As we begin the new quarter, now is an excellent time to take stock of your basic investment thesis. Ask yourself if your allocations still reflect what you think the world is going to look like over the next several months. And as part of that process, I'm here to tell you that making "financial" decisions based solely on "financial" inputs grossly oversimplifies the way the world really works. As I've said before, investing in debt, equity, or commodity markets without geopolitical intelligence is like trading juice futures without getting a weather forecast. You can do it, but good luck to you.

I get my geopolitical intelligence from Stratfor. My friend George Friedman and his team have just published their 3rd Quarter Forecast. I got George to give me a copy I can share with you in this Special Edition of Outside the Box. As a Stratfor Member, you can get the 3Q Forecast - as well as their other forecasts and daily analyses - at a preferential rate available to my readers by clicking here. I strongly encourage you to add this valuable weapon to your investing arsenal.

Here are just some quick examples of how I use Stratfor to guide my thinking, in these cases on energy prices:

• Just living in Dallas, I'm pretty familiar with rig counts and EIA inventory numbers, but I confess that the power-sharing negotiations between the Nigerian government and the Ijaw tribe aren't the most common lunchtime talk.... What will those talks mean for Nigerian supply figures?
• At first glance it's not obvious that the Olympics is supporting oil prices. But then you dig down and realize that China's showcase for global credibility requires lots and lots of smiling citizens. Lots and lots of smiling citizens requires plentiful and cheap fuel. Plentiful and cheap fuel requires government purchases/subsidies - at prices that may not be sustainable. So when the TV cameras go home, how much will the communist government keep paying out to maintain those smiles?
• And those Iranian missile tests that just spiked crude prices? Do those mean war is really coming, or are these the last-round raises, before the US and Iran reach a settlement on Iraq?

There are no simple answers here. No price targets or earnings estimates to the penny. But gentle reader, that's the real world. Today's markets require hard thinking on a whole range of fronts, with geopolitics being right at the top of the list. Join Stratfor today, and you'll get the same intelligence I use to map out where I think the markets are going. And enjoy this Forecast...

John Mauldin, Editor
Outside the Box

Quarterly Forecast: Third Quarter 2008
By George Friedman

Introduction

For the first half of 2008, Stratfor focused its attention on three features of the international system. All three remain key factors, but all have also evolved notably.

First, we anticipated an endgame between the United States and Iran over the future of Iraq. We have been surprised at just how fast U.S.-Iranian negotiations have progressed, and consequently violence has dropped to its lowest levels since the 2003 invasion (something that would be impossible without Iranian assistance). What is truly amazing is how few items necessary for a deal are not already in place. We are unlikely to have a formal "Camp David" moment, but the U.S.-Iranian understanding seems to be building quickly on the ground.

Second, Russia's efforts to rebuild its influence throughout Eurasia have been at a critical point. With the Western-backed independence of Kosovo making a mockery of Russian foreign policy, we predicted that Moscow either had to strike back or see its credibility in key former Soviet Union territories crumble. As it turned out, Russia's internal factional struggles distracted and exhausted the Kremlin. Striking back at Europe and the United States in any place that would have caused harm proved impossible, forcing the Russians to concentrate on places such as Central Asia, the Caucasus and Ukraine. In the long run, this may well prove to be the worst of all worlds, as the Europeans are convinced they beat the Russians, while the Russians are equally convinced that they have drawn a line in the sand. For the moment, however, Russia requires time to plan and flesh out its new organizational structures. That will take up the bulk of the third quarter.

Third, we forecast that high energy prices would create a flood of petrodollars that mostly would end up flowing into U.S.-dollar assets, greatly stabilizing the financial system and helping the United States shake off its economic funk. This prediction proved true in spades, and U.S. economic growth has certainly turned a corner, but two related developments have taken root. First, having oil prices increase by 40 percent in three months cannot help but have an enervating impact on economic growth, particularly in the heavily industrialized states of East Asia. Second, all that oil income is beginning to have additional impacts.

The Arab Gulf states are grossing approximately $2 billion per day, with half of that amount flowing into the coffers of Saudi Arabia. This provides the Saudis -- and other Gulf Arabs -- not only with tremendous wealth, but also with tremendous political power. A key trend in the third quarter will have these states using that wealth to invest, bribe and cajole their friends and enemies into following policies more to Riyadh's liking.

