I had discussed ESG in this previous article entitled: ESG: Externalities Unpriced, in an attempt to encourage a more rigorous analysis of ESG, arguing that ESG leads to better investment results due to a more comprehensive understanding of the factors surrounding a business so that these factors can be integrated into both risk mitigation as well as a business origination. This provides a more comprehensive picture for management in terms of control, and for shareholder in terms of allocation and governance.

Even with these ideals in mind, ESG is more complicated than I’d thought. And here we are not even talking about greenwashing but assuming good faith efforts in the pursuit of more sustainable business practices.

Purpose. The purpose of business is profit. It is practically intractable to maximize two measures at the same time unless we establish a strong dependence between the two. For a business to maximize profits and social or environmental impact is simply too difficult to do. A business should profit maximise. The reason ESG is important to a profit maximiser is that it increases the information available to management in their strategic planning. The objective horizon is important. Short term gains can be made through irresponsible behaviour which has long term costs. It is therefore important that management is incentivised to maximize value over sufficiently long time frames. Attempts to maximize measures other than or in addition to profit, present management with confusing mandates which risk management failure. This is an unnecessary risk and should be avoided. Businesses are expected to make money, and to avoid irresponsible practices while they go about it.

Identifying and prioritizing ESG factors. As ESG is a relatively new concept, the availability and quality of data is an issue. Business managers need to identify all factors which can impact financial performance and to determine the importance and priority of such factors to the business. The importance of a factor can vary over time and can correlate with other factors. For example, the climate impact of a firm can vary over time as its product line evolves. An fashion business that pivots from leather shoes to canvas trainers may need to address its water consumption or its use of recycled plastics. The social profile of a firm also varies with the evolution of its client base. As European fashion courted Chinese demand, witness Dolce and Gabanna’s epic fail in respecting the cultural sensitivities of its target audience in late 2018. Managers need to understand the risks and opportunities to their business more holistically, and ESG provides such a completion to the traditional financial metrics. Similarly, investors need to understand the scope and priority of the ESG measures managers focus on both to understand the business better, and to benchmark the performance of management.

The ESG label implies a systematic focus which sometimes obscures the bigger picture. ESG appraisals often focus on internal processes and appraises the firm in isolation rather than its role as a part of an ecosystem. A firm’s impact on society and environment begins before it acquires raw materials and persists long after it sells its product. The sustainability and financial fate of a firm is impacted by its sourcing decisions and its legacy. Using electric vehicles as an example, the non financial impact of battery manufacture often includes the consumption of massive quantities of water, in countries where water is inefficiently priced, and the use of exploitative labour practices to further under-state the true cost. The cost of recycling, decommissioning and otherwise disposing of lithium based batteries can potentially be put back to manufacturers someday, directly, or indirectly if buyers are charged decommissioning costs. Firms are best appraised within their ecosystem, and not just within their competitors and their immediate supply chain. Impact investing, which is distinct from ESG investing, has tools for measuring the impact of a business within its ecosystem, tools which it may be useful for ESG investors to borrow.

ESG heightens the trade-off between subjectivity and objectivity. In any form of decision making, such as in the field of investments, there is always a trade-off between a subjective versus an objective approach. The ESG investing industry is thus bifurcated. One camp prefers a systematic and transparent approach which is rooted in exclusions and inclusions based on objective ESG metrics. The other approach integrates ESG factors into traditional discretionary securities analysis.

The systematic approach is decisive, auditable and transparent. However, it is susceptible to type I errors, i.e. rejecting acceptable candidates. The integrated approach is less susceptible to type I errors, is not more susceptible to type II errors, that is, accepting an unacceptable firm, but is less transparent, less systematic and less decisive, often leading to more indeterminate classifications, that is, neither accepting nor rejecting a candidate. On the one hand, a systematic approach makes the investment problem more tractable while on the other the discretionary approach makes it more purposeful. Some investors take the view that their capital should animate social, environmental and corporate governance improvement and so favour the integrated approach. This necessitates the use of some impact metrics to validate the thesis. For most investors, some combination of the systematic and the discretionary approaches is useful. There will be type I and II errors but there are sufficient investment opportunities that some level of waste is acceptable. 

