From Rotten Heart to Braveheart?

Boris was wrong!

Regular readers, especially those toiling away in dusty cities will be less than amused that I have written this note in the beautiful setting of Nafplio, in south west Greece, whilst attending the excellent Eliamep/JeanMonnet30 seminar.

That the Greek stock market is up 35% this year and its bond yields trade some 33 percentage points below their levels of five years ago suggests some closure on the euro-zone crisis.

Another sign of this came in the market reaction to additional stimulus from the ECB. Effectively European asset prices did nothing, which I hope will persuade the ECB to move on to other policy aspects of the euro-zone system such as the need to properly regulate Europe’s fintech and payments sector.

Another important milestone in the ‘story for Europe’ came with the announcement of the composition of the von der Leyen Commission. In a previous Sunday note I have mentioned the method behind the creation of European Commissions found in the tale of political ‘three cushion billiards’ recounted by the late Wilfried Martens, formerly Belgian Prime Minister, in his 2009 book ‘I Struggle, I Overcome’.

The Commission has done well this time, though it was not always the case. One of the first books I read that helped to explain how Brussels worked was Bernard Connolly’s ‘The Rotten Heart of Europe’. It was a huge hit (in the UK) and hugely controversial. Indeed, a second edition came with a cover recommendation from the then editor of the Spectator Boris Johnson (‘one wanted to stand on the desk and cheer’).

The book did much to propagate Euroscepticism in British politics, and I suppose we might trace some of the roots of Brexit to it. With some irony, Brexit has however shown that the Commission can function in a forceful way. The challenge for the EC is to now step up a level and reinforce itself for a multipolar world where it will compete more acutely with China and the US, with at the same time Russia snapping at its heels.

Perhaps for this reason the new EU President referred to her Commission as a ‘geopolitical one’. It is welcome that there is a growing realization in Brussels of the implications of the emerging multipolar world, but for my liking, Europe-Brussels does not yet have a strategic mindset, and does not fully have a sense of its power and identity in the world.

There has already been some controversy over the designation of a Commissioner with responsibility for migration as one who would ‘Protect our European way of Life’. This clumsy effort at communication is likely a nod to right wing parties across Europe, the kind of people who ‘value the Church and families as opposed to bike riding vegetarians’ as one person put it to me.

What this incident should do, is spark a serious debate on what the core values of the EU are, and in ‘The Levelling’ I invoke Alexander Hamilton to do this. The more public life in the US and the UK disintegrates, and the more heavy-handed China is in Hong Kong, the more we are reminded that liberal democracy is at the core of Europe’s value system. One of the challenges is to make the benefits of this clear to people in Poland and Hungary whose leaders contest such a view of the world.

Back to the Commission, where several appointments will have macro and investment implications. Overall, the Commissioners are less wealthy than the Trump cabinet, better organized than the Johnson government and more colourful than the Xi Jinping administration.

Trade first. The appointment of Irishman Phil Hogan as trade commissioner means the EC will hold a firm negotiating line on Brexit, and that it is increasingly focused on the risk that President Trump might open up a trade war with the EU. The appointment of Sabine Weyand to the trade team reinforces this view.

Then, the re-appointment of Margaret Vestager as EU Competition Commissioner underlines the fact that a growing market trend will be regulatory risk to large US tech companies. Europe has already taxed and fined the FAANG companies and some Democrats increasingly agree with this stance. As the 2020 election approaches, tech will be increasingly under regulatory scrutiny and like it or not Europe will lead the way.

The final point worth waking here is the emphasis that the EC is putting on green investment, on governance in Eastern European countries and on socially responsible finance. This all adds up to a much greater emphasis role for ESG (Environment, Social and Governance) in investing and markets, not just in Europe but further afield.

So, the EC is moving away from ‘Rotten Heart’ but is not yet ‘Braveheart’!

Have a great week ahead,

Mike

The consequences of bad behaviour

Waiting for comeuppance

In chapter five (page 127 to be exact) of The Levelling I wrote about the apparently growing tendency for some politicians to be self-centered and incompetent, and drew a contrasting portrait of Boris Johnson MP and the late Peter Carrington. It went as follows…

‘A further contrast in political types might help illustrate this point further. In July 2018 Boris Johnson resigned as British foreign secretary. Britain no longer has an empire, but the office of foreign secretary is still respected. During his tenure, however, Johnson made a number of gaffes and was generally seen to have damaged rather than advanced Britain’s interests. Similarly, in the aftermath of the Brexit referendum, he was also seen as a natural leader of the Tory Party, but the way he has conducted himself since then has led many party colleagues to the view that, even by the standards of politicians, he is too self-serving, and he has lost support within his party.

