Tag: finance

What Will 2026 Bring?

It’s that time of year when investors and economists release their prognostics for the year ahead, and eclectic and contrarian as we like to be, The Levelling brings you its top ten themes for 2026, with apologies for the length of the note – in fact this week we are simply giving you the first five themes, with the others to follow next week. It’s really one to print out and read with a coffee, or even a stiff drink.

Given the approach of the holidays, we have also added in some pertinent film and book recommendations.

Some of the ten themes we flag here are based on observations we have made during the year, and relate to trends that are now becoming clearer, chief amongst them is the imprint of AI on economies, geopolitics, and society.

We hesitate to make outright forecasts for GDP and rates for two reasons – first we expect growth to rise modestly during the year (though this is very much dependent on the capex cycle) and second, most of the interesting developments will take place at the sector level.

#1 RAIlway Boom

In the late 1990’s as the dot.com bubble built, there was a polite debate amongst central bankers as to whether or not an asset price bubble was present in stock markets, most notably in dot.com related companies. The upshot of the debate was that even if the central bank could identify a bubble, there wasn’t much it could do to puncture the bubble (notwithstanding Alan Greenspan’s ‘irrational exuberance’ moment).

Today, central banking has changed, and so too have asset bubbles. There is a very broad narrative – from investors and economists – that we are indeed in a ‘bubble’, the only question is whether markets are in the foothills or the peak of the bubble. My sense is more ‘foothills’ than peak, largely because we are not yet seeing the folly and exuberant behaviour that was present in 2000 (I will share some stories in a future note).

Of course, the obvious danger of such a narrative is that for some but not all investors, it permits the belief that investors can continue to buy very expensive assets and later hand them off to ‘greater fools’, and the illusion that ultimately they are not the fools.

Every asset bubble needs an underlying logic, a belief that ‘this time its different’ and this is supplied in spades by the adoption and investment in Artificial Intelligence (AI). Signs that companies and households are deploying AI are manifold. This bubble is also different in the case that AI is producing revenues, as evidenced in the operating and market performance of large AI centric firms (the so called ‘Magnificent Seven’ companies who together now make up nearly 40% of the US stock market capitalization), but those earnings are predicated on the success of the AI business model and are increasingly circular, in that investment by META becomes revenue for Nvidia and so on.

What is altogether less clear to me is how the economics of AI play out. While the adoption of AI is occurring more quickly than other technologies (the internet), competition will surely lower margins quickly. Chinese projects are a case in point, and some of the large US AI platforms, of which OpenAI is the leader, may find their economic models undercut.

Neither is the distribution of the productivity benefits that convincing – specialized firms and operators with access to proprietary data will be able to leverage AI to great benefit, along the lines of my ‘One Man and his Dog’ thesis. However, for most people, once some basic administrative tasks have been swallowed by AI applications, the positive economic impact on their lives might be more limited. Another consideration is that AI model technology is in the hands of a small number of investors, so the capital productivity benefits of it can also be limited.

The Future: The AI boom or bubble is gathering momentum. Levels of capital investment (relative to GDP) are already surpassing those of prior bubbles, but have not yet attained the giddy heights reached during the railway bubble of the 1900’s. The railway bubble was one of the great asset bubbles – and helped build the crucial infrastructure of the first wave of globalization. In 1900, investment in railway infrastructure amounted to 6% of GDP, AI today is just over 1.3%. Also, at the turn of the 19th century nearly 60% of the market capitalization of the US stock market was made up of railway stocks (today it is 0.3%) which as a rule of thumb suggests we might see talk of a USD 10 trn valuation for Nvidia and SPX 10,000 ((the US S&P500 index hitting 10,000 points) as a ‘sell everything’ moment.

Read: Charles Kindleberger’s ‘Mania’s, Panics and Crashes’

#2 ‘Dalloway’

One of the more memorable films I saw in 2025 is Dalloway, a French film starring the ever-excellent Cecile de France, which I hope will make its way to the Anglophone world. The object of the film is to show how pervasive and sometimes pernicious AI could become as a social force, and as we head into 2026, this is a theme that will become more important – in healthcare, labour markets and society – and more startlingly obvious.

To start with an alarming example, in 2021 the Swiss government’s Spiez Laboratory, one of whose specialisations is the study of deadly toxins and infectious diseases, is located right in the heart of Switzerland, performed an experiment where they deployed their artificial intelligence driven drug discovery platform called MegaSyn to investigate how it might perform if it were untethered from its usual parameters.

Like many AI platforms MegaSyn relies on a large database (in this case public databases of molecular structures and related bioactivity data) which it ordinarily uses to learn how to fasten together new molecular combinations to accelerate drug discovery. The rationale is that MegaSyn can avoid toxicity.  In the Spiez experiment MegaSyn was left unconstrained by the need to produce good outcomes, and having run overnight, produced nearly 40,000 designs of potentially lethal bioweapon standard combinations (some as deadly as VX). It is an excellent example of machines, unconstrained by morality, producing very negative outcomes. It’s a chilling tale of the tail risks of AI.

