New Global Macro Evidence and Forecasts
National Security
In the October 2020 edition of The Index Investor, we published a long analysis of an emerging threat: Will Xi Jinping Launch a Surprise Attack on Taiwan Before the 20th Party Congress of the CCP in November 2022? And What Happens if He Does? We updated our analysis in March 2021, and issued this warning: The Probability of a US-China War Over Taiwan Is Increasing. In the course of preparing both of these, we assessed a lot of research prepared by other analysts. We concluded that one of the best is Dr. Oriana Skylar Mastro, a former Air Force Intelligence Officer who is now a fellow at both Stanford University and the American Enterprise Institute (AEI).
In an invited column in this week’s Economist, she issued a blunt warning: China’s Huge Exercises Around Taiwan Were A Rehearsal, Not A Signal. “On August 4th, the People’s Liberation Army kicked off the largest and most sophisticated military exercises it has ever conducted. Over the course of a week, the Chinese launched dozens of missiles and conducted drills near Taiwan with 100 aircraft, ten destroyers and support vessels. Submarines and aircraft carriers also played a role. The display has made the third Taiwan Strait crisis, which occurred between 1995-96, when China conducted four rounds of tests over the course of several months with barrages of no more than six missiles look like child’s play... Compared with 1996, China’s forces today are barely recognizable… Now China’s armed forces are comparable to America’s in quality and quantity… But even with all these improvements it is unclear whether China could take Taiwan by force. China has not fought a war since 1979…
“An amphibious attack, and to a lesser degree a blockade of the type the exercises off Taiwan were simulating, would demand complex joint operations (involving army, air force and navy), which in turn require impeccable logistics and command and control. Xi Jinping, China’s leader, launched a massive organisational reform to improve in these areas, and the PLA undoubtedly has. But the war in Ukraine may have given him heightened anxiety, given that the Russians struggled precisely with logistics and command. For this reason we should see the massive exercises off Taiwan less as a signal, and more as a rehearsal for combat… China will seize the opportunity to practise as much as possible. It has announced already that thisround of exercises will continue and that another round in the Bohai Gulf/Yellow Sea is next. And it won’t just be large-scale exercises. It is unlikely that Beijing will return to its previous level of operations. Instead China might attempt to normalise greater Chinese activity around Taiwan. That makes war more probable.”
In People Win Wars: A 2022 Reality Check on PLA Enlisted Force And Related Matters, Clay, Blasko, and Lee conclude that, “The people of the PLA remain the weakest link of China’s defense modernization effort…and this may have direct consequences for Chinese Communist Party leaders’ calculations on the use of force — especially their confidence in initiating conflict.
In A Bloody Mess With Terrible Loss Of Life: How A China-US Conflict Over Taiwan Could Play Out, Breaking Defense reported that, “Early results from a the Center for Strategic and International Studies’ wargame suggest the US would prevail in defending Taiwan from China, but at a heavy cost that would leave it ill-prepared for new threats from Russia or Iran…The simulation made some significant assumptions, but the results so far suggest that if the US intervened, it could likely prevent a complete takeover or at least reach a stalemate. But any successes would be marred by heavy losses on both sides in terms of ships, planes, submarines and, most importantly, people…
“’It is a very tough sell for China such that if Taiwan resisted and the US came to Taiwan’s aid, there’s an extremely low possibility that China would be successful,’ said Matthew Cancian, who partnered with CSIS as one of the wargame’s chief architects. ‘But, the US takes a lot of losses… In a lot of games, the US will lose almost its entire global fleet of tactical aviation.’ CSIS had not finished calculating the number of assets lost across all its games by the time of publication, but, in general, project staff said the US usually loses around 500 aircraft, 20 surface ships and two aircraft carriers per game — a staggering loss unseen for the US since World War II, in just a matter of weeks. The loss of the carriers alone – the US has only 11 total, and each carries at least 5,000 souls — would have potentially disastrous results on the nation’s ability to project power abroad…The wargame, which the think tank is playing out 22 times this year with various defense experts, retired military officers and former Pentagon officials, will culminate in a public report by CSIS in December.” Definitely a report you’ll want to read.
The Economy
A new paper from the IMV (Housing Boom and Headline Inflation: Insights from Machine Learning) conclude that, house prices are a leading indicator of headline inflation in the US and eight other major economies. Moreover, in the near term, “for most countries, two housing components (rent and owner-occupied housing cost) could have a relatively large and sustained impact on headline inflation, as broad inflation measures are just starting to reflect higher house prices.”
