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Archive for June 2014

Archive for June, 2014

Thoughts from the Frontline: The New Normal of Healthcare Spending

 

A rather interesting shockwave came across the newsfeeds this week. I was actually doing a TV interview when the host announced that GDP was down 2.9% for the first quarter. There was not much else I could do but note that that was a really bad, ugly, terrible, not very good number. But I had no real basis, without any facts in front of me, by which to understand why the revision was so extreme. Sure, we were all expecting a pretty large revision, but what we got was the worst decline in five years and the largest downward revision since recordkeeping began. Later, a quick perusal of the data on the BLS website revealed the culprits: exports and healthcare spending.

Last year I was one of the very few who suggested that the implementation of Obamacare could cause a recession (see more below). Such a suggestion was universally dismissed by all right-thinking economists, and for very good reasons based in sound economic theory, I might add. But sometimes the real world neglects to adhere to our models and theories, and that was my concern.

While I doubt we’ll see a recession – classically understood as two quarters in a row of negative GDP – this rather large bump in the road offers a number of teaching opportunities. This week’s letter will look at the actual numbers; and then, rather than try to spin the numbers to fit some preconceived political agenda, we will examine what actually happened in the spending data and why. And while it may surprise some of you, I actually think a few good things did happen, things I find encouraging.

Anytime I write about healthcare it’s controversial, and I expect this letter will be received that way as well. However, as I (and many others) haveclearly established, the healthcare system in the United States is massively dysfunctional. We are simply spending too much money on healthcare and are on a path to spending an unsustainable amount of money by the end of the decade. Things are going to change no matter what. The Affordable Care Act (ACA or Obamacare) was one way to try to address the problem. The majority of the country now feels this might not have been the best way, but that really doesn’t make any difference. It is going to be the basic law for another three to four years. My job, at least in this letter, is not to discuss policy but rather the economic effects of the policies we have chosen to implement, and what those effects may mean for our investment portfolios.

GDP Shocker: a Drop of 2.9%!

First, let’s look just at the facts as given to us by the BLS. US Q1 GDP Q/Q was revised much lower, to -2.9% on an annualized basis, down from the -1.0% previously reported (which itself was revised lower from the +0.1% initially reported) and well below the expected decline of -1.8%. How did we go from barely positive to down 2.9%?

When the BLS gives us its first estimate of previous-quarter GDP, it is forced to use models based on previous trends until the actual data comes in. This is why we get two monthly revisions and in future years will get even further revisions. (Sidebar: don’t you wish the US Bureau of Labor Statistics could be as good as their Chinese counterparts? The Chinese never have to revise their numbers. Obviously they are very good at this type of thing.)

And we all know that assumptions will sometimes bite you in the derrière. Look at this chart of projected healthcare spending from the original release of first-quarter GDP data in April. Notice that the projected spending was almost double what it had been just the previous quarter and over four times the previous year’s average. I’m not quite certain how trend models got to that number, but then I’m not a mathematician. In any event, here’s the chart, courtesy of Zero Hedge:

Now fast-forward to last week’s revision and notice that the healthcare spending number has dropped from the previous quarter, not doubled. In fact, it dropped an enormous 6.4%. Rather than contributing 0.62% to GDP is it did in the fourth quarter of 2013, in Q1 2014 it subtracted 0.16% from GDP growth.

Just for the record, here are the actual numbers from the BLS data. Roughly 2/3 of the negative revision in Q1 GDP was from healthcare spending, and the rest was from falling exports and rising imports (from an accounting standpoint, imports are a negative in figuring GDP).

I want us to look quickly at two charts to get some historical perspective on growth in the US. The first is GDP quarter by quarter for the last seven years. Notice that only two quarters ago we had a 4.1% positive quarter. During the 19 quarters since the current expansion began in June 2009, the economy has grown at an annual rate of 2.1%, compared to the 4.1% average in every other expansion since 1960.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

Thoughts from the Frontline: The New Normal of Healthcare Spending

 

A rather interesting shockwave came across the newsfeeds this week. I was actually doing a TV interview when the host announced that GDP was down 2.9% for the first quarter. There was not much else I could do but note that that was a really bad, ugly, terrible, not very good number. But I had no real basis, without any facts in front of me, by which to understand why the revision was so extreme. Sure, we were all expecting a pretty large revision, but what we got was the worst decline in five years and the largest downward revision since recordkeeping began. Later, a quick perusal of the data on the BLS website revealed the culprits: exports and healthcare spending.

Last year I was one of the very few who suggested that the implementation of Obamacare could cause a recession (see more below). Such a suggestion was universally dismissed by all right-thinking economists, and for very good reasons based in sound economic theory, I might add. But sometimes the real world neglects to adhere to our models and theories, and that was my concern.

While I doubt we’ll see a recession – classically understood as two quarters in a row of negative GDP – this rather large bump in the road offers a number of teaching opportunities. This week’s letter will look at the actual numbers; and then, rather than try to spin the numbers to fit some preconceived political agenda, we will examine what actually happened in the spending data and why. And while it may surprise some of you, I actually think a few good things did happen, things I find encouraging.

Anytime I write about healthcare it’s controversial, and I expect this letter will be received that way as well. However, as I (and many others) haveclearly established, the healthcare system in the United States is massively dysfunctional. We are simply spending too much money on healthcare and are on a path to spending an unsustainable amount of money by the end of the decade. Things are going to change no matter what. The Affordable Care Act (ACA or Obamacare) was one way to try to address the problem. The majority of the country now feels this might not have been the best way, but that really doesn’t make any difference. It is going to be the basic law for another three to four years. My job, at least in this letter, is not to discuss policy but rather the economic effects of the policies we have chosen to implement, and what those effects may mean for our investment portfolios.

GDP Shocker: a Drop of 2.9%!

First, let’s look just at the facts as given to us by the BLS. US Q1 GDP Q/Q was revised much lower, to -2.9% on an annualized basis, down from the -1.0% previously reported (which itself was revised lower from the +0.1% initially reported) and well below the expected decline of -1.8%. How did we go from barely positive to down 2.9%?

When the BLS gives us its first estimate of previous-quarter GDP, it is forced to use models based on previous trends until the actual data comes in. This is why we get two monthly revisions and in future years will get even further revisions. (Sidebar: don’t you wish the US Bureau of Labor Statistics could be as good as their Chinese counterparts? The Chinese never have to revise their numbers. Obviously they are very good at this type of thing.)

And we all know that assumptions will sometimes bite you in the derrière. Look at this chart of projected healthcare spending from the original release of first-quarter GDP data in April. Notice that the projected spending was almost double what it had been just the previous quarter and over four times the previous year’s average. I’m not quite certain how trend models got to that number, but then I’m not a mathematician. In any event, here’s the chart, courtesy of Zero Hedge:

Now fast-forward to last week’s revision and notice that the healthcare spending number has dropped from the previous quarter, not doubled. In fact, it dropped an enormous 6.4%. Rather than contributing 0.62% to GDP is it did in the fourth quarter of 2013, in Q1 2014 it subtracted 0.16% from GDP growth.

Just for the record, here are the actual numbers from the BLS data. Roughly 2/3 of the negative revision in Q1 GDP was from healthcare spending, and the rest was from falling exports and rising imports (from an accounting standpoint, imports are a negative in figuring GDP).

I want us to look quickly at two charts to get some historical perspective on growth in the US. The first is GDP quarter by quarter for the last seven years. Notice that only two quarters ago we had a 4.1% positive quarter. During the 19 quarters since the current expansion began in June 2009, the economy has grown at an annual rate of 2.1%, compared to the 4.1% average in every other expansion since 1960.

In fact, rather than the comfortable +3% from 1950 through 2000, growth fell to +1.9% for the entire decade of the aughts and has not risen appreciably above that in the last four years. Here is a chart showing the rolling four-quarter average for GDP growth since 1980. With last quarter’s negative revision included, we’ve only grown 1.6% for the last 12 months. Dude, who stole my productivity?

The New Normal of Healthcare Spending

On October 6, 2013, I penned a rather lengthy discussion of the economic impact of the Affordable Care Act. I still think it was one of the better pieces I have written. You can read it here. I offered an analysis of what healthcare will look like within a few years. Essentially, we are moving to a three-tiered system. Somewhere between 3 to 5% of people will have what is coming to be known as concierge care, another 20% or so will have what we think of as traditional insurance, and the remaining 75% will get by with some form of government-mandated and -controlled healthcare (with high deductibles and increasing costs).

I titled the letter I wrote back in October “The Road to a New Medical Order.” Business Insider, which posts my letter each week (a surprising number of people think I actually write for them, which is fine by me, I guess) generally tries to come up with impactful and somewhat controversial headlines to attract readers. Their headline over my piece was “Obama Care Will Change Everything – And I Think It Might Cause a Recession.” And yes, buried deep in the article I did write:

When I am asked what keeps me up at night about our economy, my ready answer for the past few months has been the unknown transition costs associated with the ACA. I hope Jack Rivkin is right and that the transition to Obamacare proves to be just another Y2K. I truly believe that healthcare will be significantly better in 10 years, largely due to advances in technology, but also as we streamline our healthcare delivery. So I’m a long-term optimist, though I have to confess that, in the short term, which would be through the last half of 2014, I am quite concerned that dislocating 1 to 2% of the economy could be enough to push us into recession. I have nothing factual to base that on – no inverted yield curve, no evident bubble getting ready to burst – so I will stop far short of a prediction. Let’s just say that these issues need to be right up front on our radar screens. And it wouldn’t hurt to keep our fingers crossed.

Let’s run through a quick summary of my analysis then – which is the same as how I see things today. We are going to reduce the amount of money we spend on healthcare by around 1% of GDP a year for the next four years, or about 5% per year in actual reductions. While right-thinking economists will point out that that money will be spent elsewhere, and they are correct, my concern was – and it is evidently turning out to be pretty correct – that the transition will be messy. I simply do not believe that you can change the “plumbing” of how healthcare dollars are spent, totally change the incentive structure, and demand more service for 20% fewer dollars while reducing the number of workers at hospitals, without serious short-term dislocations. Like we saw last quarter.

Will all this wash out over the next few years? Absolutely. We are not on some permanent healthcare spending death march where quarter by quarter healthcare spending will keep dropping. It is just, to borrow a phrase from my friend Mohamed El-Erian, that we are entering into a New Normal of Healthcare Spending. And eventually that money that we are not spending on healthcare will get spent on something else, and those people that are not employed in the healthcare industry will find other jobs or end up taking less pay for doing the same job. But it is the turmoil created in the midst of that process that is going to create some ups and downs in the economy (more on that later).

I have regular conversations with numerous friends about what’s happening in the healthcare world, as I think that is where the real action is. For an economist, this is a wonderful experiment in incentive structures. And if you are an economist worth your salt, you know that economics is all about incentives. Individuals have an incentive to maximize their healthcare services and reduce their actual out-of-pocket expenses. Healthcare businesses have an incentive to make sure that expenses don’t exceed revenues. And the ACA is nothing if it is not an enormous incentive-changing machine.

Jack Rivkin sent me a note yesterday detailing a conversation he had recently with a healthcare provider. (I’ll remove names, just in case.)

Had a great 3 hour dinner discussion in Chicago three weeks ago with the head of the … Hospital. He realizes he’s at the bottom of the food chain but is very excited about what is happening. First dinner with him was three years ago when he was just beginning. He’s substantially changing the mix of his work force. That includes doctors who are now employees, not independent business folks. He has made the switch to outcomes-oriented medicine and is looking to become his own insurance company where he believes the big ripoff has been taking place. You should hear what he has to say about Blue Cross/Blue Shield and the people running it. He is tired of getting paid for procedures as opposed to outcomes, e.g., [he’s] down from using 7 different types of hip replacements to 3, based on those with the best long-term success. The doctors were told you either switch to what we have chosen or find another hospital. Actually “fired” some doctors when the data showed what a high rate of repetition [their] patients had.

That complaint about insurance companies is showing up a lot. Here’s a section from a great little article by Jake Novak at CNBC called “An Obamacare bailout? Insurers already got one!”

Whether the ACA has actually helped more citizens than it’s hurt has turned into a partisan war of statistics. That war will be waged for years to come. While I believe the new law will ultimately hurt more people than it helps, I realize those on the other side of the political spectrum will never agree with that assessment.

So let’s not have that fruitless argument.

Instead let’s focus on something the two major political camps can agree on, even if it is something that will make both of them very angry. Based on the non-partisan, hard numbers, the big winners in Obamacare America are… drumroll please… the insurance companies!

Yes, those greedy, heartless, bureaucratic, and anti-competitive health-insurance companies that President Obama kinda sorta blamed for his mother’s death and Republicans blasted for seeking a bailout, and doctors accused of interfering with their medical judgment are all still alive and kicking in the 2014 world of the ACA.

Of course, insurance companies would simply argue that they’re playing by the rules and that they’re having a really difficult time making profits. Most insurance plans under Obamacare are going to rise significantly in cost later this year or next year.

Again, we find out something about incentives. It should be no surprise that a significant number of people with serious health issues who had no insurance have now signed up for the new healthcare programs. Lanhee Chen on the BloombergView site sees it this way:

At its base, the data show that people insured through the law’s exchanges have higher rates of serious medical conditions. Of the enrollees who have seen a doctor or other health-care provider in the first quarter of this year, 27 percent have significant medical problems, including diabetes, cancer, heart trouble and psychiatric conditions. That rate is substantially higher than that for patients in nonexchange market plans over the same period. And it’s more than double the rate of those who were able to hold onto their existing individual market insurance plans after President Barack Obama was forced to allow them to keep them.

This outcome should not surprise anyone. The law’s one-size-fits-all regulatory regime, which requires insurers to offer coverage to all comers and prohibits pricing of coverage based on an applicant’s health status, was bound to increase the number of relatively sicker people purchasing insurance through the exchanges. Moreover, Obama’s executive action, which effectively allowed many people who had individual market plans to remain in them through at least 2016, bifurcated the insurance markets such that healthier people remained in the plans they already had, while relatively sicker patients were left to acquire coverage through the Affordable Care Act’s exchanges.

Some of the bad risk in the exchanges has been offset by the enrollment of relatively healthy people who acquired coverage because of the law’s generous subsidies. Yet the numbers make clear that the exchanges remain a haven for those who may consume more medical services than others. (Bloomberg)

The ACA is going to be enormously contentious, as the rules are conflicting as to how insurers can make up their losses. President Obama would like to do it one way that he thinks is allowed within the rules, but there are many in Congress who think that’s a bailout for insurance companies and is against the rules. However it plays out, the ACA is going to cost someone, whether it’s taxpayers or those buying insurance, a great deal more money than initially budgeted. And the insurers will continue to be everybody’s favorite whipping boy.

As an aside, I find it an enormously intriguing idea that a healthcare hospital group is seriously thinking about setting up its own insurance company. You gotta love America, 100 different experiments going on at once. Some of them are sure to be game changers.

Why Healthcare Spending Went Down

My contacts in hospitals and elsewhere in the healthcare industry confirm that healthcare spending was down dramatically (though perhaps not quite the 6.4% in the data) in the first quarter. These same sources suggest that healthcare spending has rebounded during the second quarter. The first week of June was actually the best week ever for one major healthcare provider, but the overall trend is still for somewhat lower healthcare spending than last year.

So what happened in the first quarter? Evidently, several things. Number one, if you haven’t noticed, the deductibles for most of the ACA programs were quite high, often running as much as $5000 (which, for what it’s worth, is the deductible on my own insurance program – buying a lower deductible is significantly more expensive than simply paying the higher deductible. Go figure.)

The high deductibles were a shock to many people who were used to more-traditional health insurance. They postponed some services and started looking for transparency of pricing for the more expensive services. It is no longer uncommon for a patient to ask for a prescription for an MRI that they can take to another provider across the street who will charge them half of what the hospital provider will. If you’re paying it out of pocket, you begin to pay attention to what you’re paying. I think we should applaud that increase in transparency.

To those points, Dr. Toby Cosgrove, CEO of Cleveland Clinic, recently noted:

The entire healthcare system will have less money coming into it – we are taking costs out, so will all hospitals…. Obamacare is accelerating the process…. but this is due to transparency of costs and consumer[s] with high-deductible plans. This is a huge social experiment involving almost 18% of GDP and 100% of people… this will take four to five years to shake out.”

Further, there were a lot of people who didn’t get Obamacare insurance in the first few months and had to wait until March or April for their insurance to kick in. Other people have lost their insurance inexplicably because insurers are losing control of their internal management systems amid all the turmoil. People are postponing what they can until their insurance kicks in or gets reinstated. Apparently, some of this has gotten sorted out in the second quarter, and healthcare spending is on a trajectory to the “new normal,” which may eventually be about 20% less than what we spend today.

Muddle Through Economy Redux

I still think the next shoe to drop may be in the third and fourth quarter when hospitals begin to realize that they have significant cash-flow problems. Estimates are that we have about 10% too many hospitals, and the creative destruction of the new healthcare system is going to relieve us of that excess. Only the strong and well-managed will survive. This is of course going to create turmoil in the whole healthcare employment world, etc., etc.

Further, Obamacare is the largest middle-class tax increase in history. Yes, enrollees are getting healthcare for their additional expenditures, but you get extra government services for an increase in regular taxes. Call it a premium or call it a tax, it still amounts to a reduction in disposable income for individuals and families. Tax increases have a negative effect on the economy equal to roughly three times their actual amount. We have gone over that research numerous times.

And that negative effect doesn’t come all at once but is actually spread out over about three years, so the Obamacare taxes will still be creating a headwind to growth this year and next.

Further, although the president has postponed some of the “features” of the ACA, such as the business mandates, they are going to kick in eventually. We’ve already seen a rather large rise in temporary employment as employers shed full-time employees so they don’t have to cover their insurance. We’re going to see more such unintentional consequences, because that’s just where the incentives are. This will of course create even more headwinds for growth and productivity.

We would have to achieve 3% GDP growth in each of the next three quarters simply to average 2% for 2014. If you go back and look at the chart on US real GDP growth, you will notice that we haven’t grown that consistently since the recovery began in 2009. GDP growth has been rather noisy.

We are at best in a slow-growth Muddle Through economy. And the problem is that consumers are getting hammered from all directions: incomes are roughly flat and core expenses are rising.

Returning to the BLS GDP report, we see that inflation was 1.3% in the first quarter as measured by personal consumption expenditures (PCE). One of the “checks and balances” I like to look at when thinking about PCE is what the Dallas Federal Reserve calls the “trimmed mean PCE inflation rate.” Basically they take all the components of inflation in the PCE (which is the Fed’s preferred measure of inflation) and remove the “outliers” (trimming them off, as it were) to smooth out the noise. And sure enough, when you go back and look at the one-month PCE inflation rates for the first quarter, 1.3% seems to be close enough for government work. But then when you look at the chart of what’s happened since then, you see a rather sharp rise in PCE. If that inflation shows up in the BLS statistics next quarter, in their first measure of Q2 GDP (which we will see in late July), it could reduce overall real GDP growth by about 1%. Just saying.

Sidebar: It is all well and good for Janet Yellen to talk about how noisy inflation is and therefore ignore it, but in the things that you and I buy there are what economists call “inelastic” items, which means that we have to buy them no matter what the price – things like food and gas and healthcare. We can talk about whether the overall inflation rate for the entire economy is low, but for the mass of consumers in the middle, inflation is running considerably higher than 1.3%.

