Over the past 5 days I wrote this preliminary research note on the role of central banks in the coming Paradigm Shift. Based on my independent analysis, I think markets may have to move away from merely expecting risk events, political change and volatility episodes. Contingency plans are needed.
What we have in front of us, is a potential Paradigm Shift for the world economy and financial markets. The next 5 to10 years are likely to be very different from the past 20 to 40 years. Thus, investors and decision makers have to move away from the temporary crisis mindset, to prepare for systemic permanent changes & disruptions. I can’t be more precise than this: Some governments have begun preparations for them.
In recent years markets dealt with rather isolated voter revolts, terror attacks, small-scale wars etc. Well, that is about to change, in part, because Central Banks’ behavior is about to change.
I have written recently on how a convergence of tensions in the military-security-food-energy realms is on the horizon. This implies the growing likelihood of defense realignments, Trade Routes & Supply Chain disruptions, but also wars and natural disasters among a wider array of large scale/systemic events. At a recent gathering of central bank officials I explained how these disruptions will affect some of the largest economies and markets, to which sadly most investors are over-exposed. Also how religion in its different facets is shaping the rising powers in the East and South. The biggest winners will likely take consensus off guard. A whole industry’s Asset Allocation and diversification is optimized for the past 40 years. This is one of the most exciting times for active investors with strategic foresight and visibility.
The Coming Paradigm Shift and the siege on Central Banks – Vulnerable Markets
1) Focus on volatility vs lasting change & disruptions
We are currently seeing that more than half of all the global geopolitical & macroeconomic trends we are monitoring (they are 22) are overlapping. This is not the first time we see this, but it is happening as Trade & Geopolitical “Wars” are unfolding and the FED is normalizing Monetary Policy (thus, withdrawing excess liquidity) against investors’ resistance.
This means we are likely to see high levels of friction over the next 12 to 24 months. The first 18 months are of particular importance.
As I have warned repeatedly in the past, financial markets should prepare for a Paradigm Shift. Now it is near us. This is happening right at a time when for the 1st time in 21 years investors will not have the seemingly perfect shield of central banks they have enjoyed since the Asia Crisis. This shift is likely to allow for massive transfers and losses of wealth. Many banks and asset managers are not used to deal with geopolitical & political risks by themselves any longer. At many institutions the senior fund managers have only 5 to 10 years of experience. These managers know what it is to ride a full (normal) credit cycle and to really “own” geopolitical risk. They were simply not around before 1998. When I managed money in the 1990’s a seasoned veteran in the global investment industry had at least 20 or 30 years of experience.
Most risk-accustomed and risk-embracing investment veterans have moved on. They were replaced by an army of portfolio implementers, risk controllers, semi-passive & index investments and quant/algorithm models. The last 21 years as a whole were an amazing time for trend-following buy&hold investing. A whole era is coming to an end.
In denial of what is at stake?
Being a totally independent economist & analyst allows me to get strategists’ and economists’ personal views. And I see something unsettling in the expectations of their clients. They tend to believe that if markets throw a big enough tantrum, central banks will once again come to the rescue.
Sure, central banks could provide liquidity again to prop up markets, but unlike the past two decades, a growing number of policy makers are now worrying about their own survival or independence, and many are looking at the stormy clouds that are gathering over the horizon. Thus, policy makers are bracing for the challenges ahead rather than being consumed with keeping investors pleased. Given the over-extended central banks’ balance sheets, ultra-low interest rates and the complex geopolitical-political backdrop, an immediate return to active market support could expose central banks to serious political threats and possibly take systemic vulnerability to the maximum levels we have seen since WW2 or 1962.
No longer in the same boat .. Better times for active traders and PM’s
Most investors haven’t prepared for a possible paradigm shift in geopolitics and the political process in the near future. Economists, investors and business leaders are trained to see the political process predominantly as a mere temporary source of noise and disruption. Tracking the expectations of strategists and economists I can see that they still imply that the interests of central banks & investors are pretty much aligned. If you push investors at their assumptions, some would dare to tell you “we are in the same boat, they (policy makers) have to look after us. We are system relevant”.
The lack of strategic and geopolitical-political foresight among most investors is likely to finally seal their fate. This is good news for those investing in geopolitical and political FORESIGHT, the coming years could set them apart. Having said that, strategic foresight will not be enough. The next ten years will be a great time for active traders that have foresight. To take advantage of sudden events, the best ideas will need to be smartly “traded”. If you know what is coming and you have trading skills, you can survive the next 10 years and possibly make a fortune.
Yet, money will not be the best asset. Much wealth will be lost as easily as it was created in first place. The key for the next two decades will be Clear Foresight and Peace of Mind.
