The Growing Economic Sandpile

By John Mauldin 


“How did you go bankrupt?” 
“Two ways. Gradually, then suddenly.”
             Ernest Hemingway, The Sun Also Rises

As you may have noticed, I’ve been in a pensive mood lately. I’m re-thinking a lot of things as I process economic developments, personal issues, and the clock ticking as I reach birthday number 69 in a few weeks. Many good things are happening but with them comes change.

Change will be today’s topic. Below I’m reproducing part of a letter I originally wrote in December 2007 and have referred to several times. It is the single most-read letter I have written and the most commented-on, too. I consider it, in some ways, my most important letter. If you’ve read it before, you should read it again. I have updated it a little bit, but the principles are just as timeless as ever. And for the time conscious, we have shortened it a bit and at the end, I try to apply those principles to present economic times.

Change happens quickly and often, unpredictably. And as we will see, the unpredictable part is actually a mathematical principle. As in the Hemingway quote above, not just bankruptcy but change also happens slowly and then seemingly all at once. It’s time passing without change that causes the worst problems, including some historic economic catastrophes. It turns out we shouldn’t just accept change; we actually require it.

I’ll be quoting from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it if you, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, the book is about chaos theory, complexity theory, and critical states. It is written so any layman can understand—no equations, just easy-to-grasp, well-written stories and analogies.

Here’s what I wrote in 2007, with new comments and thoughts.

Ubiquity, Complexity Theory, and Sandpiles

We have all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic bucket and making sandpiles? Slowly pouring the sand into ever bigger piles, until one side of the pile starts to collapse?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time, it’s a small one. But sometimes, it builds up and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists named Per Bak, Chao Tang, and Kurt Wiesenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out there is no typical number:

Some involved a single grain; others, ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.

The pile was indeed completely chaotic in its unpredictability. Now, let’s read this next paragraph slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (emphasis mine)

To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, “ready to go,” color it red. What do you see? They found that at the outset, the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually, for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... . In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.

Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes; in wholesale changes in an ecosystem; or in a stock market crash? “Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?” Buchanan asks. Could it help us understand not just earthquakes but why a cartoon in a third-rate paper in Denmark could cause worldwide riots?

Buchanan concludes in his opening chapter:

There are many subtleties and twists in the story... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds—atoms, molecules, species, people, and even ideas—have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.
So, what happens in our game?

[A]fter the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into “fingers of instability” of all possible lengths. While many are short, others slice through the pile from one end to the other. So, the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate, or long finger of instability.

Now we come to a critical point in our discussion of the critical state. Read this next excerpt with the markets in mind (again, emphasis mine, and this is critical to our understanding of markets and change. Maybe you should read it two or three times.):

In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

Now, let’s couple this idea with a few other concepts. First, economist Dr. Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist, and then when the trend fails, the more dramatic the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

Relating this to our sandpile, the longer a critical state builds up in an economy—or in other words, the more “fingers of instability” that are allowed to develop a connection to other fingers of instability—the greater the potential for a serious “avalanche.”

A second related concept is from game theory. The Nash equilibrium (named after John Nash, subject of the Oscar-winning movie A Beautiful Mind) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

(2018 sidebar: One of my concerns with President Trump initiating tariffs, even when other countries have higher tariffs, is the world had a kind of Nash equilibrium based on the current state of affairs. Trump was and is purposefully disturbing that equilibrium, and it was unclear at the beginning what would happen. It now looks like there is at least the potential for a new and better equilibrium. Brexit is another case where a Nash equilibrium had been reached and then was disturbed. Few trading systems use multiplayer game theory in their algorithms because it is devilishly hard for a program to see in advance where all those fingers of instability lie and what will trigger an event.)

So, we end up in a critical state of what Paul McCulley calls a “stable disequilibrium.” We have “players” of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their personal outcome and to reduce their exposure to “fingers of instability.”

But the longer the game runs, asserts Minsky, the more likely it is to end in a violent “avalanche,” as the fingers of instability have more time to build, and eventually the state of stable disequilibrium goes critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russia is awash in capital. Who could have anticipated such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies.

Something that had not been seen before happened. The historically sound and mathematically logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified. The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

And now, a different set of fingers of instability are creating an even worse crisis in the credit markets.

All right, back to the present. When I originally wrote this letter, it was 2007 and the fingers of instability had not created the Great Recession. You could certainly see red dots in the sandpile, most notably subprime debt, but there were literally hundreds of dots scattered throughout the world economy, most of them innocuous until they weren’t. And then the scramble for liquidity began, except the liquidity wasn’t there, and well, you know the rest of the story.