More commonly, AI will increasingly become part of our economic and social lives, and its effects will be more apparent.

In labour markets, there is already plenty of evidence to suggest that AI is curtailing hiring, markedly so in the case of graduates. When AI and robotics start to combine, they can have very positive outcomes (in education and elderly care) but in warfare (see the Netflix documentary ‘Unknown Killer Robots’), fruit picking, warehouse management and even construction – to give a few examples, the blue collar labour force will feel the effect. This could set up a political reaction, and we might well see a Truth Social post from the White House to the effect that AI is not such a great idea and needs to be regulated.

A potential side-effect of the more negative effects of AI on the labour market could be a rise in anxiety and what social scientists call ‘anomie’. Much the same is becoming clear from the ways in which social media is skewing the sociability of humans (think of declining fertility rates, pub closures and the mental health effects of social media). As such, the social effects of AI may lead to ‘deaths of despair’. If this is grim, there is potentially very positive news in the use of AI to improve medical diagnoses in inexpensive ways, and the marginal impact of this in emerging countries can potentially be very significant (leading AI firm Anthropic is targeting science and healthcare in terms of applied AI solutions).

The Future: The economic and social side-effects of AI will become clearer – many of them will be positive, but others will start to provoke a political reaction. While the EU has softened some of the restrictions in the EU AI Act, the interesting development is that at the state level in the US there is a growing desire to curb some of the effects of AI, a trend that is supported by case law. Moreover, local politicians in the US (Republican Josh Hawley is an example) are more vocal about the negative side-effects of AI on labour markets and education.

Read: Carl Benedikt Frey ‘The technology Trap’(2019), and Robert Harris’ ‘The Fear Index’ (2011)

Watch: ‘Dalloway’ (1997)

#3 AI Cold War

A further facet of AI to keep an eye on is geopolitics, and as we leave 2025 behind, we will hear more about the notion of an AI Cold War or ‘Sovereign AI’ according to a good Pitchbook note. This emerging idea refers to the strategic uses of AI, in the context of strategic competition between the ‘great’ powers. This race is already on, and the US is in the lead, with China chasing behind (my recent note on The Plenum details how China is prioritizing frontier technologies as the spearhead of its economic plan). Europe is very much in third place, with energy policy and half formed capital markets the biggest obstacle. 

In a ‘Cold War’ AI world, model development and deployment  increasingly take a multipolar form (see #8 below), regulation is competitive and technology firms  closely align with governments – forming symbiotic parts of national infrastructure – while national security considerations are embedded into investment processes and supply chain planning. In time, governments may steer model developers towards new datasets if there is a strategic advantage to be gained.

The Future: From an investment point of view, we expect private equity/credit to become an enabler of this trend, and for their part governments will open up the flow of pension capital to private asset classes. Governments may also become more active investors – either in steering merger and consolidation activity, or in the fashion of the Trump administration, taking stakes in firms that are judged to be strategic. Military uses of AI will become more commonplace, and we will slowly learn more about the effects of this on navigation systems, genetics, finance and social media, to name a few.

Read: ‘Breakneck’, by Dan Wang (2025), ‘Chip Wars’ by Chris Miller (2022)

Watch: Dr Strangelove (1964)

#4 Expensives to Defensives 

An age-old joke goes that when asking for directions, the traveller is told ‘I wouldn’t start from here’. It is much the same for investors looking into 2026, though less so tactical traders who believe that they can time the ebbs and flows of the emerging stock market bubble.

The dilemma for asset allocators is that with the US stock market making up some 60% plus (depending on the benchmark) of world market capitalization, and trading at near record valuation multiples (price to earnings or price to long term earnings (Shiller PE), or even market capitalization to GDP (Buffet Indicator), the exposure to American assets is increasingly expensive and risky.

For example, a model that combines monetary, business cycle and market valuation indicators, suggests that from this point onwards, returns in the next couple of years for US equities will be close to zero. Add to that the fact that the dollar still looks expensive and corporate bond (and high yield) spreads are very narrow, and the conundrum for allocators next year will be considerable.

As we end the year, volumes have been very low and speculative activity (options) very high, and this points to high levels of volatility through 2026, and remarkably, a few of the large bank CEOs have warned of significant market drawdowns.

The Future: We expect to see investors put more money to work in cheaper defensive sectors – Staples and Healthcare for example, and for capital to flow to other regions beyond the US. In addition, in the next five years, if multiple surveys of family offices and pensions are to be taken at face value, we expect private assets to make up a much more significant proportion of investment portfolios.

