Revolution In The Air

To quote Bob Dylan, “there was music in the cafés at night and revolution in the air” (Tangled up in Blue). We’ve seen Tunisia discard its long-time strongman Zine al-Abidine Ben Ali. And all week Egypt has seen street demonstrations and riots on a scale not seen in decades. It seems that the Middle East is seething with revolutionary fervor. But, these revolutions aren’t rooted in Islamism. Rather than the discarded underclass rising up, it is the nascent middle class that is taking to the streets (at least so far in Tunisia and Egypt). The chant is for democracy, not theocracy. These people are demanding a voice and a vote in the future of their country.

But, this is not some pro-democracy rant, although it could be. We are capitalists and we wonder what investment implications are in this new wave of unrest in North Africa. Until Friday, global markets had not really acknowledged any anxiety about the riots in Egypt or the government change in Tunisia. While Egypt is a nation of 80 million people it had not had the same market impact as Greece with barely 11 million. When Greece saw government employees striking, global markets sank. When Egyptians take to the streets, hardly anyone noticed outside the Middle East, at least until Friday.

There is a reason for this, and it is directly tied to the fact that Greece is in the Euro and Egypt isn’t. Greece’s future was tied to the future of Germany, France, Italy and Spain (people who count to the financial markets). The Greek experience may have parallels in Belgium, Britain or even America. You could say that Greece might have been the first domino in a long line of far larger dominoes. Egypt could also be a big fat domino ready to set off a string of changes across the Middle East, but we don’t know that yet. So, since the day the riots started Egyptian stock prices have fallen about 17%, Israeli prices are down only 4% and many of the world’s bourses have gained, but there is little sense of panic. That could all change and very suddenly.

Egypt is not just another Middle Eastern satrapy. They are a bulwark against Islamist fundamentalism, though much of the modern reversion to fundamentalist Islam began in Egypt in the early part of the last century, the Mubarak regime has fought to maintain a secular Egypt.

The US has a difficult time with Egypt due to the conflicts between our old cold war stance that our dictator was preferable to their dictator, the Post-Camp David Peace where Egypt became a partner with Israel in Mid-East peace, and the new Post 9/11 era where Egypt is our buddy in a dangerous neighborhood. Egypt is among the biggest recipients of US foreign aid, both military and civilian. They are the champion of the Arab world, a counter-weight to Iran. If Egypt is out of the fight even for a little while the game could go to Iran by default. (Though a fairly peaceful transition of power might encourage Iran and other regimes to embrace change as well, or risk a worse fate.)

Without being overly simplistic, the real prize here is the oil in Saudi Arabia and to a lesser extent the Suez Canal. Without this element in the game, there would be no game and we wouldn’t even comment (have we commented on Zimbabwe or Guinea?). Without Egypt, Iran might feel it could move in on the prize. Saudi Arabia is a big country with relatively few people but lots of money. A loose partnership between Saudi Arabia and Egypt has existed where Egyptian muscle and Saudi money work together to stabilize the region. That could fall apart.

The next few weeks could see historic changes in Egypt, or maybe not. Whatever happens in Egypt is unlikely to stay in Egypt. We could see a wave of democracy movements, or we could see a reaction which would set back the cause of democracy for years. The other parallel to Iran could be that their local version of this movement was brutally crushed in 2009 while the world looked on helplessly. The security apparatus in Egypt could probably crush this movement the same way. It is our hope that change does come to Egypt. In what we like to call the golden rule of nations, we should do unto others as we would like to have done to us. We prefer to be ruled democratically, we should help others who believe the same way. We probably wouldn’t like being brutally repressed, why should we stand by while others are brutally repressed?

Issue of the Week

Well, the Financial Crisis Inquiry Commission appointed by President Obama has rendered its verdict on the events leading up to the financial crisis of 2008. In what should not be considered a surprise to anyone, lax regulation and easy money were deemed the culprits. Sure, blame Reagan and Greenspan.

Three of the ten members of the committee delivered a dissenting opinion which held that a series of 10 major and many minor elements lead to the market meltdown and aftermath, including poor government housing policy which markedly increased demand, inflated ratings on mortgage-backed securities, lax underwriting standards at Fannie and Freddie, incentives to increase risks in housing investment, and others.  This seems much more believable to us.

In the commission version, greedy bankers created this mess with an eye on the high fees they were generating selling mortgage-backed securities to gullible investors. Yes, a lot of that went on, but no one put a gun to the head of investors before they bought the securities. And if the bankers had known this stuff was going to explode, they wouldn’t have sold it to anyone, because their banks blew-up along with everybody else.

Low interest rates and new, untried mortgages fostered a house-buying stampede from the latter 90s to 2005. Confused home buyers would use whatever credit vehicle allowed them to buy the most house for the least monthly payment. Liar’s loans and floating rates with zero down and even 125% loan to value loans were a recipe for disaster. That is all too clear now.

The trouble with all of this is that everything was just fine so long as the underlying trend in real estate could be counted on to go up forever. No one thought that Freddie Mac’s and Fannie Mae’s mandate to make half of their loans to borrowers in the bottom half of the income range could cause trouble. The Fed complained about moral hazard but went ahead and bailed out all the big players anyway. There is plenty of blame to go around on this one, but the Commission decided that deregulation and greed were the major problems.

