The Fear Factor in Global Markets

Kenneth Rogoff
 tightrope walker

CAMBRIDGE – The phenomenal market volatility of the past year owes much to genuine risks and uncertainties about factors such as Chinese growth, European banks, and the oil glut. For the first two months of this year, many investors were panicked that even the United States, the world’s most comforting growth story, was about to fall into recession. Indeed, among the experts who participate in the Wall Street Journal’s monthly poll, 21% believed a recession was around the corner.
I won’t deny that there are risks. A big enough hit to China’s growth or to Europe’s financial system could certainly tip the global economy from slow growth to recession. An even more frightening thought is that by this time next year, the US presidency may have turned into a reality television show.
Yet, from a macroeconomic perspective, the fundamentals are just not that bad. Employment numbers have been strong, consumer confidence is solid, and the oil sector is just not large enough relative to GDP for the price collapse to bring the US economy to its knees. In fact, the most under-appreciated driver of market sentiment right now is fear of another huge crisis.
There are some parallels between today’s unease and market sentiment in the decade after World War II. In both cases, there was outsize demand for safe assets. (Of course, financial repression also played a big role after the war, with governments stuffing debt down private investors’ throats at below-market interest rates.)
Even a full decade after World War II, when the famous economist John Kenneth Galbraith opined that the world might experience another depression, markets went into a tizzy. People still remembered how the US stock market had fallen 90% during the early years of the Great Depression.
Back in the 1950s, it was not hard to imagine that things might go wrong again. After all, the world had just navigated through a series of catastrophes, including two world wars, a global influenza epidemic, and of course the Depression itself. Sixty years ago, the specter of atomic war also seemed all too real.
People today need no reminding about how far and how fast equity markets can fall. After the 2008 financial crisis, US stocks fell by more than 50%. Equity markets in some other countries fell significantly more: Iceland’s, for example, plummeted by over 90%. No wonder that once the recent market drop hit 20%, many people wondered how much worse it could get – and whether fears of a new recession could become a self-fulfilling prophecy.
The idea is that investors become so worried about a recession, and that stocks drop so far, that bearish sentiment feeds back into the real economy through much lower spending, bringing on the feared downturn. They might be right, even if the markets overrate their own influence on the real economy.
On the other hand, the fact that the US has managed to move forward despite global headwinds suggests that domestic demand is robust. But this doesn’t seem to impress markets. Even those investors who remain cautiously optimistic about the US economy worry that the US Federal Reserve will view growth as a reason to continue raising interest rates, creating huge problems for emerging economies.
There are other explanations for volatility besides fear, of course. The simplest is that things really are that bad. Maybe the individual risks aren’t of the same order of magnitude as in the 1950s, but there are more of them, and markets are starting from a much more inflated position.
Moreover, financial globalization has profoundly deepened interlinkages, magnifying the transmission of shocks. There are large pockets of fragility and weakness in world debt markets, with current monetary easing covering up deep-rooted problems beneath the surface. Some have pointed to a lack of liquidity in leading markets as driving the massive price fluctuations; in a thin market, a small change in demand or supply can sometimes require a big shift in prices to restore equilibrium.
The most convincing explanation, though, is still that markets are afraid that when external risks do emerge, politicians and policymakers will be ineffective in confronting them. Of all the weaknesses revealed by the financial crisis, policy paralysis has been the most profound.
Some say that governments did not do enough to stoke demand. Although that is true, it is not the whole story. The biggest problem burdening the world today is most countries’ abject failure to implement structure reforms. With productivity growth at least temporarily stuck in low gear, and global population in long-term decline, the supply side, not lack of demand, is the real constraint in advanced economies.
In the long run, it is supply factors that determine a country’s growth. And if countries cannot manage deep structural reform after a crisis, it is hard to see how it will happen. Running the government like a reality TV show, with one eye always on the ratings, is not going to do the job.

Mexico as a Major Power

George Friedman
Editor, This Week in Geopolitics

Mexico has the 11th-highest GDP in the world based on purchasing power parity, according to the International Monetary Fund. As Europe weakens, it will be in the top 10 in the not-too-distant future. Yet, this country is regarded by many Americans as a Third World nation, dominated by drug cartels and impoverished people desperate to get into the United States.

While it is true that organized crime exists in Mexico and that many Mexicans want to immigrate to the US, a roughly equal number are leaving the US and returning to Mexico… drawn by economic opportunities in their home country. The largest auto plant in the Western Hemisphere is in Mexico, and Bombardier builds major components for aircraft there. Mexico has many problems, of course, but so does the U.K. (the 10th-largest economy) and Italy (12th).

No one would be surprised by the U.K. or Italy rankings, but many people would be stunned to find that Mexico is ranked right up with them. Obviously, Mexico is not as developed as Britain is. Like most nations transitioning from underdevelopment to greater development, Mexico suffers from substantial class and regional inequality, and the emergence of a dominant middle class is still unfolding.

At the same time, Italy also has substantial regional inequality. Mexico can't aspire to British standards, but Italy is a reasonable model. Inequality diminishes the significance of being 11th in some ways, but it doesn't change the basic reality of Mexico’s relative strength.

Mexico is commonly perceived, far too simplistically, as a Third World country with a general breakdown of law and a population seeking to flee north. That perception is also common among many Mexicans, who seem to have internalized the contempt in which they are held.

Mexicans know that their country’s economy grew 2.5 percent last year and is forecast to grow between 2 percent and 3 percent in 2016—roughly equal to the growth projection for the US economy.  But, oddly, they tend to discount the significance of Mexico’s competitive growth numbers in a sluggish global economy.

Here, therefore, we have an interesting phenomenon. Mexico is, in fact, one of the leading economies of the world, yet most people don’t recognize it as such and tend to dismiss its importance.

This week, I spoke at the annual meeting of the Mexican Association of Banks in Acapulco. It was a major event, with the Mexican president and the head of the central Bank speaking, along with Americans such as Larry Fink, chairman of BlackRock. The contrast between what Fink and I had to say about Mexico, and what the Mexicans had to say, is interesting. The Mexicans were cautious, frequently dwelling on the challenges facing Mexico and not focusing very much on the country’s achievements.