The day after Johnson resigned as foreign secretary, the death of Lord Carrington (at the age of ninety-nine) was announced. Carrington had been British foreign secretary from 1979 to 1982. He was generally recognized as an exemplar of integrity in public life. Early in his political life, he had served in Winston Churchill’s cabinet of the early 1950s; later he was defense secretary for Edward Heath and then foreign secretary to Margaret Thatcher. To cut a long and good story (of his life) short, he resigned as foreign secretary three days after the Argentine invasion of the Falkland Islands on the grounds that the invasion happened on his watch and was therefore his fault.

As political resignations go, this one was seen to be selfless and principled and stands in contrast to the tactical maneuvering of some politicians today. Carrington, along with many contemporary central bankers (Paul Volcker, Ben Bernanke, Janet Yellen, and Mario Draghi, for instance), is a good example of sincere public service and his behavior stands in contrast to that of successors like Boris Johnson.

The distinction I wish to draw is to have policy makers who are more responsible for and focused on policy making than on their own personal advancement. Advancing oneself is, of course, prevalent across all organizations and institutions, but the difference with politics is that people’s lives are affected by bad policy making’.

At the time, I did not think Boris Johnson would become Prime Minister, though there was a good chance that this might happen. Further, given everything that has happened with Brexit so far, it was still hard to imagine that in a few weeks his government has managed to effectively destroy the Tory Party, the Union and the very large stock of goodwill that Britain has built up with neighbouring countries like Ireland.

I believe that the Tory Party will soon formally split, and that the nucleus of a new centrist party in British politics will be formed around the twenty one MP’s who were expelled from the Conservatives.

Another consequence is that the barriers to Scottish independence are falling. Most of the arguments deployed by Brexiteers for ‘taking back control’ appear logical in the case of Scottish independence. Everything the Johnson government does shears away at the moral and emotional ties between London and Scotland. Moreover, the departure of Ruth Davidson as head of the Scottish tory Party will hand back a number of seats to the SNP. The challenge for Nicola Sturgeon now is to convince Scots that the SNP can execute new policy ideas that will make Scotland more stable economically, and richer in terms of human development.

Then, both the Irish government and the EC will feel that their opposite numbers in London have no credibility and no sincerity. Whereas they were often puzzled by Theresa May, Boris Johnson has done nothing to encourage Brussels to trust him. That is a pity because once Britain leaves the EU, the truly complex business of negotiating its future relationship with the EU will only begin. This is apparently lost on the Johnson government.

To return to the distinction I drew between Johnson and Carrington, there is an emerging theme in public life that the consequences of bad behavior are in many cases low. There are many instances, Jeffrey Epstein is the latest, where individuals have engaged in enabled, persistent abuse. Politics is sadly becoming similar. The world stage is increasingly replete with examples, with little distinction between leaders in emerging or developed countries.

In time, very bad, divisive behavior in politics hits its limits and is sanctioned. What is disappointing is that those limits are being stretched to breaking point.  At times, markets can sanction bad policy by politicians, but bad personal behavior is seemingly harder to check. Infuriatingly, social media seems to amplify and reward bad behavior in politics.

A more profound policy issue is that the lack of real economic growth, and the poor distribution of its benefits (in countries like the US) means that voters will look beyond reckless policy in search of economic rewards. In the US specifically, few on the right are prepared to stand up to the President. They might do well to look at the example set by the likes of Ken Clarke, Jo Johnson and Rory Stewart last week. Boris Johnson himself might do well to look at the example set by Peter Carrington.

Have a great week ahead,

Mike

Faultlines in a fracturing world

Cracks appear in the world order Source: Esquire

The front cover of ‘The Levelling’ – clearly the best part – shows a deflated globe. Another way of getting this message across might have been a crystal globe, with cracks appearing.

This came to mind last week as I was summing up some of the important geopolitical and economic catalysts for my first column as a contributor to Forbes, where the aim is that I write on events outside the USA for a largely USA centric audience (https://www.forbes.com/sites/mikeosullivan/2019/08/29/faultlines-in-a-fracturing-world/#3f9c31415890))

My sense, which is now reinforced daily by events such as the trade war, is that there is a fracturing of the old world order that is exposing a range of faultlines. The established world is cracking, the question is whether it will shatter, or whether it can be repaired.

There are at least two varieties of faultline. The first set is where we have the intersection of a disruptive macro development with an existing or incumbent industrial structure – think of the impact of negative interest rates on the European banking system, or the effect of the trade war on corporate supply chains or increasingly, the collision of ethics and technology (for instance opioid drugs or big data).

The second element in the fracturing of the world order relates to geographic areas and/or nation states. A number of them are increasingly making the news and are beginning to cause market ripples.  Strikingly, in each case the fracturing is picking up speed at an alarming rate such that we now go into September beset by three full crises.  