This should be even more concerning if you think about my recent Train Wreck series (recap here). We are adding sand to not just one inevitably-collapsing sandpile, but dozens and maybe hundreds of them. They will not keep growing forever.

I explained in Part 1 of that series, Credit-Driven Train Wreck, how a liquidity crisis will probably set off the chain of events that end in the Great Reset. Which particular sandpile will fall first? It could be many, but I think high-yield corporate debt is the most likely. Millions of investors think they can collect those juicy yields and then be able to sell when trouble appears.

They’re partly right. They will be able to sell… but well below the prices they expect.

Yesterday, I did an interview with the extraordinarily astute Howard Gold of MarketWatch. We discussed the connectedness of so many global markets and how the debt crisis, unfunded pension liabilities, and government promises all over the world seemingly keep mounting, yet markets go up more.

I think the mother of all Minsky moments is building. It will not be an instant sandpile collapse, but instead take years because we have $500 trillion of debt to work through. Remember, that debt just can’t be pooped away. It is both money somebody owes and an asset on somebody else’s balance sheet. If you are retired, your pension and healthcare benefits are part of your net worth. They are assets on your balance sheet that you count on to cover future spending. We can’t just take that away without huge consequences to culture and society.

But the fingers of instability, the total credit system, are seemingly growing with more red sand dots every month. All are inextricably linked. One day, another Thailand or Russia or something else (it makes no difference which) will start the cascade.

Remember, very astute people saw the subprime crisis and made a lot of money shorting that market. I saw it coming but didn’t know how to trade it. I guarantee you, I’m paying attention now to who can profit from the next credit crisis. Maybe I’ll be successful and maybe I won’t, but just once, I would like to be on the right side of a crisis.

One last comment that I picked up over the years. My friend Peter Boockvar actually crystallized this thought a few months ago, but I think I’m going to make it part of my own liturgy: We no longer have business cycles, we have credit cycles. Central banks and governments, not to mention investment banks and investors, are all using credit in formerly unbelievable numbers and ways, and I am here to shout that the world is becoming one massive finger of instability.

Going back to that 1987 mathematical experiment, the simple fact is there are green sand dots all over the world. They represent stability in the global system, which is allowing the fingers of instability to build up in a potentially deadlier way than we have ever seen before.

We take comfort from the stability we see around us. Unemployment rates are low. Interest rates, while rising somewhat on the short end, are still historically very low. Corporate profits are up. We are greeted every day with some amazing new technological innovation that changes everything in some industry. Living standards keep rising.

And yet, Minsky tells us stability breeds instability. That sandpile program, as simple as it seems now, shows that the longer the stability lasts, with the fingers of instability connecting in hidden and unknown ways, the greater the avalanche will be.

I suggest you read at least the first half of Nassim Nicholas Taleb’s book, Antifragile. (He is also the author of the must-read books, Incerto: Fooled by Randomness and The Black Swan.) Here are three lessons that will show you what it means to be antifragile:

1.   Fragile items break under stress, antifragile items get better from it.

2.   In order for a system to be antifragile, most of its parts must be fragile.

3.   Antifragile systems work because they build extra capacity when put under stress.

This is a great way to explain the sandpile game in economic terms. Economic sandpiles that have many small avalanches never have large fingers of stability and massive avalanches. The more small, economically unpleasant events you allow to happen, the fewer large and eventually massive fingers of instability will build up.

The efforts by regulators and central bankers to create stable systems and prevent small losses actually create the large fingers of instability that bring down whole systems and spark global recessions. And increasingly, it is the unfunded liability of government promises that will be the most massively unstable finger.

In that crisis, things that should be totally unrelated all of a sudden become intertwined. The correlations of formerly unrelated asset classes all go to one at the absolute wrong time. Panic ensues, losses are taken. Government steps in trying to stem the tide, perhaps appropriately so, but eventually the markets have to clear.

There is a surprising but critically powerful thought in that computer model from 30 years ago: We cannot accurately predict when the avalanche will happen. You can miss out on all sorts of opportunities because you see lots of fingers of instability and ignore the base of stability. And then you can lose it all at once because you ignored the fingers of instability.

You need your portfolios to both participate and protect. Don’t blindly buy index funds and assume they will recover as they did in the past. This next avalanche is going to change the nature of recoveries as other market forces and new technologies change what makes an investment succeed. I cannot stress that enough. Do not get caught in a buy-and-hold, traditional 60/40 portfolio. Don’t walk away from it. Run away.

