Geopolitical Risk and European Elections May Undermine Fed

By Victor Sperandeo with the Curmudgeon

Introduction: The Fed and the Markets:

After 134 years of the real economy being the major driver of stock prices, the past few years have shown that is no longer the case. Since at least 2010, the U.S. stock market has not been correlated to economic fundamentals. What has changed is the Fed's money printing (QE) and zero short term interest rates (ZIRP). To a lesser extent, the same is true for Europe and Japan with their ultra-easy monetary policies with assertions of more of the same (see ECB head Draghi's comments below).

Many now believe that owning stocks when the Fed wants you to own them removes the risk of a bear market or even sharply falling stock prices. Exploding margin debt is one symptom of that thesis. Risk takers believe the Fed (and the ECB) will prop up the market "no matter what it takes." Hence, they're using lots of leverage to magnify potential gains on their long stock positions. The bond market has also benefitted from ZIRP, QE and "operation twist."

It seems Mayer Amschel Rothschild was right when he said, “Give me control of the nation’s money and credit and I care not who makes the laws." Apparently, nothing else matters to the market at this point in time. Indeed, a counterfeiter (the Fed) can turn a weak economy into a booming stock market. But what could possibly go wrong?

Geopolitical Hotspots Pose Uncontrolled Risk:

We think the potential risks in the market are geopolitical hotspots that can boil over into something that could have very negative fallout for the global economy and financial markets. Historically, markets don't discount war until it is happening. World War I and II are two great examples of that thesis.

An erupting geopolitical hot spot can cause a significant decrease in global trade, which might even precipitate a trade war. That would be horrendous for the world economy. The Fed (or foreign central banks) won't be able to stop or control such geopolitical eruptions--even if they print more money.

Specifically, we think that energy /oil prices could dramatically increase as a result of hostilities in Ukraine. Russia could decrease or stop exports of liquid natural gas to Europe. They could control oil prices too, despite Saudi Arabia acting as the swing OPEC producer and the U.S. producing more oil.

[Note: Russia’s net crude oil export revenues amounted to approximately $290 billion in 2012 and therefore were more than four times as high as net natural gas exports in the same year. Energy Information Agency (EIA) data show that in 2012, Russia exported approximately 7.4 million barrels per day of total liquid fuels. The majority (79%) of Russia’s crude oil exports were to European countries (including Eastern Europe).]

There are numerous other geopolitical risks we'll examine later in this article. While the probability of any one causing economic damage and financial fallout is low, it's quite high when all the hotspots are taken into account.

The Russian Federation:

Russia is the highest risk to the global economy and the markets. Moving into Ukraine might be just the first stop on their agenda of reconstructing a "greater Russia." As a leading oil and gas supplier, Russia might be able to raise energy costs either directly (by raising prices) or indirectly (curtailing supplies by cutting off energy supplies to Western Europe).

Let me state emphatically that no one can stop Russia -no matter what it wants to do. Their military strength is superior to any country.

· Russia's nuclear arsenal totals 8,500 total nuclear warheads, of which 1,800 were strategically operational. The nuclear weapons of all other countries combined together totals 8,800. The U.S. nuclear warhead count is 7,700. (Source: "World Nuclear Stockpile Report," January 7, 2014)

· Russia has a total military force of 3,250,000 (766,000 active military, 2,035,000 reserves, and 449,000 para-military). In contrast, Germany has a total military of 326,927 with only 182,927 on active duty.

· Perhaps Vladimir Lenin's quote explains how easy Russia can march into most places in the world. "One man with a gun can control 100 without one." There are only a few nations that allow gun ownership and few of these nations have anything you would call an army.

Who can stop Russia? Aside from China, which Russia would not invade because they are ideological "comrades." If Russia puts boots on the ground in Ukraine and (later) other countries in Eastern Europe would President Obama be able to stop him? No chance! I'm not saying Russia intends on doing this - my point is Putin could do so with little risk of U.S. troops interfering.

Also, Putin might force Europe to buy oil in Rubles, which would severely damage the U.S. dollar. That tactic could spread and cause other countries to trade in their currencies. We've previously hinted that China wants to make the Yuan the world’s reserve currency. That could be the death knell for the dollar, which would've likely crashed a long time ago if it were not the world's reserve currency and currency used to buy/sell OPEC oil.

Economic Sanctions are Ineffective:

In a joint statement on May 10th, Germany's Chancellor Merkel and France's President Hollande warned Russia that it would face tough sanctions if it did not help defuse the crisis in Ukraine, including taking “visible steps” to pull back its troops from Ukraine’s border. Last week, President Vladimir Putin said he had already done so, but NATO and Western leaders said they had seen no evidence of a withdrawal.