The one that preoccupies me most is the situation in Hong Kong, partly because I love the city and mostly because the ongoing demonstrations there are a microcosm of grander political battles to come – between a state of the world where people sacrifice their liberty for order and economic growth or one that we could call an open society/open economy model.

Should the situation deteriorate further, the onus will be on the US, EU and especially the UK to speak out more volubly, to China’s chagrin. Police violence and the recent arrest of some of the prominent demonstrators is an escalation in this conflict – I am not sure whether this is simply an error or a provocation to the protestors.

I have underlined in past notes that the Hong Kong protests are primarily an issue of liberty and identity, but market and investors are now also been drawn towards it with some focusing on the Hong Kong dollar peg as a source of volatility. I am not so sure – only a major political event such as a Chinese takeover of Hong Kong could push the peg to the top of its range. A more obvious Hong Kong contagion play might be the Chinese currency itself, with a long yen trade as an additional way of expressing risk aversion in Asia.

The situation in Hong Kong would be more alarming if we did not have Brexit as a benchmark, which was the first big rupture in the ‘end of globalization’ thesis. In a sense, nothing has happened with Brexit in that the UK has not yet left the EU, but at the same time the road to Brexit has taken a mind-boggling series of twists and turns.

A difficult, messy ‘hard-Brexit’ looks likely in late October, largely because Boris Johnson has caused so many people to lose faith in him and has whittled away any goodwill he had with Brussels. The step to prorogue Parliament took Brexit into a new realm, a very disturbing one for those who hold the view that what makes Britain are its laws, democracy and institutions. The move will possibly make a hard Brexit more likely, and certainly means that the post Brexit political climate will take on the bitterness of a civil war.

Finally, I am keeping an eye on the two biggest economies in Latin America – Argentina and Brazil. Both represent last chance experiments for populist politics, with the possible electoral overthrow of Mauricio Macri by Alberto Fernandez in Argentina and the increasingly troubled tenure of Jair Bolsonaro.

I recently wrote that the steep fall in the Argentine peso and in its government debt means that it is one of the few countries where sovereign risk is now beginning to be correctly priced, though the implications of Argentina’s attempt at yet another debt restructuring could lead to further downside for the currency and stock market. This would spill over to Brazil, whose stock market is vulnerable to an increasing lack of clarity in policy making and an increasingly contentious foreign policy. In each case, the strong dollar is an unwelcome financial headwind.

A potential formal default by Argentina may well also further damage the credibility of the IMF and by extension Christine Lagarde. The only good news is that Argentina’s woes will mean that austerity is no longer the knee-jerk response of bodies like the IMF to financial crises.

September promises to be lively.

With best wishes,

Mike

Gone fishing – Jackson hole in 2039

Trout, an important fish in the history of central banking

Two years ago I wrote an oped for the Financial Times (https://www.ft.com/content/9089eaf8-83fe-11e7-a4ce-15b2513cb3ff ) the byline of which ran ‘Jackson Hole offers a chance for central banks to hand over baton – It is time for central banks to let governments take on more of the burden of economic policy’. That I could reprint the same article today says much less about my foresight and much more about the stopped clock of international economics and finance.

Central banks should long ago have stepped back from generously providing stimulus to economies and markets, particularly as the economic impact of quantitative easing (QE) is diminishing, if not negative in terms of the effect of negative interest rates in banking systems.

Moreover, clever fiscal policy should be been deployed some time ago, especially in Europe where growth is stubbornly low. More broadly, the reality is that many governments do not have the fiscal capacity to stimulate their economies and more importantly to cushion the effects of a coming recession. President Trump’s economy is a case is point, with a historically high budget deficit (5%) and near record level of debt (to GDP).

Many of these issues will have been discussed at the Kansas Federal Reserve ‘offsite’ at Jackson Hole, Wyoming. The event has become one of the more important platforms for central bankers, due in little part to its proximity to decent fishing. Legend has it that up to the early 1980’s the Kansas Fed struggled to attract participants to its annual conference but came up with the idea of hosting it in Jackson Hole, because the prospect of excellent trout fishing might lure then Fed Chairman Paul Volcker (a keen fisherman) to the conference. The strategy worked and Jackson Hole gathering is now internationally famous and attracts many professional central bankers, whose pronouncements are closely followed by markets. Never before has trout played such an important role in central banking.

The title of this year’s symposium was ‘Challenges for Monetary Policy’. Whether on purpose or not, this title echoes with the Jackson Hole symposium of twenty years earlier. In 1999, the likes of Mervyn King, Alan Greenspan and late economists and central bankers like Wim Duisenberg, Rudiger Dornbusch and Martin Feldstein gathered to discuss ‘New Challenges for Central Banking’.

Their debates, which occurred in the wake of the Emerging Market and LTCM crises, just tell us much about the persistence of financial market phenomena such as asset price bubbles and the ways in which the central banking community has a tendency to fight ‘yesterday’s monetary wars’ rather than those of the future. A couple of things struck me.

