John Mauldin's Outside the Box : Africa

Fourth Quarter Forecast 2008

John Mauldin — Thu, 30 Oct 2008 17:57:08 GMT

Really hear what I'm about to tell you. The center of gravity of the world economic system has moved from New York to Washington. Let me illustrate what I mean so you understand just how profound this is. Banks used to compete against banks. US carmakers competed against each other and the Japanese. And the New York financial markets told you how they're doing against each other.

Understand what's happening now. The US Treasury has become the only "customer" that matters. The Treasury is now the customer—and investor -- with the $750+ billion checkbook. The Treasury is now the "investment banker" of last resort, arranging and financing mergers. Banks are competing against insurance companies for their slice of the bailout pie. Chrysler and GM (and the Michigan Congressional delegation) are looking to Washington, not Goldman or Merrill, to facilitate a merger. This is a seismic shift.

As investors, we have to start looking at the world in a completely different way, and getting our information from different sources. A company's 10-K is almost irrelevant if all it includes is financial statements and market outlooks. What matters now are the "exogenous" factors: government guarantees of the commercial paper market, currency interventions, direct capital infusions, etc. And how does a company describe in its Management Outlook that "Yes, our company is too big to fail."

In this environment, it's more important than ever to read unbiased geopolitical intelligence and analysis of government moves, and that's what my friend George Friedman at Stratfor offers. I'm enclosing below his team's Fourth Quarter Forecast. George's team analyzes US government policy as well as the moves that are being taken by central banks and governments around the world as the private sector gets taken public all across the globe. You will not be able to understand market moves if you don't understand who the real movers are now.

I'm sending you Stratfor's Fourth Quarter Forecast, and I strongly encourage you to join Stratfor and get access to all their daily intelligence. George has arranged a special offer on a Stratfor Membership for my readers: click here to take advantage of this opportunity. In this new era, I use Stratfor daily to give me a wide-lens, global view of politics and economics. I know you'll gain as much from reading Stratfor as I do.

John Mauldin

Fourth Quarter Forecast 2008

October 23, 2008 | 1502 GMT

Three issues will dominate the final quarter of 2008: the global financial crisis, U.S. self-absorption and the Russian resurgence.

The financial crisis has its roots in an American liquidity meltdown. But as the days flow by, it will become obvious that the crisis is evolving as it spreads to the rest of the world, and its impact will be harsher and require more time for recovery elsewhere. For in the United States, actions have already been taken to rectify the liquidity imbalances, and although plenty can still go wrong and a recession is probably inevitable, the system is beginning to mend. In Europe, however, the liquidity shortage has unearthed a deep banking debacle.

Remediation is only now being started, and the problem is only now being identified, much less evaluated. The American recession will probably be over by year's end, but Europe's will likely stretch through most of 2009. And in East Asia, where the problem is neither liquidity nor banking but loss of export demand, recovery cannot even begin until the West begins demanding Asian goods en masse. The United States might have set the crisis running, but it will be Europe and Asia that really give it its legs.

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In the midst of a presidential election, a lame-duck administration, a recession and ongoing efforts to stabilize Iraq, Washington is essentially in lockdown. It has neither the capacity for nor the interest in dealing with anything that is not on a very short list of topics. Mitigating the recession is now at the top of that list, with Iraq second in line. In Iraq, U.S. policy has mutated somewhat. Until now, Washington was forced to deal with Iran, as Iran maintained the ability to scuttle any progress in Iraq. But now Iran, for various reasons, has largely moved away from its policy of stoking militia fires in Iraq. It would be a stretch to say that all concern about Iran's ability to set Iraq on fire has evaporated, but Washington certainly feels it can shape Iraq into more or less whatever it wishes so long as it does not flagrantly cross any red lines. This does not mean for a second that things are easy; creating a functional state out of the Shiite, Sunni and Kurdish populations is a lengthy and possibly fruitless task. However, Iran's apparent inability to create chaos in Iraq has drawn some of the desperation out of U.S. policy.

Finally, and to a certain degree integrated into the financial crisis and American preoccupation, comes the issue of Russia's rise. In the third quarter Russia proved that it remains capable -- militarily and politically -- of invading a neighbor, the former Soviet state of Georgia. While not immune to global financial chaos, Russia is far better prepared than most states to weather the storm; even after massive investment outflows, Russia still holds more than $700 billion in reserve funds and a fat budget surplus. Moscow has a limited window in which to act before the United States withdraws from Iraq and turns its attention northward, so Russia will be using the time to sow as many problems for the United States as possible. Russian plans are already in the works for Latin America, the Middle East and Africa, in that order. And to keep the pressure on and the momentum going, Russia is expected to make a new thrust -- more political and economic than military -- in Ukraine. Under the cover of the financial crisis (which is hitting Europe much harder than the United States) and American preoccupation, the chances of Russia successfully expanding its influence definitely qualify as betting odds.

Note to readers: Our fourth-quarter forecast is intended to be a supplement to our annual forecast and third-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

Global Economy

Ultimately, Stratfor delayed the release of our fourth-quarter forecast due to the winds of change ripping through the U.S. financial industry. With so much uncertainty, it was impossible to peer minutes, much less months, into the future. But now, though the dust is far from settled, the outlines are in place for an American-led financial rescue package that puts the crisis into a context that allows for forecasting.

This section will not serve as an overview on how the crisis came about (we have written a history and tactical forecast on the financial crisis elsewhere), but it will outline the broad picture Stratfor sees in the weeks going forward.

Regional trend: The United States is in a liquidity crisis, but the fundamentals of the U.S. economy remain strong. Overwhelming state intervention will ensure that the United States recovers quickly from an impending, and probably inevitable, recession.

In the United States, the crisis is ultimately one of liquidity. Underneath all the froth, the American banking system remains stable. Yes, there are some questionable assets that have initiated panic, but on the whole American banks are solid. Before the political process in Washington took over the system and in essence made it impossible for banks to close, only 13 banks had gone under. During the recession of the early 1980s, several hundred went bust per year.

Liquidity crises are relatively -- and we emphasize the word "relatively" -- easy to fix. They "only" require injections of capital into the system, which the U.S. government has done on a mammoth scale, in order to restart lending and thus normal economic activity. At the time of this writing, banks have already increased their lending rates from the crisis lows, and we see the panic beginning to lift within weeks. For the United States, there will almost certainly be a short recession, but the way out has already been sketched.

Regional trend: With Europe dealing with a deeply entrenched banking crisis and Asia facing a plunge in exports, the financial contagion will be more deeply felt outside the United States than within.

When the U.S. liquidity crisis slammed into Europe it had identical impacts -- at first. But within a few days, it became apparent that Europe has other problems. Unlike the United States, Europe has a banking system with many portions that are not very healthy. Austrian, Swedish and Italian banks are overexposed to Central Europe, which is now in a credit hangover. German banks' corporatist links have left them with questionable assets far greater in value than anything American subprime practices generated. Irish and Spanish banks face much deeper subprime problems relative to their economic size than American banks. And the list goes on and on. So while the United States has a liquidity crisis that can be addressed "relatively" easily, Europe faces a banking debacle that has been uncovered by the liquidity crisis -- and dealing with that banking debacle is likely to take more than a year.

These crises have not really affected Asia directly, for Asian states are built upon massive and artificial flows of liquidity. States routinely funnel more liquidity into their systems than even the U.S. Federal Reserve is doing with its record-breaking operations to combat the American liquidity crisis. So even with the United States and Europe struggling, there are very few liquidity problems in China or Japan.

The Asian problem will be neither liquidity nor banking, but exports. The United States faces a short recession and the Europeans likely a long one. For Asian economies, the problem will be a plunge in Western demand for Asian exports that will hit these economies at their most sensitive point: employment. China and Japan keep their systems flush with liquidity in order to ensure maximum employment regardless of profitability. As Western growth slows, demand for Asian goods will drop, and the Asians will have to either shut factories down or subsidize them to keep operations active. Luckily -- and we are not sure that "luckily" is the correct word -- this will take some time. We do not expect East Asia to really slide into crisis mode until late in the fourth quarter, but the crisis will strike the region to its very core.

Regional trend: Inflation is on the rise on a global scale.

High inflation was the primary economic issue for countries across the globe for the first nine months of 2008. Overextension, combined with a deepening economic crunch, will finally turn this trend on its head in the final quarter. Across the developed world, demand is dropping, and that cannot help but put a cap on commodity prices.

Regional trend: The global financial crisis' contagion will contribute to a significant decline in the price of oil and defuse much of the "geopolitical heat" in the markets.

Let us close this section with a few words on oil. Stratfor has been saying for some time that the high oil prices of the last three years are not rooted in fundamentals or even in reality in general, so we stopped forecasting any specific prices. In our last quarterly forecast, we said the price of oil would drop (and it did), but we were focused more on causes rooted in geopolitical risk rather than the effects of the financial crisis. At present, much of the speculative froth and fervor that had built up prices has been dying down. In its place is a growing realization that the United States and Europe are in recession, while East Asia is about to slip into recession. With the world's three largest economies using less energy, prices are certain to slide. This realization is dawning only now, when prices have already dropped from their highs by 50 percent. The hype is mostly gone; all that remain are universally bearish fundamentals. The price drop to date is just the beginning -- and several countries, including Venezuela and Russia, stand to lose a lot from a precipitous drop in oil prices.

