Debt Purgatory

Roland Garros is one of the more stylish and elegant parts of Paris, and not a bad location to discuss finance and economics. Unfortunately, France’s political elite did not rise to the occasion. At the end of last week, (MEDEF), the large French business network gathered the principal candidates for the 2027 presidential campaign to listen to their views on the economy, and in particular their policies to pare back France’s gargantuan fiscal deficit and debt load. With a few exceptions, they disappointed. 

The candidates for the far-left (Jean-Luc Melenchon of La France Insoumise) and far-right, Marine Le Pen of the Rassemblement Nationale, appeared to treat the event as a light-hearted post-holiday chat show, and not a forum to debate the faultline that could pitch the euro-zone into another debt crisis. 

Though France’s presidential election is far off (the first round is on 18 April 2027), international investors need to pay close attention to it, both as a specific risk factor for bonds, foreign exchange and equities, and as a harbinger of what might befall most of the other major economies. 

In this respect, France has at least two things in common with the US. First, its weak finances. The budget deficit has been stuck at 5%, a level historically associated with a recession, and debt to GDP is on course to hit 120% according to the OECD. Second, there is no appetite to tackle this dire fiscal situation. In the US, there is little prospect of corrective tax hikes or spending cuts, and the Trump administration appears to have a fetish for intervening in markets.  

In France, three governments have been consumed by the process of setting a budget, and there is no political nor popular will to set France’s finances on a sustainable track. What is worse is that wild, populist suggestions that France could cancel the debt that the Banque de France holds (as a result of quantitative easing) are being aired in the media. France’s political class and populace are not known for their financial literacy, and the belief in some quarters that debt can be magicked away is dangerous and sets the economy up for a sharp reality check. 

Having witnessed the brutal effect of a debt crisis and the subsequent austerity on the Irish economy from 2010 onwards, French policymakers and its public are badly unprepared for what may come. Government spending at 57% of GDP is comparatively huge, and much of this goes on social welfare (healthcare and pensions). 

Unlike the US, France is not enjoying an AI capital expenditure fuelled wealth effect, and the notion that it might act to structurally boost economic growth is anathema to nearly all of its politicians. In a demonstration of moral hazard, France has accumulated debt at a pace and amount more than any other euro-zone country, without much protest from the ECB.

Markets however, are reacting. French ten-year bond yields have just passed Italy’s. While long-bond yields in Japan, the US and UK have all broken higher to multi-decade highs, the re-rating of France is troubling. For international investors, France’s changing status, from a core, safe haven, to a periphery market is one of several signals of a coming debt purgatory – a long period where indebtedness dominates markets, government politics and geopolitics. 

For European policy makers, the fact that France is the indispensable nation on geopolitics, defence and military innovation complicates matters because it means that politically, in the context of German underperformance, France is harder to corral into a fiscal straightjacket in the same way the European Commission did with Greece, Ireland and Spain. On the European political stage, there is no-one fiscally credible politician who might stand up to France and avert the potential for contagion across the euro-zone. 

If for instance, both Melenchon and Le Pen make it through to the second round of the presidential election, bond investors will desert France, French bank share will collapse, luxury goods firms will become bargains, and the euro will likely fall. Bond investors will likely rush to the few safe havens the euro-zone offers – Germany, the Netherlands and Ireland as well as assets in ‘old’ periphery countries like Norway and Switzerland. 

More broadly, a continued rise in French yields, in the face of policy inaction (a draft budget is to be presented to parliament at the end of September), will for the first time in over a decade sensitize international investors to the credit risk inherent in government balance sheets. What is intimidating is that here France is in good company, most of the major economies, China, Japan, the UK and the US are as indebted as it is. 

Everything is Fine

On September 16, 1992, the British pound was ejected from the rigid European Exchange Rate Mechanism (ERM) system that it had joined in 1990. In the ERM, the pound was linked to the Deutsche Mark but effectively at too high a valuation, making it uncompetitive. A few days later, Chancellor Norman Lamont tried to sound upbeat, telling journalists that ‘My wife said she had never heard me sing in my bath before,”, suggesting that he was happy to be rid of the ERM. This characteristic gaffe by Lamont was badly received at a time when British industry and households faced a sharp rise in interest rates.

The pound’s exit from the ERM came after painful interest rate hikes (from 10% to 15% in one day) and massive intervention from the Bank of England on one side of the foreign exchange market. On the other side, famously, was the speculator George Soros, who ‘broke the pound’ by selling billions of pounds in the expectation of a devaluation. At the time, a youngish Scott Bessent worked in Soros’ Quantum Fund. Today, as US Treasury Secretary, Bessent is having his ‘singing in the bath moment’.

Bessent has made two interventions in markets in the past month. The first, a historic joint move (the last one was in 1998) with the Japanese authorities to boost the yen. The involvement of the Treasury ensured that Japan was able to buy yen without selling Treasuries, which would have pushed US yields up. In that context, Bessent’s second intervention was a promise to effectively sell short duration bonds, and with the proceeds buy long duration ones, the intention being to push down long-term yields.

