Losing Control 

Doug Nolan


Tesla’s market capitalization surpassed $1.1 TN this week, the first junk-rated company with a trillion-dollar valuation. 

Now the richest individual in the world, Elon Musk’s wealth this week reached a staggering $300 billion. 

The S&P500, Dow, Nasdaq100, and Nasdaq Composite ended the week at all-time highs. 

Microsoft retook the top spot as the world’s most valuable company. 

October 29 – Reuters (Gaurav Dogra and Patturaja Murugaboopathy): 

“U.S. equity funds attracted large inflows in the week to Oct. 27… According to Lipper data, U.S. equities funds attracted investments worth a net $12.99 billion, which were the largest since the week to Aug. 18.”

Plenty to divert attention away from critical global market developments. 

Ominous Bond Market Convulsions.

October 28 – Reuters (Wayne Cole): 

“Australia’s central bank on Friday lost all control of the yield target key to its stimulus policy as bonds suffered their biggest shellacking in decades and markets howled for rate hikes as soon as April. 

An already torrid week for debt got even worse when the Reserve Bank of Australia (RBA) again declined to defend its 0.1% target for the key April 2024 bond, even though its yield was all the way up at 0.58%. 

Scenting capitulation, speculators sent the yield sky-rocketing to 0.75% while yields on three-year bonds recorded their biggest monthly increase since 1994. 

All eyes were now on the RBA’s policy meeting on Nov. 2 where investors were wagering it would call time on yield curve control (YCC) and its guidance of no rate rises until 2024.”

October 29 – Financial Times (Hudson Lockett and Tabby Kinder): 

“The Reserve Bank of Australia declined to defend its bond-yield target, a pillar of its quantitative easing programme, unleashing what one trader described as ‘carnage’ in the country’s sovereign bond market. 

The yield on the government bond maturing in April 2024 jumped as high as 0.8% on Friday in a dramatic rise that began after a round of stronger than expected inflation data released on Wednesday. 

The bank had said as recently as October 5 that it was targeting a 0.1% yield on the security. 

This week’s sharp rise in yield… signalled to many traders and investors that the RBA was abandoning its so-called yield curve control…”

The Australian bond market this week provided further evidence of an unfolding disorderly global market (and yield curve!) adjustment process, as raging global inflation forces central banks to retreat from ultra-loose and intrusive monetary policies. 

Australian two-year yields surged 33 bps Thursday and another 24 bps Friday, with a 66 bps spike for the week to 0.775% - the high since January 2020. 

After trading as low at 0.53% in August, five-year yields jumped 38 bps this week to 1.57%, the high since March 2019. Ten-year Australian yields surged 29 bps this week to 2.09% - the high since March 2019. As noted above: “carnage.”

October 27 – Financial Times (Matthew Rocco, Kate Duguid and Tommy Stubbington): 

“The Bank of Canada surprised investors by abruptly ending its bond-buying programme on Wednesday and pulling forward its expected timeline for interest rate rises, triggering a heavy sell-off in Canadian government debt. 

The announcement puts the BoC at the head of a growing number of central banks that have responded to surging inflation by signalling a shift towards tighter monetary policy… 

The main forces pushing up prices — higher energy prices and pandemic-related supply bottlenecks — now appear to be stronger and more persistent than expected,’ the bank said… 

‘Higher-than-expected inflation prints and the expected rise in prices from consumers and businesses has put the fear of God into them,’ said Karl Schamotta, chief market strategist at Cambridge Global Payments. ‘I don’t think anyone was expecting this.’”

Canadian two-year yields jumped 22 bps this week to 1.09%, the high since March 2020. Two-year yields were at 0.40% on September 14th. 

Five-year yields jumped 17 bps this week to 1.51% - having gained 68 bps in just seven weeks to the high since January 2020. 

Ten-year yields were up seven bps to 1.72%, the high since May 2019. 

October 29 – Financial Times (Tommy Stubbington and Kate Duguid): 

“A violent shake-up in bond markets has intensified as fund managers are wrongfooted by a global drop in short-term debt, say analysts and investors. 

Stubbornly high inflation around the world and a hawkish response by some central banks have fuelled a rapid rise in short-dated government bond yields. 

At the same time, concerns about growth prospects in the coming years have kept a lid on long-term bond yields, resulting in a dramatic ‘flattening’ of yield curves. 

Short-term bond markets have ‘experienced unprecedented volatility’ this week, said George Saravelos, Deutsche Bank’s global head of currency research. 

He said a sell-off in Australia’s market was the most severe since 1996, while Canada had been hit with its worst decline since 2009. 

Saravelos said the moves have been exacerbated by investors being forced to abandon soured bets as markets move against them. 

‘What is happening now runs beyond macro,’ he said… 

‘This is the closest we can get to a distressed market.’”

FT (Hudson Lockett and Tabby Kinder): 

“‘The RBA [Reserve Bank of Australia] simply doesn’t show up to defend their yield target, the bonds are slaughtered,’ one fixed income trader said, also describing the latest moves for Australian, New Zealand and Canadian bond yields as ‘massive carnage’.”

New Zealand two-year yields jumped 28 bps this week (84bps in four weeks!) to a four-year high 2.06%. 

Five-year yields rose 25 bps – 54 bps in two weeks – to 2.36%, the high since April 2018. 

Ten-year yields rose 14 bps to 2.64%, the high since November 2018 (up 50bps in four weeks).

October 28 – Financial Times (Martin Arnold and Tommy Stubbington): 

“Christine Lagarde rebuffed investor expectations that the European Central Bank could raise rates next year to quell fast-rising prices, even as she acknowledged that its latest governing council meeting was dominated by a discussion of ‘inflation, inflation, inflation’. 

The ECB president said the council had done ‘a lot of soul-searching’ to test its assumption that inflation would fade next year, and its analysis did ‘not support’ market expectations for a rate rise before the end of 2022. 

