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Rabobank: The Great Greek Gamble

By Michael Every of Rabobank

The Great Greek Gamble

Back in 2017, when the Fed was pressing ahead with its last hiking cycle under FOMC Chair Yellen, we referred to it as ‘The Great Gamble’: it could pay off handsomely; but if it failed, we would end up in a world where central banking was seen to have failed in the eyes of populists, and talk would be of fiscal policy, MMT, universal basic income, protectionism, and geopolitics. One global pandemic later, here we are; and yet markets are again focused on the next Fed hiking cycle, on even more fragile foundations, and with more ridiculous global liquidity to be removed.

Except it’s not even true that the global pandemic is in the past. Yes, media have largely stopped putting it on the front pages: vaccinations are up; cases are down; deaths are sharply down; people are rightly frustrated and bored of reasonable and totally unreasonable restrictions for many good reasons; and the socio-economic damage has not even begun to be properly tallied. However, and very regrettably, it seems another great gamble is underway here too.

The vast majority of mankind has NOT been vaccinated. I am not talking about refuseniks in the West, but around 90% of global population – and not just in the poorest countries: Thailand and Indonesia are both being hit very hard by Covid at present, and both lag on the vaccine front. So is Australia, albeit in splendid isolation, and with intermittent lockdowns to prevent outbreaks. This leaves not only massive human suffering, but an equally-massive human ‘petri dish’ within which Covid can keep mutating, to what end we do not yet know. There are already suggestions the so-called Lambda variant from Latin America may be vaccine-resistant – and there are plenty of Greek letters left in the alphabet before we get to our Omega.

The two leaders in public vaccinations, the UK and Israel, are also both seeing an acceleration of growth in cases of the dangerous Delta variant. Israeli data suggests over 40% of those now seriously ill in its hospitals are aged over 60 and are fully vaccinated with Pfizer; and that the vaccine only offer 64% protection from all illness – though importantly the figure remains at 93% in terms of avoiding hospital and critical illness. Nonetheless, this is a step back from where we looked to be a few months ago: once again, the elderly and unhealthy *may* be vulnerable even if vaccinated, so trade-offs need to be made. Israel is now looking at reintroducing some of the virus controls it recently removed, while controls on international travel destinations remain.

By contrast, UK PM Johnson has announced that ‘Freedom Day’ to roll-back virus measures will go ahead on July 19 – despite the government stating virus case numbers could rise to 50,000 daily by that point, and BoJo admitting many deaths will follow; furthermore, international travel without quarantine for anyone who has been double-jabbed is on the cards. The strategy, if that is the right word given the track record so far, is again now to “live with it”; to open up for the summer…and keep fingers crossed this will not mean disaster in the autumn/winter. As the government’s own scientific advisors note, if a more pathogenic variant emerges when case numbers are high and have to be brought down “then restrictive measures would be required for much longer.”

So, a great gamble on Covid and rates. For markets, however, it’s all upside. Either the bet pays off and we open up -bullish!- or we can’t, and so get free liquidity forever – bullish! The risk of society and the economy freaking out if the virus comes back stronger and/or vaccine resistant is not being focused on; neither is that of the Fed hiking too much.

Yet markets have other high stakes too. China’s Caixin services PMI yesterday was a major downside surprise at 50.3 vs. 55.1 in May and the 54.9 expected. Consider that as Bloomberg publishes an article today (“When Will China Rule the World? Maybe Never”) echoing what we published back in 2017 on the risk of a new Cold War: there is no guarantee China’s economy will ever be larger than the US. Yes, China could overtake the US in nominal dollar terms by 2031; or it may level off as a permanent number two given its population is shrinking, its capital stock is already over-built/supplied, and its tech sector is likely to be increasingly isolated, hitting productivity. On which, are Americans going to continue to gamble with China tech IPOs after the latest state crackdown on Didi and two other tech platforms? And when the Wall Street Journal reports Chinese regulators had suggested that Didi executives delay the IPO “but Didi pushed ahead, under pressure to reward shareholders.”? Meanwhile, Facebook, Twitter, and Google warn they may halt operations in Hong Kong if proposed legislation is introduced that will make them directly responsible for any comments or content users might post/tweet/share.

Call this US-China gamble right and it will pay off handsomely: call it wrong and lose your stake.

Which is a nice segue to EU president – sorry, I mean French president Macron – and EU Chancellor Merkel -sorry, I mean German Chancellor Merkel (for another few months anyway)- holding another video chat with China’s Xi Jinping yesterday. The rest of the EU will be delighted at this latest Franco-German diplomatic outreach, especially the two EU presidents who squabble over sofas. The meeting saw a Chinese offer of high-level dialogue on trade, tech, and climate; of “fast track” personnel exchanges; a request for support for the Beijing winter Olympics; and a Quadrilateral (a new Quad!) offer for France and Germany (alone) to join China in developing infrastructure in Africa. M&M asked for more passenger flights to China and more open Chinese markets for EU firms. In short, M&M are being wooed; and both like being wooed because it feeds their “global strategic autonomy” dreams.

As the White House will note, this comes just weeks after France and Germany announced at the G7 that they would stand behind a US-led effort for a green, democratic “B3W” alternative to China’s Belt and Road. Ultimately M&M -and the EU if they get a voice- may still need to decide which strategic road to go down; or if they will just to do the catering for the rest of the world and have no real say on anything. That is also a truly great gamble – and from one leader who is shortly to be handed her chips.

Allow me to finish by tying all the above threads together via the following conclusion from an expert on green energy transitions – which the EU (and US) are so very big on:

“…Governments need proactively to anticipate energy security risks surrounding market concentration, critical minerals and an increased reliance on electricity systems, including their vulnerability to cyber attack: in 2050, almost 50% of global energy would be used in the form of electricity, up from 20% in 2020. This will necessitate a huge increase in the production of lithium, cobalt, nickel, graphite, rare earths and copper, whose supplies must be secured by individual nations. As the mining or processing of these resources is concentrated in only a few countries, potential geopolitical problems seem almost inevitable.”

Or, just carry on as if they aren’t, Mr Market and Mrs Merkel: there’s a great gamble for you!

The China Question

In matters of trade and manufacturing, the United States has not been the naive victim of cunning Chinese masterminds. We asked for this.

MICHAEL LIND

MAY 19, 2020

On May 25, 2000, President Bill Clinton hailed the passage of legislation by the House of Representatives establishing permanent normal trade relations with China: “Our administration has negotiated an agreement which will open China’s markets to American products made on American soil, everything from corn to chemicals to computers. Today the House has affirmed that agreement. … We will be exporting, however, more than our products. By this agreement, we will also export more of one of our most cherished values, economic freedom.”

Two decades later, the chickens—or rather, in the case of the novel coronavirus that spread to the world from China, the bats—have come home to roost. In a recent press conference about the pandemic, Gov. Andrew Cuomo of New York complained: “We need masks, they’re made in China; we need gowns, they’re made in China; we need face shields, they’re made in China; we need ventilators, they’re made in China. … And these are all like national security issues when you’re in this situation.”

We should not be shocked to discover that many essential items, including critical drugs and personal protective equipment (PPE), that used to be made in the United States and other countries are now virtually monopolized by Chinese producers. That was the plan all along.

Politicians pushing globalization like Clinton may have told the public that the purpose of NAFTA and of China’s admission to the World Trade Organization (WTO) was to open the closed markets of Mexico and China to “American products made on American soil, everything from corn to chemicals to computers.” But U.S. multinationals and their lobbyists 20 years ago knew that was not true. Their goal from the beginning was to transfer the production of many products from American soil to Mexican soil or Chinese soil, to take advantage of foreign low-wage, nonunion labor, and in some cases foreign government subsidies and other favors. Ross Perot was right about the motives of his fellow American corporate executives in supporting globalization.

The strategy of enacting trade treaties to make it easier for U.S. corporations to offshore industrial production to foreign cheap-labor pools was sold by Clinton and others to the American public on the basis of two implicit promises. First, it was assumed that the Western factory workers who would be replaced by poorly paid, unfree Chinese workers would find better-paying and more prestigious jobs in a new, postindustrial “knowledge economy.” Second, it was assumed that the Chinese regime would agree to the role assigned to it of low-value-added producer in a neocolonial global economic hierarchy led by the United States, European Union, and Japan. To put it another way, China had to consent to be a much bigger Mexico, rather than a much bigger Taiwan.

Neither of the promises made by those like Clinton who promoted deep economic integration between the United States and China two decades ago have been fulfilled.

The small number of well-paying tech jobs in the U.S. economy has not compensated for the number of manufacturing jobs that have been destroyed. A substantial percentage of those well-paying tech jobs have gone not to displaced former manufacturing workers who have been retrained to work in “the knowledge economy” but to foreign nationals and immigrants, a disproportionate number of whom have been nonimmigrant indentured servants from India working in the U.S. on H-1B visas.

The devastation of industrial regions by imports from China, often made by exploited Chinese workers for Western corporations, is correlated in the United States and Europe with electoral support for nationalist and populist politicians and parties. The Midwestern Rust Belt gave Donald Trump an electoral college advantage in 2016, and the British Labour Party’s Red Wall in the north of England cracked during the Brexit vote in 2016 and crumbled amid the resounding victory of Boris Johnson’s Conservatives in 2019.

The second implicit promise made by the cheerful advocates of deep Sino-American economic integration like Bill Clinton was that China would accept a neocolonial division of labor in which the United States and Europe and the advanced capitalist states of East Asia would specialize in high-end, high-wage “knowledge work,” while offshoring low-value-added manufacturing to unfree and poorly paid Chinese workers. China, it was hoped, would be to the West what Mexico with its maquiladoras in recent decades has been to the United States—a pool of poorly paid, docile labor for multinational corporations, assembling imported components in goods in export-processing zones for reexport to Western consumer markets.