Bessent’s moves were greeted with puzzlement and some disdain in markets. Interventions in markets are rare, normally occuring when something is broken or about to break. When they do occur, they need to be large (almost unlimited) to have credibility. Mario Draghi’s announcement that the ECB ‘would do what it takes…and believe me it will be enough’ is the best example. Thus, the Treasury Secretary’s interventions give the impression that something is not quite right, and in this regard, at least three problematic issues are raised.

The first is that Bessent has announced the arrival of a debt crisis, or rather a debt purgatory, a long period where indebtedness weighs on government policy, markets, and geopolitics. The bond market intervention coincided with America’s debt burden topping the USD 40 trillion mark, and the Treasury Secretary has simply succeeded in drawing greater attention to this.

Markets registered this in May when long dated (30-year) bond yields on US, UK and Japanese debt hit levels not seen since before the global financial crisis. Bessent’s intervention shows that governments are now feeling the financial pain associated with this rise in yields and are starting to worry about how to curb it. A particular problem for the US, is that a mixture of geopolitics and AI driven debt issuance, mean that there are fewer natural or passive buyers of its debt.

The second element of note in Bessent’s actions is that they betray a philosophy across the Trump administration that is intensely focused on asset prices to the detriment of economic policy. The president’s active stock trading and public promotion of stock trades, billion-dollar forays into cryptocurrencies, and attempts to shepherd the oil price through social media are all part of this. At the same time, the US has a historically enormous budget deficit, which the rating agency Fitch expects to surpass 7%. In the past a deficit of such magnitude would only occur during a deep recession or financial crisis.

Today, in the context of a record high stock market, and an AI boom, it is a dangerous anomaly. Should something go wrong to pitch the US into a recession, there is no fiscal cushion. Bessent has done nothing to reduce the deficit and his tinkering in the bond market shows that the deficit is not his priority.

Thirdly, the bond market intervention is ill timed because the other ‘wing’ of American financial policy, the Federal Reserve, has a new chief, Kevin Warsh, also a former hedge fund manager. Warsh has a preference for a Fed that communicates less to markets, but he has so far not communicated well. Markets are unsure of his stance on inflation. The added complication is that Warsh prefers a more spartan Fed, one that is less active in bond markets, so the Treasury intervention is a contradiction of this. The other concern is that the Fed begins to suffer from fiscal dominance, which in simple terms means that in making policy, it is looking over its shoulder at the actions of the Treasury, and the sentiment in a wobbly bond market.

With markets still focused on AI, Bessent has unwittingly opened up a macro ‘battle’, which the bond market will surely win.

Have a great week ahead, Mike

Bezzle Bonds

In my summer reading note (‘A Good Read’) an important omission was a couple of books by the celebrated economist JK Galbraith, the ‘Affluent Society’ which is relevant to the many economies struggling with low growth (e.g. UK, Germany), and ‘The Great Crash’, a text that will surely come in handy in the next twelve months.

In this book, Galbraith introduces the term ‘bezzle’ by which he means the rise in fraudulent financial activity as an investment bubble gathers momentum. A slightly different version of this is the rise of what we might call ‘non-traditional’ or opaque forms of financing as the asset bubble gathers pace.

One nuance of the bezzle, is that there is a moment of suspended financial animation, where the investor in the ‘bezzle’ feels rich, thinks he/she is a financial genius and at the same time the bezzle premium starts to accrue to the architect of the ’bezzle’. Falling economic activity and asset prices bring home the truth of the ‘bezzle’ to the investor.

Last week’s note on the intense financialization of the South Korean stock market gave a taste of the giddiness that is building around the AI capital expenditure boom. In this context, investment products, such as leveraged exchange traded funds and ‘single-deal’ special purpose investment vehicles in IPOs like SpaceX are ‘bezzle-like’, and it might be argued that new AI startups that raise capital at a high valuation are also bezzles, if not simply hubristic.

Now, activity in the bond markets and private lending segment is beginning to acquire a ‘bezzle’ premium. For example, last week six of the largest banks and private equity houses announced the creation of a USD 500bn ‘pool of capital’ for Nvidia, to facilitate the buildout of its AI infrastructure. The details of the deal are complex to say the least. This financing package will be considered ‘off balance sheet’, so it won’t immediately show up in Nvidia’s balance sheet, but it will bind the financial and AI industries more closely together (note that a chapter in the Galbraith book has the ironic title ‘In Goldman, Sachs we trust’).

What is interesting is that bond markets are starting to react. Bonds issued by the large AI firms, or ‘hyperscalers’, are beginning to trade at a higher yield, reflecting the market view that they are increasingly risky. For instance, spreads on the index of hyperscaler bonds are now nearly double what they were at the start of the year, and it is much the same for credit default swaps.

