New Global Macro Evidence and Forecast Updates
The extent of uncertainty and downside risk we face is still underestimated by many, who don't yet fully appreciate the fundamental changes in many macro system dynamics that are now underway.
"Each [failed forecast] involved historical discontinuity, and, in the early stages…unlikely outcomes. The basic problem was…situations in which trend continuity and precedent were of marginal, if not counterproductive value." – 1983 CIA Study of Significant Historical Forecasting Failures
New Evidence This Week
Technology
RAND warned that, America May Not Be Ready for the Looming Tsunami of Deepfakes. “Open AI's recent release of the DALL-E 2 text-to-image generator and Meta's subsequent announcement of its “Make a Video” tool could erode barriers to creating “deepfakes,” synthetic images or video content created through artificial intelligence. These new products, along with similar tools being developed by other companies, may provide significant advances in promoting the next wave of digital creators. At the same time, they could be exploited to create deepfakes that could have unintended economic, social, and geopolitical consequences.”
More evidence of accelerating improvement in automation technologies’ capabilities, and the speed at which these technologies re being deployed.
The Financial Times reported that, “Amazon has debuted a new warehouse robot that can pick up and sort millions of individual unpackaged products, in a move that will automate more jobs as the US ecommerce giant faces pressure to significantly cut logistics costs.”
And in Harvard Business Review, Davenport and Mittal report on How Generative AI is Changing Creative Work. “Generative AI models for businesses threaten to upend the world of content creation, with substantial impacts on marketing, software, design, entertainment, and interpersonal communications. These models are able to produce text and images: blog posts, program code, poetry, and artwork. The software uses complex machine learning models to predict the next word based on previous word sequences, or the next image based on words describing previous images.”
A third important piece of new evidence on this theme is Tyler Cowen’s discussion with John Cochrane and Niall Ferguson on AI and the Future of Work, on the Hoover Institution’s Goodfellows podcast. Cowen argues that the implications of near-term improvements in AI performance, particularly large language models, will be far more disruptive than many currently expect. He also discusses how workers can best prepare themselves to survive and thrive in the world of work that lies ahead.
Energy and the Environment
This month’s Australian Rare Earth Conference heard sobering findings about how hard it will be to dislodge China’s leadership in this critical sector. As reported in the ASPI Strategist, “Western Australian critical minerals analyst Kingsley Jones argues that China is no longer pursuing a monopoly of rare-earth supply. Its strategy, he says, is one of ‘monopsony’, as the sole buyer of rare earths. China’s share of raw material supply has dropped from 85% to 60% as demand has outstripped the capacity of its own mines, some of which have been shut for environmental reasons.
“Where China retains a monopoly is in processing and fabrication. Mined rare earths must first be turned into a carbonate, which is a relatively simple process, and then refined into an oxide, which is much more complex. Then the oxide is turned into a metal, which may be alloyed before it is fabricated into permanent magnets and the huge range of other products using some portion of rare earths. China holds between 85% and 90% of all the downstream processes. Global production of permanent magnets was 174,000 tonnes last year, of which Japan accounted for less than 9% and China nearly all the rest.”
Health and Disease
A new report concluded that, “the world-wide decline in male sperm count is continuing in the 21st century at an accelerated pace...The decline reflects a global crisis related to our modern environment and lifestyle, with broad implications for the survival of the human species…Research on the causes of this continuing decline and actions to prevent further disruption of male reproductive health are urgently needed” (Temporal Trends In Sperm Count: A Systematic Review And Meta-Regression Analysis Of Samples Collected Globally In The 20th And 21st Centuries, by Levine et al).
The Economy
Warnings about trouble ahead in global housing markets continued to mount. For example, The Economist recently ran stories on A Global House Price Slump is Coming and Where the Coming Housing Crunch Will Be Most Painful. Both forecast that Australia, Canada, and Sweden would experience big falls in housing prices as highly leveraged homeowners in the most overvalued markets faced rapidly rising interest rates and the prospect of widespread job losses in a global economic recession.
Like the Economist, another new analysis, Demographia: International Housing Affordability 2022,takes a more granular approach, identifying the most overpriced city housing markets in the world. It also reaches a broad conclusion about what housing inflation and the prospects of a housing crash similar to 2008 could mean: “There is a broad view that declining housing affordability is driving higher costs of living that threaten the future of the middle-class. In Under Pressure: The Squeezed Middle-Class, the OECD finds that the middle-class faces ever costs of living and that rising owned house prices are the main driver of rising middle-class expenditure.”
