It will never catch on!

When the euro was introduced just over twenty years ago, there were tales of people around Europe refusing to exchange their national currency notes for the single currency, on the basis that the euro ‘will never catch on’. When the hacking group Darkside ransomed the dataset controlling the Colonial pipeline last week, the ransom was paid in a cryptocurrency.

These two, different tales from opposite ends of the ‘money’ spectrum tell us much about how finance, and money in particular is evolving. At one end, we see the development of a new, traditional money (euro) and the centralised financial and capital markets (to an unsatisfyingly incomplete degree), that go with it. At the other end of the spectrum is decentralised crypto finance, that exists on a largely anonymous, unregulated way beyond the ‘old’ global financial system.

These two worlds are soon set to collide. Regulators, witnessing the speedy rise of cryptocurrencies, the lurid ways in which they are traded (e.g. dogecoin) and the threat they present to the incumbent financial system, will I suspect soon take a heavier hand in overseeing the architecture around crypto currencies like bitcoin which currently can’t be regulated, though the infrastructure or architecture that trades it can be overseen.

For context, these two approaches criss-cross many other related debates – the rise of sophisticated organised crime, the future of the dollar as the world’s reserve currency and the need to build emerging market financial systems that can curb corruption.

A potentially decisive development is the acceleration in the rollout of central bank digital currencies (CBDC). Central banks are set to issue digital versions of their currencies to accompany outstanding reserves and bank deposits. Theoretically, central banks will give each of us a retail account, and households can exchange money directly with them (as opposed to going through the banking and economic systems). The logistical and communication aspects of this project will be fiendishly complex to the extent that ‘it will never catch on’ echoes through my head.

It is however, catching on. Nearly twenty million Chinese are hooked up to an experimental digital yuan run by the People’s Bank, whose intention is that the 2022 Winter Olympics in China will serve as a showcase event for the digital yuan. Small, advanced economies – notably Switzerland and Singapore (not forgetting the Bahamas’ Sand dollar) are to the forefront in planning digital currencies as is the Bank of England, which egged on by the strategic urgency created by Brexit, may be the first large central bank to roll out a digital currency (the Fed and ECB also have blueprints).

It strikes me that the ingredients necessary for this sort of manoeuvre are a well banked and financially literate population, one that is well penetrated technologically, and a central bank with a very good policy and regulatory brains trust. (I attach a link below to a good overview from the BIS)

Digital central bank currencies can achieve a range of aims – from making the transmission of money a cheaper and faster process (though I am not at all sure that this is good for payment companies and banks), a potentially more secure banking system, and the possibility to rebuild decrepit banking systems (stablecoins – that are linked to an underlying asset/currency – can play a role here). Two other factors are prominent.

One is the ability of central banks to better tailor monetary policy. As it stands, quantitative easing is delivered through financial markets. With a digital central bank currency where households have retail ‘accounts’ at the central bank, it can drop money directly into household accounts, with even a bias towards certain types of households. For example, if the central bank decides that families with two children tend to have a particularly strong impact on the economy then it can funnel relatively more money to them.

The other aspect of the CBDC that deserves greater attention is the enhanced power that it will give central banks. In opening up accounts with the public and businesses there is the risk that central banks assume a Leviathan level of control over financial systems, and to a very large extent subsume them. In China where the government aggressively policies social media content, it may seem automatic that an institution like the central bank can have immense power over people finances, and to an extent act like a fiscal authority as well.

So, if central bank independence and their outsized role in the political economy will be called into question, the counterveiling argument, for the larger central banks at least, is the geopolitical value in rolling out digital central bank currencies. Indeed, China’s announcement that it was advancing its digital currency project has prompted the Fed and the ECB to flag their own programs.

This trend raises many questions, the most prominent of which is the long term role of the dollar. What is perhaps more pertinent is to think how the architecture of central bank digital currencies will evolve – to what extent will central banks have power over household finances and economic behaviour, and to what extent will digital currencies change banking systems (I half suspect that the Chinese authorities’ attempts to rein in Alibaba is conditioned on its plans for the digital yuan).

Two of the important structural issues are outstanding. One relates to emerging countries, whose currencies and relatedly central banks are not as liquid as the ‘old’ monies – will they try to launch their own digital currencies or will we see competing waves of dollarization, euroifciation and yuanificiation across countries like Argentina, Serbia and Malaysia? What is promising here is that countries like Colombia and Uruguay are already active in terms of either mobile payments systems or digital currencies, and in Africa Kenya’s MPESA is a notable digital success story.

