Can We Move Away from the Nuclear Options?

Accountability is lacking because somehow we found ourselves in a system where only the nuclear options have any deterrence effect. For instance, only wars can stop a dictator intent on invading others. No amount of diplomacy would work. The ‘good guys’ have to hit the ‘bad bullies’ where it hurts to stop them. This is something people understand. Yet, this was supposed to be a rare occasion where this rule applied. In other aspects of life, there was supposed to be room for compromise if not checks and balances. This is not how it is playing out. 

Police is only changing now because of their leadership and budgets are on the line. The complaints and pressures before did not work. 

Bigots are only trying to right their past wrongs now that they could lose their jobs. The HR complaint systems and social pressures before had no use.

Officials are only paying attention to the health risks and supply chain vulnerabilities due to covid. Past warnings and studies had no effect. 

Economic managers are only seeing the fragility of the ‘living pay check to pay check’ model due to covid. Previous statistics did not mean much because the pay checks did come in. 

As bad as these issues are, recent events have hit the powers where it hurts and accountability should improve going forward. However, there are two issues that still lack accountability. The nuclear option blowback for them could come one day, but that would not be a good outcome f. 

The first is the post Bretton Woods dollar system. The US dollar is the global reserve currency, which the world uses to trade, transact, save, and invest. (Long story short, this is the case because USD derives its value from US having the biggest economy and its security from US having the strongest military) Given only the US government can print USD or digitally create USD, it gives US a certain advantage. At this point, the world has grown used to this set up and accepts it for what it is. However, if the US does not use this power responsibly, then one day a big blow back would come. This is still a far-fetched scenario because there are no alternatives. It takes a lot to convince 6 bn people on earth to suddenly stop using USD and use EUR, RMB, or Bitcoin instead. As for what would happen, Lionel Shriver’s satire fiction called ‘The Mandibles: A Family, 2029-2047’ is recommended reading. It is a family story about what happens after the US government defaulted on its treasury. 

The second is China. It has done a good job in meeting the basics hierarchy of needs such as the physiological and safety needs, but it has shown much less interest in supporting the belonging, esteem, and self-actualization needs of people. This is becoming a problem because accountability is lacking. Since the calls for these greater needs are suppressed and even criminalized, it becomes next to impossible for the system to respond. Externally, China’s project of power has come fast and furious over the last few years. China argues everything it does is in its own right and others should mind their own business. This status quo could last. China gets to do what it wants, but the lack of accountability could lead to nuclear options one day. This could come in the form of unrests or an international conflict someday. The very probability of these events happening is a bad sign. These nuclear option outcomes are not in the interest of the people, the powers, and the world. 

A return to accountability and a move away from having to use the nuclear options are sorely needed. Here are some ways: 1) central authority to hold things accountable 2) create new ways for credible pushbacks 3) incentivize behavior so there is more accountability. 

These methods have been tried in various forms, whether they are the UN, CIA funded rebels/grassroot organizations, or backroom deals with promises of the bigger picture. I do not know which ways is the way out to tackle this accountability problem, but I do know we need one soon.

What Coronavirus? Says the Market - My take on why central banks can still dictate the market and for how? long

‘Cognitive dissonance’ is the word the Guggenheim Partners Global CIO Minerd used when he described the disconnect between the economics and financial markets right now.  

For a long time now, financial markets have been living on ‘QE’. The program to buy up government debt using created money 1) has lowered the cost of borrowing for the economy 2) pushed investors to buy other financial assets as they are crowded out from government securities. Whether one liked it or not, the result has been clear. Central bank balance sheet expansion drives up market prices. Many have made comments similar to Minerd over the past 12 years and they were shrugged off. However, the coronavirus is making comments like this relevant again.

China, the world’s second largest economy at around 15% of global, has been devastated by the coronavirus, but the market still marches on. Many believe the disruption is temporary and things will go back to normal (V-shape recovery) so there is nothing to see.

Yet, behind the sanguine outlook lies the more important assumption, which is that central banks are always here to save the day. Therefore, bad coronavirus news is actually good news because it makes supportive central bank policies more likely. For instance, if the gets worse in China, perhaps China’s People’s Bank of China will cut interest rates to zero and do QE for the first time. To take it a step further, if the virus spreads to the US and it becomes a pandemic, then perhaps the Federal Reserve Bank will cut rates to zero and do QE for the fourth time. We, as people who may contract the virus and die, know that these certainly are not good outcomes, but if China does QE and US does QE4, you can bet the market will just rip up mechanically.