Measuring impact is hard to do. If one is borrowing impact metric measurement to augment their ESG program, it is important to be able to measure this impact. This is doubly important since our interest is ultimately not the impact itself, but its information content as regards the financial outcome. How do we know that the impact metric we are interested in has real impact on financial outcome, whether as a driver or a risk mitigant? This requires good econometrics. It also brings to the fore the problem of gestation. The investment community is focused on measurement, which is understandable, but often is unaware of the gestation periods between decision and result. In public markets, the availability of daily prices encourages very short-term expectations. Private markets dearth of pricing data encourages longer term expectations. In the area of non-financial impact, the lag between action and result can be considerable. In climate change for example, the consequences of current behaviour can manifest over decades. The desire for better and higher frequency data can encourage short termism. Also, the complex relationships in non-financial metrics require careful model specification, a problem compounded by the financial industry having a patchy track record in theoretical rigour. Impact measurement is an area ripe for further research. 

Common sense is not so common. There is sometimes a lack of common sense in investment management. The narrow focus on profit can lead to tunnel vision. Complexity replaces simplicity. Conventions which may be irrational persist due to investor inertia. Many ESG factors and considerations are a matter of common sense and not some specialized analytical lens. Many impact goals would evidently reward an investor seeking to address them since they address a present need. If there are persistent gaps and adverse outcomes, they are often due to market failures. Solving these market failures is more efficient than addressing the gaps and adverse outcomes. In fact, such gaps and micro failures can be outright profit opportunities to private capital willing to provide a solution. This raises the question faced by many a for-profit organization. Fix the problem once and for all, or provide analgesics for ever, bringing us back to the question of purpose.

 

Reduce equity exposure.

Equity markets have outpaced fundamentals recently. In any reversion to mean, equities will perform in line with fundamentals which suggests a much more moderate performance in 2020. On that basis alone, investors should reduce equity exposure. By how much? In a balanced portfolio with 35% in equities and 65% in fixed income, one might reduce exposure to 25% in stages. The economy is experiencing a short term rebound which could impact monetary policy expectations and lead to a weaker market. Further out along the horizon weaker growth could lead to re-emergence of rate cut expectations which could propel markets to higher valuations.

Maintain a close allocation to the MSCI World.

Markets are very flow driven which helps the simplest allocation outperform more sophisticated ones. Over the long term one would expect China and India to outperform. Moderate over-weights in those countries at the expense of US make sense, but one should not deviate too much. Sector deviations can be volatile this year.

There is opportunity to outperform in fixed income.

Reduce EUR and JPY duration. The ECB and BoJ are exhausted. Japan and Europe will turn to fiscal policy for their economic support and this will mean higher yields across EUR and JPY yield curves.

USD duration is complicated. Maintain a neutral to underweight duration exposure. The Fed has room to cut and could do so if pressured by the President or if economic data weaken. Fiscal policy remains loose and both political parties are not focusing on fiscal prudence. This will likely steepen the USD curve.

Maintain neutral IG corporate credit exposure. There is still some return to be squeezed from corporate credit. In investment grade, the long duration (circa 6 to 8 years) may call for hedging.

In high yield rotate from bonds to loans. The general duration + credit spread trade has done well but is long in tooth. Leveraged loans are a better trade expression. Very low duration by reason of floating rate coupons, senior, secured, and higher in the priority of claim, loans are preferable to bonds.

There is some opportunity in CLOs.

CLOs repackage loans into a variety of liabilities from equity to mezzanine to senior. In the current environment, the liquidity and balance of credit risk in the BBB segment is attractive. The time for equity investment is not yet upon us but if the economy slows and corporate balance sheets get stressed, be ready to buy CLO equity or junior mezz.

Overweight residential mortgages in the US.

The relative credit quality of household balance sheets relative to corporates’ or the states’ makes agency residential mortgage backed securities an attractive investment. Even here, pricing is tight but relative to everything else, there is still safer yield to be harvested.

Bank subordinated capital.

Last year was a very strong year for so-called CoCos. However, the market is still relatively cheap compared to non-financial corporate credit. 

