In business and economics, the biggest threat is the one that we cannot forecast. This is why it is important to consider the contrarian view to the consensus and identify the wild cards that could play out differently from what the majority is expecting. Betting against the consensus can have its rewards. Beyond the thrill that comes from defying the highly paid analysts of Wall Street, there is the fact that the consensus often turns out to be wrong. Professional institutions have the habit of “talking their books” or rendering opinions that reflect what they already own. If for example every one says that oil prices will remain firm, it is safe to assume that the majority are holding long oil positions in their portfolios. This can only mean that the tide is about to turn as increasingly more investors will start to reduce their long positions.
The consensus is that a weakening US housing market will slow world economic growth to 3.2 percent in 2007 from 3.8 percent in 2006, with the US growing at 2.5 percent down from 3.4 percent in 2006. This will put downward pressure or oil prices keeping them closer to the $55 level compared to the $65 a barrel average for 2006. Expansionary fiscal policies, in the various Arab countries and stable to lower domestic interest rates, moving in tandem with dollar rates, will help sustain strong economic growth in the region and delay any major decline in real estate price. The region’s stock markets should perform better in 2007 compared to 2006, although no where close to the boom conditions seen in 2003 — 2005.
Here are some of the surprises or wild cards that could form credible threats to the consensus view. Their importance derives from the fact that they are inter-related. A surprise in one area could trigger events and generate surprises elsewhere, leaving their impact on the regional and global scene.
1. The first wild card is a sharper slowdown in the US triggered by a bigger slump in the housing market. Home building in the US dropped at an annual rate of 17.4 percent in the third quarter of 2006, the biggest slump since the last quarter of 1990. The burst of the housing bubble will eventually spill over into consumer spending and credit expansion reducing growth further and possibly dragging the US into a recession. Canada, Mexico and China, with exports to the US ranging between 15 percent to 20 percent of their respective GDP, would be the hardest hit.
Slower economic growth worldwide would impact global demand for oil and would bring forth lower oil prices and weaker regional growth rates. Hedge funds seeking alternative investments in commodity markets rose from $3 billion in 2000 to about $100 billion last year, with oil being the single largest component of most commodity indices. It is estimated that from 2003 onwards, financial flows have pushed up the price of oil by some $30 a barrel. If increasingly more hedge funds continue to reverse the long positions they are holding and sell oil contracts in the forward market, and reduce their exposure to commodities in general, oil prices could tumble to the $40s level. While beneficial for the Arab oil importing countries, however, the region as a whole would suffer as lower oil revenues and the reversal of feel good effect would leave their impact on economic growth and corporate profitability. This could bring forth lower asset prices (stocks and real estate) and deflate household wealth.
2. The other wild card is the threat of a financial shock originated from OPEC’s massive financial surpluses. In 2006, OPEC’s current account surpluses is estimated to have reached $250 billion, exceeding the combined surpluses of Asia’s developing countries, including India and China. In the meantime, the US owes $3 trillion to overseas creditors making it much more vulnerable to foreign financial manipulation. If a political confrontation develops between the US and Iran or the US and Venezuela, the two nations could create financial turmoil, motivated not by economics but by nationalistic policies. For example, they could ask certain unregulated hedge funds to create a spark that could set off a broader investor stampede, featuring a run on the US dollar, or a run on US treasuries, or whatever is perceived to harm the US economy. Such a scenario may force other OPEC members to be on the defensive and take unexpected measures aimed at protecting their own interests.
3. A third wild card is the bursting of the real estate bubble surfacing in our region. Rapid increases in property prices in the main cities of the region over the past few years are raising concerns about potential overheating. Similar to what had happened in the region’s stock markets, a sudden burst in the real estate bubble should not be ruled out. The perception that real estate prices have peaked may encourage speculators to sell the property they hold before prices start to actually decline in their domestic markets. The additional supply coming to the market will be seen in the form of building of inventory, less sales and eventually lower prices. The bursting of the real estate bubble would reduce household wealth, bring forth lower consumption and economic growth and possibly damage the asset quality of banks. Its impact will vary from one city to another, being more visible in the UAE, Jordan, Qatar and Egypt and less so in Saudi Arabia and Kuwait.
4. Instead of staying and failing in Iraq the Bush administration may decide to cut its losses and withdraw first out of the population centers then out of Iraq in the hope that the Republicans will then have a chance to retain the White House in 2008. However, such a development could bring complete anarchy, the consequence of which is a full-scale civil war and the disintegration of the Iraqi state along sectarian lines leading to refugees streaming out of the country. The instability is bound to leak across borders, drawing in Iraq’s neighbors to protect their own interests. This could prove to be the beginning of a long and bloody civil war similar to what happened in Lebanon in 1970s and 1980s, but there the stakes were lower. Algeria’s civil war took 13 years before that conflict burned out.
5. The flame for regional conflict could come from Lebanon where the feuds of the Middle East have long been fought by proxies on the streets of Beirut. A development like this could spill over to include such regional powers as Iran, Syria and Israel and add to the radicalization of the whole region.
To conclude, the region is experiencing a period of growth and prosperity that is likely to prevail in 2007. Even when conditions are good and there has rarely been a better time to do business in the region, one should not be complacent. Instead, we should try to heed the lessons of previous years, i.e. to expect the unexpected.
(Henry T. Azzam is founder & CEO of Amwal Invest.)