All this is to say that while I don’t think the US will fall into an “official recession” next quarter, we are extremely vulnerable to “exogenous shocks.” If either China or Europe has a serious problem, or the price of oil increases dramatically for this or that geopolitical reason, then, with the economy flying barely above stall speed, it wouldn’t take much to push us into a recession. We need to have our antennae up in a world where the biggest bull market seems to be in complacency.

Let’s wrap this session up with a cautionary note from my friend Rich Yamarone (aka Darth Vader)

According to the latest data from the Bureau of Economic Analysis, there has never been a time in history that year-over-year gross domestic income has been at its current pace (2.6 percent) without the U.S. economy ultimately falling into recession. That’s more than 50 years of history, which is about as good as one could ever hope for in an economic indicator.

Stay tuned.

The Frontiers of Life Extension Science

Since we are on the subject of healthcare, let me throw in an additional “bonus note” that my friend Pat Cox, who writes Transformational Technology Alert for Mauldin Economics, sent out to the readers of his free technology updates. Pat and I have regular discussions about the latest discoveries on the very cutting edge of technology and especially biotechnology. This is one of the things that keeps me optimistic, because I think that in 10 to 15 years technology will have totally transformed our healthcare delivery systems and significantly reduced the cost in the system, because we will be healthier and there will be cures for some of the most expensive diseases – we’ll actually be fighting back against the ravages of old age. At least that’s my hope as I approach my 65th birthday in a few months.

So let’s look at this fascinating and rather optimistic piece of research that Pat has come across. (More and more, biotechnology is coming to resemble the science fiction that I read.) By the way, if you like what you read, you can subscribe to get his regular updates for free at this link.

By Patrick Cox

In the article below, I discuss work on the frontiers of life-extension science, including the importance of growth differentiation factor 11 (GDF11), and my friendship with the brilliant writer Robert Heinlein.

There’s an obscure reference to me in Robert Heinlein’s (RAH) book To Sail Beyond the Sunset. It came about due to something I said to him in the home he built in Bonny Doon, California. RAH had asked me to write an article about him and his soon-to-be-published book, The Cat Who Walks Through Walls, for the Wall Street Journal.

So I chose the wine, and his wife Ginny cooked several meals that day as the conversation extended into the morning hours. Pixel, the cat that inspired the book title, was there as well. If you’re interested, I’m pretty sure the article I wrote can be found online if you search for my and his names.

The Cat Who Walks Through Walls is interesting for several reasons. One is that it may be viewed as a sequel to Heinlein’s The Moon Is a Harsh Mistress, though it also continues story lines found in The Number of the Beast. As such, one of the main characters in the book is Lazarus Long, who first appeared in Methuselah’s Children. As the name of that book implies, it involves extremely long-lived characters.

Heinlein gave two explanations for his characters’ longevity. One was selectively bred genetics. The other was periodic blood transfusions from very young donors.

Of course, we’re talking about science fiction, so nobody really believed that young blood could extend lives. If they had, it would have certainly been a simple hypothesis to test. In fact, 73 years after Methuselah’s Children was serialized in Astounding Science Fiction, the experiment was performed last month at the Stanford University School of Medicine – using mice.

Interestingly, the senior author of the Stanford blood study, Tony Wyss-Coray, PhD, noted that the experiment could have been done 20 years ago. Actually, it could have been done long before that. The procedure was relatively simple.

The team gave 18-month-old mice components of blood from 3-month-old mice eight times in 24 days. Then they gave the aged mice a kind of rodent IQ or memory test, which showed significant improvements.

The overview of the study, published in the journal Nature, states:

As human lifespan increases, a greater fraction of the population is suffering from age-related cognitive impairments, making it important to elucidate a means to combat the effects of aging. Here we report that exposure of an aged animal to young blood can counteract and reverse pre-existing effects of brain aging at the molecular, structural, functional and cognitive level. Genome-wide microarray analysis of heterochronic parabionts – in which circulatory systems of young and aged animals are connected – identified synaptic plasticity–related transcriptional changes in the hippocampus of aged mice.

In other words, the brains of the older mice given transfusions of plasma (the cell-free portion of blood from the young mice) did not simply perform better, they exhibited physical signs of a reversal of aging. Clearly, this is a pretty big deal. To reiterate the last sentence of the summary: “Our data indicate that exposure of aged mice to young blood late in life is capable of rejuvenating synaptic plasticity and improving cognitive function.”

Many of the stories about the Stanford study focused on the likelihood that specific factors in the young blood responsible for the rejuvenation can probably be isolated and used on their own. A prime suspect is the protein expressed by the growth differentiation factor 11 (GDF11) gene. GDF11 protein production decreases with age; prior research has shown that it has rejuvenating effects in parts of the body other than the brain.

I’ve written several times in my weekly alerts, for example, about the Amy Wagers and Richard Lee Harvard experiment. Reported in Cell, it showed that age-related damage to heart muscle in older mice will reverse when GDF11 proteins are transferred from younger mice. This is of enormous interest to researchers because, as you probably know, heart muscle does not normally regenerate in older animals.

It’s not surprising, therefore, that Wyss-Coray is the cofounder of Alkahest, a biotech startup exploring the possibility of commercializing some therapy based on his experiments. I don’t think that Alkahest is likely to be the leader in this field, however.

The reason is that therapies based on the Wyss-Coray experiments would be less than optimal. If you are given an exogenous dose of a naturally occurring protein, it tends to upset the regulatory axis that balances all the interactive and complex forces at work in our bodies.

I’m convinced, therefore, that there are better ways to restore rejuvenating GDF11 to youthful levels. One way is to introduce youthful stem cells, engineered from the patient’s own induced pluripotent stem cells (iPSCs), which express GDF11 at high levels.

Induced Pluripotent Stem Cells

One of the most exciting developments in modern medicine is the creation of induced pluripotent stem (iPS) cells. As it happens, I’ve had skin cells taken from inside my left arm transformed into iPS cells by one of the companies in our portfolio. Those iPS cells are identical to the embryonic stem cells that I came from. Because they have my DNA, there’s no chance of immune rejection, which is one of the advantages they have over cells derived from embryonic stem cell lines.

My iPS cells were then engineered to become youthful heart muscle cells. Based on animal experiments, we have every reason to believe that those cells would become part of my body and repair any damage that my heart may have suffered. Here’s a shot of my youthful cardiomyocytes beating in the lab.

Those same iPSCs, however, could also be engineered to become the type of cell, already developed and patented, that produces high levels of GDF11. Placed into my circulatory system, they would replicate and produce their rejuvenating proteins permanently. This would eliminate the need for periodic transfusion or pills. Another method, owned by a different company in the portfolio, is to put DNA plasmids engineered to express GDF11 into a group of cells so that they permanently produce the protein.

This type of therapy is inevitable. Friends of mine who keep track of high-end anti-aging clinics tell me that extremely wealthy clients are paying for youthful blood transfusions right now. The cost, they tell me, is astronomical. Superior results, however, could be attained using induced pluripotent stem cells or DNA vaccines for far less money.

It’s ironic that most ancient cultures and religions seemed to treat young blood as a sacred symbol of power and life. Historically, there are many stories about victors and vampires who drank blood to acquire youth and strength. Ancient instincts were correct, however, in that youthful, healthy blood does have power, as the ancient kings and warlords of mythology believed.

There’s a race going on right now to see who delivers that power and life first. As Dr. Wyss-Coray noted in the paper about his experiment, “As human lifespan increases, a greater fraction of the population is suffering from age-related cognitive impairments, making it important to elucidate a means to combat the effects of aging.” Personally, I suspect that Alzheimer’s and other sources of cognitive impairments will be cured in the next decade. The human desire for increased health and time, however, is limitless, so we’ll continue to follow these life-extending biotechnologies closely as they develop.

(To learn more about Pat’s Breakthrough Technology Alert and other Mauldin Economics publications, click on this link, where you will find an offer to subscribe to all of our publications at a significant discount. This is a permanently low price, and the offer will go away after Monday.)

The Strategic Investment Conference Presentations

The first group of presentations and select videos from the 2014 Strategic Investment Conference is now available! Videos of two of our most popular speakers, Kyle Bass and David Rosenberg, are available, as well as numerous other presentations and summaries. If you are a Mauldin Circle member, you can access the videos by going to www.altegris.com to log in to your “members only” area of the Altegris website. Upon login, click on the “SIC 2014” link in the upper-left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your information will be sent to you.

If you are not already a Mauldin Circle member, the good news is that this program is completely free. In order to join, you must, however, be an accredited investor. Please register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers at our 2014 conference.

Nantucket, New York City, Maine, and San Antonio

What would be considered a normal schedule for me would see me doing all of the above-named cities in less than a month, rather than according to my current travel schedule, which lets me spread them out over three months! I will be in Nantucket at a private conference in the middle of July, then in New York July 13-16. Then, as always, I (along with my son Trey) will be in Grand Lake Stream, Maine, the first Friday in August. I think this will be my eighth annual summer expedition to northern Maine and Leen’s Lodge for David Kotok’s big to-do. Then in the middle of September I will join a number of friends and a great roster of speakers at the Casey Research Conference in the Hill Country outside of San Antonio. I’m sure there will be other trips here and there, but I am anticipating being at home a little more for the next few months.

One of the benefits of being home is that I can get into a regular routine at the gym. I and a partner are working with a personal trainer at the gym in our building. His training style is a little different for us and has me doing things that I quite frankly haven’t thought about doing in 40 years. Wind sprints, steps, all sorts of novel ways to torture the body and get your heart rate up, and yes, old-fashioned weights now and then. This morning he introduced me to boxing gloves. The last time I had on boxing gloves, I was a sophomore in high school when our gym coach had us put on gloves and I went into a ring for about three minutes. I took them off with a vow to never touch them again. It was an exhausting three minutes trying to avoid getting pummeled. At least this morning the big brute wasn’t hitting back, but it was quite the workout. I really do need to get in better shape.

I’m cooking for a group of friends and family, so I need to hit the send button and get the prime rib started. Have a great week.

Your wishing I could avoid the healthcare system altogether analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Outside the Box: The Four Horsemen of the Geopolitical Apocalypse

 

Ian Bremmer, NYU professor and head of the geopolitical consulting powerhouse Eurasia Group, consults at the highest levels with both governments and companies because he brings to the table robust geopolitical analysis and a compelling thesis: that we are witnessing “the creative destruction of the old geopolitical order.” We live, as his last book told us, in a “G-0” world. In today’s Outside the Box, Ian spells out what that creative destruction means in terms of events on the ground today. As Ian notes, the most prominent feature of the international landscape this year has been the expansion of geopolitical conflict. That expansion is gaining momentum, he says, creating larger-scale crises and sharpening market volatility.

Hold on to the reins now as Ian take us for a ride with the “Four Horsemen of the Geopolitical Apocalypse.” (For more information about the Eurasia Group or to contact Ian Bremmer, please email Kim Tran at tran@eurasiagroup.net.)

We’ll follow up Ian’s piece with an excellent short analysis of the Iraq situation from a Middle East expert at a large hedge fund I correspond with. Pretty straightforward take on the situation with regard to ISIS. This quagmire has real implications for the world oil supply. (It appears that the Sunni rebel forces are now in complete control of the key Baiji Refinery, which produces a third of Iraq’s output.)

Back in Dallas, it’s a little hard to focus on geopolitical events when seemingly all the news is about ongoing domestic crises. But the outrageous IRS loss of emails doesn’t really affect our portfolios all that much. What happens in Iraq or with China does. There’s just not the emotional impact.

One domestic humanitarian crisis that is brewing just south of me is the massive influx of very young children across the US-Mexican border. When this was first brought to my attention a few weeks ago, I must admit that I questioned the credibility of the source. We have had young children walking across the Texas border for decades but always in rather small numbers. The first source I read said that 40,000 had already come over this year. I just found that to be non-credible, but then with a little reasonable research it not only became believable but could be a bit low – it looks as many as 90,000 children will cross the border this year.

What in the name of the Wide Wide World of Sports is going on? First of all, how do you cover up something of this magnitude until it is a true crisis? When the administration and other authorities clearly knew about it last year? (The evidence is irrefutable. They knew.)

I am the father of five adopted children. In an earlier phase of my life, I was somewhat involved with Child Protective Services here in Texas. It was an emotionally difficult and heartrending experience. (One of my children came out of that system and three from outside of the United States). I have no idea how you care for 90,000 children who don’t speak the language and have no connection to their new locale. Forget the dollar cost, which could run into the tens of billions over time. These are children, and they are on our doorstep and our watch. You simply can’t ignore them and say, “They are not supposed to be here, so it’s not our responsibility.” They are children. Someone, and that means here in the US, is going to have to figure out how to take care of them, even if it is only to learn why they try to come and figure out where to send them back to. And frankly, trying to to send them back is going to be a logistical and legal nightmare, not to mention psychologically traumatic to the children.

Maybe someone thought that waiting until there was a crisis to let this information slip out (and we found out about it because of photos posted anonymously of children packed together in holding cells) would create momentum for immigration reform. And they may be right. But I’m not certain it’s going to result in the type of immigration reform they were hoping to get.

I have to admit that I’ve been rather tolerant of illegal immigrants over the course of my life. There are a dozen or so key issues that I think this country should focus on, but I’ve just never gotten that worked up about illegal immigration. The simple fact is that everyone here in the US is either an immigrant or descended from immigrants. It may be, too, that I’ve hired a few undocumented workers here and there in my life. As an economist, I know that we should be trying to figure out how to get more capable immigrants here, not less. What you want are educated young people who are motivated to create and work, not children as young as four or five years old who are going to need housing, education, adult supervision, healthcare, and most of all a loving environment where they can grow up.

It is one thing for undocumented workers to come across the border looking for jobs or for families to come across together. It is a completely different matter when tens of thousands of preteen children come across the border without parents or supervision. They didn’t get across 1500 miles of desert without significant support and a great deal of planning. This couldn’t be happening without the awareness of authorities in Mexico and the Central American countries from which these children come, and if this is truly a surprise to Homeland Security, then there is a significant failure somewhere in the system.

And if it was not a surprise? That begs a whole different series of questions.

This is a major humanitarian crisis, and it is not in the Middle East or Africa. It is on our border, and we need to figure out what to do about it NOW!

I don’t care whether you think we need to build a 20-foot-high wall across the southern border of the United States or give amnesty to anyone who wants to come in (or both), something has to be done with these children. It is a staggering problem of enormous logistical proportions, and we have a simple human responsibility to take care of those who cannot take care of themselves.

And on that note I will go ahead and hit the send button, and let’s focus on the critical geopolitical events happening around the globe. Iraq is a disaster. Ukraine is a crisis. What’s happening in the China Sea is troubling. It just seems to come at you from everywhere. Even on a beautiful summer day.

Your stunned by the magnitude of it all at analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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(From Ian Bremmer)

dear john,

we’re halfway through 2014, and the single most notable feature of the international landscape has been the expansion of geopolitical conflict. why should we care? what’s the impact; what does it mean for the global economy? how should we think about geopolitics?

my thoughts on the topic, looking at the four key geopolitical pieces “in play”–in eurasia, the middle east, asia, and the transatlantic.

geopolitics

i’ve written for several years about the root causes of the geopolitical instability the world is presently experiencing. a new, g-zero world where the united states is less interested in providing global leadership and nobody else is willing or able to step into that role. that primary leadership vacuum is set against a context of competing foreign policy priorities from increasingly powerful emerging markets (with very different political and economic systems) and a germany-led europe; challenges to the international system from a revisionist russia in decline; and difficulties in coordination from a proliferation of relevant state and non-state actors even when interests are aligned. all of this has stirred tensions in the aftermath of the financial crisis: instability across the middle east after a stillborn arab spring; a three-year syrian civil war; a failed russia “reset”; rising conflict between china and japan; fraying american alliances with countries like brazil, germany, and saudi arabia.

and yet geopolitical concerns haven’t particularly changed our views on global markets. each conflict has been small and self-contained (or the spillover wasn’t perceived to matter much). geopolitics has been troubling on the margins but not worth more than a fret.

that’s about to change. though perceived as discrete events, the rise of these geopolitical tensions are all directly linked to the creative destruction of the old geopolitical order. it’s a process that’s gaining momentum, creating in turn larger-scale crises and broader market volatility. we’ve now reached the point where near- to mid-term outcomes of several geopolitical conflicts could become major drivers of the global economy. that’s true of russia/ukraine, iraq, the east and south china seas and us/europe. in each, the status quo is unsustainable (though for very different reasons). and so, as it were, the four horsemen of the geopolitical apocalypse.

russia/ukraine

the prospect of losing ukraine was the last straw for a russian government that has been steadily losing geopolitical influence since the collapse of the soviet union over two decades ago. moscow sees nato enlargement, expanded european economic integration, energy diversification and the energy revolution as direct security threats that need to be countered. ukraine is also an opportunity for the kremlin…for president putin to invigorate a flagging support base at home.

putin intends to raise the economic and military pressure on kiev until, at a minimum, southeast ukraine is effectively under russian control. the ukrainian government’s latest effort in response, a unilateral week-long cease fire in the southeast, was greeted with lukewarm rhetoric by putin and rejected by russian separatists in the region, who escalated their attacks against the ukrainian military. meanwhile, thousands of russian troops recently pulled back from the ukrainian border have now been redeployed there, bolstered by putin ordering 65,000 russian troops on combat alert in the region.

the choices for kiev are thankless. if they press further, violence intensifies and russian support expands, either routing the ukrainian military, or taking serious losses and requiring direct “formal” intervention of russian troops. if they back off, they lose the southeast, which is critical for their internal legitimacy from the ukrainian population at large. all the while the ukrainian economy teeters with much of their industrial base off line, compounded by russian disruptions on customs, trade, and gas supply.

the growing conflict will lead to further deterioration of russia’s relationship with the united states and europe: gas flow disruptions, expansion of defense spending and nato coordination with poland and the baltic states, turbulence around moldova and georgia given their european association agreements this week…and “level 3″ sectoral sanctions against russia. that in turn means a serious economic downturn in russia itself…and knock-on economic implications for europe, which has far greater exposure to russia than the united states does.

for the last several years, the major market concern for europe was economic: the potential for collapse of the eurozone. that’s no longer a worry. the primary risk to europe is now clearly geopolitical, that expanded russia/ukraine conflict hurts europe, in worst case pushing the continent back into recession.

iraq

like so much of the world’s colonial legacy, many of the middle east’s borders only “worked” because of the combination of secular authoritarian rule and international military and economic support. that was certainly true of iraq–most recently under decades of control by the baath party, beginning in 1963. saddam hussein’s ouster forty years later by the united states and great britain, combined with the dismantling of nearly all of the military and political architecture that supported him (in dramatic contrast to, say, the ouster of egypt’s hosni mubarak) undermined iraq’s territorial integrity. since then, iraqi governance could still nominally function given significant american military presence and military and economic aid. once that was removed, there was little left to keep iraq functioning as a country.

sectarianism is the primary form of allegiance in iraq today, both limiting the reach of prime minister nouri al maliki’s majority shia government and creating closer ties between iraq’s sunni, shia and kurdish populations and their brethren outside iraq’s borders. extremism within iraq has also grown dramatically as a consequence, particularly among the now disenfranchised sunni population–made worse by their heavy losses in the war against bashar assad across the largely undefended border with syria. the tipping point came with the broad attacks by the islamic state of iraq and syria (isis) over the past fortnight, speeding up a decade-long expansion of sectarian violence and ethnic cleansing between iraq’s sunni and shia. the comparatively wealthy and politically stable kurds have done their best to steer clear of the troubles, seizing a long-sought opportunity for de facto independence.

