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Last week, a Middle Eastern city-state that represents approximately 0.1% of global GDP sent shockwaves through world financial markets. Dubai, part of the United Arab Emirates (UAE), requested a debt standstill on behalf of its flagship holding company, Dubai World, on the back of a debt-fueled investment binge. That's a clear-cut concern for international bond investors, but why should U.S. stock market investors care?
Does it matter?
In terms of its impact on the U.S. companies and the U.S. economy, the impact of Dubai's problem is a rounding error. Among foreign banks, British institutions, including Royal Bank of Scotland (NYSE: RBS ) , Standard Chartered, HSBC (NYSE: HBC ) , and Barclays (NYSE: BCS ) , have the highest exposure to Dubai. The direct exposure of U.S. banks such as Citigroup (NYSE: C ) , Bank of America (NYSE: BAC ) , or JPMorgan Chase (NYSE: JPM ) is negligible.
However, its impact on investor psychology is material, as the reaction on global stock markets demonstrated last week. In an environment in which U.S. stocks (and many other assets) look overvalued, that is a very real problem; indeed, when prices are inflated by sentiment, they are vulnerable to even a tiny pin prick that can burst investor confidence. In a global economy, it's impossible to predict when that pin prick will originate.
A warning for U.S. investors
The other lesson from the UAE's atrocious mishandling of Dubai's plight is that governments aren't always as predictable -- or as skillful -- as investors would wish them to be. At a time when the U.S. stock market's valuation implies "business as usual" (better than usual, in fact), it's a useful reminder that the U.S. now faces an unusual set of risks, and investors would be better off treating a seamless exit from this situation as a remote assumption, not a standard one.