Nevertheless, even as Lagarde spoke…, investors ramped up their bets of an ECB rate rise. Markets are currently pricing in a 0.1 percentage point rise by September next year. 

‘The view in the market is that central banks are behind the curve,’ said ING rates strategist Antoine Bouvet. 

‘The ECB is no exception.’”

“Yield curve control” blew up in the Reserve Bank of Australia’s face. 

Perhaps not as explosive, but Christine Lagarde’s effort to talk down European yields and rate expectations elicited a rather thunderous backfire. Italian 10-year yields jumped 23 bps Thursday and Friday to 1.17%, the high since July 2020. 

After rising six bps Thursday, Greek 10-year yields surged 25 bps in Friday’s session to 1.31%, the high since June 2020. Portuguese yields jumped 10 bps Friday to 0.52% (high since May), and Spanish yields rose nine bps Friday to 0.61% (near high from June 2020). 

Meanwhile, EM bond market carnage continues. 

Brazilian 10-year yields traded Thursday to a near five-year high 12.43% (ended the week at 12.20%). 

Brazil dollar 10-year yields rose nine bps this week to 4.82% (high since July 2020). South African yields rose 28 bps to an 18-month high 10.18%. 

Russian yields surged 37 bps to 8.22% - up 73 bps in two weeks to the high since March 2020.

EM currencies remain under pressure. 

The South African rand dropped another 2.7% this week, with the Mexican peso down 1.9%. 

Eastern Europe’s bonds and currencies weakened further. 

The Polish zloty declined 1.0%, the Russian ruble 0.9%, the Romanian leu 0.8%, the Bulgarian lev 0.7% and the Czech koruna 0.7%.

October 29 – Bloomberg (Hema Parmar and Nishant Kumar): 

“A rapid convergence in key global bond yields is behind losses for some of the biggest macro hedge funds. 

Chris Rokos’s hedge fund has sunk 11% in October, in part because of wagers that the difference between short- and long-term U.K. and U.S. government bond yields would widen, according to people familiar with the matter. 

Instead, they’ve tightened. The market’s shift to expecting Bank of England rate hikes sooner caused most of the harm at Rokos Capital Management… 

The fund, down 20% for the year, is on track to post its worst annual loss ever. 

The firm isn’t alone as traders bet central banks will curtail stimulus measures much faster than had been expected, roiling so-called steepener trades.”

Speculative yield curve trades are blowing around the world, surely inflecting painful losses upon a segment of the leveraged speculating community. 

The UK’s two year-10 year spread dropped 32 bps this week to 44 bps. 

In Canada, this spread declined 12 bps to 50.5 bps – with a three-week drop of 25 bps. 

In chaotic Wednesday trading, Canada’s 2yr-10-yr spread sank 18 bps to 44 bps (narrowest since January). 

The 2yr-10yr spread dropped 31 bps in Australia to 93 bps. In the U.S., it fell 12 bps to 105 bps.

October 28 – Reuters (Karen Pierog and Gertrude Chavez-Dreyfuss): 

“Investors are gauging what a furious flattening of the U.S. yield curve suggests about expectations for growth and how aggressively the Federal Reserve may tighten monetary policy in the face of surging inflation. 

Yields on 20-year Treasuries rose above those on 30-year bonds several times on Thursday, a move analysts pinned on technical factors, including higher demand for much more liquid 30-year bonds as well as expectations of a more hawkish Fed.”

October 28 – Reuters (Clare Jim and Andrew Galbraith): 

“Chinese developers took a drubbing on Thursday, with shares and bonds falling, creditors seizing assets and rating agencies distributing more downgrades, ahead of a final debt payment deadline for China Evergrande Group on Friday. 

Shares of Kaisa Group were hardest-hit… after rating agency downgrades that highlighted the company's limited access to funding and significant U.S. dollar debt obligations.”

It's also worth noting that global bank stocks were under pressure this week. 

The Hang Seng China Financials Index sank 3.2%, with Japan’s TOPIX Bank Index falling 3.3%. 

Even high-flying U.S. financial stocks lost a little altitude, with the KBW Bank Index falling 2.8%. 

But for the most part, U.S. equities completely disregarded U.S. and global bond market spasms. 

Persistent squeeze dynamics and the unwind of hedges – not to mention strong fund inflows – sustained momentum for the week.

Every cycle is different – each with its individual nuance. 

There are, however, recurring speculative dynamics. 

For me, the current backdrop is increasingly reminiscent of the summer of 1998. 

At July 20th, 1998 highs, the S&P500 enjoyed a y-t-d return of 23%. 

Financial stocks were outperforming, with the Broker/Dealer index up 31%. 

I was convinced Russia was on the cusp of financial crisis. 

How could markets disregard the risks associated with such a major development? 

The answer in the summer of 1998 was a rather simple mantra: “The West will never allow Russia to collapse.”

I knew the hedge funds had huge levered positions in Russia’s debt. 

I was also focused on a big increase in derivatives activity to hedge against declines in the ruble and Russian bonds. 

It was clear to me that Russia was in trouble, and if their markets faltered, there was a high probability of illiquidity, dislocation, and a financial collapse that would rock the leveraged speculating community and global markets.

In the six weeks between July 20th highs and September 1st lows, the S&P500 sank 21%. 

And between July highs and October lows, the Broker/Dealer index collapsed 56%. 

I was familiar with Long-term Capital Management going into the crisis. 

I was as shocked as anyone to learn of their egregious leveraging and $1 TN notional value derivatives portfolio. 

It’s not an exaggeration to say the global financial system was pushed to the brink. 

The Fed orchestrated a bailout, there was the so-called “Committee to Save the World” – Greenspan, Rubin and Summers – along with rate cuts – that reversed crisis dynamics and unleashed the 1999 mania. 