This money will be most politically active in two locations: Lebanon and Iraq. In both places the Saudis want to see some flavor of a peace deal. The common thread to the two issues is the Saudi fear of Iran. An Israeli-Syrian peace deal means reducing Tehran's influence within the Sunni world -- specifically, the influence it holds over Damascus and Hezbollah. A U.S.-Iranian deal over Iraq means re-establishing Iraq as a buffer against Iranian expansion. In both cases, Saudi money is useful in bringing the various players to the table -- most notably Damascus and the various Iraq Sunni factions -- and paying them to stick to an agreement. In the case of Israel and Syria, the constellation of forces in play suggests a deal will be struck sooner rather than later.

There is one additional topic that will feature grandly in the third quarter: the Beijing Olympics. Ruling China has always been a difficult prospect, as the country is riven with urban-rural and coastal-interior splits. But while the Olympics were supposed to have been a celebration of China's "arrival" as a modern state, they are instead serving as a showcase for all the ways in which China falls short. But dealing with these issues -- entrenched corruption, financial dysfunction, (unapproved) regional autonomy, unaffordable energy subsidies -- is difficult for Beijing in the weeks leading up to the Olympics because, under the glare of international spotlights, it can no longer use the tried-and-true tools of an authoritarian state. The result is a string of patchwork fixes that highlight China's weaknesses, making the Asian giant vulnerable to any foreign power with an interest in demonstrating that the emperor is less than fully clothed. Not exactly the global celebration that Beijing intended when it bid for the Olympics all those years ago.

Note to readers: Our third-quarter forecast is intended to be a supplement to our annual forecast and second-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

Middle East

• Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so it may inadvertently trigger tensions with Israel.

In the second quarter, U.S. efforts in the Middle East received a surprising boost in the form of petrodollars. Like the United States, Saudi Arabia wants to see Iraq stable and Iran blocked from expanding its influence. High oil prices are bringing the Saudis more than a billion dollars a day in revenues, some of which they are using to push Sunnis into Iraq's governing coalition.

Syria has found a role in the tightening Arab-American alliance, but that role has taken an unexpected form: peace talks with Israel. Soon after the negotiations came into the public eye, political instability in Israel threatened to derail them, but a deal between Israel's Kadima and Labor parties now ensures that the talks will proceed even if Israeli Prime Minister Ehud Olmert is replaced toward the end of the third quarter. While Washington certainly has its reservations about an Israeli-Syrian detente, the United States is refraining from sabotaging the talks -- in part because Saudi money is supporting the initiative, in part because Turkey is hosting the talks, and in part because Hezbollah will be defanged if the talks prove successful.

The third quarter could well prove to be a decisive turning point for many actors in the region. Hezbollah has no good options. It needs to find a way to scuttle the Israeli-Syrian peace talks, and an attack on Israel might be the only way it can do so -- but then it risks inviting a major retaliatory attack by Israel. Iran and the United States need to seal a deal on Iraq before the U.S. elections in November, or else risk the situation remaining unresolved for years. If a U.S.-Iranian deal proves elusive, Israel needs to ensure that Iran is knocked down a few pegs before a new U.S. administration potentially restricts the Jewish state's military options. Israel can bomb Iran only with U.S. approval.

The player that will work the hardest to ensure none of these situations spins out of control is Saudi Arabia. High commodity prices are showing signs of eating into global demand, and the last thing Riyadh wants is a war-related price spike that would push many economies over the brink. So Saudi oil income will play a growing role in buying calm throughout the region.

We expect rapid progress in the region's major peace negotiations -- those between Israel and Syria and those between Iran and the United States -- because most of the heavy lifting has already been done. There has been a near-halt to violence in Iraq, and Israel has been preparing its public to give up the Golan Heights. We would not be surprised at all to see deals materialize in the third quarter, with Syria and Israel more likely to be successful than Iran and the United States.

In the Israel-Syria talks -- assuming that they are not derailed -- we expect the traditional fanfare of a peace deal, complete with public handshakes. The U.S.-Iranian negotiations, however, are unlikely to present such a tableau. Tehran and Washington seem content to dial back tensions without dropping their public hostility, for fear that their respective populations would not approve of a public burying of the hatchet.

• Regional trend: Turkey is emerging as a major regional power and in 2008 will begin to exert influence throughout its periphery -- most notably in northern Iraq.

Turkey is becoming bolder on the international stage: sending troops into northern Iraq, mediating Israeli-Syrian peace talks, pushing energy projects in the Caucasus and Central Asia and making its influence felt in the Balkans. But internally, the country is paralyzed. A domestic power struggle over the nature of the state, pitting the new socially and religiously conservative elite against the established ultrasecular elite, has stalled not only local economic growth and foreign investment but also Ankara's progress toward regional player status.

