The next war

The growing danger of great-power conflict

How shifts in technology and geopolitics are renewing the threat

IN THE past 25 years war has claimed too many lives. Yet even as civil and religious strife have raged in Syria, central Africa, Afghanistan and Iraq, a devastating clash between the world’s great powers has remained almost unimaginable.

No longer. Last week the Pentagon issued a new national defence strategy that put China and Russia above jihadism as the main threat to America. This week the chief of Britain’s general staff warned of a Russian attack. Even now America and North Korea are perilously close to a conflict that risks dragging in China or escalating into nuclear catastrophe.

As our special report this week on the future of war argues, powerful, long-term shifts in geopolitics and the proliferation of new technologies are eroding the extraordinary military dominance that America and its allies have enjoyed. Conflict on a scale and intensity not seen since the second world war is once again plausible. The world is not prepared.

The pity of war

The pressing danger is of war on the Korean peninsula, perhaps this year. Donald Trump has vowed to prevent Kim Jong Un, North Korea’s leader, from being able to strike America with nuclear-armed ballistic missiles, a capability that recent tests suggest he may have within months, if not already. Among many contingency plans, the Pentagon is considering a disabling pre-emptive strike against the North’s nuclear sites. Despite low confidence in the success of such a strike, it must be prepared to carry out the president’s order should he give it.

Even a limited attack could trigger all-out war. Analysts reckon that North Korean artillery can bombard Seoul, the South Korean capital, with 10,000 rounds a minute. Drones, midget submarines and tunnelling commandos could deploy biological, chemical and even nuclear weapons. Tens of thousands of people would perish; many more if nukes were used.

This newspaper has argued that the prospect of such horror means that, if diplomacy fails, North Korea should be contained and deterred instead. Although we stand by our argument, war is a real possibility. Mr Trump and his advisers may conclude that a nuclear North would be so reckless, and so likely to cause nuclear proliferation, that it is better to risk war on the Korean peninsula today than a nuclear strike on an American city tomorrow.

Even if China stays out of a second Korean war, both it and Russia are entering into a renewal of great-power competition with the West. Their ambitions will be even harder to deal with than North Korea’s. Three decades of unprecedented economic growth have provided China with the wealth to transform its armed forces, and given its leaders the sense that their moment has come. Russia, paradoxically, needs to assert itself now because it is in long-term decline. Its leaders have spent heavily to restore Russia’s hard power, and they are willing to take risks to prove they deserve respect and a seat at the table.

Both countries have benefited from the international order that America did most to establish and guarantee. But they see its pillars—universal human rights, democracy and the rule of law—as an imposition that excuses foreign meddling and undermines their own legitimacy.

They are now revisionist states that want to challenge the status quo and look at their regions as spheres of influence to be dominated. For China, that means East Asia; for Russia, eastern Europe and Central Asia.

Neither China nor Russia wants a direct military confrontation with America that they would surely lose. But they are using their growing hard power in other ways, in particular by exploiting a “grey zone” where aggression and coercion work just below the level that would risk military confrontation with the West. In Ukraine Russia has blended force, misinformation, infiltration, cyberwar and economic blackmail in ways that democratic societies cannot copy and find hard to rebuff. China is more cautious, but it has claimed, occupied and garrisoned reefs and shoals in disputed waters.

China and Russia have harnessed military technologies invented by America, such as long-range precision-strike and electromagnetic-spectrum warfare, to raise the cost of intervention against them dramatically. Both have used asymmetric-warfare strategies to create “anti-access/area denial” networks. China aims to push American naval forces far out into the Pacific where they can no longer safely project power into the East and South China Seas. Russia wants the world to know that, from the Arctic to the Black Sea, it can call on greater firepower than its foes—and that it will not hesitate to do so.

If America allows China and Russia to establish regional hegemonies, either consciously or because its politics are too dysfunctional to muster a response, it will have given them a green light to pursue their interests by brute force. When that was last tried, the result was the first world war.

Nuclear weapons, largely a source of stability since 1945, may add to the danger. Their command-and-control systems are becoming vulnerable to hacking by new cyber-weapons or “blinding” of the satellites they depend on. A country under such an attack could find itself under pressure to choose between losing control of its nuclear weapons or using them.

Vain citadels

What should America do? Almost 20 years of strategic drift has played into the hands of Russia and China. George W. Bush’s unsuccessful wars were a distraction and sapped support at home for America’s global role. Barack Obama pursued a foreign policy of retrenchment, and was openly sceptical about the value of hard power. Today, Mr Trump says he wants to make America great again, but is going about it in exactly the wrong way. He shuns multilateral organisations, treats alliances as unwanted baggage and openly admires the authoritarian leaders of America’s adversaries. It is as if Mr Trump wants America to give up defending the system it created and to join Russia and China as just another truculent revisionist power instead.

America needs to accept that it is a prime beneficiary of the international system and that it is the only power with the ability and the resources to protect it from sustained attack. The soft power of patient and consistent diplomacy is vital, but must be backed by the hard power that China and Russia respect. America retains plenty of that hard power, but it is fast losing the edge in military technology that inspired confidence in its allies and fear in its foes.

To match its diplomacy, America needs to invest in new systems based on robotics, artificial intelligence, big data and directed-energy weapons. Belatedly, Mr Obama realised that America required a concerted effort to regain its technological lead, yet there is no guarantee that it will be the first to innovate. Mr Trump and his successors need to redouble the effort.

The best guarantor of world peace is a strong America. Fortunately, it still enjoys advantages. It has rich and capable allies, still by far the world’s most powerful armed forces, unrivalled war-fighting experience, the best systems engineers and the world’s leading tech firms. Yet those advantages could all too easily be squandered. Without America’s commitment to the international order and the hard power to defend it against determined and able challengers, the dangers will grow. If they do, the future of war could be closer than you think.

