With 100,000 Russian troops massing on the borders of Ukraine and enjoying a buildup of supporting airpower and logistics, I was happy to receive Admiral James Stavridis and Elliot Ackermann’s cheerily entitled book ‘2034 – a Novel of the Next World War’ through the letterbox (with thanks to Michael Levitt).

The book outlines how a potential naval focused war between China and the US might play out. It is a fun read though also an unvarnished appeal for the USA to spend more on cyber capabilities, and at times ascribes a tactical naivety to the US navy that is implausible.

While there is a cottage industry of writers opining on the ‘next’ war in the South China Sea, Stavridis is well qualified as a warrior and scholar. From my own non-military perch, the book emphasized at least four things about the ‘new world order’ that Xi Jinping references at last week’s Boao Forum.  

The first of these is that clusters of books that warn against coming wars, may eventually be worth paying attention to. The outstanding example here is Erskine Childers’ ‘The Riddle of the Sands’ which intricately unveiled the contours of how Britain was vulnerable to a surprise attack by the German navy (a trajectory later enacted by Maldwin Drummond in Rune VII).

A related thought is that history repeats itself, which is why the argument of Graham Allison’s ‘Thucydides Trap’ is a seductive one. In addition, reading Margaret McMillan’s ‘The War that Ended Peace’ I was struck by the inexorable buildup of navies (principally Germany and Britain) in the early part of the 20^th century (that Norman Angell also flagged in ‘The Great Illusion’) and the parallels between this phase of history and the growth of the Chinese navy, which on number of ships alone is bigger than the American one.

The third point is that Stavridis and Ackermann have their timing all wrong – today it already feels like we are close to a ‘2034’ type scenario. New geopolitical ‘gangs’ are forming – the Quad (Australia, Japan, India and the US) and the SCO (China, Pakistan, Russia…with guest appearances by Iran), and China in particular is at odds with most of the countries in its geopolitical hinterland (notably India where border skirmishes have been followed by cyber attacks).

Add to that the growing effectiveness of drones on the battlefield (as witnessed during the brief war between Azerbaijan and Armenia) and talk of ‘quantum warfare’ as the ‘next big thing’ and the future does indeed look bleak.

In that context, there are maybe a few other points to set straight. First, and this might be my markets background talking, but there is so much discussion of a grand naval battle in the South China Sea, that it is unlikely to happen. A piece of grand naval theatre has few winners. Instead, look at the way that Hong Kong has been subsumed by China, with only a whimper from the West. China’s approach is multifaceted, based on constructive ambiguity.

This provokes a second point that in the future we will see fewer outright wars, but a lot more conflict and tension (over ‘rare places and rare materials’, my February 27^th note).

In this scenario, outright war takes a backseat to strategic contests – where cyber power, soft power and in particular financial power are brought to bear on rival nations and constellations. This is especially the case with digital currencies, where the People’s Bank of China’s trial roll out of a digital yuan (Digital Currency Electronic Payment, DCEP) in cities such as Shenzhen, Chengdu and Suzhou has ignited a debate as to whether this is, in part, a maneuver to supplant the dollar as the world’s dominant currency, and also threatening the place of other currencies such as the pound.

Reflecting this, the Bank of England and Treasury have announced the joint creation of a Central Bank Digital Currency (CBDC) taskforce to coordinate the exploration of a potential UK CBDC. In my view this ups the ante in the roll out of digital currencies and underlines the notion of ‘money is power’. It does not mean that the dollar is in demise – digital currencies from central banks come at a cost in the sense that the central banks gain ever more information and control over economies and transactions. For this reason, I am not sure that African companies for instance would prefer – a digital dollar or digital yuan?

To close out the ‘total war’ loop, the ruble is one currency that is unlikely to transplant the dollar or the pound anytime soon. Indeed, it oscillated last week on every flex of the Russian army’s muscle. As I finish writing this note, the Russians have pulled back from the Ukrainian border – possibly because the terrain is still too muddy for a decent tank charge, but more likely because they feel they have sent a message regarding NATO enlargement and the Russian view of Ukraine’s geopolitical role.

The real question is – what will Russia be like by 2034? By then Vladimir Putin will still have two years to run on his elongated presidential cycle…who knows what he will have gotten up to?

Have a great week ahead

Mike

Baldwin’s Beard

One of the notable, recent developments in the arcane world of economics was the news that Andy Haldane, the chief economist of the Bank of England is to leave the Bank in September (to become the chief executive of the Royal Society for Arts).

Haldane is an interesting character, aware of the need to broaden the public appeal and communication of economics, and who has a gift for the obscure but telling anecdote. For instance, in one paper on lending he highlighted how the beard of the 12^th century King Baldwin II of Jerusalem (originally from the north east of France), was used as collateral for a loan. Then, in an address to the influential Jackson Hole central banker gathering, Haldane delivered a paper called ‘The Dog and the Frisbee’. It says much about the dullness of central banking that the paper was greeted with raised eyebrows.