the american response has been cautious. domestic support for military engagement in iraq diminished greatly as the war in iraq continued and the economic and human costs mounted. obama repeatedly promised an end to the occupation and considered full withdrawal a major achievement of his administration. there’s little domestic upside for taking responsibility in the crisis. obama’s position has accordingly been that any direct military involvement requires a change in governance from the iraqis–initially sounding like a unity government and increasingly evolving into the replacement of prime minister maliki. the pressure on maliki has gained momentum with shia grand ayatollah ali al-sistani calling on the iraqi prime minister to broaden the government to include more kurds and sunnis.

but maliki, having successfully fought constitutional crises and assassination attempts, to say nothing of decisively winning a democratic election, is unlikely to go. isis poses a threat to the unity of the iraqi state, but not to maliki’s rule of iraq’s majority shia population, which if anything now stands stronger than it did before the fighting. and maliki’s key international sponsor, iran, has little interest in forcing maliki into compromise as long as there’s no threat to baghdad: they see themselves in far better strategic standing with a maliki-led iraqi government where they exert overwhelming influence, than over a broader government where they’re one of many competing international forces. further, even if maliki were prepared to truly share power with iraq’s kurds and sunni (something made more likely by the informal “influence” of 300 us military advisors now arriving in baghdad), he’s unlikely to see much enthusiasm responding to that offer. the kurds are better off sticking to nominal (and a clearer road to eventual formal) independence; and sunni leaders that publicly find common cause with maliki would better hope all their family members aren’t anywhere isis can find them.

absent american (or anyone else’s) significant military engagement, the iraqi government is unlikely to be able to remove isis from leadership and, accordingly, reassert control over the sunni and kurdish areas of the country. that will lead to a significant increase in extremist violence emanating from the islamic world, a trend that’s already deteriorated significantly in recent years (and since obama administration officials announced that cyberattacks were the biggest national security threat to the united states–a claim president obama overturned during his west point speech last month). since 2010, the number of known jihadist fighters has more than doubled; attacks by al qaeda affiliates have tripled.

the combination of challenging economic conditions, sectarian leadership, and the communications revolution empowering individuals through narrowing political and ideological demographic lenses all make this much more likely to expand. that’s a greater threat to stability in the poorer middle eastern markets, but also will morph back into a growing terrorist threat against western assets in the region and more broadly. that creates, in turn, demand for increased security spending and bigger concerns about fat tail terrorism in the developed world, particularly in southern and western europe (where large numbers of unintegrated and unemployed islamic populations will pose more of a direct threat).

the broader risk is that sunni/shia conflict metastasizes into a single broader war. isis declares an islamic state across sunni iraq and syria, becoming ground zero for terrorist funding and recruitment from across the region. the saudi government condemns the absence of international engagement in either conflict and directly opposes an increasingly heavy and public iranian hand in iraqi and syrian rule. the united states completes a comprehensive nuclear deal with iran and declares victory (but doesn’t work meaningfully with teheran on iraq), steering clear of the growing divide between the middle east’s two major powers. the gulf cooperation council starts to fragment as members see opportunity in economic engagements with iran. iranian “advisors” in iraq morph into armed forces; saudi arabia publicly opposes isis, but saudi money and weapons get into their hands and an abundance of informal links pop up. militarization grows between an emboldened iran and a more isolated, defensive saudi arabia. that’s when the geopolitical premium around energy prices becomes serious.

east/south china sea

ukraine and iraq are the two major active geopolitical conflicts. but there are two more geopolitical points of tension involving major economies that are becoming significant.

in asia, it’s the consequences of (and reactions to) an increasingly powerful and assertive china. the growth of china’s influence remains the world’s most important geopolitical story by a long margin. but, at least to date, china’s growth is mostly an opportunity for the rest of the world. for the middle east, it’s the principal new source of energy demand as the united states becomes more energy independent. for africa, it’s the best opportunity to build out long-needed infrastructure across the continent. for europe and even the united states, it’s a critical source of credit propping up currency, and a core producer of inexpensive goods. that’s not to argue that there aren’t significant caveats in each of these stories (or that those caveats aren’t growing–they are), but rather that overall, china has been primarily perceived as an opportunity rather than a threat for all of these actors, and so it remains today.

for asia, a rising china has been seen more clearly as a double-edged sword. the greater comparative importance of the chinese economy has translated into more political influence (formal and informal) for beijing, at the expense of other governments in the region. meanwhile, china’s dramatic military buildup has fundamentally changed the balance of power in asia; it’s had negligible interest elsewhere.

china’s military assertiveness has also grown in its backyard. in other regions, china continues to promote itself as a poor country that needs to focus on its own development and stability. in east and southeast asia china has core interests that it defends, and it is increasingly willing to challenge the status quo as its influence becomes asymmetrically greater.

that’s been most clear with vietnam, where china first sent one oil rig to drill in contested waters directly off vietnam’s shore–accompanied by several hundred chinese fishing vessels. they announced last week that they are repositioning four more. unsurprisingly, the vietnamese response has been sharp–anti-chinese demonstrations, violence, increased naval presence in the region, and coordination with the philippines.

none of that creates significant political risk on its own: vietnam isn’t an ally of the united states and so engenders less support and response from washington than the philippines or japan…which is precisely why beijing has decided that’s the best place to start changing the regional security balance.

but tokyo feels differently. the japanese government understands that a rising china is longer term a much more existential threat to its own security position in asia, and it isn’t prepared to wait to raise concern until its position weakens further. so prime minister shinzo abe has declared his security support for vietnam. for america’s part, obama has jettisoned the official “pivot” to asia. but the administration continues to believe that america’s core national security interests, now and in the future, are in asia; and if china significantly escalates tensions in the east and south china seas, the united states is not likely to sit as idly by as they have on syria or ukraine.

the good news here is that–unlike with the countries driving the tensions in eurasia and the middle east–china has solid political stability and isn’t looking for international trouble. but the realities of chinese growth, coupled with strong leadership from japan and (over time) india, along with the persistence of a strong american footprint are contributing to a much more troublesome geopolitical environment in the region.

the principle danger to the markets is what happens if the chinese government no longer holds that perspective. president xi jinping’s commitment to transformational economic reform has been strong over the first year of his rule, and he has gotten surprisingly little pushback from the country’s entrenched elites. but the uncertainty around china’s near- to medium-term trajectory is radically greater than that of any of the world’s other major economies. should significant instability emerge in china, very plausible indeed, china’s willingness to take on a far more assertive (and risk-acceptant) security strategy in the region, promoting nationalism in the way putin has built his support base of late, would become far more likely. and then, the east and south china seas move to the top of our list.

us-europe

finally, the transatlantic relationship. advanced industrial economies with consolidated institutions and political stability, there’s none of the geopolitical conflict presently visible in the middle east, eurasia, or asia. geopolitical tensions have long been absent from the transatlantic relationship, the great success of the nato alliance. for all the occasional disagreement in europe on us military and security policy both during the cold war and since (the war in iraq, israel/palestine, counterterrorism and the like), european states never considered the need for broader security ties as a counterbalance for nato membership.

but the changing nature of geopolitics is creating a rift between the united states and europe. american global hegemony had security and economic components, and it was collective security that had been the core element holding together the transatlantic alliance. that’s no longer the case–a consequence of changing priorities for the americans and europeans, and an evolving world order (russia/ukraine a major blip, but notwithstanding). the transatlantic relationship is much less closely aligned on economics.

it’s not the conventional wisdom. most observers say that, after bush, american policy looks more european these days–less militarist, more multilateralist. but actually, us foreign policy isn’t becoming more like europe, it’s becoming more like china. it’s less focused on the military, except on issues of core security concern (in which case the united states acts with little need to consult allies), while american economic policy tends to be unilateralist in supporting preferred american geopolitical outcomes–which is seen most directly in us sanctions behavior (over $15bn in fines now levied against more than 20 international banks–mostly european) and nsa surveillance policy (with no willingness of the us to cooperate in a germany requested “no spying” mutual agreement)

transatlantic economic dissonance is also in evidence in a number of more fundamental ways: america’s “growth uber alles” approach to a downturn in the economy, compared to germany’s fixation on fiscal accountability. europe’s greater alignment between governments and corporations on industrial policy, as opposed to a more decentralized, private-sector led (and occasionally captured) american policy environment. a more economy-driven opportunistic european approach to china, russia and other developing markets; the us government looking focused more on us-led/”universalist” principles on industrial espionage, intellectual property, etc.

as the g-zero persists, we will see the united states looking to enforce more unilateral economic standards that the europeans resent and resist; while the europeans look to other countries more strategically as counterbalances to american economic hegemony (the german-china relationship is critical in this regard, but that’s also true of europe’s willingness to support american economic policies in russia and the middle east). all of this means a much less cooperative trans-atlantic relationship–less “universalism” (from the american perspective) and less “multilateralism” (from the european perspective). more zero-sumness in the transatlantic relationship is a big change in the geopolitical environment; a precursor to true multipolarity, but in the interim a more fragmented and much less efficient global marketplace.

* * *

so that’s where i see geopolitics emerging as a key factor for the global markets–much more than at any time since the end of the cold war. there’s some good news and bad news here.

the good news is none of these geopolitical risks are likely to have the sort of market implications that the macro economic risks did after the financial crisis. there are lots of reasons for that. a low interest rate environment and solid growth from the us and china–plus the eurozone out of recession–along with pent up demand for investment is leading to significant optimism that won’t be easily cowed by geopolitics. the supply/demand energy story is largely bearish, so near-term geopolitical risks from the middle east won’t create sustained high prices. and markets don’t know how to price geopolitical risk well; they’re not covered as clearly analytically, so investors don’t pay as much attention (until/unless they have to).
 
the bad news…that very lack of pressure from the markets means political leaders won’t feel as much need to address these crises even as they expand, particularly in the united states. this is another reason the world’s geopolitical crises will persist beyond a level that a similar economic crisis would hit before serious measures start to be taken to mitigate them. these geopolitical factors are going to grow. now’s the time to start paying attention to them.

* * *

every once in a while, it’s good to take a step back and look at the big picture. hope you found that worthwhile. i’ll surely get back in the weeds next monday.

meanwhile, it’s looking like a decidedly lovely week in new york.

very best,
ian

 

From intel sources:

Dislodging ISIS Will Be a Difficult Task

The ISIS advance toward Baghdad may be temporarily held off as the government rallies its remaining security forces and Shia militias organize for the upcoming Battle for Baghdad. There is a rather clear reason why the ISIS leader has renamed himself Abu Bakr al-Baghdadi, meaning the Caliph of Baghdad . ISIS will at a minimum be able to take control of some Sunni neighborhoods in Baghdad shortly and wreak havoc on the city with IEDs, ambushes, single suicide attacks, and suicide assaults that target civilians, the government, security forces, senior members of government, and foreign installations and embassies. Additionally, the brutal sectarian slaughter of Sunni and Shia alike that punctuated the violence in Baghdad from 2005 to 2007 is likely to return as Shia militias and ISIS fighters begin to assert control of neighborhoods and roam the streets.

Even if Iraqi forces are able to keep ISIS from fully taking Baghdad and areas south, it is unlikely the beleaguered military and police forces will be able to retake the areas under ISIS control in the north and west without significant external support, as well as the support of the Kurds.

ISIS and its allies are in a position today that closely resembles the position prior to the US surge back in early 2007. More than 130,000 US troops, partnered with the Sunni Awakening formations and Iraqi security forces numbering in the hundreds of thousands, were required to clear Anbar, Salahaddin, Diyala, Ninewa, Baghdad, and the “triangle of death.” The concurrent operations took more than a year, and were supported by the US Air Force, US Army aviation brigades, and US special operations raids that targeted the jihadists’ command and control, training camps, and bases, as well as its IED and suicide bomb factories.

Today, the Iraqis have no US forces on the ground to support them, US air power is absent, the Awakening is scattered and disjointed, and the Iraqi military has been humiliated badly while surrendering or retreating in disarray during the lightning fast jihadists’ campaign from Mosul to the outskirts of Baghdad. This campaign, by the way, has been remarkably and significantly faster than the U.S. armored campaign advance to Baghdad in 2003 . The US government has indicated that it will not deploy US soldiers in Iraq, either on the ground or at airbases to conduct air operations.  Meanwhile, significant amounts of US made advanced armaments, vehicles, ammunition, and diverse military equipment have fallen into ISIS jihadists’ hands .

ISIS is advancing boldly in the looming security vacuum left by the collapse of the Iraqi security forces and the West’s refusal to recommit forces to stabilize Iraq. This has rendered the country vulnerable to further incursions by al Qaeda-linked jihadists as well as intervention by interested neighbors such as Iran. Overt Iranian intervention in Iraq would likely lead any Sunnis still loyal to the government to side with ISIS and its allies, and would ensure that Iraq would slide even closer to a full-blown civil war and de facto partition, and risk a wider war throughout the Middle East.

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Outside the Box: The Four Horsemen of the Geopolitical Apocalypse

 

Ian Bremmer, NYU professor and head of the geopolitical consulting powerhouse Eurasia Group, consults at the highest levels with both governments and companies because he brings to the table robust geopolitical analysis and a compelling thesis: that we are witnessing “the creative destruction of the old geopolitical order.” We live, as his last book told us, in a “G-0” world. In today’s Outside the Box, Ian spells out what that creative destruction means in terms of events on the ground today. As Ian notes, the most prominent feature of the international landscape this year has been the expansion of geopolitical conflict. That expansion is gaining momentum, he says, creating larger-scale crises and sharpening market volatility.

Hold on to the reins now as Ian take us for a ride with the “Four Horsemen of the Geopolitical Apocalypse.” (For more information about the Eurasia Group or to contact Ian Bremmer, please email Kim Tran at tran@eurasiagroup.net.)

We’ll follow up Ian’s piece with an excellent short analysis of the Iraq situation from a Middle East expert at a large hedge fund I correspond with. Pretty straightforward take on the situation with regard to ISIS. This quagmire has real implications for the world oil supply. (It appears that the Sunni rebel forces are now in complete control of the key Baiji Refinery, which produces a third of Iraq’s output.)

Back in Dallas, it’s a little hard to focus on geopolitical events when seemingly all the news is about ongoing domestic crises. But the outrageous IRS loss of emails doesn’t really affect our portfolios all that much. What happens in Iraq or with China does. There’s just not the emotional impact.

One domestic humanitarian crisis that is brewing just south of me is the massive influx of very young children across the US-Mexican border. When this was first brought to my attention a few weeks ago, I must admit that I questioned the credibility of the source. We have had young children walking across the Texas border for decades but always in rather small numbers. The first source I read said that 40,000 had already come over this year. I just found that to be non-credible, but then with a little reasonable research it not only became believable but could be a bit low – it looks as many as 90,000 children will cross the border this year.

What in the name of the Wide Wide World of Sports is going on? First of all, how do you cover up something of this magnitude until it is a true crisis? When the administration and other authorities clearly knew about it last year? (The evidence is irrefutable. They knew.)

I am the father of five adopted children. In an earlier phase of my life, I was somewhat involved with Child Protective Services here in Texas. It was an emotionally difficult and heartrending experience. (One of my children came out of that system and three from outside of the United States). I have no idea how you care for 90,000 children who don’t speak the language and have no connection to their new locale. Forget the dollar cost, which could run into the tens of billions over time. These are children, and they are on our doorstep and our watch. You simply can’t ignore them and say, “They are not supposed to be here, so it’s not our responsibility.” They are children. Someone, and that means here in the US, is going to have to figure out how to take care of them, even if it is only to learn why they try to come and figure out where to send them back to. And frankly, trying to to send them back is going to be a logistical and legal nightmare, not to mention psychologically traumatic to the children.

Maybe someone thought that waiting until there was a crisis to let this information slip out (and we found out about it because of photos posted anonymously of children packed together in holding cells) would create momentum for immigration reform. And they may be right. But I’m not certain it’s going to result in the type of immigration reform they were hoping to get.

I have to admit that I’ve been rather tolerant of illegal immigrants over the course of my life. There are a dozen or so key issues that I think this country should focus on, but I’ve just never gotten that worked up about illegal immigration. The simple fact is that everyone here in the US is either an immigrant or descended from immigrants. It may be, too, that I’ve hired a few undocumented workers here and there in my life. As an economist, I know that we should be trying to figure out how to get more capable immigrants here, not less. What you want are educated young people who are motivated to create and work, not children as young as four or five years old who are going to need housing, education, adult supervision, healthcare, and most of all a loving environment where they can grow up.

It is one thing for undocumented workers to come across the border looking for jobs or for families to come across together. It is a completely different matter when tens of thousands of preteen children come across the border without parents or supervision. They didn’t get across 1500 miles of desert without significant support and a great deal of planning. This couldn’t be happening without the awareness of authorities in Mexico and the Central American countries from which these children come, and if this is truly a surprise to Homeland Security, then there is a significant failure somewhere in the system.

And if it was not a surprise? That begs a whole different series of questions.

This is a major humanitarian crisis, and it is not in the Middle East or Africa. It is on our border, and we need to figure out what to do about it NOW!

I don’t care whether you think we need to build a 20-foot-high wall across the southern border of the United States or give amnesty to anyone who wants to come in (or both), something has to be done with these children. It is a staggering problem of enormous logistical proportions, and we have a simple human responsibility to take care of those who cannot take care of themselves.

And on that note I will go ahead and hit the send button, and let’s focus on the critical geopolitical events happening around the globe. Iraq is a disaster. Ukraine is a crisis. What’s happening in the China Sea is troubling. It just seems to come at you from everywhere. Even on a beautiful summer day.

