New Global Macro Evidence and Forecasts
New Evidence This Week
National Security
China has ramped up its brinkmanship in an attempt to dissuade US House Speaker Nancy Pelosi from visiting Taiwan. If China’s attempted intimidation succeeds, it would represent a significant loss of face for the United States. The Financial Times reported that, “China has issued stark private warnings to the Biden administration about the upcoming trip to Taiwan by Nancy Pelosi, Speaker of the US House of Representatives, triggering alarm bells among White House officials who oppose her visit. Six people familiar with the Chinese warnings said they were significantly stronger than the threats that Beijing has made in the past when it was unhappy with US actions or policy on Taiwan… Several people familiar with the situation said the private rhetoric…threatened a possible military response... Beijing has not been explicit about its potential reaction. Its military could try to block Pelosi from landing in Taiwan or take other actions to impede her visit, such as using fighter jets to intercept her US military aircraft.”
In a new report, Getting Ready for a Long War With China, AEI’s Hal Brands concludes that, “The United States may be preparing for the wrong kind of war with China. Much of America’s planning for a potential war with China appears to hinge on an assumption that the war would be short and localized. Yet most modern great-power clashes have been long wars, lasting months or years rather than days or weeks. And as great-power wars go long, they frequently get bigger, messier, and harder to untangle. A Sino-American war that occurs in the coming years would most likely fit this pattern. Such a conflict is likely to be long, rather than short; it would probably sprawl geographically rather than remaining confined to the Taiwan Strait. It would feature far higher risks of nuclear escalation than many observers recognize and present the United States with severe challenges of warfighting and war termination.”
In What If the War in Ukraine Spins Out of Control?, Fix and Kimmage write that, “For all the talk of Russia crossing the West’s red lines with its conduct in the war and of the West crossing Russia’s red lines with its military assistance to Ukraine, the true red lines have not yet been breached. At the outset of the war, both sides hashed out a set of invisible rules—unspoken but nonetheless real. They include Russia’s acceptance of allied heavy-weapons deliveries and intelligence support for Ukraine, but not the use of Western troops. And they include Western states’ grudging acceptance of Russian conventional warfare within Ukraine’s borders (eager as these countries are to see Moscow defeated), as long as the conflict does not lead to the use of weapons of mass destruction. So far, these invisible rules have continued to function, proof that neither U.S. President Joe Biden nor Russian President Vladimir Putin wants a wider war.
“Yet a wider war is certainly possible… One possibility is sheer accident. Th e other is a cycle of events that “demands” escalation. To be sure, these possibilities can converge, and a single accident could be the pretext for an escalatory spiral—as occasionally occurred during the Cold War… The war’s invisible rules may be fully apparent to Putin but less so to his commanding officers, many of whom are dealing with the frustration of battlefield setback, equipment problems, inadequate manpower, and a Ukrainian military that has fought with skill and resolve. Their adventurism could encourage an air or missile strike outside of Ukraine—for example, to halt the passage of weapons into Ukraine. Th at, of course, would be a Russian attack on a NATO member state, and not because the Kremlin directly made a risky choice. Th e risk, of course, is that Washington would interpret such an attack as Kremlin-directed escalation. Having based his entire war on prevarication, Putin might have no credible means of changing this interpretation and no ability or willingness to communicate a mistake. A Russian-NATO war would be imminent…
Russia announced that it will cut gas flows through the Nord Stream 1 pipeline to just 20% of capacity, which will reduce the ability to Western European customers to build up gas storage supplies in advance of winter. Russia clearly plans to use gas supply as a means to pressure on Western European nations to reduce their support for Ukraine, and to put more pressure on it to reach a negotiated end to the war that includes ceding some territory to Russia. As Lionel Barber wrote in the Financial Times, “Putin’s stamina for war will test the West’s resolve.”
Economy
The Financial Times’ Martin Sandbu published a thought provoking column on “Reasons to Think Differently About Inflation” that is in line with out own thinking at The Index Investor and Retired Investor. He argues that the current inflation was largely caused by a series of supply shocks due to COVID and war in the Ukraine. Given this, he notes that rising food and fuel prices, declining real wages (due to rising inflation) and the gradual withdrawal of COVID-related fiscal stimulus are now reducing demand relative to supply (which has not yet fully recovered). Sandbu acknowledges that a further concern by policymakers is the entrenchment of a wage/price spiral, where “people could come to expect current high inflation to continue, and their behaviour to protect themselves against that will make this a self-fulfilling prophecy.”
