January 2011

January 31, 2011 09:45 a.m.
Egypt and Your Money

At the world leaders conference in Davos, Switzerland last week, an interesting comment was made by Kenneth Rogoff, co-author of This Time Is Different: Eight Centuries of Financial Folly. Rogoff, who has been saying that it takes a decade or more to begin recovering from a serious financial crisis, said the biggest risk he sees in the world isn’t economic. He said the biggest risk was geopolitical.

No sooner had he said that than investment markets around the globe were rattled by the street demonstrations in Egypt. These followed the overthrow of the government of Tunisia and demonstrations in other Middle East or Arabian countries. We recently wrote that the sharp rise in agricultural commodity prices, which translates into higher food prices, will lead to problems in the emerging countries. This is another of the secondary consequences and probably unintended effects of the Federal Reserve’s QE 2 policy. I’m not an expert in geopolitics or the history of the region. So, to put the headlines into perspective, let’s turn to George Friedman of the highly-regarded private intelligence service STRATFOR. You can learn more about the service at www.stratfor.com.

The Egypt Crisis in a Global Context: A Special Report

By George Friedman

It is not at all clear what will happen in the Egyptian revolution. It is not a surprise that this is happening. Hosni Mubarak has been president for more than a quarter of a century, ever since the assassination of Anwar Sadat. He is old and has been ill. No one expected him to live much longer, and his apparent plan, which was that he would be replaced by his son Gamal, was not going to happen even though it was a possibility a year ago. There was no one, save his closest business associates, who wanted to see Mubarak’s succession plans happen. As his father weakened, Gamal’s succession became even less likely. Mubarak’s failure to design a credible succession plan guaranteed instability on his death. Since everyone knew that there would be instability on his death, there were obviously those who saw little advantage to acting before he died. Who these people were and what they wanted is the issue.

Let’s begin by considering the regime. In 1952, Col. Gamal Abdel Nasser staged a military coup that displaced the Egyptian monarchy, civilian officers in the military, and British influence in Egypt. Nasser created a government based on military power as the major stabilizing and progressive force in Egypt. His revolution was secular and socialist. In short, it was a statist regime dominated by the military. On Nasser’s death, Anwar Sadat replaced him. On Sadat’s assassination, Hosni Mubarak replaced him. Both of these men came from the military as Nasser did. However their foreign policy might have differed from Nasser’s, the regime remained intact.

Mubarak’s Opponents

The demands for Mubarak’s resignation come from many quarters, including from members of the regime – particularly the military – who regard Mubarak’s unwillingness to permit them to dictate the succession as endangering the regime. For some of them, the demonstrations represent both a threat and opportunity. Obviously, the demonstrations might get out of hand and destroy the regime. On the other hand, the demonstrations might be enough to force Mubarak to resign, allow a replacement – for example, Omar Suleiman, the head of intelligence who Mubarak recently appointed vice president – and thereby save the regime. This is not to say that they fomented the demonstrations, but some must have seen the demonstrations as an opportunity.

This is particularly the case in the sense that the demonstrators are deeply divided among themselves and thus far do not appear to have been able to generate the type of mass movement that toppled the Shah of Iran’s regime in 1979. More important, the demonstrators are clearly united in opposing Mubarak as an individual, and to a large extent united in opposing the regime. Beyond that, there is a deep divide in the opposition.

Western media has read the uprising as a demand for Western-style liberal democracy. Many certainly are demanding that. What is not clear is that this is moving Egypt’s peasants, workers and merchant class to rise en masse. Their interests have far more to do with the state of the Egyptian economy than with the principles of liberal democracy. As in Iran in 2009, the democratic revolution, if focused on democrats, cannot triumph unless it generates broader support.

The other element in this uprising is the Muslim Brotherhood. The consensus of most observers is that the Muslim Brotherhood at this point is no longer a radical movement and is too weak to influence the revolution. This may be possible, but it is not obvious. The Muslim Brotherhood has many strands, many of which have been quiet under Mubarak’s repression. It is not clear who will emerge if Mubarak falls. It is certainly not clear that they are weaker than the democratic demonstrators. It is a mistake to confuse the Muslim Brotherhood’s caution with weakness. Another way to look at them is that they have bided their time and toned down their real views, waiting for the kind of moment provided by Mubarak’s succession. I would suspect that the Muslim Brotherhood has more potential influence among the Egyptian masses than the Western-oriented demonstrators or Mohamed ElBaradei, the former head of the International Atomic Energy Agency, who is emerging as their leader.

