10 Potential Surprises for 2008 – midyear assessment

In December 2007 I made my 10 potential surprises for 2008 and Predictions post.  I put the odds of each surprise at less than 50/50 at the time and was hoping to get 5 or more right to be able to pat myself on the back as a "soothsayer". 

What I’ve gotten right so far:

4.  The Chinese stock market will crash by more than 30% from its peak.

5.  At some point in 2008, the Fed Funds rate will be at or below 3%.

10.  John McCain will be the Republican presidential nominee.

What I’ve gotten wrong:

1.  The West (namely the US) and Russia will have a major standoff over the fate of Kosovo.  The magnitude of the crisis will surprise the Western media.  Georgia will be sucked into the crisis somehow. [Russia backed down.]

9.  John Edwards will be the Democratic presidential nominee. [no explanation needed]

Jury still out:

2.  The US and North Korea will sign a treaty officially ending the Korean War. [Things are moving in the right direction, not sure if it’ll get this far before the end of the year, though.]

3.  The US and Iran will have a high-profile detente. [I actually think this will happen, but we’re not there yet.]

6.  The US current account deficit will end the year at less than 3% of GDP. [This might happen, but I should have specified Real GDP, which is the most watched measure.]

7.  The US dollar will rally by more than 10% against the Euro and the Pound.  [Not looking good, but in the realm of possibility.]

8.  Russia will effectively merge with Belarus. [What a random prediction…why did I make this?  why would I care about Belarus?]

Moving on to my actual predictions for 2008:

Despite the subprime-driven credit market crisis, 2008 will be a good year for the world economy.  The US will avoid a recession, with economic growth driven by exports and business investment.  The technology and capital goods industrials sectors will do well.  Commodity prices will stay strong, so the mining and oil sectors will also remain strong.  Expect continued M&A in all of these sectors, with the ultimate end game being the formation of global oligopolies.  For these and other reasons, 2008 could actually end up being a good year for the equity markets, but I expect credit risk spreads to remain elevated.

[The world economy is doing ok, but it’s not going to be remembered as a "good" year, I don’t think.  I now doubt we’ll avoid a technical recession, but I continue to believe that the headline number will hold up ok based on the factors I mention above…exports, business investment, matierals, agriculture.  I do not now think it will be a good year for the equity markets…ahem.]

Interest-rate sensitive, consumer-driven sectors will continue to suffer, with autos hit especially hard.  Some time before the end of 2009, it will become obvious that Cerberus’ investment in Chrysler is in serious trouble.  The housing market will continue to weaken, too.  No surprise there.   Housing is in for a long slump.  The huge run up in prices and supply/demand imbalance are bad enough.  Add in declining demographics with the baby boom generation past their home-buying years, and we’re looking at a long, Japan-style real estate deflation.  The demographics are bad for commercial real estate, too.

[I’m liking this paragraph.]

The US current account and budget deficits will continue to narrow.  Because economic growth driven by a narrowing current account deficit doesn’t feel as good as growth driven by a widening deficit, consumer sentiment on the economy will stay low.  High CPI increases will continue, but will likely start slowing markedly near the end of the year.  The US dollar has likely put in an intermediate term bottom in late 2007 and should rise modestly in 2008.

[This is on track, too.  I continue not to be a dollar bear, but my patience is being tested.]

The cracks in the foundation of global growth will really start to show in 2008, particularly in the form of runaway inflation in China and the Petro-states.  China will be forced to clamp down, probably just after or around the time of the Olympics, starting a chain of events that will lead to a real estate and stock market crash.  The problems in the Chinese economy will likely be overshadowed by Olympics hype, however.  In 2009, deflation will start to spread from China to the rest of the world.

[I still believe this to be true.]

All in all I expect the current trends to continue into 2008, but for it to ultimately be a transition year.  I expect 2008 to represent the peak year of the global expansion.

[I’ll stick with this too.]


Taxpayers: congratulations, you will soon own Fannie Mae and Freddie Mac!

As I outlined in my previous post Deflation Avoided?, I highlighted the massive deflationary force sweeping through the land.  If you click on the link to my market update, presented internally here at Catalyst the week before the demise of Bear Stearns, I highlight the ludicrously irresponsible leverage levels of not only the investment banks, but also the GSEs (also known as Fannie Mae and Freddie Mac).  As I said at the time, I find it highly unlikely that the investment banks or the GSEs will survive in their current form.

