RISKY
BUSINESS Markets oblivious to geopolitical
risks By Jephraim P Gundzik
Washington's military action and
democratization efforts in the Middle East are
creating unprecedented instability in the most
important oil-producing region in the world -
instability that will likely increase during 2006.
Growing instability in the Middle East has
made global geopolitical risk extreme. Investors
worldwide have yet to link
extreme global geopolitical
risk with high global economic growth risk, as
evidenced by the very modest impact these rapidly
rising risks have had on the world's financial
markets. Risk perception may finally meet actual
risk this year, sending interest rates soaring and
stock markets plummeting around the world.
What's geopolitical
risk? Geopolitical risk can be defined as
the risk of one country's foreign policy unduly
influencing or upsetting domestic political and
social stability in another country or region. In
isolation, geopolitical risk rarely rates
consideration by investors. One reason for this is
that prior to the terrorist attacks on the United
States in September 2001, and the resultant launch
of Washington's "war on terror", global
geopolitical risk was almost non-existent.
The Cold War greatly limited adventurous
foreign policy by any one country. The collapse of
the Soviet Union and the end of the Cold War left
the US as the world's sole superpower - power used
to advance Washington's global economic agenda
rather than to stake political claims in another
country or region. With geopolitical instability
mostly limited to individual countries during the
six decades between the end of World War II and
the beginning of the "war on terror", investors
rightly focused on domestic issues to evaluate
investment risk in individual countries or
regions.
The world's relatively benign
geopolitical environment changed dramatically once
the US invaded Afghanistan, heralding the
beginning of the "war on terror". From trying to
advance America's economic agenda, the Bush
administration's foreign policy was immediately
dominated by efforts to depose unfriendly regimes,
first in Afghanistan and later in Iraq.
This dramatic shift in the focus of US
foreign policy, and accompanying upward leap in
geopolitical risk, has barely registered with
equity and bond investors worldwide. Judging from
world equity and bond-market performance over the
past two years, most portfolio investors continue
to ignore geopolitical risk when making investment
decisions.
Link between geopolitical
risk and economic growth risk High
geopolitical risk in an individual country
indicates that external forces strongly influence
domestic political and social stability. Changes
in political and social stability, in turn,
strongly influence domestic economic stability.
For example, the US invasion and occupation of
Iraq has produced unprecedented political and
social instability, leading to economic freefall.
Economic growth risk in Iraq is extreme because
there's little chance the economy will expand in
the face of this instability.
More
broadly, instability in Iraq is creating enormous
regional political and social instability.
Increasingly, frequent terrorist strikes across
the Middle East and intensification of the
Arab-Israeli conflict demonstrate how extreme
geopolitical risk can affect an entire region at
once. Extreme geopolitical risk emanating from
events in the Middle East have significant
consequences for the global economy as well.
The most prominent impact of extreme
geopolitical risk in the Middle East on the global
economy thus far has been ever higher
international oil prices. Since the end of 2001,
benchmark crude-oil prices have jumped by about
140%. Though some of this increase can be
attributed to growing oil demand in China and
India, the primary factor driving international
oil prices higher has been very weak investment in
new oil production caused by instability in the
Middle East.
Without new oil sources,
natural production declines in the world's aging
oilfields have reduced global oil supply. At the
same time, supply shocks in countries such as
Nigeria have become more frequent. These shocks
can also be partly attributed to instability in
the Middle East arising from the "war on terror".
By strongly influencing international oil prices,
extreme geopolitical risk in the Middle East is
having a global impact, pushing global economic
growth risk higher, making extreme geopolitical
risk a global phenomenon.
In addition to
undermining investment in global oil production,
extreme global geopolitical risk also began to
undermine other forms of fixed investment
worldwide last year. Weakening corporate
investment outlays in the US were mirrored across
developed and developing countries, leading to
slower global economic growth. Global inflation
also continued to creep higher in 2005. Inflation
expectations shifted to a much higher plane,
judging from hefty gains in precious-metals prices
over the past six months.