One was the focus on price stability – in particular comments from Wim Duisenberg, then the first head of the European Central Bank, whose comments reflected the orthodoxy of central banks like the Bundesbank that price stability was the holy grail of central banking, something that itself had roots in prior decades of inflation.

Inflation, in consumer prices at least, is now well and truly dead, killed off not so much by central bankers but by the residual effects of the global and eurozone financial crises on household balance sheets. In this light and with the euro-zone in mind, it is interesting that (apart from Feldstein) there was very little mention in 1999 of the frailties of the euro-zone system.

The second interesting factor in the 1999 meeting was a discussion on asset prices and monetary policy. There was a firm consensus then that central banks should not tackle asset price bubbles head on. The rest as the say is history – the 2001 dot.com bubble and then the housing and derivative bubbles of 2007 that led to the financial crisis. Today, there is not enough discussion amongst central bankers about the effect of monetary policy on wealth inequality or on the bubble in fixed income markets. If and when the trillions of bonds in and around negative yield territory sell-off, this will produce a crisis in central banking.

Indeed, if we move forward twenty years and think of what the 2039 Jackson Hole symposium will discuss, I can hazard at least three topics. The first will be an evaluation of central banking credibility following the ‘Great QE Bubble of 2021’. The second might be ‘Does Facial Recognition Improve the Efficiency of Central Bank Digital Currencies’ and a third might be ‘The Effects on the Emirate Economies of Euro-zone Membership’. Much to think about for the future.

Have a great week ahead,

Mike

Death of the bond market

Now time for the death of bonds?

This week a very wise friend alerted me to the fact that exactly forty years ago, BusinessWeek magazine decorated their frontpage with the proclamation of  ‘The Death of Equities’. As with many bold magazine covers, they got it horribly wrong. At the time the S&P 500 index stood at 107, and it has recently touched over 3,000.  

Part of the reason that equities have done well is that inflation has been brought under control (largely by Paul Volker and to a degree by Alan Greenspan) and as a result interest rates have fallen structurally. Indeed, if one were to craft a magazine cover today, it might carry the title ‘Death of the Bond Market’ such has been the rally in bonds (half of bonds internationally have a yield below 2% and 20% are in negative yield territory. Perhaps the ‘Death of the Central Bank’ might be an even more provocative headline.

The historically odd phenomenon of negative yields signals lower trend economic growth, the end of globalization, the fracturing of the world order and the failure of policy makers to address these issues. The bottomless ‘central banking toolbox’ has as they say become the only game in town, but it increasingly produces market distortions rather than economic solutions.

With many other writers scribbling away on negative rates, the development that struck me last week came in the tiny sliver of the bond market where yields trade above 10%, and specifically with Argentina, which a year before the BusinessWeek headline, won the World Cup. Argentina has been a constant source of volatility in markets – it has defaulted on its debt eight times since its independence, seen many restructurings and economic crises.

Last week, a primary election vote suggested that Mauricio Macri is unlikely to gain re-election and this prompted an over 30% collapse in the peso (to 55 to the dollar compared to 18 when Macri came to power), and a similar downshift in its stock (Argentina was admitted to the MSCI Emerging Market index in May) and bond markets. With broader bond markets now beginning to price in a recession, there are several lessons from Argentina.

The first relates to country strength – which I define as the ability of a country to withstand economic and financial shocks. The robustness of its economy and the quality of its institutions are two of the factors that make up country strength. That markets can move so dramatically on the likelihood that Macri may not win a second term, shows that Argentina is low on ‘country strength’.

Conversely, as David Skilling of Landfall Strategy shows in his excellent, annual ‘State of Small Advanced Economies’ Report, the likes of Singapore, Norway and Switzerland rank amongst the highest in the world on factors like productivity and human development that help to generate ‘country strength’ or ‘resilience’ (https://twitter.com/dskilling/status/1162232440468824069). As the trade war deepens, this factor or quality will become increasingly prized by markets.

In emerging markets, this will be doubly the case, not least as globalization gives way to a multipolar world. Here, the example of  Argentina in the 1920/30’s is worth studying. At the time, the world was coming to the end of the first wave of globalization, and Argentina was an economic and financial powerhouse. However its economy was heavily dependent on agriculture and as a result was not resilient enough to deal with the collapse of globalization. The rest as they say, is history.

Argentina and the predicament of Mr Macri also hold lessons for international policy makers. Should Macri be replaced with the Alberto Fernandez government that markets fear, this will further damage the reputation of the IMF, and its austerity first policy recipe-book. Macri had pursued financial reforms but the effect of austerity has been politically costly. Much the same is true across the euro-zone. In future, if there are to remain relevant, bodies like the IMF will need to work around the political consequences of reform programs, and the time inconsistency implications of them for politicians.

