Barron's Cover 

AI: Coming to a Portfolio Near You

By Crystal Kim

 Photo: Maciek Jasik for Barron 


Imagine calling an 800 number and not getting frustrated. Trains run on time. Waiting rooms are considered archaic. People and corporations are taxed at the perfect rate. And everyone will have enough money to retire, because, in the future, artificial intelligence will make managing your finances—and your life—as easy as pouring a bowl of cereal.  

Long the domain of apocalyptic science fiction movies, artificial intelligence has already stepped off the screen and into real life in subtle ways—and it’s about to hit your portfolio. Ask almost any money manager what they’re most interested in these days and it’s not proselytizing new investing styles—it’s artificial intelligence. Artificial intelligence is the ultimate competitive edge.

It has the potential to deliver an infinite workforce that never tires and virtually never makes mistakes. Can AI save the beleaguered asset management industry? Could it make investing even easier, cheaper, more effective? The biggest fund firms have been spending billions to find out.

BlackRock, Vanguard, Fidelity, and T. Rowe Price, among others, have all invested time and money setting up tech centers in major cities, apart from their headquarters. BlackRock’s digs are in Palo Alto, Fidelity’s in Boston, Vanguard’s in downtown Philadelphia, and T. Rowe Price’s in New York City—all satellites designed for a very specific set of people and type of work in mind. They are outfitted with standing desks, mock-garage project rooms, shag rugs, Christmas lights, puzzles, Kit Kat bars, and LaCroix soda—more start-up chic, less grandfather’s mahogany and leather. It’s part of the effort to draw the best minds, data scientists, information architects, and algorithm wranglers otherwise headed to Google or Amazon.  

“We are in a technological arms race,” says Andrew Lo, director of the Laboratory for Financial Engineering at the Massachusetts Institute of Technology. “Financial institutions have to participate just to keep up with the competition.”

What are they competing for? Cost savings, for starters—anything to offset the shrinking margins as investment products get cheaper and cheaper. AI, done right, could also give portfolio managers an edge, and better serve investors with a wider array of financial planning tools that make today’s robo-advisors look like an abacus. “Every major CEO of every major company is bullish on AI. Everyone is chasing the nugget of gold,” says Vipin Mayar, head of Fidelity’s AI initiatives.

Artificial intelligence starts with a machine learning data, as a child might, as opposed to being programmed to execute a specific task. Machines learn by being fed data via a set of statistical techniques, which are unique and proprietary. The term “Big Data” refers to the bazillions of data points—where you are at any given moment, how much you’ve spent on coffee this month, even who your friends are—that could be available to data scientists to help create and feed into these statistical models.






Deep learning is a sub-methodology of machine learning, where the biggest breakthroughs are happening now. Deep learning is basically teaching computers to process information more like humans do. Natural language processing, for instance, means computers can come to actually understand and develop responses to language, rather than react according to a series of programmed rules. Computer vision allows a computer to see and recognize visual images, not only making the distinction between a photo of an apple, a drawing of an apple, and an actual apple, but also distinguishing a multitude of variations of each. This type of AI has enabled self-driving cars, and machines that can identify tumors or choose the best grapes to make a Cabernet. And, of course, augment financial data analysis.

AI has limitations, as any film buff (or sentient being) can tell you. Self-driving cars crash. IBM’s Watson can beat world-renowned chess players, but can’t explain why people play chess. HAL tried to kill people. Financial firms are thinking big but starting small. Could AI one day bring about better financial education, empowerment, equalizing access to and opportunities for individualized advice? Probably. But right now, most financial firms are focusing their initial efforts around cost savings—for themselves. “Asset managers can’t afford the business model they operate today,” says John Lehner, State Street’s global head of investment manager services, on the urgency of AI adoption.

When a major bank approached MIT’s Lo several years ago, it was hemorrhaging $50 million a day in losses from people not paying their credit-card debts. Its initial solution was to cut credit lines across the board by 50%. Lo and his team combined statistical credit bureau data, FICO scores, past history of delinquencies and defaults with banking records, ATM transactions, and direct deposits, into their machine- learning models. The models found that people whose direct deposits stopped in the last three months were five times more likely to be delinquent or default.