Fink and I were effusive about Mexico. Given the condition of the rest of the world, we argued, North America is an island of tranquility and opportunity—with Mexico as the most promising region economically. The contrast between our views, the views of many Mexicans, and the views of most Americans is so vast that it feels as if we dwell on different planets. I know of few places on earth that are viewed so differently by different observers.

Let me summarize the argument I made. First, the Eastern Hemisphere (Eurasia in particular) is moving toward systemic failure. The EU is struggling to manage a host of problems. Russia is contending with strategic and economic challenges, particularly the collapse in oil prices. China is trying to find a stable new normal and maintain social stability. As for the Middle East, no summary will suffice. The rest of the Eastern Hemisphere is experiencing what I might call “normal instability.”

Compared to other parts of the world, North America is not only remarkably stable but is also doing well economically. One of the main views of the Geopolitical Futures model is that, following the collapse of the Soviet Union, there was no longer any European global power. The center of gravity of the international system had shifted away from Europe, to North America. This argument rests heavily on the inherent military and economic power of the United States. The US Navy controls the oceans, and the United States produces 22% of the world’s GDP. Just as important, the United States is an inefficient exporter, a factor that cushions the US from the Eastern Hemisphere’s crisis.

While roughly 30% of GDP comes from exports in Russia, 46% in Germany, and 23% in China, US exports account for only 13% of GDP with over a third of that total sold to Canada and Mexico. Thus, while Eastern Hemisphere powers teeter on the edge of an economic volcano or tumble in, the United States finds itself relatively insulated from declines in global import demand, and the US insulates the countries on its northern and southern borders to a great extent.

The contrast between the European Union and NAFTA is critical. There are institutional differences between the attempt by the EU to integrate heterogeneous countries and NAFTA’s limits on integration. But the most important difference is that Germany, the foundation of the European system, is a massive exporter, while the United States is a net importer. Given the vastness of the US economic base, the net negative flow has little impact. However, it has an important twist in terms of Mexico. Exports, more than 80% of which go to the United States, constitute 32% of Mexico’s GDP. Thus Mexican exports to the United States amount to about a quarter of Mexico’s economy.

US GDP is about $17 trillion, and imports from Mexico’s are about 0.2 percent of the US economy, so they have very limited impact. But their impact is further mitigated because Mexican-manufactured exports contain a substantial quantity of components made in the United States. For example, Mexico is one of the top exporters of automobiles to the United States. These cars are not sold under a Mexican label, since Mexico manufactures them for foreign companies. But unlike Japanese or Chinese exports to the United States, cars manufactured in Mexico contain about 40% of their parts purchased from the United States. This means that US manufacturers contribute to the total value of Mexican exports.

Synergies have driven Mexico into dependence on the United States. The US has had the option of shifting its imports away from China and sourcing from Mexico instead.

This shift has had a huge impact on Mexico’s growth. It is also one of the reasons why the Mexicans are less than positive about their economic position.

There is much history between Mexico and the United States, with the pivotal event being the American conquest of northern Mexico—from present-day California to Texas—in the 1830s and 1840s. This conquest created a complex view of the United States, informed by both anger and envy. The tragedy of Mexico, from its point of view, is that it is still so tied to the United States.

NAFTA, much debated in the US, had an even greater effect on Mexico. Access to the American market reshaped the Mexican economy, strengthening it immeasurably. It also created an enormous imbalance—economically in Mexico’s favor, politically in the United States’ favor. When you send 80% of your exports to one country, that country has tremendous power over you. This is not only a political fact, in the sense that some politician could try to shut down trade, it is also distinctly macroeconomic: If the American economy catches a cold, Mexico catches pneumonia. As other exporting countries have discovered, their well-being is in the hands of their customers. So long as the US–Mexico imbalance is there, the Mexicans will and ought to feel uneasy.

The American conquest of Northern Mexico implanted an image in American minds. The Mexicans ought to have defeated the Texans. The Mexicans had the larger army, better equipment, and, in many ways, better commanders. But the Mexicans also had the defect of a class-ridden society. The army General Santa Anna brought north into Texas had well-trained French generals and good artillery, but it was an army drawn from Chiapas, composed of indigenous people without shoes or training. It was a Napoleonic army of the impoverished led by the nobility, fighting as a mass rather than with individual skill.

When Santa Anna crossed the northern deserts, his army found itself facing the coldest winter in years, with ice and even snow. The soldiers suffered terribly, and by the time they reached the Alamo, they were exhausted. Their commanders didn’t care about the troops and made their way east to San Jacinto… where the Texans defeated them.

It is important to understand the vast chasm that existed between the officers and soldiers in Mexico's army. There are always such differences, and they sometimes run very deep. But the chasm in the Mexican army resembled the divide in the British army so apparent at Waterloo, when the commander, Wellington, called his men “scum.” The Mexicans adopted the European model, in which the soldiers were induced by money or simply pressed into service. This was the lot of Mexican soldiers; it was their lives. But when they confronted the Americans, where the gap between enlisted men and officers was substantially smaller, an army that was inert (unless pressed) confronted an army that encouraged initiative at all levels. The latter army won.

The model of European colonialism defined the Mexican forces… but not the Americans. And for the next century and a half, the Mexican legacy of colonialism continued to define the difference between the two countries’ armies.

The experience of the Mexican-American War also defined American perceptions, and perceptions turn into habits, and habits become truths. The Mexican soldiers were seen as typical Mexicans and held in contempt, while the generals were seen as fools.

Further, the border that was created shielded Americans from a real understanding of Mexico. The border was arid and mountainous—hard to penetrate. As in many borderlands, it was a brutal place of criminals and desperate men. Certain commodities are always worth more on one side of the border than on the other. Sometimes it is cattle; sometimes it is drugs. Sometimes the goods are rightfully owned, and sometimes they are stolen.

The area north of the US–Mexico border is not like the rest of the United States, and the area south of the border is not like the rest of Mexico. But the borderland is a shield, and the shield is all that most people on either side tend to see.

The American view of Mexico was formed at San Jacinto and confirmed by endless images of Mexican revolutionary Pancho Villa raiding US border towns. He was depicted as ignorant, brutal, and dangerous. Today, Mexico is seen as a land of drug dealers, the descendants of Villa, far more dangerous than he was to American security. This perception is like viewing the United States today as if it were Chicago in the 1920s and 1930s and as if Al Capone were the typical American.