This is important in at least two respects. First, it signals that individually some of the hyperscalers (META and Oracle are often mentioned) are running down their cashflow rapidly and building up debt just as quickly. Second, the corporate sector is becoming indebted again (from modest levels), under the spell of AI infrastructure build.

This is concerning as we look towards 2028 (when in my view the AI capital expenditure boom judders to a halt) because public debt levels are already considerable, in fact they have never been higher across the major economies. To that end, public debt markets are also beginning to price in a riskier outlook (long dated bond yields in the UK, South Korea, Japan and the US are at or close to multi-decade highs). Rising real yields (inflation adjusted) tend to be a more cautious signal for markets. Equity markets appear not to notice, or care, but other asset classes like foreign exchange are also signalling trouble in the engine room (the joint US-Japanese intervention in the yen was a case in point).

The net economic effect is a sort of balance sheet ‘bezzle’, to stretch the analogy. In the US, households have never been more exposed to the equity market, and its rise is producing a marked wealth effect. Based on long run valuations, this wealth effect may be close to peaking though the psychic wealth effect remains strong. On the other side of the balance sheet, government debt continues to grow – one third of all the debt that has been issued by the US has come during the Trump administrations, and corporate debt is edging up as AI infrastructure spending gathers steam.

Have a great week ahead, Mike

Is China OK?

China's economy grows at one of lowest rates in decades

For much of the last decade or so, Chinese friends and acquaintances, as well as many people I know in Singapore and Hong Kong, have remarked that their view of Europeans is a lazy and decadent people, too tolerant of the problems that beset their societies. This view is in part gentle mockery, and part sincere. Europeans, not used to being mocked, will look up from their Aperol spritz and ask what they are doing wrong?

Indeed, according to the latest (and fourth) University of Alberta ‘How China sees the World’ survey, it seems that most Chinese don’t rate the EU as a major geopolitical player, though a significant economic partner and more importantly, a tourism destination.

The survey highlights that the Chinese have a strong view of their country’s importance on the international stage, pitting it ahead of the USA in a bi-polar world order. The interesting elements in the survey are the casting of Russia as an indispensable, trusted partner on the international stage for China, and the confidence with which participants gauge a war with Japan as a likely geopolitical event.

To an extent, it is welcome to consider Chinese views on the rest of the world, granted the irony that for such an important economic and geopolitical player, there are relatively so few Western experts on China, and in Western public discourse there is not a well-developed conversation on Chinese culture and politics. Consider that there are very few Irish public figures who know China well, and the evolution of China’s economy does not get enough detailed attention in the Irish media, despite China’s enormous role in the world economy.

This might be because China makes it increasingly difficult for outsiders to understand it. In the past seven years, Western investment in China has dropped significantly, and the flow of Westerners to work in China has also fallen. A further illustration is that there are now fewer than 2000 Americans studying in China according to the Straits Times (down from 11,000 in 2019) while there are still some 250,000 Chinese studying in the US (down from 354,000 in 2019), and a further 150,000 Chinese studying in the UK (and close to 4,000 in Ireland).

The reduced social, political and commercial connection between China and the West makes it harder to read what is happening to the Chinese economy, with the additional concern that official Chinese data is not helpful either. Granted that China last week printed one of its lowest official GDP growth readings, this is a significant hurdle. Indeed, there is a sense amongst many Western economists that only an amalgam of very detailed, micro indicators (e.g. electricity usage) can help build a picture of what is really happening in the Chinese economy.

For example, In the USA, the Conference Board has reconstructed China’s economic data, and has concluded that not only has the performance of the Chinese economy overestimated, but it has been driven by the flow of huge amounts of capital into the economy that has steadily become less productive (in the sense that one dollar of capital leads to a decreasingly small return). It may be that the Conference Board team has gotten it wrong, but there is simply neither the forum nor the spirit for an open debate on Chinese data. Also, a prominent Chinese economist Gao Shanwen, who died of cancer last month, had stated publicly that the trend rate of growth in China is far lower than official figures suggest.

Despite that, the most interesting element is that the Chinese authorities have managed their economy better than most have thought, and to use a headline from the New York Times, China’s economy ‘has failed to fail’ in the sense that it has not had an obvious cyclical recession in decades.

If there is a strategy behind this, it looks from afar, as the state pushing activity from one economic engine to another. The Chinese property market has steadily deflated over the past six years, and the financial consequences of this have in my view not fully registered with banks and households. At the same time, through a mixture of state guidance and ruthless industrial competition, China has shifted the locus of activity to manufacturing (and the last Plenum, policy making forum, has ordained deep tech as the spearhead of the Chinese economic effort).

One consequence has been the creation of over-capacity, but in goods of sufficient quality and low production cost, that they displace European markets. Last week, exports of Chinese cars to Europe have just topped a monthly tally of 1 million, while European manufacturers (even Porsche) are struggling in China. The result is a crisis of confidence in German manufacturing, and a policy debate on how to curb the flow of Chinese exports into Europe.

