Masters of the universe

The rise of the financial machines

Forget Gordon Gekko. Computers increasingly call the shots in financial markets




THE JOB of capital markets is to process information so that savings flow to the best projects and firms. That makes high finance sound simple; in reality it is dynamic and intoxicating. It reflects a changing world. Today’s markets, for instance, are grappling with a trade war and low interest rates.

But it also reflects changes within finance, which constantly reinvents itself in a perpetual struggle to gain a competitive edge. As our Briefing reports, the latest revolution is in full swing. Machines are taking control of investing—not just the humdrum buying and selling of securities, but also the commanding heights of monitoring the economy and allocating capital.

Funds run by computers that follow rules set by humans account for 35% of America’s stockmarket, 60% of institutional equity assets and 60% of trading activity. New artificial-intelligence programs are also writing their own investing rules, in ways their human masters only partly understand. Industries from pizza-delivery to Hollywood are being changed by technology, but finance is unique because it can exert voting power over firms, redistribute wealth and cause mayhem in the economy.

Because it deals in huge sums, finance has always had the cash to adopt breakthroughs early.

The first transatlantic cable, completed in 1866, carried cotton prices between Liverpool and New York. Wall Street analysts were early devotees of spreadsheet software, such as Excel, in the 1980s. Since then, computers have conquered swathes of the financial industry.

First to go was the chore of “executing” buy and sell orders. Visit a trading floor today and you will hear the hum of servers, not the roar of traders. High-frequency trading exploits tiny differences in the prices of similar securities, using a barrage of transactions.

In the past decade computers have graduated to running portfolios. Exchange-traded funds (ETFs) and mutual funds automatically track indices of shares and bonds. Last month these vehicles had $4.3trn invested in American equities, exceeding the sums actively run by humans for the first time. A strategy known as smart-beta isolates a statistical characteristic—volatility, say—and loads up on securities that exhibit it. An elite of quantitative hedge funds, most of them on America’s east coast, uses complex black-box mathematics to invest some $1trn. As machines prove themselves in equities and derivatives, they are growing in debt markets, too.

All the while, computers are gaining autonomy. Software programs using AI devise their own strategies without needing human guidance. Some hedgefunders are sceptical about AI but, as processing power grows, so do its abilities. And consider the flow of information, the lifeblood of markets.

Human fund managers read reports and meet firms under strict insider-trading and disclosure laws. These are designed to control what is in the public domain and ensure everyone has equal access to it. Now an almost infinite supply of new data and processing power is creating novel ways to assess investments.

For example, some funds try to use satellites to track retailers’ car parks, and scrape inflation data from e-commerce sites. Eventually they could have fresher information about firms than even their boards do.

Until now the rise of computers has democratised finance by cutting costs. A typical ETF charges 0.1% a year, compared with perhaps 1% for an active fund. You can buy ETFs on your phone. An ongoing price war means the cost of trading has collapsed, and markets are usually more liquid than ever before.

Especially when the returns on most investments are as low as today’s, it all adds up. Yet the emerging era of machine-dominated finance raises worries, any of which could imperil these benefits.

One is financial stability. Seasoned investors complain that computers can distort asset prices, as lots of algorithms chase securities with a given characteristic and then suddenly ditch them. Regulators worry that liquidity evaporates as markets fall. These claims can be overdone—humans are perfectly capable of causing carnage on their own, and computers can help manage risk.

Nonetheless, a series of “flash-crashes” and spooky incidents have occurred, including a disruption in ETF prices in 2010, a crash in sterling in October 2016 and a slump in debt prices in December last year. These dislocations might become more severe and frequent as computers become more powerful.

Another worry is how computerised finance could concentrate wealth. Because performance rests more on processing power and data, those with clout could make a disproportionate amount of money. Quant investors argue that any edge they have is soon competed away.

However, some funds are paying to secure exclusive rights to data. Imagine, for example, if Amazon (whose boss, Jeff Bezos, used to work for a quant fund) started trading using its proprietary information on e-commerce, or JPMorgan Chase used its internal data on credit-card flows to trade the Treasury bond market. These kinds of hypothetical conflicts could soon become real.

A final concern is corporate governance. For decades company boards have been voted in and out of office by fund managers on behalf of their clients. What if those shares are run by computers that are agnostic, or worse, have been programmed to pursue a narrow objective such as getting firms to pay a dividend at all costs?

Of course humans could override this. For example, BlackRock, the biggest ETF firm, gives firms guidance on strategy and environmental policy. But that raises its own problem: if assets flow to a few big fund managers with economies of scale, they will have disproportionate voting power over the economy.

Hey Siri, can you invest my life savings?

The greatest innovations in finance are unstoppable, but often lead to crises as they find their feet. In the 18th century the joint-stock company created bubbles, before going on to make large-scale business possible in the 19th century.

Securitisation caused the subprime debacle, but is today an important tool for laying off risk.

The broad principles of market regulation are eternal: equal treatment of all customers, equal access to information and the promotion of competition.

However, the computing revolution looks as if it will make today’s rules look horribly out of date.

Human investors are about to discover that they are no longer the smartest guys in the room.

German scepticism of the ECB reveals a eurozone paradox

Berlin remains wary of being the paymaster for a ‘transfer union’

Tony Barber

Sabine Lautenschlaeger, former vice president of the Bundesbank, speaks during a farewell ceremony at the Geman central bank in Frankfurt am Main, on May 13, 2014. Lautenschlaeger recently joined the European Central Bank (ECB) as member of the Executive Board. AFP PHOTO / DANIEL ROLAND (Photo credit should read DANIEL ROLAND/AFP/Getty Images)
Sabine Lautenschläger, Germany’s representative on the ECB’s executive board, has resigned two years before her eight-year term is up © AFP


At the heart of Europe’s 20-year-old currency union lies a disturbing paradox. The beating heart of the eurozone economy is Germany. Yet, from the highest levels of policymaking to the lowest levels of the mass media, Germans are the most outspoken critics of the unconventional measures taken over the past decade to ensure the eurozone’s survival.