Former Soviet Union

Regional trend: Russia is re-emerging and will take advantage of the imbalance in U.S. power that has resulted from the wars in Iraq and Afghanistan.

Russia's third quarter was dominated by the war with Georgia, which was Moscow's coming-out party to prove that it could dominate and/or crush its neighbor unless the United States rushed to the smaller country's aid. The Kremlin had been making technical preparations for such a war for years, but timing was an issue. Moscow was forced to act in the third quarter because of the possibility that the United States might be freed from its entanglements with Iran and in Iraq. Since the war in August, the ripple effects of Russia's bold move have been felt throughout the world, but they are most defined in Russia's periphery. As each country re-examines its relations with Russia, Moscow is taking stock of the levers it has carefully placed in its periphery and around the world and considering who it can pressure, or even break.

Regional trend: Following the Russo-Georgian war, each former Soviet state -- and much of the rest of the world -- is redefining its relationship with or perception of Russia. Moscow will next turn its focus to Ukraine, which will become the center of the Kremlin's universe in the fourth quarter.

The center of Russia's focus for the fourth quarter is Ukraine, which Moscow sees as the cornerstone of its ability to reach into Europe and protect itself from Western encroachment. Since the 2004 Orange Revolution, Ukraine has been unstable and chaotic in its attempts to push away from its former master, Russia, and toward the West. Moscow has encouraged Ukraine's instability as a means of preventing the former Soviet state from aligning fully with the West, but now is the time to pull Kiev firmly back into the Russian fold.

Russia will use countless levers to influence Ukraine's inner dynamics, including: the Russian security services' high degree of infiltration in Ukraine; the country's complete dependence on Russian energy; Ukraine's financial and economic turmoil; Russia's control over most of the Ukrainian oligarchs; the interconnection between the two countries' organized crime systems; Russian military forces on Ukraine's soil; and the mere fact that approximately half the Ukrainian population considers itself beholden to Russia.

But the largest opportunity for Moscow will come in the December snap elections, scheduled after the Ukrainian government collapsed (again) in October. Elections in Ukraine are never certain to take place, but the dynamic surrounding possible elections in the country will remain whether or not the polls actually take place. The pro-Western Orange Coalition has already broken up over Kiev's relationship with Russia, and those coalition partners who are leaning back toward Moscow, along with the pro-Russia parties, are in a healthy lead in public opinion polls. Ukraine has never been predictable, but it also has never seen an election or governmental shift while Russia's full focus is on ensuring that Ukraine stays as far away from the West as possible.

A few other former Soviet states are on Moscow's agenda, though they are not as high-priority as Ukraine. Georgia's government is still seeing the fallout from the war, and Georgian President Mikhail Saakashvili's future is unclear. Russia has allowed Saakashvili to remain in office because he is a spent force, but the Kremlin has a line of political forces in place to remove him should he gain strength. Russia and Belarus spent much of the third quarter arguing over energy prices, bank credits, missile defense and Minsk's delay in recognizing the independence of Georgian breakaway regions Abkhazia and South Ossetia. The fourth quarter will be a test for Belarus as it decides whether to bend to Moscow's will or risk reaching out to the West and being crushed by Russia in the process.

Russia is also active in the Baltic states. An upcoming election is likely to leave Lithuania with a government more amenable to Moscow, but it remains to be seen how this new government will fit in with Lithuania's historical allies -- Poland, Estonia and Latvia, which are all vehemently anti-Russian -- and how Moscow can use the new government to divide that allied bloc. Azerbaijan is weighing its future relations with Moscow, since Russia has proven it can cut off the country's energy flow, which in turn cuts off its cash source. Baku will work to balance its desire to maintain good relations with Moscow and its desire to keep Western cash flowing in.

Regional trend: The global financial crisis is ripping through Russia, but it is not crippling the country. Rather, the Kremlin is using the situation to assert more control over regulations, banks, businesses and the oligarchs inside Russia while looking for opportunities abroad.

Market economies do not work in general in a country like Russia. Since the Russo-Georgian war, the Russian stock markets have been on a wild roller-coaster ride, and Russian companies have seen massive foreign investment flight. This has left those companies and their oligarchs looking for funding in their own pockets or from the state. But unlike most countries, Russia is not in danger of collapsing financially, because it sits on massive amounts of foreign currency reserves, built up over the past decade from soaring energy prices.

Instead, the Kremlin is using the unstable financial situation to reassert the primacy of the Russian state by weeding out small- and medium-sized institutions that were never really under government control. The Kremlin is also using the situation to force the oligarchs to pour their own cash -- which they had stored abroad, far from the Kremlin's grasp -- into the system in order to keep the markets stable and the oligarchs' companies afloat.

This proves just how much control Russian Prime Minister Vladimir Putin has over this class of billionaires, and it bodes an end to the oligarchic tradition that ruled Russia during most of the 1990s and well into the following decade. The oligarchs are no longer independent power brokers, but simply another tool -- and a very wealthy one -- for Putin and the Kremlin. The fourth quarter will start revealing who can keep up with the Kremlin's demands and who will fall. A massive realignment inside Russia's business sector is under way, though the Kremlin is orchestrating all of it in order to strengthen and prove its power within the country -- and over those who thought they could keep their cash outside the motherland.

Russia can now also meddle in, prop up, buy or influence financial systems around the world. It is reaching out with its vast amounts of cash to "help" other countries hit hard by the financial meltdown -- though in typical Kremlin style, Moscow is extending aid to states it considers politically valuable. In the past, the Kremlin used oligarchs' cash to do this covertly, but since that cash is needed at home, the government is openly targeting other countries' institutions. Russia is getting involved in the financial situations in Iceland, the United Kingdom, Ukraine, Kazakhstan and Georgia, to name a few. But the Kremlin must balance this desire to take advantage of financial tremors around the world with its need to keep the domestic situation stable and plan for the future of Russia's resurgence, amid concerns that its cash flow could soon dry up as energy prices tumble.

Regional trend: As Russia reasserts itself against the West, it has many levers with which to counter the United States in regions such as the Middle East and Latin America. However, Russia's ability to divide the United States' allies in Europe will give it the most success.

Since the war with Georgia, Russia has shown that it is interested in countering the United States' status as global hegemon by strengthening its relationships throughout the world. Moscow has also proved to Washington that it has levers in place to erode the United States' position in the Middle East (which is Washington's primary focus) and in Latin America (which is in the United States' backyard). But Russia will not push its ability to meddle with Middle Eastern countries like Iran too far; Moscow does not want a strong Tehran in the long run, and Washington could seriously lash back at the Russians. Moscow also knows that its actions in Latin America are mainly symbolic in that the efforts needed for real military, energy, grassroots or political moves would be enormous and would not benefit Russia much. However, this does not mean Moscow's friendship is not incredibly important to those in Latin America looking for their own leverage against Washington.

It is in Europe where Russia's moves against the West will be felt the most. In short, the Europeans are splitting apart and much of it has to do with Russia -- a situation Moscow is trying to magnify. Russia is already using Europe's economic instability to pit the countries against each other. But Moscow is also undermining NATO, a fact that will be highlighted when the alliance meets in December to discuss Russia and the possibility of extending membership action plans to Georgia and Ukraine. Germany has already staunchly come out against this Washington-initiated plan and is also discussing the possibility of a private security agreement with Russia, a major shift toward Berlin's usual role when Europe is split. But Russia also has its customary levers, like energy, to use in Europe; energy deals with Germany, the Czech Republic, Lithuania and Ukraine will still be up in the air in the next quarter.

Middle East

Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so, it might inadvertently trigger tensions with Israel.

Regional trend: The Russo-Georgian war interrupted a window of opportunity for the Iranians and the United States to make headway in their negotiations over Iraq. With a U.S. political transition approaching, these negotiations will remain in limbo through the next quarter.

In writing our third-quarter forecast, Stratfor had many reasons to be optimistic about several major trends in the Middle East. We calculated that as the U.S. election season wound down, the United States and Iran would be approaching the endgame in their negotiations over Iraq. After all, Iran's supreme interest in consolidating Shiite control over Iraq, the United States' strategic interest in freeing up its forces from Iraq, and the winding down of violence in Iraq over the past year -- made possible in part by Iran's cooperation in taming its Shiite militant proxies -- laid the foundation for the United States and Iran to reach a rapprochement sooner rather than later.

For our fourth-quarter forecast, however, we are far less optimistic about the United States and Iran coming to any sort of final understanding, at least in the short term. Following the Russo-Georgian war that took place in the third quarter, the United States more urgently wants to end the war in Iraq in order to free up U.S. forces for more pressing concerns in Eurasia and the Pakistan/Afghanistan theater. The Iranians, on the other hand, have all the more reason to stall in talks with Washington. Iran knows that in the face of a resurgent Russia, the United States will worry about Moscow using the Middle East as another theater for challenging the West, namely by providing advanced weapons systems to a country like Iran. With the added leverage of Russian backing, the Iranians could push for a better deal with the Americans.

