Deeper Implications of Middle East Turmoil

It is important to understand how the events unfolding in the Middle East can and will affect the rest of the world, including the United States.  The markets and media are not discussing these issues to the extent needed, so we want to share some excerpt from an article by Mercenary Trader that addresses some of these issues. Notice that many of these fall under the theme of "increased inflation".

Increased pressure on U.S. consumer discretionary income. Higher food and energy prices act like a regressive consumption tax, taking money from consumer wallets and hitting lower income spenders the hardest (as food and energy is a higher proportion of total budgets). The frightening possibility here is that the recent uptick in consumer spending, a possible “wealth effect” brought about by QE2 and rising markets, could dissipate just as the real pain of rising gas and grocery costs begins to bite.

Increased pressure on corporate profit margins. There are certain industries and sectors that do quite well against a backdrop of rising food and energy prices. Unfortunately, most do not. Investors conveniently forget it was inflation that Businessweek blamed for “The Death of Equities” when the famous cover ran in the late 70s. (The 1979 subtitle: “How Inflation is Destroying the Market.”) We are in the early stages of a potential new inflation cycle with profit expectations unduly optimistic. Rising input costs on the food, energy and materials side could hit corporate margins just as the long stretch of productivity gains from cost-cuts peters out.

Increased risk of recession via deflationary shock. As we noted in Deflationists Still In It To Win It, a key argument of those still bearish is that the anemic U.S. recovery, driven as it is by stimulus drugs and thinly justified hopes, is still vulnerable to exogenous shock. Along with multiple other candidates, a further surge in oil prices could be that shock. As James Hamilton of Econbrowser notes in respect to oil market disruptions and economic downturns since WWII, “Every recession (with one exception) was preceded by an increase in oil prices, and every oil market disruption (with one exception) was followed by an economic recession.”

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