Your stunned by the magnitude of it all at analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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(From Ian Bremmer)

dear john,

we’re halfway through 2014, and the single most notable feature of the international landscape has been the expansion of geopolitical conflict. why should we care? what’s the impact; what does it mean for the global economy? how should we think about geopolitics?

my thoughts on the topic, looking at the four key geopolitical pieces “in play”–in eurasia, the middle east, asia, and the transatlantic.

geopolitics

i’ve written for several years about the root causes of the geopolitical instability the world is presently experiencing. a new, g-zero world where the united states is less interested in providing global leadership and nobody else is willing or able to step into that role. that primary leadership vacuum is set against a context of competing foreign policy priorities from increasingly powerful emerging markets (with very different political and economic systems) and a germany-led europe; challenges to the international system from a revisionist russia in decline; and difficulties in coordination from a proliferation of relevant state and non-state actors even when interests are aligned. all of this has stirred tensions in the aftermath of the financial crisis: instability across the middle east after a stillborn arab spring; a three-year syrian civil war; a failed russia “reset”; rising conflict between china and japan; fraying american alliances with countries like brazil, germany, and saudi arabia.

and yet geopolitical concerns haven’t particularly changed our views on global markets. each conflict has been small and self-contained (or the spillover wasn’t perceived to matter much). geopolitics has been troubling on the margins but not worth more than a fret.

that’s about to change. though perceived as discrete events, the rise of these geopolitical tensions are all directly linked to the creative destruction of the old geopolitical order. it’s a process that’s gaining momentum, creating in turn larger-scale crises and broader market volatility. we’ve now reached the point where near- to mid-term outcomes of several geopolitical conflicts could become major drivers of the global economy. that’s true of russia/ukraine, iraq, the east and south china seas and us/europe. in each, the status quo is unsustainable (though for very different reasons). and so, as it were, the four horsemen of the geopolitical apocalypse.

russia/ukraine

the prospect of losing ukraine was the last straw for a russian government that has been steadily losing geopolitical influence since the collapse of the soviet union over two decades ago. moscow sees nato enlargement, expanded european economic integration, energy diversification and the energy revolution as direct security threats that need to be countered. ukraine is also an opportunity for the kremlin…for president putin to invigorate a flagging support base at home.

putin intends to raise the economic and military pressure on kiev until, at a minimum, southeast ukraine is effectively under russian control. the ukrainian government’s latest effort in response, a unilateral week-long cease fire in the southeast, was greeted with lukewarm rhetoric by putin and rejected by russian separatists in the region, who escalated their attacks against the ukrainian military. meanwhile, thousands of russian troops recently pulled back from the ukrainian border have now been redeployed there, bolstered by putin ordering 65,000 russian troops on combat alert in the region.

the choices for kiev are thankless. if they press further, violence intensifies and russian support expands, either routing the ukrainian military, or taking serious losses and requiring direct “formal” intervention of russian troops. if they back off, they lose the southeast, which is critical for their internal legitimacy from the ukrainian population at large. all the while the ukrainian economy teeters with much of their industrial base off line, compounded by russian disruptions on customs, trade, and gas supply.

the growing conflict will lead to further deterioration of russia’s relationship with the united states and europe: gas flow disruptions, expansion of defense spending and nato coordination with poland and the baltic states, turbulence around moldova and georgia given their european association agreements this week…and “level 3″ sectoral sanctions against russia. that in turn means a serious economic downturn in russia itself…and knock-on economic implications for europe, which has far greater exposure to russia than the united states does.

for the last several years, the major market concern for europe was economic: the potential for collapse of the eurozone. that’s no longer a worry. the primary risk to europe is now clearly geopolitical, that expanded russia/ukraine conflict hurts europe, in worst case pushing the continent back into recession.

iraq

like so much of the world’s colonial legacy, many of the middle east’s borders only “worked” because of the combination of secular authoritarian rule and international military and economic support. that was certainly true of iraq–most recently under decades of control by the baath party, beginning in 1963. saddam hussein’s ouster forty years later by the united states and great britain, combined with the dismantling of nearly all of the military and political architecture that supported him (in dramatic contrast to, say, the ouster of egypt’s hosni mubarak) undermined iraq’s territorial integrity. since then, iraqi governance could still nominally function given significant american military presence and military and economic aid. once that was removed, there was little left to keep iraq functioning as a country.

sectarianism is the primary form of allegiance in iraq today, both limiting the reach of prime minister nouri al maliki’s majority shia government and creating closer ties between iraq’s sunni, shia and kurdish populations and their brethren outside iraq’s borders. extremism within iraq has also grown dramatically as a consequence, particularly among the now disenfranchised sunni population–made worse by their heavy losses in the war against bashar assad across the largely undefended border with syria. the tipping point came with the broad attacks by the islamic state of iraq and syria (isis) over the past fortnight, speeding up a decade-long expansion of sectarian violence and ethnic cleansing between iraq’s sunni and shia. the comparatively wealthy and politically stable kurds have done their best to steer clear of the troubles, seizing a long-sought opportunity for de facto independence.

the american response has been cautious. domestic support for military engagement in iraq diminished greatly as the war in iraq continued and the economic and human costs mounted. obama repeatedly promised an end to the occupation and considered full withdrawal a major achievement of his administration. there’s little domestic upside for taking responsibility in the crisis. obama’s position has accordingly been that any direct military involvement requires a change in governance from the iraqis–initially sounding like a unity government and increasingly evolving into the replacement of prime minister maliki. the pressure on maliki has gained momentum with shia grand ayatollah ali al-sistani calling on the iraqi prime minister to broaden the government to include more kurds and sunnis.

but maliki, having successfully fought constitutional crises and assassination attempts, to say nothing of decisively winning a democratic election, is unlikely to go. isis poses a threat to the unity of the iraqi state, but not to maliki’s rule of iraq’s majority shia population, which if anything now stands stronger than it did before the fighting. and maliki’s key international sponsor, iran, has little interest in forcing maliki into compromise as long as there’s no threat to baghdad: they see themselves in far better strategic standing with a maliki-led iraqi government where they exert overwhelming influence, than over a broader government where they’re one of many competing international forces. further, even if maliki were prepared to truly share power with iraq’s kurds and sunni (something made more likely by the informal “influence” of 300 us military advisors now arriving in baghdad), he’s unlikely to see much enthusiasm responding to that offer. the kurds are better off sticking to nominal (and a clearer road to eventual formal) independence; and sunni leaders that publicly find common cause with maliki would better hope all their family members aren’t anywhere isis can find them.

absent american (or anyone else’s) significant military engagement, the iraqi government is unlikely to be able to remove isis from leadership and, accordingly, reassert control over the sunni and kurdish areas of the country. that will lead to a significant increase in extremist violence emanating from the islamic world, a trend that’s already deteriorated significantly in recent years (and since obama administration officials announced that cyberattacks were the biggest national security threat to the united states–a claim president obama overturned during his west point speech last month). since 2010, the number of known jihadist fighters has more than doubled; attacks by al qaeda affiliates have tripled.

the combination of challenging economic conditions, sectarian leadership, and the communications revolution empowering individuals through narrowing political and ideological demographic lenses all make this much more likely to expand. that’s a greater threat to stability in the poorer middle eastern markets, but also will morph back into a growing terrorist threat against western assets in the region and more broadly. that creates, in turn, demand for increased security spending and bigger concerns about fat tail terrorism in the developed world, particularly in southern and western europe (where large numbers of unintegrated and unemployed islamic populations will pose more of a direct threat).

the broader risk is that sunni/shia conflict metastasizes into a single broader war. isis declares an islamic state across sunni iraq and syria, becoming ground zero for terrorist funding and recruitment from across the region. the saudi government condemns the absence of international engagement in either conflict and directly opposes an increasingly heavy and public iranian hand in iraqi and syrian rule. the united states completes a comprehensive nuclear deal with iran and declares victory (but doesn’t work meaningfully with teheran on iraq), steering clear of the growing divide between the middle east’s two major powers. the gulf cooperation council starts to fragment as members see opportunity in economic engagements with iran. iranian “advisors” in iraq morph into armed forces; saudi arabia publicly opposes isis, but saudi money and weapons get into their hands and an abundance of informal links pop up. militarization grows between an emboldened iran and a more isolated, defensive saudi arabia. that’s when the geopolitical premium around energy prices becomes serious.

east/south china sea

ukraine and iraq are the two major active geopolitical conflicts. but there are two more geopolitical points of tension involving major economies that are becoming significant.

in asia, it’s the consequences of (and reactions to) an increasingly powerful and assertive china. the growth of china’s influence remains the world’s most important geopolitical story by a long margin. but, at least to date, china’s growth is mostly an opportunity for the rest of the world. for the middle east, it’s the principal new source of energy demand as the united states becomes more energy independent. for africa, it’s the best opportunity to build out long-needed infrastructure across the continent. for europe and even the united states, it’s a critical source of credit propping up currency, and a core producer of inexpensive goods. that’s not to argue that there aren’t significant caveats in each of these stories (or that those caveats aren’t growing–they are), but rather that overall, china has been primarily perceived as an opportunity rather than a threat for all of these actors, and so it remains today.

for asia, a rising china has been seen more clearly as a double-edged sword. the greater comparative importance of the chinese economy has translated into more political influence (formal and informal) for beijing, at the expense of other governments in the region. meanwhile, china’s dramatic military buildup has fundamentally changed the balance of power in asia; it’s had negligible interest elsewhere.

china’s military assertiveness has also grown in its backyard. in other regions, china continues to promote itself as a poor country that needs to focus on its own development and stability. in east and southeast asia china has core interests that it defends, and it is increasingly willing to challenge the status quo as its influence becomes asymmetrically greater.

that’s been most clear with vietnam, where china first sent one oil rig to drill in contested waters directly off vietnam’s shore–accompanied by several hundred chinese fishing vessels. they announced last week that they are repositioning four more. unsurprisingly, the vietnamese response has been sharp–anti-chinese demonstrations, violence, increased naval presence in the region, and coordination with the philippines.

none of that creates significant political risk on its own: vietnam isn’t an ally of the united states and so engenders less support and response from washington than the philippines or japan…which is precisely why beijing has decided that’s the best place to start changing the regional security balance.

but tokyo feels differently. the japanese government understands that a rising china is longer term a much more existential threat to its own security position in asia, and it isn’t prepared to wait to raise concern until its position weakens further. so prime minister shinzo abe has declared his security support for vietnam. for america’s part, obama has jettisoned the official “pivot” to asia. but the administration continues to believe that america’s core national security interests, now and in the future, are in asia; and if china significantly escalates tensions in the east and south china seas, the united states is not likely to sit as idly by as they have on syria or ukraine.

the good news here is that–unlike with the countries driving the tensions in eurasia and the middle east–china has solid political stability and isn’t looking for international trouble. but the realities of chinese growth, coupled with strong leadership from japan and (over time) india, along with the persistence of a strong american footprint are contributing to a much more troublesome geopolitical environment in the region.

the principle danger to the markets is what happens if the chinese government no longer holds that perspective. president xi jinping’s commitment to transformational economic reform has been strong over the first year of his rule, and he has gotten surprisingly little pushback from the country’s entrenched elites. but the uncertainty around china’s near- to medium-term trajectory is radically greater than that of any of the world’s other major economies. should significant instability emerge in china, very plausible indeed, china’s willingness to take on a far more assertive (and risk-acceptant) security strategy in the region, promoting nationalism in the way putin has built his support base of late, would become far more likely. and then, the east and south china seas move to the top of our list.

us-europe

finally, the transatlantic relationship. advanced industrial economies with consolidated institutions and political stability, there’s none of the geopolitical conflict presently visible in the middle east, eurasia, or asia. geopolitical tensions have long been absent from the transatlantic relationship, the great success of the nato alliance. for all the occasional disagreement in europe on us military and security policy both during the cold war and since (the war in iraq, israel/palestine, counterterrorism and the like), european states never considered the need for broader security ties as a counterbalance for nato membership.

but the changing nature of geopolitics is creating a rift between the united states and europe. american global hegemony had security and economic components, and it was collective security that had been the core element holding together the transatlantic alliance. that’s no longer the case–a consequence of changing priorities for the americans and europeans, and an evolving world order (russia/ukraine a major blip, but notwithstanding). the transatlantic relationship is much less closely aligned on economics.

it’s not the conventional wisdom. most observers say that, after bush, american policy looks more european these days–less militarist, more multilateralist. but actually, us foreign policy isn’t becoming more like europe, it’s becoming more like china. it’s less focused on the military, except on issues of core security concern (in which case the united states acts with little need to consult allies), while american economic policy tends to be unilateralist in supporting preferred american geopolitical outcomes–which is seen most directly in us sanctions behavior (over $15bn in fines now levied against more than 20 international banks–mostly european) and nsa surveillance policy (with no willingness of the us to cooperate in a germany requested “no spying” mutual agreement)

transatlantic economic dissonance is also in evidence in a number of more fundamental ways: america’s “growth uber alles” approach to a downturn in the economy, compared to germany’s fixation on fiscal accountability. europe’s greater alignment between governments and corporations on industrial policy, as opposed to a more decentralized, private-sector led (and occasionally captured) american policy environment. a more economy-driven opportunistic european approach to china, russia and other developing markets; the us government looking focused more on us-led/”universalist” principles on industrial espionage, intellectual property, etc.

as the g-zero persists, we will see the united states looking to enforce more unilateral economic standards that the europeans resent and resist; while the europeans look to other countries more strategically as counterbalances to american economic hegemony (the german-china relationship is critical in this regard, but that’s also true of europe’s willingness to support american economic policies in russia and the middle east). all of this means a much less cooperative trans-atlantic relationship–less “universalism” (from the american perspective) and less “multilateralism” (from the european perspective). more zero-sumness in the transatlantic relationship is a big change in the geopolitical environment; a precursor to true multipolarity, but in the interim a more fragmented and much less efficient global marketplace.

* * *

so that’s where i see geopolitics emerging as a key factor for the global markets–much more than at any time since the end of the cold war. there’s some good news and bad news here.

the good news is none of these geopolitical risks are likely to have the sort of market implications that the macro economic risks did after the financial crisis. there are lots of reasons for that. a low interest rate environment and solid growth from the us and china–plus the eurozone out of recession–along with pent up demand for investment is leading to significant optimism that won’t be easily cowed by geopolitics. the supply/demand energy story is largely bearish, so near-term geopolitical risks from the middle east won’t create sustained high prices. and markets don’t know how to price geopolitical risk well; they’re not covered as clearly analytically, so investors don’t pay as much attention (until/unless they have to).
 
the bad news…that very lack of pressure from the markets means political leaders won’t feel as much need to address these crises even as they expand, particularly in the united states. this is another reason the world’s geopolitical crises will persist beyond a level that a similar economic crisis would hit before serious measures start to be taken to mitigate them. these geopolitical factors are going to grow. now’s the time to start paying attention to them.

* * *

every once in a while, it’s good to take a step back and look at the big picture. hope you found that worthwhile. i’ll surely get back in the weeds next monday.

meanwhile, it’s looking like a decidedly lovely week in new york.

very best,
ian

 

From intel sources:

Dislodging ISIS Will Be a Difficult Task

The ISIS advance toward Baghdad may be temporarily held off as the government rallies its remaining security forces and Shia militias organize for the upcoming Battle for Baghdad. There is a rather clear reason why the ISIS leader has renamed himself Abu Bakr al-Baghdadi, meaning the Caliph of Baghdad . ISIS will at a minimum be able to take control of some Sunni neighborhoods in Baghdad shortly and wreak havoc on the city with IEDs, ambushes, single suicide attacks, and suicide assaults that target civilians, the government, security forces, senior members of government, and foreign installations and embassies. Additionally, the brutal sectarian slaughter of Sunni and Shia alike that punctuated the violence in Baghdad from 2005 to 2007 is likely to return as Shia militias and ISIS fighters begin to assert control of neighborhoods and roam the streets.

Even if Iraqi forces are able to keep ISIS from fully taking Baghdad and areas south, it is unlikely the beleaguered military and police forces will be able to retake the areas under ISIS control in the north and west without significant external support, as well as the support of the Kurds.

ISIS and its allies are in a position today that closely resembles the position prior to the US surge back in early 2007. More than 130,000 US troops, partnered with the Sunni Awakening formations and Iraqi security forces numbering in the hundreds of thousands, were required to clear Anbar, Salahaddin, Diyala, Ninewa, Baghdad, and the “triangle of death.” The concurrent operations took more than a year, and were supported by the US Air Force, US Army aviation brigades, and US special operations raids that targeted the jihadists’ command and control, training camps, and bases, as well as its IED and suicide bomb factories.

Today, the Iraqis have no US forces on the ground to support them, US air power is absent, the Awakening is scattered and disjointed, and the Iraqi military has been humiliated badly while surrendering or retreating in disarray during the lightning fast jihadists’ campaign from Mosul to the outskirts of Baghdad. This campaign, by the way, has been remarkably and significantly faster than the U.S. armored campaign advance to Baghdad in 2003 . The US government has indicated that it will not deploy US soldiers in Iraq, either on the ground or at airbases to conduct air operations.  Meanwhile, significant amounts of US made advanced armaments, vehicles, ammunition, and diverse military equipment have fallen into ISIS jihadists’ hands .

ISIS is advancing boldly in the looming security vacuum left by the collapse of the Iraqi security forces and the West’s refusal to recommit forces to stabilize Iraq. This has rendered the country vulnerable to further incursions by al Qaeda-linked jihadists as well as intervention by interested neighbors such as Iran. Overt Iranian intervention in Iraq would likely lead any Sunnis still loyal to the government to side with ISIS and its allies, and would ensure that Iraq would slide even closer to a full-blown civil war and de facto partition, and risk a wider war throughout the Middle East.

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Important Disclosures

Things That Make You Go Hmmm: The Slip ‘n’ Fail Mutts

 

Now the news has arrived
From the Valley of Vail
That a Chippendale Mupp has just bitten his tail
Which he does every night before shutting his eyes
Such nipping sounds silly. But, really, it’s wise.

He has no alarm clock. So this is the way
He makes sure that he’ll wake at the right time of day.
His tail is so long, he won’t feel any pain
‘Til the nip makes the trip and gets up to his brain.
In exactly eight hours, the Chippendale Mupp
Will, at last, feel the bite and yell “Ouch!” and wake up.
-Dr. Seuss

Theodore Seuss Geisel was a master of anapestic meter.

An anapest is a metrical foot used in poetry which comprises two short syllables, followed by a long one. More familiarly (particularly in the world created by Seuss), it consisted of two unstressed syllables followed by a stressed one:

“Twas the night before Christmas and all through the house…”

Description: euss%20Stamp.psd

Or, in keeping with this week’s theme:

“The sun did not shine.
It was too wet to play.
So we sat in the house
All that cold, cold, wet day.”

Simple, but at the same time extremely difficult to pull off effectively.

Geisel was an English major at Dartmouth who eventually became the editor-in-chief of the college humor magazine, the Dartmouth Jack O’ Lantern; but after being forced by the dean to resign his post after being caught drinking gin in his dorm room, he rather cunningly adopted the nom de plume “Seuss” in order to continue to be able to write for the magazine.

Apparently, nobody at the Ivy League college figured out the identity of the mysterious “Seuss.”

When banned from his post for a gin-drinking crime
The scribe picked a name and then bided his time.
In a different guise he remained on the loose
By pretending to be the mysterious “Seuss.”

Geisel graduated from Dartmouth and left the USA to pursue a PhD in English literature at Lincoln College, Oxford; but, whilst there, he met a lady named Helen Palmer who persuaded him that he should give up his dream of becoming an English teacher and pursue a career as a cartoonist.

Returning home without a degree but with a fiancée (named Helen Palmer), Geisel found that his drawing ability allowed him to earn a rather handsome living as a cartoonist after he succeeded in getting his first cartoon published in theSaturday Evening Post on July 16, 1927.

Geisel took a job as a writer and illustrator at the humourous magazine Judge in October of 1927, married Palmer a month later, and five months after that, his first work was published and credited simply to “Dr. Seuss.”

A successful career as an illustrator allowed Geisel and his wife to travel extensively. According to Geisel himself it was on the journey home from an ocean voyage to Europe that the rhythmic noise of the ship’s engines inspired him to write his first book, the anapestically titled And to Think That I Saw It on Mulberry Street.

While at Oxford (in England) a lady supposed
To suggest he choose drawing instead of his prose.
When the young man relented his future unfurled
And he ended up famous all over the world.

And that, Dear Reader, is how Theodore Geisel became Dr. Seuss.

Thirty-five years after the publication of And to Think That I Saw It on Mulberry Street, Seuss wrote The Sleep Book, the brilliant story of a contagious yawn, started by a small bug called Van Vleck, that would lull even the most spirited toddler successfully off to sleep.

On page 32 of The Sleep Book, we are introduced to the Chippendale Mupp, a curious creature with an extraordinarily long tail. The Mupp bites the end of that tail when he goes to sleep every night, and its length ensures that the sensation of pain only reaches him eight hours later, causing him to wake up. It’s a brilliant and flawless alarm clock.

Description: upp%20Cropped.psd

Of course, once the Mupp has bitten his tail, the end result — in this case, a rather nasty, sharp pain — though delayed for quite some time, is assured; and there is nothing he can do about it.

