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 19^th 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

Samuelson vs. Sahm

Next week the Federal Reserve will very likely cut interest rates, for the first time since the COVID related rate cutting cycle. Recall of course that at the end of this speedy sets of cuts, most of the leading central banks had declared inflation to be ‘transitory’. The Fed cut will come on the back of a series of rate cuts from ‘elder’ central banks – the Bank of England, Riksbank and the Swiss National Bank, as well as the European Central Bank from whom we had another rate cut last week.

The anticipated move by the Federal Reserve is instructive in several respects. Market based interest rates are lower than Fed rates and many investors expect (or rather crave) the Fed to make a 50 basis point cut, as opposed to a ‘standard’ one of 25 basis points. At the weekend, the lead headline in the Financial Times read ‘Investors raise bets on bumper half-point Fed rate cut’.

This is yet another sign of monetary addiction – the result of the conditioning of investors to financial liquidity. In mid-August, following a dip in the stock market, I wrote that the idea of the ‘Fed put’ – the notion that the Fed would react to a fall in asset prices by cutting rates – is very much alive in markets.

The market dip led several seasoned and apparently credible investors to call for an emergency cut in rates. However, the Fed has only ever taken such dramatic action in the thick of deep crises (LTCM/Russian economic collapse, the dot.com collapse, 9/11, the global financial crisis and the COVID crisis). Similarly, it has not begun a rate cutting cycle with a 50 basis point cut, outside of financial crises. There is no financial crisis today (though plenty of mounting financial risks such as very high debt levels), but a crisis of expectations.

That crisis of expectations is at play as investors position for the Fed meeting next week. In my experience, the Fed is, in normal economic conditions, a cautious and slow-moving beast, and it would be untypical for them to begin a rate cutting phase with an outsized rate cut. To do so would suggest that they are in a hurry to correct a mistake of their own making.

To the extent that investor behaviour demands a 50-basis point cut, this recalls the quip from Paul Samuelson, the first winner of the Nobel Prize in Economics, that the market has predicted nine out of the last five recessions.

Set against this apparent concern by investors (do they fear a recession or desire lower rates?) is a debate around a relatively new economic rule of thumb called the Sahm Rule, named after research by economist Claudia Sahm at the Federal Reserve. Her rule states that when the medium-term unemployment rate rises an impending recession is signalled (the three month average of unemployment needs to rise by 50 basis points). It is a surprisingly simple rule that appears to have prefigured eleven US downturns going back to 1953. Sahm’s aim in establishing a reliable rule was that stimulus checks can be sent out at the outset of recessions (as opposed to waiting for GDP data to indicate a recession).

I am tempted to trump the Sahm Rule with two observations.

The first is Goodhart’s Law, named after Bank of England and LSE economist Charles Goodhart which states that ‘when a measure becomes a target, it ceases to be a good measure’, or more colloquially that fame kills a good model.

More seriously, most of the last ten business cycles were conventional ones, whereas this business cycle bears the scars of reversing demographics, the lingering effects of COVID fiscal policy and labour market distortions (work from home) not to mention the contortions of strategic industrial policy (i.e. the CHIP’s Act, Inflation Reduction Act) and the political ramifications of high inflation and immigration. It is anything but a typical business cycle, and very hard to read.

Somewhat unusually at this stage in the cycle government finances are weak (from France to the US) whilst the large corporates of the Western world are in a generally healthy financial state. Of the major economies, China poses the greatest risk to the downside in the near-term.

With different components of the US economy moving in different directions, my expectation is for a slowdown than a deeper recession (this may eventually come at the end of 2025 if inflation rises again). Equally, I expect the Fed to make a series of rate cuts rather than deep cutting cycle. If that view is correct, the interest rates market will be very volatile, as investors periodically over react to data points and price in ‘booms’ and busts’.

Expect a market tantrum next week with investors complaining that the Fed is behind the curve. Samuelson would tell us that the curve has got it wrong.

Have a great week ahead,

Mike

The End of Globalization

In last week’s note(s) I focused a lot on France, to the exclusion of mentioning other debates that are live around the world. One that preoccupies me is that of globalization – which for most readers will seem so esoteric and distant, that they may rightly care little about it. It is in my view worth stopping to think about the direction of globalization – given the way it has shaped the past thirty years. I sense that as globalization crumbles, we are already starting to miss its notable characteristics – peace, low inflation and international prosperity.

Three things happened last week that have globalization, or its demise, back on my mind.

First at the Rencontres Economiques, I had a row with a former German economic minister who claimed that a new wave of globalization was about to start. This claim seemed fanciful, not least that the German economy is cleaven between a reliance on China, a need to be better aligned with the US, a disastrous energy policy and a fascination with Russia that has still not been broken by the war in Ukraine.

Granted that globalization refers to a world that is interdependent and interconnected, it is wrong to hold that we live in a globalised world when dependencies are shifting (the US and Europe want to be much less dependent on China for instance) while the US and China barely have any political and policy connections, and are, in the minds of many, about to embark on war.