Read: Benjamin Graham ‘The intelligent Investor’ (1949)

Watch: ‘Margin Call’(2011), ‘The Big Short’(2015)

#5 K Shaped economy

In the context of a political-economic climate in the US where good, regular economic data is hard to come by, commentary from industry leaders as they report earnings is providing some fascinating insights. For example, some weeks ago, Chipotle, the burrito chain, reported a surprise drop in revenues because two key consumer groups, households earning USD 100k or less, and younger customers (24-35 years old) are cutting back discretionary spending, even on fast food.

A range of firms with similar client bases underline this trend – car manufacturers report that sales of expensive, large vehicles are strong, but that lower income customers are preferring smaller, fuel-efficient models. McDonalds is revising its ‘extra value meal’ option, and credit card providers like Amex report very different types of activity from rising card balances and distress in the lower segments, to robust spending in its ‘Platinum’ category.

Economists are blithely referring to this phenomenon as the ‘K-shaped’ economy, whistling past the graveyard of economic history that portends revolutions are made of such obvious divergences in fortune.

Now all of the talk is of a K shaped economy – which refers to multiple divergences between the price insensitive wealthy and those in economic precarity who are sensitive to inflation, a services sector that is either shedding jobs and holding back from hiring compared to the upper echelons of the technology and finance industries where unprecedented levels of wealth are being created.

There are two other effects ongoing. The first is the economic effect of AI-focused capital expenditure (across the energy, logistics and technology sectors). The second, more important trend is a mangling of business cycles, such that few of them are synchronized across geographies, or between the real and financial economies (German chemicals is in the doldrums but German finance is on an upswing).

Yet, a better diagnosis might be the ‘Marxist’ economy – one where the owners of capital and the source of labour are at odds.

The Future: In the US, the top 10% of the population own 87% of stocks and 84% of private businesses, according to data from the Federal Reserve. On the other hand, we have previously written about the rise of economic precarity in The Road to Serfdom. So, whilst it is a new observation amongst the commentariat, the diverging fortunes of capital and labour should start to trouble policymakers in 2026. Expect this to be a headline policy issue net year – the White House is already paring back some tariffs, and in Europe governments compete to either tax the wealthy (France and the UK) or to lure them (Italy).

Read: the NBER Business Cycle website

Watch: Falling Down (1993)

The UnRavelling Rule

Amidst the slew of corporate earnings and macro-economic data released in the past week, two developments struck me, both of which give the impression of the tectonics of geopolitics pushing against each other.

First, in the past year the number of children born in the US has caught up with the EU, at close to 3.6 million babies each (though the EU has a much bigger population). For comparison, Nigeria – whose population is less than half that of the EU – welcomed 7 million babies last year.

Second, in recent months the trend rate of consumer inflation in Japan has surpassed that of the US for the first time in decades, signalling a long awaiting shift in the Japanese economy that has been accompanied by a rise in long-run bond yields (a potentially critical development for the international financial system).

These two examples will give a sense of the rise and fall of nations, that is accelerating since the fall of globalisation (which I date to the effective end of democracy in Hong Kong). This rise and fall – think of countries like football clubs – is also associated by an unravelling of the world order. For example, in a recent note ‘Atlas Shrugging’, we detailed how the independence of the Federal Reserve was being undercut by the White House, and the attempt to remove Lisa Cook from the Fed’s rate setting committee confirms that Donald Trump wants to direct the Fed as an engine of his economic policy (as a giant bond buying machine I suspect).

The independent Fed has been one of the pillars of the globalised world system of the past forty years – and the snuffing out of its independence heralds the unravelling of that system. In the same way that the period of globalisation was characterised by low inflation and the absence of major wars – the presence of inflation and conflict today, is a sign that we are moving into ‘something else’.

In that context I find myself playing a mind game which I call the ‘Unravelling Rule’. Very simply, it is to identity the principal factors that have supported globalisation and that are positive outcomes of it and identify if and how they are unravelling. The crisis of democracy is one such trend (the Economist Intelligence Unit’s Democracy Index has fallen to its lowest level in twenty years).

Other certainties are also unravelling – notably the assumption that the USA is an unflinching ally of Europe and many Asian countries, and the possibility that it could even actively undermine them. In this regard, the fact that the Danish government had to summon the US ambassador over the conduct of three Americans in Greenland is troubling and reflects very badly on the White House.

The danger with the ‘Unravelling Rule’ is that in a chaotic world, it is tempting to see unravelling everywhere. It is more obvious though in the case of world institutions – the United Nations, IMF, World Bank and World Trade Organisation, who are frequently ignored by the very large economies, and sometimes badly undermined by them (the WTO is an example). These institutions need to be recast, most likely for the benefit of the populous emerging economies.

On a more speculative basis, there are at least four trends that have marked the past forty years, and that are now worth watching for a change of course.

The first is poverty. It is an underestimated facet of globalisation that it helped a billion people rise out of poverty, according to the World Bank. My concern is that in a world where the major economies (2/3 of the world’s GDP) have debt to GDP ratios above 100%, economic precarity may return, and this time to developed countries. We have already noted (The Road to Serfdom) the extremely high level of inequality in the US and broad economic vulnerability. In Europe, British and French policymakers conjured the spectre of IMF intervention in their economies (it would have to be a new, bigger IMF – which under this White House is unlikely). In that respect the growing disparity in incomes in the UK regions (relative to London) bears watching.