Sanctions are laughable as a deterrent, in my humble opinion. They've done nothing to stop Russia's aggressive involvement in Ukraine or their support for the Assad regime in Syria. Do you think sanctions on Cuba have worked? The Cuba embargo/sanctions are 52 years old, but the Castro brothers are still in total control of that island nation. They couldn't care less about changing their totalitarian version of communism to benefit the people who live there.

We think sanctions may even be counter-productive. As payback for European sanctions, Russia could cut off natural gas shipments to Europe. That would be a disaster in winter time, because natural gas is used for heating homes and commercial buildings. Shortages of gas and higher energy prices might even cause the Euro to breakup, as leaders are voted out of office and more nationalist politicians take their place. See Elections in Europe - May 22-25, 2014 below for more on this important topic.

In the end, we think sanctions don't have much impact, other than to anger the target country into responding in a way that might hurt the global economy.

Iran and Israel:

Iran's uranium enrichment program is thought to be part of a master plan to develop nuclear weapons. Iran and the five permanent members of the UN Security Council – the United States, France, Britain, Russia, China – plus Germany have been holding talks aimed at reaching a comprehensive deal on the Islamic Republic’s nuclear energy program. The two sides sealed an interim deal in the Swiss city of Geneva on November 24, 2013, which went into force on January 20th. Under the Geneva agreement, the six countries undertook to provide Iran with some sanctions relief in exchange for the Islamic Republic agreeing to limit certain aspects of its nuclear activities during a six-month period. But the monitoring of Iran's nuclear reactors has been very difficult, so compliance is in doubt.

Israel's Netanyahu has repeatedly stated that Iran must not be permitted to possess a nuclear bomb. Many foreign affairs experts have speculated that Israel would launch a pre-emptive strike on Iran's nuclear reactors to prevent them from obtaining nuclear weapons. This has been on the front burner for a long time now and many people feel it won't happen. But what if it does?

It's my opinion that Israel cannot allow Iran to develop nuclear weapons that can kill 20 - 30% of its population in one fell swoop. Then there'd be radioactive fallout that would kill even more people. Israel--the homeland for the Jews--is a very small country. 7.7 million people live on 8,019 square miles of territory. Could the Jewish state survive such a catastrophe? I don't think so.

Therefore, I believe that at some point in time Israel will be forced to attack Iran's nuclear facilities, which could lead to oil prices spiking to $150 to $200 a barrel. Such an "oil shock" would likely crater world stock markets. Like Russia's invasion of Ukraine, it would be another unanticipated event that neither the Fed nor foreign central banks would be able to control.

Other Geopolitical Hotspots That Might Erupt:

A few other geopolitical problems worth mentioning are the following:

· China vs Japan over a territorial dispute in the five uninhabited Islands. The Japanese call them the Senkaku Islands. The Chinese call them the Diaoyu Islands. Japan controls the islands, but China wants them. While international law favors Japan, many say that China will attempt to take them over. Since the early 1970's, China has argued that Japan seized the islands in violation of international law. Whether Japan should resist or retreat is a military and political question, not a legal one. No one knows if China’s ambitions extend only to these tiny unoccupied islands in the South China Sea or if this is the first step in a larger march of conquest of territories in Asia. Don't forget that China and Japan are the world's number two and three economies, respectively.

Japan becomes a significant problem if they can’t peacefully settle their disputes with China. Japan's stated debt to GDP ratio is 227.2% - the highest in the world. Any increase in Japan's budget deficit (e.g. for military spending), at this high risk level, could cause a meltdown of Japan's economy.

· China vs Vietnam over oil drilling rigs 200 miles off Vietnam. Chinese ships have been ramming into and firing water cannons at Vietnamese vessels trying to stop Beijing from putting an oil rig in the South China Sea. This is a dangerous escalation of tensions over waters considered a global flashpoint.

· Civil War in Venezuela--a full blown Statist government, Venezuela's economy is in shambles. There are food scarcities and now water rationing. The government has started to issue cards to track families' purchases of food. Critics say it's another sign the oil-rich Venezuelan economy is headed toward Cuba-style dysfunction. If its economy deteriorates further, that could instigate a people's revolt or even civil war. There have already been a series of protests, political demonstrations, and civil unrest throughout Venezuela. Those protests could worsen into a full blown civil war.

Venezuela produces an estimated 2.9 million barrels of oil a day (as of February, 2014). Any civil war or internal fighting (like in Syria) could cause Brent crude oil to move towards $130 per barrel. That would certainly be a significant risk to the global economy.

· North Korea Threats--nuclear armed North Korea has long been seen as a threat to both South Korea and Japan. These tensions cannot be overlooked as their leader -Kim Jong-Un - is an unpredictable, calculating ruler. Some say that Mr. Kim, who has proved to be more ruthless, aggressive and tactically skilled than anyone expected, most likely has a psychological disorder?