But the leaders of China, not unreasonably, are not content for their country to be the low-wage sweatshop of the world, the unstated role assigned to it by Western policymakers in the 1990s. China’s rulers want China to compete in high-value-added industries and technological innovation as well. These are not inherently sinister ambitions. China is governed by an authoritarian state, but so were Taiwan and South Korea until late in the 20th century, while Japan was a de facto one-party state run for nearly half a century by the Liberal Democratic Party (LDP), which was neither liberal nor democratic.

Even a democratic, multiparty Chinese government that sponsored liberalizing social reforms would probably continue a version of the successful state sponsorship of industrial modernization in order to catch up with, if not surpass, the U.S. and other nations that developed earlier. That is what China’s neighbors, Japan, South Korea, Taiwan and Singapore, all did following WWII. Indeed, when the United States and Imperial Germany were striving to catch up with industrial Britain in the 19th century, they employed many of the same techniques of national developmentalism, including protective tariffs and, in America’s case, toleration of theft of foreign intellectual property. (British authors visiting the U.S. often discovered that pirated editions of their works were as easy to purchase then as pirated Hollywood movies and knockoffs of Western brands are to obtain in Asia today.)

The question, then, is not why China pursued its own variant of classic state-sponsored industrial development policies in its own interest. The question is why the U.S. establishment did not retaliate against China’s policies for so long, given the damage they have done to American manufacturing and its workforce.

The answer is simple. American politics and policy are disproportionately shaped by the rich, and many, perhaps most, rich Americans can do quite well for themselves and their families without the existence of any U.S. manufacturing base at all.

We are taught to speak about “capitalism” as though it is a single system But industrial capitalism is merely one kind of capitalism among others, including finance capitalism, commercial capitalism, real estate capitalism, and commodity capitalism. In different countries, different kinds of capitalism are favored by different regimes.

Recognizing that there are, in fact, different kinds of capitalism, not only among nations but within them, allows us to understand that the different variants of profit-seeking can interact in kaleidoscopic ways. National economies can compete with other national economies or they can complement them.

The United States could decline into a deindustrialized, English-speaking version of a Latin American republic, specializing in commodities, real estate, tourism, and perhaps transnational tax evasion.

America’s economic elite is made up mostly of individuals and institutions whose sectors complement state-sponsored Chinese industries instead of competing with them. It is pointless to try to persuade these influential Americans that they have a personal, financial stake in manufacturing on American soil. They know that they do not.

The business model of Silicon Valley is to invent something and let the dirty physical work of building it be done by serfs in other countries, while royalties flow to a small number of rentiers in the United States. Nor has partial U.S. deindustrialization been a problem for American financiers enjoying the low interest rates made possible in part by Chinese financial policies in the service of Chinese manufacturing exports. American pharma companies are content to allow China to dominate chemical and drug supply chains, American real estate developers lure Chinese investors with EB-5 visas to take part in downtown construction projects, American agribusinesses benefit from selling soybeans and pork to Chinese consumers, and American movie studios and sports leagues hope to pad their profits by breaking into the lucrative China market.

For their part, many once-great American manufacturing companies have become multinationals, setting up supply chains in China and other places with low-wage, unfree labor, while sheltering their profits from taxation by the United States in overseas tax havens like Ireland and the Cayman Islands and Panama. Many of these so-called “original equipment manufacturers” (OEMs)—companies that outsource and offshore most of their manufacturing—are engaged as much in trade, marketing, and consumer finance as they are in actually making things.

We should not be surprised that multinational firms, given the choice, typically prefer to maximize profits by a strategy of driving down labor costs, replacing well-paid workers with poorly paid workers in other countries, rather than by becoming more productive through replacing or augmenting expensive labor with innovative machinery and software in their home countries. Labor-saving technological innovation to keep production at home is hard. Finding cheaper labor in another country is easy.

In short, the United States has not been the naive victim of cunning Chinese masterminds. On the contrary, in the last generation many members of America’s elite have sought to get rich personally by selling or renting out America’s crown jewels—intellectual property, manufacturing capacity, high-end real estate, even university resources—to the elite of another country.

A century ago, many British investors did well from overseas investments in factories in the American Midwest and the German Ruhr, even as products from protectionist America and protectionist Germany displaced free-trading Britain’s own unprotected manufacturing industry in Britain’s own markets. By building up China’s economy at the expense of ours, America’s 21st-century overclass is merely following the example of the British elite, which, like a bankrupt aristocrat marrying a foreign plutocrat’s daughter, sells its steel plants to Indian tycoons and state-backed Chinese firms, sells London mansions to Russian gangsters and Arab aristocrats, and sells university diplomas to foreign students including Americans and Chinese.

When asked whether the rapid dismantling, in a few decades, of much of an industrial base built up painstakingly over two centuries has been bad for the United States, the typical reply by members of the U.S. establishment is an incoherent word salad of messianic liberal ideology and neoclassical economics. We are fighting global poverty by employing Chinese factory workers for a pittance! Don’t you understand Ricardo’s theory of comparative advantage?

Some of the profits made by rich Americans in the modern China trade are recycled as money flowing to universities, think tanks, and the news media. The denizens of these institutions tend to be smart and smart people know who butters their bread. Predictably, intellectuals and journalists who benefit from the largesse of American capitalists with interests in China are inclined to please their rich donors by characterizing critics of U.S. China policy as xenophobes who hate Asian people or else ignorant fools who do not understand that, according to this or that letter in The Wall Street Journal or The New York Times signed by 1,000 or 10,000 or 100,000 economics professors, free trade always magically benefits all sides everywhere all at once.

All of this idealistic verbiage about the wonders of free trade and the moral imperative of ending global poverty by replacing American workers with foreign workers cannot muffle the click of cash registers.

The dangerous dependence of the United States and other advanced industrial democracies on China for basic medical supplies has been exposed by the current pandemic. The U.S. and other industrial democracies now confront a stark choice. Western countries can continue to cede what remains of their manufacturing base and even control of their telecommunications and drone infrastructure to Beijing and specialize as suppliers of technological innovation, higher education, agriculture, minerals, real estate, and entertainment to industrial China. Or they can view Western economies as competitors of the Chinese economy, not complements to it, and act accordingly.

Rejection of the view that our economy should compete with, rather than complement, that of China in key sectors does not require us to endorse demagogic claims that the Chinese regime is a crusading ideological enemy hell-bent on world domination like Nazi Germany or the Soviet Union. On the contrary, a strategy of U.S. industrial independence informed by sober realism would entail recognition of the legitimate interest of China, under any regime, in building up its own advanced industries—on the condition that China in return recognize America’s legitimate interests in preserving its own domestic supply chains in the same key industrial sectors.

Econ 101 to the contrary, the purpose of international trade should not be to maximize the well-being of global consumers by means of a global division of labor among countries that specialize in different industries, but to allow sovereign states to pursue industrial policies in their own long-term interest, as they define it. Trade, investment, and immigration policies should be subservient to national industrial strategy. The purpose of trade negotiations should be the modest one of reconciling different, clashing, and equally legitimate national industrial policies in a mutually acceptable way.

National industrial policies are like national militaries—essential local public goods provided by a sovereign government to a particular people. The model for trade negotiations should be bilateral and multilateral arms control, which are based on the premise that all parties have a perpetual right to their own militaries, rather than global disarmament, which seeks the utopian goal of eliminating all militaries everywhere.

All modern economies are mixed economies, with public sectors and private sectors, and all modern trade should be mixed trade, with wholly protected sectors, partly protected sectors with managed trade, and sectors in which free trade is not dangerous and is therefore allowed. In a post-neoliberal world, it would be understood that the legitimate self-interest of sovereign nations and blocs inevitably imposes strict limits on the acceptable flow of goods, money, and labor across borders. Institutions which limit the right of sovereign states to promote their own national industries as they see fit, like the World Trade Organization (WTO), should be reformed or abolished.

All major countries like the United States, China, and India and all major trading blocs like the EU should insist on having their own permanent domestic supply chains in medicine, medical gear, machine tools, aircraft and drones, automobiles, consumer electronics, telecommunications equipment, and other key sectors. They should have the right to create or protect these essential industries by any means they choose, at the expense of free trade and free investment if necessary.

If China and India want to have their own national aerospace industries in addition to the United States and European Union, more power to them—as long as the United States and European Union can intervene to preserve their own national aerospace supply chains on their own soil employing their own workers. If this approach means accepting that Western-based aerospace firms like Boeing and Airbus cannot hope to enjoy a permanent shared monopoly in global markets for large jets, well, too bad. Boeing and Airbus cannot claim in good times to be post-national global corporations to justify offshoring policies and then claim in bad times to be national champions when they need bailouts.

The alternative—deepening the complementarity among China’s industrial and America’s postindustrial economies—would be much worse for the United States. The same American overclass whose members have profited the most from transferring national assets to China in the last generation has also been far more insulated from the effects of imports from China, both manufactured goods and viruses. The United States, which has always had features of a Third World country as well as a First World country, could decline into a deindustrialized, English-speaking version of a Latin American republic, specializing in commodities, real estate, tourism, and perhaps transnational tax evasion, with decayed factories scattered across the continent and a nepotistic rentier oligarchy clustered in a few big coastal cities.

It would be ironic as well as tragic if the strategy of Sino-American economic integration which American elites in the 1990s hoped would turn China into another Mexico for the United States ends up turning the United States into another Mexico for China.

The China Question – Tablet Magazine

The ghost of Arthur Burns- Stephen Roach

via Project syndicate

May 25, 2021STEPHEN S. ROACH

The US Federal Reserve is insisting that recent increases in the price of food, construction materials, used cars, personal health products, gasoline, and appliances reflect transitory factors that will quickly fade with post-pandemic normalization. But what if they are a harbinger, not a “noisy” deviation?

NEW HAVEN – Memories can be tricky. I have long been haunted by the inflation of the 1970s. Fifty years ago, when I had just started my career as a professional economist at the Federal Reserve, I was witness to the birth of the Great Inflation as a Fed insider. That left me with the recurring nightmares of a financial post-traumatic stress disorder. The bad dreams are back.

