New Global Macro Evidence and Forecasts
“We underrate the unpredictability of the future because we overrate the inevitability of the past” — Marc Andreessen
Technology
Becoming an AI-Fueled Organization is Deloitte’s new report on the state of AI in the Enterprise. The first key theme is the interacting processes of technology improvement, organizational adoption, and the need to modify processes, staff, structure, and culture to realize the full benefits of AI. The second is the accelerating rate at which this is happening, and the benefits accruing to those organizations that are overcoming the obstacles to making these changes.
AI leaders “view AI as a key element of business differentiation and success and set an enterprise strategy that is championed from the top”… “They establish new operating models and processes that drive sustained quality, innovation, and value creation”… “Over the past few decades, the pace of business and technology change has quickened, requiring workers to adapt, perpetually learn new skills, and make decisions amid growing ambiguity. For many organizations, these shifts have challenged a critical facet within their organization: their culture”…“Since data is intrinsically intertwined with AI, raising the level of data literacy across the organization is key to AI success. While for some this involves advanced data capabilities, for the majority it means building the critical thinking skills needed to ask the right questions and the data fluency needed to find the right data to solve problems in their everyday work… “AI fueled organizations nuture a trusting, agile, data-fluent culture and invest in change management to support new ways of working.”
For those of us who lived through the evolution of Business Process Reengineering in the 1990s, these themes are very familiar. Then too, the initially slow rate of BPR adoption due to the time required adapt organizations led many to underestimate the eventual scale of its impact. The same thing is almost certainly happening today with respect to artificial intelligence.
Energy and Environment
In Is Heating Homes With Hydrogen All But A Pipe Dream? An Evidence Review Jan Rosenow concludes that, “Despite the significant attention heating that hydrogen has received, independent evidence does not support widespread use of hydrogen for space and hot water heating. This review of the evidence identified 32 independent studies, and none of them provides evidence that would support the case for widespread use of hydrogen for heating.”
Underwater explosions closed down the Nord Stream 1 and 2 pipelines carrying natural gas from Russia to Western Europe. As Russian gas supplies had already been cut, many analysts interpreted this incident as a covert warning to Western nations by Russia that continued support for the Ukraine could lead to further physical and/or cyber attacks against their critical energy infrastructure this winter.
Writing in the Financial Times, Pierre Andurant provided this critical data point: “Much European gas demand comes from heating. If Europeans just lower thermostats in their homes by an average of 3C — from 22C (72F) down to 19C (66F) this winter — that could make a big difference” (How Europe Can Adapt to Living Without Russian Gas for Years).
National Security
Following his 21 September speech announcing a broad military mobilization, and rushed “referendums” in four occupied Ukranian territories, on 30 Sept Vladimir Putin announced their annexation by Russia. Statements made by Putin in his speech were interpreted as a further threat to possibly use nuclear weapons: “I want the Kyiv authorities and their real masters in the West to hear me, so that they remember this. People living in Luhansk and Donetsk, Kherson and Zaporizhzhia are becoming our citizens. Forever… We will defend our land with all the powers and means at our disposal … The United States is the only country in the world that has twice used nuclear weapons, destroying the Japanese cities of Hiroshima and Nagasaki, and setting a precedent."
As one analyst has recently noted, “Putin, who has staked everything on this war. He can’t win, but he can’t afford to lose either, so he relies on cannon fodder… The mobilization is a sign of desperation on the part of Putin… So humiliating is the prospect of a defeat that he is determined to continue the war at any cost, because he hasn’t achieved the vague goals that he set for himself in February. And since Putin has long since turned his regime into a sultanate, nothing and nobody can stop him: not his advisers and not the leaders of the states that he regards as his allies…
“Putin’s frustration and fury about this losing war and his determination to escalate hostilities became apparent in the initial days of the successful Ukrainian counterattack. At first, his answer was missile strikes against Ukraine’s critical infrastructure, such as electric power stations and waterworks. These tactics, however, were a clear admission of weakness rather than a display of strength. By destroying critical infrastructure on territories that he regards as his own, he was revealing that he knows Russia has no hope of actually subjugating and assimilating them” (Putin’s Roulette, by Andrei Kolesnikov).
