Year of the Octopus, Part 2

Only two weeks in and 2018 is already breaking records – mostly in a good way. But that leaves 50 potentially less enjoyable weeks to go. So rather than focus on promising current events, I think I’d better dip back into my annual forecast bag and share a few more highlights with you.

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First, let me mention that you have just two days left to accept your Alpha Society invitation. After January 15, society membership will be closed for at least another year. So if  “stop procrastinating” is one of your New Year’s resolutions, here’s your chance to get off to a good start. (Plus, you can try Alpha Society out for 30 days and get a refund if you don’t think it’s a good fit.)

Looking down the road, I think this is going to be Alpha Society’s best year. Just in the next couple of months, we have our first-ever quarterly conference call with the Mauldin Economics editors, Alpha Society-only get-togethers at the SIC, and lots more. I hope you’ll join us.

Last week I called 2018 “the Year of the Octopus” because it has so many tentacles. There are many more than eight, so I should probably have made it the Year of the Centipede. In any case, let’s run through a few more projections from my still-growing pile.

Optimism and Hong Kong

Two years ago, when I was at the same Bank of America Merrill Lynch investment conference that I attended last week in Hong Kong, the mood in the room was quite somber, even bearish. The sentiment, shared by many at that gathering, turned out to be wrong.

Last week (while still suffering mightily from jet lag) I had a good conversation with my host, Ajay Kapur (who could not have been more delightful), in which we noted the mood of this year’s conference, which was almost universally upbeat. There was a clear consensus among these very seasoned and powerful traders. Given how wrong the mood was last time, Ajay and I wondered whether we should perhaps be a little trepidatious about the Chinese, Hong Kong, and other Asian markets. I’m not sure what to make of the mood this year, but I just thought I would share that experience. Now let’s move on to the forecasts of some of my other Friends.

Easterling: Correction and Continuation

We’ll start with Ed Easterling’s invaluable Crestmont Research. Ed is one of the top experts on market valuations. We looked at some of his work right after the 2016 election (see “The Trump Rally Will Morph”), specifically concerning price/earnings ratios. P/E is a good timing indicator over very long periods, but stocks can stay overvalued or undervalued for years. The P/E has stayed between 10 and 25 most of the time but can move way above or below that range and stay there awhile. As of this writing, the S&P 500 trailing P/E ratio is around 22 – elevated but not signaling imminent doom. It’s higher by some other metrics.

Here’s a bit from Ed’s year-end update:

P/E is above sustainable levels and beyond the level that is appropriate for a low-inflation environment. Regardless of whether the current environment is designated as a secular bear or secular bull, an elevated P/E means that returns over the next 5–10 years will be below average, and years with excess returns (like 2017) simply pull forward future returns and increase the magnitude of subsequent corrections.

By Ed’s methodology, stocks are still in the bear market that began back in 2000. P/E ratios troughed at a below-average level, as you can see in the lower right of this chart.

The next bull cycle won’t begin until the P/E ratio troughs somewhere below 15. That means prices have to drop considerably from here. Will it happen this year? I think probably not, but Ed says it better than I do:

Outlook: Two of the mostly likely scenarios for this year are Correction and Continuation.

Correction recognizes that the current level of valuation is unsustainable. Therefore, the inevitable result is a decline in the market to levels that can provide an appropriate return.

The level of return for financial assets is driven by the inflation rate. Higher inflation drives higher bond yields and higher stock returns. Thereby, markets adjust the prices of financial assets to adjust the level of investment return as the expectation for future inflation moves up or down. For example, higher inflation drives bond prices lower, which results in higher yields. Likewise, higher inflation drives stock prices lower (i.e., lower P/Es) in order to result in higher stock market returns...and vice versa.

Valuation matters. Prices for bonds and stocks can become overvalued or undervalued. This occurs when prices get out of line with the expected level of inflation. Currently, inflation is low and P/E should be high; but the current level of P/E is well beyond the level associated with a low inflation environment. Today’s excessively high P/E for the stock market could portend a correction back to the level of P/E that is appropriate for the expected inflation rate environment.

Keep in mind, when inflation is below average, stock market returns will appropriately be below average. Today’s expected low inflation environment means that P/E should be above average (just not this much above average), which means that future returns from here will be well below average.

Continuation reflects a market with additional momentum. Further gains in the market could be driven by a pickup in the economy. Recent tax and regulatory changes are likely to promote economic production, which should drive stronger economic growth.

Although valuations and profit margins are elevated, the effects of good economic news could propel prices further.

As Ed says, valuations should not be this high while inflation is this low. Yet they are.
That disconnect will get resolved at some point but perhaps not imminently.

Jensen: The US Is 1980s Japan

Niels Jensen of Absolute Return Partners is a rarity: a risk manager whose writing is informative and entertaining at the same time. Hard to imagine, I know – risk managers specialize in spoiling parties. But Niels is different. Visit his Absolute Return Partners site to read some of his letters, and you’ll see.

In his latest, Niels lists five top predictions for 2018:

1. Turbulent Brexit negotiations taking the UK to the cliff edge.

2. General elections in Italy turning the country anti-EU.

3. Mayhem in Saudi Arabia leading to a dramatic rise in oil prices.

4. Synchronized GDP growth leading to rising wage inflation.

5. The US equity market turning into the Japan of the late 1980s.

He then explains them in more detail, which you can read here. I’ll quote his point on the US turning into Japan because I think it has some similarity to Ed Easterling’s outlook above.