Today’s risks so greatly dwarf 1998 that they’re hardly comparable. 

In key respects, China’s bubble is without precedent. 

Its global financial and economic impact today rivals, if not exceeds, the U.S. 

The amount of global leveraged speculation today makes ‘98 excess seem trivial. 

And while I presume there are no global funds as recklessly positioned as LTCM, there are reasons to fear that scores of funds have pushed the risk and leverage envelope. 

A seasoned hedge fund operator ran Archegos with more than 10 to 1 leverage in concentrated stock holdings. 

We also witnessed in March 2020 the chaos unleashed when de-risking/deleveraging gained momentum. 

Now yield global “carry trades” and yield curve bets have started blowing up.

There’s another big difference between now and 1998: open-ended QE, and now unshakable confidence that central banks will do “whatever it takes” to sustain the boom. 

1998’s “the West will never allow a Russia collapse” has evolved to today’s “Beijing and global central bankers have everything under control.” 

And such market perceptions are fundamental to the type of egregious speculative leverage and excess that ensure future crises. 

And, clearly, the world has never witnessed the scope of excess that has accumulated over the past decade – and especially over the last 19 months. 

The shifting winds of global liquidity backdrop are palpable. 

Chinese contagion has ratcheted up general risk aversion. 

De-risking/deleveraging dynamics have gained important momentum in the emerging markets. 

And this week there were forced unwinds of levered yield curve trades. 

Global liquidity has begun to wane, and financial conditions have started tightening, which is now impacting the more vulnerable markets and economies. 

Ominously, talk returned this week of liquidity concerns in sovereign debt markets, including Treasuries. 

Meanwhile, inflation has become a pressing issue around the globe, unsettling central bankers and bond markets alike. 

This comes with major policy and market ramifications. 

Chinese contagion has already manifested into weakening EM currency markets, compounding inflation risk in key EM economies. 

There is now heightened pressure on central banks – EM in particular – to raise rates - to bolster sinking currencies and counter mounting inflationary pressures. 

The world today confronts a unique confluence of synchronized fragile bubbles and surging inflation. 

And, importantly, the worsening inflationary backdrop is reducing central bank flexibility to use monetary stimulus in response to market instability. 

This is poised to become a key issue, with major ramifications for vulnerable market bubbles. 

For some time now, markets have assumed that central bank liquidity would put a floor under market prices, while ensuring rapid market recovery in the event of a bout of instability. 

But central banks pushed things much too far. 

Especially after the pandemic response, unprecedented monetary stimulus further inflated historic bubbles, stoking the most powerful inflationary dynamics in decades. 

This creates a critical dilemma: When bubbles falter, central bankers will confront dislocated markets demanding Trillions of additional liquidity, in a backdrop of already powerful inflationary pressures. 

This is poised to be a real nightmare for central bankers that supposedly have everything under control.

Next week will be the Fed’s turn to operate in the new environment. 

The FOMC will be pondering whether leaning “dovish” or “hawkish” would be best received by an unsettled bond market. 

From Friday WSJ: “Consumer prices rose at the fastest pace in 30 years in September while workers saw their biggest compensation boosts in at least 20 years…” 

With inflation raging and the Fed so far “behind the curve,” expect the bond market to lose patience with the idea of waiting months to get rate normalization started. 

But then there’s the faltering Chinese Bubble, along with global de-risking/deleveraging gaining momentum. 

Today’s unparalleled degree of uncertainty is anathema to leveraged speculation. 

There was evidence this week that central banks are Losing Control, a precarious dynamic that will spur a ratcheting down of risk throughout the global leveraged speculating community.

Government Is Getting Bigger. What It Means for the Stock Market.

By Reshma Kapadia

Illustration by Lincoln Agnew


For decades, investors would say they couldn’t fight the Fed—but many took pride in ignoring both ends of Pennsylvania Avenue. 

Long-term investors have grown accustomed to dismissing the type of wrangling that played out this week over the debt ceiling and continues with the $1 trillion infrastructure bill and the sweeping $3.5 trillion spending package. 

Instead, investors stuck with what they could measure. 

But that’s changing as the government is influencing the economy and markets in ways we haven’t seen in generations. 

Investors must embrace the new reality: What happens in Washington, D.C., will shape what happens on Wall Street.

Many of this nation’s biggest challenges—pandemic response, slowing growth, crumbling infrastructure, climate change, and wealth inequality—cannot be managed through monetary policy. 

Fiscal policy can target systemic issues that influence the economy and enable sustainable growth.

The next few weeks should offer more clarity on just how big government might get. 

Most analysts expect the bipartisan infrastructure package to pass, which will help repair the nation’s water facilities, upgrade transportation systems, and improve broadband and make it more accessible. 

The bigger question is the fate of the 2,465-page Build Back Better fiscal package that includes an array of provisions: expanded dental and vision benefits for Medicare recipients; drug pricing initiatives; increasing pay for caretakers, including relatives; green energy strategies; and corporate tax increases to pay for much of it.

That package isn’t likely to get through in its current form: Michael Zezas, head of U.S. public policy research at Morgan Stanley, says his base case calls for a smaller deal in the fourth quarter, anywhere from $1.9 trillion to $2.9 trillion over the next decade. 

Even this smaller package could boost the deficit by a total of $550 billion to $990 billion over the next five years, he says.

This level of spending and a more active government could mean that investors will have to get used to some inflation, higher interest rates, more volatility, crimped returns, and a reassessment of the companies that emerge as winners and losers. 

That’s a lot of change—but there are ways that investors can start thinking about and positioning for these shifts. 

“Now, if portfolio managers ignore [government policy], it’s at their peril,” says Joe Amato, chief investment officer of equities at Neuberger Berman.

