In 1972, Edward N. Lorenz gave a talk that turned out to be a landmark in the development of chaos theory. Its title was ‘Predictability: Does the flap of a butterfly's wings in Brazil set off a tornado in Texas?' Lorenz said even a tiny action the flapping of a gossamer wing could set off a train of events leading to a violent storm in another hemisphere. This is ‘deterministic chaos,' the recognition that the world is so complex that certain outcomes cannot be accurately predicted.

Lorenz was a meteorologist, but his insights are applicable in many fields notably including finance, where obscure local events have periodically been transformed into major storms in distant markets. Last week on Wall Street, there was, at least, the question of whether such a phenomenon was already under way: Is it possible that protests on the streets of Egypt will derail the bull market in the U.S.?

It isn't very likely that they will. But the risks are being widely assessed.

Bob Doll, chief equity strategist at BlackRock, the asset management firm, says disturbances in Egypt could conceivably prompt a market correction in New York.

“Since August 26, the stock market has gone up in what was almost a straight line,'' Doll said.

“As you know, the market never moves in a straight line for very long.'' Concern about Egypt has already caused some hiccups, he said. While he is bullish about the market's long-term prospects, he said, “sooner or later, we are going to have a real correction. Could this be it? I don't know. It could be.''

He says Egypt is not the most likely source of problems for global markets. Although its geopolitical importance is indisputable it has about 80 million people, and the Suez Canal is an indispensable link in trade routes between Europe and Asia, its weight in the world economy is negligible.

Disturbing ripples

Audrey Kaplan, co-head of international equity at Federated Investors and manager of the Federated InterContinental fund, says her fund owns no Egyptian shares.

And Kevin Gardiner, the head of global investment strategy for Barclays Wealth, said that while “the human implications of what is going on in Egypt are very important,'' so far, at least, the financial implications are not.

In a survey of the world economy, Gardiner said the overall outlook was positive, but he started his discussion with a description of the disturbing ripples emanating from Egypt.

“Last month, I'm sure I wouldn't even have mentioned Egypt,'' he said.

Are investors merely reacting prudently to the latest news headlines? Quite possibly. But it isn't hard to envision Egypt's unrest morphing into a global nightmare.

The most unsettling scenarios include a major war and terrorism spreading from the Middle East and South Asia, accompanied by an oil shock and a depression. Even if such developments are extremely unlikely, investors may worry about them if demonstrations intensify and governments topple.

Because financial markets are barometers of investors' moods, worries can be pernicious. On January 28, for example, riot police in Cairo fired tear gas and rubber bullets on crowds challenging President Hosni Mubarak. Global stock markets fell sharply and the Standard & Poor's 500-stock index dropped 1.8 per cent while the dollar, Treasuries and gold rose. The markets have been intermittently jumpy since then.

Rising oil prices

Short of violence, rising oil prices may be the most obvious way to transmit contagion from Egypt, even though it isn't an important oil producer. But about 4.5 per cent of global oil supplies flow through the Suez Canal and the SUMED pipeline connecting the Red Sea with the Mediterranean, and 14 per cent of global liquefied natural gas moves through the canal. No serious disruptions have occurred, but the markets have reacted anyway, perhaps factoring in the possible risk of blockages or, far worse, of turmoil spreading to a crucial producer like Saudi Arabia.

In the U.S., there could be serious repercussions. If oil prices rise, every 25-cent-a-gallon increase in the price of gasoline which is equivalent to a $10.70-a-barrel increase in crude oil would result in a decline of 0.25 per cent in annual gross domestic product and in the loss of 270,000 jobs, according to a study by IHS Global Insight. Food price inflation could be a carrier of contagion. In developing countries like Egypt, where food accounts for a major slice of average income, such inflation is becoming a major problem. Hoarding, exacerbated by civic unrest in Egypt and elsewhere, could lead to greater price spikes, an economist at HIS Global Insight said.

While that isn't likely to be much of a problem for consumers in the U.S., indirect effects are possible. Investors could become skittish about emerging markets, and highly leveraged bets on local currencies or indexes could go awry, with consequences that are impossible to predict. That may be unlikely, but not far-fetched.

Recall the events of 1997: A currency plunge in Thailand turned out to be the impetus for a broader crisis. It led to a Russian debt default and the near-collapse of Long-Term Capital Management, a hedge fund in Connecticut that, for a time, threatened the stability of the global financial system. But there is no evidence of such a threat now. Should investors bother to protect themselves against improbable but potentially serious events emerging from the crisis in Egypt? Most people should “just sit tight,'' Gardiner said, as “we haven't seen anything that looks like systemic risk for a portfolio.''

Still, he said, it depends on how nervous you are. If your main concern is oil prices, for example, you can buy call options on oil futures. And there are plenty of exchange-traded funds and other vehicles for making bets.

Of course, there are countless other spots on the planet to worry about, many of them still well below the radar of the financial markets. What should an investor do? Exercise too much caution, and you will miss many opportunities. Ignore all danger, and you are likely to suffer.

There is no simple answer, alas. Butterflies can cause tornadoes, but those storms can't be predicted.

New York Times News Service


Upswing in oil, food prices February 6, 2011