Cautious optimism is always the long-term winner. Always. But a buy-and-hold portfolio in today’s world is neither cautious nor optimistic. Hope is not a strategy. That’s precisely what a buy-and-hold portfolio is.
Worst Football Game Ever

I technically have no actual flight plans until a November speaking engagement in Frankfurt—well, except for a day trip to Houston—but I know I will have to be all over the country, and probably somewhere in the UK, in the coming months. I really like to be more scheduled, but that’s just not the way the world is working right now.

Last week, Shane and I went to a pre-season Dallas Cowboys football game with new friends Howard Getson and his wife Jen, whom I met at Camp Kotok this summer. We had a great time but it may have been the worst football game I’ve ever seen. I actually wanted to stop the game out of pity, or at least go down on the field to introduce the players to each other.

I felt a bit like those football rookies when I first went to Rice University decades ago. I arrived there certain I would be the physicist to crack the secrets of the atom. After about six weeks, I re-thought that career choice, which was good because I would’ve been a mediocre scientist. Fortunately, I did have a way to turn a phrase, and I turned that into a career.

It’s kind of like the sandpile game. Identify the biggest avalanche in your personal career path, and you’re on your way. It may not be your first choice, but it’s what will give you the most pleasure because you’ll be doing what you do best. I’m not sure that was the case for some of those Cowboys players.

And with that, let me hit the send button and wish you a great week. If you’re in the US, Happy Labor Day!

Your in a bit of a philosophical mood analyst,

John Mauldin
Chairman, Mauldin Economics

Trump’s tariffs prove tougher obstacle than China expected

Beijing leaders weigh likely effects of retaliation on domestic economy

Tom Mitchell in Beijing

Xi Jinping’s administration has sought to stabilise China’s domestic economy, currency and stock markets, while also appealing to people’s patriotism © AFP

As China’s top leaders huddled on their annual summer retreat on August 3, US President Donald Trump loomed large over their deliberations.

Just two days earlier, Trump administration officials had said they were considering taxing Chinese exports worth $200bn at 25 per cent — compared to a previously announced tariff of 10 per cent. The world’s two largest economies had formally started trade hostilities in July, when they slapped punitive duties on $34bn of each other’s exports.

Chinese officials hoped their unwanted trade war with the US would pause there, at least for the summer. “Everyone has been surprised by Trump,” said one Chinese economist who is close to Beijing policymakers. “Most Chinese officials assumed that Trump was just trying to push the boundary but would eventually back off.”

Mr Trump has instead pressed ahead with his efforts to turn up the heat on Chinese President Xi Jinping. Next week, the US will impose already announced tariffs on another $16bn in Chinese exports, which will be matched by Beijing.

In the face of this unprecedented economic and geopolitical challenge, Mr Xi’s administration has sought to stabilise China’s domestic economy, currency and stock markets, while also appealing to people’s patriotism.

In its most recent meeting on July 31, the Chinese Communist party’s politburo — comprising its 25 most senior officials — called for “stable employment, stable finance, stable foreign trade, stable foreign investment, stable investment and stable expectation”.

Days later at Beidaihe, a seaside resort near the Chinese capital, politburo member Chen Xi urged a group of the country’s leading scientists to “keep a patriotic heart” and help China “independently control core technologies”.

During the two months before the Politburo’s appeal for economic stability, the renminbi had fallen more than 6 per cent against the dollar to a low of 6.85 — a huge move for the carefully controlled currency. Since the Politburo’s statement, the renminbi has traded sideways.

The country’s stock markets, which Mr Trump gleefully noted on August 4 had dropped more than 20 per cent this year, gained ground last week.

China’s central bank also guided interbank lending rates to their lowest levels since the country’s stock markets crashed three years ago. In addition, it reimposed rules that make it more expensive to bet against the renminbi.

Chinese officials must strike a balance between their determination to reduce financial risks and ensuring that economic growth does not slow too sharply in the face of Mr Trump’s onslaught. “The authorities have not given up on [reducing] risk, but they also want to support the real economy,” said Andrew Polk at Trivium, a Beijing consultancy. “The two may not be compatible.”

Keeping the currency at less than Rmb7 to the dollar, which one prominent central bank adviser last week called an important “psychological barrier”, could prove expensive.

“In an environment where growth continues slowing down and the China-US relationship doesn’t improve, holding at seven would just raise a lot of other issues,” said one currency strategist. “You would have to burn reserves, tighten capital controls and tighten monetary conditions, which runs against your current monetary policy.”