“We are spending a lot of time with our ear to the ground in Washington and accessing more consultants than we ever did before,” says Sarah Ketterer, CEO of value manager Causeway Capital Management, adding that she is increasingly interested in the concerns that politicians are hearing from their constituents about issues like the burgeoning deficit. 

The more investors worry, she reasons, the more it could influence policy.

The recent market volatility is exacerbated by the polarization in government and the magnitude of policy changes—including some of the biggest legislative changes in many years for industries like energy and healthcare. 

While the Senate hammered out a deal this week to push the debt-ceiling showdown off to December, there’s still a risk another round of brinkmanship could bring about a U.S. credit-rating downgrade and further rattle markets. 

Indeed, the S&P 500 index has fallen as much as 5% since the beginning of September as the dysfunction has grown. 

“Making big portfolio changes right now is almost like gambling because the political situation is fluid,” says Jason De Sena Trennert, CEO of Strategas Research Partners. 

“There’s a lot of headline risk in the next couple months.”

There’s much more to this paradigm shift than the upcoming spending packages. 

“We have had this period of great moderation and liberalization, with low inflation, low macroeconomic volatility, and massive returns, for nearly four decades,” says Joyce Chang, global head of research at J.P. Morgan. 

“Now, everyone is questioning if that worked—and rewriting the rule book.”

Some of those new rules call for more targeted fiscal policy to deal with the side effects of years of easy monetary policy, such as income inequality. 

Low interest rates have exacerbated inequality, as its benefits accrue primarily to people with financial assets: Just 56% of Americans own stocks and 65% own their homes. 

Federal Reserve chief Jerome Powell has said that income inequality is the nation’s biggest challenge in the next decade, and economists such as Larry Summers and Jason Furman say the benefits of higher debt and fiscal deficits incurred to address inequality outweigh the risks, until inflation rises meaningfully. 

That view could mean rethinking what level of debt to gross domestic product is acceptable, and the spending could usher in a period of higher inflation that will require investors’ attention.

The government is taking an outsize role in ways beyond spending, as well. 

Expect to see efforts designed to tackle healthcare discrimination, student-loan debt, pollution, and a host of other issues next year. 

Agencies like the Federal Trade Commission and the Environmental Protection Agency are largely staffed up, according to Beacon Policy Advisors, which indicates where we’ll see the first regulatory push—a potential yellow flag for companies in the crosshairs of antitrust, data-privacy, or environmental issues.

Foreign policy also could have a much bigger impact on markets as the U.S. tries to chart a new course with China, recalibrating a relationship that is crucial to the growth of many U.S. companies and how investors evaluate them. 

Investors’ assumptions about things like supply-chain bottlenecks and inventory levels may need to change as both nations endeavor to become less dependent on each other, making supply chains operate less smoothly and historical averages less applicable, Chang says.

It will be a slow reckoning in the markets. 

One potential catalyst could be an increase in interest rates: Rates have been so low for so long that many investors have essentially ignored the national debt. 

But as interest rates rise, the cost of servicing that debt, now at record lows, will increase dramatically and have a meaningful impact on stocks, says Jean Boivin, head of the BlackRock Investment Institute. 

If the 10-year Treasury yield—which recently ticked up to just over 1.5%—crosses 2.5%, he says, servicing the country’s $28 trillion debt burden will return to its historical average of 2% of GDP, up from the tiny fraction it is now. 

Even this reversion to the mean will shine a much harsher light on the debt and its potential impact on variables that investors care a lot about: interest rates, inflation, multiples, and margins. 

“The policy revolution is real, but it’s still under the surface in its impact,” Boivin says. 

“As interest rates start to rise, we will discover fiscal policy as a driver becoming the focus of attention.”

We talked to money managers and strategists to see how they are thinking through this policy revolution, the potential effects they’re bracing for, and how best to prepare portfolios.

Adjust for Inflation

Perhaps the biggest byproduct of current fiscal policy is inflation. 

And while economists, strategists, and investors can endlessly debate the minutiae involved in defining inflation, Americans know it when they see it: Dollar Tree (ticker: DLTR) is raising its prices on some items above $1, prices of used cars and trucks were 32% higher in August than they were a year earlier, and workers are discovering bargaining power over wages for certain positions for the first time in years. 

Businesses are feeling the pinch, too: The cost of shipping a 40-foot container from Shanghai to New York City has gone from $2,500 a year and a half ago to $20,000 today, while the cost of fuel oil rose 65% in the past year.

“Inflationary pressures are likely to rise because everyone is spending—including the government—and it becomes a self-sustaining cycle,“ says Karen Karniol-Tambour, co-chief investment officer for sustainability, and a member of the investment committee at Bridgewater Associates. 

Government spending drives inflation differently, since it is determined by a political process and public interest, rather than by what things cost. 

“There usually isn’t a player who doesn’t make decisions based on prices or demand, so now you are adding more fuel to the fire.”

Money managers are closely monitoring fiscal proposals that could lead to more lasting inflation. 

It’s not just about how much any given package costs, says Sonal Desai, chief investment officer of Franklin Templeton fixed income. 

Investors also need to understand exactly how these packages are structured. 

Spending on recurring items like child care or education subsidies, for example, will have a much longer impact than extended unemployment benefits, says Desai, who has long been warning that interest rates are likely headed higher.

Desai is tilting toward shorter-duration bonds like bank loans, and higher-quality high-yield bonds rated single-B. 

Another option: inflation-linked bonds, including Treasury inflation-protected securities, or TIPS, whose principal is tied to the consumer-price index. 

TIPS have historically been the single-most diversifying asset to equities, Karniol-Tambour says: Stocks do well when growth is rising and inflation is falling; TIPS do well when inflation is rising and growth is slowing.

Manage Volatility

The likelihood of Washington, D.C.–influenced volatility is exacerbated by the fact the S&P 500 is at near-record highs, and any ding to corporate profits could send stocks sliding. 