In the past year, China has pursued an ‘involution’ policy, of reducing spare capacity across a range of industries, but this does not yet appear to have borne fruit and raises the risk that there is still a lot of operational leverage in the economy. Two other risks loom. One consequence of the funding of real estate and manufacturing through the banking sector is that in terms of assets, China’s banks are amongst the largest in the world, a systematic risk in the event of a downturn, and its public (including local and regional authority) debt, is dangerously high.

With trading partners, such as Germany, beginning to react to China’s export boom, the policy options for Beijing are increasingly limited as they try to maintain economic momentum. Another bad GDP print and investors will start to fear the worst.

Have a great week ahead, Mike

Modern Times

On May 15, 1932, there was an attempted coup d’etat in Japan, led by a militant, nationalistic faction in the Imperial Army. The principal victim was the Japanese Prime Minister, Inukai Tsuyoshi. The perpetrators of the coup were given relatively light prison sentences, a pointer to the less democratic and belligerent Japan that would soon follow.

The bizarre element of the coup, which fortunately did not succeed, was a plan to murder the actor Charlie Chaplin. The thinking was that such a deed would incite popular fury in the US, and thus lead to war, in which Japan would prevail. At the time of the coup, Chaplin was watching a sumo wrestling match with the Prime Minister’s son, and thereby escaped the assassins.

This was more than lucky and in many ways Chaplin’s film The Great Dictator is a fine riposte to the destructive nationalism and totalitarianism that took hold across the world from the mid 1930’s. It is a film that still resonates today in our world of ‘predators’.

While our view of Japan today is of a placid, highly civilized country, its history in the past two centuries is a reminder of the pitfalls of isolationism, nationalism and war – concerns that are now echoing louder across the international political economy debate. It should be said at the same time that the post second world war relationship between the US and Japan is a good example of how two feuding countries can come together (Al Alletzhauser’s ‘House of Nomura’ is good on this topic).

Yet, such was Japan’s economic rebound after the second world war that America feared the rise of Japan as it now does China, and fans of economic history may know that during the 1980’s and 1990’s Donald Trump was an eminent Japan-trade basher. For instance, the April 13 1987 cover of Time magazine carried an image of Uncle Sam pitted against a sumo wrestler under the banner ‘Trade Wars – the US gets tough with Japan’ (the stock market crashed five months later).

Now, following decades lost to the after-effects of its economic crisis, Japan is undergoing an awakening, spearheaded by the historic election of the first female prime minister of Japan, Sanae Takaichi. This awakening takes different forms, a more assertive diplomatic stance on China, a ramping up of defence spending amidst greater public comfort with the idea of Japan as a budding military power. Also, Japan’s government is ambitious for its economy and has announced a record state budget of 122 trillion yen (over Eur 600 bn), and Japanese firms like Softbank are in the vanguard of the AI boom.

There are two other financial aspects of this awakening. In an attempt to revitalize the Japanese economy, the Bank of Japan had kept interest rates at or below zero for some time. It has abandoned that policy recently and with both growth and inflation picking up, bond yields have surged. For much of the last fifteen years, the ten-year bond yield in Japan has been well below 1%, but in 2024-25 normalised toward the 1.5-2% range, and is now 2.7%, whilst the longer term 30-year bond yield is 3.95%.

As one of the world’s most indebted countries (Japan’s headline public debt to GDP ratio is well over 200% according to the IMF), the effect of this is that fiscal policy is increasingly smothered by the effect of interest payments on that debt, and policy is trapped between trying to grow the economy, control inflation and not upset the bond market.

Equally the yen is grabbing attention, falling to a forty-year low this week. Indeed, it might well be lower, but traders are wary of a market intervention by the Japanese authorities. There are several factors driving this, the hedging of foreign exchange risk by investors buying Japanese assets, real interest rate differentials, and worries over the effects of expansionary fiscal policy. A costly bout of yen intervention might be close.

As Japan’s asset prices hit records for largely the wrong reasons, it serves as a reminder that many large indebted economies exist on a financial tightrope between growth and calamity. Britain is the most prominent example, but Japan is a more systematic case and over the summer could be the source of a market wobble, if not outright crisis as bond market sell-offs become more common in our ‘age of debt’.

It’s all enough to make me think of Charlie Chaplin’s depression era film Modern Times.

Have a great week ahead, Mike

AI as an asset class

A very early career memory of mine came in late 1999 when the UBS investment bank took the team of analysts covering the staid Paper & Packaging team and re-directed them to become the ‘dot.com’ team. This I reckon came about six months before the peak of the ‘dot.com’ bubble and, I am now wondering if investment banks are channeling resources into AI banking teams (surely AI can do the work!). If so, it would be proof of the idea that AI is everywhere, from the Mythos breakthrough we wrote about a few weeks ago to, with good timing the thoughtful note, Magnifica Humanitas, from Pope Leo XIV on how AI should be deployed.

