The Big Forces
Letter from Croatia
So compelling is the evidence of our own eyes and ears, so swift is your mind to assume your own version of the story, that one of the hardest things in this world is to understand there’s another way of seeing things.
This Is Happiness, Niall Williams, 2019
THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.
There are economic cycles and big secular forces. They are different.
Because this cycle has been so dramatic—Covid, big fiscal stimulus, surging inflation, the most rapid tightening in 40 years—much attention has been justifiably focused on the cycle. We are now in the part of the cycle where growth slows, unemployment rises and central banks ease. There is much attention placed on specific data to figure out where precisely we are in this part of the cycle but the essence is already evident. The ECB, Bank of Canada, Bank of England and People’s Bank of China have all eased and soon the Fed will too. The question is how much easing is necessary (a lot) and how sensitive will the economy be to such easing (quite). The key metric to stare at are real (inflation adjusted) short rates. They are high and getting higher as inflation falls.
Cycles unfold against the backdrop of the big secular picture, which can take years to unfold.
Here are the big forces I see.
A productivity shift. We know AI is changing how we work already. Bigger changes are on the way. Like you, I read a lot of articles about the way AI can impact the future (everything from drug discovery to software construction to self-driving cars and robots). Yes, the related stocks have see-sawed up and down, but that future remains firmly in place. Our reality will shift meaningfully in coming years. This spending is pushing money into the economy, financed mostly by existing profits.
A technology shifts that is outpacing cultural shifts. The above tech-driven shift is one of a series of technology shifts that are leading to rapid economic creative destruction. The pace of this destruction is outpacing culturally ingrained habits and norms, which have a much slower self-reinforcing momentum of their own. This disconnect between modern economics and slower moving cultural norms is a good framework for much of the global conflict we see. A modern, secular government does not invade its neighbor and seize land or hostages and barter them like onions in the village market. As big as the differences are between Canada and the US, no one worries about such a scenario. Yet that is what Putin is doing. Radical Islam operates with a similar logic as does China’s effort to seize islands and reefs of various sizes. Culture has a momentum of its own. It shifts, but slowly. In the US we no longer burn witches but a residue of Puritanism lives on.
A defense spending shift. In part as a result of these cultural clashes, there are now two hot wars. The weak are attacked, the same way one group of chimps wipes out what they see as their weaker rivals. It’s not an attractive human trait but it seems innate. Nukes are the best defense but short of nukes you need to have a robust military to keep Russia from moving forward and China from mimicking Russia and Iran from attacking Israel. Billions of dollars of spending is coming. Plus the nature of warfare is shifting due to “1”, the productivity shift. Ukraine’s drone attack boats paralyzed Russia’s navy. This also forces money into the economy, financed mostly by government borrowing.
A climate spending shift. Shifting energy production from oil to solar is an effort to reduce the cause of climate change, burning fossil fuels. Another angle is targeting the effects of climate change, record heat. In my recent travels to Argentina and Croatia, the impacts of climate change are vivid. A dengue outbreak in Buenos Aires and an explosion of slime in the once crystal clear Adriatic caused in part by water so warm it is like swimming in a heated pool. The World Health Organization estimates about 500,000 people are dying a year due to excessive heat. Less than 40% of the world population living in hot climates has AC right now. Either older people in these places will die or they will flee to the colder countries or AC becomes akin to water for people who live in places most vulnerable to climate change. Ditto flood retention in cities on the water. A lot of money will be spent for cooling and flood protection.
A China-centered deflationary depression that radiates outwards. The above forces are global. Because China is the second biggest economy in the world, the impact of the change in China’s growth is also global, particularly for raw materials prices. China is undergoing a classic deflationary debt crunch, like what happened in Japan (1990), US (2008 and 1929) and many other countries. The solution is known—print—but China won’t undertake the solution under their leader, Xi. At least I doubt they will. This is pulling money out of the global economy.
In terms of investing, I do my best to:
understand the big forces
understand where we are in the cycle
estimate what pushes and pulls of money this will create
see what degree those ebbs and flows are discounted in markets and
build a portfolio that is not overly reliant on any one view, using every possible technique (shorts, longs, options) to build the most stable structure I can.
Figuring out what’s going on is part of the battle. Figuring out how to build a portfolio around this probable future is the other part of the battle. More on that later.