If the Build Back Better package increases corporate tax rates to 25% from 21% and raises the tax rate on foreign income to 15%, it could spark volatility, says David Giroux, manager of the $52 billion T. Rowe Price Capital Appreciation fund (PRWCX). 

The tax increase alone, he estimates, will cause a 5% hit to earnings-per-share expectations for the S&P 500, though that would be mitigated by benefits from the spending—ultimately, Giroux expects corporate profits to fall roughly 3%.

Most strategists say a potential tax increase is not yet baked into earnings expectations. 

“There could be some October surprises and a correction,” says Neuberger’s Amato. 

“You could have not just a repricing on the ‘e’ in the price/earnings ratio, but multiples may pull in because of the combination of a rate hike and tax policy.”

The typical buffers to volatility, like government bonds, may not be as resilient in the face of greater government spending. 

While 10-year Treasury note yields have historically fallen some 25% during periods of stock market stress, Boivin, who has recommended underweighting government bonds, notes that they have barely budged recently. 

This could mean that government bonds won’t offer the same type of buffer as in the past, especially for investors in bond funds, which can lose money when prices fall, as managers sell existing bonds to purchase higher-yielding ones.

While Amato isn’t bearish, he says that it’s wise to have extra cash and a more defensive portfolio, given the prospect for volatility. 

Desai also favors a more balanced approach, and isn’t taking big bets with massive overweight or underweight positions that she had been willing to take in the past.

A longer-term shift that contributes to inflation and volatility could also spark a longer-term “return crisis,” warns J.P. Morgan’s Chang. 

The 60% stocks/40% bonds portfolio may not generate the 10% average return that investors are accustomed to, but rather just 3% to 4%.

As a result, Chang recommends that investors consider higher-yielding fixed income, as well as some commodities—both actual commodities and commodity equities. 

But instead of precious metals, Chang says that agriculture and livestock, as well as a small amount of energy futures, are good hedges for longer-term inflation risk.

A somewhat contrarian way to reinforce a portfolio is with small stakes in Chinese government bonds. 

That might seem like an odd choice, given the debt implosion of property developer China Evergrande Group, and the deteriorating relationship between the U.S. and China. 

But Desai stresses that sovereign debt is different from corporate debt: China’s more restrained approach to stimulus in the past 18 months—reflected in its 2.9% yield for 10-year bonds—runs counter to most of the Western world. 

Since China hasn’t expanded its deficit as much, Desai says the People’s Bank of China has more fiscal firepower to cushion any sharp downturns. 

Plus, a stake in China’s sovereign debt offers a source of diversification as the two countries continue to butt heads.

Rethink International Strategy

It’s not just fiscal policy claiming the attention of fund managers: The reshaping of the U.S.-China relationship means that they need to pay much more attention to foreign policy. 

This includes inside-the-Beltway nuances around measures coming out of various federal agencies. 

The U.S., for instance, is trying to restrict China’s access to critical technologies through tools like export restrictions and entity lists, which can create ripples for U.S. companies that rely on China as a large customer.

The recognition that the rocky relationship with China needs to be recalibrated is one of the few pockets of bipartisanship in Washington, bolstered by the growing realization that China’s experiment with capitalism really isn’t going to change its political system. 

China is imposing strict regulatory measures on its most successful companies, emphasizing social good over profitability, and is moving to become less reliant on an increasingly hostile world. 

It’s encouraging its companies to buy locally rather than from U.S. suppliers, for instance.

The Senate already passed sweeping China legislation, and the Biden administration is continuing to review its policy, with a slew of additional measures expected in coming months, largely aimed at bolstering U.S. technology dominance by spending on research and development, and incentives to get companies to reassess far-flung supply chains.

Investors need to understand the political dynamics underpinning the geopolitical chess match between the world’s two largest economies, and think about the ramifications of globalization fraying.

S&P 500 companies have about 5% of direct sales exposure to China, but the ripples could be much more far-reaching. 

Correlations between China’s GDP and S&P 500 earnings per share suggest that China’s importance to U.S. companies has gone from zero in 2010 to 90% today, according to a recent note from Bank of America strategist Savita Subramanian. 

In fact, she writes that roughly 80% of S&P 500 margin expansion has come from globalization over the past 30 years, as companies have capitalized on things like cheaper labor abroad and supply-chain efficiencies.

T. Rowe’s Giroux worries that companies that get sizable business from China, like Nike (NKE) and Apple (AAPL), could get caught in the crossfire, a reason he doesn’t own companies with sizable exposure to China. 

“If you have a three- to five-year time horizon and we see more actions from China that are antibusiness, you have to be more worried that China wants to be less dependent on the West,” he says. 

“Multiples haven’t come down for companies that have a lot of exposure—and maybe they should.”

As both nations try to reduce their interdependence, it could raise the cost of trade, add inflationary pressure, and crimp profits. 

Globalization has caused geographic diversification among asset classes to lose its edge over the years, but that’s beginning to change: Correlations between the S&P 500 and Chinese stocks recently fell to the lowest level since 2018, says Subramanian. 

As the U.S. and China begin to hash out a plan for becoming less tightly integrated, the case for geographic diversification could grow. 

BlackRock’s Boivin, for example, says investors need to be more deliberate in allocating to Asia directly, as tensions between the two countries potentially creates different ecosystems.

Consider ESG

Many of the administration’s plans line up nicely with the environmental, social, and governance, or ESG, factors that more investors are embracing. 

“The minute that major players like government and business say they care about climate change, it becomes a major force that investors have to understand,” says Bridgewater’s Karniol-Tambour. 

“These issues that were never important to investors are now drivers of huge parts of the economy.”

Much of the world is facing some sort of energy shortage crisis. 

China was forced to ration electricity, Indian factories and households are grappling with the prospect of power cuts, and much of Europe is bracing for pricey heating bills. 