In its quest for stability on all fronts, the Chinese government has had to calibrate its response to Mr Trump’s escalating tariff threats. “Beijing is de-emphasising ‘retaliation equal in intensity and scale’ because that is difficult to execute without unacceptable pain to the Chinese economy,” said Yanmei Xie, a China political analyst at Gavekal Dragonomics.

When Mr Trump’s second round of tariffs takes effect on August 23, only 10 per cent of China’s exports to the US — or 2.2 per cent of its total exports — will have been affected. As the official China Daily newspaper said in a commentary, “the two countries’ trade conflict is merely push and shove at the moment”.

But if the Trump administration follows through on its most recent threat against an additional $200bn worth of Chinese exports, bringing the total value of affected goods to $250bn, about half of China’s exports to its largest trading partner — and 11 per cent of its total exports — will be taxed at 25 per cent. Last year China exported goods worth $505bn to the US.

In contrast China, which imported US goods worth $130bn last year, has already taxed — or threatened to tax — US exports worth $110bn.

In its response to Mr Trump’s latest 25 per cent tariff threat, China’s commerce ministry said it would respond with duties ranging between five and 25 per cent. Products that are harder to source from countries other than the US will be taxed at lower rates. Chinese officials have, for now, have exempted US oil exports from retaliation.

Having hoped in vain for the best, they are also now girding themselves for the worst. “Some people are loath to see a lion awaken or a dragon take off, feeling uncomfortable with a population of more than 1.3bn living a better life,” the Communist party’s flagship newspaper, People’s Daily, said in a commentary on Thursday. “We will stand firm.”

Argentina raises taxes in attempt to stem peso crisis

President Macri admits ‘emergency’ after collapse of investor confidence

Benedict Mander in Buenos Aires and Robin Wigglesworth in New York 

Mauricio Macri: 'The world has told us that we are living beyond our means' © AFP

Argentina’s president Mauricio Macri has unveiled austerity measures as he admitted the country faced an “emergency” in the wake of market panic after the peso’s collapse.

In an impassioned address to the nation from the presidential palace, Mr Macri said Buenos Aires needed to act quickly to restore investor confidence following his request last week for an accelerated $50bn IMF rescue package.

“We believed with excessive optimism that we could go along fixing things bit by bit. But reality shows us that we have to move faster,” said Mr Macri. “The world has told us that we are living beyond our means.”

Nicolás Dujovne, the economy minister, signalled he would quickly try to tighten control of spending, saying the government would next year eliminate its primary fiscal deficit: the gap between spending and income before taking debt servicing into account.

Argentina is to raise taxes and slash its bureaucracy to try to hit the target, which is much more aggressive than a previous plan to lower the deficit to 1.3 per cent next year.

The country has been lashed by a global storm in emerging markets since the peso plunged last week to it lowest level against the dollar, taking its depreciation this year to more than 50 per cent.

The elimination of the fiscal deficit will in part be financed by increasing export taxes, with Mr Macri saying the country needed help from “those who have most capacity to contribute”.

Taxes on exports have been highly contentious for Argentina’s powerful farming sector and Mr Macri had promised this year to continue to reduce taxes on exports of soya. But on Monday Argentina’s president said the crisis was forcing him to implement measures he would prefer to avoid.

“We know that it is a bad tax and it goes against what we want to encourage, but this is an emergency and we need your help,” he said, attributing much of Argentina’s economic problems to external factors, including rising US interest rates and oil prices, the US-China trade war, problems in Turkey and Brazil and the worst drought in almost half a century.

Mr Macri also announced that he would reduce the number of ministries by more than half in an attempt to cut spending, folding more than 10 ministries into others and in effect demoting more than half of his ministers. He described the currency crisis, which erupted in late April, as “the worst five months of my life” after his kidnapping 27 years ago.

Mr Macri said last week he would ask the IMF to speed up disbursement of a planned $50bn support programme to try to protect the country’s finances.

Investors have been looking for the Argentine government to ditch its policy of “gradualism” in reducing its spending, and are likely to welcome the promise to eliminate the primary budget deficit by next year.

“This is the only way they will arrest this crisis,” Federico Kaune, head of emerging market debt at UBS Asset Management, said ahead of Mr Dujovne’s announcement. “They need to show that the strategy has changed from gradualism to a more orthodox fiscal tightening.”

