From Brexit to Dixit

When the UK voted to leave the European Union, there was a strong consensus that proximate economies would suffer the macro fallout – Ireland, Belgium and the Netherlands were all expected to take a hit, and in particular I recall speaking with business leaders in both Brussels and Amsterdam at the time and registering their concerns for the local economy. In fact, Brussels was strengthened as a political capital by the way in which it managed the Brexit process, and Amsterdam has been bolstered as a financial capital by Brexit.

Returning to both cities, which sadly are off my well beaten track, I found great curiosity regarding the vision and tactics of Donald Trump. Like Brexit, Trump’s first term was about smashing globalisation, whilst his second term is an attempt to create a new world order, or at least a new American role in the world order.

The prosecution of his tariff strategy has been chaotic and unpredictable, and there are signs that the DOGE project to cut costs in the government sector is simply disruptive. As a result, policy uncertainty has spiked higher. For example, the Economic Policy Uncertainty index has shot to levels seen only during COVID. As such there is great concern that the US may tip into a recession or even that this is the express policy of the administration, with the goal of reducing borrowing costs (see ‘Un train peut cacher un autre’).

Neither the annihilation of the state nor tariffs may cause a recession, but uncertainty might. In this context, a very well regarded, though complex economics text worth knowing of is Avinash Dixit’s “Investment and Hysteresis’ appearing in a 1992 edition of the Journal of Economic Perspectives, and later as a book co-authored with Robert Pindyck. Avinash spent much of his career at Princeton and is a kind, softly spoken and thoughtful economist, in contrast to many of the more head-line grabbing varieties of the species we hear from on social media.

One of Dixit’s pre-occupations was the ways in which companies made investment decisions, and to summarise his findings in a crude way, he noted that firms often didn’t react immediately to a change in economic circumstances but opted to ‘wait and see’. As a result, an environment of high economic uncertainty produces inertia on the part of companies (and investors), but this can be beneficial to them as it gives them the option to wait and see how that environment develops.

We are in a ‘Dixit’ moment, where companies are beginning to stall investment plans because of the uncertainty emanating from the White House and the ever deeper fracturing of trade and diplomatic relationships across the world. In financial markets there is a risk that the capital market pipeline remains constipated as mergers and initial public offerings are stalled.

Similarly, the growing uncertainty of America’s diplomatic and military intentions is causing nation-states to change course. For example, Portugal has just cancelled an order for F-35 fighter jets and will instead buy European planes, while the centrepiece of Australia’s military strategy, AUKUS, is in disarray.

It is difficult to tell how long this ‘Dixit’ moment persists, and much depends on the Treasury and White House being able to communicate a clear economic strategy. Notably the administration has been silent on its intentions towards China, which strikes me as odd given that many members of the administration are united in their antipathy towards America’s geostrategic rivalry (Marco Rubio for example published ‘The World China Made’).

Until we have this clarity, markets will remain jittery, macro data will be unpredictable and activity will err towards the softer side in the US, but perhaps not in Europe where strategic clarity and ambition are picking up from low levels.

Granted that far too much of the macro debate focuses on the big multipolar zone (US, Europe and China), one of the pleasures of my visit to Amsterdam was the chance to meet with David Skilling (the expert on small, open economies) and also serendipitously with Afshin Molavi (the expert on ‘the other 75%’, by which I mean the emerging world economies). It is worth focusing a little on how both of these groups are adjusting to a changing world.

Many small open economies are now in a state of high alert, sceptical of the strategic consequences of the actions of the large nations. In many cases, they are mobilising militarily – the Nordics and Baltic states are an example, and in a recent note I detailed how Singapore, though it is one tenth the size of County Cork, it has an active army nearly ten times the size of that of Ireland, and a reserve army of 250,000 well trained soldiers).

At the other end of the spectrum, large populous emerging countries (think of Indonesia, Nigeria and Bangladesh) are worried about the fallout of the US-China rivalry, but in many ways non-aligned and ambitious for their own economies. On a more positive note Afshin and I think that our ‘4^th Pole’ thesis – that the greater economic region linked by the UAE-Saudi Arabia and India – has the makings of a new pole of economic activity.

Have a great week ahead,

Mike

The Road to Serfdom

I was sauntering through the centre of Vienna last Wednesday, admiring its stylish cafes and bars, and Friedrich Hayek came to mind.

Hayek argued against the suffocating role of government (‘central planners’) on the economy and for greater individual liberty, and his arguments still contain a grain of truth in the context of many European economies. Ironically, Austria’s brand-new finance minister had previously worked as an economist for a trade union and might well prove to be an ‘anti-Hayek’.

Hayek was one of the inspirations (after he won the Nobel Prize in 1974) behind what many American libertarians call the ‘Austrian’ school of economics, and his book ‘The Road to Serfdom’ is undoubtedly on the bookshelves of the most ardent members of team Trump, alongside works like Ayn Rand’s ‘Atlas Shrugged ‘.

In the Americas, Hayek is a favourite of the ‘chainsaw’ economists, with a large dollop of irony given the push for total control of the economy by an elite. Indeed, the risk for Americans is that the dismantling of the government led economy in America risks turning Americans into serfs of the private sector. But, this scenario is not yet immediately obvious given the way public attention remains focused on Ukraine and the victims of American tariffs.

