Unless one has fallen down a
mineshaft, it is impossible to not notice that the United States is in the home
stretch of its quadrennial (or is that perennial?) presidential election season.
Rightly, the moribund economy, with its sub 2% growth and 8%-plus joblessness,
has been the key issue. But given recent events such as the terrorist attack on
U.S. facilities in Libya, the ongoing carnage against Syrian civilians and
Israeli Prime-Minister Netanyahu’s red-line drawn during last week’s U.N.
gathering with regard to Iran’s pursuit of nuclear capability, foreign policy
has belatedly come to the fore.
Starting with the subject of
America’s role in the world, several entries between now and the first Tuesday
in November will concentrate on election-related issues. Keeping with the
mission of these pages, analysis will concentrate on how such themes can impact
financial markets and the real economy.
Three international issues with direct economic implications are the
ongoing tribulations in the Middle East, the ascendency of China, and America’s
historical position as champion of open markets.
One of the many axioms governing
markets is that investors hate uncertainty. As long as they can attach
probabilities to likely outcomes, they are able to manage risk and go about
their business of valuing assets and enterprises. Any upheaval in the
underlying geopolitical foundations of the global economy will see investors
dumping risky assets and heading towards safe havens like Treasuries, the U.S.
Dollar and gold. This means that traders who happen to have long positions in
such assets at the time of a crisis stand to make a healthy, if marginally scrupulous,
return. Despite immediate sell-offs accompanying global flair-ups, market
participants, particularly those with longer-term horizons, quickly reassess
the altered landscape, price in the new risks and often send asset prices higher
in relatively short order.
The Framework
For decades the U.S. has largely sculpted
the framework, if not written the rules, for the global economy. The model is
based on open-markets for goods and services, the free flow of capital and the
rule of law, often accompanied by the promotion of democratic values. These underpinnings
have come into question in light of the colossal blow up of overleveraged
developed economies beginning in 2007. Furthermore, the rise of China over the
past two decades has putatively put forth an alternative paradigm for emerging
countries to emulate. One of the key questions hanging over the geopolitical
landscape is whether China will play by the long established rules of a
liberalized global economy or whether it will push forth with its semi-mercantilist
model?
Economic turmoil may also be altering
other recent trends in global economics. Has globalism run its course and is
regionalism on the rise? Already intra-emerging market trade is displacing commerce
between developing and developed nations as giants like China import materials
and semi-finished products to feed its juggernaut manufacturing base. There is
essentially a conveyer belt…in the form of freighters….between Brazil and China
carrying iron ore, other metals and myriad soft commodities. Already, perhaps the greatest benefit of
globalization, that of the disinflationary effect of cheap Asian labor on
global prices, has grown long in the tooth, thus limiting the rationale for
further economic integration. Another consequence of the crisis is the growth
of protectionism in both developing and developed countries at the expense of
the open-markets agenda. Fuel for this shift includes politicians looking for a
boogieman (ideally foreign) on which one
can blame economic ills, the knee-jerk reaction of slowing emerging markets to
go back to erecting trade barriers, and the populist backlash in several
countries regarding the growing disparity between rich and poor. Regardless of
the motive, protectionist steps almost always backfire, curtailing trade,
punishing local consumers and propping up inefficient state-favored domestic
enterprises.
A Very Crude Assessment
At the risk of being tastelessly
pragmatic, I am going to view the multiplicity of events occurring in the
Middle East through the prism of the oil markets. This is not to slight the
aspirations of the region’s citizens as they struggle for greater freedoms and
representation, but the main conduit between these countries and the global
economy is the energy market. For over a year, the Arab Spring has roiled the
region as long-entrenched regimes fall to the power of the street….and a few
well place NATO sorties in the case of Libya. With the exception of that
country, no major oil producers have been impacted. Yet.
Western powers’
response has been piecemeal, as best contrasted by the rooting out of Qaddafi,
while Syrian rebels have been left in the lurch. Further complicating regional matters
is Iran’s continued drive towards nuclear capability, purportedly for peaceful
purposes. Although this issue has been brewing for a while, the passage of time
means that a point-of-no-return may eventually be reached. Will Iran cave to
sanctions? Will Israel strike, with or without U.S. consent? Does Washington
unambiguously put its military option on the table? And how would the region’s
Sunni regimes react to a Shia nuke? Given that the region accounts for half of
global crude reserves and two-fifths of production, oil traders….and any
investor with exposure to energy intensive sectors…..have plenty to keep them
awake at night.
The election slogans of energy
independence must have David Ricardo spinning in his grave. Recent technological
advancements are clearly boosting North American production, but if other
regions can extract oil more cheaply, then let them go for it. Given the global
nature of energy markets, there is certainly a need to expand domestic production
especially now that (usually energy-inefficient) emerging markets’ usage is
rapidly rising. So even with rising domestic production, tighter excess
capacity, with extra barrels flowing to the highest bidder, means that prices
will continue to be set globally. The best example of that is seen in the chart
below, which shows price differentials between the more globally-sensitive
BRENT crude contract and America’s WTI benchmark. From 2001 to 2009 BRENT
traded at a 4% discount to WTI. In the past three years, it has averaged an 11%
premium.
The potential for a regional
disturbance to impede the flow of crude would send commercial users...and
speculative traders…scrambling to lock up dwindling supplies, thus spiking
prices. In such a situation commodities investors would stand to make a
killing. But during a sustained crisis, such as an all-out regional conflict, persistently
high crude prices would eviscerate economic growth, likely pushing the world a
step….or two or three…towards recession. In such a scenario, higher prices
would effectively act as a tax on consumers, forcing Americans shackled to
their commutes to cut back on other expenditures. At the same time,
energy-intensive industries would see expenses rise, but unable to pass along
costs to customers in a period of no real wage growth and high unemployment,
earnings would take a massive hit. This in turn would be reflected in lower equities
markets…..ignoring for now the distortive effects of Fed policy.
