On Monday morning, Evergrande Group China’s second largest property development group will likely find itself unable to make the interest payments on a series of loans to China’s banks and will technically likely default, with trading in many of its onshore bonds already suspended. A key test will come on 23 September when the company is due to pay a coupon on a USD-denominated offshore bond.
With September being a seasonally choppy period in markets and the echo of the Lehman collapse (September 2009) audible, many will extrapolate the failure of Evergrande and talk of a coming market collapse, with contagion rippling across the banking sector. I am not so sure about this (just yet).
Most investors have had ample warning of the implosion of Evergrande (it has been paying liabilities with cash from pre-sold apartments that are not yet built), and to a degree market prices reflect this – Chinese junk bond yields are trading at 14%, the highest since onset of the coronavirus crisis (Evergrande accounts for nearly 15% of junk issuance).
While it can’t be ruled out that on Monday morning stockbrokers will circulate lists of companies that have exposure to Evergrande and the broader Chinese property market, the central expectation I have is that the Chinese authorities will permit a controlled, cushioned collapse of Evergrande where banks provide liquidity for viable projects and others are parceled off to other developers.
This approach may also see the arrest and denunciation of its executives, the restructuring of the company (though no state bailout) and the injection of liquidity into the financial system. China is unique amongst major economies in that it has plenty of scope to stimulate its economy.
What will be far more interesting and instructive than chatter about a ‘Lehman’ moment, is the insights the collapse of Evergrande will give us into the principles and durability of the China that Xi Jinping is trying to build.
The Chinese authorities, having carefully studied how Europe dealt with its financial crisis, will not want three things to happen – that the government takes more debt onto its balance sheet, that there is widespread unrest (which unusually we have already seen last week), and that as a result, the China Dream is derailed.
If I am correct this gives a clue as the iteration of the Chinese model (what to Westerners can be described as the ‘social democratic’, without the democracy) that Xi Jinping has manifestly been shaping since the start of this year, marked notably by crackdowns on business leaders, strategic industries and economic activities that might harm social cohesion (such as video games and private tuition), will fare. Its guiding light seems to be to avoid anything that harms or distracts the ‘common good’, and by extension the Communist Party.
To that end we can expect the authorities to respond by allocating as much financial and social pain as possible on the owners, executives and promotors of Evergrande and other property firms, plus investors in the company’s offshore bonds to avoid moral hazard.
In the context of Xi Jinping’s dictum that ‘houses are for living in’ I don’t expect a broad bail out of investors, but the authorities may either invest more in social housing, or once prices have adjusted, aid younger families to buy a home (housing affordability is just one reason for the low birth rate). The exposure that many have to property related wealth management product and to property itself partly reflects China’s under developed savings and pensions industry, and this is one area where we may see policy makers pay greater attention (in The Levelling )
If there is unrest in parts of China because of the turn in property investments, I am unsure how the Chinese authorities will deal with it. While there is currently an effort to dampen and shape reporting of the fallout from Evergrande, social media networks across the country are animated by the topic.
Given that the contract behind the China Dream is founded on the exchange of liberty for prosperity a negative wealth effect may result in a more angry populace. A wise way to deal with this would, as above, for the authorities to double down on the idea of the social welfare safety net, wiser still if Evergrande is just the first in a range of economic shocks.
Just over a decade on from the global financial crisis it is hard not to write about a credit event like Evergrande without conjuring the spectre of debt crisis past. It should be a reminder that with world debt to GDP at near record levels, the prospect of an international debt crisis awaits us at some stage. My thesis (in The Levelling) is that it happens in 2024 on the centenary of the 1924 debt conference. One of the ways I distracted myself during the early part of the coronavirus crisis was to sketch a script as to how the politics of the 2024 world debt conference might play out, though I suspect it has little chance of making it to Netflix.
Neither do I think that we are now on the cusp of a 2021 debt crisis – China has too much monetary and fiscal space, and the central banks of the developed world are hard wired to meet any market risk with more and more liquidity, until they do too much and cause a monetary accident.
The greatest near term risk is that, having avoided a major (domestically inspired) recession for a considerable period, China now suffers a simple, negative demand shock, that dents the post COVID recovery but that also removes inflation as a concern for markets (and thus interest rates remain low).
Let’s see what Monday morning brings.
In this note, I often write about faraway places – most of which I have visited. COVID has deprived me and many others the chance to add to my list of ‘rare places’ but it may well have enabled a new land called ‘the Metaverse’. The Metaverse is something – socially and economically – that we will hear a lot more about in the future, and one that many people will struggle to comprehend. A sure sign of its arrival is that the likes of Facebook and Microsoft are pouring billions into the building out of this virtual reality universe.
To start with, I confess I have little direct experience of the Metaverse, so I write about it somewhat uneasily, but like bitcoin some five or so years ago, it is popping up on the radar in numerous blogs and newsletters and there is a sense that the metaverse itself is becoming better organised and notably, developing its own economy.
As I see it, the rise of the Metaverse is the product of technological (blockchain, virtual reality) changes as well as social ones – most of which I have found bizarre but that more oddly have been sanctioned by the social side-effects of the coronavirus crisis. They include online funerals, the virtual work phenomenon and contactless dating (there is a section on this in Chen Quifan and Kai-Fu Lee’s forthcoming book ‘AI2041’).