Now the storm is circling around the GSEs and Lehman Brothers.  There is no real reason for Lehman Brothers to exist as a standalone company and it likely won’t much longer.  It only survives today because the list of potential buyers who are healthy enough is so short and the value of the target’s equity so uncertain that it is hard to envision a deal happening until it has to, with Lehman’s equity basically wiped out.  Sorry to my friends at Lehman, but that’s the fate the company has earned, anyway.

Fannie Mae and Freddie Mac are another matter altogether.  They have debt and guarantees outstanding roughly equivalent to that of the Treasury of the United States of America.  That debt is held against collateral that is losing value, and the companies are basically as thinly capitalized as Bear Stearns was.  They are so instrumental the functioning of the mortgage market that the government just increased their role in keeping the market afloat.  If they were allowed to just collapse it would literally bring the apocalypse.  I don’t mean a figurative apocalypse in the sense of another Great Depression…I mean like a chaos-would-reign-over-the-Earth type of apocalypse.

The good news is everyone knows this, so the government will ride to the rescue.  The bad news is the government is funded by you, the taxpayer, and it will mean our national debt will double overnight.  On the other hand, the good news to that is the bond market has always looked at agency debt as having a government guarantee.  Another piece of good news is that the debt is collateralized by our houses (which are losing value but not all their value) and we already owed the money anyway, so its not like we just went out and borrowed $5 trillion and shot it out into space.

Hopefully we will learn a lesson from this.  Any rational person who really thought about it knew this would happen someday.  You had a for-profit company enjoying the benefit of an implicit government guarantee on its debt, so it could borrow unlimited quantities at rate below it actual level of risk.  In pursuit of pure self-interest, you as the management team would naturally decide to issue yourself tons of stock options, leverage your company as much as possible to make as much money in as short a period of time as possible.  When grumpy Republicans try to regulate your balance sheet because you’re taking on too much risk, lavish money on your Democratic friends to keep them at bay.  Pay yourself $75MM to $100MM per year to congratulate yourself for the great public service you are doing.

Right there you have the last 15 years biography of former Fannie Mae CEO Franklin Raines and his cronies at the GSEs.  Well done, Franklin, I hope you’re enjoying the beach.  Back here in the real world we’ll just watch the value of our houses decline and bank lending seize up.

Cloud Computing a boon for the heartland

In this article in AlwaysOn, Greg Ness writes about how cloud computing may be further freeing IT workers from having to live near big cities and, along with telecommuting, bringing good jobs to rural America.  Not unlike how electricity and the automobile freed industrial plants from needing to be concentrated in big cities or near rivers.  The strategic resource for rural areas to attract cloud computing "factories": access to cheap power.

Stratfor on a New Geopolitical Era

With all the gloom-and-doom out there, it’s refreshing to read something that put things into a more optomistic, and I belive proper, perspective.  Stratfor, in the article posted in its entirety below, explains that not only are we an the verge of a peace deal between Syria and Israel, and that we are likely to see a deal between the US and Iran that dramatically lowers tensions, and that with that the Iraq War will be over and won, and that Al Qaeda has been effectively neutralized for awhile now…but that we are likely on the verge of a whole new Geopolitical Era.  And while they don’t explicitly state what that era is, given the circumstances it appears that the idea of Pax Americana may actually be alive and well.

By the way, for those of you who don’t know about Stratfor, they provide geopolitical intellegence information for a subscription fee.  I am a longtime subscriber and it is great.  I recommend it to anyone with an interest in foreign affairs.  They tend to be right way more often than they are wrong.

Strategic Forecasting, Inc.



By Peter Zeihan

As students of geopolitics, we at Stratfor tend not to get overexcited when this or that plan for regional peace is tabled. Many of the world’s conflicts are geographic in nature, and changes in government or policy only rarely supersede the hard topography that we see as the dominant sculptor of the international system. Island states tend to exist in tension with their continental neighbors. Two countries linked by flat arable land will struggle until one emerges dominant. Land-based empires will clash with maritime cultures, and so on.

Petit vs. Grand Geopolitic

But the grand geopolitic — the framework which rules the interactions of regions with one another — is not the only rule in play. There is also the petit geopolitic that occurs among minor players within a region. Think of the grand geopolitic as the rise and fall of massive powers — the onslaught of the Golden Horde, the imperial clash between England and France, the U.S.-Soviet Cold War. By contrast, think of the petit geopolitic as the smaller powers that swim alongside or within the larger trends — Serbia versus Croatia, Vietnam versus Cambodia, Nicaragua versus Honduras. The same geographic rules apply, just on a smaller scale, with the added complexity of the grand geopolitic as backdrop.

