New Global Macro Evidence and Forecasts
“We underrate the unpredictability of the future because we overrate the inevitability of the past” — Marc Andreessen
New Evidence This Week
Technology
In his new book Chip War: The Fight for the World’s Most Critical Technology, Chris Miller notes that, “World War II was decided by steel and aluminum, and followed shortly thereafter by the Cold War, which was defined by atomic weapons. The rivalry between the United States and China may well be determined by computing power.” Given that context, the United Sates’ decision to limit the export of advanced semiconductor manufacturing equipment to China is extremely important. As the Financial Times reported, “semiconductors made with US technology for use in AI, high performance computing and supercomputers can only be sold to China with an export license — which will be very difficult to obtain…Moreover, Washington is barring US citizens or entities from working with Chinese chip producers except with specific approval. The package also strictly limits the export to China of chip manufacturing tools and technology China could use to develop its own equipment.”
The FT also notes that, “Two years after the US hit Huawei with harsh sanctions, the Chinese technology group’s revenue has dropped, it has lost its leadership position in network equipment and smartphones, and its founder has told staff that the company’s survival is at stake…”
“The biggest question is how China responds. ‘We’re in a negative cycle where the US continues to push for restrictions, which pushes the Chinese to strive for technological independence, which in turn pushes the US towards harsher restrictions,’ said an industry insider in Beijing. But Beijing’s levers are limited. ‘This will propel the Chinese to look for alternatives but with the acknowledgment that alternatives to US technology are decades away,’ the person said” (China’s Chip Industry Set For Deep Pain From US Export Controls).
Anybody who remembers what happened after the US imposed an embargo on oil and gas exports to Japan on 1 August 2022 (when more than 80% of Japan’s oil came from the United States) should observe these developments with a great deal of trepidation – especially with so much of the world’s advanced semiconductor manufacturing capacity is located in Taiwan.
In a new report (Why AI-Managed Supply Chains Have Fallen Short and How to Fix Them), BCG and AERA Technology conclude that, “despite heavy investments, companies have not realized the vision of AI-managed supply chains…We found that the root cause lies not with technology but with how and where companies are applying it. Most still focus on using AI for analytics and prediction—for example, to forecast demand and plan production. Companies have not pursued the more valuable application of using AI to make recurring decisions by recognizing patterns in big data that humans cannot see.
“To unlock the full potential, companies need to deploy an AI-powered learning system that is integrated across functions. This system makes decisions based on enterprise-wide and external data and continuously learns from the outcomes to improve performance. Analytical engines automate decision-making instead of jus providing insights to practitioners, who must retain the burden of making decisions. Success requires fostering people’s trust in AI and introducing a new operating model, among other enablers. Companies that make the right investments will increase their resilience to market volatility and talent scarcity and achieve higher sustained performance.”
This lines up with the conclusions reached by the always insightful Adrian Wooldridge, in a very thought provoking new column on Five Ideas that Will Reshape Capitalism’s Next Century. It includes, The Great Knowledge-Worker Cull:
“First, they came for the agricultural workers. Then they came for the industrial workers. Now they are coming for the knowledge workers. The great labor relations theme of the rest of the current century is that intelligent machines will do for workers by brain what dumber machines did previously for workers by hand — destroying their jobs, suppressing their wages, battering their psyches and generally driving them to the margins of society. Techno-optimists like to put a positive spin on the march of the machines. Knowledge workers will become more productive by working with machines rather than against them, they said; machines would stop at the most sophisticated jobs — making leaps of imagination of thinking profound thoughts — thereby leaving human beings to do what they do best while the grunt work is taken care of by computers. Don’t believe a word of it.
“Intelligent machines have already moved on from jobs that simply involve processing lots of data (compiling tax returns or reading medical charts or searching for the best value stocks) to jobs that require what used to be regarded as ‘the human touch.’ Machines can produce plausible-sounding news reports. IBM Corp. and the Baylor College of Medicine have developed a system called KnIT (“knowledge integration toolkit”) that scans the medical literature and generates new hypotheses for research problems. Software regularly outperforms humans in predicting the outcome of court cases ranging from patent disputes to landmark Supreme Court rulings.