The Mexican fear of the United States is not unreasonable. Nor is the American fear of Mexico. It is easy to construct a tale of Mexico that is heavy on cartels and illegal aliens seeking to plunder and terrify the country. There is a deep history between our nations, a history that regenerates in different ways at different times.

The bankers I met at the conference in Mexico were cautious. They have been disappointed many times before by their own country. The Americans were enthusiastic. Americans tend to forego history in favor of the future… especially where money is concerned. But everyone there knew what Donald Trump has been saying during his campaign and resented the way he preys on American fears. There is no denying these fears, and there is no denying that Trump understands them. There is also no denying that, like most fears, there is some truth to them. There are cartels, and there are illegal immigrants, if fewer than before. But it is the distance between the Mexico that these fears conjure and the reality of what Mexico has become that is startling. The Mexicans themselves don’t trust the transformation of their country that has happened. They expect success to be snatched from them—probably by the United States.

But the fact is that Mexico is the 11th-largest economy in the world, with free access to the largest economy in the world and vast amounts of American investment pouring in. It may still have to contend with the challenges of sharing a border with Central America, but with China in decline, even the poor of the south might be mobilized by the low-level industries that made China successful and that now seek a new home.  

The borderland and the smugglers who live there do not represent Mexico. Mexico will be one of the top 10 economies in the world shortly, and since North America is now what Europe once was, the prospect of two great powers on one continent is worrisome.

Of course, most of us cannot imagine Mexico as a great power. Nor could most people have foreseen the emergence of China or the resurrection of Japan—or even the United States itself—as a great power. This is a failure of imagination masquerading as common sense. I always doubt the ability of humanity to manage its future. The inevitable rolls over us. But here is a moment when an understanding of what Mexico has become might just have some real value, if only for our grandchildren.

There is an old Mexican saying: “Poor Mexico. So far from God, so close to the United States.” I don’t know about Mexico’s proximity to God, but it is clear to me that Mexico is no longer paying a price for its closeness to the United States, and neither is the United States. But now Mexico, as the junior partner, must manage this relationship.

The Only Safe Haven Left In The World Is Gold

Chris Vermeulen

Globally, Central Banks are resorting to measures which have never before been witnessed in history. Since the beginning of time, ‘boom and bust cycles’ have been a natural economic cycle. Economies, globally auto correct themselves by punishing the ‘excesses’ and ‘rewarding prudence.’

Nonetheless, since the last ‘financial crisis’, the Central Banks, around the world, have been attempting to avert this cycle by artificially supporting the economy and their markets, by using various ‘financial engineering’ tools. However, they have not been capable of solving the problem! They are merely postponing the inevitable!

When Bubbles Burst, Banks Make Mistakes

Following the ‘dotcom bubble burst’, the FED embarked upon an easy monetary policy, which encouraged subprime lending and thereby finally resulting in a ‘financial crisis’ Since 2009, the FED maintained a zero interest rate policy, until December of 2015, at which time they increased rates by 25 bps. Technically, interest rates are still close to zero percent, as indicated in the chart below.

US Fed funds rate

Surprisingly, the policy makers of the Eurozone, Japan, the UK and China have also copied this ‘quick fix’ methodology by the FED, leading to the same disastrous results, globally.

All of these years of ‘easy monetary policy’ have led to inflated assets globally. Vikram Mansharamani, a lecturer at Yale University, told CNBC, "I think it all started with the China investment bubble that has burst and that brought commodities down with it, which started deflation and those ripples are landing on the shore of countries literally everywhere. I mean, we've got a bubble bursting, In Australian housing markets look like they are beginning to crack; South Africa — the whole economy; Canada — housing and the economy;  We can keep going on and on."

Did the Central Banks only resolve these issues by reducing interest rates? No!  They have also resorted to massive money printing, as well. Since the ‘financial crisis’, the total debt of the world, has increased dramatically, as indicated in the chart below.

Central Banks Go Negative Above

Considering the ‘easy monetary policy’ worldwide, and the amount of money printed, one would assume inflation to be skyrocketing, and growth to be expanding.  However, the reality is far from this situation. Most nations are struggling to ward off deflation, and avoid further recession, which means that the Central Banks have not been capable of achieving their objectives.

This has led a few Central Banks to push interest rates into negative territory, for the first time ever. It all began with the ECB, and has spread to Sweden, Switzerland and Japan. As the negative interest rates have not achieved their objectives, the ECB and Bank of Japan are contemplating pushing interest rates even further and deeper into a more negative territory. The FED even considered following the same path. Chairwoman Yellen recently stated, “they are studying it closely, in order to use it, if needed in the future”.

There are a number of experts who believe that the current low inflation rates and low growth environment are due to the incorrect monetary policy of the Central Banks. The Bank of England's Governor, Mark Carney, recently said, “Negative interest rates will only help to perpetuate a world of lower rates and slower growth and are a signal that central bank monetary policy options are now severely limited”, as reported by The Week.

The world is frantically losing confidence that the Central Banks, led by the FED, will be able to react to any financial crisis, within the near future. This was evident in the recent ‘market crash’, despite announcements that were made of further easing by the ECB and negative interest rates, by the Bank of Japan.

When the Central Banks fail, investors move towards different asset classes which are perceived as ‘safe havens’. The U.S. Dollar, the Japanese Yen and the Swiss Franc have been considered ‘safe havens’, in the past. However, no longer are they deemed so! The famous investor, Jim Rogers, states that the U.S. Dollar is the most flawed currency, the Yen is a ticking time bomb considering the unmanageable debt of Japan, and the actions of the Swiss Central Banks led to massive bankruptcies in January of 2015.  

Gold Is The Definition Of A Safe Haven

This brings us to the final ‘safe haven’, which has withstood the ‘test of time’, which is gold. It has maintained its’ value during the past 5000 years, and the current rise in gold during the ‘market collapse’ is proof that it is a ‘safe haven status’ which is still intact. Gold rose more than 16%, within two months, on the notion of a ‘financial crisis’.  Imagine how high gold will rise when the ‘real crisis’ affects the world economies.

