The Middle East – What’s Really Driving The War?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
July 18, 2006

IN THIS ISSUE:

1. Is This The Beginning Of World War Three?

2. Stratfor’s Analysis Of The Players & Motivations

3. Will Hezbollah Resort To American Hostages?

4. Where Things Go From Here In The War

5. On The Economy & The Fed– Recession Ahead?

6. On The Markets & Investing Now

Introduction

In a matter of only three weeks, the world’s geopolitical landscape, and indeed the international investment landscape, has been turned on its head. While I would hesitate to say that the war in the Middle East is spiraling out of control, there are those who are now predicting that we are witnessing the beginning of World War III. Although I would not agree with that assessment, the latest developments between Israel and Lebanon (and the related players – Hezbollah, Hamas, Syria, Iran, et al) are indeed troubling and could quickly deteriorate into something much more serious, especially if Israel were to attack Syria.

The global equity markets, not surprisingly, have reacted very negatively. While already in a downward correction, largely due to inflation concerns and fears of more Fed rate hikes, the equity markets sold off hard on the news of the war in the Mideast, and the fact that oil has soared to over $77 a barrel last week. The Dow has fallen over 1,000 points since the peak in early May, and it looks like we haven’t seen the bottom yet, what with Hezbollah rockets increasingly falling in Israel and the war escalating.

Over the past month or so, I have suggested that the recent drop in equities would provide a new buying opportunity, and that we are not headed for a recession. So is that advice out the window? Quite honestly, I’m not sure yet. We will have to let the events in the Middle East play out a little longer in order to assess whether the crisis will blow over or escalate much further, and how that will likely impact the investment markets. Simply put, we just have to wait and watch.

Along that line, I think it would be insightful for us to take a look at some of the latest analysis from our good friends at Stratfor.com regarding the situation in the Middle East. While the mainstream media is following the developments 24/7, Stratfor – as usual – has some insights and analysis on the terrorist groups in the Middle East that you won’t find in the mainstream press.

Hezbollah – The Players Out Front & Behind The Scenes

The following analysis from Stratfor is very interesting. Stratfor gives us a condensed history on the development of the current players in the Mideast, especially Hezbollah and Hamas. The terrorist groups like Hezbollah and Hamas are some very bad people. Plus, Stratfor gives us some concise information on which states are funding the terrorist groups in the region and are therefore pulling the strings (think Syria and Iran). Here we go:

"Hezbollah's decision to increase operations against Israel was not taken lightly. The leadership of Hezbollah has not so much moderated over the years as it has aged. The group's leaders have also, with age, become comfortable and in many cases wealthy. They are at least part of the Lebanese political process, and in some real sense part of the Lebanese establishment. These are men with a radical past and of radical mind-set, but they are older, comfortable and less adventurous than 20 years ago. Therefore, the question is: Why are they increasing tensions with Israel and inviting an invasion that threatens their very lives?

There is a generation gap in Hezbollah. Hezbollah began as a Shiite radical group inspired by the Iranian Islamic Revolution. In that context, Hezbollah represented a militant, nonsecular alternative to the Nasserite Fatah, Popular Front for the Liberation of Palestine, and other groups that took their bearing from Pan-Arabism rather than Islam. Hezbollah split the Shiite community in Lebanon -- which was against Sunnis and Christians -- but most of all, engaged the Israelis. It made a powerful claim that the Palestinian movement had no future while it remained fundamentally secular and while its religious alternatives derived from the conservative Arab monarchies. More than anyone, it was Hezbollah that introduced Islamist suicide bombings.”

Hezbollah is primarily supported financially by Syria and Iran (and arguably Russia). Hezbollah’s other primary source of income comes from the international drug trade. Hezbollah maintains a large network of processing centers for turning Afghan opium into heroin and operates methamphetamine labs in the Bekaa Valley, with some opium and marijuana produced locally as well. So Hezbollah is a major player in the world drug trade.

