Hidden Gems

One of the rituals associated with the World Economic Forum’s conference in Davos in late January is that a growing number of think tanks uses this event as an opportunity to release headline grabbing studies (Oxfam’s ’22 richest men in the world have greater wealth than all the women in Africa’ is one example). Of the prominent ones to catch the eye, the Bloomberg Innovation Index, the Economist Intelligence Unit’s Democracy Index and the WEF’s own, interesting Social Mobility Index, all stand out, for at least two reasons.

The first is that they underline the accelerated rise and fall of nations (in the Transparency International Corruption Perception Index, America has fallen to its weakest rating in eight years – at a time when ‘trust in government in the US’ is only 17% according to the Pew Research Centre) and the ongoing crisis of democracy worldwide (the Economist Intelligence Unit reports that ).

The second is that small, advanced economies top the league tables in nearly all of the studies published last week. For instance, the least corrupt countries in the world are New Zealand, Denmark, Finland, Singapore, Sweden and Switzerland, while the top ten countries in the WEF Global Social Mobility index are also small, advanced countries. Then, eight of the top ten countries in the EIU Democracy Index are also small, advanced states (New Zealand, Ireland, Switzerland, the Nordics), and to top it Singapore, Switzerland, Sweden, Israel, Denmark & Finland are in the top ten most innovative countries as ranked by Bloomberg.

Given that innovation, corruption, democracy and inequality are the key issues of our day, it is surprising that more investors and commentators, especially those in large economies, do not study the success of small states more carefully.

Regular readers will however know that this topic is one that is dear to my heart and is something I have written a great deal on with David Skilling of Landfall Strategy (his note on the ‘Decade Ahead for Small States’ is worth a read, https://www.landfallstrategy.com/commentary/2020/1/15/into-the-next-decade-for-small-economies).

At the risk of repeating myself, I think a few aspects of the ‘success of small states’ are worth restating as the new decade begins.

One is that, as growth slows globally, and at some stage the world economy faces the prospect of a recession, there will be a debate as to how (apart from taking on more debate and undertaking more QE) long term economic growth can be generated. The recipe for this lies in the many public goods (education, institutions) that are being denigrated in large developed and many emerging economies, but that remain healthily manifest in many small, advanced states.

Most of these economies are also highly globalized and offer a convincing rebuttal to the view that globalization creates inequality. Inequality is a function of the way in which individual states process globalization and the effect of financial markets on their economies. The US is the best example I can find, where wealth inequality is at record high levels. In contrast Ireland does experience income inequality at a gross level, but its highly redistributive tax system levels this out.

What small states in aggregate do well, with I should say some glaring omissions, is think strategically about the impact of the wider world on their economies and societies (Denmark for instance has a ‘Minister for Silicon Valley’), and then try to buffer these outside influences.

The other interesting phenomenon regarding small states and the wider world is how they are reacting to changes in geopolitics. Brexit has robbed Ireland and the Netherlands of a natural ally in Brussels, and both nations are now part of the ‘Hanseatic league 2.0’ group of small EU states that broadly speaking are pro-growth, fiscally responsible nations. On a broader scale, David Skilling and I have written on the need for a ‘g20’ of smaller, advanced states. Such a body might be one of the coalitions of the 21^st century, given that many small, advanced states have far more in common (democracy, leaders on environmental policy, focused on soft power). A platform like this might also give countries like Singapore, now torn between America and China as geopolitical partners, a different platform.

If readers are not convinced of my entirely biased case for small states, consider their investment performance. Over the last ten years, a portfolio of resilient, larger cap, export-oriented stocks in the twelve leading, small advanced economies have handily beaten Asian and European indices, and are not far off matching the S&P index. Time to pay more attention to small, advanced economies.

Have a great week ahead,
Mike

Peak Stocks, Peak Trump?

I recently gave a ‘Levelling’ related talk in Paris, where one of the points I made related to the way in which markets and finance have dominated our lives. I am often sensitive to the way markets are discussed in France. In contrast to the USA, where markets are seen as a source of wealth and to a degree, a part of American culture, in France, the opposite is the case.

This, in my view has something to do with France having a much longer economic history (August Landier and David Thesmar’s book ‘Le Grand Méchant Marché is worth a read on this point), and therefore more financial crises, than the US. Indeed, when John law was blowing up the French economy, the US was a ‘frontier market’ and colony of King George I.

One perspective on markets that I think interesting is they way they act as laboratories, signalling the impact of real-world events and economic policies. Markets can be brutally honest in this regard, pricing the effect of tragedies, wars and economic blight in an unsentimental way.

Some recent market behaviour has been revealing. For instance, the price of soya beans fell once the US and China signed their ‘trade’ deal. The drop in soya bean prices likely reflects a very sceptical view on the quality and enforceability (specifically that China would buy large amounts of US agricultural produce). In my view, this scanty deal only serves to provide the President with some politically helpful headlines, eases the stress on the Chinese economy and, profoundly underlines the fracturing in the relationship between the two countries.

In contrast to weakness in agricultural commodities, there are other market price moves that tell us little about the real economy, but a lot about how the plumbing of markets works. The recent, rapid rise in the price of Tesla stock is a case in point (the value of the company has doubled in the past six months and its equity value is worth more than the likes of Volkswagen, who produce far, far more electric cars). The rise in the value of Tesla tells us little about the health of the car market (modest in the US, weaker in Germany and China), but a lot about investor behaviour and the state of banking.

First, in terms of investor behaviour, by October of last year there was a sizeable community of investors sceptical that Tesla would ever become a profitable business. This set of investors had established large ‘short’ positions in Tesla stock. However, as markets rose, they were forced to cover or buy back these short positions, pushing the price ever higher. Anyone who thinks the sharply rising price is an indicator of Tesla’s future is mistaken, it is simply a function of investor positioning.