I was discussing the Chippendale Mupp with Steve Diggle recently as we pondered the actions of central banks in recent years and, more specifically, the great inflation/deflation debate that has raged constantly ever since the dawn of QE. As the ECB battles to stave off what looks like deflationary pressures, Japan continues to struggle to generate the promised 2% inflation, and the US continues to pretend to the world that the cost of living from sea to shining sea is rising at just 1.46% per annum, it’s abundantly clear to me that the day QE was unleashed into the world was the very same day that the world’s central bankers — the Slip ‘n’ Fail Mutts — bit their own tails.

The pain from that bite is now working its way towards the brain and will, at some point, manifest itself in an almighty “OUCH!” that will wake the entire world; BUT there is one X-factor at this point: none of us knows exactly how long the Slip ‘n’ Fail Mutts’ tail actually is.

We will find out.

Description: 303.png

Back in 2012 — July 26th to be precise — Mario Draghi, in a speech at the Global Investment Conference in London, uttered those famous words which put an end to the seismic volatility roiling European debt markets once and for all for the time being:

(Mario Draghi): …the third point I want to make is in a sense more political.

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders underestimate the amount of political capital that is being invested in the euro.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Almost instantaneously, the clouds seemed to part, the oceans calmed, and the storm abated — all based on an ephemeral promise from a man under immense pressure who, let’s face it, if he was prepared to DO whatever it took, would most certainly SAY whatever it took.

Click here to continue reading this article from Things That Make You Go Hmmm… – a free newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore.

Thoughts from the Frontline: Italy: When Hope Is a Strategy

 

I came back from Italy this week, and one of my guilty pleasures was being able to sit down and watch the last three episodes, including the season finale, of Game of Thrones. For those readers who are not enthralled with the fantasy epic from HBO or have not read the first five books (will he ever finish?), author George R.R. Martin has written one of the most complex fantasy series ever, about a world where everyone is occupied with who will sit on the Iron Throne.

It is a land of numerous countries and cultures, where the average person might just enjoy a little peace and quiet but where their leaders are seemingly always ready to go at one another, dragging their armies behind them, whether at the hint of an insult or the prospect of the ultimate prize. The series is utterly unpredictable, as Martin seems to routinely to kill off both protagonist and antagonist alike with unexpected finality. You have to be careful not to become too involved with any of the characters, as fate (i.e., the author) can pluck them from the scene all too quickly. Plot twists abound in every chapter, and seemingly minor characters can become major players as time unfolds.

In other words it’s a place not unlike Europe.

After spending a few days in Rome trying to deepen my understanding of the situation in Italy – which of late has seemed as convoluted as the plot from Game of Thrones, mercifully minus the swordplay but with about the same level of spectacle (who could come up with this cast of characters?), I think I have perceived what might become a significant plot twist in the offing.

So let’s look this week at what I uncovered in Italy, which rather surprised me, and think through some of the implications that the new developments suggest for the ultimate outcome of the euro project.

(I want to acknowledge up front the significant help of Christian Menegatti and Brunello Rosa of Roubini Global Economics in setting up key meetings with politicians, bureaucrats, and the Italian central bank. I am also grateful for the candid conversations we had after the meetings, as we tried to work through what we had heard. While this letter will not present a consensus view of our meetings and conversations, I did learn a great deal more than if I had simply gone on my own. Thanks, guys. (They of course are not responsible for any mistakes or inaccurate predictions herein. I can make enough of those on my own.)

Game of Thrones, European-Style

What surprised me about Italy was the emergence of something that felt like speranza, which I am told is the Italian word for hope. On my previous visits to Italy over the years, I have seen frustration, anger, and resignation – generally, there was a feeling that there was very little anyone could do to really change things. Even though the names and personalities and even governments changed, there was an underlying assumption behind every conversation that simply said, “This is the Italian way,” especially when it came to doing business. Government was slow and inept and bureaucratic; it took years or decades to get anything through the courts; and that’s just the way it was. Italians have displayed a marvelous aptitude for getting things done in spite of government, not because of it.

Italy, and especially the north of Italy, is a manufacturing powerhouse; and while it’s not the export behemoth that Germany is, the Italians do quite well, thank you very much. It is a testimony to their entrepreneurial skills and design talent that they have done as much as they have, given the ineptitude of their government. That might seem a little harsh, but I think you could find more than a few Italians who would agree.

But something different seems to be happening now. In the last European elections, a clear winner was an upstart politician in Italy. The EU Observer explains what happened:

In June 2013, Matteo Renzi was still pretending that his greatest ambition was to serve a second mandate as mayor of Florence, a mid-sized town of less than 400,000.

A year on, he is rubbing shoulders with the likes of Barack Obama at G7 summits, and is emerging as the biggest counterweight to German Chancellor Angela Merkel on the EU political landscape.

A historic win in last month’s European Parliament elections, where his Democratic Party (PD) took 40.8 percent of votes – the best-ever result for the Italian left, and the highest score ever recorded by a single party since the Christian Democrats in 1958 – has given him a strong hand to challenge Berlin-backed austerity policies, as Italy takes on the EU’s six-month presidency on 1 July.

“He has meticulously planned his rise to the top for the past 10 years. Not many people, be it in politics, journalism or business, have the same tenacity, drive and determination that he has displayed,” says David Allegranti, a political reporter from Florence who has written two books on Renzi. In February, the 39-year-old became Italy’s youngest-ever prime minister.

Renzi is photogenic and charismatic, but most of the commentary I read prior to going to Italy three weeks ago seemed to dismiss him as just another one in the series of soon-to-be-sacked Italian prime ministers, there having been four in as many years. Given the current volatility of Italian politics, it seemed just a matter of (not very much) time before Renzi’s government would fall. The only question was what might emerge next from the sausage grinder of Italian politics.

In a little bit we’re going to cover in detail some of the rather serious economic realities that face any Italian government. The challenges are daunting, and heretofore the system seemingly just hasn’t been properly designed to deal with them. With a debt-to-GDP ratio of over 135%, simple interest costs of 5% of GDP, ultra-low inflation, high unemployment, low to no growth, and rising debt, Italy’s economic problems are all too real.

So where is the hope coming from? Renzi is not just going after the economic troubles. He seems to be attacking the very deep structural issues in a novel way. He is seeking serious constitutional reform in a country that has seen no constitutional changes for 30 years. Changing the constitution is difficult and requires a super-majority, which Renzi does not have. But when you meet with Parliament members and ministers from Renzi’s party, there is an optimism that is almost catching. Somehow or another Renzi has convinced a lot of people in the Italian political system that reform is possible. In particular, he wants to do away with the upper house (their senate) and streamline the decision-making process in the remaining house of Parliament, with different rules for creating majorities.

Further, he is looking to reform the judicial process in a way that will allow court cases to actually be resolved in a realistic timeframe, removing the “justice delayed is justice denied” issue. Of course, labor reforms are also on the docket.

Meeting with ministers and government leaders who are involved in developing the budget, I found acknowledgment that the only way they can get out of their current situation is to grow their economy. They admitted they needed 2% real GDP growth, 2% inflation, and a 4% “primary surplus” (more on that later). They candidly acknowledged that this outcome is possible is only with significant outside foreign direct investment, substantial growth in exports, and a drop in the unemployment rate. “We have to unleash Italian industry and business.”

The current system discourages foreign direct investment and is actually chasing Italian businesses from Italy. The recognition that things need to change if there’s going to be any progress in the economy is widespread across the spectrum of political views.

Renzi is seemingly unafraid of pressing ahead on multiple fronts and is perfectly willing to see his government fall and to then hold new elections as a referendum on his policies. For a center-left politician, he is forging political pacts and alliances with an odd cast of characters.

I think the mood can best be summed up by a snippet from a conversation I had late one evening. I was talking with a successful businessman and long-time nominal conservative supporter who told me that he had recently picked up his 18-year-old son at the airport, as the young man returned home from college in another part of Europe. He came back on the day of the recent elections, and as his dad was driving him to the polls, he asked, “Papa, I really don’t understand anything about this election, as I’ve been away. Whom should I vote for?” His father told him to vote for Renzi.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

140622-01

Thoughts from the Frontline: Italy: When Hope Is a Strategy

 

I came back from Italy this week, and one of my guilty pleasures was being able to sit down and watch the last three episodes, including the season finale, of Game of Thrones. For those readers who are not enthralled with the fantasy epic from HBO or have not read the first five books (will he ever finish?), author George R.R. Martin has written one of the most complex fantasy series ever, about a world where everyone is occupied with who will sit on the Iron Throne.

It is a land of numerous countries and cultures, where the average person might just enjoy a little peace and quiet but where their leaders are seemingly always ready to go at one another, dragging their armies behind them, whether at the hint of an insult or the prospect of the ultimate prize. The series is utterly unpredictable, as Martin seems to routinely to kill off both protagonist and antagonist alike with unexpected finality. You have to be careful not to become too involved with any of the characters, as fate (i.e., the author) can pluck them from the scene all too quickly. Plot twists abound in every chapter, and seemingly minor characters can become major players as time unfolds.

In other words it’s a place not unlike Europe.

After spending a few days in Rome trying to deepen my understanding of the situation in Italy – which of late has seemed as convoluted as the plot from Game of Thrones, mercifully minus the swordplay but with about the same level of spectacle (who could come up with this cast of characters?), I think I have perceived what might become a significant plot twist in the offing.

So let’s look this week at what I uncovered in Italy, which rather surprised me, and think through some of the implications that the new developments suggest for the ultimate outcome of the euro project.

(I want to acknowledge up front the significant help of Christian Menegatti and Brunello Rosa of Roubini Global Economics in setting up key meetings with politicians, bureaucrats, and the Italian central bank. I am also grateful for the candid conversations we had after the meetings, as we tried to work through what we had heard. While this letter will not present a consensus view of our meetings and conversations, I did learn a great deal more than if I had simply gone on my own. Thanks, guys. (They of course are not responsible for any mistakes or inaccurate predictions herein. I can make enough of those on my own.)

Game of Thrones, European-Style

What surprised me about Italy was the emergence of something that felt like speranza, which I am told is the Italian word for hope. On my previous visits to Italy over the years, I have seen frustration, anger, and resignation – generally, there was a feeling that there was very little anyone could do to really change things. Even though the names and personalities and even governments changed, there was an underlying assumption behind every conversation that simply said, “This is the Italian way,” especially when it came to doing business. Government was slow and inept and bureaucratic; it took years or decades to get anything through the courts; and that’s just the way it was. Italians have displayed a marvelous aptitude for getting things done in spite of government, not because of it.

Italy, and especially the north of Italy, is a manufacturing powerhouse; and while it’s not the export behemoth that Germany is, the Italians do quite well, thank you very much. It is a testimony to their entrepreneurial skills and design talent that they have done as much as they have, given the ineptitude of their government. That might seem a little harsh, but I think you could find more than a few Italians who would agree.

But something different seems to be happening now. In the last European elections, a clear winner was an upstart politician in Italy. The EU Observer explains what happened:

In June 2013, Matteo Renzi was still pretending that his greatest ambition was to serve a second mandate as mayor of Florence, a mid-sized town of less than 400,000.

A year on, he is rubbing shoulders with the likes of Barack Obama at G7 summits, and is emerging as the biggest counterweight to German Chancellor Angela Merkel on the EU political landscape.

A historic win in last month’s European Parliament elections, where his Democratic Party (PD) took 40.8 percent of votes – the best-ever result for the Italian left, and the highest score ever recorded by a single party since the Christian Democrats in 1958 – has given him a strong hand to challenge Berlin-backed austerity policies, as Italy takes on the EU’s six-month presidency on 1 July.

“He has meticulously planned his rise to the top for the past 10 years. Not many people, be it in politics, journalism or business, have the same tenacity, drive and determination that he has displayed,” says David Allegranti, a political reporter from Florence who has written two books on Renzi. In February, the 39-year-old became Italy’s youngest-ever prime minister.

Renzi is photogenic and charismatic, but most of the commentary I read prior to going to Italy three weeks ago seemed to dismiss him as just another one in the series of soon-to-be-sacked Italian prime ministers, there having been four in as many years. Given the current volatility of Italian politics, it seemed just a matter of (not very much) time before Renzi’s government would fall. The only question was what might emerge next from the sausage grinder of Italian politics.

In a little bit we’re going to cover in detail some of the rather serious economic realities that face any Italian government. The challenges are daunting, and heretofore the system seemingly just hasn’t been properly designed to deal with them. With a debt-to-GDP ratio of over 135%, simple interest costs of 5% of GDP, ultra-low inflation, high unemployment, low to no growth, and rising debt, Italy’s economic problems are all too real.

So where is the hope coming from? Renzi is not just going after the economic troubles. He seems to be attacking the very deep structural issues in a novel way. He is seeking serious constitutional reform in a country that has seen no constitutional changes for 30 years. Changing the constitution is difficult and requires a super-majority, which Renzi does not have. But when you meet with Parliament members and ministers from Renzi’s party, there is an optimism that is almost catching. Somehow or another Renzi has convinced a lot of people in the Italian political system that reform is possible. In particular, he wants to do away with the upper house (their senate) and streamline the decision-making process in the remaining house of Parliament, with different rules for creating majorities.

Further, he is looking to reform the judicial process in a way that will allow court cases to actually be resolved in a realistic timeframe, removing the “justice delayed is justice denied” issue. Of course, labor reforms are also on the docket.

Meeting with ministers and government leaders who are involved in developing the budget, I found acknowledgment that the only way they can get out of their current situation is to grow their economy. They admitted they needed 2% real GDP growth, 2% inflation, and a 4% “primary surplus” (more on that later). They candidly acknowledged that this outcome is possible is only with significant outside foreign direct investment, substantial growth in exports, and a drop in the unemployment rate. “We have to unleash Italian industry and business.”

The current system discourages foreign direct investment and is actually chasing Italian businesses from Italy. The recognition that things need to change if there’s going to be any progress in the economy is widespread across the spectrum of political views.

Renzi is seemingly unafraid of pressing ahead on multiple fronts and is perfectly willing to see his government fall and to then hold new elections as a referendum on his policies. For a center-left politician, he is forging political pacts and alliances with an odd cast of characters.

I think the mood can best be summed up by a snippet from a conversation I had late one evening. I was talking with a successful businessman and long-time nominal conservative supporter who told me that he had recently picked up his 18-year-old son at the airport, as the young man returned home from college in another part of Europe. He came back on the day of the recent elections, and as his dad was driving him to the polls, he asked, “Papa, I really don’t understand anything about this election, as I’ve been away. Whom should I vote for?” His father told him to vote for Renzi.

“But Papa, why should I vote for Renzi?” he asked, recognizing that this choice was out of character for his father.

“Because, son, he is the only politician with any hope of changing things so that you can come back to Italy and find a job.”

“I understand, Papa.” And he went in and cast his vote.

Most of the political types we talked to were a little unusual from my perspective. Some very senior positions were not held by the usual career politicians but rather by former businessmen and bankers who had recently joined the government (in some cases returning to Italy to do so) in order to help bring about change. Something about Renzi just made them want to get involved. These guys were very successful in their former endeavors and brought a level of competency to their current projects.

However, competency and enthusiasm may not be enough. What I think I see developing reminds me in an odd sort of way of an Alcoholics Anonymous prayer. Any realistic assessment of the situation in Italy leads to the hard conclusion that Italy has its back to the wall and that they need everything to go exactly right in order to get out of their current predicament,– which is of their own creation. There seems to be an acceptance of the things they cannot change (the economic realities on the ground) and a willingness to try to change the things that they can. They have to create an environment that can foster economic growth, and anything that is in the way of doing so simply has to be changed. Anything less will prove disastrous.

Frankly, the odds of pulling off the significant constitutional changes that are necessary are quite daunting. When we would go over the process with various ministers and bureaucrats, there was an acknowledgment that it would not be easy, but there does seem to be a sense of urgency in the air. And I think that urgency is driven by the serious unemployment problems facing Italy.

And so now it’s time to look at the economic realities.

Let’s begin with the saddest of the facts. Youth unemployment is the third highest in the European Union at 43%, almost double the EU average of 22%. You can see it when you walk around Rome. While less than in Spain or Greece (which are both over 50%), it is a depressing statistic for any country to grapple with. The plight of our children is a common emotional theme across all cultures and countries. It tends to focus the mind on the problems at hand.

General unemployment in Italy is at 12.6%, and it has been rising since the beginning of the Great Recession. There has been no recovery in Italy.

As in the US, the official unemployment rate masks the true extent of the problem. If you count the underemployed and those employed part-time for noneconomic reasons, unemployment in Italy rises to 25%. The following chart is a little dated (by one year), but the general relationships are the same. It shows the various “U-6” unemployment rates across Europe.


Source: Real-World Economics Review Blog

The next few charts and fact sets are from a lengthy report that interested readers can find on the website of the Bank of Italy (the Italian central bank). We had a lengthy meeting with six members of the bank, which was rather refreshing in its frankness. There has been significant progress in parts of the economy, specifically in the turn-around of the balance of payments, which is now positive and which has long been an important factor in the general malaise of the peripheral European countries. The overall deficit is also being reduced, but that is pretty much where the good news ends.

For the past year, the number of people employed is down, as is the total number of hours worked. While the deficit is down, Italy still had to borrow €75 billion last year. The debt-to-GDP ratio is now at 133%. (Remember when it was “only” 120% and everybody was talking about the crisis that was going to come about?)     

Italy is still in a recession and has been for over 2½ years. Prior to that time growth was anemic at best.

The optimistic goal in the bank of Italy’s projections is to get the primary surplus up to 4.2% in 2016, from 2.2% today. This bears a little explaining for most readers. You can find a very readable explanation here. Essentially it is the surplus or deficit in a government budget, not counting interest payments. A country is considered to have a “primary surplus” when it can cover all of its actual expenses other than the cost of paying the interest on its debt. What that technically means is that if you are willing to ignore (not pay back) your loans and interest, you can meet your other expenses. Economists and politicians seem to consider a primary surplus as a desirable condition, as opposed to merely being in a complete surplus.

Today it takes 5.3% of the entire GDP of Italy just to pay the interest on its debt, which is the third-largest pile of government debt in the world. By the optimistic projections of the Bank of Italy, that will go down to 5.1% in 2016, even as the total interest payments rise. That means that today Italy has to borrow about 3% of GDP every year. But in order to continue to do so, Italy must achieve significant growth in the next two years.

How do you get out of this debt trap? The easy answer is that you have to grow your way out. If you get 2% real GDP growth and can get the primary surplus well above 3%, you can very slowly make headway. In the government’s positive projections, Italy would also have 2% inflation, and the primary surplus would be 4%. Which would mean the debt would shrink by approximately 3 to 4% of GDP per year. (Remember that these are central bank projections. And then remember how accurate US Federal Reserve economists’ projections have been. Just saying.)

But is a 2% growth rate achievable? For the last 54 years, Italy has averaged just 0.6% a year GDP growth. How do you get to a primary surplus of 4%? You have to do a lot more cost-cutting, and your tax receipts have to rise. But tax receipt growth in Italy has been negative for the past few years.

And 2% inflation? Inflation is running about 0.5% now and is less than 1% throughout Europe. Furthermore, inflation has been trending down. And as the chart below from Merrill Lynch indicates, in a low-inflation scenario and with realistic growth assumptions, Italy’s debt-to-GDP in will be approaching 150% within four years. And that means interest-rate payments will be rising along with the debt.