However, fund managers say that, after a series of mis-steps and a worsening crisis that has burnt many investors who kept faith with the government, markets will need to see tangible evidence and hard commitments before they dip back into the country.

The peso fell another 3.6 per cent against the dollar on Monday to trade back near the record lows touched last week, despite the government’s announcements.

And Then, The Fall

by: The Heisenberg

- Wall Street returns from the summer doldrums next week and there's a lot to digest headed into autumn.

- The divergence between U.S. equities and everything else has never been so pronounced and emerging markets continue to teeter on the brink.

- Some pros think a September rally is in the cards as hedge funds scramble to play catch up to a market that's left them behind.

- But looming large on the horizon are myriad domestic and geopolitical risks.

Wall Street will return from summer vacation next week to a market narrative that features all manner of embedded contingencies.
With summer in the rearview mirror, traders are now casting a wary eye towards fall, and geopolitics is front and center when it comes to market risks.
When last I checked in with my readers here, I mentioned that some analysts believe a September rally is in the cards. The "consensus" hedge fund strategy that in part revolves around being long Growth (IVW) and short Value (IVE) had a miserable run following Facebook's (FB) post-earnings plunge and the concurrent FANG+ correction. That underperformance may lead some on the buy-side to play catch up to a U.S. equity market that refused to rollover in August despite the worst month for European equities (FEZ) since February and a fifth consecutive monthly loss for emerging market currencies.
Here's a chart from Nomura's Charlie McElligott that illustrates the point made above about hedge fund underperformance since the FANG+ correction:
(Bloomberg, Nomura)
The following chart is the Hedge Fund Research HFRX equity fund index and the highlighted portion on the right shows how funds have failed to keep pace with the S&P (SPY) which motored higher over the same period:
In order to provide some additional context, below find a bit of color and a couple of accompanying visuals from Goldman that together shed further light on how the late July stumble for tech heavyweights and falling exposure have conspired to dent hedge fund returns:
Volatility among the most popular stocks and low net leverage in a rising market have weighed on recent hedge fund returns. Despite outperforming earlier this year, our Hedge Fund VIP basket of the most popular long positions has lagged the S&P 500 by 118 bp YTD (7% vs. 8%). 
Nearly 100 hedge funds owned Facebook as a top 10 portfolio position at the start of 3Q, keeping it atop our Hedge Fund VIP list and weighing on fund returns as the stock tumbled in July. Our VIP list of the most popular long positions has suffered large performance swings this year, lagging the S&P 500 by 500 bp since June.  
Declining net leverage as the equity market rebounded and outperformance of concentrated short positions have also worked against hedge fund returns. 
If the buy-side ends up having to play catch up to the broader market rally and the consensus strategy of being long Growth and Momentum starts working again, it could catalyze still more gains for U.S. equities in September.
Meanwhile, some on the sellside have been forced to up their year-end targets for the S&P in order to account for the recent push to fresh record highs. Rationales vary across firms, but Barclays actually changed their model last month in order to get to a year-end target of 3,000 on the index. Here's a look at the evolution of Wall Street's year-end target for the S&P versus the index itself:
To be sure, the earnings backdrop has virtually never been better and everyone knows that buybacks have provided a reliable pillar of support.
That said, I can't emphasize enough how much this hinges on the dollar (UUP) in the months ahead. One the main reasons U.S. stocks were able to hit new highs late in August was down to the dollar taking a breather. That relieved some of of the pressure on emerging market currencies and equities (EEM), with the latter having fallen into a bear market earlier in the month.
To be clear, Jerome Powell has been proven at least partially wrong when it comes to his contention that EM economies would be resilient to Fed tightening. I suggested that would likely be the case in a series of posts for this platform earlier this year (you can read the second of those posts here and work your way back, although I've penned dozens more that touch on the same issue). In August, the collapse of the Argentine peso and the Turkish lira grabbed the headlines, but the pain was widespread. Volatility on the South African rand soared, for instance, and the Indonesian rupiah hit its weakest levels since the Asian financial crisis. Oh, and the yuan (CYB) is now more volatile than the euro (FEZ) based on 30-day realized. This has never happened before:
Here's a snapshot of the EM FX space:
Something has to stop that slide if U.S. investors hope to avoid spillover. While U.S. stocks have remained resilient this year in the face of EM turmoil, I cannot emphasize enough how important it is for folks to understand the dynamics at play. The same factors that have forced the Fed to lean ever more hawkish, driving the dollar higher and weighing on EM have helped create the conditions for record corporate profits and record buybacks in the U.S. I spent a lot of time documenting that in "Paradox: U.S. Stocks Need A Break From 'America First'" so I would have a comprehensive post to refer back to in the future. You can read that for the full story, but for our purposes here, just note that the sugar high from late cycle stimulus will wear off, and once it does, it would be extremely helpful for stretched valuations stateside not to have to contend with bear markets and generalized malaise in ex-U.S. assets.
When assessing where things go after September, traders will be intently focused on quantitative tightening, trade and the U.S. midterms. On the former, do note that the ECB will taper asset purchases to €15 billion/month from September. Meanwhile, the Fed's balance sheet rundown is proceeding and on Friday, the Bank of Japan announced they will reduce the frequency of purchase operations this month. The October QT "hangover" (so to speak) is one reason the above-mentioned Charlie McElligott describes his bullish call on U.S. equities in September as "tactical". He believes it could be followed by a bout of rates volatility next month tied to the QT effect.
On trade, optimism around the bilateral deal struck between the U.S. and Mexico on Monday was quickly overshadowed by the breakdown of talks between the Trump administration and Canada on Friday. More worrying, though, was a Bloomberg story out on Thursday that suggested the U.S. is prepared to move forward with tariffs on an additional $200 billion in Chinese goods as early as next week. Remember, it will be impossible for the President to avoid a rise in the prices of consumer goods at home in the next round of tariffs on China. Multiple strategists have suggested that the effect on inflation could be substantial, and when you consider that the U.S. economy is operating at full employment with fiscal stimulus piled on top, you come away thinking the Powell Fed will be inclined to keep hiking until something "breaks" (so to speak).