Though extreme
global geopolitical risk and high global economic
growth risk have clearly undermined fixed
investment around the world, equity and bond
investors continue to pump money into increasingly
risky investments. Stock markets in developed
countries are trending higher. Stock markets in
many developing countries are flirting with record
high levels. Bond yields worldwide do not reflect
rising inflation or inflation expectations.
Finally, emerging-market bond spreads are near
all-time lows.
Portfolio investors appear
oblivious to extreme global geopolitical and high
global economic growth risks that the world's
fixed investors have clearly become aware of. Much
of this disparity can be attributed to the vast
difference between the investment horizon of
portfolio investors, which is short-term by
nature, and that of fixed investors, which is
long-term by definition. Risk perceptions evolve
over time for fixed investors, while risk
perceptions among portfolio investors usually
change suddenly and dramatically.
When
perceptions meet reality Extreme global
geopolitical risk and accompanying high global
economic growth risk originating in the Middle
East are extremely unlikely to decline this year.
Rather, regional instability will intensify as
Iraq's civil war gains traction, Iran responds to
sanctions, Hamas in Palestine discards
negotiations with Israel and Washington works to
destabilize all three in an attempt to reshuffle
the region's political deck in its favor.
How long can a country be on the verge of
civil war? The answer is not very long if
sectarian violence has killed upwards of 1,000
people in one week. Rapidly spreading sectarian
violence in Iraq indicates the country is no
longer on the verge of civil war - it has become
engulfed by civil war. After Iraq completely
fractures along sectarian lines, an event very
likely to occur this year, historians will
identify the bombing of the Askari Shrine in
Samarra as the trigger for civil war.
Iraq's civil war will hasten the departure
of al-Qaeda-allied foreign fighters from the
country. These fighters will return to their home
countries in the Middle East, Africa and Asia,
sowing terrorism. Recent terrorist attacks in
Saudi Arabia and Pakistan probably offer a glimpse
of what is to come in the months ahead. Terrorist
strikes in the Middle East will produce periodic
oil supply shocks.
Another, potentially
larger oil supply shock looms in Iran. Tehran's
strengthening resistance to the West's efforts to
halt uranium enrichment in Iran will lead to one
of two outcomes this year: economic and political
sanctions or a US military strike. Either outcome
will prompt a significant reduction of Iran's oil
exports.
As shocks disrupt Middle East oil
exports, Hamas will stiffen Palestinian resistance
against Israel. With Israel's upcoming elections
likely to usher in another conservative
government, it is a safe bet that the Arab-Israeli
conflict will deepen in the months ahead. Recent
revelations that al-Qaeda has set up shop in the
Palestinian territories secures this bet.
With absolutely nothing in the region
going Washington's way, it is no great leap to
imagine that the administration of President
George W Bush will work to undermine adversarial
governments in Iraq, Iran and the Palestinian
territories - a process that has already begun.
Washington is trying to lead an international
political and economic blockade against Hamas and
has announced grand plans to foment internal
revolution in Iran. Judging from these actions, it
seems more than possible that there has been some
US involvement in Iraq's civil war designed to
discredit the country's Iran-backed Shi'ites.
Increasing instability in the Middle East
spells much higher international oil prices in the
months ahead. Crude-oil prices could easily top
US$100 per barrel by July. Such an increase in oil
prices will have grave consequences for the global
economy, through higher inflation and interest
rates. However, plunging equity markets worldwide
could do much more damage to the global economy
than rising inflation.
From precarious
heights occur the greatest falls - an aphorism
that can easily be applied to the world's equity
markets, where valuations offer zero premium for
extreme global geopolitical and high global
economic growth risks. A sudden change in risk
perception among portfolio investors, bringing
perceived risks into closer alignment with actual
risks, may well push the world's financial markets
sharply lower in the months ahead. This sudden
loss of investor capital could easily trigger a
global economic recession.
Jephraim
P Gundzik is president of Condor Advisers,
Inc. Condor Advisers provides investment risk
analysis to individuals and institutions
globally.
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