The Metaverse then, to have a go at defining it, is where people enjoy digital experiences (driven by augmented and virtual reality) that are real to them in the sense that they involve activity, interaction and emotion, and that are increasingly anchored by infrastructure like the digital economy, digital identities and decentralised forms of organisation.
To clarify this a bit, some examples of the Metaverse or ‘mirror world’ are online video game Fortnite, virtual reality design tools for architects, social media tools like SnapChat’s Lens Studio, augmented reality tools that superimpose an interactive virtual world on a real one like a street map (on a car windshield for instance) that has pop ups signs customised for the user, and of course the growing ‘esports’ and virtual sports industry.
To give a sense of the amplitude of the MetaVerse, in China 10% of the population (i.e. more than 100 million people) use the online game (or mobile multiplayer battle arena!) Honor of Kings on a daily basis.
So, the Metaverse is catching on. It might be cruel, careless and complacent of me to portray it as one where unhappy people in windowless rooms leap to the MetaVerse where they are happy, fulfilled and rich. I am perhaps only revealing how old fashioned I am – most of the things I like reading, travelling, running and the odd drink, are real rather than virtual experiences. For instance, a virtual marathon is nothing like a real one.
Beyond my own crude view of the MetaVerse, its growth will highlight a number of new trends and sources of friction between the real and virtual worlds. This is often the case when new eco-systems grow, let alone new universes or ‘shared-worlds’. One area of contention is identity.
In the real world our identities are largely set by factors like birth, geography, culture and education, and are largely known to the extent that they are captured by passports and id systems and by our interactions with other humans. In the MetaVerse, one can construct a new identity, which is free of geography and social ties (theoretically a more egalitarian setting), and potentially very different to the user’s real-world identity.
One lesson we learn from social media is that people behave differently online to in the real world and are often badly behaved given the cloak of a twitter handle. The MetaVerse is likely no exception, and apart from scoring systems and digital contracts on blockchain, is hard to police.
This also opens the intriguing question that, if the Metaverse does grow in terms of enjoying hundreds of millions of active participants, who governs or polices the MetaVerse?. The idealist’s answer is that it is uniquely organised through decentralised contracts and relationships, and that various avatars have their own codes of value. They may also be established by the programmers of online games and engineers at Facebook, betraying the reality that the organisation of the MetaVerse reflects the nature of those who build it.
A backlash against aspects of the MetaVerse has already begun. This is partly because in some countries – notably Japan where 40% of millennials reportedly are virgins – the use of social media and prevalence of fantasy based augmented reality, diminishes socialisation. In China, there is a backlash against the overuse of video gaming, screens and social media by the young, to the extent that last Thursday the share prices of ‘metaverse infrastructure’ providers Bilibili Inc. and Kuaishou fell by about 8%. It is an interesting, and open question as to whether the desire by the Chinese authorities to control the internet more tightly, pushes Chinese people towards the MetaVerse or limits their access to it.
One area where the MetaVerse is indubitably on the rise is the economy. NFT’s (non-fungible token) are a component of the MetaVerse (Sotheby’s announced on Thursday that two ‘Bored Ape’ nft’S sold for USD 24.4mn), and we might say that the main commodity of the Metaverse is Ethereum which effectively fuels the construct of many of the elements that make up the MetaVerse.
The Metaverse economy – where people for example buy real estate in virtual reality games or sponsor avatars – will, if futurologists are to be believed – be a big thing. Predictably we will see MetaVerse investment funds and maybe even specialist corporate finance boutiques for Metaverse assets.
What is not yet clear is the extent to which the growth and inflation of MetaVerse assets is a function of the record levels of liquidity in the global financial system – I suspect that this is the case, and the real tests of the MetaVerse may come when, and if, the Federal Reserve raises interest rates.
Have a great week ahead,
Last year, following the election of Joe Biden as President of the United States I wrote a note on his diplomatic and security team entitled ‘They Speak French’, the aim of which was to contrast the feckless Trump foreign policy team with the erudite (French speaking), principled Biden team, made up of the likes of Tony Blinken.
The hope, I thought at the time, was that the (Jake) Sullivans and Blinkens of the world would restore order and prestige to the State Department, thought the risk was that they would spend too much time debating policy papers and speaking French. This is not regarded as a positive in American politics as catcalls (‘Monsieur Kerry”, “Jean Chéri”, or “Jean-François Kerry”) to John Kerry have shown!
In the context of the fiasco of the Afghanistan withdrawal, the Blinken team is chastened, though still united (unlike the Trump crew). True to the title of my earlier note, Blinken gave several interviews to French media during the crisis but failed to heed the recommendations of the French intelligence service to start the pull-out in May. On the face of it, the USA has suffered diplomatically, and sadly has also borne a human cost, as have many Afghans.
Too many people, some of them military and security experts, have analysed the faults of the withdrawal, and here I have little new to contribute.
From a different, finance led angle, one might say that Biden is doing the right thing in finally withdrawing, and so ‘taking the loss’ as traders say, and ignoring ‘sunk costs’ as accountants say. If there is a failure, it is a deep seated institutional one – of the military industrial complex as Eisenhower termed it, though recent readers may be aware of my upgrade of the term to the Military Industrial Financial Data complex.