Gold is still more than 30% below its highs. As advised in my last article, traders and investors should buy 10-15% of their portfolio allocation in gold, when it drops to $1150-$1190/oz. levels which I expect will happen over the next 1-4 weeks.

How high can gold go? I believe it can elevate as high as $5000/oz., during a ‘full blown crisis’. With a limited downside risk, and a huge profit potential, followers should buy gold.  

After Moore’s law

The future of computing

The era of predictable improvement in computer hardware is ending. What comes next?

IN 1971 the fastest car in the world was the Ferrari Daytona, capable of 280kph (174mph). The world’s tallest buildings were New York’s twin towers, at 415 metres (1,362 feet). In November that year Intel launched the first commercial microprocessor chip, the 4004, containing 2,300 tiny transistors, each the size of a red blood cell.

Since then chips have improved in line with the prediction of Gordon Moore, Intel’s co-founder.

According to his rule of thumb, known as Moore’s law, processing power doubles roughly every two years as smaller transistors are packed ever more tightly onto silicon wafers, boosting performance and reducing costs. A modern Intel Skylake processor contains around 1.75 billion transistors—half a million of them would fit on a single transistor from the 4004—and collectively they deliver about 400,000 times as much computing muscle. This exponential progress is difficult to relate to the physical world. If cars and skyscrapers had improved at such rates since 1971, the fastest car would now be capable of a tenth of the speed of light; the tallest building would reach half way to the Moon.

The impact of Moore’s law is visible all around us. Today 3 billion people carry smartphones in their pockets: each one is more powerful than a room-sized supercomputer from the 1980s.

Countless industries have been upended by digital disruption. Abundant computing power has even slowed nuclear tests, because atomic weapons are more easily tested using simulated explosions rather than real ones. Moore’s law has become a cultural trope: people inside and outside Silicon Valley expect technology to get better every year.

But now, after five decades, the end of Moore’s law is in sight. Making transistors smaller no longer guarantees that they will be cheaper or faster. This does not mean progress in computing will suddenly stall, but the nature of that progress is changing. Chips will still get better, but at a slower pace (number-crunching power is now doubling only every 2.5 years, says Intel). And the future of computing will be defined by improvements in three other areas, beyond raw hardware performance.

Faith no Moore
The first is software. This week AlphaGo, a program which plays the ancient game of Go, beat Lee Sedol, one of the best human players, in the first two of five games scheduled in Seoul. Go is of particular interest to computer scientists because of its complexity: there are more possible board positions than there are particles in the universe. As a result, a Go-playing system cannot simply rely on computational brute force, provided by Moore’s law, to prevail. AlphaGo relies instead on “deep learning” technology, modelled partly on the way the human brain works. Its success this week shows that huge performance gains can be achieved through new algorithms.

Indeed, slowing progress in hardware will provide stronger incentives to develop cleverer software.

The second area of progress is in the “cloud”, the networks of data centres that deliver services over the internet. When computers were stand-alone devices, whether mainframes or desktop PCs, their performance depended above all on the speed of their processor chips. Today computers become more powerful without changes to their hardware. They can draw upon the vast (and flexible) number-crunching resources of the cloud when doing things like searching through e-mails or calculating the best route for a road trip. And interconnectedness adds to their capabilities: smartphone features such as satellite positioning, motion sensors and wireless-payment support now matter as much as processor speed.

The third area of improvement lies in new computing architectures—specialised chips optimised for particular jobs, say, and even exotic techniques that exploit quantum-mechanical weirdness to crunch multiple data sets simultaneously. There was less need to pursue these sorts of approaches when generic microprocessors were improving so rapidly, but chips are now being designed specifically for cloud computing, neural-network processing, computer vision and other tasks. Such specialised hardware will be embedded in the cloud, to be called upon when needed. Once again, that suggests the raw performance of end-user devices matters less than it did, because the heavy lifting is done elsewhere.

Speed isn’t everything
What will this mean in practice? Moore’s law was never a physical law, but a self-fulfilling prophecy—a triumph of central planning by which the technology industry co-ordinated and synchronised its actions. Its demise will make the rate of technological progress less predictable; there are likely to be bumps in the road as new performance-enhancing technologies arrive in fits and starts. But given that most people judge their computing devices on the availability of capabilities and features, rather than processing speed, it may not feel like much of a slowdown to consumers.

For companies, the end of Moore’s law will be disguised by the shift to cloud computing.

Already, firms are upgrading PCs less often, and have stopped operating their own e-mail servers. This model depends, however, on fast and reliable connectivity. That will strengthen demand for improvements to broadband infrastructure: those with poor connectivity will be less able to benefit as improvements in computing increasingly happen inside cloud providers’ data centres.

For the technology industry itself, the decline of Moore’s law strengthens the logic for centralised cloud computing, already dominated by a few big firms: Amazon, Google, Microsoft, Alibaba, Baidu and Tencent. They are working hard to improve the performance of their cloud infrastructure. And they are hunting for startups touting new tricks: Google bought Deepmind, the British firm that built AlphaGo, in 2014.

For more than 50 years, the seemingly inexorable shrinking of transistors made computers steadily cheaper and more capable. As Moore’s law fades, progress will be less metronomic.

But computers and other devices will continue to become more powerful—just in different and more varied ways.

Re-assessing the classic risk-return trade off

When the going gets tough, the wise get out until it is calm, says research
FRANKFURT AM MAIN, GERMANY - FEBRUARY 11: A trader looks up at the board displaying the day's course of the DAX stock market index at the Frankfurt Stock Exchange on February 11, 2016 in Frankfurt, Germany. Stock markets across the globe have been exceptionally volatile in recent weeks as investors fear a global economic slowdown. (Photo by Hannelore Foerster/Getty Images)©Getty

“If you can keep your head when all about are losing theirs, it’s just possible that you haven’t grasped the situation.” That was how the American satirist Jean Kerr updated Rudyard Kipling’s poem, and new financial research suggests she was on to something.

It also adds to the growing supply of data suggesting we should re-examine the traditional financial view that investment is about trading off risk and return, with greater risk ultimately rewarded with greater return.
According to new research by Alan Moreira and Tyler Muir, two academics at Yale University’s School of Management, the correct response to an increase in volatility — and with it, risk — is to exit the market. The time to re-enter is only when the volatility has already started to subside.
This means not buying until the market has bottomed and started to recover, and also implies selling when the market has already started to fall. But over time, it still beats the returns from simply buying the market and holding it. And it also rather worryingly contradicts the widespread belief, based on much research, that higher volatility creates a great opportunity for brave contrarians to buy at the bottom.