National Security
In an important new article in Foreign Affairs, Andrew Krepinevich Jr. asks, Is Putin a Rational Actor? Because Deterrence Theory is build on the assumption that all actors are rational, this question is central to one of the most important uncertainties we face today – whether Russia will use nuclear weapons in the Ukraine war.
As many other researchers before him have found, Krepinvich notes that human beings aren’t the “calculating creatures” assumes by theories ranging from nuclear deterrence to micro and macroeconomics. For example, “research reveals that all other factors being equal, people are generally less willing to take risks to acquire what they do not have than preserve something of equal value that is already theirs—“prospect theory,” as the phenomenon is known in behavioral economics…But rival actors may both believe that they are vying over something that is rightfully theirs. Such is the case with Ukraine. Putin views it as a wayward province of Russia that must be recovered. Ukrainians and their NATO backers see it as an independent country that must be defended from the Kremlin’s depredations. Thus both sides are willing to engage in relatively high-risk behavior to possess what they believe is theirs.”
He also notes that, “cognitive science research finds that political leaders have an inflated confidence in their ability to control events, making them more willing to take on risks. That misguided self-belief makes them more prone to double down when facing failure, taking greater risks rather than cutting their losses…This appears to be the case with Putin. Instead of looking for an off-ramp out of the war, he has escalated the conflict”…
“Leaders make some decisions that appear irrational when viewed from a strictly transactional perspective, but less so when taking into account perceptions of honor and justice. In Putin’s case, he seems convinced that his war is a mission to restore Russia’s national honor, redeeming the country from the humiliation that followed the end of the Cold War and the disintegration of the Soviet Union.”
Krepinevich concludes that “Given these considerations, the West cannot discount the possibility that Putin will turn to nuclear weapons to compel Ukraine and NATO to seek peace on terms favorable to him.”
It is very likely that classified analyses have reached similar conclusions. Hence it was an important signal when CIA Director William Burns recently met in Ankara with his Russian counterpart to warn him against the use of nuclear weapons.
Unfortunately, even if he can’t or won’t use nuclear weapons, there are other steps that Putin could take to increase pressure on the west. The recent underwater explosions that ruptured the Nord Stream pipelines carrying Russian gas to western Europe may hint at what could come next. As described in a 2021 report by the Center for Strategic and International Studies, undersea cables carry over 95 percent of international data. In comparison with satellites, subsea cables provide high capacity, cost-effective, and reliable connections that are critical for our daily lives. There are approximately more than 400 active cables worldwide covering 1.3 million kilometers (half a million miles), and in recent years Russia has displayed increasing interest in them (and presumably how they could be cut).
There is also additional evidence that deterrence is dangerously weakening in the Pacific, despite President Biden’s apparently successful meeting with Xi Jinping in Indonesia at the G20 summit meeting. Speaking at a Navy Submarine League meeting in early November, Navy Adm. Charles A. Richard, commander of the US Strategic Command (that controls the nation’s nuclear weapons), said, "This Ukraine crisis that we're in right now, this is just the warmup. The big one is coming. And it isn't going to be very long before we're going to get tested in ways that we haven't been tested a long time."
As this is written, reports are emerging of widening protests in China over continued lockdowns associated with Xi Jinping’s “zero COVID” policy, and the negative impact they are having on the nation’s economy. Needless to say, this are highly unusual given China’s extensive surveillance state, and the consequences it may portend for the protestors. What has yet to receive widespread coverage, however, is a key reason for the continuation of the Zero COVID policy: the relative ineffectiveness of China’s Sinovax COVID vaccine, and the limited number of people who have received it, in combination with the much-improved ability of the latest strain of the SARS-CoV-2 virus to evade immunity protection conferred by previous vaccination and/or infection. To be sure, while elsewhere in the world this strain has caused many infections, its impact on hospitalizations and deaths has been muted. However, there is a possibility that this may not be the case if it is allowed to spread in China. So the bind that China is likely more serious that many appreciate.
Finally, two uncertainties involving Iran are quickly escalating in potential importance. Externally, Iran has increased supplies of missiles to Russia that are being used to attack Ukranian energy infrastructure, while there have been warnings by Saudi Arabia and US National Security officials that Iran is preparing to attack Saudi Arabia’s energy infrastructure (perhaps to increase the effectiveness of Russia’s cutoff of gas supplies to western Europe). In response, US B-52 bombers staged a number of flights over the Middle East, in partnership with aircraft from 13 partner nations.
