GLOBAL RISK MONITORING reaches critical threshold. One of 15 factors is Geophysics: USA at risk?

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For the 1st time since 2008 our GROM Global Risk Indicator has reached the critical level of 9 (1 – 10).

By Christian Takushi MA UZ, May 6 2015.

The Global Risk Level has now reached the threshold of 9. Based on our experience with models, we should say that this doesn’t necessarily mean that a Crisis is about to break out or is imminent. It shows rather that we are entering a space where the conditions are present for a major global crisis or a serious cascading of crises. Put it simply, monitoring 15 major global sources of risk and tension, we can say we are headed into a volatile 2nd half 2015.

Actually it is the first time since 2008 that we have a reading of 9. With crisis’ ingredients now present – something many observers are unaware of – the current global convergence or overlap of trends is not limited to the conventional macroeconomic and geopolitical realms. Other trends even in the realm of religion and our physical-natural world are interestingly overlapping one another during 2015-2018 as well. In other words, we are dealing with an unprecedented convergence process. Therefore a serious crisis could cascade into multiple spheres of life and society, reaching beyond the monetary system and financial markets – resulting in a super crisis.

Being critical with every risk model, ours included

Screen Shot 2015-05-13 at 12.54.41 PMHaving said that, with the high level of control by policy makers over financial markets, only a significant event or array of events is likely to unleash a major crisis. A small to mid-level event is likely to make policy makers intervene directly and quickly in the aggregate supply and demand, for instance by lending to businesses, buying bonds, REITS and equities to keep asset prices where they want them to be. Central bankers will try again to support economic activity by supporting asset prices. Thus, policy makers could be able to contain a small to mid-level event. But the point I want to make is: over the next 3 years a significant or major event is likely, either completely external or resulting from the friction of several trends overlapping with fury. Such a significant event or overlap could additionally shock most of the over 15 global risk sources we face, allowing them to reinforce one another and cascade. Such a super crisis would overwhelm policy makers, too used to be able to control supply, demand and interest rates over the past 5 years.

Nevertheless we cannot rule out, that despite a heightened risk situation at several regions, i.e. Ukraine and the Middle East, we could see the Global Risk Level dropping from 9 down towards 8 again. There are 12 other risk factors (economic growth, monetary policy, food security, geophysical & climate stability etc) that could decline and allow for a global relaxation of tensions.

Additionally when a model output reaches a threshold, we should interpret that number as being a stochastic (i.e. a probabilistic or approximate figure) rather than an exact figure. Thus a reading of 9 is in fact an approximation (of the true value). We all should enjoy model results with caution and even a healthy disbelief, since models simplify reality and use assumptions to achieve their goals. In that sense they are an aid, a helping tool to an informed mind. Economic and financial history is littered with disasters, because of excessive reliance on models and computing power. We must keep our common sense and proactively balance different or opposing perspective before reaching any conclusions.

Policy makers have become a double-edged sword: Unlike past decades, policy makers now dare to directly intervene in the market functioning, effectively at will without restrain and oversight. Central governments, parliaments and citizens tolerate this out of fear of recession or crisis escalation. This interventionistic mindset is dreaded by many macro economists, that see in it the factual de-activation of our Free Market Economy. Some see already the terminal fading-away of the Free Market Economy. From a pure macroeconomic perspective I agree with this view, but as a geopolitical economist – obliged to a broader research scope – I also see the positive side-effect of an interventionistic policy-making mindset, because very bold swift policy action can contain a crisis from spilling over or spiraling. Thus, if the crisis is diagnosed early on, it is possible our policy makers will intervene decisively and effectively contain it. The downside is, policy makers are getting used to control or manipulate markets rather than working to prevent crises from breaking out. Another side-effect is overuse: like the EU avoiding meanwhile to really solve any crisis. Why solving a crisis in 3 months if we can get away with solving it over five years – policy makers don’t want to be without the extreme executive powers that a crisis gives them. And it works, continued crises force individual nation states to transfer sovereign powers to Brussels.

On the one hand, policy makers have had to deal with several crises over the past 5 years alone, thus they are crisis-tested. On the other hand, with more than 10 major global crises since 1998 and a long array of never-ending simmering crises (i.e. European debt crisis) to deal with, many policy makers and investors are crisis-fatigued to say the least. This in itself is of course another risk, because many investors are no longer paying attention to new crises, many have reached their saturation point. In fact the many crises since 1998 have taken their toll in the health and mind of many policy makers, investors and corporate leaders.