 

Generally Cautious:

Hold a bit more cash in 2020 than in 2019. Resist the temptation to extend risk just to get that extra bit of yield.

Political risk is higher given the US Presidential elections. Trump can be even more erratic as he seeks re-election. Sanders and Warren, while long term positive for the US economy will be a drag on growth and markets in the short term. In Japan, Prime Minister Abe is in his final term. The China US struggle continues. A trade deal is likely to be cosmetic and represent short lived détente.

Valuations are high, not only in equities but in credit. Liquid IG and HY corporate bonds are unattractive. Yes, one could expect markets to tighten 50 yo 60 basis points over the year, but the risks are asymmetrical with a higher chance of widening. The yield compression from capital inflows from ETFs and tourists is significant and thus also is the unwind risk. Once attractive areas where the more sophisticated investor squeezed returns, i.e. CoCos, CLOs, ABS, are now expensive. They are not as expensive as corporate debt but their additional complexity and somewhat lower liquidity demands a higher hurdle.

The economy is slowing. The next 6 to 9 months may see some improvement but this is likely to be temporary. There are new innovations driving the next leg of growth. The trade war has reduced the productive efficiency of the economy. The acute inequality in the world has reduced the allocative efficiency of the economy.

Central banks are at capacity. If there is any serious slowdown, the ECB and BoJ are already at their limits. They have cut rates to below zero and are still buying bonds. The US Fed may have stopped cutting rates but they are also still buying bonds. The PBOC is operating a comprehensive policy of easing. Central banks did not reset their policy tools soon enough after the last crisis and their capacity to support the economy is seriously diminished.

Too early for distressed investing. But do the homework now. There are areas of stress and distress even in a period of growth. The large cap defaults are likely to be deferred at the expense of recoveries. Caution is warranted. When the corporate defaults come, the scale may be substantial and could take markets by surprise.

Bank Regulation. Banking regulatory capital requirements continue to support bank disintermediation and or bank regulatory capital arbitrage. Private lending continues to be a good opportunity despite a good deal of spread compression. Focusing on credit quality, covenant strength and collateral quality is key. Trade finance and real estate finance are areas of interest. So too are mid market senior first lien loans. 

Look for shorts. It is still too early for a turn in the economic or market cycle but scanning, filtering and looking for short ideas takes time and effort. Sometimes, they are easier to spot by their rarity.

Duration is not a haven. Fiscal policy is likely to push yields higher. Inflation may creep higher as the labour market gets tighter. Central banks being at the limits of efficacy also speak against duration. EUR and JPY duration are unattractive. USD duration is in an uncertain place. The Fed may cut further or extend the duration of their SOMA holdings but the balance of fiscal and monetary policy puts USD duration in a fine balance. 

The repo market is showing signs of strain. When QE was initiated the term structure flattened. When QE was tapered, the expectation was that the curve would steepen back up. It flattened further instead. When the Fed balance sheet was actually shrunk, the term structure actually inverted. In September 2019, overnight repo briefly rose to 10%, well beyond the Fed fund’s target range. This is an anomaly. The Fed has had to intervene in the repo market with large scale liquidity provision, and resume buying bonds at rate of 60 billion dollars a month, now increasing its balance sheet. They assure us this is not QE. It looks more like a QE trap. 

Prefer safety over gain. Generally, prefer value over growth, dividends over capital gains, senior over junior, secured over unsecured, and quality over yield.

 

 

The case for gold has never been stronger with the rise in geopolitical risk since 2016. Since 2000, the price of gold has risen sharply, at an annualized rate of nearly 14%, only to peak in 2012 before losing 40% in 3 years for an annualized rate of -7.4%. Since then it has risen erratically to the current height of over 1550, a gain of nearly 50% in 3 years or an annualized gain of over 9%.

The main uses of gold are jewellery and electronics. The rest of gold’s utility is as a store of value. Gold’s economic value is therefore mostly derived by its being an alternative to other financial instruments. It’s value derives from the value of everything else. When other currencies are debased, the value of gold rises. When other assets are debased, the value of gold rises. When central banks cut rates to zero, when bonds yield less and less, when there is a surfeit of money, the scarcity and constancy of gold enhance its value.