The paradox captured attention this week when Sabine Lautenschläger, Germany’s representative on the European Central Bank’s executive board, said she would resign more than two years before her eight-year term is up. This makes her the third German to resign from the ECB’s 25-member governing council, either wholly or partly because of disagreements with its policies, since 2011.

No representatives of the eurozone’s other 18 countries have ever resigned from the ECB council because of policy disputes. Germany’s dissent feeds concerns that Europe’s monetary union, rocked to its foundations in the sovereign debt and banking sector crises of 2010-12, is still not solid enough. György Matolcsy, central bank governor of Hungary, a non-eurozone country, even says: “The EU should admit the strategic error of the euro.”

In Germany, unhappiness with the ECB extends way beyond the rarefied realm of central banking. After Mario Draghi, the ECB president, announced the bank’s latest monetary stimulus measures on September 12, Helmut Schleweis, the head of the German Savings Banks Association, denounced the steps as “disastrous”. Bild Zeitung, Germany’s bestselling tabloid, likened Mr Draghi to a vampire sucking the blood of ordinary German savers.

Across the political spectrum, and across society, mistrust of the ECB’s actions is widespread. Chancellor Angela Merkel has lent quiet support to Mr Draghi and taken care not to make public criticisms of his initiatives. However, many politicians, economists, business leaders and media pundits display less restraint. The flood of attacks on Mr Draghi is submerging the once sacrosanct German principle that a central bank must be independent from political pressure.

Germany’s outlook reflects a certain reading of 20th-century history as well as the nation’s present-day circumstances. The hyperinflation of 1923 is a trauma never to be repeated. Fewer lessons are drawn from the disinflation and economic depression that propelled the Nazis to power in the early 1930s. German anxieties about inflation appear exaggerated, given that the eurozone’s average annual inflation rate since 2011 has been 1.1 per cent.

The ECB’s negative interest rates arouse indignation in Germany, where, it is argued, an ageing population needs decent returns on savings. However, the ECB’s measures benefit wealthy Germans by increasing the value of property, shares and other assets. Furthermore, the ECB’s unorthodox interest rate policies have handed a windfall to the German government by pushing sovereign bond yields to record lows.

With borrowing costs so cheap and the economy on the edge of recession, a chorus of voices is calling for Germany to loosen its fiscal strings and launch an infrastructure investment plan. Dieter Kempf, head of the BDI, Germany’s most influential business lobby, says it is time for the government to relax its insistence on balanced budgets. Bruno Le Maire, France’s finance minister, says: “Germany must invest and invest now. ”

The Christian Democrat-Social Democrat “grand coalition” that holds power in Berlin may one day take this advice. Its reluctance to do so reflects the view that Germany must set an example of budgetary prudence to other countries, mainly in southern Europe. Germany’s caution also illustrates a lack of firm direction at the heart of government. Ms Merkel is near the end of her long reign. Each ruling party senses that the CDU-SPD partnership — the third “grand coalition” out of four governments since 2005 — has outlived its usefulness.

Despite party squabbles, a consensus exists that Germany should not be lured into grand schemes of European integration that cast Berlin in the role of paymaster of a “transfer union”. Germany offered a lukewarm response to the proposals for deeper integration by President Emmanuel Macron of France.

At the ECB, the problem for Christine Lagarde, the IMF chief who will replace Mr Draghi on November 1, is that Germans are not the only critics. Nine ECB council members expressed opposition or reservations about the new measures at the September 12 meeting. They included the national central bank heads of Austria, France and the Netherlands, as well as Germany.

Independent experts have doubts, too. Ashoka Mody, a Princeton University economist, warns that the ECB’s measures could not only damage eurozone banks but have dangerous consequences if financial markets fear that heavily indebted governments will have to bail out the banks.

In principle, Europe’s central bankers and politicians can strike a bargain that balances tighter monetary policy and fiscal expansion. Without such a deal, the risk is that markets will focus on the eurozone’s faultlines and the ECB’s internal disputes.

As long as Germany is the odd man out, doubts about the eurozone’s stability will persist.

The Most Crowded Trade

by: Lyn Alden Schwartzer
Summary
 
- Being long the dollar and dollar-related assets (especially Treasuries at the moment) has been the most popular trade this year and for most of the past decade.

- We may be reaching a tipping point for the dollar, where a multi-year bullish trend reaches its apex and sets up for a reversal.

- Look for a weaker dollar in 2020. Nothing is for certain, but that's how the math seems to converge.
 
According to Bank of America Merrill Lynch, being long U.S. treasuries (TLT) has been the most crowded trade over the past four months into September.
 
This is a good cyclical play. When growth is slowing, back-tests show that going into the dollar and treasuries makes sense as a safe-haven trade.
 
However, that cyclical play is starting to run into a structural trend, where rising U.S. deficits are starting to matter. This is likely going to require a weaker dollar to fix, and the market is inherently self-correcting. It's largely a question of timing at this point.
 
I find very few investors that are bearish on the strength of the dollar (UUP) or bullish on anti-dollar bets like emerging markets (EEM). Being long the dollar and viewing dollar-denominated assets as a safe haven is today's most-crowded trade.
 
Deficit-Driven Liquidity Shortage
 
A significant chunk of U.S. economic outperformance over the past five years has been about fiscal stimulus.
 
In my opinion, this next chart is one of the most important visuals to be aware of over the next few years and I've included it in a few recent articles, because this isn't going away. The blue line is the U.S. federal budget deficit as a percentage of GDP. The red line is the unemployment rate. For the first time in modern history, the U.S. deficit is widening to a large deficit during a non-wartime non-recessionary period:
 
U.S. Deficits and Unemployment
 
 
Meanwhile, the Euro Area has focused on austerity. As a group, they have consistently reduced their budget deficits each year so that now, at under 1%, their debts are growing more slowly than nominal GDP.
 