I suspect that much of the commentary around the withdrawal will continue to swirl around banners such as ‘American decline’, ‘end of empire’ and so on. I am not so sure about this train of thought but would also point to some of the other, potentially profound geopolitical implications.
To start in Afghanistan, the Taliban are likely wiser and more politically sophisticated than the savages that took Afghanistan in the mid 1990’s, but not by much. Their immediate aims will be to avoid international controversy (in terms of not instantly clamping down on foreign workers and Afghans with foreign ties), subsume the Afghan state or what is left of it. An economic and financial crisis may be their first challenge.
To this end, China may provocatively become more commercially involved in Afghanistan – it can source commodities such as iron, copper and niobium and may also seek to edge the Belt and Road project into Afghanistan in terms of providing physical infrastructure. Such a move would constitute a fillip to the West but China has already been warm in its diplomatic response to the Taliban. To that end the war on terror has not ended but is shifting location, whilst the ‘Great Game’ between the US and China is now well underway.
In the broader region, there are at least three broad concerns. The first is the relationship between India and Pakistan. It is widely believed that Pakistan is the progenitor of the Taliban, and while not controlling them, can certainly coordinate with them. The cold reality of this may finally break the political relationship between the USA and Pakistan, to the advantage of India.
India is a member of the QUAD grouping of countries (with the USA, Japan and Australia) and it may now deepen ties to the USA which in turn would mark the rivalry between the QUAD and the SCO (Shanghai Cooperation Organisation – largely Pakistan, China and Russia) as the one to watch in the 21st century.
The second regional implication relates to Islam itself, the perception the West has of it, and the geopolitics of Islam. To many who do not understand the intricacies of the Islamic world, the Taliban represent a severely negative view of Islam, to the extent that they discredit it, and some may use the existence of the Taliban in the debates that Europeans and Americans have on issues like Islam and immigration.
To that end, Sunni Muslim countries like Saudi may publicly at least feel a need to put distance between themselves and the new Afghan government, though this will likely drive internal tensions with their Wahabi population.
As far as Shia Islam is concerned, Iran had come close to an outright war with the Taliban in 2000 and will regard them with great distrust (so far there have already been attacks on Shia Muslims in Afghanistan), notwithstanding the way in which the Taliban have embarrassed the United States. The geopolitical implication for Iran is that it now has marginally more power in terms of its dealings with the US, and dangerously, it may feel that the power of insurgent style warfare is validated, as far as Lebanon and Syria are concerned.
Thirdly, terror groups across the world will be watching the way the Taliban have acted – their gruesome, savage tactics, their strategic patience and the ways in which they have used the vulnerabilities of Afghanistan against it. My worry is that Africa is at risk in this respect – from Mozambique to Nigeria to Ethiopia to Mali – where efforts by the US, British and French to train locals to fight are bearing little fruit and where the institutional quality of these countries is very poor. Counter-insurgency strategists and security services will have to carefully calibrate not their tactics, but strategies for fighting terror groups in these countries.
That leads me to the issue of the strategic direction of security strategy in Europe. In the UK, which has put much into Afghanistan, the lesson is that it likely needs to become closer to key European countries (Netherlands, Norway, Sweden and especially France). From a military point of view, the irony being that despite Brexit, Britain and France are operationally very close.
The other related trends to watch for are the debate on military spending in Europe, and the emergence of a bigger, more robust European army from the cloak of NATO. Even in neutral Ireland, which has a small army in absolute terms, the Afghan crisis has triggered a debate on military hardware, and the necessary security it should adopt (there is a review ongoing). Much the same will happen around Europe, and the stance of the next German Chancellor on this area will be crucial if other countries are to step forward and match the military capabilities of France and the UK.
As a last word (I realise that this note is already longer than the usual 800 words, but I have been ‘off’ for the past two weeks), the underestimated element in the Afghan withdrawal is that it allows the US security establishment some clarity on its true objectives – countermanding Russia and limiting China. I suspect that in coming months the Biden team will take a much more aggressive approach to these countries, potentially in the form of a fulsome cyber retaliation on Russia, and the export of high-level military technology into Asia.
Have a great week ahead,
Since the COVID-19 pandemic began, I have periodically tried to assess what type of country, political system or culture has best dealt with the crisis. In general, while I biased to think that smaller advanced economies have done well, the only workable rule of thumb I can find, is that once a nation thinks it has triumphed over COVID, it immediately suffers a nasty reversal – the quick spread of the Delta variant across the USA and June’s outbreak in the Netherlands are two good examples.
Other people have done a better job than me at delineating the way governments have dealt with the coronavirus. One of the better explanations I have heard is from David Skilling who makes the distinction between liberal market economies (LMEs) and coordinated market economies (CMEs). LMEs use decentralised, competitive and flexible market mechanisms; CMEs rely more on established informal, relational arrangements between a range of stakeholders. In that context, the liberal market economies were initially quicker to organise supplies of vaccines and to distribute them. In both models, anti-vaccine protests are on the rise, as we noted last week.
A new helpful study from Australia’s Lowy Institute adds to the debate. They have produced a COVID Performance Index which analyses data across 100 countries to determine how they have responded on economic, health and other criteria. Interestingly it shows that authoritarian countries have performed better than democratic ones, and more encouragingly that states with competent institutions, medical expertise and higher levels of trust in government have performed well. Many Asian countries have performed well, given they possess the above characteristics and potentially granted their prior experience with SARS. In addition, islands appear to do relatively well also. What is striking is that there is little difference in ‘COVID performance’ between developed and emerging countries.
