“Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world…
The best lack all conviction, while the worst
Are full of passionate intensity”
W.B. Yeats, “The Second Coming”
“I’ve seen the future, baby — it is murder…”
Leonard Cohen, “The Future”
This article was submitted for publication December 28, 2015.
Spengler is enjoying a good run — like Malthus, who appears to have missed his timing rather than the ultimate outcome, Spengler’s “Decline of the West” thesis is benefitting from a whole new lease on life. An increasingly profound sense of malaise now permeates the West. The American political process has been hijacked by economic interests, reducing its electoral process to a sad parody of Democracy; meanwhile, the European institutions and elites seem paralyzed, imprisoned in a dangerously outmoded political correctness rooted in 19th century liberalism, with a manifest loss of even the most rudimentary survival instincts.
The West spends increasing time looking into the mirror — and clearly does not like what it sees: a world seemingly drifting into madness and mayhem absent any single unifying theme. Into the mix go the oft-abused term “terrorism”, religious fanaticism (whether Moslem, Hindu or Christian), the radical curtailment of basic civil liberties facilitated by technology, the loss of credibility of institutions (in particular, governments and the mainstream media), the rise of non- traditional extremist political parties of the left and the right, armed conflicts in the Middle East, Eastern Europe and the South China Sea, massive migrations of people, and increasing ecological and climatologic havoc. The key player — the “exceptional power” — is becoming increasingly militarized, aggressive and assertive — but with its reputation for even minimal diplomatic competence in tatters.
Meanwhile, Europe gives signs of being afflicted with a death-wish, a prisoner of a tragically outmoded 19th-century liberal ideology, as the “conflict of civilizations” smolders along its periphery. Having lost all self-confidence, Brussels has allowed EU foreign policy to be hijacked by Washington with disastrous consequences: a true existential threat as millions of desperate refugees flood in, fleeing the conflicts triggered by the ignorant, arrogant policy of regime-change-without-obvious- alternative — reminiscent of the opening of the Roman Rhine Frontier to the Goths. Worse than a crime — a mistake.
Meanwhile, G7 debt levels have reached dizzying heights — given the failure to deal with the consequences of the catastrophic deleveraging of 2008 — the fundamental laws of economics have apparently been suspended in the name of political expediency. Despite unprecedented monetary stimulus, growth remains anemic and the middle classes are seeing income stagnation at best, at worst gradual impoverishment with the constant threat of unemployment/underemployment and social marginalization.
Beneath the surface lie several driving factors:
Periods of historical transition are by far the most dangerous — as in plate tectonics, when two of the plates making up the earth’s crust push slowly past each other forming earthquake zones — movement is blocked, pressures build silently below the surface — then catastrophically explode. The decline of the agrarian, feudal order and the rise of the bourgeoisie led to the events of 1789; the old European order fell with the Bastille. The subsequent advent of nationalism and millennialist ideologies led to the break up of the multinational Empires with the catastrophic ideological and the imperial struggles of 1848–1945 as the German plate collided with the rest of the European continent, leading to hitherto unimaginable devastation — by 1945 the two moieties had essentially nullified each other, leaving a vacuum filled by the bipolar US/Soviet world-order. Now, following the collapse of the USSR, the increasing economic distress in the Arab Crescent, the decline of Europe into irrelevance, and the inexorable rise of a powerfully capitalistic China as the global center of economic gravity are shaping a New World order in ways we can only guess at. Whether the current political institutions can manage this handover without another round of upheavals remains very much an open question. The danger arises not from intent but from accident — essentially none of the major actors in 1913 believed that a cataclysmic outcome would actually occur, all the while doing everything in their power to render it inevitable.
The secular rise of China has finally slinked into the Western mindset — despite the heroic attempts of the tame corporate media to reassure its readership of the continued viability of the post-war order, doubts as to the inherent superiority of our (pseudo-) liberal politico-economic model are taking root. It seems most unlikely that the fading “sole global superpower” — rudely awakened by a suddenly assertive China from its Panglossian dream of win-win solutions meant to assure its perpetual preeminence — will take kindly to its own relative decline. How this conflict will be managed shall be the key question for the remainder of our century.
