The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

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Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.

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What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

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Macro Letter – No 71 – 24-02-2017

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

  • In 2006 NATO partners agreed to spend at least 2% of GDP on defence
  • Germany’s defence spending shortfall since 2006 equals $281bln
  • Retrospective adjustment is unlikely, but Europe needs to increase spending substantially
  • A minimum of $64bln/annum is required from Germany, France, Italy and Spain alone

Given the mutual relationship of the NATO treaty it could be argued that, for many years the US has been footing the lion’s share of the bill for defending Europe. Under the new US administration this situation is very likely to change.

The July 2016 Defence Expenditures of NATO Countries (2009-2016) presents the situation in clear terms. At the Riga summit back in 2006 NATO members agreed to raise defence expenditure to 2% of GDP. In that year only six countries met the threshold – Bulgaria, France, Greece, Turkey, the UK, and the US. Eight years later, at the NATO meeting in Wales, members renewed their commitment to this target. Last year only five members achieved the threshold – Estonia, Greece, Poland, the UK, and, of course, the US.

The original NATO treaty was signed on 4th April 1949 by 12 countries, it was expanded in 1952 to include Turkey and Greece and in 1955 to incorporate Germany. In 1982, after reverting to a democracy, Spain also joined. Further expansion occurred in 1999, again in 2004 and most recently 2009.

Back in 1949 Europe was still recovering from the disastrous social and economic impact of WWII. Today, in the post-Cold War era, things look very different and yet, whilst defence spending has waxed and waned over the intervening years, the US still spends substantially more on defence, both in absolute terms and as a percentage of GDP, than any of its treaty partners. The table below reveals the magnitude of the current situation:-

nato_expenditure_-_geopolitical_futures

Source: Geopolitical Futures, Mauldin Economics

US defence spending last year amounted to $664bln which equates to 3.61% of US GDP based on current estimates.

Setting aside the political debate about whether we should be spending more or less on defence, it would appear that the US continues to do more than its fair share, in economic terms, in defence of its NATO allies.

The next table looks at the budgetary implications of making the NATO budget equable. Firstly, all NATO countries committing 2% of GDP to defence (which would dramatically reduce the total NATO budget) or, secondly, maintaining the current level of spending, which would imply all countries contributing 2.58% of GDP. In both scenarios the US is a clear winner in economic terms:-

nato_expenditure_as_percentage_of_gdp_-_analysis-1

Source: NATO, UN, IMF

I have excluded the smaller, mainly Eastern European, countries from this analysis – their combined contribution is less than $13bln/annum. I do not wish to appear disparaging, on a percentage of GDP basis many of these countries contribute more than their larger European neighbours. My purpose in this analysis is to look at the relative increases or decreases under each scenario. Below are the Budget to GDP and Debt to GDP ratios before and after adjustment to the less demanding 2% defence expenditure target:-

nato_budget_and_debt_to_gdp_after_adjustment_to_2_

Source: NATO, UN, IMF, Trading Economics

The Maastricht Treaty incorporated certain criteria in order to satisfy Germany, along with other cautious countries, of the fiscal rectitude of all countries seeking to join the Eurozone. Although they were never really taken seriously by politicians, these fiscal restrictions included a maximum Government debt to GDP ratio of 60% and a Budget deficit to GDP ratio of less than 3%. Applying these arcane criteria, only three countries – Denmark, Norway and Turkey – are in the enviable position of being able to undertake the required defence spending increases with equanimity.

The burning question going forward is how the largest countries in Europe will react to the US compliant that they have failed to increase spending since 2006. As George Friedman of Geopolitical Futures – The Evolving NATO Alliance succinctly explains:-

…the US accounts for about 50% of NATO members’ total GDP and 32% of their total population—and yet the US makes up about 72% of defense spending.

… Western European countries (excluding the UK) account for 31% of NATO members’ GDP and 33%  of their population, and yet they contribute 16%  to NATO members’ total defense spending.

Eastern European countries, which account for 4.2% of NATO members’ GDP and 12.7% of their population, are much poorer and smaller than Western European countries. Eastern Europe contributes 2.7% to defense spending. In effect, Eastern Europe contributes closer to its share than its far wealthier and stronger neighbors to the west.

According to SIPRI Milex data for 2015, Russia spent 5.4% of GDP on defence. Other notable defenders of their realms include Pakistan (3.4%) and India (2.3%).

At the Munich Security Conference which took place last weekend, the prospect of Germany finding an extra Eur20bln per year for defence spending was raised, but, being an election year, little more was heard on the topic. The conference was fascinating however, here are some of the key quotes:-

A stable EU is as much in America’s interest as a united NATO – Ursula von der Leyen – Minister of Defence – Germany.

American security is permanently tied to European security – James Mattis – Secretary of Defence – USA.

The role of Germany in Europe is always to be a bridge – between North and South and East and West – Wolfgang Schauble – Minister of Finance – Germany.

Make no mistake, my friends. You should not count America out – John McCain – Chairman of Senate Committee on Armed Services – USA.

Let us not forget that NATO is the backbone of our value system – Jeanine Hennis-Plasschaert – Minister of Defence – Netherlands.