They center on the Fed’s legendary chairman at the time, Arthur F. Burns, who brought a unique perspective to the US central bank as an expert on the business cycle. In 1946, he co-authored the definitive treatise on the seemingly rhythmic ups and downs of the US economy back to the mid-nineteenth century. Working for him was intimidating, especially for someone in my position. I had been tasked with formal weekly briefings on the very subjects Burns knew best. He used that knowledge to poke holes in staff presentations. I found quickly that you couldn’t tell him anything.

Yet Burns, who ruled the Fed with an iron fist, lacked an analytical framework to assess the interplay between the real economy and inflation, and how that relationship was connected to monetary policy. As a data junkie, he was prone to segment the problems he faced as a policymaker, especially the emergence of what would soon become the Great Inflation. Like business cycles, he believed price trends were heavily influenced by idiosyncratic, or exogenous, factors – “noise” that had nothing to do with monetary policy.

This was a blunder of epic proportions. When US oil prices quadrupled following the OPEC oil embargo in the aftermath of the 1973 Yom Kippur War, Burns argued that, since this had nothing to do with monetary policy, the Fed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index. The staff protested, arguing that it made no sense to ignore such important items, especially because they had a weight of over 11% in the CPI. Burns was adamant: If we on the staff wouldn’t perform the calculation, he would have it done by “someone in New York” – an allusion to his prior affiliations at Columbia University and the National Bureau of Economic Research.

Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather – specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertilizer and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food – which had a weight of 25% – out of the CPI.

We didn’t know it at the time, but we had just created the first version of what is now fondly known as the core inflation rate – that purified portion of the CPI that purportedly is free of the volatile “special factors” of food and energy, where gyrations were traceable to distant wars and weather. Burns was pleased. Monetary policy needed to focus on more stable underlying inflation trends, he argued, and we had provided him with the perfect tool to sharpen his focus.

It was a fair point – to a point; unfortunately, Burns didn’t stop there. Over the next few years, he periodically uncovered similar idiosyncratic developments affecting the prices of mobile homes, used cars, children’s toys, even women’s jewelry (gold mania, he dubbed it); he also raised questions about homeownership costs, which accounted for another 16% of the CPI. Take them all out, he insisted!

By the time Burns was done, only about 35% of the CPI was left – and it was rising at a double-digit rate! Only at that point, in 1975, did Burns concede – far too late – that the United States had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.

Fast-forward to today. Evoking an eerie sense of déjà vu, the Fed is insisting that recent increases in the prices of food, construction materials, used cars, personal health products, gasoline, car rentals, and appliances reflect transitory factors that will quickly fade with post-pandemic normalization. Scattered labor shortages and surging home prices are supposedly also transitory. Sound familiar?

There are many more lessons from the 1970s that shed light on today’s cavalier dismissal of inflation risk. When the Fed finally tried to tackle the Great Inflation, it fixated on unit labor costs – rising wages accompanied by sagging productivity. While there are always good reasons to worry about productivity, wages appear to be largely in check; unionized labor, which, in the 1970s had sparked a vicious wage-price spiral through cost-of-living indexation, has been neutralized by global competition. But that doesn’t rule out a very different form of global cost-push inflation – namely, the confluence of supply-chain congestion (think semiconductors) and protectionist clamoring to reshore production.

But the biggest parallel may be another policy blunder. The Fed poured fuel on the Great Inflation by allowing real interest rates to plunge into negative territory in the 1970s. Today, the federal funds rate is currently more than 2.5 percentage points below the inflation rate. Now, add open-ended quantitative easing – some $120 billion per month injected into frothy financial markets – and the largest fiscal stimulus in post-World War II history. All of this is occurring precisely when a post-pandemic boom is absorbing slack capacity at an unprecedented rate. This policy gambit is in a league of its own.

Top of Form

Bottom of Form

For my money, today’s Fed waxes far too confidently about well-anchored inflation expectations. It also preaches the new gospel of “average inflation targeting,” convinced that it can condone above-target inflation for an unspecified period to compensate for years of coming in below target. My students would love to throw out their worst grade(s) as well!

No, this isn’t the 1970s, but there are haunting similarities that bear watching. Timothy Leary, one of the more memorable gurus of the Age of Aquarius, purportedly said, “If you remember the 1960s, you weren’t there.” That doesn’t apply to the 1970s. Sleepless nights and vivid flashbacks, complete with visions of a pipe-smoking Burns – it’s almost like being there again, but without the great music.

An Emerging Problem

by John authors via Zerohedge

Generational Turning Point- Doug Noland

There is an overarching issue I haven’t been able to get off my mind: Are we at the beginning of something new or in the waning days of the previous multi-decade cycle?

May 5 – Wall Street Journal (James Mackintosh): “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation. After more than 40 years of policies that gave priority to the fight against rising prices, investor- and consumer-friendly solutions are becoming less fashionable, not only in the U.S. but in much of the world. Investors are woefully unprepared for such a shift, perhaps because such historic turning points have proven remarkably hard to spot. This may be another false alarm, and it will take many years to play out, but the evidence for a general shift is strong across five fronts.”

The “five fronts” underscored in Mr. Mackintosh’s insightful piece are as follows: 1) “Central banks, led by the Federal Reserve, are now less concerned about inflation.” 2) “Politics has shifted to spend even more now, pay even less later.” 3) “Globalization is out of fashion.” 4) “Demographics worsen the situation.” 5) “Empowered labor puts upward pressure on wages and prices.”

The analysis is well-founded, as is the article’s headline: “Everything Screams Inflation.” After surging another 3.7% this week (lumber up 12%, copper 6%, corn 9%), the Bloomberg Commodities Index has already gained 20% this year. Lumber enjoys a y-t-d gain of 93% – WTI Crude 34%, Gasoline 51%, Copper 35%, Aluminum 26%, Steel Rebar 32%, Corn 51%, Soybeans 22%, Wheat 19%, Coffee 18%, Sugar 13%, Cotton 15%, Lean Hogs 59%… The focus on inflation is clearly justified. Yet Mackintosh began his article suggesting a “Generational Turning Point for finance” – rather than inflation. Let’s explore…

I mark the mid-eighties as the beginning of the current super-cycle. A major collapse in market yields (following the reversal of Paul Volcker’s tightening cycle) promoted financial innovation and the expansion of non-bank Credit expansion. Markets were turning increasingly speculative, while the economic boom was spurring increasingly destabilizing trade and Current Account Deficits. These deficits were helping feed Japan’s Bubble, fueled both by international financial flows as well as the misguided Japanese policy response seeking to use monetary stimulus to boost U.S. goods imports and rectify its ballooning trade surpluses. In the U.S., increasingly acute Monetary Disorder led to the “Black Monday” – October 19th, 1987 stock market crash.

The Greenspan Fed’s crash response launched a regime of activist central bank measures specifically directed at supporting the securities markets. U.S. stocks swiftly recovered, while loose financial conditions stealthily promoted the evolution of non-bank finance. Post-crash Bubble reflation developments cemented the “decade of greed” moniker. Michael Milken and the proliferation of junk bonds and leveraged finance. Insider trading, Ivan Boesky, the LBO boom, Charles Keating, and the Savings & Loan (S&L) fiasco. And, importantly, post-crash reflationary measures pushed Japan’s Bubble to catastrophic “Terminal Phase Excess.” After ending 1987 at 21,564, the Nikkei Index traded to an all-time high 38,916 on the final trading session in 1989.

All kinds of things went wrong in 1990 – including war and recession. Late-eighties U.S. bubbles burst in unison, including coastal real estate, junk bonds, LBOs, and the S&Ls. Japan’s Bubble began to unravel. Collapsing Bubbles left the U.S. banking system badly impaired, with multiple major failures and even concerns for the solvency of Citicorp. Already huge fiscal deficits were at risk of exploding uncontrollably, due to ballooning costs of bank and S&L recapitalizations.

“The Maestro” pushed central bank activism to a whole new level, collapsing rates and manipulating the yield curve. Banks were encouraged to borrow short (cheap) and lend long (dear), pocketing easy spread profits while rebuilding capital. Finance, financial structure and policymaking were changed forever. Importantly, Greenspan’s policies were a godsend to the fledgling leveraged speculating community that prospered on hugely profitable “carry trades” and levered derivatives strategies – and never looked back.

When the bond/derivatives Bubble burst in 1994, the rapidly expanding GSEs were elevated to quasi-central banks. The GSEs began aggressively buying debt securities during periods of market instability, creating a liquidity backstop that fundamentally altered the risk vs. reward dynamics of leveraged speculation and derivatives strategies more generally. With their implicit government debt guarantees, the GSEs enjoyed unlimited access to cheap market-based borrowings. Meanwhile, the Mexican bailout and global policy responses (including from the IMF) to a series of devastating EM Bubble collapses (SE Asian “Tigers” to Russia) reinforced the market perception that central banks, governments and inter-governmental agencies were all now fully committed to backstopping the rise of market-based “Wall Street finance”.

The 1998 LTCM bailout – and post-crisis GSE/Fed reflation measures – pushed the U.S. “tech” Bubble in 1999 to dangerous “Terminal Phase Excess.” The Fed’s post-tech Bubble reflationary measures then stoked the more expansive and systemic “mortgage finance Bubble”. And yet another post-Bubble reflation stoked this super-cycle’s “Terminal Phase” “global government finance Bubble.”

The pandemic erupted at a critical Bubble juncture. Speculative excess had already turned problematic. Financial and economic fragilities were manifesting globally, particularly in Bubble heavyweights U.S. and Chinese financial systems. In the summer of 2019, China was facing instability at its Credit system’s “periphery”, notably within the giant “small banking” sector. In the U.S., the eruption of repo market (a key source of finance for leveraged speculation) instability provoked the latest iteration of activist/inflationist monetary management – the so-called “insurance” monetary stimulus.