The Middle East is a region rife with petit geopolitics. Since the failure of the Ottoman Empire, the region has not hosted an indigenous grand player. Instead, the region serves as a battleground for extra-regional grand powers, all attempting to grind down the local (petit) players to better achieve their own aims. Normally, Stratfor looks at the region in that light: an endless parade of small players and local noise in an environment where most trends worth watching are those implanted and shaped by outside forces. No peace deals are easy, but in the Middle East they require agreement not just from local powers, but also from those grand players beyond the region. The result is, well, the Middle East we all know.

All the more notable, then, that a peace deal — and a locally crafted one at that — has moved from the realm of the improbable to not merely the possible, but perhaps even the imminent.

Israel and Syria are looking to bury the hatchet, somewhere in the Golan Heights most likely, and they are doing so for their own reasons. Israel has secured deals with Egypt and Jordan already, and the Palestinians — by splitting internally — have defeated themselves as a strategic threat. A deal with Syria would make Israel the most secure it has been in millennia.

Syria, poor and ruled by its insecure Alawite minority, needs a basis of legitimacy that resonates with the dominant Sunni population better than its current game plan: issuing a shrill shriek whenever the name "Israel" is mentioned. The Alawites believe there is no guarantee of support better than cash, and their largest and most reliable source of cash is in Lebanon. Getting Lebanon requires an end to Damascus’ regional isolation, and the agreement of Israel.

The outline of the deal, then, is surprisingly simple: Israel gains military security from a peace deal in exchange for supporting Syrian primacy in Lebanon. The only local loser would be the entity that poses an economic challenge (in Lebanon) to Syria, and a military challenge (in Lebanon) to Israel — to wit, Hezbollah.

Hezbollah, understandably, is more than a little perturbed by the prospect of this tightening noose. Syria is redirecting the flow of Sunni militants from Iraq to Lebanon, likely for use against Hezbollah. Damascus also is working with the exiled leadership of the Palestinian group Hamas as a gesture of goodwill to Israel. The French — looking for a post-de Gaulle diplomatic victory — are re-engaging the Syrians and, to get Damascus on board, are dangling everything from aid and trade deals with Europe to that long-sought stamp of international approval. Oil-rich Sunni Arab states, sensing an opportunity to weaken Shiite Hezbollah, are flooding petrodollars in bribes — that is, investments — into Syria to underwrite a deal with Israel.

While the deal is not yet a fait accompli, the pieces are falling into place quite rapidly. Normally we would not be so optimistic, but the hard decisions — on Israel surrendering the Golan Heights and Syria laying preparations for cutting Hezbollah down to size — have already been made. On July 11 the leaders of Israel and Syria will be attending the same event in Paris, and if the French know anything about flair, a handshake may well be on the agenda.

It isn’t exactly pretty — and certainly isn’t tidy — but peace really does appear to be breaking out in the Middle East.

A Spoiler-Free Environment

Remember, the deal must please not just the petit players, but the grand ones as well. At this point, those with any interest in disrupting the flow of events normally would step in and do what they could to rock the boat. That, however, is not happening this time around. All of the normal cast members in the Middle Eastern drama are either unwilling to play that game at present, or are otherwise occupied.

The country with the most to lose is Iran. A Syria at formal peace with Israel is a Syria that has minimal need for an alliance with Iran, as well as a Syria that has every interest in destroying Hezbollah’s military capabilities. (Never forget that while Hezbollah is Syrian-operated, it is Iranian-founded and -funded.) But using Hezbollah to scupper the Israeli-Syrian talks would come with a cost, and we are not simply highlighting a possible military confrontation between Israel and Iran.

Iran is involved in negotiations far more complex and profound than anything that currently occupies Israel and Syria. Tehran and Washington are attempting to forge an understanding about the future of Iraq. The United States wants an Iraq sufficiently strong to restore the balance of power in the Persian Gulf and thus prevent any Iranian military incursion into the oil fields of the Arabian Peninsula. Iran wants an Iraq that is sufficiently weak that it will never again be able to launch an attack on Persia. Such unflinching national interests are proving difficult to reconcile, but do not confuse "difficult" with "impossible" — the positions are not mutually exclusive. After all, while both want influence, neither demands domination.

Remarkable progress has been made during the past six months. The two sides have cooperated in bringing down violence in Iraq, now at its lowest level since the aftermath of the 2003 invasion itself. Washington and Tehran also have attacked the problems of rogue Shiite militias from both ends, most notably with the neutering of Muqtada al-Sadr and his militia, the Medhi Army. Meanwhile, that ever-enlarging pot of Sunni Arab oil money has been just as active in Baghdad in drawing various groups to the table as it has been in Damascus. Thus, while the U.S.-Iranian understanding is not final, formal or imminent, it is taking shape with remarkable speed. There are many ways it still could be derailed, but none would be so effective as Iran using Hezbollah to launch another war with Israel.