Vying for their own existence and facing greater challenges? central banks
That which is system relevant will become more complex in years to come. While so many investors are preoccupied with this year’s performance and the health of the Credit Cycle, here is a glimpse at the growing complexities that policy makers are bracing for:
Growing geopolitical competition between existing and rising powers, concerns about military security along the Maritime Routes – without it there is no Energy & Food Security for many economies, the breakdown of many traditional economic patterns (partly policy-inflicted), challenges by the far left, far right and now center political movements on central banks’ untouchability, growing rifts amongst central banks and the unprecedented convergence of military risks in the coming years, not to speak of natural phenomena.
As security or the lack thereof takes center stage, the interests of financial institutions will drift aside. Market tantrums are not going to be as effective as they were in past decades with policy makers.
Facing the growing convergence of all the above one central bank after the other is looking outside consensus. And understandably so. Academic and market consensus have utterly failed in recent years in foreseeing major shifts. Driven by both a regulatory onslaught and artificial market stability, market & academic consensus have unfortunately become tight too (closed ranks), co-dependent and partly auto correlated. But it was systemic. Even great achievements of Modern Financial Theory such as market portfolios, market consensus and benchmarking got a self-fulfilling “life and momentum of their own”, one few can afford to exit.
Political Process I – Polarization reminiscent of the 1920’s and 1930’s
The current political polarization has made many Western developed economies almost ungovernable and vulnerable – It has indeed badly hurt, if not obliterated, the traditional parties at the center that were the anchor of political stability, but also reform inertia: In France the traditional government parties imploded and many want the recently elected president to step down, in Italy a radical government empowered by dissatisfied & angry voters threatens the future of the EU-project, in Germany the governing coalition of CSU-CDU-SPD suffered massive defeats that led to Chancellor Merkel’s demise. Outside of Germany a huge number of impoverished citizens across the EU are open for radical ever less democratic solutions. The timing couldn’t be worse and the consequences for Europe and the global liberal order are far reaching. I see the writing on the wall.
One political discussion will accompany and possibly shape policy makers’ behavior in the coming years: The very policies central banks used to support markets (e.g. asset price inflation and zero interest rates) is seen as having advanced oligopolies, reduced competition, eroded the middle class and accelerated the political polarization that shattered the government parties.
Political Process II – Investors overlook Central Banks’ Status Quo is at stake
As a result of the above even political thought leaders within traditional center parties are seeing the shareholder-friendly policies of central banks of the past 20 years as a key source of social and political discontent. Even moderate politicians believe central bank policies have directly or indirectly increased the threats to democracy and the liberal order. The understandable but immediate concerted pushback by financial and mainstream media is proving counterproductive – many political leaders on all continents are discussing the options in private now. It is against this backdrop that I see a growing number of central banks struggling for their independence, if not existence, in the coming years. With changing geopolitical realities and failed policies, I expect ultimately a Currency Reform or Realignment. But this is not part of this report.
As we are tracking it, in more than a dozen nations, central banks may have to distance themselves from shareholders, big banks and large multinationals in order to deflect political pressure or avert limits to their independence. Many members of parliament across the Western world believe the collusion between central banks and big banks cannot be remedied – since banking is over-regulated, they are considering an overhaul of their central bank.
The odds are not good, because over the next few years central banks will be fairly or unfairly blamed for the vulnerable state in which many economies will enter the next disruptions and periods of drastic change. The fact that central banks had to step in and print money in the face of political paralysis and lack of reforms by the law-making and executive branches of governments is not dominating the political discussion. Not used to communicate with the public, central banks are likely to adapt or become the scape goats of politics.
Political Process III – Traditional parties see central banks aligned with big shareholders – Conservative parties see them aligned with globalist organizations
Traditional center parties are no longer unconditional supporters of central banks. Having suffered dramatic losses on the back of fierce political polarization, many disgruntled political leaders believe the rising left and right parties owe their massive growth to central banks’ rescues of big banks, negative rates and their somewhat risk-free financial asset inflation boom. They say this widened the gap between rich and poor, while eroding the middle classes. They conveniently omit the role of mass or illegal immigration and their own flaws.
The moral hazard exhibited in recent decades, the explosion of global trade benefitting foremost the economic rent of multinational oligopolies and large shareholders has led disgruntled politicians of traditional parties to see central banks as part of the risk to the democratic liberal order.
Now add the following. Rising conservative forces in Brazil, USA, Poland, Hungary, Austria, Romania, Japan etc. increasingly see central banks as a growing risk or threat to their nation’s sovereignty. The reason is that central banks are being “perceived” as much more loyal to a liberal globalist agenda than to their own nation states. How we got here is a long and intricated story of its own that goes beyond the scope of this research note. It suffices to say that both, defeated traditional parties and rising conservative parties, increasingly perceive central banks as a risk and part of their systemic problems. Central banks will have to get used to being the political scapegoat – Given the support of the financial press for central banks, the advance of this criticism is not public.