Enjoy It While You Can

If you travel as much as I do, you come to value nonstop flights. Connections introduce uncertainty and potential delays, not to mention what often feels like wasted time; but sometimes connections are just unavoidable. But you don’t want them to be too tight. Those five-minute sprints from one concourse to another are never fun. Better to have some breathing room.

So it is with economic cycles. Rarely do we move directly from boom to bust; but when the shift comes, it can develop quite quickly, even though the transition isn’t usually obvious in real time. As I look at the data and talk to my contacts, I’m beginning to conclude that we’re approaching one of those transitional phases. I think we’ll look back at 2018 as an in-between year… from good times to something eventually not so good.

Getty Images

Now, let me stress that I’m not predicting imminent doom. As you’ll see below, I think the party can last another year, maybe even longer. But I do see storm clouds on the horizon, and they’re blowing our way.

That ominous horizon means that some strategy adjustments are probably in order.

You need to be aware that the volatility we have seen in the stock market the past few days will become more the norm. I’ll get to that later. Let’s start by considering where we are now.

Y2K Relief

So far, economically and GDP-wise, 2018 looks not too different from 2017.

Economically, the first full-year estimates for 2017 show US real GDP rose 2.3%, or 4.1% in current (nominal, not inflation-adjusted) dollars. That’s not stellar performance, but not awful either. I expect about the same in 2018, and perhaps we’ll see even slightly stronger growth in the first six months, but that growth may be front-loaded and thus lower in the second half.

A great chart from the Atlanta Fed on their GDP Now page shows the blue-chip consensus on growth at 2.6%, with a range from just above 2% to just above 3%.

But notice the green line jutting upward in the upper right-hand corner. That is the Atlanta Fed GDP Now forecast, which was raised just this week from 4.2% to 5.4% for 2018. That’s massively more bullish than the blue-chip consensus is. For those of you unfamiliar with the Atlanta Fed’s forecasting methodology, I should note that they have been more bearish than blue-chip forecasters in most recent years. This is the most bullish I can recall them being since they created this methodology a few years ago.

If this kind of thinking infects the rest of the Fed’s researchers, you can expect them to suggest more than three rate hikes this year. Just saying…

For now, though, this week’s Federal Open Market Committee statement sums it up well: “Gains in employment, household spending, and business fixed investment have been solid, and the unemployment rate has stayed low.”

Recently volatility notwithstanding, stocks still point higher as analysts raise earnings estimates almost incessantly. Investors aren’t shying away from risk assets. Quite the opposite: The Conference Board reported that Americans are now more bullish on stocks than they have been since January 2000 – notwithstanding yesterday’s 666-point drop (-2.54%) on the Dow.

Let’s stop right there. What was happening in January 2000? We had just made it through the Y2K scare with barely an economic or societal blip, much to the chagrin of doomsayers who stocked up on beans, bullets, and Band-Aids. I had written a book saying to expect some hiccups but not disaster. As it turned out, even I was too pessimistic.

But people had other reasons to feel good that January. The NASDAQ 100 Index had just doubled in 1999 and looked to be headed higher still. It did – until March 2000, when the picture changed dramatically for the worse.

Fast-forward 18 years, and now we have Bitcoin and all its little crypto-cousins in addition to tech stocks. They are off their highs, but few fans are throwing in the towel. I suspect that instead of competing, Bitcoin and stocks may be feeding each other. Both contribute to the general “risk-on” attitude among investors. This feedback may get to be a problem if they pull each other down, too, but that’s not happening yet.

The Republican tax cuts have a lot to do with the current good feelings. The package’s corporate impact is already apparent. Numerous companies have announced bonuses, pay raises, and expansion plans. One key tax change is behind much of this activity: Companies can now deduct equipment purchases from taxable income immediately instead of amortizing them over several years. This change both simplifies planning and encourages quick decisions. There are numerous stories about companies purchasing equipment so they can write it off this year and reduce their tax costs, rather than postponing the purchases.

Deregulation is helping, too – or at least the promise of it. Some readers correctly reminded me that most of the Trump administration’s desired changes are still in process. While that’s true, I think it misses a broader point: Perception matters. Business owners may not see specific relief yet, but they believe it is coming. They are hearing optimism from their respective business associations. They also see a more cooperative attitude from regulatory agencies. Those changes give them confidence the regulatory burden will at least get no worse, and that confidence shows up in their investment decisions.

So, all this is good news. I think it’s enough to keep the expansion phase going through the end of 2018. Why not longer? Several reasons – one of which looms darkly over the others.

Getty Images

Federal Compulsions

Our Federal Reserve leaders believe keeping inflation under control is their key mission. Fair enough. The problem is that inflation is not now a threat – yet they still feel compelled to stamp it out. Worse, they are doing so while simultaneously undoing their much-larger-than-it-should-have-been QE stimulus program. This is a massive monetary experiment, and they have nothing more to go on than a few models, which assure them that reducing their balance sheet by $1 trillion over the next two years will have no effect on the asset markets.

Even though they told us, and most of us believe, that QE was responsible for the inflation of asset prices across the board, somehow quantitative tightening (QT) is not supposed to have the opposite effect.

The Fed’s main justification for tightening is the persistently low unemployment rate. They think it will spark wage inflation. Maybe so, but so far we have seen only sporadic evidence of it. Real wages have been falling, not rising.

And now I have to add, “Except for yesterday’s jobs report.” We find that in January wages rose by 0.3%, or by 2.9% year-over-year. A few more reports like this and the Fed governors are going to have a real excuse to talk about wage inflation. Two hundred thousand new jobs is a very good report, much higher than the average over the past two years. The ding on the report was that average hours fell a few tenths of a percent, so that actual wages paid did move all that much. Was that impact weather-related? Let’s look at the February and March data and decide.