Nowhere is the sense that AI is everywhere more true than in finance. According to Pitchbook, 45% of all American unicorns (venture-backed companies with a valuation above USD 1bn) are AI-driven, not bad for a technology that, to public eyes, barely existed three years ago. In more detail, two earlier venture-backed successes, Bytedance (i.e. TikTok) and Uber had been established for 80 months when they launched their first products. OpenAI and Anthropic have done so after 30 months, and each is now worth close to USD 1 trn. Equally, illustrating the link between investor exuberance and AI, the FT recently estimated that two-thirds of the value of SpaceX is attributable to investments made in the company in the six months since December 2025.

When this trio of AI firms lists on the stock market, revised index inclusion rules will add their weight to the already substantial 44% representation of technology stocks in the major indices. To that end, AI is no longer a market theme or fad, but is becoming an asset class in its own right.

One of the factors that distinguishes a genuine asset class from a market theme or fad is the presence of a transformative technology, with a lasting economic impact. In the context of an otherwise pedestrian US economy, AI capital expenditure is the dominant growth driver and in the last year, expenditure on data centres in the US hit USD 1 trillion.

A comprehensive study from Stanford’s Forecasting Research Institute (March 2026) compared GDP forecasts from different types of forecasters – economists in the private sector, academics, AI experts and the general public. Unsurprisingly, those closest to the AI industry tended to have the highest GDP forecasts, while academics were more grounded. On balance though, there is a consensus view that AI will lift the trend rate of growth in the US.

There are also increasingly varied ways to invest in AI. An AI-centric portfolio can now span private equity, venture capital, infrastructure (clean energy for data centres), real estate (data centres), currencies such as the Korean won, corporate bonds (Amazon, Meta, Oracle and Alphabet have issued nearly USD 150bn in bonds this year) and private credit. Indeed, AI-related private credit investments are expected to grow by over USD 1.5 trn in the next two years. While there is already a rich mix of AI-centric asset classes, the correlations between them remain high, limiting the diversification benefit.

In addition to investment banks committing resource to AI-driven deals, another hint that AI is an emerging asset class is that it has its own distinctive mode of corporate governance – strong-willed founders who monopolise voting rights, enormous pay packets and neutered boards. This concentration of control is likely to prove one of the structural vulnerabilities of the AI complex as scrutiny from regulators and institutional investors intensifies.

Given the scale of AI’s footprint across markets, one of the essential tasks for investors will be to identify assets uncorrelated with AI (e.g. luxury goods, food), as well as hedges on AI assets. And, as the suspected AI bubble grows in value, investment managers will have to find ways of protecting portfolios against sharp reversals in AI valuations.

The investment dimension of the AI boom carries particular urgency. Given the risk that AI (as per Mythos) creates potentially existential security and economic risks, and could disrupt labour markets, there is a strategic need for pension funds and sovereign wealth funds to have exposure to the economic benefits of AI. As it stands, the risk is that billions of people will have their lives and livelihoods changed by AI, but the benefits accrue to only a narrow group of investors and executives. In that regard, the advent of AI as an asset class gives individuals, countries and investment funds a means of participating in the upside of the AI boom.

The one formidable obstacle investors will have to navigate is the sense that we are in the thick of an AI bubble. Already long-run valuation measures – such as the ratio of market price to long-run earnings (the ‘Shiller P/E’), or the ratio of the value of the US stock market to GDP – are testing all-time highs, at levels not seen since 1929 and 2000. In this way, AI is truly everywhere, in our savings, investments and pensions, and that will be a risk.

To return to my first point on the switching of analyst roles. A couple of brokerages have, according to the Wall Street Journal’s China correspondent, dropped coverage of Chinese consumer stocks because of the weak outlook for spending. It might be the next trend to watch.

Have a great week ahead, Mike

Lost at Sea

As a child I was fascinated and terrified by tales of the Bermuda Triangle, an area between Florida, Puerto Rico and Bermuda where ships and planes disappeared without warning, allegedly. Legend had it that a mysterious magnetic field around the Sargasso Sea drew vessels to perdition, or that even darker forces were behind the disappearance of the crew of the Mary Celeste.

Without stretching the analogy too far, my feeling is that financial markets have entered a logical Bermuda Triangle, or even Trilemma. Data, models, rules and indicators go in, but come out logically impaired. In particular, there is an unreal sense from at least three asset classes that are at historically extreme levels, each apparently contradicting the other. They cannot all be right.

In one corner, the US has, for the first time since 2007, issued long-term debt (30 years maturity) at a yield of 5%. Then, US stock market valuations are at an all-time high since 1929 and, as we stressed in last week’s note, semiconductor stocks are in a speculative frenzy. In another corner of the triangle, oil prices are pushing the highs of the last two decades.

This trio of market signals leaves investing logic in a grey zone — a Bermuda Triangle-like make-believe world. This stretched logic suggests that the prosperity and productivity of AI-related capital expenditure will rescue the world from both high inflation and a debt crisis, and will also prove powerful enough to compensate for the effects of a momentary energy crisis. I am not sure.