Meanwhile, comments from Trump to Bloomberg about the prospect of tariffs on European autos suggest the U.S. position has not materially changed on that front. The Stoxx 600 automobiles and parts index is mired in a bear market.
As far as the U.S. midterms are concerned, the risks are myriad and for investors, there are two key considerations when it comes to assessing the implications for market volatility. First, it is likely that the House will flip to Democrats. That's not me speculating, that's just what prediction markets say. Second, if the House does flip, it would likely prompt a series of investigations that could cause headaches for markets if they cloud the domestic political picture further. On the latter point (about the legal issues), Axios revealed the details of an internal Republican spreadsheet this week, and on the former point (the likelihood that the House flips), here are the odds:
While there are glaringly obvious reasons to believe that this time could be different, Goldman notes that "the median change in the S&P from the close the day before Election Day to the close the day after Election Day has been +0.7% in midterm elections back to 1954." The results are similar if you look only at elections that have resulted in Congress flipping from one party to the other or in years when the President’s party has performed poorly. In other words, if history is any guide, stocks should hold up fine in and around the actual voting, but again, we live in unprecedented times politically and investors should keep that in mind headed into November.

As far as how to hedge all of this, Goldman likes shorter-dated S&P put spreads and BofAML's FX team favors three-month USD/JPY volatility, which is sitting well below its one-year average.
It's also worth noting that Italy risk could resurface as it appears that a budget battle with Brussels is in the cards this month.
As ever, you can take all of that for what it's worth. Ultimately, the gist of it is that contingent on the dollar not rising too far, too fast in the very near term, people who do this for a living think September might be ripe for further gains.
After that, as summer officially turns to autumn, things could get dicey. Or, as I put it in the title, "and then comes the fall".

Globalization with Chinese Characteristics

Barry Eichengreen

BERKELEY – US President Donald Trump’s erratic unilateralism represents nothing less than abdication of global economic and political leadership. Trump’s withdrawal from the Paris climate agreement, his rejection of the Iran nuclear deal, his tariff war, and his frequent attacks on allies and embrace of adversaries have rapidly turned the United States into an unreliable partner in upholding the international order.

But the administration’s “America First” policies have done more than disqualify the US from global leadership. They have also created space for other countries to re-shape the international system to their liking. The influence of China, in particular, is likely to be enhanced.

Consider, for example, that if the European Union perceives the US as an unreliable trade partner, it will have a correspondingly stronger incentive to negotiate a trade deal with China on terms acceptable to President Xi Jinping’s government. More generally, if the US turns its back on the global order, China will be well positioned to take the lead on reforming the rules of international trade and investment.

So the key question facing the world is this: what does China want? What kind of international economic order do its leaders have in mind?

To start, China is likely to remain a proponent of export-led growth. As Xi put it at Davos in 2017, China is committed “to growing an open global economy.” Xi and his circle obviously will not want to dismantle the global trading system.