Nothing in this jobs report will discourage the Fed from raising interest rates at least three times this year, and there is reason to worry about four rate hikes. And maybe even more hikes going into 2019. Yesterday’s report certainly moved the bond market in the US, as 10-year Treasury yields went to 2.84% and the 30-year bond went to 3.09%. TIPS are suggesting that the implied inflation rate is closing in on 2.2% for the next 10 years.

What is happening here? Despite today’s job numbers, when we look at the last two years, if the job market is so tight then why are wage gains so muted? That’s a mystery. I think people who left the labor force and those working part-time for economic reasons amount to a sizable hidden labor supply. At some point the economy will have soaked up that supply, but we don’t seem to be there yet.

In fact, I know that many Millennials are working two and three part-time jobs in order to make ends meet. If they could actually get a full-time job? With some benefits? They would jump on that opportunity. Now, nothing will change in the employment picture when these workers go from being employed part-time to being employed full-time, which still just counts as “employed.”

There are now 96 million potentially employable people in America who are not in the labor force now – almost 30% of the population. That is unusually high number for this late in a GDP growth cycle, but I expect the number would drop if opportunities develop. Not everyone in the “not in labor force” group would turn down a job if one became available. I can’t find any real data or research on that, but it just seems like common sense to me.

I can understand the Fed’s raising rates from the near-zero level to something more normal. That makes sense. What we don’t need is to raise rates and wean the bond market off its quantitative easing bottle at the same time. Yet that is what the Fed is doing.

I think many investors don’t realize that the reverse of quantitative easing, what my friend Peter Boockvar calls “quantitative tightening,” is only just beginning. The chart below from Investopedia shows the projected path. Right now we are still at the top of that big purple slide.

The Fed intends to stop buying bonds at the very time the US Treasury will issue more bonds to fund a growing budget deficit. The Treasury announced last week that net borrowing will be an estimated $441 billion this quarter and another $176 billion in the second quarter. It was “only” $282 billion in 4Q 2017. It would not be surprising to see the US official deficit at $1 trillion, with another $500 billion in off-book debt increases. Remember, these are the numbers in relatively good economic times, at least GDP-wise.

The US debt is officially $20,622,176,525,000 as I write this: $20.6 trillion. We could be easily north of $22 trillion going into 2019 (or at least scaring $22 trillion) if the economy is supposedly still doing well. What happens when we go into recession? We will be at $30 trillion in total debt within three to four years. Using government projections, we could easily be there, even without a recession, shortly after the middle of the next decade. 

Sidebar: Projected revenues from this tax cut are not going to be near what Congress or the CBO expect. My accountant and I have already looked at the new tax rules; and, annoyingly, if you are a small businessman or a contractor, you cannot just deduct expenses that are employer-reimbursed. It’s not quite that simple, but it’s close. The business actually has to pay for those expenses. What that means for me is that my accountant/associate will have to write a few more checks at the end of the month from both my personal account and my business account in order to not have to declare additional income. I can guarantee you that any small business that normally just reimburses is going to change their policies in order to help not only the owners but the employees. That will mean less revenue than the feds are probably projecting.

The tax games played by corporations from small to large to gigantic are only starting to come into the public awareness. There is simply no way to project what actual revenues will be as a result of this tax cut. But I think it is safe to say that businesses small and large are going to do their best to pay the least possible amount of taxes. And something as broad-reaching as this new tax law opens up many new opportunities.

As a second sidebar, it looks right now as if this tax “cut” that I’m supposed to be getting is kind of a push, as they are taking away so many deductions that I really don’t see any more money appearing in my bank account than I would have under the old system. And I’m having to do a lot of extra work to meet the new requirements. I’m hearing much the same from friends all over the country. This was actually a tax cut that benefitted the bottom 50–70% of the individual income structure more than it did the top. And corporations made out really well. Now back to the letter.

When the supply of available bonds rises and demand falls, the result is lower prices, which in the bond market means higher rates. For T-bonds in particular it means higher long-term interest rates. How much higher remains to be seen. Inflation expectations – which again, I think are misplaced – are also driving rates up. But short-term rates are rising, too, and at an even faster pace for now, so the yield curve is still flattening.

This trend has spillover effects outside the Treasuries market – in mortgages, for one. Here’s Peter Boockvar from last Wednesday:

With the highest average 30 year mortgage rate since March 2017 at 4.41% (and moving higher still), purchase applications fell 3.4% w/o/w but is still up 10% y/o/y. Refi apps were down by 2.9% w/o/w but still up 3.2% y/o/y. Maybe because long term fixed rates are now moving higher, there was a pick up in ARM's as a % of total loans. The MBA forecasts that refinancing volumes will be about $425b in 2018 which would be the smallest amount since 2000 and that would be down by 60% from where it stood in 2016.

At some point higher rates will start cutting into housing purchases and potentially reduce the mild inflation the Fed sees. Meanwhile, other central banks are beginning to plan their own policy turns. The Bank of England and the Bank of Canada are both theoretically in tightening mode already. The European Central Bank is starting to reduce its own QE program – a first step toward tightening. The Bank of Japan might do likewise at some point.

If we see global liquidity conditions tighten, the impact on stocks will turn more serious. The two-year Treasury yield recently surpassed the S&P 500 dividend yield for the first time since before the crisis. As that gap widens, the incentive to own bonds instead of stocks grows.

Rewind the Tape to 1987

We are actually going to look at two years, 1987 and 1994. 1987 is instructive because the prelude to the market crash of October was a selloff in the bond market that started a few months earlier, combined with the weakening of the dollar. Sound familiar?

I should point out that bear markets like 1987 or 1998, when not accompanied by a recession, are typically V-shaped and quickly over. It’s when you have a bear market, no matter how deep, that is accompanied by a recession that you really have to worry about lengthy recoveries.