Any human could surmise that being unemployed makes it harder to pay your bills. But the machine was able to identify who among the massive customer base were the most hard-pressed. The bank reduced its risk by eliminating the credit lines of the 4% of customers who showed the highest likelihood of default instead of cutting the credit lines of everyone by 50%.

On the fund side, hedge fund firm Man Group is one of the AI pioneers. Its AHL unit, the quantitative investing side of the firm, is using AI to reduce slippage, the difference between the expected price of a trade and the price at which it was actually executed. In probability theory, the “multi-armed bandit” is a mathematical problem in which resources have to be distributed across a number of different choices to maximize the reward. Think of strategically putting a bucket of coins in a row of slot machines. “I was reading about that and thought ‘this is similar to trade execution,’ but instead of receiving a reward, we incur a cost when we pick certain trade execution algorithms,” says Anthony Ledford, chief scientist at Man AHL.

Usually, humans determine which algorithm to use to incur the lowest possible expense and least market impact. But Man’s research found that an algorithm was best-suited to pick the right algorithm for the job. “It did two things: It got rid of all that human time spent by delegating it to machine learning algorithms and reduced slippage by about 10%,” says Ledford. That AI has been so successful, it is being deployed in Man Group’s other units. Fidelity Investments is developing these capabilities as well.

Next Up: AI and Stock-Picking

Some of the most interesting developments in AI are in portfolio management. Machines have already commandeered the passive investing trend: The $3 trillion exchange-traded fund industry couldn’t have happened without modern computing, and the newest ETFs are likely to make even greater use of AI.

Passive investing is simply the buying and selling according to a set of rules on a particular schedule. The best-known passive investment, a Standard & Poor’s 500 index fund, only adjusts its holdings according to its criteria around market value. Others, like the Russell indexes, rebalance annually. But funds using much more complicated—though still technically passive—rules are being launched, and embraced. These new products are passive in that the securities they own and when they’re bought or sold adhere to a set of rules, but those rules have become so complex that they are essentially active products. AI can take the decision-making even further, using Big Data—satellite images of foot traffic on New York’s Fifth Avenue or the shadows cast by oil tankers—to process massive amounts of information, filter out the “noise,” and seize on the “signals” to buy or sell.

AI will make the distinction between active and passive even more subtle, perhaps subsuming the debate into a completely new form of investing, says Jeff Shen, co-head of BlackRock’s scientific active equity group. “We just don’t have a name for it yet.”

Machine learning combined with natural language processing can tell portfolio managers how bullish a CEO sounds in an earnings call by mining transcripts for specific language it was trained to identify. It can be used to scout tweets to get real-time analysis of consumers’ changing tastes and trends. Fidelity has been mining social media to figure out how, for example, Under Armour’s popularity compares with competitors and how customers feel about Chipotle’s “queso” rollout, says Tim Cohen, co-head of equity. “What we’re not doing is automating investing decisions. We’re exploring and trying to enhance our existing models. The challenge is finding new techniques that we can use long-term.”



 Next up? Machines will evaluate and predict human behavior, such as how portfolio managers trade around management meetings and earnings. Today’s simple analytics are backward-looking, examining historical trading information around these specific events. Machine learning, one day, will sniff out a pattern that can be used to correct behavior and provide a competitive edge.

Man AHL offers an example of using AI today for a more traditional quantitative approach: Using machine learning, the firm tried to “re-learn” momentum characteristics. In most cases, the AI corroborated that the firm was doing something right in its system of buying and selling stocks based on how fast and in what direction they were moving. But momentum strategies are tricky, particularly when prices are rising or falling rapidly. Most momentum ETFs aren’t able to capture and respond to the “signals” that surface in especially volatile markets, which is why many have spotty track records. Man’s AI uncovered those signals reversing during extremely volatile markets, and the model pivoted quickly to capture the turnaround. “That’s the kind of thing which is impossible to write down in a model and capture with a more traditional approach,” Ledford says. “Deep learning helps find signals we don’t know about.”