I spoke at a banking conference in Rome on Monday afternoon. I was the last speaker on a panel in which we were asked to address the question, “How will the markets react when monetary policy returns to normal?” My answer was that we are a long way from monetary policy in Europe approaching anything that one could call normal. I used the above chart and a similar one that depicts even worse dynamics for France. Countries with spiraling debt and a growth problem need a little inflation along with some growth in order to work out of their problems. And that is not an environment that calls for normal monetary policy.

A proper response will require a change of attitude at the European Central Bank. Everyone we talked to seemed to believe that the Italian head of the ECB, Mario Draghi, was getting ready to unleash quantitative easing in the Eurozone in order to begin to bring back inflation. These were people who know him; and whether they are depending on hope or insider knowledge, they are acting as if inflation is going to become a fact.

When Hope Is a Strategy

And that brings us to my rather intriguing conclusion. The current Italian leadership has decided to deal with their problems. They’re going to try to restructure their system to the best of their ability to create opportunities for growth. They’re going to remove every obstacle they possibly can. They are going to be – or at least attempt to be – at the very forefront of a movement that will be necessary all across Europe to reform the bureaucracy and labor markets.

If everything goes perfectly – and I mean to a degree that has not been seen in Italy in a very long time – they will get their deficit and debt under control and begin to grow their way out of the problem. Anything less than perfection becomes a problem.

I generally followed up every optimistic meeting and presentation with two questions. The first dealt with the elephant in the room that nobody really wanted to talk about: “How do you deal with the rising debt and interest payments if you don’t get the growth and inflation you need?” Those of us with a little time under our belts remember the TV series Happy Days and the character Fonzie. Fonzie was almost incapable of saying the word sorry. In Italy I could not get anyone to say the words “debt restructure.” Sometimes they would look away or just ignore the question, but it was evidently a topic that was inappropriate in polite conversation.

Well, that’s not entirely true. An English hedge fund manager was quite willing to state that the Italians would be forced to restructure their debt within three years. But that’s the English for you.

And that may be the reality. At some point the debt simply becomes too gargantuan for even the most optimistic of Italians. No one wants to admit that they can’t deal with their problems; but at some point, if the Italians don’t get their perfect economic scenario, the judgment of the market is going to be imposed upon them. Today interest rates for Italian debt are at their lowest in a very long time. But if rates were to rise just 1% – let alone 2% or 3% at 140% debt-to-GDP – interest costs would quickly spiral out of control.

And then there was my second question. At the end of our presentation on Monday, I quickly dealt with my belief that France will be the next Greece. Unlike Italy, France is simply not dealing with its problems and seems to be in a state of denial. What happens when the market begins to demand higher interest rates from France and their debt becomes an even bigger problem? France has a much larger structural issue with their budget than Italy does and cannot handle nearly the debt load that Italy can. The euro, I maintained, is not so much a currency as an experiment, and will remain so until the Eurozone has dealt with the crisis that is going to ensue, starting in France.

(This was evidently a rather provocative statement at the end of the day on Monday. The head of the conference told me Tuesday evening that one of the few consensus notes coming out of the conference was that France would be the next big problem facing Europe. Well, except that the representative from the French central bank took exception. Go figure.)

“Who will lead Europe,” I asked, “when there is a crisis in France?” The Germans are going to be very uncomfortable trying to force France into the necessary reforms. Could the role of leadership in Europe actually fall to the Italians? If they make all the necessary reforms to their own economy and government, that leadership role might in fact be theirs. At some point there is going to have to be either a mutualization of debt across the Eurozone, or the ECB is going to have to be allowed to work out financing through a broad restructuring plan. Germany will have to go along or watch the euro collapse.

And upon reflection, that is the basic outline of an unspoken plan I think I see the Italians developing. Fix what we can in our own situation, and if everything works out, then great. But if not, we will have the moral high ground to provide a plan to help all of Europe move out its malaise.

They also believe that ultimately, no matter what happens, Draghi has their back. They really do intend to find out what Draghi meant when he said, “Whatever it takes.”

When I look at the choices the Italians have, the concept I have sketched above actually seems to be about the best one available. You can’t go back in time to get rid of your debt; you have to deal with the reality on the ground. So create a plan that hopes for the best but includes a backdoor in case you get the worst instead.

And if “the worst” is a restructuring of your debt after you’ve reformed your economy, then maybe that’s not so bad. Of course, there is the problem that Italians own 60% of their own debt. Their banks are loaded with Italian debt. So the word restructure is definitely laden. Which is why the Italians need a banking union. And it’s another reason why debt mutualization and the moving of some or all European debt to the balance sheet of the European Central Bank, in lieu of a classical restructuring and default such as happened in Greece, make a great deal of sense from the Italian point of view.

Things are going to be very interesting in the next season of Game of Thrones. The coming seasons of the Saga of the Euro will be just as captivating. Stay tuned.

Nantucket, New York, and Maine

I know my travel schedule always seems to change, but right now the calendar has me home for more than 12 out of the next 14 weeks. I can’t remember the last time that happened. I hope to be able to get into something like a routine at the gym and with work. I’ll be in Nantucket and New York City in the middle of July and Maine at the beginning of August. And there’s only one short trip so far in the middle of September. I’m sure September will change.

The travel gods didn’t cooperate on the return trip from Rome. We got off a few hours late, eventually landing in Chicago. American Airlines conveniently put us on a flight later in the afternoon, but then there was a little weather problem in Dallas. So we sat in the Admirals Club as they moved the departure time back 20-30 minutes every half hour or so. Eventually we got out at about 3 AM and were finally able to leave the Dallas airport at around 5:30 – without our bags, of course. Rather than the full day I’d optimistically planned, I finally got to bed at 7:30 AM and slept most of the day. But eventually the luggage showed up, and by Friday morning all was right with the world. It was time once again to begin to write this letter.

I pretty much finished it by Friday evening and decided I would get up early Saturday morning for one more read. Besides, I really did need to catch up on Game of Thrones. Everything was going according to plan until I sat down at my computer Saturday morning. Something, and our techies can’t figure out what, caused my computer to crash at 5:30 AM. And I stupidly had not saved my Word file. I know better than that. How many times have I told my kids that the first thing you do is title and save your document? Seriously. And for whatever reason, the crash happened so quickly that Word was not able to back itself up even into a temporary file. After trying everything I know, I got my tech consultants online to see if they could figure it out. Nothing. So there was nothing to do but to start over. Let that be a lesson to you, boys and girls. Always save your work – early and often.

Thinking back on Italy, one of the more interesting parts of the tour last Sunday through Rome was visiting the Church of St. Ignazio. It is an early Jesuit cathedral, evidently built before they had all the money in the world. As they were getting to the end of construction, they ran out of dough before they could build the dome. In stepped Brother Andrea Pozzo, an enterprising priest who said, “You want a dome? I’ll give you a dome.” Unfortunately he was not an architect but an artist. So rather than building a dome he painted one. And so we have one of the most remarkable pieces of perspective art anywhere in the world.

From the center of the church looking upward, you see this perfectly shaped oval dome structure, full of marvelous paintings and lighting. Except that when you walk around under the “dome,” you clearly start to see that you aren’t looking at a real dome at all, but a painted picture of a dome. I walked back and forth several times trying to come to terms with the fabulous grasp of perspective that it took to be able to create such a massive architectural artwork.

As I thought about it later that night, it occurred to me that the painting is a marvelous visual representation of the euro. If you don’t get too close, it actually looks like a currency. At some point, the members of the Eurozone are going to have to actually create the sort of fiscal union that is required for any successful monetary union. If they don’t, the illusion of their currency is going to break down as we get closer to the next crisis. Which is why I’m paying attention to France.

Let’s close this letter with a little bit of idle speculation. At the end of the day, I wonder whether France, when confronted with a crisis as I think they will be, will really elect National Front leader Marine Le Pen and let her take them out of the Eurozone. While there may be a complete rejection of the Socialist Party after the miserable performance Hollande is giving, could not the right conservative take second place in the first election and then win in the final? And who might that be? It will be interesting to see what Christine Lagarde does after a few more years as head of the IMF. Silly speculation, I know. But isn’t European politics fun?

Have a great week. I have planned my travels perfectly to be in Texas in July and August. But Texas is why God invented air conditioning.

Your saving his work analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Outside the Box: Musical Chairs at the FOMC

 

“You can’t tell the players without a program. Get your program here!” yelled the stadium vendors of my youth. In today’s Outside the Box I bring you an excellent piece of Fed watching by Nouriel Roubini and colleagues, a “program” of the new Fed members and where they rank on the hawk-dove scale. They point out that, with a new chairperson (Janet Yellen) and vice-chair (Stanley Fischer), and with higher than normal turnover on the Federal Open Market Committee (FOMC) – over the past year, 75% of the FOMC’s membership has changed – the Fed’s need for clear communications with regard to monetary policy and forward guidance is greater than ever.

And it’s not as though the Fed has wielded its powerful communication tool with perfect aplomb in recent years. Last year at about this time, you’ll recall, we were in the midst of a frightful hullabaloo when the Fed threatened to release upon the world the Dread Taper … and then changed its mind. And then this past March, just as everybody was learning to live with the Taper, Yellen went to the mike and attempted to explain the Fed’s statement that the federal funds rate would remain near zero for a “considerable time” after QE ended. That meant interest-rate hikes could happen “in about six months,” she allowed – and all hell broke loose. Again.

And then there’s this whole business of FOMC members speaking out of school. We didn’t see much of that during Greenspan’s reign, which our authors characterize as being “close to an absolute monarchy,” but Bernanke took things in the direction of a collegial democracy – and paid a price for being nice. Yellen is similarly inclined – indeed, as our authors note, she has been at pains to ensure that her expressed views are close to those of the FOMC majority (which is decidedly dovish, yet not so dovish as Janet herself). So we may be treated to further instances of regional Fed presidents popping their heads up here and there around to the country to share their innermost feelings in the wake of official FOMC statements.

I think you’ll agree that the following piece brings us up to speed about as painlessly as possible on all things FOMC – I enjoyed it, and I think you will too.

I have spent the last three days with Christian Menegatti, the managing director of Nouriel’s research firm. We have been in nonstop meetings and presentations (and dinners!) with a wide variety of businessmen, bankers, hedge fund managers, central bankers, government officials and ministers (even an off-the-record talk with a person from the Vatican Bank). Quite the whirlwind. I will readily admit that I’m surprised at what I have learned. I brought the expectations from my reading and my previous numerous trips to Italy, but I found out that things are now different here for the first time in a VERY long time. This week’s letter, which I will write in Dallas on Friday, will give you the details. For what it’s worth, Christian, who grew up in Italy but has been in New York for the last 14 years (or so), was also surprised. We spent a lot of time animatedly discussing what we learned and what it means for Europe and the world. You’ll want to read this one.

I spent nine hours on Sunday on a very aggressive walking tour of Rome. John Noronha is perhaps the most knowledgeable and enthusiastic guide I have ever had on any tour anywhere. He is a polymath with multiple technical and artistic and theological degrees, and he seemingly remembers everything he has ever read. In the process of seeing the major tour sites, we stopped at this or that church that happened to be “on the way” and that had a Raphael or a Caravaggio or two or three. The art I saw on the day was better than in all but a few museums I have ever visited. Billions of dollars’ worth of art and no guards. I was actually allowed to touch a Michelangelo sculpture (what museum will allow you to do that?), and I swear you could feel the bones and ligaments underneath the marble. I mean I could feel details that my eyes could not see. I was in awe for the rest of the trip. We must have toured nine churches (“We simply have to stop to see this one!”) and John knew every artifact in each of them. At a few points I actually tried to stump him with a question about some arcane object, but he assumed I was truly interested and launched into detail about the history of object after object. As good as he was, he could not organize the weather, and the rain came down in sheets at the Coliseum. But the double rainbow after was a perfect end to an exhausting but memorable day. (I think John doubles as a personal trainer.) If you are ever in Rome, you should get him to be your guide and make him bring his wife to dinner. She teaches communications at the Vatican. You can contact him at www.johnandashley.org.

And for those who asked, the website of the villa where we stayed in Tuscany is  http://www.ifiordalisi.com/ . It was my fourth time to go there and spend a few weeks. It is a perfect base to tour Tuscany and the surrounding regions.

It is time to hit the send button. My flight back to Dallas will leave from Rome in a bit. Have a great week!

Your going to miss the food analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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Musical Chairs at the FOMC

By Nouriel Roubini, Sheryl King and Prajakta Bhide
Roubini Global Economics
May 29, 2014

  • Communication is one of the main tools at the Federal Reserve’s disposal in what will soon be the post-QE, post-Evans rule era, making it critical to assess the Fed’s ability to deliver a coherent monetary policy message. Even in normal years, the FOMC struggles to deliver a clear view about the economic and policy outlook as its voting members rotate so frequently. Here, we analyze the communication challenge presented by the significant turnover of FOMC members, exploring the views of individual members and assessing the implications for core policy decisions.
     
  • Bottom line: While the mean FOMC voter is more hawkish this year than in 2013, the view of the median FOMC voter – more important for decisions – has not changed much. However, there is still some potential for market volatility induced by disparate and relatively unknown voices at the Fed, particularly with regard to the new vice-chairman, Stanley Fischer. We believe that Fed Chair Janet Yellen, a consensus-builder with a solid grasp of the Fed’s communication challenge, will be largely able to counter individual hawkish noises. Still, delivering a clear forward guidance message under these circumstances will be tricky during a critical period of policy normalization. Ultimately, we believe Yellen’s dovish views will prevail, but Fed communication and forward guidance may become less explicit.
     
  • Market implications: We do not expect a repeat of the bond-market gyrations experienced last summer, when the Fed signaled the launch of QE tapering and then did not deliver, but increased market volatility around Fed communication is a risk. As the central FOMC view is dovish, the risks are skewed toward sudden jumps in Treasury yields and equity market sell-offs on market commentary from new Fed speakers, particularly Fischer and some of the new hawks in the FOMC.

High FOMC Turnover Makes for Mixed Messages

In the post-Evans rule era, the Fed’s policy approach has returned to a more discretionary one, with no clear explicit or implicit policy reaction function upon which markets can draw. In recent years, the Fed’s communication strategy has been anchored by QE. But with QE set to end by Q4 2014, the Fed will no longer possess this quantitative policy tool.

Until such time as the Fed decides to take a policy measure again (mostly likely to be a hike in the policy rate), the policy stance will be one of watchful inaction, with the Fed and policy-watchers scanning the incoming economic data for signs that higher policy rates are warranted. In this vacuum, the Fed will rely heavily on communication, enhanced perhaps by a reverse repo facility and/or a term deposit facility intended to keep short-term interest rates anchored. With so much riding on communication, the potential costs of miscommunication are that much higher. (The turmoil in financial markets last summer – when the Fed botched the taper signal, sparking a “taper tantrum” – is a clear example of said costs.) Once the first policy rate hike occurs (perhaps sooner), the Fed will have to communicate to the markets what its likely policy reaction function will be with regard to the speed and pace of policy rate normalization.

In this context, the substantial churn in the composition of the FOMC of late merits close attention. Over the past year, 75% of the FOMC’s membership has changed – more than twice the normal rate. With so many new faces joining the committee, delivering clear policy and forward guidance will prove tricky – especially as the Fed exits QE and looks toward policy rate normalization. Fed Chair Yellen expressed it best when she said that effective forward guidance “…depends critically on [the Fed’s] ability to shape expectations of the future, specifically by helping the public understand how it intends to conduct policy over time, and what the likely implications of those actions will be for economic conditions.”

Delivering the message in a clear and consistent manner is always difficult for monetary policy makers. With a constantly changing roster of decision makers and varied views on how monetary policy should be conducted to achieve policy goals, the message becomes all the more muddled. At least four FOMC voting members, the Fed bank presidents, rotate on and off the board of governors every year, and governors on the Fed board rarely serve a full 14-year term, meaning that even in normal years the FOMC is susceptible to criticism regarding muddled messages.

The rate of FOMC-member turnover has been particularly high over the past year, which has seen the departure of three board members (Chairman Ben Bernanke, Sarah Raskin and Elisabeth Duke) and Governor Jeremy Stein, along with the retirement of Cleveland Fed President Sandra Pianalto at the end of May. As a result, three seats on the committee have changed in the past year, on top of the normal rotation of four of 12 Fed bank presidents per year.

The rotation in Fed presidents does not present too much uncertainty: Even non-voting members speak to the public regularly, so their views on the economy, markets and monetary policy are well known. However, the views of the other new FOMC members are much less familiar.

The FOMC: Known Unknowns

There are two important factors to consider: First, the individual views of the new and prospective FOMC members, which could tilt the FOMC in a more hawkish or dovish direction; second, the new rotation’s potential influence on the FOMC’s decision-making core, led by Yellen.

The question of who will succeed the departing FOMC members is only partly settled. Loretta Mester, a long-time staffer (head of research and chief policy advisor to Charles Plosser) at the Philadelphia Fed, takes the helm of the Cleveland Fed in June; and former Bank of Israel Governor Stanley Fischer has been confirmed by the Senate to become Board vice-chairman. Lael Brainard, the under-secretary for international affairs at the U.S. Treasury and a former senior member of the National Economic Council, is a nominee for governor. She has yet to be confirmed, but is expected to be sometime in June.

Two more members of the board need to be nominated and confirmed to fill up the body’s seven positions. The Obama administration is likely to choose relative doves – i.e., policy makers who care about both inflation and growth/unemployment and would likely vote in similar ways to the FOMC’s current dovish members. Among the names floated as probable candidates for the board are several distinguished academics: Christina Romer and Alan Krueger (former heads of the Council of Economic Advisors, or CEA, in the first Obama administration) and Janice Eberly (formerly an official at the U.S. Treasury). One of the two open board slots is likely to go to a community banker; Yellen has expressed support for this idea, which is popular in Congress. Traditionally, community bankers are dovish, and they tend to agree with the views of the rest of the board members.

Starting this year, the profile of regional Fed presidents on the FOMC has become less dovish – three new relative “hawks” are in: Charles Plosser from the Philly Fed, Richard Fisher from the Dallas Fed and the new Cleveland Fed head Loretta Mester, who used to be Plosser’s policy advisor at the Philly Fed; only one hawk is out, namely Esther George from the Kansas City Fed. So, the mean FOMC voter is now more hawkish than in 2013.

Fischer: Master of Activist Monetary Policy and Forward Guidance Doubter

The new vice chairman, Stanley Fischer, was responsible for some of the earliest work on activist monetary policy. While leading the Bank of Israel (BI), he aggressively lowered policy rates in early 2008 as the credit markets went into meltdown and then had to reverse course soon after with higher rates and massive currency intervention as the shekel surged in response to the ensuing rapid economic recovery.

Fischer is uncontroversial when it comes to his views on the U.S. economy, which are mainstream. It is his skeptical views on the effectiveness of forward guidance that set him apart, introducing a note of uncertainty into the FOMC. He contends that forward guidance is not credible when the central bank cannot effectively predict the future, and therefore a commitment to keep policy rates low for longer is not very credible if it diverges from the policy reaction function of the central bank. For that reason, Fischer has argued that providing guidance gives the central bank less flexibility when some state-contingent discretion is necessary. Fischer downplayed these views before the Senate Banking Committee, but they could very well remain valid in his mind. He is of the view that the Fed may have over-communicated its policy intentions to the markets, a potentially counter-productive effort that may have made investors too reliant on Fed signaling.

