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,

Mike

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 6^th 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,

Mike

This year Independence Day falls on a Sunday so the associated bank holiday in the US will be held on Monday (5^th). 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 18^th 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 21^st 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 4^th of July.