Geopolitical risks changes benign equity outlook

By Neil Behrmann

February, 2006:- The attempt to sabotage Saudi Arabia’s oil processing production illustrates that global stock markets have been blissfully ignoring geopolitical risks.

Had the suicide bomb attack on the huge Abqaiq facility been successful, about 8 per cent of global oil supplies would have been hit. It is likely that crude oil prices, which spiked in response to the news on Friday, would have soared well beyond last year’s peak of $70 dollars a barrel. Global stagflation would have been the prospect, and with the exception of energy companies, the general earnings outlook would have been poor. Even though the attack failed the scare is sufficiently serious to keep oil quotes around current heights for some time. The vulnerability of the Saudi regime is again under scrutiny.

It will be interesting to see whether stock markets in coming weeks follow previous terrorist attacks and shrug off the latest warning. It would not be surprising if they do. The vast majority of fund managers and other equity investors are in denial about potential geo political crises that would damage economies and stock markets. This is an understandable psychological response as investors are human. They prefer to go about their business and buy stocks on the basis of a benign economic environment. They do not want to think about the unthinkable. North American, European, Japanese, Singapore, Hong Kong stocks are thus not pricing in any geopolitical risk premium. The bear market of 2000 to 2003 is already just a memory and yet the risks today are potentially greater.

Markets could have a setback in coming months

The bear market which began early 2000 after the equity bubble burst accelerated after September 11, 2001. It climaxed late 2002 and early 2003 ahead of the invasion of Iraq. At that time depressed shares carried a high risk premium, even though it was evident that the US and Britain would easily win the war with their superior weaponry and forces. Indeed in the days before the March 2003 war, stock markets bottomed and then surged in anticipation of swift victory and easy transition towards Iraqi democracy. Since the new bull market began, several markets, including Japan, Germany and Singapore have soared by 100 percent or more, the UK, French and Hong Kong indices are up by more than 80 per cent and America’s S&P 500 index has risen by by 65 percent. Emerging Portfolio Fund Research estimates that almost $18 billion has flowed into surging emerging market funds in the first eight weeks of this year, almost as high as the record inflow of $20 billion in 2005. Money has poured into commodities and mining shares which have reached heights beyond the wildest expectations of experts in that field.

The consensus view is that there are few clouds in the sky. US and European market average earnings yields, (the inverse of price earnings ratios) range between 5.5 and 7 per cent, compared with US three month rates of 4.8 per cent and ten year bond yields of 4.6 per cent. The Japanese average earnings yield is under 3 per cent. Equities are a hedge against inflation and earnings yields, which include this factor are thus not high enough to reflect the geo political risk premium.

Here are the geopolitical risks:

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