The Global Security Deficit

Michael Spence

JUL 25, 2014

Airport Security

FORT LAUDERDALESummer is normally a time to take a break from the risks and worries of everyday life, and perhaps to take stock of where we are and where we are heading. But this is increasingly difficult, because our everyday lives are becoming so much riskier and more worrying.

Much of the discussion in the period following the 2008 financial crisis focused on various economic imbalances that either threatened or impeded growth. These issues have not gone away. The US economy’s surprisingly weak performance in the first quarter, for example, has left analysts confused and uncertain about its trajectory.

But, to an increasing extent, political insecurity, potential conflict, and deteriorating international relations pose a greater threat to economic progress than the post-crisis debate foresaw.

Asia, a bright spot in terms of growth in the post-crisis years, is now experiencing rising tensions that jeopardize regional trade and growth. Japan’s somewhat fragile recovery could be derailed by an escalation of its territorial conflict with China, which is both a major market for Japanese goods and deeply integrated into Japanese firms’ supply chains.

While territorial disputes often are historically and politically important, their economic significance is usually minor, even minuscule, unless tensions like those in the East and South China Seas are allowed to get out of hand. America’s ambiguous role in Asian security owing to its interest in supporting its regional allies while not antagonizing Chinacontributes to the uncertainty.

Aside from their strategic minuet in Asia, China and the United States are engaged in a cyber-security battle that is already starting to affect flows of goods, investment, and technology. On both sides, stated commitments to resolve the issue cooperatively have not produced significant results. And disputes over electronic surveillance have caused tension between the US and Europe.

The Middle East, meanwhile, has entered a period of extreme instability that will surely have negative economic effects both regionally and globally. And the tug of war between Russia and the West over Ukraine and other former Soviet satellites will adversely affect European regional stability, energy security, and economic growth.

The downing of Malaysia Airlines Flight 17 over eastern Ukraine – and, more recently, the suspension of commercial flights to Tel Avivadds a new dimension of uncertainty. When civilian air traffic is no longer safe from attack, one may legitimately wonder about the effectiveness of the basic systems of governance that underpin global commerce.

Indeed, the World Trade Organization is once again in jeopardy, with the Indian government threatening to veto the Agreement on Trade Facilitation reached in Bali last year, owing to disagreements about food stockpiling and subsidies. A loss of confidence in the WTO would be a major blow to an institution that plays a vital role in securing international cooperation and regulation.

The global economy is a far more highly interconnected place than it was 40 years ago. The cross-border flows of goods, information, people, and capital that are its lifeblood rely on a threshold level of safety, stability, and predictability. It is this threshold that appears to be under threat. Continued economic progress in the developing world and recovery in the developed countries requires preventing local and regional conflict from delivering large systemic shocks.

In terms of priorities, it is arguably more important for G-20 governments to strengthen the core systems that enable global flows than it is to address strictly economic issues. Moreover, there is a clear, shared interest in doing so: No one benefits from the expansion of systemic risk.

Failure to contain the impact of regional conflicts and bilateral frictions may lead to more than just supply shocks in areas like energy. The principal effect is likely to be a series of negative demand shocks: investors withdrawing, travelers staying home, and consumers closing their wallets. In a global economy in which aggregate demand is a key growth constraint, that is the last thing the system needs.

We have gone about as far as we can with a global system that is at best partly governed and regulated. As the global order defined by the Cold War (and then by a briefly dominant America) recedes into history, a new set of institutions and agreements must be developed to protect the core stability of the system.

That is easier said than done. But the starting point is to recognize the broad-based damage to the global economy’s prospects that failure to address the issue implies. Ineffective regulation in areas like food safety, infectious diseases, cyber security, energy markets, and air safety, combined with the inability to manage regional tensions and conflict, will undermine global flows and reduce prosperity everywhere.

In a way, the current global environment is a classic case of negative externalities. The localized costs of suboptimal behavior – the ones one might expect to be internalized fall well short of the overall global costs.