Gold is also a hedge against political and social uncertainty. As inequality rises and with it, social unrest, indignation and anger, the value of gold rises.

The value of gold to an investor depends on increasing turbulence in the socio-political landscape and having sufficient numbers of other investors who hold less gold than they desire (or no gold.)

The risks to gold are:

Political risks subside. This is unlikely to happen in the near term given the US elections, but politics is more unpredictable than the economy or financial markets. If anything, conditions are conducive to a rise in political risk.

Central banks stop debasing currencies. This is unlikely to happen, although the debasement is unlikely to accelerate since central banks are at the limits of monetary policy.

Deflation sets in. This could happen even in a growth scenario if technology advances sufficient or if central banks cut rates further. The latter dynamics are controversial but appear to be empirically supported. The Fisher Effect and inertia of real interest rates obtains this result.

So, to own gold or not?

When my analysts recommend gold as a hedge to the ills of the world, I see that gold bugs essentially need a world in trouble and all others to be unprepared, and I tell them, “find a better way.”

 

When yield curves are sufficiently flat, a duration matched steepener is a positive carry trade with capital gains potential and is a hedge for risk assets if the fall in risk assets is substantial. In other words, it is not a good hedge for small or gradual declines.

When markets are flow driven and capital causes convergence in asset prices, often the convergence overlooks quality. Long high quality short low quality credit pairs can be low cost, sometimes zero cost hedges for long credit portfolios.

Shorting funding currencies is another cheap hedge. When markets turn risk off, funding of risk positions is unwound putting pressure on low yielding (sometimes zero or negative yielding) currencies used to fund those positions.

Welcome to a long rambling piece about the economic and market outlook. There is a lot to think about but in the end, if all you are interested in is the direction of the financial markets, go to the end of the article on US Elections and Trump.

Geopolitics. A key driver of economics and markets.

In the China versus US conflict we have a good old-fashioned rivalry between a rising power and a declining one. The conflict is already joined on the trade front. It is unlikely that two powers who are already at high levels of wealth would risk a shooting war, however, proxy wars are possible. One is likely already being fought in Hong Kong. More will likely emerge in unexpected and exotic locales, such as cyberspace.

China is rising. Proof of this can be found in US policy towards China, surely a defensive response to what it regards as a threat to its hegemony. Economic growth will slow as it does in all mature economies. Constant positive growth implies exponential growth which is unreasonable. The nature of China’s growth is changing as well. Once the 52^nd state of the USA, tasked with being the cheap factory of America, China is shifting from exports to a balanced, self-supporting economy with a more diversified export base. The Belt and Road Initiative is very interesting and parallels the US Marshall Plan in some respects. It will extend China’s influence globally and further threaten the US hegemony. It is reasonable to expect an American response, but the scale of financial resources China is holding out to the rest of the world is probably more than can be ignored, even by America’s allies.

That the US is turning its back on the rest of the world does not help its own cause, as China further integrates into the international community. As America builds walls, China builds bridges. America’s trade war is not only with China but with its neighbours and with its traditional allies, the Europeans. Not only is America turning away from business with Europe, it is turning away from NATO. This is a puzzling strategy given that NATO was the martial plan accompanying the Marshall Plan to address a belligerent Moscow. The direction America takes will depend somewhat on the outcome of the 2020 US Presidential Election.

Europe is a weak point in the global economy, especially under conditions of trade war. Brexit will soon be underway robbing the EU of its business lobby. At the same time, German leadership of the EU may not be as certain as Germany herself faces political uncertainty in the post-Merkel era. Meanwhile Macron’s differences with the French people remain unresolved and Italy continues to be plagued by populist politics.

In all this, trust Russia to strategically align itself with the China bloc. Already Russia has aligned with India and China on military exercises as well as building parallel redundancies in financial infrastructure to reduce reliance on American standards. It is almost normal to expect more electoral interference by Russia in the coming US elections.

And speaking of India, the Prime Minister continues to operate a risky form of Hindu nationalism. Meanwhile the economy flounders as poor execution hamstrings an otherwise useful raft of reforms. Most recently, its insolvency law was confounded by an inexplicable ruling by the National Company Law Tribunal, the body to implement these very laws.