We expect Turkey's court system -- operated by the ultrasecularists -- to dictate terms to the elected Islamist-rooted government, likely resulting in the ruling Justice and Development Party's dissolution. A verdict is expected in mid-August on a pending case that seeks to do just that, though we cannot rule out the possibility of a compromise. Toppling the government will not reverse or deflect the underlying trend of Turkey's re-emergence as a leading regional power, but it will delay it significantly.

Eurasia

• Regional trend: Should it occur over Russian objections, Kosovar independence would deliver a massive blow to Russian credibility. Thus, Kosovo will serve as the litmus test for either the return of Russian power or a surge in the West's expansion.
• Regional trend: Russia's internal power struggles will hamper Moscow's ability to pursue its international agenda.

Russia spent the bulk of its energy in the second quarter on managing the transition from Vladimir Putin the president to Vladimir Putin the prime minister. In the shuffle, Russia's restless power clans struggled for supremacy, with the conflict reverberating through some of Russia's most crucial institutions, including the Federal Security Service, Gazprom, Rosneft and the defense sector. This struggle is now over -- with the battle lines ending roughly where they began -- but the fighting consumed nearly all of Moscow's attention and energy for the bulk of the second quarter.

During this reorganization, the West -- particularly the Europeans -- did manage to force Kosovar independence over Russian objections, making a mockery of the Russian position in Europe. But Russia did not exact any retribution -- or at least, not in Europe. What Russia did do was focus some of its energy on the area where its influence is strong: its immediate periphery. Belarus, Ukraine, Armenia, Azerbaijan and Georgia all witnessed a surge in Russian attention as Moscow locked down its positions in regions it feared the West was eyeing.

The result is a continuing mismatch of perceptions: the Europeans feel that their victory in Kosovo proves the Russians are more bark than bite, while the Russians feel that they have made their true red-lines clear by focusing on their near abroad. Major Eurasian conflicts have been rooted in far smaller misperceptions, but that will be a crisis for another day.

Luckily for both sides, each has other issues to occupy it for now. The Europeans have turned inward after yet another failed attempt at a constitution, and the Russians have to get their affairs in order in the third quarter before venturing outward again.

Putin has implemented major personnel reshuffles across the length and breadth of the Kremlin, with the biggest changes in the energy industry, the military and the defense-industrial complex. Additionally, Russia is a major energy exporter and a moderate food exporter, but it still struggles with inflation -- doubly so now that qualitative and quantitative labor shortages are starting to bite, courtesy of Russia's deepening demographic crisis.

While Russia might be in its best posture financially, politically and militarily since the end of the Cold War, it faces a number of nagging problems that it is organizationally ill-suited to solve. Finding a way to get through these problems is not a severe challenge, but it will take time. We expect no major moves out of the Kremlin until the very end of the third quarter at the earliest. But when Russia does return, it will do so with the most money -- courtesy of petrodollars -- and the best leadership team it has had in 20 years.

• Regional trend: The Concert of Powers will return as the dominant organizing structure of inter-European relations.

Europe is returning to its roots. Countries are arguing over monetary policy, France is making a grab for control of Europe's Mediterranean policy, Poland is aggravating Russia, Greece is complicating Balkan policy and the United Kingdom stands aloof as ever. Any serious thoughts of pan-European integration were thrown into disarray in June when Irish voters defeated the Lisbon Treaty, the latest attempt at a European constitution.

For the third quarter, all eyes will be on France, which will hold the rotating EU presidency for the remainder of the year. Since France is one of Europe's heavyweights, its turn at the presidency would have been notable even had Ireland ratified the EU treaty -- but with political integration efforts in limbo, France now has a chance to realign European structures with its own national interests. This will not take the old Gaullist form of ambitions for French superpower status. Instead, Paris will seek to wrest the economic and political leadership of Europe away from Berlin by subtly (and perhaps not-so-subtly) undermining the EU institutions that France perceives as giving Germany an advantage.

Economically, France is better poised than Germany to weather the storm of sustained high commodity prices: It has a less-industrialized economy, is an exporter of foodstuffs and has a huge capacity to generate electricity from nuclear power rather than petroleum fuels. But Paris is well-positioned politically as well. President Nicolas Sarkozy's honeymoon might be over, but Germany finds itself distracted and divided by a failing, conflicted governing coalition that is about to enter an election campaign. Germany is still the rising star of Europe, but that rise has hit a bit of a pause, and France will seize the moment to adjust Europe's direction to its own liking as much as possible.