 
Euro Area Government Deficit Chart Source: Trading Economics
 
 
For example, the United States (black dotted line, right axis below) grew its debt as a percentage of GDP from 62% to 106% over the past decade while Germany (blue line, left axis) decreased its debt as a percentage of GDP from 73% to 61%:
 
 
US vs German Government Debt to GDP Chart Source: Trading Economics
 
 
So, not only does the U.S. have massive unprecedented fiscal stimulus equal to about 5% of GDP during non-recession peacetime, but we're doing so from the highest base of debt-to-GDP that the U.S. has had since World War II.
 
On the other hand, U.S. monetary policy has been the reverse of its fiscal policy. The Bank of Japan and European Central Bank have locked rates at zero and performed quantitative easing at a far larger scale relative to GDP than the U.S. Federal Reserve. The Federal Reserve stopped quantitative easing in 2014, performed quantitative tightening for a brief time, and raised rates about 2.5% higher than its peers. On that front, the U.S. has been by far the most hawkish one. However, the big fiscal stimulus is what gave the Fed ability to be hawkish.
 
The result of looser fiscal policy and tighter monetary policy than its peers over the past five years has been stronger U.S. economic growth than the rest of the developed world while simultaneously having a strong dollar, but such a situation is temporary and likely getting close to its apex.

The United States has the largest twin deficit (government deficit/surplus + current account deficit/surplus) out of its developed peers, and higher than many of the BRIC nations:
 
Twin Deficits 
 Data Source: Trading Economics
 
 
 
This twin deficit doesn't matter in the short-term, but it matters significantly in the long-term.
 
As I'll describe below, the United States appears to be reaching a point where its debts and deficits are starting to matter, causing its monetary policy to reverse, and there are some specific catalysts to look for as it relates to timing.
 
The Market is Usually Self-Correcting
 
In late 2014, the Federal Reserve finished its third and final round of quantitative easing (QE), meaning they stopped "printing money" to buy U.S. government debt from institutions. This removed a significant source of liquidity and left the U.S. economy to stand on its own two feet.
 
Dollar liquidity is a tricky thing, because as the world reserve currency, it's the primary currency for lending to emerging markets, buying commodities, and has all sorts of offshore uses.
 
The dollar quickly rose higher relative to many other currencies as that round of quantitative easing ended. The blue line in the chart below is the Fed's balance sheet (when it's going higher, that's quantitative easing), and the red line is the trade-weighted dollar index. Once QE ended, the dollar shot up. It was then choppy for a while, but the beginning of QT gave it another kick back up:
 
 
Dollar vs QE and QT Chart Source: St. Louis Fed
 
A country can't have growing deficits and growing debt vs GDP forever without QE, but they can do it for quite a while until a catalyst brings them to a halt.
 
Ironically for the United States, a strong dollar tends to be that catalyst.
 
The following chart shows the percentage of U.S. privately-owned debt that is held by foreigners (blue line) compared to the trade-weighted dollar index (red line), with a few inflection points marked:
 
Dollar Strength vs Foreign Debt Chart Source: St. Louis Fed
 
 
As the chart shows, there's a historical inverse correlation between dollar strength and the percentage of U.S. debt that foreign sources hold. Whenever the dollar grows stronger, the U.S. private sector ends up having to fund more of its own government's deficits. Foreigners stop buying, and may even begin selling to stabilize their own currencies.
 
The major exception on the chart where the inverse correlation broke down was in the 1990's. There was a three-decade trend from the mid-1980's to 2014 where foreigners were funding an increasing portion of U.S. deficits. They went from holding about 15% of privately-held U.S. debt to 60% of it.
 
This was during a rise of globalization, and particularly the rise of China. That foreign buying reversed course in late 2014, and they are now down to about 45% ownership of privately-held U.S. debt.
 
Starting in 2015, right after QE ended in the U.S. and the dollar became strong, foreigners stopped buying U.S. treasuries. Almost all new U.S. debt issued in the past five years (about $3 trillion worth) has been bought by domestic sources (blue line below). Foreigners (green line) and the Fed (red) have not been buying at significant scale:
 
Federal Debt Holders Chart Source: St. Louis Fed
 
This is quite a lot of debt for domestic balance sheets to hold. The next chart shows the amount of U.S. government debt held domestically compared to U.S. GDP, indexed to 100 five years ago:
 
 
Domestic Debt to GDP Chart Source: St. Louis Fed
 
 
Basically, various institutions have increased their U.S. treasury holdings by 12.3% per year over the past five years compared to 4.1% annual nominal GDP growth over that time period.
 
Additionally, U.S. corporate profits peaked in 2014 right when the dollar index shot up at the end of QE. Pre-tax profits are down since then, and after-tax profits have gone sideways thanks to tax cuts.
 
 
Corporate Profits Chart Source: St. Louis Fed
 
 
This shouldn't be a big surprise, considering that the S&P 500 is a large component of this and as an index they get over 40% of their revenue from foreign sources. All of those foreign income sources translate into fewer dollars when the dollar is strong.
 
This dollar strength has put a lot of pressure on the global economy. Many emerging markets have high dollar-denominated debts, so a stronger dollar effectively raises their debts and puts financial pressure on them, which has caused some of the weaker ones (i.e. Argentina and Turkey this time around) to fall into a currency crisis, and to slow the growth of others.
 
In addition, dollar strength puts a lot of pressure on the United States. Total corporate profits are down, so a combination of tax cuts, share buybacks, and valuation improvements have contributed to continued equity growth. And as previously mentioned, the U.S. has been forced to fund its own deficits.

In other words, the combination of loose U.S. fiscal policy and tight U.S. monetary policy is starting to strain the global system. Argentina and Turkey popped first, everyone has been strained, and now some leaks are starting to show up in the United States.
 
Repo Issues
 
Most investors are aware that the overnight repo market has required Federal Reserve intervention every night for the past two weeks. Starting in mid-September, repo rates spiked, implying that banks don't have cash to lend to each other, and it required ongoing liquidity injections from the Fed to push back down:
 
Repo Rate Chart Source: Trading Economics
 
 
Some commentators in financial media were freaking out because the last time the repo market was this bad was in September 2008 when U.S. banks were afraid to lend to each other overnight due to the risk that one of them would announce bankruptcy the next morning. That was an acute liquidity crisis due to an insolvent banking system.
 
