Blair's Worries Should Be Our Worries

Dennis Blair, Obama's director of national intelligence, told the Senate Intelligence Committee on Friday that based on reports from the nation's 16 intelligence agencies, the global recession is now the country's top security concern.

Unrest overseas, he says, would be a threat worse than terrorism. He said:

The longer it takes for the recovery to begin, the greater the likelihood of serious damage to U.S. strategic interests.

So the Global Peace Index will take a hit in 2009. Last year, out of 140 countries, Iceland ranked the most peaceful. But since October, all three of Iceland's major banks have become insolvent, with liabilities equivalent to seven years of its GDP. At the end of November, as citizens assembled to call for the government to resign, at least five people were injured. The krona's value has been cut in half following the banking crisis and one-third of Iceland's population is at risk of losing their homes and savings.

Blair told Congress that the economic crisis increases

the risk of regime-threatening instability [and] loosens the fragile hold that many developing countries have on law and order, which can spill out in dangerous ways into the international community.

In this matter, Blair says

time is probably our greatest threat. The longer it takes for the recovery to begin, the greater the likelihood of serious damage to U.S. strategic interests.

Wow. I decided it was time to chat with my friend James F. (Jim) Burke, a partner at a company (CBER) that tracks what institutional investors are doing. Jim's forecast on January 1 was for stocks to roll back into a bear market during the first quarter.

Jim's take is that the crisis threatens to fuel anti-Americanism around the globe and trigger a wave of destructive protectionism and global competitive disinvestment as foreign state-run or influenced investment managers, who now hold so much of U.S. public debt and publicly traded equities, shift their investments inward to prop up their own local economies and banks.

How are money managers reacting? Jim says he sees an "apparent consensus" now among global fund managers for a weak U.S. economic recovery starting by the fourth quarter of 2009. But meanwhile managers are being very cautious in the face of serious financial and geopolitical event risks. Jim says:

The recent strength of gold against the dollar-euro index since mid-January reflects the impact of increasing numbers of fund managers worldwide aggressively hedging against these risks. Managers are positioning ahead of a possible rout in the dollar: with uncertainty driven primarily by continuing pressure on banking systems in the U.S. and Europe, as well as risk that projected U.S. borrowing needs are unsustainable.

On the geopolitical event side, Jim sees the biggest risk as potential escalation over Iran's nuclear program. (Blair also singled ouit several Eastern European countries.) Coming in a close second, Jim said, is

a threat that many governments worldwide are preparing for: economic pressures triggering widespread civil disturbances (out of-control demonstrations, rioting, strikes or other political violence). Iceland is a warning for every developed country. Social contracts between governments and citizens, and among contending interest groups within countries - are severely strained in many countries.

Heis concerned about unrest in several developing countries, with Mexico high on the list, along with smaller European nations like Italy and Ireland, which he thinks might explore decoupling from the Euro.

Some top fund managers with long-term investment horizons, Jim says, have been sticking with positions built up in the fourth quarter of 2008,

but they have not (as a group) been aggressively adding to them. The buy side is dominated by some very large institutions with no choice but to try to "defend" portfolios and average in. On the other side are short-run volatility traders and an overhang of distribution pressure from pension funds getting more defensive, along with hedge-fund redemptions that were pushed forward from the fourth quarter.

It will be an interesting mid-year.