1994 is instructive because the Fed commenced a tightening cycle and there was an inflation scare. It didn’t help that there was a great deal of leverage in the bond market, which caused a lot of pain during the selloff. Historians will note that even though the 10-year yield rose significantly, inflation never really picked up. And the market recovered relatively quickly.

Correction Odds Rising

That being said, it should come as no surprise that correlations among asset classes are up to 90% (source: Deutsche Bank). Everybody seems to be playing the global growth and global reflation trade. In almost every asset class, all the traders are on the bullish side of the boat – or at least they were until the last few days.

That level of correlation means that pain in one asset class could easily translate to pain in other classes, even as the economic news seemingly gets better and better. Because, what if the Atlanta Fed is right? The Fed will have to lean into the market with more than three hikes this year, with more to follow next year. Other major central banks would also have to initiate tightening cycles. We have been addicted to easy money and low interest rates for so long that regime change is scary. We’re not unlike addicts who finally realize they’re going to have to give up their drug of choice.

In the US equities, mutual fund exposure rose to a six-year high while short interest in stocks and ETFs fell to the lowest level since 2007 in other assets fund exposure to oil is a now about 2.8 standard deviations above the average while long euro shows similar extreme readings. (Source: Bloomberg)

Much of the current good feeling hinges on consumer spending, which is up. This uptick in spending reflects confidence in the future, but its flip side is a lower savings rate. The Commerce Department reported last week that the savings rate was 2.4% of disposable household income, the lowest since September 2005. That was a housing boom year when people were flipping homes and pulling out equity with wild abandon. Many would regret it a couple years later.

My friend Steve Blumenthal just posted a note in which he talked about his top ten recession indicators. Nine of them were signaling no problem for at least the next nine months. The signals don’t go further than that. GDP growth is not the problem this year.

The problem is overstretched markets and the potential for the Fed to go too far. We simply don’t know what will happen when the Fed starts removing $150 billion per quarter from its balance sheet by the end of this year. Maybe they’re right, and it means nothing. Maybe running a $1 trillion yearly deficit doesn’t make a difference. Maybe four interest rate hikes don’t matter.

None of these factors are serious yet, but they will add up over time. Maybe the market will shrug them off, we’ll actually see the 25% earnings growth projected by analysts, and the S&P will end up much higher for the year.

Any number of tail-risk events could change the picture quickly, though: war in Korea or the Middle East, a major terrorist incident or cyberattack, spiraling trade disputes, a bank failure – you know the list. The world can change quickly.

Now is a good time to plan your de-risking strategy. You want to balance it with staying involved in growth assets, if they are part of your plan. Rather than trying to diversify asset classes, which are marching in lockstep both up and down, I would try to diversify trading strategies. Think about what you’re going to do when the market turns against you.

Hope is not a strategy. You need to have a plan, or you need to find somebody who has a plan that you feel comfortable with.

To sum up, I’m not expecting a major bear market, but a correction is a real possibility. This is going to be a much more volatile year than 2016 or 2017. Overbought and overstretched markets moving in concert with each other are just the right witches’ brew for volatile corrections. Just saying…

Sonoma, San Diego and SIC, and Elsewhere

In three weeks Shane and I will be going to Sonoma, where I’ll speak at my Peak Capital friends’ annual client conference. Then we’ll come back to Dallas, and I’ll continue the preparations for the Strategic Investment Conference. This is really going to be the best conference we have ever done, and you don’t want to miss it. We have been holding teleconferences with the various speakers on what they’re going to be presenting and how we’ll work the moderating and Q&A panels, and I’m adjusting the lineup a little to make the ideas flow better.

This will be our 15th annual conference, and we have learned a few things about making SIC more interesting and allowing attendees more interaction with the speakers. Further, we use software now that allows attendees to ask questions and for people to vote on those questions that they want moved to the top of the questions queue. It works amazingly well, and the attendees do get their most important questions answered.

Sunday night is the Super Bowl, and Shane and I are throwing our fourth annual Super Bowl party. We don’t do more than three or four parties a year (and Shane actually does most of the work now), but our house is really set up for entertaining, and the parties are an enormous amount of fun. Plus, we do have a lot of TVs here, so it’s kind of like living in a big sports bar. It’s actually perfect for people to come and watch the game, enjoy some chili, chips and guacamole, etc. I don’t really have a dog in this hunt, which means that I’ll probably be pulling for the underdog, which is obviously Philadelphia. But mostly, I’ll spend my time walking around, talking with friends, and just enjoying the fun.

One last bit of market commentary. My friend Steve Blumenthal sent me this link to MarketWatch. It is about the “maturity wall” that high-yield bonds are getting ready to walk into over the next three years. If for some reason we see a recession during that time, it is going to be difficult for these high-yield bonds issuers to refinance their debt at anything close to the rates they enjoy today. Sell signals were tripped at several major high-yield bond-timing services over the last few days, and there is little liquidity in the high-yield bond market as it is. If we get into an actual recession, the remaining liquidity will dry up, and high-yield bonds will fall in value even farther than they did in the last recession. Dodd–Frank changed the levels at which banks can make markets in the bond market, and they had been the main source of liquidity. Bids are going to simply disappear, and it will be a rout. Maybe it won’t happen this week or next; but if you are invested in high-yield, you need to have your exit strategy and timing well planned. Just for the record, this is the type of thing I often cover in my Over My Shoulder service. Over My Shoulder is an inexpensive way to have curated information delivered directly to your inbox. You get the news and reports that I find to be the most interesting and actionable.

And with that I will hit the send button and wish you a great week. And I hope your team wins!

