Syria – Assad situation

Syria is a secular state, but the religious breakdown of the Syrian population is approximately 74% Sunni Muslims, 16% Shia Muslims, 10% Christian (source – CIA World Factbook).  However, the al-Assad family which has ruled Syria since 1971 are Alawites (one of the branches of Shia Islam), and government positions are mainly held by Alawites.  The Arab Spring – the movement across the Middle East which sought to overthrow long-established autocratic leaders – saw an uprising in Syria against the Assad government; this began in March 2011 and the ensuing civil war continues today, with the Assad regime determined to stay in power.  It has become a war between Shia and Sunni Muslims.  Both share many of the same beliefs, but the Sunni Muslims, who represent about two-thirds of Muslims in the Middle East region, believe in the authority of the Koran and the sayings and actions of the prophet Mohammed as the source of truth and wisdom, whilst Shia Muslims believe that Allah has appointed certain people from Mohammed’s descendants and that they possess special spiritual and political authority over their community.

The key allies of the Syrian government are Iran and Russia.  Iran is the largest Shia Muslim state and a neighbour, and is thus determined to ensure that Syria remains controlled by Shia Muslims.  Iran and Syria have been strategic allies since the Iran-Iraq War when Syria sided with Iran, sharing a common hostility to Saddam Hussein, as well as to the US and Israel.  For Russia, Syria is of geo-strategic importance as an ally, since the Syrian port of Tartus is Russia’s only Mediterranean naval base.  In the UN Security Council, Russia has consistently supported Syria against the imposition of UN sanctions and in providing arms to the government.

Saudi Arabia has been the biggest supporter of the Syrian rebels, providing finance and arms. Saudi is predominantly Sunni Muslim and its official form is Wahhabism, often described by critics as being “puritanical” or “intolerant”.  Both Iran and Saudi have aspirations to be seen as the leaders of Islam, and Saudi interests would be served by the rebels overthrowing the Assad government and installing a Sunni regime, thus gaining a new major ally and depriving Iran of the same.

Al-Qaeda is a terrorist Islamic organisation, which sees its targets as both any non-Muslim influence on Muslim countries (hence its attacks on the US and the UK), and any non-Sunni branches of Islam. They are widely believed to be very active in supporting the Syrian rebels with finance, troops and weapons.

Qatar is another Sunni-dominated Muslim country which has given heavy support to the rebels.  Qatar is a tiny country with huge gas reserves and is very keen to build a gas pipeline into Europe via Turkey. To get to Turkey, it must pass through either Saudi Arabia or Syria, and Saudi is currently blocking the proposals.  A more reliable and Qatar-friendly government in Syria would make a huge difference to its ability to supply gas to the European market.

Israel has little direct interest in the Syrian civil war other than to be very aware that should the US engage in military action, then it poses a very convenient and close target for retaliation by Syria.  It would though be more wary of a religious-led government in Syria than the current secular government.

In the initial stages of the Syrian civil war, the three Western permanent members of the UN Security Council, the US, the UK and France were generally sympathetic to the Syrian rebels, on the grounds that a minority grouping ran the country against the wishes of the majority grouping, which would not occur in a properly-functioning democracy.   However as time has gone on, the active support of Al-Qaeda to the rebels has limited the Western desire to take sides actively in the civil war, and instead seek to broker opportunities for peace.

About a year ago, President Obama warned Assad that he would regard any use of chemical weapons in the dispute as breaching a “red-line” for him, and would be unacceptable.  Last week the US announced that they were convinced such weapons had been used by Assad.

The US faces a set of very poor choices: (i) if it decides upon military intervention and this leads to the overthrow of the Assad regime, they are likely to find that Syria’s next rulers hate the US with just as much passion as Assad, and indeed Al-Qaeda supporters may well find themselves in power; (ii) if it decides upon military intervention and this does not lead to a change in the regime, then it will look weak and Assad will become a bigger hero in the eyes of many Arabs; or (iii) if it decides against military intervention, then Obama will have allowed Assad to cross one of his “red-lines” without incurring any serious consequences.  This will be noted and seen as weakness by Iran and North Korea where Obama has also set out “red-lines” over their development of nuclear weapons.

From its beginnings as an internal uprising during the Arab Spring to its evolution as a sectarian Muslim civil war, markets have taken little notice of Syria.  It is only now, as it nears turning into a proxy war between superpowers that the gold and oil prices have started to rise, and markets have begun to be wary.  The lack of public support in the US for military intervention is however likely to mean that Obama will not wish to get heavily involved in Syria beyond a round of air strikes at key Syrian targets.

We are not recommending any changes to portfolios in the light of the Syrian crisis – we expect tensions over the next few weeks, but in the end we believe that the US will not seek a deep involvement in Syria, as it has no major national interest in the outcome of the civil war and no clear objectives and strategy that would inform any deeper involvement.  However, should there be a clear escalation of US involvement in the conflict, the risks to the oil price and the world economy would become much larger.