The confluence of these three indicators is interesting because each one points to a long-term trend that investors and policymakers cannot ignore, but equally, each one rests on a short-run vulnerability.

Rising bond yields in Europe, the UK, Japan and the US are an early warning of a debt crisis, or debt purgatory, to come. In the very short term, they signal that inflation is creeping higher whilst a number of policymakers — notably on the Fed’s FOMC — appear complacent about this development.

Equities are trading at record high levels and valuations, mostly because earnings and business cycles are strong. But a very small number of stocks has pushed the market higher, caused in part by the fact that sectors like semiconductors are heavily financialised. What I mean by this is that the deployment of exchange-traded funds and options has surcharged the prices of semiconductor stocks, and likely driven them well above long-term fundamental valuations.

In my view, Intel’s ability to treble in value since the end of March (from USD 41 to USD 129 last week) has less to do with the fundamentals of the company, and more to do with speculation. In support of this, a recent Goldman Sachs note shows that retail investors now account for around 20% of US stock market trading.

Energy prices remind us that in a multipolar world, commodities — or rather their supply and refinement — acquire a premium, and that a number of countries will have to address shortcomings in industrial supply chains. For example, last week Willie Walsh, the former airline chief executive, warned that the UK has scant jet fuel refining capacity. As such, energy infrastructure will be an area for future investment.

In the short term, however, supply pressure may be more acute: oil inventories are being drawn sharply lower. Unless there is a full and speedy resolution to the Iran War, estimates from JP Morgan point to world oil inventories dropping to 6.8 billion barrels by September — just enough to keep refineries operating worldwide.

So, like the Sargasso Sea, market compasses are spinning in different directions, and it is difficult to discern a clear narrative. The confusion arises from the changing geopolitical nature of the world, the fast shift in industrial structure away from ‘bits’ and towards ‘atoms’, shortages of refined oil and compute, and the intense financialisation of specialised sub-industries such as semiconductors and commodities.

Given the disagreement between markets, the obvious question is: which one is right? A ‘two-handed’ economist might argue that the stock, commodity and bond markets are all correct, but on different time frames.

In my experience, the bond market is the most consequential, because when it worries, it imposes a cost on other markets and on political actors. The overused but apt quote from President Clinton’s adviser James Carville in the mid-1990s captures it well: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

So, the ‘market triangle’ or trilemma is resolved by bonds showing their displeasure at high oil and inflation, slowing the economy and walloping the over-bought sections of the stock market.

From a policy angle, bond markets are highlighting the urgent need for policymakers to calm inflation — through rate rises from central banks, and an early test for incoming Fed Chair Kevin Warsh — for governments to reduce debt, and for greater policy clarity in countries like the UK. The silver lining is that credit markets are so far well behaved, signalling that the healthy business cycle should allow for these policy actions to be made now, before it is too late.

Have a great week ahead, Mike

League of Nations, II

One implication of the recent surge in the price of semiconductor firms is that the stock markets of Taiwan and South Korea are now larger than that of the UK (which in 1900 made up 25% of the world stock market capitalization). It is expected that the two East Asian countries will soon have more billionaires than Britain, many of whom have apparently been scattered to the winds by the Labour government.

Though a country’s stock market is a highly imperfect indicator of a country’s economic standing, it does offer good clues as to evolving industrial structure. Bond yield and currencies help to complete the picture, and the runaway UK 10-year Gilt yield (now above 5%) doesn’t tell a happy story either. Then, on GDP, the country whose rise impresses me is Poland, which has not suffered a recession in the past thirty years (COVID excepted). Its GDP has increased sevenfold since 1990, and by 2030 it is expected to surpass the UK in terms of GDP (based on purchasing power parity). Remarkably, Poland is also shaping up to be a geopolitical power as well.

The loosening of the globalized world order, and the advent of many new risks and challenges – from the impact of AI on economies, to climate damage to war – has the potential to knock some nations back, and present opportunities to others.

As such, we can expect that the rise and fall of stock markets and economies tells us a lot about the rise and fall of nation states. In a world where the established world order is shattered (OPEC is the latest long running institution to fall apart), the rise and fall of countries is accelerating, and has become more vivid. In 2020, in the context of how different countries and states were responding to the COVID crisis, we wrote of the idea of the ‘League of Nations’, and have emphasized the theme ever since.

There are many existing league tables of country performance – happiest nation, most innovative country and most competitive, to name a few. Those league tables tend to be dominated by small, advanced economies. Regular readers will know that one of my favourite long run economic themes is the success of the small, advanced economy model, notably so for the way in which these nations can adapt to changes in the broader world. The UAE is a case in point.

In previous notes I have also made the parallel between football and politics, and this is still valid. A few weeks ago I mentioned that in the last ten years the UK has had more ministers for housing (a whopping 14) than Chelsea FC has had managers (12). Chelsea have recently parted with their latest manager Liam Rosenior, and it might well be that a cabinet reshuffle or change of prime minister leads to Matthew Pennycook moving on from his job as UK housing minister.