The second encounter that set me thinking about globalization was that I ran into Prof Barry Eichengreen, the international authority on foreign exchange, financial flows and who was passing through Europe on his way back to the US from India, where he had delivered a paper entitled ‘Globalization and Growth in a bi-polar world’. Whilst I believe it impossible to enjoy globalization in the context of a world that is severely divided, I was much more careful to pick an argument this time, given Barry’s great mind.

In the paper he charts how trade (relative to GDP) – one of the tenets of globalization – has faced severe headwinds but remains at high levels and has changed course somewhat (trade and investment flows have pushed out to countries like Mexico and Vietnam). Capital and financial flows have retraced even more, and the Eichengreen paper details China’s efforts to deepen its financial markets and boost the use of its currency (though its political economy is a major obstacle to this).

The Eichengreen paper, based largely on what we see in trade and capital flows, paints a picture of the contours of globalization as we have come to know it, as remaining in place. However, I would add to the argument other metrics of globalization – the flow of people, the flow of tourism and overseas education, the flow of ideas and of political and diplomatic discourse between nations. On many of these criteria, walls are going up, and it is impossible to speak of there being a consensus on one global system or way of doing things. Markedly, most of the institutions of the globalised world order (IMF, WHO, World Bank to name a few) are defunct.

My argument is that globalization is not to be confused with the ongoing growth of trade, or the business cycle, it is a very specific form of interconnectedness of nations and regions that is breaking down. It started with the fall of communism, and mostly likely died with the snuffing out of Hong Kong’s democracy in 2020.

This idea was part of a great discussion I had with Chris Watling of LongView Economics as part of their podcast series. LongView is perhaps the best independent markets and economics research firm, and one of the elements they tend to capture very well is the idea of (short and long-term) cycles of risk appetite in markets and economies. In that context, the idea that we are passing from one long-running economic ‘regime’ (globalization, to something else, was apt.

The Interregnum will be a period of breaking (down the imbalances that have built up with globalisation such as climate damage and debt) and making (new world institutions and the integration of technology into economies and societies). It will be a noisy, chaotic process and its success is not yet a given.

For the moment, the very least we should do is accept that globalization has passed and start to think about the future.

Have a great week ahead.

Mike

Re-emerging Risks

I started the week chatting with one of the leading experts on globalisation, or deglobalization’ as it is now. He is a little older than me (he won’t mind me saying) but we share much the same formative experiences, notably an internalising of the way the world worked in the 1990’s and 2000’s.

Back then, the big project was the construction of the euro, to the chorus of debates on global imbalances, fiscal strength (Hans Tietmeyer the former Bundesbank chief would be horrified by Western economic policy today). Elsewhere in the late 1990’s forward guidance of monetary policy consisted of analysing the size of Alan Greenspan’s briefcase and there was a healthy debate on whether central banks should act to burst asset bubbles (today central banks seem to trade those bubbles).

The point of this reminiscence is twofold.

The first is to demonstrate that compared to previous decades (and indeed the long-run of economic history) today’s economic landscape is an aberration, out of kilter with most long-term expectations of how economies behave.

The second point is to illustrate that for very long periods, economies follow regimes of behaviour where very different norms can endure for some time. It is often the correction of these norms that triggers large scale shifts in asset allocation, and volatility. One marked echo of market behaviour today, with the early 2000’s is that the equity risk premium (the benefit of owning equities over bonds) has fallen to its lowest level since 2000, and the performance of smaller companies (to very large ones) is the weakest it has been since 2001.

In general, the 1990’s and 2000’s were periods of rising expectations, whereas today that is not generally the case across countries. A notable feature of the sense that ‘things were on the up’ in the 1990’s was the growth of emerging markets.

Indeed, that period has given us at least two economic miracles – the rise of China as an economic and geostrategic power, and the rise of small, emerging states (Singapore and the Emirates). Neither of these ‘miracles’ is given enough credit by the West for what they have done in such a short space of time.

Specifically, last week was highly instructive in the case of emerging economies – three elections registered high market volatility. Mexico has elected a new president amidst fears that the institutions of the state, and its democracy will be further undermined, combined with a leftward tack on economic policy. The peso reacted badly.

India surprised most commentators (the consensus view on Modi has been far too bullish) by failing to ‘ordain’ Modi’s third term in office with a wholesome majority. While this may be positive from the point of view of India’s democracy, it means that the Modi economic steamroller has less momentum.

Then, the failure of the ANC to regain their majority in South Africa should not be a surprise given the failure of that economy to grow much in the last fifteen years (GDP per capita is at the same level as it was in 2010).

In the cases of India and Mexico, markets appear to be pricing democracy very differently – less of it in Mexico is bad, but the checking of Modi’s near absolute power is also bad (at least for the notion that he could have forced through another round of government spending).

Similar to governments across many emerging countries, investors appear to be torn between the strong man model and the Western oriented rule of law one. This is just one parameter where emerging economy governments will be forced to choose – another is between the US and China, and a further one is how to build an economy (and cities) around new technologies and in a more efficient way.