In the past six months, a very strong international narrative has spread around the notion of ‘American exceptionalism’. The US is exceptional in a few domains – fighting (military), finance and its multinationals. Donald Trump is using these exceptional pillars to influence other countries and to set in train his vision for a more isolationist America. The response from America’s erstwhile allies has been to rapidly re-arm and re-finance.

An important sign of this was the announcement by Friedrich Merz (with the SPD’s Lars Klingbeil and the CSU chief) of a new defence spending plan, which largely swerves the issue of the debt brake. That German and Japanese bond yields rose suggests that markets are pricing the reallocation of the bill for security as an international public good to America’s former allies.

The return of war as a topic in European debate will alarm many people, and it should not be underestimated. One of my recent notes highlighted how Europe likely faces an ongoing campaign of harassment, sabotage and destabilisation from Russia. The idea that Europe is on its own is now quite starkly taking hold.

While the drumbeat of war will add to stress in our lives, it is not (yet) part of them. For the great majority of people, the geopolitical debate remains one between elites, and so far, does not impact their everyday lives.

This is where European leaders need to pay more attention and try to reset the international narrative. If America is strong in fighting and finance, it is weaker in areas where Europe is strong, and we might say that the two continents are the mirror opposite of each other. In my view, Europe is strong in the areas that matter to most people, most of the time. Specifically, Europe, as a social democracy is the best place to live in the world (6.6% of the world’s population live in ‘full’ democracies), has generally free education and healthcare and its societies are peaceful (according to the UN, the murder rate in the US is 14 times that of Italy). Life expectancy in France for instance, is four years ahead of the USA. Health spending per capita in the US is well over double what it would be for a European country (13k vs. 6k).

In this context, my counterintuitive argument (to the ‘chainsaw economists’) is that America needs less Hayek, and more ‘Europe’.

The absence of a deep social security system in the US, and the difficulty of accessing decent healthcare at reasonable prices means that a huge number of Americans live in precarity. Demolishing the department of education and cutting state aid to veterans are just two measures that increase vulnerability.

The trend that is emerging, and which will become starkly visible in a recession, is of an American society where a small but important number of households (say 20%) are wealthy enough to live well and access high quality education and healthcare, 40% of households live with the stress of becoming economically vulnerable and a further 30% live in serfdom in the sense that they have no leisure time (Newsweek estimates that one third of American workers has a second job).

Income inequality in the US is at historically very high levels, and the share of total income garnered by the top 1% of the workforce is tipping levels only seen in the 1930’s. Viewed from the point of view of wealth, 38% of the world’s millionaires live in America and over half of the ultra-high net worth (wealth over USD 50mn) individuals in the world are American. Indeed, the top 1% of wealthy Americans own 18.5% of all wealth in America, while the ‘bottom’ 50% of Americans own just 3% of wealth.

As such, the Trump 2.0 programme may not free Americans from serfdom to the government but will make them serfs of a private sector.

As a parting shot, Europe might need a little dose of Hayek. To that end, social welfare systems, state pension plans and healthcare spending may need to be streamlined across Europe as the security agenda becomes more prominent.

Have a great week ahead,

Mike

Un train peut cacher un autre

Adam Smith, though better known now as an economist held the chair of Moral Philosophy at Glasgow and as such it’s fair to assume that he knew a thing or two about the intersection of economics, philosophy and politics, and that often a political crisis is motivated by an underlying economic crisis…hence the title of this note.

Smith lived during a time of mercantilism, which we might describe as a nationalistic approach to trade that aims to maximise the exports of a country whilst keeping imports to a minimum. In this context, Smith wrote of mercantilist nations that ‘their interest lies in beggaring their neighbours’, and the phrase ‘beggar thy neighbour’ has been often used in the economic context, usually when growth is scarce (the aftermath of the Great Depression and the Global Financial crisis)

With mercantilism and ‘beggar thy neighbour’ back in fashion, it is worth returning to Smith’s ‘Wealth of Nations, book IV’ where many of the observations Smith made chime with America today, such as:

‘The sneaking arts of underling tradesmen are thus erected into political maxims for the conduct of a great empire … . By such maxims as these, however, nations have been taught that their interest consisted in beggaring all their neighbours. Each nation has been made to look with an invidious eye upon the prosperity of all the nations with which it trades, and to consider their gain as its own loss. Commerce, which ought naturally to be, among nations, as among individuals, a bond of union and friendship, has become the most fertile source of discord and animosity’.

To that end, beyond the bonfire of American values and diplomatic relationships, there is an emerging, underlying logic to the policies of the White House that China, Japan and Europe need to pay attention to.

I have written many times in this note that the world economy is in the antechamber of a fiscal-debt crisis (listen to ‘Waking up to World Debt’). Unusually, all of the major economies have become indebted at the same time, and the process(es) by which they try to reduce debt at the same time will likely prove extremely hazardous financially.

It seems that the Trump entourage understands this, and that logically the unifying factor behind disparate policies from the creation of ‘DOGE’ to the enfeebling of NATO are driven by a brutal sense of austerity, that starts with the cutting down of all the international public goods that the US has invested in since Bretton Woods.