Given this outlandish, but perhaps probable, scenario, it is a good time to ask the big questions: why does QE still work, when would it stop working, and how long can this ‘cognitive dissonance’ last?  (working as in it drives up real asset prices)

Why does it still work?

1)      Globalization, Moore’s Law, aging demographics in the developed markets have kept inflation low. This allows central banks to use their powers without limits and push back.

Globalization allows goods, services, labor, and capital to flow so that things can be done as efficiently, if not as cheaply, as possible. Moore’s Law predicts that chips’ processing power doubles about every two years, this makes technology cheaper and more widely adopted. Aging demographics in the developed markets are the richest group. If they aren’t spending on goods to drive up prices, then who can move prices? In the end, central bank can keep on creating money to buy government securities, but as long as these factors are at full force, the consumer price index will stay low. This allows central banks to use their powers without limits and push back.

2)      High quality asset needs

There is a lot of wealth in the world ($240 tn in 2014), but not enough high quality assets (something that generates a return). Don’t blame it on the rich either, this is an everyday person problem. The rich actually can afford to buy risky assets since they have more than enough already. It is the middle class who are saving for their retirement/children’s education or relying on their insurance to help them that need high quality assets the most. When central banks are making prices go up, the ETFs, money managers, and insurance firms will follow, often times no questions asked.

3)      Asset holders cooperating supports paper profits

Even though trading is a zero-sum game, global investors have cooperated with each other. Instead of rushing to sell the asset to realize the paper profit at once, they understand that they are in it together. By taking turns to sell, nearly all existing investors can realize their profits over time.

4)      Wealth effect

The paper profits are not real until realized, but the asset holders’ spending on goods and services are real. The wealth effect, the increased spending from the financial asset market wealth, does improve conditions. As the economy improves from the spending, the high assets prices become a bit more justifiable.

How long can it last?

The short answer is when capitalism gets diluted, too many people get in on the QE secret, and when there are better things to invest in.

Based on the four reasons mentioned above, central banks’ easing would stop working when inflation increases and middle class savers get scared. Yet, these scenarios may only be temporary. For instance, inflation will pass as supply or demand adjusts, the market fear behind any asset dump will fade, and consumer sentiment will bottom out at some point. For things to really change, we may need to see fundamental changes in capitalism, investor behaviors, and market structures. 

1)      A global shift away from capitalism may lead to more sustained inflation. In other words, if the profit incentive goes away, it will take longer for producers to find cheaper, faster, and better ways to produce whatever that is in short supply. This will make it permanently more difficult for the central bank to respond to support the market.

2)      A spike in investor interest given the central bank support would drive prices into a bubble. If too many people get in on the QE secret, major stock indices will be driven up like Bitcoin or TESLA. This will lead to a bubble burst, before investors come back betting on central banks’ support. In the end, successive rounds of bubble burst will either lead to central banks or investors walking away. At that point, the stock market will still exist, but at levels much lower than the bubble period. 

3)      The invention of a new market could drive interest and capital away from the major stock markets today. In a world where lifestyle, culture, and technology have changed so quickly over the past decades, who is to say the middle class savers and wealthy’ investment preference wouldn’t’ change.

As for these fundamental changes, things are already gradually happening. First, the world is moving away from the raw form of capitalism. There is now growing scrutiny over businesses’ environmental, social, governance, moral, and cultural standards. It is possible that all these forces contribute to future inflation from a supply standpoint. As for the second point, there may never be too many who get in on the QE secret. It has already been mainstream for 12 years and inequality makes it hard for everyone to participate in the market. Third, while a new market seems unlikely, weirder things have happened. Bitcoin's market cap is $130 bn because enough people said so. The difficulty is for a new market to get to a sufficient size. In 2014, there was about $240 tn of wealth in the world (Marginal Revolution). Today, global equity markets add up to $50 tn (BofA), global debt markets is about $135 tn (150% of global GDP), and US and China’s housing market is about $75 tn (Economist, Goldman Sachs). Unless there is a credible new market that rivals major equity market, middle class savers' money will still flow there. 

Ultimately, for those wondering whether the ‘cognitive dissonance’ of the market can last, watch how the market is treating the producers and whether a new asset market is on the horizon.

 

Disclaimer: risks such as political checks on central bank powers, financial stability concerns, and any end of the world scenarios are all possible, but are excluded for the sake of this thought exercise.

