A World of Risk in 2012
24th December 2011
“Due diligence of the macro kind has never been so important as in 2011 and 2012,” says the chief executive of Oxford Analytica. A quick glance at last week’s headlines explains why: The alarming compendium included the death of North Korean dictator Kim Jong-Il, renewed rioting in Egypt just a few months after the Arab Spring, fresh trade wars, and the unsettling prospect of cyber attacks as Chinese hackers broke into U.S. Chamber of Commerce computers. A former Goldman Sachs banker and United Nations official, Mousavizadeh runs the well-regarded Oxford, England-based strategic-analysis firm, and is an excellent candidate to assess one side of the risk/reward tradeoff. To learn his views, keep reading.
Barron’s: What does Kim Jong-Il’s death mean? Will we see rapprochement, or more missile attacks?
Mousavizadeh: There are a few key issues. The succession was planned by the North Korean regime, and it has been known for some time that the son of Kim Jong-Il would succeed the father. Second, as much as the leadership was personalized by Kim Jong-Il and is now handed to the son, it is a military regime run by a military committee that should be seen in a broader context: It is very, very focused on maintaining its grip on power. Third, the regime thrives on a state of war with the outside world. Some kind of provocative activity, much as the father engaged in at various times when he thought that was useful to him, is to be expected. We are looking for increased tension in relations between North Korea and the South and Japan, as well as the U.S., in the next 12 months. It accords with their continuing sense of a state of siege.
“Clearly Western governments are focused on what they see as an enormous amount of cyber activity coming from China.” — Nader Mousavizadeh
Will the well-known Korea discount expand?
I would think so, yes. The son is untested, young, and it is not clear that he has the status that his father would have wanted. The overall risk picture around Korea has gone up as part of this transition.
You coined the term “global archipelago.” What does it mean?
When the West came out of the Cold War, the expectation was of “the end of history,” and of one model of broadly free markets, and that governments would all end at the same destination, even if some took longer to get there. Everyone pretty much wanted to get to where we are in the West.
What the last decade has shown, which was accelerated by various events—including the Iraq and Afghanistan wars, 9/11, and the global financial crisis leading to the euro-zone crisis—was a couple of very important forces that made us question whether that end is likely or even desired. Over the last 25 years, you saw the relative decline of U.S. economic and political dominance.
A number of countries rethought their own economic and political models, whether Brazil, Turkey, Indonesia, Russia, or African countries. The combination of increased political independence, stronger economies driven by commodity flows, structural drivers from China, and the failures of a lot of Western development models to deliver either growth or equality for a lot of emerging markets, have led a number of countries to redesign how they govern themselves. I use the term “archipelago” because of the fragmentation of power, capital and ideas. There will be more distinct voices, all of which feel they have a reason to be heard, and interests they can now defend because they are economically stronger than 20 years ago.
For investors, this means a much larger role for the state. You will see more use of state-owned entities, state backing for national champions, state activism on trade and investment. We are used to seeing it from China and Korea, but you are going to see it more from Europe, from Britain and Finland.
Clearly we will see more trade protectionism. The fragmented archipelago is also a reflection, by the way, of the failure of some of the big global universal attempts to regulate either emissions or trade. You will see dozens of new bilateral agreements instead of the World Trade Organization being the only place that secures those interests.
What big risks do investors face in 2012?
The main risk, from an economic perspective, is a disorderly collapse of the euro zone and the common currency. The basic political division is around how unified fiscal and other policies should be. The recent agreement among the 26 governments had two problems. One is that it is too small. Two is that each of these 26 governments needs to go and get democratic popular support and endorse the shift in authority to Brussels.
No one thinks this will actually happen. Because of the lack of credibility around Greece, European leaders can’t convince markets that Spain or Italy can come out of the danger zone. So at this point, even if you don’t believe the European Central Bank should be the lender of last resort for the banks, which it is, and the sovereigns, which it isn’t, the markets believe that unless the ECB takes that role, you can’t build a strong enough firewall in Europe. Yields will go up as a function of that lack of confidence.
What do the euro zone and the euro look like in December 2012?
There’s an 80% chance the euro zone looks different. It will include Germany, France, and other core countries that believe in the common currency and can create credibility about their economic and fiscal discipline to support it. A number of others, Greece first among them, won’t be able to stay. It will be harder for the peripheral countries to justify sacrifices in domestic policies, when there is no end in sight to the austerity programs.
The risk of Greece defaulting and going into the very, very difficult process of converting back to its own currency is high. Italy is much bigger and more important: You will see Germany and France go to great lengths to keep Italy in. But it isn’t sustainable for Italy to pay 6.5%, 7% on its debts. At the end of the day, the only way the euro zone has 100% likelihood of staying intact is a shift in the role of the ECB, if it came in and said that was a greater concern than inflation, which is the current core of its mandate.
Obviously, you run the risk of greater inflation by printing more money and buying the markets of the sovereign debtors. But the authority of the ECB could transform perceptions of sovereign risk in Europe. My guess is the euro weakens in 2012.
Is a hard landing in China a concern?
There is every reason to believe the Chinese government will manage its transition to a slightly lower growth profile very successfully. We see continued strong development of the domestic market, a much less leveraged and much less crisis-prone financial sector in China, and increased trade and investment flows between Latin America and Africa and Asia, which allows them to disintermediate Western institutions as export markets and sources of investment.