NATO is not an obsolete organisation. It is an organisation to which additional mandates should be added – Fikri Isik – Minister of National Defence – Turkey.

The United States of America strongly supports NATO and will be unwavering in our commitment to this Transatlantic alliance – Michael Pence – Vice President – USA.

Europe’s defence requires your support as much as ours – Michael Pence – Vice President – USA.

Things look very different if we add up our defence budgets, our development aid budgets and our humanitarian efforts all around the world – Jean-Claude Juncker – President – European Commission

The post-war generation rose to their challenge, we must rise to ours – Jens Stoltenberg – Secretary General – NATO.

The European Union is much stronger than we European’s realise – Federica Mogherini – Vice President – European Commission – High Representative for Foreign Affairs and Security Policy – EU.

No one has any clue what the foreign policy of this administration is – Christopher Murphy – Member of the Senate Committee on Foreign Relations.

From a negotiating perspective it would not be entirely unreasonable for the US to demand that the 2006 commitment of 2% spending be honoured retrospectively, in addition to the 2% commitment going forward. The table below shows how NATO members have performed in this respect since 2005, apart from the US, only Greece and the UK have been above target over the entire period. American frustration with its NATO partners is hardly surprising:-

nato_defense_expenditure_as_percentage_of_gdp_-_ge

Source: NATO, Geopolitical Futures

The tone of US comments at the Munich conference appear slightly more conciliatory than of late. Europe’s defence ministries have, nonetheless, been seriously shaken by the change in attitude which has accompanied the change of US administration.

According to commentators, who purport to have more of a clue than Christopher Murphy, US defence spending is likely to rise by between $500bln and $1trln under the new administration. This is no “Get Out of Jail Free” card for NATOs parsimonious majority, Europe will be pressured to defence spending at a time when budgets are already uncomfortably bloated. They have had more than a decade to comply with the Riga commitment.

Looking at the bigger picture for a moment, this sudden rise in spending is a small uptick in a downward trend. Defence budgets have been falling in all the major NATO countries, as the chart below indicates. In 1989 excluding the UK and US the average budget to GDP across NATO countries was 2.9% by 1998 it had fallen to 2% but since then it has steadily declined to an average of 1.4% today. This may be good from an economic perspective – as Frederic Bastiat argued most eloquently in relation to the cost of a standing army in his essay What Is Seen and What Is Not Seen:-

A hundred thousand men, costing the taxpayers a hundred million francs, live as well and provide as good a living for their suppliers as a hundred million francs will allow: that is what is seen.

But a hundred million francs, coming from the pockets of the taxpayers, ceases to provide a living for these taxpayers and their suppliers, to the extent of a hundred million francs: that is what is not seen. Calculate, figure, and tell me where there is any profit for the mass of the people.

Nonetheless, the economic burden of defence spending borne by the US is undoubtedly going to shift, or else, NATO will cease to be tenable going forward:-

defence_spending_as_a_pecentage_of_gdp_since_1949_

Source: SIPRI

Conclusion

I believe it is likely that Germany, France, Italy and Spain will find an additional $64bln/annum for Defence and Aid budgets. They may also have to pick up part of the bill for the smaller countries to their East.

Will this impact European bond markets? It seems like a drop in the ocean beside the Asset Purchase Program of the ECB. President Draghi announced in January that they will be reducing the monthly purchases from Eur 80bln per month to Eur 60bln starting in April. I suspect the impact will be limited but it might prolong the Asset Purchase Program somewhat.

The implications for defence contractors and their stock market valuations will be more direct. Here are some of the largest listed names in Europe. Not all of them have been darlings of the stock market of late:-

areospace_and_defence_companies-1

Source: Investing.com, LSE, NYSE Euronext

For those who, like myself, who prefer to analyse the sector rather than individual stocks, the STOXX Europe TMI Aerospace & Defense (SXPARO) may appeal; here is a three year chart:-

stoxx_-_europe_tmi_aerospace_defense

Source: STOXX

The combination of increased military spending by the US and the pressure being brought to bear on Europe, should see the defence sector outperform over the longer term. During the last 12 months the SXPARO has risen 15%. Its US equivalent, the iShares US Aerospace & Defense ETF (ITA) is up by 20% over the same period, whilst the Euro has declined by around 3% against the US$. As a general rule I prefer to buy Leaders rather than Laggards, but the logic of buying European if European governments are forced to honour their defence obligations remains compelling.

The Scotian experiment and European fragmentation

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Macro Letter – No 21 – 10-10-2014

The Scotian experiment and European fragmentation

  • Scotland voted to remain part of the Union but the devolution debate doesn’t end there
  • Further European integration risks breaking the European Union
  • Economic growth in the UK and Eurozone will be damaged by long-term uncertainty

The Scottish decision to remain part of the Union, by such a slim margin – 55% to 45% on an 85% turnout – caught me by surprise. On reflection it should not have been unexpected – it was as much about the “hearts” as the “minds” of the Scottish electorate. Now that the dust has settled, I wonder what this vote means for the United Kingdom and for other regions of Europe.