Several more narrowly economic issues – for example, defective growth patterns, underinvestment in tangible and intangible assets, and the absence of reforms designed to increase structural flexibilityremain a cause for concern, because they underpin subpar growth.

But, at this moment in history, the main threats to prosperitythose that urgently need world leaders’ attention and effective international cooperation – are the huge uncontained negative spillover effects of regional tensions, conflict, and competing claims to spheres of influence. The most powerful impediment to growth and recovery is not this or that economic imbalance; it is a loss of confidence in the systems that made rising global interdependence possible.

Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, and Academic Board Chairman of the Fung Global Institute in Hong Kong. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.

Geopolitics and Markets

John Mauldin

Jul 24, 2014

Growing geopolitical risk is on everyone’s mind right now, but in today’s Outside the Box, Michael Cembalest of J.P. Morgan Asset Management leads off with a helpful reminder: the only time since WWII that a violent conflict has had a medium-term negative effect on markets was in 1973, when the Israeli-Arab war led to a Saudi oil embargo against the US and a quadrupling of oil prices. And he backs up that assertion with an interesting table of facts labeledWar zone countries as a percentage of total world… [population, oil production, GDP, etc.].”

Having gotten that worry out of the way, he takes on the dire warnings that have recently been issued by the BIS, the IMF, and even the Fed, about a disconnect between market enthusiasm and the undertow of global economic developments. (He gives this section the cute titleProphet warnings.”) Let’s look, he says, at actual measures of profits and how markets are valuing them; and then he goes on to give us a “glass half-fulltake on prospects for the US economy for the remainder of the year. He throws in some caveats and cautions, but Cembalest thinks we could finally see another 3% growth quarter this year, which could create room for further profit increases.

There are good sections here on Europe and emerging markets here, too. Cembalest gives us a true Outside the Box, with a more optimistic view than some of our other recent guests have had. But that’s the point of OTB, is it not, to think about what might be on the other side of the walls of the box we find ourselves in? I have shared his work before and find it well thought out. He is one of the true bright lights in the major investment bank research world. That’s my take, at least.

Ukraine and Gaza are epic tragedies, but gods, what wonders we humans can create when we pursue life rather than death. It just makes you want to take some people by the back of the neck and shake some sense into them.

Have a great week. And maybe commit a random act of kindness, even if you are not on The Road.

Your smiling as he writes analyst,

John Mauldin, Editor
Outside the Box

Geopolitics and markets; red flags raised by the Fed and the BIS on risk-taking

Michael Cembalest, J.P. Morgan Asset Management

Eye on the Market, July 21, 2014

You can be forgiven for thinking that the world is a pretty terrible place right now: the downing of a Malaysian jetliner in eastern Ukraine and escalating sanctions against Russia, the Israeli invasion of Gaza, renewed fighting in Libya, civil wars in Syria, Afghanistan, Iraq and Somalia, Islamist insurgencies in Nigeria and Mali, ongoing post-election chaos in Kenya, violent conflicts in Pakistan, Sudan and Yemen, assorted mayhem in central Africa, and the situation in North Korea, described in a 2014 United Nations Human Rights report as having no parallel in the contemporary world. Only in Colombia does it look like a multi- decade conflict is finally staggering to its end. For investors, strange as it might seem, such conflicts are not affecting the world’s largest equity markets very much. Perhaps this reflects the small footprint of war zone countries within the global capital markets and global economy, other than through oil production.

The limited market impact of geopolitics is nothing new. This is a broad generalization, but since 1950, with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium-term impact on US equity markets. In the charts below, we look at US equities before and after the inception of each conflict in three different eras since 1950. The business cycle has been an overwhelmingly more important factor for investors to follow than war, which is why we spend so much more time on the former (and which is covered in the latter half of this note).

As for the war-zone countries of today, one can only pray that things will eventually improve. Seventy years ago as the invasion of Normandy began, Europe was mired in the most lethal war in human history; the notion of a better day arising out of misery is not outside the realm of possibility.