With that very distasteful element injected into the picture, let’s continue with Stratfor’s analysis of how the current Mideast crisis developed and, most importantly, what the likely outcome may eventually be:

"Hezbollah had a split personality, however; it was supported by two very different states. Iran was radically Islamist. Syria, much closer and a major power in Lebanon, was secular and socialist. They shared an anti-Zionist ideology, but beyond that, not much. Moreover, the Syrians viewed the Palestinian claim for a state with a jaundiced eye. Palestine was, from their point of view, part of the Ottoman Empire's Syrian province, divided by the British and French. Syria wanted to destroy Israel, but not necessarily to create a Palestinian state.

From Syria's point of view, the real issue was the future of Lebanon, which it wanted to reabsorb into Syria, or at the very least economically exploit. The Syrians intervened in Lebanon against the Palestine Liberation Organization and on the side of some Christian elements. Their goal was much less ideological than political and economic. They saw Hezbollah as a tool in their fight with Yasser Arafat and for domination of Syria.

Hezbollah strategically was aligned with Iran. Tactically, it had to align itself with Syria, since the Syrians dominated Lebanon. That meant that when Syria wanted tension with Israel, Hezbollah provided it, and when Syria wanted things to quiet down, Hezbollah cooled it. Meanwhile the leadership of Hezbollah, aligned with the Syrians, was in a position to prosper, [in] particular after the Israeli withdrawal from Lebanon. [Emphasis added, GH.]

That withdrawal involved a basic, quiet agreement between Syria and Israel. Israel accepted Syrian domination of Lebanon. In return, Syria was expected to maintain a security regime that controlled Hezbollah. Attacks against Israel had to be kept within certain acceptable limits. Syria, having far less interest in Israel than in Lebanon, saw this as an opportunity to achieve its ends. Israel saw Syrian domination under these terms as a stabilizing force. [Emphasis added, GH.]

Destabilization

Two things converged to destabilize this situation. The emergence of Hamas as a major force among the Palestinians meant the Palestinian polity was being redefined. Even before the elections catapulted Hamas into a leadership role, it was clear that the Fatah-dominated government of Arafat was collapsing. Everything was up for grabs. That meant that either Hezbollah made a move or would be permanently a Lebanese organization. It had to show it was willing to take risks and be effective. In fact, it had to show that it was the most effective of all the groups. They moved… The second part of this occurred in Lebanon itself. After the death of former Prime Minister Rafik al-Hariri, outside pressure, primarily from the United States, forced a Syrian withdrawal from Lebanon. Now, do not overestimate the extent of the withdrawal. Syrian influence in Lebanon is still enormous. But it did relieve Syria of the burden of controlling Hezbollah. Indeed, Israel was not overly enthusiastic about Syria's withdrawal from Lebanon for just that reason.

Syria could now claim to have no influence or obligation concerning Hezbollah. Hezbollah's leadership lost the cover of being able to tell the young Turks that they would be more aggressive, but that the Syrians would not let them. As the Syrian withdrawal loosened up Lebanese politics, Hezbollah was neither restrained nor could it pretend to be restrained. Whatever the mixed feelings might have been, the mission was the mission, Syrian withdrawal opened the door and Hezbollah could not resist walking through it, and many members urgently wanted to walk through it.”

Thus far, Stratfor has walked us through the Syrian involvement with the advancement of Hezbollah. While the Iranians had been involved all along, Stratfor next illustrates how the Iranians became a much larger influence on Hezbollah once Syria stepped back.

”At the same time the Iranians were deeply involved in negotiations in Iraq and over Tehran's nuclear program. They wanted as many levers as they could find to use in negotiations against the United States. They already had the ability to destabilize Iraq. They had a nuclear program the United States wanted to get rid of. Reactivating a global network that directly threatened American interests was another chip on the bargaining table. Not attacking U.S. interests but attacking Israel demonstrated Hezbollah's vibrancy without directly threatening the United States. Moreover, activities around the world, not carefully shielded in some cases, gave Iran further leverage.