Their research involved a strategy which on average is 100 per cent exposed to the stock market. It then adjusts the amount it holds in the market at the end of each month, according to the volatility experienced in that month. As volatility increases compared to its average, it leaves stocks and goes into cash. In periods of very low volatility it can borrow to invest. The same exercise was performed for the different factors which have beaten the market over time — value stocks, smaller companies and stocks with positive momentum — and it was also applied to the “carry trade” strategy in foreign exchange, and to a range of non-US stock markets.

In all cases, using timing to exit the market as volatility increases turned out to raise long-term returns compared to a straight “buy and hold” strategy. Further, the advantage widened when the academics looked at risk-adjusted returns. Using the Sharpe ratio — the standard measure for judging returns compared to the amount the returns vary — volatility-timing improved returns in all the US factors the academics examined, and in 16 of the 20 OECD countries.
During the most famous US market breaks, the volatility-timing portfolio led the market at all times, avoiding much of the savage drawdowns seen after the 1929 Great Crash, and during the 2008 Great Recession.

In 2008, the year of Lehman, the volatility-timing portfolio was barely ever down. Even though it failed to buy at the bottom in March 2009, and went against the wisdom of many pundits, led by Warren Buffett, that this was a time to buy, it maintained its advantage. However, by 2014, after years of strong returns on the market, the buy-and-hold portfolio had almost caught up.

Full details are available in the paper, which is available free online.

Do these findings mean the complete reversal of our notion of the risk-return trade-off? Not necessarily, but they do show that we need to pay more attention to its dynamics over time.

Markets tend to grind upwards steadily over long periods of time, and correct downwards in short and more violent bursts. The premium for taking risk exists, but that premium is not necessarily available when the volatility is happening.

Why does the volatility-timing anomaly exist? As the effect has been documented long into the past, it is not just a story of modern-day investment institutions and the perverse pressures on them. It is something more fundamental, probably rooted in human nature.
One explanation is that we are slow to recognise risk when it appears, so that the market generally recovers after the first flare-up of volatility. That gives the chance to get out in time.

At the other end, the trauma of recent loss allows fear to persist.

A practical implication is that this approach should offer a clear-cut way to make money. If this research gains acceptance, expect “smart beta” funds that use volatility to time exposure to markets.

And these ideas should be very useful for the new wave of so-called “robo-advisers”, which allocate clients’ assets following a few simple rules. Expect wealth managers to program their robots to lose their heads when all about them are losing theirs.

Monetary Madness: The Upside-Down World of Hallucinating Central Bankers

Tony Sagami

How does this sound?

Give me your money. I’ll hold on to it for a few years and skim a little off the top. Then I’ll give you back less than you originally gave me.

No thanks… right? Well, in the bizarro world of central banking, investors all over the world are doing exactly that—because of negative interest rates.

What are the world’s central bankers smoking?

There were three major fixed-income Hail Marys launched last week:

Fixed-Income Hail Mary #1: The European Central Bank went “all in” with negative interest rates and lowered its key overnight deposit rate from minus 0.3% to minus 0.4%. The ECB also expanded its quantitative-easing program by an additional €20 billion per month.

All European banks have to pay the ECB 40 bps for the privilege of depositing money there. I bet the banks love that.

ECB President Mario Draghi made it clear that interest rates would stay “very low” for at least another year. He predicted that deflation is not going away anytime soon and gave himself a giant pat on the back: The eurozone would have faced “disastrous deflation,” he said, if he hadn’t gone even more negative.

Fixed-Income Hail Mary #2: In Japan, the government gets paid to loan money.
For the first time ever, the Japanese government sold US$19.4 billion of new 10-year bonds with an interest rate of 0.1% at the average price of ¥101.25, producing a negative yield of minus 0.024%.

Like the US, Japan runs a massive deficit, but these negative bonds will help because 70% of Japan’s government debt now trades with negative yields.

Japan’s government has been paid US$464 million to borrow money since yields turned negative in October 2014. I guess negative interest rates are one way to reduce your national debt.

Fixed-Income Hail Mary #3: Lots of government debt already has negative yields, but for the first time ever, a corporation was able to sell a new bond issue with negative interest rates.

German mortgage bank Berlin Hyp AG was selling a €500 million (US$550 million) 3-year bond at a yield of minus 0.162% last week.

Negative yields on corporate bonds is a very different animal than negative government bonds.

This German bank offering should be a very loud signal to you that whatever paltry interest rates you are enjoying in the US today will very likely turn negative as the Federal Reserve numbskulls are getting ready to join the NIRP (negative interest rate policy) club.

Overall, there is $7 trillion of negative-yielding debt in the world, which equals 29% of the Bloomberg Global Developed Sovereign Bond Index. I’m not talking about backwater, third-world countries either—I’m talking about central banks from developed countries like Switzerland, Sweden, Japan, Denmark, and the European Central Bank.

Don’t think for a minute that negative interest rates can’t happen here. For a short time in 2008 during the Financial Crisis, yields on US Treasury bills actually turned negative. Nervous investors bought Treasuries with such force that prices soared and yields dropped into negative territory.

When things get ugly, the Wall Street crowd has demonstrated that it is willing to lose a small amount of principal in exchange for safety.

Sadly, I think the outlook for conservative, risk-averse retirees who depend on portfolio income to survive is pretty darn bleak if they continue to invest in fixed-income securities like bonds and CDs.

The fixed-income rules have changed, and the only way to generate any substantial portfolio income is going to be with stocks that pay generous dividends.

By the way, I think the growth of negative interest rates is one of the reasons that the price of gold has risen.

One of the knocks on gold has always been that it doesn’t pay interest or dividends.

However, 0% doesn’t sound so bad when the alternative is negative interest rates.

Gold, not cash, may be the best storehouse of value in a negative-interest-rate world.

The people running the world’s central banks are as blind as Mr. Magoo and are going to run you over unless you adapt to the new rules of successful income investing.