Now to the final one of my five concerns. Japan of the late 1980s – what do I mean by that? As I am only too aware that not all my readers are as old as I am, allow me to summarise what happened in Japan in the late 1980s.
Back then Japan delivered the mother of all bull markets. Equity prices kept going up and so did property prices, with investors paying little attention to economic logic. At the peak, the land surrounding the Imperial Palace in Tokyo was said to be worth more than all of California! The Japanese even have a name for that extraordinary bubble: バブル景気.

The bubble was characterised not only by inflated asset prices but also by a largely uncontrolled money supply, excessive credit expansion, and disproportionate monetary easing. Does that ring a bell? By the early 1990s, it was all over, and the decade of the 90s turned into what is now known as the Lost Decade.

What I don’t like about US equities right now is that they defy logic, just as Japanese equities defied reason back in the late 80s. US valuations are not only out of whack with those of other equity markets around the world but also relative to past valuation levels:

Equity valuations in various countries
Source: Moody’s Investor Service, The Daily Shot

Niels continues:

Furthermore, as a result of inflated equity prices and strong property markets, US wealth is accumulating at a faster pace than anywhere else (exhibit 7). The best way to measure how much asset price inflation has affected wealth in the US is to zoom in on the wealth-to-GDP ratio, which is long-term constant. (Note: I don’t intend to go into any level of details here as to why that is, but it is a major topic in my forthcoming book.) The US mean value is 3.8, and I note that wealth is now in excess of 5 times GDP in the US; i.e. total wealth will have to drop 25–30% for equilibrium to be reestablished.

Change in total wealth, 2016–17 ($bn)
Source: Credit Suisse Global Wealth Data Book 2017, The Daily Shot

In other words, it is only a question of time before risk assets take a significant hit in the US, and I am prepared to stick my neck out and suggest that 2018 could be the year when the adjustment phase begins.

Having said that, one thing I also learned from the Japanese experience is that, when bubbles rage, asset prices can defy logic a lot longer than what you think is possible. There is absolutely no reason why the bubble cannot get even bigger before it eventually blows up, but blow up it will.

I agree with that last part. The stock bubble can get bigger and probably will, making the eventual implosion even more painful. As of now, bears are still easy to find, so we don’t seem to be near a capitulation point, but it is coming.

Lebowitz: Buy the Dip?

One of my newer favorite macro analysts is Michael Lebowitz of 720 Global. He has a way of cutting through the numerical fog to make important points jump out at you.
You can read his full “Investment Outlook 2018” here. Below are some highlights.

The primary investment theme remains “buy the dip.” That approach has worked amazingly well, a testament to the sustained strength of markets. Thanks in no small part to gradualism from the Fed on interest rate and balance sheet normalization, the blind assumption is that the favorable trajectory of risk assets can be endlessly extrapolated into the future.

There is a distinct difference between taking a defensive posture and a negative one. Remaining full-bore aggressively long at this juncture is a speculative endeavor akin to letting our kids play in the median of a busy highway. Proper care and stewardship of wealth means being protective and forward-looking to avoid large losses.

Outlier scenarioThe market is far more sensitive to changes in interest rates than currently perceived. If the Fed continues to increase the Fed Funds rate and reduce their balance sheet in response to low unemployment and moderate levels of inflation, economic activity will decline. The result is a recession that initiates the unwinding of leverage accumulated in the system compounded by and revealing many layers of hidden risks.

I think Michael’s bond outlook is especially important. I bolded some key points below.

US Treasury yields are bipolar. Short maturity yields are rising with Fed rate hikes while long-maturity yields are stable to lower. This dynamic produces a flattening of the yield curve revealing short-term optimism and long-term doubt. On an absolute basis, yields remain very low. The 2-year Treasury yield is 1.82% while the 10-year yield is 2.40%. The 2s–10s yield curve spread resides at the lowest level (0.58%) since the financial crisis of 2008.

Investors looking for income in the safety of the Treasury market will die of thirst long before achieving their targets. Accordingly, many investors are reaching for additional yield in riskier categories, namely high yield credit and dividend-paying stocks. This game has been going on for a long time. Despite the relative yield enhancement those alternatives offer, the question of whether or not an investor is appropriately rewarded for taking that risk still exists.

Non-investment grade, or “junk” bond, yields range from 4% to 10%, depending on the company and sector, with the overall average yield at about 5.75%. A bond is relegated to junk status precisely because of the elevated risk of default. At current market yields, junk bonds pose an inordinate threat of record low recovery value and terminal realized yield. Using the average yield for junk bonds of 5.75%, an average default rate of 5% and a generous recovery rate of 50%, a high yield debt portfolio is mathematically identical to a risk-free asset with a yield of 3.25%. That amounts to a risk-adjusted premium of only 0.85% over 10-year Treasuries (3.25 – 2.40). A yield pickup of less than 1% is hardly compelling, especially when one considers [that] the downside from current valuation levels is immense.

Investors who think they get a nice yield boost from owning high yield debt are not considering the risk-adjusted outcomes. The risk-adjusted premium over Treasuries should be at least 200 to 300 basis points. Fixed-income portfolio allocations should reside predominantly in the defensive havens of high-quality sovereign, well-selected municipal and investment-grade corporate bonds. We recommend no allocation to junk.

As Michael says, many yield-seeking investors have jumped into junk bonds without fully weighing the risks. I’m very interested in that segment, too, but not yet. I’ll buy when yields are much higher and the risk-reward balance is more compelling.

Lewitt: Charts Point to Caution

Another favorite of mine who really should get more attention is Michael Lewitt. He writes The Credit Strategist, which always gives me good fodder for thought. Here are some excerpts from Michael’s January forecast issue.