Do political advisers on the left, right and center have something in common in regard to central banks? Yes. Many are bitterly angry at the following: Zero rates led big firms to borrow money for “free” to take over rivals, lay off millions, increase dividends and buy back shares. None of which created much real economic value. Rather the opposite – Top executives and large shareholders reaped the benefits, while debt is everywhere. Oligopolies have replaced capitalistic competition and disrupted market economy’s self-regulating processes. The very thing central banks know struggle to cope with. The analysis fails to include the role of the executive & law-making branches, though.
Still, there are some differences: For liberal leaders oligopolies are also an ally – they help drive globalization and make nation states obsolete.
America’s foes are ready for the next systemic vulnerability .. Vulnerable 18 months for financial markets
Those who believe policy makers could soon inject massive liquidity again, may be in for a rude awakening. Should the FED prop up markets again in 2019 .. could initially lead to a welcome rally, but it could also bring the world to a very vulnerable place not seen since 1962.
The next major systemic weakness is likely to be seized upon by America’s foes. We ascertain a number of them are loaded and ready to take advantage of it. Also because time is running out for China, Russia and other US foes. After 2025 it will be tougher for them to challenge the USA (subject of another research project). Any major military conflict over the next five years could trigger a debt meltdown, a sovereign crisis, and a Currency Realignment. Those who assume cyber wars are benign, should realize that the USA now is ready to unleash a nuclear response to a cyber-attack or any attack on its ailing infrastructure. The power grid is terribly vulnerable and outdated, thus the USA is relying on radical retaliation.
I doubt the USA will risk this much to safeguard investors so soon after ten “fat” years. Nevertheless, my analysis shows that by 2H 2020 global geopolitical forces may allow Washington to resume a more active support for risk markets. It is the next 18 months that are of special concern – investors will impaired central bank shield.
Elections and Moral Hazard
The stock market is losing friends, Trump is one of them. Trump’s lip support for the S&P500 now sounds like his support for NATO. What happened? Some of the biggest firms and equity investors that benefitted from his bold policies, ended up supporting the House take-over by the Democrats. They also barely passed their big Trump windfall profits on to US workers. Over the next 18-20 months a good stock market will be “nice to have”, but I see Trump and Pence pushing more radically still unfulfilled campaign promises from 2016. At breaking point I see the White House prioritizing Main Street over Wall Street.
Our analysis shows the White House has already quietly de-prioritized large companies’ interests in order to advance the interests of US workers and consumers. Trump and Pence will want to reignite competition, affecting many big businesses in the USA that are de facto enjoying oligopolistic “windfall” profits. Health Care and Pharma are not the only possible victims. Domestic politics will matter: A big portion of US large cap stocks are owned by the richest 10% of Americans. Neither core supporters of Trump nor Pence. The demise or breakdown of oligopolies could help normalize the investment-demand-wage-inflation process. It could rally the conservative base and attract many former Bernie Sanders’ supporters.
Looking ahead ..
The likelihood of a major equity market meltdown over the next 18 months is at 30% – 40%. A global currency or monetary realignment over the next 5 years is above 20%. The likelihood that an aspiring power could use the next crisis or systemic vulnerability for a preemptive conventional/nuclear strike is up substantially, but it remains outside our main scenario. We are monitoring it though. With the world engulfed in the largest Arms Race in human history and growing tensions, war can no longer be ruled out.
The growing likelihood and advancing convergence of all the scenarios discussed above are integral part of the Paradigm Shift.
Europe, North America, Saudi Arabia and Israel are most at risk militarily in the next few years. Economically China and Europe could be devastated by any large scale war or any disruption of the Trade Routes. The only difference, China is preparing for it, while Europe is unprepared. And there will be winners of course. Countries like Brazil, Romania, South Africa, India etc. could benefit greatly. To what degree depends on their level of preparation and positioning.
Potential Market Impact of a Paradigm Shift in the Geopolitical-Political landscape
This is the current state of our scenario analysis for the most likely path ahead of us – how markets are likely to be affected by a paradigm shift in the geopolitical-political landscape. At the core of this report: investors will have to face a massive convergence of geopolitical risks just at a time when central banks won’t be able to provide the perfect shield they have so much endeavored to provide to investors over the past 21 years.
Although the facts and policy makers are all confirming our main scenario (as depicted in 2014-2H), we are working with a total of five Strategic Scenarios over the next two decades. They encompass the most likely path, but also four critical alternative scenarios with large potential impact on currencies, bonds, equities, real estate and private equity.