Another reason for the hubristic move in Tesla stock is that the federal Reserve has been infusing markets with more liquidity. There was a time when earnings, corporate strategy and good governance were determinants of stock performance. Today, in the USA at least, it seems that liquidity is the pre-dominant driver. In the aftermath of the global financial crisis, the banking system has changed in that the nature or species of participants in lending markets has become more diverse.

Hedge funds, private investors and asset managers now participate in lending marketplaces that were once the preserve of banks. The other change is that regulation has pushed banks to have smaller balance sheets, so to that end they are less sizeable players in many corners of financial markets.

At the same time, the amount of debt in the world has ballooned. The effect of this debt load, the changed composition of the banking marketplace and the refinancing pressures it puts on the marketplace is that the Fed now needs to lubricate the wheels of capital markets more often.

As it does so, it adds fuel to speculative fire, which in recent weeks has taken many measures of risk taking to extremes (Tesla’s rise is one example). Regular readers will know that I hold central banks guilty as charged for encouraging people to take on, rather than calibrate risks.

One upshot of this is that strength of the stock market is being used as a self-marketing tool by President Trump (in a recent note I commented that the number of his stock market specific tweets had increased sharply since November). Trump also loudly eggs Fed Chairman Powell on to be more accommodative. As such the Fed is now losing credibility, in a way not seen since the mid 1970’s, and it is entangling itself in asset prices in a way that will compromise it and the US economy.

As for President Trump, the potential near-term peak in equities might mean we have seen peak Trump, especially given the commencement of the impeachment hearings next week. His approach is that of a classically short-term property speculator – take on debt, pump up the value of an asset and then try to sell it. As he does so he is mortgaging the pensions of future generations, and potentially, his next four years in the White House. The stock market is due a correction, and so is Trump.

Perhaps someone, even in Paris no less, will write a book called ‘Le Grand Méchant Président’.

Have a great week ahead,

Mike

The Fracturing continues – from Tehran to Taiwan

A friend of mine, who is also a successful sportsman (rower) once told me that he trains every Christmas day, just in case his competitors take that day off. It is a quirky piece of advice but one that I have long since borne in mind.

Thus, as I returned home from my Christmas morning run, I was interested to read that Russia, China and Iran – were using the Christmas period for a naval training mission in the Gulf of Oman. Presumably, like my friend, they thought the US and its allies were taking Christmas day off.

The exercise points to the emerging rivalries of the 21^st century. China and Russia are members of the Shanghai Cooperation Organisation (SCO), which readers of the Levelling will know that I consider to be one of the geopolitical ‘gangs’ of the future. Their rival regional gang is the ‘Quad’ (India, USA, Japan and Australia).

The significance of the SCO, and the recent exercise with Iran, has now been heightened by the killing of Iranian general Quassem Soleimani. Indeed, it is just one of many implications (by the way in my last missive before Christmas I noted that in 1998 Bill Clinton had responded to impeachment by launching an airstrike on Iraq, and that another President might try the same tactic).

The immediate one is that the USA will find its moral and diplomatic power diminished, and both its allies and foes again demanding whether the White House has a coherent approach to policy making (Israel’s muted reaction was telling).

For example, the missile strike on Soleimani cuts across an increasingly successful financial and clandestine war against Iran that was producing inflation, unrest and a surge in crime across the country. The airstrike will now allow the Iranian regime to paint its socio-economic troubles as being generated by the hand of the CIA and MI6 (there is a long held, view across Iran that foreign spy agencies are behind political and economic turmoil in the country).

The killing of Soleimani also means a likely diminution in the American presence in Iraq, that Americans are less rather than more safe, and an altogether more uncertain outlook for some of the smaller states in the region, notably Bahrain, Dubai and Abu Dhabi. While the tension between both Iran and the US is perceived to have diminished following the Iranian riposte, I think this dispute is not over, and the event itself will lead to a hardening of attitudes.

To return to the SCO, Soleimani’s death will underline the rationale for this grouping and we should expect to see it become more prominent. Russia in particular may now look to play a stronger role in the long term future of Iraq and Syria (potentially with the backing of Chinese capital).

Russians will underline how the Kremlin was both concerned and emboldened by the 2003 invasion of Iraq, that it later took aggressive measures to defend what it perceived were threats to its hinterland (in Georgia and Ukraine).

At a grander level, the killing of Soleimani will cause tension within NATO, and will heighten calls by many for an EU army, that can at some stage have the capacity to act alone, though with the US under the NATO umbrella. It should also, at least in terms of the security and foreign policy push the UK towards rather than away from the EU, and in my view this partnership could well be one of the more stable pillars in the post Brexit relationship.

In sum, this critical event points to some near-term event risk, notwithstanding the apparent de-escalation (Iran’s public de-escalation points to stealth retribution), and an elevation of longer-term geopolitical risk (and by extension political risk in the US in the context of the election).

Geopolitical risk, or rather geopolitical events, rarely trouble broad equity and debt markets but my worry is that we are now seeing a fracturing of the world order (this weekend’s Taiwan election is a case in point and expect the newspaper pundits to talk of Taixit from Sunday), and the emergence of a one where geopolitical friction becomes the norm. Expect this to be increasingly reflected in the securities of pan-global companies, certain emerging market debt securities and in safe haven assets.

The real reason for calm across markets is central bank liquidity. They are the monetary battleships of the 21^st century, more powerful than many armies. What might happen if they are deployed in a conflict?

Have a great week ahead,

Mike