The political preeminence of Europe and its post-colonial outgrowths was never meant to be a permanent phenomenon. Our historic perspective is limited by our lifespans — we easily enough forget that 15th-century China was the world’s leading power in terms of economics, demographics, urbanization and technology. Civilizations are cyclical, and China saw a long period of decline, culminating in the catastrophes of the 19th century. The fact that China — now either the world’s largest (in PPP terms) or second-largest (nominal GDP) economy — is back will probably not constitute a revelation; however, the complacent Western mindset has not yet begun to assimilate the profound consequences of this shift.
There remains one other key factor — angrily dismissed, widely denied and yet a mathematical certainty rendering the situation far more perilous than is generally perceived: despite the demographic stabilization/shrinkage in the old G7 countries the world is now confronted with the consequences of the ongoing demographic explosion with its attendant ecological and social dislocations. From the (black) Arab Spring to the “clash of civilizations”, the pressure of the inexorable increase in populations is the fundamental factor driving not just the ecological havoc, but also the political upheavals — currently most obvious in North Africa/the Middle East where there is no hope of feeding or creating enough jobs for the exploding population, but soon to be seen on a far wider stage. The outlook is distinctly not cheerful.
THE WIDENING GYRE
Those of us who had the foresight to be born in the 1950s enjoyed the best of all possible worlds — not just the efflorescence of technology and widespread material wellbeing in the industrialized world — but especially, that sense of unbridled optimism which in retrospect seems embarrassingly naïve. Constant progress seemed a given; parents enjoyed the comforting certainty that their children would live better than they had. All great problems were solvable — peace was assured by the new institution of the United Nations and the nascent European Steel and Coal community (the precursor to the EU) informed by the terrible lessons of the recent past. Resources were bounteous and there was no obvious limit to the earth’s carrying capacity nor to the prosperity of the ascendant middle classes.
Nothing illustrates the death of this model better than the meteoric rise of the alternative/fringe parties of the West. From Donald Trump (incarnating the rebellion of the increasingly alienated Republican masses against the self-interested oligarchy at its helm) to the parties of the European radical Right — in particular France’s Front National (a rebellion against the death wish of the European elites, coupled with a touching desire to reconstitute a mythical past). The collapse of the middle classes has destroyed the illusion that universal prosperity would be guaranteed by the free-market orthodoxy retailed by the corporate media — the puerile, vapid “Ayn Rand doctrine”. Meanwhile, the utter failure of the Soviet system and the Capitalist transformation of China have thoroughly discredited classical Marxist orthodoxy.
Political alternatives are thus increasingly negatives rather than positives — sharing an angry rejection of the status quo while offering little more than a desire to return to an idealized past. The established parties are fossilized — fundamentally irrelevant and representing little more than a job-creation scheme for their own bureaucracies, functioning by cooption. As the controversial Russian political philosopher Aleksandr Dugin has put it — the fault line is no longer between left and right — it is now between the centre and the periphery — both within individual countries and globally, yet even Dugin himself is quite unable to predict what will ultimately take the place of the failed political ideologies which are now collapsing.
HISTORY — ALIVE AND WELL (AND LIVING IN SARAJEVO?)
Political balkanization reflects the collapse of the initially bipolar, then briefly monopolar, post-war order — once described with unintentional irony as “the end of history”. History, of course, greatly enjoyed the joke — though rather than withering, it is now accelerating at a frightening pace.
Being a strategist is a thankless occupation — get it wrong and no one forgets, get it right and soon enough you find yourself being mocked for proclaiming the obvious. Having met with some derision fifteen years ago for his assertion that China would be the world’s leading economy by the third decade of the new millennium, the present author now finds himself uncomfortably consensual; while political power has been slow to follow, that is now changing — political hegemony has always and everywhere accompanied economic supremacy.
The speed at which American thinking on China has been transformed is a wonder to behold. The secular rise of China was greatly facilitated by the hedonistic, short-term policies of the Washington political establishment. The inclusion of China into the WTO allowed the US to import vast quantities of consumer goods paid for with fiat currency — crushing inflation and filling Walmarts with cheap trinkets to purchase social tranquility. The downside — deindustrialization and the destruction of the blue-collar middle class — was not an immediate threat to the interest of the financial elite; the political system did not channel the dissatisfaction of those whose futures were sacrificed; living standards stagnated but did not collapse — technological toys became affordable for all.
