361: Position Yourself for Another Inflation Shock
Regimes Falling: A few pointers. The fall of Tunisia and Egypt is now more than likely to trigger further falls of autocratic family run moderate secular regimes in Arab North African and Middle Eastern states. What the final make-up of these states will look like is very uncertain. The obvious risk is that fundamentalist groups use the opportunity to seize power and influence. These autocratic states have been supported by the west with a goal of creating a more stable North Africa and the Middle East in part to keep the peace and in part for secure oil supplies for the western world. The gloating by the British TV media about the opposition demonstrators seizing influence and power on Tuesday evening 1st Feb felt uncomfortable the world really does not know what will happen and how bad things will get. Radical elements are probably waiting in the wings to take control - like they did in Iran.
Downside - Nightmare Scenario: This could be the start of something absolutely dreadful leading even to the threat of nuclear war. Israel, Iran and Egypt could be a vicious combination. As the educated Egyptian middle class leave the scene - many leaving the country - it's most likely power will be taken by the working class and with this the Muslim Brotherhood party - the only established opposition party - that also have an alliance with Palestine and against Israel. If this happens, the western media and government can look back on the last week and their lack of support for Mubarak with an element of shame. Then the Egypt and Israeli Peace Treaty will be dead in the water. Lots of ideology knocking around but the reality is that a power vacuum in Egypt would lead to Egypt going the way of Iran. Then - sparks will fly with Israel. The oil would sky-rocket to over $200/bbl and food prices would sky-rocket along with it. Yes, Tunisia the Black Swan.
Upside - Hope: On the upside it could lead to freedom, democracy and even stability. But we believe its more likely to lead to a more unstable world and a war either civil or regional. Anyone that knows anything about the history of Lebanon will understand the risks a secular state that turned into a tinder box - civil war and strife for 20 years.
Geographical Significance: Egypt borders Palestine and Israel along with Libya and is just over the water to Saudi Arabia and Jordan. A third of the world's Arab population lives in Egypt. Right in the middle - a country with the biggest Arab population in the world.
Black Swan: A Black Swan for Lebanon. It could turn the same in the next few days or weeks. The restraint of the military so far is something no-one expected. Israel must be very worried as must other neighbouring states. We all know what happened 40 years ago.
Massive Population, Little Food, In a Desert: But this time, Egypt has 18 million people living in Cairo and 80 million people living in the country. It's not an easy situation to control - and certainly we shouldn't expect any help from the US after all their rhetoric in the past few days. It can get very bad very quickly. And remember, 20% of the world's oil passes through the Suez Canal with 2.5 million barrels by pipeline. Any disruption would lead to oil prices sky-rocketting - we'd give this now a 30+% chance of occurrence. Israel is on Egypt's door-step. Many angry people. Lots of emotion.
Peak Oil: People have been warning that Peak Oil would lead to civil disorder. Egypt appears to be a classic early example of this - just to make it clear what happens:
Oil supply and revenues drops - reversal of export revenue to import costs
Oil prices go up - import costs increase
Food prices increase
Governments are not able to subsidize food anymore - food prices rise further
Populations continue to growth - less revenue for more people - less social support per person
Population gets angry, hungry and wants change
Civil disorder breaks out
Imports Start and Increase Rapidly: We have prepared a plot showing the net exports (or imports) of oil - this is the oil production minus oil consumption. Consumption has risen as the population has exploded. But now production has dropped and hence Egypt is not able to finance food subsidies in this desert nation. We could do similar plots for other North Africa and Middle Eastern countries - essentially Tunisia, Syria, Egypt and Jordon are all exposed to higher food prices, less oil revenue, high oil import bills, expanding populations and desert agriculture.
Import Costs Skyrocket: As you can see below, Egypt used to export about $4 Billion worth of oil. Egypt now has oil import costs - projected to increase to $4 Billion by 2015 -this is massively increasing because of higher oil prices and declining oil production. This adds to the gigantic debt levels of 80% of the GDP. The violence will soon start to affect oil production and tourism revenue - as the local currency crashes, food prices will rise further. Neighbouring countries are likely to start stock-piling more grain in case of unrest - this will further increase food prices. If it's bad for Egyptians now, it's likely to get far worse in the short term.