Reform minded governments usually do not last to see the fruits of their labour, and as such reform programs may well need to be tilted away from fiscal consolidation and more towards supply side and institutional measures that will improve a country’s ‘strength’, and that will give serious political reformers a chance of staying in power to enact their policies. To this end, it may make more sense for bodies like the OECD to be more involved in economic rescues than the IMF.

For the time being, Argentina’s debt is an outlier in that it is perhaps one of the few fixed income assets that correctly reflects a country’s fundamentals, rather than the mirage of ‘QE’ (quantitative easing) driven pricing. In this way it is ‘normal’ and the rest of the bond world is increasingly absurd.

Have a great week ahead,

Mike

Is Trump Hoover?

Herbert Hoover in better times

Over a week ago I penned an article for Dow Jones/Marketwatch where I predicted (note that I only use this verb after the event) that the recent rate cut by the Federal Reserve would mark the top for equities. The subsequent volatility, and of course last week’s missive on the yuan, prove me to be a financial market genius.

More seriously, recent volatility is a reminder of the fragility of investor behavior and of the risks lurking in the global economy. On a longer scale, as we approach September, they are a reminder that while the global financial crisis of 2008 did not quite end in an economic depression, neither has it produced a true economic renaissance. Many of the factors that caused the crisis in the first place—indebtedness, corporate risk taking and poor governance—have simply been in abeyance, hibernating, and are now again emerging into the daylight.

One consequence of these persistence economic fault lines is that we are in a political depression. In this light, some respected commentators—notably, Madeleine Albright in her book Fascism: A Warning—draw parallels between political figures today and those of the 1920s and ’30s. Recent events in the US, and comments by the President reinforce the parallel.

In ‘The Levelling’ my intention is to avoid the gloomier comparisons with the 1920’s/30’s, but the deepening trade dispute between the US and China makes them inevitable. One reason that President Trump has been eager to push the Federal Reserve to cut interest rates is that he ‘doesn’t want to be the next Hoover’.

Other commentators have already been making this comparison with Herbert Hoover (President from 1929 to 1933). Paul Krugman recently wrote that the level of tariffs applied by the Trump administration is now close to that of the Great Depression.

Hoover was different to Trump in that he distinguished himself in various ways, notably in his humanitarian work in Belgium with the US Food and Drug Administration, and in Central Europe in the aftermath of the First World War.

In other ways, he has several things in common with President Trump: German/British parentage, a business background, and a mastery of new communications channels, in Hoover’s case the use of radio (rather than Twitter) to reach voters and the introduction of the press conference as a regular political event.

Furthermore, the trade dispute between the United States and China has excited commentators who fear that Trump may repeat the mistakes of the Hoover government. Even the Wall Street Journal editorial team warned last year that the Trump trade team is like Senator Reed Smoot and Representative Willis Hawley, promotors of the disastrous 1930 Smoot-Hawley Tariff Act. The same newspaper now talks of a ‘Navarro Recession’, in honour of Trump’s trade adviser Peter Navarro.

 The Act aided and abetted the onset of the Great Depression with the introduction of tariffs of up to 60 percent on twenty thousand types of goods imported into the United States. The net effect of the Act was to squash any hope of an economic recovery in the aftermath of the Great Depression and to cut world trade by 33 percent.

In addition, readers might tremble to know that Hoover took office with US equity valuations at very high levels. Robert Shiller’s excellent database highlights that the US market’s price to earnings ratio was at 32 in January 1929 (the highest it reached was 44 in December 1999) and that it reads 29.5 today, which is 75 percent higher than the historical average of 16 and thus puts the market in expensive territory from a valuation standpoint. Eight months into Hoover’s term the Wall Street Crash occurred, and the United States lurched first into recession and then into the Great Depression.

Whenever the market wobbles as it did last week, some investors revisit the ‘Great Depression’ hypothesis, and many others point to a coming recession. For my part I am sticking to my cautious line for a number of reasons.

First the trade war is a reminder of the many policy risks in the world (widespread negative yields are another pointer), and of the fact that as growth slows, countries will squabble more over the crumbling pie of globalization.

Second, moves in other asset classes than equities – government bonds, even corporate and high yield bonds and particularly commodities are bearish

Third, the world is becoming more fractured. South Korea and Japan are locked in a trade dispute, and there is a growing risk of some form of confrontation between India and Pakistan. Do not of course forget events in Hong Kong, and the untethering of the yuan.

With lots to watch, have a great week ahead,

Mike

All consequences are at your risk

Lasers battle cameras in Hong Kong

The Chinese military garrison in Hong Kong released a video under the banner ‘All consequences are at your risk’. This an excellent dictum, though only when applied to the behavior of investors, banks and central banks in financial markets. Readers of The Levelling will know that I think the consequences of risk taking across markets are badly distorted, and risk taking and risk baring are mis-aligned.