So how does Putin plan to survive, as the Ukranian Army regains territory and Russian army morale declines towards the point of collapse? Between the mobilization, annexation, and Putin’s cutoff of natural gas supplies to Western Europe will weaken Western support for the Ukraine, the short-term probability of a negotiated end to the war on terms acceptable to the Ukraine has significantly declined.
However, the likelihood that Russia can defeat the Ukraine through sheer mass and attrition (using newly mobilized but poorly trained, equipped, and led troops) still seems low.
In addition, any perceived Russian defeat at the hands of the Ukraine is almost certainly unacceptable to Putin, as it could pose an existential risk to his rule, if not his life.
What does that leave? Putin might see a defeat of Russia by NATO far more attractive, provided he could remain in power. And how might that defeat be brought about? Through the use of a battlefield nuclear weapon that triggered a powerful (but non-nuclear) NATO response, to which Russia would respond with cyber and other non-nuclear attacks on Western energy infrastructure that would lead to the end of the war. Putin has been characterized as a gambler. Facing his own destruction, the probability he could make this gamble, while still unlikely, increases with every Ukranian battlefield victory.
If he does, the critical uncertainty is whether Putin’s order to use a nuclear weapon would be carried out by the Russian military, in light of their perception of the tradeoff between uncertain and almost certainly terrible consequences for their nation (and possibly themselves and their families) and the potential benefits for the leader who initiated the war.
Some commentators have claimed that our current situation is reminiscent of President John F. Kennedy’s key lesson from the Cuban Missile Crisis: “Above all, while defending our own vital interests, nuclear powers must avert those confrontations which bring an adversary to a choice of either a humiliating retreat or a nuclear war.” Yet Russia’s invasion of the Ukraine and the destruction and horrors that have happened since February have also made supporting the Ukraine about as clear a moral imperative as the West has faced in years. And Putin himself seems to be upping the (nuclear) ante, in an attempt to force Western nations to throw the Ukraine under the proverbial bus – which would, psychologically and politically, almost certainly have an intensely corrosive effect on the West, in ways few appreciate (save Putin and those of us old enough to remember Srebrenica, which happened on a far smaller scale). Today Western leaders face a challenge we have not seen in years.
Technology surprise has always been a major national security concern (e.g., as evidenced by this report and this one). That is an even greater uncertainty today, given the rapid pace of development across multiple technologies, as well as innovations in combining them to achieve different effects. In Drone Swarms Aren’t Science Fiction. America Must Meet the Threat, author Steven Bucci begins by observing that, “A CIA cyber analyst once told me: ‘There is a difference between fantasy and science fiction. Fantasy cannot happen, it is wizards and dragons (apologies to ‘Harry Potter’ and ‘Game of Thrones’ fans), but science fiction is different. We can’t really do it now, but we will in the future, and probably much sooner in the future than you and I think today.’” He goes on to note that, “a swarm is a fleet of unarmed aerial vehicles that may be targeted as a unified whole, either autonomously or directed by a small number of operators in order to overwhelm the defenses of a target or target set…
“Presently, a swarm of 1,000 drones could overwhelm the defenses of any major target in the U.S. or our overseas assets. The drones could penetrate production facilities, critical energy production or transmission infrastructure, cities, military bases, government buildings, commercial, shipping critical to the supply chain, or our warships at sea. They certainly could disrupt the normal functioning of any large metropolitan area for a significant amount of time. As a true nightmare scenario, a 10,000-drone swarm would be unstoppable… Is this story completely nonsense? Consider this: Today, you can purchase a 1,000-vehicle swarm of DJI Phantom 4 drones from Amazon for just over $2 million. Lots of legitimate uses exist for such a swarm, but they easily may be turned to deadly purpose.”
The Economy
Hurricane Ian’s destructive path across Florida has once again highlighted the threat to the property and casualty insurance industry from climate change, as well as increased development in areas subject to severe natural disaster risks (e.g., earthquakes on the West Coast, wildfires in the Mountain West, and hurricanes along the Gulf and East Coasts). Worsening losses have already led to increased in the price of private carrier insurance coverage, where it can still be obtained (e.g., in Colorado, some insurance companies have stopped writing fire insurance as the area subject to increasingly destructive wildfires has grown). In California the shortage of earthquake coverage has led to it being provided by a state pool. Ditto for hurricane coverage in Florida, and, soon perhaps, wildfire coverage in the Mountain West. All of this coverage has been priced below what actuarial analysis concludes is reasonable to cover projected losses.