Well aware of these dynamics,
past price spikes were met with increased production by OPEC, namely the
Saudis. Higher prices and more profits are welcome so long as they don’t sink
the global economy. What has changed is tighter excess capacity to combat price
spikes now that emerging markets are demanding a greater share of the global
energy pie. Should a flair-up involve Iran, which straddles the northern shore
of the Strait of Hormuz, it could cut off that vital passageway, thus
eliminating any chance for the Saudis to balance world markets.
China’s Century?
No commentary on foreign policy
is complete without addressing China’s increasing global influence. So far
Beijing has been occupied with fortifying its role in the global marketplace,
leaving policing and charity to the likes of the United States. There is no
assurance that this will not change, however. The main question being bandied
about in American policy circles is what is the nature of the U.S. – Chinese relationship?
Are the countries partners, competitors or adversaries? Twenty years ago, a
friend who had lived in China observed that at that time China needed America
more than vice-versa, but that the dynamic would change. The present situation
is best encapsulated by Larry Summers’ assessment called the Balance of Terror. They need us to buy
their products. We need them to buy our bonds…especially light of 10% budget
deficits to GDP.
The dynamic of the relationship
will clearly evolve. Much is made of the necessity for China to transition to a
greater reliance on domestic consumption rather than exports. But even then, it
isn’t like they will be buying American-made cheap t-shirts and lead-tainted toys.
Instead, as the country’s manufacturers move up the value-added chain, they
will be in the market for complex American capital goods to further catalyze productivity
growth. Such a development would benefit U.S. industrial powerhouses (and their
share prices). These firms are already becoming ever more reliant upon emerging
market sales to goose growth.
On the flipside, the U.S. and
other advanced economies are finding themselves in resource competition with
China, best illustrated by the country accounting for nearly half of global
demand for several key industrial metals. Not only will this add to global inflationary
pressure, but various players will seek to build regional influence in order to
secure future materials and energy supplies. China’s investment in African
resources and the infrastructure through which to move them provides a template
for how the country will likely interact globally in years to come. What
remains to be seen is how much China intends to flex its muscle in eastern
Asia, currently by developing trade relationships but possibly militarily as
well. On a similarly ominous note, the issue of intellectual property
protection and industrial espionage also clouds the relationship between China
and the West. Not only does such activity impact the supply chain of firms that
have set up shop in China, but it robs them of the opportunity to penetrate the
massive markets for goods as China shifts towards more domestic consumption.
Trade
The U.S. has been one of the
leading advocates of unfettered trade in the post WWII era. The one-two punch
of a weaker economy and an election season, in which candidates on all sides offer
more than a whiff of protectionist sentiment, threatens, at least in the
short-term, to undermine America’s message about the benefits of open markets. In
contrast to the domestic economic debacle of the 2000s thanks to the housing
bubble, the decade brought advancements in the realm of linking international
markets. The number of countries with which the U.S. had Free Trade Agreements
(FTAs) increased from three to seventeen. Since the crisis, the pace has
slowed, although agreements have recently been enacted with both Columbia and
South Korea.
America’s argument for free trade
is that in many cases it already offers unimpeded imports of industrial inputs
from developing markets. Yet those countries have tariffs in place to protect
domestic industries, hindering the sale of American capital goods. Although
this relationship benefits the…often politically well-connected…local players,
it denies domestic buyers the ability to purchase higher quality products at
possibly lower prices. This allows the local enterprises to evade the
productivity enhancing discipline provided by competition. And obviously, it
hinders the revenue growth of advanced economy manufacturers.
The U.S. and Europe live in glass
houses when complaining about trade barriers as both block the import of
agricultural goods that compete directly with powerful local producers, the
sugar industry being the best example of U.S. trade doublespeak. Just as in the
example above, domestic consumers suffer, as well as farmers (often extremely
poor ones) in agrarian-dependent undeveloped economies. The consistent
implementation of a free trade agenda would go a long way in meeting other
foreign policy goals such as the alleviation of poverty and establishment of
stable governments in transitional regions.
A Few Others Hot Topics
Not mentioned here is the ongoing
Eurozone debt crisis as U.S. foreign policy initiatives have little impact on
developments in Brussels and Frankfurt, although the Fed and administration
have not been afraid to chime in about the joys of debasing one’s currency to
dig out of a fiscal mess. Should the crisis continue, U.S. corporate earnings
would likely suffer due to lost exports and lower sales by their European
operations. A weakening of the Euro against the dollar would also make European…namely
German….industrial products more competitive in global markets versus their
American counterparts.
Tied into the Arab Spring is the democracy agenda championed by recent
administrations. While true that representative governments seldom go to war
with each other, it remains to be seen how pragmatic newly established regimes
in the Middle East (and beyond) are in their relations with the West and adhering
to the rules of the global economy. These questions are the same raised with
regard to China.
Lastly, as has been pointed out
on the campaign trail, domestic economic issues are tied to foreign affairs.
The stronger America is financially, the more likely it can both influence the
debate on a range of international issues, and symbolically it can continue to
serve as an example of open markets and economic opportunity. With luck,
American voters will hear national level candidates address these issues in a
thoughtful manner in coming weeks and offer viable strategies. With the economy
stuck in low gear, politicians will need to take into account all issues,
foreign and domestic, that have an economic impact and avoid paths that will
only exacerbate the situation.
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