Investors Worry That Mideast Will Be Market's Next Crisis

Like the European debt crisis in 2010, the uprising in Egypt and other Middle East nations in recent weeks has raised the fear among investors that the markets could be in big danger if the crisis spreads.

Egyptian demonstrators demanding the ouster of President Hosni Mubarak, gather around the national television building guarded by members of the Presidential guard in Cairo on January 28, 2011.
Khaled Desouki | AFP | Getty Images
Egyptian demonstrators demanding the ouster of President Hosni Mubarak, gather around the national television building guarded by members of the Presidential guard in Cairo on January 28, 2011.

After being generally immune to the uprisings in Tunisia, Lebanon and elsewhere, markets sold off aggressively Friday, with investors looking for safety in gold, oil and US government bonds.

It was part of what one strategist called "a typical flight-to-quality market" in which investor fear is rekindled over geopolitical risks—seemingly the only major obstacle for red-hot stocks these days.

"What the markets are fearful of is further spillover into other authoritarian nations," said Christian Hviid, chief market strategist at Genworth Financial Management in Pleasant Hill, Calif. "Syria, Saudi Arabia and Yemen ought to be very concerned about this considering their government structure and potential for similar flare-ups."

Investors in US markets also felt the need for concern in light of the strategic importance the area holds.

While Egypt itself is not a major oil producer—its primary export is cotton, also an important good—the Suez Canal is used to transport much of the world's petroleum and other materials. In addition, President Hosni Mubarak, whom protesters want to see ousted, has long been a US ally.

"There is the importance of Egypt in it being a very close ally to the Western world and an anchor of stability for the region," Hviid said. "The importance of Egypt has to do with the Suez Canal. That's the major link between Europe and Asia trade flows. It's real critical that the canal remains open, that the tension doesn't escalate to the point where trade may be impaired."

As for the nearer-term threat to the 21-month stock market rally in the US, how well Middle Eastern governments manage the uprisings could be key to whether Friday's sell-off is an isolated event. Markets went through the same hand-wringing last April, when Greece appeared to be in danger of being the first domino in a series of European debt defaults, leading to a steep selloff over the summer.

"It will be a one-off only if it's a one-off in Egypt," said Andre Julian, market strategist at OpVest Wealth Management in Irvine, Calif. "If the uncertainty doesn't go away you're going to see continued correction in the market...There is going to be some sensitivity in the market if this problem in Egypt spills into some other regions."

Both Julian and Hviid advise investors to examine the situation and consider sector rotation into areas that didn't participate fully in the market rally. Julian mentioned pharmaceutical and defense specifically.

In addition, Hviid said investors may want to start hedging against higher oil prices and expect some increase in the US dollaras investors look for safety.

A weak dollar, in fact, has been key to the Middle Eastern unrest.

The cheaper greenback, which has been held lower as the Federal Reserve continues its easing programs, has resulted in higher commodity prices, which are priced in dollars and thus cheaper to buy with foreign currencies. The cheap dollar also has boosted spending in the US.

"While the FOMC noted 'measures of underlying inflation have been trending downward' in the US on Wednesday, persistent financial stimulus can lead to increased consumer spending in the US, which can spill over and drive up prices in other less stable markets," analysts at Boston-based Canaccord Adams said in a note to clients. "Uncertainty in the region creates concern surrounding the price of oil."

While conventional wisdom has it that global central banks are unlikely to ease in efforts to keep rates low, the Mideast unrest could push policy to a more hawkish stance.

"Inflation has accelerated to a degree in raw materials much swifter than in consumer prices," said Jessica Hoversen, fixed income and foreign currency analyst for MF Global in New York. "Central banks are going to be forced to hike interest rates in order to fight pressure in commodity markets."

Hoversen said the process toward raising rates likely would be a slow one but it could nevertheless signal some easing for price inflation that is squeezing the large poverty-level population in Egypt and throughout the region.

Inflation in the US, in fact, is likely to double this year, Deutsche Bank chief economist Joe LaVorgna said in a note to clients Friday.

That trend is likely to keep the unrest fires alive in the Middle East and create at least a volatile environment for US stocks.

"We started to witness even before today somewhat of a slowing down of price appreciation" in stocks, Hviid said. "The argument there was the market was getting a little bit tired and needed a little bit of a pause if not a slight correction just to absorb a lot of the news and earnings that have come out. This might have accelerated some of that."