Domestically, protests that were originally set off by the death of 22-year-old Mahsa Amini (who had been arrested by the morality police for allegedly flouting Iran’s strict dress code for women) have continued to escalate. In return, the regime’s response to these protests have become more violent and deadly. At this point, it seems that a stalemate is emerging, where the extent of the protests has made it impossible for the regime to eliminate them, but the protestors lack sufficient organization to pose a threat to the Khamenei government.
Politics
In the mid-term elections in the United State, the Republican “red wave” many had forecast failed to materialize, apparently because of voter aversion to supporting candidates backed by Donald Trump, and a stronger than usual turnout by heavily Democratic (and often Progressive) young voters.
However, while they retained control of the Senate, the Democratic Party lost control of the House of Representatives, which will limit the Biden administration’s ability to pass legislation for the last two years of its term.
Moreover, deeper post-election analyses suggested that in the runup to the 2024 presidential election, the Democratic Party’s position has very likely improved by less than many initially thought.
First, it has likely raised the probability that Joe Biden will seek a second term in his eighties.
Second, while the youth turnout was indeed impressive, the Progressive of many of these voters will likely limit the Biden administration’s ability to tack towards the center.
Third, the Democrats continued to lose ground with two key groups: Hispanic voters and Working Class white voters.
Finally, in Florida Republican Governor Ron DeSantis (who is 44 and a much more of a disciplined conservative policy wonk than Donald Trump) romped to victory, carrying even traditionally Democratic strongholds. This puts him in a strong position to successfully challenge Donald Trump for the party’s nomination in 2024, setting up a race against a much older and more Progressive Joe Biden.
Conclusion: Impact on Macro Scenario Forecasts Based on This New Evidence
Disruptive technologies with potentially very large disruptive impacts – like Deepfakes, robotics, and Large Language Models (LLMs) are improving far faster than many people realize. They threaten to reduce employment and worsen inequality (even in high cognitive skill roles formerly believed to be protected from automation), increase corporate profit concentration and pricing power (due to the non-linear impact of winning the competition for scarce talent), and reduce confidence in the accuracy of information that people and organizations (including intelligence and military organizations) receive, and thereby delay and reduce decision quality. Regarding the latter, “information assurance” will almost certainly become as important a concern as cybersecurity is today.
The potential negative economic implications of declining male sperm counts and birth rates are not significantly understood. In the best case, they could be offset, to some extent, by the benefits of accelerating cognitive and physical automation technologies. The potential social and political effects remain much more uncertain (e.g., the impact of rising retiree public pension and health care budget demands on military spending).
China’s dominance in rare earth metals and related downstream technologies continues to be a critical issue whose importance has not yet been assimilated by many investors.
Declining male sperm counts is a wildcard issue that could further depress birthrates and worsen the dependency ratio (children plus retirees/working adults). Unless reversed (which at this point seems unlikely in the next three years at least), this will very likely lead to a wide range of negative effects, from slowing economic growth, permanently weak housing markets, and increased pressure on public pensions and government budgets.
Housing prices are poised for significant declines in key markets due to the impact or rising interests rates and recession-induced job losses on highly leveraged homeowners. At the national level these appear to include Australian, Canada, and Sweden. In other countries, certain city markets also appear to be very significantly overpriced. The extent to which these housing price declines will lead to a wave of debt defaults remains a critical uncertainty and key indicator to watch.
The probability that Vladmir Putin should be assumed to be a rational actor in the context of forecasts of the probability he will order the use of nuclear weapons is seems to rest on increasingly shaky grounds. What remains equally uncertain, and less understood, is whether the Russian military would comply with a nuclear release order from Putin.
Even without nuclear use, and as evidenced by the alleged Russian subsea sabotage of the Nordstream Pipelines, Putin still has potentially very disruptive attack options at his disposal. One of the most damaging would be cutting subsea cables that carry a substantial amount of the world’s data traffic.
