The Bear’s Lair: Markets are not pricing in increased global risk

When the NASDAQ Composite share index last week touched 5,000, its level at the top of the 2000 tech bubble, sober commentators everywhere including the head of NASDAQ intoned that things were different from 2000 and the market was not in anything like so much of a bubble. They were right. Things are very different indeed from 2000 – in particular the global risks, geopolitical and financial, are far, far higher. Needless to say, markets are completely failing to price these into their calculations.

As in 2000, the most troubled region of the world is the Middle East, but that region’s problems are more severe now. In 2000, the most serious threat to regional stability appeared to be an aging dictator Saddam Hussain, who had been neutralized but not definitively removed by the 1991 Gulf War. Hussain had a modest stock of “weapons of mass destruction” but he was an essentially isolated figure. Peace between Israel and the Palestinians appeared within reach, as President Bill Clinton’s Camp David summit came agonizingly close to success.

Today the picture is very different. Iraq is close to being a failed state, while Syria is in the middle of an interminable civil war. An Islamic extremist sect is in control of large parts of both countries, and appears to be consolidating both its position and its support from at least a substantial minority of the Islamic world in general. Iran is close to acquiring nuclear weapons, but not closer to acknowledging Israel’s right to exist. Libya, a hostile but harmless dictatorship in 2000, has been turned into a “failed state” by botched U.S. intervention. Egypt, a relatively prosperous and peaceful country in 2000, is staggering from the loss of its tourist industry following the recent troubles. And so on.

In 2000, Russia was an object of some pity; it had experienced a rotten 1990s, with privatization loused up by inept foreign advisors and the country’s long-standing natural corruption. By 2000 it was only just beginning to recover from the bankruptcy of 1998, though 1999 had seen a good “dead cat bounce” on the Moscow Stock Exchange. The dying Boris Yeltsin had resigned the presidency on December 31, 1999, and Vladimir Putin was elected President on March 26, about two weeks after the stock market peak. Still, Russia, which at that stage had the GDP of Denmark, didn’t appear a threat to anybody except the unfortunate Chechens within its own borders.

Russia is still not an especially strong economy. Putin’s first period in power to 2008 was highly successful, with rising oil prices and a 13% flat tax combining to produce rapid growth. However since then the economy has fallen back, as have living standards and Putin has resorted to international aggression in order to bolster his internal position. Recognizing weakness when he sees it, Putin has taken advantage of feeble and distracted leadership in the U.S. and the EU to launch two separate invasions of Ukraine and adopt a belligerent posture towards other unlucky members of the former Soviet Union.

Unlike Adolf Hitler, who carried out his incursions into other people’s countries with excessive rapidity that eventually alienated even the pacific Neville Chamberlain, Putin appears to recognize that an immediate attack on – say – a Baltic state would arouse opposition to him. As President Obama’s administration winds slowly to an end however, there can be no certainty that he would not try such an adventure. Needless to say, some Western force would have to be cobbled together to stop him before he reached Berlin and Paris.

There are further threats that did not exist in 2000. China was in 2000 an almost entirely pacific state with minimal capability beyond a large and ill-equipped army. That is no longer the case, and it is by no means clear that China like Putin’s Russia will not take advantage of current weak leadership in the West to advance its interests by military means. In addition, both Russia and China clearly have the danger to do irreparable damage to the U.S. economy through computer hacking. Then there’s North Korea, in 2000 an ill-armed and starving joke, today an ill-armed and starving nuclear power, close to having the capability to launch nuclear missiles at both Japan and the U.S. West Coast.

We are therefore living, not in the simple bipolar world of 1945-91, nor in the complex but balanced “Diplomacy” pre-1914 world with several more or less equal powers, run by more less rational leadership, nor in the world we appeared to have entered in 2001 with only “asymmetric” threats from terrorism, but in a new world altogether, combining all three kinds of threats. Maybe this new world has a stability that is not immediately obvious, but it must surely be more likely that the new world, by containing several different kinds of threats, is more dangerous and unmanageable than the previous simpler models.

The world is also more dangerous economically than in 2000. At that time, it still appeared that the World Trade Organization would solve most disputes, and China was well advanced towards membership of that organization. Protectionism seemed a relic of the past – it was after all anathema to the economic “Washington Consensus” under which the major multilateral institutions were guiding the global economy towards greater prosperity. Admittedly Africa was a worry, having economically regressed over the 40 years since the colonial powers left, but being so poor Africa was not a significant factor either economically or militarily.

The optimism of 2000 now seems a long way away, although Africa’s position has markedly improved. Since that date we have suffered, not only a collapse of that stock market boom, which did remarkably little damage, but a far more damaging global financial crisis, which has led to a partial revival of protectionism. Since the 2008 crisis, emerging markets have grown to become much more important players in the global economy, but that has intensified protectionism rather than quelling it, both among the emerging markets themselves and among the wealthy Western powers. Japan has fallen into what appears to be a permanent recession, with public debt at unprecedented levels and showing no signs of diminishing or being paid off. The current massive oversupply of Chinese steel is only the latest potential trigger to a surge of unilateral protectionist actions by other countries.

The forces of protectionism have thus grown much stronger, as they did in the decades leading up to World War I, and the mechanisms available for dealing with it, apparently robust in 2000, have been shown to be completely inadequate.

Above all, global leverage has increased immeasurably, raising the likelihood of another financial crisis even more damaging than that of 2008. Total debt in the United States has risen by 128% since 2000 and household financial debt by 92%, compared with a 69% increase in nominal GDP. Since 2000 was already the peak of a major credit boom, after the longest economic advance on record, for leverage to have increased still further is a very worrying sign. Globally, ultra-low interest rates have had a similar effect, with Japan and the weaker countries of the EU seeing especially robust increases in borrowing.

There is above all a “bubble risk” less apparent than in 2000 but in reality far greater. Ray Dalio, head of the massive Bridgewater hedge fund, last week warned on the “unintended consequences” of a Fed rate hike by a tiny ¼%, suggesting that it might lead to a 1937-style downward lurch in the economy.. Dalio of course was talking his book – he is a massive beneficiary of two decades of funny money, elevated from a regular guy when we were in class together in the early 1970s to one of the world’s richest men through successful hedge fund investment. Yet there is truth in his warning; by cementing extreme policies in place for so long the Fed has made it very difficult to dislodge them, and has produced a massive superstructure of diseased malinvestment that will collapse in ruin when interest rates are finally increased.

By my guess, the Fed will never actually dare to increase rates; it will maintain them at their current level until the bubble finally bursts, and will then indulge in a massive further round of “quantitative easing” money printing in an effort to mitigate the effects of the bubble bursting. Whether that will produce hyperinflation, and how we will finally wean the global economy off this nonsense, are both questions for which my crystal ball is currently cloudy – to some extent, reasonably so, for the answers will be very much bound up with the politics of the time, which are as yet unknowable.

In summary, the world is currently a very risky place. Geopolitically, risks are as great as at any time since the 1962 Cuban Missile Crisis. Economically, the risks are as great as at any time since the Great Depression, and the policy tools being used to manage the dangers are wholly inadequate. In these circumstances, the optimistic outlook of the world’s bond and stock markets is literally insane.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)