As Yellen is still a strong proponent of forward guidance and transparent communication, FOMC meetings could prove lively as Yellen and Fischer have differing views about forward guidance. At worst, any public comments Fischer may make on the subject could be seen as signaling friction within the FOMC. Ultimately, however, we believe Yellen’s views will mostly prevail, but Fed communication and forward guidance may become less explicit and direct.

Brainard: Likely to Align Well With Dovish Yellen

Brainard’s views on monetary policy are essentially unknown beyond her circumspect opening statement on the subject during her appearance before the Senate Banking Committee. However, her work on poverty and income disparity at the Brookings Institution suggests that she tilts toward dovishness and is generally sympathetic to interventionist policies. Her stint as under-secretary for international affairs at the U.S. Treasury indicates that she will bring a wealth of experience on global economic and market issues.

Mester: Possibly Hawkish Like Plosser

The monetary policy views of the new Cleveland Fed president, Loretta Mester, are also little known, but we believe they are skewed toward the hawkish end of the spectrum. Since Mester retained her role under Plosser, the hawkish Philly Fed president, it seems likely that her views align with his.

Her speeches on the economic outlook have not strayed far from the central tendency of Fed forecasts, but a speech she gave last year reveals some reservations about forward guidance and macroprudential policy tools. Mester pointed out that forward guidance may not work in practice since in the real world there is no perfect commitment (a view shared by Fischer), although she acknowledged that QE played a role in helping to bolster the Fed’s future commitments. She is even less convinced that monetary policy has a role to play in financial stability, as it is difficult to see a bubble forming in advance. She argues that macroprudential tools are in their infancy and it is difficult to calibrate the magnitude of policy needed to assure financial stability. Finally, Mester discussed the Fed’s independence, pointing out that in the future, the central bank may face political pressure to remain in accommodative mode; she also touched on the political implications of a sensitive potential scenario in which the Fed is paying interest on excess reserves to banks while making zero or net negative remittances to the Treasury from its balance sheet.

Nonetheless, having attended most FOMC meetings in her prior role as head of research at the Philly Fed, Mester is well acquainted with the committee’s inner workings.

The Fed Now Less of an Absolute Monarchy Than Under Greenspan

Under Alan Greenspan, the FOMC was close to an absolute monarchy as the views of the chairman were dominant and accepted by the rest of the committee. Under Ben Bernanke, the FOMC became a cross between a constitutional monarchy and a collegial democracy, as the chairman had to work hard to ensure that his views were shared by the majority of the FOMC. That required a constant dialogue between the chairman and the rest of the Board to ensure that a majority of the FOMC would agree with the chairman’s views. Bernanke was frustrated by the cacophony of views expressed by FOMC members – voting and otherwise – and he instituted press conferences in part to ensure that investors were clearly aware of the FOMC’s central view, despite the noise coming from speeches and public comments made by individual FOMC members. Close interactions between board members at least ensured some coherence of views within this group, but, even with the press conferences, the Fed cacophony never stopped as regional Fed presidents continued to express publicly views that differed from the FOMC median.

Under Yellen, the Fed will remain as much of a constitutional monarchy (or possibly even a collegial democracy) as it became under Bernanke. Yellen has a collegial personality and approach and will work hard to ensure that she takes views close to those of the rest of the FOMC. For example, she has previously expressed sympathy for the idea of optimal control – i.e., allowing inflation to increase above the Fed’s 2% target to allow the unemployment rate to fall below the non-accelerating inflation rate of unemployment (NAIRU) for a while, thus allowing a faster reduction of labor-market slack generated by years of low employment. But the idea of optimal control never garnered a majority within the FOMC, as there is a risk that once inflation rises above target, inflation expectations would become unhinged. Thus, as Fed chair, Yellen has already stopped supporting optimal control, a shift in stance from her days as vice-chair. She also aligned herself with the rest of the FOMC in December – before becoming chair – by supporting the start of QE tapering.

The FOMC Still Has a Dovish Majority

The Fed chair still wields significant power and is likely to have a board that remains relatively dovish: indeed, under Bernanke, the board became more dovish over time and moved closer to Yellen’s views. In spite of all the changes, the voting FOMC still has a majority of relative doves (Daniel Tarullo, Jerome Powell, William Dudley and Narayana Kocherlakota, as well as Fischer and Brainard when confirmed) who will align with Yellen’s views on the economy. Once the two additional board vacancies are filled by Congress, this dovish majority will be reinforced.

In her April 16 speech to the Economic Club of New York, Yellen offered a detailed explanation of the central bank’s current thinking on forward guidance and policy rules, and set the groundwork for a coherent forward guidance message. Coming after her remark about a six-month lag between the end of QE and the start of rate hikes, Yellen’s speech was a form of corrective action, highlighting the high degree of labor-market slack and the weak inflation outlook; the market correctly interpreted these signals as dovish with respect to policy rates.

Fed Must Next Devise a New Policy Rule

With markets and investors now focusing on the date of the first rate increase – as the tapering schedule is on track to be completed by October – the key issue for the Fed will be to communicate to markets which rule will be followed regarding the pace and end point of policy normalization once rate normalization begins. With regard to the end point, the neutral long-term fed funds rate will be closer to 4% than the higher levels (5.25% and 6.5%) seen during the last two cycles. A 4% neutral fed funds rate is consistent with a 2% inflation target and a 2% real fed funds rate. Historically, the equilibrium real fed funds rate was higher (closer to 2.5-3%), but Fed officials have made several arguments for why the equilibrium real short rate is now closer to 2% – if not lower.

As recently argued by New York Fed President William Dudley, there are three reasons for a lower equilibrium real fed funds rate. First, economic headwinds seem likely to persist for several more years. Second, slower growth of the labor force and moderate productivity growth imply a lower potential real GDP growth rate, which implies lower real equilibrium interest rates even once all current headwinds have fully dissipated. Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Higher capital requirements for banks imply somewhat wider intermediation margins, which is likely to push down the long-term equilibrium federal funds rate somewhat.

Some very dovish FOMC members may believe that the equilibrium fed funds rate may be even lower than 4% (a view that is currently priced in by financial markets), while some more hawkish members believe that an equilibrium rate closer to the historical average of 4.5% is more warranted. This dispersion of views is clear from the forecasts contained in the FOMC’s Summary of Economic Projections (SEP). But for the median FOMC voter, the new neutral rate is 4%, so it seems likely that this will be the neutral rate.

How fast will the Fed get to 4% and with which policy rule? The median FOMC voter sees the fed funds rate at 1% by the end of 2015 and 2.25% by the end of 2016, only reaching the neutral level of 4% toward the end of 2018. This is an extremely slow pace of policy normalization, a process that would last about 3.5 years from start to finish, assuming normalization does not begin until mid-2015. In the 2004-06 normalization cycle, the rate went from 1% to 5.25% in just two years.

The need to use aggressive forward guidance – low for longer relative to even a modified Taylor rule – to make these SEP projections credible to markets is obvious: Since the median FOMC voter forecasts that the unemployment rate will be close to NAIRU by the end of 2016 and that inflation will be close to its 2% target at that time, a fed funds rate of 2.25% by the end of 2016 implies that the real fed funds rate will still be close to or barely above 0%, despite the economy being close to full employment and inflation being close to target. In normal times, such a scenario would have justified a real fed funds rate closer to 1% and therefore a nominal fed funds rate that is closer to 3% than 2.25%. And indeed, some analysts and market participants believe that the Fed will normalize faster than the SEP dots (individual participant’s forecasts) predict, with the fed funds rate close to 3% by the end of 2016.

This is why Fed communication and forward guidance are key. If those within the FOMC who are skeptical of forward guidance (such as Fischer and the hawks) were to have the upper hand, it is likely that markets would start pricing in a more rapid policy rate normalization – closer to 3% by the end of 2016 and closer to the neutral rate of 4% by the end of 2017. If instead, the dovish view were to prevail, it would be critical for the Fed to defend the credibility of its “lower for longer” message.

Those skeptical of forward guidance would most likely prefer the Fed to communicate to markets a policy rule closer to a Taylor rule with some discretion, rather than a policy rule based on strong forward guidance. Therefore, the key issue ahead will be whether Yellen can convince the rest of the FOMC to maintain the “lower for longer” forward guidance approach. While the median FOMC voter currently adheres to the Yellen view, the situation may change for several reasons:

  1. The less dovish members may push to de-emphasize forward guidance and the SEP dots;
     
  2. As uncertainty recedes about the end-2016 outlook for inflation and labor-market conditions, the policy reaction function of the median FOMC voter may change: that median FOMC voter may decide that a near-0% real fed funds rate is too low and would thus choose to front-load the policy rate normalization process toward 3% by the end of 2016;
     
  3. Concerns about asset bubbles and financial stability may induce FOMC members to consider using monetary policy to control bubbles, especially if macro-pru policies fail to contain current and future frothiness in financial markets. While Yellen is wary of using monetary policy (policy rates) to control bubbles, other FOMC members are more open to this option if macro-pru policies prove insufficient.

Therefore, for the FOMC to make its multi-indicator-based forward guidance approach work, we believe that the members will need to follow Yellen’s lead and make a stronger and more cohesive effort to communicate the FOMC’s policies and views on the economy. If Yellen continues to communicate in this manner, and is able to rally the overall signaling of the Fed’s stance around her views, then the Fed may be able to temper the headwinds generated by the current absence of a more explicit policy framework. If not, we would be concerned that a somewhat less dovish FOMC membership may have an impact on the market’s perception of the timing and speed of the Fed’s policy normalization and the degree to which the Fed will continue with forward guidance in the future. Certainly, the Fed is now in the middle of a serious debate on the nature of its policy reaction function once policy rates start to rise above 0%. The result of this debate will be key to assessing whether the pace of policy normalization currently priced in by markets – that is, close to the Fed’s SEP dots – is correct or not.

The Known Knowns

Although the market will have to adjust to a number of new Fed officials over the next year, the FOMC’s 2014 and 2015 cohorts contain a number of familiar figures. Below is a summary of their current views on how monetary policy should evolve over the next few years.

New York Fed President William Dudley is a dove and a core member of the FOMC. In a speech on May 20, Dudley did not add color on the timing of the first rate hike, but noted that the pace of tightening thereafter “will probably be relatively slow.” Dudley expects that the fed funds rate consistent with a 2% rate of long-run personal consumer expenditure (PCE) inflation is likely to be well below the 4.25% historical average that accompanied 2% inflation. (With respect to the labor market, Dudley noted that he believes a much greater proportion of long-term unemployment is the product of cyclical forces.) Dudley is likely to align with Yellen in pressing to keep rates “lower for longer.”

San Francisco Fed President John C. Williams will be a 2015 voting member, and therefore likely to play a role in the forward guidance debate in 2015. In a May 22 speech, Williams noted that “a real tightening of policy – which would mean raising the fed funds rate – is still a good way off.” Although Williams is dovish, he is a mild dove at best and may have views diverging from the “lower for longer” pledge; for instance, Williams had seemed to be leaning in the direction of an expeditious retreat from QE last spring.

Dovish Atlanta Fed President Dennis Lockhart will be a voting member in 2015 and is likely to support “lower for longer” forward guidance. In a May 11 speech, Lockhart said that the first rate hike would likely come in H2 2015, stating that “When the first move to tighten policy is taken, I would expect it to begin a cycle of gradually rising rates.” Lockhart sees both a shortfall from potential and below-objective inflation as justifying patience in raising policy rates.

Chicago Fed President Charles Evans is markedly dovish and a clear proponent of forward guidance. As a 2015 FOMC voting member, he will be strongly in favor of maintaining forward guidance to shore up the recovery. In an April 9 speech, Evans observed that “It certainly seems that the fallout from the financial crisis and persistent headwinds holding back economic activity are consistent with the equilibrium real interest rate being lower than usual today.” In Evans’ view, the FOMC’s March “lower for longer” pledge accounts for the possibility of lower real rates.

Richmond Fed President Jeffrey Lacker is generally hawkish, although he has not spoken recently regarding the Fed’s March communication changes on interest rates. He votes in 2015, and may lean against the forward guidance pledge.

Philadelphia Fed President Charles Plosser is a hawk and a member of the FOMC in 2014. In a May 20 speech, Plosser said that “as we continue to move closer to our 2% inflation goal and the labor market improves, we must be prepared to adjust policy appropriately. That may well require us to begin raising interest rates sooner rather than later.” Plosser’s next voting term is in 2017, however, and therefore he will influence the debate (rather than the vote) on “lower for longer.”

Minneapolis Fed president Narayana Kocherlakota, a 2014 voting member, is a hawk turned noted dove. In a May 21 speech, Kocherlakota stated that he currently saw the Fed as undershooting both its price stability and maximum employment mandates. Kocherlakota’s next voting term is also 2017 and therefore, like Plosser, he will influence the debate rather than the vote on “lower for longer.”

Finally, there is Dallas Fed President Richard Fisher, who is currently a member of the FOMC and also a noted hawk. Fisher has never been a proponent of QE, long arguing that Fed asset purchases can lead to excessive risk taking and the creation of market bubbles. As Fisher rotates off the Committee this year and will not be a voting member again until 2017, his views will have less bearing on the timing and pace of rate hikes over the next couple of years.

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Important Disclosures

The article Outside the Box: Musical Chairs at the FOMC was originally published at mauldineconomics.com.

Thoughts from the Frontline: The Age of Transformation

 

One of the many luxuries that my readers have afforded me over the years is their willingness to allow me to explore a wide variety of topics. Not all writers are so blessed, and their output and responses to it tend to stay focused on specific, often quite narrow topics. While this approach allows them to dig very deep into particular subject matter, it can reduce the total scope of their research, vision, and advice. But don’t get me wrong; these types of letters are very important. I benefit greatly from being a subscriber to a number of letters that give me detailed analysis for which I simply don’t have the time to do the research. There’s just too much going on in the world today for any of us to be an expert in more than a few areas.

I seem to find the most enjoyment and elicit the best response when I try to give my readers the benefit of my broad scope of reading and research as I try to figure out how all the various and sundry pieces of the puzzle fit together. For me, the world is just that: a vast and very complex puzzle. Trying to discern the grand themes and detailed patterns as the very pieces of the puzzle go on changing shape before my eyes is quite a challenge.

To try to figure out which puzzle pieces are going to have the most influence and impact in our immediate future, as opposed to languishing in the background, can be a frustrating experience. I often find myself writing about topics (such as a coming subprime crisis or recession) long before they manifest themselves. But I think it is important to see opportunities and problems brewing as far in advance as we can so that we can thoughtfully position ourselves and our portfolios to take advantage.

Today I offer some musings on what I’ve come to think of as the Age of Transformation (which I have been thinking about a lot while in Tuscany). I believe there are multiple and rapidly accelerating changes happening simultaneously (if you can think of 10 years as simultaneously) that are going to transform our social structures, our investment portfolios, and our personal futures. We have had such transformations in the past. The rise of the nation state, the steam engine, electricity, the advent of the social safety net, the personal computer, the internet, and the collapse of communism are just a few of the dozens of profound changes that have transformed the world in which we live.

Therefore, in one sense, these periods of transformation are nothing new. I think the difference today, however, is going to be the simultaneous nature of multiple transformational trends playing out within a very short period of time (relatively speaking) and at an accelerating rate.

It is self-evident that failure to adapt to transformational trends will consign a business or a society to the ash can of history. Our history and business books are littered with thousands of such failures. I think we are entering one of those periods when failing to pay close attention to the changes going on around you could prove decidedly problematical for your portfolio and fatal to your business.

This week we’re going to develop a very high-level perspective on the Age of Transformation. In the coming years we will do a deep dive into various aspects of it, as this letter always has. But I think it will be very helpful for you to understand the larger picture of what is happening so that you can put specific developments into context – and, hopefully, let them work for you rather than against you.

We’re going to explore two broad themes, neither of which will be strange to readers of this letter. The first transformational theme that I see is the emerging failure of multiple major governments around the world to fulfill the promises they have made to their citizens. We have seen these failures at various times in recent years in “developed countries”; and while they may not have impacted the whole world, they were quite traumatic for the citizens involved. I’m thinking, for instance, of Canada and Sweden in the early ’90s. Both ran up enormous debts and had to restructure their social commitments. Talk to people who were involved in making those changes happen, and you can still see some 20 years later how painful that process was. When there are no good choices, someone has to make the hard ones.

I think similar challenges are already developing throughout Europe and in Japan and China, and will probably hit the United States by the end of this decade. While each country will deal with its own crisis differently, these crises are going to severely impact social structures and economies not just nationally but globally. Taken together, I think these emerging developments will be bigger in scope and impact than the credit crisis of 2008.

While each country’s crisis may seemingly have a different cause, the problems stem largely from the inability of governments to pay for promised retirement and health benefits while meeting all the other obligations of government. Whether that inability is due to demographic problems, fiscal irresponsibility, unduly high tax burdens, sclerotic labor laws, or a lack of growth due to bureaucratic restraints, the results will be the same. Debts are going to have to be “rationalized” (an economic euphemism for default), and promises are going to have to be painfully adjusted. The adjustments will not seem fair and will give rise to a great deal of societal Sturm und Drang, but at the end of the process I believe the world will be much better off. Going through the coming period is, however, going to be challenging.

“How did you go bankrupt?” asked Hemingway’s protagonist. “Gradually,” was the answer, “and then all at once.” European governments are going bankrupt gradually, and then we will have that infamous Bang! moment when it seems to happen all at once. Bond markets will rebel, interest rates will skyrocket, and governments will be unable to meet their obligations. Japan is trying to forestall their moment with the most breathtaking quantitative easing scheme in the history of the world, electing to devalue their currency as the primary way to cope. The US has a window of time in which it will still be possible to deal with its problems (and I am hopeful that we can), but without structural reform of our entitlement programs we will go the way of Europe and numerous other countries before us.

The actual path that any of the countries will take (with the exception of Japan, whose path is now clear) is open for boisterous debate, but the longer there is inaction, the more disastrous the remaining available choices will be. If you think the Greek problem is solved (or the Spanish or the Italian or the Portuguese one), you are not paying attention. Greece will clearly default again. The “solutions” have so far produced outright depressions in these countries. What happens when France and Germany are forced to reconcile their own internal and joint imbalances? The adjustment will change consumption patterns and seriously impact the flow of capital and the global flow of goods.

This breaking wave of economic changes will not be the end of the world, of course – one way or another we’ll survive. But how you, your family, and your businesses are positioned to deal with the crisis will have a great deal to do with the manner in which you survive. We are not just cogs in a vast machine turning to powers we cannot control. If we properly prepare, we can do more than merely “survive.” But achieving that means you’re going to have to rely more on your own resources and ingenuity and less on governments. If you find yourself in a position where you are dependent upon the government for your personal situation, you might not be happy. This is not something that is going to happen all of a sudden next week, but it is going to unfold through various stages in various countries; and given the global nature of commerce and finance, as the song says, “There is no place to run and no place to hide.” You will be forced to adjust, either in a thoughtful and premeditated way or in a panicked and frustrated one. You choose.

I should add a note to those of my readers who think, “I don’t have to worry about all this because I am not dependent on Social Security.” Wrong. A significant majority of the retiring generation does depend on Social Security and also on government-controlled healthcare, and their reactions and votes and consumption patterns will have an impact on society. Ditto for France, Germany, Italy, and the rest of Europe. The Japanese have evidently made their choice as to how to deal with their crisis. If you are a Japanese citizen and are not making preparations for a significant change in your national balance sheet and the value of your currency, you have your head in the sand.