Machine learning is starting to show up in more mainstream products, but early efforts are a little underwhelming. BlackRock launched seven new sector ETFs last month, such as the iShares Evolved U.S. Technology ETF (ticker: IETC) and iShares Evolved U.S. Consumer Staples ETF (IECS). The firm uses natural language processing to sift through public filings for specific words and phrases describing the business. That determines which companies go in which ETFs and at what weighting. The end result is similar to traditional sector categories, though some companies appear in more than one sector. IBM’s Watson is also on the ETF bandwagon. The $134 million large-company AI Powered Equity ETF (AIEQ) launched six months ago.

Expect to see more AI-inspired products, but investors should be as wary of them as they would any other new product that seems based more on buzzwords than proven track records. Artificial Intelligence processes can be as unique as the people building them.

“A massive amount of data is required to make AI work, and machine learning is not just one thing, but many different things,” says Campbell Harvey, a Duke University professor and Man Group consultant. “This is a common problem with robo-advisors. People are fooled thinking it’s algorithmic or whatever, but some are just garbage. Be very careful.”

Plus, markets are complicated. “The market is a biological system, not an immutable one, and we don’t have laws that can explain how this ecology evolves over the course of a year or even decades,” says Lo. “AI can address the who, what, when, where and how, but the underlying logic of the decision—which is what makes Warren Buffett successful—is lacking.”

AI Will Become Your Fund Manager, Financial Advisor, and Therapist

That uniquely human ability to reason means that Buffett, Fidelity’s Will Danoff, DoubleLine Capital’s Jeffrey Gundlach, and the like can breathe easy. But it’s not just about portfolio management: Some financial firms are betting that AI can accurately ascertain behavioral traits and predict individual reactions to financial and market events.

When the AI team at Fidelity got wind that it was going to have access to supercomputers to crunch massive amounts of data, James Aylward left the office, got in his car, and headed home. He wanted to know what kinds of problems the families in his neighborhood needed solved. Top of the list: They wanted to know how they measure up to families that look just like them, and learn how their counterparts paid for college or child care, where they chose to live, and what trade-offs they made.




AI can’t advise families what trade-offs to make now, but the Fidelity team, led by Aylward, has the capacity to identify households with common traits. Next up is building a predictive app customers can use to learn what steps they should take to feel more financially secure. This is tricky business, since there are so many moving parts, and ultimately no benchmark to measure against, says Mayar, Fidelity’s head of AI: “Google Maps solves an easy problem. Get from point A to point B. The path to financial health is far more complicated, but our research found the AI opportunity.”

Aylward, the lead on this particular project, points out that the promise of AI is that its capabilities strengthen and expand over time. “AI builds on itself, starting with a diagnostics approach, and then becoming predictive: ‘If you take this path, this will probably happen to you,’ ” he says. “Then, as it learns, it gets prescriptive: ‘You should do A or B.’ ”

Lo, meanwhile, is working with a large brokerage firm to develop a measure of investor behavior his team is calling the “freakout factor.” There are many algorithms that say what investors ought to do, but none that account for what they actually do, he says. He is using data from hundreds of thousands of anonymized accounts, spanning 12 years, to measure behavior. They’ve constructed demographic profiles to identify the investors most at risk of “freaking out” during a market correction or downturn. Imagine how much pain that AI could have saved investors during the last financial crisis, says Lo.

“We need artificial stupidity. We can tell people all day long that the market will come back, but that’s like trying to prevent teenage pregnancy by preaching abstinence. It’s not realistic because it doesn’t account for human nature,” Lo says. He expects research results in months. Models like his could be commercially available in two to three years.

Research firm Morningstar is also applying AI technology to its very human-oriented tasks. The firm launched its new quantitative rating system in February. A machine-learning model aims to mimic the firm’s analyst ratings, which are qualitative assessments of how analysts view the outlook for a fund. Analyst ratings are predictive and qualitative, versus the firm’s star ratings, which are backward-looking and quantitative.

The methodology report shows that the learning model in testing matched existing analyst ratings 55% of the time for negative ratings and 78% of the time for positive ratings. That’s a level of accuracy Morningstar’s head quant Timothy Strauts told Barron’s the firm was comfortable with. Whether advisors will agree with that assessment is another matter.