• Regional trend: Serbian elections will end Belgrade's position in geopolitical no-man's-land -- one way or the other.

Europe has seen Serbia as the litmus test of whether the Balkan region as a whole will move decisively toward the West -- with each of the Balkan states eventually joining the European Union -- or whether there will be a radical wild card in the center of Southeastern Europe, which could give Russia a foothold in the region.

However, we should have known better than to think that the Serbian election could generate a clear result. While Serbia enters the third quarter with its most stable government yet, it would be a mistake to label it firm enough to execute a clear break with the country's past. Undoing 18 years of contradictory policies and international isolation is simply too large a task for any government to complete in short order, much less an untested coalition containing five parties and three ethnic groups.

Nevertheless, steps toward Serbia rejoining Europe -- complete with halting steps toward EU membership -- appear to be in the cards for the third quarter. Vojislav Kostunica, whose power plays have often upended Serbian policy, will not be in the new government, leaving pro-Western factions with more flexibility than they have known in years. But it will take far more than three months of progress before the probabilities for success can be assessed.

Global Economy

• Regional trend: Oil prices will soften in 2008 due to the fading of geopolitical risks in key locations. The price drop, however, is contingent upon an expected weakening of geopolitical risks.

Things are going to get worse before they get better. Global crude oil prices have risen by 40 percent since the beginning of the year -- and all of that took place in the second quarter -- largely because of geopolitical risks that Stratfor believes will likely ease. We envision four events occurring in the third quarter that should take some of the heat out of the markets.

First, the U.S. Congress appears to be moving toward regulations intended to lessen the impact of speculation in oil trading. This will almost certainly have some unintended consequences, but will probably result in at least a minor cooling of prices.

Second, we expect a planned Nigerian energy summit to result in additional sums of oil income being funneled to the ethnic Ijaw of southern Nigeria. The Ijaw, who typically feel cut out of the oil patronage system, are responsible for most of the large attacks on oil infrastructure. A deal that enfranchises them should result in more stable Nigerian output.
Third and fourth, we expect two deals to slide into place in the Middle East: one between Iran and the United States on the future of Iraq, and another between Israel and Syria on the future of Lebanon. The Iranian-U.S. negotiations are taking place largely behind the scenes, but will impact the oil markets indirectly if they succeed in finally stabilizing Iraq. Meanwhile, Israeli-Syrian moves toward a very public peace deal should calm those parts of the oil markets that get jumpy every time they see a headline containing the words "Israel" and "Arab."

• Regional trend: Countries the world over will pull their energy sectors back from the free market in order to stave off social instability and/or maximize profit.

The primary manifestation of this forecast in the second quarter came in the form of reinforced energy subsidies, with Russia, France, Italy, India, Venezuela, Argentina and Iran being the most obvious players. Technically, such steps are not nationalizations, but they make the liberalization of energy sectors de facto impossible (no private firm wants to supply a subsidized market).

In the third quarter, we expect more dramatic steps toward direct management of energy sectors in Malaysia and China -- two states in which recent efforts to lighten the subsidy burden are likely to backfire. Europe, too, will wrestle with moves to involve the state more deeply in energy questions, as high energy prices finally begin to bite hard enough to force a government response.

• Regional trend: Despite much talk to the contrary, the United States will enjoy strong economic performance. In part, this is because of the massive inflow of money into the United States from Asian and Arabian states.

While talk of recession in the United States remains par for the course, the U.S. Federal Reserve is both becoming optimistic and leaning toward interest rate increases to contain inflation. The Fed will always err on the side of triggering faster growth (and inflation with it) rather than slower growth that could lead to deflation and induce a Japanese-style depression. Add in roughly $100 billion in stimulus checks, and the United States is well past the worst that the slowdown of the latter half of 2007 presented. This does not mean that the "strong economic performance" we anticipated has materialized -- but the truth so far is much more positive than the doom-and-gloom talk that dominated American media the first half of the year.

Obviously, not all things are cheery. The American property market is far from recovery -- the rising inventory of unsold homes in particular is a critical factor to watch -- and strong commodity prices are making the U.S. consumer take pause. Additionally, a combination of American subprime contagion and regional structural and cyclical weaknesses could trigger a European banking crisis in the third quarter. But Stratfor's primary economic concern for U.S. growth remains tied to the election cycle. Neither presidential candidate has any interest in pointing out positive aspects of the current government's economic management. And, in past elections, "It's the Economy, Stupid" has not only garnered votes, but also has had the side effect of amplifying public perceptions of the economy's problems.