The Fed redeployed QE in the face of highly speculative markets (stocks near records) and unemployment at multi-decade lows. Arguably, this stimulus and resulting Bubble excess contributed to latent fragilities that erupted in near market collapse in March 2020. The Fed’s balance sheet has more than doubled (108%) in 86 weeks to $7.81 TN. A full-fledged mania erupted – stocks, cryptocurrencies, corporate Credit, SPACs, derivatives, houses, etc. Washington ran a $4.8 TN, or almost 25% of GDP, deficit in only 18 months.

Considering the unprecedented nature of recent excess, there is today every reason to contemplate a secular shift in inflation dynamics. The Fed is locked into runaway monetary inflation, while its new inflation-targeting regime specifically seeks to promote above-target inflation. Moreover, Washington had grown comfortable with massive deficits even prior to covid. Now, the Biden administration is pushing gargantuan spending programs, in what is a predictable political response to flagrant inequality and derelict infrastructure. There is also the astronomical cost of adjusting to climate change. Mr. Mackintosh’s above article highlights the major factors supporting the secular inflation thesis.

But what about finance? Central bank policies now command market trading dynamics, while government-related debt dominates system Credit expansion. There is every reason to believe state-directed lending, after reaching new extremes during the pandemic, will become only more obtrusive going forward. A compelling case can be made this new age of government directed finance and spending is now driving a new inflationary cycle.

However, I certainly don’t want to dismiss end-of-cycle dynamics. “Blow-off” dynamics, after all, are proliferating. One can start with the trajectory of the Fed’s balance sheet, along with unbounded fiscal deficit spending. There are, as well, myriad indications of “Terminal Phase” speculative excess, including numerous manias, over-leverage, ETF flows, corporate bond issuance, the Ark funds, etc. The breadth and scope of such extreme behavior portend change is in the offing.

These days, markets and about everyone anticipates that historic monetary and fiscal stimulus will continue to fuel historic asset bull markets. The existing cycle is very much intact, it is believed, with New Age central banking continuing to underpin unrestrained fiscal spending. But could both monetary and fiscal authorities have pushed things too far? Could we be nearing a major adjustment, where the respective interests of an expansive government and the markets finally diverge? Might a bout of market discipline catch Washington, along with about everybody, by complete surprise? A crazy thought.

This history of monetary inflation informs us that once it begins in earnest, it becomes extremely difficult to rein in. After expanding assets by $4.0 TN in about 18 months – and stoking historic manias in the process – any Fed retreat in the direction of “normalization” will prove highly destabilizing (a dynamic clearly not lost on Fed officials). A similar dilemma holds true for the Federal government after it’s $4.8 TN deficit spending free-for-all. Meanwhile, “melt-up” speculative market dynamics are similarly problematic. There is no reason to expect the type of historic excess we’ve been witnessing to end with a whimper.

All the key dynamics shaping finance have been pushed to such egregious “Terminal Phase” extremes. Shouldn’t we today be contemplating how such end-of-cycle dynamics might play out? A harsh market reaction to reckless Washington policymaking would appear long overdue. The flow of magma to the surface has been restricted for far too long. Could an inflation scare prove the catalyst for a market eruption?

Credit has been expanding rapidly throughout this most-protracted cycle. There has been tremendous debasement, yet for various reasons consumer price inflation remained relatively contained. Liquidity flowed into the securities and asset markets, while bond yields collapsed despite a historic increase in supply/issuance. Markets have been more than happy to accommodate huge fiscal spending and the attendant supply of government bonds. Of course it’s easy to extrapolate this wondrous dynamic far into the future.

But the markets’ failure to impose discipline had predictable consequences. Governments succumbed to late-cycle massive over-issuance, pushing the limits of market accommodation while also stoking general inflationary pressures. To this point, however, the Fed’s ongoing massive QE buying has masked deepening fragility. This has only emboldened deficit spending proponents, while throwing more fuel on both speculative manias and mounting pricing pressures throughout the real economy.

It all points to a major shakeout. An inflation upside surprise could come with momentous ramifications. The bond market would face major instability. Beyond debasement, there would be fear of a destabilizing de-risking/deleveraging dynamic taking hold. And market instability and illiquidity become even greater issues at the point when inflationary pressures weaken the Fed’s propensity for quick QE liquidity injections. Suddenly, the marketplace would be forced to reassess the reliability of its coveted liquidity backstop.

There’s a scenario we need to contemplate: Mounting inflationary pressures spook the bond market concurrent with the Fed moving forward its plans to wind down QE and commence rate increases. Bond market instability unleashes a bout of de-risking/deleveraging, a particularly problematic development for a highly levered corporate bond complex, as well as quite speculative equities markets. In such a scenario, the Fed would be under intense pressure to employ large QE purchases to underpin marketplace liquidity. A failure to act would be highly destabilizing for the markets. At the same time, another huge bout of QE in a backdrop of heightened inflationary concerns might prove problematic for bond investors.

It is worth recalling the chaos that ensued early in the March 2020 pandemic policy response. Markets continued a panicky de-risking/deleverage even as the Fed announced major liquidity operations. It was not until the Fed ratcheted up the response to monumental liquidity injections that crash dynamics were reversed. But speculation and leverage have surely expanded significantly over the past year, raising the issue of the scope of the next QE bailout necessary to again hold Bubble collapse at bay.

I believe another massive QE bailout program is inevitable. And such a program in the face of rapidly building inflationary pressures would risk a bond market backlash. This could throw Fed monetary doctrine into disarray: does it inflate its balance sheet to provide liquidity support to the markets, or must it focus instead on reining in inflationary policy measures to stabilize unsettled bond markets? A crisis of confidence in Federal Reserve policymaking would be a distinct possibility. And such a scenario would risk ending the past three decades’ nexus between progressively activist monetary management and ever-expanding financial Bubbles.

Markets have enjoyed reliable liquidity backstops going back to the GSEs in the mid-nineties. When accounting irregularities eventually ended Fannie and Freddie’s open-ended growth, the Fed’s balance sheet took over liquidity backstop operations. There are much different financial and economic worlds without a reliable Fed/central bank market liquidity backstop.

And while the assertion the Fed will always be there to backstop the markets has some merit, there are major challenges developing. Previous QE programs essentially directed liquidity into the markets. U.S. investment booms were for the most part disinflationary, with spending on new technologies, services, and digitized output creating an endless supply of “output” devoid of traditional upward pricing pressures.

Going forward, the investment boom will shift to infrastructure, along with a domestic manufacturing push. Climate change will require enormous investment in physical capital stock and associated manufacturing capacity. A strong case can be made this changing investment dynamic will play a significant role in evolving inflation dynamics. There will be tremendous demand for various commodities as well as skilled labor. Moreover, this will be a global phenomenon.

There were inflation concerns when the Fed initially employed QE in 2008. But that was in a post-Bubble backdrop replete with powerful real economy disinflationary forces. The liquidity and resulting inflationary effects remained largely contained within the securities markets. The “QE2” near doubling of the Fed’s balance sheet between 2011 and 2014 injected liquidity into a system with ongoing real economy disinflationary pressures, but with increasingly powerful inflationary Bubble Dynamics in the securities markets – at home and abroad. Market Bubbles, furthermore, fueled an investment boom throughout the expansive technology sector with minimal inflationary impacts upon the broader economy. Actually, the massive increase in supply of myriad technology gadgets, services and digitalized downloads acted as a sponge absorbing what would have traditionally been inflationary spending power.

There is already evidence the latest round of QE is fueling divergent inflationary dynamics. For one, it’s at such greater scope. Secondly, it has unfolded concurrently with unprecedented fiscal spending. Thirdly, QE was employed in an environment of already heightened real economy inflationary pressures – i.e. labor, housing, commodities, physical investment beyond new technologies, etc. And, finally, massive monetary stimulus comes following decades of inflationary dynamics that profoundly benefited securities prices and the wealthy at the expense of the working class. The inevitable social and political backlash, further energized by covid-related inequities, has spurred a flurry of wealth redistribution policy initiatives.

There is indeed every reason to contemplate the possibility of a momentous secular shift in inflation dynamics. This doesn’t necessarily mean CPI begins rising dramatically, although the likelihood of such an outcome is rising. But the strongest inflationary biases are poised to shift from the securities markets back to more traditional real economy impacts. This implies the Fed going forward will face obstacles in its “whatever it takes” open-ended QE doctrine. Rising inflation and a fragile bond market will force it to contemplate the risk of additional QE, while QE liquidity will now gravitate more toward inflationary dynamics within the real economy. This dynamic is already observable in booming commodities markets.

But back to the original question: Are we witnessing the start of something new – or the previous cycle’s end-game? There’s an understandable focus on how central banks and governments have hijacked Credit systems. To this point, this “money” has created an extraordinarily stable dynamic relative to runaway monetary inflation and debt growth.

Though bastardized by government intrusion, Credit remains dominated by market-based finance. Is this cycle of market-based Credit underpinned by activist central bank management sustainable? Or has the massive expansion of non-productive Credit, egregious monetary inflation, manic market excess and associated inflationary pressures created fragilities that place the existing financial structure at risk?

The Fed is in no hurry to find out. QE to the tune of $120 billion a month masks fragilities, while holding market adjustment at bay. And the mania rages on, while Washington luxuriates in blank checkbook overindulgence. Inflationary pressures mount. It’s worth noting the Dollar Index dropped 1.1% this week and is now only a couple percent from 2018 lows.

The future could not be murkier. Everyone is prepared for unchecked monetary and fiscal stimulus as far as the eye can see. But is existing market structure sustainable in a backdrop of unrelenting non-productive debt growth, rising inflation, waning central bank flexibility and shifting political priorities? A Bloomberg headline from Friday evening: “Reflation, Inflation, Deflation: Stocks Can Live With Everything.” I’m not convinced the financial Bubble can live without QE. Is massive monetary inflation the only thing sustaining a multi-decade market cycle?

http://creditbubblebulletin.blogspot.com/2021/05/weekly-commentary-generational-turning.html

Ferg’s Find

Ferg is a smart guy and he sends a weekly mail of his reading.