In this month’s issue of The World Today, Chatham House – A result that resolves little Malcolm Chambers – Research Director at the Royal United Services Institute (RUSI) made the following observations: –

The Scottish referendum was supposed to settle the UK’s constitutional uncertainties, but the result has raised more questions than it answers. How Britain addresses the devolution issue and the question mark over its commitment to Europe will shape perceptions of its ability to wield influence and hard power abroad for years to come.

Britain’s 2010 National Security Strategy, published shortly after the coalition government took office, was entitled ‘A Strong Britain in an Age of Uncertainty’. It made no mention of the two existential challenges – the possible secession of Scotland from the United Kingdom, and the risk of a British withdrawal from the European Union. Yet either event would be a fundamental transformation in the very nature of the British state, with profound impact on its foreign and security policy.

The article goes on to discuss the promises made to Scotland by Westminster’s political elite, from all the main parties, which may now create the conditions for eventual independence: –

Devolution max could have a similar effect, making the final step from ‘devo-max’ to ‘indy-light’ appear less traumatic, even as it still allows Westminster to be blamed for any ills that remain. If a further referendum is to be avoided five or ten years from now, it will not be enough to make constitutional changes.

Prime Minister Cameron took the opportunity to raise the issue of Scottish MPs voting on English issues; whilst this was politically expedient, it sows the seeds for regional calls for devolution of power to the poorer areas of Britain: –

Yet growing awareness of the constitutional imbalances created by devolution to Scotland – and, to a lesser extent, to Wales and Northern Ireland – is creating a series of shockwaves that will not dissipate easily. The UK, as a result, could now see a long period of constitutional experimentation and controversy, with profound effects on the governance of the country as a whole.

Chambers then turns to investigate the “European Question”. Here he sees a parallel between the UKs relationship with the EU and the Scottish desire for independence: –

Britain’s relationship with the European Union is similar, in important respects, to Scotland’s position in the United Kingdom. It has a special financial arrangement, involving a rebate of most of its net contribution, that is not available to other member states. It retains its own currency and border controls, and has a permanent exemption from the common currency and passport-free travel to which other states have agreed. As in Scotland, there is strong political pressure for the UK to be allowed special treatment in further areas, such as immigration controls. In both cases, attempts to construct ‘variable geometry’ governance frameworks are made more difficult by the asymmetry in size between the opting-out nation and the political union as a whole.

From the Brussels’ perspective the issue of devolution is not just restricted to the “Sceptred Isle”: –

While the nature of the Britain’s constitutional crises is unique, they are part of a wider crisis of European politics. Over the past five years, the eurozone has faced successive crises as it has sought to find a way to reconcile vast differences in economic interest and viewpoint between its member states. Relations between Germany and the southern states have worsened as the former takes on a more openly hegemonic role.

Without further significant sharing of political sovereignty – for example through a banking union – the risk that one or more member states could leave the eurozone will remain very substantial. Yet further political integration could bring its own challenges, with powerful nationalistic parties in northern Europe already pushing against those who argue that all the answers must come from Brussels. One of the reasons that Britain’s European allies were so worried about the Scotland vote was precisely their concern as to the example that a Yes vote could have sent to separatist movements in Spain, Belgium, Italy or Bosnia. This concern will not have been entirely dissipated, both because of the precedent set by London’s willingness to hold the vote, and by the closeness of the margin.

In conclusion Chambers states: –

It is still far from likely that the United Kingdom will perish, or that it will abandon its commitment to the European Union. But the possibility of one or both of these separations taking place seems set to be a central part of British politics for a decade or more.

The impact on Sterling

Sterling is still some way below its longer-term average on a trade weighted basis as this chart of the Sterling Effective Exchange Rate (ERI) Index shows, however, it’s worth noting that the average between 1994 and 2013 is around 90: –

GBP Effective Exchange rate - BoE

Source: Bank of England

Uncertainty always undermines the stability of ones currency and the Scottish referendum was no different, although its impact proved relatively minor. In a recent speech, Bank of England – The economic impact of sterling’s recent moves: more than a midsummer night’s dream – Kristin Forbes – MPC member, downplayed what could have been a dramatic decline in the value of the GBP:-

There has been some volatility in sterling recently, especially around the time of the Scottish referendum, but sterling is currently only 1% weaker than its recent peak in July 2014.

In her conclusion she points to the appreciation of the GBP since the Great Recession and cautions those who fail to anticipate the negative inflationary consequences of a weaker exchange rate: –

Where sterling’s recent moves may have had the greatest economic impact is on prices and inflation. A “top down” analysis estimating the pass-through from exchange rate movements to prices suggests that the lagged effect of sterling’s appreciation during 2013 and early 2014 may have acted as a powerful dampening effect on inflation. Although model simulations may be overestimating the magnitude of the effect, sterling’s past moves have reduced the risk of inflation increasing sharply, despite the strong growth in employment and the overall economy.

This dampening effect of sterling’s past appreciation, however, will peak at the end of 2014 and then begin to fade. As a result, it is becoming increasingly important to monitor trends in domestically-generated inflation – and especially unit labour costs – so that monetary policy can be adjusted appropriately and also be allowed to work through the economy with its own set of lags. Unfortunately, understanding recent trends in the domestic component of inflation – especially the slow growth in wages – has been challenging. A “bottom up” analysis of inflation that focuses on current measures of domestically-generated inflation (which attempt to minimize the dampening effect of sterling’s moves) show price pressures that are well contained and little evidence of imminent inflationary risks.