Perhaps the greatest obstacle for AI isn’t technology but perception. With privacy issues moving to the forefront of public debate, more than one CEO of an asset manager told Barron’s that they had far more data on their customers, and far more technological use for that data, than they were willing to acknowledge to those customers for fear of unsettling them—even if the end result was to improve the customer experience. “How do we deliver a solution that doesn’t feel intrusive and strange and Big Brother-ish?,” wonders Lisha Davis, the head of Vanguard’s tech center, adding that she asks that question regularly. “We’re trying to strike that right balance between being helpful and being a nuisance,” says Davis.

What AI is asked to do today will determine what it becomes tomorrow. The transition can be hard to spot, though. “Data scientists joke that when AI is turned into a product [like Apple’s Siri or Google Maps] it is no longer AI—it’s just the name of the product,” says Aylward with a laugh. “So AI is always in the future.”


The Next Crisis Will Be The Last

by: Lance Roberts


It is an interesting thing.
 
Throughout the last four decades, there is a direct link between the actions of the Federal Reserve and the eventual economic and market outcomes due to changes in monetary policy. In every case, that outcome has been negative.
 
 
 
The general consensus continues to be the markets have entered into a "permanently high plateau," or an era in which asset price corrections have been effectively eliminated through fiscal and monetary policy. The lack of understanding of economic and market cycles was on full display Monday as Peter Navarro told investors to just "buy the dip."
"I'm thinking the smart money is certainly going to buy on the dips here because the economy is as strong as an ox."
I urge you not to fall prey to the "This Time Is Different" thought process.
 
Despite the consensus belief that global growth is gathering steam, there is mounting evidence of financial strain rising throughout the financial ecosystem, which as I addressed previously, is a direct result of the Fed's monetary policy actions. Economic growth remains weak, wages are not growing, and job growth remains below the rate of working age population growth.
 
While the talking points of the economy being as "strong as an ox" is certainly "media friendly," the yield curve, as shown below, is telling a different story. While the spread between 2-year and 10-year Treasury rates has not fallen into negative territory as of yet, they are certainly headed in that direction.
 
 
This is an important distinction. The mistake that most analysts make in an attempt to support a current view is to look at a specific data point. However, when analyzing data, it is not necessarily the current data point that is important, but the trend of the data that tells the story. Currently, the trend of the yield curve is highly suggestive of economic growth not being nearly as robust as the mainstream consensus believes.
 
Furthermore, economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed. In a consumer based economy, where 70% of economic growth is driven by consumption, you have to question both what is driving consumer spending and how are they funding it. Both of those answers can be clearly seen in the data and particularly in those areas which are directly related to consumptive behaviors.
 
Stephanie Pomboy recently had an interview with Barron's magazine in which she made several very salient points as it relates to current monetary policy and the next crisis. To wit:
"In January, the savings rate went from 2.5% to 3.2% in one month-a massive increase. People look at the headline for spending and acknowledge that it's not fabulous, but they see it as a sustainable formula for growth that will generate the earnings necessary to validate asset price levels."
Unfortunately, the headline spending numbers are actually far more disturbing once you dig into "where" consumers are spending their dollars. As Stephanie goes on to state:
"When you go through that kind of detail, you discover that they are buying more because they have to. They are spending more on food, energy, health care, housing, all the nondiscretionary stuff, and relying on credit and dis-saving [to pay for it]. Consumers have had to draw down whatever savings they amassed after the crisis and run up credit-card debt to keep up with the basic necessities of life."
 
When a bulk of incomes are diverted to areas which must be purchased, and have very little of a "multiplier effect" through the economy, spending on discretionary products or services becomes restricted. The mistake the Federal Reserve and the Administration are currently making is by hitting consumers where they have the LEAST ability to compensate - interest payments and the items required for daily living like food and energy through tariffs.
 
Despite the recent "windfall" from tax reform, corporations aren't "sharing the wealth" as consumption trends remain weak. When revenue, what happens at the top line of the income statement, remains weak, corporations continue to opt for share buybacks, wage suppression and accounting gimmicks to fuel bottom line earnings per share. The requirement to meet Wall Street expectations to support share prices is more important to the "C-suite" executives than being benevolent to the working class. 
 