In addition, it allowed Iran to reclaim its place as the leader of Islamic radical resurgence. Al Qaeda, a Sunni group, had supplanted Iran in the Islamic world. Indeed, Iran's collaboration with the West allowed Tehran to be pictured among the ‘hypocrites’ Osama bin Laden condemned. Iran wants to become the dominant power in the Persian Gulf, and one part of that is to take away the mantle of Islamic radicalism from al Qaeda. Since al Qaeda is a damaged organization at best, and since Hezbollah pioneered Islamist terrorism on a global basis, reactivating Hezbollah made a great deal of sense to the Iranians.

Hezbollah's Position

Syria benefited by showing how badly it was needed in Lebanon. Iran picked up additional leverage against the United States. Hezbollah claimed a major place at the negotiations shaping the future of Palestinian politics. It all made a great deal of sense.

Of course, it was also obvious that Israel would respond. From Syria's point of view, that was fine. Israel would bog down again. It would turn to Syria to relieve it of its burdens. Israel would not want an Islamic regime in Damascus. Syria gets regime preservation and the opportunity to reclaim Lebanon. Iran gets a war hundreds of miles away from it, letting others fight its battles. It can claim it is the real enemy of Israel in the Islamic world. The United States might bargain away interests in Iraq in order to control Hezbollah. An Israeli invasion [of Lebanon] opens up possibilities [for the Iranians] without creating much risk.

It is Hezbollah that takes it on the chin. But Hezbollah, by its nature and its relationships, really did not have much choice. It had to act or become irrelevant. So now the question is: What does Hezbollah do when the Israelis come? They can resist. They have anti-tank weapons and other systems from Iran. They can inflict casualties. They can impose a counterinsurgency. Syria may think Israel will have to stay, but Israel plans to crush Hezbollah's infrastructure and leave, forcing Hezbollah to take years to recover. Everyone else in Lebanon is furious at Hezbollah for disrupting the recovery. What does Hezbollah do?”

This is where Stratfor’s analysis becomes most troubling and, frankly, is the main reason I wanted to walk you through this whole exercise.

”In the 1980s, what Hezbollah did was take Western hostages. The United States is enormously sensitive to hostage situations. It led Ronald Reagan to Iran-Contra. Politically, the United States has trouble handling hostages. This is the one thing Hezbollah learned in the 1980s that the leaders remember. A portfolio of hostages is life insurance. Hezbollah could go back to its old habits. It makes sense to do so. [Emphasis added, GH.]

It will not do this while there is a chance of averting an [Israeli] invasion. But once it is crystal clear it is coming, grabbing hostages makes sense. Assuming the invasion is going to occur early next [this] week -- or a political settlement is going to take place -- Western powers now have no more than 72 hours to get their nationals out of Beirut or into places of safety. That probably cannot be done. There are thousands of Westerners in Beirut. But the next few days will focus on ascertaining Israeli intensions and timelines, and executing plans to withdraw citizens. The Israelis might well shift their timeline to facilitate this. But all things considered, if Hezbollah returns to its roots, it should return to its first operational model: hostages.”

Before I continue, I wish to thank Dr. George Friedman and all the good folks at Stratfor.com for allowing me to reprint portions of their analyses for you from time to time. I highly recommend their various intelligence services. For a limited time InvestorsInsight readers and ProFutures clients can subscribe to Stratfor for a special reduced price of only $199 per year. If you want access to Stratfor’s premium intelligence, this is a great deal – CLICK HERE. (FYI, I receive nothing whatsoever in return if you subscribe.)

Where Things Go From Here?

As this is written (and time to hit the “send” button), there is no way to know what will happen next in the Mideast crisis. All kinds of options exist. It is difficult to imagine that Israel will agree to a cease-fire even if Hezbollah agrees to return the captured Israeli soldiers, especially now that Hezbollah has intensified the rocket attacks.