But while Iran stalls, the United States is losing interest. It appears that Washington does not feel nearly as pressured as it previously did to deal with the Iranians over Iraq, and the political and military reality in Iraq has shifted substantially over the past two years. In October 2006, a month prior to U.S. congressional elections, Iran significantly escalated Shiite militia attacks in Iraq in an attempt to force a U.S. withdrawal, and it could have used its Shiite militant proxies to trigger a civil war. Now, however, these militias either have been fully integrated into the Iraqi security apparatus (as in the case of the Badr Brigade) or have disintegrated to the point where they are no longer an effective force (as in the case of the Mehdi Army). Much of Iran's current ability to wield influence in Iraq comes through its political and economic links as well as from small groups of well-trained special operations units, such as Hezbollah in Iraq.

While the United States still has a strategic interest in reaching some level of understanding with the Iranians over Iraq, it no longer faces an immediate threat of Iran triggering civil war in the country. This gives Washington a lot more leverage in dealing with Iran, as well as more time and space to concentrate on other, more pressing issues.

In the coming quarter, Iran will not be the United States' main focus in Iraq; Washington will be too preoccupied with its own political transition, and the Iranians will need some time to work out their next steps in Iraq with a new U.S. administration. Instead, the United States will be heavily involved in the internal Iraqi political scene, working to undermine Iranian influence in Baghdad by exploiting deep rifts within the Shiite political community and reasserting Sunni political strength in provincial elections, which are to be held before Jan. 31, 2009. The surrounding Arab states, for the most part, will be in lockstep with the United States in pursuing this strategy.

Iran will use its remaining militant proxies to try and influence the results of the upcoming elections, mainly through bribes and assassination attempts against select candidates. Infighting among Shiite parties, particularly in the south, is expected to flare as Iran tries to accuse the United States of destabilizing Iraq -- a move meant to bolster Iraqi opposition to the Status of Forces Agreement (SOFA), which would provide the legal basis for U.S. troop presence beyond December, when a U.N. mandate runs out. With Iraqi politicians holding out for political and security guarantees from the incoming U.S. administration, it will be difficult for the United States to get the SOFA signed by the December deadline. But Washington is still on course to maintain a military presence in Iraq that is large enough to counterbalance Iran for at least the medium term.

While Iran will be looking to boost its leverage in relation to the West this quarter, it is unlikely to find a dependable ally in Moscow. The Russians have signaled in several different ways that they could step up arms deals and covert operations in the Middle East to undermine Western interests. But with the Israelis and the Turks playing defense and Moscow exhibiting more of a cautious attitude in its actions against the United States in this region, we expect Russian activity in the Middle East this quarter to be more talk than action.

Regional trend: Syria has found a role in the tightening Arab-U.S. alliance, and it will take concrete steps toward a peace deal with Israel that will both reassert Syrian influence in Lebanon and defang Hezbollah.

In our previous quarterly forecast, we anticipated rapid progress in Syria-Israel peace negotiations. The talks were moving at a healthy pace in the first part of the quarter, but paused after the Russo-Georgian war as Syria saw the opportunity to boost its negotiating leverage by reaching out to the Russians. Syria will continue to flirt with Moscow, but Israel and Turkey (which is mediating the peace talks) have been holding their own negotiations with the Russians and have so far kept the Russians at bay. Syria is still in many ways committed to these peace talks, but any major progress is unlikely until Israel puts its political house in order this quarter. Israeli political horse-trading is in full swing, and early elections could still be called, but Stratfor's bet is that Kadima leader Tzipi Livni will form a coalition and stave off early elections to prevent a political comeback by the far-right Likud party, allowing for progress later in the quarter on the Israel-Syria talks.

While Israel sorts out these issues, the Syrian regime will move ahead in its plans to reassert its hegemony over Lebanon. Any peace deal with Israel would inevitably include a guarantee of Syrian domination over Lebanon in exchange for the dismantling of Hezbollah's military arm to secure the Israeli northern frontier. Though the peace talks with Israel are currently in flux, the Syrians are wasting no time laying the groundwork for a possible military intervention in Lebanon by instigating attacks through militant proxies. Syria will take its time in implementing this strategy. Attacks on both sides of the Lebanese-Syrian border are likely to escalate, but the Syrians are unlikely to make any overt moves in Lebanon this quarter. Syria will also be on guard for Iranian attempts to destabilize the Syrian regime as Iran's main militant proxy, Hezbollah, gets backed into a corner.

Regional trend: Turkey is emerging as a major regional power and in 2008 will begin to exert influence throughout its periphery -- most notably in northern Iraq.

Our annual forecast on Turkey's regional expansion is on track and was reinforced this past quarter by Russia's actions in Georgia. Turkey is a traditional stakeholder in the Caucasus and does not like the idea of the Russians throwing punches in this region, especially when doing so threatens Turkey's economic standing as the main energy hub for Europe. The Turks, therefore, are in a diplomatic frenzy to reassert their influence in the Caucasus, even going so far as to kick-start the normalization process with longtime foe Armenia. Using adroit diplomacy, Turkey will work aggressively this quarter to block Russian destabilizing actions in the Middle East and hold its ground against Moscow in the Caucasus. Turkey is not looking for a fight with Moscow, but it wants to show that it will not be toothless in the face of further Russian aggression. (Indeed, Turkey is the state with the most tools to counteract Russian expansionism.)

Energy diplomacy will be a big theme this quarter, as the Turks will use their relations with Azerbaijan, Iran and even Armenia to promote themselves as the alternative to Russia in the Caucasus. Both Armenia and Iran will be tempted by the idea of establishing potentially lucrative energy links with Turkey to access the European market, though any such deals would face substantial political obstacles.

In northern Iraq, Turkey will become more aggressive in pursuing Kurdish rebels and implementing an informal buffer zone along the Turkish-Iraqi border. Turkish actions in northern Iraq will serve more than Ankara's internal security interests; Turkey also has deep political interests in keeping Iraqi Kurdistan and the Kirkuk issue in check as negotiations in Baghdad intensify this quarter.

Europe

Regional trend: After exactly 60 years of trying to reshape itself under the aegis of the European Union, Europe in 2008 will return to an earlier geopolitical arrangement: the Concert of Powers.

The decade-long Stratfor forecast that the European Union will slowly evolve from a Pan-Continental government to a glorified free trade zone is on track. Europe has indeed returned to an arrangement more reminiscent of the Concert of Powers, with France and Germany squabbling over leadership, newcomer Poland rising in status as the next leader and the traditional power of the United Kingdom missing in action. This has played out on all levels, both within the European Union and in foreign relations. Russia has seized the opportunity to magnify the cracks in the European Union, while the United States is now locked into alliances with actors that are constantly disagreeing, weakening Washington's ability to rally forces around any particular agenda -- particularly in dealing with the Russians.

Regional trend: As the traditional geopolitical arrangement similar to the Concert of Powers returns, Europe is being wrecked domestically, economically, institutionally and internationally. This trend in the fourth quarter is caused partly by the return of the old relationships, but also by the global financial crisis and a resurgent Russia.

Regional Trend: The financial crisis will continue to shatter Europe economically, as each state fends for itself in the absence of a Pan-EU decision.

Nearly every European country entered the fourth quarter in a recession, and this situation will not change through at least the end of the year. The European Central Bank (ECB) has done a decent job thus far, but it cannot regulate banks in Europe, so each state will have to come up with its own rules -- further undermining the ECB and the European Union. An EU-wide plan is simply impossible, because there is no institution able to enforce such a decision and each state is primarily concerned with itself.

Bailouts have become routine in Europe, but the fourth quarter will be about European governments attempting to prevent banks from actually failing, which could break the entire system. The less economically and financially advanced countries, which happen to be mainly on the eastern side of the Continent, are most at risk. Central and Eastern Europe are highly dependent on foreign banks and capital -- capital that will be called home, mainly to Western Europe, to help stabilize its native banking systems. The countries most vulnerable to economic crashes are Estonia, Latvia, Lithuania, Slovenia, Bulgaria, Hungary, Croatia, Slovakia, Romania and Serbia. France and Italy are also vulnerable but are better able to handle the crisis due to the sheer size of their economies.

In the fourth quarter, many countries will be reassessing the benefits and drawbacks to being part of the European Union, and nations that are considering joining the eurozone will weigh their priorities as well. European countries will also be reassessing their budgets, with many cuts in programs and funding on the table. This could lead to even more political and social volatility in all European countries. These potential cuts and thin wallets are coming in the most financially stressful season for Europe, as energy costs are high due to cold weather and Europe's largest energy supplier, Russia, is preparing to raise energy prices at the end of the year. European leaders are facing many very difficult and dangerous decisions that will shape not only the fourth quarter, but the years to come.

Regional trend: Europe is divided -- politically, economically and regarding security -- on how to respond to a resurging Russia.

The topic of Russia, and particularly how to respond to Moscow after the Russo-Georgian war, is dividing Europe even further. Politically, many Western European countries have been looking for ways to neutralize the Russian threat. Some nations, like the Czech Republic, Poland and the Baltic states (though Lithuania could soon reverse its opinion on Russia), are preparing to confront Moscow, while others are strengthening their ties with Russia in order to avoid becoming casualties of Moscow's next moves.

Economically, Europe is divided because the squeeze it is feeling from the global financial crisis is being compounded by Russian moves in the financial sector. Moscow has moved its cash around in a bid to influence financial institutions in certain strategic countries. Russia is also in negotiations with much of Central and Eastern Europe over energy supplies and prices for the next year, and Moscow has told most countries to prepare for excruciatingly steep price hikes. This puts Moscow in a position of great strength from which to negotiate with the countries that need lower energy prices during the current financial crisis.

