6/2/21: Longer Trends in Economic Uncertainty

 

Quite dramatic trends in terms of rising economic uncertainty over the last 21 years:

And, not surprisingly, the rise of uncertainty in Europe, the U.S., and globally pre-dates the Covid19 pandemic. In fact, Europe has been experiencing dramatically elevated uncertainty levels since the start of the Euro area crisis, while the U.S. saw a virtually exponential rise in uncertainty from 2017 on. Global measures of uncertainty have been running high through 2016 and rose dramatically thereafter. 

While amelioration in the Covid19 pandemic dynamics is likely to lower the levels and the volatility of the uncertainty in global economic systems, it is highly unlikely to return us to the pre-Global Financial Crisis state of affairs.

12/12/20: Hungary's risk improvement in peril

 My comment for Euromoney on changes in sovereign risk profile for Hungary: https://www.euromoneycountryrisk.com/article/b1pjjpq2xr2bfy/hungarys-risk-improvement-in-peril-as-it-bites-the-hand-that-feeds-it. 

3/10/20: Identity & Risk: Financial Services in a Time of Transformation & Uncertainty

 

Delighted to announce that I will bee keynoting October 22 conference Identity & Risk: Financial Services in a Time of Transformation & Uncertainty.

Details here: https://www.ptools.com/draft/conference-home-page/2020-annual-global-virtual-conference.html.

17/9/20: Exploding errors: COVID19 and VUCA world of economic growth forecasts

 

Just as I covered the latest changes in Eurozone growth indicators (https://trueeconomics.blogspot.com/2020/09/17920-eurocoin-leading-growth-indicator.html), it is worth noting the absolutely massive explosion in forecast errors triggered by the VUCA environment around COVID19 pandemic.

My past and current students know that I am a big fan of looking at risk analysis frameworks from the point of view of their incompleteness, as they exclude environments of deeper uncertainty, complexity and ambiguity in which we live in the real world. Well, here is a good illustration:

You can see an absolute explosion in the error term for growth forecasts vs actual outrun in the three quarters of 2020 so far. The errors are off-the-scale compared to what we witnessed in prior recessions/crises. 

This highlights the fact that during periods of elevated deeper uncertainty, any and all forecasting models run into the technical problem of risk (probabilities and impact assessments) not being representative of the true underlying environment with which we are forced to work.  

19/8/20: The VUCA World of World Trade

 

WTO projections for global merchandise trade by volume:

Let's take a closer look. Optimistic scenario is for a 13% y/y drop in merchandise trade flows. Pessimistic one is for a 30% drop. Swing is 17 percentage points. These are not forecasts, but are uncertain guesses. We are in a VUCA world, folks.

Let's take a second look: COVID19 shock will be permanent (new trend line post-recovery is permanently below old trendline and flatter) with a minor impact post-2022 that will compound over longer period of time. In pessimistic scenario, the impact appears to be also permanent, but seriously severe.

On a linear trend projection, pre-2008 consistent trend would have left us at around 155 index reading in 2022. 2009-2019 trend would have gotten us to around 122 index reading. Optimistic scenario would leave us around 119 in 2022; pessimistic - at around 95. Wait... optimistic gap for COVID19 and GFC impacts to no GFC and no COVID19 impact is... 33 points! One third of 2015 annual level of trade activity. GFC but no-COVID19 gap to pre-2008 is between 36 points and 60 points. 

And the final look: notice 2019 line... it is virtually flat. As WTO notes (see Chart 4 here: https://www.wto.org/english/news_e/pres20_e/pr855_e.htm) there was, basically, no growth in trade in 2019, before the COVID19 hit. 

We are in a VUCA world, folks.

25/7/20: Markets and COVID19: Unwinding Restrictions

My column for Manning Financial on the direction of the markets in the period of COVID19 restrictions unwinding: https://cfc.ie/2020/07/10/where-to-mr-market/.

5/5/20: A simple view of Globalization: some thoughts

Globalization in  retreat chart via PIIE: https://www.piie.com/blogs/realtime-economic-issues-watch/pandemic-adds-momentum-deglobalization-trend

A neat visual summary of the extent of economic openness and globalization, via trade dimension alone. The caveats here are that this only captures trade in goods & services flows (see https://fredblog.stlouisfed.org/2017/05/are-you-open/), but ignores capital flows and the extent of globalization-induced complexity within modern economic systems.