The risks in China include the leadership change next year. You will see a more assertive China that is soon going to be the largest economy in the world, even as it will have a gross domestic product per capita that is an eighth or ninth of the richest parts of the world. We will, in effect, have two Chinas for a long time to come, and that will lead to decision-making that at some times will seem sensible and at others perplexing.
Another risk is that the political pressures within China come not so much from dissidents like Ai Weiwei, but from a highly connected younger population on the Internet that has a more nationalistic perspective than the Beijing government, more anti-American and anti-Western, pushing the Chinese leadership to be assertive in the world. That is another way the archipelago will manifest.
Do you mean militarily, as in the South China Sea?
The envelope will be pushed on trade issues: You will see more spats about tariffs between other economies and China. You will see the continued “going-out” strategy: More and more large-scale Chinese investments in emerging markets, and some very sizeable Chinese acquisition moves on major Western companies. In terms of companies, the resource space is obvious. Some of the surprises in 2012 will be in other sectors—financial services, consumer areas, technology.
What are the risks from the Middle East?
In 2011, the Arab world went through a once-in-a-generation change. In many ways it caught up with the rest of the world in terms of the force of globalization, technology and the chance to create a political and economic system that can unleash its talents. Now the big challenge is the transition to some form of democratic rule.
In the Arab world, democracy is not intimately associated with economic deprivation and penury of the kind you saw in Russia after the fall of the Berlin Wall, which is a huge reason why [Russian Prime Minister] Putin has had the support he’s had for as long as he’s had it.
The risk in 2012 for the Arab world is that as they structure democratic, responsive forms of governance, the economic burdens overwhelm them and people think nostalgically of [former Egyptian president] Mubarak or [former Tunisian president] Ben Ali because they could put food on the table. That is a big challenge for the West, which supported Mubarak and these regimes to the tune of billions of dollars. Now these countries are asking themselves if the West will support them now that they are trying to be democratic.
As for the U.S. withdrawal from Iraq, it is considered a good thing, although Arab leaders worry whether that means increased influence for Iran. At the leadership level, there is a mixture of peril and paranoia around the role of Iran. That all falls under the biggest worry among Arab leaders now. The future of their region will be determined by three countries that are not Arab: Turkey, Israel, and Iran.
Let’s talk about Iran’s nuclear program.
The Iranian government claims the program is for civilian uses, but few outsiders believe this. For some time, there has been a concerted, successful policy of sabotaging, delaying, and disrupting this program. The U.S., Israel and others are believed to be involved, and the efforts have succeeded so far, in that Iran has not crossed the nuclear threshold.
The key risk is that in Israel, important elements of the leadership do not believe the West has either the will or the capability to prevent Iran from becoming a nuclear power. If you combine this view with a sense that the change sweeping the Arab world is a source of instability and hostility to Israel, and that an Iranian nuclear capability will so substantially change the power balance in the region as to make their own strategic position unviable, then the risk of military action goes up in 2012.
The current relations between Israel and the U.S. contain a very strong element of distrust at the very senior leadership level, between [Israeli Premier] Netanyahu and [President] Obama. That might contribute to a decision to take military action. This comes at a time when Iran’s position is substantially weakened. When the Assad regime falls, Iran will lose its only ally in the Arab world, Syria.
The final piece, as we know from the 2009 Green Movement, is that the Iranian people do not in any way share the hostility of the regime for the West. These factors all count against the ability of the regime to disrupt Western and Arab strategies, but haven’t prevented a heightened state of paranoia and peril.
How likely is military action?
I think it is less than a 20% probability. If it happens, it will happen in the spring because the weather elements make it better to do it then. The U.S. political calendar has an impact. It’s unlikely to happen in the initial period after either the President has been reelected or there is a new president.
If it happens, it will be started by Israel, and will draw in the U.S. either immediately or in the medium term. There is a very high risk of it becoming a major war in the region.
From the Iranian perspective, closing the Strait of Hormuz is clearly one of the tools in its arsenal to make the West pay a very high price for an attack. It is highly likely you would see a major disruption in energy supplies and therefore a rise in the price of oil.
Beyond Iran, a conflict will likely affect the standing of a number of key Arab allies. The leadership may support the action, but the people would not. If you go to the Persian Gulf now, people are talking very tough about attacking Iran, which they see as the major destabilizer in the region. But once another major war is started on another Muslim country in the Middle East, popular sentiment is unlikely to hang with the leadership.
There is zero appetite in the U.S. and British governments and militaries for a war with Iran.
You are also concerned about cyber attacks.
Over the last 10 years, you’ve seen the Pentagon establish a cyber command and spend enormous resources to counter cyber attacks. The attempts to delay the Iranian nuclear program include cyberware, the Stuxnet virus. We have reached the stage where the technology is advanced, and both state and nonstate actors have the ability to launch an attack on a private or government institution.
It isn’t lack of capability that has prevented such an attack. One of the peculiarities is, we may never know when it starts or who started it. You may simply see a major technological failure at a Western institution. Clearly, Western governments and institutions are focused on what they see as an enormous amount of cyber activity coming from China, whether government-backed or not. You will see the threat matrix multiply on the risk of an actual successful attack of meaningful size in 2012.