Is Marie Kondo bad for the economy? A Thought Exercise on Global Demand

U.S. consumers spend, and the global economy depends on it. Though the 320 mn U.S. population is only about 4% of the global population, U.S. consumption represents 10.6% of global GDP, and this figure’s impact is understated since the rest of the world’s investments, exports, and consumption associated with U.S. consumption is excluded. So, if ‘Tidying Up with Marie Kondo,’ the new Netflix show that helps people combat hoarding embrace minimalism, becomes the new norm, does it mean the economy will suffer?

I believe the answer is no, but it requires advanced economies to sort out housing and emerging markets to figure out politics. With 7 bn in global population, there is no shortage of people who want to live the good life. Regardless of the different views on materialism and frugality and the different stages on Maslow’s hierarchy of needs, people want modern shelter, appliances, technology, and conveniences. However, the first problem is that increasingly those who have the means don’t need or want to spend. The second problem is that those who truly need don’t have the means to spend.

Let’s take Japan, the third largest economy in the world, for example. Japan’s elderly owns most of the wealth, but the lack of desires, retirement insecurities, or concerns for their kids’ future keep them from living it up. The problem underneath is Japan’s bad demographics. The country’s bad demographics, characterized by the rapidly aging population and low fertility rates, threaten the stability of the stability of the retirement system and the vibrancy of the economy and its future prospects.

As for what explains the bad demographics, I believe housing played a big role. Japan’s massive housing bubble made having children expensive, unreachable, and undesirable. Buying a home or paying rent is an option for a young individual, but having a stable home becomes more of a necessity for a couple looking to raise a family. As a result, when Japan’s housing price outpaced wage gains, it became rational for people to have fewer kids or forgo having kids.

Increasingly, this trend may play out in U.S. as well. The combination of the knowledge economy’s cluster effect and global wealth investing in U.S. cities have driven up housing prices in metropolitan cities. For instance, the tech jobs in San Francisco, the finance jobs in New York, and the biotech jobs in Boston draw young talents to these cities. This results in a cluster effect where the talent influx creates a bigger ecosystem for these jobs, which draws even more people to these cities. In addition to the increase in demand from the population growth, investors also add to those who wish to own a piece of these growing cities.

In the end, the high home prices reduce these residents’ disposable income in the short-run and may reduce their willingness to have children in the long-run. While wage gains and home prices ebb and flow, these advanced economies’ demand becomes permanently impacted once demographic takes a dip. As a result, housing plays a big role on why advanced economies may decide to spend less than they are able to.

As for the second problem, emerging markets’ messy politics often prevent them from achieving their full potential. China is a poster boy on how politics matter. Since Deng opened up China with a single-minded focus on pursuing growth, China has been on a tear. In the past decades, China has lifted close to 800 mn of its 1.3 bn population out of poverty. Growth inducing policies allowed people to get jobs and buy things to improve their quality of life. However, things may be starting to slow in China.

Automobile sales contracted for the first time in 20 years and smartphone sales have been falling for over a year now. This doesn’t mean that China is running into a wall or a crisis, but it does mean that it is important for other emerging market to take over the baton for demand. The difficulty is that there are few countries can match China’s size and trajectory for growth. Messy politics have kept other large emerging markets such as Brazil, India, and Indonesia from achieving their full growth potential. Politics matter because bad policies prevent technology and organizations from maximize productivity and full utilizations of their land, labor, and capital.

China Automobile Sales (mn of units)  

China Smartphone Shipments (mn of units)

As I see it, there are five ways to tackle the two problems so that Marie Kondo doesn’t become the new scape goat for a global economic slowdown.

1. Transfer money from the haves to the haves-nots in the advanced economies and emerging markets for them to spend.
2. Lend money to the haves-nots in the advanced economies and the emerging markets for them to spend.
3. Encourage investments in financial securities and discourage investments in real estate.
4. Loosen building and zoning laws and adopt accelerated building techniques to meet housing demand.
5. Influence emerging markets to pursue better growth policies and achieve more global economic coordination for mutual gains.

However, not all of these solutions are feasible, practical, or advised. First, transferring money is not productive and will be lobbied hard against. Second, lending money to those who can’t payback results in high non-performing loans at best and another economic crisis at worst. Third, channeling wealth from real estate is possible, but the current homeowners will become unhappy voters. Fourth, turning every desirable metropolitan city into dense concrete jungles of stacked modular apartments works on paper, but not in practice. This leaves the last option, which is also the best out of all the potential solutions.

The difficulty here lies in the world’s current state of political economy. As politicians around the world see global economy as a zero-sum game (maybe globalization or the winner-takes-all development has indeed turned it into a zero-sum game), this also makes the last option unlikely. 