I found this interesting because I have a sense that for the first time in over twenty years, the pace of development of emerging economies is being checked, and manifestly slowed. There was a time when emerging market growth and the evolving consumer behaviour that accompanied it was one of the most exciting themes in financial markets, and for a spell, emerging markets easily outperformed developed ones (in the very long run there is little to separate them performance wise).
This is beginning to change and my sense that there is a gap opening up between the emerging world (outside China) and the developing world. The availability and roll-out of vaccines is one such marker (Ireland has a vaccination rate of 80% which contrasts to a rate of 3% across Africa).
In addition, in many of the exciting themes I have covered in recent notes, such as the race for rare earths/materials/places, the importance of cybersecurity, the premium on innovation and the scarcity of democracy, most emerging nations are far behind Europe, the US and China. There are exceptions of course, as the excellent Emerging World daily highlights (such as growing urbanization and the rise of ‘unicorn’ companies in South Korea and India), but my sense is that as the new, decisive trends of the 21st century are concerned, the emerging world is dropping off the pace.
One notable indicator of this is interest rates. Developed world central banks continue to whirr their printing presses, amidst mild mannered talk of a ‘taper’. At the same time, 50% of emerging market central banks have raised interest rates, notably Brazil did so recently by a full 1%. The sense is that the emerging world is operating into a financial headwind, much of which is its own making. Turkey is a prime example of how a leader can destroy institutions, talent and the stock of economic potential.
Much of this is reflected in financial market prices, the performance of emerging market equity indices relative to developed markets is still close to the lows of the year, and both a stronger dollar and a ‘taper’ of asset purchases by the US Fed (tune into the Jackson Hole monetary policy offsite on 26th August).
The notion that the emerging world is now less speedy in terms of its growth outlook than the developed world is reinforced by GDP forecasts from the IMF which expects the economic rebound in Russia, Nigeria, Brazil and South Africa to tally at 3%, 2%, 2.6% and 2.2% respectively in 2022, as opposed to 4.2% for ‘sick economies’ like France and Italy, and 5.8% for Spain.
If my intuition is correct this means we may see greater economic, financial and political volatility across emerging markets, especially if interest rates continue to rise, and if in the near term Asia suffers a ‘delta’ led economic slowdown (lead indicators in China and Indonesia for example are dipping).
There are two more profound implications, both of which involve a breaking of steadily built expectations.
The first is that many emerging nations are held together socially and politically by the sense that they are on a path of improvement and prosperity. If that contract is broken, as it is manifestly in South Africa, this will produce greater political volatility.
The second relates to the relationship between the non-China emerging world and the developed world, to the extent that most developed world leaders recognize such a relationship. There are not many instances of the emerging world checking the power of the developed countries, but my feeling is that we will see both a growing dissatisfaction with world bodies (UN, IMF) and efforts to create new alliances between growing, populous countries from Rwanda to Nigeria to Bangladesh.
This might herald a new era where populous emerging nations seek to become more independent from the Western world (and potentially the China centric world), and by necessity seek to improve the quality of institutions, governance and transparency, all of which are lacking. This will be a very long term project, but logically could well be the ‘next’ phase of the emerging world’s development path.
Have a great week ahead,
Donald Trump, remember him? He recently asked his supporters to help choose the design of a ‘Trump card’ which they would carry as proof of their allegiance, and of course, their patriotism. Following several failed projects (blogs, radio shows) this lurid tactic represents the further gamification of politics and reflects Trump’s instinct for marketing and his aim to turn politics into a consumer goods subsector. No doubt donors of differing levels of generosity will be offered platinum and gold Trump cards.
There are two other, more serious implications. The first is that such a move, together with recent eye-popping fund-raising rounds by Trump, will deepen the divide in the Republican Party, and set the political agenda for the next midterm elections and 2024 presidential race. The first and main issue any Republican candidate must make is how to position vis a vis Trump (the Missouri Senate race for Roy Blunt’s seat is a case in point).
The second is that in the post COVID world (we are slowly getting there) we are seeing a range of new markers of political behaviour and values. The most striking and deadly is the difference between those who wish to get vaccinated and those who do not (sadly many in emerging countries don’t have this choice).
I have seen many versions of a chart that plots the proportion of people in each US state that have been vaccinated together with the predominant political affiliation in that state – Republican states have low vaccination rates whilst those in Democratic states have a much higher rate. I presume that any of those who will carry the Trump card, do not have a vaccination pass.
Similarly, in France vaccinations have become a political issue but what is not generally remarked on is that the number of people who have signed up to be vaccinated following Emmanuel Macron’s speech (where he declared cinema, restaurant going conditional on the production of a vaccine certificate) vastly outnumber those who protest against vaccines. What is now interesting is the way in which this ‘marker’ or divide is quickly becoming institutionalized – many companies will only allow vaccinated employees to return to their offices and governments across a range of countries are tilting incentives towards those who are vaccinated.