Given the short electoral cycle and the loss of any meaningful ideological orientation of the political parties, any problem not posing an immediate threat will be reliably handed off to the next administration. The Deng doctrine of hiding one’s light under a barrel had been intended to reassure and pacify China’s future competitors while The Dragon underwent the fastest industrialization in human history. Thus, it was only during Obama’s second term that the awareness that the US was being quickly overshadowed by China sprung into the collective consciousness. The Panglossian official US discourse had been self-serving in the extreme: the rise of China was to be a win-win process, with China becoming a “responsible global player” (i.e. placing American geopolitical interests above its own), while remaining militarily toothless and diplomatically subservient to Washington.
Needless to say, anyone remotely familiar with world history and the rise of new global powers would realize how wildly improbable this happy scenario was; however, the academic study of history was never the strong suit inside the Washington beltway, and in any event, given their absolute faith in American Exceptionalism, historical precedent was dismissed as irrelevant. Indeed, this misjudgment is not without parallel with events in the Middle East where desperately incompetent policy was erected based upon the childlike faith that the US model was so universally attractive that by simply eliminating secular but obstructive leaders — Saddam Hussein, Kaddafi, Assad — the populace would naturally choose a compliant, pro-Western regime, an absolute flight of fancy in a region currently undergoing a fundamentalist religious revival of epic proportions. It should have been borne in mind that propaganda is intended solely as an export commodity — it is desperately foolish to consume one’s own domestically.
Mr Obama has abandoned any foreign policy he may have once had to the hard Right of the Republican Party in tactical alliance with the equally militaristic Democratic imperialists clustered around Hillary Clinton. There is no mainstream Opposition, with the media serving as an echo-chamber at best. The problem, of course, is that this gives rise to flashes of tactical brilliance coupled with strategic idiocy. In particular, future historians — if any remain — will long puzzle over the thinking of the Western foreign policy establishment which, faced with the sole true threat to its global dominance, did everything in its power to drive a valuable ally — Russia — into the arms of China, an own-goal of epic proportions.
THE NEW COLD WAR — BIPOLAR DISORDER
Alongside reflexive militarization, the American response to the rise of China has been an attempt to create a web of global anti-Chinese alliances — the TTP, the TTIP and the successful push for the remilitarization of Japan. On the other hand, attempts to federate the ASEAN countries — in particular, those bordering on the South China Sea — are doomed to failure given their overwhelming economic dependency upon China. While countries like Vietnam or Malaysia may express outrage at Chinese territorial claims, their economies would collapse overnight were China to close her borders; this economic integration will only grow stronger over the coming years.
Returning briefly to the subject of our last submission to Marc’s opus — the US-sponsored coup d’état in Ukraine is working out very much as predicted: default, political paralysis — and of course, a few thousand dead civilians scattered around the devastated cities of Eastern Ukraine. The Kiev regime is headed by the same clutch of vicious, corrupt oligarchs who had been key to every previous failed Ukrainian government, but it is now prisoner to small, heavily-armed and openly fascist militias; what could possibly go wrong?
Whilst the catastrophe does not quite attain the magnitude of those following upon similar “liberations” in the Middle East, it is equally intractable. A political accommodation appears very unlikely. Crimea was never properly Ukrainian — having been handed over to Kiev within the framework of the USSR in 1954 by a slightly tipsy Khrushchev as a sort of birthday gift to the Ukrainian Soviet; needless to say, done without the formality of consulting with a Crimean populace which overwhelmingly welcomed the 2014 reunification with Russia (~90%, both by the results of the referendum and by repeated opinion polls since that time) — a fait accompli now tacitly recognized by all sides. The fate of the Eastern provinces — Donbas and Lugansk — is far more complex. These were part of the (artificial) modern Ukrainian state — though Russian in language and culture and largely apolitical, they had familial and economic ties with Moscow at least as strong as those with Kiev; it was the votes of this borderland population which elected Yanukovich in an election widely seen as free and fair, at least by local standards. No less corrupt than his US-appointed successor Poroshenko, to his credit Yanukovich refused to open fire upon his own people — both during the Orange Revolution (which removed him from power after a stolen election) and again, during its replay at Maidan, where a legitimately-elected (if corrupt and incompetent) government was overthrown by what was initially a popular protest movement gradually infiltrated by heavily armed militias funded and sponsored from abroad.
