2012 was a year when politics at times trumped economic fundamentals, from worries about a break- up of the euro zone to anxiety about U.S. budget policy. In 2013, security concerns may do the same thing.
In the Middle East, the U.S. and Israel are on a potential collision course with Iran over that country’s nuclear program - - a clash that could roil oil markets throughout the year. The region also is racked by fighting in Syria that threatens to escalate and spread the longer it goes on. In Asia, a still- unresolved territorial dispute between China and Japan already has undercut trade ties, hurt companies including Toyota Motor Corp. (7203) and contributed to Japan falling back into recession.
“The uncertainty that is out there with respect to Iran, as well as other parts of the world, is something that is very, very real,” said retired Navy Admiral Michael Mullen, a former chairman of the U.S. Joint Chiefs of Staff. “The global economic impact of another war in that part of the world would be pretty draconian.”
Investors seem to be underplaying the risks, according to strategists at Bank of America Corp. A survey of U.S. credit investors last month by the bank found just 6 percent citing costlier crude oil as a major concern.
Bonds of all types worldwide were on pace to return 5.84 percent this year as of Dec. 14, about the same as in 2011, which was the most since 2002, according to the Bank of America Merrill Lynch Global Broad Market Index, which tracks more than 21,000 securities with a market value of about $45.9 trillion.
The S&P 500 has returned 16 percent including dividends this year, compared with an average calendar-year return of 3.5 percent since 2000, according to data compiled by Bloomberg.
Volatility measures also suggest that financial markets aren’t particularly fazed by the geopolitical and other dangers out there, said Robert Engle, winner of the Nobel Prize for economics in 2003 and professor of finance at New York University’s Stern School of Business.
The Chicago Board Options Exchange Volatility Index, known as the VIX, has fallen about 30 percent this year to 16.34 (VIX) yesterday. That compares with an average of 20.45 as of Dec. 14 since calculations started in 1990.
Russ Koesterich, chief investment strategist at BlackRock Inc. (BLK:US) in New York, said investors may want to have “some exposure to energy companies” that would benefit from higher oil prices.
The VIX also may increase if tensions in places such as the Middle East worsen. “Volatility is very low, so could rise,” Koesterich, whose company manages $3.7 trillion, told reporters in a presentation from Tokyo on Dec. 12. “Geopolitics aren’t dead.”
Confluence Investment Management recommends that investors put 5 percent to 10 percent of their money into “hard assets,” such as gold, as a buffer against geopolitical and financial risks, said Bill O’Grady, chief market strategist. The St. Louis-based company manages more than $1.5 billion.
The focus of financial markets in the closing days of 2012 is on Washington, where President Barack Obama is trying to work out a deal with Republican lawmakers to avoid more than $600 billion in automatic spending cuts and tax increases next year. Failure would push the U.S. into recession, according to the nonpartisan Congressional Budget Office.
Concerns about the projected fiscal squeeze are “already affecting business investment and hiring decisions by creating uncertainty” or “pessimism,” Federal Reserve Chairman Ben S. Bernanke said at a Dec. 12 press conference in Washington. “Clearly this is a major risk factor.”
Politics also has been at the forefront in the euro region in the past year. Greek elections in June delayed a bailout as anti-austerity leaders gained ground. Francois Hollande won power in France questioning Germany’s crisis-fighting strategies, and Spain put off requesting a politically unpopular rescue.
Just this month, Italian bond markets were rattled when Prime Minister Mario Monti announced his intention to resign after losing the support of billionaire former premier Silvio Berlusconi’s party. Berlusconi now is campaigning against Monti’s austerity agenda ahead of an election that probably will be held in February. Germany also has elections next year.
The seeming lack of concern among investors about developments in the Middle East isn’t surprising, according to Robert McNally, a former White House energy adviser and now president of the Rapidan Group in Bethesda, Maryland, an energy- market and policy-research company.
For the past nine years, the U.S. and Israel have been warning they wouldn’t tolerate further advances in Iran’s nuclear program, he said. Still, nothing happened.
The two countries and European allies accuse the Iranians of pursuing a nuclear-weapons capability. Iran says its program is for civilian energy and medical research.
“It’s like the boy who cried wolf,” McNally said. Just as the wolf eventually does show up in the fable, 2013 may be the year when the U.S. and Israel finally make good on their threats as Iran closes in on nuclear capability, he said.
Former U.S. ambassador to Iraq James Jeffrey agreed that the president will follow through on his warnings if Iran appears to be on the verge of developing a weapon.
