The Mid-East turmoil is not over, and, most likely, has only begun. The revolt in Tunisia spread to Egypt, and now Libya, a nation that produces 2% of the world’s oil. There have also been demonstrations in other Arab nations such as Bahrain, Yemen, Algeria and Iran. Others may be next. History tells us that revolutions of this type are contagious once the first nation shows what could be done. This was true hundreds of years before the age of the internet and cell phones, and is therefore even truer today.
We also know that revolutions seldom end in benign fashion and that violence and chaos are more the norm. This is particularly valid in the Mid-East where revolts have never ended with the formation of stable democracies. It is therefore likely that turmoil in this section of the world will continue for some time with unpredictable results.
As a result of this unpredictability and the extremely small chance of a quick and benign outcome, oil prices have already soared and will remain high and volatile for an extended period of time. Libya produces 2% of the word’s oil, an amount that could probably be replaced by Saudi Arabia within a reasonable period. What is particularly worrisome is that demonstrations in largely Shia Bahrain could spill over into neighbouring Saudi Arabia, whose provinces bordering Bahrain produce most of its oil. This area also contains most of the minority Shia in a mostly Sunni country. In addition Bahrain’s rulers are Sunnis as well. Therefore it is easy to see that the potential for trouble is not insignificant.
The upshot of all this is that oil prices will probably remain high and could very well rise significantly even from current levels. For the U.S., studies indicate that every $1 rise in the price of a barrel of oil is about equivalent to a 2.5 cent increase in a gallon of gas. Oil prices have already jumped about $10 a barrel since the start of the crisis and $22 since November, translating into an eventual 55 cent a gallon rise in the price of gas. Since every 1 cent rise in a gallon of gas costs consumers about $1.2 billion the increase to date will cause a $66 billion rise in spending for gas alone alone without even including the gas components in the price of such items as airline tickets, express mail and anything that is transported by truck. This is virtually the same as an increase in taxes since it means less money available for spending on discretionary goods. When we consider the possibility of even further increases in oil prices and then add in the prospective rise in food prices, it is easy to see the highly negative effect on economic growth in the period ahead.
This all in addition to high unemployment, modest income growth, lower housing wealth, high rates of mortgage foreclosures, elevated inventories of unsold homes and tight credit conditions. Furthermore, don’t overlook the impact that higher oil and other commodity costs will have on overly optimistic earnings forecasts that will have to be revised down.
Ordinarily, in order to combat such a headwind to growth the Fed would ease monetary policy and the Administration and Congress would provide fiscal stimulation. At this time, however, this policy is not feasible as the interest rates under Fed control are already near zero and Congress is pressing to reduce the deficit. When we also consider that QE2 ends in June, we think that current economic growth forecasts are subject to important downward revisions in the months ahead.
At the same time, the market is up 100% in two years for the first time since the depression era in the 1930s, and is overbought, overextended and overvalued. It is therefore likely that the Mid-East turmoil is the catalyst that finally ends this secular bear rally and starts the market on a downward course.