“The problem with Californians is that they think that death is optional.”
When men are confronted with unsolvable problems they reliably tend to shift their attention elsewhere — we spend rather too much time discussing symptoms while politely ignoring root causes. Much of the increasing chaos ultimately springs from a single driver — the continued explosive growth of one animal species — man; a theoretically infinite growth process is colliding with the limits of a large but distinctly-finite planet. The argument that Malthusian catastrophe has been wrongly predicted before is true but also irrelevant (the arrival of waves of desperate migrants onto European shores was also repeatedly predicted).
Those who wish to cling to the happy worldview may wish to consider some numerical data: Between Adam and Eve and the present author’s birth, then again from that momentous date until his 40th birthday, the same number of people were added to the world’s population — zero to 3 billion, then 3 billion to 6 billion … in just 40 years. At the beginning of that same period there were several million lions living in the wild — there are now an estimated 50,000 — sharing a rapidly shrinking habitat with at most a few dozen rhinoceri. Most commercially valuable fish stocks are now classed as endangered or critically endangered, while the phytoplankton content of the world’s oceans has fallen by an unimaginable 40%. Coincidentally, some 40% of the coral reefs are dead — with most of the remainder endangered. Nine of the hottest years in recorded history have occurred over the past decade. We could continue, but to what purpose? Those who would deny the obvious for ideological reasons — whether Young Earth creationists, or those who believe infinite growth is possible within the confines of a finite geophysical system — will remain impervious to rational argumentation, believing what they wish without reference to inconvenient realities; for the others:
While increasing wealth does indeed lead to a dramatic decline in birth rates, an increase in material wellbeing in the impoverished countries of Africa and Asia is impossible without population control. The highly successful industrialization of China was rendered possible largely by the draconian limitation of Chinese birth rates, allowing resources to be invested rather than spent on a burgeoning population; compare and contrast with India which has seen its population triple since independence (1947), currently growing by 1.58–1.70% per annum, with a 2.72/female fertility rate and 65% of the population aged 35 or younger. The obvious impossibility of properly providing for this booming mass of humanity is illustrated by the fact that despite impressive headline GDP growth, something between 21% and 24% of the Indian population lives beneath the (desperately low) official poverty line — US$1.25/day.
But for a better look at what awaits us one needs to consider the Arab Crescent — where the bounteous news flow is now largely driven by the consequences of uncontrolled demographics. Egypt provides an excellent example: during Pharaonic times the great Egyptian civilization comprised an estimated 4 million people; a couple of millennia later, by 1955 that population had increased to ~24 million; since then, it has more than tripled to some 86 million. Although the rate of growth has decreased from 2.54% to 1.80% (source: CIA Factbook), the absolute number of people being added each year has nearly tripled. Poverty is thus widespread, infrastructure desperately inadequate, and each year another wave of frustrated young males, frequently well-educated, aware of what is going on in the rest of the world, and with no hope of formal employment, marriage or formation of a family, provide more tinder for social explosions. This situation is mirrored throughout the Arab Crescent — thus the Arab Spring — as well as the explosion in fundamentalist religious beliefs, which tend to attribute to foreign conspiracies the economic consequences of the failure of their own societies to self-regulate. This is not specific to the Arab world; a bit further south in Sub-Saharan Africa, the situation is even worse. Nigeria awaits us (its population has almost quadrupled since 1950, and is expected to exceed America’s by 2050).
Out of courtesy to our readers and in keeping with the cheerful New Year’s spirit we would be delighted to end this first section on an upbeat note — some reassuring clap-trap about new technology, or Chinese exceptionalism, or the Great Earth Spirit that will surely save us. We shall instead leave a few blank lines for the reader to insert his own faith-based engines of salvation; we struggle … but since the Gloom, Boom and Doom Report is a financial publication we move on to the question of how to trade it.