Keeping the balance: There are areas of improvement in our world

Monitoring over 20 major global macro and geopolitical trends, one could get too negative too soon, and we don’t want to do that. Three examples: (1) The US economy typically picks up momentum in the 2nd or 3rd quarter and that should help us until the late part of the Summer. (2) The excessive concentration of the global supply chain is being contained. Firms and governments even from Asia – faced with an ever more aggressive China – are trying to reduce their huge dependence on China production, shifting new production to other world regions. This is helping to gradually reduce the hugely clustered global supply chain since 2011. A process that started with Fukushima waking up World leaders to the unhealthy dependence on China-Taiwan-South Korea-Japan for key parts and products. Nevertheless the West realized this strategic mistake way too late and sits in the trap. It is very difficult to move the gigantic core of the World’s supply chain away from North-East Asia. It is an intricate laberynth of suppliers and intermediary firms. You need to build all that at every new regional supply chain hub. Nevertheless the tedious “de clustering” process has begun, meaning China doesn’t have to smile at Western firms anymore. (3) the formerly rapid shift in the balance of economic power – in favor of Emerging Markets – has slowed down thanks to the crises and structural imbalances affecting Brazil, China, India, Russia, South Africa and Turkey. Any rapid change in this balance of economic power creates friction, uncertainty and fears.

A vulnerable global financial system, but a resilient world economy

Having worked with mathematical models over the years, we’ve learnt through negative experiences the need to compare their results with economic theory and common sense. And our Risk Model does confirm what we see in the monetary system, economics and financial markets. We are entering the 2nd half of 2015 with unprecedented extremes and vulnerability: company earnings have been artificially boosted; bond and stock prices have reached elevated levels thanks to artificial support by central banks; interest rates are artificially low; implied volatilities are also artificially low; but in fact global risks and tensions are elevated to say the least. The extremely low volatilities induced by central banks simply do not reflect the level of uncertainty and risk in the real world. And the pervasive zero interest rates are inducing asset bubbles and deflation, creating so much confusion that some analysts see perfectly stable price expectations in totally artificial Yield Curves. Furthermore, in most major economies, discretionary consumption is being squeezed by the rising burden of longer living elderly people and the implosion of the full-benefits full-time working labor force. Policy Makers have also gone very far in intervening in financial markets and the economy, to the point that many experienced financial experts feel uneasy about policy makers behaving as if they were “gods” that can control or manipulate market prices and interest rates at will. The foundations in Macro Economics speak clearly: you can’t control inflation, interest rates and the currency at the same time. Governments are also trying to devalue their currencies to improve their Terms of Trade (some people call it “competitiveness”; to me that is just a short term boost). Policy Makers now dominate the demand for assets (i.e. how many Treasuries are bought), they set the supply (i.e. they reduce the issuance of Treasuries), they print the paper-money to buy those assets out of thin air (i.e. they finance the purchases of Treasuries with money they print, so-called QE), they set the monetary policy expectations economic agents take as yardstick (i.e. what level of employment, growth and inflation they should expect), and they themselves calculate and report the labor statistics, the GDP, and the CPI. In fact the government manages and controls way too much. I believe that the intervention was necessary in 2008-2011, but policy makers should have retreated from fixing market prices long ago, handed the statistical reporting over to independent private agencies and submitted all key economic and monetary reports to external audits. Policy makers control policy, market prices and reported statistics – the potential for conflicts of interest are high and the ethical implications significant. When democratic governments expand their role mightily, they have to take extra measures to meet the highest ethical standards: transparency, reporting, independent audits. Imagine the fund manager handling the Federal Social Security Funds of a leading economy, calculating his own performance, choosing his own benchmark and doing his own reporting. No serious fund manager would dare to do that. The Global Investment Performance Standard (GIPS) of the CFA Institute, which sets the most comprehensive reporting standard for the global investment community shows somehow a higher ethical standard than the very governments that are now trying to manage money supply, the economy, the bond market, interest rates, the currency, the financial industry etc.

The ideal timing for a partial normalization would have been 2H 2014. Contrary to consensus I believe the world economy could have digested the removal of QE. Overly focused on the EU, Japan and the USA, most financial experts overlook that 2/3 of mankind have been living in economies that for the most part have been expanding at 3% to 7% over the past 5 years. As it is, G7 economies have meanwhile become dependent on artificially supported asset prices. Just as the financial system is more vulnerable than what the bond & stock market rally convey, the real economy is more solid than what it looks like. A big part of the financial system has anyway decoupled indeed from the real economy. Having said that, economic growth is trending lower in most large economies. But some would see that as an opportunity to shift away from GDP targets towards GDP per capita and other qualitative targets.

