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Will QE2 Trigger War Games?

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Global tensions are on the rise.

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"War's going on across the sea, street soldiers killing the elderly. What ever happened to unity? It's like that, and that's the way it is." -- Run DMC

I'll be the first to admit I'm no geopolitical expert; I've got my hands full trying to map our next steps as the rules of engagement continue to change.

Evolving socioeconomic strife was, however, one of my primary themes for 2010. (See: Ten Themes for 2010.)

As discussed in early January:
 

The Tricky Tri-Fecta

In 2007, we previewed the deterioration of the middle class and the friction between the "have's" and "have not's." In 2008, we forecast percolating societal acrimony and last year, we spoke of the migration towards social unrest and geopolitical conflict.

As this dynamic evolves, real risk remains across the spectrum of social strife. While this assumes many shapes and forms -- populist uprising, the rejection of wealth and an emerging class war -- we should remember that many global conflicts have historically been triggered by financial hardship.

An Israeli strike on Iran remains a top-line concern, as are uprisings in South America (Venezuela), protectionist policies in China (isolationism is the death knell of globalization), and saber rattling in Russia.


Fast-forward to present day. While some of those dynamics have proved true -- societal acrimony, including a bulls-eye on the back of Goldman Sachs (GS), BP (BP), superstar athletes, policymakers, and politicians, as well as select cases of social unrest, stateside and abroad -- others thankfully haven't, at least not yet. (Read: The Short Sale of American Icons.)

I'm reminded of these lyrics by Robert Hunter, as sung by the Grateful Dead.
 

We used to play for silver now we play for life
And one's for sport, and one's for blood at the point of a knife
And now the die has shaken; now the die must fall
There ain't a winner in the game, he don't go home with all, not with all.


The talented Mr. Hunter was right -- there are no winners in war. As the computer Joshua said in the movie War Games, "The only winning move is not to play."

Dude, before you call me a barefoot tree-hugging pacifist, I realize the notion of perpetual world peace, while wonderful, is highly unrealistic. I ate dinner with Don Graham of the Washington Post a year or so ago and he asked what worried me most. Before I could self-edit, I said "World War III; global conflicts are usually born from economic hardship or religious differences and that's where the needle seems to be pointing." (See also Lloyd's Wall of Worry.)

I'm not talking nuclear Holocaust, mind you. That's, well... game over. I'm talking about global friction reaching a tipping point, sovereign nations protecting themselves, lines being drawn in the sand -- and those lines being defended.

As referenced above, protectionism is the "other side" of globalization and that makes this topic fair game for a financial forum. We strive to see both sides in Minyanville, even when the other side isn't particularly pleasant. Optimism and realism make for strange bedfellows but they beat the pants off ignorance and apathy.

Why Share These Thoughts Now?

The signs are pointing towards an unfortunate destination. Earlier this year, we wrote about the percolating cross-border problems, from the Flotilla friction to Iran tensions to saber rattling on the Korean Peninsula to leaks of Afghan war logs, with European social strife on the rise and a global play for crude mixed in for good measure. Sovereign posturing is ever-present and on the rise. Can you feel it?

Following the second iteration of quantitative easing last week, we received more troubling data points from around the world. President Barack Obama defended the additional stimulus by saying, "The Fed's mandate, my mandate, is to grow our economy. And that's not just good for the United States, that's good for the world as a whole." Unfortunately, global leaders didn't share his enthusiasm.

Wolfgang Schäuble, German Finance Minister, called the Fed's actions "clueless" and said, "It doesn't add up when the Americans accuse the Chinese of currency manipulation and then artificially lower the value of the dollar... I have great doubts about whether it makes sense to pump unlimited amounts of money into the markets. There is no shortage of liquidity in the US economy. I can't see the economic argument for this move."

Dilma Rousseff, Brazil's president-elect, warned, "The last time there was a competitive devaluation of currencies it ended up where it did, in the Second World War."

Zhu Guangyao, the Chinese vice finance minister, offered, "The US decision 'does not recognize, as a country that issues one of the world's major reserve currencies, its obligation to stabilize capital markets."