Stocks: Last year, like many others, I underestimated the power of the bull market as central banks poured another $2 trillion into the markets. My 2017 prediction of an 1800-2400 range on the S&P 500 was way off as markets exhibited the lowest volatility in history and never experienced even a 3% correction. My range is very wide again in 2018 (3000/2300) and we could easily hit the high end of my range at some point during the year. The reason for this is that, despite the charts shown above, the structure of markets favors stocks – fewer shares outstanding due to stock buybacks, 50% fewer public companies today versus 20 years ago, few attractive fixed income alternatives, and ETFs and other passive strategies hoovering up huge amounts of mindless capital. There are fewer places for people to invest their money, and Wall Street makes it easier than ever to invest it in stocks with very little intellectual effort.

I expect higher volatility in 2018 as central banks tighten and stocks start to see more competition from the short end of the curve. I expect the VIX to trade at an average closer to 15 than 10 in 2018. There will be more opportunities for short sellers (if there are any left) to make money in 2018 while long-only and index investors will have a tougher go. It would be very surprising if 2018 were anywhere as easy as 2017 was for bulls (and if people thought their famous managers had trouble making money when the market was rising, how do they think they are going to do when the market is struggling?).

Bonds: I expect short rates to rise another 50–75 basis points as the Federal Reserve raises the Federal Funds rate three times in 2018. The 2/10 Treasury curve flattened by 65 basis points (to 53 basis points) in 2017 as the 10-year yield fell by four basis points (from 2.45% to 2.41%) and the 2-year rose by 69 basis points (from 1.19% to 1.88%).

The yield curve will likely flatten further and may come close to inverting as short rates keep rising and the 10-year yield squeezes closer to 3%, a level that may spook markets in a US economy carrying ~$60 trillion of combined public and private sector debt.

It is hard to see how 10-year yields won’t exceed 3% next year if 2-year rates track three 25-basis-point hikes in the Fed Funds rate, so this is something to watch very closely. If 10-year yields exceed 3%, stocks will likely react poorly; if they don’t, we will know that we are truly in the blow-off phase of a bubble.

That last part is key. I think a 3% yield with no credit risk in 10-year Treasury bonds could tempt many income-oriented investors out of stocks and corporate bonds. Why take equity risk in a market at historically high valuations for a 2% dividend yield (2% if you’re lucky)? Worse, yields at that level might start pulling pension money out of stocks, too. A 3% T-bond yield is quite reasonable if the Fed stays its present course.

Insights from Lacy Hunt

Lacy Hunt was at the conference in Hong Kong with me, and while he acknowledges that there is reason for optimism, he feels that in general the economy is likely to be slower this year than it was the last three quarters of last year. Part of that is the savings rate, and part of it is the Fed’s having to reduce the monetary base in order to raise rates. That is just simply a drag on the economy. I will have Lacy’s full Hoisington Management letter for you as an Outside the Box in a couple of weeks, so you can get the entire sense of what he is saying, but there seems to be a common theme among his and other forecasts that I have shared this week: Caution is warranted. The markets could go up a lot further, but be careful out there.

Housel: What a Time to Be Alive

These forecasts have been generally negative, and I don’t want to end on a downer. I believe we’ll get through whatever challenges 2018 throws at us, and we may even be better off for it. In that spirit, here’s an uplifting piece from Morgan Housel.

John D. Rockefeller was the richest man the world had ever seen.

But for most of his adult life he didn’t have electric lights, air conditioning, or sunglasses. And he never had penicillin, sunscreen, or Advil. This is not ancient history: One in twenty Americans were born before Rockefeller died.

The majority of Americans think the next generation of adults will be worse off than their parents.

I think of two things when I hear this.

One, the pessimists are probably wrong, extrapolating a bad decade into infinity. Two, progress is like compound interest – you don’t even notice it in the short run, but it’s mind-blowing when you zoom out and see what can be accomplished over long periods.

There are so many things still wrong with the world, and the future will always be hard. But when confronted with pessimism, Warren Buffett reminds us that normal Americans “live better than John D. Rockefeller did.”

From there, Morgan goes on to list several dozen examples of how right Warren Buffett is. You can read them here. By all sorts of criteria, most of us in the developed world live better than the world’s wealthiest man did a century ago. That some of us still have the gift of life at all shows the progress in medicine, and better is coming. We have technology and luxuries Rockefeller couldn’t even have imagined. It really is worth clicking on that link and just appreciating how much better things are today than they were just 50 years ago. I continue to be very bullish on the human experiment. On our little experiments with governments, maybe not so much…

That doesn’t mean we have no challenges. We have many, chief among them making our progress more accessible to everyone. I believe that will happen and that I will live long enough to see it, as will most of you reading this. The future is bright.
Boston and Baltimore

Right now, I am scheduled to fly into Boston for a series of meetings and then will in theory make my way down to Baltimore to meet with Patrick Cox and to review some new medical developments. What wonderful times we live in.

On Saturday in Hong Kong my friend Peter Churchouse took Lacy and I and our wives, JK and Shane, on a trip around the harbor in his racing yacht. It was quite windy, so we were clipping along at a good pace even though we were inside the harbor. At the end of that exhilarating tour, I offered to buy Peter a drink, as he always seems to be doing things for me. So we walked over to the Excelsior Hotel, where there is a famous bar down in the basement called the Dickens. Peter, Lacy, and I said at one end of the table and our wives at the other. Peter is a very astute investor, and it didn’t not take long before he and I had engaged Lacy on some rather technical economic issues that I knew would be boring to our wives; but they seemed to be enjoying themselves immensely, laughing and having fun. When we broke up about an hour later, we learned the reason for their high spirits. Every time someone in men’s group uttered the words yield curve, the gals would clink their glasses and take another drink, thereby turning our rather sober economic conversation into a fine drinking game.