Elections in Europe - May 22-25, 2014:

Ukip of the United Kingdom and the National Front of France are gaining more momentum leading up to elections later this month. That could spell trouble for European economies and the Euro.

Ukip has been accused of hypocrisy and double standards for paying Eastern Europeans to distribute their election leaflets, despite the party's leaflets warning that immigrants from the EU pose a threat to British jobs.

The National Front (or FN) is an economically protectionist, socially conservative nationalist political party in France. The party was founded in 1972, seeking to unify a variety of French nationalist movements of the time. It has been the unrivalled major force of French right-wing nationalism force of French right-wing nationalism since 1984. If the NF party wins or gets a significant vote in the French elections, it may be the end of the Euro. (At least that would be a bloodless resolution.) It's looking more and more to me that the Euro is going to lose its place as the single currency of the Euro-zone.

France's President François Hollande says he won't run for re-election if unemployment remains high (it was 19% as of April 2014). Hollande visited the Michelin plant on Friday where he made a shocking announcement during a lunch with employees: If unemployment continues to plummet between now and 2017, Hollande said he will have “no reason to be a candidate” for a second term. Meanwhile, the French president's approval rating -now at 18% - has hit a new record low (as of March 2014).

State of the Markets and Monetary Policy:

Yet despite a very weak economy, sky high unemployment, and President Hollande's horrible approval rating, the French stock market (as measured by the CAC 40) has been in a steep uptrend for the last two years. The steep up move is quite evident in the chart below:

That strange market reaction is hardly an exception. The stock markets in Japan, Europe, the U.K. and U.S. are up strongly and are at or near all-time/recovery highs for only one reason: Central Banks easy monetary policy--holding short term interest rates at virtually zero for five full years, coupled with the Fed's QE buttressed by ECB head Draghi saying he'll do "whatever it takes...." And he may actually follow through with that next month!

In a statement earlier this week, Draghi hinted the Eurozone economies could see the emergence of negative interest rates as early as this June. He told reporters that the ECB has room available to use various monetary policy tools available to them and that the 24-member ECB Governing Council is “comfortable with acting next time.” He said policy makers discussed all tools available, including extending the offer of unlimited central-bank cash against collateral. Other possibilities include long-term loans to banks and halting the sterilization of liquidity created by crisis-era bond purchases.

We think anticipation of such ECB easy money action is preventing European stock markets from falling, which would otherwise be expected considering the weak economies in the region (with the possible exception of Germany).

As bizarre as it seems, the evidence suggests that weak economies and high unemployment is actually bullish for equity markets. Why? It makes the Fed and/or other central banks print more money which then flows into financial markets. Stock market correlation with QE has certainly been true for the U.S. and Japan. Draghi hints that the Euro-zone is next to experience QE and possibly negative interest rates.

In reality, that's a monetary policy only a counterfeiter would love. Credit is created by central bank money printing to buy debt issued and/or already sold by the Treasuries of the countries using QE. As the CURMUDGEON has repeatedly pointed out, the Fed's QE is a Ponzi scheme of the highest order. QE does nothing to promote the welfare of ordinary citizens that don't own stocks.

Meanwhile, corporations are hoarding cash rather than investing in new plant, equipment or hires. Wages are contained due to economic uncertainty and lack of collective bargaining power of employees. Workers are afraid of losing their jobs so they are more cautious with their purchases. The velocity of money has been dropping precipitously, so there's been no inflation to speak of at this time. Therefore, some say the Fed/ Central Banks should do more QE? Its insanity, but it keeps going on....

Conclusions:

Under normal conditions the Fed has some ammunition to act as a safety net to prevent or at least contain an economic/financial crisis. Having already pinned interest rates to zero for five+ years and augmenting that with massive amounts of QE (which has not worked to stimulate the real economy), the Fed has no magic bullets left.

This will be an issue that is dependent on the type of crisis that boils over. For example, if oil increases to $150 per barrel how could the Fed justify additional QE, which logically would drive oil prices higher and weaken the U.S. dollar?

Institutional money managers and pension funds "invest" money on behalf of others. They don't seem to appreciate the risks in the market as they are not paid to worry about geopolitics or other threats. Yet they can't afford to be left behind, holding cash or short positions in a rising market that's independent of economic fundamentals.

The end game of bull markets with weak economies will not be pretty. It's highly likely that one or more geopolitical events or unfavorable elections will end the party for the bulls. We think that the catalyst for a steep stock market decline will be some type of geopolitical risk or other unanticipated event that neither the Fed nor foreign central banks will be able to control. The markets will be caught by surprise, but don't say we didn't warn you!

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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