But in other respects, globalization with Chinese characteristics will differ from globalization as we know it. Compared to standard post-World War II practice, China relies more on bilateral and regional trade agreements and less on multilateral negotiating rounds.

In 2002, China signed the Framework Agreement on Comprehensive Economic Cooperation with the Association of Southeast Asian Nations. It has subsequently negotiated bilateral free-trade agreements with 12 additional countries. Insofar as China continues to emphasize bilateral agreements over multilateral negotiations, its approach implies a diminished role for the World Trade Organization (WTO).

The Chinese State Council has called for a trade strategy that is “based in China’s periphery, radiates along the Belt and Road, and faces the world.” This suggests that Chinese leaders have in mind a hub-and-spoke system, with China the hub and countries on its periphery the spokes.

Others foresee the emergence of hub-and-spoke trading systems centered on China and also possibly on Europe and the United States – a scenario that becomes more likely as China begins to re-shape the global trading system.

The government may then elaborate other China-centered institutional arrangements to complement its trade strategy. That process has already begun. The authorities have established the Asian Infrastructure Investment Bank, headed by Jin Liqun, as a regional alternative to the World Bank. The People’s Bank of China has made $500 billion of swap lines available to more than 30 central banks, challenging the role of the International Monetary Fund. Illustrating China’s leverage, in 2016 the state-run China Development Bank and Industrial and Commercial Bank of China provided $900 million of emergency assistance to Pakistan, helping its government avoid, or at least delay, recourse to the IMF.

A China-shaped international system will also attach less weight to intellectual property rights.

While one can imagine the Chinese government’s attitude changing as the country becomes a developer of new technology, the sanctity of private property has always been limited in China’s state socialist system. Hence intellectual property protections are likely to be weaker than in a US-led international regime.

China’s government seeks to shape its economy through subsidies and directives to state-owned enterprises and others. Its Made in China 2025 plan to promote the country’s high-tech capabilities is only the latest incarnation of this approach. The WTO has rules intended to limit subsidies. A China-shaped trading system would, at a minimum, loosen such constraints.

A China-led international regime would also be less open to inflows of foreign direct investment. In 2017, China ranked behind only the Philippines, Saudi Arabia, and Indonesia among the 60-plus countries rated by the OECD according to the restrictiveness of their inward FDI regimes.

These restrictions are yet another device designed to give Chinese companies space to develop their technological capabilities. The government would presumably favor a system that authorizes other countries to use such policies. In this world, US multinationals seeking to operate abroad would face new hurdles.

Finally, China continues to exercise tight control over its financial system, as well as maintaining restrictions on capital inflows and outflows. While the IMF has recently evinced more sympathy for such controls, a China-led international regime would be even more accommodating of their use. The result would be additional barriers to US financial institutions seeking to do business internationally.

In sum, while a China-led global economy will remain open to trade, it will be less respectful of US intellectual property, less receptive to US foreign investment, and less accommodating of US exporters and multinationals seeking a level playing field. This is the opposite of what the Trump administration says it wants. But it is the system that the administration’s own policies are likely to beget.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era.

Fidelity Tries Luring Investors With 2 No-Fee Funds. So What’s the Catch?

By Tara Siegel Bernard

CreditMinh Uong/The New York Times

Investing just became even cheaper — free, actually.

Fidelity introduced two new index mutual funds last week that have no fees whatsoever, taking the democratization of investing to a whole new level. Consumers now have access to domestic and international stock markets without any hurdles, including no required minimum investment amount.

The move continues an industry trend toward lower-cost investing, with several giant firms — Fidelity, Schwab and Vanguard among them — all but daring one another to push their already rock-bottom fees even lower.

But when companies start to dangle free offers, one can’t help but ask: What’s the catch?

It’s simple, analysts said. If Fidelity can lure investors in with a promise of no fees, it is in a position to sell other products and services — a money-market account, say, or financial advice — that offer fatter profit margins. And given its size, the company can afford to sell no-fee funds below cost.

“They’re bait,” Jeffrey Ptak, an analyst with Morningstar, said of the new funds.

The good news is that the bait — Fidelity Zero Total Market Index Fund and Fidelity Zero International Index Fund — is as advertised: There are no hidden fees, and costs are not simply waived temporarily. (The funds track indexes created by Fidelity.)

“It is not a rebate, it is not temporary, it is not a promotional offer,” Kathy Murphy, president of Fidelity’s personal investing business, said. “It is permanent.”