“The great problem of management will shift inexorably from how to manage knowledge workers (who will be progressively “outplaced”) to how to manage the marginalization of knowledge workers. Ever more senior figures who have spent their lives celebrating technological progress and decrying Luddism will find themselves surplus to requirements (imagine the howl from columnists as columns are automated!) Ever more university graduates will find themselves working in the bowels of the service economy. And ever more university departments, having profited briefly from the academic arms race, will have to close as potential students realize that no number of qualifications will save them from the knowledge-worker cull.
“Disappointed brainworkers have always provided combustible fuel for revolutions in the past: Look at the role that alienated intellectuals played in driving the Russian revolution or downwardly mobile graduates played in the rise of Nazism in Germany. From a social point of view, the next wave of technological progress is likely to prove the most disruptive yet.”
Another new paper that analyzes these issues is The Globalization of Remote Work, by RAND
Last but not least, don’t forget this: The problem of labor being displaced by ever improving cognitive automation technologies is going to be made much worse if the US education system fails to recover the substantial learning losses the nation’s K-12 students suffered during COVID. Unfortunately, accumulating evidence indicates that’s not going to happen.
Energy and Environment
Saudi Arabia cut oil production (to maintain current prices in the face of falling demand in a slowing global prices), while Anib Nasser, Saudi Aramco’s CEO, warned about the global energy industry’s oil supply capacity in light of reduced investment in exploration and production in recent years. This needs to be seen in light of a long-standing trend in the energy industry – the increasing cost of finding and producing incremental units of oil and gas supply (e.g., because of more difficult geological conditions), as well as the rapid decline in the productivity of wells developed using hydraulic fracturing.
Health and Disease
The BBC reported that India Is Facing A Pandemic Of Antibiotics-Resistant Superbugs. “India is one of the countries worst hit by what doctors call "antimicrobial resistance" - antibiotic-resistant neonatal infections alone are responsible for the deaths of nearly 60,000 newborns each year. A new government report paints a startling picture of how things are getting worse. Tests carried out at Kasturba Hospital to find out which antibiotic would be most effective in tackling five main bacterial pathogens have found that a number of key drugs were barely effective…Some of the main antibiotics were less than 15% effective in treating infections... resistance to a powerful class of antibiotics called carbapenems had risen by up to 10% in just one year alone.” India is not alone — antimicrobial resistance is an emerging threat that has continued to grow worse under many people’s radar.
Mckinsey published a new report, The Gathering Storm:The Uncertain Future Of US Healthcare. The once-in-a-century pandemic thrust the healthcare industry into the teeth of the storm. The combination of accelerating affordability challenges, access issues exacerbated by clinical staff shortages and COVID-19, and limited population-wide progress on outcomes is ominous… Our analysis finds that national health expenditure could grow at a rate of 7.1 percent over the next five years from 2022 to 2027, compared with an expected economic growth rate of 4.7 percent. In aggregate, this would equate to healthcare expenditure growth in excess of economic growth of 2.4 percentage points. Health expenditure growth could exceed economic growth by up to 5.9 percentage points in 2023, creating enormous affordability pressure…The combination of significantly higher healthcare costs than expected and the challenges facing end payers—employers, consumers, and government—will face in paying for this increase will force a reckoning in the industry.” When this happens, it will almost certainly further worsen inequality and increase social anger and political polarization — in this case, between the elites and the masses.
The Economy
The IMF’s latest World Economic Outlook (WEO) painted a gloomy picture of what lies ahead, concluding that, “The global economy continues to face steep challenges, shaped by the lingering effects of three powerful forces: the Russian invasion of Ukraine, a cost-of-living crisis caused by persistent and broadening inflation pressures, and the slowdown in China.”
As Larry Summer wrote, “it is likely that in the next year the United States will go into recession, Europe will be battered by high energy costs and China will suffer its lowest growth in decades. A major slowdown in the global economy is almost inevitable” (IMF-World Bank Meetings Are The Last Stop Before A Coming Economic Storm).