The common thread is energy shortages and higher prices that are largely a byproduct of policy changes, as governments try to shift toward greener energy and energy efficiency, wrote Gavekal Research’s Tom Holland in a recent client note.

If inflation, taxes, and more difficult relations with China depress market multiples, it could help active managers who tend to do better against that backdrop. 

More dynamic government policy could also speed up market rotations, which could help active managers, says Olga Bitel, global strategist at William Blair.

Indeed, Causeway’s Ketterer says that her portfolio is filled with companies that can benefit from government priorities, like Siemens (SIE.Germany), with its smart infrastructure, mobility, healthcare, and digital businesses all well positioned.

T. Rowe’s Giroux is looking beyond the most direct beneficiaries of the spending packages, like industrials, which he says already reflect the opportunity from increased spending but have not yet factored in potential costs from, for example, tax increases.

Instead, Giroux sees better opportunities from other beneficiaries of the proposed fiscal packages—like utilities, which could gain from provisions that support wind energy or nuclear merchants, and potentially pass on the less favorable parts of the package, like tax increases, to customers. 

Potential winners include Exelon (EXC) and Ameren (AEE), which could benefit from solar and wind provisions in the package.

“You have to be in the weeds,’’ Giroux says. 

In Washington this fall, there will be plenty of gardening for everyone.

Stagflation sensation

Is the world economy going back to the 1970s?

Despite some eerie echoes, the past is not the best guide to the present


It is nearly half a century since the Organisation of the Petroleum Exporting Countries imposed an oil embargo on America, turning a modest inflation problem into a protracted bout of soaring prices and economic misery. 

But the stagflation of the 1970s is back on economists’ minds today, as they confront strengthening inflation and disappointing economic activity. 

The voices warning of unsettling echoes with the past are influential ones, including Larry Summers and Kenneth Rogoff of Harvard University and Mohamed El-Erian of Cambridge University and previously of pimco, a bond-fund manager.


Stagflation is a particularly thorny problem because it combines two ills—high inflation and weak growth—that do not normally go together. 

So far this year economic growth across much of the world has been robust and unemployment rates, though generally still above pre-pandemic levels, have fallen. 

But the recovery seems to be losing momentum, fuelling fears of stagnation. 

Covid-19 has led to factory closures in parts of South-East Asia, hitting industrial production. 

Consumer sentiment in America is sputtering. 

Meanwhile, after a decade of sluggishness, price pressures are intensifying (see chart 1). 

Inflation has risen above central-bank targets across most of the world, and exceeds 3% in Britain and the euro area and 5% in America.

The economic picture is not as bad as the situation during the 1970s (see chart 2). 

But what worries stagflationists is less the precise figures than the fact that an array of forces threatens to keep inflation high even as growth slows—and that these look eerily similar to the factors behind the stagflation of the 1970s.


One parallel is that the world economy is once again weathering energy- and food-price shocks. 

Global food prices have risen by roughly a third over the past year. 

Gas and coal prices are close to record levels in Asia and Europe. 

Stocks of both fuels are disconcertingly low in big economies such as China and India; power cuts, already a problem in China, may spread. 

Rising energy costs will exert more upward pressure on inflation and further darken the economic mood worldwide.

Other costs are rising too: shipping rates have soared, because of a shift in consumer spending towards goods and covid-related backlogs at ports. 

Workers are enjoying greater bargaining power this year, as firms facing surging demand struggle to attract sufficient labour. 

Unions in Germany, for instance, are demanding higher pay; some workers are going on strike.

Stagflationists see another similarity with the past in the current policy environment. 

They fret that macroeconomic thinking has regressed, creating an opening for sustained inflation. 

In the 1960s and 1970s governments and central banks tolerated rising inflation as they prioritised low unemployment over stable prices. 

But the bruising experience of stagflation helped shift thinking, producing a generation of central bankers determined to keep inflation in check. 

Then, after the global financial crisis and a period of deficient demand, this single-minded focus gave way to greater concern about unemployment. 

Low interest rates weakened fiscal discipline, and enabled vast amounts of stimulus during 2020. 

Now as in the 1970s, the worriers warn, governments and central banks may be tempted to solve supply-side problems by running the economy even hotter, yielding high inflation and disappointing growth.

These parallels aside, however, the 1970s provide little guidance to those seeking to understand current troubles. 

To see this, consider the areas where the historical comparison does not hold. 

Energy and food-price shocks typically worry economists because they could become baked into wage bargains and inflation expectations, causing spiralling price rises. 

Yet the institutions that could underpin a new, long-lived era of labour strength remain weak, for the most part. 

In 1970 about 38% of workers across the oecd, a club of mostly rich countries, were covered by union wage bargains. 

By 2019, that figure had declined to 16%, the lowest on record.

Cost-of-living adjustments (cola), which automatically translate increases in inflation into higher pay, were a common feature of wage contracts in the 1970s. 

But the practice has declined dramatically since. 

In 1976 more than 60% of American union workers were covered by collective-bargaining contracts with cola provisions; by 1995, the share was down to 22%. 

A paper published in 2020 by Anna Stansbury of Harvard and Mr Summers argued that a secular decline in bargaining power is the “major structural change” explaining key features of recent macroeconomic performance, including low inflation, notwithstanding the decline in unemployment rates over time. 

As dramatic as the pandemic has been, it seems unlikely that such a big shift has reversed so quickly.

Moreover, stagflation in the 1970s was exacerbated by a sharp decline in productivity growth across rich economies. 

In the decades after the second world war, governments’ commitment to maintaining demand was accommodated by rocketing growth in productive capacity (the French called the period “les Trente Glorieuses”). 

But by the early 1970s the long productivity boom had run out of steam. 

The habit of stoking demand failed to help expand productive potential, and pushed up prices instead. 

What followed was a long period of disappointing productivity growth.