The dictum might also be applied to President Trump’s twitter account, whose latest salvo has been to up the ante in the trade war between China and the USA after a very lukewarm meeting between US and Chinese officials in Beijing. China, which has been relatively restrained during the trade war will now respond, potentially with a boycott of certain US goods. US tech and capital goods companies look vulnerable.

Then, I should say emphatically that the ‘consequences/risk’ dictum should not apply to largely peaceful crowds in Hong Kong who protest in favour of democracy and an open society of sorts. China, for its part in the domains of economics and technology, has shown an ability to learn from both history and other countries. It should also do so with regard to the situation in Hong Kong and resist the urge to adopt a heavy handed approach.

While the backdrop of the trade dispute helps to paint events in Hong Kong as a context between China and the West, this is not the case, my sense is that the protesters are more standing up for their preferred ‘system’ than against China. A more violent response will change all this.

One of many reasons I drawn to the case of the Hong Kong protesters is the parallels with Levellers. The Levellers were generally constructive in their approach and experts at pamphleteering (the social media of the day). Similarly, the Hong Kong protesters have a (rather short-term) list of demands and are also particularly resourceful, deploying lasers against facial recognition cameras.  The second reason is that the Levellers failed in their project, as many other idealistic, reform minded movements have. Recall the brutal way the Arab Spring was suppressed. The Hong Kong movement need to study the history of other groups, and guard against being outmaneuvered.

One trigger that may upset the balance of power is the scope for damage to the Hong Kong economy, property market and financial sector, and any contagion they may hold for international markets.

A transformation of the protests into a deeper conflict would have grave humanitarian and political implications, and I am simply reflecting my own expertise in focusing on the economic consequences here.

First, the Hong Kong stock market is the fifth largest in the world, heavily dependent on financial and property stocks, and a crucial gateway for Chinese companies that want to access liquid markets and international investors. A sell-off would be contagious via an unwind of investor positioning, the unwind of investment products and heightened credit risk across Asia.

Secondly, the Hong Kong property market, one of the pillars of the local economy, is one of the most precarious in the world in terms of valuation. A house price to income ratio of 18 times is eye watering in a market where the purchase of property is funded by relatively large cash deposits. Also, the property market is heavily financialized in terms of the number of funds and investment products that are tied to it.

The third risk is the Hong Kong dollar peg. In recent months the Hong Kong Monetary Authority has been spending more of its large reserves in supporting the peg. A stronger dollar, combined with lower local interest rates in Hong Kong has put upward pressure on the peg.

Well-established currency pegs are very hard to break, but any signs that the HK peg is pushing its lower limits in the context of a weaker local economy will at least fuel speculation about the peg. This in turn can lead to negative feedback on the local economy and property market, and by extension may also see investors worry more about the yuan. When the yuan weakens, international markets go ‘risk-off’.

There is now an unfortunate ‘perfect storm’ of factors gathering – stronger dollar, deeper trade dispute, acute tension on the streets of Hong Kong. For the sake of people in Hong Kong I hope it doesn’t worsen, though if it does expect contagion to spread quickly to financial markets.

Have a great week ahead,

Mike

AI should do no harm

This could be the central bank of the future

Last week the excellent MIT Tech Review came through the letterbox – it is reassuring that in a hyper tech age some people still have the grace to publish printed material. Part of the Review was devoted to a listing of the top 35 innovators under 35, about which two things struck me. The first is that 23 of the 35 innovators were born outside the US, a fact that should temper the belligerence of the ‘send them home’ crowd.

The second is that at least one fifth of the innovators are working with Artificial Intelligence (AI). It reflects a broader trend. Whilst these scientists and entrepreneurs are at the forefront of AI science, I have a growing feeling that like blockchain two years ago and the ‘dot.com’ mania some twenty years ago, many entrepreneurs are injecting the term ‘AI’ into their business descriptions in order to boost their profiles.

If anything, this proves that humans will abuse and manipulate technology for their own ends, rather than the other way around. Indeed, I recently read a research paper in ‘Science’ magazine that described how false (bad) news diffused more quickly than good news, though humans rather than robots were responsible for this effect.  

A cynic might describe AI as a liberated regression equation set loose on a beefed up data set. Thankfully, far cleverer minds than mine have focused on this area and two excellent books I can recommend are Shoshana Zuboff’s ‘The Age of Surveillance Capitalism’ and Kai-Fu Lee’s ‘Artificial Intelligence’ are the best ones I have come across.

One of the tricks I employ in ‘The Levelling’ is to resurrect Alexander Hamilton and ask him what advice he would give the great powers as they march into the twenty first century. With the US in mind he reminds the US that must often new technologies develop quickly, too quickly for legal, philosophical and regulatory frameworks to keep up with them. Moreover, he states that those countries that can set the standards and rules of the game around new technologies will largely control the development of those technologies.