• Regional trend: Inflation is on the rise on a global scale.

But while the United States is looking toward better times, the reverse could prove true elsewhere. The sheer size of combined American purchasing power means that the United States can weather high energy and commodity prices relatively well -- runaway commodity inflation plus the subprime meltdown still did not push the U.S. economy into negative growth. The same cannot be said for the rest of the global system, where inflation is now pushing 5 percent.

And of course $140 a barrel oil is still $140 a barrel oil. Most countries can no longer absorb such cost increases, and Stratfor expects to see the cracks that developed in major industrialized economies in the second quarter begin to lead to fundamental breaks in the third. Barring a truly deep price drop, a great many states are beginning to have a great many problems. Between robust prices for energy and food, there is not an economy in the world that has not had to make some sort of adjustment. Stratfor divides the effects into two categories.

First, food shortages impact political stability immediately; so food prices have been -- and remain -- the key issue to watch. In the second quarter, the world witnessed only sporadic, minor, localized food shortages. While grain prices continue to rise, there is some light at the end of the tunnel: plantings and weather have been favorable for most crops, and most grain forecasts for harvest in the next few months are atypically large (with corn in the U.S. Midwest being the notable exception.) It is far too early to predict a price drop, but it seems safe to say that there will not be onerous supply crunches.

Second, the broader inflationary trend remains firmly in place and will disproportionately impact the heavily industrializing -- and thus energy-intensive -- economies of East Asia (which is hardly to say that the rest of the developing world will escape). The country facing the biggest problems will be China, which imports massive amounts of increasingly expensive commodities. Beijing will face a growing risk of widespread social unrest as these pressures take their toll on its economy, but it will be constrained from restoring order in its accustomed fashion -- that is, a security crackdown -- in the third quarter because of the international spotlight brought by the Olympics. Efforts to manage the problem thus far have not proven very effective, and they are complicating parallel efforts by the government to recentralize control of the energy sector.

High commodity prices -- specifically high energy prices -- have also had an unforeseen impact. The political power of countries raking in large numbers of petrodollars -- the Arab states of the Persian Gulf now gross a combined $2 billion daily -- is at its highest point in a generation. The last time these states had this amount of financial power they underwrote projects such as the Afghan mujahideen and contributed to the fall of the Soviet Union. This time around, they are concerned with Iran's involvement in Iraq and Lebanon, and are applying their riches toward pushing the Israeli-Syrian and American-Iranian peace processes forward.

East Asia

• Regional trend: The Chinese government intends for the year 2008 to be China's day in the sun, with the Olympics showcasing how advanced and stable the country has become. This requires Beijing to act preemptively to prevent anyone with an interest in marring China's image from disrupting the Olympics.

Anti-Chinese foreign activist campaigns have been neutered with a mix of visa policy and slick organizing of counterprotests, while security has been tightened ostensibly in response to the threat of domestic terrorism. But these small victories belie much larger problems that have nothing to do with the Olympics.

The Olympic Games have created an inflection point in Chinese development, disrupting the stability of Beijing's political decision-making process. On some issues, this break point has caused the government to postpone decisions beyond when they would usually have been made, while on others, decisions have been accelerated ahead of the time frame Beijing would have preferred. Reducing energy subsidies was a policy from the former group, but the attempt to delay skidded out of the government's control. Meanwhile, allowing more media access because blackouts proved no longer feasible is an example of the latter.

In short, the Olympics have forced what is normally a gently-gently decision-making process into chaotic fire-fighting mode, and rising commodity prices are forcing the entire system into the pressure cooker. All things considered, China is juggling the issues admirably, but the scope and depth of the challenges it faces guarantee tension and a continuous trickle of small crises for the next quarter (not to mention that everyone who has an interest in seeing a weaker China will use the next several weeks to nudge the country toward as many of those crises as possible).

But the Olympics are still the Olympics, the Chinese people are still very proud to be hosting them, and regional leaders fully realize that the Politburo will certainly come for them if they spoil the show. Stratfor expects this combination of nationalism and fear to see the government through the worst of the problems. Then, once the last hungover tourist steps onto the last departing plane, cracks will likely start showing, the system will start creaking, and the gloves will come off -- with the acceleration of price reforms the most likely first order of business.

• Regional trend: In order to tighten its grip on an often unstable and chaotic economy and Communist Party, the Chinese Central Committee is reshuffling the bureaucracy, with an eye to creating energy, aviation and finance superministries directly under its control.

