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Markets: Tipping Point?
New York: October 15, 2007
By John R. Stephenson

It seems like all is forgotten. The markets have recovered nicely since the August sell-off with the S&P 500 hitting new highs. Volatility is down and a great buying opportunity in base metals and oil & gas names seems to have subsided. So are we done? Probably not! A wave of protectionist sentiment seems to be enveloping most of the western world at precisely the time when globalization seems to be hitting its zenith. So just what are the likely scenarios and who are the likely beneficiaries?

That's hard to say, but it seems that the possibility of a future shock to the markets has only increased rather than decreased in recent months. That's because several forces appear to be on a collision course. When those forces meet, and they eventually will, there will be a dramatic shock to the market. So what could go wrong?

The most important economic influence over the last thirty years has been globalization. The influence of the free flow of goods, services and ideas can't be understated. It is the force behind the rise of China and the strength of the US stock market at the precise time when weakness should be expected. With more than half of the companies that comprise the S&P 500 deriving more than 50% of their revenues from abroad, US dollar weakness is translating into record US dollar earnings and increasing highs for the S&P 500.

But just as the fruits of globalization are starting to be harvested a strong protectionist sentiment is sweeping through Europe and the United States. A potent combination of waning economic influence, the high cost of "regime change" and worries about terrorist activities on the home turf threaten to destabilize the very growth that has allowed the world to prosper over the last several decades. From Europe's refusal to accept Muslim Turkey into the European Union to US lawmakers who are threatening a punitive 27.5 percent tariff on Chinese imports unless the country revalues its currency upward, the West is in danger of becoming a gated community.

But no matter how rich our societies are, the risks to entrenchment from the global community cannot be overstated. Behind the protectionist gates, a society is cut off from the dynamic and ever changing nature of the modern global economy. Only through the free exchange of information, people and commerce can a sustainable global economy be built. Engagement, not estrangement, is the necessary precursor for a successful domestic economy and a more stable world.

Unfortunately, many governments in the West are practicing policies of estrangement and isolation while the risks for such a course of action remain higher than ever. Countries or regions where instability and isolation are the order of the day are breeding grounds of crime, terrorism, refugees, drugs and disease. Yet as we find our own economic grip on world affairs loosening, we are increasingly choosing to isolate those countries that are least like us.

Economic growth and political stability go hand in hand. In regions where there is political chaos there is an absence of a vibrant functioning economy. But the implications of political and economic instability are often broader than the specific country or region in which the instability occurs. If a neighboring state were to fail, the consequence could result in chaos in adjacent countries as refugees, armed conflict and disease spill across borders. For all these reasons citizens and nations should engage in the policies of engagement and openness rather than retreating behind the fortifications of their own making.

When these shocks occur they have huge implications for investors. This is increasingly true in a world that is ever more interconnected and global in nature. Today, the shocks to the world order are increasingly coming from fringe players within a society who is concerned about advancing its own political agenda rather than furthering a capitalist agenda.

So what are the likely threats to world order? Increasingly, they are coming from jihadists who are willing to sacrifice their lives in exchange for an outlet for their anger and a sense of pride and purpose. They have little economic stake in the success of their nations. Only through openness and engagement can we appease these sub-factions within their various societies.

Nowhere is the threat to world order more ominous than the intersection between terrorism and weapons of mass destruction. Stopping the proliferation of nuclear weapons is mission critical for the West since the destabilization of the economic order and hence the world stock exchanges can only be assured if the threat of rogue elements armed with nuclear technology is contained.

One area of concern is Iran, which is too big and influential to be ignored. It borders Turkey, Afghanistan, Pakistan and Iraq and has the distinction of being the only country where its highest elected official must answer to an unelected "supreme leader." Not only that, but it holds about 11 percent of the global oil reserves and the world's second-largest natural gas reserves and is moving at breakneck speed to acquire nuclear weapons. By some accounts, it may already have succeeded in becoming a nuclear nation, a sobering thought for the 60 percent of Israelis who inhabit Tel Aviv.

