Critical Issues of 2012: How Investors Can Position Themselves for the Year Ahead
In order to position themselves for success in 2012 and beyond, investors must first put recent events in context and develop a framework to understand how the market is reacting to them.
Twenty-two years ago half a million people occupied a square in Berlin and brought down a symbol of oppression that endured for decades. Years of misallocated capital and unfulfilled promises eroded the bonds that united a diverse population, which eventually broke apart into 15 individual countries. This event was part of a gradual assertion of individual freedoms and collective autonomy, in which mostly peaceful protests brought down one of the most powerful governments ever formed. Whether the eurozone ultimately breaks apart in a manner similar to the Soviet Union remains to be seen, but the conversation highlights that a new world is taking shape in which regional powers rise to assert their interests.
In order to prospectively position themselves for success in 2012 and beyond, investors must first put recent events in context and develop a framework to understand how the market is reacting to them. My framework is based on several broad theories: that military and economic power expand and contract together, economic growth happens where capital is invested, lower prices drive economic expansion and improve productivity, and stable growth comes from focusing on margins and operating efficiency.
Developed economies are weak, and their power is being challenged both internally and externally. The solution to the debt crisis, thus far, consolidates economic power into regional authorities that are not accountable to voters. In contrast, there is a greater overt expression of democratic principles around the world. Whether it is in Egypt, Greece, or the United States, the protests we are seeing will gain strength, until a transition occurs or growth resumes. When economic growth slows, the ability of the population to improve their quality of life slows, and economic inequality becomes more difficult to justify.
In Europe while many think the monetary union will break up, I would not underestimate the probability that the eurozone follows the US example by devaluing its currency and consolidating economic power into organizations like the European Central Bank. After all, we have seen Greece, Ireland, and Italy adopt austerity measures, and while the leaders that passed the measures were removed from power, the legislation has not been reversed. Whether Europe stays together or breaks apart, understanding that these transitions have happened throughout history allows us to optimistically embrace the uncertainty of our future, rather than fear the inevitable volatility that follows major shifts in political and economic power.
Following the collapse of the Soviet Union, the US and NATO expanded their military and economic power through two decades as the unchecked global "super power." It is no surprise that the political establishment, which is viewed as inept and enormously unpopular in our own country, is even less popular in nations where we have troops on the ground engaged in military actions. So even if democratically elected regimes come to power in Middle East nations like Egypt, Iraq, and Libya, we should not be surprised if those regimes fail to embrace US objectives and actions in the region. In fact, there is popular support across the Middle East for Iran's nuclear program, as many fear the unchecked aggression of the US. The Iranians are leveraging distrust of American actions to entrench themselves as a regional power that stands as an alternative to Western powers. Whether Iran becomes nuclear or not is secondary to their partnership with Russia, which allows them to exert significant influence over global energy prices, one of the most powerful economic weapons in the world.
Both times oil prices climbed over $100/bl (and gasoline $4.00/gallon), it stamped out the ability of the economies to grow. The world was paying attention and discovered that economic expansion becomes increasingly difficult when energy prices increase and the economy becomes less efficient and productive. For all of the discussion about the widening Output Gap in the US (the difference between the potential economic output and the actual level), little attention has been paid to the impact of energy prices on that disconnect in productivity.
Carrying this farther, the Federal Reserve's Quantitative Easing Program (called QE2) was a failure, because the impact was the inverse of what was intended. Instead of lowering interest rates, they climbed higher and triggered inflation at the same time. While many in the market are looking for another round of QE, I think the Federal Reserve rightfully realizes the negative impact that higher interest rates and higher inflation had on the fragile economy. With the Federal Funds Rate at zero, the price of oil becomes the new mechanism to transmit monetary policy into the economy. Unfortunately, this is not under the direct control of the Federal Reserve.
Throughout history, cheap energy has yielded greater economic productivity, which is why it has been at the heart of many geopolitical battles. Europe originally unified, in part, to secure collective access to energy resources. If the EU breaks-up, the northern countries will be cut off from the oil supplies on the Middle East and Africa, and the Southern countries lose the financial and military backing to secure access to oil resources in the Middle East. This makes the north much more dependent on North Sea production, which has been steadily declining since peaking in 1999, and Russia, which recently completed a pipeline delivering natural gas directly into Germany. We have seen the European and NATO alliance begin to split, as Germany sided with Russia in failing to support the US sponsored resolution on Libya proposed to the United Nations Security Council. However, those calling for a break-up of Europe because of financial issues, ignore that a united Europe is considerably more powerful than a divided Europe.
Whether one agrees with theories of peak oil or not, the statistics show that the world is becoming more dependent on oil from less efficient, "unconventional," sources. The chart below, adapted from data compiled by Dr. Tom Murphy of the University of California San Diego, shows that any alternative energy source will be less efficient than conventional oil. The consequence of this is that energy is becoming more expensive and those with access to cheap energy will have a productivity advantage. In conjunction, those nations that export energy gain greater economic and political power because they can influence the performance of larger economies that have to import oil and gas. Higher energy prices act like a tax that slows the economy by reducing productivity, and transmits wealth from the consumer to the producer. In addition, the Federal Reserve also influences prices, as devaluing the dollar increases the value of energy resources, all else equal.
Throughout economic history, military power has supported trade and economic growth. In fact, the military is too expensive to support unless the profits from trade bring tax revenue that pays for the military expansion. For the last decade, the dramatic increase in US military spending has not been offset by an increase in tax revenue, because trade is not balanced, and the profits are flowing to emerging economies or off-shore subsidiaries of domestic corporations which are sheltered from US tax authority. The US government has been more aggressive in its efforts to pressure those benefitting from exporting to the US to purchase US goods and bring trade into balance, but has not had tremendous success. The recent announcement of a permanent US Naval Base in northern Australia is an indication that the US intends to remain a powerful military force around the globe.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter