Fingers point at hedge funds after Japan bond sell-off

Trend-following investors switched bets after price crossed key threshold

Laurence Fletcher and Tommy Stubbington in London and Leo Lewis in Tokyo

M&A bankers and lawyers say a 'profound' change of attitude is slowly embedding itself in Japanese boardrooms, making hostile bids a more plausible reality
Massive holdings of Japanese government bonds at the country’s central bank mean that the market rarely budges © Bloomberg

Hedge funds are taking the blame for a drop in Japanese government bond prices that has reverberated around global debt markets.

Benchmark bonds in the US, Germany and the UK have all taken a tumble in recent weeks, driven by an unusual outbreak of optimism about the global economic outlook that has boosted equities.

But sharp price falls in the typically tranquil Japanese government bond market have stood out — and some analysts say they bear the fingerprints of trend-seeking computerised hedge funds scrambling to cover losses.

The suspicions are rekindling a debate about the influence of these hedge funds, which have frequently been blamed when markets swing to extremes without clear fundamental triggers.

“Futures-driven selling has been the main cause of the [Japanese market] move,” said Peter Chatwell, head of rates strategy at Japan’s Mizuho International. “It looks like an unwind of leveraged long positions.”

Massive holdings of JGBs at the country’s central bank mean the market rarely budges, but the 10-year benchmark yield leapt this week to a high of minus 0.02 per cent, from minus 0.19 per cent at the start of November — a large move by Japanese standards that reflects falling prices.

The yield slipped back to minus 0.09 per cent on Thursday.

Line chart of 10-year government bond yield (%) showing Hedge funds dump Japanese debt

Certain types of hedge funds that try to latch on to trends in global markets — known in the industry as commodities trading advisers, or CTAs — had been betting successfully on rising JGB prices since around this time last year, according to Société Générale’s Trend Indicator.

But their investments turned sour as the market went into reverse in early September, leaving them nursing losses. The Trend Indicator has, as of late last week, shifted to betting on falling prices.

The global pullback in fixed income since mid-September has been sparked by easing trade tensions and a sense that the gloom about the prospects for the world economy was overdone.

Selling in JGBs — which also reflects receding expectations that the Bank of Japan is on the brink of cutting interest rates — has been a catalyst for broader moves at crucial points during the sell-off, including over the past week, according to Jim McCormick, global head of desk strategy at NatWest Markets.

“CTAs have built in some cases record long positions in core fixed income markets,” Mr McCormick said. “With momentum signals now turning less bullish, positions could be set to follow.”

Bond traders and analysts in Tokyo point out that trend-following hedge funds had built huge net long exposure to Japanese bonds by the end of August. Those positions, said analysts at Nomura, were highly leveraged and prone to sharper moves in the weeks and months that followed.

Some analysts calculate that the key point for many of those funds in 10-year yields was minus 0.11 per cent. Once the yields popped above that level in November, many funds that had bought the bonds in the August rush were left holding losses, turning them into automatic sellers.

Critics say these funds, which run about $300bn in assets, push markets further than they otherwise would have moved, damaging other market participants. But many managers of trend-following funds say the amount they trade is only a fraction of total market volume and their footprint is small.

And while these managers have sold Japanese government bonds, the extent to which they are now betting on falling prices varies. The bonds are “not a big short”, said an executive at one hedge fund.

Rotterdam-based hedge fund Transtrend, which manages $5.4bn in assets, owned Japanese government bonds for most of this year, making money in the process, but started cutting this position late last month. Rather than betting on falling prices, the fund now has no exposure. 
“We do not believe that Transtrend has played a significant role in exacerbating the safe haven or JGB trend,” said executive director André Honig. “For the CTA sector as a whole, it shouldn’t be the case either.”
CTAs employ teams of PhD scientists to design algorithms to spot and profit from market trends, and they have been enthusiastic buyers of bonds on very low or negative yields in recent years.
While many human hedge fund traders and other investors have recoiled at the prospect of effectively paying for the privilege of lending money to a government, quants, which feel no fear, kept holding on as the trend took yields into the deep freeze.
That has been a big driver of gains at trend-following funds this year. Such funds are on average up 6.2 per cent this year to the end of October, according to data group HFR, despite suffering some losses in recent months as bonds weakened.
London-based Aspect Capital has gained 18.5 per cent this year in its main fund. It has been betting on rising bond prices, according to an investor letter seen by the Financial Times, and suffered a loss on its bond position in early November. The letter did not detail which countries’ bonds Aspect owned. Aspect declined to comment.
Mr Chatwell said the swings in the market had undermined bond-buying strategies in recent weeks. He said: “While there’s all this volatility it’s harder to generate income from the JGB market. A lot of investors are sitting on the sidelines and waiting for a better entry point.”

Old, not yet rich

China’s median age will soon overtake America’s

Demography may be the Chinese economy’s biggest challenge

SHORTLY AFTER 9am the neighbourhood care centre for the elderly shuffles to life. One man belts out a folk song. A centenarian sits by his Chinese chessboard, awaiting an opponent.

A virtual-reality machine, which lets users experience such exotic adventures as grocery shopping and taking the subway, sits unused in the corner.

A bigger attraction is the morning exercise routine—a couple of dozen people limbering up their creaky joints.

They are the leading edge of China’s rapid ageing, a trend that is already starting to constrain its economic potential.

Since the care centre opened half a year ago in Changning, in central Shanghai, more than 12,000 elderly people from the area have passed through its doors.

The city launched these centres in 2014, combining health clinics, drop-in facilities and old-people’s homes. It plans to have 400 by 2022.

“We can’t wait. We’ve got to do everything in our ability to build these now,” says Peng Yanli, a community organiser.

The pressure on China is mounting.

The coming year will see an inauspicious milestone. The median age of Chinese citizens will overtake that of Americans in 2020, according to UN projections (see chart).

Yet China is still far poorer, its median income barely a quarter of America’s.

A much-discussed fear—that China will get old before it gets rich—is no longer a theoretical possibility but fast becoming reality.

According to UN projections, during the next 25 years the percentage of China’s population over the age of 65 will more than double, from 12% to 25%.

By contrast America is on track to take nearly a century, and Europe to take more than 60 years, to make the same shift.

China’s pace is similar to Japan’s and a touch slower than South Korea’s, but both those countries began ageing rapidly when they were roughly three times as wealthy per person.

Seen in one light, the greying of China is successful development. A Chinese person born in 1960 could expect to live 44 years, a shorter span than a Ghanaian born the same year.

Life expectancy for Chinese babies born today is 76 years, just short of that in America.

But it is also a consequence of China’s notorious population-control strategy.

In 1973, when the government started limiting births, Chinese women averaged 4.6 children each.

Today they have only 1.6, and some scholars say even that estimate is too high.

Fertility was bound to decline as China got wealthier, but the one-child policy made the fall steeper.

Even though the country shifted to a two-child policy in 2016 and may soon scrap limits altogether, the relaxation came too late.

The working-age population, which began to shrink in 2012, will decline for decades to come.

By the middle of the century it will be nearly a fifth smaller than it is now.

China will have gone from nine working-age adults per retired person in 2000 to just two by 2050.

The economic impact is being felt in two main ways.

The most obvious is the need to look after all the old people. Pension payouts to retired people overtook contributions by workers in 2014.

According to the Chinese Academy of Social Sciences, the national pension fund could run out of money by 2035.

The finance ministry is taking small steps to shore the system up: in September it transferred 10% of its stakes in four giant state-owned financial firms to the fund.