A second is corporate governance and the rule of law as it extends to international business. We have not seen a rule of law or broad governance crisis in sometime, but the rise of decentralised finance (i.e. crypto), the new idiom of the ‘art of the deal’ in the US, and the geopolitically tinged trade relationships that China is developing worldwide. As a global ‘way of doing things’ gives way to more regional or localised approaches, the watertightness of contracts and the oversight of business relationships is something that businesses will need to consider more carefully.

A true litmus test of the ‘Unravelling’ hypothesis will be the role of US multinationals in the world economy. Described as the ‘B-52s’ of globalisation in the late 1990’s by a prominent trade economist, they have shaped the world economy and come to dominate financial markets. I have lost count of the number of charts circulating that declare that Nvidia for example is worth more than the major European stock markets together. Whilst cash rich, they now face a number of challenges – the difficulty of selling into China as it broadens its technological self-sufficiency, and the collateral damage to overseas sales from the Trump trade and foreign policies, and the rise of more specific local tastes in markets like Africa and India.

A final unravelling, and one I would welcome, is for the EU to unleash its nasty side. In the past forty years the successes of the EU – enlargement, holding the euro together and the creation of a European identity (based on borderless travel the Erasmus programme for example). The likes of Poland and Estonia have benefitted greatly from this, and it is fair to say that the UK would be better off ‘in’ than ‘out’. But the emphasis has been largely on soft rather than hard power, and in a ‘harder’ world, the EU will need to take a tougher stance in terms of how it projects itself. 

There are many challenges but three in particular are the potential exclusion of existing and prospective member states like Hungary and Serbia who habitually refuse to act in accordance with EU values and interests, a specifically more aggressive approach to countering sabotage by Russia (and at times China and Iran) in Europe, and then a retaking of the narrative as to what Europe stands for.

Have a great week ahead,

Mike 

Bushido

One of the favourite books I have received as a gift is ‘Bushido’, the framework of the Japanese code of chivalry. I was given the book in the very early 2000’s, when it was not yet obvious that Japan would stagnate for quite so long and, the talk was still of the collapse in Japanese golf club membership prices

Indeed, one of the remarkable socio-economic trends in Japan up to the mid-1990’s was the startling rise in Japanese gold club membership fees, which in the heady 1980’s Japan, had become a tradeable asset, so much so that an index was created (always a warning sign). During the period 1982-1989 the average golf club membership fee rose by 400%, with a final 190% spurt from 1989 to 1990. Companies such as Ginza Golf Services initially made a lot of money trading golf club memberships and at the peak of the market some were changing hands for close to USD 3mn.

Naturally, this bubble collapsed, and as a nod to the future I flag a blogpost from ‘GolfProp’ magazine that shows that on average entry fees for American gold club memberships have been increasing at a rate of 23% per annum since 2019. Indeed, within the past year the membership fee at Mar-a-Lago has gone up by 43%

Back to Bushido, which as a noble, chivalric code developed in the 16th century, is unlike European ‘Chivalry’ (see Maurice Keen’s book of this title is a must read) in that the idea of ‘Chivalry’ came about much earlier, and largely because of an effort to stop the knights of Europe killing each other in jousts and disputes. Bushido is still part of the mindset of many Japanese, and Japan is increasingly unique as a country where very strong social codes frame behaviour.

To that end, the sense of bushido and Japanese diplomacy will have been taken aback by the unexpected decision by President Trump’s to slap a 25% tariff on America’s main allies in Asia, Japan and South Korea. Japan has always enjoyed close ties to the US (Al Alletzhauser’s 1990 book ‘House of Nomura’ is a very good account of how America helped build the modern Japanese financial and corporate system). I have a sense that another book of that era, Ezra Vogel’s ‘Japan as Number One’, seems to have stuck in Trump’s mind (in the 1990’s he went on CNN to castigate Japan American foreign and trade policy on Japan).

Trump and ‘bushido’ are anathema to each other, and the Japanese will be disappointed by his behaviour, given that Tokyo has always had close relationships with American presidents – though never as close as that with Jacques Chirac who visited Japan over 40 times (for various reasons which I shall not disclose).

The potential rupture in relations between Tokyo and Washington introduces a strategic dilemma for Japan, at a time when its economy is awakening from decades of slumber. Like the UK, Japan’s geopolitical moorings are coming unstuck. President Macron’s state visit to London shows the direction of travel for the UK on security and defence, and whilst it is accelerating defence spending, Japan may end up considering more radical solutions for its defence in the context of Chinese belligerence (in 2024 Japan’s air force scrambled jets 704 times against incursions by Chinese and Russian jets). For instance, Japan is the one country that could quickly build a nuclear weapons programme, if it needed to.