Efforts to consolidate the energy sector are proceeding, but not quickly. The central government is meeting resistance from all of the expected groups -- state oil firms, local distributors and retailers, and especially regional leaders -- who stand to see their influence, wealth and sources of income all subjugated to Beijing's will. With the added complications of the Olympics and global high energy prices, the central government has been forced to shuffle and reshuffle the plans several times to keep them more or less on track.

In the quarter to come, President Hu Jintao will attempt to bring all the disparate threads of the energy sector more or less under his personal control, a task that will become even more complicated once the burning incentive of the Olympics has passed and all the players take a good hard look at their bottom lines. But in many places, the push for consolidation will not rise above the level of rhetoric, given that many of Hu's key supporters are local leaders who continue to resist change on multiple issues in order to maintain their own viability and profitability. As such, Hu will likely take his campaign to provinces and regions led by people outside of his personal network -- a move that will create some tensions and contradictions in the inconsistent application of central government directives across the country.

By comparison, consolidation of the aviation sector will be a cakewalk.

• Regional trend: The U.S. alliance structure in Asia is being readjusted as states feel out both bilateral and multilateral relationships in order to maximize their influence in an evolving world.

This readjustment intensified in the second quarter, with several states becoming increasingly proactive in how they manage their bilateral relations with the United States and their neighbors. As we expected, U.S. allies sought not to sever, but simply to adjust, the ties that bind.

Australia short-circuited several plans to exclude the United States from various proposed Asian clubs by proposing to create and lead its own version of the Asia-Pacific Economic Cooperation to manage the region's economic and military affairs. South Korea, despite domestic opposition, continues to put finishing touches on a free trade deal with the Americans, still vying to become the only major Asian state to land such an agreement. Taiwan's new government sought to find a middle ground that keeps its American alliance intact while allowing it to nudge closer to Beijing. And the United States took advantage of a hurricane disaster in the Philippines to demonstrate vividly that, while it might not be flying the flag in Asia as much as in times gone by, it has hardly vacated the premises. Meanwhile, one state that is by no means a U.S. ally -- North Korea -- saw its relations with the United States continue shifting away from crisis management toward routine bureaucracy.

This process is only in the beginning stages and will continue to intensify and accelerate in the third quarter. Bear in mind that all four of Washington's primary allies in the region -- South Korea, Australia, Thailand and Taiwan -- have freshman governments that are feeling their way forward. And with China's attention absorbed by the Olympics and the Americans preoccupied by the Middle East and their own election cycle, all four realize that the time to adjust their alliance relationships is now.

South Asia

• Regional trend: The Pakistani army/state will hold together even as confusion and distractions in Islamabad greatly reduce the Pakistani government's ability (and willingness) to rein in jihadists.

This has certainly proven to be the case. Pakistan's incoming coalition is fractious, inexperienced (it has been 10 years since civilians ran the government) and certainly not in the mood to rock any domestic boats. This has led Islamabad to do everything in its power to avoid unduly angering Islamist militants operating in the country's northwestern reaches. The dawning problem is that this ungoverned land is providing opportunities for militants battling NATO forces in neighboring Afghanistan to rest, recruit and rearm -- re-creating precisely the sort of environment that allowed al Qaeda to operate so efficiently until Sept. 12, 2001. In response, NATO forces are beginning to target these militants regardless of the political border, critically damaging the credibility of the Pakistani government.

The third quarter will force the new government in Islamabad to decide whether it is more afraid of NATO forces or of its own militants -- who now have made leaps eastward out of the tribal areas into the North-West Frontier Province (NWFP). Ultimately, we expect the government to choose to target the militants, however half-heartedly, rather than make a stand against NATO's incursions into territory that is nominally under Islamabad's writ. The government will be driven by the fear that a conflict with NATO could, at worst, destroy Pakistan or, at best, trigger a military coup -- which would end the first civilian government in a decade. In the meantime, U.S. forces will escalate their overt operations in the tribal badlands and perhaps even in the NWFP, which will complicate both the security and political situation in the country.

• Regional trend: India's schizophrenic policies regarding everything from tax regimes to special economic zones to basic infrastructure are proving that the idea of "Shining India" is a myth and will lead to a waning in foreign investment.

Hopes for a "Shining" India have all but darkened, and even that assumes that there is no fallout from the deepening militant struggle in Pakistan.