The second issue relates to the way in which ‘centralised’ digital currencies will interact with decentralised finance (cryptocurrencies and stablecoins). There is a vision of how these systems can join harmoniously together (see Giles’ excellent DigitalEconomist post on this below). The concern is that by definition the evolution of the crypto world is happening at such a rate, and in such a disorganised way that it presents a threat to the established financial order, and that the two systems grow in parallel, competing ways.  It is an exciting and potentially very messy clash, though ultimately CBDC’s might just catch on.

Have a great week ahead,

Mike

https://www.bis.org/publ/othp33.htm

https://digital-economist.com/about/

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

2034 – are we already there?

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 20th 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 27th 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

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 12th 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 16th 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 12th 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

Identity Angst

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 ESG Paradox

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

Ever Stuck in the Great Lockdown

Ever Stuck

The encumbering of the supertanker MV Ever Given in the Suez Canal is the image of the week, or perhaps the year. It speaks to a world economy that has overgrown its natural infrastructure – a vessel greedily stacked with cargo that becomes so unwieldy that it is grounded by a puff of wind (high winds and a dust storm did for the Ever Given). It takes little imagination to think of problems like climate change and inequality taking the place of the tanker in the channel of the world order.

It is also an image that brings home the tangible elements of globalization – as I write 300 ships are stuck behind the Ever Given (at a cost of USD 400mn per hour), and their delayed passage through the Suez Canal will deprive people of vital goods, like toilet paper.

Besides demonstrating what a ‘house of cards’ globalization has become, the grounding of the ship echoes with other supply chain blockages – consider the deprivation of Parisians now that a supply of decent sausages, clotted cream and cheddar is cut off from the continent by Brexit (Marks and Spencer shelves are bare!) or the fact that the fortunes of the semiconductor industry are concentrated in a few hands, with chip shortages rippling through other industries (Volkswagen will produce 100,000 fewer cars because of chip shortages).

We could write off the various supply chain shortages, especially the unfortunate Ever Given, to a continuation of ‘2020’ style bad luck. Indeed, we might even blame COVID on supply chains as some analysts have traced the initial European human-to-human infections to Starnberg in Germany, where a local car parts supplier (Webasto) organized a training session with a Chinese colleague from its operation in Wuhan!

Before we shout ‘down with supply chains’, consider that they have proven both durable and complex over the course of the last year, having been stress tested by Donald Trump, tilted by the rise in new technologies (especially data management) and the ups and downs of the post COVID recovery.

The crisscrossing web of supply chains is the fabric of the global economy, but it is emerging from the COVID crisis in a different shape. Consider two of the themes I have referred to in recent weeks – the post COVID ‘Decameron’ effect (that new, good trends are born out of a pandemic driven economic crisis) and the ‘scramble for rare places’.

Take the scramble for rare places (and rare materials) first. This trend will place a premium on supply chains and could exacerbate blockages. To underline this – and indeed to emphasis that risk to China/US relations comes from a real war rather than a mere trade war under President Trump – twenty Chinese fighter jets (including four nuclear capable bombers) flew into Taiwanese airspace on Friday. Taiwan is the locus of the world’s semiconductor industry (one of the few technologies China has not mastered) and any disruption of it would lay bare supply chains.

It might also echo the work of Norman Angell, a Nobel Peace Prize winner in 1933 and author of ’The Great Illusion’(1909).He argued that the buildup of great navies risked a world war that this would not likely happen because international economies were so interdependent. The war did happen.

Tensions in the South China Sea emphasise how in the future supply chain rollout will be driven not only by economic imperatives, but also by the twin ideas of national security and strategic autonomy. The restriction of vaccine exports from Europe and India is a good example. Increasingly, new industrial capacity will be located in geopolitically friendly locations – Intel announced a USD 20bn investment last week in two new facilities in Arizona, additional capacity in Ireland and more contracts for partner firms in Taiwan and South Korea.

The other consideration is the ‘Decameron’ effect. Every major macro dislocation in the last two centuries – from the global financial crisis to the aftermath of the Great War, has been met with a variety of fiscal, monetary and institutional responses. This time should be no different and the ‘Great Lockdown’ (Harold James’ term) is being met by a barrage of fiscal activity (with monetary support), though undercut by a real absence of collaboration across counties.

The next phase in this will be an infrastructure plan announced by President Biden next week. The imperative here will be to upgrade infrastructure across the US – which lags other countries badly (airports, telecoms, fast trains for instance). The plan may also look to link the more closely with South America and Canada, such that it builds out the backbone of a regional infrastructure.