These “bottom up” indicators present a very different story then the “top down” estimates of inflation after adjusting for sterling’s recent appreciation. Has sterling’s appreciation had less of a dampening effect on prices than has traditionally occurred – perhaps due to structural changes in the UK or global economy? Or are the measures of domestic inflation understating current inflationary risks – perhaps due to the long lags before timely data is available? To answer these questions, it is critically important to monitor measures of prospective inflation to determine the appropriate path for monetary policy.

If concern about political devolution of power to the regions, at the expense of the power-house of the UK’s South East, and expectation of rising Euro-scepticism, are destined to be the pre-eminent political issues for the next decade, then an appreciation in the value of Sterling is likely to be tempered. Since the UK economy is closely integrated to Europe this persistent undervaluation will be less obvious in the GBP/EUR exchange rate but hopes of the trade weighted value of GBP rising like the USD due to structurally stronger growth will be muted.

In the aftermath of the referendum RUSI – Never the Same Again – What the Referendum Means for the UK and the Worldobserved:-

Having, for the first time, looked at what a ‘yes’ vote might mean for them, private investors and businesses are now more sensitised than ever before to the risks that a further referendum could pose. If some of them were to begin to hedge their bets accordingly, there could be a risk of an extended period of underinvestment in Scotland, with serious consequences for its prosperity.

Better together?

The campaign slogan of the Westminster elite was “Better Together” but, setting aside the rhetoric of power hungry politicians, what are the pros and cons of devolution versus Union? Writing ahead of the referendum Adam Posen of the Peterson Institute – The Huge Costs of Scotland Getting Small made a valiant case for continued integration: –

When is it ever a good idea for a small nation to set up on its own? Leaving aside cases of colonization and outright oppression, there is little good reason ever to shrink on the world scene by leaving a larger unit. The internal politics of democracies always get better deals for regions within them than small sovereigns can elicit from identity-ignoring market forces. The few small nations that did gain in welfare by seceding from transnational entities are those that escaped failed autocratic systems. The Baltic countries escaping the former Soviet Union’s dominance can be seen in this light. But setting out on your own is only beneficial when the system left behind has directly constrained your nation’s human potential. Whatever else, that cannot be said of the current Scottish situation in the United Kingdom.

It is a fact of life in today’s world that a small economy on its own is always buffeted by the forces of the global economy more than a region within a larger union. Even well-run small states like Singapore and Estonia are subject to huge swings in their economy resulting from capricious capital flows in and out. These swings disrupt employment, investment, and competitiveness via real exchange rate fluctuations. More important, small economies are fundamentally undiversified because of their small scale, and they risk their specializations falling out of favor in world markets. Events beyond their control can overwhelm the small nation’s high value-added industries, no matter how good it is at those things, be they oil extraction or banking or whisky distilling. Scottish independence in form will instead mean increased vulnerability in fact, because, inherently, smaller means more exposure when the markets turn—and turn they will.

…The economic debate over independence has tended to focus on the one-time transfer costs: setting up a new government administration, apportioning the accumulated public debt, grabbing as much oil as possible. But these issues are of minimal importance, however one chooses to measure them, compared to the ongoing costs of permanently greater insecurity to households and businesses. Even if an independent Scotland were to start out with the Scottish National Party (SNP) fantasy of relatively low public debt and a relatively high share of remaining oil revenues, it would have to save more, pay higher interest rates, and keep more space in its budget for self-insurance, hampered by a narrow tax base, in order to cope with the vicissitudes of the global economy on its own.

When one looks at the economic austerity foisted on the population of Greece and at the hopeless prospects much of the unemployed youth of Europe I wonder whether there is an alternative to the “integrationist” approach.

Looking for an answer I went back to the forging of the United Kingdom. This is how John Lancaster describes the events which led to the Act of Union in 1707:-

During the 17th century, Scottish investors had noticed with envy the gigantic profits being made in trade with Asia and Africa by the English charter companies, especially the East India Company. They decided that they wanted a piece of the action and in 1694 set up the Company of Scotland, which in 1695 was granted a monopoly of Scottish trade with Africa, Asia and the Americas. The Company then bet its shirt on a new colony in Darien – that’s Panama to us – and lost. The resulting crash is estimated to have wiped out a quarter of the liquid assets in the country, and was a powerful force in impelling Scotland towards the 1707 Act of Union with its larger and better capitalised neighbour to the south. The Act of Union offered compensation to shareholders who had been cleaned out by the collapse of the Company; a body called the Equivalent Society was set up to look after their interests. It was the Equivalent Society, renamed the Equivalent Company, which a couple of decades later decided to move into banking, and was incorporated as the Royal Bank of Scotland. In other words, RBS had its origins in a failed speculation, a bail-out, and a financial crash so big it helped destroy Scotland’s status as a separate nation.”