Iran is home to the only religious revolution in modern history and its voice influences debate throughout the Muslim world. Ruled by a conservative religious elite, the country has gone to extraordinary lengths to shut out the forces of globalization. Much of the blame for Iran's isolation can be placed squarely at the feet of the West, particularly the United Kingdom and the United States who for decades have manipulated and exploited Iran.

When the Shah of Iran was deposed in 1979, there were 30 million people in Iran. Today, there are closer to 70 million with more than 70 percent under the age of twenty-four. As Iran's population has grown, its economy has shrunk and is now a third of what it was in 1978. Not only has the economy shrunk but also the country has endured a brutal eight-year war with Iraq, which killed 300,000 Iranians, wounded 600,000 to 700,000 more and made refugees of 2 million. Many Iranians today believe that if they had a nuclear deterrent in 1980 they would have been spared that horrific war.

But for the youth of Iran the situation is untenable. They want jobs and a vibrant economy. They want access to Western culture and the things that a liberal and outward looking nation can bring. Unfortunately, U.S. — enforced isolation has offered up what the Mullahs would want. The message to the youth of the country is that the West hates you and that they are working hard to undermine your dignity and the future of Iran.

For Israel, the stakes couldn't be higher. Iran is rushing towards nuclear technology at precisely the same time that their leader, Mr. Ahmadinejad, has been denouncing the Holocaust as a myth and stating that Israel should be wiped off the map. Will Israel, whose population is concentrated in a small area, show restraint or will it act unilaterally to stop the development of these weapons is anyone's guess. Even if the U.S. or Israel were to launch such an attack, the likelihood of total success is not great since many of the country's nuclear facilities are housed underground and spread widely across the country. The only solution to ridding Iran of these weapons would be a sustained ground invasion after an aerial bombardment, a difficult scenario to contemplate given the ongoing conflict in Iraq.

But if Iran were to dissolve into chaos either through war, military strikes or civil war, the implications for investors and the world at large could not be greater. A nuclear state that dissolves into chaos may send nuclear equipment and technologies in all directions.

China is another country that investors should watch with keen interest. Not because of its economic success, but because of the political evolution which is necessary, to keep the country stable and economically successful in the years that lie ahead. China's dilemma is increasingly a global dilemma since its influence on world politics and markets is great and growing.

In China, the government and the economy are one. The reason China has been growing at around 9 percent or more for the past twenty-five years is the ability of the government to unilaterally make decisions and mobilize the country's massive workforce. But in spite of the country's impressive economic performance, the Communist Party refuses to tolerate political dissent and most of the important decisions are made in secret.

China has economic openness but is closed politically. This is a recipe for a future disaster since the benefits of such a system are likely to benefit only a minority of people — those capitalists that are politically well connected. At some point, the fact that the wealth is unevenly distributed will become a huge problem for China, as the social frustrations this will cause will have no politically acceptable outlet.

According to the Chinese state media, the wealthiest 20 percent of Chinese earn half of the country's total income where the poorest 20 percent earn just 4.7 percent. In 2001, 10 percent of the population was sixty-five or older while in 2030 that number should exceed 25 percent. How will the government respond when 300 million Chinese start demanding pensions and subsidized medical care?

Not only are demographics and wealth distribution pressing issues for China to grapple with, but pollution is also a major concern. Nine of the world's ten most polluted cities are in China. Acid rain falls on over one third of China's agricultural land and a quarter of the country is a desert.

Just how China and Iran evolve is increasingly important to investors. Alone, or in combination, an unpleasant evolution could spell problems or opportunities for investors. In investing, the vast majority of the upside comes from investing with a profitable trend in place. But the most money can be made at inflection points when a new trend supplants an old one. Both of these countries, for various reasons, are too big and influential to be ignored. To determine the best course of action for investors, these countries should be watched with keen interest because increasingly, their destiny is our destiny.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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