Food For Thought: Instability and Political Interference

There are instances where markets need the comforting hand of politically justified guidance.  However, such instances are few and far between.  The ongoing efforts of the world’s leading Central Banks as they strive to maintain calm and confidence in short term money markets is perhaps one of those rare instances.

However, market interference is becoming a more regular feature of today’s newsflow.  The EU is reportedly considering pronouncing the European energy industry ‘strategic’.  The French government has finally engineered the merger of Suez and GdF.  Political interference/influence is the modus operandi of the Russian energy industry.  And today we are reminded that it is not only energy that government’s consider to be strategic.  It is also food.

Russia is considering imposing a ban on its wheat exports.  The apparent reasoning is not so much strategic as economic:  the ban is designed to restrict inflationary pressures in Russia’s own food prices.  Russian inflation rose to 8.7% in July from 8.5% in June and was partially driven by higher food prices.

Global cereal markets are under substantial and protracted pressure.  The emerging Chinese and Indian middle classes are fuelling demand for cereals as their aspirations evolve away from traditional rice-based diets.  Poor harvests in Europe, North America and Australia have dented the supply-side of the equation.  The costs of the world’s most basic need is increasing and nobody seems confident those costs will subside any time soon.

Rather than allowing the operation of markets to deal with the supply/demand imbalance, the Russian government is simply shifting its own inflationary pressures abroad and creating artificially low prices for its own consumers.  Short-term political expediency fails to resolve long-term structural issues.

Traders will not want to short wheat and cereal markets will continue to soar as they discount the possibility of delivery defaults and watch the Australian weather with heightening tension.

Not only are the costs of life’s basics increasing, as energy and food prices fuel inflation, but markets are having to discount political interference as a key variable in evaluating value.  The consequences for markets could well be catastrophic.  The fact of the matter is there is an emerging dislocation between operation of free-markets and the reality of political interference.  This dislocation is certain to have one long lasting effect:  instability.

Rock. Hard Place.

Perhaps the central tenet of free markets is the Darwinian threat to poor performance:  if a management team doesn’t perform, fails to create value for shareholders, the business will be vulnerable to takeover.  Poor managements can, ultimately, create value for shareholders as, more often than not, strategic value is greater than any company’s fair trading value.

It’s one of the wonderful paradoxes of the free market.  It’s a paradox that drives innovation and progress throughout the western, democratic free markets.  It’s why we are most comfortable when markets are free to operate without the heavy hand of government intrusion or regulatory restriction.

Yet, as governments and regulators become attuned to the profound changes afoot in the energy industries we are possibly faced with the prospect of the EU’s energy industries being labelled ‘strategic’.  In effect these industries could well be too important, too critical, to be left to the mercy of free markets.

It’s not that markets don’t work, per se.  The EU’s thinking stems from the fact that these free markets are coming under the increasing influence of parties who themselves do not respect free market rules.

Energy is the global economy’s sine qua non.  Any economy that possesses cheap and abundant energy and cheap money is positioned for growth. Either of those two factors fail and we’re talking a possible recession.  Both fail and we’re screaming pain.

The EU is pondering a quandary that markets haven’t ever really had to consider.  In the past the markets have been too powerful for vested interests to disturb with any meaningful success.  Such is the power of money.  Such has been the value of cheap strategic resources.

The fact of the matter is that expensive energy is a difficult and challenging enough obstacle for the global economy.  Any increased regulation of markets would make that obstacle all the more complex and protracted.  The inevitable consequence is confusion and uncertainty.  Add those ingredients to a recipe of a liquidity crisis and volatile oil prices and the global economy will have to do something fairly spectacular to continue to sustain its value.

The FT’s front page this morning confirms one thing:  reading market performance is becoming an increasingly political affair.  Read the politics right and you’ll be more than halfway to reading the markets.

Bluff or Dare?

Vladimir Putin seems determined to fuel the imagination of every leader writer in the Western media.  Don’t we just love to agonise over that gnawing question:  is this a new Cold War?  We are still obsessed by the Cold War and doesn’t Putin know it!

Incidents such as the cyber-attack on Estonia’s government websites, the war of words over America’s plans to place missile defence systems in Eastern Europe and Russia’s declaration of control over the Arctic’s natural resources have plotted a narrative that drips with potential for the more hawkish media pundits.

In what is beginning to look like a premeditated unravelling of Putin-inspired events, he has ordered the resumption of strategic nuclear bomber patrols over the North Atlantic and at the opening of the Moscow Air Show proclaimed, “the task stands before us of maintaining our leadership in the production of military aviation technology.”

His words do not seem designed to convey a sense of general well-being in the USA and Europe. So, are these the opening steps of a new Cold War dance?