But far more is needed. Government spending on pensions and health care is about a tenth of GDP, just over half the level usual in older, wealthier countries, which themselves will have to spend more as they get even older.

The second impact is on growth. Some Chinese economists—notably Justin Lin of Peking University—maintain that ageing need not slow the country down, in part thanks to technological advances.

But another camp, led by Cai Fang of the Chinese Academy of Social Sciences, has been winning the argument so far.

A shrinking labour pool is pushing up wages and, as firms spend more on technology to replace workers, pushing down returns on capital investment.

The upshot, Mr Cai calculates, is that China’s potential growth rate has fallen to about 6.2%—almost exactly where it is today.

The labour shortage is hitting not just companies but entire cities.

From Xi’an in the north to Shenzhen in the south, municipalities have made it easier for university graduates to move in, hoping thereby to attract skilled young workers.

China could, in theory, mitigate the downside from its ageing by boosting both labour-force participation and productivity—that is, getting more people into work and more out of them. Neither is easy.

Retirement ages are very low in China (in many jobs, 60 for men and 50 for women), but the government has resisted raising them for fear of a backlash.

And a return to state-led growth under Xi Jinping appears to be hurting productivity.

As George Magnus, an economist, writes in “Red Flags: Why Xi’s China is in Jeopardy”, demography is not destiny, and China has time to change course.

“The bad news, though, is that the time that is available is passing by rapidly,” he says.

One piece of good news is that China is thinking creatively about how to look after the swelling ranks of pensioners. Traditionally, children have been expected to care for their elderly parents, which helps explain why public investment in old-age homes has been minimal.

But most families now have just one child, and that child is working. Suzhou, a wealthy city near Shanghai, shows how China can take advantage of its scale.

In 2007 Lu Zhong, an entrepreneur, founded Jujiale as a “virtual retirement home”, dispatching helpers to private homes on demand.

It now has 1,800 employees serving 130,000 retired people.

Mr Lu says that it needs to grow by about 15% a year to keep up with demand.

Yet that is a silver lining in a grey-haired cloud. On October 1st China celebrated the 70th anniversary of the People’s Republic.

By the centenary in 2049, Mr Xi has vowed, China will have developed to the point that its strength is plain for the world to see.

But as Ren Zeping, a prominent economist, tartly noted in a recent report, the median age in China in 2050 will be nearly 50, compared with 42 in America and just 38 in India.

That, he wrote, raised a question: “Can we rely on this kind of demographic structure to achieve national rejuvenation?”

A U.S.-China Trade Deal Won’t Rescue Emerging Market Stocks

What is happening in the slowing Chinese domestic economy matters far more for the MSCI EM index than the latest mood on tariffs

By Mike Bird

The prospect of a limited truce on trade between China and the U.S. was enough to lift global stocks in October, but even an actual deal—however likely that is—would offer little more than temporary relief for beleaguered emerging markets.

Rather, emerging-market stocks will have an opportunity to outperform only if the Chinese economy enters an unexpected upswing.

Given Beijing’s reluctance to undertake a 2016-style stimulus this year, that seems unlikely.

Emerging markets are a diverse bunch, but if there is a dominant driver of their problems in 2019 it is probably the slowing Chinese domestic economy, which is only partly related to U.S. tariffs.

The MSCI EM Index is trailing the MSCI World Index by 10 percentage points this year on a total-return basis.

Even once the U.S. is removed from the calculation, EM stock markets are lagging well behind those of the world’s other advanced economies for 2019.

The flagship EM index has seen its direct weighting to China increased in recent years, from 17.9% a decade ago to almost 32% now.

But it isn’t just Chinese stocks themselves dragging the benchmark down.

Shoppers at a Costco in Shanghai. Photo: wu hong/Shutterstock

South Korea, the second-largest component of the index, has had an even more miserable year.

In large part, that is because of its exposure to the manufacturing sector of its big neighbor. China buys around 25% of its exports, up from 10% 20 years ago.

There is a similar story for commodity exporters outside Asia, such as Brazil.

China accounts for more than a quarter of the South American country’s outward trade, up from more like 2% in 1999.

Excluding Asia makes little difference to the underperformance of EM stocks versus their developed-market counterparts this year.

When EM stocks fared badly last year, the difference was often attributed to the unwinding of Federal Reserve largess, which had helped them in previous years.

A mountain of dollar debt would become more difficult to service in a world of higher interest rates.

This year, that monetary trend has reversed, sending 10-year Treasury yields a full percentage point higher.

This may have saved them from a worse fate, but it hasn’t been enough to fuel an EM rally.

Their recent underperformance hasn’t left EM stocks on particularly cheap valuations.

The index is priced around 12 times its expected earnings for the next 12 months, not far from its highs over the past decade. In fact, their performance could have been a lot worse.

The EM index is up 9% for 2019, while more modest Chinese growth has left the CRB Raw Industrials Spot Price Index down 9%. The two usually move in tandem.

Halting additional U.S. tariffs on Chinese goods might provide a meager lift for EM equities.

But given China’s struggle to deal with its mounting debt pile while providing further stimulus to the economy, growth will very likely continue to slow.

Unless something on that front changes, EM stocks—whose wagons have become firmly hitched to China—will struggle to make major gains.

Hong Kong Protesters Call for U.S. Help. China Sees a Conspiracy.

The United States, viewed as a champion of democracy, occupies a symbolic role in the protests. Activists now want President Trump to take a tougher stand against Beijing.

By Edward Wong

Protesters rallying last month in Hong Kong.Credit...Lam Yik Fei for The New York Times

HONG KONG — The Hong Kong protests at times seem like love fests with the United States. Depending on the day, demonstrators wave American flags or Uncle Sam recruitment posters, and even dress as Captain America, complete with shield.

The United States represents democracy, and the activists hope that maybe, just maybe, it will save Hong Kong. Five months in, they are trying harder than ever to draw the United States into their movement.

The protesters are pressing Hong Kong officials and their overseers, the authoritarian Communist Party leaders of China, for greater democratic rights and rule-of-law in the autonomous territory. As they see it, the Trump administration might be able to make demands of Chinese leaders or Hong Kong officials, especially because members of elite political circles want to maintain access to the United States.

Also, they note, the trade war with China, started by President Trump, is adding pressure over all on President Xi Jinping.

For the American government, the protests are more complicated — a potential policy dilemma but also a potential point of leverage with Beijing and a way to channel American values to the rest of the world.

“The United States should continue to deter Beijing from use of force, maintain an unblinking eye on Hong Kong, and make Beijing pay a heavy reputational cost for curtailing the rights and freedoms of Hong Kong citizens,” said Ryan Hass, a former State Department and National Security Council official now at the Brookings Institution.

Yet, he added, “I worry that the protesters in Hong Kong risk misinterpreting American sympathy and support of their cause for expectation that the United States will shield them from Beijing’s heavy hand.”

If the protesters are sending out a siren song, some American officials and lawmakers are answering it, eager to show their commitment to the cause.

Members of Congress have appeared in Hong Kong in public displays of solidarity. Last month, Senator Ted Cruz, Republican of Texas, donned an all-black outfit, while Senator Josh Hawley, Republican of Missouri, posted photographs from a protest.

In Washington, Nancy Pelosi, the speaker of the House, has met with activists, pro-democracy politicians and Jimmy Lai, a publisher considered radioactive by Beijing. Vice President Mike Pence singled out Hong Kong as a beacon of liberty in a speech, saying, “We stand with you; we are inspired by you.”

And versions of a bill that would give support to the protesters are moving though Congress with bipartisan backing. The legislation, among other things, would allow the United States to impose economic sanctions and a travel ban on Hong Kong officials deemed responsible for human rights abuses.

“We hope this bill will pass,” said Selina Po, a 27-year-old protester wearing a mouth mask in the Admiralty neighborhood as she held up a sign with the bill’s name, the Hong Kong Human Rights and Democracy Act. “It’s our hope for winning this war. We’re trying all we can.”

But American officials say the United States needs to weigh its moves carefully.

Greater involvement by Americans could give Beijing more ammunition in its propaganda effort to portray the pro-democracy movement as one stoked by foreign forces.

The Chinese government and state-run news organizations talk about “black hands” behind the unrest and spread conspiracy theories, including one centered on an American diplomat in Hong Kong who was photographed with activists in the lobby of the JW Marriott Hotel.

As the protests persist, American officials are watching for surges in violence and tracking the movement of People’s Liberation Army soldiers into Hong Kong. Some are beseeching demonstrators to stick to nonviolent tactics, even in the face of police crackdowns and attacks by people sympathetic to Beijing.

On Sunday, at least six people were injured when a man with a knife who is believed to be against the democracy movement attacked a family at a shopping mall. In the melee, the attacker bit off part of the ear of a pro-democracy district council member, Andrew Chiu.

“We’re telling everyone that we interact with, we don’t want violence,” Secretary of State Mike Pompeo said on Wednesday. “We think there should be a political solution to the conflict that’s taking place there.”

Two Democratic Congressmen, Tom Suozzi of New York and John Lewis of Georgia, the icon of the American civil rights movement, posted a video last month praising the activists for their “great work” and urging them to stick to nonviolence.

Whether the United States takes greater action on Hong Kong hinges on the unpredictable Mr. Trump. Administration officials and American lawmakers talk openly about checking the authoritarian impulses of the Chinese Communist Party. But the president rarely, if ever, mentions human rights and democracy, and he has not made strong statements on Hong Kong.

He is a transactional president. In June, he told Mr. Xi on a call that he would stay quiet on Hong Kong as long as Washington and Beijing were making progress on trade talks, according to an American official who spoke on the condition of anonymity.

In October, the Trump administration imposed some restrictions on Chinese companies and organizations for their roles in the mass repression of Muslims in mainland China, but Mr. Trump has held back from harsher actions for fear of upsetting the trade negotiations.

If a Hong Kong bill reaches Mr. Trump’s desk, analysts say, the president might see it as merely a tool to wring concessions from China and could forego support if a trade agreement were close.

“Strong American bipartisan support for the peaceful protesters is not enough to override President Trump’s transactional instincts,” Mr. Hass said. “He does not look at Hong Kong through a values-based lens. And as long as he remains president, this outlook will limit America’s responses to developments in Hong Kong.”

Administration officials argue that Mr. Trump’s approach gives the United States a stronger hand in constraining Beijing on Hong Kong — even if it appears that Mr. Trump just wants to use the Chinese territory to his advantage.

“America expects Beijing to honor its commitments,” Mr. Pence said, “and President Trump has repeatedly made it clear it would be much harder for us to make a trade deal if the authorities resort to the use of violence against protesters in Hong Kong.”

In the eyes of Beijing, there has been no shortage of provocations by American politicians. On Oct. 22, Ms. Pelosi posted on Twitter a photograph of herself on Capitol Hill with three pro-democracy figures — Mr. Lai, Martin Lee and Janet Pang.

“My full support and admiration goes to those who have taken to the streets week after week in nonviolent protest to fight for democracy and the rule of law in #HongKong,” she wrote.

On Wednesday, Ms Pelosi slammed the decision by Hong Kong officials to bar the activist Joshua Wong from running in local elections. She said it was “another blow against rule of law in Hong Kong and the principle of ‘one country, two systems,’” referring to the foundation for the policy of autonomy that Britain and China agreed would be used to govern the territory.

Ms. Pelosi met Mr. Wong in Washington in September.

A Chinese Foreign Ministry spokeswoman, Hua Chunying, lashed out, saying, “It is precisely because of the naked cover-up and connivance of external forces such as Pelosi that the violent anti-law forces are even more fearless.”

“No matter how your eyes are blinded by prejudice, no matter how your heart is filled with evil, Hong Kong is China’s Hong Kong,” the spokeswoman added. “Any attempt to interfere in Hong Kong affairs will not succeed.”

Many demonstrators want American intervention and are focusing their attention on the legislation. The mere threat of American sanctions, they say, would give the movement greater voice with Beijing.

On Oct. 14, the night before a vote on the bill in the House of Representatives, protesters held a rally in the Central district to call for its passage. Tens of thousands attended, many of them carrying American flags.

“The power of Hong Kong people alone is limited, and we need other countries, such as the U.S., to help us counter China and keep ‘one country, two systems,’” said Eric Kwan, 32. “I doubt the act can be an ultimate game-changer, but I think it is enough to give pressure to China.”

Along with allowing for sanctions, the legislation requires the State Department to review each year whether Hong Kong is still autonomous enough to qualify for the benefits of the 1992 Hong Kong Policy Act, which grants the city a trade and economic status different from that of mainland China.

Some American officials say the bill could harm Hong Kong residents if the United States determines that the territory no longer qualifies as an autonomous entity. But the bill’s proponents defend its practical and symbolic value.

“Standing in support of Hong Kongers and preserving Hong Kong’s autonomy should be a priority of the United States and democracies worldwide,” said one of the bill’s sponsors, Senator Marco Rubio, Republican of Florida.

The bill passed the House by unanimous vote last month. Though the Senate majority leader, Mitch McConnell, has not scheduled a vote yet, the measure is expected to pass that chamber easily, with a veto-proof majority. Then Mr. Trump would have to decide whether to sign it into law.

Ezra Cheung contributed reporting from Hong Kong, and Amber Wang contributed research from Beijing.

The Case for International Civil Servants

Cooperation among nation-states is still the most important element of global governance. But organizations and civil servants that serve the world as a whole are an indispensable source of support for necessary collective action to address major opportunities and threats.

Kemal Derviş


WASHINGTON, DC – The notion of an “international” civil service goes back a century, to the establishment of the League of Nations after World War I. Whereas civil servants had until then always served their countries or empires, the League’s small secretariat would facilitate cooperation among member states.

The founding of the United Nations following World War II gave a new and much stronger impetus to the idea and practice of an international civil service. And today, when global efforts are essential to address issues such as climate change and the spread of new digital technologies, the world needs high-quality international civil servants more than ever.

The concept is enshrined in Article 100 of the UN Charter: “In the performance of their duties the Secretary-General and the staff shall not seek or receive instructions from any government or from any other authority external to the Organization.” Moreover, “They shall refrain from any action which might reflect on their position as international officials responsible only to the Organization.”

Whom, then, are international civil servants supposed to serve, if not national governments?

Although national governments determine the missions of multilateral institutions, the staff of organizations that are bound by the UN Charter – including the International Monetary Fund and the World Bank – are formally international civil servants. They serve the peoples of the world through their organizations, and travel with “international” UN passports, not their national ones.