What is interesting in the Japanese case is that as geopolitical uncertainty rises, its economy and financial markets are thawing. The property sector is just reaching levels last seen in the early 1990’s (while Tokyo prices have recovered beyond 1991 levels, the rest of the Japan’s residential market is still below the price point reached then).

Having suppressed bonds yields for a long time, the Bank of Japan is now raising rates, and Japanese bond yields have been pushing higher, and given the size of the Japanese bond market (and the balance sheet of the Bank of Japan), it is driving yields higher internationally, and deserves watching as a medium-term risk to markets.

However, while bond yields are rising in the absence of yield curve control by the central bank, factors that are regarded as engines of the economy – earnings, consumer behaviour and employment are more muted, and give rise to the sense that Japan is either in the ante chamber of a full recovery, or on the precipice of something nastier.  

Tariffs, and a confusing break with the US, could upset the Shigeru Ishiba’s unpopular government (Upper House elections are soon), which is struggling in the context of a very ‘un-bushido’ world.

Have a great week ahead,

Mike  

Grasshopper

I had intended to write about universities this week but, strolling through the City of London, I was surprised, shocked even, to find myself on Trump Street, and then amused to see that it is joined by Russia Row.

My first thought was that this was part of a grand plan by the British establishment ahead of President Trump’s visit to London in September, the idea being to stage an event at the nearby Guildhall and to then tell the president that a nearby street had been named after him. Trump Street was apparently named so because several trumpet makers lived there in the 18th century, but let’s ignore that for the time being.

Yet, the far more meaningful coincidence of Trump Street is its proximity to Gresham Street.

Sir Thomas Gresham was a trader and financier in 16th century London, at a time when coffee houses in the lanes around the Royal Exchange formed the basis of what is known as the City. Gresham was an important player in Queen Elizabeth I’s economy, and his emblem – a grasshopper – is still present in various parts of the City (there is a giant-sized golden grasshopper on the roof of the Royal Exchange….if you can dare to make it up there).

While Gresham’s imprint can be seen across the City, he is remembered by Gresham’s Law which was named after him and states ‘bad money will drive out the good’. Gresham’s Law which echoes similar observations from Copernicus and other scientists through the ages is founded on the idea that in an economy where coins with the same face value but that are made from different base metals (say nickel and copper) there is a tendency for traders to hoard the coins made of the more valuable metal and to circulate lower quality coins. Bad coins stay in circulation, good ones are re-commoditized. From an economics point of view the law is conditioned on all the coins (of variable quality) having the same face value.

Unlike the 16th century, today, coins have the same physical consistency and in general there is little incentive for people to shave bits off coins (historically coins have serrated edges to prevent this) but broadly the Gresham’s Law is applicable in different domains.

Think of how cheap goods (made under questionable labour conditions) have forced quality players out of markets, or how in the run-up to the global financial crisis, low quality financial institutions offering generous loan conditions caused better quality banks to step back from lending. In both cases, regulation or policing of markets is necessary to ensure that ‘bad’ actors do not gain an advantage over good ones. Social media is another example, where it seems a lot of nonsense thrives at the expense of information.

Additionally, the idea of Gresham’s Law is applicable to politics, where in many countries it appears that political actors with extreme views and extreme modus operandi are forcing out ‘good’ ones in the sense that most normal people would be terrified of a career in politics.

Readers will guess that my argument is leading back to Washington. Bad behaviour, bad ideas and bad policies are infesting themselves in public life, the economy and markets – to the surprise of many ardent supporters of President Trump. What is not clear is whether this will result in an evacuation of capital and talent from the US, or whether there will be a counter-reaction. Gresham’s point in describing how bad money drives out good was to avoid the debasement of the currency (schilling), which when Elizabeth I came to power, was already in a bad state. She appointed Gresham as a finance minister of sorts in 1560, and within a year he had ‘bad’ coins taken out of circulation and replaced them with money made from precious metal, the result of which was a dramatic improvement in Britain’s status as a trading and economic power.

The lesson of this should be very clear today. As a final point, it is interesting to note, from the point of view of coins and money, that the ratio of gold (precious metal) to a cyclical commodity (copper) is the most stretched it has been since at least the 1980’s, suggesting that markets at least are thinking of Gresham’s Law.

Have a great week ahead

Mike

Watching and Waiting

N’interrompez jamais un ennemi qui est en train de faire une erreur.

During the Battle of Austerlitz, Napoleon quipped to one of his commanders (General Soult) that one should never interrupt an enemy when he is making a mistake. Austerlitz was one of Napoleon’s tactical triumphs, but some seven years late the Emperor gathered one of the largest armies ever assembled and crossed Russia. The Russians burnt Moscow, harassed the French army and then patiently waited for the cold weather to cruelly teach Napoleon the error of his way (Sylvain Tesson’s book ‘Berezina’ offers a lively account of the retreat from Russia).