Several Arabic nations that would not normally make such a gesture have joined to condemn Hezbollah, including Jordan, Saudi Arabia, Yemen, the United Arab Emirates and others. Thus, Israel must feel that it has an unprecedented window of opportunity to wipe out Hezbollah, or at least render it powerless. At the least, Israel will almost certainly attempt to disarm Hezbollah, what with rockets striking Haifa and other Israeli cities and potentially Tel Aviv.

I look for Israel to put the hammer down in the next few days and weeks. Look for Israel to intensify the bombings. I believe the prior bombings and air campaign have been to clear the way for a ground campaign that could begin any day now. I could be wrong, of course, but this looks like the most likely scenario to me. Stratfor seems to agree. Fasten your seatbelts!

One puzzling aspect to all of this, however, is why the US has not already ordered mandatory evacuations of Americans from Lebanon, given the growing threat of a ground invasion by Israeli forces and the intensifying level of bombing by both sides. Transportation out of Lebanon is being provided for Americans beginning today (Tuesday) but on a voluntary basis, not mandatory.

This has led some to speculate that the US is privy to some inside information suggesting that Israel will not invade, or that some last-minute peace accord is in the works. I find that doubtful, but stranger things have happened. It may simply be that it is taking longer to move the Americans out due to the large numbers and the logistics and safety issues involved in such an operation. In any event, it seems strange that this hasn’t happened sooner.

The United Nations, France and the usual suspects are demanding a cease-fire and warning against an Israeli ground invasion of Lebanon. But we should not be surprised to see Israeli forces inside Lebanon later this week (or perhaps even as you read this). As such, I expect the Mideast crisis will continue to be a destabilizing force in the markets for at least several more weeks to come. How destabilizing remains to be seen.

On The Economy & The Fed – Recession Ahead?

I had intended to devote this week’s E-Letter to a discussion of the latest economic reports, what is likely the next step(s) for the Fed, and what the impacts are likely to be for the markets. Let me briefly summarize, with the above geopolitical uncertainties in mind.

The US economy soared at an annual rate of 5.6% in GDP in the 1Q, well above expectations. As a result, most economists increased their forecasts for 2Q growth, with most expecting a number in the 3-3.5% range. The first report on 2Q GDP will be released on July 28. The economy clearly slowed down a bit in the 2Q. Personal consumption spending slowed; consumer confidence eased; leading economic indicators weakened; durable goods orders were down; and CEO confidence took a big drop in the 2Q.

Now as for GDP growth in the second half of the year, most economists have significantly revised their estimates lower – even before the war in the Middle East and before oil prices soared to new highs. The latest Bloomberg survey of 51 leading economists showed an average estimate of 2.7% GDP in the 3Q and 2.3% in the 4Q. This is consistent with my view in recent months that the economy would slow down rather significantly in the second half of the year.

Which leads us to what to expect from the Fed. There is now a broad consensus that the Fed will raise short-term rates yet again on August 8 to 5.5%. The big question now is whether the Fed will hike rates yet again on September 20. In its latest policy statement on June 29, the Fed stated:

“Readings on core inflation have been elevated in recent months… Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.”

Obviously, this statement gave no comfort to the markets that the Fed is done raising rates, and the war in the Middle East and soaring oil prices only made matters worse.

I have maintained all year, and even before, that we are not likely looking at a recession this year. I still believe that, even if the economy is on course to slow down significantly in the second half of the year. However, we must all admit that the odds of a recession, either late this year or next year, have increased in light of recent developments.

There is no way to know how things ultimately play out in the Middle East, or how high oil prices are headed. We routinely hear the talking heads on TV refer to oil prices of $100-$150 per barrel, despite the fact that the supply/demand fundamentals have not changed materially this year. While I don’t know how they support such claims, were oil prices to reach such lofty levels, or if the war in the Middle East were to devolve into a global conflagration, then certainly a recession is not out of the question. But I still do not believe it is the most likely scenario.

