As we enter the final month of the year most of us can look back on 2014 and say it has worked out better than we had expected in January. Back then we were worried about the sluggish economy, the narrowness of a market relying mostly on the performance of technology and biotechnology, the various pockets of political instability and conflict around the world and the ineffectiveness of our political process. In spite of all that investors were optimistic and the Standard & Poor’s 500 made grudging gains through the summer. That came to a temporary end in September and October when the index retreated back almost to its January starting point, but here we are with Christmas approaching and the year-to-date gain is 14%.
There have been some surprises along the way. I don’t know anyone who thought the price of West Texas Intermediate oil would sink to $63. Even though the major economies of the world were slowing, most expected demand from the emerging markets to keep oil prices around beginning-of-the-year levels and there was the possibility of reduced production from the Middle East as a result of unsettled conditions there. One development that has been celebrated in the United States has been the move towards energy independence in North America and reduced reliance on imports from Saudi Arabia and elsewhere. Much of the increase in domestic production is a result of hydraulic fracking, which is a relatively expensive process. As the world-wide price of oil has dropped, some capital spending projects to increase fracking production have been put in abeyance and there is a risk that current output could be reduced because of declining profitability.
A drop in interest rates was also unexpected by most observers, not only in the United States (1.86% on the 10-year Treasury at October 15th), but also in Europe, where the German ten-year yield went below 1% and other sovereign bonds, like those of France, Spain and Italy, traded at yields that would have been considered highly unlikely two years ago. Many commentators were skeptical of China’s claim that it was growing at a better than 7% rate, but few thought that the Shanghai composite (A-shares) would be up 27% this year, outperforming every developed country market. While the Japanese Nikkei rose, the yen declined sharply, which should have helped Japanese exports, but the economy still slipped back into recession in the third quarter in spite of an unprecedented amount of fiscal and monetary stimulus.
The strength of the dollar was also unexpected (1.23 against the euro at November 7th). After a weak first quarter the U.S. economy picked up momentum, growing almost 4% in the third quarter, faster than any other major economy except China. That helped the currency, but the improvement in the budget deficit and the safety of investments in the U.S. drew capital from all over the world. Some worry that the strength of the dollar will hurt the U.S. economy going forward, but exports are a relatively small part of GDP and the continued low price of oil will be a big help to our trade balance.
Looking ahead, there is reason to think that the present favorable trends will continue. Initial unemployment claims have been generally declining and the unemployment rate continues to move lower. Consumer confidence is rising and retailers are hiring aggressively in anticipation of a strong Christmas selling season, fueled partly by lower gasoline prices. The level of inflation remains low, which should help consumer spending. Next year the factors to watch are household formations and housing as well as capital spending. Recent data showing higher paychecks for younger workers should help the former and improved small-business confidence should help the latter.
On the list of worries should be the possibility of Europe falling back into recession as a result of the slowdown in Germany, partly caused by reduced demand from Russia. Hopefully Mario Draghi and the European Central Bank will become more accommodative and provide the funds necessary to keep Europe on the modest growth path. Japan will also need a new round of stimulus to keep out of recession. China will require some credit expansion to stay on its desired growth path, but the recent interest rate cuts show the authorities are sensitive to the challenges facing them. China is still not rebalancing the economy toward the consumer sector, which is a necessary step toward continued growth.
The major uncertainties at this time seem more geopolitical than economic. The conflict between Russia and Ukraine remains unresolved even though a partial cease-fire is in place. The Israel/Gaza situation continues to be tenuous, but there will be much more about that later in the essay. There is no definitive agreement yet with Iran on its nuclear weapons development effort and, as expected, the November 24th deadline has been deferred. The conflict among China, Japan and others over the South China Sea would appear to have quieted down for a while. Any of these could erupt into a condition that would destabilize both the world economies and the financial markets, but the one that worries me most is the Syria/ISIS/Iraq conflict. ISIS is an al Qaeda–inspired stateless terrorist movement designed to create a Sunni caliphate in the Middle East and it has already proven its military effectiveness and its ability to recruit disaffected young people from all over the world. The intensity of its effort seems to have been reduced for the moment, but its long-term objective is clear and the implications beyond the region could be significant. No country in the Middle East or elsewhere is willing to provide troops other than the two countries that are directly involved, and it is unclear whether ISIS can be stopped or turned back with Syria and Iraq fighting them alone. Some believe that eventually Shiite Iran may have to do the job.