Haldane’s latest paper is on inflation (link below), where like any well trained economist he gave on one hand the reasons inflation could continue to be well contained and on the other, why there are compelling forces that drive it higher. Haldane concluded by coming out in favour of the higher inflation thesis, which may make him unpopular at the Bank – it is the fashion amongst central bankers to deny the risk that inflation could shift higher (at a time when market expectations of inflation are at multi-year highs).

I have flagged the risks of inflation to markets recently (‘Return of the Prodigal Economy’, March 27), and while volatility in the bond market has calmed, equities are encroaching on valuation extremes and market metrics like margin debt are very high. This is not yet accompanied by extremes in sentiment (e.g. complacency) but it does beg the question for most investors (institutions, pension funds, family offices and the like) as to whether equities can continue to produce positive returns. In the context of historical returns, there would have to be a very strong upturn in earnings, and a flattening out of interest rates, for equities to offer more upside.

The argument that equities have reached or are close to a slowing in upward momentum is a more nuanced one than ‘when is the next crash?’ A clue to the way ahead comes from the imprint of markets over the last year – lumber, gasoline, pork, oil, ethanol, soybeans, and small cap stocks are the best performers while government bonds, volatility and the dollar are the worst performers, a pattern that points to higher growth and higher inflation. To that end, markets will continue to be driven by the narrative surrounding the speed and ‘temperature’ of the recovery.

A more pernicious side-effect of inflation if we do see it (depends much on the velocity of money in the economy) is the impact of food prices on emerging economies. One way to think about this is to consider the UN FAO world food price index which since 2015 has hovered around the 100 level, but in the past six months has jumped to 120.

This move, should it persist, represents a high, large cost to families in the emerging world (who spend a large share of their disposable income on food staples). Add to this the high toll of coronavirus in countries like India, Russia and brazil, not to mention currency and bond volatility, and the prospect is that the coming decade could be as problematic for emerging markets as the 2000’s were glorious.

Whether this is the case or not, goes back to Baldwin’s beard. When Baldwin of Bourgogne (and Jerusalem) lived, real interest (loans) rates where in the mid-twenties, and economies oscillated from high inflation to deep deflation (the Crusades had a marked impact on land prices across Europe). There were some notable, subsequent highs in rates – mid 16^th century Flanders, the reign of Charles II in England and a spike around the time of the Napoleonic wars. Despite that, the historic trend in rates has been downwards, markedly so as Western economies managed to get inflation under control in the 1990’s and as globalisation led to deeper commoditisation of prices.

The very, very big picture question then (going back to the 12^th century), is whether we are at a historic low in rates, and that in certain countries they will move higher as growth and inflation finally pick up, as in some cases country risk premia rise and as the weight of a multi-century high in debt to GDP ratio is felt.  

If rates rise, it will result in one of the biggest changes in fortune across countries in decades, perhaps centuries. The emerging economic world could be at the epicentre of this because it is at the tail end of the inflation tiger. To that end, emerging economies need to think of how to recover from the deadly effects of COVID, whilst keeping their financial systems strong and stable.

Have a great week ahead

Mike

Only three people have ever really understood the Schleswig-Holstein business—the Prince Consort, who is dead—a German professor, who has gone mad—and I, who have forgotten all about it. Lord Palmerston, British statesman.

Palmerston’s musing on the Schleswig-Holstein question was always useful during Brexit, to illustrate its mystery and complexity. It is even better as a description for Northern Ireland, at least in terms of how well people outside Ireland understand the complexity of its political and social problems.

Indeed, with the exception of select pockets of the USA, and oddly still fewer pockets of the UK, there are not many who comprehend or are interested in the complex history of Northern Ireland, though to its credit, the European Commission gave it great attention in the Brexit negotiation process.

This lacuna should be filled by two recent books – Charles Townsend’s ‘The Partition’ and Ivan Gibbons ‘Partition’. I do not want to repeat the arguments of these books, but rather to simply make two points in the context of vicious rioting across Northern Ireland in the last week. The first is that the kindling of the riots is partly due to the fact that the historic Good Friday Agreement has not been accompanied by an ambitious Marshall style plan for the north that could have remade its society and economy.

The Irish governments recent ‘Shared Island Plan’ is a nod in the right direction, but politically Northern Ireland’s Assembly largely exists (when it sits) to channel money from London into the local economy. No one has yet dared a radical program of change for Northern Ireland, and the consequences are being felt.

Second, to a large extent however, the rioting in the North is provoked by the uncertainty over once steadfast boundaries. In particular the unionist/loyalist community is, together with British fishermen and farmers, realising the negative consequences of the Brexit deal for which they thoughtlessly campaigned (if in doubt look up the views of Sammy Wilson MP for example). The prospect of a de facto customs border through the Irish Sea (dividing the North from the UK) and talk of a united Ireland have sown discord. It lies with Boris Johnson to fix this.

I do not think that Northern Ireland will erupt into the kind of violence witnessed in the 1970’s and 1980’s, but it is an important warning sign for the implications of Brexit for the rest of the UK.

It may also be a sign of things to come, in a world where the fading of globalisation and the disruptive effect of the coronavirus, we will see more and more signs of ‘identity angst’ where shifting feel they are no longer anchored in ‘their own country’. Ironically in the context of Northern Ireland, the ‘Scots (Ulster) Irish’ in the USA are a case in point. As a demographic group they are one of the marginal forces behind the rise of Donald Trump (remember him?).

