Today, we will look at a Middle-Eastern geopolitical scenario that we believe can possibly happen?an Israeli strike on Iran. However, the likelihood of it is impossible to quantify. Nevertheless, it is our firm conviction that investors will do better to be prepared for it (even though it may be an arguably improbable event) than completely ignore it because its effects will have a massive impact on their portfolio.
It is interesting to note that ING, one of the world?s largest investment banks, had came up with an internal report to analyse the possibility and effects of this scenario. It is certainly even more interesting to note that they had come up with a possible timeframe (February to March 2007) for such an extraordinary event. For the sake of today?s discussion, we will assume that the report is genuine. We encourage you to read this report with an open mind. Please note that ING is not predicting that this scenario will happen?rather, they are saying that this scenario is possible and that should it happen, what the impact on the financial markets will be.
As we said in How the folks in the finance industry got the idea of ?risk? wrong!, this is an example of a ?fat-tail? scenario in which by definition of the normal distribution curve assumption (which we sees it to be an academic assumption that does not fully reflect reality), is so highly improbable that it borders towards the realm of impossibility. Hence, we believe that this scenario is a risk that is not fully appreciated and ?priced in? by the financial markets. Thus, there are some in the financial industry who have the mind-set that since it is impossible to quantify the probability of such a scenario, it should be ignored.
As contrarian investors, we believe that it is unwise to adopt such a mind-set. Firstly, though the probability of an Israeli strike is impossible to quantify, its impact on our investments will be extremely severe. Since the financial markets will be taken by surprise by such an event, we can be assured that it will trigger a massive shift of capital from one asset class to another. (No prize for guessing which asset class we prefer!) Thus, a high impact but low probability event is something which should not be completely ignored. Secondly, though we cannot do everything to hedge every aspect of our lives if such a scenario eventuates, we certainly can do something now to hedge ourselves in terms of our investments. Doing something now is certainly better than doing absolutely nothing.
Assuming that a military strike is being seriously considered, what is the most logical course of actions to take?
Definitely, military training is the first step. Indeed, there are rumours of it in this news report. Secondly, preparation for Iranian retaliation will have to undertaken. Already, there are unusually significant US navel and marines deployment in the region. The recent deployment of 20,000 more US troops in Iraq may perhaps be not what it seems. Thirdly, oil will have to be stockpiled because there is no doubt that oil supplies will be disrupted. The recent fall in oil prices in response to reports of rising oil inventories may be the result of such accumulation. Lastly, it is certainly interesting to note the Saudis? nonchalance about the recent falls in oil prices?they declined to agree on another OPEC oil production cut to prop up the price of oil. We do know that the Iranian economy is not in good shape and they have heavy reliance on oil revenues. The Saudis (who are Sunni Muslims) have the motivation to undermine the Iranians (who are Shias Muslims), who looks to be taking steps towards dominating the Middle East.
Are we implying that there will be military action? Again, we stress that we don?t know the answer. We believe it is possible. But we would not want to place our heads on the chopping board by making geopolitical predictions.
Is an Israeli strike on Iran so improbable and ?mad? that only those who belong to the conspiracy theorists fringe groups will even bother to consider it?
To answer this question, we have to consider this: As investors, since we may often see things through an economic prism, we can make the mistake of seeing certain actions as ?irrational? when it is completely rational in the context of the overall big picture. In this case, even though an Israeli military strike on Iran is ?crazy? in our eyes, it may be perfectly rational in the context of national survival. The Israelis may see that since the Iranian nuclear issue is such a serious threat to their national survival, if the world economy has to be damned to eliminate this threat, so be it!
In conclusion, our advice is: Be prepared.