Bidenomics explained- Noah Smith

It’s the end of the Age of Reagan, but it’s much more than that

“If the formula doesn’t work, you change the formula.” — Arin Hanson

“The era of ‘big government is over’ is over.” — James Medlock

I know this post has a very Vox-like title, but in fact I’m not going to go through Biden’s new infrastructure plan point by point and tell you what’s in it. if you want that, you can check out the actual Vox explainer, or the always-excellent writeup by the WaPo’s Jeff Stein et al. You can also check out Brad DeLong’s thoughts and David Roberts’ deep dive into the climate aspects. I’m sure there will be more in the days to come, and I’ll have plenty of thoughts on the specific provisions as well.

What I want to do in this post, however, is try to figure out what it all means. By now I think everyone has realized that something is changing in American economic policy. The tenor, pace, and scope of Biden’s economic programs proposals, and the muted nature of the ideological opposition, suggest that we’ve entered a new policy paradigm — much as when FDR took office in 1933 or Ronald Reagan in 1981. Every President comes in with a laundry list of initiatives, but once every few decades a President comes in with a new philosophy for what policy should look like. And that is happening now. The fact that a $1.9 trillion COVID relief bill was passed with relatively little fuss, and was really just the warm-up to an even bigger infrastructure bill, and that other “big” policies like student debt cancellation are being pursued on the side as an afterthought, should make it clear that Biden is blitzing.

But what’s the unifying philosophy here? What is Bidenomics? I have some thoughts. First, we need to talk a bit about why the old paradigm wasn’t working.

Why we needed a new paradigm

The last economic policy paradigm, bequeathed to us by Ronald Reagan (and Paul Volcker), was based around tax cuts, deregulation, welfare cuts, and tight monetary policy. These were intended as remedies for the two main economic problems of the 1970s — slow growth and inflation, together known as “stagflation”. The idea that tax cuts boost growth comes from basic economic theory; in almost any model, taxes distort the economy (except for things like carbon taxes), so if you cut taxes it should make the economy more efficient, thus increasing growth at least temporarily. The idea that deregulation boosts growth was more of an article of faith — since “regulation” means a ton of different things, there’s no economic model that can capture it in a general sense (actually deregulation really started under Carter, who arguably did more than Reagan). Welfare cuts were partly based on economic theory — means-tested welfare programs are a form of implicit taxation, which theoretically discourages people from working — and part dogma about a “culture of dependence”. As for tight monetary policy — or more accurately, an anti-inflationary bias at the Fed — that was obviously just a response to inflation.

We can argue back and forth about whether the Reagan paradigm ever boosted growth; in fact, I don’t know the answer. The late 80s and 90s were good years for American incomes and the 90s and early 00s were good years for productivity. How much tax cuts and deregulation had to do with that is up for debate, and how much the country benefitted from reduced inflation is also arguable.

But it’s clear that by the 2000s and 2010s, the Reaganite paradigm wasn’t doing what it was supposed to do. Bush cut taxes for investors, but as Danny Yagan — who is not working in the Biden administration — showed, this didn’t boost business investment at all. In fact, tax cuts in general failed to stem the overall drop in private business investment during 1980-2020:

And if income tax cuts made people work more, it certainly isn’t apparent in the aggregate data:

As for productivity, by 2005 the computer boom was over and we were back to slow growth. That came coupled with weak competitiveness, as industrial activity fled to China.

The one really enduring economic success of the Reagan age was that inflation stayed low, but there’s a good argument to be made that in the aftermath of the Great Recession it was too low; if the Fed had allowed inflation to rise more, it might have helped speed the recovery of the 2010s (not just through macroeconomic effects, but by hastening deleveraging).

So growth slowed and investment slowed; the Reagan program wasn’t fixing those problems. Meanwhile inequality soared during the years after 1980. Slowing growth and soaring inequality combined to produce a stagnation in median incomes after 2000.

There was an encouraging rise in the late 2010s, but not enough to shake the perception that progress for the average American had stalled. Americans were no longer doing better than their parents. Meanwhile, increased risk from the country’s broken health care system, a rise in evictions, the unemployment and house price declines of the Great Recession, and the vicissitudes of 401(k) programs meant that true standards of living performed even worse than the above graph suggests.

Thus it was clear that the Reagan policy program of tax cuts, deregulation, and welfare cuts wasn’t working. So we needed to come up with a new paradigm. We should have come up with one in the Great Recession, but we didn’t. Instead, it took COVID and the insanity of the Trump administration to push us over the edge and make us realize big changes were needed.

Well, we finally woke up, and here we are. The big changes are Bidenomics.

Cash benefits, care jobs, and investment

The Biden program is multifaceted — it includes things like support for unions, environmental protection, student debt cancellation, immigration, and a bunch of other stuff. But it would be wrong to characterize his program as merely a grab bag of long-time Democratic policy priorities. Three approaches stand out above the maelstrom:

Cash benefits
Care jobs
Investment

Cash benefits were at the center of the COVID relief bill that already passed. In addition to the standard COVID relief items (quasi-universal $1400 checks, special unemployment benefits, housing and medical assistance, etc.) there was a very big program that is officially temporary but which will probably be made permanent: A child allowance. It’s very big in size — $3000 to $3600 per child. There’s no time limit and no work requirement. It’s basically a pilot universal basic income program for families.

The second pillar of Bidenomics is care jobs. The new “infrastructure” bill includes tens of billions of dollars a year for long-term in-home care for disabled and elderly people. Biden has made it explicit since early on that he intends to make caregiving jobs a pillar of his strategy for mass employment.

The third pillar of Bidenomics is investment — government investment, and measures to encourage private investment. The former includes tens of billions a year in new research spending, massive construction of new green energy infrastructure like electrical grids and charging stations, retrofits of existing infrastructure (e.g. lead removal from pipes), and repair of existing infrastructure like roads and bridges. This will help restore government investment as a fraction of GDP, which has been drifting downward for decades:

In other words, if private businesses aren’t investing enough, have government plug the hole. But in fact it’s not just about plugging the hole, since things like a modernized electrical grid, a network of charging stations, and lead removal are not things the private sector is likely to do (or do enough of) on its own.

But the administration isn’t relying entirely on direct government action to lift investment — not by a long shot. First of all, infrastructure is a complement to private investment; repair roads, and private businesses will buy vehicles to take advantage of those roads. Government research is also complementary to private investment — there’s a clear pipeline from government-funded labs to privately-funded product innovation and the investment that goes with it. And finally, Biden’s clean electricity standard for the power sector, which will force all U.S. electricity to be carbon-free by 2035, will require huge private investment — in solar, wind, storage, hydro, and nuclear.

Note how little of this investment program relies on indirect investment incentives like capital gains tax cuts or depreciation allowances. Bidenomics doesn’t just turn the knobs and hope that useful investment comes out — it actively directs investment into particular sectors (green energy) and particular activities (science).

Together, these three things — cash benefits, care jobs, and investment — are the pillars of the new approach that’s going to replace Reaganomics. It’s not a direct one-for-one substitute, any more than Reaganomics was a direct repudiation of the New Deal. Instead, while there are some reversals, much of it is orthogonal to the old paradigm, because it’s focused on addressing the problems of today.

Bidenomics: Creating a two-track economy

Before I go on to discuss the justification for this new paradigm, I’d like to sum up all these “pillars” into one more-or-less cohesive vision of where I think Bidenomics is taking us. I think it’s aiming to create a two-track economy — a dynamic, internationally competitive innovation sector, and a domestically focused engine of mass employment and distributed prosperity.

I basically get this notion from Japan. In the 1970s and 1980s, Japan cultivated a world-beating export sector, based around all the companies you’ve heard of (Toyota, Panasonic, etc.). But this was only perhaps 20% of its economy, and the rest was a domestic-focused sector. Although some domestic-focused industries were highly productive (health care!), much of the domestic-focused sector — retail, finance, agriculture, utilities, and a few non-competitive manufacturing industries — was not very productive compared to the U.S. But those sectors did manage to employ a huge number of people; Japan has traditionally had very low unemployment, and that has not changed with the mass entry of women into the workforce since 2012. Japan in many ways built the most effective corporate welfare state in the world.

Biden and his people, I’m sure, do not want the domestic-focused sectors of the economy to be unproductive. But they want those sectors to do the heavy lifting in terms of giving most Americans a job, as they did in Japan. Those domestic sectors include the care economy, where Biden’s team believes much of future employment will come from.

This is partly a story about technology — automation, the end of mass manufacturing employment, etc. With even retail jobs commonly believed to be at risk from new technologies, many people look to care work as the last thing we know we want humans to do. But it’s also a story about globalization, and the shift of global economic activity from the U.S. to Asia. With Asia becoming the workshop of the world, the U.S., with its low population density and relatively remote location, has been forced to become something else — the world’s research park.

The U.S. still has the world’s best research universities, and an enormous concentration of talent from around the world. If we can sustain both those things, we’re well-positioned to continue to be the world’s idea factory; innovation is our comparative advantage. And as long as we do that, we will maintain highly competitive knowledge industries whose specialty is continuous innovation that’s downstream from government science — software, high-tech manufacturing, and pharma/biotech. That’s an assembly line even China may never be able to match.

But while this sector will generate a lot of productivity and a lot of export revenue, it is not going to employ most Americans. Instead, most Americans will work in less competitive, domestically focused sectors — selling houses to each other, pulling each other’s wisdom teeth, preparing each other’s food, bagging each other’s groceries, taking care of each other in their old age. That vast domestic sector will distribute the income generated by the highly competitive knowledge sectors (in fact, this is exactly how an agglomeration model of the economy works, as you can read in Paul Krugman’s book with Masahisa Fujita and Anthony Venables).