In financial terms, what we have now is a number of state governments that have been selling volatility – which is a great and profitable business, right up to the point that it’s not. Even worse, they have been doing it knowing full well that day will one day come, and they will be faced with payouts far above what they have collected in premiums and earned on their investments. The big question is who will then end up paying? Could a state sell bonds to cover its losses? But since those bonds need to be repaid, would taxes increase? And/or what areas of the budget would be cut? Or would a state demand to be bailed out by the Federal Government? But again, at what cost to the taxpayers and/or the budget? In many ways, this is similar to the questions raised by the ticking time bomb that is poorly funded state defined benefit pension plans. But at this point, nobody knows what will happen when the inevitable crisis arrives.
Is China Running Out of Policy Space to Navigate Future Economic Challenges? Clark and Dawson from the Federal Reserve Bank of New York observe that, “After making progress slowing the pace of debt accumulation prior to the pandemic, China saw its debt levels surge in 2020 as the government responded to the severe economic slowdown with credit-led stimulus. With China currently in the midst of another sharp decline in economic activity due to its property slump and zero-COVID strategy, Chinese authorities have responded again by pushing out credit to soften the downturn despite already high levels of debt on corporate, household, and government balance sheets…
“International experience suggests that rapid buildup of debt is often followed by financial crises or at least extended periods of much slower economic growth. Thus far, China has managed to avoid a severe day of reckoning, and Chinese authorities are still viewed as having considerable policy tools to manage the nation’s economy and associated financial risks…
“Despite this unique array of policy tools, China has not been immune to financial turbulence over the past decade. China experienced an interbank market crisis in 2013, equity market busts in 2007 and 2015, massive capital outflows in 2015-16, a spate of bank failures in 2019, and most recently a crisis in its property sector accompanied by additional pressures on parts of its banking sector. Against such a backdrop, there are strong reasons to be watchful for signs of a sustained downshift in China’s historical pattern of economic performance. First, there is evidence that China’s credit-driven growth model is facing serious diminishing returns, as shown, for example, in the high and steadily increasing incremental capital to output ratio and rising credit intensity. The decline in the “GDP bang for the credit buck suggests that the old playbook of turning on the credit spigots will be less effective than in the past, while leading to the potential for increases in bad debt…
“Second, fiscal and monetary policies appear to face political and institutional constraints that may not be readily apparent from the data. On the fiscal side, even though official debt levels appear quite manageable, local governments are experiencing rapidly increasing debt burdens that remain hidden in local government affiliated enterprises and financial institutions. Based on China’s historical precedent, addressing these issues will likely take years of reform and fiscal tightening, which will create an additional drag on growth. On the monetary side, the authorities likely face constraints on cutting interest rates and reserve requirements for fear of sparking capital outflows or weakening banks’ profitability and encouraging additional buildups of risky borrowing.
“Finally, China faces other important challenges that will represent a sharp departure from the conditions it has experienced since Deng Xiaoping launched the country on its path of economic reform roughly four decades ago. Most profoundly, China’s demographic profile is aging quickly, which will greatly increase old-age dependency and lead to a reduction in the working population. Moreover, as its share of global trade stops rising, China’s export engine eventually will downshift to a growth rate similar to that of world trade, or perhaps even lower. Against this backdrop, the medium- to long-term outlook for China’s economy will likely hinge more than ever on the quality of its economic and institutional policies”, which as we’ve noted multiple times, are in many ways weak.
The significance of this in the context of Taiwan is that worsening domestic economic performance, and the associated rise in social and political tensions, is likely to tempt Xi Jinping to move sooner rather than later against Taiwan, as other authoritarian governments have in the past under similar circumstances.
Society
While they are difficult to measure individually, and accurately assessing the potential consequences of their interactions is notoriously difficult, we ignore evolving social trends at our peril.
