Middle East North Africa, unlike other emerging markets like Asia and Latin America, Europe, the US, has a large proportion of young men itching for a fight.

Sub Saharan Africa is disproportionately populated by young able bodied potential combatants, and has predictably been in an interminable state of conflict, internal, cross border, cross social class, cross race, cross tribe. It look like its MENA’s turn.

We can argue about the catalyst for the revolutions in Tunisia and Egypt and the troubles in Libya and across the rest of MENA. The fact it is that the region has become convincingly unhinged. Ask any Arab over 30. Revolutions are not always marked by a point in time but by a period of varying levels of precariousness. And a political vacuum, which is what is likely to emerge in MENA given the decades of lack of political alternatives, is fertile ground for unpredictable behaviour.

The immediate impact of the barely gleeful reporting by international news agencies headquartered in countries far away is that Panic Assets like oil and gold surge. The forecasts vary depending on the horizon of one’s extrapolation, nothing more. Who knows how matters will unfold. Will Libya fracture into a dozen tribes? Will Yemen do the same? Who will spend the aid in Jordan? Who will man the locks at Suez? Will the US resume their accumulation of Strategic Petroleum Reserves? Will Japan? Or China? What else can we burn for energy? Which are the power hungry nations and what are their alternatives? What is the price of oil in gold and where are we historically?

High factor prices result in substitution. Microeconomic theory tells us that. What are the substitutes? Oil is not only found in the Middle East. It is found elsewhere, available albeit at higher extraction costs and wider crack spreads. These margins we know from experience will fall with scale and time. In the meantime, alternatives include fusion, distributed grids, alternatives and renewables.

Unfortunately, this is not very useful commentary, and I have no trade recommendations. If I knew what to trade and in which direction, I wouldn’t be writing this, would I.

Wait. Worry.

Oil at over 100 usd is bound to irritate the American SUV driver. When oil was at 147 usd in 2008, inflation was 5% and the world was a wonderful place. Yet we worry now when inflation is 1.6%. A high oil price is, however, a brake on economic growth.

There are complex relationships underlying the single number that characterizes inflation.

Demand outstripping supply is one way to stoke inflation.

Too much money for a given level of real demand chasing too little supply is another.

One cannot help but suspect that at least for the developed nations, who coincidentally form the bulk of the indebted nations, inflation is not such a bad thing. Central banks might conspire to ignite it or at least ignore it.

In emerging markets inflation has reared its head and central banks have been quick to raise interest rates in response.

The US Fed, however, seems content to hold down rates and to print money. Inflation there is a mere 1.6%, aided and abetted by falling house prices and costs of housing which account for over a quarter of the CPI basket. If housing stabilizes, it could place the Fed in a difficult position. For now, this phenomenon provides the Fed with latitude to print and to drive equity and credit markets higher. Until the Fed reverses its policy, equity markets, commodities and oil are likely to keep going higher.

Emerging markets’ fiscal rectitude and hawkish monetary policy have created a correction in their risky assets such as equities, but investors are likely to reward their responsibility once evidence that inflation is under control emerges. It is likely that this will only surface once the Fed starts tightening as well. This is the signal to rotate into emerging market equities.

As an asset class, equities are likely to continue their bull run. Global growth, at least the nominal variety seems supportive. Any pullbacks seem to be driven by responsible monetary policy and represent opportunities to buy. The outlook for bonds is less optimistic. Inflation is unfriendly to fixed income. Only short memories can argue for a the continuation of a 3 decade long bull run in fixed income. The 4 decades preceding Volcker’s inflation fighting crusade were very poor for fixed income.

The wildcard here is Middle East North Africa. The instability seems not to stem from religious or even political fracture but from social and economic pressures, notably along the lines of age on the one hand and orthogonally along the lines of income or wealth inequality.