Soviet invasions of Hungary and Czechoslovakia did not lead to a severe market reaction, nor did the outbreak of the Korean War or the Arab-Israeli Six-Day War.

We did not include the US-Vietnam war, since it’s hard to pinpoint when it began. One could argue that Vietnam-era deficit spending eventually led to rising inflation (from 3% in 1967 to 5% in 1970), a rise in the Fed Funds rate from 5% in 1968 to 9% in 1969, and a US equity market decline in 1969-1970 (this decline shows up at the tail end of the S&P series showing the impact of the Soviet invasion of Czechoslovakia).

The Arab-Israeli war of 1973 led to an oil embargo and an energy crisis in the US, all of which contributed to inflation, a severe recession and a sharp equity market decline. Pre-existing wage and price controls made the situation worse, but the war/embargo played a large role

Separately, markets were not adversely affected by the Falklands War, martial law in Poland, the Soviet war in Afghanistan, or US invasions of Grenada or Panama. The market decline in 1981 was more closely related to a double-dip US recession and the anti-inflation policies of the Volcker Fed.

Equity market reactions to US invasions of Kuwait and Iraq, and the Serbian invasion of Kosovo, were mild. There was a sharp market decline after the September 11th attacks, but it reversed within weeks. The subsequent market decline in 2002 was arguably more about the continued unraveling of the technology bust than about aftershocks from the Sept 11th attacks and Afghan War. As for North Korea, in a Nov 2010 EoTM we outlined how after North Korean missile launches, naval clashes and nuclear tests, South Korean equities typically recover within a few weeks.

Prophet warnings. So far, the year is turning out more or less as we expected in January: almost everything has risen in single digits (US, European and Emerging Markets stocks, fixed-rate and inflation linked government bonds, high grade and high yield corporate bonds, and commodities). 

What made last week notable: concerns from the Fed and the Bank for International Settlements (a global central banking organization) regarding market valuations. The BIS hit investors with a 2-by-4, stating thatit is hard to avoid the sense of a puzzling disconnect between the market’s buoyancy and underlying economic developments globally”. The Fed also weighed in, referring to “substantially stretched valuations” of biotech and internet stocks in its Monetary Policy Report submitted to Congress. What should one make of these prophet warnings?

Let’s put aside the irony of Central Banks expressing concern about whether their policies are contributing to aggressive risk-taking. They know they do, and relied on such an outcome when crafting monetary policy post-2008. Instead, let’s look at measures of profits and how markets are valuing them. The first chart shows how P/E multiples have risen in recent months, including in the Emerging Markets. The second chart shows valuations on internet and biotech stocks referred to in the Fed’s Congressional submission. The third chart shows forward and median multiples, an important complement to traditional market-cap based multiples.

Are these valuations too high? Triangulating the various measures, US valuations are close to their peaks of prior mid-cycle periods (ignoring the collective lapse of judgment during the dot-com era). We see the same general pattern in small cap. On internet and biotech, valuations have begun to creep up again after February’s correction, and I would agree that investors are paying a LOT of money for the presumption that internet/biotech revenue growth is “secular” and less explicitly linked to overall economic growth.

As a result, we believe earnings growth is needed to drive equity markets higher from here. On this point, we see the glass half-full, at least in the US. After a poor Q1 and a partial rebound in Q2, US data are improving such that we expect to see the elusive 3% growth quarter this year (only 6 of 20 quarters since Q2 2009 have exceeded 3%). With new orders rising and inventories down, the stage is set for an improvement. Other confirming data: vehicle sales, broad-based employment gains, hours worked, manufacturing surveys, homebuilder surveys, a rise in consumer credit, capital spending, etc. If we get a growth rebound, the profits impact could be meaningful. The second chart shows base and incremental profit margins. Incremental margins measure the degree to which additional top-line sales contribute to profits. After mediocre profits growth of 5%-7% in 2012/2013, we could see faster profits growth later this year. With 83 companies reporting so far, Q2 S&P 500 earnings are up 9% vs. 2013.