Uncertainty with respect to China’s domestic stability has spiked with spreading protests over Xi Jinping’s “Zero COVID” policy and its associated rigorous social isolation measures. The extent to which this could threaten Xi’s continued leadership remains uncertain. However, given that at the recently ended Communist Party Conference Xi further consolidated his power, and given the expansion of the surveillance/state security control state over the past decade under his rule, at this point it is very unlikely the spreading protests will result in his removal in the short-term. However, this probability could increase over time, given that the alternative to increasingly unpopular “Zero COVID” lockdowns could be widespread infection and deaths in a population with weak vaccine and previous infection immunity to new COVID strains that are significantly more effective at evading both. Rising domestic unrest (which will also be caused by a slowing economy caused by lockdowns and the growing impact of US sanctions on China’s high technology sector) is and threats to his rule is likely to increase the probability that Xi may move sooner rather than later against Taiwan.
Iran remains another wildcard, with spreading unrest and a continuing stalemate between protesters and the government the most likely outcome. However, as domestic and foreign pressure on Iran (due to its support for Russia’s war on Ukraine) increase, it will raise the probability of Iranian attacks on Saudi energy infrastructure (as recent intelligence warnings indicated), and, in the worst case, could lead to Iran accelerating its program to develop and display nuclear weapons capability. This would almost certainly lead to military reprisals by Israel, and very likely Saudi Arabia and the US.
At this point, with US military capabilities increasingly utilized to respond to the Ukraine and Iran contingencies, both China and North Korea would almost certainly raise their own perceived probabilities of success in attacks on South Korea and Taiwan. In sum, there is an increasing probability (which at this point is very hard to estimate, given the lack of base rate data) that we could accidently find ourselves involved in another World War. The events leading up to the First World War provide stark evidence that this possibility – as inconceivable as it may seem – is something that should no longer be discounted.
The recent mid-term elections in the United States make it very likely that very little will get done legislatively between now and the 2024 presidential election, in which (at this point), it seems likely that almost 82 year old Joe Biden, running on a more Progressive Democratic Party platform will face 45 year old Ron DeSantis, running on a platform focused on policy proposals that address the frustrations that gave rise to the popular anger than energized many Trump voters in 2016 and to a lesser extent 2020 and 2022.
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Background
At the Index Investor and Retired Investor, our information collection, analysis, and forecasting process is based on this model of how developments in different issue areas interact in a rough chronological sequence (albeit in a complex manner) to produce different global macro regimes (which we label Normal Times, High Uncertainty, High Inflation, and Persistent Deflation).
In each of these areas we continuously seek new evidence, which classify as significant and highly valuable if either (1) it is an “indicator”, which reduces our uncertainty about the value of a parameter in our mental model for making sense of the dynamic macro system, or (2) it is a “surprise” which increases our uncertainty about either the range of potential values for a parameter or the structure of our model.
Each week in this newsletter we review high value new evidence and its significance in some or all of these areas. Each quarter we summarize these weekly newsletters in new issues of The Index Investor and Retired Investor, as well as updated 12 and 36-month global macro regime probabilities and any changes to our model portfolios.
The Neutral portfolio places 10% weights on nine major asset classes, and 5% each to two active strategies (Equity Market Neutral and Global Macro), which should have low correlations with returns on major asset classes.
The Systematic portfolio changes asset class weights based on the extent of our estimate of their respective degrees of over or undervaluation. This portfolio expands the fixed income asset class to include possible allocations to Investment Grade and High Yield credit products. Allocations to Equity Market Neutral and Global Macro remain constant at 5% each. Finally, when some asset classes are so overvalued that they have a zero weight, but other asset classes are not sufficiently undervalued to absorb reallocations away from the overvalued classes, the excess cash is placed in a mix of Cash (short term Treasury Bills and Notes) and Gold.
The Subjective portfolio is our attempt to outperform the Neutral and Systematic portfolios via active management. More often than not, it underperforms the Systematic portfolio, proving that we find successful active management over the long term just as challenging as everyone else.
Model Portfolio Performance
In the second quarter of 2022, as high valuations retreated across multiple asset classes, the Neutral portfolio was down (10.1%) from the end of March, the Systematic portfolio was down (8.1%), and the Subjective portfolio was down (8.0%). By comparison, a Traditional portfolio of 60% US Equity and 40% US Government Bonds was down (11.4%).
For the first half of 2022, the Neutral portfolio was down (8.0%) from 31 December 2021, the Systematic portfolio was down (4.9%), and the Subjective portfolio was down (5.0%). By comparison, a Traditional portfolio of 60% US Equity and 40% US Government Bonds was down (8.7%).