The catalyst for the unrest is usually unpredictable, which has been the case. For the US the situation is dire. It risks not only energy security but strategic impairment in one of the most important regions in the world. Ironically, its ally and longtime Arab bugbear, Israel, has been reduced to a bewildered and quaking kibbitzer in this insane game.

There is the risk that the revolutions in Egypt and Tunisia spread to the rest of MENA. There is no good analogue. The fall of Communism in the late Eighties also left a clutch of countries irrevocably changed. The vacuum that Communism left behind was filled not with democracy or capitalism but chaos. MENA could go the same way. It is unclear what the Arab Street wants, although it is quite clear what it doesn’t want. Freedom and self determination are laudable ideals but not a sufficiently defined blueprint for nation building. Nature abhors a vacuum and tends to fill it with anarchy and chaos. The risk of more failed states arising is high.

Long term instability in MENA may encourage hoarding and further drive up the prices of commodities. A chronically high oil price while not catastrophic will act as a tax on global trade. The inflation rate associated with a given level of global output must rise.

It is hard to predict how the instability in MENA will unfold and it is futile to speculate on the repercussions to unpredictable events. One can only wait and see and react to the situation as it unfolds.

In the meantime we are nervously long the market with a tight stop and a tricky trigger finger.

Bernie Madoff alleged that JP Morgan “had to know” about his fraudulent scheme. Forget about JP Morgan.  Many of the victims of Madoff were just dishonest.

Madoff never hid the fact that his fund was self custodied and administered. He got investors to look the other way by suggesting that he was front running his own broker dealer operation.

Investors would have known that a simple split strike conversion trade could not achieve the results Madoff did except if he had an unfair advantage.

Not all of Madoff’s victims were dishonest. But the more sophisticated ones were. They knew he was ripping somebody off. They just never guessed it was them.

Inflation:

I had written about inflation in October 2010, cautioning that the output of the central bank’s printing presses would inevitable lead to rising prices.

Today, inflation is one of the main concerns in the global economy. Its not ideal but it is far from a catastrophe. Some inflation is healthy and the economy can sustain a higher level of inflation than it thinks it can.

US inflation

US CPI under-measures inflation due to a large weight (25.5%) in housing, owners’ equivalent rent.

Housing prices in the US are in a double dip, the Case Shiller 20 is -1.59% YOY for November 2010 (next reading Feb 22, 2011).

Discounting owners’ equivalent rent, all other items are rising at about 2.2% for the CPI number to equal the reported 1.3%.

If owners’ equivalent rent, which is correlated to house prices and mortgage rates starts rising, and there is evidence of recovery in the US(better GDP, manufacturing and employment numbers) as well as a pickup in mortgage rates, the impact on CPI could be significant. If housing simply flatlines, CPI will jump to 2.6%. If housing costs start to rise inflation will be higher.

Notably, inflation breakevens are around 2.95% so the market is not entirely mispricing inflation.

Is inflation a serious concern?

The source of the current inflation has been rising commodity prices from energy to industrial metals to agricultural products. Food is 13.7% of the CPI and of that 10% is likely raw foodstuffs. Fuel for transportation is 4.5%. In all commodities ex food and beverages is some 25% of CPI. In 2010 the CRB Index rose 16.60%.

Economic theory tells us that in the long run prices will rise to ration scarce resources. Also, sufficiently high prices will drive the search for alternatives.

Hyperinflation of the sort found in failed states tends to be a consequence of a failure of confidence and is discontinuous. This is not a systemic risk in the current inflationary environment. It can arise though if the situation in Egypt should spread into a wider paradigm shift akin to the fall of Communism in the early 1990s.

Wage price spirals tend to be persistent and self reinforcing. Theory does not account for political and social factors that render substitution away from labour infeasible. The current inflationary environment is not driven by wage inflation. In fact the labour market remains slack. US personal income growt peaked in 2006. While it has recovered robustly from the crash in 2009, it appears to have hit a ceiling again in late 2010.