Accelerated monetary tightening could derail interest-rate sensitive sectors of the economy, so we’re watching the Fed along with everybody else. Perhaps it’s a reflection of today's circumstances, but like Bernanke before her, Yellen appears to see the late 1930s as a huge policy fiasco: when premature monetary and fiscal tightening threw the US back into recession. That’s what Yellen's testimony last week brings to mind: she gave a cautious outlook, cited "mixed signals" and previous "false dawns", and downplayed the decline in unemployment and recent rise in inflation. In other words, she’s prepared to wait until the US expansion is indisputably in place before tightening.

An important sub-plot for the Fed: where are all the discouraged workers? For Fed policy to remain easy, as the economy improves, the pace of unemployment declines will have to slow and wage inflation will have to remain in check. The Fed believes discouraged workers will re-enter the labor force in large numbers, holding down wage inflation. Fed skeptics point out that so far, labor participation rates have not risen, creating the risk of inflation sooner than the Fed thinks. It’s all about the “others” in the chart, since disabled and retired persons rarely return to work. Ifotherscome back, it would show that there hasn’t been a structural decline in the pool of available workers. The Fed believes they will eventually return, and so do we.


Germany and France are slowing; not catastrophically, but by more than markets were expecting. This has contributed to a decline in European earnings expectations for the year. As shown on page 2, Europe was priced for a return to normalcy, and with inflation across most of the Eurozone converging to 1%, things are decidedly not that normal. Markets are not priced for any negative surprises, which is why an issue with a single Portuguese bank contributed to a sharp decline in banks stocks across the entire region.

Emerging Markets

The surprise of the year, if there is one, is how emerging markets equities have rebounded. As we wrote in March 2014, the history of EM equities shows that after substantial currency declines, industrial activity often stabilizes. Around that same time, we often see equity markets stabilize as well, even before visible improvements in growth, inflation and exports. This pattern appears to be playing itself again: the 4 EM Big Debtor countries (Brazil, India, Indonesia and Turkey) have experienced equity market rallies of 20%+ despite modest improvement in economic data (actually, things are still getting worse in Brazil and Turkey).

There’s also some good news on the EM policy front. In Mexico, it appears that the oil and natural gas sector is being opened up after a 25% decline in oil production since 2004. This would effectively end the 75-year monopoly that Pemex has over oil production. Other energy–related positives: Mexico has shifted the bulk of its electricity reliance from oil to cheaper natural gas over the last decade, giving it low electricity costs along with its competitive labor costs

Factoring in new energy investment, new telecommunications and media projects opened to foreign investment and support from both private and public credit, we can envision a 2% boost to Mexico’s GDP growth rate in the years ahead. This can not come soon enough for Mexico: casualties in its drug war rival some of the war zone countries on page 1.

Now for the challenges. Brazil has bigger problems right now than its mauling at the World Cup. With goods exports, manufacturing and industrial confidence slowing and wage/price inflation rising, Brazil is about to experience a modest bout of stagflation. Markets don’t appear to care (yet).

As for China, growth has stabilized (7%-8% in Q2) but we should be under no illusion as to why: credit growth is rising again. China ranks at the top of list of countries in terms of corporate debt/GDP. I don’t know what the breaking point is, but we’re a long way from pre-crisis China when GDP growth was organically driven and less reliant on expansion of household and corporate debt. There’s some good news regarding the composition of growth: investment is slowing in manufacturing and real estate, and increasing in infrastructure; and while capital goods imports are flat, consumer goods imports are rising, suggesting a modest transition to more consumer-led growth. But for investors, the debt overhang of state-owned enterprises and its impact on the economy is the dominant story to watch

That explains why Chinese equity valuations are among the lowest of EM countries (only Russia is lower; for more on its re- militarization, economy and natural gas relations with Europe, see “Eye on the Russians”, April 29, 2014).

On a global basis, demand and inventory trends suggest a pick-up in economic activity in the second half of the year. If so, our high single digit forecast for 2014 equity market returns should be able to withstand the onset of (eventually) tighter monetary policy in the US. The ongoing M&A boom probably won’t hurt either.