While it is not terribly edifying to search for the next socio-political breakdown, two further thoughts are worth drawing out in this regard. The first concerns emerging economies. Last week the IMF released growth forecasts for the chief economies of the world. What was striking was the relatively sluggish forecast growth for emerging economies, with a generalised rise in poverty. A structural slowing in growth in emerging nations will go against the grain of steadily rising prosperity of recent decades, and this could provide the backdrop to a more challenging political backdrop in Brazil, Ethiopia, Venezuela, Turkey and Pakistan to name a few countries where faltering economics, identity and ethnicity are faultlines.  

The other cohort of ‘identity angst’ candidates is in eastern Europe – principally Hungary, the Czech Republic and Poland, whose status as EU members is challenged by ‘strong men’ politicians, corruption, the influence of Russia (in the case of Hungary) and ugly Sammy Wilson style views on women’s rights, the LGBT community and liberal democracy.

The growing tensions in these countries – between, at a very stylised level, liberal pro European and generally younger generations versus those with a more regressive view of their country, will become more pronounced. These tensions may produce unrest, but they also need to be tended to by the EU, which has to increasingly defend and incentivise its values.

Have a great week ahead,

Mike

The departure of Donald Trump from the political stage has left a void of sorts in the flow of lurid and dramatic media. But this is a void that the financial industry seems keen to fill. Since January we have witnessed a crypto mania, Reddit craze, and the blow up of two investment funds (Greensill in Europe and Archegos on Wall St), to mention a few spectaculars.

This comes at a time when one of the most significant trends in the financial services industry is the rise of ESG (Environment, Social and Governance) investing, whose ostensible aim is to channel capital towards companies that are environmentally friendly, socially responsible and good governance.  The investor reaction to the Deliveroo initial public offering in London and the coming into force of the EU’s SFDR regime suggest that ESG focused investing is becoming more meaningful.

However, there is still an intrinsic contradiction in the behaviour of parts of the financial services industry and their efforts to sell trillions of euros in ESG products to investors and clients. Without being overly cynical, this incongruity is driven by incentives – the attraction of ESG as a cottage industry career path, and as one where as far as exchange traded funds are concerned for example, fees are higher than for plain vanilla products.

There is also a data problem. The ‘E’ part of ESG is a relatively data rich area and one where a firm’s climate impact is increasingly straightforward to capture. The quality of corporate social responsibility and governance are harder to capture, and much of the data collected by research firms that measure ESG comes directly from the companies being scrutinized and therefore susceptible to ‘greenwashing’.

While some new ESG ratings companies such as Equileap are trying to rectify this (from the point of view of gender equality) there are other vulnerabilities in the investor practice of ESG, most notably in investor voting on issues like pay and governance, which across the board is mild-mannered at best, and is not activist enough.

One overlooked aspect of ESG is that it is highly coloured by regional and national cultures. American corporates are more focused on the ‘S’ part of ESG, Europeans it seems focus on the ‘E’ part while the ‘G’ element is most important to emerging market investors. In general, corporate performance on ESG criteria is clustered in progressive countries – the Netherlands, Nordics and New Zealand for instance.

Against that backdrop, we need to ask whether there are ways to gauge what financial services firms are sincere when selling us ESG and ‘Impact’ funds, and generally preaching that they are ‘doing God’s work’. There are maybe three rules of thumb here.

The first, echoing Harry Truman’s desire for a ‘one handed economist’ is that the ‘left hand’ and the ‘right hand’ of a financial institution must be philosophically ‘joined up’ in the sense of being consistent in the ethics of what they do. Too many banks or asset managers have one division that pronounce the sanctity of their ESG or Impact efforts, and another that runs banking deals in extractive industries, pumps over priced investment funds or over-allocates to flawed enterprises (Wirecard was an example). 

Secondly, efforts to boost a financial institutions’ social responsibility need to permeate an entire institution, and its customers. There is little point in banks (one of the least female friendly industries) responding to gender equality by adding women to its board if issues like pay equality, childcare and sexual harassment are not fully addressed through organisations. Equally, there is a good deal of survey evidence to show that banks do a poor job of addressing the financial needs of women as customers.

The third area to examine is regulation and central banking. Since especially the financial crisis regulators have acquired a reputation for arriving late at the scene of banking accidents. Arguably one mistake they have made is to focus on disciplining corporate entities, in terms of fines, rather than individual bankers. A change in the burden of accountability towards irresponsible individuals would likely curb risk taking.

Related to this is the vogue on the part of central banks to try to solve the ‘E’ and ‘S’ parts of the ESG problem set. Whilst at the Fed, Janet Yellen nobly made reducing longterm unemployment a policy focus. In Europe, the ECB now talks about its role in spurring the green economy. While it is good to see central banks ‘caring’, the great danger is that the more active they become in say trying to change society, the more generous they become in monetary policy, and eventually, the more inflation and banking accidents we endure.

Have a great week ahead,

Mike