America’s cliffhanger

The US fiscal cliff agreement, which passed through Congress on the first day of the year, showed most US politicians in a bad light.  Only at the very last minute before significant tax increases and spending cuts would have taken effect, did all participants agree to (i) a deferral of these measures for two months, (ii) a 4.6% tax increase on all incomes over $450,000, and (iii) a 2% payroll tax increase on all incomes up to $107,000.  Obama got the tax increase for the top 1% of earners that he had campaigned for, which will raise about $60bn a year, and the Republicans demanded no further extension of the payroll tax cut, which will raise about $125bn a year.  Together these measures will reduce US consumer incomes by a little over 1% of GDP in 2013.

This was just about the minimum possible level of agreement, and the fact that it took until 1st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1st March.  However, several important conclusions can be drawn from recent events:

  1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
  2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
  3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
  4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
  5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
  6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.

Time for Mitt to take the gloves off

The US Presidential election is between two candidates, one of whom believes that it is not worth worrying about the 47% of voters who do not earn enough to pay income tax, and the other who tells small businessmen that it was the government that enabled their business to be successful. Such a clear ideological difference should mean that the result matters greatly to Wall Street and financial markets.

Yet, 2012 has seen little impact on markets from US politics – the headlines this year have been about the Eurozone debt crisis, the Federal Reserve’s policy and the Chinese economy. The election should be close given the poor performance of the US economy (though not its stock market) under Obama, but the lack of strong Republican candidates has left them with the rather uncharismatic Romney as their best choice. His gaffes in recent weeks leave him currently trailing Obama in most of the key swing states as the contest enters the final straight.

There are three election debates to come, which could turn things around, but it seems unlikely that the experienced and eloquent Obama would lose out so badly to the more formal Romney in head-to-head debate.  A Romney win from here would be a big surprise but would in all likelihood also come with Republican majorities in both Congress and the Senate This is typically a combination that Wall Street would cheer. However an Obama win would be combined with a continued Republican majority in Congress and the only question for markets would be what happens to the Senate. Currently the Democrats have a 51-47 majority with 2 Independents – with 33 Senate seats being contested in November. Of those 7 (6 of which are currently held by Democrats) are believed to be races that are too close to call.

This all matters because of the “fiscal cliff”. This is (i) a number of previously agreed tax cut measures which expire on December 31, and (ii) the penalty clause US politicians set for themselves if they were unable to agree on long term measures to reduce the budget deficit, which make roughly equal cuts in defence and welfare spending. The idea of the penalty clause was that each side would be forced to make compromises on a longer term deal in an attempt to avoid large cuts in the area that most concerned them (defence for the Republicans and welfare for the Democrats) – sadly it didn’t work. The combination of all these measures would be to tighten fiscal policy by about 4% of GDP in 2013 and would send the US economy into recession.

No one seriously believes that such a massive tightening of policy would be allowed to happen, but to avoid it , the “lame-duck” sessions that occur from the election until Christmas with the old membership of both Congress and Senate, will have to agree to some compromises. It is perhaps understandable that, before the elections, neither side were prepared to make any compromises, but the hostility shown by many in the Republican Party towards Obama since he became President has taken the working relationship in Washington between the two parties to a very low ebb. It is not clear that this would change if Obama were to be re-elected and still faced a hostile Republican party in the two Houses. It is possible that an angry and upset Republican Party would not make any compromises and let the US economy fall into recession.

Markets are currently pricing in an Obama victory, and then some sort of compromise over the fiscal cliff that doesn’t drive the US economy into recession. A Republican victory would lead to a rally on Wall Street, but a bad-tempered defeat for them where emotions ran high would be a very negative development for America and the world.

Dear Diary – possible reflections of some of those at the G8 meeting

The G8 meeting achieved nothing, despite the sense of crisis in the markets. The communiqué was bland and meant different things to different people. Below are what the leaders may well have really thought  about the summit.

Barack.  Re-election chances continue to drop – only 6 months to go. Have to say that Angela has some backbone, kept going with the German Nein all weekend long despite all of us ganging upon her to open her wallet. Played at being best buddies with Francois, the new boy in our club – it keeps David and Angela on their toes. Anyway he and I do have a lot in common, the rich should be paying a whole lot more towards getting us out of this mess, and it shouldn’t be the ordinary Joe who takes the hits all the time. Europe really worries me though – if it all blows up this summer, it could send our economy back into recession just about election time and I’ll be a very young ex-President.

Angela.  Re-election chances continue to drop – only 16 months to go. Well, that goes down as one of the most miserable weekends of my life. I know I’m still at the top of Barack’s European speed-dial, but it was horrible to watch him buttering up Francois. At heart though neither of them believe in balanced budgets and sound money like I do; they just want the money and public expenditure to keep on flowing and keep their supporters sweet. I am now only really left with David as a true right-of-centre ally in Europe; at least he is backing our drive for a political union as the best option to save the monetary union. Even so, he joined in with the others that Germany must spend lots of money we don’t have and let the ECB print and cause inflation – I was totally alone on this but stood my ground.