Take Note: Whatever happens and whatever your beliefs, for property investors take note:
· Oil prices will rise further and with it inflation and interest rates
· Middle East and North African stability will be reduced, at least for a while
· Israel will feel threatened and with it investment in the region will decline - tension increase
US disown Israel: The USA left Israel high and dry on 1st Feb when they undermined President Mubarak - encouraging their (until then) alley to leave his post. After 30 years of stability - a few thousand demonstrators seem to have convinced the US government to switch sides. The result has been increasing instability, uncertainty and a power vacuum. Zero US leadership. The USA has left the world stage - threatened to pull the plug on Egypt's funding and meanwhile threatened the 35 year old Egypt-Israel peace treaty. Let's just hope and pray the US won't look back on this tipping point as the great strategic mistake - from an administration that seems to think on the fly only intent on populist messages for its own national audience. Israel has just become a far riskier place - as has the rest of North Africa and the Middle East. USA has shown its populist short term colours. The rot is likely to set in.
Democracy and the Arab World: Firstly, we are not by any means knowledgeable on this topic - though we have lived in the region. Unless we are mistaken, there is no successful democracy in the Arab World. Whatever happens, it will be a first. We cannot look back on history for any guidance. All Arab nations have autocratic kingdoms or chiefs - normally family run countries run by an elite. Iran, which is not an Arab nation, seems to be the only democracy in the region - with 10% of the population being Jews. Lebanon is another nation that can be described as a democracy. Iraq is trying to be a democracy. The examples that Egypt would follows are precarious and dangerous. If it works, it will be the very first successful democracy in the region. If anything, Egypt reminds us of the Lebanon before civil war broke out in view of its religious mix. Hopefully it will not go the same way as Lebanon did in 1975. Lebanon was a Black Swan - no-one saw it coming.
Avoid: So for investors, there will be a dash for stock in oil production companies, away from airlines, and Middle Eastern and North African tourism. Retail spending will suffer because of the higher oil prices. Food prices will rise further food riots will break out. So do not invest in property in:
· North Africa
· Middle East and Levant
A Few Rules: Any oil price above $100/bbl will eventually lead to high inflation and reduced global growth then a likely financial crash as debt ridden western states cannot afford import bills (e.g. Greece, Portugal). OPEC countries suffer as well when oil prices crash and global growth drops - the financial crash in Dubai early 2009 is evidence of this. The USAs import bills are about $350 billion at $100/bbl they cannot afford $100/bbl - it's just a question of time - these prices are not sustainable. USAs budget deficit is $1.5 Trillion or 10% of GDP and the whole country could suffer a financial meltdown after mismanagement by the current administration. President Obama also blows hot and cold on the foreign policy in the Middle East and North Africa can they be trusted to keep the peace? Any country with a deficit of 10% of GDP would normally get a credit downgrade especially if there was no evidence they were serious in tackling the problem. We think its just a question of when not if the USA gets a credit downgrade and the current administration will frankly look foolish set on the back foot. Expect the dollar to continue its decline and with it greedy Middle Eastern oil exporting nations will use it as an excuse to jack-up oil prices by limiting supplies. We cannot see the Obama administration lasting after 2012. The mess will be severe needing a decade to fix. It will be like the UK in May 2010 but worse.
Inflation: One thing is certain, global inflation is the problem and not deflation. China has an inflation problem, the Eurozone inflation problem is just beginning, the UK inflation problem has been with it for two years and the USA is starting to feel the effects of Obamas $2 Trillion printing spree.
Population Bubble: Despite interest rates rising, if your borrowing is not high and you own property then with building costs rising, land prices rising, global population rising and planning getting more difficult its highly likely that house prices will drift higher following retail inflation upwards in a high level long view. That is one of the reasons why wealthy people buy property as a hedge against inflation. Otherwise your money will wither and die if its left in a bank earning very little interest as prices rise for all things in part triggered by commodities price increase and demand from China and India.
Gold - No: Watch out for gold as well because we are not convince it will rise further. It could be at the peak. Instead, the most intelligent investors seem to be piling into oil and who can blame them with Peak Oil (crude) having hit 6 years ago now. Do you really believe OPEC has 6 million bbl/day spare capacity? It likely all but Saudi Arabia are going flat out and Saudi has probably only got 2 million bbls/day spare at a push of mainly low grade heavy oil that it would be unlikely to ramp up quickly.
Hedge Against Inflation: Its not all bad new for property owners at least you are hedged against inflation. If you can keep your borrowing costs down as interest rates rise again and your property washes its face then in the longer term in the UK as population rises and demand recovers you could still be making a healthy after tax profit.
We hope this Special Report has help frame some insights into the turbulent happenings in North Africa and get you thinking about some of the uncertainties that lie ahead in 2011.