The ever tighter grip of the government over every aspect of the economy and even citizens’ surveillance has so many side-effects, we now find less and less fundamental differences between the US and the Chinese economy. On paper they still differ clearly, de-facto they are converging. But what is most stunning of all is two-fold (1) no one seems to be bothered that the statistical reporting has not be handed over to independent agencies and auditors. And (2) financial institutions and economists are using these artificial bond yields, the resulting Yield Curve and implied volatilities to deduct the market participants’ expectations on interest rates, inflation and risk. Not that I think government agencies are cheating and tweaking the numbers, but it is a governance fiasco that financial media is silent about. In a nutshell, the so much praised recovery of the global financial system from the Great Financial Crisis has been to some extent artificial. Even in China. I have no doubt that Professor Irving Fisher, the leading Founding Father of the FED itself would have said this recovery has been engineered with a dangerous kind of money and systemic illusion. Yes, as most investors rely on policy-support for their asset prices, they have become overly dependent on policy makers. Rather than searching the truth objectively and weighing all risks with opportunities, many investors’ interests and expectations have become aligned with policy makers’. We saw that strikingly when the Swiss National Bank lifted the peg of the Swiss Franc to the Euro. Although the SNB had warned this was a temporary measure, many professional investors were caught underweighting the Franc and ended up outraged. Central banks that try to please markets aren’t doing neither them nor themselves a favor.

Freely moving markets & currencies essential for shielding the Macro Economy and Risk signaling

A tightly government-controlled financial market will unfortunately fail to play its critical role as an early indicator of risks approaching and as an effective valve for the releasing of pressures. With the most important financial market (US Treasuries) directly managed by the FED and important currencies removed (Eurozone), pegged (China) or de-facto managed (Euro, Yen etc), the next major shock may have an unhindered powerful impact on the real economy. Financial markets will not cushioned it, they may actually exacerbate the shock. The concern is that tightly government-managed and tightly government-supervised markets will fail to operate as an effective valve for the release of pressures and allow adjustments. Freely operating markets, despite their excesses, are a mighty shield and cushion for the real economy (jobs, pensions and specially those most vulnerable: the millions of single-parenting mothers, part-time workers, and also the less experienced, foreign or handicapped workers). Seasoned analysts, traders, investment bankers, fund managers, economists and strategists are trained to assess risks independently, to handle and take risks. Apart from allocating capital, they are a kind of shock-absorber in a healthy economy. Policy makers did well in toughening supervision and addressing excesses, but they went too far. They have stifled market dynamism and robbed professional investors of the necessary constant training in risk reading and risk taking. Most of them are now forced into one official opinion and uniformed behavior around a very crowded consensus. Now, many of them have left their jobs. Those who stayed are kind of “hand-cuffed” or void of sharpness. Many officials used the Great Financial Crisis to live out their envy or anger at their bonuses, but rather than providing a more balanced framework, they routed the risk-taking industry – not knowing the extent of what they were doing. These risk takers are the only ones that have the instinct, training and guts to trade against a panicking market. Normal bankers, the ones regulators want, lack the independent minds and risk-taking ability. Yes, banks used to mainly cater to retail and commercial clients, but the world economy was not that interconnected and markets fast-moving as today.