I don’t disagree with this and think that as regards the COVID pandemic it is for the good. As a policy exercise it has lessons for how governments can shift, or ‘nudge’ to use the popular term, popular behaviour in positive ways. At the same time, it has obvious dangers in the sense that some governments may take the vaccination template and replicate it for other problems. Will it for example be applied to healthcare where those who drink, eat and smoke too much will be denied state funded healthcare or forced to pay a higher price for it?
What is equally interesting is the way in which the political climate will be shaped by the policy response to the COVID pandemic and the various trends (i.e., digitization) that it has set in motion. In short, what I have in mind is that healthcare related choices like vaccination have become markers of political identity, in the same way that at a country level a government’s stance on LGBT rights has become, in my view, a marker for broader qualities such as a country’s openness, the quality of its democracy and its ability to innovate.
If willingness to become vaccinated against COVID-19 is a marker of political disposition, what might others be?
Keeping with the idea that digitization is growing, one of the developments we may see in the future is the digital passport, effectively a key that can reliably identify someone and link their identity to a national database (i.e. social security). This development may become necessary as part of the roll out of digital currencies, as part of the broad initiative on cyber security and, to an extent, to police anti-social and illegal behaviour on the internet (note that the EU plans to have such a digital identity in operation by 2030).
As these measures come into place they will create political friction, and in particular a group of people who choose to be ‘outside’ or against the system. Other key and emerging issues will become political markers – an awareness of climate damage is now coming into mainstream politics, with Germany a lead test case, and the emergence of crypto and digital currencies will also test the sense that ‘with/against the system’ will become an axis in political debate that may supplant the traditional left/right.
Trump should have gone for a ‘Trump digital wallet’ rather than a gold card.
Have a great week ahead,
Zhou Enlai, one of the founders of the Chinese state and its first premier, is at the centre of an often used misquote. It is reported that he was asked (during the 1972 Nixon visit to China) for his assessment of the 1789 French Revolution and that he replied, ‘Too early to tell’. In fact, the question had referred to the 1968 student riots in France, and the translator had succumbed to the temptation not to let the truth get in the way of a good story.
Similarly, with the Hang Seng index and the more specific China technology indices down 10% at the start of the week, it is ‘too early to tell’ if this is the beginning of a China led financial market and economic crisis of the type that we witnessed in 2014/2015 and to a lesser extent in 2018. A China crisis proper is high on the list of my ‘things that could go wrong’, but so far China remains the ‘country that has failed to fail’.
The collapse in Chinese equities, especially those in the social media and education sectors owes much to weighty government regulation. In the education sector, the authorities have declared that the rise of private education companies is warping the public education offer and creating inequalities in access to public goods. I generally agree and would suggest that the same is true in Western countries such as the UK and US (ironically there are hundreds of thousands of Chinese students in British and American universities). Most economists will agree that cheap or even free good quality education is the basis of a civil and innovative country.
Where China is different is in the force of its policy making. It has imposed harsh restrictions on its education companies, including a proviso that they cannot make a profit. As a result the price of New Oriental Education fell from USD 8 at the beginning of July to below USD 2 last Tuesday. Equally the share prices of social media driven companies from TenCent to DiDi to Alibaba have also fallen as the Chinese government has also looked to exert a heavy hand over the use of consumer data. They have bounced back somewhat but the credibility of the Chinese market is still at stake.
In the West, these moves will cause some confusion and alarm, not least amongst those who think China is a lesser version of the West. In my view, China is the most successful developmental story of our time, and one where policy (unlike the West) follows a textbook approach, and is importantly, guided by the goal of keeping the ‘Chinese Dream’ on track.
In China, the idea of the ‘rule of law’ is quite different from the way Westerners interpret it, and rather means rule from above, or by the central authority. Here the calculation in Beijing, is that short sharp shocks to certain industries will limit greater socio-economic imbalances and thus avert a larger, existential crisis later.
There are also strategic elements, both for the Communist Party and its leaders, the need to shake up dominant layers and drive investment to other sectors (i.e., semiconductors), and the need to, like the EU, take a lead in forming data regulation.
To that end, investors should view this sell-off, which has pushed Chinese equities into a bear market, as tactical, especially if in coming days it is accompanied by measures to support credit growth in the Chinese economy.
There is a risk of contagion, and there are plenty of ingredients for this. For example, margin debt on trading accounts in China is very high, Chinese high yield bond spreads are the highest they have been in five years (except during the initial COVID sell-off) and economic momentum is sluggish.
In this context, a revolt by investors – both domestic and international – who fear that the Chinese government is going ‘all communist’ would trigger a more prolonged sell-off. In particular, there is a risk that international investors increasingly demand a ‘government intervention’ premium for Chinese assets.
Signs to watch here are weakness across the Chinese credit complex, rising government bond yields and a dip in the yuan, as well as in other cyclically sensitive Asian currencies and international equity indices (e.g. DAX). More broadly a ‘China scare’ for markets would quickly reverse the reflation trade and see fear mongers talk of a demand shock. It might yet be ‘too early to tell’ but China is set to become the driving story in the marketplace.
Next week the retail trading platform Robinhood will go public under the ticker ‘HOOD’. Robinhood’s public offering will likely value it at over USD 35bn, and together with a recent fundraising round for European digital bank Revolut, the acquisition of wealth manager Nutmeg (by JPMorgan) and a listing for trading platform eToro (in a special purpose acquisition company), the Robinhood IPO marks a pivotal moment in the transition from ‘old’ banking and towards what is known as fintech. As such, it is a good milestone from which to judge a number of evolving trends in finance.
