Daily Comment (January 3, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] U.S. equities appear poised to grind higher.  Here is what we are watching this morning:

Iranian update: Iran has seen six consecutive days of protests with 22 dead and over 450 people incarcerated.  These protests are fundamentally different from the 2009 event we mentioned yesterday.  First, the participants are different.  The 2009 protests were a fight between competing elites—the “reformists” and “hardliners” were vying for power.  The hardliners won.  However, these terms should be used with great care.  The hardliners are fairly obvious in their views, but the reformers were not “reformers” in the Western sense.  They were as committed to the Islamic Revolution as the hardliners.  The reformers were simply willing to give more social and market freedoms compared to the hardliners, but neither group was willing to allow for full democracy.  When Akbar Hashemi Rafsanjani[1] is considered a reformer, it is clear the differences between the two groups aren’t all that great.

The current protests are similar to political issues we are seeing in the West, where populism has become widespread.  These protestors are angry about the state of the Iranian economy.  Officially, unemployment is 20%, but economists estimate that unemployment among Iranian youth is probably closer to 40%.  Many of the protestors are from the underclass from the countryside who have moved to towns and cities in the hope of finding work only to find unemployment.  These people have traditionally supported the regime.  In 2009, they would have been opposed to the Green Movement.  But, Iranian President Rouhani raised hopes of economic improvement as a benefit of the nuclear deal that has so far failed to materialize.  Apparently, one of the catalysts for the protests was a leaked government budget that showed billions of dollars going to the clerical elite and the Iranian Republican Guard Corps (IRCG), while cutting social spending and raising subsidized fuel prices and educational tuition.

Iran’s geopolitics are key to understanding this issue.  Iran is a mountainous nation with an internal flatlands of salt.  It is a difficult environment.  History shows it is very tough to invade—imagine a land army trying to march through the Rockies.  Thus, Iran has been mostly safe from invasion and, if invaded, the invaders were usually spent due to the effort.  At the same time, it is really costly for Iran to project power.  Just running the economy is costly and funding forces to take territory further increases the costs.  Throughout history, Persian empires used proxies to project power, just as Iran does today by co-opting the Iraqi government and through Hezbollah.

A common theme heard in the protests is the call for keeping resources at home to help the lower classes instead of expending those resources to project power.  This was also a theme in the U.S. presidential elections, not only in 2016 but also in 2008 and 2000.

So, what happens next?  The regime has been remarkably restrained so far.  We believe this is because it recognizes that it really doesn’t face much of a threat from the protests.  Relative to the 2009 event, the protestors are not well organized and they lack the resources to maintain the protests indefinitely because they are poor.  The young protestors in 2009 were children of the elite who had resources and were well versed in social media.  Those protests were a threat to the hardliners but not the regime.  These protests are a threat to both the hardliners and the reformers, but not a serious one.  At the same time, the simmering anger has to be a concern for the regime.  After all, such anger can be co-opted by revolutionary leaders.  The Russian Revolution of 1917 shows how a small group of talented leaders can use mass anger to bring revolution.  The most rational response from Rouhani and Khamenei would be to sack the aforementioned budget, take resources from the clerics and the IRCG, raise subsidies and cap prices of key goods and try to improve the lot of the poor.  However, that choice will limit Iran’s ability to project power just when it is on the cusp of winning—after all, it pretty much controls Baghdad, Islamic State is essentially defeated and Assad remains in power in Syria.  A path to the Mediterranean is opening up and the budget is designed to take advantage of that.  The protests might delay or undermine Iran’s ability to become the regional hegemon in the region.  Or, the leadership can decide to stay the course and hope that an alternative leadership doesn’t emerge.

Fed minutes: The FOMC minutes will be released later this afternoon.  Like most analysts, we will comb the report for clues about future policy, although, as we have noted at length, the voting composition will be unusually hawkish this year.  These minutes will reflect the Yellen Fed which will soon pass into the ether.

War of words: Yesterday, President Trump responded to Kim Jung-un’s threat of having a nuclear button ready to strike the U.S. by stating that his “nuclear button is bigger and more powerful.”  Although the escalation of rhetoric is nothing new, it does appear that Kim Jung-un is becoming increasingly bolder while seeking a dialogue with South Korea.  Reports from the Korea Times suggest that North Korea could be preparing to launch another ICBM test in the near future.  At the same time, the New York Times reported that North Korea has reopened its border hotline with South Korea, which could be a prelude to direct dialogue between the two countries.  South Korea has been open to talks with North Korea in an attempt to prevent any possible crises during the upcoming Olympics.  North Korea appears to be trying to drive a wedge between the U.S. and South Korea; the latter fears the U.S. will start a war with the North where the costs of war will mostly fall on South Korea.  The situation remains fluid.

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[1] https://www.confluenceinvestment.com/weekly-geopolitical-report-exit-shark-february-6-2017/