In this context, the ‘beggaring’ of Europe pushes the bill for European security back across the Atlantic and has shaped the debate in Europe towards greater debt accumulation (for example the debt brake is one of the most contentious topics for the new German government and the EU will soon embark on the issue of EU defence bonds). Japan, South Korea and Australia might be next.

In effect, the White House is using areas where America is exceptional – financial markets, the military and multinationals – to coerce its allies, and in the case of Ukraine to undermine them. Debt might be next.

The closest we have to a template for a Trump grand macro plan is a paper written by Stephen Miran, who may soon take up the role of head of the Council for Economic Advisers. The elements in this plan have popularly become known as the ‘Mar-A-Lago Accord’, which is not unlike the world debt conference idea I have written about in The Levelling, though my version takes place in the recently refurbished Raffles (Singapore).

One of the pillars of the cited ‘Mar-A-Lago Accord is that holders of Treasuries exchange these securities for very long-term loans (that might not provide a coupon). The result would be to restructure the maturity and fiscal burden of America’s debt load. It is a neat idea but will not work in practice. Any debt accord will likely need the impetus of a major financial crisis as a motivator, will need to restructure the debt of all the major economies and will entail a rewriting of financial regulations across the world (for pension funds for example).

In reality, an attempt to enact a Mar-a-Lago Accord, in the same fashion as the debate around NATO, may create aversion (distrust in) to US financial assets and the dollar. Whilst Europeans may not appreciate the extent to which a ‘beggar thy neighbour’ philosophy is driven by US security policy, the White House is underestimating the value that America’s wide ranging financial, diplomatic and commercial infrastructure bring it. An example is that close to 40% of the revenues of large American firms come from overseas.

In the short-term, we are also starting to witness the effects of austerity on the American economy. Though ‘hard’ data on the economy remain solid, the outlook will become very noisy in the next few months as government job cuts take hold and as social welfare cuts (notably in the mortgage industry) sow anxiety. Markets have started to become jittery too, amidst a belief that the administration is much more focused on lowering bond yields (and thus the cost of government debt) than boosting the stock market.

In a scenario where the (US) economy weakens, investors normally turn to Treasuries, but the prospect of a Mar-A-Lago Accord being foisted upon them could lead to a buyers’ strike. The public attack on president Zelensky has disabused diplomats of the intentions of the Trump White House, investors could be next.

Have a great week ahead,

Mike

Full Mettle Jacket

A week ago I started reading Admiral Jim Stavridis and Elliott Akerman’s second book, ‘2054’, which like the first (‘2034’) is a work of fiction designed to tell us about how our own world is evolving and the risks that will confront us. Without spoiling the plot, ‘2054’ demonstrates how new technologies can be deployed in nefarious ways, with the goal of turning the tide of geopolitics. However, as much as I enjoy the work of the Stavridis/Akerman team, my reaction to ‘2054’ was much the same as ‘2034’ (‘2034 – are we already there?’), which is that it has been rendered out of date by bizarre events in the real, political world

The detonation of over seventy years of American diplomacy and soft power by the various speeches and deeds of the Trump administration is a fin de siècle moment, that has drawn comment across the diplomatic world (the most pertinent was that of the Singaporean defence minister who described how he saw the USA moving from a force for ‘moral legitimacy’ to a landlord seeking rent’).

The worry now is that the US will treat its allies like enemies and its foes like friends. There was much consternation in Europe, but as this note has argued so many times, very few European countries have faced up to the challenges of the post-globalized world (Mario Draghi’s speech to the EU parliament last week put it very well…’do something!’).

There is now a furore over Eur 500 bn defence bonds, joint nuclear shields and defence equipment shopping lists. But, a more urgent task than buying fighter jets is the need for Europe to have a coherent security strategy. In a weekend where many are anticipating the results of the German election, a neglected development was the collapse of government formation talks between Austria’s centre-right OVP and the far-right FPO.

Some weeks ago, the parties had agreed on an economic programme, but could not settle on a common foreign policy, a critical stumbling point was oversight of the intelligence services (the OVP wanted to be in charge). This is a sensitive topic given that the FPO has a soft spot for the Kremlin, and specifically the fact that in 2018 the Herbert Kickl (FPO leader), when he was Austria’s interior minister, ordered an investigation into the country’s security services. Today, few of its EU peers share intelligence with Austria.

Reflecting that, the immediate challenge from Russia is infiltration, sabotage and manipulation across Europe (the Gerasimov doctrine and David Kilcullen’s work on Russian/Chinese tactics are both worth a read here ‘From Great War to Total War’). The EU has done relatively little to push back on this interference, and now has an urgent security (as well as defence) challenge.

This could take various forms.

The first is to penalise EU states that systematically go against the grain of the policies, values and interests of the Union. Hungary is the main offender here and whilst some EU funds have been withheld from Viktor Orban, the EU has in general failed to confront him. In the recent past there has been talk in the European parliament of excluding Hungary from the EU, which is technically difficult, but is a necessary part of a more ideologically consistent Europe, and one where bad actors face a penalty for their actions.