Now, before I hit the send button, I want to tell you about a special five-part series I have put together for you, in which I delve deep into minds of the five individuals who have been most influential in shaping my worldview. It took me hundreds (yes, hundreds) of hours of writing and thinking through the content to put it together, so I’m excited to hear what you think about it.

The purpose of this series is to share with you the most important insights that I’ve gleaned through my personal conversations with these five great minds. These individuals have changed how I view the world, our economy, and the future of society. I say, without hesitation, that you are going to learn so much from these essays. I encourage you to check them out for free, here. Please note, we are releasing the content over several days, so don’t worry about the two articles that can’t be viewed yet – I’ll send you an email when we release them.

Your still suffering from jet lag analyst,

John Mauldin

Trump’s looming bust-up with China is bad news for 2018

Competing global ambitions and a clash of egos with Xi Jinping points to a stand-off

Edward Luce

Flattery gets you everywhere with Donald Trump. But only while it lasts. Like any addiction, it needs regular boosts in higher doses. Amid fierce bidding, China’s Xi Jinping won first prize as 2017’s most effective Trump flatterer. All it took was a lavish banquet in the Great Hall of the People. In return, Mr Trump forgot to raise America’s trade complaints or human rights. Mr Xi easily outflanked the US at the Asian summits following Mr Trump’s China visit. If the key to seducing him is a dish of Kung Pao chicken, what’s not to like?

The problem is that Mr Xi must continually feed Mr Trump. At a certain point, the ratio of Trump flattery to loss of self-respect will be too high. Would another flurry of trademark approvals for Ivanka Trump break China’s bank? Probably not. What about giving the go-ahead for a Trump Tower in Shanghai? Possibly. Another red carpet reception is unlikely to cut it. The law of diminishing returns applies to favours already bestowed. In 2018, it is likely to turn negative. China has always been in Mr Trump’s sights. Massaging his ego buys only brief respite.

The other ego is Mr Xi himself. China has acted with caution for more than a generation. For Washington’s “never Trumpers”, Beijing’s restraint gave it honorary membership of the axis of adults that would curb Mr Trump’s instincts. If Mr Trump was a loose cannon, China could be counted on to behave responsibly. In the opening months of Mr Trump’s presidency, Mr Xi did just that. China, not the US, is now the darling of the Davos economic elites. Mr Xi can lecture on Ricardian trade theory with the best of them.

But China’s age of forbearance is over. In October, Mr Xi opened a bolder chapter in China’s foreign ambitions. Deng Xiaoping, China’s great moderniser, spent his last years with no official role other than chairman of China’s bridge association. Hu Jintao, Mr Xi’s predecessor, was happy with just being president. Mr Xi, by contrast, has grabbed every title going and immortalised his own thought in the party’s constitution. Mr Trump has competition, in other words. For the first time since Mao Zedong, China has a living personality cult. US-China relations are now in the hands of two gargantuan egos.

That is bad news for 2018. Added to this are two bigger clouds. For the first time since the cold war, the US has an explicit competitor. Mr Xi’s China has set itself the target of becoming the world’s top dog within a generation. Unlike the Soviet Union, China can sustain technological rivalry with the US. America’s dominance in the Asia Pacific is no longer a given. Mr Xi’s aim is to achieve military parity. Second, America’s president thinks in hourly increments. China’s leader plans in decades. The battle between these two egos is one-sided. Mr Xi holds a telescope. Mr Trump stares at the mirror.

The scope for misunderstanding is growing. Too much attention has been paid to the spectre of a nuclear conflict between the US and North Korea — too little to the looming fallout in US-China relations. That is in spite of Mr Trump’s latest tweet boasting that he had a bigger nuclear button than Mr Kim.

The US president still believes China can disarm Kim Jong Un on America’s behalf. No one else thinks that is likely. Last week, Mr Trump said his patience with China was running out. Mr Trump’s advisers have so far curbed his protectionist impulses. But Mr Trump is rarely muzzled for long. His one consistent belief is that the US is being ripped off. China, whom he has repeatedly accused of raping America, tops the list. “If they don’t help us with North Korea, then I do what I’ve always said I want to do,” he told The New York Times. We should expect 2018 to produce US trade actions against China and Beijing to fight them at the World Trade Organization. There will also be more nuclear tweets.

But the US-China fog extends far beyond the Korean peninsula. As does the potential theatre of confusion. Last year China opened its first overseas base, in Djibouti. A Chinese aircraft carrier made its first visit to the Mediterranean. Mr Xi also stepped up China’s installations in the South China Sea — a subject on which Mr Trump has yet to comment.

Mr Trump has not uttered the word “Taiwan” since he spoke to its leader after his election. His first tweet of 2018 was to accuse Pakistan of “lies and deceit”. China rushed to Pakistan’s defence. “China and Pakistan are all-weather partners,” said Beijing after praising Islamabad’s “outstanding contribution” to fighting terrorism. Mr Trump was far closer to the truth. But there are few gulfs of perception wider than that.

In a stand off between Mr Trump and Mr Xi, who would blink first? There is no way of knowing. However, China is giving hints of over-confidence. From the Iraq war to Mr Trump’s election, China has been reaping one windfall after another. His disdain for democratically elected leaders plays straight into Beijing’s hands. But its luck cannot last for ever. Mr Xi should remember that Mr Trump launched missile attacks on Syria when the two were having dinner in Mar-a-Lago. Many in China believe Mr Trump is a paper tiger. They may be right. But it would be rash to test that theory.