These officials’ special status extends global governance beyond cooperation among nation-states, but it does not reflect a utopian attempt establish a world government. Rather, international organizations and civil servants strengthen global collective action by advancing the “common good,” as Bruce Jenks, Senior Adviser at the Dag Hammarskjöld Foundation and former Assistant General Secretary at the UN Development Programme (UNDP), puts it, rather than any particular private or public interests.

Game theory has taught us that individual nation-states, while rationally pursuing their own interests, can end up in a situation that is suboptimal for all of them. On the other hand, as Todd Sandler argues in his 2004 book Global Collective Action, “impartial” international organizations can provide an institutional framework that helps to produce mutually beneficial results.

In practice, impartiality is not easy to maintain. Governments both promote and try in various ways to influence their nationals within international organizations, and nationality is often a determining factor in appointments to top international jobs. When I was Administrator of the UNDP, I had to deal with constant “requests” from government representatives.

Usually, they were formulated in an acceptable way, asking me to “look into” a particular issue. But I also received requests – often from the global superpowers – in a way that was in clear violation of Article 100 of the UN Charter, and I had to spend a great deal of time trying to avoid engaging with governments on such terms.

Nonetheless, my overall experience at the UNDP and the World Bank suggested that staff and management could and did behave in accordance with Article 100. Being responsive to member states’ concerns and priorities was right and normal; taking orders from them was not.

In addition to mediating and helping to forge political compromises, international civil servants can launch initiatives and act as advocates. The late Kofi Annan was emblematic in that regard. Coming from a small country, Ghana, and having made his career at the UN, Annan certainly did not have the special backing of any major international power.

Yet, as secretary-general, he developed great moral authority, and was revered by civil-society leaders around the world. On Annan’s initiative, the UN launched the Millennium Development Goals at the turn of the century, giving development cooperation new momentum – which the current 2030 Agenda for Sustainable Development is maintaining.

Critics argue that international organizations should not exercise such “independence,” on the grounds that these bodies derive all their legitimacy from governance and consent by member states. And because nation-states remain the constitutive units of the international political system, it is tempting to define multilateralism, or even global governance, as simply the process of cooperation among them. But such a view is too narrow.

The problem of climate protection provides a good example of what is at stake. The UN system, including the World Bank and the IMF, is working with civil society to raise global awareness about the extent of the threat, and conducting or supporting impartial technical analyses of the costs and benefits of alternative courses of action. In addition, UN Secretary-General António Guterres, and his predecessors Ban Ki-moon and Annan, have played leading roles in advocating for climate protection.

All these efforts have created a political space that has made climate-related negotiations among national governments somewhat easier. It is not the job of international civil servants to try to determine specific national policies, or to decide how governments will share the burden of combating global warming. Rather, their role is to advocate generally for science-based measures that can address the challenge, and to help implement them once member states have decided on the specifics.

Thirty years ago, the fall of the Berlin Wall appeared to hold out the promise of lasting peace and cooperation, fostered by a new, fully global multilateralism. Today, we are still far short of that optimistic vision, and cooperation among nation-states remains the most important element of international governance. But in an era of unprecedented opportunities and threats that transcend political borders, organizations and civil servants that serve the world as a whole are an indispensable source of support for necessary collective action.

Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Senior Fellow at the Brookings Institution.

Paris Soloist

Macron Plays Fox in the EU Hen House

French President Emmanuel Macron has a grand foreign policy vision for Europe and he has been energetically pushing it forward. In the process, though, he has angered Germany and other European Union allies.

French President Emmanuel Macron
French President Emmanuel Macron

With a microphone in his right hand, his left shoved casually into his pocket, French President Emmanuel Macron was standing on the stage inside a former slaughterhouse in Paris, turning from side to side to address his entire audience. And it was quite an audience. United Nations Secretary-General António Guterres was there, as was future European Commission President Ursula von der Leyen, German Foreign Minister Heiko Maas, the president of the Democratic Republic of the Congo and other leading politicians.

It was Tuesday morning of this week and Macron was holding the opening address at the Paris Peace Forum, a two-day event aiming to bring together some of the major actors on the world stage. It's an invention of the French government, a typically ambitious Macron project.

Macron spoke for 22 minutes about hegemony and colonialism, about World War I and the fall of the Berlin Wall. In closing, he quoted the recently deceased Hungarian philosopher Ágnes Heller, who said, in Macron's telling, that more than ever, a certain amount of heroism is needed to provide answers to the present. Looking away in cowardice, remaining stuck in old habits and doing nothing, Macron continued, is not an option for all those who have been handed a political mandate by the electorate.

The message Macron was trying to send by quoting the Hungarian intellectual was relatively clear. I, Emmanuel Macron, he seemed to be saying, did nothing more in my widely criticized interview with the Economist than take a fresh look at our crisis-ridden present and draw my own conclusions. Part of that exercise was casting doubt on NATO's functionality and on the readiness of the Germans to work toward establishing a strong, sovereign Europe.

Rarely has an interview triggered as much consternation in Europe as Macron's sit-down with the Economist, which hit the newsstands last Thursday. In the piece, the French president posited that NATO has suffered from "brain death," questioned whether NATO's Article Five is still functional and warned of a possibly apocalyptic future for Europe.

'This Isn't It'

Allegedly, say sources in Paris, the French Foreign Ministry was only informed of the content of Macron's interview with the Economist 48 hours before it was published. Berlin, meanwhile, was blindsided. Ahead of Macron's famous 2017 speech at the Sorbonne, where he laid out far-reaching proposals for the EU's future, German Chancellor Angela Merkel had received an advance copy. But on this occasion, she was caught unawares.

"You always have to ask how trust develops," said one German diplomat. "This isn't it."

Still, the German government very much shares Macron's doubts about the effectiveness of the trans-Atlantic alliance. But calling Article Five into question, NATO's foundational article that requires all alliance members to help out if one member is attacked, is something one would tend to expect more from someone like U.S. President Donald Trump.

Foreign Minister Heiko Maas is concerned that the current NATO discussion could end up dividing Europe. Eastern Europeans, in particular, feel as though the French president is completely ignoring their concerns. "In addition, they all, of course, assume that his comments were coordinated with us, which was not the case," Maas says. He went on to say that the upcoming 70th anniversary celebrations for NATO, set to take place in early December in London, must now be extremely well-prepared.

In Brussels, too, understanding for Macron's comments is limited, though that's not necessarily due to his analysis, which is shared by many in the EU capital. "Emmanuel Macron is right about 95 percent of what he said," says Luxembourg Foreign Minister Jean Asselborn. "But the existence of NATO as a military alliance is not up for debate."

Macron has no fear of taboos. The path that ended with his installment in Élysée Palace in May 2017 ran counter to all the rules of French politics. For the first time since 1958, the French elected a president who did not belong to one of the established political parties. Macron found success precisely because he didn't conform to existing structures, and that remains his key political achievement to this day.

A Man of Convictions

It also explains why he saw fit to act like the fox in Europe's henhouse without informing his German partners first. He is hoping that the shock value of his comments will set change in motion, and that someone else will clean up after him. Macron, the ambitious elite-school product, is also a gambler. And a man of convictions.

That became apparent as early as 2017, when he challenged the EU to awake out of its stagnant slumber. Since then, he has been waiting in vain for an adequate response from Berlin to his many proposals for the reform of the EU. Last week, Macron transformed that 2017 wakeup call into a shrill alarm, in part out of his firmly held conviction that there is very little time remaining to save the EU.