HOW TO TRADE IT — WHILE AWAITING THE ASTEROID
(Drafted in late December 2015. The markets could have had the courtesy of waiting until we published to tank…)
Predictions are hazardous — especially as regards the future
Given the difficulty of hedging against a direct asteroid hit we shall leave the long-term projections to the futurologists. Our current event horizon is 18 months at best, and for brevity we will here stick to the markets we know best — Eastern European, Latam and Asian emerging fixed income — where a combination of high carry and extremely inefficient and illiquid markets affords some compelling opportunities to those instinctively distrustful of what they read in the WSJ/FT/ The Economist.
We were skeptical of global equity markets in 2015 — and were at least half-right. The emergings tanked; on average the G7 have gone precisely nowhere; we would expect considerably worse in 2016, and are keeping our fingers well clear of the machinery. Likewise, long dollar/short commodities must be the most crowded trade in the galaxy; caveat emptor — a lot of good news is discounted in the dollar rate, and if we are correct and the US economy is set to turn down, there may be a rush for the exits. We would be equally wary of any trade predicated on the expectation of a Chinese hard landing — we are always entertained by talk of a “crisis” in China as it somehow attempts to get by with ~7% GDP growth; would that Europe/US had that problem! There has clearly been a fundamental shift in the type of Chinese growth — away from basic materials towards technology and services, and the demand for minerals is unlikely to regain its previous trajectory; that said, we suspect that the magnitude of some of the price declines is more a function of speculative positioning than of supply/demand — and at some point it will have to reverse. Again, we are not getting in front of this trade.
Here on the ground in Moscow, following a period of confusion verging on panic in December 2014, Russian Central Bank head Elvira Nebuillina has done an admirable job of managing a very difficult situation, allowing the rouble to devalue in line with crude oil, thus cushioning both the federal budget and the profitability of the vital mineral extraction sector, preserving macroeconomic stability at the expense of popular consumption. We do not see the overall economic edifice threatened by any conceivable oil price — although already-anemic growth would be further impacted by further declines. (Beware: when considering the confidently bearish oil price forecasts of the experts, we would first enquire whether 18 months ago any had predicted oil prices below $40…we can’t remember any who did.)
2015 was a challenging year for Russia, almost entirely due to the collapse in global commodity prices. Western sanctions were something of a side-show; indeed, in our view, they should be seen as a net-net positive: Russian agricultural countersanctions led to the rapid growth of the agricultural and food-production sectors. (While the Soviet Union was once the world’s largest grain importer, Russia is now one of the world’s top grain exporters, and increasingly self-sufficient in dairy and animal protein.) The critically dangerous dependency of the Russian banking system on Western capital markets has been curtailed, although at the price of a sharp decrease in domestic investment; fortunately, and after some delay, Chinese capital is now increasingly replacing investment from the West. Sanctions on export of high-tech and oil-extraction equipment have been a total failure, simply allowing China to seize market share; Russian oil extraction in 2015 reached an all-time high (whether or not this was a wise policy is another question altogether). Finally, the sanctions have greatly accelerated Russia’s turn towards Asia, which (ex-Japan) has laughed off Washington’s attempts to force compliance with its sanctions regime [emphasis added — ed. note].
Given the uncertainty in commodity price outlook, we remain cautious about Russian equities and local currency, while continuing to favor the hard-currency carry trades (while the rouble is almost certainly a long-term buy, we would avoid catching falling knives). The Russian RTS equity index is a leveraged play on oil — if prices rebound to 60–80, there is a good 50% upside; if not — not. On the other hand, while just a year ago the readers of the Western financial press (the “pink paper”, in particular) were breathlessly warned of the coming wave of bond defaults in the Russian corporate sector, thus far, the count has been precisely zero, given the well-targeted government and Central Bank support for entities excluded from Western capital markets. Russian dollar indebtedness has declined by nearly half as companies have paid down their USD borrowing and found new sources of finance. On the other hand, profitability outside of the minerals and agricultural sectors has been sharply curtailed by the decline in the rouble (in parallel with plunging oil prices) and high domestic borrowing costs; while economic activity probably bottomed out a few months back, absent a sharp rebound in oil prices 2016 GDP growth will remain sluggish.