In a similar vein, as another modern-day, would-be emperor careens from financial calamity to geopolitical catastrophe, my sense is that the world beyond America, is best served by waiting and watching.

In the next two months the economic damage to America from the tariff campaign will become clear. The corporate earnings season has just started – some of the large banks have done well from the trading volumes created by market volatility – but as the focus turns to technology and other export focused firms, we can expect to see significant drops in earnings, a development that will make the still high valuation multiples for the US stock market hard to sustain. Relatedly, while investment banks are profiting from volatility, most of them are reporting that capital markets activity (public offerings, mergers and funding rounds for private equity firms) have stopped dead.

This is a shock for Wall St. With president Trump having installed a market trader as commerce secretary, a hedge fund manager as Treasury, a private equity titan in the defence department, and so on, capitalists might well have thought that the White House was on their side, but the annihilation of up to 8 trillion dollars in market capitalisation has proven them wrong. There is I imagine, a limit to Wall St’s patience and the pushback on policy will grow.

As it does, the hard (as opposed to ‘soft’ survey) data is likely to worsen dramatically, and the US will enter into an economic breakdown. At the start of this year I had sifted through the IMF GDP forecasts for 2025 and 2026, where uniquely they expected nearly all of the world’s economies to register positive growth. From this starting point, a global recession was a very low probability, but the Trump administration has blundered into one.

Now, policy makers in the US and abroad are realising that watching and waiting is the best way to entice Trump away from his tariff policy. There were signs of this on Wednesday when the Federal Reserve chair declared that tariffs would augment inflation and make it much harder for the central bank to cut rates. This statement represents quite the departure for a monetary authority that has greeted every flicker of economic trouble with lashings of cheap money. Mr Powell knows very well that it is not the job of a central bank to fix the mistakes of an errant policymaker, and very likely that a short, sharp market shock now might deter a great fiasco (and the credibility of the dollar) later.

In contrast, other central banks, who are unburdened by any sense of conflict of interest with Mr Trump, can feel much more free to cut rates into a coming recession, as the ECB did on Thursday. In that context, we may see the dollar strengthen in coming weeks, and much of the stress of the White House policies on the economy, transferred to the corporate bond market.

Then a key, patient player in this unfolding drama is China which, whilst it has deep economic faultlines of its own, is politically and socially coherent enough to weather the onslaught from Washington. Like the Russians who took on Napoleon, China’s strategy is partly one of endurance, partly ‘guerrilla’ (think of rare earth export controls, supply chain manipulation leading to shortages of goods in the US) and a patient attitude to the market turmoil that is starting to undermine the financial credibility of the USA.

Europe may follow suit. Giorgia Meloni spent Thursday in the US with president Trump and then raced back to Rome to host JD Vance. Her visit was useful in terms of Italian and EU diplomacy, but the EC is carefully signalling to Washington that any negotiations on trade will have to be done through Brussels alone, which as the Brexit process revealed, is a hard defence to breech.

Napoleon left Moscow in the middle of October 1812, eventually to creep into Paris just before Christmas. His army was devastated, only 100,000 or so men from an initial force of 600,000 survived. Donald Trump is no Napoleon. In two months’ time the US economy may well be in a state of disarray, consumer confidence and confidence in the president will likely have plummeted further, and the world will be watching and waiting for his capitulation.

Have a great week ahead

Mike

Did no-one see it coming?

In November 2008, in the darkest hour of the global financial crisis, Queen Elizabeth II asked an audience at the London School of Economics ‘Why did no one see it coming”. We might ask the same question today in respect of Donald Trump’s tariff war, where he has diminished the things that he was reputed to hold dear – the economy, the stock market and the dollar.

One disturbing template that might offer insight into the path that the American economy takes is Brexit. As noted by the current prime minister of Canada, Brexit was not the solution to the problems that Britain faces. Certainly, the disengagement of the US from the world trade system is becoming as soap operatic and sometimes ludicrous as Brexit was.

An even more pertinent example might be Britain at the turn of the 19th century when there was a palpable sense that the might of its empire was peaking. At the time tariffs and trade were widely debated, and leading politicians like Joseph Chamberlain proposed the idea of an ‘imperial preference’, a lower tariff on trade with its colonies, to create a trading zone that would buffer the rise of the US and Germany.

To a certain extent, tariffs and trade became the issue of the day, but in the 1906 general election the public voted overwhelmingly for liberal, open trade (less restrictive tariffs) candidates. This I suspect was also the intention of those who supported Donald Trump in November last – keep the economy and markets strong, whilst evening up the status quo (a little). That tariff rates set by the US (and China) are at levels only last seen in the 1920’s completes the shock, and rhymes with history.

One reason tariffs were a popular policy tool one hundred years ago is that the fiscal side of the economy was not well developed (only a small proportion of Americans paid tax) and, in some cases, central banks did not exist. Today, tax systems are well developed and as small, open economies show, they are the best mechanism to reduce inequality, and to entice investment, both stated objectives of the Treasury secretary.