Inside the German Foreign Ministry -- led, as it is, by the Social Democrat Maas -- is where one can find the most understanding for Macron's impatience, given the prevailing feeling there that the chancellor never really provided an adequate response to the French president's reform proposals. Nevertheless, there is a widespread feeling inside the ministry that Macron's decision to go solo is rather un-European.

"I think it is legitimate to launch such discussions," Maas says, "even if I might not agree with his choice of words. But in the German-French relationship, we need to aim for unity when it comes to our strategic approach so that no lasting damage is done."

Over in the Chancellery, there is frustration at the fact that the German government is consistently depicted as being hesitant while it's always Macron with the bold ideas. "We have moved significantly on a number of issues, and then we read that the German position on the eurozone is untenable," says one government adviser. "Thanks a ton."

Essentially, there is something of a paradox in the current German-French relationship. On the one hand, the two countries have made great strides in a number of areas over the last two-and-a-half years. In summer 2017, they agreed on the development of a joint fighter jet and proposed a joint European defense fund. In the next five years, the European Stability Mechanism, the permanent euro backstop fund, is to be financed to the tune of more than 55 billion euros. And German Finance Minister Olaf Scholz just recently presented his plans for an EU-wide deposit insurance scheme.

Determination, Energy and Fearlessness

On the other hand, though, Berlin and Paris have proven unable to sell joint projects as successes.

Another aspect of the paradox is the fact that Macron is still quite well-liked by the Germans. His determination, energy and fearlessness continue to impress politicians in Berlin. At the same time, though, the German government has never been able to muster the courage to throw its weight behind Macron's EU vision. And now, after more than two years of waiting, the constant stream of Macron's solo initiative has led German diplomats -- not normally known for public displays of emotion -- to lose their composure. They see 2019 as a year in which Macron has stood in the way on many issues and isolated himself with his demands.

A NATO exercise in Latvia in February
A NATO exercise in Latvia in February

The Franco-German discord began in early February, when France suddenly and without warning joined the side of those opposed to the construction of the natural gas pipeline Nord Stream 2. German negotiators were taken by surprise and France's flip-flop meant that there was suddenly an EU majority in favor of new natural gas rules that would have made it more difficult to complete the project. It would also have handed the European Commission the opportunity to place new hurdles in the way of the controversial project. A compromise was only found at the last minute.

Mistrust between Paris and Berlin then grew at the end of February when it came to the question as to how the EU should position itself in the trade tiff with U.S. President Donald Trump. Whereas Berlin was eager to give European Trade Commissioner Cecilia Malmstrom a negotiating mandate to ward off looming tariffs on automobile imports from Europe, Paris was in no hurry at all. With European Parliament elections on the horizon, the French were keen to avoid giving the impression that a trade conflict with the U.S. could also involve agricultural products and negatively affect French farmers.

French diplomats in Brussels are open about the fact that differences between Berlin and Paris are growing more frequent. Berlin officials, by contrast, insist that the frontlines now run between Paris and the rest of the EU. That has also been easy to see when it comes to Brexit. In recent months, Macron has repeatedly failed in his demand that Britain not be granted a deferral or, if unavoidable, merely a short delay. Most recently, the French had virtually no allies left on the issue.

A 'Historic Mistake'

Macron was similarly isolated at the EU summit in mid-October, when he blocked the beginning of accession negotiations with North Macedonia by making use of his veto. Outgoing Commission President Jean-Claude Juncker referred to it as a "historic mistake" that could endanger the Balkan country's stability. Merkel likewise said pointedly that the EU had to "remain reliable."

Insiders say that it only became clear how Macron would vote on the issue just one day before EU heads of state and government gathered for the summit. When Chancellery staff inquire at the Élysée as to why they aren't always kept informed, they sometimes receive answers that they have thus far only associated with the Trump administration in Washington: Élysée staff, they hear, only has limited influence over the president.

In August, Macron initiated a new approach to Russia without consulting at all with his allies. Just a few days ahead of the G-7 summit in Biarritz, a group that Russia was expelled from after the annexation of the Crimea, Macron invited Russian President Vladimir Putin to southern France for talks.

Not speaking with Russia would be a major mistake, Macron said immediately before the consultations. Russia, he said, is part of Europe and it cannot and should not be ignored, adding that he believed in the power of geography and European history. Even then, it was growing clear that Macron was thinking about a new security concept for Europe.

For Macron, a strong Europe is one that self-confidently seeks dialogue with the large and mid-sized powers the world over. The more we do to ensure that Russia becomes a power within Europe, Macron said at the time, the better. Shortly after the summit, Macron sent French Foreign Minister Jean-Yves Le Drian and Defense Minister Florence Parly to Moscow. After years of radio silence, the two spoke with their Russian counterparts of a possible French-Russian security cooperation. Both the Chancellery and the Foreign Ministry in Berlin learned of the talks from the newspaper. Even in Paris, observers have begun bemoaning the lack of diplomatic build-up ahead of the president's numerous foreign policy activities.

There are many who argue that the French president's extremely active foreign policy is motivated by domestic considerations. Macron needs visible accomplishments ahead of municipal elections approaching in March. Otherwise, his party -- which is not deeply rooted in small towns or in the countryside -- could be facing a defeat. The protests that have been announced for the end of the year -- the Dec. 5 strike by the rail operator SNCF and the Paris Metro in addition to the expected resistance to the government's pension reform plan -- have the potential of placing even more pressure on Macron's shoulders.

Those Who Fight

Ultimately, though, Macron is likely just doing what he said he was committed to doing from the very beginning: Pursuing an active, self-confident approach to European policy with the aim of positioning the old Continent as a new geopolitical player.

That includes his trip to China two weeks ago, on which he demonstratively brought along German business leaders, German Education Minister Anja Karliczek and a European commissioner. Macron would like to see relations with China to be "Sino-European" from now on. And even if he did a bit of marketing for French products at the China International Import Expo in Shanghai, the Chinese very much saw their guest as an envoy of Europe. On the final day of his visit in Beijing, when the treaty between the EU and China to protect various European food products from counterfeiting was signed, both the Chinese flag and the EU flag were on display in the Great Hall of the People. That, too, was rather unusual for a bilateral visit.

For Macron, it is not a contradiction to put NATO through a kind of stress test in the name of his Europe policy. As the French president likely sees it, Europe cannot be strong and sovereign without a reliable and independent security policy.

The French state secretary for Europe, Amélie de Montchalin, has been involved in several discussions in recent days. It fell to her to soothe alarmed Eastern Europeans and to explain the comments her president had made. "The timing of the interview was not randomly chosen," she says. "The new European Commission will soon start work and the NATO summit in London is approaching in just over two weeks. We find ourselves at a moment when such questions must be asked."

It looks as though Emmanuel Macron -- at "a time of unprecedented crisis for our democracy," as he calls it -- simply doesn't want to wait any longer. He doesn't want to wait for Germany, nor does he want to wait for those who are primarily occupied with themselves at the moment, countries like Britain, Italy and Spain.

Being a good team player has never been among his top priorities.

Perhaps he has simply read a bit too much Victor Hugo: "Ceux qui vivent sont ceux qui luttent," he wrote. "Those who live are those who fight."

The Berlin Wall and the rise of nationalism

The 1989 promise of liberal democracy was a squandered opportunity

Philip Stephens

web_Global nationalism
© Ingram Pinn/Financial Times

Two great earthquakes shaped the present global order.

The first, in 1989, seemed to promise an irresistible march towards liberal democracy and open markets. The opportunity was squandered by those intoxicated with their apparent triumph.