And finally, Japan, host of the Olympics this year. Who will replace Abe? The Prime Minister is in his third and final term as head of the LDP, although he may be able to get an extension for a fourth term.

 

Trade War.

As previously noted, the trade war is most visibly one between the US and the rest of the world, with special attention paid to China. If successful, the US will have reduced trade account imbalances, caused a great unwinding of globally supply chains, catalysed a spike in capital expenditure as capacity is relocated globally, and led to more robust but less efficient production. The result is likely to be higher prices at each given level of growth. This limits already limited central bank policy. Simply, it means either higher prices or lower growth and less capacity for policy to deal with it.

 

Fiscal and monetary policy. Central banks at their limits.

10 years of loose monetary policy has inflated assets while failing to raise growth or inflation. Orthodoxy is slowly pivoting towards fiscal policy.

In 2019 we saw the US Fed do a U turn and reverse its rate hikes, not only cutting rates 3 times but basically restarting QE and calling it something else. Most other major central banks were already in easing mode. The ECB had previously contemplated reversing QE but realized that the economy was too weak for that and in the end had to formally restart QE and cut rates further into negative territory. The PBOC had been easing all year, albeit in less noticeable fashion.

Why the need for so much monetary easing? The global economy had begun to slow, in part in line with its natural cycle and in part to do with a trade war. Either way, regulators were unwilling to let nature take its course and thus had to cut rates, buy bonds and provide liquidity somehow.

The ECB has recognized that it is at the end of its monetary rope. The negative rates are waterboarding the financial system. Banks, insurers and pensions are suffering. Outgoing ECB president Mario Draghi called for fiscal help even as he announced QE and a rate cut. Incoming ECB president Christine also called for fiscal help further signalling that more monetary easing would be of limited utility.

Among central banks, the ECB and BoJ are probably at zero marginal effectiveness. The US Fed has room to cut and may need to do so just to maintain the economic status quo. The PBOC has its own toolkit and is far from exhausted.

This fiscal policy. Europe has the most reason and room to do it but has political frictions to overcome. In the end, the relative weakness of the German economy will likely lead to some give from the Germans. The other members of the EU are less likely to press for budgetary discipline.

In the US, the Republicans are most likely to maintain fiscal discipline except that they are led by Trump, a natural profligate. The Democrats are unlikely to be any more disciplined given their current agenda.

Fiscal policy seems almost like an idea whose time has come again.

The textbook dangers of unlimited monetary and fiscal support are excessive and rising national debt and the eventual loss of confidence in policy and currency leading to runaway inflation or a currency crisis. This has not happened in Japan where nearly 3 decades of constant support have failed to either provide results or induce a crisis. Whether such policies can be operated elsewhere with such benign and ineffective results remains to be seen. Japan might be a special case.

A more fundamental question is, what is the right level of growth that policy should aim for? Is it that level that maintains low unemployment? And what if inflation resurfaces?

Since the 1980s most policy responses to recessions have been monetary which exerts downward pressure on interest rates. The engagement of fiscal policy exerts upward pressure on interest rates and will have unfamiliar implications for markets and the economy. Additionally, fiscal policy is not only an economic decision but involves many political ones and can raise lines of division.

 

Inequality. Beyond fairness.

In a knowledge economy the ability for capital or institutions to accumulate generations of intellectual capital versus a human being’s ability to store one lifetime of IP encourages a chronic decline in labour’s share of output. Owners of capital benefit from passive accumulation of intellectual property and hence wealth whereas labour must constantly actively acquire intellectual capital to maintain relevance. This increases inequality, potentially without bound.

In many countries, electoral success correlates with the ability to raise campaign finance such that political outcomes are influenced by wealth. Political lobbying is also a costly activity further biasing outcomes towards the interests of the wealthy.

Inequality in moderation encourages progress. However, excessive inequality lowers the informational efficiency of an economy and lowers growth. It is also a risk to social order. The awareness of inequality has risen in recent years. When inequality begins to feel like injustice, social stability is threatened. Dissatisfaction can manifest in many ways which may be appear only tangential to the real issue.