There are other budding infrastructure networks – such as a planned trade infrastructure between Israel and the UAE, a busier night train network across Europe and multiple plans for drone and air taxi networks give a glimpse of the future. If possible, we might also spare a few shovels for the Ever Given.

Have a great week ahead

Mike

Return of the Prodigal Economy

42,000 years ago the magnetic poles of the Earth reversed, causing a hugely destabilizing climate disaster. The event provoked a series of environmental shocks that today could only be captured by the most wildly imaginative Hollywood director – chaotic weather patterns, a smashing of the ozone layer, intimidatingly large ice sheets and ripping solar winds.

By analyzing the rings of New Zealand swamp kauri trees scientists have modelled some of the conditions and potential side-effects of this jolt to the Earth’s magnetic field (https://science.sciencemag.org/content/371/6531/811). For instance, Neanderthals and many large species were wiped out and humans would likely have sought shelter in caves.

Though this fascinating story tallies with my recent Mars focused missive, it maybe strangely, had me thinking about the bond market. In many ways, the bond market is the magnetic field of the financial system – when it is destabilised, other markets and broad economies suffer.

Its financial and economic power is legendary, so much so that when something happens in the bond market commentators dust off quotes about ‘bond vigilantes’ or James Carville’s (political adviser to Bill Clinton) that if reincarnated he would like to return ‘as the bond market …because you can intimidate everybody’.

The bond market has largely been dormant for much of the past ten years, because inflation has been feeble and central banks have continued to hoover up the supply of bonds. Some issues, such as Austrian 100-year bonds have been stellar performers, but in the course of the past month have fallen by over 20%, a shock to the risk averse type of investors who hold these instruments.

More importantly, the US 10-year bond yield – the lynchpin of the global system – rose from 1% at the end of February to 1.63% this week, a move that is historically rapid and significantly large, even if yield levels are still low. Contrast the ECB’s odd comment that it was ‘monitoring’ yield moves even though many euro zone bond yields are negative, with the advice textbooks (up till 2010) gave that 3.5% was a good benchmark for the 10-year yield.

The move in bonds is significant in at least four respects. First, it has checked the dizzying ride higher in equity and credit markets and in the near future should make these markets more two sided. In particular technology stocks whose valuation multiples are sensitive to the level of yields have suffered while banks, whose business model is bolstered by higher yields, have done well.

Secondly, the rise in yields is a mini revolt of sorts against central bank policy. Third, it reminds us that should interest rates rise further, the colossal load of debt that hangs over the world economy could become existentially dangerous.

So far what has been interesting is that while bond yields (even adjusted for inflation expectations, or real yields) have risen, credit risk has been very well behaved. Should the level of bond yields rise further (to 1.65% and above for the US 10 yr) then this will create problems for leveraged investors and leveraged companies.

The fourth germane point is inflation. Like a long-lost friend, we haven’t seen inflation in quite some time – or so headline inflation indicators tell us (consumer price inflation in the USA is 1.3%). Many people forecast that with a triple whammy of the ‘end of COVID’, huge stimulus packages and easy central bank monetary policy we will see a surge in spending and therefore inflation (notwithstanding the taming effects that demographics and technology have on inflation).  

For the moment inflation is everywhere, except in the official inflation figures (it is beginning to show up in producer prices though). Inflation expectations, as measured by markets are high and rising however (close to 2.5%) and there is a generalized sense that inflation has been redirected into asset prices rather than consumer goods.

This phenomenon is more easily understood if we consider that survey’s report that half of 25–34 year-old Americans plan to put the money from their stimulus checks into the stock market. Treasury Secretary Yellen has been largely silent on this though I can’t imagine that any of her close academic economist friends from Joe Stiglitz to her husband George Akerlof would regard this use of ‘stimmy’ checks as economically productive. To that end, Yellen might surprise us by introducing some sort of transaction tax or tweak to capital gains, or more simply try to prompt changes in margin requirements.

The other pressing issue is how central banks will react to both rising yields and the likelihood that inflation is finally materializing. An overt reaction to yields in the shape of a ‘yield curve control’ policy (keep long duration bond yields low) would likely set off a powerful rally in technology stocks. What is more likely is that central bankers will ‘whistle past the graveyard’ of inflation in the sense of publicly denying its existence, though privately fearing that eventuality. If we were to get an inflation shock, small and momentary as it might be, then central bankers may have to maneuver into a very difficult policy change.  

This may be some way off. However, the ‘prodigal’ phenomenon of higher bond yields is here to stay especially if the velocity of money picks up. Like a jolt to the magnetic pole of the Earth, this new market regime will have wide ranging implications. With debt, stocks and housing all expensive, a breach higher in yields might have us all living in caves too.