Israel Is Building a Secret Tunnel-Destroying Weapon

As Hamas expands its tunnel network in Gaza, Israel, and the United States are collaborating on a clandestine project to thwart the Islamist group’s subterranean advantage.

By Yardena Schwartz

Israel Is Building a Secret Tunnel-Destroying Weapon

KHAN YOUNIS, Gaza — Bassem al-Najar has been homeless since August 2014, when Israeli warplanes demolished his house during the 50-day conflict that killed more than 2,000 Gazans and 72 Israelis. Najar lost his brother in the war, and for the next four months, he lived in a U.N. school with his wife and four children, along with 80 other families. They moved into a prefabricated hut, resembling a tool shed, in December 2014, where they expected to live for just a few months until their home was rebuilt. Today, he is still one of an estimated 100,000 Gazans who remain homeless.

Yet while much of Gaza still lies in ruins, what has taken less time to rebuild is Hamas’s subterranean tunnel network, the very thing Israel entered Gaza to destroy.

During Operation Protective Edge, the name used by the Israel Defense Forces (IDF) for the 2014 war, the military uncovered and destroyed 32 cross-border tunnels that snaked for miles beneath Gaza and reached into Israeli territory. Many of them, according to the IDF, began inside homes and mosques in Gaza and ended inside or on the edge of Israeli border towns.

Hamas has made no secret of its efforts to fortify its labyrinth of tunnels, which have emerged as the group’s most powerful weapon — far more effective than its rocket arsenal. In just a handful of tunnel attacks over the course of that summer, Palestinian militants managed to kill 11 Israeli soldiers and capture the bodies of several soldiers in the hope of arranging a future prisoner exchange, in which Israel would trade Palestinian prisoners for the return of soldiers’ bodies.

“The resistance continues on its path of liberation of the land,” Ismail Haniyeh, a political leader of Hamas and former prime minister of the Palestinian Authority, told a crowded mosque in Gaza City in late January.  During the 2014 war, Hamas fired more than 4,800 rockets and 1,700 mortars at Israel, according to Amnesty International. Thanks to the Iron Dome, a first-of-its-kind anti-rocket system developed by Israeli engineers with the help of nearly $1 billion from the U.S. government, many of them were shot out of the sky before they could reach civilian towns and cities. The Iron Dome explains the extremely low number of civilian deaths on the Israeli side.

But there is no Iron Dome-type system that has proved as effective at thwarting Hamas’s tunnel network.

Although they are still waiting for their homes to be rebuilt and are living with just a few hours of electricity a day and barely any potable tap water, Najar and other Palestinians are not angry with Hamas for rebuilding the tunnels, which could lead Israel to wage another war to destroy them.

“What angers me is that the occupation is still imposing a siege on Gaza, which prevents the building process,” he says.

In fact, since the cease-fire between Israel and the militant Islamist group Hamas, more than 3 million tons of construction material have entered Gaza through Israel’s Kerem Shalom border crossing, according to Israeli figures. The first major tunnel attack occurred near that same crossing in 2006, when 19-year-old Israeli soldier Gilad Shalit was captured by Hamas militants. Hamas held Shalit in Gaza until 2011, when Israel exchanged him for 1,027 Palestinian prisoners. The prospect of capturing another Israeli soldier, and concluding another prisoner exchange, is one reason the tunnels are so valuable to Hamas.

According to experts in Palestinian politics, there is actually a surplus of cement and other construction materials in Gaza, leading to a black market that has enabled Hamas to easily repair the tunnels that Israel destroyed in 2014 and build new ones.

“It’s no secret that Hamas has its ways of getting these construction materials,” says Mkhaimar Abusada, a professor of political science at Al-Azhar University in Gaza. “There are some Palestinians who buy cement to rehabilitate their homes at the fixed price of 560 NIS (new Israeli shekels) per ton [roughly $143] but sell it on the black market for 800 NIS [roughly $205]. This is part of the problem. Some of the Palestinians aren’t using the cement to rebuild their homes.”

While Israel struggles to prevent the construction material it is allowing into Gaza from ending up in Hamas tunnels, it is developing a secret military weapon designed to eradicate the problem.

According to intelligence officials, Israeli engineers are working tirelessly to develop what’s being called the “Underground Iron Dome” — a system that could detect and destroy cross-border tunnels.

According to a report on Israeli Channel 2, the Israeli government has spent more than $250 million since 2004 in its efforts to thwart tunnel construction under the Gaza border.

The United States has already appropriated $40 million for the project in the 2016 financial year, in order “to establish anti-tunnel capabilities to detect, map, and neutralize underground tunnels that threaten the U.S. or Israel,” said U.S. Defense Department spokesman Christopher Sherwood. While the majority of the work in 2016 will be done in Israel, Sherwood added, “the U.S. will receive prototypes, access to test sites, and the rights to any intellectual property.”

Contrary to reports quoting the Israeli Defense Ministry, which claimed that the United States had already earmarked $120 million for the project, Sherwood said that appropriations are done annually, thus there is no guarantee that an additional $40 million will be appropriated in 2017 and 2018.

Among the Israeli companies working to develop the new anti-tunnel mechanism are Elbit Systems and Rafael Advanced Defense Systems, the same company that developed the Iron Dome rocket defense system. Both companies declined to provide any details due to security reasons, as did the IDF and other Israeli officials, who fear that such information could play into Hamas’s hands. Yet according to intelligence sources who spoke with Foreign Policy on the condition of anonymity, the system involves seismic sensors that can monitor underground vibrations.

IDF Chief of Staff Gen. Gadi Eizenkot hinted at these efforts in February. “We are doing a lot, but many of [the things we do] are hidden from the public,” he told a conference at Herzliya’s Interdisciplinary Center. “We have dozens, if not a hundred, engineering vehicles on the Gaza border.”

Yaakov Amidror, a former national security advisor to Prime Minister Benjamin Netanyahu and former head of Israel’s National Security Council, told FP the confidential new system is not yet operational, but it is “in a testing mode.”

Since the beginning of 2016, nearly a dozen Hamas tunnels have collapsed on the Palestinians who were building them, killing at least 10 of the group’s members. While winter rains have been blamed as the culprit, the wave of collapses has led many here to wonder if Israel’s new secret weapon is already at work.