We tend to think about globalization as a mass-type measurement, where the volume or the value of flows is what matters. Alas, things are more complex. Mass measurements should be properly adjusted for risks inherent in the flows and stocks, including geopolitical risks. Imagine a flow of goods from China to the U.S. as opposed to the same volume flow of the same goods from China to Ecuador. Geopolitical risks and uncertainties, as well as non-monetary costs/values involved in the two flows are distinct. Similarly, consider a set stock of capital from the U.S. domiciled in, say, the Netherlands as opposed to, say, in Russia. Once again, even when nominal values are identical, risk-adjusted values are distinct.

In simple terms, as neat as the above chart might be, it does not even begin to reflect the VUCA/risk-indicative nature and volumes of globalization-related flows and stocks.

3/5/20: Financial Strength Across Emerging Markets

A somewhat simplified, but nonetheless telling heat map of financial strengths and vulnerabilities across emerging market/middle income economies via the Economist:

I have outlined European economies included (for some strange reason, the Baltics are not in the assessment, neither are Bulgaria, Moldova, etc). The top 9 as well as those ranked 11th, 12th and 15th are economies with no risk category at or below 'moderate'.  The bottom 15 have no risk category within a 'safety' zone.

Have fun with these...

30/4/20: No, Healthcare Systems are Not Lean Startups, Mr. Musk

A tweet from @elonmusk yesterday has prompted a brief response from myself:

https://twitter.com/GTCost/status/1255681426445365248?s=20

For two reasons, as follows, it is worth elaborating on my argument a little more:

1. I have seen similar sentiment toward authorities' over-providing healthcare system capacity in other countries as well, including, for example in Ireland, where the public has raised some concerns with the State contracting private hospitals for surplus capacity; and
2. Quite a few people have engaged with my response to Musk.

So here are some more thoughts on the subject:

'Lean startups' is an idea that goes hand-in-hand with the notion that a startup needs some organic growth runway. In other words, it needs to ‘nail’ parts of its business model first, before ‘scaling’ the model up. ‘Nailing’ bit is done using highly scarce resources pre-extensive funding (which is a ‘scaling’ phase). It makes perfect sense for a start up, imo, for a startup.

But in the ‘nailing’ stage, when financial resources are scarce, the startup enterprise has another resource is relies upon to execute on a ‘lean’ strategy: time. Why? Because a ‘lean’ startup is a smaller undertaking than a scaling startup. As a result, failure at that stage carries lower costs. In other words, you can be ‘lean’ because you are allowed to fail, because if you do fail in that stage of development, you can re-group and re-launch. You can afford to be reactive to news flows and changes in your environment, which means you do not need to over-provide resources in being predictive or pro-active. Your startup can survive on lean funding.