A second strand is to have much greater oversight over the movement of Russians in Europe, and of their capital. Vienna, Milan and the south of France, not to mention parts of Switzerland, are popular destinations for wealthy Russians and some European capitals are saturated with Russian money (Mark Hollingsworth’s book ‘Londongrad’ is instructive here as is Oliver Bullough’s ‘Butler to the World’). To emphasise the point, Russian interference in UK and lately Irish politics has not been aggressively countered, and my fear is that this is much worse in other countries like Germany.

Instead of clamouring to buy rocket launchers, Europe’s political classes have a lot to do domestically to shut the door on Russian interference in European affairs.

Then, on a more structural level, there is scope for much greater intelligence sharing across governments and joint task-forces on organised crime (gangs are a favourite extension of the Russian state). From the point of hardware, there is a need for increased joint use of satellites and electronic warfare collaboration.

The distinction between security and defence is an important and urgent one and a reminder of how complacent European governments have been. Whilst defence capabilities will take time to build up, the measures to be enacted in the security domain are less challenging to operationalise, but constitute a real test of European governments’ mettle.

Have a great week ahead,

Mike

Marmite

The number 13 tram in Zurich winds its way through the centre of the city before turning and pushing uphill to the Uetliberg. The inhabitants of the tram are typically older people and bank employees, but occasionally you might come across a few excited, wealthy individuals journeying to look at their gold in the Credit Suisse (now UBS of course) building at Uetlihof. The entrance to the building is on the 8^th floor, betraying a deep underground complex where it is said, the bank stores gold bars, and sometimes invites the owners of the gold to view their stash.

Those investors who own gold will be very happy. It has returned 40% in the past two years and is now closing in on the USD 3,000 level, despite a stronger dollar and high interest rates.

There are few assets like gold. The vast majority of investors do not hold it, nor have they a sense of how its price behaves. But there are others who are passionate about gold and hold large quantities of it in their portfolios. Finance theory suggests investors should hold 2% of gold in a portfolio, but my experience is that in practice, it is either 0% or greater than 10%. To that end gold is a ‘Marmite’ asset class, because like the Marmite spread, you either love it or hate it.

It used to be that a difficult interview question for graduates was to ask them what the drivers of the gold price are. Now that question is more likely to focus on the drivers of bitcoin. Bitcoin’s architects likely wanted it to behave like digital gold, but instead it seems to trade like digital Nasdaq futures on steroids.

The gold price has perhaps three drivers – the role of gold as a monetary variable, the effects of commodity or physical demand and its role as a store of value in times of crisis.

Typically gold as a ‘rival’ for paper money is driven by changes in the monetary environment – namely the value of the dollar and medium-term interest rates. For example, from the early 2000’s onwards the price of gold has moved inversely with the inflation adjusted yield on ten-year US bonds (rising bond yields tend to be bad for gold). But, in 2022, something funny happened – inflation adjusted bond yields rose, but gold kept rising and has not stopped since. Indeed, I now see more and more financial headlines that ‘gold is breaking out’, which is likely a sign that the ‘top’ is not far away.

The strength of the gold price is curious because in many quarters demand for gold has been muted – according to the Banque de France, demand for gold is made up of jewelry (49%), central banks (23%), financial investors (21%) and the electronics sector (7%).

In 2024, Chinese and Indian households have been buying more gold, and before that, emerging economy central banks – notably Russia and South Africa had been buyers, most probably to diversify out of dollars and euros given the risk of sanctions and asset confiscation. Financial holders of gold, exchange traded funds (ETF’s) have not been heavy buyers. Overall though, commercial and financial demand for gold has not been dramatically strong in the past eighteen months.

That still leaves a big chunk of gold’s outperformance unexplained (if it were only driven by the interest rate environment gold would likely be trading close to USD 2,000 given the stubbornness of high bond yields). There are likely two factors at play.

The first is technical. There is a short squeeze taking place in the gold market, which means that a lot of financial actors (bullion banks and speculators) have short positions in gold (hoping that the price will go down) and now have to buy gold to cover loss making positions. This short-squeeze is exacerbated by a spike in demand for physical gold because of fears of tariffs on gold and silver (from Canada – home to many gold miners).

The second factor that is more interesting and harder to calibrate is geopolitics. Gold is a pure store of value – an asset to run to when the world is turned upside down. For those who live adventurous lives, a belt with gold coins sown in is a good escape plan (I have met at least one person with this plan). In a week where the global security architecture has been dismantled by the Trump administration, the reasons for holding gold are clear.

The disintegration of relations between the US and China, the uncertainty caused by tariffs and generally weak government finances across the G2 and G7 countries are just a couple of more detailed reasons to own gold. In that sense it is a barometer of ‘Trump’s world’, but also highly susceptible to his actions – he could send gold much higher if he announces tariffs on gold, but the prospect that he could let Russia off the financial hook as it were, is a reason to call the top.

Have a great week ahead,

Mike

Remember the Washington Consensus?

Does anyone remember the Washington Consensus? Such a phrase might seem odd in today’s world but in the early 1990’s the notion of a ‘Washington Consensus’ was very powerful as a method for globalisation, and hotly debated by the left.