Your expecting more volatility analyst,

John Mauldin

Switzerland embraces cryptocurrency culture

Alpine country emerges as global hub for initial coin offerings

Ralph Atkins in Zúrich

Swiss officials are eager to exploit opportunities presented by initial coin offerings but stress they do not want to compromise 'the integrity of our financial markets' © FT montage/Bloomberg

In other countries, politicians express concern about the cryptocurrency craze, citing worries about security, regulation, volatility and a speculative bubble. Not in Switzerland.
The affluent Alpine country wanted “to be the crypto-nation”, Johann Schneider-Ammann, economics minister, told journalists as he arrived for a private crypto finance conference in St Moritz last week. Of the 10 biggest proposed initial coin offerings — by which start-ups raise funds by selling tokens — four have used Switzerland as a base, according to PwC.
The burgeoning ICO industry is burnishing Switzerland’s business friendly reputation and sometimes buccaneering spirit — a reputation spoilt by the past decade’s scandals over the help its traditional private banks gave to wealthy clients in evading tax.
But it has created a dilemma for Swiss politicians and regulators: just how far should they go in encouraging a digital “wild west”?
As Mr Schneider-Ammann spoke in St Moritz, the government in Bern announced an ICO working group to consider possible actions by regulators and lawmakers. Separately, the Finma financial regulator is expected soon to give an update on how it is policing ICOs.
“We think there is huge potential — but the market is not as disciplined as we want,” says Jörg Gasser, state secretary at the Swiss finance ministry. “We want it [the ICO market] to prosper but without compromising standards or the integrity of our financial markets.”

Countries that raised more that $20m from ICOs in Jan-Oct 2017

“They want Switzerland to be the place to make it happen — but they don’t want to be seen as the ‘wild west’. It is Swiss pragmatism,” says Martin Eckert, partner at MME, a Swiss law firm.

Digital pioneers say Switzerland emerged as an ICO hub because it has a cluster of rich investors and technology specialists. The small canton of Zug, near Zurich, has unofficially become “Crypto Valley”. The Crypto Valley industry association says it receives five to ten inquiries a day from start-ups around the world interested in how to do a Swiss ICO.

ICOs build on the Blockchain distributed ledger technology behind bitcoin. As well as fuelling the fantasies of speculative investors, they threaten to disrupt the venture capital industry by slashing the cost of fundraising — and opening up the possibility of investing in start-ups to anyone with a smartphone.

Zug, near Zurich, has unofficially been dubbed 'Crypto Valley'

Some practitioners dislike the term ICOs because it suggests they are just get-rich-quick schemes which seek to avoid cumbersome investor protection regulations. Proponents argue that many “tokens” offer access to services or property rights and are not meant as speculative investments. An alternative is to call them “token generating events”.
Other EU countries and the US have warned of the dangers of ICOs — and China and Korea have banned them.
But another reason for Switzerland’s crypto success, argue proponents, has been its openness to business innovation. Mr Eckert at MME says: “Swiss regulators are among the few that really have a deep understanding of the technology and how it works.”
Nevertheless, Finma last September struck a note of caution, warning it was investigating “a number” of ICO cases for possible breaches of regulations, including on preventing money laundering and the financing of terrorism.

CRYPTO TRAFIFC: Regulators´ different views on ICO´s

Crypto traffic: regulators’ different views on ICOs

Red light/bans                                       Advising caution                               Favourable

China, South Korea,                           US, UK, European Union,              Switzerland, Gibraltar,
 Vietnam, Russia                                  Hong Kong, Canada,                      Isle of Man, Mauritius
                                                                Australia, Singapore                     Cayman Islands      


Kari Larsen, attorney at Reed Smith in New York, says Switzerland’s approach was pragmatic but also “may be to a certain extent opportunistic”. It could face competition from places such as Gibraltar — leading to damaging competition to attract ICOs. “Just being welcoming, without also looking where consumer and market protection may be appropriate, would be short sighted,” Ms Larsen says.

Digital purists argue no action is needed by politicians or regulators. The government “should be incredibly welcoming. It is a huge opportunity for Switzerland,” says Richard Olsen, founder and chief executive of Lykke, a Swiss company building a Blockchain based financial exchange.

Top 10 initial coin offerings

Mr Olsen argues technology will allow ICOs to become self-policing — just as users of the Airbnb property rental site steer clear of anyone with poor reviews. “It will become an ultra transparent world if people have to pay more to hide . . . It is a huge opportunity to clean up the world.”

Switzerland is unlikely to be so liberal. A big worry in Bern is of cyber currencies being used for illicit activities, especially given that Switzerland dominates the market for the cross-border management of private wealth.

“They don’t want to fall into the same trap as banks over the past 30 to 40 years — they are extremely sensitive to things like anti-money laundering rules and ‘know your customer’,” says Oliver Bussmann, president of the Crypto Valley association.

Against that, industry practitioners say Swiss ICOs are, in practice, obliged to follow strict anti-money laundering procedures anyway: if they do not, traditional banks will turn away their funds. Bern could also toughen up how different ICOs are categorised, and when they fall under strict financial market or bank rules. It could also strengthen consumer protection. Significantly tougher rules could kill the Swiss ICO business and drive it elsewhere.

But Bern’s stated objective is to ensure Switzerland keeps a competitive edge in blockchain technologies. By removing uncertainty about its legal framework, it hopes to encourage ICOs.

Mr Bussmann says: “I see a desire by the government to continue to be a leading [ICO] hub, and provide the right balance between innovation, attracting business — and having a stable regulatory environment.”

Additional reporting by Martin Arnold in London

Sceptic converted after successful token sale

Swiss entrepreneur Marc Degen, 40, was initially sceptical about many initial coin offerings. He worried the “tokens” investors acquired often locked them into a single technology, preventing evolution.

But he changed his mind when raising funds for his latest venture: Modum, a Zurich start-up that provides blockchain-based services to monitor shipments of medicines. Traditional venture capitalists were reluctant to commit. Many meetings with them “were a waste of time”, he says.