As you scale startup, you accumulate resources (investment and retained earnings) forward. In other words, you are securing your organization by over-providing capacity. Why? Because failure is more expensive for a scaling startup than for a 'lean' early stage startup. The notion of retained and untilized cash is no longer the idea of waste, but, rather a prudential cushion. Tesla, Mr. Musk's company, carries cash reserves and lines of credit that it is NOT using at the moment in time precisely because not doing so risks smaller shocks to the company immediately escalating into existential shocks. And a failure of Tesla has larger impact than a failure of small 'lean' startup. In other words, Mr. Musk does not run a 'lean startup' for a good reason. Now, in a public health emergency with rapid rates of evolution and high degree of forecast uncertainty, you cannot be reactive. You must allocate resources to be pro-active, or anticipatory. In doing so, you do not have a choice, but to over-supply resources. You cannot be ‘lean’, because the potential (and highly probable) impact of any resource under-provision is a public health threat spinning out of control into a public health emergency and a systemic shock. ‘Lean’ startup methods work, when you are dealing with risk and uncertainty in a de-coupled systems with a limited degree of complexity involved and the range of shocks impact limited by the size of the organization/system being shocked. Public health emergence are the exact opposite of such a environment: we are dealing with severe uncertainty (as opposed to risk) with hugely substantial impacts of these shocks (think thousands of lives here, vs few million dollars in investment in an early stage start up failure). We are also dealing with severe extent of complexity. High speed of evolution of threats and shocks, uncertain and potentially ambiguous pathways for shocks propagation, and highly complex shock contagion pathways that go beyond the already hard-to-model disease contagion pathways. So a proper response to a pandemic, like the one we are witnessing today, is to use an extremely precautionary principle in providing resources and imposing controls. This means: (1) over-providing resources before they become needed (which, by definition, means having excess capacity ex-post shock realization); (2) over-imposing controls to create breaks on shock contagion (which, by definition, means doing too-much-tightening in social and economic environment), (3) doing (1) and (2) earlier in the threat evolution process rather than later (which means overpaying severely for spare capacity and controls, including - by design - at the time when these costs may appear irrational). And (4), relying on the worst-case-scenario parameterization of adverse impact in your probabilistic and forecasting analysis and planning. This basis for a public health threat means that responses to public health threat are the exact opposite to a ‘lean’ start up environment. In fact they are not comparable to the ‘scaling up’ start up environment either. A system that has a huge surplus capacity left in it, not utilized, in a case of a start up is equivalent to waste. Such system’s leadership should be penalized. A system that has a huge surplus capacity left un-utilized, in a case of a pandemic is equivalent to the best possible practice in prudential management of the public health threat. Such system’s leadership should be applauded.

And even more so in the case of COVID pandemic. Mr. Musk implies something being wrong with California secured hospital beds capacity running at more than double the rate of COVID patients arrivals. That's the great news, folks. COVID pandemic carries infection detection rates that double the population of infected individuals every 3-30 days, depending on the stage of contagion evolution. Earlier on, doubling times are closer to 3 days, later on, they are closer to 30 days. But, utilization of hospital beds follows an even more complex dynamic, because in addition to the arrival rates of new patients, you also need to account for the duration of hospital stay for patients arriving at different times in the pandemic. Let's be generous to sceptics, like Mr. Musk, and assume that duration-of-stay adjusted arrivals of new patients into the hospitals has a doubling time of the mid-point of 3-30 days or, close to two weeks. If California Government did NOT secure massively excessive capacity for COVID patients in advance of their arrival, the system would not have been able to add new capacity amidst the pandemic on time to match the doubling of new cases arrivals. This would have meant that some patients would be able to access beds only later in the disease progression period, arriving to hospital beds later in time, with more severe impact from the disease and in the need of longer stays and more aggressive interventions. The result would have been even faster doubling rate in the demand for hospital beds with a lag of few days. You can see how the system shortages would escalate out of control.

Running tight supply chains in a pandemic is the exact opposite to what has to be done. Running supply capacity at more than double the rate of realized demand is exactly what needs to be done. We do not cut corners on basic safety equipment. Boeing did, with 737-Max, and we know where they should be because of this. We most certainly should not treat public health pandemic as the basis for cutting surplus safety capacity in the system.

14/2/20: Pandemics, Panics and the Markets

In my recent article for The Currency I wrote about the expected market effects of the 2019-nCov coronavirus outbreak: https://www.thecurrency.news/articles/8490/constantin-gurdgiev-pandemics-panics-and-the-markets.

While past pandemics are not a direct nor linear indicators of the future expected performance, the logic and the dynamics of the past events suggest that while the front end short term effects of pandemics on the economies and the markets can be significant, over time, rebounds post-pandemics tend to fully offset short run negative impacts.

Key conclusions from the article are:

• "...The market appears to worry little about public health risks, after their impact becomes more visible, although the onset of a pandemic can be associated with elevated markets volatility. This volatility is higher the faster the evolution of the health scare, but so is the market rebound from each crisis lows."
• "This is not say that investors have little to worry about in today’s markets. We are still trading in the heavily over-bought market, and concerns about global growth are not getting much of a reprieve from the newsflows. The good news is, to date, the latest global health crisis does not seem to be a trigger for a major and sustained sell off. The bad news is, we are yet to see its full impact."