Globalisation worked well because, to be overly simplistic, it was facilitated by a very clear world order that helped to establish the rules of the ‘globalisation game’ and the norms associated with this. At their core, these rules were American, or at the very least they were made in Washington within the institutions that were set up to marshal the post-World War II world order, the IMF (International Monetary Fund), the World Bank and the United Nations in New York. America held the purse strings of these organisations and regular meetings at these institutions became a means of schooling ministers from both developing and emerging economies in the ways of American economic power.

These discussions aired what soon became known as the ‘Washington Consensus’ – effectively an approach to world economic development and globalisation, that was denounced by critics on the left as a neo-liberal policy recipe book. With the benefit of hindsight today, the Washington Consensus was valuable in the sense that it was a consensus, it encapsulated an approach that many countries were content to go along with as part of their first foray into real economic development.

Today, the Washington Consensus is in disarray. The institutions that it was built around, like the IMF are defunct, and others like the WTO have been undermined by both China and the US in recent years. The decision of the US to leave the World Health Organisation is another blow. The ‘Consensus’ is dead because there are now other competing methods as to how countries can develop, and of the independent paths they can take.

Here, an important milestone was Xi Jinping’s China Dream speech, in November 2012, which well before MAGA (Make America Great Again) coined the term ‘China Dream’ during a visit to the National Museum of China. Now, countries like Indonesia or Nigeria can try to follow the classical Western model of development, or China’s non-democratic, state led approach. Or, like Argentina and El Salvador, they can pursue the ‘Trumpian’ model that is taking a grip on Washington, but that is anything but a consensus.

Without going into day-by-day developments coming from the White House, the second Trump presidency can be seen as an early stage in the post-globalisation world order.

Globalisation was based on American economic and political strength and promulgated by the ‘Washington Consensus’ and the B-52’s of American capitalism (multinationals). Eventually globalisation ran out of steam, and events like Brexit, the first Trump presidency and the snuffing out of Hong Kong’s democracy shattered it. We are now in a multi-polar world where at least three large powers (EU, China and the US) do things increasingly differently (look at how they treat AI).

Uniquely, this Trump presidency represents an attempt to do something new and can be seen as an early chapter in the formation of the new world order, and to an extent its success depends on the will and the coherence of the groups of people that are driving the Trump project (from sectors like private equity, innovation and wealthy families). One stark difference with globalization is already clear. Globalization was built on the US being umbilically tied to much of the rest of the world, and vice versa, by flows of ideas, money, trade and people. In contrast, it now seems that Trump 2.0 relies on American exceptionalism, attempting to rise above the rest of the world, and in the process severing the relationships and ties built up since the end of the First World War.

For example, consider the words delivered to Canadians by President Kennedy in May 1961 ‘Geography has made us neighbors. History has made us friends. Economics has made us partners. And necessity has made us allies’ and how remarkably different they are to the way the Donald Trump has treated Canada.

In that context, the rest of the world may increasingly choose to avoid America, and the risk to ‘Exceptional America’, notably with the dollar as strong as it is, is that its financial power ebbs, in the way that of many other empires has. The template for this is expertly laid out in Barry Eichengren’s ‘Mars or Mercury’ paper that analysed the link between empires and their monies, though I feel that in the absence of obviously strong competing currencies, this thesis could take time to play out.

A more plausible side-effect of ‘exceptional’ America, is the advent of a new point of economic gravity, pinpointed at the UAE (United Arab Emirates). This is my ‘Fourth Pole’ thesis – that the UAE together with India and Saudi Arabia has the makings of a new pole of trade and commercial activity, with low regulatory barriers and that encompasses a potentially huge market (Prof Afshin Molavi calculates that there are 2.5bn bn people within five hours flying time of Abu Dhabi). The Mercosur trade deal between Latin America and the EU might also be the basis for a new trade corridor.

The other necessary outcome in a world where America is going its own way, is that Europe stops trying to contain Trump, and takes a far more aggressive stance with respect to its risk environment, notably Russia. The German election in two weeks’ time might be the start of that stance.

Have a great week ahead,

Mike

ChatCCP

Technology happens quickly. This time two years ago, few people had heard about ChatGPT, and few investors knew what Nvidia did. On January 6th 2023, I wrote a note entitled ‘Talos’ where I remarked …

’A recent development here is the arrival of ChatGPT an interactive ‘intelligent’ bot that has been developed by OpenAI (set up seven years ago to build socially constructive AI, and recently valued at USD 30bn). ChatGPT is catching on quickly, not least because students have found that it can write half decent essays. I recently tested it out, asking for a response to the question ‘Is globalization over?’- the result is below, and in my humble opinion is a good rendition of the kind of response that a ‘two handed economist’ might give (‘on one hand…on the other’). I think I can just about do better, and if there is any lesson to draw it is for human writers to be more opinionated, quirky or style driven in how they write. I am not out of a job just yet.

I am still writing, and don’t use ChatGPT to do so. In January 2023, my presumption was that because ChatGPT had already been in place for some time, investors knew about it and had factored it into share prices (the theory of efficient markets in finance says that all publicly available information is quickly reflected in market prices).