The next frontier

Using thought to control machines

Brain-computer interfaces may change what it means to be human

TECHNOLOGIES are often billed as transformative. For William Kochevar, the term is justified. Mr Kochevar is paralysed below the shoulders after a cycling accident, yet has managed to feed himself by his own hand. This remarkable feat is partly thanks to electrodes, implanted in his right arm, which stimulate muscles. But the real magic lies higher up. Mr Kochevar can control his arm using the power of thought. His intention to move is reflected in neural activity in his motor cortex; these signals are detected by implants in his brain and processed into commands to activate the electrodes in his arms.

An ability to decode thought in this way may sound like science fiction. But brain-computer interfaces (BCIs) like the BrainGate system used by Mr Kochevar provide evidence that mind-control can work. Researchers are able to tell what words and images people have heard and seen from neural activity alone. Information can also be encoded and used to stimulate the brain. Over 300,000 people have cochlear implants, which help them to hear by converting sound into electrical signals and sending them into the brain. Scientists have “injected” data into monkeys’ heads, instructing them to perform actions via electrical pulses.

As our Technology Quarterly in this issue explains, the pace of research into BCIs and the scale of its ambition are increasing. Both America’s armed forces and Silicon Valley are starting to focus on the brain. Facebook dreams of thought-to-text typing. Kernel, a startup, has $100m to spend on neurotechnology. Elon Musk has formed a firm called Neuralink; he thinks that, if humanity is to survive the advent of artificial intelligence, it needs an upgrade. Entrepreneurs envisage a world in which people can communicate telepathically, with each other and with machines, or acquire superhuman abilities, such as hearing at very high frequencies.

These powers, if they ever materialise, are decades away. But well before then, BCIs could open the door to remarkable new applications. Imagine stimulating the visual cortex to help the blind, forging new neural connections in stroke victims or monitoring the brain for signs of depression. By turning the firing of neurons into a resource to be harnessed, BCIs may change the idea of what it means to be human.

That thinking feeling

Sceptics scoff. Taking medical BCIs out of the lab into clinical practice has proved very difficult. The BrainGate system used by Mr Kochevar was developed more than ten years ago, but only a handful of people have tried it out. Turning implants into consumer products is even harder to imagine. The path to the mainstream is blocked by three formidable barriers—technological, scientific and commercial.

Start with technology. Non-invasive techniques like an electroencephalogram (EEG) struggle to pick up high-resolution brain signals through intervening layers of skin, bone and membrane.

Some advances are being made—on EEG caps that can be used to play virtual-reality games or control industrial robots using thought alone. But for the time being at least, the most ambitious applications require implants that can interact directly with neurons. And existing devices have lots of drawbacks. They involve wires that pass through the skull; they provoke immune responses; they communicate with only a few hundred of the 85bn neurons in the human brain. But that could soon change. Helped by advances in miniaturisation and increased computing power, efforts are under way to make safe, wireless implants that can communicate with hundreds of thousands of neurons. Some of these interpret the brain’s electrical signals; others experiment with light, magnetism and ultrasound.

Clear the technological barrier, and another one looms. The brain is still a foreign country.

Scientists know little about how exactly it works, especially when it comes to complex functions like memory formation. Research is more advanced in animals, but experiments on humans are hard. Yet, even today, some parts of the brain, like the motor cortex, are better understood.

Nor is complete knowledge always needed. Machine learning can recognise patterns of neural activity; the brain itself gets the hang of controlling BCIS with extraordinary ease. And neurotechnology will reveal more of the brain’s secrets.

Like a hole in the head

The third obstacle comprises the practical barriers to commercialisation. It takes time, money and expertise to get medical devices approved. And consumer applications will take off only if they perform a function people find useful. Some of the applications for brain-computer interfaces are unnecessary—a good voice-assistant is a simpler way to type without fingers than a brain implant, for example. The idea of consumers clamouring for craniotomies also seems far-fetched. Yet brain implants are already an established treatment for some conditions.

Around 150,000 people receive deep-brain stimulation via electrodes to help them control Parkinson’s disease. Elective surgery can become routine, as laser-eye procedures show.

All of which suggests that a route to the future imagined by the neurotech pioneers is arduous but achievable. When human ingenuity is applied to a problem, however hard, it is unwise to bet against it. Within a few years, improved technologies may be opening up new channels of communications with the brain. Many of the first applications hold out unambiguous promise—of movement and senses restored. But as uses move to the augmentation of abilities, whether for military purposes or among consumers, a host of concerns will arise. Privacy is an obvious one: the refuge of an inner voice may disappear. Security is another: if a brain can be reached on the internet, it can also be hacked. Inequality is a third: access to superhuman cognitive abilities could be beyond all except a self-perpetuating elite. Ethicists are already starting to grapple with questions of identity and agency that arise when a machine is in the neural loop.

These questions are not urgent. But the bigger story is that neither are they the realm of pure fantasy. Technology changes the way people live. Beneath the skull lies the next frontier.

Why Low Inflation Is No Surprise


People shop at an Ikea home furnishing store

BERKELEY – The fact that inflation has remained stubbornly low across the global North has come as a surprise to many economic observers. In September, the always sharp and thoughtful Nouriel Roubini of New York University attributed this trend to positive shocks to aggregate supply – meaning the supply of certain goods has increased, driving down prices.

As a result, Roubini observed, “core inflation has fallen” even though the “recent growth acceleration in the advanced economies would be expected to bring with it a pickup in inflation.” Meanwhile, the US Federal Reserve “has justified its decision to start normalizing rates, despite below-target core inflation, by arguing that the inflation-weakening supply-side shocks are temporary.” Roubini concludes that, “even though central banks aren’t willing to give up on their formal 2% inflation target, they are willing to prolong the timeline for achieving it.”