Greater inequality also means more financial investment which means richer assets. That inequality slows growth by skewing the marginal propensity to consume of a population means that demand for financial assets rises as growth slows leading to higher valuations.

 

Global Outlook

A temporary respite. A difficult future.

Growth had slowed but is currently flattening out. Expect 6 months to a year of recovery in the global economy but that this is only a temporary respite as the world reorganizes itself to a new trading environment. It is likely to be a capex driven recovery as new capacity is built and old decommissioned in the reorganization of supply chains. Beyond this, there is unlikely to be any game-changing technological advance to drive growth to a protracted and new cycle. Growth likely peaks within a year.

With the supply chain reorganization following the trade war, inflation is likely to resurface. Fiscal policy, if engaged by then, will keep economies at close to full employment and could fuel more price pressures.

US equity markets have done well in the past year and are expensive. For them to rise further would require rising earnings, a cessation of trade war, more rate cuts or rising share buybacks. If the US economy slows, the Fed could resume rate cuts. It is already operating QE in all but name. Rising earnings or a cessation of trade war are low probability events. For buybacks to re-accelerate would require low interest rates.

There is a heightened risk of underperformance from US equities relative to the rest of the developed markets.

Credit markets should correlate well with equity markets. Duration is another story. There is significant risk around duration as geopolitics impacts the treasury market. The Presidential Election coupled with threat of a Trump impeachment, will add volatility. One should be cautious around duration exposure, which will be less predictable than credit spread exposure. Household credit (RMBS) is preferred to corporate credits. Floating coupon is preferred to fixed. A year’s outlook is too short to prefer IG or HY with the preferences probably switching through the year.

European equities also did well despite a weak economy, so even Europe is no longer cheap. European rates have been cut to rock bottom and it is hard to see any more rate cuts, or acceleration of QE. If fiscal policy is engaged, the EUR curve will likely steepen. European equities, however, are supported by cheap funding which is advantageous if they do significant business outside Europe. For banks, a steeper term structure will be a relief. Apart from banks, European equities are at risk of underperforming developed Asia.

European credit will correlate with equities. The IG term structure has done well and there is no need to extend spread or rate duration. The duration outlook is less rosy as fiscal policy looms in the background. CoCos have been an area of focus and while the outlook remains good, extension risk will have to considered.

China’s growth while slowing remains high. Also, there is some visibility to future growth as investments in Belt and Road Initiative pay off. This is, however, not a 2020 trade but one for the longer term. The PBOC is likely to remain accommodative and provide significant credit and liquidity via the formal banking system. In the shorter term, this dovish monetary policy is likely to drive equities.

The credit market will be more challenging. It is clear that China is balancing between stability, which it craves, and a more robust credit system. Robustness requires a working NPL resolution process, which by definition involves some level of instability as companies file for bankruptcy or default. The market may take some time to absorb this new reality. It is best to avoid any reliance on moral hazard, and to remain with quality credits until bankruptcy becomes part of the normal course of business.

 

US Elections and Trump:

Many factors can move the market but at any one time, only one does. The challenge is identifying that one factor. In 2019, that one factor was central bank policy. It doesn’t mean its easy to figure out the market, since its just a transformation of the problem from figuring out the market to figuring out central bank policy. Sometimes, central banks themselves can seem a little lost.

In 2020, financial markets will likely be driven by geopolitics. 2020 has not a busy election calendar except for the US Presidential Elections. The European calendar is fairly quiet, though ructions can arise off-calendar. French PM Macron’s ratings seem to have stabilized after falling sharply during his spat with the gilet jaunes. Even with impending Brexit, the UK now seems stable as the recent election allowed PM Johnson to consolidate his control. The risk may come from Germany, the pillar of stability which is now rocked by the rising support for AfD and the challenge Merkel successor Kramp-Karrenbaur faces in holding her coalition together. Spain seems to be seeking to form a government on a continual basis.

The most important event in the calendar will be the US Presidential Elections. The incumbent Trump heads into battle under the shadow of impeachment. His strategy for staying out of trouble and in the White House will determine influence the path of international and domestic politics, which will in turn impact markets in 2020. Given also, his psychological profile, President Trump will make this election all about him.

 

Trump versus the Fed.