So in August last year, Modum launched a token sale, offering token holders the right to vote on future payouts if certain milestones were reached by the new company.

Swiss regulators did not create any hurdles. The country has “a libertarian but also accountable environment,” says Mr Degen. “The legal setting and the mindset around it is exactly what creates a tremendous opportunity.” US investors were excluded to avoid any clash with the US Securities and Exchange Commission.

Modum’s ICO raised $13.5m in one week, and Mr Degen is now a convert. “You can talk eye-to-eye with investors,” he says “You can really focus on your idea and making it fly — you are not just running from funding round to funding round.”

As they survey the market, Swiss regulators should do little, Mr Degen argues. Existing laws and regulations are sufficient to prevent fraud and abuse.

“ICOs give everyone the possibility of participating in the early stage of a company — including the possibility of losing everything. Why should the only possibility be lotteries or casinos, which have much worse odds?”

Ralph Atkins

How Gargantuan Can Private Equity Get?

The previous fundraising boom led to some of the most troubled deals ever done by private equity

By Paul J. Davies

Stephen Schwarzman has a simple mission for Blackstone , the world’s biggest listed private-equity group: double assets under management. For a group that already has $434 billion up from less than $100 billion a decade ago, that sounds ambitious, but Blackstone isn’t alone. 
The biggest private-equity firms are in a fund-raising frenzy, fed by insurers’ and pension funds’ hunt for yield and a conviction that private markets will produce better returns than highly liquid and efficient public markets.

Across the entire private equity, hedge fund and alternatives industry globally assets under management are forecast to more than double to $21 trillion by 2025, according to consultants PwC. That would include $10.2 trillion in private equity—or enough money to buy half of the $22 trillion of stocks listed on the New York Stock Exchange today or every stock in mainland China.

Apollo Global Management , APO 1.03%▲ Blackstone, Carlyle and KKR increased their assets by a mind-boggling $247 billion between them just last year — and they all have plans to raise billions more.

The question is whether the biggest firms, which have attracted a growing share of the money, can keep finding the returns that have made them such money magnets. The industry built its reputation on being the most active of managers, that trick will be tough to repeat on an ever-larger scale.

Part of their answer is to move away from classic private equity into other areas. First that was private credit, where they double-up on their existing skills by buying and lending to the same or similar companies. That is a smart synergy in good times, but means they can be twice exposed when companies hit trouble.

More recently they increasingly moved beyond their core skills into infrastructure, real estate and other assets sometimes targeting lower returns and tying up money for longer.

Blackstone alone took in $108 billion of new assets last year, but just 12% of that was in private-equity funds, while more than half, or $59 billion, was raised in its credit business, and of that nearly $23 billion was in insurance company assets. Blackstone is following the example of Apollo, which already manages $85 billion for insurance companies it built. 
The point of all this: generating streams of management fees, which are predictable, steady and valued by public shareholders. On many of their funds, firms collect management fees of 1% to 2% of assets before doing anything. They can then get 20% of the profits as performance fees.

They are tying up investor funds for longer by running listed vehicles that never have to return capital, such as in business development companies, and striking strategic partnerships where investors’ money is tied up for 15 years, instead of the customary eight to 10 years. Scott Nuttall, co-president of KKR, told a conference in December that the firm had good sight of its revenues out to 2035. “And yes, I meant to say 2035,” he added.

When the industry has $1.6 trillion of uninvested money to deploy, $1 trillion of which is in private equity, it is going to be ever harder to find good deals. Valuations on buyout deals, for instance, have risen steadily since the crisis and are now higher at 10.5 times underlying earnings than they were in 2007.  
The previous fundraising boom led to some of the most troubled deals ever done by private equity: think of Chrysler, or TXU, or Caesars Entertainment . Since the crisis, returns for the industry have been in the low-to-mid teens rather than the 20%-plus levels it built its reputation on.
The more money that floods in, the greater the likelihood of disappointment.

How Stimulus Made a Soft Landing Harder

The tax cuts and high valuations so many have been cheering have made the Fed’s job even harder—and could end up being the bull market’s undoing

By Justin Lahart

The tax package that got signed into law late last year is complicating things for the Federal Reserve, which faces a situation in which it will be tapping on the brakes as the fiscal policy is pushing on the accelerator. Photo: Pablo Martinez Monsivais/Associated Press

Investors are suddenly worried about just how much the Fed might tighten policy. They should be.

Federal Reserve tightening cycles always tend to get messy. Throw in fiscal stimulus hitting the economy just as the Fed will be trying to cool it down and already-steep bond and stock-market valuations, and this cycle looks messier than most.

Last Friday’s job report provided some of the strongest evidence yet that a tight labor market is finally throwing off faster wage growth. The Dow promptly had its largest point loss since 2008. That wage strength is a sign for the Fed that inflationary pressures are building, opening the possibility that the central bank may have to raise rates faster than it has forecast in order to prevent the economy from overheating.

The S&P500´s  forward Price-earnings ratio

This is a phase that has always been tricky for the Fed. It mustn’t tighten so little that it falls behind the curve, but also not so much that it sends the economy into a recession. It is something the Fed has only accomplished occasionally, most notably in the so-called soft landing it helped guide the economy to in 1994.

The tax package that got signed into law late last year only complicates things. Lower corporate tax rates and the tax-cut-related bump many people are now seeing in their paychecks will boost the economy this year. The Fed faces a situation in which it will be tapping on the brakes as the fiscal policy is pushing on the accelerator. Making the situation even more complex, nobody knows exactly how much of a boost to growth the tax plan will induce or how long it will persist.

Then there is the matter of markets. Even after the recent selloff, the 10-year Treasury’s yield of 2.84% remains historically low. As a result, it would take much less of an increase in yields to send bond prices down significantly than if at the 4% the notes yielded just before the last recession started.