In my view, interpreting today’s low inflation as a symptom of temporary supply-side shocks will most likely prove to be a mistake. This diagnosis seems to misread the historical evidence from the period between the early 1970s and the late 1990s, and is thus based on a fundamentally flawed assumption about the primary driver of inflation in the global North since World War II.

Since the 1970s, economists have maintained a near-consensus belief that the Phillips curve has a substantial slope, meaning that prices react strongly to changes in demand. According to this view, relatively small increases in aggregate demand above levels consistent with full employment will have a substantial impact not just on inflation, but also on expectations of inflation. A period of rapidly accelerating inflation in the recent past will lead people to believe that inflation will increase in the future, too.

More than 20 years ago, I wrote a paper called “America’s Only Peacetime Inflation: The 1970s,” in which I challenged this narrative. I showed that, when the now-standard view about inflation was developed in the 1970s, increases in aggregate demand above levels consistent with full employment were actually few, short-lived, and small, and that past inflation jumps had been incorporated into future expectations not rapidly, but slowly over time.

In fact, it took three large adverse supply shocks for expectations to adjust. In addition to the Yom Kippur War of 1973 and the Iranian Revolution of 1979, productivity growth began to slow at the same time that unions still had substantial pricing power, and previously negotiated wage increases were already locked into many workers’ contracts.

Despite these shocks, central bankers, chiefly then-Fed Chair Arthur F. Burns, were hesitant to commit to achieving price stability. Instead, Burns, understandably worried that fighting inflation would bring a deep recession, decided to kick the can down the road. And as we now know, that set the stage for 1979, when Paul Volcker succeeded Burns as Fed Chair, hiked up the federal funds rate (a move now known as the “Volcker disinflation”), and brought on the Near-Great Recession of 1979-1982.

Strangely, this history of what actually happened was for some reason swallowed up by an alternative narrative that many still cling to today. According to this pseudo-historical retelling, Keynesian economists in the 1960s did not understand the natural rate of unemployment, so they persuaded central bankers and governments to run overly expansionary policies that pushed aggregate demand above levels consistent with full employment.

This was of course an affront to the gods of the market, who responded by meting out divine retribution in the form of high and persistent inflation. The Volcker disinflation was thus an act of penance. To expunge the original sin, millions of workers’ jobs and incomes had to be sacrificed.

The clear lesson from this telling is that economists and central bankers must never again be allowed to run overly expansionary policies. But that is obviously bad policy advice.

After all, it has been more than 20 years since economists Douglas Staiger, James H. Stock, and Mark W. Watson showed that the natural rate of unemployment is not a stable parameter that can be estimated precisely. And economists Olivier Blanchard, Eugenio Cerutti, and Lawrence H. Summers have toppled the belief that the Phillips curve has a substantial slope. In fact, to say that it had a substantial slope even in the 1970s requires one to avert one’s eyes from the supply shocks of that decade, and attribute to demand outcomes that are more plausibly attributed to supply.

Those who have used the prevailing economic fable about the 1970s to predict upward outbreaks of inflation in the 1990s, the 2000s, and now the 2010s have all been proven wrong.

Why, then, does the narrative still have such a hold on us today?

The best – albeit inadequate and highly tentative – explanation that I have heard is that it fits with our cognitive biases, because it tells us what we want to hear. It seems to be in our nature to look for stories about sin and retribution, crime and punishment, error and comeuppance.

Finding out why we have this cognitive bias will no doubt launch many careers in psychology in the future. In the meantime, we should free ourselves from a heuristic prison of our own making.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

 So That’s What Volatility Looks Like  

2017 was literally the smoothest stretch of highway that US stocks have ever traveled. Rising almost every day and seldom falling hard, they made it virtually impossible for investors to lose money.

Here’s the Dow Jones Industrial Average over the past two years. Note how unnaturally smooth the recent action was.

As a result, measures of volatility (i.e., fear) like the Vix fell to all-time lows. Note how the index’s wild swings of the past gradually give way to a steady decline that mirrors the steady ascent of share prices in the previous chart.

Rising prices and declining volatility convinced individual investors (sigh) that stocks will always behave this way. Retail money began pouring into both equities and call options. The following chart is compiled by CNN, and shows the put/call ratio (lower means more bullish) plunging to a record low, which the chart labels “Extreme Greed.”

But today something different happened. Stocks opened massively higher, riding the momentum of last week’s record close. The Dow pierced 26,000 for the first time ever, making all those tech stock positions and call options look like strokes of genius. Then those gains evaporated in a 282 point reversal, one of the biggest of the past few years.

The Vix, in response, jumped by 14%, after an even bigger spike intra-day:

Whether this the start of a trend won’t be clear for a while. But what is clear is that today’s reversal and vol spike are consistent with the aftermath of every single previous period of soaring prices and collapsing volatility. By sucking dumb money into the market, blow-off bubble tops eventually beget their opposite.

So while today might or might not be one of those times, when the next bust does come, it will probably start like this.

Finally, a Clearer Picture on Inflation

Last year’s bout of weak inflation figures really was transitory, just like Janet Yellen said

By Justin Lahart

The Federal Reserve Building in Washington, D.C. Photo: Pablo Martinez Monsivais/Associated Press 

Janet Yellen can take a victory lap about inflation on her way out as Federal Reserve chairwoman. She has been saying the weakness in last year’s inflation readings was transitory, and she was right.

That clears the way for the Fed to raise rates at least the three times it expects to this year. That would surprise investors who have been skeptical of inflation and higher rates.