Policy makers, ill-advised, want a globalized world economy without (a) freely functioning markets, (b) freely moving currencies and (c) freely acting investment professionals experienced in taking and handling risks. As a result they are getting a world economy vulnerable to spreading shocks and needing ever more of their policy interventions. They have through their dual total control-approach (excessive supervision and excessive intervention in the market) removed their best and most capable allies and aides in managing big risks. They’ve got what they wanted: contained & uniformed risk-shy bankers. Since this very week we celebrate the Victory Day in Europe 70 years ago, allow me to make this parallel: It is like an US High Command shutting down all battalions of rangers and paratroopers, because of their repeated excesses. Once removed one boasts a nicer army, but one that is void of its most daring troops. Rangers and parachuting commandos are the “characters” that charge against fortified enemy beaches or land behind enemy lines. The pressures such front-line soldiers are exposed to cannot be appreciated by the generals and reservists landing on the beaches after the brutal fight for the beach-head is over. The paratroopers that landed behind the German lines before the Invasion of Normandy went on to lead many crucial attacks, suffering heavy losses. The attrition ratio for the daring boys of the 82nd and the 101st Airborne Divisions was a staggering 48% at that campaign. That alone should leave in us a sense of thankfulness towards the daring American, British and Russian front-line soldiers (among other allied forces) that dared to face a formidable enemy for a cause greater than themselves. Subdued people don’t do such exploits nor are they used to handle the fear that goes with risks. Allow me a more personal note: My Japanese grand-uncle, who survived WW2, saw his three destroyers sunk (where he operated the radio) only to face close-range ground combat in the Pacific, told me something I’ll never forget: “Those undisciplined Americans scared us and defeated us in our hearts: they would come back and again for their wounded comrades, unafraid of us killing them. When I saw their free spirits, initiative and the courage that came with it, I knew we would lose the war. They won my deepest respect”. You should know he was holding his school class photo – out of some 30 young boys, only two came back from the war (not that exceptional for Okinawans in WW2). Yet he was not bitter, he was still moved by the courage of those free yankees. He taught me a great lesson: Totally disciplined men are good for parades and day to day operations, but in the rage of combat or a crisis they are just as good as their leader, possibly a man used to control the situation. And it takes more to win. We should not go to the extreme of shutting down volatility, risks and the independent minds that can handle them.

We shall reap what we have sown: At the next major crisis Implied Volatilities in key markets will practically shoot from almost zero to infinitum within minutes. Most managers at export firms, politicians and even financial experts see market or currency volatility as a simple evil or as a cost. This widespread view is OK within a micro context, but at the aggregate levels of the world economy it is a fatal error. An example: If all firms do the right thing at the same time at company level and cut back debt, they can unleash a spiraling balance-sheet recession (Japan in 1990’s). What business economists applauded was finally diagnosed as a fatal error by macro economists ten years later. 25 years later Japan has not yet recovered from it.

As we see, freely trading financial prices and currency exchange rates send valuable signals to the whole economy and policy makers of adjustment, tension, impending danger or pressure being released. If we keep a tight grip on rates, prices and currencies, the signal-mechanism fails, we get misled by a deceitful stability and the adjustments take place in the real economy – the painful way. In the 1990s some macro economists – myself included – fought against the idea brought forward by politicians and business leaders that the EURO introduction would be a major blessing, because it would do away with the presumed evil of currency exchange uncertainty and volatility. We explained that “those currency exchange moves allowed for considerable pressure to be released and massive adjustments to take place within financial markets. If removed for the sake of a single currency and deceitful stability, those big adjustments will take place in the real economy, affecting real people and their households. This is exactly what millions of citizens have had to face in the Eurozone after the first few years of celebration. The introduction of the Euro and to some extent the introduction of the Euro-CHF peg by the SNB in 2011 induced a transfer of economic rent from the consumers to producers; it boosted their corporate profits for some time. Manufacturers transferred their cost of assessment and handling of macro & currency risks to consumers and tax-payers. But the long term effects would weigh on everybody.

Underestimated Risks during 2015 to 2018 – is the USA at risk?

Screen Shot 2015-05-08 at 8.55.20 PM

(chart to the right shows 197 earthquakes on one single randomly chosen day over the past month. Most quakes took place in the USA. Not an exception anymore. Source USGS)

In my personal view the one factor that could deteriorate fast or surprise massively during 2015-2018 is “geophysical & climate stability”. A powerful natural disaster should not be ruled out and several government measures seem to point to it. Geophysical events can be manifold; they might be visible on earth and caused locally, but they could also reflect the interaction of electro-magnetic-gravitational forces of all planets in our solar system and beyond.

The USGS just counted 1’833 earthquakes worldwide over the past 7 days. What is relevant for us is that many quakes are taking place in the USA and also that many quakes are occurring at amazing depths (for instance very deep under Alaska, even more so under Indonesia or Papua New Guinea. The USA is the world’s main economy and largest “single” consumer – a natural event of large proportions could shock the world economy, sending China, South Korea, Taiwan and Japan straight into recession and weigh on the world economy. Less advanced and less interconnected economies would be less affected – for instance the Russian hinterland and young African economies are likely to be less affected.