Other commentators were saying the repo spike was nothing, just temporary timing issues. Quarterly corporate taxes were due mid-month. The U.S. Treasury is sucking up a couple hundred billion dollars in extra debt issuance to refill its cash reserves following this summer's debt ceiling issue that forced the Treasury to draw down its cash levels.
 
Evidence shows pretty clearly that the issue is somewhere in the middle. It was not and is not an imminent bank collapse liquidity crisis, nor was it purely a one-time thing. Instead, five years of domestic institutions fully-funding U.S. deficits basically saturated the banks with treasuries and they have trouble holding more. Their cash reserves have run low.
 
In particular, large U.S. banks that serve as primary dealers have been filling up with treasuries and drawing down their cash levels ever since QE ended. This chart shows the percentage of assets at large U.S. banks that consist of treasuries (blue line) vs the percentage of assets that consist of cash (red line):
Bank Liquidity Bedrock Chart Source: St. Louis Fed
 
 
 
Primary dealers are the market makers for treasuries. They don't really have a choice but to buy the supply as it comes, and supply is starting to turn into a fire hose and foreigners aren't buying much of it.
 
The percentage of total assets held as treasuries at large U.S. banks is now over 20%, which is the highest on record.
 
Cash as a percentage of assets at those institutions is now down to 8%, which is right at post-Dodd Frank post-Basel 3 lows. They're pretty much at the bedrock; they can no longer continue drawing down cash and using it to buy treasuries. Cash levels can't (and shouldn't) go lower like they did in the 2000's because that's the type of leverage that led to the financial crisis back then and current regulations require banks to have more cash.
 
A lot of people are confused at how there can be too much supply of treasuries, because there is clearly investor demand for treasuries, especially long-duration treasuries that have performed very well this year.
 
However, most U.S. debt is short-term, and that sheer quantity of short-term debt has been pressuring the banks all year. Over the past few years, bid-to-cover ratios have been declining leading to some messy treasury auctions this year, and starting this spring, the federal funds rate has gone over the interest rate on excess reserves:
 
IOER-FFR Chart Source: St. Louis Fed
 
 
Clearly, this issue has been building for years and has accelerated throughout 2019, and September just happened to be when a couple extra pressures finally caused the system to reach its limit. It doesn't take a repo expert to see that it's not a repo-specific problem. It's a sovereign debt problem.
 
The Dollar's Apex is in Sight
 
As this liquidity squeeze plays out and global economic growth continues to slow, the dollar is still in an upward trend, but these trends historically can reverse very quickly:
 
Chart Data by YCharts

 
Unless the dollar weakens, foreigners are unlikely to resume buying U.S. treasuries at scale.
 
Even though U.S. treasuries pay higher rates than European or Japanese sovereign bonds, currency hedging eliminates that difference, so only investors daring enough to hold un-hedged U.S. treasuries can take advantage of that rate differential. This means that domestic institutions likely have to keep funding most the deficits of over $1 trillion per year, and primary dealers already clearly have a liquidity problem and are already holding a record amount of treasuries as a percentage of assets.
 
There are a few ways this can play out. The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetizing U.S. government deficits. This would inject liquidity into the system, take some of the burden off of domestic institutions for absorbing all of those treasuries, and is likely to weaken the dollar which could allow foreign investors to step in and buy some more treasuries as well.
 
However, timing and details will be interesting.
 
Scenario 1) No U.S. Recession
 
If the Federal Reserve shifts from temporary open market operations "TOMO" to permanent open market operations "POMO" to permanent organic balance sheet expansion (QE by another name), it could address the issue for now.
 
Many investors assume that we would need a crisis scenario for the Fed to re-start QE, but as I showed with bank liquidity hitting bedrock and no end to U.S. debt issuance in sight, the Fed is likely to expand its balance sheet gradually simply due to liquidity pressures. They used to expand their balance sheet gradually prior to the global financial crisis anyway, so this would be a resumption of that but from a much higher starting point.

In a mild scenario, we could see the dollar leveling off and then weakening due to Fed easing, which could help some emerging markets show signs of life. It would give U.S. corporations some currency tailwinds for once rather than headwinds like they've had. In this case, I'd want to be positioned in emerging markets.
 
Vanguard has a good valuation/growth breakdown of the S&P 500 (VOO) and emerging markets (VWO) via their ETFs:
 
VOO vs VWO 
 Table Source: Vanguard
 
 
Emerging markets have higher 5-year growth rates and much lower valuations. They would be my top choice in a weakening dollar environment.
 
As a recent data point, when the DXY dollar index dropped from about 100 to 90 in 2017, the MSCI emerging markets index soared over 37% in dollar terms. Lower debt burdens gave them a burst of earnings growth and then strengthening currencies added onto it for dollar-based investors.
 
However, I don't particularly like just owning an emerging market index due to how heavily weighted they are in China. I prefer analyzing individual markets based on growth, valuations, sector composition, stability, currency fundamentals, and debt levels. I'm optimistic about forward equity returns for Chile, Russia, India, South Korea, Taiwan, and a few others, especially if we get further sell-offs this quarter. I don't have a strong conviction either way on China at this time.
 
One of my favorite emerging market stocks at the moment is Sberbank (OTCPK:SBRCY) as a small position as part of a diversified portfolio. Many investors underestimate how resilient the company is, it has a single-digit P/E ratio, and it offers a very high dividend yield with a modest payout ratio.
 
I would have a moderate outlook on gold (GLD) in dollar terms in this scenario. It would benefit from a weaker dollar and lower U.S. interest rates, but without a recession it wouldn't get a fear trade. I'd be a buyer at current levels.
Scenario 2) U.S. Recession
 
In a more severe scenario, Fed dovishness and liquidity injections aren't enough to keep things going and the U.S. begins encountering recessionary conditions in 2020. We could have some rough earnings numbers for these last two quarters of 2019 (the one that just ended, and the next one), leading into ongoing weakness in 2020.
 