While the Robinhood IPO is a sign that the fintech world has ‘arrived’, like many totemic IPO’s it may also signal a top or high point for digitally driven companies. Bear in mind that a couple of months ago we pointed out that prominent market listings (e.g. from Glenore to Coinbase) tended to mark the end rather than the beginning of a market trend.
My own judgement is that from an industry point of view, the fintech megatrend is only beginning and will evolve over the next decade. It does also remind us that to a large extent investing in incumbent banks is fruitless, especially so in Europe and Asia, where apart from the ebb and flow of the yield curve, bank performance is undercut by poor governance, inefficient IT spend and short-termist management.
To put this in stark, performance terms, since May 2006 the MSCI European Equity market index has doubled, while the MSCI European banks index has halved. It doesn’t look like European banks will catch up any time soon even though these ‘dinosaur’ banks (that still collectively hold well over Eur 700bn in investor capital. In contrast the global fintech benchmark has doubled in the past three years.
That doubling has been the result of the emergence a number of new finance eco-systems – retail trading, the retail options market, and crypto to name three – each has its own luridness, excitement, specific sociology and anthropology (from master of the universe options traders to crypto ‘bros’ – the crypto universe is not a female friendly one), to the meme stock traders of the Wall Street (WSB) bets discussion forum on Reddit.
Mindful of the rise and fall and rise again of the WSB traders, the Robinhood IPO will be an excuse for many commentators to trot out the phrase that we are witnessing the ‘democratisation of finance’, but the reality is that we are seeing the democratisation of risk in the sense that different forms of financial risk (leverage, liquidity risk, information asymmetry) are being packaged and sold to the public.
At the other less democratic, indeed elite end of finance (established hedge funds and family offices), there is greater demand for ‘private assets’ (top quality credit funds, venture capital and stakes in growth companies) and in many respects this is one of the more interesting, less discussed parts of the financial world, and certainly the most lucrative.
Another trend that needs greater attention, especially from anyone looking to invest in fintech is how the fintech business model works or doesn’t work. From the outside the likes of Robinhood seem likely highly profitable trading engines, in fact, a perusal of the four-hundred-page SEC S-1 regulatory filing for the IPO (which has over 70 pages on ‘risk factors’) shows that despite USD 81bn in client assets, Robinhood makes the lionshare of its revenue from selling data on client trades to, predominantly, two large hedge funds. In that respect it is more like Facebook than it is like say UBS or Bank of America.
At the same time, there is a strategic, industrial structure-based shift in finance with the steady encroachment of technology companies into finance. The logic of fintech is allowing technology companies to enter the finance world – either as trading platforms, social networks devoted to finance or payment platforms that then develop a more complete service offering (TransferWise, which recently listed on the London Stock Exchange as ‘Wise’, is a good example).
What is not entirely clear here is the way in which the tech and fintech ecosystems will change both the incumbent banking system, and the overall financial system – with implications for monetary policy and regulation.
The Robinhood pre IPO documents also show that 14% of client assets are in crypto, which from a standard asset allocation of portfolio point of view is enormous (I can imagine that a proper portfolio theory approach would put it as 1-2%). Nonetheless, that shows that ‘crypto’ has captured the investment narrative, especially amongst young people and this has much to tell us -about the ‘spirit of the market’ today, not least for the dangers it presents to wealth.
In this respect one of the very significant trends in coming years will be the battle between centralised and decentralised finance – led by governments and regulators, but that will encompass many areas – law, philosophy, politics and technology. One of the coming challenges will be assigning responsibility across the US regulatory system for crypto assets like bitcoin and the infrastructure that drives them. What is worrying is that even ‘experts’ like Gary Gensler (head of the SEC) have not stepped forward to take this particular bull by the horns.
Theoretically the ‘defi’ world (decentralized finance) operates outside of the ‘old’ centralized financial world and its real economy, but ‘defi’ cannot viably operate independently of the much greater centralized finance world (made up of the likes of JPMorgan, central banks and governments). To that end, the ‘defi’ winners will be those who can adapt to the ‘old world’ and that are alert to geopolitical sensitivities around the evolution of the world financial order.
Have a great week ahead,
One of the more remarkable and still under-estimated films I have seen in recent years is ‘A Face in the Crowd’, a 1957 production by the two-time Oscar winner Elia Kazan. The film is remarkable in a number of senses, especially for the way in which it prefigures the populist use of media – radio and television for political purposes. Anyone watching Andy Griffiths play Larry Rhodes in the film will think immediately of a recent US president, and given the film is based on a book called ‘Your Arkansas Traveller’ by Budd Schulberg, it’s hard not to think of another President from Arkansas.
‘Face in the Crowd’ highlights not only the umbilical link between populism and the media but also the disastrous end that many populist figures face. Populism is one of the plights of our times, for a range of reasons – the dislocations of globalization, the side effects of immigration, poor policy responses to inequality and the rise of social media are a few.
An excellent analytical resource in this regard comes from three German economists (Manuel Funk, Moritz Schularick and Christoph Trebesch) who have previously carried out excellent work on the connection between financial crises and the rise of populism. The researchers have compiled a database of populism that tracks the rise and fall of the phenomenon over time and its economic and political consequences.