Why are we focusing on this type of risk for the USA? Earthquake activity has been present for centuries in the USA, but our world – still in transition – will be facing the convergence of more than ten significant risk-loaded trends over the next 3-4 years. Thus, a powerful disaster would be taking place during a period of high global vulnerability. On some days now the USA seems to be most seismically active nation of the world.

While most earthquakes used to take place at 15 KM, 50 KM or 150 KM below the surface, they seem to be going deeper. Major earthquakes are now taking place at 400 KM, 500 KM, 600 KM or 700 KM deep inside the earth. Geophysically or astro-physically, this could mean that the magnetic or gravitational (or other?) forces tagging or pulling on our planet are getting so big that the earth crust is being shifted at ever deeper levels. The next earthquakes could be therefore very powerful and happen at places not considered typically at risk.

Investment considerations

Most investors overestimate the “economic risks” in the USA – and we don’t mean the US economy could not see a recession and given certain conditions even a 5% to 10% contraction over the next 10 years. But many in Europe and Asia tend to underestimate the dynamism, resourcefulness and the positive spirit of the USA as a nation. Yet something else they also underestimate is the possible return or likelihood of natural disasters in the USA. This is one of the geopolitical-macro factors most institutional investors are not prepared for. One that could sink many pensions and firms, because US equities, bonds and private equity are among the biggest asset classes in many portfolios. Risk Diversification is still two-dimensional, backward looking and highly driven by a mono-cultural environment. Most portfolios are highly skewed to old and rapidly aging economies (Europe, China etc) and the Northern Hemisphere.

Just in the same way I would recommend institutional investors to avoid buying too much Real Estate in Indonesia and Japan, .. I would suggest them to consider diversifying Real Estate in parts of Africa or Russia. They boast regional economies not yet highly connected to the world economy, with comparatively less geophysical risks, furthermore with positive demographics and less geopolitical risks in some African economies. The crisis in Russia early in 2015 was a good entry point for those who could get the currency and assets at distressed levels. The crisis in Nigeria earlier this year was a similar opportunity.  Back to the USA, a plus: The US government seems to be taking natural risks and the subsequent risks to public order seriously, mobilizing her military to the home-land and significantly boosting her emergency resources in preparations for such an eventuality. You may want to look at the FEMA preparations and her new extraordinary powers. Let’s hope this won’t materialize. The extent of the preparations by specific governments is another element that adds relevance to our research approach and global risk assessment.

Concrete Investment Suggestions: On the global landscape we would suggest investors and decision makers to consider beginning preparations for elevated risk events and massive risk events over the next 3-4 years. Just looking at the currently tightly government-managed financial markets in the context of our Global Risk Monitoring, this coming Q3-Q4 2015 could see a powerful asset price correction and a massive jolt to volatilities and currencies. My last words on this subject is that you should never take action on one single analysis or opinion alone. Please, kindly ponder other alternative views and perspectives before reaching any conclusions for your enterprise or institution or government.

We really hope to add value with this note. Our synthesis of Global Macroeconomic and Geopolitical Research tries to deliver more accurate or more realistic Outlooks for the Economy. Allowing decision makers to make hopefully better or more informed decisions. For the good of many.

Christian Takushi, Macro Economist, on May 6th 2015.

Note: Our gratitude goes to Jorge Takushi, whose computing capabilities help us monitor global geophysical activity.

Disclaimer and Warning: The opinions expressed here reflect the personal view of Christian Takushi and the current stage of his Global Macroeconomic & Geopolitical Research. His analysis and views are completely independent. The view of our independent research contributors and experts in Christian’s global network was also taken into consideration. Readers should be aware that global macroeconomic and global geopolitical research are highly complex and subject to sudden changes and shocks, even more so the analysis of the link and interconnection between global geopolitics, economics and markets – as we do at Geopolitical Economics. Our view may change within 3 to 6 hours following an event of data release, and we will notify and advise our clients first. This website will only be updated a few days later!

Any Investment Strategy consideration is for institutional investors & corporate decision makers only. Other investors should NOT take any action based on our research without consulting a professional investment advisor first. They should heed the advise of professionals who can continually follow the markets for them and their portfolios. Overall this research should be considered as an additional independent perspective, and not as the sole basis for any important decision. No matter how realistic and correct our predictions may be, the same analysis could lead to very different conclusions and actions in different portfolios. That depends on portfolio structure, risk pattern, benchmark, reference currency, risk budget, personal background, tax profile, personal asset & liabilities and other factors.

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