“I think if we don’t get a negotiated settlement and these guys are actually on the threshold, as Obama said during the campaign, then the president is going to take military action,” said Jeffrey, who is a visiting fellow at the Washington Institute for Near East Policy.
He added that a “decision point” will come around the middle of the year if there is no deal and Iran pushes ahead with its uranium-enrichment program.
Obama and other top U.S. officials have repeatedly said they prefer a nonmilitary resolution and have stiffened sanctions in hopes of achieving it.
“There is still a window of time for us to resolve this diplomatically,” the president told a White House news conference on Nov. 14.
Retired Navy Admiral Dennis Blair, a former U.S. Director of National Intelligence, said he’s “more than 50-50 thinking we can succeed” in getting an agreement. “There is a basis there for a deal.”
Oil prices would spike by more than $20 a barrel if negotiations fail and Iran’s nuclear installations are attacked, according to an October survey by Rapidan of about two dozen oil traders and analysts.
Prices would rise an additional $25 if Iran retaliated by disrupting shipments through the Strait of Hormuz, even with the release of oil from national stockpiles held by the U.S. and other energy-consuming nations, the survey found.
The consequences for the world economy of a military attack would be “dire,” according to McNally.
The markets already are tacking on a $10 to $15 per barrel premium to take account of the risk of supply disruptions in the Middle East, said Nariman Behravesh, chief economist for IHS Inc. (IHS:US) in Lexington, Massachusetts. He put the chances of an attack against Iran in 2013 at 20 percent to 30 percent.
Brent oil, the benchmark grade for more than half of the world’s crude, has gained less than 1 percent this year. Futures for February settlement fell 54 cents to $107.64 a barrel yesterday on the London-based ICE Futures Europe Exchange. West Texas Intermediate, the U.S. benchmark, has fallen about 12 percent on the New York Mercantile Exchange in 2012 because of the U.S. shale-oil boom. The January futures increased 47 cents to $87.20 yesterday.
“We are heading for a perfect storm” in the region, said Henri Barkey, a former U.S. State Department official who is now a professor at Lehigh University in Bethlehem, Pennsylvania.
He pointed to the dispute over Iran’s nuclear program, the rebellion against its ally Bashar al-Assad in Syria and the recent conflict between Israel and Tehran-backed Hamas, which controls the Gaza Strip and is considered a terrorist organization by Israel, the U.S. and European Union.
The Syrian regime has recently escalated to “more vicious weapons” such as missiles and anti-personnel “barrel bombs” in its battle with the rebels, State Department spokeswoman Victoria Nuland said in Washington on Dec. 12.
Obama has warned Assad against deploying or distributing the country’s stock of chemical weapons.
“If you make the tragic mistake of using these weapons, there will be consequences and you will be held accountable,” the president said in a Dec. 3 speech at the National Defense University in Washington.
The fighting -- which opposition groups estimate has killed more than 41,000 people -- already has spilled over into Turkey, the world’s 15th biggest economy. The U.S. last week agreed to send two Patriot anti-missile batteries and 400 American personnel to Turkey to help defend against potential Syrian attacks.
In Asia, the world’s second and third largest economies are at odds over ownership of a group of islands in the East China Sea. The standoff has soured the $340 billion trade relationship between the two as Japanese car producers Toyota and Honda Motor Co. (7267) run into a backlash from Chinese consumers. The number of Chinese visitors to Japan also slumped 33 percent in October from the previous year.
The Japanese Coast Guard spotted a Chinese marine surveillance propeller plane last week near the uninhabited islands, known as the Senkaku in Japan and Diaoyu in China. While Japan dispatched eight F-15 fighter jets, the plane already had left the area. China said the flight was a normal activity in its own airspace. This was the first known violation around the islands by a Chinese plane, the Japanese Defense Ministry said.
Japanese Liberal Democratic Party leader Shinzo Abe, who is set to become prime minister after a Dec. 16 election victory, has pledged to increase control over the islands and bolster defense spending.
Such flashpoints probably will grow in the region as China exercises its increasing economic might, said Ian Bremmer, president of Eurasia Group, a New York-based consulting company. “This is going to cause a lot more impact in markets,” he said.
The world may be even more prone to geopolitical tensions in the years to come, according to Stephen Jen, co-founder of London-based hedge fund SLJ Macro Partners LLP. An index he helped craft based on elements including military expenditures and energy consumption shows that power is more dispersed than in any period since 1815, even though the U.S. and China wield the most might.
“When you have a power vacuum, countries are going to exert their own military strength or get into disputes with neighbors,” said Jen, a former International Monetary Fund economist. “We’re starting to see localized tension points already, and it’s hard to be too optimistic with this backdrop.”
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