And that distribution of income via domestic industries is supplemented by active government redistribution of income — taking a bit of money from the Elon Musks of the world and using it to make sure the mass of people have a claim to food and houses and schools and medical care.

So I think Bidenomics, with its dual focus on research/investment/immigration and care jobs + cash benefits, is an attempt to boost both sectors of the economy at once — to make the export sector more productive while making the domestic sector better at spreading the wealth around. If there’s one unified characterization of the vision Bidenomics is creating for our future, I think that’s it.

Bidenomics and economics research

As with Reaganomics, Bidenomics is based on multiple sources of inspiration — economics research, political imperatives, gut instinct, wishful thinking, and so on. I’ll talk here about the economics part, since that’s the part I know the most about.

The idea that the U.S. needs more research spending probably comes from the work of Paul Romer. Romer was a pioneer of endogenous growth models, which said that the generation of new ideas is key to growth (he won a Nobel for this in 2018). That theory implies that if you spend more on research you get faster growth, and Romer has been vocal in promoting this idea. Also important is the recent research of Bloom et al. and especially of Charles Jones; these researchers suggest that we need to pour more resources into science to keep innovation going. John Van Reenen has done a lot of important work in this area as well; see his call for “innovation policy to restore American prosperity”. See also the work of Daniel Gross and Bhaven Sampat, as well as that of Jonathan Gruber and Simon Johnson, who show how the “spend more money on research” approach worked for us before.

The idea of cash benefits — without work requirements or time cutoffs — owes much to the work of Hilary Hoynes, who keeps a low profile but is incredibly influential. The child allowance is directly from a 2018 paper by Hoynes and Diane Schanzenbach. Heather Boushey, who works in the Biden administration, has been deeply influenced by this literature. Meanwhile, an increasing amount of empirical research is showing that unconditional benefits usually don’t stop people from working. See the famous paper on the Alaska Permanent Fund payouts, by Damon Jones and Ioana Marinescu. And see Marinescu’s 2018 literature review on unconditional benefits, showing that they don’t have much of a deleterious effect on work output, if any. That research basically debunks the “culture of dependency” argument, at least as far as unconditional cash benefits are concerned. Then see Henrik Kleven’s research on the EITC, showing that it was probably the cash benefit aspect, rather than the work incentive, that accomplished most of that program’s much-lauded poverty reduction.

As for Biden’s environmental focus, much of it comes from research outside the field of economics, but Martin Weitzman’s research on the risks of climate change deserves a mention.

This is an impressive body of research. It doesn’t constitute a slam-dunk case — nothing ever will — but it’s a heck of a lot better than a graph on a cocktail napkin.

Bold, persistent experimentation

There are some elements of the Biden plan I didn’t mention, because numerically they’re not very big. One of these is the industrial policy part of the infrastructure bill, which would create a new office in the Commerce department that would actively try to relocate certain industries and their supply chains in the U.S. This aspect of the bill is certain to cause the greatest howls of rage from various people who have decided that industrial policy is bad bad scary-bad.

There is little solid reason to believe that industrial policy is bad bad scary-bad. The case against it has always been far more based in dogma than in evidence; like regulation, industrial policies are so multifarious and complex that it’s not really possible to conclude that it “works” or “doesn’t work”. There is some research suggesting that it’s important — Ricardo Hausmann’s work on economic complexity, various research by Dani Rodrik, a few exploratory papers by the IMF, scattered studies on export subsidies, and so on. This literature is nowhere near conclusive; it doesn’t even agree on what constitutes industrial policy.

But that’s how policy actually works, in real life. There are things that experts think won’t work, based on theoretical grounds; until some bold policy entrepreneur or wild-eyed nutcase actually goes and tries these things, we won’t really know if they work or not.

A great example is the minimum wage. Back in the 1970s, economists almost all believed that minimum wages hurt employment a lot. But they had been getting too high on their own textbook models — when the evidence started rolling in, it turned out that minimum wage was a lot less harmful to employment than Econ 101 had suggested. That prompted people to dust off old theories like monopsony power to explain the newly realized facts. The pipeline here was 1) policy entrepreneurship —> 2) empirical studies —> better theory. Not the other way around.

I expect Bidenomics to contain a lot of stuff like that. Union policy. Subsidies for care jobs. Various new types of infrastructure. Industrial policies. Competitiveness policies vis-a-vis China. And so on. The three basic pillars I described above are the starting point, but they won’t be the whole thing.

That’s going to make a lot of people at the Cato Institute and the Heritage Foundation and the Manhattan Institute and other think tanks that still believe in the old Reagan orthodoxy pull their hair out. It’s going to ruffle the feathers of some economists who still think theory comes first. It’s going to worry older Democratic policy advisors who came up during the Age of Reagan and who still instinctively believe in technocratic knob-turning rather than in directly mucking about in the bowels of the economy.

And that’s OK. It’s good to have a “loyal opposition” that watches and critiques the new paradigm. Sometimes that opposition will be right; like every policy paradigm before it, Bidenomics is going to make some mistakes. That is the price of progress.

The key will be making sure the mistakes don’t get too big.

How Bidenomics could go wrong

Obviously I’m pretty excited about Bidenomics — I don’t agree with everything Biden is doing, but overall this has the general contours of the change I’ve long thought needed to happen. Still, there are some ways the program could fail, and I think it’s important to keep an eye on these as we push ahead. The main ones I can think of are:

1) Debt constraints. Biden has shown a much greater willingness than previous Democratic Presidents to borrow and spend, and the exigencies of COVID caused a big bump in government debt. Some people (mostly online meme warriors) believe there’s no constraint on government borrowing, and others believe there are constraints but we’re nowhere near them. I tend to think it’s not much of a problem right now, but I also recognize that the effects of government debt are not well-understood. If bond investors get nervous and long-term interest rates spike, the Fed will have to decide whether to push those rates down. If it does (perhaps concerned that failing to do so would cause government interest costs to spiral out of control), the result could be accelerating inflation. Or not. I don’t know, since I don’t understand the relationship between monetary policy, fiscal policy, and inflation, and I don’t think anyone yet does. But it bears keeping an eye on.

2) Ruinous costs. The U.S. has an excess cost problem in two big industries — health care (plus child care), and construction. Care work and construction are exactly the two biggest sectors that Biden wants to pump money into. Remember how when we poured all that money into California’s high-speed rail program and it became a giant boondoggle and lots of it got wasted and we didn’t actually get high-speed rail? If that happens with Biden’s new electrical grid etc., we’re in trouble. And if pumping money into long-term care just makes the cost spiral out of control, it will waste labor and add to our overall health cost problem. Either of those outcomes would depress productivity and growth, leaving a smaller pie to be distributed to the nation’s masses. Thus, in order to make sure we actually get bang for our buck, Biden and his team should focus on identifying and mitigating the sources of excess costs in construction and care, rather than just assuming that throwing more money at these things is enough.

There are other dangers, such as higher consumer prices from some of Biden’s less-well-thought-out industrial policies, but I think they’re really second-order compared to these big two. Of the two, I’m much more worried about the second one; excess costs are the big millstone around the neck of the U.S. economy, a looming problem that so far I haven’t seen either Biden or his Republican opposition talk or think much about.

But anyway, I don’t want to end on a negative note. Always remember that America needed a new paradigm. Our old one wasn’t working, and economic research and basic data analysis both suggested clear directions for change. There will be missteps and mistakes on the way to change. Many people will resist the changes, some for better reasons than others. But when it comes time to turn the ship, you must turn the ship, and that is what Biden is doing. Let’s see where it goes.

https://noahpinion.substack.com/p/bidenomics-explained

Why Wall-Street-Bet’s GME squeeze might not be good news many think it is…

Kevin Muir Jan 25

Say what you want, but this is one of the best trading markets I can remember in ages. For those complaining the moves make no sense – I agree! But – this is way better than those quiet-no-one-is-interested sleepy sessions.

This morning’s action was just plain wild. No other way to describe it.

Take a gander at the past two day’s of trading in Game Stop:

This is a stock that a week ago was trading at $40, and the week before that $20. This morning, it ticked north of $150. A few days ago, famed short seller Andrew Left from Citron Capital, withdrew from public discussions about this company after receiving death threats against his family. The absurdity of anyone feeling strongly enough to threaten death on someone with a differing opinion of a company’s prospects says a lot about the emotional nature of this market.

You see, a group of enthusiastic of traders on a reddit sub-group called Wall Street Bets (WSB), orchestrated a squeeze on GME. I won’t bother repeating all their scheming, but there is little doubt that this was a concerted effort by a group of traders to squeeze a heavily-shorted stock.

Now, you may believe anyone foolish enough to short a stock with such a high short-interest deserves what they get. I’m not here to figure out the morality of this situation.

Instead, I want to bring to your attention an often overlooked by-product of this recent market action.

This morning’s squeeze wasn’t just relegated to GME.

There was a whole host of heavily-shorted names that got ramped.

Bed, Bath and Beyond:

iRobot:

Express Inc:

The more heavily shorted the name, the more it was a target this morning.

The problems arise due to the fact that there are a whole slew of quantitative and fundamentally based large hedge funds short these names. For example, many on WSB were supposedly specifically targeting Melvin Capital’s large short book. When the stocks that these funds were short all collectively get squeezed, this increased the volatility of their portfolio.

Look at GameStop. Two weeks ago, $1 was considered a decent-sized move.

Earlier today, we were up over $90 at one point!

That’s an obscene change in the dollar value of an expected daily move.

This morning’s WSB concerted-squeeze ended up being a massive increase in the volatility of the short book for many of these hedge funds.

When this happens, these funds are faced with two unfortunate developments – P&L losses and increases in their daily VAR (value-at-risk). These two factors combine to force a general de-risking of the fund’s portfolio.