Poorer economies such as China are at risk of wage price spirals. Food represents 34% of CPI in China. Wage growth in China is in the high teens and has been accelerating of late. Whereas India’s RBI has been proactive and hawkish on inflation, China’s PBOC is torn between maintaining some form of export competitiveness, upholding the value of its foreign reserves and tackling inflation.

The probability for runaway inflation to take hold in any of the major economies is non-trivial but the odds are low. The developed world has become accustomed to low inflation rates for too long. In fact a certain level of inflation is desirable, especially given the level of debt still on sovereign and household balance sheets. Higher interest rates too are not entirely undesirable as they represent a hurdle rate for investments and ensure a healthy respect for opportunity costs.

Longer term outlook for inflation:

The reason that developed world inflation has been so benign while interest rates were persistently low and economic growth was surprisingly robust is simple; even if central bankers were slow to realize it. As capacity utilization rates headed in to the 80% – 85% region in the US for example, developed countries began to outsource low value added services such as manufacturing, in effect, off-shoring capacity. This meant that the national, as opposed to domestic capacity limit was actually over 100%. There was slack in the system. The off-shoring of manufacturing also increased domestic productivity as developed economies became more heavily weighted in services.

The success of this strategy necessarily resulted in balance of trade, current and capital account imbalances.

The future will likely see developed economies attempt to rebalance their economies in favor of manufacturing and exports. The consequences are likely to be lower domestic productivity and a higher level of inflation associated with each given level of output growth, assuming that the technology of economy remains constant.

Higher commodity prices and food inflation appears to be fact of life. You can read about this elsewhere.

Higher fuel costs are expected to persist. Apart from the usual inflationary effects higher fuel costs act as a tax on trade. For countries where imports and exports are a significant portion of GDP, higher fuel costs can drive inflation indirectly.

While inflation is expected to be structurally higher going forward it is unlikely to be debilitating. As developing countries evolve towards better technology and innovation their productivity will rise to ease some of inflationary pressures. At higher frequencies, however, markets are driven by psychology and misunderstanding and a good deal of overshooting and cyclicality can be expected.

Artradis is basically a volatility fund which seeks to buy cheap convexity where it can find it. It is a structurally long volatility fund. And it has become tired of volatility falling steadily since the crisis of 2008.

Investors are selling FX vol, equity vol, commodity vol, credit vol, usually in the form of some structured product. So structured that they often don’t realize that they are in fact selling short vol, i.e. selling vol they don’t already own.

How much lower can vol go? Let’s look at the VIX index. Vols have a peculiar trading pattern. They tend to trend downwards over long periods and then spike up in times of stress. So shorting vol is a bit like playing the game of chicken. How long are you happy to career towards that oncoming car before you (or it) veer away? Too much courage ends in a blaze of glory.

The VIX spent the first half of the 1990s slowly receding to 10 before picking up in 1996 and spiking to 35 in 1997 on the back of the Asian crisis. It spiked again to 44 when LTCM imploded in a puff of leverage. It stayed elevated through the Dotcom bust, 9-11, peaking in 2002 at 40 amid accounting scandals and sagging equity markets. As the economy recovered from its wounds the VIX went into decay mode once again reaching a low of 10 in early 2007 before the US non-conforming mortgage market began to unravel. When global markets stared into the chasm in Sep 2008, the VIX hit a high of 60. It has spent the next 2 years receding to a level of 17 in Jan 2011.

With a global economy as unstable as it is today, granted in recovery mode, a strategy of shorting vol is simply risky. Shorting vol is equivalent to providing insurance. Premia are low. The compensation for providing insurance is therefore not commensurate with the risks. In such environments the safer trade is buying insurance, not selling it.

Its time to be long volatility. Unfortunately, for some habitually long volatility traders like Artradis, 2 years of receding vols have been too much to bear. And its usually when the 800 lb gorilla has left the room that the party begins.