Beyond the free funds, Fidelity has introduced other changes that make it easier and cheaper to invest. It has eliminated its minimum investment requirements for opening brokerage accounts (previously $2,500), 529 college savings plans and the vast majority of its indexed mutual funds when bought through Fidelity.

The company has also cut prices on nearly two dozen existing stock and bond index funds, so that all investors now have access to its lowest-priced class of fund shares. For people already invested in these funds, according to Fidelity, that translates to a reduction of roughly 35 percent, with some funds costing as little as 0.015 percent of assets, or a penny and a half for every $100 invested.

Fidelity’s latest changes come after another consumer-friendly move: The company significantly expanded the number of commission-free exchange-traded funds available on its platform, to 265 from 95. (Generally speaking, E.T.F.s are similar to index funds but trade like stocks on an exchange, meaning investors must pay commissions whenever they buy or sell shares, which also carry underlying investment fees). Vanguard also recently expanded its stable of commission-free E.T.F.s.

Lowering costs and easing access to investing is a universal good for consumers. But analysts and others who work in the industry said they expected Fidelity would try to sell more of its other wares — at least one of them probably in the form of advice. That is, the company may try to get investors to pay a separate fee to manage their money or perhaps try to entice them aboard its digital-investing platform, Fidelity Go, which charges 0.35 percent of assets total, including investment costs.

None of that is necessarily bad, if the advice is needed, the financial adviser is truly acting in the investor’s best interest (not, for example, motivated by a push to meet sales goals) and any fees are reasonable. But as some costs come down, the possibility of a sales pitch in other areas is something to watch for.

Investors have flocked to lower-cost index funds, which generally focus on a selection of investments that track the stock or bond markets (or segments of them). Over time, index funds tend to outperform actively managed mutual funds that hold investments handpicked by humans, in part because the active funds often cost significantly more.

The average index fund costs 0.52 percent of assets, compared with .87 percent of assets for actively managed mutual funds, according to a Morningstar analysis, which excluded funds that carry sales charges in addition to the underlying cost of the investment.

Fidelity introduced its latest price cuts as it grapples with broader challenges to its mutual fund business. Investors have been fleeing its actively managed funds in favor of cheaper index funds.

The company crows on its website that its index funds are now cheaper than Vanguard’s — “There’s no match for Fidelity in index investing — not even Vanguard.” Vanguard, the indexing pioneer, has long been heralded as the lowest-cost provider, and Morningstar says that, over all, it still holds the crown when comparing its universe of actively managed and index funds with Fidelity’s total collection of funds.

But Fidelity’s index funds are now a few pennies cheaper than Vanguard’s when looking at only passive investments, according to a Morningstar analysis: Investors are paying 0.04 percent of assets on average at Fidelity versus 0.07 at Vanguard.

Whether others will try to match Fidelity’s no-fee funds is unclear. The company’s move does not only put pressure on other index-fund providers, analysts said. It also has implications for actively managed funds, which may need to do even more to justify their much higher fees.

BlackRock, which has a huge E.T.F. business under the iShares name that competes in part with retail index funds, offers an E.T.F. that tracks the domestic stock market at a cost of 0.03 percent of assets. Martin Small, who leads BlackRock’s iShares business in the United States and Canada, said the firm had “zero plans” for a zero-fee E.T.F.

A Schwab spokeswoman declined to say whether the firm would make further changes to its prices. “Any time costs go down, investors win,” the spokeswoman said in a statement. She said Schwab was “laser focused” on straightforward, low-cost products that could be sold broadly to many investors “so we can continue to pass the benefits of our scale” to them.

Vanguard, whose mutual fund shareholders effectively own the company, said it was structured to lower the cost and complexity of investing in all of its funds, indexed and actively managed, for all of its customers.

“This is now a game of inches, with firms trying to gain supremacy one basis point at a time,” Mr. Ptak of Morningstar said.

The difference can be counted in pennies. Fidelity’s free domestic fund, for example, competes with Schwab’s Total Stock Market Index fund, which charges just 0.03 percent of assets, or 3 cents for every $100 invested; Vanguard’s Total Stock Market Fund, which, depending on the amount invested, ranges from 0.02 percent of assets, or 2 cents per $100, to 0.14 percent of assets.

“If you examine the recent history, we’ve had Schwab, Vanguard and Fidelity all make moves to try to gain an edge by removing fees and barriers,” Mr. Ptak added. “We’re now at a point of diminishing returns, so these firms will have to find other ways to differentiate, but it’s shaping up as a slugfest, with these firms trading blows.”

For now, consumers appear to be winning that fight.