Since the worst of the pandemic, however, productivity has strengthened: output per hour worked in America grew at about 2% in the year to June, roughly double the average rate of the 2010s. 

Booming capital spending could mean such gains are sustained.

Another important break with the 1970s is that central banks have neither forgotten how to rein in inflation nor lost their commitment to price stability. 

In the 1970s even some central bankers doubted their power to curb wage and price increases. 

Arthur Burns, then the chairman of the Federal Reserve, reckoned that “monetary policy could do very little to arrest an inflation that rested so heavily on wage-cost pressures”. 

Research by Christina and David Romer of the University of California at Berkeley suggests that Mr Burns’s view was a common one at the time. 

But the end of the era of high inflation demonstrated that central banks could rein in such price rises, and this knowledge has not been lost. 

Last month Jerome Powell, the Fed’s current chairman, declared that, if “sustained higher inflation were to become a serious concern, we would certainly respond and use our tools to assure that inflation runs at levels that are consistent with our longer-run goal of 2%.”

The new fiscal orthodoxy likewise has its limits. 

Budget deficits around the world are forecast to shrink dramatically from this year to next. 

In America moderate Democrats’ worries about excessive spending may mean that President Joe Biden’s grand investment plans are pared down—or fail to pass at all.

What next for the world economy, then, if it does not face a 1970s re-run? 

Rocketing energy costs pose a serious risk to the recovery. 

Soaring prices—or shortages, if governments try to limit rises—will dent households’ and companies’ budgets and hit spending and production. 

That will come just as governments withdraw stimulus and central banks countenance tighter policy. 

A demand slowdown could relieve pressure on supply-constrained sectors: once they have paid their eye-watering electricity bills, Americans will be less able to afford scarce cars and computers. 

But it would add a painful coda to nearly two years of covid-19.

Another important respect in which the global economy has changed since the 1970s is in its far greater integration through financial markets and supply chains; trade as a share of global gdp, for instance, has more than doubled since 1970. 

The uneven recovery from the pandemic has placed intense stress on some of the ties binding economies together. 

Panicking governments could hoard resources, causing further disruption.

Past experience, therefore, is not the clearest lens through which to view the forces buffeting the global economy. 

The world has changed dramatically since the 1970s, and globalisation has created a vast network of interdependencies. 

The system now faces a new, unique test.  

US has already lost AI fight to China, says ex-Pentagon software chief

Nicolas Chaillan speaks of ‘good reason to be angry’ as Beijing heads for ‘global dominance’

Katrina Manson in Washington

Nicolas Chaillan: US cyber defences in some government departments are at ‘kindergarten level’ © Monica King


The Pentagon’s first chief software officer said he resigned in protest at the slow pace of technological transformation in the US military, and because he could not stand to watch China overtake America.

In his first interview since leaving the post at the Department of Defense a week ago, Nicolas Chaillan told the Financial Times that the failure of the US to respond to Chinese cyber and other threats was putting his children’s future at risk.

“We have no competing fighting chance against China in 15 to 20 years. Right now, it’s already a done deal; it is already over in my opinion,” he said, adding there was “good reason to be angry”.

Chaillan, 37, who spent three years on a Pentagon-wide effort to boost cyber security and as first chief software officer for the US Air Force, said Beijing is heading for global dominance because of its advances in artificial intelligence, machine learning and cyber capabilities.

He argued these emerging technologies were far more critical to America’s future than hardware such as big-budget fifth-generation fighter jets such as the F-35.

“Whether it takes a war or not is kind of anecdotal,” he said, arguing China was set to dominate the future of the world, controlling everything from media narratives to geopolitics. 

He added US cyber defences in some government departments were at “kindergarten level”.

He also blamed the reluctance of Google to work with the US defence department on AI, and extensive debates over AI ethics for slowing the US down. 

By contrast, he said Chinese companies are obliged to work with Beijing, and were making “massive investment” into AI without regard to ethics.

Chaillan said he plans to testify to Congress about the Chinese cyber threat to US supremacy, including in classified briefings, over the coming weeks.

He acknowledged the US still outspends China by three times on defence, but said the extra cash was immaterial because US procurement costs were so high and spent in the wrong areas, while bureaucracy and overregulation stood in the way of much-needed change at the Pentagon.

Chaillan’s comments came after a congressionally-mandated US national security commission warned earlier this year that China could surpass the US as the world’s AI superpower within the next decade.

Senior defence officials have acknowledged they “must do better” to attract, train and retain young cyber talent, but have defended what they argue is their responsible approach to the adoption of AI.

Michael Groen, a Marine Corps lieutenant general and director of the defence department’s Joint Artificial Intelligence Center, told a conference last week he wanted to field AI across the military in an incremental way, saying its adoption would require a culture shift within the military.

His comments come after US secretary of defence Lloyd Austin said in July his department “urgently needs” to develop responsible artificial intelligence as a priority, adding a new $1.5bn investment would accelerate the Pentagon’s adoption of AI over the next five years and that 600 AI efforts were already under way.

But he committed that his department would not “cut corners on safety, security, or ethics”.

A spokesperson for the Department of the Air Force said Frank Kendall, secretary of the US Air Force, had discussed with Chaillan his recommendations for the Department’s future software development following his resignation and thanked him for his contributions.

Chaillan announced his resignation in a blistering letter at the start of September, saying military officials were repeatedly put in charge of cyber initiatives for which they lacked experience, decrying Pentagon “laggards” and absence of funding.

“[W]e are setting up critical infrastructure to fail,” he said in his letter, which made only cursory reference to advances by China. 

“We would not put a pilot in the cockpit without extensive flight training; why would we expect someone with no IT experience to be close to successful? [ . . .]While we wasted time in bureaucracy, our adversaries moved further ahead.”

