  Thus, it is perhaps the most important oil producer in the world.

At present, it is hard to handicap who will be the next generation of leaders in the kingdom.  This lack of knowledge suggests that it isn’t obvious what the goals, aspirations and attitudes of the next generation will bring.  The transition could be rocky as the current generation tries to hand over power, most likely to their favorites.  Although Abdullah appears in good health, he is 89 years old and so it would be reasonable to expect that a transition may occur sooner rather than later.  Obviously, uncertainty surrounding leadership transition could upset the oil markets.

Issue #6: Syria

Like many of the nations in the Middle East that were former colonies, the European powers that ruled these regions tended to use “divide and conquer” methods to control the local populations.  Often, these colonial powers would put a minority group in control, knowing this group would be dependent upon the colonial government for protection.  The majority was usually suppressed. 

Such a situation occurred in Syria, where the French supported the Alawites and the Druze, a Christian group, against the majority Sunnis.  After independence, ethnic and religious groups vied for power.  In Syria, the Baathist Party, a Pan-Arab movement, took control in the 1960s.  Eventually, Hafez Assad became the leader of Syria and ruled with an iron hand.  Suppression of the Sunnis and dominance by the Alawites and Christians continued.  However, Assad used the secular tenets of Baathism as a way to argue that these sectarian issues were not really relevant.  

As the Arab Spring expanded, Syria began to see scattered protests a little over a year ago.  Due to the ham-fisted response by Bashar Assad, the current president and son of the former president, Syria has devolved into what is looking increasingly like a civil war.  The Sunnis are rising up against the Alawites and others; as these Sunnis become better armed, they are creating problems for an increasingly stretched Syrian military.

The recent downing of an unarmed Turkish military plane by Syria has raised tensions significantly.  Due to Syria’s location, it is a pivotal state.  If the Assad regime falls and is replaced by a Sunni-dominated government, it would be a major loss for Iran (as Hezbollah would be cut off from its sponsor) and a win for Turkey (which is mostly Sunni).  It would not be out of the question to see Syria divided into Sunni and non-Sunni nations, with the Alawites controlling a rump state on the Lebanon border.  Iraqi Sunnis might consider creating a new nation with Syrian Sunnis, given that the former are being persecuted by the dominant Shiites. 

The bottom line is that a Syrian civil war would likely not be contained within Syria.  Other powers would have an interest in the progress of the conflict and would try to affect its outcome.  A Syrian civil war would likely become a regional conflict with an uncertain outcome.  Again, this is a key situation that requires persistent monitoring. 

Ramifications

The market ramifications of these issues are inconsistent.  The impact of a financial meltdown in Europe yields a different result than a war in the Middle East, for example.

In general, our advice remains the same—equities remain in a secular bear market, meaning that investors should be favoring dividend paying equities with a position in fixed income to add “ballast” to the portfolio.  In addition, a small (5% to 10%) position should be in commodities to protect from wars and other supply disruptions.  The economic and geopolitical environment remains difficult and investors should remain cautious. 

 

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

 

(c) Confluence Investment Management

www.confluenceinvestment.com