So, what will happen and will Marie Kondo become the scapegoat? I don’t think so, but may be it is not impossible. 

What Would Warren Buffet Do? Big Tech vs Productivity

When Warren Buffet speaks, people listen. In 2017, 42,000 showed up for the annual Berkshire Hathaway meeting and another 17 million streamed the event online. While it is his views on cryptocurrency (he hates it) that grabbed the headline this year, I believe his bit on productivity (from 2015) below is far more relevant, especially in the current environment, which has many calling for breaking up big tech and universal basic income.

“Too few Americans fully grasp the linkage between productivity and prosperity. To see that connection, let’s look first at the country’s most dramatic example – farming – and later examine three Berkshire-specific areas. In 1900, America’s civilian work force numbered 28 million. Of these, 11 million, a staggering 40% of the total, worked in farming. The leading crop then, as now, was corn. About 90 million acres were devoted to its production and the yield per acre was 30 bushels, for a total output of 2.7 billion bushels annually. Then came the tractor and one innovation after another that revolutionized such keys to farm productivity as planting, harvesting, irrigation, fertilization and seed quality.

Today, we devote about 85 million acres to corn. Productivity, however, has improved yields to more than 150 bushels per acre, for an annual output of 13-14 billion bushels. Farmers have made similar gains with other products. Increased yields, though, are only half the story: The huge increases in physical output have been accompanied by a dramatic reduction in the number of farm laborers (“human input”).

Today about three million people work on farms, a tiny 2% of our 158-million-person work force. Thus, improved farming methods have allowed tens of millions of present-day workers to utilize their time and talents in other endeavors, a reallocation of human resources that enables Americans of today to enjoy huge quantities of non-farm goods and services they would otherwise lack. It’s easy to look back over the 115-year span and realize how extraordinarily beneficial agricultural innovations have been – not just for farmers but, more broadly, for our entire society. We would not have anything close to the America we now know had we stifled those improvements in productivity. (It was fortunate that horses couldn’t vote.)

On a day-to-day basis, however, talk of the “greater good” must have rung hollow to farm hands who lost their jobs to machines that performed routine tasks far more efficiently than humans ever could….The answer in such disruptions is not the restraining or outlawing of actions that increase productivity. Americans would not be living nearly as well as we do if we had mandated that 11 million people should forever be employed in farming.”

In other words, society should welcome progress, but also help those left behind. Buffet’s maxim is simple enough, but do monopolies and the speed of disruption complicate things? Is there a case for breaking up big tech because it actually hurts progress and productivity?

Investors have always recognized and valued productivity. As a result, the market rewards technology stocks with high valuations even if they make no money. Today, investors have become even more enamored with them. Given the monopolistic positions companies have built using their network effects and ecosystems, Apple, Microsoft, Amazon, Facebook, and Alphabet (Google) now have a market cap of $3.78 trillion dollars (March 12). These five make up of 15% of the S&P’s market value, more than the entire financial, health-care, or industrial sectors. Taking a step back, one finds that the tech sector’s 25% share of the S&P is the highest since the dot-com bubble, when it peaked at 35%.

A big question now is if these companies are monopolies, what are their implications for productivity? Do they help productivity in the short-run, but harm it in the long-run? Would they resist the temptation to buy out competitors and hike prices on consumers in the future? On the other hand, is it possible that they keep their disruptive spirit and drive productivity gains? Just as Amazon is entering into healthcare, is it possible that it will upend the DMV and save the day too?

Another big question is whether the technological disruptions today are any different for their effects on the labor market. While the farmers who were put out of work by machines may have found other jobs, is it possible that future disruption will be so widespread that the farmer equivalent today will not be able to find any job? This is presidential hopeful Andrew Yang’s view. He says that “we’re going to have a million truck drivers out of work who are 94 percent male, with an average level of education of high school or one year of college.” In other words, self-driving trucks “will be enough to create riots in the street. And we’re about to do the same thing to retail workers, call center workers, fast-food workers, insurance companies, accounting firms.” To play devil’s advocate, one can then ask whether technology actually improves productivity if it puts a large part of the labor force out of a job. If people are constantly asked to re-train their skills because technology keeps on making them obsolete, then maybe society’s productivity has not improved much after all.

In response to these questions, I am sure Warren Buffet will hold his ground, but I do not know the answer to these questions. Maybe it is inevitable that information technology’s network effect produces large companies and only they can be productive given the high fixed costs. Maybe savvy consumers, activist shareholders, and conscientious employees can prevent big tech from doing evil. Maybe robots will takeover, but people will find something else to do like people have always done.