Stocks are also expensive, in large part because low Treasury yields have made them seem relatively attractive to many investors. Even after the recent selloff, the S&P 500 trades at 17.5 times expected earnings, according to FactSet, near the highest since 2004. That means that stocks, too, could be unusually sensitive to Fed tightening.

The situation might have been very different if today’s fiscal stimulus had come in, say, 2012, points out Robert Barbera, co-director for the Center for Financial Economics at Johns Hopkins University. Back then there was plenty of slack in the economy, with the unemployment rate averaging 8.1%, so the Fed wouldn’t have had to worry about overheating.

It also might not have had to buy assets so aggressively—actions that contributed to today’s richly valued stock and bond markets.

Unfortunately, the Fed and investors aren’t dealing with what might have been, but what is. The tax cuts and high valuations so many have been cheering could end up being the bull market’s undoing.

The 1% Get A Scare — More To Come?

Most Americans have spent the last few years pressed up against the proverbial bakery window, watching the 1% enjoy a life of ever-increasing wealth and seemingly total indifference to the multitudes who aren’t favored by zero interest rates, big trust funds and political/corporate connections.

The one consolation for the have-nots has been that, by owning few stocks and bonds, they would suffer less when those bubble markets did what bubbles always do, which is burst.

Today was a small but satisfying taste of that eventuality. From Bloomberg:

World’s Richest People Lose $68.5 Billion in Stock Selloff 
The fortunes of the world’s 500-richest people dropped by $68.5 billion Friday as equity markets swooned with investor worries about the pace of interest rate hikes in the U.S. Warren Buffett led the declines, shedding $3.3 billion to end the day at No. 3 on the Bloomberg Billionaire Index with $90.1 billion. J 

The chart shows about $100 billion of play money evaporating in the past week. Not enough to seriously inconvenience most of the people on Bloomberg’s billionaires list, but still a nice reversal of fortune versus the average person with a house, small bank account and not much more – who didn’t lose a thing.

As for whether Friday was just a blip in an ongoing “secular bull market” or a sign that fundamentals are at last gaining the upper hand on “liquidity,” that remains to be seen.

Longer-term though, there can’t be much doubt that today’s stock and bond valuations are higher than they’ll be during the next downturn.

Here’s a chart from John Hussman’s latest (Measuring the Bubble) that illustrates the point.

The adjusted price/earnings ratio on US stocks is now higher than before both the Great Depression and the dot-com bust.

A Tale of Two Italys: One Exciting, the Other, Terrifying

Europe’s political class sees great risk in the March 4 elections, while investors are focusing for now on the resurgent economy.

By Simon Nixon

Former Prime Minister Silvio Berlusconi, seen last week on an Italian TV show, is rising in the polls. Photo: Fabio Frustaci/Zuma Press 

All eyes are on Italy ahead of its general election on March 4—but they are not seeing the same thing.

Europe’s political class sees only risks in a country where the antiestablishment 5 Star Movement looks certain to emerge as the largest single party in the new parliament and the best hope of defeating the populists appears to hinge on a newly-resurgent Silvio Berlusconi.

Investors see opportunity.

The Italian stock market is up 9% already this year and Italian 10-year bonds are yielding 2.2% with the spread over German bonds back to the levels last seen before political concerns started rising in the run-up to the 2016 constitutional referendum that cost former Prime Minister Matteo Renzi his job.

Recent economic data explains the market’s enthusiasm. Italy, like the rest of the eurozone, is enjoying a robust cyclical recovery helped by global growth and ultraloose monetary policy which is keeping borrowing costs down.

Growth in the third quarter of 2017 hit an annualized rate of 1.7% and the latest indicators suggest growth may be accelerating toward 2%. Admittedly, that is still among the slowest in Europe but impressive in the context of the recent worst depression Italy has ever endured.

Household spending, capital expenditure and exports are all contributing to growth. And unemployment is finally falling, down 0.9 percentage points to 11% from a peak of 13% in the year to the end of November.

This growth pickup appears to be structural as well as cyclical, which means that the recovery should be at least partly self-sustaining. No one doubts there is still much that Italy could do to raise its growth potential, not least by overhauling its institutions.

But it took important steps over the past years to root out corruption, improve tax collection, reduce red tape and boost public sector efficiency. A major 2015 overhaul of labor market rules is also likely to have encouraged hiring, particularly when combined with tax incentives designed to encourage the creation of higher quality permanent jobs, according to the Bank of Italy.

The corporate landscape has also been transformed: companies that survived the recession tend to be more resilient and flexible and so better placed to take advantage of buoyant conditions.

Crucially, the worst of Italy’s banking crisis is clearly over. Bad debts have finally been written down to realistic valuations, as is clear from a booming secondary market for nonperforming loans that is attracting strong foreign interest. And bank capital ratios are now well above regulatory minimum levels and in line with Eurozone averages.

True, the stock of bad debts remains eye-wateringly high at €66.3 billion ($82.2 billion) or 13.4% of all loans, but this is down by 24% in the past year. The rate at which loans are turning sour is back to precrisis levels. As a result, banks are now in a position to lend again, with credit growing by 2.3% in December.

Of course, the real risk in Italy relates to the public debt, which stands at 133% of GDP. This is primarily a function of the collapse in GDP which still stands 8% below precrisis levels. The debt stabilized in 2017 and should now fall naturally so long as interest rates remain low and the government continues to run a healthy primary budget surplus. That means that it only needs to borrow to pay for interest costs and to roll over existing debt.

The markets seem to be betting that interest rates will continue to be held down even after the European Central Bank winds down its bond buying, most likely later this year, by a strong domestic market for public debt and growing current account surplus which further reduces Italy’s reliance on external funding.