The most troubling aspect in their research is to show that populism is at its highest point historically – 25% of the countries in their sample (16 of 60) have or recently (in 2018) had populist governments, as compared to only 14% in the 1930’s. Typically, populism is associated with weaker growth or economic volatility – an occurrence that makes sense if we think of the weakness of the Turkish lira, unrest in South Africa and in general, the consistently poor handling of the coronavirus crisis by populist leaders. The German researchers also show that most populist leaders suffer an ‘irregular’ political exit, and will no doubt be adding the events of January 6th in Washington to their database.
The ‘populism peak’ is important in many respects, not least for the way in which populists feed off and exacerbate the issues of the day – the ambivalence of some Tory politicians over racist acts against English football players is one example.
My hunch is that inflation is about to become the latest populist focus. Recent data show that in the US and increasingly in Europe, inflation is awakening after a long slumber. Indeed, many professional economists and investors have never experienced high inflation. In the USA, some inflation measures and price components are the highest that they have been since the 1980’s. The consensus and official view on rising inflation is that it is ‘transitory’ – driven by a burst of coronavirus recovery spending. The risk, across many fronts is that it proves more enduring and thus can cause financial, economic and political pain.
This is where inflation becomes interesting to populists – anything that causes economic pain and social discomfort is populist ammunition. Indeed, there is plenty of evidence to show that inflation is often the offshoot of populist economic policies as the economic history of Latin America shows.
Inflation, if it is here to stay, will become a political issue in at least three ways. The first is housing where the OECD’s housing affordability gauge has gone vertical (i.e. housing is extremely unaffordable), easily surpassing the levels of 2008 (recall the housing crisis). In some countries like Ireland there is a persistent and acute housing crisis, the debate around which is becoming populist – though it should be said that there has been a broad failure to manage this issue from a policy point of view.
The second way in which inflation becomes an issue is where rising real living costs are not matched by wage rises (we may see this in about six months’ time as economic activity and policy normalizes) and ‘the price of things’ becomes a topic of political debate and increasingly, agitation. In the past, and particularly in emerging economies where households spend a large amount of disposable income on food, price rises can lead to unrest (i.e. the Arab Spring).
Third, rising inflation brings the prospect of rising interest rates which will not only make life more complicated for mortgage holders but will ignite a debate on indebtedness, its consequences and remedies. Lurking behind this is the fact that central banks by declaring inflation ‘transitory’ and not yet giving any sense that they are worried about asset price inflation nor the consequences of asset purchases, find themselves snookered. As we have seen with the tussles between Donald Trump and Fed Chair Jay Powell, central banks make easy targets for populists and can be forced into bad policy decisions by them.
So, inflation if and when it materializes, may be political fodder for populists and if it does, this will complicate the policy and political outlook. Populism is difficult to counteract, and often the best remedy for it is the incompetence of populists themselves. What might be the best solution for inflation – I propose that it is populism. As the study I mentioned earlier shows, populists tend to depress growth, and therefore inflation.
There were three events that occurred last week, two of which mirror each other, and that are logically tied up in the third.
The first is the decision of the Chinese internet regulator to suppress the use of the Didi (effectively a Chinese version of Uber or indeed Uber is a Western version of Didi) web application based on concerns over the way it collected personal data and the related potential governance and disclosure shortcomings in the Didi initial public offering.
The second was the decision by US Department of Defence to reopen its JEDI Cloud contract process (note to all arms dealers if you want to convince a government to buy a weapon or weapons system, it needs to have an appropriately convincing name).
The two events are united by a key sentence in President Biden’s midweek speech on the withdrawal of forces from Afghanistan where he stated ‘we will be more formidable to our adversaries and competitors over the long run if we fight the battles of the next 20 years, not the last 20 years’. China and Russia have the same idea, and the battles of the next twenty years will be ‘total’ in that they will encompass cyber security, finance, social media, and trade as well as military aspects, and they will have a strong competitive (as opposed to outright conflictual) aspect.
As a result, the broad topic of security will be all encompassing – stock markets and cloud computing are just two elements that will be drawn into this vortex. This reminds me of the comment of another President Ike Eisenhower, one of only three Presidents to hold a high military rank (after Washington and Grant) who warned ‘we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military–industrial complex. The potential for the disastrous rise of misplaced power exists and will persist. We must never let the weight of this combination endanger our liberties or democratic process’.
His words ring true today, more so in the light of data and cyber security. They should also alert us to the fact that the military-industrial-financial-data complex (MIFD) will be an expensive affair. In the USA at least, military spending is vast, and often wasteful. Bear in mind that one of George W. Bush’s economic advisers Larry Lindsay, effectively lost his job for estimating the cost of the Iraq War at between USD 100-200bn (it was multiples of this).
Also bear in mind failed spending projects such as the Future Combat Systems Program (USD 46bn), the Crusader gun, a new Bradley tank, the Commanche helicopter (again pay attention to the project names). Also, set all of this against the early warning from the US Defence Intelligence Agency in November 2019 of an emerging pandemic in China and the subsequent government failure to spend on preventative measures, we get the sense that military hardware led investment is overly prioritised.
To give the military a break, all this raises two finance related questions. One is whether the geopolitical contest between the US and China will skew government spending, and the other relates to the combination of military research and innovation.
