Forecasting is difficult, especially the future

Nils Bohr, the Danish physicist is rumoured to have stated ‘Prediction is very difficult, especially if it’s about the future!’. I agree.

Last March with the pandemic in full, terrible flight, I laid out three scenarios for how the coronavirus hit world and its financial markets might develop (https://thelevelling.blog/2020/03/28/why-did-nobody-notice-it/). To a certain extent, each of my optimistic, medium and pessimistic scenarios played out – such was the unpredictability of the virus and the ways in which it and other forces caused economies and political systems to contort themselves.

In particular, my prediction of a nasty, second wave was largely correct –

Under this ‘pessimistic’ (20%) scenario, much of the world’s workforce is disrupted by the virus, and second waves become the norm. Social unrest, political disunity and a breakdown in diplomacy between nations (US and China for instance) are some of the resulting side-effects. Monetary and fiscal policies cannot contain the full effects of bankruptcies and unemployment, to the extent that central banking ‘accidents’ crop up. The 1930’s is the nasty template to follow here. Property markets and alternative asset classes like private equity are hard hit

What is striking is the part I got wrong, that financial and market collapse was not the natural consequence of the second wave of COVID and the economic damage it has caused. That much is due to the speedy arrival of vaccines, generous fiscal packages and the seemingly never ending supply of central bank liquidity. This last factor is the one that has made the difference between an ebullient market environment and a cruel and testing real world.

In last March’s note I wrote that the distinguishing feature of the coronavirus’ passage through societies and economies was its speed, and this continues to be the case. Vaccines have been developed at a record pace, in many countries – the US for example – the economic rebound is speedy and the adjustment of businesses to a more digitally driven economy has been rapid.

With vaccination rates rising quickly in developed countries – Switzerland and France for instance are accelerating their programs – it is now time to take stock, and offer a few more predictions, or at least frame some broad scenarios.

As background, we know the following ‘truths’ in the light of the coronavirus crisis. Central banks continue to be the force that holds markets together and loftily above the reality of an at times wretched world. In coming weeks, the beginning of the debate on the Federal Reserve’s tapering strategy may induce more volatility.

Then, at a country level we do not yet know what kind of ‘model’ has best withstood the side-effects of the virus, though it is clear that populists (Modi, Trump, Bolsonaro for instance)  struggle with the health, social and economic effects of the virus.

In addition, the rise of the digital economy and manifest changes to the way we work are increasingly well understood. What is altogether less welcome is the general lack of collaboration between nations (the spat between Britain and France over fishing rights near Jersey is another example of this), and the emergence of a steadfast geopolitical rivalry or ‘Great Game’ between the USA and China (and Russia), that increasingly incorporates a scramble for scarce resources (rare earths, computer chips, and the Arctic for example).

Looking ahead, pent up demand and hefty fiscal and monetary stimuli, together with the fact that different countries are exiting the coronavirus crisis at different times, and the background factor that the crisis begun at the end of one of the longest periods of expansion in economic history, makes forecasting the near future all the more difficult. Notwithstanding that I can think of three scenarios to bear in mind till the end of 2021.

‘Brave new World’ (30% probability)

The ‘Brave New World’ is one of extremes. In this scenario, the large economies have emerged from the coronavirus and growth is barrelling forward. Despite manifest inflation, central banks are slow to rein in activity. Investment in new technologies is booming – Europe leads in green technology, the USA has a 5G revolution and China is the quantum computing leader. Central banks introduce digital currencies faster than many think necessary, drones become the frontier military technology and a debate begins on a new world institution to police the internet. Climate change becomes a significant driver of security across Africa and Asia.

In finance, investors increasingly differentiate between ‘new’ industries and companies and ‘old’ ones, such that many long established banks, consumer brands and energy companies trade at record high dividend yields. At the margin, asset managers and large family offices build portfolios that include sizeable private asset portfolios (private debt and venture like investments), crypto currency and stablecoin portfolios, agriculture centric assets in Latin America.  

High food price inflation slows growth in many emerging countries, and in the developed world, falling bond prices cause pension fund crises across Europe.

‘Two Armed Economist’ (45% probability)

This scenario is more probable, but less clear – if that makes sense. The reason for this is that once the initial ‘post-COVID’ bounce is over, we will enter a world where imbalances are met with market and policy responses, and overall economic and market outcomes will be volatile. For example, it is now clear that the Biden administration is reacting to wealth inequality in the way it is framing fiscal policy, and that in addition extreme price moves in eclectic assets – from Ethereum, semiconductor chips to lumber – are causing real world economic pain and confusion.  

This pattern of ‘equilibrium’ building continues – in many countries economic activity becomes better distributed away from capital cities (Paris to Bordeaux, Dublin to Galway) and across regions (Amsterdam to Barcelona, Zurich to Nice?) such that there is a new wave of infrastructure spending on telecoms and public services, and property market growth follows a similar path. There is a slow but meaningful revolution in healthcare and education, and at the universities level, the multidisciplinary ‘complex systems’ approach is in vogue (again, following Nils Bohr’s example).

In markets, the lingering coronavirus (and inflation) slows growth in emerging markets, the trend towards the democratisation of risk continues and the apparent rise of inflation causes both the major asset classes, developed world equities and bonds, to underperform somewhat. The surprise is the ongoing failure of the dollar to rise, though printing presses may have something to do with that.