Like football, the manager of a country is important. For decades, Singapore and the Emirati states have made a virtue of strong, visionary leadership, Greece’s Kyriakos Mitsotakis and more recently Mark Carney in Canada are associated with turning their nations away from troubled waters.

In today’s League of Nations, the winning formula is changing, and shifting towards all things ‘sovereign’ and ‘atom-like’. For example, last week Canada announced the creation of a sovereign wealth fund to help the buildout of critical infrastructure, and it also laid claim to be the host of the new multilateral defence bank (Chris Collins and I wrote about this in a recent note for Barrons). Further, as I mentioned last week’s note (‘Mythical’), successful countries will need to cultivate their own AI stack, and the merger of Cohere and Aleph Alpha is a sign of things to come (their main shareholder is German but the firm will effectively be Canadian from now).

Then, with a step change in the industrial structure of the developed economies of the world underway, from services and ‘bits’ (software, crypto) to ‘atoms’ (energy, infrastructure, defence, AI and quantum), those countries with the universities, capital base and innovation ecosystems, will thrive. America is the standout example, but the Nordic countries and the economic zones that surround the Alps (particularly Switzerland) are good examples.

One consideration regarding the stature of nations is age and pedigree. One of the elements that makes small, advanced countries successful is that their laws, democracies and institutions have been in place for some time, and therefore offer clarity and consistency to businesses for example. At the same time, as economies get older they can become sclerotic, acquire layers of regulation and fail to engage in the creative destruction necessary to keep economic growth at healthy levels. Whilst this is simply an observation, I have a hunch that like aging athletes, older, large economies (US, Japan, UK, France) resort to a ‘boost’ in order to keep their economies going, which may explain why they are excessively indebted.

A final word in praise of older economies and societies, which relates to the cultures, behaviours and ‘family silver’ they accumulate over time. King Charles III’s various speeches in Washington last week demonstrated the value of heritage, and he might just have saved Britain from relegation to the lower leagues.

Have a great week ahead,

Mike

Do No Harm

An unusual but non surprising cameo in the response of the UK to the burgeoning energy crisis that is resulting from the Iran War, was the inclusion of Bank of England Governor Andrew Bailey in last Tuesday’s emergency COBRA (Cabinet Office Briefing Room) meeting. The prospect that inflation and a cost-of-living crisis could further derail the fledgling economic recovery in the UK, has struck fear into politicians (the OECD reckons that the UK will be the worst hit country), though monetary policy purists won’t like the appearance that the independence of the ‘Old Lady’ (the Bank not Bailey!) is compromised.

What is more interesting is that this is yet another datapoint in a trend where finance, war and politics are becoming interwoven. In peacetime, central banks were the only game in town, the monetary battleships of the 2010’s, keeping the peace in bond markets and tilting currency moves in their country’s favour.

That was not always the case, books like Liaquat Ahmed’s excellent ‘Lords of Finance’, show the key role that central banks played in maintaining the stability of war time economies.

Now, the world order that is unravelling before our eyes is more like that of the 1910’s than the 2010’s, and a particular concern for central bankers is the extent to which economies have become frictioned.

By this, I mean the extra costs and inefficiencies that are bubbling up because of the end of globalization (a period associated with intense commoditization of prices and low inflation), a pandemic of supply chain disruption, and great power competition for ‘rare’ things (from rare earths to rare places like Greenland to rare technologies like quantum computing).

In general, these frictions will tend to bump up the rate of inflation. A famous example is the way in which the side effects of the war on Ukraine combined with short-sighted energy policy in Europe to produce a prolonged rise in inflation from 2021 to 2022.

From the point of view of central bankers, inured to a decade of stubbornly low inflation, this was a surprise, and prominent members of the central banking community were badly caught out by their view that this burst of inflation was ‘transitory’. Their difficulty is that the economic context of the 2010’s was characterised by demand weakness whereas the main policy problem of the 2020’s is supply constraint.

We now live in an economy of ‘atoms’ (energy, commodities, deeptech), where historically huge amounts of investment capital expenditure is/are being deployed amidst supply constraints to build a new (AI) economic infrastructure. About half of this will be financed by different forms of credit. Within this model, the debate on the productivity benefits of AI, which has produced a wide range of estimates of the potential impact of AI on the economy, illustrates what a demanding environment it is for central bankers to read.

The potential energy shock from the Iran war complicates matters even more and raises the prospect of a policy error. Echoing the schoolboy mistake by Jean-Claude Trichet to raise interest rates in 2006 when a spike in the dollar helped trigger a spike in oil prices, current ECB President Christine Lagarde has stated that the ECB was ‘ready to raise rates’. This may be a pre-emptive move to push markets to do the ECB’s job, and to warn companies and unions off raising prices. If not, Lagarde and other central bankers should do no harm. A rate rise from the ECB will do nothing to re-open the Strait of Hormuz (good note on the disruptive effects from the Kiel Institute), nor to rebuild refining capacity in the Gulf states.

