Economic Commentary
Daniel Laufenberg, Ph.D.

Numerous economic data series are released between the publication dates of the Laufenberg Economic Quarterly (LEQ). These commentaries are designed to provide insight on the more recent data and their implications for the economic outlook.

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More trouble in the Middle East
(February 26, 2011)

In the wake of recent events in the Middle East, investors became concerned that such events would have a substantial adverse effect on the global economy. Stock markets responded accordingly. Whether these events actually have a sustained adverse effect on the pace of economic activity will determine whether any retrenchment in financial markets is the start of a long bear market or a buying opportunity in the midst of a bull market.

I do not forecast geopolitical events, but that does not stop me from having an opinion about what they might mean for the economy once they occur. The inference by many commentators is that the protesters in the Middle East are demanding a more democratic political system. Although that may be the hope of many of the protesters, I doubt that is what they get. I suspect that there are other forces at work (very strong forces) that will use this opportunity to push toward a political outcome that looks more like the theocracy of Iran than anything else. The concern of financial market participants is that such a shift toward theocracy in the oil-exporting countries would increase the likelihood that they will use oil as leverage to increase their influence around the world, especially as it applies to the West’s support of Israel. Based on our experience with the Arab members of the Organization of Petroleum Exporting Countries (OPEC) in the 1970s, there most certainly could be an initial shock to global oil supplies.

A prolonged oil embargo would have a devastating effect on the global economy. In particular, an oil embargo, if maintained, would retrict the supply of oil available. If there is no oil available, it really does not matter what price you might be willing to pay for it. This brings back memories of the lines at gasoline stations in the 1970s. [The 1973 oil crisis started in October 1973, when the members of Organization of Arab Petroleum Exporting Countries or the OAPEC (consisting of the Arab members of OPEC, plus Egypt, Syria and Tunisia) proclaimed an oil embargo in response to the U.S. decision to re-supply the Israeli military during the Yom Kippur war; it lasted until March 1974. According to the National Bureau of Economic Research, the recession began in November 1973 and ended March 1975. I moved to Washington, DC, to work at the Board of Governors of the Federal Reserve System in August 1973, just in time for the oil embargo and gas lines.]

Although I do not consider a widespread oil embargo the most likely outcome, it is possible. Nevertheless, I believe that any disruptions to oil supplies, if applied by OPEC, would be temporary (six months or less) because the new regimes in the oil-exporting countries, whatever they might be, will need revenue to make the revolution domestically popular; that is, to stay in power. Since the only major source of revenue available to these countries is oil, they will need to sell oil. In fact, I contend that the resulting higher oil prices from an OPEC wide oil embargo would create a huge incentive for these countries to cheat.

Crude oil prices are expected to go higher regardless of whether there are regime changes in the Middle East. Nevertheless, it is unclear that higher oil prices alone would be enough to derail the U.S. economy. According to most econometric models, a $10 increase in the price of a barrel of crude oil (if sustained for a year and assuming nothing else changes) would detract about 0.2 percentage point from U.S. real gross domestic product (real GDP) growth over the four quarters of 2011. In other words, if the price of oil per barrel increases $10 and remains at this higher level for the remainder of 2011, it would mean that real GDP would grow 3.7% over the four quarters of this year rather than the 3.9% increase shown in the February 2011 issue of the Laufenberg Economic Quarterly. It would also boost the average unemployment rate 0.1 percentage point (8.8% instead of 8.7%) and the fourth-quarter to fourth-quarter advance in the consumer price index about 0.2 percentage point (2.4% versus 2.2%) in 2011. In other words, at this stage of the U.S. expansion, oil prices would have to climb dramatically (probable in response to an oil embargo) and remain elevated for a considerable period of time before it would derail the expansion and push the U.S. economy into another recession.

After all, the U.S. is far less dependent on the Middle East for its oil now than it was in the 1970s, but it is still very dependent on imported oil. And given that the rest of the world uses more oil today than they did in the 1970s, any reduction in supply of crude oil will have a noticeable impact on global growth. More importantly, other countries may be better positioned to compete for oil on a price basis than the U.S., especially if the new governments in the oil-exporting countries do not impose an embargo but rather insist on being paid in a currency other than U.S. dollar. This would put considerable downward pressure on the dollar, which in turn would make U.S. products far less expensive and imports considerably more expensive (including imported oil). On the one hand, it would boost consumer inflation, which could depress consumer spending if wages did not keep pace. On the other hand, it would boost economic activity around exports. On balance, this outcome most certainly would have a net negative effect on the U.S. economy. Whether it would be enough to derail the U.S. economy at this stage of the expansion is unclear. I doubt that oil prices would go high enough to do so. After all, the rest of the world still relies on the U.S. as important customer. Without the U.S. buying their products, their economies would suffer.

Of course, it is easy to imagine all kinds of horror stories around events in the Middle East, in part because we have seen some in the past. Also, fear is easy to sell. Indeed, the basis of advertising is fear—fear of not looking good, not being healthy, not being cool, not being seen in the right places, not driving the right car, etc. The key here is not to let fear drive your investment decisions.

That being said, I still expect another recession in a few years. If it takes that long for all of this to play out (which I doubt), it will be just another factor weighing on the economy by then. If events unfold faster and the new regimes turn out to be as anti-west as now feared, then they most likely will slow the pace of the expansion but I doubt that they will derail the expansion.

Obviously, the market does not like uncertainty and events in the Middle East have increased uncertainty. But I would be reluctant to make any major changes in my investments in light of these developments. Be sufficiently liquid to withstand a prolonged oil crisis, but do not get trapped by it. Indeed, the current situation may turn out to be another buying opportunity rather than the beginning of another bear market. My stock market indicator agrees--it is still very positive. This means that any decline in the stock market is likely to be temporary. However, temporary may mean it lasts for several months. Traders typically consider the long run to be a month, while investors consider the long run to be several years. Those of you who asked may recall that in October 2010, my estimate for the S&P 500 for October 2011 was 1300 to 1350. Since we are already above the lower end of that range, I would not be surprised if the stock market remains in a wide trading range between now and then, and that most of the price appreciation in equities in 2011 may already be behind us. Nevertheless, I also believe that the S&P 500 will climb to 1450 sometime in the next two years, so I am willing to be patient during times like this.

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


2011 Commentary

Living in interesting times
-- September 8, 2011

A not so pleasant surprise!
-- September 2, 2011

Surprise!
-- August 16, 2011

Debt ceiling politics
-- July 25, 2011

Q2 growth: Another disappointment likely
-- July 14, 2011

Interpreting the ISM manufacturing index and the employment situation report for May
-- June 4, 2011

A slower start to 2011 than anticipated earlier
-- April 14, 2011

Is the dollar's status as the reserve currency at risk?
-- March 21, 2011

More trouble in the Middle East
-- February 26, 2011

Searching for the next debt crisis
-- January 13, 2011

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