Recessions significantly reduce U.S. tax revenue:
 
Government Tax Receipts Chart Source: St. Louis Fed
 
 
If we have a recession in the coming year, it'll be the first one where the government is already running an annual deficit at 5% of GDP before the recession even begins, which could make for some very interesting situations. We could easily blow a $500 billion hole in the budget as a low-end estimate, and depending on any stimulus measures the government takes, the range of numbers goes up from there. Annual deficits could balloon from over $1 trillion to over $1.5 trillion or upwards of $2 trillion.
 
The amount of QE by the Fed to monetize U.S. deficits would likely be larger than many investors realize, just looking at it mathematically. I'd expect at least 20% dollar devaluation in the coming years, if not more.
 
In this scenario, I consider it highly probable that gold would do especially well. I also think emerging markets, while they would likely be in for a volatile time, would do better than most investors assume at these valuation levels and with a weaker dollar, and would come out strong on the other side of any sell-offs. The night is darkest just before the dawn, in other words.
 
Most investors have it in their minds that emerging markets necessarily do bad when the U.S. has a recession. The sample size for this, however, is just three. There have been only three U.S. recessions since the MSCI emerging markets index was created in the late 1980's. During the "big one" in 2007-2009, emerging markets were a bloodbath but for context, they went into that global crisis with record high valuations and high expectations, not low valuations and low expectations like we have now.

Look how emerging markets held up during the two quarters surrounding the flash crash of 4Q2018 compared to the S&P 500, even without a weaker dollar:
 
Chart Data by YCharts
 
At these valuations, although I'd expect to see an emerging market draw down in a U.S. recession scenario, I'm optimistic about emerging markets coming out strong on the other side and would be a buyer of corrections, and particularly of select countries. Especially because, this time around, a weaker dollar is on the table and that would relieve some of their debt pressures like they enjoyed in 2017.
 
Final Thoughts
 
Summing this all together, there are multiple ways this can play out, but mathematically they all seem to require a lower dollar, one way or another.
 
It has been a longstanding belief that U.S. government debt and deficits are a far-off problem and don't really matter, but we are starting to run into tangible effects from treasury bill oversupply and in the coming years this will be a factor to work around. I classify U.S. debt/deficits as one of my four economic bubbles to be aware of.
 
The dollar has positive momentum at the moment, so it could trend higher in the short-term, but the higher it goes, the more it dooms itself by increasing the likelihood and timeline of a large U.S. recession and the associated debt monetization. Diversification is the safest way to play it. Traders may want to watch it for now, and be prepared to take advantage when/if the dollar strength turns over.
 
As far as I can tell, most of the dollar bulls who expect a much higher breakout in the dollar underestimate the damage that a strong dollar self-inflicts on the United States economy, which would then likely self-correct via a recession and major deficit monetization. The strong dollar reduces foreign corporate income and forces U.S. institutions to fund the U.S. government deficit, and after five years of doing this they are nearly tapped out and with flat dollar-denominated profits. Any major dollar breakout would likely be brief, self-correcting, and unpleasant.

I am including gold and emerging markets (with an emphasis on certain countries) in my portfolio, and which asset class will do better between the two will depend on how events unfold. I also have dry powder in the form of cash-equivalents and short-term bonds to add to my foreign or domestic equity allocation should we get a big equity sell-off later this year or in 2020.

How to Rethink Capitalism

The 2008 financial crisis, together with failed efforts to combat climate change and sharply rising inequality, has frayed the neoliberal consensus that has prevailed in the United States and much of the West for more than two generations. Three issues must be considered in weighing what comes next.

Simon Johnson

johnson120_Spencer PlattGetty Images_businessmansitswallstreet


WASHINGTON, DC – The United States Business Roundtable, an organization of CEOs of large US companies, recently issued a statement that caused quite a stir in some circles. Rather than focusing primarily or exclusively on maximizing shareholder value, America’s corporate titans argued, companies should attach more weight to the wellbeing of their broader stakeholder community, including workers, customers, neighbors, and others.

As CEOs of large companies are hired and fired mostly on the basis of their contributions to profits, such statements merit a certain amount of cynicism. Unless and until incentives created by financial markets change, we should expect the short-term profit motive to prevail.

The Business Roundtable’s views are part of broader attempts to reimagine capitalism – the topic now of high-profile courses at Harvard Business School, Brown University, and elsewhere. In his recent book The Economists’ Hour, Binyamin Appelbaum, an influential New York Times journalist, argues that economists are to blame for tilting too much of the world excessively toward profits. And Democratic presidential candidates are putting forward ideas that range from modest reform to a more substantial overhaul of how markets work.

There are three main issues to consider when thinking about how to adjust the role of markets in the modern American economy in a sensible way.

The first issue is that market incentives are actually positive in some contexts. If you are an entrepreneur and want to raise capital, appealing to a broader social good will get you very little. To transform an industry – and challenge the incumbents represented on the Business Roundtable – you need a business model that promises future profits. For example, private venture capital financed the process of converting research on the human genome into life-saving drugs over the past two decades.

Second, a balance obviously needs to be struck between public and private (profit-seeking) efforts. Appelbaum’s strongest argument is that leading economists denigrated public action and, at least since the 1960s, viewed private business through rose-tinted glasses.

As James Kwak (my co-author on other matters) correctly points out, powerful interests lay behind the development and dissemination of these ideas (although his own book, Economism, also highlights how policymakers distort sensible economic analysis to bolster the naive view that business is infallible).

Third, the private sector typically does not consider positive and negative externalities – actions that affect other people but not the actor. For example, in Jump-Starting America, Jonathan Gruber and I argue that the public sector has a robust role to play in investing in basic science, because the general knowledge that results affects many people, in ways that are hard to predict.

This was exactly the rationale behind the very successful government backing provided to the human genome project; it also motivates the broader funding provided to the National Institutes of Health. Almost all modern drugs emerge from a process supported, at its early stages, by the NIH.