This was not the case, and with hindsight, I realise that students of economic and finance of the 1990’s spent far too much time imbibing the ‘efficient markets hypothesis’, which was a big thing at the time and the big guns of academic finance raged about it into the 2000’s. I suspect that more people today believe markets are rigged than efficient, with the rigging done by vampire squid type funds and central banks, to name a few culprits.

The performance of AI centric stocks (notably Nvidia) shows that the early promise of AI was underestimated, perhaps to the extent to which it is overestimated today. Indeed, the concentration of the top ten companies in the US stock market (they make up 40% of the market capitalisation) is as high as it only has been in 1930. In that context, the apparent supplanting of ChatGPT by DeepSeek (we might call it ‘Chatccp’) in the Apple app store is a reality check.

It is also an efficient markets check. I had seen the initial model test results from DeepSeek at the start of this year (Azeem Azhar’s blog had mentioned it back in November, and also as far back as December 2023). To that end the technology world has been well aware of DeepSeek for months, so it is a surprise, and another slap in the face for efficient markets hypothesis (I am still a little obsessed about this).

Whatever about efficient markets, the advent of DeepSeek is a reminder of how the cycle of innovation in economies works, and will have some commentators rushing for their Schumpeter. The Austrian economist coined the term ‘creative destruction’, but his views on capitalism are worth re-reading for he believed that it would undermine itself (different cohorts or corporates would effectively block the system) and collapse. His work on business cycles is also well overdue a comeback.

We don’t quite know whether DeepSeek (who claim to have produced superior model results compared to ChatGPT and Claude AI for a fraction of the cost) have been helped by the Chinese state, whether any espionage is involved nor the extent to which they have piggybacked on work already done by US based teams. Nor is it too important that the bandwidth of the model is restricted in China and that it is unlikely to be widely used in the West.

The important development is that the cost of production threshold for large AI models has been set much lower. Other cheaper models are on the way, Bytedance’s Doubao-1.5 or Moonshot’s Kimi k1.5 are two emerging examples.

To that end, the first phase in the AI boom now comes to an end. Much like other key technology infrastructure breakthroughs – railway (railway companies made up 50% of the stock market in 1900), automobiles (France dominated the auto market from 1903 to 1929, at times manufacturing half of the world’s cars) to the internet (anyone remember AOL or Netscape”) – the initial innovation garners huge amounts of capital, is expected to change the world, which it does but often not in the ways investors expect. The legacy is usually a new web of infrastructure.

In the next phase of AI, Investors will now not likely pay up for model developers but will focus on unique datasets, applications of AI (health) and the AI industrial supply chain – energy for AI for example (see last week’s note ‘Humphrey’).

The view of the stock market, which quickly rebounded, is that the consumer is the winner – that DeepSeek opens up the prospect of cheaper, better AI for common use, and I think the investor conversation will turn to how this impacts consumption patterns and the way people work (from police officers to teachers). The fact that the stock market took the positive view of the DeepSeek news suggests that the AI bubble in stocks is alive and well.

Elsewhere in AI, model development is accelerating in a sinister way. In a paper entitled ‘Frontier AI systems have surpassed the self-replicating red line’, scientists at Fudan university highlight how AI can build replicates of itself, and when this process runs into obstacles, demonstrate a survival instinct (such as rebooting hardware to fix errors). It strikes me that this is the real AI development we need to pay attention to.

Humphrey

I’m glad to mention that my ‘GoldenEye’ note generated a lot of feedback, some of it cursing my good luck to spend a week in the Caribbean. To atone, I spent four days last week in the foggy cold of England, touring from Oxford to Manchester to the Cotswolds and finishing in London. Many of the places I visited are points of reference that I have known for a long time. Some have changed for the better (the Elizabeth line in London is very useful), some for the worse (this Manchester United team is indeed the worst ever), and some have not changed at all (the food at Pepper’s Burgers in Oxford is just as good as it was thirty years ago).

Economically and politically, Britain is worse off. Brexit has been a terrible mis-step, and the new Labour government is struggling to even diagnose the sputtering economy. Real-wage growth is feeble, productivity is at multi-decade lows, the fiscal deficit dominates policy making and the bond market is more troubled than when Liz Truss was prime minister. The only saving grace is that Britain isn’t Germany.

In foreign policy, while Britain is an active supporter of Ukraine and still a UN Security Council member, it is at risk of becoming lost geopolitically – Britain is stranded outside the EU and the special relationship between Washington and London is all but dead politically in the Trump 2.0 era.

However, Britain is good at remaking itself. I think that at some point it will have its ‘Brian’ moment when, to borrow from the Monty Python film (The Life of Brian), a political leader will emerge, haphazardly or by design, with the force of personality and ideas to right the country. Nigel Farage is not this person, and without being unkind, I am not sure that Keir Starmer is either.

It used to be the case that Britain didn’t need talented politicians, it had a large, expert civil service to run the country. Instead of ‘Brian’s’ it had ‘Humphreys’ after ‘Sir Humphrey Appleby’ the fictional cabinet secretary in the excellent 1980’s tv series ‘Yes, (Prime) Minister’. The series revolves around the art of non-decisions and the careful practice by civil servants of keeping elected officials far from the levers of power.