I thought it was a pretty smart idea to take 3 hours off from our discussions to watch the Champions League Final – it would be 3 hours not having to defend sound economic principles and a chance for Germans to show the football world how good we are (again) – but it didn’t work out. Bayern lost (on penalties – Germans never do that) and the symbolism was so awful – a team of foreign imports on huge salaries from the part of London inhabited by investment bankers, managed to overcome the bulk of the German national team, who were so strong, courageous and disciplined, and from Munich, the most successful centre of the German export industry. Worst of all that photo of us all watching the game has gone viral thanks to Twitter.

David. Re-election chances starting to drop – though still have 36 months to go. Politics is a rum old game. Who would have thought that a British Conservative Prime Minister would be telling the nations of Europe that their best (and only) hope was to move toward a full-on political union led by Germany? Yet George keeps on telling me that really is the best hope for our economy until the next election. Maybe, but it would be terrible for Britain’s influence with the US and China if Europe was truly one country with an elected President. I really can’t see it happening though, but I just don’t know if that is a good or a bad thing. That photo should do me the world of good with all the ordinary footy supporters in the country though – not many Posh Boys really like association football. Like Angela I had to be grovel a bit to Francois.

Francois. Chances in the parliamentary elections in 4 weeks definitely on the up. Life is amazing right now. Two weeks I was M. Normal, a French Socialist leader that had never had responsibility for anything in my life except for other Socialists, and now the President of the United States of America is telling me and the others what wonderfully interesting ideas I have. Also quite a nice feeling for Angela and David to have to be extra nice to me right now – I shall make good use of that back home in the next few weeks ahead of the elections.

Mario. Politicians are so transparent, always worrying about their election prospects.

Vladimir. Why are these guys so afraid of elections? Everyone’s beating up on Angela. I reckon she needs a good friend like me, and then just maybe we can get Germany to see Russia as their best European ally, instead of always looking westward.

Coming soon – a real electoral debate about the US fiscal deficit and a weak 2013

Recent general election campaigns in fiscally-challenged countries such as the UK, Spain and France have been noticeable for their politicians’ reluctance to spell out specific measures that they would introduce to bring down the enormous fiscal deficits in these countries. The electoral success of the right-of-centre parties in the UK and Spain was however immediately followed by significant programmes of cutbacks to government spending as well as some tax increases.

It is now clear that the US Presidential election will be between Obama and Romney (who would have believed five years ago that a US election would be between an African-American and a Mormon). With Obama having presided over trillion dollar deficits throughout his term in office, how best to manage these deficits and the ensuing government debt will be the key battleground of the election campaign. The two candidates will argue from the two opposing economic and political traditions. Obama, the Keynesian, a believer in public spending acting as a stimulus to the economy to offset private sector deleveraging against Romney, the orthodox conservative, a believer in small government and balanced budgets. Obama wants to tax the richest 1% more and maintain government benefits to the poorest in society whilst Romney wishes to cut taxes, particularly for the wealth-creators, and cut all areas of government spending except for defence (in practice this means welfare  and health spending). It is only in America that Obama’s tax plans for the top 1% would be called “class warfare” and many would agree with that assessment.

Both men are highly intelligent, clear thinkers, who can produce very articulate presentations of their respective cases and let the American people then make an informed decision as to in which direction they want their country to go for the next four years. It could be democracy’s finest hour (or three months) although the history of recent elections tends to suggest that other rather more superficial issues will also get much attention.

The end of this year though is critical for US public finances, as both sides have put off all the difficult decisions regarding the budget until after the November election. If nothing changes between now and next January 1st then 2013 will see the expiry of the Bush tax cuts, which heavily benefit those whose income is high and generated from corporate dividends, and the Obama payroll tax cuts which benefit those in work. In addition, spending cuts affecting both defence and welfare in roughly equal measure are due to come into effect. If all these measures are allowed to come into being at one time the aggregate effect is likely to be to drive the US economy straight into recession. However no one expects all these measures actually to occur though – if Obama wins he will seek to reduce the welfare cuts and extend the payroll tax cuts and if Romney wins her will seek to reduce the defence cuts and extend the Bush tax cuts.

Financial markets do not appear to have these measures in focus just yet, or be paying attention to the fact that whoever wins there will be significant fiscal consolidation in 2013. They should be because Europe’s recent history demonstrates clearly that this consolidation, also known as austerity, necessarily involves reducing people’s disposable incomes, either because taxes are rising or because government spending is falling, and that this has to have an initial, deflationary effect on private sector demand. 2013 is very likely to be a pretty bad year for the US (and thus probably also for the world) economy. Markets tend to look 6 to 9 months ahead, so the next few weeks should see them begin to discount this weakness – this should be good for government bonds but less good for equities.