‘Reckoning’ (25% probability)

A reckoning scenario, where many of the risks that are building in the global system (climate damage and super high debt levels) begin to erupt, is in my view likely between now and 2024, but just not in 2021 (I sound like a two armed economist or a central banker!).

This scenario will most likely develop around the permanent effects of the coronavirus on the labour force, a macro environment characterised by stagflation, which in turn leads to widespread popular discontent as real wages fall. In such an environment, fiscal policy is effectively spent from the recent rounds of stimuli, and monetary policy is rendered ineffective by rising inflation and low growth. As such markets begin to price in the risks associated with very high debt levels and a credit crisis ensues. In this scenario credit and broad equity markets falls by up to 20%, with short-term government debt in developed world countries gaining. ‘Democratisation of finance’ type investments suffer a huge liquidity drawdown that produces a numbing ‘democratisation of risk’ retail investment crisis in the US and China.  

This is a sobering scenario, but at least it may not play out just yet, not next week anyway.

Have a good week ahead, Mike

Grün und Eisen

In last week’s note I wrote about the ‘2034’ style prospect of the next world war, ostensibly between the world’s dominant power the United States, and the rising power, China. In the back of the collective minds of those who think about such scenarios, is the rise of Prussia in the 19th century, and by extension, the rise of Germany in the early 20th century, with the resulting two world wars.

We could trace the rise of Prussia (and Germany as we know it) back to a speech in September 1862 by Otto von Bismark on the issue of German unification where he stated ‘The position of Prussia in Germany will not be determined by its liberalism but by its power … Not through speeches and majority decisions will the great questions of the day be decided—that was the great mistake of 1848 and 1849 but by iron and blood’. Bismark’s ‘blood and iron’ came to define Germany (not to forget other factors…I have Fritz Stern’s ‘Gold and Iron’ on the shelf near me).

It may well be that other countries neglect the lessons of ‘blood and iron’ and that it becomes their geopolitical mission. What I find interesting is that as a phrase it no longer defines Germany, something that is exemplified by the rise of Annalena Baerbock as the leader of Germany’s Green party, and by the rise of that party itself.

Fusty, geopolitical hawks won’t be happy with this. The Germany of the ‘well sealed windows’ to use Angela Merkel’s characterisation of her country, is one where only one sixth of the army’s tanks and helicopters are operational and the army has a major recruitment problem. Worse, most of Germany’s politicians seem to want to accommodate the actions of Vladimir Putin, offering dialogue whatever the provocation. The hawkish response is for Germany to cut off the Nord Stream II gas pipeline, invest heavily in its army and wait for the Russian tanks to come.

For better or worse, that scenario is unlikely to come to pass. While much of the international press focuses somewhat mistakenly on whether Marine Le Pen can supplant Emmanuel Macron as French President in 2022, the future of Europe lies in the hands of the successor to Angela Merkel. From afar it seems like a contest between a group of colourless, older men and Annalena Baerbock. While she enjoys a high rating in the polls, it may well transpire that Baerbock ends up leading the junior party in a coalition government. Still, her arrival on the political stage has at least three important messages.

The first is that the Green Party is moving towards the centre of the political stage in many countries. This comes at a time when banks and central banks are embracing ‘green investment’ and when many mainstream political parties are adopting the environment and the fight against climate damage as a core policy issue. Commensurately, Green parties across Europe (apart from Jill Stein and Tom Steyer the USA does not have a green party worth speaking of – though corporate America is very active here) are beginning to focus more of their attention on non-environmental centric policy issues. A good example is the recent interview that Baerbock gave to the Sunday edition of FAZ (Frankfurter Allegemeine Zeitung) where she gave a balanced centrist view on foreign policy.

Related to this is, in the context of ongoing severe climate damage across the planet, the hitherto failure of Green parties across countries and potentially across continents, to better coordinate amongst themselves. Arguably, the green or environmental cause is the only one that is universal in the sense that it is a risk all countries face, in the same way though to different extents.

To that end it is surprising that Green movements across countries are not better coordinated. This might be due to the fact that Green movements in individual countries have idiosyncratic founders, and that increasingly green policies are being adopted by centrist parties.

The second lesson from the rise of the Greens in Germany, apart from what it says about voter fatigue with incumbent political parties, is that it demonstrates the idea that values are becoming an important driver for both voters and consumers. Regular readers will know that I think that globalization is giving away to a multipolar world where large regions are defined by increasingly different ways of doing things or values.

Amongst them, Europe, led by Germany is driving a value set that prizes the green economy, protection of its citizens from the negative side effects of technology (i.e. data and AI). One of the great challenges for the first post-Merkel government is the extent to which it prosecutes this approach, notably in the way countries like Hungary are wilfully out of step on issues like the treatment of women, minorities and the respect for the rule of law.

The third factor to watch is how the deeper involvement of the Green party in German politics transforms German industry, so that for instance it makes Germany the world leader in energy cells and battery technology and vaults the German car industry into a position of dominance in electronic vehicles, not to mention its energy dependence on gas imports from Russia.

If all that can happen, in years to come we will speak of ‘Grün und Eisen’.

Have a great week ahead,

Mike