With oil prices skyrocketing, India's energy subsidized economy cannot cope and state oil refiners are buckling under the pressure. This not only spells a highly uncertain political future for the ruling Congress party, but it also raises the specter of fuel shortages in an extremely riot-prone society should the government slip in managing this fuel crisis. Add in infrastructure bottlenecks and a government that is paralyzed due to rising food prices, and it is clear even to the Indian government that New Delhi's foreign direct investment (FDI) hopes are overinflated. But with inflationary pressures in the country nearing a critical point, maintaining FDI has slid well down the government's priority list.

In the third quarter, India will continue to be squeezed by economic pressure and stymied by political paralysis, both getting worse by the day. A break point is unlikely in the next three months, however. New Delhi still has enough quick fixes at its disposal to manage the impact of the commodity crisis day-to-day, but its attention is now almost fully consumed with containing domestic dissent. The political tension will continue to intensify, but with elections still more than half a year away, the situation will continue to simmer without quite boiling over.

• Regional trend: The rest of South Asia will be consumed with domestic issues.

In the rest of South Asia, domestic squabbles between governments and their opponents took place as per our predictions with one exception: Afghanistan. The advances made by the Taliban, the diversion of U.S. attention to Afghanistan because of progress in Iraq, and the rise of Pakistan's own indigenous Taliban movement has pushed Afghanistan into a world very different from the self-contained situations in Sri Lanka, Bangladesh and Nepal. In the third quarter, the decaying security situation in Pakistan will intensify Afghan militant activity, and will push NATO in general and the United States in particular to boost the involvement of their troops in southeastern Afghanistan.

Latin America

• Regional trend: Brazil is rising as the continental hegemon of South America.

Politically, financially and militarily, Brazil is truly prospering by Latin American standards. Independent of the fact that the country discovered yet more oil fields in the second quarter, Brazil certainly surged ahead of the rest of the continent by any measure.

The economic realm is where Brazil is shining brightest. It exports or is self-sufficient in many of the commodities whose prices are causing the rest of the world no end of problems -- but its governance is professional and competent enough that it is, so far, managing the stress of high prices at home.

In the meantime, its primary regional competitors -- Argentina and Venezuela -- are struggling, falling backward in relative power as Brazil strides forward. Brazil is leveraging this growing space competently. In the second quarter, Brazil became the largest single investor in Argentina. And in the third, it will take its first shipments of liquefied natural gas, setting the stage for it to declare full energy dependence from its unreliable neighbors. And with its investment into the energy industries of those same neighbors, Brazil is laying the groundwork for controlling their energy options, not the other way around.

• New regional trend: Crises are brewing in Latin America's leftist bloc.

In the annual and second-quarter forecasts, we dealt with Argentina, Bolivia and Venezuela separately. We now weave those three trends together: The populist policies that all have adopted are coming home to roost.

Argentina's financial, political and economic stability is taking a sharp turn for the worse. Argentine President Cristina Fernandez de Kirchner's populist efforts to placate a variety of groups have consistently laid the foundations for future, greater problems. The juggling already has radically increased Argentina's debt and reduced the country's trade surplus by a quarter -- despite soaring international prices for all of Argentina's exports. This shortsightedness is triggering unrest on a national level, sparking runaway inflation of the type that has made previous Argentine governments fall. It also is gutting the country's productive capacity in industries in which it was until recently a global leader, and is raising the specter of food shortages in the not-so-distant future -- quite possibly before the end of the third quarter.

Meanwhile, Bolivia is slowly sinking into chaos as the divisions deepen between the poorer, populous and indigenous highlands led by President Evo Morales and the more European and richer lowlands. Morales will hold a referendum on centralizing power in the third quarter, essentially attempting to force the lowlands into economic and political submission. So long as the lowlands physically control the economy on which the government depends, however, they cannot be talked or voted or threatened into submission. When the government realizes it cannot resolve the situation through constitutional channels -- and we do not expect this realization to occur in the third quarter -- Bolivia will have its defining crisis. Until then, the imbalance of political and economic forces in the country will only become more skewed, making the eventual conflict that much worse.

In Venezuela, it appeared at the beginning of the year that the opposition was beginning to coalesce into a meaningful political force that could challenge President Hugo Chavez. That trend has since faded away, but Chavez's own economic and political mismanagement has more than compensated for the lack of threats to the regime. Chavez has in many ways become his own worst enemy. Rising food and commodity prices, combined with self-destructive means of dealing with them, have soured the Venezuelan population on Chavez's leadership and fractured the ruling party. Many of Chavez's attempts to rally nationalist sentiment -- threatening war against Colombia, for example -- have instead backfired badly.

