New Global Macro Evidence and Forecasts
New Evidence This Week
National Security
In the aftermath of US Speaker of the House Nancy Pelosi’s visit to Taiwan, the PRC flew simulated attack missions against the island involving an unprecedented number of planes, and commenced missile “live fire” exercises into area around Taiwan that, for all intents and purposes, simulated a blockade. Actually, it more than simulated it, because the exclusion zones around Taiwan established for the exercise actually disrupted air and sea traffic. Provocatively, some of the missiles fired landed in ocean waters that Japan considers its exclusive economic zone. Both drills have substantially escalated tensions between the China and the US and its allies.
At an annual conference on deterrence, Admiral Charles Richard, the commander of US Strategic Command warned that China is expanding its nuclear forces at a “breathtaking” pace. He was quoted as saying that, “No one knows with certainty where this is going, and this is why I’m calling for a more frequent examination of our capability, capacity and posture, so that we can execute our strategy as the threat evolves.” A much larger nuclear arsenal is logically an attempt by China to deter an aggressive Western response to a future Chinese invasion of Taiwan, and, possibly, a broader initiative to dominate the Western Pacific.
These events made particularly timely the publication of Can China Take Taiwan? Why No One Really Knows, by the Brookings Institution’s Michael O’Hanlon. His analysis concludes that, “a potential U.S.-China war over Taiwan, likely also involving some American allies, poses analytical and policy challenges that make predicting outcomes especially difficult. In particular, the outcome of a Chinese maritime blockade of Taiwan scenario, in which a U.S.-led coalition aids Taiwan’s military to break the blockade and keep the island polity economically viable, may be too close to call…The results strongly suggest that any predictions by either adversary would be unreliable.”
The Economy
The Federal Reserve Bank of New York’s Survey of Consumer Expectations reported that “median one and three year ahead [annual] inflation expectations both declined sharply in July, from 6.8 percent and 3.6 percent in June, to 6.2 percent and 3.2 percent, respectively.” Expectations for future energy, food, and housing price increases all significantly declined. While this is good news on the inflation front, it signals an overall weakening of economic demand as well as some recovery of supply.
The headline of a new Economist article says it all: The Global Housing Boom is Running Out of Steam. The Economist notes that, “The question now is how low prices will go. The Royal Bank of Canada thinks sales in its home country will plummet from their peak in 2021 by more than 40%, worse even than in the financial crisis when they fell by 38%. Things may not be quite as dramatic elsewhere. But for owners used to prices heading in only one direction, any drop will come as a shock.” Given that many houses have been purchased using substantial amounts of debt, housing price declines (and the increase in uncertainty that accompanies them) will very likely put further downward pressure on aggregate demand.
In Is the Sri Lankan Debt Crisis a Harbinger?, Devarajan and Kharas note that “the friction between China and Western countries has made it harder for developing nations to renegotiate their debt, since Beijing does not want to bail out private U.S. or European financial institutions and Western governments do not want to bail out Chinese financial institutions. To stave off a string of devastating defaults in the developing world, two things will have to happen at once: at-risk countries will need to seek help from international financial institutions before it is too late, and Chinese and Western creditors will need to do a better job of coordinating their debt restructuring processes.” Back in the days when most developing country foreign debt was in the form of syndicated loans led by a small group of international banks, restructuring was much easier. Today restructurings are much harder because bonds make up a larger share of countries’ external debt and Chinese creditors resist playing by Western rules. So expect the coming developing country debt crises to be much worse than many investors probably expect.
In How Many Americans Work Remotely, Brynjolfsson, Horton, and Markidis observe that, “While there is widespread recognition that the remote work rate surged during the coronavirus pandemic, there is disagreement about the extent of this change.” To address this limitation, [they] “field a new, nationally-representative survey: the Remote Life Survey (RLS). After constraining the sample to working respondents who were employed before and during the pandemic, we find that in October, 2020, 31.6% of this continuously employed workforce always worked from home and 22.8% sometimes or rarely worked from home, totaling 53.6%”. This is significantly higher that other estimates, because it captures not just people who began working from home during the pandemic, but also those who were working from home before COVID arrived. This provides further evidence that the commercial office market and the economies of many cities’ central business districts, as well as future load factors on rapid transit and commuter rail has almost certainly undergone a structural change that is very unlikely to quickly reverse back to what was normal in 2019.
Technology
Too rarely, do we see articles that temper our overconfidence and fears about the speed at which artificial intelligence technologies are improving. In Testing Relational Understanding in Text-Guided Image Generation, Conwell and Ullman note that, “relations are basic building blocks of human cognition. Classic and recent work suggests that many relations are early developing, and quickly perceived. Machine learning models that aspire to human-level perception and reasoning should reflect the ability to recognize and reason generatively about relations.” They systematically examine a recent text-guided image generation model, and find that “only 22% of images matched prompts…based on a set of 15 basic physical and social relations.”
Politics
In his column, Will We Escape Our Age of Failure? Martin Gurri cites one of our favorite books – Paul Ormerod’s 2004 Why Most Things Fail: Evolution, Extinction, and Economics. A central theme that runs through Ormerod’s writing the ubiquity of failure the distortions caused by media’s preference for covering success stories. The net result is an overly optimistic set of expectations about what individuals, organizations, and institutions can accomplish is a world that is ever more complex, and therefore difficult to explain, much less predict in order to guide action to achieve goals. Yet in order to maintain our sanity and capacity for action in pursuit of our goals (or “animal spirits” as Keynes long ago observed), we demand that both ourselves and our leaders deny this essential truth, which leads overconfidence about our understanding of situations and the likelihood that our actions will produce their intended results. So when these results diverge from their declared goals or expectations, public respect for and confidence in them is undermined over time (something that doesn’t occur nearly as often at the individual level…).
While I agree with Gurri’s points, it is unfortunate that he neglected to mention another of Ormerod’s insights. In another paper, How Much Can Firms Know? Ormerod and Roswell show that even a slight improvement in an investor’s or organisation’s ability to acquire knowledge about the sources of competitive success and failure can dramatically improve their long term survival rate. That is also very likely true for institutions and the people who lead them.
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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%).