The Labor Department on Friday reported that overall consumer prices rose 0.1% in December from the previous month, but the real news was the 0.3% rise in prices excluding food and energy items—the so-called core that economists watch to gauge inflation’s trend. Core prices were up 1.8% versus a year earlier, and even if inflation moderates, the annual figure will should be more than 2% by April.

Change in consumer prices excluding food
and energy ítems from a month earlier

The Fed would hardly count such a pickup in inflation as dangerous. What is important is that any doubts among Fed policy makers about inflation are in the past and Friday’s report should make them a lot more comfortable with raising rates.

The numbers also set a higher starting point for inflation at a time when wage growth should accelerate—something that seems likely with all the raises and $1,000 bonuses companies are doling out. There is now a strong possibility for four quarter-point rate increases this year.

Investors are starting to get it—two-year Treasury yields are now at their highest level since 2008. But interest-rate futures imply investors only expected two and a half rate increases. You aren’t supposed to fight the Fed, but that is exactly what some people are doing.

The Danger in Today’s Good Economic News


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WASHINGTON, DC – As 2018 begins, things are looking up for the global economy. Over the last six months, growth projections by official institutions like the International Monetary Fund, matched or even exceeded by private forecasts, have been adjusted upward. But not all of the news is good.

To be sure, there are plenty of positive indicators to inspire optimism. The eurozone Purchasing Managers’ Index for manufacturing hit an all-time high last month, and even Greece’s economy is finally growing. In the United States, growth now appears likely to exceed the IMF’s October prediction of 2.3% for 2018.

In the emerging world, China seems to have staved off the risk of a sharp slowdown: while its economy is no longer achieving double-digit growth, its increased size implies that, in absolute terms, today’s 7% annual rate exceeds the 10% rates of the past. Turkey, for its part, posted 11% growth in the third quarter of 2017. Even Brazil, which experienced negative growth in 2016, is likely to exceed the IMF’s forecast of 1.5% growth in 2018.

As the real economy strengthens, equity values – which, for a time, seemed disconnected from fundamentals – are increasingly being validated. The Financial Times Stock Exchange All-World Index rose by nearly 22% in 2017 – its best performance since the post-crisis rebound of 2009.

As the growth pessimism of recent years fades, some of the warnings that have been made in recent years seem to have become outdated. Northwestern University’s Robert Gordon, for example, argued that the US economy was bound to slow down, because today’s technological innovations would not boost growth to the extent they had in the past. Harvard’s Lawrence H. Summers got a lot of attention for his argument that the world risked sliding toward “secular stagnation,” because the interest rate needed to bring desired investment in line with desired savings was below zero.

Yet, while the zero lower bound no longer seems to be a binding constraint, there are potential causes for concern, one of which relates to debt levels. With the advanced economies no longer needing to maintain extraordinary monetary policies, nominal interest rates are set to climb from their current historic lows. As that happens, high debt levels could become problematic, impeding growth by triggering disorderly deleveraging. That said, given low inflation, there is little reason to expect interest rates to rise sharply, and gradual monetary-policy normalization would not necessarily have negative effects on growth or inflation.

But there is another potential obstacle in the path of sustained recovery: the long-term decline in productivity growth has not yet been reversed. Instead, the current boom seems to be demand-led, with private consumption being the biggest driver, though private investment, too, is finally starting to rise. These trends have been accompanied by solid employment growth, which is welcome news, but cannot last forever.

In the longer run, economic performance and potential growth will depend on the supply side and, in particular, on a revival of productivity growth. Techno-optimists claim that technology will fuel the needed gains, as the lag between digital capabilities and their applications in the economy shortens. But it is too early to say, with any evidence-backed certainty, whether they or techno-pessimists like Gordon are right. There are convincing arguments on both sides, though we count ourselves as cautious techno-optimists.

What is not really up for debate is that inequality within countries is rising fast. While individual countries show different levels of inequality, its rise has been evident almost everywhere, with income and wealth increasingly concentrated at the very top. This trend will accelerate as new technologies, regardless of how much productivity growth they generate, continue to increase the skill premium, shift income to frontier firms, and allow new types of near-monopoly, “winner-take-all” positions to develop on a global scale.

Herein lies the biggest danger in today’s exuberant headlines about growth. Many believe that rapid growth can act as a virtual panacea for countries’ political and social woes, including the rise of populism and nationalism. But if the benefits of rapid growth accrue to the top 5% or 1%, social tensions are bound to rise. And the fact is that it will be difficult to develop policies that can reverse damaging political trends and promote more widely shared growth.

This is not to say that nothing can be done. On the contrary, devising solutions should be a high priority, with the policy debate centering on measures that would help to create truly inclusive economies.

One such measure would be broad-based access to affordable and quality education, including skills upgrading and retraining. The development of regulatory frameworks that encourage competition would also help, as would limiting tax-base erosion. Public research should be funded in a way that gives taxpayers a stake in profitable outcomes. Likewise, infrastructure investments should have explicit equity-related objectives. The goal should be to attack inequality on two fronts: ensuring that pre-tax incomes rise in a more inclusive fashion and strengthening the equalizing role of taxes and transfers.

Given the global nature of markets, many policies will require international cooperation to be effective. With issues concerning international trade, investment, competition, and intellectual property rights increasingly linked, global approaches that can address them in a holistic way have become vital.

Failure to achieve greater inclusiveness – a difficult but attainable goal – would stoke social tensions and fuel already-resurgent nationalism, producing disruptions that would ultimately lead to losses for everyone. Yet today’s good growth news risks obscuring that risk, as it threatens to weaken the will to make the needed changes, leaving economies to rely on trickle-down effects.