15/1/20: What Trade Deal Phase 1/N Says About the Four Horsemen of Apocalypse

Phase 1 of N of the "Greatest Trade Deal" that is "easiest to achieve' by the 'stablest Genius' is hitting the newsflows today. Which brings us to two posts worth reading on the subject:

Post 1 via Global Macro Monitor: https://global-macro-monitor.com/2020/01/15/phase-1-of-potemkin-trade-deal-signed-sealed-and-yet-to-deliver/ is as always (from that source) excellent. Key takeaways are:

• "We never believed for one moment that China would cave on any of the big issues, such as restructuring its economy and any deal would be just some token political salad dressing for the 2020 election."
• "Moreover, much of the deal depends on whether the Chinese will abide by Soviet-style import quotas," or in more common parlance: limits on imports of goods into the country, which is is 'command and control' economics of central planning.
• "We are thankful, however,  the economic hostilities have momentarily ratcheted down but the game is hardly over," with tariffs and trade restrictions/suppression being the "new paranormal".
• "Seriously, after more than two years of negotiations, they couldn’t even agree on dog and cat food imports?"

Post 2 via Market Watch: https://www.marketwatch.com/story/phase-one-trade-deal-wont-end-the-uncertainty-in-markets-hsbc-strategist-says-2020-01-15. Key takeaways:

• "The [trade] environment remains very much in flux and a source of concern and challenge for investors".

My takeaways from Phase 1/N thingy: we are in a VUCA world. The current U.S. Presidential Administration is an automated plant for production of uncertainty and ambiguity, while the world economy is mired in unresolvable (see WTO's Appellate Body trials & tribulations) complexity. Beyond the White House, political cycle in the U.S. is driving even more uncertainty and more ambiguity into the system. The Four Horse(wo)men of the Apocalypse in charge today are, in order of their power to shift the geopolitical and macroeconomic risk balance, Xi, DNC leadership, Putin and Trump. None of them are, by definition, benign. 

The trade deal so far shows that Xi holds momentum over Trump. Putin's shake up of the Russian Cabinet today shows that he is positioning for some change in internal power balances into 2020, and this is likely to have some serious (unknown to-date) implications geopolitically. Putin's meeting with Angela Merkel earlier this week is a harbinger of a policy pivot to come for the EU and Russia and Lavrov's yesterday's statement about weaponization of the U.S. dollar and the need for de-dollarization of the global economy seems to be in line with the Russo-German New Alignment (both countries are interested in shifting more and more trade and investment outside the net of the U.S. sanctions raised against a number of countries, including Iran and Russia).

DNC leadership will hold the cards to 2020 Presidential Election in the U.S. My belief is that it currently has a 75:25 split on Biden vs Warren, with selection of the former yielding a 50:50 chance of a Trump 2.0 Administration, and selection of the latter yielding a 35:65 chance in favour of Warren. The electoral campaigning climate is so toxic right now, we have this take on the latest Presidential debate: https://twitter.com/TheDailyShow/status/1217431488439967744?s=20. Meanwhile, debate is being stifled already by the security agencies 'warnings' about Russian 'interference' via critical analysis of the candidates.

Mr. Trump has his Twitter Machine to rely upon in wrecking havoc, that, plus the pliant Pentagon Hawks, always ready to bomb something anywhere around the world. While that power is awesome in its destructiveness vis-a-vis smaller nations, it is tertiary to the political, geopolitical and economic powers of the other three Horse(wo)men, unless Mr. Trump gets VUCAed into a new war.

BoJo's UK as well as Japan, Canada, Australia et al, can just sit back and watch how the world will roll with the Four punchers. The only player that has a chance to dance closely with at least some of the geopolitical VUCA leaders is the EU (read: France and Germany, really). 

16/10/19: Euromoney Risk Survey Q3 2019 Results

Euromoney analysis of Q3 2019 results for country risk surveys and risk outlook forward, with lots of comments from myself and others: https://www.euromoney.com/article/b1hjf7xr90tdkj/ecr-survey-results-q3-2019-us-china-canada-mexico-punished-by-tariffs.