There is, of course, the usual discussion of what U.S. President Barack Obama’s view is, or what the Europeans think, or what the Iranians are up to. All of them undoubtedly have thoughts and even plans. In my view, trying to shape the political dynamics of a country like Egypt from Iran or the United States is futile, and believing that what is happening in Egypt is the result of their conspiracies is nonsense. A lot of people care what is happening there, and a lot of people are saying all sorts of things and even spending money on spies and Twitter. Egypt’s regime can be influenced in this way, but a revolution really doesn’t depend on what the European Union or Tehran says.

There are four outcomes possible. First, the regime might survive. Mubarak might stabilize the situation, or more likely, another senior military official would replace him after a decent interval. Another possibility under the scenario of the regime’s survival is that there may be a coup of the colonels, as we discussed yesterday. A second possibility is that the demonstrators might force elections in which ElBaradei or someone like him could be elected and Egypt might overthrow the statist model built by Nasser and proceed on the path of democracy. The third possibility is that the demonstrators force elections, which the Muslim Brotherhood could win and move forward with an Islamist-oriented agenda. The fourth possibility is that Egypt will sink into political chaos. The most likely path to this would be elections that result in political gridlock in which a viable candidate cannot be elected. If I were forced to choose, I would bet on the regime stabilizing itself and Mubarak leaving because of the relative weakness and division of the demonstrators. But that’s a guess and not a forecast.

Geopolitical Significance

Whatever happens matters a great deal to Egyptians. But only some of these outcomes are significant to the world. Among radical Islamists, the prospect of a radicalized Egypt represents a new lease on life. For Iran, such an outcome would be less pleasing. Iran is now the emerging center of radical Islamism; it would not welcome competition from Egypt, though it may be content with an Islamist Egypt that acts as an Iranian ally (something that would not be easy to ensure).

For the United States, an Islamist Egypt would be a strategic catastrophe. Egypt is the center of gravity in the Arab world. This would not only change the dynamic of the Arab world, it would reverse U.S. strategy since the end of the 1973 Arab-Israeli war. Sadat’s decision to reverse his alliance with the Soviets and form an alliance with the United States undermined the Soviet position in the Mediterranean and in the Arab world and strengthened the United States immeasurably. The support of Egyptian intelligence after 9/11 was critical in blocking and undermining al Qaeda. Were Egypt to stop that cooperation or become hostile, the U.S. strategy would be severely undermined.

The great loser would be Israel. Israel’s national security has rested on its treaty with Egypt, signed by Menachem Begin with much criticism by the Israeli right. The demilitarization of the Sinai Peninsula not only protected Israel’s southern front, it meant that the survival of Israel was no longer at stake. Israel fought three wars (1948, 1967 and 1973) where its very existence was at issue. The threat was always from Egypt, and without Egypt in the mix, no coalition of powers could threaten Israel (excluding the now-distant possibility of Iranian nuclear weapons). In all of the wars Israel fought after its treaty with Egypt (the 1982 and 2006 wars in Lebanon) Israeli interests, but not survival, were at stake.

If Egypt were to abrogate the Camp David Accords and over time reconstruct its military into an effective force, the existential threat to Israel that existed before the treaty was signed would re-emerge. This would not happen quickly, but Israel would have to deal with two realities. The first is that the Israeli military is not nearly large enough or strong enough to occupy and control Egypt. The second is that the development of Egypt’s military would impose substantial costs on Israel and limit its room for maneuver.

There is thus a scenario that would potentially strengthen the radical Islamists while putting the United States, Israel, and potentially even Iran at a disadvantage, all for different reasons. That scenario emerges only if two things happen. First, the Muslim Brotherhood must become a dominant political force in Egypt. Second, they must turn out to be more radical than most observers currently believe they are – or they must, with power, evolve into something more radical.

If the advocates for democracy win, and if they elect someone like ElBaradei, it is unlikely that this scenario would take place. The pro-Western democratic faction is primarily concerned with domestic issues, are themselves secular and would not want to return to the wartime state prior to Camp David, because that would simply strengthen the military. If they win power, the geopolitical arrangements would remain unchanged.

Similarly, the geopolitical arrangements would remain in place if the military regime retained power – save for one scenario. If it was decided that the regime’s unpopularity could be mitigated by assuming a more anti-Western and anti-Israeli policy – in other words, if the regime decided to play the Islamist card, the situation could evolve as a Muslim Brotherhood government would. Indeed, as hard as it is to imagine, there could be an alliance with the Muslim Brotherhood designed to stabilize the regime. Stranger things have happened.