A great example of this is found in a new book by John Clifton, Gallup’s CEO. It’s title provides a pithy summary of the issue: Blind Spot: The Global Rise of Unhappiness and How Leaders Missed It. Clifton notes that “anger, stress, worry, and sadness reaches record highs in 2021”, based on surveys Gallup conducted of people around the world. Why? Clifton argues (with a lot of data) that this is due to declines in each variable in his “wellbeing” model, which includes how people feel about their (1) work, (2) community, (3) physical health, (4) financial security, and (5) relationships with family and friends. People with the highest level of wellbeing “have five things in common: They are fulfilled by their work, have little financial stress, live in great communities, have good physical health, and have loved ones they can turn to for help.” Clifton argues that “wellbeing inequality” is even more important than income inequality for explaining growing social malaise and anger around the world. But leaders (if not some analysts like Martin Gurri or Joel Kotkin) have mostly missed this trend, because they were more focused on traditional measures like GDP growth and unemployment.
Lee Siegel’s provocative new essay is a good example of Clifton’s points. In Antidepressants, Empathy, and Democracy, he begins with this observation: “You can learn much about what a civilization lacks by observing what sentiments it elevates as an ideal. The ancient Greeks, who invented the concept of the “golden mean” between extremes, were, on the basis of Greek tragedy and historical accounts, given to wild eruptions of rage. For years now, Americans have exalted empathy as our king of sentiments, but on the evidence of everyday life, empathy is in short supply. We’re surrounded by polls, studies, memes, and viral events said to reveal or shape our national existence. It could be, though, that the social forces that most determine our collective destiny are barely talked about because they are impossible to quantify. To take one profoundly consequential trend: nearly one in four American adults is taking psychiatric medication, and a substantial portion of these people report experiencing “emotional blunting”—an inability to feel their own and other people’s emotions.”
“We all hear sophisticated explanations for the divisions in America now: political, cultural, social, historical. They are all legitimate, in one degree or another. But it seems to me that the widespread use of drugs that can abolish our ability to empathize with what another person is feeling risks creating a collective hell—even if it is a living, functional, and sometimes even pleasurable and gratifying one…Yet in a democratic society, where individual freedom abounds at historically unique levels, empathy is indispensable. In a dictatorship, it doesn’t matter if you’re aware of another person’s inner state; the regime regulates relations between people. In a democracy, however, the people themselves regulate the relations between them. In order for that arrangement to proceed harmoniously, people must grasp what others are feeling…
“If it is true that the essence of a functioning democracy is the ability of its people to feel empathy for one another, then the widespread reliance on antidepressants—and I lament not their necessary use, but their unnecessary overuse—is like some cruel joke. Add to the pharmacological cultivation of emotional blunting the emotionally blunting effect of lives lived increasingly online, and you have a democracy resting on a fundamentally anti-democratic way of life.”
As the father of three young men, I strongly recommend Richard Reeves’ new book, Of Boys and Men: Why the Modern Male Is Struggling, Why It Matters, and What to Do about It. He also discusses it in a very interesting podcast with Andrew Sullivan. Both are filled with great insights about a critical and destructive social issue that we too rarely discuss – the decline of men across multiple metrics, and the implications of that for our society, economy, national security, and politics. For the far left, masculinity is toxic. Reeves notes that when he asks people who rail against toxic masculinity to describe what healthy masculinity looks like, they are usually speechless. He also notes that the far right is no better, as it rails against toxic feminism and promotes and angry hyper-masculinity in response. There is a middle ground, and both our sons and our daughters need to be aware that it exists.
Politics
Georgia Meloni’s election victory in Italy (leading a coalition of right wing parties) first led to a set of fear-based stories on gains by right wing populist parties, which were soon replaced by more sober views. To be sure, Meloni is a conservative, but there are no signs she is, as was claimed by some, a “fascist” (i.e., an ideology that exalts the nation or race above the individual). As one writer noted, these days Vladimir Putin is far more fascist than Georgia Meloni. That said, the now faces the same challenge as other candidates from the ideological extremes that win office: How to govern effectively. Either her failure or her success will be interesting indicators to watch for.
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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%).