As part of an ongoing attempt to increase my understanding of the Middle East and to improve Blackstone’s business presence in Israel, I spent eight days there in November. During four days in Tel Aviv, I met with bankers, insurance company executives, entrepreneurs, corporate leaders and government officials. Our firm’s Senior Advisor in Israel, Dan Gillerman, the former Israeli Ambassador to the United Nations, did an exceptional job of setting up the trip. Like almost everyone else who has ever visited the country, I came away impressed with the vitality of the place but also with a deeper understanding of the complex political issues facing the people there.
Let me start by saying that when you are talking to business managers, politics is not likely to come up in the conversation unless you bring it up. Discussions center on business problems – even though, during the third quarter, missiles hurled from Gaza reached as far as Tel Aviv, forcing some people to spend time in a bomb shelter. The Iron Dome system of intercepting missiles likely to hit populous areas was effective in preventing widespread Israeli casualties, but retaliation caused many casualties in Gaza. This resulted in criticism from around the world that Israel used excessive force in the conflict. Israel’s response is that it was attacked without warning, that it was only defending itself and that it took all reasonable measures to minimize casualties.
Those living in the country say they are used to “living on the edge.” Many I spoke with are the children of Holocaust survivors who came to Israel seeking a place safe from the oppression they had experienced. Whether they discuss it openly or not, most believe there must be a land for Jews to go to seek a normal life. They know that anti-Semitism is a timeless threat and a recent wave of immigrants from France emphasizes the importance of Israel as a refuge where they will be welcome. Few I met seem to stress the historical importance of the country in Jewish history. Everyone is conscious that Israel has been established in the middle of the Arab world and it is generally considered an unwelcome neighbor. Most believe this condition will never really change. When I asked a leading Israeli business person the reason for the economic success of Israel, he answered that Jews are never satisfied. Ironically, when I asked a leading Israeli politician why it is so difficult to reach an agreement with the Palestinians, he said, “Giving up land won’t solve the problem. We gave up Sinai, we gave up Gaza, and we are willing to give up most of the land we won in the 1967 war. The Arabs are never satisfied.” The one thing that the two sides have in common may be a source of the lack of resolution.
Part of the problem is the complexity of the situation. Aside from being a Jewish country in an Arab region, Israel itself is not a simple place. Of its eight million people there are two million Arab-Israelis, Christians and Muslims who live, work and vote in the country. Only about 15% of the Jewish population is ultra-religious. The rest are secular, as are most Jews in the United States. Most of the economic strength and taxes come from about two million people. Israel was founded as a socialist country and a good part of its highly regulated framework endures, particularly in financial services. The Tel Aviv Stock Exchange is a good example of excessive regulation; it causes many promising Israeli high tech companies to go directly to the NASDAQ rather than listing at home. Unions are also important but both regulation and union influence have been eroding for some time.
In Israel’s early days, it was highly dependent on financial support from the United States, but views itself as financially independent now, having no external debt and substantial foreign exchange reserves. The rapidly growing parts of the economy are in areas established in the last two decades – energy and technology. Israel has discovered huge natural gas reserves and its technology sector has thrived, driven by innovations that began in the 1980s with the huge influx of highly educated Russian immigrants. The military also played an important role in Israel’s technological development as it created its sophisticated defense system. So did the country’s great universities. In the longer term the hope is that electricity and even motorized transportation would be based on natural gas. The resource could also be liquefied and shipped to parts of Europe. Israel is also the world leader in water treatment.