On The Markets & Investing Now

As noted above, the US equity markets have been in a downturn since May, exacerbated by the recent developments in the Mideast. Obviously, we could see more downward pressure if things deteriorate in the Middle East. Ditto if oil prices skyrocket, as some would have us believe. On the other hand, corporate profits and productivity remain very strong, and US stocks could rebound nicely. So stocks are a tough call at this point.

Bonds have been the beneficiaries of all the latest uncertainty and unrest in the Middle East. Bonds have historically been a refuge in times of international unrest. Additionally, if the US economy is going to continue to slow down, bonds could continue to gain ground in that long- and-medium-term rates could continue to ease. But with inflation continuing to hold above the Fed’s target, the upside for bonds is probably somewhat limited as well.

One of the most common questions I get is about the US dollar. There remains a very broad consensus that the US dollar will move lower over the long-term. I agree. Yet the dollar has surprised investors several times over the last couple of years with counter-trend moves to the upside, as has been the case since mid-May. The latest rally has not been impressive by any means, but it has been yet another rally. My analysis is quite simple: any time you have such a broad consensus that any commodity is going to move one way, there will almost invariably be occasional corrections in the opposite direction.

Gold. We have many clients who have more than a passing interest in gold and precious metals. As you know, gold made the largest move in decades over the last couple of years, with prices reaching $720 in May. Interestingly, gold moved from $550 in mid-March to $720 in mid-May, only to plunge back to $570 or so by mid-June. Now, it’s on the rise again with prices back up above $650. Obviously, this is not a market for the faint of heart, and it is not one which lends itself to reliable predictions at this point, at least in my opinion.

Oil. Commodity prices are famous (or infamous) for over-reacting on both the upside and the downside. Oil is particularly known for overshoots because of (in part) geographic sensitivities, geopolitical tensions and transportation vulnerabilities, in addition to the usual supply/demand issues. Since 9/11, oil prices have also included what is called a “terror premium” which some analysts believe is as much as $10 per barrel or more – and this was before the latest war in the Middle East.

I happen to believe that oil prices, and energy prices in general, are going up over the very long-term. But prices have gone up tremendously over the last couple of years. While there is no question that oil prices could spike even higher if things turn worse in the Middle East, a sharp drop in prices would not surprise me at any time, especially if there is a cease-fire or some kind of settlement in the Middle East soon.

In Closing

We live in a dangerous and unpredictable world, as we’ve seen in the last few weeks. Surprises happen. Markets react accordingly and frequently over-react. This is why I advocate using professional money managers that employ time-tested “active management” strategies that have the potential to get out of the way or hedge positions in the event that unexpected things happen and markets react adversely.

Let me be clear: I believe that “buy-and-hold” strategies have a place in most diversified portfolios. But I do not believe that one’s entire portfolio should be subject to the whims and sometimes severe ups and downs of the market indexes, or of particular stocks or bonds or mutual funds.

The S&P 500 Index fell over 44% in the bear market of 2000-2002. It has yet to recover to new highs some 4-6 years later. Millions of buy-and-hold investors are in this position today. This is one reason I am a big believer in active management strategies that seek to reduce the losses during down markets.

If you are interested in learning more about the active management programs I recommend, call us at 800-348-3601 or e-mail us at mail@profutures.com or visit our website at www.profutures.com.

That’s all for this week. Hope you’re having a great summer!!

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Middle East: Shaken Awake By War (a very good read).
http://www.latimes.com/news/opinion/commentary/la-oe-grossman18jul18,0,4708612.story?coll=la-opinion-center

This writer has a good point: Iran & Syria are the problem; US -
deal with conventional threats today, or nuclear threats tomorrow.
http://www.opinionjournal.com/federation/feature/?id=110008667

Hillary supporter tells her how to win (let’s hope not).
http://www.nydailynews.com/front/story/435814p-367097c.html