If you were wondering why Nasdaq all-of-a-sudden plunged this morning, it was most likely from this effect:

And this lesson does not apply solely to increases in volatility to the heavily-shorted stocks portion of a hedge fund’s portfolio. Any increase in volatility will often have the same effect.

The reality is that most modern-portfolio management uses volatility-of-returns as a method of “dialing” the amount of risk they are willing to hold. Some funds use hourly volatility, some use daily, and others use monthly, but make no mistake – the more volatile, the less risk these funds are willing to take.

So, ironically, this morning’s WSB squeeze that took many of these individual stocks higher, caused a general de-risking from many of the large sophisticated hedge funds.

And the real question is whether this selling starts a negative feedback loop.

I’m not smart enough to know the answer to that question, but I wanted to take a moment to explain why even though it might seem like the stock market bulls should be cheering WSB’s squeezes, their success might end up being the trigger that brings about the general stock market correction many have been waiting for.

Remember – increases in volatility cause general de-risking from hedgies and other quantitively-modeled funds. The greater increase in volatility, the more they have to sell.

Watch the VIX closely in the coming days. If we get an increase in demand for protection, this will also cause some “vanna” related selling which could reinforce the negative feedback loop.

The danger signs are piling up. I continue to trade defensively.

Thanks for reading,
Kevin Muir
the MacroTourist

Epsilon Theory: The Investment Thesis That Makes You Nod Your Head

by Ben Hunt

As I write this email, 10-year Treasury yields have spiked to 1.08% and stocks are at all-time highs, even though yesterday we saw a record number of Covid deaths in the United States and a mob storming the Capitol.

Why? Because our common knowledge – what everyone knows that everyone knows – is that enormous fiscal stimulus is coming soon (bullish!), and with that will come inflation (bullish?), and with that will come … something … that will impact our portfolios in a major way.

Every investor in the world is now trying to figure out that something. Every investor in the world is now trying to figure out what inflation means for their portfolio.

Here’s how it will play out in your own head.

Your first instinct will be to try to figure out on your own what inflation really and truly means for your portfolio. You will read about the history of inflation and think really hard about it. You will have some ideas and, depending on your ego, more or less confidence in those ideas. But then, on reflection, you will decide that you want to understand what everyone else thinks inflation really and truly means for your portfolio. You will do this by watching CNBC and reading Bloomberg Opinion articles and brokerage research reports and portfolio manager letters and the like. You will call this “doing your research” and “listening to smart people”. Over time you will begin to recognize a common thread running through what you hear and what you read. You will call this common thread an “investment thesis”, and you will find yourself nodding your head by the fourth or fifth time you recognize this common thread on what inflation really and truly means for your portfolio. You will begin to recognize this common thread in more and more of what you hear and read, and you will provide positive feedback in one form or another to the creators of this content. You will congratulate yourself on being smart enough to tease out this common thread from your “research” and you will begin to implement your “investment thesis” in your portfolio. Soon you will have conversations with other smart investors who have similarly identified this investment thesis from their research, and you will take great comfort in that. You will increase your position in the investment thesis.

I am not saying that your investment thesis is wrong. I am not saying that you will lose money with your investment thesis. On the contrary, if you are early with your investment thesis and that thesis evolves into common knowledge, I think you’ll do very well.

I am saying that what you call an investment thesis is, in truth, a narrative.

I am saying that the business of Wall Street and financial media is to create an investment thesis that makes you nod your head. I am saying that you will always find an investment thesis that makes you nod your head, and that this process of selling you an investment thesis that makes you nod your head is as predictable and as regular as the sun rising in the east and setting in the west.

Right now, Wall Street is trying to identify which inflation narrative will be an investment thesis that makes lots of people nod their heads.

This is what it looks like when common knowledge – what everyone knows that everyone knows – is being formed.

Recognizing THAT – and maybe even trying to get ahead of THAT – is how you play the game of markets successfully.

Louis Gave: Inflation Will Come Back With a Vengeance

Louis-Vincent Gave, CEO and co-founder of Gavekal Research, sees a dramatic paradigm shift playing out in the world economy. In this in-depth conversation, he explains how investors should position themselves for the future.

Louis-Vincent Gave is a master of the big picture. The co-founder of Hong Kong-based research boutique Gavekal is one of the most esteemed writers about geopolitical and macroeconomic developments and their impact on financial markets.

In this in-depth conversation with The Market NZZ, Mr. Gave shares his views on the Dollar, stock markets, oil and gold prices – and he explains why the United States are starting to act like a «sick emerging market».

This year’s debt buildup in the US has funded zero new productive investments. No roads, no airports, railroads, nothing: Louis Gave.

Mr Gave, 2020 has been a catalyst for some big shifts in the global investment environment. Looking into the future, what are the biggest topics for you?

I’ve spent most of my career in Asia, so my lens is fundamentally biased towards Asia. With that disclaimer, I would say this: When the Covid crisis started, the view in the West was that this would be China’s Chernobyl Moment. That they completely screwed up, which would eventually weaken the regime. Fast forward to today, and China comes out of this looking much better than most Western countries. If there is one big divergence in the world, it is this: In most Western countries, the population is angry at how their government dealt with the pandemic, either because they think the government did too much or too little. But in China, there is a feeling that there were two big crises in the past 15 years, the Global Financial Crisis in 2008 and now Covid, and China in both cases came out ahead of the West. Most of Asia actually came out of this much better than the Western world.

What else do you see?

When I look at markets, there are three key prices in the world economy: Ten year Treasury yields, oil, and the Dollar. One year ago, yields were going down, oil was going down, and the Dollar was going up. Today, Treasury yields are going up, oil is going up, and the Dollar is going down. This is a huge reversal. When I see a market where interest rates are rising and the currency is falling, alarm bells go off.

Why?

This is what you would see in a sick emerging market. If you’re invested in, say, Indonesia, rising interest rates and a falling currency is a signal that investors are getting out, because they don’t like the policy setting there. Today, the US is starting to act like a sick emerging market. We even have a question mark over whether they have the ability to run a fair election. Suffice to say that at least 30% of Americans believe their election system is rigged. This is mindblowing.

What’s the policy setting investors don’t like in the US?

Government debt in the US has increased by more than $4 trillion this year, which adds up to $12,800 per person. This is a world record, but actually most Western governments have gone on a massive spending spree during this crisis. In a way, they’re using the playbook that China followed after 2008, when they allowed a massive increase in fiscal spending and monetary aggregates. Today, Beijing sits on its hands in terms of fiscal and monetary policy, while the West knows no limits.

They’re doing it to soften the blow of the pandemic. What’s wrong with that?

When China did this in 2008, they funded massive infrastructure projects: airports, railroads, roads, ports, you name it. Some of these projects turned out to be productive and some not, but I always thought they would be definitely more productive than social transfers. But this year, the debt buildup in the US has funded zero new productive investments. No new roads, no airports, railroads, nothing. They were basically just sending money to people to sit at home and watch TV. In the end, this buildup of unproductive debt can be reflected in one of two things: Either in the cost of funding for the government, i.e. in rising interest rates, or in a devaluation of the currency. This is what the French economist Jacques Rueff taught us years ago. Very soon, this is going to put the Fed in a quandary.

In what way?

They will have to decide whether to let bond yields rise or not. If they let them normalize to pre-Covid levels, 10-year Treasury yields would have to rise to about 2.5%. But if they do that, the funding of the government becomes problematic. A 50 basis point increase in interest rates is equivalent to the annual budget for the U.S. Navy. Another 30 bp is the equivalent for the U.S. Marines, and so on. The U.S. is already borrowing money to pay its interest today. If rates go up, they’re getting into the cycle where they have to borrow more just to be able to pay interest, which is not a good position.

Do you expect the Fed to move in and cap interest rates?

Yes, I do. And when they do, I’d say the Dollar will take a 20% hit.

Ten year Treasuries currently yield around 0.95%. At what level will the Fed step in?

I think they will have to cap interest rates at 2%, otherwise the drag on the government will become too big. That question will arise rather soon, because come this spring, the base effects for growth and for inflation will kick in. Growth will be very strong, and so will inflation, which means that yields will quickly try to get back up to 2%.

«Capital flows into positive real rates just like water flows downhill.»

You recently wrote a piece where you recommended buying gold and financials to prepare for this event. Why gold, and why financials?

My base case is that Treasury yields will move up to around 2%, at which point the Fed will introduce some variant of yield curve control. In this case, the Dollar would tank, real interest rates would drop and gold would thrive. But maybe I’m wrong, maybe the Fed freaks out when they see inflation rising to 4%, and maybe they decide to let yields rise. If that’s the case, then financials will rip higher, driven by a steeper yield curve. So come this spring, if the Fed caps interest rates, gold will thrive, and if it doesn’t, financials will thrive.

But you’d lean towards gold?

Yes. It’s quite possible that in the coming weeks, the Dollar will rise while Treasury yields move up. This could provoke a sell-off in gold. If that were to happen, I’d take the other side of that trade, I would buy gold. But at the same time, you can buy out of the money call options on financials. That would be the hedge for the scenario of the Fed changing its mind and letting the yield curve steepen.

The Dollar has been strong for the past ten years. Has it entered a new structural bear market?

Yes, there is no doubt in my mind. A year ago, the Dollar was the only major currency offering positive real rates. My view is that capital flows into positive real rates, just like water flows downhill. Today, the U.S. has one of the most negative real interest rates worldwide. Given the year-on-year rise we will see in inflation this spring, real interest rates in the U.S. will drop even further.

Apart from negative real yields, what are the other reasons for the Dollar bear market?

We first have to ask ourselves why we even had a Dollar bull market in the past decade. The answer is the shale oil revolution. As the United States moved towards energy independence after 2011, its trade deficit shrank. The shale oil revolution meant that all of a sudden, the U.S. was no longer exporting money.

And that tide has now turned?