One thing I do know is that when big tech takes over the market, may be the only active management left will be for tech analysts (sarcastically). 

Source - WSJ graphics 

Don’t Buy What You Don’t Understand: ETF for Millennials and Finance Nerds.

What is an ETF?

With the rise of robo advisers such as Betterment and the word of mouth praises for how cheap and good it, more and more have dabbled in ETFs, but many may not know much more than what the acronym stands for and how it is a stock that buys a basket of stocks. Here is my ETF primer for my fellow millennials and finance nerds.

According to Bloomberg analyst Eric Balcunas’s ETF origin story, one of ETF’s inventors Nate Most said the idea of ETFs came from commodity warehouse receipts. Given it is costly and difficult to move commodities around the globe, commodity traders keep them stored at the warehouse and trade the warehouse receipts around. ETF does the same thing, except the commodities are stocks and they are stored at a custodian bank rather than in a warehouse.

ETFs are essentially the same, except slightly more complicated. To begin, the ETF issuer finds a fund custodian to store the basket of stocks. The ETF shares are created off of the basket of stocks stored at the fund custodian. Then, the ETF issuer finds a broker dealer bank to serve as the authorized participant (AP) to help manage the size of the ETFs and the basket of stocks stored at the custodian bank. For instance, if people want to buy more shares of ETF than created, the AP may buy stocks and exchange them for newly created ETF shares and sell these ETFs to the investors. Thus, the AP helped increase the size of the ETFs and the basket of stocks stored at the custodian bank. Similarly, if people want to sell their ETFs, the AP may buy ETFs and exchange them for stocks from basket of stocks stored at the custodian bank. Thus, the AP helped decrease the size of the ETFs and the basket of stocks stored at the custodian bank.

If this again sounds like gibberish, here is an analogy that might help. The basket of stocks is gold, the ETF is gold standard British Pound, the ETF issuer is the Bank of England, the custodian bank is Bank of England’s vault, and the AP is the Bank of England’s bankers. During the gold standard era, one could theoretically go to the Bank of England to exchange one’s British Pound into gold from its vault. As a result, gold and British pound are interchangeable (this requires the ridiculous assumption that there is no fractional reserve banking and there is enough gold to cover all the British pound). Similarly, the ETF and the basket of stocks are the same because one could theoretically exchange one’s ETF into the basket of stocks from the custodian bank. Also, when Bank of England has more gold, it can issue more British pound, which is no different from the ETF issuer creating more ETFs when it has a bigger basket of stocks. This is how ETF works.

What are its risks? (More for finance nerds)

First, what if the gold in the vault is impure or fake? In that case, the people who bought British Pound for the gold would have lost all faith in their British Pound. They will rush to the bank to exchange whatever pure or real gold in the vault and sell the rest of their British Pound. This could happen to ETFs. Since many ETFs hold financial derivatives that mimic the value of the basket of stocks rather than the actual stocks, it is possible that when investors rush for the exit one day, the financial derivatives will fail to mimic the value during extreme periods, leading to panic. Second, what if Bank of England changed British Pound’s conversion to include silver because it ran out of gold? In this case, people may also lose faith in their British Pound and rush to the exit. This could also happen to ETFs. There have been instances where too many people wanted to buy ETFs and not enough stocks to back them up. In this case, the ETF issuer decided to add other stocks into their basket of stocks so that they could keep on creating and selling ETFs. Third, what if many new countries are formed and they all start creating their own precious metal backed currencies? How will it affect the normal mining and trading of precious metals? The liquidity of ETFs and stocks are now called into question as ETF continue its explosive growth both in terms of size and number.

What are the implications of its risks? (definitely for finance nerds)

If the financial derivatives that back up many ETFs fail or lose value unexpectedly, many will take big losses. This may be just another market sell-off like the dot com bubble or it could lead to a bigger financial crisis where large systemically important financial institution are challenged. One reason to feel downplay this risk is that the global ETF market is only about $3 tn compared to the $240 tn total wealth worldwide and it is unfeasible that all ETFs will suffer big value losses due to the unforeseen risks mentioned above. However, one must also refrain from being complacent. The supposed infallibility of Mortgage Backed Securities led to the massive credit default swap bets on the side. While the MBS market at the time was only $8 tn, the notional value of the CDS was around $60 tn! It is often difficult to see the risks lurking in the shadows until it is too late. Lastly, even if it is unlikely ETF will be a trigger of a financial crisis, it is possible that ETFs’ explosive growth in terms of number and size have introduced changes to the market ecology that increase the system’s vulnerability.