Those readers who followed our advice to buy selected emerging markets fixed income — in particular the Russian second-tier bank subordinated debt, and more generally, Russian corporate bonds — with side-pockets including Kazakh banks, the Belarusian sovereign, Chinese property and high-beta Latam — owe us lunch. Indeed, our core Russian bank trade worked out far better than we would have reasonably predicted had we known that oil was going to $37. (Smart is good … lucky is better!) Given the limited opportunities for local loan growth and substantial support from the Central Bank, virtually all of the Russian banks have been repurchasing their own debt — either by public tender, in the secondary market, or both. As a result, spreads are now back to their pre-crisis levels.
We missed the bounce in Ukrainian sovereign bonds (the banks/corporates have largely defaulted or been restructured) and shall continue to miss it — the government bonds are ultimately worthless as they will be increasingly subordinated to further IMF lending. Our deeply pessimistic predictions on Ukraine have, if anything, proved to be overly rosy, with the country currently spiraling into political chaos and economic depression.
As regards China, we cannot remember a year since 2000 which did not begin with dire warnings in the Western press of the imminent Chinese meltdown; during the ensuing decade-and-a-half we have indeed witnessed several meltdowns — none of which involved China (although the local equity markets have seen a touch of volatility). In the interim, China has grown to be the world’s top industrial and trading economy, with world-class infrastructure and rapidly increasing technological expertise. We are not betting against it.
The difficulty is, of course, that for offshore investors to make any money in China has proved very challenging. At some point the Shanghai equity market/casino becomes cheap, and we might be tempted to take a bit of exposure, but the best risk/reward ratio we can find is in the B/BB-rated USD bonds in the property sector — benefitting from the gradual recovery in housing prices and improved lending, as the government gradually winds down measures taken several years ago to restrain a threatened property bubble. While prices have currently rebounded from last year’s scare, incompetent Western journalism — verging on the frankly hysterical — will occasionally drive asset prices back down to bargain levels. Watch the news flow.
While we expect a further weakening of the Yuan against the USD (the Chinese central bank is now correctly targeting not just the dollar but a basket of currencies, all of which have declined against the ascendant USD), the risk to the property sector of currency mismatches is mitigated by the opening up of the domestic Yuan bond market, where the cost of funding is substantially below that of offshore dollar issuance. Finally, as for most of our preferred trades, there is an element of moral hazard, i.e. the Chinese government is keen to keep open channels of funding, and have thus provided some measure of support for what remains a key economic sector. Caveat emptor: bond documentation in this sector is very weak, although the sole major default to date — Kaisa — is slowly being restructured with its bonds having recovered most of their losses.
Elsewhere, while no liquidity-driven bubble could be uglier than the US high-yield market (verily an accident waiting to happen), we would be equally disinclined to touch those emerging bond markets fueled by cross-over investors squeezed out of domestic US high-grade and junk. In particular, we would avoid the now-popular African issuance — where the risks are not remotely compensated for by the spreads. Similarly, given the onset of the Fed tightening cycle (while we assume that, like the last ECB hike, this “cycle” will be stillborn and the next move by the Fed may well be to cut rates back to zero, this is still a matter of conjecture — we might be wrong), we would avoid investment-grade Asian and Latin American borrowers, while Latam high-beta and Russia are better cushioned against a rise in treasury rates. Our overweight Argentina played out rather better than expected — we would now trim exposure given our skepticism about the new Macri government. Highly risk-tolerant accounts may wish to hold some Venezuela PdVSA given the extremely high carry and continued Chinese support, albeit for a government which has given a whole new definition to the term “economic incompetence”. Finally, the Indian high-yield sector has been impacted by exogenous market factors, and selected issuers provide some tempting carry with very acceptable risk. Rolta is a personal favorite.
As Marc might put it, this is one of those times where the return of capital takes precedence over the return on capital — so, exercise caution in all things, “don’t invest money you can’t afford to lose”, and especially, do keep some powder dry to buy into the coming dislocations, as good assets become cheap during the occasional waves of panic.