 
 
But if that all sounds very familiar, it's because it is. As I penned previously in "Consumer Credit & The American Conundrum:"
"Therefore, as the gap between the 'desired' living standard and disposable income expanded, it led to a decrease in the personal savings rates and increase in leverage. It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth."
What the chart below shows is the differential between the standard of living for a family of four adjusted for inflation over time. What is clear is that beginning in 1990, the combined sources of savings, credit, and incomes were no longer sufficient to fund the widening gap between the sources of money and the cost of living. With surging healthcare, rent, food, and energy costs, that gap has continued to widen to an unsustainable level which will continue to impede economic rates of growth.

The Fed Will Do It Again

While it is currently believed that central bankers now have everything "under control," the reality is they likely don't. It is far more likely one of following two conclusions is more accurate:
  1. The Fed is absolutely aware the economy is closer to the next recession than not. They also know that hiking interest rates in the current environment will likely accelerate the next downturn. However, the "lesser of two evils" is to face the recession with the Fed funds rate as far from zero as possible, or;
  2. the Fed believes the economic data is indeed trending stronger and are overly confident in their ability to guide the U.S. economy into a "Goldilocks" type scenario where they can control inflationary pressures and growth rates to sustain a lasting economic cycle.
     
I agree with Stephanie's point on how the next crisis will begin:
"Fed tightening continues to ratchet up and turns the screws on households and speculative-grade corporations, and the markets begin to anticipate more defaults, and reprice credit risk."
 
Credit risk is already on the rise as consumers are much more sensitive to changes in rates. As the Fed continues to hike rates, the negative impact on households will continue to escalate which is already showing up in credit card delinquencies.
 
 
 
Of course, it isn't just credit card debt that is the problem. Subprime auto loans are pushing record levels as consumers have been lured into "cars they can't afford" through low rates and extended terms.
 
 
 
Consumers have also completely forgotten the last financial crisis and have once again turned to cashing out equity in homes to make ends meet.
 
 
 
 
Eventually, since a lot of this debt has been bundled up and sold off in the fixed income markets, this all ends badly when, as Stephanie states, the markets begin to reprice risk across the credit spectrum. As shown, when the spreads on bonds begin to blow out, bad things have occurred in the markets and economy.
 
 
 
For the Federal Reserve, the next "financial crisis" is already in the works. All it takes now is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem. As stock prices decline:
  • Consumer confidence falls further eroding economic growth.
  • The $4 Trillion pension problem is rapidly exposed which will require significant government bailouts.
  • When prices decline enough, the record levels of margin debt are triggered which creates a liquidation cascade.
  • As prices fall, investors and consumers both contract further pushing the economy further into recession.
  • Aging baby-boomers, which are vastly under-saved, will become primarily dependent on social welfare which erodes long-term economic growth rates.
With the Fed tightening monetary policy, and an errant administration fighting a battle it can't win, the timing of the next recession has likely been advanced by several months.
 
The real crisis comes when there is a "run on pensions." With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the "fear" that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.
 
But it doesn't end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more government funding will be required to solve that problem as well.
 
As debts and deficits swell in coming years, the negative impact to economic growth will continue.
 
At some point, there will be a realization of the real crisis. It isn't a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.
 
The issue for future politicians won't be the "breadlines" of the '30s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.
 
The good news, if you want to call it that, is that the next "crisis" will be the "great reset" which will also make it the "last crisis."

Trump has no business in South America

By John Paul Rathbone


Donald Trump has no business in Latin America. That is not a slur. It is a statement of fact.

The US president is to remain at home during this weekend’s Summit of the Americas in order to oversee the US response to Syria. That makes him the first US president to skip the summit — although with a 16 per cent approval rating in the region, he is unlikely to be missed.

Yet Mr Trump has no business in Latin America in the sharper sense of Calvin Coolidge’s famous quote: “The chief business of the American people is business”. The past week saw a kerfuffle over his former hotel in Panama City. It transpired that on March 22, Trump Organization lawyers appealed directly to Juan Carlos Varela, Panama’s president, to reverse the company’s acrimonious eviction as managers of the 70-storey luxury high rise, formerly known as the Trump Ocean Club International Hotel & Tower.