The Europeans are also divided over how their security alliances should respond to a resurging Russia. The West (especially Washington) failed to respond meaningfully to the Russo-Georgian war -- a fact that Moscow hopes to use to prove the inherent weakness of the West's security club, NATO. Berlin and Paris have already publicly recognized the weakness and believe that this is not the time to stand up to Russia, as NATO is entrenched in Afghanistan and the United States has the additional burden of Iraq. These two European heavyweights are leading the resistance against Washington over extending NATO membership plans to the former Soviet states of Georgia and Ukraine. Countries like Poland and the Baltics are still behind the U.S. plans, but going into the December summit, NATO members -- especially those in Europe -- are anything but in agreement.

Latin America

Regional trend: Aiming to sow instability in the U.S. backyard, Russia will focus much of its attention on Latin America, where a number of Cold War-era tactics are likely to come into play.

The Russian invasion of Georgia in the third quarter was a wake-up call to the West that Russia was resurging. Shortly after the war, Russia arrived on the scene in Latin America. Having promised at least $1 billion in arms aid to Venezuela and reopened dialogue with Cuba over a return to Cold War-era alliances, Russia clearly intends to direct Washington's attention toward the U.S. southern flank. No longer constrained by a need to promote an international communist ideology to gain a foothold in the region, Russia will focus more on generating instability in Latin America -- a pastime that could lead to a resurgence of Soviet-era militias.

Several Latin American states, including Venezuela, Nicaragua, Bolivia and Ecuador, show promise as Russian allies. States that are vulnerable to Russian maneuvering include, at the very least, Colombia, Peru and Mexico. With economic troubles on the rise across the region, this list could expand, and with a lame-duck administration and no clear Latin America policy to begin with, the U.S. government will be slow to respond this quarter.

Cuba is critical to the question of Russian resurgence not just for its historical relations with Russia, but also for its strategic location at the mouth of the Caribbean. Cuba is trying to both encourage the United States to lift the trade embargo as well as urge Russia to actually put its money where its mouth is in promised investments. Which way Cuba swings will depend on whether the incoming U.S. administration gives any indication that the embargo could be lifted. Otherwise, the Russians will have a greater political opening in Cuba to exploit. For the fourth quarter, however, Cuba will mostly spend its time feeling out Washington's and Moscow's intentions without making any big moves.

Regional trend: The U.S. financial crisis will contribute to a long-term economic downturn in Latin America.

The impact of the global financial crisis on Latin America boils down to two basic factors: the shrinking credit market and falling commodity prices. Latin America is largely dependent on foreign capital for the infrastructural and industrial development that allows the region to produce the primary materials it relies on for income. The relative boom of the past decade rode high on the back of increased industrial production the world over, which created higher demand for Latin American minerals, and on rising food prices, which injected cash into agriculture-dominated economies such as Argentina's.

But as the global economy slows in the wake of the financial crisis, there will be lowered demand for primary materials. This will have a combined effect. For importer states, lower commodity prices, especially on food, are welcome news. But for major commodity producers, such as Venezuela (oil) and Argentina (agriculture), this spells disaster for local economies and government budgets. Though the region is less exposed to the U.S. financial crisis than either Europe or Asia, Latin America is facing an overall economic slowdown. Though widespread financial collapse is unlikely to occur in the fourth quarter, the strains will become apparent.

Regional trend: Brazil is rising as the continental hegemon of South America.

With more oil and natural gas discoveries announced in the past quarter, Brazil is still on track to become a regional superpower in the coming decade, but it will face some challenges in this upcoming quarter. Though blessed with substantial monetary reserves, Brazil faces a slowdown along with the rest of Latin America as the global economy shrinks and access to international credit withers.

Regional trend: Crises are brewing in Latin America's left-wing bloc.

This trend continued unabated in the third quarter, although the only state in which tensions came to a head was Bolivia. The evolution of Bolivian lowland pro-autonomy groups toward a more activist role will be defined next quarter. Though they could be willing to make peace with Bolivian President Evo Morales' government, the odds are not good. In the fourth quarter, Morales will try to push through the enactment of a constitutional referendum that would cement his socialist policies. The opposition will use this opportunity to stage further unrest.

In Argentina, the economy is suffering under President Cristina Fernandez de Kirchner's administration. A lifting of price controls on the edges of the economy could continue, but comprehensive reform is unlikely. Over the next quarter, the agricultural sector will ratchet up pressure on the government to reduce price caps so that it can operate profitably. But falling commodity prices, while helping to contain rising inflation, cut into government income, making it all the more difficult for Buenos Aires to adequately address its economic ailments. The credit crunch has already led Argentina to call off its initial offer to pay back debt to the Paris Club. Other signs of fiscal strain will become evident over the next quarter, bringing Argentina closer to a day when it will once again no longer be able to service its debt or prevent an economic crisis.

Meanwhile, in Venezuela, municipal and state-level elections are slated for Nov. 23. While domestic opposition against Venezuelan President Hugo Chavez is strengthening, the president has already taken action -- by barring more than 200 opposition politicians -- to ensure he makes it through these elections in one piece. Once the elections are over, economic issues will come to the fore. We will likely see a grasping at straws for energy, but this will become increasingly difficult, if not impossible, as credit shrinks and oil prices continue to fall. Although the economy will probably hold for the next quarter, the cracks will be evident. The Russians will remain active in Venezuela, particularly in military cooperation, and signs that Chavez is a conduit for Russian arms transfers to the rest of the region could also come to light.

Regional trend: Mexico is facing a moment of truth in the government's war against the drug cartels.

Mexico's security situation is deteriorating. The third quarter showed an emerging trend of public opinion turning against the violence -- although not necessarily against Mexican President Felipe Calderon. As violence rises, and particularly if civilian casualties become more prevalent, public outcry will increase over the next quarter. For now, the public's discontent is working in the government's favor. But there is a slight possibility that Mexico's citizens will decide the war has failed and start pressuring Calderon. This could erode Mexico's ability to use all its forces against the cartels for fear of backlash. In the past quarter, we did not see any indications that Mexico City felt pressured enough to strike a truce with the cartels to save the country's territorial core, nor any evidence of the cartels striking a truce with each other to place the government on the defensive. But these scenarios are not impossible as the security situation continues spiraling out of control.

Mexico is also particularly vulnerable to Russian covert activity. If the Russians become more active in Mexico, organized criminal activity is likely to increase, though this will be difficult to distinguish from ongoing cartel activity. We will be watching for any signs of an uptick in organizational capacity or tempo of operations in groups like the Popular Revolutionary Army, as the potential exists for Russia to tap into such left-wing organizations to create security problems on the southern U.S. border.

South Asia

Regional trend: The Pakistani army/state will hold together even as confusion and distractions in Islamabad greatly reduce the government's ability (and willingness) to rein in jihadists. Pakistan will be forced to decide whether it is more afraid of NATO forces or of its own militants. It will opt to target the militants, however halfheartedly, rather than make a stand against NATO's incursions into territory that is nominally under Islamabad's writ.

As the jihadist insurgency spread deeper into the Pakistani interior, U.S.-Pakistani relations came to a head in the third quarter, with Pakistani forces taking direct shots at U.S. forces along the Pakistani-Afghan border. But as we expected, the Pakistanis could not go too far in pushing back U.S. forces. Toward the end of the quarter, it became clear that the Pakistani political and military leadership was at least making some attempt to comply with U.S. demands and purge Pakistan's intelligence apparatus, the Inter-Services Intelligence, of jihadist sympathizers while committing more firmly to military operations against al Qaeda and Taliban forces in the tribal areas.

But there is still a lot more work to be done in this theater. With U.S. Gen. David Petraeus now at the helm of Central Command, the evolving U.S. strategy for Pakistan and Afghanistan will likely entail devoting more U.S. forces to Afghanistan and engaging in complex political negotiations with certain Taliban factions, similar to the U.S. policy pursued in Iraq.

For the next quarter, however, little is expected to change on the ground militarily. The United States simply will not have sufficient forces to make a meaningful difference in the Pakistan/Afghanistan theater in the short term. While U.S. forces can escalate cross-border operations into Pakistan, the levels of intrusion will not grow if the United States lacks the forces to back them up. The region also will be entering the winter months, when the fighting on both sides is expected to drop significantly, giving the Taliban and al Qaeda more time to recuperate. Though the United States has announced its intention to continue conducting offensive operations through the winter, the operations will still be limited in scale.

During the winter lull, the bigger focus will be on working toward a negotiated settlement with select factions of the Taliban. Talks involving the Taliban, the Karzai government, the Tajik-dominated opposition, Saudi Arabia, Pakistan, Iran, NATO and the United States will intensify in coming months. This process will be about identifying elements within the Taliban movement that would be willing to do business at a time when the Taliban feels it has the upper hand and thus is not under significant pressure to negotiate. Nonetheless, the mere idea of negotiations taking place will cause existing rifts within the jihadist insurgency to widen. The United States will rely heavily on Saudi Arabia to use its political and financial clout with the Taliban to ensure progress on the negotiating front.