The private sector is also not generally good at regulating itself, again mainly because of externalities. For example, financial sector firms lobby hard to relax regulation – allowing them to make higher profits but also to take greater risks. No individual firm cares enough about risks to the entire system. Similarly, energy companies want to extract more natural resources. Their CEOs are not paid to worry about climate change.

The long-prevailing model for the US economy was to allow the market to organize most economic activity and then regulate or redistribute relative to the outcomes. But the 2008 financial crisis, together with failed efforts to combat climate change and disappointing longer-term economic outcomes for most Americans (while some rich people have become much richer), has frayed the consensus underlying this model.

Can we have a more inclusive form of capitalism that yields better outcomes? Yes, according to Senator Elizabeth Warren, who is running for the Democratic presidential nomination on a pro-reform platform. Warren, who made a political name for herself by advocating for stronger consumer protection for financial products, is not at all anti-market.

Rather, she argues that designing market structures differently will lead to different (and better) outcomes. Many of her various proposals amount to rethinking what is allowed in terms of market structures and firm behavior, as well as how to limit the influence of money in politics.

The market is not necessarily good or bad. What you get out of capitalism depends on how you shape it. If you rely on wealthy people and already powerful businesses to make the key decisions, you will mostly get what you already have – a highly unequal economy, prone to crises, rushing headlong toward a climate catastrophe.


Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with Jonathan Gruber, of Jump-Starting America: How Breakthrough Science Can Revive Economic Growth and the American Dream.

Family feud at La Repubblica owner bursts into the open

Carlo De Benedetti seeks to buy a stake in the newspaper publisher he founded

Rachel Sanderson in Milan

Carlo De Benedetti, honorary chairman and director of Compagnie Industriali Riunite SpA (CIR), poses for a photograph in Milan, Italy, on Monday, Feb. 11, 2013. CIR holds interests in car parts manufacturer Sogefi Spa, and Gruppo Editoriale L'Espresso SpA, the publisher of Italian daily newspaper La Repubblica. Photographer Alessia Pierdomenico/Bloomberg
Carlo De Benedetti gave up day-to-day management of GEDI media group in 2009 © Bloomberg


A feud at one of Italy’s most powerful dynasties has burst into the open after tycoon Carlo De Benedetti sought to regain a stake in the newspaper business he founded and has accused his sons of mismanaging.

Shares in GEDI media group, which is home to titles including La Repubblica and La Stampa, surged more than 15 per cent on Monday after the octogenarian made a €38m offer over the weekend to buy a 30 per cent stake in the group.

The 84-year-old, who has been a towering figure in Italian media for almost half a century, also launched a withering attack on his sons Rodolfo De Benedetti, 58, and Marco De Benedetti, 57, to whom he handed control of GEDI in 2012.

He accused them of having “neither the competence nor passion” to manage the media group, according to a letter quoted by Italian news agency Ansa. He added that he wanted to relaunch “the group with which I have been associated for most of my life”.

His sons shot back, with Rodolfo De Benedetti declaring he was “shocked” by his father’s behaviour, the news agency reported. A statement from CIR, the family holding company that owns about 44 per cent of GEDI, on Sunday described the offer as “inadmissible”.

Carlo De Benedetti, who founded the left-leaning La Repubblica and gave up day-to-day management of GEDI in 2009, offered 25 euro cents a share for the 30 per cent stake, Ansa reported. Despite surging on Monday, shares in GEDI have plunged 85 per cent from a recent high in 2014, leaving the group with a market capitalisation of under €150m.

In an effort to combat the broader downturn in the Italian media market, three years ago La Repubblica, its sister titles and Genoan local paper Il Secolo XIX were merged with the Agnelli family’s La Stampa. Agnelli scion John Elkann, who is also chairman of Fiat Chrysler, kept a 5 per cent stake in the merged group.

CIR turned down a takeover offer for GEDI from former media and telecoms executive Flavio Cattaneo last year, according to Italian media.

The attempt to return to the fray by the senior Mr De Benedetti is the latest in a flurry of activity by high-profile Italian octogenarian tycoons who made their fortunes during Italy’s economic boom of the 1980s.

Leonardo Del Vecchio, 84, the eyewear tycoon who built Ray-Ban maker EssilorLuxottica, and Luciano Benetton, 84, the retail magnate behind the Benetton jumpers to toll roads dynasty, have both returned to the frontline in a bid to revive businesses facing the challenges of globalisation and technological disruption.

Even Silvio Berlusconi, 83, the former Italian prime minister and longstanding media foe of Mr De Benedetti, has backed changes at Mediaset, the broadcaster he founded, as his daughter Marina and son Pier Silvio seek to expand it into a pan-European media group.

The feud at Credit Suisse that has shaken Swiss banking

Car chases and rows over cocktails: the fallout threatens CEO Tidjane Thiam

Stephen Morris in London


Tidjane Thiam and Iqbal Khan © FT montage; Bloomberg; Reuters


The staid world of Swiss banking has been rocked by lurid details of the breakdown in the relationship between Credit Suisse chief executive Tidjane Thiam and Iqbal Khan, who ran the bank’s wealth management division.

Swiss prosecutors are investigating an alleged physical confrontation last week between Mr Khan and up to three men hired by Credit Suisse to follow him after he resigned in July to move to arch-rival UBS.

While Credit Suisse has admitted it hired the spy firm, Investigo, each side disputes the other’s version of events.

Mr Khan alleges a group of three men chased him and his wife through the streets of Zurich by car and on foot, which culminated in a physical confrontation behind the Swiss National Bank.

However, an Investigo detective has provided a sworn statement to Credit Suisse and authorities that he was alone, rather than in a group of three, and that Mr Khan chased him, rather than the other way around. Investigo was asked to follow Mr Khan only on weekdays from a suitable distance and identify any people he met, according to documents seen by the FT.

The controversy has shown no signs of ending. It has raised new questions about longstanding personal animosity between Mr Thiam and Mr Khan — and whether the bank acted appropriately in hiring investigators.