When we look at the political dynamic of Egypt, and try to imagine its connection to the international system, we can see that there are several scenarios under which certain political outcomes would have profound effects on the way the world works. That should not be surprising. When Egypt was a pro-Soviet Nasserite state, the world was a very different place than it had been before Nasser. When Sadat changed his foreign policy the world changed with it. If Sadat’s foreign policy changes, the world changes again. Egypt is one of those countries whose internal politics matter to more than its own citizens.

Most of the outcomes I envision leave Egypt pretty much where it is. But not all. The situation is, as they say, in doubt, and the outcome is not trivial.

Read more: The Egypt Crisis in a Global Context: A Special Report | STRATFOR

As Friedman said, the situation in Egypt shouldn’t amount to much in the global economy if the most likely outcomes are what happen. There won’t be another Islamic Republic in the Middle East, and there still will be global access to the Suez Canal. But there is uncertainty. Friedman identified four possible outcomes. That uncertainty is why we maintain balanced, diversified portfolios that offer some protection in different environments. You can make more money, at least in the short term, by betting on one scenario, but you better be right and watch your portfolio closely. I think it’s better to use a risk management approach to portfolio management and always have a margin of safety.

January 20, 2011 10:00 a.m.
China, Currencies, and Commodities

Next week I’m going to have another free investment webinar in conjunction with TJT Capital of Stamford, CT. It’ll be on Wednesday, Jan. 26 at 11:30 a.m., eastern time on the subject “Year of Transition: Opportunities and Risks in 2011.” Participation is limited, and we had a good crowd for the last one. To reserve your spot, call 877-282-4609 or email info@tjtcapital.com.

In this Bob’s Journal I want to take a few minutes to bring together several trends that need to be considered together. They have affected your finances in the recent past and are likely to affect them more this year and the next.

The factors affecting your investments now and in coming years are new. These factors weren’t studied in too many classes, and you won’t find many financial advisors who are conversant with them. Even more significant, the factors are acting together in ways they haven’t before. We touched on them in recent issues of Retirement Watch and will follow them closely going forward.

China is the centerpiece of economic change and influence now.

Though few acknowledge it, China’s stimulus plan probably did more to pull the global economy out of the 2008 decline than anything else. Relative to GDP, China’s stimulus was more significant than any other country’s and than most countries’ efforts added together. China’s internal growth creates tremendous demand for commodities, for building, manufacturing, and consumption. Commodity prices are soaring. Some analysts attribute this to fears of inflation and currency collapses. There’s some element of that, but a great deal of the commodity price inflation is due to demand.

The best way to see this is to look at agricultural commodities. These aren’t inflation hedges. They can’t be stored and treated as alternatives to currencies. They’re purchased to be consumed. Yet, agricultural commodity prices have been soaring more than they did in any modern inflation scare. Every commodity should have its own supply and demand dynamics. Even so, agricultural commodity prices are rising across the board by large percentages.

The price increase is due to the effects of strong economic growth in emerging economies. This growth increases demand and also increases living standards. People want and are able to consume more. The depreciation of the dollar due to excessive monetary growth also is a factor when commodities are priced in dollars.

The rise in commodity prices has political implications. In emerging countries, food is a much higher percentage of household budgets than in the U.S. Rapidly rising agricultural commodity prices are a burden on most of the population. Already we’ve had a government replaced in Tunisia and riots in Middle East countries, largely because of sudden jumps in food prices.

Supplies of agricultural commodities are so tight that governments are taking action. Producing countries, such as Russia, are limiting exports of some of their commodities. Other countries are trying to boost their domestic production of agricultural commodities. The shortages are good for the U.S. in the short-term, because it is a major exporter of a number of commodities. Longer term the efforts by other countries should lead to higher world supplies.

Higher food prices also translate into higher consumer price inflation in emerging nations, again because food is a higher percentage of household budgets.

Emerging economies, including China, are taking measures to reduce inflation. These anti-inflation measures so far are modest. They likely won’t have much effect, and stronger measures will be needed as the year goes on.

The emerging economies, especially China, are propelling global economic growth. Should they be successful in reducing inflation (and ultimately they need to be successful), their efforts will reduce global economic growth. With the developed world (including the U.S.) in a precarious financial situation and struggling to generate sustainable economic growth, a growth reduction in emerging countries will pose a problem. Much of the revenue and profit growth by large U.S. companies is from sales to emerging markets.