A second set of seismic shocks then saw the world turn back towards nationalism and protectionism.

The end-of-history theory of the fall 30 years ago of the Berlin Wall was always, well, ahistorical.

There was nothing ineluctable about the advance of political pluralism and market economics.

The splintering of Yugoslavia into warring nationalisms should have been sufficient warning against hubris.

And yet.

The peaceful dissolution of the Soviet Union, the glad embrace by formerly communist states of parliamentary systems, and rising prosperity in China and other emerging economies gave reasonable cause for optimism that the world was set on a new course.

The UN awoke from cold war paralysis.

The US-led expulsion of Iraqi forces from Kuwait secured the backing of a global coalition.

European integration looked very much like an exportable prototype.

The UN doctrine of “responsibility to protect” underscored collective abhorrence of ethnic cleansing and genocide.

So if the destination may not have been assured, the direction of travel indisputably was on the side of democracy.

The Washington-based think-tank Freedom House’s annual survey of rights and liberties pinpoints 2007 as a high-water mark, with a retreat ever since.

China and Russia have grown bolder in their embrace of authoritarianism.

The Arab spring has turned to winter.

Nations such as Turkey, Hungary and Poland have been sliding steadily into illiberalism.

Rising populism and anti-immigrant sentiment in rich western democracies, Freedom House’s 2018 report notes, have offered succour to leaders who “give short shrift to fundamental civil and political liberties”.

Among them, it adds, is US President Donald Trump who voices “feelings of admiration and even personal friendship for some of the world’s most loathsome strongmen and dictators”.

You can find half a dozen plausible explanations as to what went wrong. Russia’s fall to economic anarchy threw open the doors to a leader promising to restore order and national pride.

China was never going to forget its “century of humiliation” and sign up for a global order led by the US.

As imagined by its friends, the Pax Americana would be that of a benign hegemon overseeing the international peace.

The events of September 11 2001 saw Washington repudiate rules in favour of unilateral military intervention.

In 1990, US President George HW Bush had laboured to gather broad backing for the war against Iraq’s Saddam Hussein.

His son George W Bush declared simply that others were “with us or against us”.

Democracy becomes tarnished when its promoters deliver it from the bay of a B-52 bomber.

For its part, the EU overlooked the role national identity had played in eastern Europe’s uprisings against rule from Moscow.

Nations that had only recently reclaimed their sovereignty were unlikely to share the postmodern enthusiasm of existing members for the pooling of national decision-making.

In the Middle East, the west’s focus on elections overlooked the need for the institutions and conventions that underpin liberal democracy.

The ballot box alone was never going to transform Libya.

One way or another, all of these things chipped away at the gloss of superiority bestowed on the west by its victory in the cold war.

None were of great consequence when measured against the event that shredded the claims and ambitions of the post-cold-war order.

The 2008 global financial crash, and the subsequent recession, delivered a powerful economic blow to the rich democracies even as it shattered the illusions invested in liberal democracy and globalisation.

There it was for all the world to see — the west had got it wrong, and wrong on a scale not seen since the Depression in the 1930s.

For all the gains that accrued from globalisation — and the rising fortunes of hundreds of millions in China, India and elsewhere attest to them — the devotion to unfettered markets enshrined in the so-called Washington consensus had been a catastrophic error.

Financial capitalism, it turned out, was inherently unstable; and once destabilised it collapsed like a house of cards.

Suddenly, the state-directed capitalism favoured by autocrats no longer seemed anachronistic.

The real damage, though, was done at home.

The rise of populists — Mr Trump in the US, the Brexiters in Britain, myriad nationalist parties elsewhere — exposed a fundamental divide.

The gains of globalisation had been reaped in the west by the few; the social contract that hitherto sustained public faith in politics and the market had been broken.

The elites had grown richer at the expense of the majority.

These populists offer scapegoats in place of remedies.

Nor should anyone harbour illusions about authoritarian alternatives.

The world is not flocking to imitate Moscow, Budapest and Ankara.

Even as they scorn democracy, tyrants and demagogues feel compelled to pay it lip service.

There is though one obvious lesson.

If they want to restore authority abroad, western leaders must first rebuild credibility at home.

Santiago Under Siege

How could the most prosperous city of what is, by all accounts, Latin America’s most prosperous and law-abiding country explode in protests marred by riots and looting? And what do recent events teach us about citizen dissatisfaction and the potential for violence in modern societies?

Andrés Velasco

velasco98_CLAUDIO REYESAFP via Getty Images_santiagoprotestmaskfire

SANTIAGO – At least 19 dead and untold wounded. A half-dozen subway stations attacked with firebombs. Hundreds of supermarkets vandalized and looted. The downtown headquarters of the country’s largest power distributor in flames. A city of nearly seven million people paralyzed. After a state of emergency is declared, army units patrol the streets and enforce a curfew.

How could Santiago, Chile – the most prosperous city in what is, by all accounts, Latin America’s most prosperous and law-abiding country – come to this? And what do recent events teach us about citizen dissatisfaction and the potential for violence in modern societies?

In fact, we cannot be certain. It all happened with dizzying speed. And a few days after the violence came the peaceful protests. Last Friday, 1.2 million people marched in downtown Santiago, in the largest street protest since those that helped remove General Augusto Pinochet from office 30 years ago.

The most common explanation is that a 3% increase in metro fares caused public indignation at rising prices and high inequality to boil over. That must be true: people with sufficient income who feel they are treated fairly do not loot and riot. But as an explanation on which to base policy changes, the standard account risks being simplistic.

Take price increases. Yes, Chile has a history of inflation. And, yes, because it is more prosperous, Santiago is more expensive than most Latin American cities. Yet Chilean inflation in the 12 months to September was barely 2.1%, and the central bank has been cutting interest rates because inflation is below its target.

Or take income inequality. Yes, for an upper-middle-income country, Chile is very unequal, with a Gini coefficient (most economists’ preferred measure of income disparity) at a high level of 46.6 in 2017 (100 represents absolute inequality). Yet according to the World Bank, the coefficient has fallen from an eye-popping 57.2 when Chile returned to democracy in 1990. The notion that rising income inequality is behind citizen discontent does not fit reality.

To understand the causes of a social phenomenon, one always must ask: Why here? Why now? Neither inflation nor rising income inequality provides a satisfactory answer.

Others claim that Chileans are simply fed up with the intrusion of markets and profit-seeking into every corner of daily life. Again, this hypothesis has an air of plausibility. Polls show widespread dissatisfaction with private companies that provide public services ranging from water and electricity to health insurance and pension-fund administration.

Yet those same surveys also show anger at the quality of state-provided services, whether in hospitals, clinics, or foster-care facilities. Over half of parents choose to send their children to privately-run voucher schools, even when it involves paying a fee, despite the availability of free state schools of comparable quality. And in 2017 a substantial plurality of Chileans voted for President Sebastián Piñera, a billionaire businessman and unabashed apologist for capitalism who ran on a platform of reigniting growth.

So, what is it, then? Why are millions of Chileans still marching in protest, ten days after the violence erupted?

For starters, Chile is not alone. In the last decade, places as diverse as Great Britain, Brazil, France, Hong Kong, and Ecuador have experienced similar episodes. Whatever the immediate local trigger, the scope, intensity, and often the violence of the ensuing protests seemed out of proportion with the initial cause. Rapid social change fuels tensions and contradictions in modern societies – even rich and successful ones – that seem to keep them barely a step or two from mayhem.