The country's social stability has been reduced to the point where it depends on Chavez's lavish social programs. But the cost of these programs is rising faster than the country's oil income, making Venezuela unique among oil exporters as the only one getting poorer with global crude prices at historic highs. Against this backdrop, it would be logical for foreign states hostile to Chavez to take a swipe at him, or for domestic opposition to rally against him, but no one with the capability to hurt Chavez has a deep enough interest to take any dramatic steps (the same, incidentally, goes for the Argentine and Bolivian governments). In the third quarter we expect Chavez's credibility to take hits -- abroad, but even more so at home -- as the system's coherence begins to crumble.

The problems of all three states feed upon each other. Bolivia's secession crisis and poor economic management are reducing natural gas flows to Argentina, complicating Argentina's existing power crisis. Venezuela's political -- and by some reports, military -- support for Bolivia's Morales only outrages and emboldens the secessionist lowlanders there. Venezuela's financial support for Argentina not only reduces the cash Caracas has to stabilize its own system, but several billion dollars of debt linkages now tie the economic problems of one state to the other. These connected problems, mostly rooted in the three countries' populist economics, have been building for years. In the first two quarters, cracks in the facade began to show -- but in the third quarter the depth of the problems will become apparent. We do not expect any catastrophic failures in the next three months, but it is time to start thinking of just that.

• New regional trend: Mexico is facing a moment of truth in the government's war against the drug cartels.

In our annual forecast, we predicted a continuing intensification (but not a resolution) of the Calderon administration's war against the country's powerful drug cartels, particularly along the Mexican-U.S. border. But in the second quarter, the cartels began carrying out high-profile assassinations of top law enforcement personnel in Mexico City itself, and this has forced the country to a decision point that will evolve the war into something new. Sustained attacks on key personnel in the halls of power are something that no state can tolerate. If they continue, it will mean that one (or a combination) of three things must happen eventually:

1. Mexico City could strike a truce with the cartels to save the central region.
2. Mexico could hurl every asset it has into the war in an effort to at least secure the country's core.
3. The cartels could strike a truce with each other and force the government away from the border and onto the defensive. In essence, this would turn Mexico into a failed state.

None of the options is easy or pretty -- and none might come to pass in the third quarter -- but this much is clear: the current situation is untenable.

Africa

• Regional trend: In contrast to previous years, there will be little direct involvement of the major outside -- or even inside -- players. The one exception will be Angola, which will enjoy a rare day in the sun as the continent's up-and-comer.

It would have been hard to hit this one any more directly: Africa simply has not seen any meaningful direct involvement from the traditional players, whether from the continent or beyond. China has made a couple of commodities deals, but little more. India and Japan each hosted Africa summits but have not pursued other engagements. The French are participating in the European Union peacekeeping force (EUFOR) in eastern Chad, but they are keeping their heads down and have not intervened between the Chadian government and opposing rebels. The United States pulled back on plans to relocate its Africa Command (AFRICOM) headquarters from Germany to Africa. Nigeria is preoccupied with managing the Niger Delta, and South Africa has engaged in very little direct activity in Zimbabwe. Even Angola, the region's up-and-comer, is currently focused on internal development. (In the second quarter, it overtook Nigeria to become Africa's leading oil-producing state.)

But if the second quarter was quiet, it will seem like a roar compared to the third.

China has the Olympics, France has the EU presidency, and the United States is in the middle of an election campaign season and has little capacity for putting pressure on its African allies over relocating AFRICOM.

Nigeria's perennial problems with internal stability will take center stage as the country's Ijaw ethnic community makes its firmest -- and, if necessary, most violent -- bid for a larger slice of the country's oil revenues when Nigeria's government convenes the Niger Delta Summit, expected to commence in late July.

In South Africa, the internal issues that absorbed the country's attention for the past quarter continue to beckon. President Thabo Mbeki truly is already a lame duck and has minimal room to maneuver in either domestic or international politics. A leadership transition is only a year away, and the likely next president, African National Congress chief Jacob Zuma, continues to be hounded by corruption allegations, complete with court cases. The single issue on which Mbeki can act is Zimbabwe, where growing international condemnation has provided an opening for Pretoria's more nuanced policy of engagement.

Only Angola, awash with oil revenues, will have the luxury of picking the issues it wants to address without fear of reprisal or competition. But even Angola will have internal issues to keep it busy. Parliamentary elections -- the first since 1992 -- will occur in the third quarter, and the government wants to add a stamp of electoral legitimacy to its list of achievements. The rest of the world, it seems, can wait for another day.