The letter is unusual on several counts. While never mentioning Mr Trump’s presidency, it notes Panama’s separation of powers but then essentially asks Mr Varela to intervene anyway. It suggests that the eviction of its management team by the hotel’s majority owner, Orestes Fintiklis, violates a bilateral investment treaty — although the Trump Organization is not an investor in Panama but rather a service provider. It then adds that the Panamanian government could be blamed for any wrongdoing.

A conflict of interest? Not for Trump Organization lawyers in Panama, who in a statement said the letter was not an attempt to pressure any “official of the government” and such appeals were “very common”.

In strict business terms, the letter is moot anyway. That same day, a New York judge blocked the Trump company from pursuing additional arbitration claims aimed at restoring its management of the hotel. That decision followed a March 9 ruling by a Panama judge, which argued the same. Finally, on March 27, an international arbitration panel also declined to reinstate the Trump team.

Now that the hotel management question has been definitely settled, and the Trumps thrown out, all that is left now is for both sides to finish their fight about damages, lost profits and other costs. The Trump Organization has, for some reason, dropped its alleged damages from an initial $150m claim to $9m, versus a $15m claim by the hotel owner.

After losing Panama, nixing a 2009 hotel project in Mexico, dropping out of a Brazil luxury hotel and cancelling a mooted Buenos Aires project, the only other Trump business project in South America is a licensed building in Uruguay’s Punta del Este. According to the company website, it will open late this year.

Donald Trump has no business in Latin America. That is not a slur. It is a statement of fact. The US president is to remain at home during this weekend’s Summit of the Americas in order to oversee the US response to Syria. That makes him the first US president to skip the summit — although with a 16 per cent approval rating in the region, he is unlikely to be missed.

Yet Mr Trump has no business in Latin America in the sharper sense of Calvin Coolidge’s famous quote: “The chief business of the American people is business”. The past week saw a kerfuffle over his former hotel in Panama City. It transpired that on March 22, Trump Organization lawyers appealed directly to Juan Carlos Varela, Panama’s president, to reverse the company’s acrimonious eviction as managers of the 70-storey luxury high rise, formerly known as the Trump Ocean Club International Hotel & Tower.

The letter is unusual on several counts. While never mentioning Mr Trump’s presidency, it notes Panama’s separation of powers but then essentially asks Mr Varela to intervene anyway. It suggests that the eviction of its management team by the hotel’s majority owner, Orestes Fintiklis, violates a bilateral investment treaty — although the Trump Organization is not an investor in Panama but rather a service provider. It then adds that the Panamanian government could be blamed for any wrongdoing.

A conflict of interest? Not for Trump Organization lawyers in Panama, who in a statement said the letter was not an attempt to pressure any “official of the government” and such appeals were “very common”.

In strict business terms, the letter is moot anyway. That same day, a New York judge blocked the Trump company from pursuing additional arbitration claims aimed at restoring its management of the hotel. That decision followed a March 9 ruling by a Panama judge, which argued the same. Finally, on March 27, an international arbitration panel also declined to reinstate the Trump team.

Now that the hotel management question has been definitely settled, and the Trumps thrown out, all that is left now is for both sides to finish their fight about damages, lost profits and other costs. The Trump Organization has, for some reason, dropped its alleged damages from an initial $150m claim to $9m, versus a $15m claim by the hotel owner.

After losing Panama, nixing a 2009 hotel project in Mexico, dropping out of a Brazil luxury hotel and cancelling a mooted Buenos Aires project, the only other Trump business project in South America is a licensed building in Uruguay’s Punta del Este. According to the company website, it will open late this year.


The dragons fly

Chinese aviation takes off

The West should not pull up the drawbridge against a new wave of disrupters
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OVER the past few decades, established airlines in Europe and America have been hit by one thing after another. First came low-cost carriers, chipping away at their short-haul routes.

