Market Uncertainty the Four Fronts of Concern

With equities yielding to the pressures of an economic slowdown, the heydays of the decade-long bull market appears to be coming to an end. The multiple effects of oil price shocks, fear of high inflation, rising interest rates, and world tensions are pointing to an inevitable decline in global equity markets.

Many investors are beginning to realize that recent declines in U.S. stock markets are more than just a short-run phenomenon. Nearly all facets of the stock markets have experienced dramatic drops in their profits. The rapid early growth in the market was in large part due to consumer optimism fueled by the self-fulfilling prophecy of an equities driven "wealth effect." However, with consumer confidence beginning to sway as profit growth slows, uncertainty is creeping into investors' minds from four separate, but equally unsettling "fronts."

The Oil Front

The most obvious potential cause of an economic slowdown is the unrelenting oil price shock. Even though oil prices have slowly come down from nearly $40 per barrel, the lingering effect upon the economy and profit growth will stay with us until well into next year. Meanwhile, the effects of the oil price hikes are making their way through the producer level and are eventually going to be felt by consumers just as we move into the fourth quarter and the holiday shopping season. With fears of a global recession fueled by the high oil prices, many consumers are beginning to cut back on aggregate demand, an outcome that will further crimp economic growth. Wall Street pundits and incumbent politicians in Washington, D.C. want us to believe that our economy can no longer be affected by an energy crisis. Investors, as Stephen Roach of Morgan Stanley Dean Witter notes, should not discount oil price shocks, "History does not look kindly on the view that an oil shock is a non-event for the global economy. Such a disruption rarely happens in isolation from other factors that also put pressure on the macroclimate. In that important respect, today's circumstances are strikingly reminiscent of past. The Fed and the ECB have both engineered significant monetary tightening over the past 15 months. The lagged impacts of those moves are only just beginning to play out."

The Fed Front

The results of the Fed rate hikes are also adding to the economic slowdown. The increased interest rates have significantly increased borrowing costs for consumers and businesses. As consumers restrain their spending, a faltering consumer confidence is sending clear signals of a spending pull back going into the holiday season, which many analysts predict will in no way match the record high retail sales figures of 1999.

Another issue facing the Fed is the continued tight labor market. Wage growth remains a constant threat with the unemployment rate recently falling to 3.9 percent. Concern is mounting that worker's bargain positions are strengthening as the tight labor market continues into the busiest season for retail sales.

The recent decision by the Fed to leave rates unchanged, and to maintain a bias towards a tight monetary policy, signals that the Fed is still concerned that the economy has more slowing ahead before the policy will be reversed. Unfortunately, if the Fed's timing is off, inflationary risks could very well strengthen, introducing the possibility of another boom-bust scenario as seen in the 70s.

The Euro Front

Investor confidence has further been tarnished by the recent impact of the withering euro. Much of corporate America is issuing warnings on third quarter earnings due in large part to the weak performance of the euro. Many investors were hoping for a soft landing to the economic plunge, however, the weak euro has U.S. multinational companies announcing large drops in their profits as they translate to dollars from euros.

Concerned about the recent lack of performance from the euro triggering more global economic woes, European and American central banks have joined with Japan to buy euros in a concerted effort to prop the ailing currency. More recently, the European central bankers have taken to hiking up interest rates in order to further boost the economy. Many analysts feel that a simple rate hike will do little, and it certainly is not going to help growth in the economy. "If you look at their economic condition it doesn't look like their economy is going to be humming along any time soon," said Ralph DelZenero, vice president at Bank One Capital Markets in Chicago. While the euro and the European market may recover, given time, the investor confidence lost will be very difficult to regain.

The Middle Eastern Front

Adding to the worldwide uneasiness is the emergence of violent outbreaks of world tension. In the continuing crisis between Israel and the Palestinians, Wednesday's talks in Paris failed to secure peace.

More importantly, Iraqi president Saddam Hussein and Iranian leaders have raised the stakes in the current conflict over the Gaza strip. Iran's sobering statement regarding the conflict demonstrates its unwillingness to work toward a peaceful settlement. "The only solution to the current conflict is to continue the holy war against the enemies of Islam, and that will not stop," said Iranian supreme leader Ali Khamenei. The Iranians can back their threats with the recent deployment of the Shihab-3 ballistic missile, which is capable of reaching Israel. According to Iranian authorities the missile is meant to be a defensive weapon and part of a "policy of strengthening its defense capability on the basis of the principle of deterrence."

Hussein was even more disturbing in his televised displays of anger and threatening statements. He stated that his country would be able to effectively destroy Israel in a short period of time and that Iraq didn't need to wait for the lifting of sanctions before striking Israel. Even Iraqi citizens are qualifying Saddam's current statements as some of the most threatening statements he has made in years.

The possible implications of an all-out war in the Middle East would be devastating to the world economy. With worldwide oil supplies as tight as a 55-gallon drum, countries like Iran and Iraq hold the potential to create an economic crisis overnight. Their contribution to the world's supply of oil could be critical, if demand jumps during the winter--an opportunity either country would love to leverage for both political and economic reasons.

We are inching closer to an economically grave situation as noted by Roach, "My greatest concern for world financial markets is that an oil shock is inherently stagflationary - it both cuts output and increases inflation. Many of today's investors were still in diapers during the great stagflation of the 1970s. Those who weren't will never forget the darkest period in modern financial market history. It was as far from a zero-sum outcome as you could imagine."

Investors need to do more than just be aware of the possible threats to their wealth. They need to act. Act now to properly diversify your portfolio against an extended downturn in the stock market. Gold is consistently the most negatively correlated asset to stocks and investors should take advantage of today's low gold prices to diversify their portfolio before events affect your hard-earned wealth.