The Pakistanis, on the other hand, will be too consumed with domestic ailments to contribute in any significant way to U.S. efforts in fighting the insurgency. Pakistan's civilian government is caught between fighting anti-Islamabad jihadist forces and working with pro-Islamabad Afghan Taliban. Continued unilateral cross-border U.S. strikes against al Qaeda and its Pashtun allies in Pakistan will further constrain Islamabad's options as domestic dissent continues to rise. Compounding matters is the fact that Pakistan is sliding toward bankruptcy and is now dependent on bailouts and bartering tactics to make it through this quarter without collapsing financially. Pressure from the insurgency and the deteriorating economic situation will further threaten Pakistan's internal stability and raise the potential for a rift to emerge between the civilian government and the army. Overall, Pakistan will institutionally remain in disarray, and fragmentation of the state will worsen in the coming quarter.

Regional trend: India's roller-coaster policies on everything from tax regimes to special economic zones to basic infrastructure are proving that the idea of "Shining India" is a myth and will lead to waning foreign investment.

The global financial crisis that spread in the third quarter only reinforced our forecast that India's attractiveness to foreign investors would significantly wane this year. Though India's banking sector is fairly insulated and not as vulnerable to the financial crisis as those of other Asian countries, it is more than likely to experience a drop in capital inflows and foreign direct investment in the medium to longer term as foreign companies, particularly those based in the United States, are forced to cut back on their overseas operations.

Though India is unlikely to feel a devastating economic impact in the short term, its problems stemming from the financial crisis will be mainly political. Rising inflationary pressures will only add to the opposition's strength in stifling the ruling Congress party at a time when India is also dealing with heightened religious tension and increasingly frequent, albeit low intensity, attacks by more localized Islamist militant cells. On the foreign policy front, India also will be largely politically hamstrung. Securing the civilian nuclear deal with the United States was a huge feat for India's Congress in addressing the country's energy security, and it puts India on a path toward greater strategic cooperation with the global superpower. At the same time, New Delhi cannot politically afford to take any big or overt steps in line with U.S. foreign policy for some time, though it will be closely watching for signs of a complete security and economic meltdown in Pakistan in search of both threats and opportunities.

India also will be keeping its eye on Bangladesh, where national elections are supposed to be held Dec. 18. With the Bangladeshi military tightening its grip over the government, the country's two main rival political leaders have threatened to boycott the polls, raising the potential for the elections to be delayed. Without the participation of these two leaders, there is a high probability of Bangladesh returning to its usual state of political violence and chaos ahead of the polls.

India also has security concerns to its south in Sri Lanka, where the military has made significant advances in its war of attrition against Liberation Tigers of Tamil Eelam rebels in the north. While the military's successes are often exaggerated, it stands a decent chance of overtaking Tiger strongholds in the strategic Jaffna Peninsula to the north. The Tigers will be cornered at that point, but they will not be a vanquished force. The Sri Lankan military has made comparable advances into Tiger-held territory in the past, only to see the Tigers make a significant comeback after several years. As they continue to get beaten in the north, the Tigers will make a stronger attempt to carry out attacks inside Colombo in an attempt to prove to their constituency that they are still viable.

East Asia

Regional trend: The Chinese government postponed any key reforms in 2008 until after the Olympics in August, but as Beijing now begins tackling these issues, it is confronted by a global financial crisis that will convolute all its reform plans.

Thus far, the Olympics have dominated 2008 in China, with Beijing consumed with quashing any disruptions or embarrassments that would cast a shadow over the country during its time in the global spotlight. While Beijing was distracted, issues like economic and social disparity, corruption and rising domestic frustrations festered. Beijing was convinced that as soon as the Olympics were over, it could finally address these issues with full force. But the reforms China makes will not necessarily be the ones it originally planned, as the global economic slowdown will interfere.

Many key debates are raging behind the scenes of China's central government over issues like rural development, informal and state banking, the central bank's short- and long-term lending rates, the yuan's exchange, price controls, the growth of small- to medium-sized businesses, international trade and the export sector, and energy supply and policy. These debates have put a dangerous amount of stress on the Communist Party of China and the country's top leadership.

The largest debate has been over to what degree to redistribute wealth, particularly between the wealthy coastlands and the much poorer internal regions of the country. The divide between China's mostly poor rural masses and its wealthier urban elite has generated considerable tension, causing worry among the nation's leaders about social stability and sustainable economic growth. Attempts at massive renovations and development projects in the interior, meant to boost agriculture's role in the Chinese economy, were supposed to trigger a series of policy actions that would play out through the end of the year.

But the global financial crisis will force Beijing to focus on ensuring internal stability, employment, business operations and the ability to hold onto its own cash, and this means Beijing must turn its attention back to the coast, the country's moneymaker. China is in a conundrum: It needs to redistribute wealth to guarantee internal stability, but it cannot do that if the wealth is not coming in. The financial meltdown's effects in the West are impacting China's export sector and putting at risk China's businesses (which are already seeing thin profit margins) and laborers (who are on the brink of financial ruin and unemployment). China will have to basically run in place; the economy might look like it is growing, but the trickle-down effect will be barely sustainable.

China will respond by promoting growth through cheap credit and big public spending, as it is afraid of unemployment getting out of control. It will be more important for China to use its reserves to contain the internal situation than to contribute funds to other countries, including the United States. China needs all the excess liquidity in its system to go toward appeasing the social groups most likely to be affected negatively by the economic slowdown.

Regional trend: The global financial crisis will also hit East Asia's other two economic powerhouses, Japan and South Korea, along with the smaller Southeast Asian states -- though the major effects will not be seen until the end of the year.

Japan and South Korea are both powerful economies, and both are in dire economic trouble. Japan has massive reserves, but its debt is enormous, its exports are faltering, and now the yen is rising rapidly as the carry trade unwinds, further damaging the export sector. Japan will print money frantically to slow the yen's rise, but will only see moderate success because the crisis is already far too deep. Japan is facing a major recession -- if not the disastrous economic dislocation that awaits it if it proves incapable of reforming its system.

South Korea is also in dire straits. Its economy is hurting because of the won's rapid loss of value as investors withdraw from risky assets. The weakened won will hurt South Korean businesses that are struggling to manage costs while exports fall. Market uncertainty, inflation, poor consumer sentiment and a declining currency will cause South Korean businesses to suffer unless the country is willing to repeatedly dip into its foreign currency reserves to combat the slowdown.

Most of the Asian states have plenty of liquidity due to the nature of their financial systems. The Southeast Asian countries are nervous about their fates but are not thoroughly linked to the outside world, so their economic troubles will have little impact on the rest of the globe. But these nations have not become the hotbed of economic growth they were expected to be; some never recovered from 1997 crisis, while others, like Vietnam, will not see money influxes now. Southeast Asian countries are also highly interlinked through their supply lines and trade, so when one or two economies struggle or slow, the others are hit as well. The credit crunch is causing cash and investment to flow away from them, and their export sectors are flagging. Two states that will be hit hard by this are Singapore and Malaysia, both of which have re-exports making up a large chunk of their exports. This means that even if their strong exports continue, these countries' dependence on others to use them as a subprocessing hub could sting them when other exporters' activities slow. Southeast Asian nations are expected to feel the crush of loss of credit -- just not to the extent of Japan or China. But the ripples of this crisis will likely cause economic slowdowns that could exacerbate social tensions in the region, making for a lot of noise in the fourth quarter.

Africa

Regional trend: In contrast to previous years, there will be little direct involvement from the major outside (or even inside) players in Africa. The one exception will be if Russia has any capacity to meddle in Africa this next quarter. However, Africa is not high on Moscow's list of priorities.

The second- and third-quarter forecasts for Africa predicted that the continent would not see any meaningful direct involvement from the traditional players, whether from the continent or beyond. This situation will continue through the end of the year (though for different reasons than before), with only one possible exception. Most of the big foreign players in Africa -- the United States, France, China, India and Japan -- are completely entangled in the global financial crisis and do not really have the wherewithal to handle any new engagements in Africa.

Moreover, the portfolio investment that Africa recently attracted as a "frontier market" will be constrained as global investors seek to stabilize their investment returns. Startup and junior mining interests will find it difficult to secure financing for mining projects, and while major mining companies will be able to find sufficient financing, slowing demand for commodities will mean that African economies will slow -- or, more to the point, there will be less money for the governments to keep. Interest in Africa's energy and mining sectors will remain high, but cost factors will make investors more selective.

The one possible exception to this trend could be Russia. During the Soviet days, Russia supported liberation movements and governments in Africa (as in Latin America), which it used as proxies against U.S. interests. Thus, Russia already has access to a deep set of networks constructed in Africa during the Cold War. Russia began moving in on Africa during the third quarter, when it began negotiations with the Somalian government on providing military and technical assistance and decided to send a naval vessel to strengthen maritime security off Somalia's piracy-plagued coast. African countries that cooperated with the Soviets during the Cold War did so less out of ideology and more to acquire weaponry, funding and training to fight their own battles. These conflicts and tensions are ongoing in several countries besides Somalia (such Guinea, Mali and Angola) and could help Russia renew both overt and covert relationships in Africa.