China and Russia both would like to see the Middle East off balance — if not on fire in the case of Russia — although it is hardly because they enjoy the bloodshed. Currently, the United States has the bulk of its ground forces loaded down with Afghan and Iraqi operations. So long as that remains the case — so long as Iran and the United States do not have a meeting of the minds — the United States lacks the military capability to deploy any large-scale ground forces anywhere else in the world. In the past, Moscow and Beijing have used weapons sales or energy deals to bolster Iran’s position, thus delaying any embryonic deal with Washington.

But such impediments are not being seeded now.

Rising inflation in China has turned the traditional question of the country’s shaky financial system on its head. Mass employment in China is made possible not by a sound economic structure, but by de facto subsidization via ultra-cheap loans. But such massive availability of credit has artificially spiked demand, for 1.3 billion people no less, creating an inflation nightmare that is difficult to solve. Cut the loans to rein in demand and inflation, and you cut business and with it employment. Chinese governments have been toppled by less. Beijing is desperate to keep one step ahead of either an inflationary spiral or a credit meltdown — and wants nothing more than for the Olympics to go off as hitch-free as possible. Tinkering with the Middle East is the furthest thing from Beijing’s preoccupied mind.

Meanwhile, Russia is still growing through its leadership "transition," with the Kremlin power clans still going for each other’s throats. Their war for control of the defense and energy industries still rages, their war for control of the justice and legal systems is only now beginning to rage, and their efforts to curtail the powers of some of Russia’s more independent-minded republics such as Tatarstan has not yet begun to rage. Between a much-needed resettling, and some smacking of out-of-control egos, Russia still needs weeks (or months?) to get its own house in order. The Kremlin can still make small gestures — Russian Prime Minister Vladimir Putin chatted briefly by phone July 7 with Iranian President Mahmoud Ahmadinejad on the topic of the nuclear power plant that Russia is building for Iran at Bushehr — but for the most part, the Middle East will have to wait for another day.

But by the time Beijing or Moscow have the freedom of movement to do anything, the Middle East may well be as "solved" as it can be.

The New Era

For those of us at Stratfor who have become rather inured to the agonies of the Middle East, such a sustained stream of constructive, positive news is somewhat unnerving. One gets the feeling that if the progress could hold up for just a touch longer, not only would there be an Israeli-Syrian deal and a U.S.-Iranian understanding, the world itself would change. Those of us here who are old enough to remember haven’t sensed such a fateful moment since the weeks before the tearing down of the Berlin Wall in 1989. And — odd though it may sound — we have been waiting for just such a moment for some time. Certainly since before 9/11.

Stratfor views the world as working in cycles. Powers or coalitions of powers form and do battle across the world. Their struggles define the eras through which humanity evolves, and those struggles tend to end in a military conflict that lays the groundwork for the next era. The Germans defeated Imperial France in the Franco-Prussian War in 1871, giving rise to the German era. That era lasted until a coalition of powers crushed Germany in World Wars I and II. That victorious coalition split into the two sides of the Cold War until the West triumphed in 1989.

New eras do not form spontaneously. There is a brief — historically speaking — period between the sweeping away of the rules of the old era and the installation of the rules of the new. These interregnums tend to be very dangerous affairs, as the victorious powers attempt to entrench their victory as new powers rise to the fore — and as many petit powers, suddenly out from under the thumb of any grand power, try to carve out a niche for themselves.

The post-World War I interregnum witnessed the complete upending of Asian and European security structures. The post-World War II interregnum brought about the Korean War as China’s rise slammed into America’s efforts to entrench its power. The post-Cold War interregnum produced Yugoslav wars, a variety of conflicts in the former Soviet Union (most notably in Chechnya), the rise of al Qaeda, the jihadist conflict and the Iraq war.

All these conflicts are now well past their critical phases, and in most cases are already sewn up. All of the pieces of Yugoslavia are on the road to EU membership. Russia’s borderlands — while hardly bastions of glee — have settled. Terrorism may be very much alive, but al Qaeda as a strategic threat is very much not. Even the Iraq war is winding to a conclusion. Put simply, the Cold War interregnum is coming to a close and a new era is dawning.

Copyright 2008 Strategic Forecasting, Inc.