This particular market crisis is interesting because it is nearly entirely man-made. Turkey has taken a similar path in recent years, all but eviscerating its bond market and currency, but these are inconsequential compared to the depth of US markets. Whilst the president has stepped nimbly and profitably (some say) away from the financial brink, he still risks contagion of his actions in a number of respects.

Two such risks loom on the horizon, an economic war with China and a crisis of credibility in US financial assets.

We are now led to believe that ‘it was China all along’, but it would have been easier to tackle China with the support of America’s former allies in Canada, Japan, the UK and Europe.

For its part, China has plenty of tools to respond to the US with – it can allow its currency to weaken further and through supply chain disruption can inflict higher consumer prices, shortages of goods and lower (Chinese) demand on the US. Informal boycotts of American goods, investigations of US service firms and rare earth restrictions are just a few other tools at China’s disposal.

Should an economic war between the US and China materialise, my sense is that a supportive response from the Federal Reserve has been made less likely by Wednesday’s tariff capitulation by the White House, which demonstrates how arbitrary policy is under this administration.

In the longer-run, the actions of the Trump team could manifest themselves in a capital crisis in the context of the way they have undermined confidence in the US and by extension its financial system. What the likes of Peter Navarro seem not to have grasped is that the quid pro quo of America’s trade deficit is its enormous financial power – the role of the dollar and Treasuries as lynchpins of the international financial system, the dominance of US financial systems and its integral role in the fabric of capital markets, and the capital that overseas investors provide them.

With Mr Trump behaving in the way that some might caricature as ‘emerging market’, If we apply an emerging market stock market valuation rating to US stocks, the SPX index would be half its current size for instance. Equally, the mid-week selloff in Treasuries which was most likely the result of hedge funds unwinding positions, but the poor performance of bonds underlines the sceptical view that markets are starting to take on the administration.

In this context, we may be at the beginning of a great unwind of American financial power.

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 

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  

Druk!

Winter it seems, across much of Europe, has come early. Two instincts that grow as the evenings darken are the inclination to have a tipple in the evening and to watch a good film. One Danish work that captures both sentiments is ‘Druk’ or ‘Another Round’, which won the Oscar for best international film in 2021. I recommend it.

In the film a group of four school teacher friends decide to test the hypothesis of a Norwegian psychologist that humans have a deficiency of alcohol in their blood, and the protagonists undertake an experiment to maintain a ‘warm’ level of alcohol in their blood. It is an experiment I attempt often, but the real lesson today is with central banking.

It seems that central bankers have decided that in the spirit of ‘Druk’, the liquidity in the world financial system is not sufficient and have set out to administer near daily injections of cheap money. The number of central banks changing policy (i.e. to negative) is the greatest it has been, apart from the global financial crisis and the COVID period. In September alone there have been 24 rate cuts from central banks around the world.

Chief amongst these has been the 50-basis point cut from the Federal Reserve and the very dramatic, multiple policy moves by China. In short China has cut rates, infused the banking system, made mortgages cheaper and generally tried to spread liquidity over the emerging cracks in China’s economy. In the spirit of ‘Druk’ it is the equivalent of going on a five day bender in order to cure a serious disease.

Nonetheless, the easing in policy from the Fed and China, together with what will likely be a couple of more rate cuts this year from the European Central Bank mean that the world financial system is flush with liquidity. Chinese markets – hitherto the worst performing markets of a major economy – show the impact and importance of liquidity. The market cap of the Hang Seng index has grown by a quarter in less than two weeks. China has overtaken the US in terms of equity market performance to date.

There is no change to fundamentals – I don’t see this policy move having a decisive impact on the downward trend in Chinese earnings, but that doesn’t matter in the near term – liquidity is coursing through the pipes of the Chinese financial system, and in turn might bring a temporary easing to conditions in the property market.

For all the analysts who devote time to measuring earnings and calibrating valuations, the reality is that in this era of ‘quick to please’ monetary policy, liquidity matters a lot for asset prices. My rule of thumb in constructing a measure of liquidity would encompass money supply, the state of central bank balance sheets, the key role of the dollar and net issuance of debt by treasuries.

The arcane notion of financial liquidity has attracted enough attention that the Financial Times recently ran an article breaking down its component parts. A couple of top-flight economics consultancies run their own measures of liquidity – such as LongView Economics and Michael Howell at CrossBorder Capital. The latter holds that we are on the cusp of a significant upswing in global liquidity.

 If that is true, the implication for markets is ‘Druk’- a persistent giddyiness whilst central banks keep rates low and liquidity flush, amidst an acceptable level of GDP and profit growth. Friday’s job market figures in the US were very strong, suggesting that in fact there was no need for a large rate cut. This is the kind of macro climate we have seen in the mid and late 1990’s, and one that tends to dampen the market implications of turbulent geopolitics.  