In Chile, an obvious suspect is monopoly abuses. While general price inflation in Chile is low, some prices that matter for family budgets are high and rising. Regulatory regimes designed to ensure investment in utilities, for example, have given companies excessive leeway to keep prices high. Likewise, Chile’s pharmacy chains have been found guilty of collusion and price gouging, as have toilet paper producers, chicken farmers, and long-haul bus companies.

Here is the paradox. Collusion and price fixing did not begin yesterday in Chile. But until a decade ago, sanctions were weak and the agency in charge had little authority and few resources to investigate. When the law changed, scandals began erupting every few months, raising public awareness of, and indignation with, monopolistic behavior. Today, price fixing is a criminal offense that carries jail sentences, and it seems plausible that such behavior is receding. But that very progress may have helped plant the seeds of public anger.

Turn next to the labor market. Chile’s unemployment rate hovers around 7% and wages have been rising well ahead of inflation. The bad news comes when you look at the structure of employment. Nearly one-third of the labor force is either self-employed or works in domestic service, in many cases without a formal contract and benefits.

Among those who have a formal job, most work on short-term contracts. Employment rates for women and young people are among the lowest in the OECD. Discrimination is rampant. Hundreds of thousands of women who head households do not have a job, while millions of workers who have a job today cannot be sure they will have any kind of income tomorrow.

The list of reforms that would remedy this situation – such as adaptable work schedules, modernized severance payment schemes, easier part-time work, better job training, and anti-discrimination laws with real teeth – is pretty self-evident. That is what worked in other countries in similar circumstances.

But here is the next paradox: as Chile has become more democratic, the same problems that plague advanced democracies have appeared. Politically influential insiders have blocked reforms, while labor-market outsiders are not represented. Few politicians speak for the unemployed young woman with two kids and no high-school diploma, who seldom votes anyway.

Puny pensions also contribute to people’s sense of fragility. Chile’s individual capitalization system earns kudos abroad, but the reality on the ground is more complex. Precisely because the labor market functions badly, Chileans retire with fewer than 20 years of savings, on average, in their accounts. And due to sharply rising longevity (itself a tremendous developmental success), they can expect to live 20 years or more after retirement.

Pensions could be adequate only if the rates of return on those savings were huge, but they are getting smaller by the day, in line with falling global real interest rates. Government-funded minimum pensions for people with no savings at all, plus a top-up for those with very low pensions, help alleviate the plight of 1.3 million people at the bottom of the income scale. But now the middle class is feeling the pinch – increasingly so as Chile’s baby-boom generation begins to retire under the private system.

And while income inequality has not been getting worse, other kinds of inequality may well have become more evident. Chile has joined the OECD club of rich countries, but in many ways it remains a traditional society riven with class privilege. Business leaders and cabinet members tend to come from a handful of private secondary schools in Santiago, especially when right-wing parties are in power, as they are today. The elite often seems to live in a world of its own. Last week, Cecilia Morel, the president’s wife, described the looting as “an alien invasion.”

None of this is new. But it may have become more painfully evident as the country develops. A generation ago, few working-class children attended university. Today, seven of ten students in higher education are the first in their families to attend college. Once they graduate, the frustration begins: to land the best jobs, academic performance matters less than having the “right” surname or connections.

Anger at elites is rampant in Chile, but scorn for the country’s political class is particularly deep. In 2018, 70% of Chileans believed that the country was governed for the benefit a handful of powerful groups. Barely 17% and 14% expressed trust in parliament and in political parties, respectively.

This is relatively new. High regard for civilian politicians during the transition to democracy nearly three decades ago gave way to a growing perception of insularity, and then a wave of campaign finance scandals. Today, the absence of term limits and parliamentarians’ outsize compensation (among the highest in Latin America) are huge magnets for public anger.

Lack of trust in politicians weakens people’s hopes for the future. And Chile’s recent economic deceleration, standing as it does in sharp contrast to Piñera’s ringing promises of economic growth, has exacerbated the problem. Perhaps it was these dashed hopes that brought the many tensions and contradictions in Chile to a boil.

There is now a unique opportunity to rewrite the social contract and deal decisively with the sources of citizen anger. But the risks are many. One is that voters will conclude that Chile’s gains were all more illusory than real, and will therefore throw the baby out with the bathwater. Another is that the current climate of fear and division will bring a populist to power, as has happened in Mexico, Brazil, and now Argentina.

In Chile, polls already show gains for populists of the extreme right and left. If that trend continues, the country’s turmoil could be far from over.

Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities.

Are Investors Being ‘Aggressively Passive’ in Bond ETFs?

For bond allocations, think twice before reflexively allocating to index ETFs.

By David L. Braun, Avi Sharon

With investors looking to reduce risk in uncertain late-cycle markets, it’s not surprising that flows into bond exchange-traded funds (ETFs) have surged this year, outpacing flows to equity ETFs for the first time in a decade.

The lion’s share of the $97 billion in fixed income ETF flows through September have gone to passive, index-tracking ETFs (according to Bloomberg). But are investors missing out by defaulting to passive approaches?

Many investors may assume ETFs are passive by nature or by definition (they are not). Passive bond ETFs are not the only option – and for investors looking to potentially improve performance, actively managed fixed income ETFs may offer distinct advantages.

Bonds are different when it comes to active management

A key rationale many investors cite for preferring index-tracking equity approaches is that active management hasn’t paid off historically. But this has not held true for fixed income allocations.

Over the past 10 years, the median active equity manager has underperformed passive peers by approximately 86 basis points (bps) and lagged stated benchmarks by another 20 bps (see Figure 1).

The opposite has been true for fixed income: The median active bond manager has beaten its stated benchmark by an average of 81 bps per year and outperformed passive peers by 91 bps over the past decade (as of 30 June 2019).

Are Investors Being ‘Aggressively Passive’ in Bond ETFs?

Bond market inefficiencies provide alpha opportunities

Why is the story so different for bonds than for equities? We believe it boils down to inefficiencies across the fixed income markets, which can provide rich ground for active managers to seek beyond-benchmark returns – often with more attractive risk profiles.

Equities are traded in milliseconds on public exchanges, while bonds are largely still traded over the counter, slowly and in large blocks. And whereas equities are highly standardized, perpetual securities, bonds are far more heterogeneous in their terms and have finite maturities.

New issues of bonds (analogous to initial public offerings for stocks) are frequent, constituting about 20% of the U.S. corporate bond market each year, versus about 1% for U.S. equities.

This can give a potential advantage to asset managers with strong credit teams to analyze these new issues.

Moreover, when looking at the most prominent bond and equity indices – the Bloomberg Barclays U.S. Aggregate Bond Index and the S&P 500 – both give greater weight to entities with some of the least attractive characteristics: stocks with the highest market caps, and issuers with the most debt outstanding. That means that passive bond investors are essentially lending more to those with more debt.

Reconsider being ‘aggressively passive’ in bond ETFs

The ETF vehicle offers certain advantages, including efficient trading on an open exchange, continuous pricing throughout the day, and a simple way to gain diversified allocations. But passive ETFs generally suffer from below-index performance given the impact of trading costs and fees.

And given that overall return potential for bonds may be modest relative to equities, the potential return differential between a passive and active approach could have a significant impact. Especially in a low yield world, the excess return potential from active management may be particularly meaningful as a means to boost overall returns (and it would represent a larger share of that overall return). Of course, as with all investments, it is possible to lose money.