The above passage, taken from Lancaster’s 2009 book It’s Finished, is quoted near the opening of a recent article by Tim Price – Let’s Stick Together in which he refers to Leopold Kohr – The Breakdown of Nations. The forward by Kirkpatrick Sale describes the problem of size when nation building: –

What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.

Kohr grew up in a small village which may have helped him to recognise one of the intrinsic weaknesses of democracy: that it works best on a small scale.

Taking this theme further and applying it to an independent Scotland, John Butler – From bravery to prosperity: A six-year plan to make Scotland the wealthiest Anglosphere region of all makes the case for a smaller more flexible approach. Here is an abbreviated version of his six point plan:-

Debt Repayment

The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.

Tax Reduction

There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting.

Human Capital

Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.

Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location.

Sound Banking

A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.

As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?)

Self-Reliance

The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.

Scottish Presbyterianism

Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.

To be fair to Adam Posen of the Peterson Institute, none of the arguments for a non-integrated Scotland solve the problems of vulnerability to external shocks. The crux of the issue is whether a larger, more integrated unit, is more effective than a smaller more flexible one.

The Politics of Empires

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton – 1834-1902.

Throughout history successful nations have grown through expansion and integration. The process is cyclical, however, and success sows the seeds of its own demise. Europe emerged from the dark ages to conquer much of the known world. Since then it has imploded during two world wars and may now be embarking on a further wave of integration. Or, perhaps, this is the last attempt to assimilate a multitude of disparate cultures before the “long withdrawing breath” into smaller, more dynamic, self-reliant units.

In the opening chapter of Edward Gibbon’s “Decline and Fall of the Roman Empire” he says:-

…but it was reserved for Augustus (who became Caesar in BC 44) to relinquish the ambitious design of subduing the whole earth and to introduce a spirit of moderation into the public councils.

However, I believe the seeds of destruction, which eventually created the conditions for the establishment of A NEW Europe, stem from Diocletian’s introduction of the Tetrarchy in AD 284. It divided the Roman Empire in four regions.

Diocletian’s son, Constantine attempted to slow this fragmentation by adopting Christianity as the official religion of the empire, however, his decision to move the seat of government from Rome to Byzantium in AD 324 set the stage for the final schism into the Eastern and Western Empires which occurred in AD395 on the demise of Theodosius.

The Western Empire sustained continuous assaults from Vandals, Alans, Suebis and Visigoths leading to the second sack of Rome in AD 410 by Alaric. The Western Empire finally collapsed in AD 476 when the Germanic Roman general Odoacer deposed the last emperor, Romulus . Europe had descended into a “dark age” of constant wars between rival tribes. The sole pan-European administrative organization after the fall of the Western Empire was the Catholic Church, which adopted the remnants of its infrastructure.

The creation of the Europe we recognise today began with the conversion to Christianity of Clovis – King of the Franks – in AD 498, but it was not until the re-uniting of the Frankish kingdoms in AD 751 under Pepin The Short and the subsequent appointment of his son Charlemagne as Holy Roman Emperor in AD 800 that the idea of a Christian “Western Europe” began to emerge. When viewed from this long historical perspective the current development of the EU is still in its infancy.

In the East, Constantinople remained the administrative center of the Byzantine Empire. Under Emperor Justinian in AD 526 the Empire expanded. Challenges from the Lombards in AD 568 saw the loss of Northern Italy, but the rise of Islam after AD 623 proved a more terminal event. Although Byzantium went into decline, due to many assailants – not least the Western Empire – it limped on until 1453 when it to finally succumbed to the Ottoman Turks.

Why the history lesson? The spark of the industrial revolution was kindled in Europe. It developed out of the chaotic collapse of the Western Roman Empire, the warring between a plethora of tribes and the rise of independent city states. It was built on the fragmented polity of petty fiefdoms and the desire to trade despite national borders and political restrictions on the movement of labour and goods. The renaissance began in Italy where the competition between small city states stimulated “animal spirits”. The flowering of art and culture that this democratisation of prosperity set in motion goes some way to support the idea that “small is beautiful”.

During the dark ages the concept of “Nationhood” was fluid, as exemplified by the Dukes of Normandy’s fealty after 1066 to the King of France, but only in respect of their French domains. As nation states began to coalesce international trade developed further. Nations waxed and waned, alliances were made and broken but no single nation succeeded in dominating the whole region. Demographic growth encouraged voyages of discovery. Colonisation followed, and finally the conditions were propitious for the birth of the industrial revolution from which we continue to benefit today.

These processes were gradual, running their course over many generations. I believe Europe is now fragmenting once more; painful for our own time but filled with promise for future generations. Calls for self-government from many regions within the EU will increase. The more Brussels attempts to make its citizens feel European the more its citizens will yearn for self-determination.

This trend will be driven by a number of factors aside from the declining effectiveness of central government. Bruegal – The Economics of big cities articulates one of these economic paradoxes, how globalisation has made the world more local: –

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital.

Human Capital may be defined as “the skills, knowledge, and experience possessed by an individual or population”. In the internet age this resource can be located almost anywhere and need not be isolated due to email, telephone or video conference technology, however, the advantages of physical proximity and social interaction favour cities.