Of the three countries, South Africa is a depressing warning to others, and I see very little hope that it can put in place a coherent developmental model. What is more reassuring is that there are plenty of examples of countries that have made the journey from emerging markets to stable economies – Poland, the Czech Republic and the Baltic states are good examples, and the cohort of Vietnam, Indonesia, Thailand and Malaysia is on its way. Other emerging economies like Nigeria and Argentina are ‘experimental’.

What is also interesting is that emerging markets show that investors are becoming more sensitive to political and institutional risks (institutional investors in Turkey have all but given up). In this respect the important question is whether they start to more severely price in the macro risks associated with some of the developed economies.

If my notional 1990/2000’s investor was to return to the marketplace today, he/she would be confounded by valuations, low volatility and miniscule credit risk, and might start to believe that markets should treat the developed world economies with the same mercilessness it has shown to emerging markets this week.

Have a great week ahead,

Mike

Treasure Chest

John Maynard Keynes is very well known for his contributions to economics and policy making, but less so for his investing prowess. In the 1920’s Keynes worked as a portfolio manager for two insurance companies and from 1921 to 1946 ran the endowment (the ‘Chest’) for King’s College, Cambridge. Keynes’ investing performance is the subject of some fascinating research by David Chambers and Elroy Dimson.

Early in his career Keynes was what we might call a macro investor, focusing on commodities and foreign exchange. Later, he became more focused on stocks, and from the 1930’s Keynes beat the (stock) market by over 5% per year despite several close shaves with personal bankruptcy.

Viewed from the point of view of today’s stock market, what was unusual about Keynes’ style was that in the 1920’s and 1930’s equities were very much the preserve of retail investors, and not so much institutional managers.

To that end, Chambers and Dimson remark that Keynes’ early allocation to equities was ‘as radical as the much later move to illiquid assets in the late 20th century by Yale’. Unsurprisingly, Keynes’ investing style, which was driven by strong macro-economic views and focused on a few, large and often concentrated positions (if he was investing today he would likely be heavily invested in mega-cap technology stocks) has influenced modern endowment managers, most notably David Swensen of Yale.

Swensen pioneered the move by large US university endowments towards private assets (notably private equity, but also infrastructure and venture), a strategy that has proven remarkably profitable. The top endowments, generally Ivy League schools and other top ranking universities like MIT, have consistently made double digit returns, spurred by annual §private equity returns in the very high teens.

However, the endowment model is coming under scrutiny, partly because some universities have overinvested in private assets at a time when capital distributions have slowed (my former employer Princeton University has effectively invested up to 40% of its portfolio in private equity and venture), and partly because universities themselves have adjusted their expenditure upwards whilst they have enjoyed generous disbursements from performing endowments.

Endowments in the US originally paid 4% of their value to universities annually but in some cases this has risen to 12% (in turn pressuring endowment managers to produce returns). Broadly, disbursements from endowments amount to close to 30% of university budgets with much of it spent on student financial aid. Given that cash distributions from private equity funds have slowed, the knock on to university spending is being felt.

Anyone who has visited a top-flight US university and witnessed the extent to which laboratories, sports facilities and student bursaries are well funded will appreciate the size of university budgets and the role that endowments play. In Europe, only ETH Zurich can match this level of financial backing.

The debate on endowment investing has been enlivened by the publication in February of the 50^th NACUBO Endowment Study. In general, the nearly 700 endowments surveyed in the report hold less fixed income than I would imagine for a typical ‘balanced’ investor, more ‘foreign’ equities than US (this might explain some underperformance), and nearly 50% alternative assets (including a large slug of hedge funds).

Interestingly from the point of Keynes’ active management stance, nearly 50% of US endowments ‘outsourced’ their investment office function. Reflecting this, allocations to private equity, returns and return distribution tend to be better in the larger endowments that have well-equipped investment teams.

In turn this reflects the reality that private equity and venture are two of the asset classes (unlike equity and bond funds) where returns are highly dispersed (i.e. there is a large difference between the best and worst performing funds). As such, finding the best performing funds and gaining access to them has a cost in terms of investment research resources. To this end, I wonder if many universities have really been following the ‘endowment’ model as pioneered by Keynes and Swensen.

Indeed, one of the secrets of the performance of the Yale and Harvard models is that they have very good networks of alumni in the private investment industry, who willingly proffered the best advice and access to their alma mater.

Supporting this theory, Keynes had a similar network of former students around the world (notably in Africa – think mining stocks and commodities) who offered him advice, information and investment opportunities and he also had access to relatively sophisticated telegram technology, so that in some cases he had access to market moving information before others. Further, Keynes was unlike many investors today in that his colleagues at King’s had great faith in him and gave him enormous freedom to pursue his own investment style.

This ‘freedom’ has been all but quashed by benchmarking and technology in public markets (i.e. equity and bond funds) but still exits in private markets – the trick is to find the Keynes like managers.

Have a great week ahead,

Mike