The final factor to consider is currencies, especially the difference between the U.S. and Chinese currencies. China tries to maintain a fixed rate between its currency and the dollar. The fixed exchange rate keeps Chinese goods affordable for U.S. consumers and boosts exports to the U.S., a strong underpinning of the Chinese economy. This would result in very strong inflation in China, as dollars flowed into the country. To avoid that, China’s central bank buys dollars in the domestic market for yuan, at the fixed exchange rate. This keeps a lid on inflation and gives the central bank a large storehouse of dollars.

China has been allowing its currency to appreciate relative to the dollar at a slow rate the last few years. It probably needs to allow the currency to rise faster to reduce the imbalance between the U.S. and China. It doesn’t want to do that, so it won’t do it fast enough.

You can see that all these factors are coming together and are likely to result in serious problems across the globe as 2011 unfolds. Food inflation in emerging countries will result in domestic unrest. Efforts to reduce inflation will reduce economic growth, and that is likely to hurt developed countries in the U.S. and Europe more than it hurts the emerging economies. Currency moves also will contribute to these problems. Any events that cause supply disruptions in one or more key commodities could cause serious ripples across the globe.

Rising commodity prices are another reason China and other nations that fix their currencies to the dollar need to let their currencies rise relative to the dollar. This will help tame domestic inflation and reduce demand for food and other commodities. Of course, If China allows its currency to appreciate, it won’t need to buy as much treasury debt as it’s been buying. This could result in higher interest rates in the U.S. That’s why I’m watching global commodity prices. They are likely to affect economic growth and interest rates in the U.S.

Some Things You Might Have Missed
January 7, 2011 11:55 a.m.

An underappreciated story is the turnaround in Brazil over the last eight years. Not long ago the country was an economic basket case. In two terms a new president was able to turn things around and make the country an economic powerhouse. It did this without bailouts from other countries or any of the stuff we’re hearing about these days. It’s a good lesson for Greece, Spain, Ireland, Italy, and even the United States.

It looks like Congress gave an interest-free loan to anyone who converted a traditional IRA to a Roth IRA in 2010. Those who converted in 2010 have the option of including the converted amount in their 2010 gross income or spreading it over 2011 and 2012. Since the 2010 tax rates were extended for 2011 and 2012, the taxes won’t change for many people. There’s no downside to electing the deferral, plus you can use or invest the money longer before giving it to the IRS.

The people who should consider paying the taxes in 2010 are those who anticipate being in higher tax brackets in 2011 or 2012. They might have an increase in income or reduction in deductions. Otherwise, holding on to the money and paying the same amount of tax over the next two years is better cash management. If you defer the taxes, invest the money in something safe. You’ll earn a modest return, but you don’t want to risk having the value of the investment decline just when you need to pay the taxes.

Medicare established the monthly premiums for 2011. The standard premium is $115.40, but this will apply only to new enrollees and those who don’t have their premiums deducted from Social Security. Since SS did not have a cost of living increase in 2011, those who deduct the premiums from SS don’t face an increase. They’ll continue to pay the 2010 premium. Higher income people, based on 2009 tax returns, pay a higher rate.

There are a few other Medicare changes in 2011. A group of about 20 preventive tests and procedures now are fully covered without deductibles or copayments. Those in Part D plans will get a new benefit when they are in the “doughnut hole” or coverage gap. They’ll be able to buy generic drugs at a 50% discount. Of course, these benefits must be paid for. Medicare Advantage plans overall have a combination of higher costs (premiums, copayments, deductibles) and lower coverage and benefits.

It looks like the CLASS program is going to be delayed. We first discussed this in the October issue of Retirement Watch and explained how actuaries consider the program unsustainable. The word we get is that it will take the government a while to figure out the details. It’s not clear when the program will be started, but it might not be until 2013.

Looking to reduce your mortgage payments without the cost or credit check of refinancing? Here’s a strategy that works. The headline says it’s “little known” but it’s been around a while. Consider it for yourself or your children.

To show we’re not all about finances and that money isn’t the root of happiness, here’s a piece on the secret to a happy, lasting marriage. It’s not what most people believe, but it’s based on scientific research. The article explores the secret not only how to make a marriage last but to make it happy and sustainable for both parties. The key: Each person should grow and help the other grow.