“The board is coming under pressure to sort this out and the regulator too,” one major investor told the FT. “It's something of extreme gravity; in Zurich it is becoming a time bomb and you can feel the panic. Both sides have been damaged, but especially Credit Suisse.”

A graphic with no description


“We have said to the chairman and board they have to provide a clear outcome and explanation; whoever did wrong has to pay,” he said.

Mr Khan, who was born in Pakistan and immigrated to Switzerland aged 12, joined Credit Suisse in 2013 after a 12-year career as an auditor at EY. During his tenure, profit at the international wealth management unit increased by around 80 per cent. He helped bring in more than $46bn of net new assets between 2016 and 2018.

French-Ivorian Mr Thiam, 57, joined Credit Suisse in March 2015 after running UK insurer Prudential for six years. He quickly set about shrinking the trading arm of the investment bank and repositioning the organisation as a wealth manager focused on ultra-rich entrepreneurs.

Whilst earning plaudits for establishing Credit Suisse as one of the top private banks in Asia, reducing the volatility of earnings and avoiding major scandals — until now — the share price has dropped more than 40 per cent under his leadership.

At first, the pair worked well together, according to people familiar with their relationship. Mr Khan was repeatedly promoted and called a “star” by Mr Thiam. But over time, Mr Khan grew frustrated with his profile within the bank, lack of public appearances, and assurances about his potential to rise to lead the organisation.

Urs Rohner, chairman of Credit Suisse Group AG, looks on during the Swiss International Finance Forum in Bern, Switzerland, on Tuesday, June 28, 2016. European stocks advanced, snapping their worst two-day losing streak since 2008, as investors speculated that policy makers may take action to shore up markets after the recent rout. Photographer: Michele Limina/Bloomberg
Urs Rohner, chairman of Credit Suisse


Personal animosity grew when Mr Khan bought, knocked down and redeveloped the house immediately next to his boss in the Herrliberg area on the north-eastern “gold coast” of Lake Zurich.

The construction work lasted for almost two years, including over some weekends, leading to Mr Thiam making a complaint to Credit Suisse chairman Urs Rohner about his subordinate, said one person familiar with the situation. Mr Khan insisted the property he bought had been in his wife’s family for years and he had done nothing wrong.

After Mr Khan moved into the newly renovated house, which shares a fence with Mr Thiam’s, the CEO hosted a cocktail party in January for colleagues, people from the neighbourhood and some friends. Mr Khan and his wife attended.

At the party, Mr Khan fell out with Mr Thiam’s partner over a dispute about some trees planted on the Thiam property.

Mr Thiam took Mr Khan aside and there was a confrontation away from the other guests, where the CEO complained about the conversation with his girlfriend. Mr Khan claims his wife had to separate them, Swiss newspaper Tages-Anzeiger has reported. Mr Khan later complained to his board and chairman about the incident.

After the falling-out in January the two were barely on speaking terms at work, creating a toxic environment at the bank’s headquarters, several people who experienced it said.

As a result of the breakdown, Mr Khan was permitted to leave with a shorter than usual gardening leave period of three months before his move to UBS, scheduled next week on October 1, one of the people said.

WA6D31 Zurich City: The Swiss National Bank Building at Burkliplatz
The Swiss National Bank Building in Zúrich


At least in public, even after the resignation, Mr Thiam and Mr Khan put on a friendly front. Mr Khan was invited back to Credit Suisse for a photo opportunity and received a standing ovation from staff, several people present said. The same week he also visited UBS to be introduced to his new fellow executives, but was kept in public areas to avoid controversy, according to a person familiar with the situation.

Yet Credit Suisse was worried that Mr Khan might try to take key staff members with him, according to people familiar with the matter.

As he plotted his exit from Credit Suisse, Mr Khan informally met or was interviewed by several international and Swiss banks in the spring and early summer, including UBS, Julius Baer, Lombard Odier and Goldman Sachs, they said.

In some of these conversations, he discussed recruiting some of the top people from Credit Suisse across different bank functions such as structured trading, lending and top-performing relationship managers, they added.

Mr Khan told prospective employers his success at Credit Suisse was a team achievement and he would want approval to bring across some of his people if he were to join.

There is no suggestion Mr Khan breached the terms of his Credit Suisse employment agreement during these discussions.


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Credit Suisse chairman Urs Rohner has ordered the independent review of the decision to tail Mr Khan, determining which executives signed off on it and if it was justified. The report will be completed in a matter of days and top jobs, including that of Mr Thiam, could be at risk, according to two people with knowledge of the probe.

“Someone’s job will go, or at least there will be an appropriate sanction,” one of the people said.

Pierre-Olivier Bouée, Credit Suisse’s chief operating officer and Mr Thiam’s closest confidant, also acts as the bank’s head of security and signed the contract with the external firm Investigo, they said.

Mr Bouée declined to comment through a spokesman.

UBS has also been forced to address the controversy. Chairman Axel Weber said in a television interview the bank had been running due diligence checks on Mr Khan as recently as today, an unusual admission considering he is supposed to start in less than a week.

“Everything needs to be by the book,” he told Bloomberg TV. “If things don’t happen by the book I’m not in favour of doing it.”

Credit Suisse declined to comment. A spokesman for Mr Khan declined to comment.
 

Additional reporting by Sam Jones in ViennaThis article has been amended to reflect the drop in Credit Suisse’s share price since Tidjane Thiam became chief executive.

George Friedman's Thoughts: War and a New Geopolitical Age

By George Friedman


It is time to end this series of philosophical ruminations and turn instead to something that is at the center of geopolitics: war. The roots of my philosophical mumblings and my thoughts on war are from two of my books. The first is from my early academic work, “The Political Philosophy of the Frankfurt School.”

The second, called “The Future of War," came later. This is the book of which I am proudest.

It is also the book that sold the fewest copies; its great moment came when the Brazilian war college adopted it as a text. I am proudest of this work because of the forecast. I wrote it in the early 1990s but envisaged a future of war that has since emerged – war waged by unmanned aircraft and hypersonic missiles and in outer space. So, I turn now to talk about the book on war in the hope that I can link the nature of enchantment to infantrymen wearing armored and powered suits.