However, in another column Sandbu pointed out weaknesses in the wage-price spiral argument. “The wage-price spiral depends on not one but two mechanisms: wage demands trying to catch up with price rises and price increases to pass on rising wage costs… Theoretically, you can prevent a wage-price spiral by disabling either of its two links: workers’ attempt to protect (or increase) their real wage, or businesses attempt to protect (or increase) their profit margin or real return” (The Class Warriors at the Bank of England). To this we would add that, in comparison to the 1970s when there was evidence of a wage-price spiral at work, in today’s world both worker and companies have much less pricing power than they did then. In the case of workers, this is due to factors like reduced unionization, greater global labor competition, and increased use (and potential use) of automation technologies. In the case of companies, globalization and increased competition are both at work in many (if not all) industries.
For these reasons, we continue to believe that the emergence of a sustained wage/price spiral is very unlikely. In the short term we believe the most likely scenario is overshooting in the other direction, as central banks raise interest rates and accelerate the decline in demand that is already underway due to rising energy and fuel costs and spiking uncertainty and anxiety. Higher rates will also very likely trigger debt servicing problems that will accelerate the drop in demand.
CALPERS, the United States’ largest public sector pension fund, reported a preliminary 6.1% portfolio loss for the fiscal year ended June 30, 2022. This likely understates the magnitude of the loss, as 18% of Calpers’ portfolio is invested in private equity and debt funds, which are valued on a mark to model rather than mark to market basis. Its public equity investments lost 13.1% and its public fixed income investments lost 14.5%. In fact, eventual losses on private equity may be larger than this, because in recent years these funds have made investments at very high valuation multiples and employed a lot of leverage. When market valuations are rising, this leads to higher returns. However, when market valuations are falling and interest rates are rising, they work in reverse, with a vengeance.
CALPERS’ losses are important because they are likely to be similar at other public sector pension funds (or more likely worse because of these funds lower allocations to private equity and debt). Since many of these funds have low ratios of the market value of their assets to the present value of their future liabilities to pension beneficiaries (the so called “funded ratio”), this will once again raise the specter of either higher employer contributions to public pensions (which, absent tax increases, will force spending cuts elsewhere in their budgets), or possible future cuts to benefits for retirees. Either or both will be highly controversial, and will almost certainly trigger political conflicts when they are raised.
Society
Two new articles remind us that potentially dangerous emerging social trends aren’t limited to Western nations. Bloomberg New Economy Daily reported that “Soaring university enrollment and graduation rates in China over the past couple decades — instead of building the innovation prowess of the world’s second-biggest economy — have instead produced to some 15 million young adults who are jobless and slashing their professional goals.” This immediately brings to mind Peter Turchin’s findings about the disruptive potential of elite overproduction. The article concludes that, “The crushed ambitions across the younger generation are a stark warning sign for officials.”
Not unrelated to this was an article in The Economist: China’s Mental-Health Crisis Is Getting Worse. “China’s youth unemployment rate has shot up to 18.4%. Don’tcomplain too much, though, lest the state take notice. Censorship, surveillance and oppression, on the rise ahead of a Communist Party congress later this year, add to the anxiety.”
From a national security perspective, an increasingly restive population would very likely raise the probability that Xi Jinping will decide to stoke nationalist sentiments through increasingly aggressive actions towards Taiwan and the United States.
Politics
Ruy Teixeira’s latest Substack post is titled Working Class and Hispanic Voters Are Losing Interest in the Party of Abortion, Gun Control and the January 6th Hearings. He observes that in recent polls, “the lack of Democratic support among working class (noncollege) voters is striking. Democrats lose among all working class voters by 11 points, but carry the college college educated by 23 points. This is less a class gap than a yawning chasm… It is difficult to avoid the conclusion that Democrats’ emphasis on social and democracy issues, while catnip to some socially liberal, educated voters, leaves many working class and Hispanic voters cold. Their concerns are more mundane and economically-driven. This is despite the fact that many of these voters are in favor of moderate abortion rights and gun control and disapprove of the January 6th events. But these issues are just not salient for them in the way they are for the Democrats’ educated and most fervent supporters…
“Strong progressives clearly live in a different world than Hispanic and working class voters. In strong progressive world, views on abortion, gun control and January 6th fit neatly into an overarching set of sociocultural beliefs that are highly salient to them and increasingly drive the Democratic party’s priorities and rhetoric. Hispanic and working class voters lack this overarching set of beliefs—in fact, don’t share many of them—and are much more concerned with the basics of their material lives. It should thus be no surprise that these voters are increasingly losing interest in the party of abortion, gun control and January 6th.”
Obviously, the trends highlighted by Teixeira bode ill for the Democrats chances for retaining control of the House and possibly the Senate in November. However, it also raises serious doubts about their ability to retain the presidency in 2024. Doing appears to depend on the Democrats nominating someone other than Joe Biden and at the same time abandoning many progressive positions in favor of more centrist ones, as well as Donald Trump winning the Republican nomination and driving more people away from the Republican party. Currently, the chances of all three happening appear to be very low.
Background to Our Methodology and Model Portfolio Results
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%).