Are the markets too complacent? The only party willing to talk seriously about the need to reduce the debt is the Democratic Party, but it is currently languishing at 23% in the polls. Yet even its leader Mr. Renzi, has proposed tax cuts.

The other parties, including Mr. Berlusconi’s right-wing coalition and the Five Start Movement, have spent the early stages of the campaign competing with each other to see who can promise the most extravagant tax giveaways and welfare entitlements. Those include promises to unwind past reforms including a vital pension system overhaul widely considered vital to Italy’s long-term debt sustainability.

The response of many Italian politicians is that none of what is said in the campaign matters. They argue that there is virtually no chance of the 5 Star Movement finding its way into government, either on its own or in a coalition since no other major party would partner with it.

Similarly, they argue that there is little chance of the right-wing coalition ever being obliged to implement its campaign commitments since Mr. Berlusconi’s calculation has all along been to form a coalition with Mr. Renzi’s Democratic Party, providing him with cover to dump his promises.

But for this strategy to work, the Democratic Party needs to secure sufficient support to join a coalition. The danger is that Mr. Berlusconi’s populist campaign succeeds too well and that he accidentally wins an election he expected to lose and feels bound by promises he never expected to have to keep. Sound familiar? No wonder Europe’s political class are anxious.

London Bridges to Nowhere

Mark Leonard

Anti-Brexit demonstrator holds the EU and UK flags outside the Houses of Parliament

LONDON – Last week, British Foreign Secretary Boris Johnson resuscitated an age-old proposal for a 22-mile bridge to be built across the English Channel. The irony has escaped no one. Johnson is calling for a fantasy bridge at the same time that he is destroying his island country’s only true bridge to the continent: the European Unión.

Johnson’s bridge proposal shows yet again that the Brexiteers’ entire project is based on a permanent suspension of disbelief. In December, the European Commission played along, allowing Prime Minister Theresa May to pretend that she can reach three mutually contradictory goals concerning the United Kingdom’s departure from the EU.

The UK’s first goal is to maintain a soft border and frictionless trade with the Republic of Ireland, which will remain an EU member state, subject to the rules of the European single market and customs union. The second is to establish identical regulatory regimes throughout the United Kingdom, including in Northern Ireland. And the third is to “take back control,” by leaving the single market, customs union, and the jurisdiction of the European Court of Justice.

Reaching any two of these goals seems eminently possible. But no one has any idea how to achieve all three. Nevertheless, EU and UK negotiators are now proceeding to phase two of the Brexit process, raising the distinct possibility that they will continue to muddle through without ever resolving the phase-one trilemma. In fact, experts in the European Commission are already predicting that the next round of negotiations will lead to three agreements with the UK before October 2018.

The first would settle the terms of divorce. Despite the uncertainty regarding Northern Ireland, negotiators have started to converge on other key issues, including the size of the UK’s exit bill and the future rights of EU citizens in Britain, and of British citizens in the EU.

A second agreement would establish a “stand-still transition,” whereby the UK would retain the benefits of EU membership, but also the obligations, such as contributing to the EU budget, allowing for the free movement of people, and adhering to European court rulings. The big difference is that the UK will lose its voice at the table. For Britons in the “Remain” camp, such a transition will allow the UK to stay in the EU in all but name. And for some of those in the “Leave” camp, it is a way to exit without falling off a cliff edge.

The third agreement in phase two will center around a roadmap for UK-EU relations after 2021. This will not be a free-trade agreement, but rather a political declaration about where both sides hope to end up. Most likely, the resulting deal will envision a future trade arrangement modeled on the Canada-EU Comprehensive Economic and Trade Agreement (CETA), together with agreements on foreign policy, security, terrorism, and law enforcement.

But this raises the same concern as in phase one. If the UK government is never forced to explain its long-term plan in great detail, then it could continue to fudge its way forward. The problem is that once the stand-still transition begins, it will be impossible to avoid a reckoning between the different tribes of Remainers and Leavers in the British Parliament. And even if there were a long-term plan that would pass muster with British parliamentarians, it is fanciful to believe that it would also be acceptable to parliamentarians and voters on the other side of the channel.

At a time when anti-globalization sentiment is running high, the remaining EU member states are unlikely to sign off on any trade deal that could undercut their own social and fiscal wellbeing. After all, whereas all previous EU trade deals were designed to achieve convergence between the EU and a third party, an EU-UK deal would be geared toward preventing divergences. Michel Barnier, the EU’s lead Brexit negotiator, has been eloquent on this point. The big question is not whether Britain leaves the EU, he points out, but whether Britain will “still adhere to the European model” of regulation.

It was easy enough for politicians and activists in Europe to oppose the Transatlantic Trade and Investment Partnership (TTIP), a monumental deal intended to defend Western trade standards in an increasingly multipolar world. But consider how much easier it will be to campaign against a deal with the UK, given that key figures on both sides of the British political spectrum pose a threat to the European model. On the left, Labour Party leader Jeremy Corbyn seems to welcome a return to 1970s-style subsidies and state aid. And across the aisle, far-right Tories openly dream of establishing a low-tax, low-regulation “Singapore-upon-the-Thames.”

Unfortunately, given the current Brexit timetable, a failure to agree on a long-term deal could well come after the UK has already passed the point of no return. The UK, having formally exited the EU and given up any say in EU decisions, would still be subject to EU laws. Its choice, then, would be between the economic calamity of a no-deal Brexit or the political calamity of a never-ending transition that leaves it no say over EU decisions. In either case, the UK will hardly have taken back control.

That brings us back to Johnson’s bridge to nowhere, which is the perfect metaphor for the Brexit movement. Rather than fall for the false promise of fantasy construction projects, British parliamentarians would do well to force a real decision on the UK’s post-Brexit relationship with the EU, before it is too late.

Mark Leonard is Director of the European Council on Foreign Relations.