Another, and related, issue is the increasingly disruptive effect of technology on employment. Bruegal – 54% of EU jobs at risk of computerisationhighlights one of the greatest economic challenges to the social fabric of the EU, but this is a global phenomenon: –

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Those authors expect that key technological advances – particular in machine learning, artificial intelligence, and mobile robotics – will impact primarily upon low-wage, low-skill sectors traditionally immune from automation. As such, based on our application it is unsurprising that wealthy, northern EU countries are projected to be less affected than their peripheral neighbours.

European governments are caught between the competing needs of an aging population and a younger generation who have little prospect of finding gainful full-time employment. Meanwhile city workers are paying for the regions where unemployment is highest. The tension between “wealth makers” and “wealth takers” are destined to increase.

Conclusion

Scotland voted to remain part of the Union. The Independence campaign was ill prepared failing to consider such issues as what currency they would use or how they would avoid a run on their banking system. The next time the Scots vote – and there will be a next time – I believe they will leave the Union because these questions will have been addressed. Other regions around the UK and Europe have taken note – the spirit of devolution is abroad. Prosperous regions, such as Catalunya and Northern Italy – Padania as it is sometimes called – crave independence from their poorer neighbours. Poorer regions resent the straight jacket of a single currency – be it the GBP for regions like the North East of England or the EUR for Greece and Portugal. To the poorer regions, the flexibility of a floating exchange rate is beguiling; as the EU stumbles through an era of debt laden low growth devolution pressures will increase.

For the GBP and EUR the Scottish “No” vote will fail to diminish the potential for social and political tension. The value of these currencies will reflect that uncertainty. Longer-term foreign direct investment will be lower. This will place an additional burden on EU budgets. A larger percentage of central government spending will be directed to regions where calls for devolution are highest rather than to economically productive projects in more prosperous areas.

European and UK equities are likely to under-perform in this environment whilst the increased indebtedness of EU governments is likely to increase their real borrowing costs.

Will this happen soon and will it be possible to measure? I think it is already happening but, given the very long-term nature of the fragmentation of nations, it will be difficult to measure except during constitutional crises. The shorter-term business cycles will still exist. Trading and investment opportunities will continue to arise. For the investor, however, it is essential to be aware of the risks and rewards which this fragmentation process will present.

Trading – the Ukraine and other geopolitical risks

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Macro Letter – No 6 –28-02-2014

Trading – the Ukraine and other geopolitical risks

This week I want to look at the impact of the events which have been unfolding in the Ukraine over the past fortnight. Below is a link to the leader from last week’s Economist – Ukraine’s Crisis: A tale of two countries, which describes the fractured nature of this country of 46 mln people:-

http://www.economist.com/blogs/easternapproaches/2014/02/ukraines-crisis

The Ukraine is also being commented on widely by the mainstream press, yet, barring a slightly heightened price of Gold and Oil together with some weakness in certain Eastern European markets, the global financial markets appear to have taken the situation in their stride.

Here is a one year chart for Spot Gold: –

Gold 1 yr

Source: Barchart.com

Below is the front month NYMEX WTI future:-

April 2014 WTI

Source: Barchart.com

Both Gold and Oil started to rise before the Ukrainian situation deteriorated but the heightening of risk has helped them move higher.

The dip and subsequent recovery in Eastern European stocks and currencies is typical of many geopolitical events and makes trading financial markets in this environment, more often than not, profitable for the shorter term “contrarian” trader.

Geopolitical exceptions

1.       German Unification

There are few exceptions to this general “contrarian” rule but one which I would like to review was the unification of Germany in 1989 since this example highlights the way geopolitics events can impact an economy – most events simply don’t meet these criteria.

German Unification led to a substantial restructuring of the unified East and West Germany. The decision in July 1990 to allow Ostmark conversion at one to one parity with the “mighty” Deutsche Mark was considered a major factor in the protracted adjustment process. A closer examination of this action shows that the reason for its significant impact on the economy and financial markets lay in the seismic economic consequences of the political edict. East German wages were well below those of workers in West Germany and their manufacturing productivity was also well below that of the West.

The relative degree of integration of the EZ at the time of the fall of the Berlin Wall meant that the shockwaves from the Unification effected pan-European bond markets. Added to this, Germany’s significant trade with the US and other major economies meant the ripples were felt globally.

The chart below shows German 10 yr Bund yields from 1986 to 1993:-

German Bund Yield 1986 - 1993

Source: Trading Economics

Here is the same period for the DAX Index: –

Germany DAX 1986 - 1993

Source: Trading Economics

It took the German financial markets more than two years to recover from the initial effects of Unification. In the broader economy this process took much longer. The Hartz Plan and subsequent reforms – a reaction to the effect of Unification – only took place between 2003 and 2005.

Below is a chart of the EuroStoxx50 from 1987 to 1996 showing the impact of German Unification on the wider EZ economy: –

EuroStoxx50 - 1987 - 1996

Source: Trading Economics

2.       Other major geopolitical events

9/11/2001 is a date few will forget. The bombing of the World Trade Center had a unique impact on financial markets in that it knocked out the settlement systems of the New York Stock Exchange in additions to its psychological affront to western democracy.