Within Africa, the major players are too busy with internal politics to get involved in issues between countries on the continent. Nigeria is still trying to manage the Niger Delta, South Africa is busy laying the groundwork for elections, and in Angola the government is concerned with consolidating its grip on power at home and either co-opting or silencing its opponents.

In Nigeria, the 2007 pact that gave the Ijaw tribe in the Niger Delta the vice presidency and led to a decrease in attacks against the region's energy infrastructure will be tested -- but not overturned -- in the fourth quarter. Northern-backed President Umaru Yaradua will move to consolidate his position in Abuja by naming a new Cabinet and purging his government of ministers appointed by his predecessor, Olusegun Obasanjo. Yaradua's moves will catch the attention of the Ijaw in the south, however, and should they believe they have lost their gains in Abuja -- for instance, if Vice President Goodluck Jonathan loses his influence -- all bets for energy security in the Niger Delta are off.

The wild card is Yaradua's frail health. If it forces him to step down, a struggle over succession will ensue, and the Ijaw will use their key weapon -- militant proxies that launch attacks in the Niger Delta energy sector -- to secure their interests in Abuja. A battle threatening all energy production throughout the Niger Delta would also raise the stakes higher than they were in 2007, demanding a military solution rather than a combination of diplomacy and economic incentives. The carnage that would result from Abuja trying to impose a military solution in the Niger Delta would be extensive.

In South Africa, the transfer of power from former President Thabo Mbeki to African National Congress President Jacob Zuma will accelerate, though elections likely will not be held early. (National elections are due by mid-2009, when Zuma most likely will push to re-establish South Africa's regional influence.) Until then, it is just regular politicking and electioneering in the country, and this will not significantly alter South Africa's policies or its relative quietude on the continent.

Angola faces more immediate concerns, including lingering tensions with the National Union for the Total Independence of Angola (UNITA) political party and rebels in its oil-rich Cabinda province. Angola will try to stamp out these rebels in the fourth quarter, following the ruling party's authoritative victory in recent parliamentary elections. The country must also be prepared to face a hostile regime in the neighboring Democratic Republic of the Congo (DRC). The United States could move to counter a possible Russian resurgence in south-central Africa by supporting the Rwandan-backed insurgency in the DRC, which in turn could move to topple the pro-Angolan government of President Joseph Kabila in Kinshasa. Installing a pro-U.S. government in the DRC could then allow the insurgents to use DRC territory to destabilize the pro-Russian Angolan government. Should the Russian arms dealers come calling, they could enflame such a conflict, embroiling Angola, the DRC and Rwanda.

Food for Thought

John Mauldin — Wed, 14 May 2008 22:10:00 GMT

What countries are truly the have and have nots of the world? Good friend and business partner Niels Jensen of Absolute Return Partners suggests we look at the old equation in a new way? Food and energy resources may be at least part of the definition in the future. In this week's Outside the Box we continue a them I mentioned a few weeks ago: agricultural needs are going to be a new and important force in the world and when coupled with energy may shift the balance of power in the world in strange a different ways.

When, as Niels points out, Afghanistan poppy farmers are shifting to wheat farming, the world is truly a different place. I think you will find the research he has done to be truly worth a few minutes of your thinking time.

And as a preface, I was reminded a little while ago that a Financial Times headline story last Friday mentioned that China is buying African farmland and building massive amounts of railroads and infrastructure to get grains to the market. I have long been bullish on African farmland. This week's OTB will tell you why.

John Mauldin, Editor
Outside the Box

The Absolute Return Letter

May 2008

"There is nothing so disastrous as a rational investment policy in an irrational world."

John Maynard Keynes

You just know that something is astray when Afghan poppy growers begin to switch from opium to wheat. According to the Independent newspaper here in the UK, that's exactly what is now happening. I have no desire to enter into a pound for pound risk/reward analysis of producing wheat versus opium. However, the consequences of the rapid rise in energy and agricultural commodity prices are far reaching and perhaps not as well understood as they should be. That is the content of this month's letter.

The Silent Tsunami

My story begins with Al Gore. While most of us lulled ourselves into the belief that he was onto something when he tried to convince us that global warming (or climate change, as I prefer to call it) was the most formidable challenge facing this planet, a silent tsunami¹, also known as the global food crisis, began to develop and is now threatening to undermine global political and economic stability, the latter of which has been key to the benign financial markets we have all benefited from in recent years.

According to the World Bank, just over 1 billion people live on one dollar or less per day. People in the poorest countries in the world spend 80% of their income on food. So when you and I have hardly noticed that the bread we pick up from the local bakery has doubled in price over the past year, it is because only 10-15% of our budget is spent on food items². In many emerging economies the number is much higher. Chinese consumers spend 28% of their income on food. In India it is 33%. If you want to know how much it is in your country, go to:

http://www.ers.usda.gov/briefing/cpifoodandexpenditures/data/2006table97.htm.

There are three food staples in the world today which dwarf all other food ingredients in terms of importance. They are (in alphabetical order) corn, rice and wheat. As you can see from chart 1 below, they have all experienced rapid price appreciation since last summer. What is it that has driven this price explosion and what does it mean to financial markets? As with most things in life, there is no simple explanation; a number of factors have conspired to create a situation which is exceptional but also destabilising and hence dangerous.

It Is The Bio-Fuel Policy Stupid!

The explanation given by most commentators is the bio-fuel policy currently being pursued by the Bush administration in Washington. The policy is driven by a desire to unlock the United States from its rising dependence on imported crude oil. The problem, as Bush and his government have been slow to recognise, is the stupidity of the policy in its current form. Let's back that claim up with some hard facts.

In the United States, corn (better known as maize over there) is the primary ingredient in ethanol production although wheat and soybeans are also used. According to a recent UN report, it takes 232 kg of corn to fill an average 50 litre car tank with ethanol - enough corn to feed a child for an entire year. It is estimated that almost 20% of total US corn production will go towards ethanol this year and the number is set to rise to 45% by 2015³.

The problem with corn is that it is low on carbon hydrates, which is where the energy comes from. Instead, American ethanol producers rely heavily on fertilisers with the energy being extracted from the nitrogen in the fertiliser. This is an inefficient and very costly approach - in particular in an environment of rising energy prices because crude oil and/or natural gas are major ingredients in fertiliser production. 33,000 cubic feet of natural gas are required to produce just 1 ton of ammonia!

So what does all this mean? According to estimates from Goldman Sachs, the cost of ethanol from corn is now over $80 per barrel, it is about $145 from wheat and over $230 from soybeans. Other countries recognised this problem a long time ago and use crops with higher carbon hydrate content. In the Philippines they use coconut oil and the Brazilians use sugar cane. Goldman reckons that the cost of one barrel of ethanol based on sugar cane is about $35. So why not import sugar cane from Brazil instead of using corn? One simple answer: Brazilian farmers do not vote at American elections. Idaho farmers do.

Are Investors To Blame?

There is no question that the US bio-fuel policy which, by the way, is now being copied in other parts of the world including the EU, has to take its share of the blame. But it is by no means the only reason for the food crisis. The next culprit on my list is our very own industry - investors of all kinds. In recent years there has been rising demand for commodity-linked investment products from investors all over the world. Pension funds, hedge funds, mutual funds and private investors have all allocated more and more to commodities and, in recent months, demand growth has been explosive, as is evident from chart 2 below. It is estimated that the aggregate value of commodity-linked index funds now exceeds $200 billion, a very significant number in a not very large market.

For those of you following the market for exchange traded funds (ETF), you will have noticed that not a day has passed in recent months without yet another new commodity ETF being launched. Since the issuers of these ETFs do not want to take any risk on their books, all these ETFs are hedged - typically through commodity futures. In other words, every time you buy a commodity ETF, you contribute to the continued rise of commodity prices and hence inflation.

For that very reason, it is possible - but not a given - that much of the recent rise in commodity prices is based more on market technicalities than on fundamentals. If so, this could be the next bubble waiting to burst. We continue to hear stories about institutional fund managers being overloaded with commodity futures but have found limited hard evidence so far.

Water Shortages Are A Problem

Water is next on my list. Australia - one of the world's largest grain producers - suffered badly last year due to severe drought with its wheat harvest being only 50% of the prior year's output. However, water, or rather lack thereof, has played havoc in more ways than one. In China, water depletion is a serious problem and the problem is exacerbated by top soil erosion and poor fertility. China has an estimated annual water shortfall of 40 billion cubic metres. Closing that gap through artificial means (desalination, etc.) would consume the equivalent of 3% of the world's oil output.

Until recently China has been one of the world's major grain exporters. Those days are now over. By 2010 China expects to import the equivalent of 40% of US corn exports. According to estimates from UBS, China's foreign currency reserves, which are the largest in the world, could be slashed in half over the next few years if grain prices were to double again from current levels. As an aside, China has recently decided to abandon its bio-fuel programme. The reasons? A lack of water and cost inefficiencies.

In Saudi Arabia, a country of 28 million people, water depletion is a serious problem. Estimated recoverable water reserves are now less than 10 years and falling rapidly. For that reason, the Saudis have decided to wind down their domestic agricultural industry. Historically, the Saudis have been self sufficient on food. They now say that they will import 100% of their food requirements by 2016.

Have We Been Complacent?

Number 4 on my list is complacency. Al Gore (yes, him again!) seduced us all into focusing on the climate. Many a government agency around the world took its eyes off the ball and allowed food stocks to deplete. US wheat inventories, for example, are now at the lowest level since 1947/48 when the US population was only half the size it is today.