Have a great week ahead

Mike

Curing Politics

Jupiter

In my Christmas missive I sketched out a number of ‘surprise’ events that might occur in 2021, one of which was that

As part of its policy of ‘national strategic autonomy’ France opts to favour two French made vaccines for its citizens, but adverse reactions lead to a health and political crisis. Emmanuel Macron’s standing drops in the opinion polls, and the French establishment search for a centre right candidate for 2022’.

Though I wrote the note under the jovial banner ‘Drinking with Dickens’, I have to adhere to the first rule of forecasting which is to loudly take credit for any prediction that is mildly correct.

France, like much of the EU, is struggling to distribute COVID vaccines and shows little sign of lifting lockdown restrictions. To be fair, much of the blame for the slow rollout of vaccines rests with the odd modus operandi of Ursula von der Leyen’s cabinet.

The French situation is however compounded by Emmanuel Macron’s attack on the Astrazeneca/Oxford vaccine, 1 million vials of which lie unused in France, and by the failure so far of French scientists and pharmaceutical companies to speedily come up with a French ‘cure’ like that of fusty old Oxford (by the way Oxford has 72 ‘affiliated’ Nobel Prizes to 70 for France).

In the end it looks like Europe’s quest for ‘strategic autonomy’ (a French concept) and its admirable desire to implement a European solution to the vaccine problem, that got in the way. This unity is now crumbling – small, states Austria and Finland want to join forces with Israel, and Italy has intervened to stop the export of vaccines to Australia. As with the initial months of the COVID crisis, countries are beginning to fail the ‘solidarity’ text, which is not a great sign for the international order.

All of this begs at least two questions – do we yet have any sense as to what ‘type’ of country has managed to best deal with the COVID crisis, and second what the political implications and fallout of COVID (especially for Emmanuel Macron) are.

First, at the beginning of the crisis it seemed that countries that had experienced a pandemic in the recent past (Asia), and those with robust social democracies (small, advanced economies and Germany) dealt best with the fallout from the coronavirus, whilst the Anglo-Saxon countries (and diverse others) did less well. The UK and the US, together with Israel and the UAE of course, have now done much better with vaccination programs.

This disparity in performance, with countries like India confusing the picture even more, will try policy students for some time. 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 quicker to organise supplies of vaccines and to distribute them.

We could spend a great deal of time debating which model is better – but it is a redundant conversation because changing a country from an LME to an CME, takes a great deal of time, and to quote the Skilling paper the race against COVID is a marathon, not a sprint’ (https://davidskilling.substack.com/p/vaccinations-and-varieties-of-capitalism)

What is more pertinent is how countries are set up for the next challenges – the potential for political unrest amidst enduring lockdowns (uncharacteristically Ireland witnessed a small but violent ‘anti-lockdown’ protest last week), the possibility of a large number of broken small businesses, the need to rethink how healthcare services can be made flexible, more focused on mental health and better funded on a permanent basis, and how the ‘scramble’ I referred to last week where numerous countries are chasing strategic assets, will distort supply chains and inevitably lead to new disputes.

Given that task list, who would be a politician? Back to my speculative comment on Macron. First, I find that commentators outside France regularly overestimate the chances that he might be de-throned, and that Marine Le Pen might take his place. In my view Macron’s greatest failing during the COVID crisis (and most leaders have been tripped up by it) is his failure to be ‘close’ to the French people during the crisis to the extent that his ‘Jupiterean’ stance may become a liability.

To that end, if he is displaced (I don’t think so) it will not be someone from the right (General de Villiers, Philippe Juvin or Le Pen) but rather a centrist who is more avuncular (Edouard Philippe or Michel Barnier). On the left, my bet is that their leading candidate will be Annie Hidalgo as a modernising/eco/egalitarian candidate. There is still lots of time to go till the next French election, but in the light of the post-Merkel world, it will matter hugely for Europe.

On a broader landscape, by the time we get to mid 2022, the political topics that preoccupy us will be changing. While tackling inequality (especially in the US) will be prominent, politicians and societies will be dealing with an environment that is ‘the opposite of confinement’ in the sense of people’s desire to socialise and travel, the potential headwinds of higher interest rates and higher prices, and ongoing challenges to the democratic model (Freedom House’s latest report highlights just how vulnerable democracy is).

On that note, my credit goes to the French judiciary who have now tried and passed sentence on two of the previous three presidents, and in doing so uphold the credibility of the republic. Other countries might examine this example when it comes to the conduct of their (former) presidents and prime ministers.

Have a great week ahead,

Mike