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Wargames

September 09, 2013

The US-lead market and global markets remain in treacherous waters, and fat tail-risks are increasing that bear close watching and could very likely cause more indigestion by markets in the near-term.

 

First, Syrian developments are heating up and the odds of some sort of military strike by some US-led coalition appears to be growing and causing concern in global equity markets. Second, US and global interest rates are continuing to rise and too much further on the upside could lead to increasingly negative follow-on developments throughout the globe. Third, an EM debt crisis is starting to boil over and is a bigger threat to global economic growth and market action than most analysts are yet acknowledging.

 

Global stock markets have been selling off and oil rallying as concerns grow surrounding an increasingly probable military strike by a US-led coalition against Syria in retaliation for its use of chemical weapons upon its populace. Even BofA analysts now project a "short-lived spike" in oil prices to $120-$130 if the military strikes are "tailored and limited." Another $20 increase in the price of oil would add $60B per month in higher energy expenses to the world energy bill, with an impact likely to be quite similar to a commensurate amount of tightening. SocGen analysts further project that if the conflict in Syria metastasizes, oil prices could jump to $150 per barrel as they did in July 2008. A lingering "limited" conflict that keeps oil prices up for several months is likely to noticeably slow global growth, while a spike over $116 in West Texas Crude for more than a few weeks runs a substantial risk of leading to an eventual global recession.

 

Obama has delayed surgical strikes on Syria and is discussing with the Russians on the issue next week that could draw things out. Several intelligence sites are suggesting that Kerry is working behind the scenes to work out a token-strike that then leads to a multi-lateral peace negotiation. The UK parliament has barely voted against Britain participating in punitive military action against Syria (285 to 272 votes, with 13 abstentions), but France, Japan, and the US appear set to act on their own if necessary. Obama is promising proof of use of chemical weapons and most Western sources acknowledge that chemical weapons were used, although not all, and not China and Russian sources, while Iran and Syria claim such accusations are ridiculous. Scientists suggest that there is some guesswork involved in trying to determine if chemical weapons were used, and this uncertainty is leading many to recall the WMD speculation that was used to rationalize the Iraq War that turned out to have been misleading. It is also possible that non-banned substances were used. Boehner has confirmed he will back a strike as use of chemical weapons must be responded to. Also strange have been the leaks about US attack plans which have allowed the Syrians to move underground and prepare for an attack in a way that either represents military incompetence or a propaganda effort for the benefit of the press instead of movement toward a serious military operation. Israel has defeated Syria's Russian integrated air defense system three times in the past eighteen months in attacks that were not retaliated against directly, but a Western attack could breed Iranian and Hezbollah terrorist retaliations against the US, Western Europe, the Persian Gulf states, and wherever Iranian Revolutionary Guard corps have a presence.

 

Russian, Chinese, and Iranian warnings against military intervention have reached a fever pitch, with Moscow saying any such action would have "catastrophic consequences" for the region, and Gen. Jazayeri, deputy chief of staff of Iran's armed forces saying Sunday that "any crossing of Syria's red line will have severe consequences for the White House," while Khamenei himself has said that if the US attacks Syria "the entire Middle East will suffer from burns.[in a] disaster for the entire region." The UN is likely to be too divided to decide anything, and NATO cannot realistically bomb Syria without US military primary leadership as Libya showed. The latest UN estimate is that more than 100,000 people have been killed and nearly 2 million registered refugees have developed since the uprising against President Assad began more than two years ago.

 

US B-1B bombers and F-22 Raptor stealth fighter jets have been moved from Qatar, Masirah and Diego Garcia to Jordan and areas closer to Syria, while Syrian personnel, weapons and military assets have been moved to safe places in case of US assaults. Russian anti-submarine ships and missile cruisers (including the Moskva with the strongest firepower of any Russian warship) are on the way to the region. A number of intelligence sites suggest the tail risks of WWIII lay in the balance of what happens in the conflict.

 

Regardless what happens in Syria, there are other fat tail-risks to be aware of and watch out for. US and global interest rates are continuing to rise and too much further on the upside could lead to increasingly negative follow-on developments throughout the globe. 

 

We've discussed potential market rioting against artificially low interest rate manipulation by central banks. Yet even without such a "bang point" there are risks of rates continuing to rise. Right now there is a disconnect between inflation expectations and real rates of interest. Inflation expectations are near 2% while the real rate of interest (after inflation) on the 10yr Tbond is still under 1%. A rise in real rates to 2% or higher would be normal given current inflation expectations, and just that rise could increase nominal rates to more than 4%. Economists are starting to point out that the promise to keep short-rates low until unemployment drops below 6.5% from the current 7.4% rate could mean that the "extended period" of low rates could end as early as 2014 (since unemployment is down 1% over the last year). That hardly means much to long-term bonds. Nor does the current debate about when to taper likely have much impact on rates 2 years or further out. If inflation expectations stay high and the budget deficit is not attacked meaningfully, it is not unreasonable to assume even higher real rates of interest that imply a 10yr nominal rate of 5% or higher. Investors reached for yield in 2008 and it ended very badly as central bank policy of artificially low rates created bubbles that eventually popped. Today bond buyers are assuming inflation risk, duration risk, and credit-quality risk and hardly being paid for these risks. The reach for yield flowing from artificially low rates is likely to backfire again, and bond-holders could be the bag holders of an asset in long-term decline. There are many risks of higher rates beyond just rioting against debt levels to consider. 

 

Many institutional investors are already aware of this, and have been reducing their fixed income exposure over the past several months.  Almost all fixed income indexes and portfolios have produced negative YTD returns with significant volatility along the way. Wall Street loves to tell bond investors, "don't worry, you are not really losing.  As long as you don't sell, it's not a realized loss."  We say that's balderdash.  The marked to market liquidation value of an investment is what is real at any given point in time.  And at this point in time, investors in treasury bonds, muni bonds, corporate bonds and REITs are losing money on the year.  One exception has been in diversified peer to peer consumer credit portfolios like Prime Meridian Income Fund (which is limited to accredited investors).

 

Past performance is not necessarily indicative of future results. The risk of loss exists.

 

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