In the past, warring states have pushed themselves to the brink of bankruptcy – the Napoleonic Wars, the gigantic expense of the German and British navies in the 1910’s and nuclear weapons spending in the cold War. The risk here, and as with the comparison of military and COVID-health spending, is that there is a great, ultimately value destroying wave of investment spending in cloud computing, cyber and data security and drone technology.
The risk also is that the increasingly fashionable idea of industrial strategy in the US (again another example of America becoming more like France) becomes led by the MIF’D. Brian Deese, President Biden’s National Economic Council adviser is already pointing towards developing strategic industries such as semiconductors and telecoms, but the risk is that this strategy becomes skewed by the geopolitical side of the debate rather than the necessarily important focus on productivity.
My final thought is on innovation, where despite inefficiencies in the way military procurement is handled, the underappreciated side of military related spending is innovation. Israel, somewhat controversially I should say, proves this point. A great many of its leading technology firms have been developed as follow throughs from its soldiers and some of its battlefield technologies (Iron Dome, and its drone and robotic battlefield programs) have spawned successful commercial applications and reflect a thriving public-private innovation partnership. Indeed, Israel is cited as a case by Mariana Mazzucato in her thesis that states have a key role to play in driving innovation.
However, beyond extreme data points like Israel, the reality is that the countries that are best at innovating, do not have MIFD complexes, but rather good education systems, progressive incentive structures and state support (rather than control). In that respect, the biggest obstacle to innovation in the US is that it becomes the plaything of geo-politics, and increasingly of a small community of investors who it seems increasingly view innovation as something to trade rather than to nurture.
Have a great week ahead,
This year Independence Day falls on a Sunday so the associated bank holiday in the US will be held on Monday (5th). This is not wholly unusual. Benjamin Franklin celebrated the first Independence Day with a dinner for close friends (including John Adams) in Paris. Franklin’s dinners were part of his diplomacy as America’s man in Paris, and the American Club in Paris has continued this tradition (as I am on the topic of Paris, visitors and residents alike should visit the superb, newly restored Hotel de la Marine which will give a taste of the magnificence of the ‘Franklin era’ in Paris).
Franklin is a good example of a political figure who is associated with food, Churchill being an obvious one (Cita Selzer’s book ‘Dinner with Churchill’ is good) and I suspect nearly all the French Presidents (see Jean d’Ormesson star in ‘Les Saveurs du Palais’ for example). By comparison, the post Brexit squabble over sausages is banal.
Franklin, one of my favourite historical figures, also reminds us of many other things, the first of which is that we will rarely see his like again – he was a writer/publisher, physicist, diplomat and politician, amongst many other accomplishments and hugely influential in setting the values and codes that shaped America.
Politics is now such a cruel and demanding ‘sport’ that it is unlikely that someone of Franklin’s many talents (the same is true for the other Founding Fathers) would or could rise to the top (note that the positive trend of rising female participation in top level politics is accompanied by the fact that relatively few European leaders have children illustrating that it is difficult to have a family life in politics).
The other aspect of Franklin’s great life that is worth commentating relates to his time in Paris and the very close ties between America and France. It is very likely that few of those who stride up and down Lafayette Avenue in lower Manhattan know of the contribution of the Marquis de Lafayette and also of the writer Beaumarchais to American history. France and America entered the 18th century as the lynchpins of the democratic world and together with England, Ireland and a host of other European and Asian nations, are still its flag bearers.
What is worrying however is that democracy and much of what Independence Day represents is under steady attack. Some years ago, the American political scientist Larry Diamond wrote of the global ‘democratic recession’ and in recent years think tanks like Freedom House and the Economist Intelligence Unit have remarked on a broad based decline in both the number of democracies and in the quality of democracy.
Almost 70% of countries covered by the EIU’s Democracy Index recorded a decline in their overall democracy score, while the global average score fell to its lowest level since the index began in 2006. The EIU’s database shows that the leading democracies of the world are largely small advanced countries, which contributes to a sense of the vulnerability of democracy vis a vis larger countries, while some of the ‘freedom’ maps from Freedom House show how (geographically) polarised democracy is across the world.
If asked ‘what worries you most about the world’, my response is that democracy withers away and with it the rule of law and the role of credible institutions. We can see the effects of this in countries like Brazil, Hungary and Turkey but we could just as easily dismiss these as emerging markets.
That’s wrong on two fronts – what will shape the world in the 21st century is the form of governance that populous fast growing countries like Bangladesh, Nigeria, Rwanda and Vietnam. Second, in countries like the UK that were hitherto regarded as bastions of democracy, the quality of government is visibly deteriorating.
Moreover, to return to Larry Diamond, he has recently written in Foreign Affairs magazine that the world may face the prospect that American democracy would die out, leaving the international political economy directionless and shapeless. To that end, the politics of states like Georgia may be more meaningful than what happens in domestic politics across India.
The worry is that ‘fake news’, voting restrictions and a radicalised Republican Party lead the US further away from democracy and in the absence of a unifying figure of the mantle of Hamilton (beyond President Biden it is not clear who the obvious next candidate will be given the poor performance of the Vice President) there is a leadership vacuum.
It may be, unfortunately, that such a threat is required to bring forth the next Benjamin Franklin. Happy 4th of July.