The WEO notes that, “Risks to the outlook remain unusually large and to the downside. Monetary policy could miscalculate the right stance to reduce inflation. Policy paths in the largest economies could continue to diverge, leading to further US dollar appreciation and cross-border tensions. More energy and food price shocks might cause inflation to persist for longer. Global tightening in financing conditions could trigger widespread emerging market debt distress. Halting gas supplies by Russia could depress output in Europe. A resurgence of COVID-19 or new global health scares might further stunt growth. A worsening of China’s property sector crisis could spill over to the domestic banking sector and weigh heavily on the country’s growth, with negative cross-border effects. And geopolitical fragmentation could impede trade and capital flows, further hindering climate policy cooperation. The balance of risks is tilted firmly to the downside…The risk of monetary, fiscal, or financial policy miscalibration has risen sharply at a time when the world economy remains historically fragile and financial markets are showing signs of stress.”
The IMF’s Global Financial Stability Report focused on the financial market risks we face today. “Rising uncertainty has additionally contributed to tighter financial conditions. Financial stability risks have increased, and the balance of risks is tilted to the downside. Financial vulnerabilities are elevated in the sovereign and nonbank financial institution sectors, where rising interest rates have brought on additional stress. A bright light comes from our global bank stress tests which show relative resilience for advanced economy banks. The challenging macroeconomic and policy environment is also putting pressure on the global corporate sector. Large firms have reported a contraction in profit margins due to higher costs. Among small firms, bankruptcies have started to increase because of higher borrowing costs and declining fiscal support. Many advanced economies and emerging markets may face housing-market-related risks as mortgage rates rise and lending standards tighten, squeezing potential borrowers out of the market. Emerging markets are confronted with a multitude of risks from the strength of the US dollar, high external borrowing costs, stubbornly high inflation, volatile commodity markets, heightened uncertainty about the global economic outlook, and pressures from policy tightening in advanced economies.”
Seen in this context, the recent crisis in the UK is almost certainly an indicator of rapidly rising stress on multiple fiscal, monetary, and financial markets fault lines in the global economy. As is the case with trying to forecast damage from future earthquakes in the San Francisco Bay area, the critical uncertainty is the extent to which multiple fault lines are interconnected, and how that could exponentially increase damage from an initial quake on one of them.
In A Stagflationary Debt Crisis Looms, Nouriel Roubini described what the true downside scenario could look like — and it’s not pretty.
“There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalization of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default.
“The next crisis will not be like its predecessors. In the 1970s, we had stagflation but no massive debt crises, because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation, because the credit crunch had generated a negative demand shock.
“Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.
“When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. The space for fiscal expansion will also be more limited this time. Most of the fiscal ammunition has been used, and public debts are becoming unsustainable.
“Moreover, because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, thereby increasing the probability of a synchronized global recession. This tightening is already having an effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, SPACs (special-purpose acquisition companies), bonds, and credit instruments. Real and financial wealth is falling, and debts and debt-servicing ratios are rising.
“That brings us to the final question: Will equity markets rebound from the current bear market (a decline of at least 20% from the last peak), or will they plunge even lower? Most likely, they will plunge lower. After all, in typical plain-vanilla recessions, US and global equities tend to fall by about 35%. But, because the next recession will be both stagflationary and accompanied by a financial crisis, the crash in equity markets could be closer to 50%.”
For a longer exposition of Roubini’s argument, see his new book, Megathreats: The Ten Trends That Imperil Our Future and How to Survive Them.
National Security
In The World Putin Wants, Fiona Hill and Angela Stent provide an admirably succinct summary: “Putin wants a world where Russia presides over a new Slavic union composed of Belarus, Russia, Ukraine, and perhaps the northern part of Kazakhstan (which is heavily Slavic)—and where all the other post-Soviet states recognize Russia’s suzerainty. He also wants the West and the global South to accept Russia’s predominant regional role in Eurasia. This is more than a sphere of influence; it is a sphere of control, with a mixture of outright territorial reintegration of some places and dominance in the security, political, and economic spheres of others.”
How Does the Russo-Ukraine War End? Timothy Snyder observes that, “War is ultimately about politics. That Ukraine is winning on the battlefield matters because Ukraine is exerting pressure on Russian politics. Tyrants such as Putin exert a certain fascination, because they give the impression that they can do what they like. This is not true, of course; and their regimes are deceptively brittle. The war ends when Ukrainian military victories alter Russian political realities, a process which [Snyder] believes has begun.”
