The bracing headwinds of political risk now threaten to become a full-force gale. Any one of five “hot spots,” or an unholy combination of them all, could roil markets in 2010.

Political Risk: The risk that an investment's returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control.
– Investopedia

The best sound bite you will hear this week comes from Jim Owens, the CEO of Caterpillar (CAT:NYSE).

Caterpillar, or “Cat” for short, is one of the 30 large-cap stocks in the Dow Jones Industrial Average. Cat makes “construction, mining and forestry machinery” – i.e. bulldozers, diggers, loaders, and other such “heavy equipment” of the type seen on building sites.

Caterpillar’s stock price hit the skids recently on disappointing earnings. Fourth-quarter profits fell by nearly two-thirds (65%). Though Cat reported signs of improving demand, investors dumped the stock.

The big problem for Cat – and others too – is what’s happening in China. As Beijing attempts to cool off a red-hot economy for fear of an inflationary bubble, the risk is that they go too far.

As reported on the earnings call, CEO Owens agreed that it would be “prudent” for China to step on the fiscal brakes (i.e. slow things down).

Just as long as they “tap on the brakes and not send everyone through the windshield,” he said.

There is a real risk that China gets it wrong. (There is also a risk that China’s miraculous 2009 performance was a stimulus-driven hoax in the first place.) Already there are reports of serious disruption as China’s gusher of state-mandated bank loans is abruptly cut off. Chinese importers are seeing their businesses thrown into turmoil as lines of credit get revoked without warning. Money-losing manufacturers relying on regular extensions of credit are suddenly finding that credit no longer available.

The speculative fever was so great at one point, it was reported that Chinese pig farmers were taking out loans to buy large quantities of copper and other base metals just to store them. What will happen to those pig farmers now?

There is a tongue-in-cheek saying that “a rolling loan gathers no loss.” What it means is that risky schemes can remain propped up as long as the banks keep “rolling over” old loans into new ones. Unprofitable businesses and wild speculative ventures can stay viable as long as there is new credit. But when the music stops, look out below.

Risk, Risk, Everywhere

It’s hard to know whether China will “send everyone through the windshield” as Jim Owens fears. A different Jim, noted short seller Jim Chanos, certainly thinks it will happen. He is shorting raw material plays – presumably including equipment makers like CAT – on the thesis that China’s real estate bubble will soon burst.

The more sobering reality is that “political risk” is everywhere now. The likelihood of severe government policy error, an outbreak of geopolitical conflict, or even both at the same time, is high and rising.

That is why your humble editor has dubbed 2010 “the year of political risk.” There are some very delicate choices to be made... not just in China, but also in the United States, Europe and Japan. Odds are high policymakers will get some of these choices wrong. In a worst-case scenario, they will get them very, very wrong. (As one could argue they already have.)

The sudden dominance of policy error as a theme is a big reason why risk appetite is fading now. As my colleague Kent Lucas pointed out earlier this week, the market is correction-prone here because stocks have gotten expensive. But on top of that, your editor would argue, the bracing headwinds of political risk now threaten to become a full-force gale.

Investors are responding to the rise of political risk by getting shed of risky assets. They are also returning to the perceived safety of U.S. Treasuries. In a striking example of this, one-month T-bill yields recently turned negative. This only happens when investors are so desperate for a place to put their cash, they are willing to give it to Uncle Sam at zero cost (even paying a tiny fee for the privilege of letting him hold it).

All of this has resulted in the U.S. dollar uptrend your editor long anticipated. Though others disagreed, we pointed out repeatedly how a withdrawal of risk appetite would drive the dollar higher. Among other reasons, this is happening because investors are taking their capital out of high-beta emerging market plays and bringing it back home (i.e. converting back to $USD).

View Larger Chart

The dollar has also breached a very important technical level. As you can see by enlarging the chart above, the $USD just crossed its simple 200-day moving average (red line) for the first time in nine months or so.

Whether you believe in technical analysis or not – and much of it is indeed “mumbo jumbo” – this is a key milestone. Many billions of dollars are traded in currencies on a “mechanical” basis, and the 200-day MA is a very significant input for those type of computer-based programs. Your editor believes the fundamentals of risk aversion and the unwind of the “dollar carry trade” are the most important elements here, but trend-following currency traders could also give the greenback a notable tailwind.

Key Areas of Risk

Getting back to political risk... it’s important to understand why this is such a factor now.

As we have said before in these pages, it is okay to rely solely on “bottom up” type analysis when the sky is blue and the sun is shining. But when the sky is dark and the thunder rolls, top-down macro analysis – i.e. taking into consideration key inputs like political risk – becomes more important than ever.