Similar problems have caused panic buying in the rice market in recent weeks where stocks are at the lowest levels since 1976. 3 billion people in Asia and Africa rely on rice as their primary food staple. Governments in India, Thailand, Vietnam, Argentina, Cambodia, China and Egypt have all imposed export controls in order to secure domestic needs. The World Bank is so concerned about the situation that it now predicts food riots in more than 30 countries around the world.

Productivity Levels Are Falling

Number 5 and 6 on my list are closely related. The total amount of arable land in the world is diminishing, primarily as a result of urbanisation. China alone has lost 3 million hectares of rice land to concrete in the past 10 years. In order to compensate for the reduced acreage, higher productivity levels are required. But higher yields require increased use of fertilisers which is not an option available to everyone given the price of oil. In some parts of the world, for example in Africa, there is now evidence of farmers planting less than in prior years as they cannot afford fertilisers. Falling yields are not a new phenomenon, though, as you can see from chart 3.

In one of the largest grain producing areas of the world - the former Soviet Union - the total acreage planted has dropped 12% since the iron curtain came down. The 3 largest producers in the area all suffer not only from reduced acreage but also from low yields compared to western standards. In Kazakhstan, grain yields are 1.1 tonnes per hectare, in Russia they are 1.8 and in the Ukraine 2.4. US grain yields, by comparison, are 6.4 tonnes per hectare⁴. The good news is that there is plenty of land available in places like Russia and Kazakhstan. The bad news? Experience suggests that it will take about 10 years to turn non-farm land into fertile farm land.

The Meat Culture Prevails

The final factor has to do with changing eating habits. This phenomenon has received its fair share of the blame in the media in recent months, but I actually think this is more of a concern for the future than a reason why food prices have exploded in recent months. Eating habits do not change overnight. At the macro level, a changing diet takes years to materialise. Having said that, there is clear evidence that Asia's growing middle classes are switching to meat based diets. If the rest of Asia were to follow Japan's example, the protein intake across Asia will explode over the next couple of decades. The Japanese are consuming almost 10 times as much protein as they did 50 years ago. Why is that a problem? Because it takes over 3 kg of corn to produce 1 kg of pork and over 8 kg of corn to produce just 1 kg of beef!

So What Does It All Mean?

There are very good reasons to believe that high food prices will stay with us for quite some time. Yes, there may be some elements of speculation behind the recent explosion in grain prices, maybe even hints of a bubble, but underlying supply and demand factors are such that we'd better get used to lofty food prices for years to come. That has implications for financial markets left right and centre (finally I get to what this actually means!).

The analysts at Goldman Sachs have calculated the effect rising food prices have had on overall consumer prices (see table 1). The conclusion is inevitable. Whereas in most OECD countries the feedback process between food inflation and non-food inflation is modest, in virtually all emerging economies the feedback is significant. Secondly, non-food inflation is most affected by high food inflation in countries with high inflation rates such as Russia, Indonesia, Argentina and Mexico (see chart 4).

This is an important observation because the investment community is almost universally in favour of emerging markets these days. Rarely have I experienced a period where the bulls have been more plentiful and the bears fewer and farther between. Most investors seem to believe that headline inflation will gradually come back to core inflation levels over the next year or so. Few investors seem to think the unthinkable - that core inflation will gradually rise to headline levels.

Asia May Pay A High Price

Even fewer seem to realise that if oil prices and agricultural prices continue to run amok, the Asian miracle story, upon which so many investors have pinned their hopes for the next few years, may, in fact, turn into a nightmare. The reason is simple enough. Asian countries are large importers of both oil and food staples. Very large!

To give you an idea of the appetite for oil in Asia, take a look at chart 5. As you can see, over 50% of the incremental global demand for oil over the past few years has come from Asia - almost 35% from China alone. In fact, over the last 5 years, China's energy consumption has grown 5% faster than its GDP per year. Yes - per year!

It is now projected that China will overtake the US as the world's largest energy consumer by 2010 despite its GDP being only 1/5 the size of the US GDP. No wonder the Chinese are running around in obscure parts of the world attempting to secure long term crude oil deliveries.

Based on the current crude oil price of $112, and an estimated average price of $64 over the course of 2007, I have calculated the net gains and losses to oil exporters and importers (see table 2). Not surprisingly, the Middle Eastern producers stand to gain the most - $333 billion of incremental revenues - but African producers and Russia also stand to benefit significantly. On the import side, Asia is paying the highest price. The current level of crude oil prices should add about $278 billion to the bill over and above what Asian countries paid for their oil imports last year.

Rising agricultural goods prices, although significant, are not having the same aggregate wealth effect as rising oil prices. In table 3, I have estimated the added cost of rising food prices from importing the three main food staples. Again you will see that rising prices are hitting Asia the hardest. Remember table 3 only looks at the import of raw materials. The effect from rising prices on processed foods is not included.

Neither does table 3 do any justice to the damage done at the micro level. Of the 3 billion people who rely on rice as their primary source of food, over 2 billion live on $2 or less per day. The recent price jump spells disaster for these people and could potentially cause massive economic dislocation throughout Asia. Riots are now a real possibility in many of these countries.

As far as the investment story goes, here is the problem. The prevailing view today is that the western world is yesterday's story and that the best way to ensure continued high returns in your portfolio is to focus on emerging markets - in particular Asia. The argument runs approximately as follows:

The Consensus View

The OECD area (the old world) is plagued by a rapidly ageing population with all the negatives that follow - rising health care costs being the most important. Many OECD countries also have unfunded pension liabilities and large budget deficits, raising serious questions about whether the 21^st century society can afford to maintain the retirement system as we know it today. Some even argue that structures such as the Euro are doomed because of dramatic discrepancies in performance within the Euro zone. Now consider the US dollar. The greenback is probably the most disliked currency in the world today (well, not taking the Zimbabwe dollar into consideration). If you buy these arguments it is no wonder that many investors shy away from the more established markets.

On the other hand, emerging markets - and Asia in particular - beam with opportunities. The population in most emerging market countries is still young, savings rates are high and the optimism is there for everyone to see. In short, it is exceedingly hard to find anyone who wouldn't agree that Asia offers the best growth prospects going forward. So overwhelming is this view that it is virtually impossible to find a single brokerage house, institutional investor, commentator, punter, etc. who doesn't advocate an overweight of Asian shares in equity portfolios.

Do Not Assume One-Way Traffic

While I agree that emerging markets offer better growth prospects than OECD countries, I disagree that it is going to be one-way traffic. As demonstrated above, rising commodity prices will hit Asia much harder than any other region in the world as it is in fact the only region in the world today which is a net importer of both crude oil and food staples.

In table 4 I have listed the largest holders of foreign exchange reserves in the world today. As you can see the list is dominated by Asian countries. All those investors who buy into the Asian growth story pin their argument either directly or indirectly on the size of these reserves. Growth requires investments; however, due to the high savings rates across Asia, and hence the plentiful reserves, the money is there to finance those investments without the countries becoming net debtors. What the argument does not take into consideration is that, at least in some countries, those reserves will be increasingly going towards paying for the rising cost of oil and food imports.

The 'haves' And 'have Nots'

Instead I believe investors will increasingly differentiate between the 'haves' and 'have nots'. And the 'haves' are those countries which control the world's resources. In fact, few countries are net exporters of both oil and foods on a large scale. Come to think about it, it is less than a handful. And no Asian country is on the list. So who is on it? In the old world only one - Canada. In the grey zone (emerging economies but not necessarily young and dynamic populations) perhaps two - Russia and Kazakhstan. And amongst full blooded emerging economies? Noone today, although Brazil has the potential to turn itself into a winner and so does Africa, if it can sort itself out.

All this is not to say that investing in Asia is doomed to fail. There are many good reasons why you want to invest there. However, the invest case is not as straight forward as it appears at first glance, and throwing in a bit of Africa, Brazil and/or Russia may not be a bad idea.

An Afterthought

For over 30 years, the world has had to suffer the consequences of OPEC - an organisation as keen to enrich its members as we in the Western world are hooked on its main produce - crude oil. Has pay-back time finally arrived? Should we be tempted to create OGEC - the Organisation of Grain Exporting Countries - with the objective of ensuring overall resource stability, i.e. food will only be exported to oil producing countries provided they deliver oil to us at a reasonable price?

The largest wheat exporters today are (in order of rank) the US, Canada, Russia, the EU, Argentina, Kazakhstan and Australia. Most of these countries happen to be net importers of oil. Is it unreasonable to apply a 'tit for tat' approach? My heart (as does my bank manager) tells me yes but my gut feel says no. The world has always been a better place when government interference has been kept at a minimum. The problem we face in this particular situation, though, is that not everyone plays by the same rules. If that could be fixed, the world would indeed be a better place.

Footnotes:

[1] A term borrowed with thanks from The Economist newspaper.

[2] Our food statistics come from the US Department of Agriculture and indicate that consumers in countries such as the UK and the US spend less of their income on food than consumers in other countries. This is due to the fact that take-aways and restaurant visits are not included in the USDA numbers. Adjusted for that, almost all OECD countries spend 10-15% of household expenditures on food.