This raises a question that Shawn Cochran addresses in Will Putin’s War in Ukraine Continue Without Him? Cochran notes that there is speculation “that without Putin, Russia might be more apt to abandon its war in Ukraine and seek a negotiated peace. Although supported by conventional views of war termination, any such assumption is problematic. History demonstrates that the leader who starts a costly, protracted war is rarely willing to end the war short of victory — but history also shows that leadership change does not always facilitate peace…
“For political leaders, the desire to avoid blame and domestic punishment for a failed war can have a powerful effect on war termination decision-making. Per the conventional wisdom, leaders responsible for starting a war are uniquely susceptible to blame and punishment for a how a war ends and are thus prone to keep fighting even with little hope of victory. Accordingly, leadership change is often a necessary precursor to war termination. Such a view may be well-founded, but it does not necessarily follow that new leaders — those who merely inherit an ongoing war — are free from domestic pressures and risks associated with ending the war under less than favorable terms…
“Any new leader who seeks to extricate Russia from Putin’s war likely will face tough domestic hurdles. Russia’s current domestic political environment, as characterized by an intense blame game pitting political versus military leadership, would be especially dangerous for Putin’s successor and disincentive any move to abandon Russia’s war aims in Ukraine and seek peace, at least in the short term. This holds even for a successor who opposed or did not openly support Putin’s war prior to taking office. Thus, Putin’s war may very well continue without Putin.”
Social
Brink Lindsey from the Niskansen Center has launched a very interesting new Substack, The Permanent Problem. “The premise of this blog is that we are in the midst of a global crisis of capitalism. Capitalism — which I’m using as shorthand for the social order that combines a market economy animated by consumerism with a large bureaucratic state, organized science, and mass media — has triumphed around the world, bringing material plenty to billions and promising in due course to make such plenty the global norm. But nothing fails like success, and capitalism’s stunning success is no exception. The advent of mass affluence has satisfied basic material needs, but in so doing has brought new needs to the fore — needs that capitalism is much less capable of satisfying. And even as our social system’s alignment with the requirements of human wellbeing has gone askew, its overall vigor is declining.”
In The Declining Leverage and Status of Ordinary People, Lindsey writes, “Discussion of the widening class divide tends to focus on money — the top 1 percent’s share of total income, trends in median income, wealth inequality, intergenerational mobility, and so on. The preoccupation is understandable: economics is preeminent among the social sciences in prestige and influence, and economists naturally look to economic indicators. But if you examine contemporary socioeconomic inequality through a purely economic lens, you will fail to see the true depths of the problem.
“Why? Because although the data show top incomes growing considerably faster than the rest during recent decades, they also show median income up as well. Further, the best estimates reveal that poverty has declined sharply. When you translate dollar figures into the stuff that money buys, it becomes clear beyond serious dispute that material living standards have continued to rise, for ordinary people as well as elites…So looking at inequality as just an economic phenomenon leads you to a fairly mild assessment of the impact on human wellbeing. Yes, progress is skewed toward the top, but still there’s been continuing progress overall.
“The class divide, I believe, is much more troubling than that. Outside a well-educated and comfortable elite comprising 20-25 percent of Americans, we see unmistakable signs of social collapse. We see, more precisely, social disintegration—the progressive unraveling of the human connections that give life structure and meaning: declining attachment to work; declining participation in community life; declining rates of marriage and two-parent childrearing.
“I want to focus on the root causes of the new class divide — and what they tell us about our prospects for a more inclusive future. My take, alas, is a sobering one: the conditions of mass affluence push strongly in the direction we’ve been going down, and they constitute formidable barriers against pushing back in a more inclusive direction through public policy…
“In my view, the fundamental reason for the inegalitarian turn — not just in the United States, but throughout the advanced economies — was a qualitative downward shift in the leverage and status of ordinary people. The contributions that ordinary workers are able to make to the organized division of labor are simply less important than they used to be, and as a result those workers and their families have suffered a loss of collective power and a decline in social status… Economists point in the right direction when they talk about “skill-biased technical change” and “declining relative demand for less-skilled labor.” But their technocratic terminology portrays the issue as dollars on the margin, when really it's existential.”
Now add to Lindsey’s conclusion the adverse technology trends noted above, as well as the looming failure to recover millions of students’ learning losses, at a time when talent is more important than ever, and you get an emerging threat that, because its drivers lie in technology and education, is developing below the radar screen for too many investors.
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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%).