Robert Spalding, a retired Air Force brigadier general who served as defence attaché in Beijing, said Chaillan had “rightfully” complained and added he too had resigned early in order to create his own encrypted defence technology solutions after being frustrated by “archaic” systems while flying B-2 stealth bombers at work.

Chaillan, who naturalised as a US citizen in 2016 and led efforts to install “zero trust” cyber security measures at the Department of Homeland Security before joining the Pentagon, said he was a polarising force at the Department of Defense and that he alarmed some senior officials who thought he should keep his complaints “in the family”.

The serial technological entrepreneur, who started his first business at 15 in France, said he also began to feel stale because he spent his three-year stint “fixing basic cloud things and laptops” instead of innovating.

Argentina hardens stance against IMF as debt renegotiations bog down

Time running short before $2.8bn payment comes due next March

Michael Stott and Lucinda Elliott in Buenos Aires

Martin Guzmán had been regarded as one of the more moderate ministers but with support for the government ebbing ahead of mid-term elections, he has hardened his rhetoric © Agustin Marcarian/Reuters


Argentina has hardened its position as a deadline looms for renegotiating $45bn of debt owed to the IMF, insisting that the Washington-based lender cuts the rates it charges and supports the government’s economic plans to secure a deal.

After a year of inconclusive discussions, time is running short before a $2.8bn repayment to the Fund comes due next March, part of $19bn that must be repaid in 2022. 

Argentina’s Peronist government says it cannot pay amid an economic crisis and has not included money for the IMF in next year’s budget, banking instead on a restructuring.

Economy minister Martín Guzmán told the Financial Times that, although his side had worked in a “very constructive” way so far, “it is important . . . that the IMF also does more from its side”.

“We hope that the shareholders support a modification of the policy of [interest rate] surcharges which damages the macroeconomic sustainability of our country and that they support the macroeconomic programme which the government is proposing.”

The IMF has said it is continuing an “active and cordial dialogue” with Argentina on a new programme but has not so far agreed to drop the surcharges.

IMF rules add a surcharge of 2 percentage points to loans that are particularly large in relation to the borrowing country’s quota, or capital at the Fund. 

These charges, which are designed to discourage large and prolonged use of IMF resources, increase to 3 percentage points if the bigger loan lasts more than three years.

Argentina is liable for surcharges but has campaigned for them to be scrapped, saying they run counter to the IMF’s mission because they penalise countries in difficult economic circumstances instead of helping them.

However, officials close to the talks say several key IMF shareholders oppose scrapping the surcharges and have pointed to Argentina’s history of pleading for special treatment, and then disappointing creditors by veering off track again. 

“They are not the country you would want to make an exception for,” one official observed.

It’s the Argentine leadership’s responsibility to come up with a macro plan to pay [the IMF debt] back and they have yet to do so

Marc Stanley, Joe Biden’s nominee as US ambassador to Buenos Aires

Argentina has also been criticised for failing to offer credible projections in vital areas such as reducing the budget deficit or bringing down inflation, which is running at more than 50 per cent a year despite government-imposed price and exchange rate controls.

Marc Stanley, Joe Biden’s nominee as US ambassador to Buenos Aires, told a Senate confirmation hearing on Tuesday that “Argentina . . . is a beautiful tour bus that doesn’t have the wheels working right”, adding: “It’s the Argentine leadership’s responsibility to come up with a macro plan to pay [the IMF debt] back and they have yet to do so.”

After Guzmán secured a deal with private sector creditors last August to reschedule $65bn of debt, hopes rose that an IMF agreement would swiftly follow. 

That optimism is evaporating amid increasingly hostile attacks from the government on the IMF, a perennial villain in Argentine politics.

“The latest rhetoric has become much more inflammatory against the IMF ahead of elections,” wrote Siobhan Morden, head of fixed income at Amherst Pierpont, in a recent note. 

“However, the radicalism would only serve to further undermine already weak investor sentiment and accelerate [dollar] demand . . . The tough talk against the IMF and inward isolation is not a viable medium-term strategy.”

Asked what the chances were of reaching an IMF deal by March, Guzmán said: “It will depend principally on the support of the international community for what Argentina is proposing and basically what Argentina is proposing is to be able to refinance that loan.”

Argentina’s government has been particularly critical of the $57bn IMF standby loan extended to the previous government of Mauricio Macri in 2018, saying it should never have been granted because it financed capital flight and was politically motivated.

Guzmán had been seen as one of the more moderate ministers but with support for President Alberto Fernández’s government flagging ahead of mid-term elections on November 14, he has hardened his rhetoric.

While speaking to the FT, Guzmán blamed the IMF for Argentina’s dollar payment difficulties, saying it was ironic that “the IMF enters the scene when a country has a balance of payments problem but . . . the reason why Argentina could face a balance of payments problem in 2022 is precisely because of the presence of the IMF loans”.

Eyebrows were raised among investors when Guzmán told a public forum in Buenos Aires last weekend that the IMF loan had “financed Macri’s [re-election] campaign” — an accusation normally associated with the radical wing of the government led by vice-president Cristina Fernández de Kirchner.

Guzmán also defended the government’s decision on October 19 to freeze the price of more than 1,400 household items until January, saying the state needed to step in when business leaders failed to agree to a voluntary pact to control prices.

Asked whether his economic views were now similar to those of Kirchner, Guzmán played down differences, saying: “We clearly share visions about the role which the state plays in economic recovery and economic development.”

Ignacio Labaqui, senior analyst at Medley Global Advisors in Buenos Aires, said Guzmán’s clout and credibility had “dramatically shrunk” in recent months. 

“He’s turned into a politician,” Labaqui added, saying that the minister now seemed more concerned about keeping his job.

“Guzmán lost a golden opportunity to sign a deal with the IMF in early 2021 when the pandemic was at a peak and the US position was less hard,” said one senior banker in Buenos Aires. 

“Now, Argentina is further and further away from reaching a deal.”