[3] Source: The Daily Telegraph

[4] Source: The Daily Telegraph

Your thinking about agricultural opportunities in Africa analyst,

John Mauldin

Two Essays on the Continuing Financial Crisis

John Mauldin — Mon, 28 Apr 2008 22:00:00 GMT

This week in Outside the Box we look at two brief essays which give us different perspective on the Continuing Crisis. The first is by Mohamed El-Erian, the co-chief executive and co-chief investment officer of Pimco. His book, 'When Markets Collide: Investment Strategies for the Age of Global Economic Change', will be published by McGraw Hill in June, and it will be on my summer reading list. El-Erian argues in the thought-provoking piece from the Financial Times that the crisis is still far from finished, and that those who think we are returning to more placid times may be surprised when volatility suddenly becomes even more pervasive.

The second is by good friend and Maine fishing buddy David Kotok, the chief investment officer of Cumberland Asset Managers (www.cumber.com). He was recently in Africa where he met with the head of the central bank of a small country with headline inflation of 10%. The problem is that "core inflation" is 5% and food inflation is 15%, yet accounts for 50% of the GDP. He asked a group of financial thinkers (including your humble analyst) to ponder what that central banker should do. Do you set high rates and target overall inflation or set lower rates and not worry about food inflation.

Why should we worry about inflation in a small African country? Because the principles are the same, and it makes a real difference where the Fed comes down at the end of the day on this very question.

This week's reading should be very helpful and thought-provoking. I hope you enjoy this read as much as I did.

John Mauldin, Editor
Outside the Box

Why This Crisis is Still Far From Finished

By Mohamed El-Erian

During the past few weeks we have seen a growing number of market participants predict an end to the dislocations that erupted last summer and claimed victims throughout the financial system and beyond. While their predictions are understandable, they are premature. The dynamics driving the disruptions are morphing and may again move ahead of both the market and policy responses.

The optimistic view is based on two distinct elements. First, that the deleveraging process is reaching its natural end as valuations stabilize and institutions come clean about their losses and raise capital; second, that a series of previously unthinkable policy responses have been effective in restoring liquidity to the financial system.

Both views have merit. Financial institutions, particularly in the US, have recognized the scale of the problem and are taking remedial steps. Just witness the recent round of capital raising by Citigroup, Merrill Lynch, JPMorgan and Wachovia. At the same time central banks in Europe and the US have opened up their financing windows, expanding the size of the financing, the range of institutions that can access it and the list of eligible collateral.

Yet, consistent with what we have seen since last summer, the dislocations are entering a new phase. As such, bold reactions on the part of policymakers may, once again, prove to be too little and too late.

Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.

Economic data in the US have taken a notable turn for the worse. Most importantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

Pity the US consumers. Their ability to sustain spending is already challenged by the declining availability of credit, a negative wealth effect triggered by declining house values, and a lower standard of living as the result of higher energy and food prices and a depreciating dollar. Job losses will accentuate the pressures on consumers, leading to income declines and a further loss of confidence.

While the financial system has taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks.

It is thus too early to declare the end of the turmoil that started last summer. Instead, during the next few months we may witness a new phase of dislocations, led this time by the real economy. The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activities within the banking system and beyond.

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve's dual objectives - maintaining price stability and solid economic growth - will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse.

It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.

And our next essay:

Food Price Inflation, Monetary Policy & Financial Markets

By David Kotok

Suddenly food price inflation has become the premier hot topic. The media is now attuned to food issues including emerging market country riots.

In the US, the politicians are gearing up to castigate the speculators and blame everyone but themselves. They conveniently forget that they are the ones who passed the ethanol subsidy and they are the ones who appropriate taxpayer money to pay farmers not to grow crops. And so the political circus begins.

Notice how the three presidential candidates are silent on how the US ethanol subsidy has caused a food price explosion in grains. They avoid the issue of US policy starving many in the world. 1 billion very poor people sustain themselves on $1 or less a day. We have doubled the cost of their food.

Ethanol directly impacted corn which, in turn, also drove up maize. In addition, the substitution of wheat and rice are not easily occurring because of crop issues and concomitant price inflation in those items.

Well Cumberland is in the financial market and money management business. We eat food. We don't grow it and we don't process it. So let's try to inject some serious monetary policy issues into this media hysteria and political cacophony.

In the mature countries, food is a minor portion of the price index. And some of the food costs originate from eating out and some come from food processing. Processed food cost is heavily dependent on the inputs which are non-food items. Labor, machinery, transportation and distribution all come in to play. So in the mature countries we see that the food price inflation may be topical and attention getting but it is not a crisis.

Also, the major mature countries are mostly in food surplus. In the US we are very efficient in running our agriculture enterprise. We actually pay farmers not to till their soil. This is dumb. It occurs only because of our sorrowful Congress who has learned how to bribe the farm belt for votes at the expense of the rest of us.

In the US food has a 14% weight in the consumer price index. Compare that with Canada at 17%, the Euro zone at 16%, England at 11% and Japan at 25%. Only Japan lacks the fullness of food self sufficiency. Sure, food price inflation is important. But it is not the most important issue in these major economies.

The reverse is true for the emerging markets. In some of them the food price component is as much as half the price index. In a few it is above half. Since many of these economies are open to some degree, the importation of food price inflation is hitting them particularly hard. Some are responding with tariff adjustments. Others have actually embargoed food exports. Of course they ultimately make matters worse when they restrict world trade and in the end all suffer because of this protectionism.

What about monetary policy?

Here is where it gets difficult. We will admittedly simplify now and we acknowledge to our critics that we know there are second order effects and are ignoring them to make our point. In our view, monetary policy cannot easily and directly address food price inflation when the source of the inflation is in the raw food commodity. This is also true for energy costs when the source is in the oil or natural gas. The whole concept of "core" inflation vs. total inflation originates in this notion that monetary policy should be directed at the price level changes it can affect.

Let's get to the inflation problem in an emerging economy. Our example is imaginary for simplicity's sake. But it reflects characteristics that are very similar to many countries and regions in the emerging markets of the world.

We developed this simple and theoretical case study and then sent it to a number of economist friends. We suggested that following facts: the economy in question is a small and open emerging market. The food price component is 50% of the price index and is inflating at 15%. The non-food component is inflating at 5%. Thus the overall index is inflating at 10%. In this small and open economy, the main items in the food component are based on maize; therefore, the US ethanol policy which has raised the corn priced has also pressured an increase in the maize price.

Suppose you are the governor of the central bank. You have to set your policy interest rate. Do you base that decision on overall inflation rate of 10% or on the core inflation rate of 5%? Or are you going to confront the food inflation rate of 15%. Let's further assume that your economy is growing at a trend rate of 5% and all other aspects are in trend or neutral position. You have no negative output gap and no above trend pressures. Your only direct problem is what to do about inflation.

My economist friends who answered offered a suggested policy rate as low as 6% and as high as 13.5%. The answers were about equally divided and the respondents sample size is over 20. The distribution of answers was distinctly bi-modal. About half the answers were bunched in the lower range of 6%-8%; the other half were in the double digit area between 11% and 13.5%.

The divided views centered on whether or not to target food, ignore food, or blend policy. No one wanted to set the interest rate above the 15% food price inflation. Nearly all acknowledged that this central bank would have difficulty in communicating whatever it decided. Most respondents worried about changes in inflation expectations because of the complexity of this issue. Most believed the citizens in the country would not understand the monetary policy dynamics that led to the decision.

Some worried that setting the policy interest rate in double digits would impose a very high financing cost on the non-food portion of the economy and cause it to go into recession. They argued that the real (inflation-adjusted) rate of interest for that non-food half of the economy would be 7% or so. That would set the threshold of finance too high.

Others argued that the monetary policy expectation effect would cause the rate of inflation to accelerate if the policy rate was not set in double digits. They were willing to take the recession in the non-food area in order to keep inflation expectations under control. No one mentioned substitution effects. Perhaps that was overlooked. Or it may be because rice and wheat are not easy cultural substitutes and those grains are each experiencing their own price pressures.

In sum, almost two dozen folks with some monetary economics expertise were equally divided on this technical question. It is a question that impacts billions of citizens in this world and many countries, their governments, their currencies and, possibly, their political stability.

We do not know the correct answer. Our view would support the lower interest rate and we would focus on the non-food portion of the economy but we can argue the other side with equal vigor. For us a lot would depend on how the food price inflation spreads into wages and if it could trigger a broader wage/price spiral.

In many respects this question is now being asked of the major and mature economy central banks as well. It appears that the European Central Bank (ECB) favors the higher mode while the US Federal Reserve is positioned in the lower one. For the emerging markets it appears that there is quite a mix of policy and that it is made more complicated by the management of each currency's foreign exchange rate. In sum, our simple case study is actually quite complex when applied in the real world.

David R. Kotok, Chairman and Chief Investment Officer

I trust you enjoyed this week's Outside the Box. And for the record, I thought rates in our hypothetical African country should be at the lower end. Targeting food inflation with high interest rates would hammer the productive, job creating portion of the economy. I have been to 15 countries in Africa and they are in desperate need of jobs. Better to target inflation through control of the money supply and encourage capital formation and foreign direct investment. But it is a tough question.

Your glad I don't have to be a African central banker analyst,

John Mauldin