Yes. Oil production in the U.S. is collapsing. The Texan wildcatters have lost out in the price war against the Saudis and the Russians. U.S. oil production has already gone down 2.5 million barrels per day and is slated to go down by another 2.5 million over the next twelve months, because every major oil company is cutting capital expenditures. Just look at Chevron and Exxon, their capital spending plans over the next five years are at half the level they were in 2014. And so, as the U.S. economy picks up after Covid, America will be importing oil on a massive scale again. The U.S. will be back to exporting $100 to $120 billion to the rest of the world, mostly to places that don’t like America, who will turn around and sell those Dollars for Euros. This is bearish for the Dollar.

When we see the oil price heading above $50 again, wouldn’t that cause US production to rise?

You can’t turn up oil production like a tap. It will take at least a couple of years to come back. Plus, shale oil production in the U.S. was hugely capital destructive. More than $350 billion was lost in the shale oil patch over the past ten years. Look at the energy sector today, it’s at 2.5% of the S&P 500. When oil was at $10 per barrel, back in 1999, energy was 5.5% of the S&P 500. So I’m going to answer your question with another question: If oil prices go up, and the U.S. could produce more oil again, it would require hundreds of billions of Dollars in capex. Who will provide that kind of capital, with an incoming Democratic Administration that has been ambivalent about fracking? I don’t see it.

So we are moving back into a world where the U.S. is a structural oil importer and a Dollar exporter?

Yes. The seeds are planted. That’s a huge shift that I don’t think people are taking into account yet.

When the world economy normalizes after the pandemic, where will the oil price settle?

Before Covid, it seemed that the oil market had found a balance between 60 and 80 $ per barrel.

Is that the range we’ll head back to?

I think so, and for a pretty simple reason: Above 80 $, China basically stops buying. That’s a big difference relative to ten to fifteen years ago, when China hadn’t built any sizeable inventory and was a forced buyer of oil. This is no longer the case. In fact, you saw it during the Covid crisis: Between April and June, when the oil price collapsed, China imported about 13 million barrels per day, which was 40% more than normal. Clearly, they were building up inventory, taking advantage of the low price. China is the marginal buyer, and its behaviour is a key driver for the oil price: Above 80 $ they stop buying, and below 60 $ they buy in size. Incidentally, in that range, many oil companies make pretty decent money. Saudi Aramco makes a killing at this price level.

You see the Dollar in a bear market. Meanwhile, the Renminbi has strengthened significantly. Is that also a structural shift?

I think so. In the past, every time there was a crisis, the reaction of the People’s Bank of China was to freeze the exchange rate. During and after the global financial crisis, the RMB flatlined against the Dollar at 6.82 for two years. In 2015, when the Chinese equity bubble burst, the RMB was flat for several months. When things went bad, historically, they froze it. Not this year. This year, we saw the sharpest six month RMB rally in history. That is a clear change in policy.

What’s behind that change?

I don’t know, but the facts are clear. China today is the only major economy in the world that offers large positive real interest rates. Thus, capital flows into the Chinese bond market. The PBoC is the only major central bank publicly saying they won’t destroy their currency and they won’t proceed to the euthanasia of the rentier. The consequences of this are hugely important. A strong RMB is a fundamentally inflationary force for the world economy.

How so?

Manufacturers around the world have to compete with Chinese producers. Therefore, a weak RMB drives prices down, whereas a strong RMB drives prices up. You can compare it to the role of the Yen forty years ago. A stronger RMB means stronger consumption in China and Asia, and it means that whatever we buy from China is going up in price. It’s not surprising that as the RMB rerates, the U.S. yield curve steepens and oil prices go up: It’s all part of the same reflationary backdrop.

Given this backdrop: Do you see a return of structural inflation in Western economies?

Yes, I think inflation will come back with a vengeance. One of the key deflationary forces in the past three decades was China. I wrote a book about that in 2005; I was a deflationist then, as my belief was that every company in the world would focus on what they can do best and outsource everything else to China at lower costs. But now, we’re in a new world, a world that I outlined in my last book, Clash of Empires, where supply chains are broken up along the lines of separate empires. Let me give you a simple example: Over the past two years, the US has done everything it could to kill Huawei. It’s done so by cutting off the semiconductor supply chain to Huawei. The consequence is that every Chinese company today is worried about being the next Huawei, not just in the tech space, but in every industry. Until recently, price and quality was the most important consideration in any corporate supply chain. Now we have moved to a world where safety of delivery matters most, even if the cost is higher. This is a dramatic paradigm shift.

And this paradigm shift will be a key driver for inflation?

Yes. It adds up to a huge hit to productivity. Productivity is under attack from everywhere, from regulation, from ESG-investors, and now it’s also under attack from security considerations. This would only not be inflationary if on the other side central banks were acting with restraint. But of course we know that central banks are printing money like never before.

«I’m a big bull on Japan.»

What will that mean for investors?

First, there will be two kinds of countries going forward: countries that massively monetized the Covid shock and those that did not. I’d compare the picture to the late 1970s, where countries like the U.S., the U.K. or France monetized the oil price shock, while Japan, Germany and Switzerland did not. This led to a huge revaluation of the Yen, the Deutschmark and the Swiss Franc. Today, the Fed and the ECB were among the central banks that massively monetized, while many central banks in Asia did not. So I expect a big revaluation of Asian currencies over the coming five years, which in itself is inflationary for the world. If you look at the U.S. today, inventories are at record lows. With the economy improving in 2021, companies will have to restock, and they will have to restock with a falling Dollar. The Dollar is down 20% to the Mexican Peso over the past six months, down 10% to the Korean Won, down 8% to the RMB, so whatever Americans buy from abroad will be more expensive. Countries with weak currencies, the U.S. first among them, will have higher inflation.

Where will inflation rates settle?

I don’t know. There is the idea among central bankers that they can engineer inflation rates around 2.5% and keep them there. I doubt that this will be possible to control. But just for the sake of it, let’s assume they manage to do what they say, that they are the perfect engineers they think they are and get inflation at 2.5% for the next five years. Why on Earth would you want to own Treasuries at 0.9% or German Bunds at below zero? You don’t even have to get to a scenario where inflation accelerates to 4 or 5% to see that bonds are madness today. Even if central banks just manage to do what they say, you are guaranteed to lose money with bonds.

What should investors do to position themselves in this new world?

In the old world, where interest rates were falling, the Dollar was strong and oil was weak, you bought Treasuries and U.S. growth stocks and went to the beach. Now, the world has changed. This means you have to stay away from bonds and U.S. growth stocks. In a world of Dollar weakness, you buy emerging market equities and debt, and within emerging markets, I prefer Asia. In a world where either the yield curve will steepen or the Dollar will collapse, either financials or the commodities sector will be doing well. Everything seems to point towards commodities, including energy, but as mentioned, I’d still buy financials as a hedge against a steepening yield curve. So, in a nutshell: Buy value stocks, buy the commodities sector, and buy emerging markets. And for the antifragile part of your portfolio, buy RMB bonds and gold.

How about Japan?

Absolutely, Japan is in a stealth bull market, it has been very strong, and nobody talks about it. We never get questions on Japan from clients. I’m a big bull on Japan, it’s not a crowded trade, so I feel comfortable in it. In a world that is reflating, Japan typically does well. And in this unfolding new Cold War between the U.S. and China, Japanese industrial companies are well positioned.

Aren’t you a bit early in writing off big U.S. tech?

Growth stocks have had their run in the past ten years, with falling bond yields and a rising Dollar. In a reflationary world, they will underperform. Plus, tech is the main battleground in the war between the U.S. and China. I see the tech world breaking into three separate zones, one dominated by America, one dominated by China and India evolving into a zone by itself. You can own the champions in each zone, which means you can own Amazon or Google for the West, or Tencent in China. In danger are companies that straddle the two worlds. Huawei tried, and we saw it being killed. I see Apple at risk, too. I know I said this to you a year ago, and I turned out to be completely wrong, but I still think Apple is in danger, as it straddles the U.S. and Chinese tech spheres.

We should think of Taiwan the way we used to think of Saudi Arabia.

In the middle of this tech war sits Taiwan. What are your thoughts about Taiwan and the semiconductor industry?

Taiwan today is what Alsace-Lorraine was 120 years ago. There were two hugely important events this year that most people have missed because of the Covid crisis. One, the market value of the global semiconductor industry has moved above the market value of the global energy sector. The market is telling us that semiconductors are more important than energy; they are the commodity of the future. We should think of Taiwan the way we used to think of Saudi Arabia.

What’s the second important event?

At the end of 2019, the market value of Taiwan Semiconductor Manufacturing was $200 billion, while the market value of Intel was $350 billion. Today, TSMC is $450 billion, while Intel has dropped to $200 billion. Why? This summer, TSMC came out and said they can produce 7 nanometer chips and will be able to produce 3nm chips in 2023. A week later, Intel came out and said they won’t be able to produce 7nm chips by 2021. So in the summer of 2020, we witnessed the passing of the technological baton from Intel to TSMC. The leadership in the semiconductor industry now belongs to Taiwan.

Why does this matter?

It matters because Washington has decided to make semiconductors the battleground in its war against China. And that means that Taiwan is the battleground in the great conflict of the 21st Century, an island that Beijing regards as a renegade province, sitting 60 miles from its shore. Taiwan has always been a sore point between China and the U.S., even when Taiwan produced plastic toys and bicycles. Imagine if Saudi Arabia was a political uncertainty between America and China, where the regime depended on Washington for survival, but the territory was claimed by China. We’d be very worried.

How will that conflict play out?

I don’t know what will happen. But I’d just say that the fact that the Trump Administration decided to make semiconductors the battleground in its fight with China strikes me as extremely dangerous, given the fact that the U.S. has just lost the technology leadership baton to Taiwan. That, to me, will be the most important event in 2020, more important than Covid.

https://themarket.ch/interview/louis-gave-inflation-will-come-back-with-a-vengeance-ld.3307