Lately, a new crop of super-connecting airlines in the Gulf, Emirates, Etihad and Qatar Airways, has lured away their long-haul passengers with superior service and lower fares. Now looms the biggest threat of all—the rise of several promising Chinese airlines. Unfortunately, the response of the incumbents risks depriving passengers of the benefits from this latest wave of competition.



China’s airlines are rising up the world rankings at a breathtaking pace. In 2007 passengers in China made 184m journeys by air; last year around 550m did. The International Air Transport Association, a trade group, predicts that China will leapfrog America as the world’s biggest market in the coming five years. During the next two decades Airbus and Boeing, the world’s two big manufacturers of passenger aircraft, forecast that Chinese carriers will buy more jets than American ones.

Passengers who had a choice used to avoid Chinese airlines. Delays were common, accidents frequent and the food inedible. However, after a concerted effort to improve standards, they are winning flyers over. OAG, a data firm, reckons that in 2011-17 the proportion of passenger seats between China and America on Chinese airlines rose from 37% to 61%.

Losing the battle to fly people in and out of China is one thing. But the menace to the world’s established carriers goes deeper. Just as the Gulf airlines expanded by offering connecting flights to international passengers through their Middle Eastern hubs so, too, are Chinese airlines turning themselves into connectors. The cheapest way to get from London to Australia, for instance, is no longer via Dubai or Abu Dhabi but through Guangzhou, Shanghai or Wuhan. The Chinese authorities have loosened visa requirements to encourage this kind of transfer traffic.

China’s arrival as an aviation superpower has prompted two responses from big Western carriers—both predictable, neither good. The Europeans are crying foul about government aid, just as they did when the Gulf airlines became a threat. The bosses of Air France-KLM and Lufthansa wail that they are the victims of “unfair trade”. They are lobbying for rules that would let the European Union place unilateral sanctions on subsidised foreign rivals, Chinese carriers among them, even before any investigation has been concluded.

The fact that Chinese airlines benefit from support from the state is not in question. But the outrage of rivals is shamelessly confected. Around the world, the aviation industry has been built on government support. CE Delft, a research firm, reckons that French airlines get €1bn ($1.2bn) in energy subsidies alone each year. Unilateral sanctions might benefit incumbents, but would restrict choice and harm passengers. A tit-for-tat battle over flying rights would hit Europe harder than China, which is fast becoming a sizeable net exporter of tourists.

The big three American carriers have taken a different tack. They are also happy to play the protectionist card when it suits them. American, Delta and United have all been lobbying hard against the Gulf carriers, for instance. But with China they sniff an opportunity as well as a threat. They want an open-skies treaty, which would allow airlines to fly between any airport in the two countries.

Fare trade

In theory, passengers have much to gain from a deal of this sort. In practice, open-skies deals open the door to joint ventures (JVs), which are granted immunity from antitrust rules and so can potentially lead to higher prices. In 2006-16 the share of long-haul passenger traffic controlled by such JVs leapt from 5% to 25%. Three JVs account for almost 80% of the transatlantic market. The established American airlines would love to team up with Chinese rivals in order to dominate the Pacific, too.

Neither shutout nor carve-up is good for passengers. In an ideal world, Europe and America would seek open-skies deals with China but design them to nurture competition rather than mute it. Airline JVs would be barred from gaining antitrust immunity. Airport slots would be allocated more fairly, so that the best landing and take-off times were not hoarded. State handouts would be transparent.

Alas, the chances of reaching such a sensible accommodation with China’s airlines are low.

Rising trade tensions between America and China are only part of the explanation. The real problem is that big Western carriers would not much like such policies either.


The West Is Wrong About China’s President

Keyu Jin

China's President Xi Jinping speaks next to US President Donald Trump


BEIJING – China’s recent constitutional amendment eliminating the term limits for the president and vice president has left much of the West aghast. Critics fear the emergence of a new and unaccountable dictatorship, with President Xi Jinping becoming “Chairman Mao 2.0.” This response is more than a little inappropriate.

Long tenures are not exactly unheard of in the West. For example, German Chancellor Angela Merkel has just begun her fourth four-year term – a development that the rest of Europe has largely welcomed rather than criticized.