The dilemma for central bankers is in distinguishing between an energy centric rise in prices and an eventual generalised rise in inflation expectations.

In my view the economic consequences of the Iran War can be short lived, but as long as it endures, amounts to a tax on consumers, a hit to risk appetite and a blow to confidence in US financial assets. Furthermore, the many costs of the war (see our note of two weeks ago, ‘It will be over by Christmas’) include a rise in the debt burden that countries like the US and UK will suffer, and an elevated level of uncertainty as the world’s former policeman turns bully.

It could be worse for central bankers, they could be politicians, who now must contend with another cost-of-living crisis, with little money left in the fiscal jar.

Have a great week ahead, Mike

Old Money

A recent book, Samuel Moyn’s ‘Gerontocracy in America, highlights the growing concentration of wealth and power in the much older generations in the US, whilst younger generations face historically high valuations in real estate and financial assets, and how this growing intergenerational divide might be mended. Moyn, in my view, has struck a chord that will become one of the new dividing lines in politics, in Asia and the West.

His book brings demographic change into focus, a slow-creeping risk to economies, society and public life, but whose implications are only just surfacing in the public debate. Despite that, from a popular point of view, the sense in many Western countries is that there are too many people, or rather that infrastructure has not kept up pace with population growth – I am writing this in Dublin, which is an excellent case in point.

Yet, the long-run demographic trends – falling fertility, longer life expectancy and a shift in population composition towards a much smaller working (tax paying) population, will have enormous impacts on society, pension systems and debt loads, to name a few economic issues.

As much was evident in Germany’s recent pension reform debate which was nearly upended by Helmut Kohl’s grandson Johannes Volkmann and a group of other young parliamentarians who voiced the right of the younger generation to not have to shoulder the financial burden of their parents’ generation (under the German system, and many others, the working population effectively funds the retirement system of the older generation)..

The best starting point on the outlook for demographics is the United Nations World Population Prospects website. and the data – especially in chart form – are quite striking.

The UN data show that as we approach 2100 the world population will plateau and start to shrink. From roughly 2080 onwards the world population growth rate will turn negative for the first time in centuries (wars apart), as the death rate passes out the birth rate. Within the age cohorts, the over 65 group will expand by a billion people in the next thirty years.

More specifically, at the country level, the US death rate will surpass the birth rate in around 2040, and population growth is likely to only be sustained by immigration. The picture is worse for some European countries – Italy for example is already in negative population growth territory, and the most negative forecast scenario from the UN has the Italian population dropping from over 60 million today to 25 million by 2100 (the same level as when Garibaldi unified the country).

Equally, China, which has been renowned for its economic and population growth, will endure a collapse in the 24–65-year age group, who today number 830 million people and by 2100 are expected to comprise 280 million people. China is projected to be the country most affected by ageing, with its, China’s elderly dependency ratio is projected to surpass 100% by 2080, meaning there will be more people aged over 65 than those aged 15 to 65.

The expected collapse in the working population begs serious questions for the economy – who will pay taxes, sustain pension systems and where will demand for financial assets come from. Markets are not worried, yet.

In general, researchers find that there is a positive link between demographics and asset prices, a finding that is predicated on the rise of the boomer middle class and the coincident equity bull market and fall in bond yields. The idea is that until they retire, working households invest more in real estate, equities and other riskier assets, but then shift to income-oriented assets like bonds as they get older and require income from investments. The oddity in that respect is that despite an ageing population, equities and real estate are very expensive. This may well owe to a growing investment culture, a record level of wealth (USD 500 trillion worldwide) and the prosperity boon that has resulted from globalization.

In this context, old money will become a political target, both in terms of demands for lower inheritance taxes, to more populist measures to tax the ‘old’ and give the ‘young’. For governments who worry about demand for their bonds, wealthier older citizens might make ideal candidates for financial repression (their children would face lower inheritance tax provided that capital spent a period of ‘purgatory’ invested in government bonds – I outlined a similar theme in ‘Patriotic Capita l’)

At the same time, pension systems will have to change to accommodate a proportionately smaller number of workers (to pensioners). Private pension systems will become more common, they will invest more, earlier, with a tilt to riskier assets.

Concurrently, I expect to hear more on the need for states to establish sovereign wealth like funds (based potentially on the sale of state assets) to help provide for future pension liabilities. Another concern will be the need for states to cushion the potential blow of AI on workforces (a fund that holds equity in AI firms might be an avenue), at least through a transition period. In the long term, AI and robotics may well allow more older people to work for longer and for more women to enter the workforce. And, I haven’t managed to tackle the topic of later retirement ages and how that will impact the workforce and society.

The effects of demographics are not yet showing up in markets, and are just creeping into the investment industry, but it will become a major fiscal and financial megatrend.

Have a great week ahead, Mike