February 7th, 2011 | By Nick Sargen
In light of the political unrest in Tunisia and Egypt and the potential for it to spread, we have been analyzing the investment implications of recent developments in the Middle East. We distinguish between the potential impact of these developments on Developed Markets and on Emerging Markets (EM)
Whenever there is political unrest in the world, it always grabs headlines in the media, and markets often over-react, if only temporarily. That said, not all countries matter from an economic or geopolitical perspective, and therefore we have to discern which ones are important from the standpoint of affecting global markets. Using this criterion, we did not react to the news of the ousting of Tunisian dictator, Ben Ali, in mid-January, because Tunisia does not stand out on the global radar screen.
By comparison, the demonstrations in Egypt to overthrow Hosni Mubarak immediately captured our attention for a variety of reasons: (i) Egypt is one of the largest economies in the Middle East and also one of the most powerful; (ii) It was the first country in the region to sign a peace treaty with Israel, and President Mubarak has been an ally of the U.S. and (iii) It is also important because of its location and the control it has over the Suez Canal. As the movement gained traction, it contributed to a one day sell-off in U.S and global equities. However, world equity markets have rallied since then, and the U.S. stock market currently is at a 2 ½ year high on the back of an improving economy and continued strong corporate profit growth.
Why have the U.S. and other developed markets largely ignored what is happening in the Middle East? We think the main reason is that the political movement in Egypt thus far has not led to widespread conflict, and the Egyptian military, which has close ties to the U.S., is the most powerful force in the country. While there is considerable uncertainty about the final outcome, the turmoil in Egypt is very different from the situation in Iran in 1979, when the overthrow of the Shaw was led by Islamic clerics.
One factor that could alter the equation would be a disruption in oil supplies. A recent report by J.P. Morgan Asset Management (Feb 3), however, suggests that Egypt is a relatively minor player:
“Egypt is not a significant oil producer, ranking only 29th in the world in oil production. Nor is the Suez Canal that critical a trade route for oil, as it is too narrow for the largest supertankers. Moreover, unlike the Straits of Hormuz at the mouth of the Persian Gulf, goods that can’t get through Suez always have an alternative route.”
The main risk, in our opinion, is the possibility that the political turmoil in Egypt could spread to other Middle East countries. In that event, there is a much greater risk that oil prices could spike on fears that oil supplies would be curtailed. If so, the higher oil prices would act as a tax on oil-importing countries, and would dampen economic activity around the world. (A study conducted by the International Energy Agency in 2004 estimates that a $10 per barrel hike in the price of oil translates into a cut in U.S. real GDP of 0.3%.)Consequently, while U.S. markets have shrugged off the developments in Egypt, we are monitoring the situation in the Middle East closely to ascertain whether the turmoil will spread to other countries. If it does, we believe U.S. and world equity markets would pull back amid a flight to quality into U.S. treasuries and the dollar. For the time being, however, we have not modified our investment strategy, and we are continuing to underweight treasuries in our bond portfolios.
By comparison, the Emerging Markets appear more vulnerable than the developed markets.
First and foremost, EM equities have had a remarkable run over the past two years – rising at one point by about 150% from the lows reached in March 2009. As a result, many of the emerging markets appear frothy now. In the past few months, some of the larger markets have under-performed amid concerns that economies such as China, India and Brazil are over-heating. Moreover, as inflation pressures build, market participants are anticipating further tightening in monetary policies in these countries.
Second, the developments in the Middle East appear to be adding to investor concerns. The lead story for this weekend’s Financial Times carried the headline “Funds in $7 bn emerging market exit.” According to the FT, the withdrawal was the biggest in more than three years, and it comes on the heels of record investor inflows of $95 billion during 2010. The article also notes that many investors reallocated this money back into the U.S., Japan and Europe, as developed market equity funds took in $6.6 billion, the fifth consecutive week of inflows.
Based on these developments, it appears that global investors are now re-assessing the risk-reward opportunities in the emerging markets. While it may be too early to draw a strong conclusion, we suspect the emerging markets will lag the developed markets this year. Meanwhile, the Middle East developments serve as an important reminder that emerging economies may be the fastest growing part of the world, but they are also the most unstable from a geo-political perspective.