Asked by the Palestinian Maan News Agency in February whether or not Israel was behind recent tunnel collapses, the coordinator of government activities in the Palestinian territories, IDF Maj. Gen. Yoav Mordechai, responded, “God knows.”

Hamas, too, is paying close attention to Israeli attempts to thwart its tunnel network. Haniyeh, the senior Hamas official, told Gazans at Friday prayers on Feb. 19 that the Islamist group had “discovered an underground vehicle on which were installed cameras and sensors to monitor tunnels and fighters.”

Even if Haniyeh’s claim is true, Israel still appears unable to completely counter Hamas’s subterranean advantage. And if the development of the Underground Iron Dome is any indication, it could be several years before Israel is able to employ an effective anti-tunnel system.

In the meantime, Israeli residents of Gaza border towns are growing frustrated with what they perceive as a government that lacks any vision beyond fighting a war with Hamas every two or three years. Israel has fought three wars with Hamas since it withdrew from the Gaza Strip in 2005 — 2008’s Operation Cast Lead, 2012’s Operation Pillar of Defense, and 2014’s Operation Protective Edge. While border residents wish the government and military would do more to protect them from Hamas’s tunnels, many of them also want the government to help the people of Gaza.

“Gaza is a pot that’s about to boil over, and unless something changes there, nothing is going to change here,” says Adele Raemer, who lives a mile from the Gaza border in Nirim, an Israeli settlement.

“People can’t live like that without exploding. They are going to go underground and build tunnels if that’s how they are going to make a living.”

According to veteran Israeli journalist Avi Issacharoff, the former Arab affairs correspondent for Haaretz, digging tunnels is one of the best ways to make a living in Gaza. Tunnelers typically earn about $400 a month, says Issacharoff. It’s a decent salary by Gaza standards, where unemployment is among the world’s highest, at 38 percent, according to the Palestinian Central Bureau of Statistics.

“It’s a two-pronged problem,” says Raemer, a New York native and mother of four. “On the one hand, we have to protect ourselves, but on the other hand, we have to make it livable on the other side. I believe the people in Gaza want the same things we want here: security, safety, the ability to put food on the table for our children. It’s just complicated when you have Hamas ruling there. They’ve held us and the people of Gaza hostage.”

Raemer ends our conversation with a lament: “We’re worse off now than we were before Operation Protective Edge, because Gaza is getting worse. Operation Protective Edge was supposed to protect me.”

It’s a feeling echoed by many Israelis living along the Gaza border, who would like to see a long-term solution to the problem that is Gaza, not just the symptom that is the tunnels.

The Return of the 1930s

Donald Trump’s demagoguery may be a foretaste of what’s to come.

By Bret Stephens

Italian dictator Benito Mussolini saluting during a public address in 1938.

Italian dictator Benito Mussolini saluting during a public address in 1938. Photo: Keystone/Getty Images
In temperament, he was “bombastic, inconsistent, shallow and vainglorious.” On political questions, “he made up his own reality as he went along.” Physically, the qualities that stood out were “the scowling forehead, the rolling eyes, the pouting mouth.” His “compulsive exhibitionism was part of his cult of machismo.” He spoke “in short, strident sentences.” Journalists mocked his “absurd attitudinizing.”

Remind you of someone?

The description of Benito Mussolini comes from English historian Piers Brendon’s definitive history of the 1930s, “The Dark Valley.” So does this mean that Donald Trump is the second coming of Il Duce, or that yesteryear’s Fascists are today’s Trumpkins? Not exactly. But that doesn’t mean we should be indifferent to the parallels with the last dark age of Western politics.

Among the parallels: The growing belief that democracy is rigged. That charisma matters more than ideas. That strength trumps principles. That coarseness is refreshing, authentic.

Also, that immigrants are plundering the economy. That the world’s agonies are someone else’s problem. That free trade is a game of winners and losers—in which we are the invariable losers. That the rest of the world plays us for suckers. That our current leaders are not who they say they are, or where they say they are from. That they are conspiring against us.

These are perennial attitudes in any democracy, but usually marginal ones. They gained strength in the 1920s and ’30s because the old liberal order had been shattered—first at Gallipoli, Verdun and Caporetto; then with the Bolshevik coup in Russia, hyperinflation in Germany, Black Tuesday in the United States. “What are the roots that clutch, what branches grow/Out of this stony rubbish?” wondered T.S. Eliot in “The Waste Land,” in 1922. Mussolini’s Blackshirts marched on Rome the same year.

Modern Americans have experienced nothing like those shocks, which is one important difference with the 1930s. The French army lost more men on an average day on the Western Front than the U.S. lost in our worst year in Iraq. At the height of the Great Depression, real per capita GDP fell by nearly 30% from its previous peak. At the depth of the 2008-09 recession, it fell by about 6%, and soon recovered.

Then again, the pain you’re in is the pain you tell yourself you’re in. Or, at least, the pain you’re told you’re in, usually by political doctors who specialize in hyping the misery of others.

So we’re being “invaded” by Mexicans—except that for years more Mexicans have been returning home than coming here. So China is destroying our manufacturing—except industrial employment has surged in recent years, especially in the Rust Belt. So the great mass of Americans are now unprotected from the vagaries of the global economy—save for Medicare, ObamaCare, the earned-income tax credit, public-employee pensions and every other entitlement that Mr. Trump promises to protect.

All this generates the hysteria, the penchant for histrionic rhetoric, the promise of drastic measures, the disdain for civility, the combination of victimhood and bullying on which the Trump candidacy feeds, and which it fuels. Reading through the avalanche of pro-Trump emails that arrive in my inbox (by now numbering in the thousands), what’s notable are the belittling put-downs (“you’re an $@%&, Bret-boy”), the self-importance (“I make more money than you”) and the sense of injured pride (“how dare you call me a vulgarian?”). This is precisely the M.O. of their candidate.

“In breaking the taboos of civility and civilization, a Trump speech and rally resembles the rallies of fascist leaders who pantomimed the wishes of their followers and let them fill in the text,” writes the University of Maryland’s Jeffrey Herf in a brilliant essay in the American Interest. “Trump says what they want to say but are afraid to express. In cheering this leader, his supporters feel free to say what they really believe about Mexicans, Muslims, and women.”