17/1/19: Why limits to AI are VUCA-rich and human-centric

Why ethics, and proper understanding of VUCA environments (environments characterized by volatility/risk, uncertainty, complexity and ambiguity) will matter more in the future than they matter even today? Because AI will require human control, and that control won't happen along programming skills axis, but will trace ethical and VUCA environments considerations.

Here's a neat intro: https://qz.com/1211313/artificial-intelligences-paper-clip-maximizer-metaphor-can-explain-humanitys-imminent-doom/. The examples are neat, but now consider one of them, touched in passim in the article: translation and interpretation. Near-perfect (native-level) language capabilities for AI are not only 'visible on the horizon', but are approaching us with a break-neck speed. Hardware - bio-tech link that can be embedded into our hearing and speech systems - is 'visible on the horizon'. With that, routine translation-requiring exchanges, such as basic meetings and discussions that do not involve complex, ambiguous and highly costly terms, are likely to be automated or outsourced to the AI. But there will remain the 'black swan' interactions - exchanges that involve huge costs of getting the meaning of the exchange exactly right, and also trace VUCA-type environment of the exchange (ambiguity and complexity are natural domains of semiotics). Here, human oversight over AI and even human displacement of AI will be required. And this oversight will not be based on technical / terminological skills of translators or interpreters, but on their ability to manage ambiguity and complexity. That, and ethics...

Another example is even closer to our times: AI-managed trading in financial assets.  In normal markets, when there is a clear, stable and historically anchored trend for asset prices, AI can't be beat in terms of efficiency of trades placements and execution. By removing / controlling for our human behavioral biases, AI can effectively avoid big risk spillovers across traders and investors sharing the same information in the markets (although, AI can also amplify some costly biases, such as herding). However, this advantage becomes turns a loss, when markets are trading in a VUCA environment. When ambiguity about investors sentiment and/or direction, or complexity of counterparties underlying a transaction, or uncertainty about price trends enters the decision-making equation, algorithmic trading platforms have three sets of problems they must confront simultaneously:

1. How do we detect the need for, structure, price and execute a potential shift in investment strategy (for example, from optimizing yield to maximizing portfolio resilience)? 
2. How do we use AI to identify the points for switching from consensus strategy to contrarian strategy, especially if algos are subject to herding risks?
3. How do we migrate across unstable information sets (as information fades in and out of relevance or stability of core statistics is undermined)?

For a professional trader/investor, these are 'natural' spaces for decision making. They are also VUCA-rich environments. And they are environments in which errors carry significant costs. They can also be coincident with ethical considerations, especially for mandated investment undertakings, such as ESG funds. Like in the case of translation/interpretation, nuance can be more important than the core algorithm, and this is especially true when ambiguity and complexity rule.

9/1/2019: Assets with Negative Returns: 1901-present [Updated]

Updating the chart for major assets performance 1901-present, based on data from http://trueeconomics.blogspot.com/2018/12/191218-assets-with-negative-returns.html:

This is epic.

28/12/18: BTCD is neither a hedge nor a safe haven for stocks

A quick - and dirty - run through the argument that Bitcoin serves as a hedge or a safe haven for stocks. This argument has been popular in cryptocurrencies analytical circles of recent, and is extensively covered in the research literature, when it comes to 2014-2017 dynamics, but not so much for 2018 or even more recent period dynamics.

First, simple definitions:

1. A financial instrument X is a hedge for a financial instrument Y, if - on average, over time - significant declines in the value of Y are associated with lower declines (weak hedge) or increases (strong hedge) in the value of X.
2. A financial instrument X is a safe haven for a financial instrument Y, if at the times of significant short-term drop in the value of Y, instrument X posts increases (strong safe haven) or shallower decreases (weak safe haven) in its own value.

So here are two charts for Safe Haven argument:

The first chart shows that over the last 12 months, there were 3 episodes when - over time, on average, based on daily prices, stocks acted as a strong hedge for BTCUSD. There are zero periods when BTCUSD acted as a hedge for stocks. The second chart shows that within the last month, based on 30 minutes intervals data (higher frequency data, not exactly suitable for hedge testing), BTCUSD did manage to act as a hedge for stocks in two periods. However, taken across both periods, overall, BTCUSD only acted as a weak hedge.

