The Shape of Things

H.G. Wells is considered the father of science fiction—he produced such classics as The Time Machine, The Invisible Man and The Island of Dr.Moreau. Orson Welles took his novel, The War of the Worlds, and created classic live radio theater. Wells’ prophetic 1933 work The Shape of Things to Come accurately predicted a number of World War II events. An unabashed socialist, he was also wrong about a lot of things, but Shape is probably more useful as a description of the kinetic forces already in place that would lead to global war. I read it in college in conjunction with Macbeth, another work of dark forces and prophecy, where many of the characters are swept along in a vortex of intended and unintended consequences.

Many of us have experienced situations where we lose control of our physical selves: the skidding automobile, the careening rollercoaster, the momentary loss of memory (what was I going to say?). Markets have these moments too, and unlike the several seconds of car skidding, a stop-us-in-our tracks memory loss, these “moments” can last months. What I am referring to is commonly called by economists and social psychologists, an “inflection” point – where, because of seen and unseen forces being put in motion, fates, fortunes and lives of many will be changed.

It is impossible to de-link inflection points between current political and economic affairs and market action. Yet investors are often surprised when market or commodity prices surge or crash. This is true even though the inevitable political and economic causes have been in the news for months, if not years. Take oil prices, which are largely a function of political uncertainty, demand and supply dynamics. Let us review: we have had a precipitous rise is Islamist-sponsored terror, a still unresolved Middle East war, and emerging Asian economic growth in excess of 8% per year since 2000. There was no dramatic effect on the markets in the early 2000s timeframe, but in 2005 and 2006 we began hitting $70/barrel oil with regularity.

What has changed appears very complicated on the surface, but it is actually quite simple. Forces that impact the markets directly (interest rates, housing, corporate profits, and consumer spending) have become more volatile during those two years and have combined with political and economic events (Iraq war, Asian demand for commodities etc.) When those forces line up in such a fashion, uncertainty reigns, and markets become capable of huge swings one way or another.

One thing is certain-- the politics of oil are not going to be less complicated. Geography (the Middle East) and uncertain alliances (Russia) will continue to be major forces in energy price volatility. Can it be otherwise with this group of owners?

What other forces are driving us to a market inflection point? Well, for one, central banks providing low or zero interest rates over the last few years have created huge pools of liquidity. This liquidity has spawned a whole new generation of hedge fund managers, who tend to trade maniacally and mostly in concert. Will the recent 17 straight Fed increases change their behavior and will they begin to bail from stock, bond and asset markets? Well, here is a clue from one sector.

Second, the large emerging economies, like India and China, are bringing “middle class” living to the people, much like the U.K. in the late 19th century, the U.S. in the 1950’s and Japan in the 1970’s. The difference is in the vast numbers of people --1.3 billion in China and 1.1 billion in India—multiples more than the 31 million (England in 1899), 125 million (U.S. in 1955) or 101 million (Japan in 1970). So these massive economies continue to bid up the price of commodities to build infrastructure, housing and to heat new homes. This underlying demand for oil and commodities will continue, even though there will be wild price swings along the way. Look at these numbers; of the top ten populations in the world, there are only two “developed” countries, the U.S. and Japan

Unlike the witches on the heath and Wells in 1933, I have no prophecies that I haven’t shared with you already. But when the hurlyburly’s done, expect the following to add some spice to the brew:

--Iraq will be a costly “protectorate” for years to come. Iraq and Iran account for 20% of the World’s oil reserves. That cauldron is only beginning to heat.

--A flattening of growth in the U.S. will create a probable Democratic takeover of U.S. political leadership in 2008. Many conservative market participants are beginning to figure out how to play that inevitability. The Thane of Crawford has done his party no favors.

--Commodity and oil prices will continue to be volatile, but the direction, based on simple supply and demand, is up through the next U.S.Presidential cycle. Toil, trouble and then bubble?