When the engine of the economy was whirring, the job of the ‘Humphreys’ was to keep politicians from putting a spanner in the works. Now that productivity is dead across the UK (below the US, Germany and France) due to a lack of investment in capital and skills, the country needs to be inspired by new ideas. Thankfully, two of them came along last week.

The first was the latest in a series of notes on the UK economy by the excellent LongView Economics. In brief their diagnosis is that Britain faces several, long-growing problems – to many ‘Humphreys’ or rather too much regulation and bureaucracy (government spending is at seventy year highs), the death of risk capital and the need to re-generate investment flows across the British economy and the financialization of the economy.

Two of the solutions flagged by LongView are the needs to reform the NHS and to cut bureaucracy across government. This might happen sooner than many think because the second inspirational idea to come out of the UK was the launch a week ago of the UK AI Opportunities Action Plan, which in effect was authored by the venture capitalist Matt Clifford with a little help from the likes of Sir Demis Hassabis. It is applied and well thought through enough that it could not have been written by civil servants. In a week where the USD 500bn Softbank/OpenAI/Oracle AI investment has grabbed the headlines, the UK AI Plan deserves much closer attention and in my view, is the best framework for an AI value chain.

Whilst there are fifty recommendations in the report, all of which have been endorsed by the government, the main ones involve ‘feeding’ AI models by making high quality data more available (changing copyright laws), accelerate investment in data centres and also set up an AI Energy Council to plan the energy sources to power the data centres. There are also plans for a national data library and for the use of AI in the NHS.

One striking element, announced this Tuesday, is the use of AI assistants to speed up public services, with data-sharing deals across siloed departments; and a new set of AI tools — dubbed “Humphrey”. The aim is to speed up and make the work of civil servants more efficient – with the stated aim of saving GBP 55bn (this is very ambitious and if achieved would cut significantly into the budget deficit).

The plan, at least, is ambitious. Whether or not the Labour government can implement this plan is very much an open question but at least they have in their hands a blueprint for investment and perhaps the beginning of something better for the British economy.

Have a great week ahead,

Mike

GoldenEye

I may well lose half of my readers with the next sentence but, whilst many of you were struggling in sub-zero temperatures I spent much of last week in the Caribbean. As the plane passed south over azure sea and white beaches I thought to myself that we were not far from Goldeneye, the Jamaican residence of ‘James Bond’ author Ian Fleming. Indeed, the character of James Bond has some local Caribbean flavour, Fleming was a keen ornithologist and named his main character after an expert ornithologist and author of ‘Birds of the West Indies’ called James Bond, who subsequently visited Fleming at Goldeneye in 1964 (Goldeneye was the name of a 1941 intelligence operation in Spain that Fleming as involved in).

Early in his career, Fleming struggled to match his more illustrious father and brother (the excellent ‘Geographies, Genders and Geopolitics of James Bond’ by Lisa Funnell and Klaus Dodd underlines how Fleming’s conception of Bond was influenced by both his brother and father), and his military career really only took off when he took up a role in Intelligence (he worked at Room 37 at the Admiralty).

He was given charge of a small but telling operation whose aim was to conceive high impact missions that had little chance of success, but that would confuse the enemy. His playbook of operations was called the Trout Memo – after the fly-fishing technique designed to entrap trout.The conception of these high risk missions formed the basis for the James Bond novels, which from 1953 onwards were very popular, and by 1965 the series had reached thirteen books.

In 1965 the writer Kingsley Amis, well known as a serious critic, poet and author, published the book ‘The James Bond Dossier’, an analysis of Ian Fleming’s Bond novels. The book which contains studied lists of Bond’s victims, lovers (at my count Bond prefers English, American, French and then Swedish ‘friends’) and adversaries (few governments, mostly individuals and warped older male sociopaths at that), helped Amis enter the world of popular culture – he clearly had a sense of the allure and longevity of the Bond brand.

Some of the films based on Fleming’s work have been spot on in identifying threats and trends. On the whole and perhaps reflecting Fleming’s own operations, many of them involve the disruption of supply chains and the resulting profiteering – for instance Goldeneye was based on the deployment of an electromagnetic device to rob the Bank of England (don’t forget that Goldfinger plotted to use a dirty bomb to steal gold from Fort Knox), Tomorrow Never Dies Involved the manipulation of the media, in Die Another Day a satellite is used to manipulate the weather over North Korea and so on.

While the Bond film franchise is struggling to settle on a new actor to take over from Daniel Craig, my sense is that we live in a world that is increasingly Bond like in its geopolitics. Whilst the period of globalizations was relatively calm, we are now in the midst of a number of trends that are Bondesque – a Cold War between the US and China, a grey war between Russia and Europe, NATO re-armament (which featured in Thunderball), the rise of oligarchy and the advent of space as a competitive domain, to mention a few.

Every time I leave Europe, the intensity of the US-China struggle for supremacy strikes me, though I feel that most Europeans are not alive to this. Neither are they alive to the shadow war that Russia (with help from China) is prosecuting on Europe. The Polish government (holder of the EU rotating presidency) unveiled a sabotage campaign by Russia to target freight aircraft across Europe. This comes after a series of assassinations, sabotage attacks and hacking campaigns that Russia has prosecuted in Europe.