The key to the above is,  however, the time frame and the data frequency. A hedge is a longer-term, averages-defined relationship. Not an actively traded strategy. And this means that the first chart is more reflective of true hedging relationship than the later one. Still, even if we severely stretch the definition of a hedge, we are still left with two instances when the BTCUSD acts as a hedge for DJIA against two instances when DJIA acts as a hedge for BTCUSD.

People commonly confuse both hedging and safe haven as being defined by the negative symmetric correlation between assets X and Y, but in reality, both concepts are defined by the directional correlation: when X is falling, correlation myst be negative with Y, and when Y is falling, correlation must be negative with X. The downside episodes are what matters, not any volatility.

Now, to safe haven:

Again, it appears that stocks offer a safe haven against BTCUSD (6 occasions in the last 12 months) more often than BTCUSD offers a safe haven against stocks (2 occasions).  Worse, the cost of holding BTCUSD long as a safe haven for stocks is staggeringly high: some 60-65 percentage points over 12 months, not counting the cost of trading.

In simple terms, BTCUSD is worse than useless as either a hedge or a safe haven against the adverse movements in stocks.

22/12/18: Millennials and Buffetts: It’s a VUCA Investment World

My August 2018 Economic Outlook for Manning Financial:


What unites Warren Buffett, Apple and the financially distressed generation of the Millennials? In one word: cash and preferences for safe haven assets. Consider three facts.

Financial Markets

One: at the start of August, Berkshire Hathaway Inc. gave Buffett more room to engage in stock buybacks, just as company cash holdings rose to USD111 billion at the end of 2Q 2018, marking the second highest quarterly cash reserves in history of the firm. This comes on foot of Buffett's recent statements that current stock markets valuations price Berkshire out of "virtually all deals", just as the company took its holdings of Apple stock from USD40.7 billion in 1Q 2018 filings to USD47.2 billion in 2Q filings. Historically, Berkshire and Buffett are known for their high risk, nearly contrarian, but fundamentals-anchored investments: a strategy for selecting companies that offer long term value and growth potential and going long big. Today, Buffett simply can’t find enough such companies in the markets. His call is to return earnings to shareholders instead of investing them in buying more shares.

Two: on August 2nd, Apple became the first private company in history to top USD1 trillion market valuation mark when company stock closed at above USD207.05 per share. Company's path to this achievement was based on far more than just a portfolio of great products. In fact, two key financial engineering factors in recent years have contributed to its phenomenal success: aggressive tax optimisation, and extremely active shares buybacks programme. In May 2018, the company pledged USD100 billion of its USD285 billion cash stash (accumulated primarily off-shore, in low tax jurisdictions such as Ireland, Jersey and in the Caribbean) for shares buybacks. As of end of July, it was already half way to that target. Apple is an industry leader in buybacks, accounting for close to 15 percent of all shares buybacks planned for 2018. But Apple is not alone. A study by the Roosevelt Institute released in August shows that U.S.-listed companies spent 60 percent of their net profits on stock buybacks between 2015-2017. And on foot of the USD1.5 trillion tax cuts bill passed by Congress in December 2017, buybacks are expected to top USD 800 billion this year alone, beating the previous historical record of USD 587 billion set in 2007. Whichever way you take the arguments, accumulation of tax optimisation-linked cash reserves, and aggressive use of shares buybacks have contributed significantly to the FAANGS (Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG)) dominance over the global financial markets.


The Squeezed Generation

And this brings us to the third fact: the lure of cash in today's world of retail investment. If cash is where Warren Buffetts and Apples of the financial and corporate worlds are, it is quite rational that cash is where the new generation of retail investors will be. Per Bankrate.com July 2018 survey data, 1 in 3 American Millennials are favouring cash instruments (e.g. savings accounts and certificates of deposit) for investing their longer-term savings. In comparison, only 21 percent of Generation X investors who prefer cash instruments, and 16 percent for the Baby Boomers. American retail investors are predominantly focused on low-yielding, higher safety investment allocations. For example, recent surveys indicate that only 18 percent of all American investment portfolios earn non-negative real returns on their savings, and that these households are dominated by the Baby Boomers generation and the top 10 percent of earners. Amongst the Millennials, the percentage is even lower at 7.4 percent.