In this respect AI is interesting in the sense that the technological know-how behind it is evenly spread between the US, China and even Europe. Yet China is far ahead in terms of the data pools that can be employed by AI technologies, and is far more permissive in terms of the applications of AI and AI datasets in socio-political settings. Partly as a response, there is now a project at Harvard that aims to educate US and Chinese data scientists on the ‘social’ dangers associated with the use of AI by governments.

Of course the USD 5bn fine that the US Federal Trade Commission has hit Facebook with is an even grander signal that regulators are taking bolder action, though of course the fact that it took Netflix less time to produce a film based on the Cambridge Analytica debacle shows that the regulatory pace may need to be increased.

Thankfully, the OECD has now stepped into this space and in a recent, detailed book (‘Artificial Intelligence in Society’) they lay out five Principles on Artificial Intelligence. I don’t at all do justice to the fine work of the OECD here but essentially the principles state that AI should ‘do no harm’ – respecting humans and the rule of law, benefit the planet and value transparency and accountability in its use. It is a useful framework but to my earlier point, I suspect that the appetite to enforce this will vary greatly across regions.

The OECD book is also useful in underlining the extent to which capital is now attracted to AI – for example AI start-ups attracted 12% of global private equity investments in the first half of 2018. This not surprising given the potential of AI applications such as transport, healthcare and medical diagnosis and financial services. 

This trend will likely continue and may well exacerbate some of the odder macro trends we have seen during this business cycle – lower spend on capital expenditure (because more capital lean business models), the dampening of inflation, the disruption of labour markets and an ambiguous impact on productivity. As it grows, the effect of AI on economies may for example make the job of central bankers more difficult. But, like medicine, it might be that artificial intelligence could prove more accurate than humans in diagnosing what ails our economies. Imagine if Christine Lagarde was the last human to chair the ECB, and her successor was a machine, sitting high in the ECB tower in Frankfurt.

Have a great week ahead,

Mike

The State of Politics

I passed through London last Wednesday and after lunch had the good luck to pop into Chatham House to see Prime Minister Theresa May’s last public speech. Truth be told, the invite I received specified only that a senior politician would be speaking, and as I trundled down the motorway towards Bordeaux airport early that morning, I was expecting be treated to a last hustings hurrah from Jeremy Hunt. Instead, Theresa May turned up to deliver a speech on ‘The State of Politics’ (though not under Chatham House Rules).

I had not seen her speak before and after I did many things fell into place. As she is at the end of her tenure as PM she deserves at least a ceasefire from the criticism that has been directed at her. However, the general lack of emotional investment in her comments and her willingness to avoid engagement on questions led me to think that she naturally won few passionate political friends in Westminster and Brussels.

To be fair, some comments did strike a chord and her thoughts on the antagonistic, negative and now habitually hostile approach to politics in the UK and US were worth listening to. In particular she lamented the lack of compromise in politics today, the deepening of divisions (the ‘Squad’ debate in the US is a very good case in point) and the rise of absolutism. What she meant here is much less the enforcement of the primacy of principles, but the conviction of those with extreme views that their perspective is right to the point that other competing views are excluded. That at least is my too wordy definition of what she said.

Absolutism can have many political effects – some voters are drawn by strong views while others are put off. In general, what we can call absolutist views get more media and social media attention than more moderate views. Bad ideas fly faster than good ones. In the longer-run, absolutism may end up breaking apart very well-established political parties, further destroying bi-partisanship and generally producing bad policies.

We might well argue that absolutism is everywhere, even in financial markets. A pronounced trend in recent months has been the strong rise of bond and equity prices in tandem, to the point that the correlation between them has reached historical extremes. The price action in each, major asset class suggests a strong degree of conviction, almost to the point of absolutism.

Surely, neither equities nor bonds can both be right? Indeed, both could be wrong. Bond prices reflect weaker economic growth, potentially lower trend growth and the apparent willingness of central bankers (Korea cut rates last week for instance) to force rates lower.

Equities exuberantly reflect this ‘surrender’ of central bankers, but in my view do not reflect lower growth. In that respect an ongoing macroeconomic shock (a longer, deeper, sillier trade dispute is the likely cause in the near term), in the context of very low unemployment may well be the signal that equities have peaked.

One remarkable offshoot of the absolutism in equities and bonds (in the sense that both have risen together) is that wealth – at least financial wealth has risen sharply. Indeed, I would hazard that with house prices generally now more choppy, the mass of household wealth (financial plus housing wealth less debt) is close to a peak. There are other signs that this may be the case, such as generous IPO (initial public offering) pipelines that suggest that business men and women want to sell businesses,

Ironically, whether we are at a peak in wealth will depend very much on the major central banks, whose overly generous approach to quantitative easing has spurred the creation of financial wealth, and at least in the case of the USA has pushed wealth inequality to historic highs. The Fed in particular is now wrapping itself in policy knots, because any change in policy could produce a large wealth effect, at least for the middle classes.