From the point of view of asset prices, there are a couple of possible trajectories. Historically, the Fed has started to cut interest rates when the price to earnings ratio on the S&P 500 has been close to 10 times (1960’s to 1990’s). Now, like in 2000, it is in the mid 20’s which suggests that extra liquidity now could run asset prices in bubble territory proper, and cultivate the next bout of inflation, something the central banks’ bank, the BIS, has warned about (helpfully the BIS has taken a counter view to that of its members ahead of a number of crisis).

For the time being, the upturn in liquidity may be most meaningful for capital markets activity and assets in the private economy. They have been in the doldrums. If the ‘Druk’ hypothesis is working we should see a rise in IPO activity into 2025, and intensification in private equity deals and a rise in funding activity (beyond AI firms) in venture.

Then, later in 2025, the hangover will arrive.

Have a great week ahead,

Mike

Building Sovereign Debt Funds

One of the attractions of elections is that they throw up new ideas and policy proposals – and it is not unkind to say that one increasingly gets the impression of politicians throwing suggestions at the ‘policy wall’ to see what sticks. Aggressive tariffs on China and taxes on unrealised capital gains are two examples from the US.  

One idea that Democrats and Republicans share is the proposed establishment of a sovereign wealth fund in the US. In the case of Donald Trump, his aim is to fund it with tariff revenues, whilst the Democrats conceive a sovereign wealth fund that might take stakes in firms in strategic industries, which is a very French idea (recalling the ‘strategic yogurt policy’ of 2005). The flaw in this particular idea, is that there is in fact no money to capitalise such a fund.

In stark contrast, I recall the last time Washington pondered a sovereign wealth fund was at the end of the Clinton presidency, when Treasury Secretary Bob Rubin had in a financial ‘end of history’ moment engineered a fiscal surplus (government earning more than it is spending). At the time, the sense was that surpluses would feed a ‘social security’ sovereign wealth fund, which would allow Americans to enjoy a prosperous retirement.

What is striking is that if you look at the history of America’s financial health, the Rubin/Clinton surplus is an anomalous blip. Since then, the US has registered nearly a quarter of a century of deficits, which irregardless of the level of growth of the economy, seem to get bigger (relative to the economy) every year. These burgeoning deficits are starting to take their toll on the US (and I should mention that many other large developed economies – Britain and France prominently so), as its debt level rises beyond 100% to GDP (expected to hit 122% in 2035). It is a very odd situation. In textbook economics, large deficits tend to exist in times of war, recession or crisis. As such, if any of these occurs, there will be scant room for governments to help the economy (and rescue plans may become a trial of strength of central banks).

That’s not all. Readers will sense that I am writing more and more about indebtedness, and it is indeed becoming a preoccupation of mine. The idea of the ‘Age of Debt’ is that debt is becoming pervasive, and as a factor will weigh on geopolitics, the tenor of political debates and the shaping of the financial markets of the future.

In that context, once we get beyond the rise of election campaigns and into 2025, governments will have to jettison dreams of sovereign wealth funds and instead subject themselves to debt sustainability analysis. It is akin to a household giving up a dream of buying a second home as their bank manager demands that the mortgage and credit card balance are paid off first.

Debt sustainability analysis is one of those arcane activities in economics, and I can count at least three friends who can run their own debt sustainability models, which is not something I should readily admit. The essence of debt sustainability analysis is that the future debt load (and its precariousness) of a country are driven by a set of factors – the rate at which a government spends, the inflation adjusted interest rate it pays, growth and demographics. These factors are inter-related – borrowing that is deployed to productive investment can produce growth and thus reduce the risks associated with debt for instance. Today, the rapid acceleration in the indebtedness of many countries, low growth and ebbing demographics are some of the factors that make debt increasingly unsustainable.

If that was a reasonably technical explanation, the best parallel I can think of to communicate debt sustainability is climate sustainability – or at least both sets of analysis point to a world that is heating up, and where there is relatively little reaction to this. Debt and climate sustainability analyses are long-term processes, and my sense is that governments gladly ignore them, until they become immediately problematic.

That is beginning to happen. France’s bond spread (over Germany) is elevated, and British bond yields are close to 4%. Neither country can afford to increase debt levels. The same is true for Canada. In the US, next February will see the installation of the new Treasury Secretary, and he or she will have the difficult task of telling the next President that there is no money in the kitty.

As such, the establishment of sovereign wealth funds is a distant, fluffy dream for most governments. A violent lesson here is that Ireland had a sovereign wealth fund in the early 2000’s, but it was swallowed up in the consequences of the euro-zone financial crisis, and is only now being re-established.

For those sovereign wealth funds that exist – in Norway or Saudi Arabia – the next trade may not be to buy quoted equities and private equity, but to either buy the discounted debt of developed countries when they have their sustainability crisis, or to engage in private lending to them. When that happens, a new shift in geoeconomic power will be under way.  

Have a great week ahead,

Mike