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.

Zia Qureshi, a former director of development economics at the World Bank, is a non-resident senior fellow at the Brookings Institution.

China Takes The High Road: 2018

by: John M. Mason


- In January 2017, Xi Jinping, China's president, assumed leadership of the world's movement to greater globalization, as the United States appeared to be backing off from this role.

- This year, the longer term strategy of Mr. Xi and China has become clearer: to tie other regions or nations more closely to China and to support massive technological innovation.

- Right now, the rest of the world seems to be quite receptive to Mr. Xi and the Chinese and are open to achieving closer ties politically, financially, and technologically.

Last year, around this time, Chinese President Xi Jinping gave a speech in Davos, Switzerland, which basically put China at the forefront of the leadership in world globalization.
I wrote about this at the time, "China Takes the High Road," but wondered what this new path would look like.
This is an important issue because Chinese leaders, as I had been wisely advised in the early 1990s, think in terms of decades, while the leaders of other countries, like the United States, think in terms of years.
Modern China, up until early 2017, had focused on becoming more competitive in world markets, accepting the fact that world markets were "open" and based on market performance. As a consequence, China was emphasizing in most of its decisions, a movement toward greater market competitiveness and opening up of trade with the world.
But, in early 2017, it was apparent that the new leader of the United States wanted to pull the United States back from its leadership in globalization and back from its efforts to build open trade agreements with communities of nations, like NAFTA and the Trans-Pacific Partnership.
Also, there was the withdrawal of the United States from the Paris climate agreement.
What would China do? How would it react to the new political environment?
Well, after observing China's behavior over the past year, it seems as if one can focus on two initiatives that set the tone of Mr. Xi's strategy.
But this strategy must be put into the context that, more than a year ago, Mr. Xi assured established himself as the dominant force in China as he has apparently established his supreme control over the Communist party, and the Communist party over the Chinese state, and the Chinese state over the Chinese people.
This movement must be remembered given that a good part of his "strategy" is based upon the performance of others that exist on the edge of greater openness. How Mr. Xi navigates this brush with openness and his vision of the Chinese future is something that remains to be seen.
Let's return, now, to the two initiatives that seem to be setting the tone of Mr. Xi's strategy.
One of Mr. Xi's efforts is addressed at winning over other the leaders of other nations by improving the relationship between China and the other nations and by providing resources to these other nations to help them better themselves.
Recent evidence of this move is seen in the efforts to tie Latin America more closely to the Chinese.
"China's emergence as a global economic rival to the U.S. is perhaps most obvious in Latin America. 
The U.S. in recent years has lost its status to China as the top trading partner in parts of Latin America, such as copper-rich Chile and agriculture and mining powerhouse Brazil.  
Now, all the uncertainty surrounding U.S. President Donald Trump's plans - from building a southern border wall, to re-freezing Cuba relations and exiting the Paris climate change accord supported by Latin America - could give an opening for China to seize more ground in the región. 
Meanwhile the Chinese government is ready to expand its dominance in a region already supplying it expanding economy with everything from farm goods to raw materials."
China is attempting to fill the void left by the United States, something that was not available to it previously. It is doing this in other parts of Asia, in Africa, the Middle East, and even in Europe.
Its efforts to build trade channels, like the new "Silk Road" plans to tie Europe and China together, inclusive of all the nations in between.
These are plans that succeed over decades, but the important thing to China is that it is planting the seeds now and will be entrenched in these areas over the years, based on the foundation it is now putting down.

The second path is also of a longer term nature and focuses upon the future of technology. China is attempting to lead the Asian boom in innovation.
"For the past 15 years, we have seen an impressive rise in technologies created in emerging Asian economies….Measured by the number of patents granted in the U. S., the 'Asian Miracles' are already contributing more than European economies to global technological progress. China's patents granted in the U. S. went from about 100 in 200 to over 8,000 in 2015, more than the UK or France (about 6,500in 2015)."
Not only do these innovations help China and the Chinese, but they also can help the China's "friend nations," the nations in Latin America and Africa and elsewhere, to leap into the twenty-first century, something they lack the resources to achieve just by themselves.
The China initiative "Made in China 2025" not only speaks to the advancement of those in China, itself, but also speaks to the spread of Chinese innovation spreading to global markets and investors.
And, the other thing that this initiative builds is the education and training of the people. For the Chinese to play the role in the world that Mr. Xi and China's leadership want to achieve, the lifetime education system of the Chinese must be second to none. And, this also takes decades.
Martin Wolf argues in the Financial Times that the disorder in the West has created an opening for China and Mr. Xi picked up the "mantle of globalization." Mr. Xi has achieved this as "the position of today's high-income countries, though still enormously powerful, is in relative decline."
Mr. Wolf continues:
"the share of high-income countries in world output has fallen by about 20 percentage points since the beginning of the century, at market prices, and their share in world merchandise trade has fallen by 17 percentage points."
By reducing its leadership at the same time this economic position is falling, the United States is only opening up greater opportunity for someone else to gain traction in world markets. China is doing this by building closer friendships with lower-income countries.

Furthermore, Mr. Wolf writes that with China's taking on the mantel of globalization, "modern western ideals of democracy and liberal global markets have lost prestige and appeal…." Although most nations are not willing to assume a political structure like the Chinese one, the decline in "prestige and appeal" has opened up opportunities for the discontented in these countries to gain a greater voice in what is going on.
Right now, Mr. Xi's strategy seems to be a winning one. At least given the current political problems faced by the West, his strategy is likely to be around for a while.