The conventional wisdom suggests that the reasons why Millennials are so keen on holding their investments in highly secure assets is the fear of market crashes inherited by their generation from witnessing the Global Financial Crisis. But the conventional wisdom is false, and this falsehood is too dangerous to ignore for all investors - small and large alike.

In reality, the Millennials scepticism about the risk-adjusted returns promised by the traditional asset classes - equities and bonds - is not misplaced, and dovetails neatly with what both the largest American corporates and the biggest global investors are doing. Namely, they are pivoting away from yield-focused investments, and toward safe havens. The reason we are not seeing this pivot reflected in depressed asset prices, yet is because there is a growing gap between strategic positioning of the Wall Street trading houses (all-in risky assets) and those investors who are, like Buffett, focusing on longer-term investment returns.


Overvalued Investment

In simple terms, the U.S. asset markets are grossly overvalued in terms of both current pricing (including short term forward projections), and longer term valuations (over 5 years duration).

The former is not difficult to illustrate. As recent markets research shows, all of the eight major market valuations ratios are signalling some extent of excessive optimism: the current S&P500 ratio to historical average, household equity allocation ratio, price/sales ratio, price/book value ratio, Tobin's Q ratio, the so-called Buffett Indicator or the total market cap of all U.S. stocks relative to the U.S. GDP, the dividend yield, the CAPE ratio and the unadjusted P/E ratio. Take Buffett's Indicator: normally, the markets are rationally bullish when the indicator is in the 70-80 percent range, and investors pivot away from equities, when the indicator hits 100 percent. Today, the indicator is close to 140 percent - a historical record.

But the longer run valuations are harder to pin down using markets-linked indices, because no one has a crystal ball as to where the markets and the listed companies might be in years to come. Which means that any analyst worth their salt should look at the macro-drivers for signals as to the future markets pressure points and upside opportunities.

Here, there are worrying signs.

In the last three decades, bankruptcy rates for older households have increased almost three-fold, according to the recent study, from the Consumer Bankruptcy Project (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3226574). This suggests that not all is well amongst the wealthiest retired generation, the Baby Boomers, who are currently holding the vastly disproportionate share of all risky assets in the economy. For example, 80 percent of Baby Boomers own property, accounting for roughly 65 percent of the overall housing markets available assets. All in, Baby Boomers have over 50.2 percent share of net household wealth. As they age, and as their healthcare costs rise, they will be divesting out of these assets at an increasing rate. This effect is expected to lead to a 3-3.5 percent reduction in the expected nominal returns to the pensions funds for the Generation X and the Millennials, per 2016 study by the U.S. Federal Reserve (https://www.federalreserve.gov/econresdata/feds/2016/files/2016080pap.pdf). The latter is, in part, the legacy of the 2007 Global Financial Crisis, which has resulted in an unprecedented collapse in wealth held by the American middle classes. Based on the report from the Minneapolis Federal Reserve (https://www.minneapolisfed.org/publications/the-region/race-and-the-race-between-stocks-and-homes), current household wealth for the bottom 50 percent of U.S. households is at the lowest levels since the mid-1950s, while household wealth of the middle 40 percent of the U.S. households is comparable to where it was in 2001. In other words, nine out of ten U.S. households have not seen any growth in their wealth for at least 18 years now.

Over the same period of time, wages and incomes of those currently in middle and early stages of their careers, aka the Generation X and the Millennials, have stagnated, while their career prospects for the near future remain severely depressed by the longer in-the-job tenures of the previous generations.

June 2018 paper from the Opportunity and Inclusive Growth Institute, titled “Income and Wealth Inequality in America, 1949-2016” (https://www.minneapolisfed.org/institute/working-papers-institute/iwp9.pdf) documented the dramatic reallocation of purchasing power in the U.S. income across generations, from 1970 to 2015, with the share of total income earned by the bottom 50 percent dropping from 21.6 percent to 14.5 percent, while the top 10 percent share climbed from 30.7 percent to 47.6 percent. Share of wealth held in housing assets for the top 1 percent of earners currently stands at around 8.7 percent, with the remained held in financial assets and cash. For top 20 percent of income distribution, the numbers are more even at 28 percent of wealth in housing. Middle class distribution of wealth is completely reversed, with 62.5 percent held in the form of housing.