Back in the Caribbean, a striking event last week was the disintegration of Elon Musk’s Starship, which reminds us of the sharp rise of oligarchs as political operators (as highlighted by president Biden), and of how space is opening up as a new, competitive domain (Bond film Moonraker gave us a taste of this).

In particular the entry of Musk into the operation of military innovation and procurement is a sign of a wave of aerospace and defence innovation, that is being pioneered by firms like Shield AI, Helsing AI and Anduril. As a sample of the thinking behind this innovations, one idea that was put to me recently is to replace fighter jets with hypersonic rockets that carry and deploy drones to the battlefield. Of course the trouble with most of these technologies is that they are unmanned, leaving little room for Bond like characters to distinguish themselves.

A final element worth mentioning is geopolitical power. Britain is a much less consequential player geopolitically than it was in the 1950’s, but it still retains a seat on the UN Security Council for instance. The trouble is that many of the institutional reference points of the Fleming era are losing their lustre, and risk being replaced by an entirely new set of institutions, and we could speculate that in the future we will see the development of a World Cyber Police, an AI led World AI Safety Institute and an authority to police genetic editing and DNA hacking, all of which might feature in future Bond plots.

James Bond may be on hold as a cinematic experience, but I wonder if the next Bond movie should be called ‘No Time for Tariffs’.

Have a great week ahead,

Mike

Contrarians and Controversialists

We spent a memorable New Year’s Eve on Dursey Island, one of the more remote parts of Europe, whose only point of access to the Irish mainland is by ‘Ireland’s only cable car’, where the principal safety device is a bottle of holy water. In 1602 Dursey was the scene of the massacre of some of the O’Sullivan clan. Some six hundred years before that, it was a staging post for the Vikings.

I am tempted to think that had the Vikings stayed the O’Sullivans could have escaped the slaughter of the Siege of Dunboy, but then again, always optimistic, I contend myself that Dursey – unlike the other Viking island (Greenland) will not attract the attention of the US Navy.

My intention this year is to be as least distracted as possible by the geopolitical strategizing of President Trump, but in the context of a far more ideological cabinet, his thoughts have consequences – not least for how they will encourage the enemies of America and the ‘west’ to behave.

For investors, political and geopolitical risks will likely play a much greater role in developed market asset returns than in any time over the past forty years, and the market reaction to Donald Trump’s victory offers them a wonderful opportunity to take a contrarian view and ‘spend American exceptionalism’.

To explain what I mean by that, our starting point in 2025 is that an array of US assets trade at very high levels. Indeed, to recap a phrase I used in December markets are starting 2025 from the ‘wrong place’ in the sense that an enormous amount of capital is tied up in assets (the top ‘7’ technology firms, the dollar, corporate bonds) that trade at all time lofty valuations.

For instance, Bank of America estimates that the dollar is the most expensive that it has been since the early nineties, and valuations for US stocks are close to the highest levels they have reached since the late 1990’s. The top fifteen companies in the US are now worth the same as Chinese and European equity markets together.

Added to that, quite a few assets have exploded in value because of their proximity to Donald Trump – notably the crypto eco-system and Tesla (which has added USD 850bn in market value around the time of the election, an amount equal to the value of its ten nearest competitors).

There is not yet a bubble in the broad US market – many segments such as value stocks (high dividend companies) and small companies have not performed, but there is sufficient capital held in very expensive dollar denominated assets that it demands the attention and action of investors.

Market analysts do not appear worried – in the time-honoured fashion the major investment houses have released their year ahead forecasts, which suspiciously all cluster around the 10% market, and equally suspiciously no investment house is forecasting a negative year for US stocks. This collective conclusion must have required great analytical power because an independent re-running of these same models points to flat or negative returns.

To that end, investors should take advantage of expensive dollar assets and diversify abroad.

They may be convinced to do so by two developments. The first is the collapse in long term US bonds since the Federal Reserve launched into a series of rate cuts from September onwards. In effect the bond market is signaling that it sees a resurgence of inflation ahead, and it is also likely flagging that the credit worthiness of the US may be deteriorating (in the sense that there is little prospect of the budget deficit and government debt being pared back).

Related to this, the second Trump administration begins in a much worse fiscal place as the first Trump government did in 2016. In the period 1960 to 2016 (with the exception of the Vietnam War) the US budget deficit has always followed the tempo of the business cycle (as proxied by unemployment).

That is to say that the budget deficit shrunk when the economy was strong (low unemployment) and it grew when the government spent more to cushion the effects of recession (high unemployment).

Today, we have the opposite – unemployment is low and the budget deficit is very high. This implies three risks – that too much spending in a ‘hot’ economy creates inflation, that there won’t be any money left to ‘rescue’ an eventual recession, and that the rising deficit implies rising debt, which bond markets don’t like.

None of these risks, and rising bond yields, appear to worry the US equity and corporate bond market, but they should. A contrarian view might look to sell expensive dollar denominated assets and allocate overseas.

So my message to start the year is – don’t invade Denmark, buy its equity market.

Have a great week ahead, Mike