Even though the conflict with Gaza slowed the economy down in the third quarter, Israel is still expected to grow at 3% in 2014 and the outlook continues to be favorable for next year. The country suffered only a slowdown but not a recession in 2008-9 because the banking system was restricted from making marginal loans. Israel is very much a capitalist country today, but it has a highly developed social network for healthcare, education and retirement. It has an idiosyncratic lifestyle which is more informal than that of the United States or Europe. Few businessmen wear ties. The streets are immaculate but there is graffiti. The good restaurants I tried in Jerusalem were down alleyways and hard to find on your own. I attended the opening of the opera and people were dressed as though they were going to a basketball game. Jean importers and manufacturers must be thriving. Jewelers and furriers must be starving. There is a lot of hugging as men greet each other; a handshake seems inadequate for someone who brings joy into your life.
Clearly the country would benefit from an end to the conflicts with its neighbors. Every American president has had peace in the Middle East as one of his objectives. Most Israelis I talked with believe an agreement in the near term is unlikely because the Arab world generally believes Israel should not exist. They hope that eventually the Jews will leave the area because they recognize that they are unwanted and don’t want to live in a hostile environment. To me, that is unrealistic. At this point Israel will never cease to exist. The Israelis believe that they have an historical, legal and earned right to be there. The controversy over the West Bank “settlements” can be resolved by Israel allocating compensating territory in Israel to the Palestinians. When Israel became independent in 1948, only 600,000 people lived there. As it has grown it has developed permanent communities in the West Bank. I visited several around Jerusalem. They were suburban towns with substantial homes, not temporary structures. The residents are not prepared to give them up. You can’t get a good pastrami sandwich anywhere. They don’t have delis in Israel.
Most of those I talked with still hold out hope for a two-state solution at some point in the future. The Palestinians would acknowledge Israel’s right to exist, monetary compensation would be offered in exchange for eliminating the “right of return” for former Arab residents and Israeli land would be exchanged for the West Bank settlements. In spite of the countless trips John Kerry and his predecessors have made to negotiate an agreement the sides still seem far apart. One of the problems with a negotiated peace agreement is that both sides have moved further to the right over time. The Palestinians now have the extremists in Hamas to deal with and the Israelis have their own set of hard liners. Neither the Likud nor the Labor party is as strong as it once was. Each used to have about 35-40 of the 120 Knesset seats, or together, two-thirds of the total, so a compromise was possible. Now they each have less than 20, or together, not even one-third. The new parties have entrenched right wing views that make compromise more difficult.
To help me better understand the situation, Ambassador Gillerman arranged for me to meet with Shimon Peres, the patriarch of Israeli politics and a former president and prime minister of the country. He now presides over the Peres Center for Peace and, approaching his 92nd birthday, is as thoughtful and articulate as any political figure I have met. Peres is optimistic about a two state solution eventually but, like others I talked with, he believes strong leadership in both Israel and the Palestinian Authority will be required to achieve it. He thinks outside influences will be important as well. He said, “America should think in terms of giving in the Middle East, not fighting. Look what was accomplished in Europe as a result of the Marshall Plan.” Some I talked with cited South Africa as an example. Only when there was strong leadership from F.W. de Klerk and Nelson Mandela was the nation they able to end apartheid. Peres believes, however, that even without strong leadership a political solution with the Palestinians will eventually be achieved. “It will be driven by women and young people who don’t want to live any longer in a condition of conflict.” I hope he is right.
Like almost everyone I spoke with in Israel, he believes Iran must not be allowed to possess a nuclear weapon. He is suspicious of any deal with the Iranians. “You will never be able to verify whether they are in compliance,” he said. Nobody really thinks they will use a nuclear bomb against neighboring states, but everyone fears an arms race in the region and the sale of weapons-grade uranium to terrorists for use in “dirty bombs.” I spent an hour and a half with Peres, one on one, and it was inspirational.
During the trip, I stopped off at a Tel Aviv facility known as MindSpace. Here entrepreneurs can rent a desk month-to-month to work on their ideas in a creative environment. Projects that gain traction can move to small offices before they go out on their own, making room for others. Like all of Israel the place is filled with optimism and creativity. The political turbulence around these people is frightening at times but there is little they as individuals can do about it. In the meantime, they will work hard to make their own tomorrow in the start-up nation, like the original settlers who founded the country.
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