While the market vigorously debates the prospects of a V-shaped recovery and the proper valuation of the S&P 500, a serious material issue is developing in the Middle East. Investors need to be acutely aware of the developments in Iran as it threatens to become one of the most serious international political crises since WWII. This summer's stolen election has allowed the hardliners, led by President Ahmadinejad, to publicly and privately strong-arm their reformist opponents. Recently, there has even been rumors of the impending arrest of one of the reformist candidates from this summer, Mehdi Karroubi. The old man, Ayatollah Khamanei, seems firmly behind the provocative foreign policy pursued by the regime and there has been zero reluctance to use the conservative Basij militia and Revolutionary Guards to crush any public dissent. Some optimists see the seeds being sown of a liberal democratic Iran in the future. While this may eventually turn out to be the case, recent developments suggest that the conservatives are using this time to strengthen their hold on power.
This suppression of dissent is allowing the regime to freely pursue its goal of developing a nuclear weapon and building a military threat to Israel. I personally do not believe that Ahmadinejad is a deranged religious fanatic seeking to annihilate Israel; he is simply a rational strategist seeking to increase his nation's ability to project power. Unfortunately, there is a very low probability that he can accomplish this without Israeli preemption. Prime Minister Netanyahu will be firm in maintaining the military option and as the clock runs down, the probability of an Israeli attack will skyrocket. Experts say such a strike may occur within the year. There is no possibility the Israelis will allow themselves to be deterred by another Middle Eastern state with a nuclear weapon. Surgical strikes by the Israelis against the Syrian nuclear facility (actually believed to be a proxy facility for the Iranians) last year and the 1981 strike on Iraq's nuclear Osiraq nuclear facility were successes. These nations were not prepared to engage the military might of Israel in response. Yet the situation is markedly different with Iran. President Ahmadinejad has built his political career on denouncing and threatening the “Zionist colony”: he would lose a great deal of legitimacy if he were to back down. The Iranian military would respond forcefully to an Israeli preemption and the fallout would be disastrous with the U.S./Iraq/Saudi Arabia caught in the middle.
The decision by the Iranian leadership to build “10 new enrichment facilities, buried under the mountains” should be seen as a flashing red warning signal that the regime will not back down from their escalations. Naively, the Obama Administration is quoted today as saying that “the door is not shut” on the recently offered compromise for the Iranians to ship their uranium to Russia for further enrichment for a medicinal reactor. The US appears softer than ever in the face of Iran's repeated rejection of this offer and its continued escalations. It is clear to everyone, especially the ever suspicious Israelis, that Iran's intentions are to build a bomb in the near future. Exhibit A: there is absolutely no reason for the Iranians, who sit on oil supplies that can last hundreds of years, to be putting billions of dollars into building a civilian nuclear energy programme. This is not to mention that Iran's hiding of the Qom facility makes it clear that they were up to something they didn't want anyone in the West to know about. Finally, the FT is reporting that the Iranian cabinet will debate whether to enrich their uranium to 20% (3-5% is the normal civilian level of enrichment) at their next meeting.
Unfortunately, the exit door on this brewing crisis is rapidly closing. The U.S. has shown zero success with its engagement policy and Russia/China remain significant barriers to effective multilateral action. Additionally, it increasing seems that the Iranians simply aren't interested in a diplomatic solution. Their attempts to hide the enrichment program seem to indicate they aren't trying to extract concessions. The North Korea solution, uneasy coexistence with a nuclear weapon, is impossible because of the Israelis. If conflict does occur, the economy will suffer massive impacts from what will be an incredible spike in the price of oil. World trade will be jeopardized and Dubai will almost certainly be forced to default by fleeing capital. If the U.S. is drawn in it will require increased deficit spending that will slam the already stretched bond market. The dollar carry trade will unwind, further endangering most of the gains in equities we've seen over the previous year. Double dip could be an understatement.