Central banks are however likely to treat any recession as an excuse to cut rates and open up the policy toolbox. This means that household balance sheets in developed countries should be relatively solid, and that financial risks will be focused mostly on corporate balance sheets (in the US and China) and on government balance sheets (in China and select EU and EM countries).

The exceptions are perhaps Hong Kong and Australia – where property prices and leverage are high. I would also put the UK in this bracket. As I left the May speech on Wednesday, I picked up a copy of the Evening Standard, whose headline read ‘property slump accelerates with biggest drop in prices in a decade’. If this continues, the ‘state of politics’ will become even more complicated. May is leaving at the right time!

Have a good week ahead,

Mike

Diplomacy

Diplomacy in action

An ambassador should be ‘an honest (wo)man sent to lie abroad for the good of his country’ according to Sir Henry Wotton, a seventeenth century British diplomat, writer and politician. It is something of a surprise then that this sage advice was unheeded by the seasoned British diplomat Sir Kim Darroch, lately UK Ambassador to the US.

His failing was to tell the truth about the court of Donald Trump, and even boringly, to be caught stating the obvious. At least, the outgoing, flamboyant French Ambassador to Washington Gerard Araud waited till he had retired to speak his mind (‘unpredictable’, ‘uninformed’, ‘America Alone’).

Darroch’s resignation, in diplomatically unusual circumstances following the President’s decision to boycott him, tells us much about the conduct of diplomacy today, the demise of Britain as a world power and importantly, America’s place in the world today.

Historically, since the foundation of nation states and the rise of the idea of the balance of power, the role of the diplomat emerged in the middle of the 17th century, with Venice as a particular centre of power. Then, diplomats were a mixture of spies, messengers, entertainers and persuaders and many still are today. Comfortingly, commentary on Sir Kim reveals that holding decent parties is still a prerequisite for the job.

A more formal definition of the role of diplomacy comes in Sir Harold Nicholson’s book ‘Diplomacy’ where he pins responsibility for foreign policy on elected governments, and assigns ‘negotiations’ as the preserve of diplomats. In the US today, we might well hold that the foreign policy of the government is very hard to identify while the art of negotiation has become the sole preserve of the President.

In days gone by, the opposite was the case with certain diplomats setting foreign policy and negotiating it. One example that comes to mind having just read George Packer’s excellent book ‘Our Man’ is Richard Holbrooke. The book tracks Holbrooke’s career and illustrates how his ambition and intensity were both his strengths and failings. Holbrooke was far more forceful and cutting in his views than most other diplomats, but in the end his career too was cut short by a President (Obama). There are relatively few characters like Holbrooke in world diplomacy today. Financial crises, social media, cyber espionage and the cult of the political personality have made the job of the diplomat more difficult and arguably more important.

I am biased but one success story of recent years is Irish diplomacy, which was mobilized on the European and world stages in the aftermath of the global financial crisis, and then again more recently in the case of Brexit and is now adding new embassies in countries like Columbia.

The same cannot be said of the State Department which has been denuded of talent and expertise under the current administration, and its budget curtailed to such a degree that it has needed the helping fiscal hand of the Pentagon. Outside the State Department though, there are interesting developments in the ‘science of diplomacy’ notably at Harvard’s Belfer Centre where for example there is now a very interesting Economic Diplomacy Initiative spearheaded by Profs Nicholas Burns and Larry Summers.

I am not sure if ‘divorce through diplomacy’ is on the curriculum at Harvard but the UK could do with some help in the area of geopolitics. To my mind, the resignation of Sir Kim destroys once and for all the notion of the ‘special relationship’ and confirms that what ails Britain is not Brexit per se but a national identity crisis in the contest of a decline in power. Britain and its political class need to urgently open up a debate as to what its place in the world is, and how realistically it can remake and reposition itself diplomatically.

One person whose advise might be worth listening to is Henry Kissinger. At 96 he is still going strong, and while I recognize that some will object to his views, his written work is superb and a great example of pithy, thoughtful writing.

On hearing of Sir Kim’s exit I picked up Kissinger’s book ‘Diplomacy’ and found it remarkable in two respects, one for its foresight (it was written in 1992/93) in international relations, and the other, for the way the values driven American foreign policy that Kissinger described is now being undermined by the current President.

Kissinger wrote that America was the first country to adopt a values based approach to foreign policy and that in this context there were two schools of thought as to how to prosecute this – either America would simply be a beacon of democracy that would inspire others or that it would be an active crusader for democracy abroad. Sadly, that beacon is fading.

Have a great week ahead,

Mike