The S&P500 started the week of 10th September 2001 at 1092, by the following Monday it was at 965. The recovery was swift, however, by the mid-October it was back above 1100.

The US equity market was already in a down-trend prior to the attacks and never breached 1200 over the next six months. It then began the next leg of its downturn to bottom at 800 in October 2002. I would argue that this was principally due to the bursting of the internet bubble of 2000 rather than the terrorist attacks on 2001.

S&P500 - 2000-2004

Source: Barchart.com

The Gulf War of August 1990 was another major geopolitical event. The chart below shows how the nascent bull-market after the 1987 crash was stopped in its tracks. During the 1987 stock market crash the S&P500 had made a low around 220. During the Spring of 1990 the market came under pressure but staged a strong recovery into the early Summer. The Gulf War broke out in August 1990 prompting a 20% correction by October – that was the last buying opportunity below 300. By March 1991 it was above the pre-war highs.

S&P500 - 1990-1992

Source: Barchart.com

There are a number of other events which have had a significant impact of the economy and financial markets for a shorter period, for example: – The Iranian Revolution – January 1979, The Bay of Pigs crisis – August 1960, Suez crisis – July 1956. The vast majority of geopolitical events, however, have limited impact economically beyond their immediate borders; to have a wider influence the actors must play a pivotal role in the global economy. I’ll come back to a couple of these potential risks later.

Analysis of Ukrainian contagion

Ukraine - Map

Source: maps.com

Among the major Eastern European markets likely to be impacted by the Ukrainian situation are Poland, Hungary and Romania, yet brief look at their currencies and stock markets indicate little cause for concern. Another casualty has been Russia; its stock market looks sanguine but the RUB has made new highs for the year.

As the rhetoric gathers momentum, the risk that Russia withholds or substantially raises the price of the Natural Gas it supplies to Europe and, in particular, Germany, may create significant problems for the German and wider EZ economy. Whilst this provides an incentive for LNG producers, especially in the US, to grab market share, the US DOE has been slow to issue LNG export licenses.

The chart below shows the wide price differential for Natural Gas between the US, Europe and Asia:-

Nat Gas Price - 2007 - 2014

Source: World Bank and Knoema

For an in-depth analysis of the Nat Gas market you may interest in this paper from the Carnegie Endowment for International Peace – Natural Gas Pricing and its Future: –

http://carnegieendowment.org/files/gas_pricing_europe.pdf

The paper was published in 2010 but it is still prescient, here is an extract from the summary: –

Unlike other internationally traded commodity markets, natural gas has disparate regional benchmark prices. The dominant mechanism for the international gas trade, however, remains oil indexation, which originated in Europe in the 1960s and spread to Asia. A contrasting mechanism based on hub pricing and traded markets developed in the United States and has spread to continental Europe via the UK. Today, Europe is witnessing an unprecedented collision between these two pricing mechanisms and gas industry cultures. According to the International Energy Agency, one of the most essential questions related to global energy supplies and security is whether the traditional link between oil and gas prices will survive.

While Europe is currently the battleground, the implications stretch beyond Europe’s borders because once-isolated regional gas markets are now interconnected through the rising trade in liquefied natural gas. If the spot market model gains the upper hand in Europe, Asia will be the last remaining stronghold of oil indexed pricing, possibly making it unsustainable. Alternatively, if oil indexation re-exerts its predominance, there is the prospect that spot prices in North America will be influenced by this model.

Though the outcomes are far from certain, the stakes are high. Any modifications to existing contractual arrangements will directly impact exporters that depend on gas revenue—including Russia, Algeria, Indonesia, and Malaysia. And these changes will enhance or exacerbate energy security and dictate the sustainability

of future supply. Gas pricing will impact the competitiveness of industry and the potential to achieve environmental targets around the world.

The UK and Norway should benefit from Nat Gas price increases. I doubt the EUR will weaken significantly in this environment since international investment flows will be repatriated if Europe heads into another recession. A higher Nat Gas price will act as a tax on production rather than stoking EZ inflation. There will be stock specific opportunities, both long and short, but I expect the higher Nat Gas price to be positive for European Government bonds. The positive capital flows are likely to be less pronounced for German bunds than for the peripheral markets since the “quest for yield” is still a major factor in European fixed income markets. Lower bond yields will support European stocks unless the “slowdown” in German growth precipitates a serious EZ wide recession.

It is also worth remembering that Russia was elected to the World Trade Organisation in August 2012. Whilst they have far to go in reforming their international trade relations, there is some hope that being a member of the WTO may temper their retaliatory tendencies. This paper from the European Centre for International Political Economy – One Year after Russia’s WTO Accession: Time for Reform goes into more detail about Russia’s prospects: –

http://www.ecipe.org/media/publication_pdfs/ECIPE_bulletin1013vanderMarel__1.pdf

Other geopolitical risks on the horizon

The sudden deterioration in the Ukrainian situation caught many market participants by surprise. The Ukraine, however, is not the largest geopolitical risk in terms of the potential for economic contagion. Putting candidates in order of magnitude is a rather subjective task but here are my top two “flash-points”:-