The problem is made worse by the fact that following the financial crash of 2007-2008, the U.S. Government failed to provide any meaningful support to struggling homeowners, focusing, just as European authorities did, on repairing the banks instead of households.


Markets Forward

What all of this means for the asset values going forward is that demographically, the economy is divided into the older and wealthier generation that is starting to aggressively consume their wealth, looking to sell their financial assets and leverage their housing stocks, and those who cannot afford to purchase these assets, facing lower incomes and no tradable equity. This is hardly a prescription for the bull markets in the long run.

In this environment, on a 5-10 years time horizon, holding cash and money markets instruments makes a lot more sense not because these instruments offer significant current returns, but because the expected upcoming asset price deflation will make cash and safe haven assets the new market king.

The same is apparent in the corporate decisions to use tax and regulatory changes to beef up their cash holdings and equity prices, as opposed to investing in new growth activities. Even inclusive of buybacks, and Mergers & Acquisitions in the corporate sector, aggregate investment as a share of GDP continues to slide decade after decade, as highlighted in the chart below.

CHART

What makes matters even worse is that until mid-2000s, the data for investment did not include R&D activities, normally classed as expenditure in years prior. Adjusting for M&As, buybacks and R&D allocations, aggregate investment in G7 economies has declined from 24.9 percent of GDP in the 1980s to around 16-17 percent in 2010-2018. In simple terms, neither the public nor the private sector in the largest advanced economies in the world are planning for investment-driven growth in the near future, out into 2025.

None of which should come as a surprise to those following my writings in recent years, including in these pages. Over the years, I have written extensively about the Twin Secular Stagnations Hypothesis - a proposition that the global economy has entered a structurally slower period of economic growth, driven by adverse demographics and shallower returns to technological innovation. What is new is that we are now witnessing the beginning of the demographics-driven investors' rotation out of risky assets and toward higher safety instruments. With time, this process is only likely to accelerate, leading to the structural reversal of the bull markets in risky assets and real estate.

19/12/18: Assets with Negative Returns: 1901-present

Highlighting the evidence presented in the earlier-linked article, here is the chart based on data from the Deutsche Bank Research team, showing historical evidence on the total percentage of all key asset classes with negative annual returns:

CHART

Source: Data from Deutsche Bank Research and author own calculations.

I have highlighted 7 occasions on which the percentage of negative returns assets exceeded 50%. Only three times since 1901 did this percentage exceed 60%, including in YTD returns for 3Q 2018.

6/12/18: Are Younger Americans More Comfortable With a Multipolar World?

When it comes to challenging status quo heuristics, the younger generations usually pave the way. The same applies to the heuristics relating to geopolitical environment. While the older generations of Americans appear to be firmly stuck in the comfort-seeking status quo ante of 'Cold War'-linked hegemonic perception of the world around us - the basis for which is the alleged positive exceptionalism of the U.S. confronted by the negative exceptionalism of Russia and, increasingly, China, Americans of younger cohorts are starting to comprehend the reality of multipolar world we inhabit.

At least, according to the Pew Research data:

The gap between the tail generations (the Z-ers and the Boomers) is massive, and the spread within the generations is relatively more compressed for the Z-ers.

6/12/18: When it comes to geopolitical & socio-economic anxiety, Europe's problem is European

Europe is a sitting duck for major geopolitical risk, but the U.S. is getting there too:

And volatility surrounding the uncertainty measure is also out of line for Europe, both in levels and trends:

Just as the Global Financial Crisis in Europe was not caused by the U.S. financial meltdown, even if the latter was a major catalyst to the former, so is the current period of extreme policy anxiety and instability is not being driven by the emergence of the Trump Administration. Europe's problem seems to be European.

24/11/18: Wisdom of Crowds, Meta-Knowledge and Behavioral Biases in Scalable Data

Social networks: scale, biases and the notion of the 'wisdom of crowds'... Here are my lecture notes from the Behavioral Finance and Economics course @MIIS: