Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q4 '10

On the Brink

Egypt and Libya have been the most visible parts of a wave of popular revolt sweeping through the Arab world. Whether this is a miracle or a catastrophe only time will tell. Who will actually end up wielding power in these countries is the critical “unknown unknown” at this time. The one clear outcome of this upheaval is that U.S. influence in the region will be substantially reduced.

The nature of the other uprising, the one in Washington, is not in doubt. House Republicans have loaded up their budget with politically targeted spending cuts that they know are unacceptable to the Senate and the White House. In so doing they are deliberately driving towards a government shutdown and a default by the U.S. government on a wide array of obligations. There is always the possibility that disaster will be averted at the last moment, but if the default happens, it could unleash a cascade of unpredictable and uncontrollable consequences. See Tim Geithner’s warning to congressional leaders on the consequences of default.

Markets

The stock market continues to push steadily higher. The DJIA and S&P500 have regained approximately 70% of their losses from the 2008 meltdown. The Russell 2000 and the Dow Transports are both approaching their all-time highs and one index, the S&P Mid-Cap 400, actually made new all-time highs this month. The tech heavy NASDAQ has bettered its 2007 highs but is still only 1/3rd of the way back to the 2000 dot-com highs.

If the quantitative easing (QE) continues, it will eventually push stocks to new all-time highs regardless of the underlying merits of owning stocks. At the moment, however, complacency is pretty high in the face of major turbulence in the Middle East and the prospect of chaos looming in Washington. I would expect to see increased volatility soon.

The bond market is another matter. Bonds have sold off sharply since the announcement of QEII in November, which ironically was intended to keep rates down. This is a clear sign that the era of artificially low rates is coming to an end. Technically bonds have completed a 60 year cycle. All indications are that the top is in (bottom in rates) and we will see a trend to higher rates for many years to come.

Precious metals have been big winners from QE, and will likely continue to be so over time. However, gold has been higher 10 years in a row, and nothing goes straight up forever. The upheaval in the Middle East has given the metals another (final?) surge to the upside, with silver leading the way to new highs. The looming government shutdown and default in Washington could provide yet another surge, or on the other hand it could kick off a deflationary scare, which would provide the overdue opportunity for a major correction in gold. If all this sounds indecisive, that’s because it is. The nature of our present situation is uncertain and unstable.

Economy

The economy is gradually recovering from the devastation of the financial meltdown of 2008, but the recovery is slow and shallow, and jobs are not a big part of it. In reality we are experiencing a controlled depression that will not be over until the imbalances created by 30 years of fiscal insanity and trickle-down economics are resolved. This would not be an easy task under any circumstances, and given the general quality of our political leadership, I don’t see resolution any time soon.

I have written previously that the only opportunity I see on the horizon to re-invigorate our economy is a national commitment to energy independence. This would at once free us from all the degrading economic and environmental influences of our addiction to oil, and simultaneously unleash a wave of entrepreneurial activity that would produce real, organic economic growth. Bobby Kennedy Jr. presents an inspiring vision of the consequences of a genuine national commitment to energy independence.

President Obama acknowledged the importance of this issue to our global competitiveness in his State of the Union speech. Subsequent events in the Middle East are providing some perspective on the insane economic and national security risks we have been taking with our dependence on foreign oil, and could provide political cover and catalyst for action. Let’s hope that Obama seizes this opportunity.

Meanwhile, our economy is vulnerable to further setbacks. The enormous stimulus that has been thrown at the financial meltdown is having its effect. Absent any unexpected shocks, which might be asking for a lot, things should hold up until 2013, the next expected downturn in the Presidential Cycle. It’s always difficult to predict the future of the stock market, but the Presidential Cycle would indicate sideways to higher markets into the first quarter of 2013. This cycle performed badly in 2008, but it has historically been a reliable indicator, and I would not expect it to fail twice in a row.

The assumption has been that QE will continue for as long as it is needed, until the economy is self-sustaining again. However, dissent is starting to manifest from within the Fed as well as in Congress. Richard Fisher, President of the Federal Reserve bank in Dallas, recently gave a speech focused on the consequences of continued money printing.

Political

It appears that President Obama has begun to emerge from a two year period of on-the-job training. His first two years were marked by caution, premature compromises and often outright capitulation to Republicans that left many of his supporters demoralized. But recently Obama has begun to look downright Presidential.

After the “shellacking” at the polls in November, Obama unexpectedly used the clout of his office to push through a series of priorities during the lame duck session, most importantly ratification of the START treaty with Russia, ending the Don’t Ask, Don’t Tell policy in the military, and an extension of unemployment benefits and tax cuts.

Republicans, shocked at the sudden change in character and tactics by the White House, felt like they had been rolled, and came back to Washington determined to regain their momentum from the election victory. They were pushing the envelope on the extreme rhetoric and demagoguery that had prevailed during the election. But sometimes it’s the totally unexpected event that becomes the game changer.

A political firestorm erupted in the aftermath of the shootings in Arizona. Republicans were put on the defensive trying to deflect charges that they had contributed to the massacre with their relentless extreme rhetoric. And it was Obama who seized the opportunity with an elegant non-partisan speech, eulogizing the fallen, and speaking to the collective spirit of the American people, noting “we can do better than this.” Shortly thereafter, Obama once again seized the day in an upbeat State of the Union speech that was at once inspiring, comforting and politically savvy.

While Obama’s filling of the leadership vacuum is a welcome development in and of itself, the unfortunate thing about his “coming out” as a leader is his agenda. Obama is most definitely not a socialist, or even a liberal, although Republicans insist on painting him as a “far leftie” in order to mask their extremism. He is, in fact, what 20 or 30 years ago would have been thought of as a moderate Republican. And he isn’t even a very moderate. Only in contrast to the far right lunatic fringe that has taken over the Republican Party does he appear moderate. In the most important elements of policy, economy and national security, with a few notable exceptions, he has fully embraced the Republican agenda.

Donald Rumsfeld summed up the dismal reality of Obama’s national security policies while receiving the Defender of the Constitution award at the Conservative Political Action Conference (no-one can say that conservatives don’t go in for irony). Citing the administration’s many reversals on national security policy issues such as Guantanamo, military commissions and CIA drone strikes, Rumsfeld said “it makes me wonder if Dick (Cheney) has had more influence on President Obama than the people that got him elected.”

At the same time the Obama DOJ has been aggressive in claiming national security to prevent lawsuits and stonewall investigations into abuses of power, turning Obama’s campaign call for more transparency in government on its head, as well as continuing and expanding the warrantless wiretaps and vacuuming of electronic communications begun under the Bush administration. Glenn Greenwald has been tireless in documenting this trend.

Regarding economic policy, William Greider recently published an insightful commentary entitled “The Death of New Deal Liberalism.” Greider’s message is summed up thus,

“Government has been disabled or captured by the formidable powers of private enterprise and concentrated wealth. Self-governing rights that representative democracy conferred on citizens are now usurped by the overbearing demands of corporate and financial interests. Collectively, the corporate sector has its arms around both political parties, the financing of political careers, the production of the policy agendas and propaganda of influential think tanks, and control of most major media.”

Republicans and so-called “moderate” Democrats have been the champions of this neo-Feudal agenda, which would not be acceptable to the American people if they recognized it for what it really is. Republicans have been successful for decades at distracting attention from their true agenda by exploiting “wedge” issues such as abortion and gay rights, and more recently by creating endless distractions (Obama’s birth certificate, “victory” mosques, “death panels,” etc) and tearing down and creating distrust of government, science, and anyone or anything not part of the so-called “conservative” movement.

The price for not standing up to this agenda is getting steeper every day. Eventually the American people will wake up and the backlash will be severe, but I am not holding my breath. That day is most likely years, if not decades away.

Geopolitical

The big story at press time is the upheaval in the Middle East. But there are many other important stories unfolding across the globe.

Developments in Pakistan top the list. The recent assassination of Punjab Governor Salman Taseer by his bodyguard, a member of an elite police force, is an ominous development, demonstrating how deeply radical Islam has penetrated Pakistan. Even more shocking is the groundswell of support for the killer by young Pakistani lawyers, who had previously been thought to be a bulwark against radical Islam.

The guard has admitted that he killed Governor Taseer due to Taseer’s opposition to anti-blasphemy laws, which call for execution for impugning Islam or the Prophet Muhammad. Mass rallies in support of the killer and blasphemy laws have continued and anti-Americanism is a pervasive theme of this movement. Our relentless drone attacks and the inevitable civilian casualties from them are stoking the fire of radical Islam in Pakistan, and the case of the American “diplomat” who shot and killed two Pakistanis on the street in Lahore has added fuel to the fire. The thought of radical Islamists in control of Pakistan’s nuclear arsenal is chilling.

Meanwhile, China is extending its gains and influence. The state dinner extended to Chinese President Hu Jintao during his recent visit to Washington demonstrated just how much so. Great care was taken to put a positive spin on Chinese-American relations, glossing over contentious human rights and currency issues.

There was a noteworthy event during a recent visit to China by Defense Secretary Gates, which demonstrated that Chinese leadership is not monolithic and raises questions about the extent of Hu’s real power. Hu was taken by surprise when he learned that the Chinese version of the stealth fighter was rolled out for an unusually public test flight on the very day Secretary Gates arrived in China.

China’s military buildup has been going on for years and has recently been getting a lot of press. If internal problems (and there are many) should ever threaten the Communist Party’s grip on power, there will be an almost irresistible urge to project its newly muscular military outward in order to rally the people to the flag, and the Party.

Food prices are putting serious stress on the world’s poorest. This will trend will exacerbate and maybe even exceed all other causes of global instability. Large numbers of hungry people will be looking for someone to blame for their suffering. Meanwhile, almost 40% of U.S. corn production goes to ethanol, undoubtedly one of the worst public policy decisions in history.

Opportunity

Major change is sweeping the globe and where there is change, there is opportunity. Unfortunately where the opportunity lies in the near term is not clear to me. What is clear is that risk is very high in all sectors. It may be that the best opportunity right now is in trying not to lose anything.

Precious metals will probably continue to benefit from global turmoil, but the metals rally is pretty long in the tooth and difficult to embrace if you aren’t already in from much lower. Complacent gold bugs could be severely tested at any time.

The situation in the Middle East is highlighting the need to embrace energy independence. Imagine $300 oil. The “plus” here is that $300 oil would probably be the catalyst for finally making a serious national commitment to energy independence, which would be wildly bullish for America. Sooner or later – inevitably -- alternative energy will be big in America.

A development that looks like it could be as disruptive as the transistor or the steam engine is featured in the 2/12 cover article of the Economist entitled “Print Me a Stradivarius.” 3D Printing, “the manufacturing technology that will change the world.”

Summary

Our situation remains delicate. Continuing to print money creates the illusion of “growth,” but inflation is creeping upward and at some point it will take off. Serious inflation is already being felt in food and energy, putting severe pressure on ordinary people globally, especially the very poorest. This is probably the underlying catalyst to the upheaval in the Middle East.

The damage to our economy and financial system was done years ago, and much of it was done deliberately by Republicans following their “starve the beast” strategy. These same people now profess to be deeply concerned about deficits and are driving the push to cut social spending, even as they continue to push tax cuts that add to the deficits. This situation speaks volumes about the quality of our public debate and in the integrity of our “leadership” in Washington.

The reality is that QE, despite its negative consequences, is at this point the only way to manage the adjustment to stability, short of allowing a full blown depression to take hold. There is no guarantee that the clever people from Goldman Sachs who run the Fed and Treasury will be able to finesse this transition successfully. Despite the fact that in a truly just universe these people would all be in jail, one can only hope that they can serve the useful purpose of managing the transition to a stable economy. We can also hope that current efforts to force a cold turkey withdrawal from deficit spending are not successful. Our condition is far too delicate for that right now. The patient might not survive the cure.

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