This is not the politics of economic anxiety or dislocation. It’s a politics of personal exhibitionism, the right-wing equivalent of refusing to be “body-shamed.” Thanks to Donald, the Trumpkins at last have a license to be as ugly as they want to be.


Mr. Trump’s bid for the presidency takes place during a period of mediocre but nonetheless unmistakable economic and employment growth in the U.S. But as a wise friend of mine noted the other day, what happens when the next bubble bursts and the next recession arrives? A reasonable person can argue that Donald Trump is more Silvio Berlusconi—Italy’s clownish billionaire and former prime minister—than he is a new Mussolini. Maybe. Or maybe Mr. Trump’s style of politics is just a foretaste of what’s to come, especially if an American downturn became a global depression.

In the work of preserving civilization, nine-tenths of the job is to understand the past and stress its most obvious lessons. Now would be a good time to re-remember the ’30s.

Chinese property

For whom the bubble blows

House prices are soaring in big cities, but oversupply plagues much of the country

SHANGHAI, China’s financial centre, does not make it easy on outsiders wishing to buy homes.

Non-residents who are single are banned from buying property. The married are welcome but only so long as they have paid local taxes for two years and make nearly a third of the purchase in cash. Shenyang, China’s biggest northern city, is far more welcoming. Anyone can buy a home there. All to little effect: housing prices in Shanghai, five times more expensive than those in Shenyang, have risen by 20% over the past year; those in the northern city have edged down.

This bifurcation is a worry for the government, which wants to spur growth without inflating bubbles.

A divergence in housing prices between wealthy cities and the hinterland is a familiar problem in other countries—just look at London and Lincolnshire, say, or New York and Nebraska. But the divisions are starker in China. In its most prosperous cities, already giddy prices continue to shoot up, while unsold flats pile up in markets where valuations were low to begin with.

Moreover, construction has long been one of the economy’s main engines, accounting for as much as a quarter of GDP growth until recently. This makes it especially important that the government get the balance right. Doing so is proving hard.

Over the past half-year, the government has unveiled a series of measures to support the housing market that specifically exclude China’s five hottest markets (Beijing, Guangzhou, Sanya, Shanghai and Shenzhen). People buying homes need only make a 20% down-payment to obtain a mortgage, except in the five conurbations, where they must put down 30%. By the same token, in most of the country transaction taxes have been cut by as much as two-thirds for people buying second homes; in the five outliers they have been left unchanged. In Shenzhen, a southern tech hub that is the frothiest market, with prices up by 53% in the past year alone, local officials have vowed to crack down on speculators and expand the supply of affordable housing.

The results of this two-tier system have been meagre so far. The frenzy in the biggest cities stems from the central bank’s steady loosening of monetary policy over the past 18 months.

Although warranted from an economic perspective, it was inevitable that low interest rates would drive asset prices higher. Initially, much of the credit pumped out by banks ended up in the stockmarket, but following its crash last summer, property beckoned as one of the few decent investment options in China (capital controls, which have been further tightened recently, make it hard for Chinese savers to invest their money abroad).

For speculators looking at property, the excess supply in smaller cities was all too evident, so they turned instead to the megalopolises. Du Jinsong of Credit Suisse describes it as a form of groupthink. “Everybody—investors, developers, policymakers and bankers—thinks that first-tier cities are safe,” he says.

Even as the government tries to restrain the excesses, however, it does not want to snuff out the rally in the big cities altogether, for they tend to influence sentiment elsewhere. There are signs that this is beginning to happen. Housing prices started rising month on month in the biggest cities a year ago. In midsized cities (in China, those with populations of 5m-10m), prices have been rising for the past four months. In smaller cities (mere hamlets of 1m-5m), gains have been evident only for the past two months (see chart).

If this upturn lasts, some investors reckon it will spur construction. Commodities used to build apartment blocks, such as iron (girders) and copper (wires), have recovered slightly from their recent swoon, partly in the hope that China’s property market is also stirring. Indeed, a series of mini-cycles in the Chinese housing sector over the past decade followed this sort of pattern: rising housing sales led to new building starts, which in turn pushed commodity prices higher.

Figures from the China Index Academy, a data provider, show that the stock of unsold homes has decreased recently, from nearly 30 months’ worth of sales early last year to 15 now. “A housing market with rising volume and prices clearly does not support the view that, on a macro level, China’s housing market is oversupplied,” notes Liang Hong of China International Capital Corp, an investment bank.

But there is a further vast increment of supply on the verge of coming to market, because developers slowed the pace of construction in recent years and in some cases halted it altogether. There were 4.7 trillion square metres of housing under construction but not yet available for sale at the end of last year, up by 25% from the end of 2011; 452 billion square metres of housing were on sale, nearly three times as much as at the end of 2011. Some provinces and cities are drafting plans to convert unsold homes into subsidised housing for poorer residents. Xi Jinping, China’s president, has said that reducing property inventory is a “battle of annihilation” that must be won to revitalise the economy. Revived demand for new construction, in short, is a long way off.

The exception is sure to be China’s biggest cities, where there clearly is an imbalance between supply and demand. Shenzhen and Shanghai, in particular, are popular with the young and the highly educated, just the kinds of people that push up housing prices. They are two of China’s best-run cities, offering good transport links, good jobs and, by Chinese standards, good air.

Unsold housing inventories cover just about five months of demand at the current pace of sales, indicating that more construction is needed.

Even with these strong fundamentals, it is hard to justify a 50% surge in housing prices over the past year. Regulators suspect that there has been some foul play. This week they said they would target online lenders that have made loans to homebuyers to cover their down-payments; these loans have, in theory, allowed speculators to buy homes entirely with borrowed cash, in contravention of the minimum down-payment requirements.

But reining in animal spirits is a hard task. At the Baoshan Property Trading Centre, where people buying homes in a district of northern Shanghai must go to register their purchases, crowds have swelled to such a size that the local government has deployed police to keep the peace. On one recent day a phalanx of security officers in white helmets stood guard alongside barricades as people lined up to submit their documentation. One of those queuing, Wang Jie, bought a new apartment for 2m yuan ($307,000) in October, and has watched its value soar by another 1m since then. “No one seems to buy when prices are falling,” he chuckled. “But everyone does when they start rising.”