For investors wanting to make the most of their fixed income allocations as they seek to manage risk, we believe the compelling potential return advantage of actively managed ETFs should not be overlooked.

Obama, Trump and the Wars of Credibility

By: George Friedman

The United States is in the process of shifting a core dimension of its strategic doctrine. In the past, the U.S. resorted to the use of force to address international threats. Barack Obama was the first president to argue that the use of force, particularly in the Middle East, was costly and ineffectual and that other means had to be used to exercise foreign policy.

He ran his first campaign for president on this basis. He was only partially able to shift the direction of U.S. strategy. Donald Trump has extended Obama’s policy and applied it more consistently by refusing to strike at Iran over the Persian Gulf crisis and the Saudi oil facilities attack and, most recently, withdrawing from the Syria-Turkey border.

The shift in strategy was something I predicted in my 2011 book, “The Next Decade.” The basic argument was that the United States is now a global power with no global challenger, only regional ones of various sizes. Having a strategic doctrine of responding to challenges with military force would leave the decision on when to go to war up to the adversary.

John F. Kennedy once said, “Let every nation know, whether it wishes us well or ill, that we shall pay any price, bear any burden, meet any hardship, support any friend, oppose any foe, in order to assure the survival and the success of liberty.”

This doctrine made sense in dealing with the Soviet Union, but in a less orderly world, it reads like a blank check on U.S. military power and an invitation to other nations to draw the U.S. into combat at their will. I reasoned that a more nuanced foreign policy would emerge in the 2010s, one that would compel the U.S. to become more disciplined and selective in committing U.S. forces to combat.

In the 74 years since World War II ended, the U.S. has spent about 28 years, roughly 38 percent of the time, engaged in large-scale, division-level combat, leaving over 90,000 U.S. military personnel dead. This includes the Korean War, the Vietnam War, the Afghan War and the War in Iraq, and there have been other deployments in smaller conflicts.

Nearly three decades over a 74-year period is a staggering amount of time for any nation to be at war, particularly the leading global power.

With the exception of Operation Desert Storm, the United States has not won any of these wars. Korea ended in an armistice, with both sides at roughly the same point as when they began. Vietnam ended with the enemy flag flying over Saigon.

Afghanistan, Iraq and related wars did not end in outright defeat, but they have not ended in victory.

Given that the United States crushed both Japan and, with the help of the Allies, Germany in World War II and emerged with overwhelming military power, the increased tempo of U.S. military operations since 1945, combined with consistently unsatisfactory outcomes, must be analyzed to understand the emergence of the Obama-Trump doctrine.

One explanation that must be dispensed with is that the American public does not have the patience to allow a war to be fought to a satisfactory conclusion. There was no anti-war movement of any significance during Korea.

There was an anti-war movement over Vietnam, but the conflict continued for seven years, and the public voted overwhelmingly for pro-war Richard Nixon and against anti-war George McGovern in 1972. There has been opposition to the Iraq War, but it was only a peripheral reason for the U.S. drawdown there, after nine years of war.

World War II was fought on a different scale. It was a total war, one that could not be lost. Defeat would have posed fundamental dangers to the United States, so all necessary resources were devoted to the war effort. It was the central focus of society as a whole. Bringing massive resources to bear, including atomic bombs at its conclusion, the United States emerged from the war victorious.

None of the other conflicts were total wars that involved existential threats to the United States.

During the Cold War, the interventions in Korea and Vietnam were the result of indirect U.S. interests. From the Truman administration’s perspective, Korea was outside core U.S. interests. The U.S. had no treaty with or strategic interest in South Vietnam. In both cases, the benefits of engaging in conflict were indirect.

The U.S. strategy in the Cold War was containment. The U.S. did not intend to invade the Soviet Union, or later China, but it opposed its expansion. The U.S. got involved in both Korea and Vietnam to defend the credibility of the doctrine of containment, fearing that a lack of U.S. engagement in these conflicts would be interpreted by the Soviets and Chinese as a lack of commitment to the doctrine.

Even more important, the U.S. was afraid that staying out of these wars would lead its allies to draw the conclusion that American guarantees were hollow and that the alliance structure needed for the containment strategy would collapse.

The U.S. engaged in the two wars, therefore, not out of strategic necessity but to demonstrate American reliability. They therefore could not be fought as total wars. The amount of effort required to show a willingness to engage was much less than the amount of effort needed to decisively crush enemy forces.

It was necessary to demonstrate U.S. will for global reasons, but imprudent to devote the force needed to win the war. It was also impossible to withdraw from the war, as abandoning a conflict would be the same as refusing to engage. The wars were being fought for the sake of demonstrating that the U.S. was willing to fight wars, and no coherent strategy or even clear definition of what victory meant or how to achieve it emerged. In a strange way, this made sense.

Maintaining the confidence of West Germany, Turkey, Japan and all other U.S. allies was of enormous strategic importance, and Korea and South Vietnam were needed to hold the alliance together. Over 90,000 died in wars that were gestures, yet how many more would have died if the gestures were not made? That was the logic, but the truth is that no one anticipated the length of engagement and amount of bloodshed in either war. Wars fought to reassure allies have no strategic basis on which to calculate such things.

What we will call the anti-jihadist wars were framed differently but had similar results. After 9/11, the U.S. goal was to destroy Islamic jihadists and governments that gave them haven and to impose governments favorably inclined to the United States. The problem was that terrorists are mobile. Al-Qaida was a global, sparse and capable force. It could exist anywhere, including hostile territory, and its members were capable and difficult to locate, making them excellent covert operators, as seen on 9/11.

To dismantle the organization, it was assumed that the U.S. had to deny al-Qaida sanctuary for its operations and have the cooperation of countries in the region, ensuring that they would resist al-Qaida and provide intelligence. The invasion of Afghanistan was designed to displace the Taliban and force al-Qaida to disperse.

The Taliban withdrew, dispersed and reformed. Al-Qaida was built to be mobile. This placed a premium on getting others to support the American effort, a difficult task inasmuch as the U.S. withdrawal from Lebanon and Somalia made them feel the U.S. wouldn’t back them up. In Iraq, there were many strands behind the U.S. invasion, but credibility was an important one. In the end, the problem was that al-Qaida was not destroyed when it had to mobilize. In addition, occupying a country that is hostile to foreign interference is impossible. Even the Nazis couldn’t defeat the Russian and Yugoslav partisans, and they were far less gentle than the U.S. was.

Demonstrating credibility was part of what motivated the jihadist wars, just as it motivated U.S. involvement in the wars in Korea and Vietnam. The problem with wars designed to demonstrate U.S. will, however, is that they are almost by definition without end. But if the U.S. is going to lead a coalition, credibility is a critical asset, even if the likelihood of success in the war is uncertain. There is therefore an inherent dilemma.

In World War II, the war was aligned with U.S. strategy. In the wars that have been fought since then, the conflicts have not been aligned with U.S. strategy. As a result, stalemate or defeat did not undermine basic U.S. interests. The conflicts created vacuums in regions where the U.S. had interests, but all forces were committed to what I will christen as wars of credibility. These were wars that didn’t have to be won, but only fought.

Given the sweeping breadth of U.S. power, and the lack of challengers that might absorb the U.S. as it was absorbed in World War II (including China and Russia), coalition building and management becomes an end in itself. And that leaves the U.S. constantly off balance, as in the long run it undermines coalitions anyway.

It was inevitable, therefore, that the U.S. would significantly curtail its military involvement and devote resources to upgrading the force, rather than constant deployment.