1.       China and Japan

The territorial dispute over the Senkaku/Diaoyu Islands needs to be seen in the context of the US as global hegemon in retreat and China moving from regional hegemon to challenge the position of the US in the Asia Pacific region. Japan – which relies on the US for military support – being the next largest economy in Asia after China, is more critical to the global economy than Taiwan, South Korea, Vietnam, Malaysia  or the Philippines. All of these countries have regional disputes with China over territory in the South and East China Sea. See map below: –

China SeaTerritorial Disput Map

Sources: Daily Mail and Globe Money Morning staff research NIPR, Google News

2.       Iran and Saudi Arabia

There has been much relief in diplomatic circles since Iran agreed to talks with the US, UK, Germany, France, Russia and China about the permissible scope of their nuclear activities. With a deal in the offing I believe the risk of conflict in the Middle East is higher rather than lower, this Spectator article sums up my cause for concern: –

http://www.spectator.co.uk/features/9122371/armageddon-awaits/

The Middle East is not simply falling apart. It is taking a different shape, along very clear lines — far older ones than those the western powers rudely imposed on the region nearly a century ago. Across the whole continent those borders are in the process of cracking and breaking. But while that happens the region’s two most ambitious centres of power — the house of Saud and the Ayatollahs in Iran — find themselves fighting each other not just for influence but even, perhaps, for survival.

The way in which what is going on in the Middle East has become a religious war has long been obvious. Just take this radio exchange, caught at the ground level earlier this month, between two foreign fighters in Syria, the first from al-Qa’eda’s Islamic State in Iraq and Syria [ISIS], the second from the Free Syrian army [FSA]. ‘You apostate infidels,’ says the first. ‘We’ve declared you to be “apostates”, you heretics. You don’t know Allah or His Prophet, you creature. What kind of Islam do you follow?’ To which the FSA fighter responds, ‘Why did you come here? Go fight Israel, brother.’ Only to be told, ‘Fighting apostates like you people takes precedence over fighting the Jews and the Christians. All imams concur on that.

There has always been the ongoing tension of Bahrain, which is under Saudi domination but which Iran seeks for itself. But then there is the quieter battle for influence in the Gulf states, which, while interventionist at times, quiver before the clashing of these bigger beasts. It was only as Syria fell apart and the regional powers were pulled inexorably into a more open battle, that the cold war between Iran and Saudi found its hot battleground.

There are those who think that the region as a whole may be starting to go through something similar to what Europe went through in the early 17th century during the Thirty Years’ War, when Protestant and Catholic states battled it out. This is a conflict which is not only bigger than al-Qa’eda and similar groups, but far bigger than any of us. It is one which will re-align not only the Middle East, but the religion of Islam.

Saudi officials more recently called for the Iranian leadership to be summoned to the International Criminal Court in The Hague for war crimes. Then, just the month before last, as the P5+1 countries eased sanctions on Iran after arriving at an interim deal in Geneva, Saudi saw its greatest fear — a nuclear Iran — grow more likely. And in the immediate aftermath of the Geneva deal, Saudi sources darkly warned of the country now taking Iranian matters ‘into their own hands’. There are rumours that the Saudis would buy nuclear bombs ‘off the shelf’ from their friends in Pakistan if Iran ever reaches anything like the nuclear threshold.

Here is a map of the Middle East region divided into Shia and Sunni spheres of influence: –

Shia and Sunni Map of the Middle East

Sources: CIA World Factbook; Adherents.com

As at 2010 1.6 bln people 23.4% of the world population was described as Muslim. Here is a world map which shows the potential global nature of this risk. Green = Sunni, Red = Shia and Blue = Ibadi: –

Islam by country 2010

Source: Wikimedia commons

The Council for Foreign Relations take a wider view of the world and pointed out that there are Ten Elections to Watch in 2014: –

http://blogs.cfr.org/lindsay/2013/12/10/ten-elections-to-watch-in-2014/

Beyond this expanded “risk list” one can include the Nuclear Weapons capable (or nearly capable) nations, these are always a source of unexpected risk: –

Map of Nuclear Armed States of the World

Nuclear weapons states

Key

LIGHT BLUE = NPT-designated nuclear weapon states (China, France, Russia, United Kingdom, United States)

RED = Other states with nuclear weapons (India, Pakistan, North Korea)

YELLOW = Other states believed to have nuclear weapons (Israel)

DARK BLUE = NATO nuclear weapons sharing states (Belgium, Germany, Netherlands, Italy, Turkey)

GREEN = States formerly possessing nuclear weapons (Belarus, Kazakhstan, Ukraine, South Africa)

Source:Wikimedia Commons

Conclusion

The current situation in the Ukraine may prove contagious but appears, at this stage, to be of minor economic importance. This situation may change if Russia becomes more belligerent. However, the weakness of Emerging Markets is likely to be more protracted and the risk of further capital repatriation, heightened by this event. The risk to Europe from a Russian Nat Gas embargo is also real and this could threaten the US recovery.

I believe the Ukrainian situation may reduce the likelihood of a rapid increase in tapering by the Fed and increase the prospects for ECB Outright Monetary Transactions. In aggregate that amounts to more QE which should support stocks and higher yielding bonds.