Having won previous rounds, there is a good chance Trump will continue to harass the Fed in 2020. The economy is slowing and data could support a resumption of rate cuts. That said, given treasury issuance and a possible international buyers’ strike, the Fed may face a steepening term structure even if it keeps short rates low. Trump may pressure the Fed to restart QE. The Fed is in fact already back on QE, just not calling it that. On balance, short rates are capped and could be cut. In the longer term, inflation will likely support the term structure but in the short term, the curve might go nowhere.

 

Trump versus China.

This is a fundamental struggle and one that will not go away. Here, Trump finds bipartisan support, although his methods may confound the more strategic plans of business leaders and more strategic minded policy makers. Before you wage war, get your assets out of there. Expect a disengagement of commercial interests and supply chains. The result will be slower growth, higher inflation and in the interim, a rise in capex.

Taiwan holds elections this Jan 2020. The result will hold opportunities and risks for both China and the US. For the US, Taiwan is an opportunity to stir trouble in China’s backyard. The strategic goals are not clear, but it would be too good an opportunity to inconvenience and embarrass China if a pro independence party won the election, or if a pro-China party wins, to stir up protest and revolt. If this happens, it could be the start of a threat to the semiconductor industry and their clients.

The ongoing Hong Kong troubles are an excellent area for stoking trouble for China. If the US has not already done it, it would make sense for them to fund, instigate or otherwise encourage more anti-China sentiment and action in Hong Kong. This could lead to another year of underperformance for Hong Kong stocks.

There is a risk that Trump’s engagement with China becomes more reckless and takes on a military dimension. This could arise in the South China Sea. Such a conflict has the potential to ignite acute risk aversion globally.

However, given China’s rising strength and influence, Trump may be more careful to pick a fight he can back out of, or win easily.

 

Trump versus Europe.

The Trump view of Europe is a transactional and tactical one. President Trump has cited contributions to NATO and bilateral trade deficits with the EU as areas of concern, seeking to extract greater commitment from Europe on defence spending as well as efforts to close the trade gap. It appears that Trump has abandoned a 70-year-old thesis that a strong and united Europe is good for America. Complicated relationships between Russia, the Middle East, Europe and the US are likely to create more tensions.

In an election year, Europe is a good target. It is still a friend and it is relatively weak. For Trump it is important to engage in a fight he can win easily and or back out of, which could be difficult with China.

 

Trump versus the Middle East.

In a region where the line between friend and foe is sometimes blurred, the aggressive approach of President Trump is likely to stir up all sorts of uncertainties. Generations of strategic thinkers have grappled with the issue in the Middle East with limited durable success. The Trump approach is likely to alienate some friendly forces while the risk of making friends of foes seems remote. Depending on the European response to Trump’s Middle East policy, the risk of further tensions between Europe and the US are heightened.

Buy oil, gold and TIPs. Keep duration short but non negative.

 

Trump versus Democrats.

At this time the Democrat front runners are Biden, Sanders, Buttigieg and Klobuchar. So far, their campaigns have been too much about Trump. Can the moderates compete against the erratic charisma of Trump? Will the progressives alienate the people? A Warren Presidency would be good for America, but only if she could do two terms and the benefits would only accrue to her successors. Warren would be immediately painful for America, like bitter, necessary medicine. A Warren or Sanders Presidency would be negative for risk assets but an opportunity for healthy reform.

Bet long the moderates, and short progressives.

 

Trump versus Russia. Its complicated…

Central planning is superior to free markets if the central planner has perfect information, and acts in good faith. Free markets are better when information is imperfect. When information is localized by a factor or location, decentralized groups can process information more effectively. These groups, can be regarded as centrally planned cells within a neighborhood in which information is close to perfect. They are then able to optimize locally and then interact with the rest of the system on the basis of the price mechanism. 

In reality we do not have a free market system. What we have are mostly centrally planned firms which interact with the economy on a market based system.

The rise of mega sized corporations is a manifestation of better information. For a given quantity and quality of information, there is an optimal firm size. Any firm which grows beyond this size is at risk of failure.

Entire economies may attain a certain level of information quantity and quality that makes central planning superior to decentralised market based organisation.