Can Iraq Turmoil Lead to ‘Stagflation’?

The new unrest in Iraq has put into play the one thing that central bankers — who’ve been busily juicing the economy with cheap money stimulus — fear most: An energy-price-fueled spike in inflation.

The independent Sunni extremist militia known as the Islamic State in Iraq and the Levant, which now apparently controls Mosul and Kirkuk, is much more than just another terror cell; it has shown the capacity to capture and run Iraq’s energy infrastructure in the north, including refineries and pipelines, and to tax citizens and companies to pay for fighter salaries, provisions and weapons.

The organization also reportedly robbed the Bank of Mosul of $450 million, and now claims to be the richest independent militia in the world. This frees them from depending on the mercies of patrons in Saudi Arabia and elsewhere who are alarmed by their take-no-prisoners approach to building a medieval-style caliphate stretching from southern Syria through northern Iraq.

Fears that the group will impair oil exports through the southern port of Basra, which is in the heart of the Shiite homeland, have proven unfounded so far. Yet energy markets will demand a risk premium for crude oil until the Iraq government or its neighbors get the group under control.

Technology stocks have a way of blithely slipping through the creases of the news to achieve their own goals in their own way.

Western equity investors care about this because a near trebling of crude oil prices between early 2007 and the middle of 2008 is now widely seen as one of the main catalysts that popped the housing bubble and threw the economy into recession. A similar, less dramatic situation played out during the Arab Spring uprisings of 2011, with crude oil prices rising 50 percent. That forced the Fed to slow its QE2 bond buying program, the predecessor to the one it is ending now. That capped stock market gains in 2011 as the promise of cheap money dried up.

It’s a big deal because higher energy prices are not only hitting consumers at an already vulnerable time when retail sales are slowing; they could force a quicker-than-expected short-term interest-rate hike. Central bankers are born to block inflation; it’s in their blood.

The result would be what economists call “stagflation” or the combination of economic stagnation and inflation. Japan is suffering a bout of this right now, which is why the Bank of Japan — the most aggressive major central bank in its cheap money injections — is whispering that it’s looking for the exit from its stimulus policies.

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This was also the nightmare scenario the U.S. suffered through in the 1970s under Federal Reserve Chairman Arthur Burns. That was the last time the Fed pushed real interest rates down as far as we’ve seen them lately (as shown in the 60-year chart above). A series of oil price shocks in 1973 and 1979 unleashed double-digit inflation and growing unemployment amid the flood of money.

The 1979 crisis was connected to the Iranian revolution, the rise of an extreme Islamic militia within a major oil producing country powered by religious fervor, and a 4 percent drop in global oil supply. Replace Ayatollah Khomeini with Sunni extremist group leader Abu Bakr al-Baghdadi, and the setup is pretty similar.

The moral of the story: Cheap money stimulus is all fun and games until the Middle East blows up.

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Technology stocks have a way of blithely slipping through the creases of the news to achieve their own goals in their own way. To be sure, energy stocks led the way last week, which was not surprising given the growing risk to the infrastructure of OPEC’s second-largest oil producer. Yet semiconductor stocks were also lifted by a sensational 6.8 percent rise in Intel (INTC) on upbeat sales and gross margin guidance. That lifted the overall PHLX Semiconductor Index 1 percent.

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There was some M&A activity as well, with Priceline (PCLN) agreeing to buy OpenTable (OPEN) for $103 a share — a whopping 46 percent premium. I guess they didn’t use William Shatner’s tough negotiating tactics on that deal. The rich valuation did, however, generate excitement in related names including GrubHub GRUB) and Yelp (YELP), lifting the two names 7 percent and 13.8 percent respectively.

I will admit that I did not get OPEN as a business when it started, but have become a lot more open-minded since to the idea of third-party organizations that can provide valuable software services to niche industries for micro-fees. OPEN and Priceline are similar in that they have time-sensitive inventories to sell — one with restaurant reservations and the other with plane and hotel reservations. Priceline has done a phenomenal job overseas with its Booking.com unit, and OpenTable can be built out the same way. Great match; I am still very positive on Priceline, which is worth at least $1,450.

Best wishes,

Jon Markman

P.S. I have 5 more red-hot technology stocks you should check out. You’ll find them in my FREE report, New Technology Superstars for 2014. Click here to download your copy right now.