It’s important to recognise that Putin’s posturing does seem to be just that:  political posturing for consumption home and abroad.  Domestically his own electorate revels in Putin’s increasingly assertive nationalism.  For a man who is due to step down from the Presidency he doesn’t seem to be losing his appetite for popular opinion in Russia.  The stronger a leader he appears and the more popular he becomes, the more we can presume the Russian people will support whoever Putin declares as his successor.

His successor, on the other hand, will know exactly where his own power will be rooted.  Perhaps it was no coincidence that the current favourite, Sergei Ivanov, was at Putin’s side throughout the Moscow Airshow.

Ivanov, apart from being First Deputy Prime Minister and regarded as a ‘hawkish’ Defence Minister, is also Chair of OAO United Aircraft Corporation.  Putin has great aspirations for UAC and following his success in establishing global power in Russia’s energy champions he appears determined to replicate that success in rebuilding Russia’s corporate defence systems.

Furthermore, UAC is due to make its market debut sometime either late 2007 or early 2008.  What else was Putin going to say, with buyers expected to place over $1 Billion of new orders with UAC throughout the duration of the show?

Putin’s principle responsibility is to maximise Russian wealth and strategic power, just as is the fiduciary duty of any Chief Executive Officer.  As Adam Smith stated in The Wealth of Nations, “The great object of every country, is to increase the riches and power of that country.”

It is in analysing Putin’s behaviour from the economic point of view, rather than the political, that we can begin to identify a clear pattern emerging and that is not the pattern of a power-crazed dictator.  It is the behaviour of an extremely aggressive, recently emboldened Chief Executive.

The Russian economic organisation has a significant competitive advantage:  its enormous reserves of natural resources.  Applying prevailing market prices to Russia’s oil and gas reserves values those reserves at approximately $17 TRILLION.  That’s the same value as the American equity markets.

Neck and neck, you might think.  America’s economic power lies principally in the efficient operation of its markets.  Russia’s economic power still lies below the Motherland’s generous and productive soil.

However, should Russia be seen to be more strident, more assertive and more of a military threat, what do you suppose would happen to the value of its hydrocarbon reserves?  And, more importantly, what would then happen to the value of those American equity markets?

While those leader writers revel in a return to the days of Checkpoint Charlie perhaps somebody should nudge them gently and remind them of the horse and cart of military and industrial.  The military is there to protect wealth.  Industrial is there to create wealth.

It’s that distinction that may actually make this more serious than the Cold War ever was.  These could be the first steps in a valuation war that could have profound consequences for Western free market dogma.

What price the pair trade:  short the US equity markets and long the RTS?

We’re all addicts, now.

Anyway, no drug, not even alcohol, causes the fundamental ills of society.  If we’re looking for the source of our troubles, we shouldn’t test people for drugs, we should test them for stupidity, ignorance, greed and love of power.
P.J. O’Rourke

George W. Bush has himself, in his 2006 State of the Union address, declared America’s addiction to oil:  “Our name is America and, guys, we’re addicted to oil!” It is an addiction, by his own admission, that threatens America’s peace and prosperity and, by definition the peace and prosperity of the world entire.

Just as a junkie is beholden to his or her despotic dealer, so too America and Europe (and India and China for that matter) are dependent on a small number of undemocratic and unstable regimes for the supply of our most precious, most valuable asset:  energy, particularly oil.

Just as that despotic drug dealer is unlikely to exhibit much in the way of compassion for his or her junkie client, so too these undemocratic and unstable regimes are unlikely to be driven by anything other than their own self-interest.

If we look at who those emerging regimes are we can begin to gauge where this addiction could be taking us. The value of Russia’s total energy reserves equates to the same as the value of America’s equity markets, around $17 TRILLION.  Iraq’s energy reserves are valued at about the same as the American Government’s national debt, $9 TRILLION.  Saudi Arabia, controlling about a quarter of the world’s proved oil reserves, has an energy balance equivalent to the annual turnover of all the Fortune 500 companies put together, or roughly half the world’s GDP, at nearly $23 TRILLION.

These are staggering figures.  The extraordinary wealth created by the world’s free markets and it still struggles to compete with the wealth that still sits below the surface of the Arabian deserts and the Russian tundra.

What might happen, should these regimes decide to utilise that immense economic, political and strategic power to maximise their own wealth and strategic power?

If the USA really has experienced a humiliating defeat in Iraq then we stand at an inflexion point in time.  It’s an inflexion point where, for the first time since the 1930s, the world’s rising political and economic powers are undemocratic regimes less troubled by the efficient operation of markets and more exercised by the need to satisfy the emerging demands of their own middle classes.

Risks that we in the West, in the midst of efficient financial markets and stable political systems, have long regarded as having been consigned to history could be about to impose themselves on us once again.

It’s these risks this commentary aims to identify, address and quantify.  Oil markets are destined to remain volatile.  Politics and economies will ebb and flow with that volatility and in the midst of that volatility there will be those who never saw it coming and those who saw a path that ultimately led to new opportunity.