Without acknowledging it, passage of last year’s Infrastructure bill, this year’s CHIPS Act, and now the strangely named Inflation Reduction Act, the United States has made a major bet on infrastructure policy. Unfortunately, there are reasons to be skeptical about whether their expected benefits will be realized, and one big one to be scared of unintended social and political consequences. With respect to infrastructure, Professor Bengt Flyvbjerg’s research provides ample evidence of why many infrastructure projects experience cost overruns, schedule delays, and deliver less than they promised. Larry Summers famous column on Cambridge’s Anderson Bridge project is a microcosm of what almost certainly lies ahead. Regarding the CHIPS act, a largely unacknowledged obstacle is the shortage of STEM and manufacturing talent in the United States (which is related to the stagnation of the nation’s K-12 education results). At some point, these issues will become more widely recognized.
The Inflation Reduction Act has three major initiatives: $369 billion for energy security and climate change projects, largely in the form of subsidies for expanded green investments. My concern is that, apart from a new credit for battery storage investments, the Act is too focused on stimulating more investment in wind and solar (e.g., the land requirements for more solar panels are very large, absent a substantial improvement in their efficiency), and too little on improving the efficiency and resiliency of the nation’s electric grid to support a higher percentage of supply from variable generation (ie., from wind and solar).
Our biggest fear is the substantial expansion of the IRS that is expected to add $124 billion to federal revenue. Specifically, a critical uncertainty is the extent to which increased enforcement in the face of worsening inequality will generate more social anger and further strengthen political extremism in the United States. To be sure, the Treasury Department has made statements that this won’t happen. Yet the failure of Congress to include in the Act such obvious revenue raising measures as higher tax rates on the highest incomes, and removal of the carried interest exception makes one skeptical about what will happen if the IRS is falling short of the Act’s expected result of $124 billion more in revenue. If this happens, it will reduce the probability that a Democrat will win the 2024 presidential election.
Technology
In a new paper from the London School of Economics (Ideas, Idea Processing, and Total Factor Productivity Growth in the US: 1899 to 2019), James, Kotak, and Tsomocos observe that, “Innovativity – an economy's ability to produce the innovations that drive total factor productivity (TFP) growth – requires both ideas and the ability to process those ideas into new products and/or techniques.” They find that “(1) innovativity [the ability to generate new ideas] predicts the evolution of average TFP growth; (2) idea processing capability is the binding constraint on innovativity; and (3) average TFP growth declined after 1970 due to a constraints on idea processing capability, not idea supply.” They authors focus on financial markets (e.g., access to capital) as a constraint on idea processing capability, they also observe that much more research is needed into other constraints. As Adrian Wooldrige has observed, a worsening shortage of talent is almost certainly playing an important role, which has negative implications for future TFP and economic growth.
Health
In Distinguishing Features of Long COVID Identified Through Immune Profiling, Klein et al note that, “individuals diagnosed with Long COVID frequently report unremitting fatigue, post-exertional malaise, and a variety of cognitive and autonomic dysfunctions; however, the basic biological mechanisms responsible for these debilitating symptoms are unclear.” In this new paper, the authors describe their breakthrough research, which highlights a set of indicators that clinicians can use to diagnose Long COVID with much greater confidence, and will thus allow much more accurate estimation of the prevalence of Long COVID and its likely future economic impact.
Social
New research from Pew found that “Large shares in many countries are pessimistic about the next generation’s financial future… a median of 70% of adults across 19 countries say they will be worse off than their parents.” Unless this improves, it does not bode well for future levels of social anger and political conflict.
Politics
The FBI executed a search warrant at former President Donald Trump’s Mara-a-Lago club in Palm Beach, Florida, and found a cache of documents marked Top Secret/Sensitive Compartmented Information, the nation’s highest level of classification. Some reports claimed that this included information on nuclear weapons that cannot be declassified – even by the President. It is noteworthy that agents from the FBI’s Foreign Counterintelligence Division allegedly took part in the raid. While Trump supporters predictably reacted vehemently, more sober analysts observed that given the unprecedented of executing a search warrant against a former president, the government would have had to pass a very high bar to get a judge’s approval of it. As such, this reduces the probability that Trump will run again for president in 2024, and, if he does, that we would win both the Republican Party’s nomination and the general election.
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%).