Like nearly everything else in America these days, the Commission was politicized from the beginning with Democrats wanting to blame the markets and Republicans wanting to blame Fannie and Freddie. The tough part was that both sides were right, to a point. Ultra-low rates and very easy money were going to find a home somewhere and housing was the easiest target. Incentives to loan money existed in a mortgaged-backed securities market that took as much paper as you could create. Everyday Americans wanted to get in on the action as house prices skyrocketed year-in and year-out. Builders wanted to build bigger and buyers wanted to buy bigger, and all for the same low payment. The biggest banks became hedge funds with off-balance sheet vehicles levered 33 to 1 or more in evidently ‘risk-less’ transactions. We built a house of debt and when it came crashing down there was enough damage to bring the entire economy to its knees.

But, the Commission spent over a year creating photo-ops for its members beating up folks from the Fed, SEC, FDIC, the biggest Wall Street firms, Fannie Mae, Freddie Mac, the Treasury Department, regional banks, builders, mortgage banks and anyone else they could get their hands on. Grand political theatre, but terrible economics. This was never really designed to get at the truth of the matter, rather it was to justify the re-regulation of the financial sector but that happened even before the report was finished. No wonder we have these episodes periodically.

Economic News

US GDP grew by 3.2% in the fourth quarter, below most Wall Street guesses, but comfortably above the break-even pace of just a couple of quarters ago. It was US consumers who drove the growth with their spending increasing 4.4%. Exports were the next biggest piece of the expansion with a 3.4% gain. We also saw our imports actually decline versus the 3rd quarter, which helps. On the investment side, inventories were virtually unchanged, spending on structures rose slightly and spending on equipment and software grew 5.8%.

On the negative side, government spending actually fell by 0.5% and savings were muted. Inflation increased by 2.1% in the quarter for all goods and services.

For all of 2010, GDP grew 2.9% and inflation was 1.2%. These inflation numbers will differ very substantially from the CPI and PPI numbers of inflation. In the GDP accounts, statisticians look at the actual dollars spent on different goods and services and the change in the number of goods and services sold. The difference between the dollars and the numbers of goods is inflation. Also, the mix of goods and services shifts every quarter in GDP. The CPI and PPI numbers use a fixed market basket of goods and focus on changes in price for the goods.

British GDP actually fell in the December quarter. What was supposed to be a pallid 0.5% gain, barely up at all, came in at down 0.5% instead. If you recall, Britain suffered one of the coldest winters in memory and much of the country was blanketed with snow for most of December. The severe weather certainly put a damper on economic activity. We’ll see just how much as further revisions come in.

Case-Shiller Home Prices were down again with 8 of the 20 cities in their index setting new lows for the housing collapse. The index level fell by 1% in November. After the somewhat artificial rise in the spring due largely to a one-time, first-time home-buyer tax incentive, housing prices have resumed their declines. Year over year the index is down 1.6% from November 2009. Of course, this is a seasonally weak time for home sales, so weakness ought to be expected during this part of the year. The only people selling now are desperate.

New Home Sales were stronger in December according to the Commerce Department. The gain was most evident in the South and West. The gain of 17% over November’s pace was the best monthly pace since April, when the first-time home-buyer tax credit juiced sales. For the entire year, sales of new homes were 321,000, 14% below the 375,000 pace of 2009. The median price was $241,500 compared to $215,500 in November.

Consumer Confidence from the Conference Board jumped to over 60 in January from only 53.3 in December. This is not only a big jump, but it reversed the entire decline in confidence seen since last spring. This number argues for better consumer spending in coming months. Most parts of the index rose, expectations, jobs, income, and spending. Though certainly far from ebullient, confidence is at least on the right track.

Consumer sentiment apparently fell in January. But, when you notice that the base number for December was revised from 72.7 to 74.5, the January number of 74.2 is actually a rise from the initial report. This is just weird.

Weekly Stuff

As alluded to above, the markets were largely ignoring Egypt until Friday and then the ‘fit hit the shan,’ so to speak. Most markets were down on Friday, but many not by much. This lead to a very mixed bag of weekly numbers through Friday, today may or may not change all that. (By the way, this week we are having one of our elongated weeks to capture month-end data.) Just as it looked like it was clear to go back into the water, wham Jaws 2.

The world was just getting used to an improved outlook on many of the regular economic and financial data series. Most indicators were green for the rest of this year and increasingly next year too. Many stock markets were at recovery highs. Bullishness was beginning to recover to healthy levels. The world was being nice. Too bad. Remember, when things seem to be going your way, watch out for falling markets.

The increased global turmoil was good for the US dollar, which had been behaving the way the monetary authorities in the US were hoping, in other words it was slipping. But, now it is rising again. The old ‘safe haven’ trade is back on. The protracted rally over the last half of last year seems to have flushed most of the dollar carry trade people out of their positions because with the stronger dollar, we didn’t see too much knee-jerk selling.

Global bond markets also reacted as expected. US rates fell as did those of the major European markets. Japanese rates were essentially unchanged as the bad news of a new downgrade offset the safe haven trade. Emerging market bonds were lower to mixed with higher perceived risk implied in the new rates. Again, after today, the situation may look different.

Commodities were winners, especially the energy complex, precious metals didn’t improve much with gold down for the week. Ag commodities and industrial metals were mixed. Real estate seemed to gain.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.