Arkaday Dvorkovich, the Russian G-20 negotiator, opined, "Russia's president will insist 'such actions (as pumping cash into the US economy) are taken with preliminary consultations with other members' of the G-20."

Unintended Consequences

We've mapped the crossroads. On one side, there's the bitter pill of debt destruction, asset class deflation, and a stronger dollar. On the other, there's more of the synthetic sweetener that got us into this mess in the first place. (See The Main Event: Inflation vs. Deflation.)

But it's not that clean. For every action, there is an equal and opposite reaction and when the actions are cumulative, the reaction will be equally severe. We saw it in 2008 and take me at my word, we'll see it again. (See: The Anatomy of a Recession.)

The issue of course is how and when this amorphous dynamic manifests and that, my friends, is a question I'm not smart enough to answer. What I can say is the lurking danger may not be on our screens as much as behind the scenes. The ramifications of policy gone awry are ever-present in the social sphere and where you are in the aforementioned "tricky tri-fecta" is perhaps a function of what part of the world you're reading this.

To be sure, there's a bull case in play. When the decision was made to give the drunk another drink with hopes he doesn't sober up, corporate credit markets continued their amazing bull run, which points to higher equity levels still. One could argue that layer of debt is sandwiched on either side by a sovereign sticky situation and consumers extended over their skis but that won't matter until it does, at which point it will matter a lot.

Factor in the animal spirits of performance anxiety -- pension fund managers have to buy a higher tape, also known as a "long squeeze" -- and voila, we see the year-end tug-o-war currently taking shape. The collective psychology and perceived credibility surrounding the decision-makers in Washington are perhaps the single greatest determinants of our global financial fate.

The Other Side of the Trade

Current policy is a Band-Aid on a broken bone and the logic is simple enough to follow. Printing more dollars increases the money supply thus lowering the value, which makes alternative currencies more attractive (and that handcuffs policymakers across the pond). That's fine in a vacuum but not so much when the greenback is the world reserve currency and the measuring stick of multiple asset classes.

Look at it this way. You're China and you own, say, gold. Since the beginning of September, gold is up 15% and the dollar is down 9%. You own gold (nice call!) but you're losing almost two-thirds of your gains on the aggregate, which sucks... if you're China.

Now pull back the lens. The dollar index is down 36% since 2002 -- Thirty-Six Percent --and during that same stretch the S&P is basically flat. All of a sudden, the notion of currency wars and economic espionage isn't that far-fetched. This has been going on for a long time and foreign holders of dollar denominated assets have every right to be pissed.


Click to enlarge

We learned the hard way that it's one thing to write about "a prolonged period of socioeconomic malaise entirely more depressing than a recession," as Minyanville did in 2006 and 2007, and another thing to live through it. No matter how prepared we were -- and our community was more prepared than most -- reality's bite was much worse than its loud and at the time, very unpopular bark. (See: The Upside of Anger.)

As the world turns and tensions churn, calmer heads must prevail to avoid a similar sense of déjà vu. The current heading is in nobody's best interest; this is not a story one wishes to foretell. Quite hopefully awareness, engagement ,and yes, humility will serve as the first steps towards preparedness or better yet, avoidance.

If the rest of the world is forced to endure austerity measures and upward taxation, the US, widely viewed as the genesis of the global financial crisis, best get used to a tighter stateside belt. Ironically, our leaders are telling us to go out and spend while punishing the savers who do not. That might prolong the relative calm but we already know what happens when you mess with Mother Nature or free-markets.

There is a difference between loss and loss; let's hope it won't again take something bad to make us realize that as hard as it is, it could be worse. Let's hope our politicians aren't so myopic as to enact laws aimed at reelection while lowering the standard of living for our children. Let's hope that higher food prices and unemployment are the worst headlines we'll be forced to absorb. Let's hope the up-and-coming Millennials enthusiastically embrace the task at hand and show this country what true will and an entrepreneurial spirit can achieve.

Watch the dollar (any lift will quell the upside asset class swell), eyeball the banks (which encapsulate our finance-based economy), note the resistance zone of S&P 1200-1220, and define your risk. It's entirely alright to dance while the music is playing. Some would say that's our mission in the rain, we simply have to make certain we have a seat when it stops.

Good luck.

R.P.

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No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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.

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