Let me begin at the beginning.

The introduction of firearms created a new culture of weapons – what I call ballistic weapons. Once fired, the round goes where the initial explosion of energy drives it, with nothing to control it but gravity and the elements, and since it is fired through hand-eye coordination, the probability of it hitting the target is low.

The solution to this problem in war was to dramatically increase the number of weapons fired, compensating for inaccuracy with many rounds from many guns, thereby saturating the horizon and increasing the probability of killing the enemy. All weapons until around 1965 were ballistic; rifles, tanks, howitzers and the like grew into a vast enterprise, centered on the industrial plant that produced them.

The solution to this, in World War II, was to mass bombers, saturating a city with bombs to destroy a single factory. Bombing was so inaccurate that the probability of any bomb load hitting a factory was near zero. This kind of war required many ballistic weapons, many soldiers to use the weapons, many factories to produce them, and many bombers to destroy the factories.

Nuclear weapons grew out of this logic. Massed bombers dropping ballistic weapons were inefficient. One ballistic missile with a nuclear weapon could increase the probability of destroying a factory to near certain. The inaccuracy of pre-nuclear weapons had created total war, and the intercontinental ballistic missile solved the problem of inaccuracy by increasing the size of the explosion.

Between 1967 and 1973 three minor events signaled the end of the ballistic era. In 1967, a Soviet team fired Styx missiles at the Israeli destroyer INS Eilat, sinking it. In 1972, American aircraft used laser-guided bombs to destroy the Thanh Hoa bridge in Vietnam, which had survived conventional air attacks since 1965. In 1973, a brigade of Israeli tanks driving south, parallel to the Suez Canal, was obliterated by a hail of rockets fired by Egyptian special forces.

The three events were linked. In each case, the attackers used projectiles whose trajectory could be changed after firing. The Styx missiles used in the attack on the Eilat were guided internally by a radar seeker that homed in on the ship, maneuvering as needed.

The Thanh Hoa bridge was attacked by a small number of aircraft firing Bullpup missiles, which the air crew could guide to the target using a television system that fixed on the bridge.

The Israeli tanks were destroyed by AT-3 Sagger missiles (note that these are NATO, not Russian, designation).

The missile trailed a wire back to a control system that allowed the shooter to guide the missile to the target. In all cases the probability of any missile hitting the target was about 50 percent, vastly higher than with ballistic weapons.

This changed the mathematics of war. It’s said that in World War I it took 10,000 rounds to kill one man. I don’t know how they counted that but it was a lot. The number of projectiles that had to be fired to hit a ship, a bridge or a tank plummeted to one or two.

This meant that traditional weapons – tanks, aircraft and ships – were not likely to survive on the battlefield in a war of equals, at least not without fiendishly expensive and doubtful defenses. The cost of defending yourself from a weapon soared while the cost of attacking plunged.

During Desert Storm, an American cruise missile could be fired from a ship off shore at a building on land and hit the second window in, on the third floor. This is not a theoretical example, and it exemplifies how the calculation of war had changed.

Rather than firing large numbers of inaccurate weapons firing, committing massive collateral damage, combatants could fire a much smaller number of weapons to destroy a target without having to saturate the surrounding areas. These precision-guided munitions, as they were called, shifted the structure of warfare.

But precision-guided munitions have one critical requirement: intelligence. You can hit a window on a building in Baghdad if you want to, but you have to know which window you want to hit; in some cases, as with the Tomahawk, which is guided by pictures of the terrain and target, you needed to get the pictures of the target first. The challenge of firing non-ballistic weapons at a target a thousand miles away was partly a technical problem but mostly an intelligence problema.

Collecting the intelligence with the requisite level of detail was not easy. Figuring out where a specific individual was in Baghdad, for example, required a combination of humans on the ground, technology to track a huge number of phone calls, and aerial surveillance, which might spook the target.

Intelligence was always at the heart of war, but now it had become the enabler of tactical combat. Fighting the Iraqis in 1991 was relatively easy. But fighting a more sophisticated enemy required more sophisticated technology.

The United States had the National Security Agency for electronic intelligence, the National Reconnaissance Office for satellite imagery and the Central Intelligence Agency for human intelligence. But the evolution of warfare put a heavy burden on them.

The traditional forms of intelligence did not always provide the data needed to launch a precision-guided missile. There were ships for intercepting data and submarines for tapping into underwater lines, but the speed of tactical warfare with PGMs outstripped their capabilities.

The emergence of an alternative to ballistic warfare demanded a different source of intelligence. As with Desert Storm, no one knew they were going to war until after it began. Building intelligence capabilities when war is a surprise means that you have to develop intelligence on a global scale with a high degree of geographic specificity on call. And it had to combine imagery, electronic surveillance and the ability to move data from sensor to shooter.

The microchip was invented for ICBMs and fighter planes and has become the center of new technology. Satellites that had looked for static missile launchers now need to be far more flexible and dynamic.

Computers’ data flows – the internet – were essential to tell the launcher where to fire. Technologies that were emerging were force-grown by the Department of Defense, much like the microchip. Space-based sensors had to take digital photos long before Apple put that technology into the phone. And space became far more important for electronic and visual capabilities.

The emergence of precision-guided munitions drove war’s center of gravity into space. Other causes came later, but space became indispensable for managing PGMs, and any serious war has to begin there. If the U.S. and China ever go to war, the Chinese will need to fire PGMs at American ships, and therefore the Americans must blind them before they can do that by destroying China’s space-based system.

Just as the ballistic era required a vast support network to function, the PGM era needs a far smaller but much more sophisticated system to sustain it. Those systems do much more than define targets for PGM, but that is a core mission.

I can’t overemphasize the importance of the 1967-73 incidents. They opened not only a new age in war but also required a new technological platform. But the most important change was the requirement that wars begin in space, in space-based Pearl Harbors. And I suppose that is enough of a link to enchantment.