What follows is a quick, off-the-cuff tally of political risk hot spots broken down by location. Any one of these hot spots, or an unholy combination of them all, could roil markets in 2010.

HOT SPOT #1: CHINA. As mentioned earlier, investors face a risk of “going through the windshield” as China slams on the fiscal policy brakes. China will be a source of all kinds of political risk in 2010 – including bubble risk, fraud and protectionist backlash. What one might call “windshield risk” comes from the possibility that Beijing hits the brakes too hard in trying to kill off inflation. Bubble risk comes from the very real possibility (per Jim Chanos) that China’s white-hot real estate bubble pops. Fraud risk comes from the distinctly non-trivial possibility that the dragon is actually made of paper... that the factory floors are empty and the appearance of rebound is an expensive Potemkin village erected by the Chinese government. Last but not least, protectionist risk comes from the danger of a serious trade conflict arising between China and the United States.

HOT SPOT #2: EUROPE. Skeptics have long argued that the euro is not actually a currency. It is an experiment. The hope of the euro experiment was that 16 different countries could band together, under one united monetary policy, while yet preserving wholly separate cultures, political structures, and economic climates. This was always a nutty idea, and the experiment is now under severe stress. With the Greek sovereign debt crisis consistently getting Page One headlines in financial newspapers worldwide, investors have awakened to the utter helplessness of the ECB (European Central Bank). What happens if Greece implodes? What if happens if Spain or Portugal is next? If Germany and the other rich countries refuse to help (i.e. whip out the checkbook), will the PIIGS (Portugal, Italy, Ireland, Greece, Spain) simply be left to die in the abbatoir? How could German political leaders even think of writing a check to Greece without a deluge of outrage at home?

HOT SPOT #3: THE UNITED STATES. The Obama White House is in a panic. The Republican coup in Massachusetts (Scott Brown filling Ted Kennedy’s old seat) was taken as a sign of deep public anger and disgust with the out-of-touch Democrat agenda. Why the focus on saving Wall Street? What about Main Street? Unfortunately, President Obama’s proposed lurch toward fiscal conservatism only makes things more uncertain. With Republicans back in fighting spirit, the odds of any future stimulus bill getting passed for 2010 are extremely low. At the same time, Treasury Secretary Geithner (aka “Turbo Timmy”) is turning out to be as bad as his worst critics predicted with new revelations coming forth on AIG. In a perverse twist, White House efforts to distance itself from Wall Street could lead to overly harsh rules and restrictions that force large banks and hedge funds to withdraw capital from the markets. Meanwhile, dissenting voices at the Fed highlight the rising dangers of monetary policy. Should the Fed raise rates? Should they not raise? This toxic cocktail of uncertainty is topped by the perilous state of the states (running out of money) and legitimate nervousness over what a schizophrenic Congress might do.

HOT SPOT #4: THE MIDDLE EAST. No one is paying much attention to the Middle East these days. Dubai was a blip on the radar screen. The troubles in Iran have been reduced to background noise. And yet, in addition to certain Middle Eastern countries’ well-advertised fiscal troubles, Iran’s authoritarian political structure looks in danger of imploding, Iraq and Afghanistan violence is escalating, and al-Qaida chatter has picked up again. We have been spared the challenge of dealing with any real “heat” from the Middle East for a good stretch of time now. Our luck could finally run out in 2010.

HOT SPOT #5: JAPAN. The land of the rising sun has been struggling with deflation for decades. The Japanese authorities have fought a seemingly endless battle with zombie banks and bloated construction projects, and by any sane measure they appear to have lost. Japan’s public debt-to-GDP ratio has reached truly insane levels (approaching 200%) as the government pumps out more and more debt in an effort to stimulate a moribund economy that refuses to awaken. Serious observers like the wonks at bond giant PIMCO now argue that Japan must adopt a reflate-or-die strategy, urging them to do whatever it takes to create inflation. Japan has been able to pursue a strategy of utter folly for 20 years now only because it is an incredibly wealthy country. Over the course of two decades it has burned through much of that wealth. If Japan’s famously patient domestic savers run out of savings with which to continue buying JGBs (Japanese Government Bonds), the Japanese fiscal situation could finally implode. This has been a latent threat for years, but the drumbeats grow louder than ever now. Japan could see real fireworks in 2010.

As an investor, what can you do about all the above (other than grit your teeth and keep your fingers crossed)? Learn how to hedge for one thing... and learn how to go short for another thing. There is risk in turmoil, but serious opportunity too. We’ll talk more about that next week.

Other Related Topics: China Investments , European Investments , Global Markets , Justice Litle , Macro Trader , U.S. Dollar

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