One of the lessons we have learned from the Fund King System is that cycles do exist and participating in them can have a significant impact on downside protection and long term returns. The timing and the magnitude are not perfectly predictable but one need only be ready for the next wave and jump on when it becomes evident.

With Greek mobs burning buildings to celebrate the deals being struck to tame the Greek Sovereign Crisis, one can sense that the market has fully discounted nearly every ugly outcome from this real life financial tragedy. A Eurozone recession, bank bailouts, austerity programs and at least one or two exits from the Euro are “baked in” to the market.

As a result, the most watched measurement of volatility, the VIX, is at a very subdued level.

VIX Volatility

Source: Bloomberg.com

So this week, we think it is worthwhile to look at the risks in the market to see what might drive the VIX to much higher levels.

The two big macro risks which spring immediately to mind are a military strike against Iranian nuclear facilities and an inflationary spike in the US.

Military Strike Against Iran

Even though the US and EU have been tightening the sanctions regime on Iran of late, the Islamic Republic appears to be forging ahead with its “peaceful” nuclear enrichment program. The leadership of Iran protests that nuclear weapons are not the goal while Israel is playing the “bad cop” to the Obama administration’s “good cop”. There are a few points (as highlighted in the Wall Street Journal) that make an Israeli airstrike in the coming months credible:

  1. Syria, Iran’s ally and Israel’s neighbor, is embroiled in near civil war conditions,
  2. the rest of the Arab world would not mind seeing Iran’s influence in the Middle East taken down a peg,
  3. Israel does have the airforce and bunker busting ordinance to inflict serious damage on Iran’s nuclear enrichment facilities,
  4. Israel has a track record of attacking nuclear facilities in Iraq and Syria when development seemed to threaten its existence.

The risk of a strike is low (Stratfor seems to think it very unlikely) but not low enough for investors to ignore. Iran’s most likely response will be to mine the Straits of Hormuz to choke off a significant amount of the world’s daily oil flow and a conventional ballistic missile strike on Israel. Although the US will certainly be informed of any strike, may be complicit in providing resources and is winding down the second of its two recent adventures in the region, Iran will not want to take on the US directly in its retaliation.

The market reaction? A short sharp price spike in Oil, Precious Metals and “safe” assets like US Treasuries is the most likely. Building a small exposure to these assets (particularly the first two) is a sensible precaution. If nothing happens, an economic recovery and the risk of US inflation would probably benefit energy and precious metal asset classes anyway.

Inflationary Spike in the US

The consensus for a long slow recover in the US is another “baked in” conclusion in the market. However, taking the recent past and projecting it in a straight line into the future is a risky bet. An inflationary spike (a temporary move to double digit inflation, for example) could arise if banks were to start lending out the high powered money created by the Federal Reserve in response to the Global Financial Crisis.

Could it happen? Already, we are seeing signs that the most bombed out property market, Las Vegas, is starting to see some clearance in January. Prices don’t have to move up for the banks to start to see the light at the end of the tunnel and restart their mortgage lending machines.

For an incumbent president running for reelection, a reigniting of “animal spirits” amongst loan officers at the banks is not a fire that the deflation-phobic Bernanke FED is going to rush to fight. With a commitment to keeping rates low through 2014, the FED can allow banks to rebuild their balance sheets while dominating the secondary market in Treasuries to keep interest rates on US debt low.
Whether the FED is able to stuff the inflation genie back into its bottle once released is another matter.

Traditionally, hard assets like commodities would be a desirable hedge against this type of inflation. However, with global demand likely to remain subdued in the short term (on the back of a European recession), hard assets in the US (like real estate), may be the better choice for the first move. If the inflation stokes demand that spills over into export orders for China, then industrial commodity plays would be an excellent way to catch the second wave.


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