U.S. WILL WIN FROM MIDDLE EAST DOMINO / THE FINANCIAL TIMES MARKET ANALYSIS ( A MUST READ )

US will win from Middle East domino effect

By Scott Minerd

Published: February 28 2011 13:43


Mark Twain famously said that “history doesn’t repeat itself, but it does rhyme”. As investors consider the ramifications of turmoil in the Middle East and North Africa, I can’t help but reflect on the political revolutions that swept through Eastern Europe and the Soviet Union in the early 1990s.


During that period, the winds of change that brought the collapse of communist regimes also precipitated turmoil in the financial markets and severe recessions. Along these lines, I believe the events in the Middle East-North Africa region today will perpetuate an economic domino effect that may result in dramatic shifts across the investment landscape over the course of the next year.


As we have already begun to see, the mere threat of a disruption to the world’s oil supply has caused the price of crude oil to spike. Short of a threat to Iran or Saudi Arabia, oil at $200 per barrel is unlikely. Nonetheless, as the democracy movement spreads across the Middle East, there is a very real prospect that perceived pressures may push prices to $125 or higher.


If energy prices linger at such elevated levels, the next domino will be heightened inflationary pressures around the world, particularly in emerging markets. Prior to the events in the Middle East, the Bric countries – Brazil, Russia, India, and China – needed to take dramatic policy actions to cool overheating markets and fight inflation. If energy prices surge, there will be even greater pressure for meaningful monetary policy tightening across all emerging market economies in 2011.


We’ve already seen this in Russia, where a surprise rate increase was announced on February 25. I believe this is a sign of things to come for emerging market economies, especially China and India, which currently struggle with inflation rates well above short-term interest rates.


Restrictive monetary policy will lead to an economic slowdown in emerging markets. And, since it’s seldom a good bet to fight against central banks, emerging market equities are not the place to be for the next few quarters. For investors looking at these markets, the next entry point should become apparent once there has been a material increase in interest rates and commodity prices begin to trend downward.


Returning to the domino theory, an economic slowdown in emerging markets will be especially painful for Germany, whose economic rebound in 2010 was fuelled by emerging market demand for German autos, industrial products, and machinery.


As German economic horsepower decreases, the slowdown will cascade into other European economies. If German gross domestic product falls to below 2 per cent, which I think is highly likely, then growth for the entire euro area will likely dip below 1 per cent, or possibly even contract. This means the euro area could find itself on the brink of another recession and the European Central Bank would be forced into accommodative monetary policy.


After all these dominos fall, global investors will likely find themselves in a world that looks like this: the Middle East is highly unstable, emerging market economies are slowing, and the crisis in Europe has been exacerbated by shrinking exports, leading to a decline in the value of the euro.


Against this landscape, the US economy and dollar-denominated financial assets will look increasingly attractive on a relative value basis. By the second half of the year I expect to see a rebound in the dollar, lower bond yields, and the outperformance of US equities relative to Europe and most of the emerging market countries, with the possible exception of Russia. The flight to safety play will also be good for gold prices, which continue to be in a generational bull market despite the recent consolidation (which I view as healthy).


Finally, what may be most ironic about the fact that the US ends up benefiting from this series of events is that the domino which set this scenario in motion across the globe – from the Middle East to Asia and then Europe – was actually the Federal Reserve’s policy of quantitative easing.


By printing almost $2,000bn dollars and using that money to buy assets, the United States created a rising tide of liquidity that has lifted all asset prices, including commodities, and more specifically agricultural products. Just as chronic food shortages were a major catalyst in the 1991 revolution in the Soviet Union, rising food prices have been a catalyst for the social unrest in the Middle East and North Africa.

Regardless of who’s to be blamed (or credited, depending on your perspective) for prompting the social unrest that has swelled into waves of democratic revolutions washing over the Middle East, the moral of the story for investors is that the US financial markets should prove to be one of the most attractive places to invest in 2011.

Scott Minerd is chief investment officer at Guggenheim Partners


Copyright The Financial Times Limited 2011.