Of course, a Westerner might argue that Merkel has an electoral mandate, whereas Xi does not. But democratic elections are not the only way to achieve accountability. And Xi’s approval rating, according to almost all international surveys, seems to exceed the combined approval ratings of US President Donald Trump and UK Prime Minister Theresa May. While there may be reason to worry that Chinese politics could change for the worse, the same is true in the United States and the United Kingdom.

Term limits are little more than an arbitrary constraint, which are not needed to ensure competent and responsive government in China. In fact, term limits could do just the opposite, cutting short the tenure of effective leaders, leading to policy disruptions, or even leading to political chaos.

The US has long recognized this. Alexander Hamilton wrote that it is necessary to give leaders “the inclination and the resolution” to do the best possible job. They can thus prove their merits to the people, who can choose to “prolong the utility of [their leaders’] talents and virtues, and to secure to the government the advantage of permanency in a wise system of administration.”

In 1947, however, following President Franklin D. Roosevelt’s election to four terms in office, Congress enacted the Twenty-Second Amendment to the US Constitution; since its ratification in 1951, US presidents have been limited to two four-year terms. The idea was to make a virtue of inexperience. But most new presidents make significant blunders at the start, and now there are more starts. If the US had no term limits, Trump might well not be in office today.

To be sure, term limits have their value. Deng Xiaoping added them to the Chinese constitution after the Cultural Revolution, in order to prevent the recurrence of chaotic and brutal one-man rule. But the new generation of Chinese leaders is not just well-educated, but also well aware of international norms and standards. Unlike the ideological diehards of the past, they can be expected to behave rationally, intelligently, and responsibly.

In this context, the removal of term limits will enable Xi to sustain a complex reform process that will take years to complete. It will not make him president for life, nor deliver him unbridled and undivided power.

Western critics emphasize that Xi has done much to concentrate power in his own hands over the last six years. And, to some extent, that is true. For example, he has taken over some of the economic policy decisions that used to be the prime minister’s domain.

But a strong leader is not necessarily an autocratic leader. And, in a high-stakes environment, a strong leader is needed to neutralize vested interests that resist crucial reforms. Xi knows the obstacles that blocked the implementation of his initiatives during his first term, and he is committed to overcoming them.

In any case, the situation is hardly a “one-man show,” as much foreign commentary suggests.

Half of the members of the Politburo Standing Committee, China’s supreme government body, are not of Xi’s choosing. And compromises were made in the placement of many senior officials, including key cabinet members.

It would be a mistake to assume that because China has vowed not to copy the Western political model, there are not hidden democratic processes at work. While leaders are not elected, either directly or by a representative body, their performance is subject to close scrutiny – for example, by the National People’s Congress (NPC) and local people’s congresses. The Chinese government is also unusually responsive to citizens on social media.

Moreover, checks and balances, though still inadequate, have been strengthened in recent years. Policy changes require consensus within the Politburo, especially the Standing Committee. On major issues, the NPC must give the green light. Nothing stops deputies from casting a dissenting vote, thanks in part to the growing prevalence of secret ballots. A small but significant feature of this year’s Congress is the elimination of the electronic voting system; instead, officials will drop paper slips into a ballot box.

This is not the first time that Western media have adopted a perspective on Chinese political developments that runs completely counter to the prevailing view in China itself. Over the last few years, Xi’s anti-corruption drive has raised many eyebrows in the West, where it is often regarded as just a means for Xi to remove would-be political rivals. But the almost two million officials who have been indicted surely weren’t all Xi’s opponents. Among Chinese, the effort to root out corruption has boosted respect and support for Xi.

In the West, government accountability is closely identified with democratic elections. In China, it is a function of how – and how well – the government responds to and protects the needs and interests of the people. Given the sheer complexity of modern China – not to mention the paramount need for the government to continue the country’s progress toward high-income status – success may require leaders to stay in place longer than initially expected. But, if recent history is any guide, the recent changes will contribute to making China’s political and economic system increasingly stable – without undermining accountability.



Keyu Jin, a professor of economics at the London School of Economics, is a World Economic Forum Young Global Leader and a member of the Richemont Group Advisory Board.