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Paul Brodsky: "Expect The Unexpected. It Might Be Time To Duck And Cover"

From Paul Brodsky of Macro-Allocation Inc.

Shift Happens

The Economist ran a special report October 3 entitled “The sticky superpower”, a long essay that questioned America’s ongoing status as an effective global economic and monetary hegemon. At times the report was unsparing in describing today’s reality: “the global monetary system is unreformed, unstable and possibly unsustainable” and the world has no “credible lender of last resort”.

The piece is noteworthy in that the Economist has a reputation for editorial conservativism; not in the libertarian sense, but in a politically centrist sort of way. It encourages a not-so obtrusive form of Keynesian economics, supporting reasonable fiscal, monetary and trade policies conjured, executed and overseen by enlightened authorities. Unlike the far Right, the magazine seems willing to play along with the notion that free market capitalism actually exists, even though the political environments in which our economies produce and distribute resources do not allow broad failure, economic contraction, or price and wage scales to be set by the marketplace. Its center-Right orientation accepts government participation as necessary when “animal spirits” drive the marketplace and capital markets to extremes. The magazine also implicitly abides un-extinguished credit as an acceptable driver of demand, and, by implication, of economic cycles.

And so one could not read the essay without marveling how far the public conversation has shifted. Suggesting a few short years ago that the global financial architecture might very well fail to overcome compounding leverage, naturally slowing output growth, and conflicting trade incentives was economic blasphemy, radical rantings uttered only on the fringe.

To be sure, the Economist supports the current regime where nation-state policies guide and support the commercial marketplace and capital markets, and in which sound fiscal, trade and monetary policies are supposed to provide solutions: “What the world needs is an engineer to design smart ways to tame capital flows, a policeman to stop beggar-thy-neighbor policies, a nurse to provide a safety net if things go wrong, and a judge to run the global payments system impartially”. It is a Keynesian call to arms – an S.O.S. – and its provenance is startling.

The report needed an antagonist to advance the narrative, and used China. It suggested political competition brewing in which the US and China compete to dominate trade and soft power over other national economies, concluding “China will not be a counterbalance to or substitute for America soon”. The report’s main concern: “so what will fill the vacuum?”

The piece had a curious conclusion; a happy ending possible through the suspension of disbelief. It called for “a fantasy American administration and Congress (that would) act in its own enlightened self-interest…to the benefit of the world.”

The point of the report seemed to be the need for better manipulation of producer, consumer and investor incentives…and soon. Things are beginning to seem ominous to the political center. It might be time to duck and cover.

Intermission

We took the liberty of updating Billy Joel’s “We Didn’t Start the Fire”:

Billy Clinton, Robert Rubin, Alan Greenspan,
Vlady Putin, dubya, nine-eleven, off to Tehran…

Hank Paulson, Countrywide, Bear Stearns, no place to hide,
Lehman Brothers, all the others, quite a Black Swan…

Save the bank, Dodd Frank, Gentle Ben, tell us when,
QE, Obamacare, Vlady Putin’s back again…

Nukes for Iranians, Janet Yellen has no friends,
ZIRP, ISIS, buy the dips, Donald Trump in the chips…

We didn’t start the fire
Their model’s forecast
That we’d start to hire…

Political Shades of Gray

These days it’s hard to tell the players without a scorecard. Actually, we know the players, but the challenge now is in recognizing which team each player is on. As it stands, Janet Yellen, the Chair of the Fed, is publicly jawboning a rate hike while Christine Lagarde, the Managing Director of the IMF, is warning against one. Meanwhile, Larry Fink, Chairman of the world’s largest asset manager is openly touting interest rate normalization while Larry Summers, the third of three de-activated members of Time magazine’s Committee to Save the World, can’t seem to get enough air time to argue against it. And those are just the progressives.

Geopolitical alliances are also not as straightforward as they once were. We know Russia’s Crimean annexation triggered broad sanctions by a US-led coalition; however, Russia’s help was instrumental in allowing the West to negotiate the Iranian nuclear agreement. Meanwhile, the US in the process of cozying up to Iran and Russia as it shifts its position on Syria, signaling it will let Bashar al-Assad stay in power. (What will this mean for US relations with Israel or the Kurds?) It seems “the enemy of our enemy is our friend” has evolved into “our enemies are our friends, but being our friends may not be such a prize”.

Speaking of Syria, the mass emigration of Syrian refugees into Germany has caused major riffs between Angela Merkel’s and one of her staunchest backers, the state of Bavaria, which is suffering from the massive inflow. If you want a friend in Washington (or Berlin), get a dog.

The relationship between the two largest global economies, the US and China, is also becoming more complicated. The countries directly exchange nearly $600 billion of goods and services annually, and yet China’s construction of potentially militarized islands in the South China Sea endangers America’s absolute hold on global shipping lanes, which has given the US enormous influence not only over materials and energy destined for China, but also over the entire region’s bilateral trade.

Sino-American relations have been further complicated through China’s successful establishment of the Asian Infrastructure Investment Bank (AIIB). The Bank was formed to give sovereign borrowers an alternative to the World Bank and IMF - US dominated lending organizations that dole out American soft power around the world. The only major nation absent from the AIIB’s founding was the US.

And what really happened behind the scenes that prompted the sudden opening of diplomatic relations between the US and Cuba this year? We don’t know, but the point is it occurred.

Clearly, things are changing quickly around the world, as they were destined to at some point. Following the demise of the Soviet empire, the US stood as the world’s only superpower, enjoying almost absolute control over the global monetary system and terms of trade. This unilateralism would eventually have to be challenged and current events seem to suggest that the geopolitical landscape is now experiencing major tremors. They have become so obvious and frequent that the established order (i.e., the Economist) cannot ignore it.

There is little in the political dimension today that investors can hang their hats on. It would be a mistake to assume that stated positions or even ostensibly bedrock principles are static, whether they are related to geopolitics or trade, fiscal, tax and monetary policies. Warm, fuzzy political blankets we can wrap ourselves in to escape the reality that politics = expedience are gone. We should expect the unexpected.

Shift Happens

Eventually, and then all at once, “over time” becomes yesterday. The future becomes the past. Hopes are tested. Expectations are met, or not. Time moves on and only then do we know what we don’t know now.

Most investors don’t take kindly to change. “The market” chooses to stay in the here and now; each human component vibrant and alert while the whole is passive and inert…like a herd of wildebeests, protected by its mass and collective wisdom that each one of them is statistically safe from lions as long as they stay together.

In the current investment environment, marked by near zero sovereign interest rates, tight credit spreads, full equity valuations, over-leveraged balance sheets, expedient politicians performing daily volume triage, and policy makers stringing new high wires and walking them without a nets; risk-adjusted opportunity lies in change.

The Economist’s special report should be taken seriously, if not for its conclusion than for its mere existence. They don’t normally do hyperbole, but they surely did this month.

Our challenge is to imagine where the wildebeests will be, and our sense is that the herd will migrate over time towards liquidity. With the return on money near zero, we don’t feel intense pressure to pick when it will go there, at least for our MACAW portfolio.