There’s no question that the reactions of the various governments as they try to forestall the inevitable and manage the crisis will create turmoil and a great deal of volatility in the markets. We have not seen the last of QE in the US, but Japan is going gangbusters with it, and it is getting fired up in Europe and China.

Most people in most places will attempt to ignore the transformational wave barreling at them. After all, aren’t bond rates in Europe lower than ever? Indeed, French and Spanish bond yields are at their lowest levels since the 1700s, believe it or not. Isn’t the market telling us there isn’t a problem? If Japan is such a problem, shouldn’t the yen be going into the toilet by now? The US deficit is shrinking, and government spending is actually falling. Seems like the problems have all gone away.

But the problems I’m thinking about are not ones that will manifest themselves this week. The markets did not foresee the 2008 credit crisis or the last two recessions or the European crisis, even just a few months before they hit. When the world doesn’t come to an end as predicted (and there were plenty of prognostications of utter doom last decade), we seem to get complacent and ignore the basic arithmetic that you have to have more income than you have expenditures, and to conveniently forget that debt, even at low interest rates, is compounding. And yes, it is possible to grow your way out of the problem – but only if you have real growth. Now, much of the world is structurally challenged in such a way that structural imbalances inhibit growth at the rate necessary to significantly put a dent in swelling debt levels.

The Second Wave of Transformation

Contrasting with this rather negative set of circumstances is the second great transformational theme that I want to explore with you, and that is the far more positive accelerating trend in a vast array of technologies. It’s not too much of a stretch to say that we’re in a race between how much wealth and value and improvement in lifestyles human ingenuity can create versus how much destruction of wealth and lifestyles governments can destroy.

It is a tendency of ours to take our recent past and project it in a linear fashion into the future. That’s the way we are hardwired. And while we all acknowledge that change is happening faster today than it did 20 or 30 years ago, we really don’t expect the pace of change to quicken in the future. The next 20 years, we figure, will more or less unfold as the last 20 years has. Not a chance. That assumption is missing the second derivative of change – the acceleration of the pace of change.

As a thought experiment, let us assume that we were going 40 miles an hour in 1984, and by 2004 we were going 50 miles an hour. But today we’re going 60 miles per hour. It took 20 years to get that additional 10 miles per hour (from 40 to 50) but only 10 years to go from 50 to 60 miles per hour. If we continue to accelerate, we’ll be going 100 miles an hour in another 20 years!

While the impact of the internet and computers is evident, what I’m suggesting is that we are going to see multiple technologies go from deceptively hiding in the background, with the pace of change they promise frustratingly slow, to suddenly taking center stage and becoming disruptive. It will be as if the steam engine and electricity and the automobile and telecommunications all appeared at the same time, after having been developed in the background for many decades.

The mobile and wireless internet, artificial intelligence and automation, the internet of things, advanced robotics, autonomous vehicles, advanced energy exploration technology, renewable energy (especially solar energy), advanced materials, the rapidly accelerating biotechnology revolution, nanotechnology, and even electronic currencies (Bitcoin et al.) are all rapidly approaching the “elbows” of their own accelerating curves. Each of these areas is going to go exponential in the next 10 to 20 years.

The change I am contemplating is not simply better phones and electric cars and a few new medical therapies. I think we are in for a radical adjustment to the very mechanisms of production and the very structure of our economic and social life.

Joseph Schumpeter described capitalism as the “perennial gale of creative destruction.” In an excellent essay on creative destruction, W. Michael Cox and Richard Alm lay out the paradox between the demise of old industries and the rise of new ones (emphasis mine):

Schumpeter and the economists who adopt his succinct summary of the free market’s ceaseless churning echo capitalism’s critics in acknowledging that lost jobs, ruined companies, and vanishing industries are inherent parts of the growth system. The saving grace comes from recognizing the good that comes from the turmoil. Over time, societies that allow creative destruction to operate grow more productive and richer; their citizens see the benefits of new and better products, shorter work weeks, better jobs, and higher living standards.

Herein lies the paradox of progress. A society cannot reap the rewards of creative destruction without accepting that some individuals might be worse off, not just in the short term, but perhaps forever. At the same time, attempts to soften the harsher aspects of creative destruction by trying to preserve jobs or protect industries will lead to stagnation and decline, short-circuiting the march of progress. Schumpeter’s enduring term reminds us that capitalism’s pain and gain are inextricably linked. The process of creating new industries does not go forward without sweeping away the preexisting order.

Transportation provides a dramatic, ongoing example of creative destruction at work. With the arrival of steam power in the nineteenth century, railroads swept across the United States, enlarging markets, reducing shipping costs, building new industries, and providing millions of new productive jobs. The internal combustion engine paved the way for the automobile early in the next century. The rush to put America on wheels spawned new enterprises; at one point in the 1920s, the industry had swelled to more than 260 car makers. The automobile’s ripples spilled into oil, tourism, entertainment, retailing, and other industries. On the heels of the automobile, the airplane flew into our world, setting off its own burst of new businesses and jobs.

Americans benefited as horses and mules gave way to cars and airplanes, but all this creation did not come without destruction. Each new mode of transportation took a toll on existing jobs and industries. In 1900, the peak year for the occupation, the country employed 109,000 carriage and harness makers. In 1910, 238,000 Americans worked as blacksmiths. Today, those jobs are largely obsolete. After eclipsing canals and other forms of transport, railroads lost out in competition with cars, long-haul trucks, and airplanes. In 1920, 2.1 million Americans earned their paychecks working for railroads, compared with fewer than 200,000 today.

What occurred in the transportation sector has been repeated in one industry after another – in many cases, several times in the same industry. Creative destruction recognizes change as the one constant in capitalism. Sawyers, masons, and miners were among the top thirty American occupations in 1900. A century later, they no longer rank among the top thirty; they have been replaced by medical technicians, engineers, computer scientists, and others.

Technology roils job markets, as Schumpeter conveyed in coining the phrase “technological unemployment”. E-mail, word processors, answering machines, and other modern office technology have cut the number of secretaries but raised the ranks of programmers. The birth of the Internet spawned a need for hundreds of thousands of webmasters, an occupation that did not exist as recently as 1990. LASIK surgery often lets consumers throw away their glasses, reducing visits to optometrists and opticians but increasing the need for ophthalmologists. Digital cameras translate to fewer photo clerks.

And while your job may be one of those that will ride easily into our brave new future, the same may not be true of your stock investments. Companies show the same pattern of destruction and rebirth. Only five of today’s hundred largest public companies were among the top hundred in 1917. Half of the top hundred of 1970 had been replaced in the rankings by 2000.

The chart below was recently produced by Richard Foster at S&P. What it shows is that the average lifespan of companies in the S&P 500 Index was about 60 years in 1960. Today they last about 15-20 years. That means we are currently replacing a stock in the index about every two weeks.

Since the index is representative of the largest US companies, that means that each year 25 big companies either can’t grow enough to keep up or are outgrown by other companies, otherwise fail or get merged; but in general terms it means that if you are invested in the S&P 500 Index, it is almost guaranteed that at least 10% of the companies in your portfolio are old dogs.

Blockbuster failed to recognize that the world was changing, and it was Netflixed, to coin a verb. (Actually I think it’s quite a workable word to describe what happens when a company fails to adapt. It gets Netflixed.) There is going to be a bright dividing line in the future between companies that “get” change and companies that don’t. Measuring companies by past performance and recent profit trends will no longer be enough in the Age of Transformation.

No industry is going to be safe. Within the next 10 years, solar technology will develop to the point where it will be cost-competitive with fossil fuels. Currently, the solar industry is growing at 30% a year; and while solar is only 1% of US energy consumption today, if we are able to keep up that compounding effort, it it could be almost 100% in 20 years. Solar roads? Possible. And yes, we need new batteries and storage systems, but those are on the way. What will your mother’s safe utility companies do?

In China they are literally 3D printing 3000-square-feet houses in a day! One company is planning to 3D print a car with 20 moving parts this fall, using advanced materials much stronger than steel and aluminum. Think AT&T is safe? The competition for new wireless systems is brutal. Both Facebook and Google are developing technologies to place “high-balloons” and permanent solar drones at 65,000 feet in order to blanket the globe with Wi-Fi. I’ve read estimates that a “mere” 40,000 such devices could do the job. Netflix itself is in danger of being Netflixed by Hulu and other competitors.

You can’t believe what they’re doing with robots and artificial intelligence. AI, long the poster child for disappointing technologies, is getting ready to go mainstream by the end of the decade.

Just for fun, look at this RadioShack ad from 1991. Essentially everything on that page is in a smart phone. And far more powerfully. And throw in a free camera. For a tiny fraction of the prices advertised then.

Now fast-forward 20 years. I’m not sure what our can’t-live-without-it computing and communication devices will look like, but they will probably be quite small, wearable, and a million times more powerful! We will likely be (or at least some of us will be) connected to our devices in rather unique ways. (Google Glass will seem so odd and quaint, which is kind of how it is perceived now.) Think of being able to access scores (hundreds?) of expert systems waiting in the cloud with answers on any topic, so that the solutions to the problems of improving our personal lives and our businesses will be limited only by our imagination in asking the questions (and doing the work to make those answers real). And we’ll be able to direct those AI experts to work together to come up with powerful, novel solutions. The cross-fertilization of technologies will soar!

Now imagine putting these tools into the hands of practically every person on earth who wants them. Along with all the other tools that are coming from all the other exponentially accelerating technologies. Especially life-altering will be the biotech breakthroughs. We won’t be physically immortal, but the things that kill most of us today will not be a problem. We will just get … older. And we will be able to repair a great deal of the damage from aging. Plan on living a lot longer and needing more money than you think.

I can see many of my readers rolling their eyes and saying it won’t happen in 20 years. Or 30 or 40. Things just don’t happen that fast, you say. But that is just your old Homo sapiens brain extending the past in a linear fashion into the future. Moore’s law tells us that the number of transistors on a chip roughly doubles every two years (and the chip drops in price). But other industries, like solar tech and genome sequencing, are on exponential paths that make Moore’s law look positively snail-like. If the power of exponential change keeps working – and it will – we will see more change in the next 20 years than we saw in the last 100!

I get lots of newsfeeds from services that list 3-5 new advances in some field every day. It can be overwhelming. (We have our own such free service here at Mauldin Economics, called Patrick Cox’s Tech Digest.) The time from proof of principle in the lab until rollout in the factory is dropping as well. We are now using over 200 different materials in our 3D printers, combined in ways that were never before possible. (We’re even starting to print human organs, a feat that I predict will seem like so “last-century” in 20 years). I am lucky in that I get to tag along every now and then with Pat Cox as he interviews the leading scientists and entrepreneurs in a wide range of industries. He does the groundwork in sorting through that gale of creative destruction, and I get to see the pick of his litter.

One of the risks in investing in technology, by the way, is not so much that your company might not discover some new, cool tech that blows away the competition, but that someone else might come along and do it even better and cheaper before you’re even out of the starting gate. You can be right about the tech and STILL lose money.

Homo rationalis

The thing that is going to be overwhelming to nearly all of us is the degree of acceleration of change as the years fly by. We are not psychologically prepared for it. The only way we will be able to adapt is to ignore that primal part of our brain that says change is bad and use our frontal lobes to rationally observe and choose a path forward. Just as Neanderthals gave way to Homo sapiens, we need to evolve, at least in our thinking, to become Homo rationalis.

All of our investments and our businesses – and our very lives – will be fundamentally changed, transformed by these two Super Trends we have looked at. Needless to say, we cannot turn our backs on the nitty-gritty details of the faltering global economy. We still have to read financial statements and government reports and stay on top of which central bank is doing what to whom, and to translate our research and analysis into smart, nimble investments. Simply knowing that things are going to change in technologically wonderful ways will not be enough. Acting too soon will be as frustrating and ineffective as not acting soon enough. We will continue to explore together in this letter to figure out how all the pieces of the puzzle fit.

I would like to remind readers that I will be part of an exclusive webinar with investment industry heavyweights Richard Perry and Jack Rivkin on Tuesday, June 24, at 1:00 p.m. EDT / 10:00 a.m. PDT, hosted by my partners at Altegris. Richard founded Perry Capital in 1988 and is one of the originators of event-driven investing – a very interesting strategy to look at right now, given increased corporate activity this year. My friend Jack brings more than 45 years of direct investing, research, general management, and investment management experience at leading financial institutions to his role as Altegris CIO. Unfortunately, this event is limited to qualified US investors. You can go to http://www.altegris.com/mauldinreg to sign up, and someone from Altegris will call and make sure you get an invitation. I hate to limit it, but that is the rule.  (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

Rome, Nantucket, New York, and Maine

I finish this letter on the train from Chiusi (in Tuscany) to Rome, where I will spend the next four nights. Tomorrow I am tourist, probably seeing the Vatican courtesy of a connection from Martin Truax. We met up in Cortona the other night, which turned into an adventure itself, and had dinner at a delightful outdoor restaurant overlooking the old town square, with 1,000-year-old walls as our backdrop. And a nearly full moon. Then I am in business mode, meeting with a series of corporate and government leaders and attending as much as I can of a very interesting conference organized by Banca IMI (the Investment Bank of Intesa Sanpaolo Group) and intriguingly titled “Back to the Future: Are Markets and Policy Makers Ready for Normality?” They have asked Christian Menegatti of Roubini Global Research and me to speak jointly to the main topic. Looking over the attendee list of government officials, bankers, and major market players is quite daunting, but we will try to provide a few useful thoughts. My first thought on hearing the question was, “What can be considered normal in Europe?” And upon reflection I am still trying to come up with an answer. Just saying.

Travel slows down this summer, with just a trip to Nantucket for a speech and to NYC for a few meetings in mid-July – and of course the annual Maine fishing trip. Even though Texas will be hot, I will enjoy being home for what will seem like an extended time.

As I am thinking a lot about change, I keep wondering how it will affect my family and friends. I know the unemployment number keeps falling, but good jobs seem problematical, and so many are going to disappear even as others appear, and that will mean learning new skills. Yet so much will not change. Humans will basically remain the same even as our tools improve. Family and good times with friends will still be important. We will still want to find meaning outside of ourselves. Most of us will still enjoy watching sports or listening to our favorite music. And serving others to take care of their basic needs will never go out of style. I hope to still be writing to you in 20 years, but I am not sure what form you will consume it in. I will adapt. And you will, too – you’ll need to.

They are calling Rome, so I guess that means it is time to hit the send button. It has been a relaxing two weeks, and I took much more time off than I had planned and read a few sci-fi books. I am enjoying Neptune’s Brood, by Charlie Stross, which offers a new version of money and economics in the far, far future (and is based on Bitcoin tech, for those interested). If you want to read a book about the near future and what will be possible with drones and AI, let me suggest Kill Decision, by Daniel Suarez. Frankly, it is the scariest book I have ever read. It is tech run amok, and the possibilities it raises are sadly more than real. While I do my best to be a cautious optimist, I admit to worrying about how some of our new tools will be used. God give us the wisdom…

Your relaxed and ready to get back to work (tomorrow!) analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Thoughts from the Frontline: The Age of Transformation

 

One of the many luxuries that my readers have afforded me over the years is their willingness to allow me to explore a wide variety of topics. Not all writers are so blessed, and their output and responses to it tend to stay focused on specific, often quite narrow topics. While this approach allows them to dig very deep into particular subject matter, it can reduce the total scope of their research, vision, and advice. But don’t get me wrong; these types of letters are very important. I benefit greatly from being a subscriber to a number of letters that give me detailed analysis for which I simply don’t have the time to do the research. There’s just too much going on in the world today for any of us to be an expert in more than a few areas.

I seem to find the most enjoyment and elicit the best response when I try to give my readers the benefit of my broad scope of reading and research as I try to figure out how all the various and sundry pieces of the puzzle fit together. For me, the world is just that: a vast and very complex puzzle. Trying to discern the grand themes and detailed patterns as the very pieces of the puzzle go on changing shape before my eyes is quite a challenge.

To try to figure out which puzzle pieces are going to have the most influence and impact in our immediate future, as opposed to languishing in the background, can be a frustrating experience. I often find myself writing about topics (such as a coming subprime crisis or recession) long before they manifest themselves. But I think it is important to see opportunities and problems brewing as far in advance as we can so that we can thoughtfully position ourselves and our portfolios to take advantage.

Today I offer some musings on what I’ve come to think of as the Age of Transformation (which I have been thinking about a lot while in Tuscany). I believe there are multiple and rapidly accelerating changes happening simultaneously (if you can think of 10 years as simultaneously) that are going to transform our social structures, our investment portfolios, and our personal futures. We have had such transformations in the past. The rise of the nation state, the steam engine, electricity, the advent of the social safety net, the personal computer, the internet, and the collapse of communism are just a few of the dozens of profound changes that have transformed the world in which we live.

Therefore, in one sense, these periods of transformation are nothing new. I think the difference today, however, is going to be the simultaneous nature of multiple transformational trends playing out within a very short period of time (relatively speaking) and at an accelerating rate.

It is self-evident that failure to adapt to transformational trends will consign a business or a society to the ash can of history. Our history and business books are littered with thousands of such failures. I think we are entering one of those periods when failing to pay close attention to the changes going on around you could prove decidedly problematical for your portfolio and fatal to your business.

This week we’re going to develop a very high-level perspective on the Age of Transformation. In the coming years we will do a deep dive into various aspects of it, as this letter always has. But I think it will be very helpful for you to understand the larger picture of what is happening so that you can put specific developments into context – and, hopefully, let them work for you rather than against you.

We’re going to explore two broad themes, neither of which will be strange to readers of this letter. The first transformational theme that I see is the emerging failure of multiple major governments around the world to fulfill the promises they have made to their citizens. We have seen these failures at various times in recent years in “developed countries”; and while they may not have impacted the whole world, they were quite traumatic for the citizens involved. I’m thinking, for instance, of Canada and Sweden in the early ’90s. Both ran up enormous debts and had to restructure their social commitments. Talk to people who were involved in making those changes happen, and you can still see some 20 years later how painful that process was. When there are no good choices, someone has to make the hard ones.

I think similar challenges are already developing throughout Europe and in Japan and China, and will probably hit the United States by the end of this decade. While each country will deal with its own crisis differently, these crises are going to severely impact social structures and economies not just nationally but globally. Taken together, I think these emerging developments will be bigger in scope and impact than the credit crisis of 2008.

While each country’s crisis may seemingly have a different cause, the problems stem largely from the inability of governments to pay for promised retirement and health benefits while meeting all the other obligations of government. Whether that inability is due to demographic problems, fiscal irresponsibility, unduly high tax burdens, sclerotic labor laws, or a lack of growth due to bureaucratic restraints, the results will be the same. Debts are going to have to be “rationalized” (an economic euphemism for default), and promises are going to have to be painfully adjusted. The adjustments will not seem fair and will give rise to a great deal of societal Sturm und Drang, but at the end of the process I believe the world will be much better off. Going through the coming period is, however, going to be challenging.

“How did you go bankrupt?” asked Hemingway’s protagonist. “Gradually,” was the answer, “and then all at once.” European governments are going bankrupt gradually, and then we will have that infamous Bang! moment when it seems to happen all at once. Bond markets will rebel, interest rates will skyrocket, and governments will be unable to meet their obligations. Japan is trying to forestall their moment with the most breathtaking quantitative easing scheme in the history of the world, electing to devalue their currency as the primary way to cope. The US has a window of time in which it will still be possible to deal with its problems (and I am hopeful that we can), but without structural reform of our entitlement programs we will go the way of Europe and numerous other countries before us.

The actual path that any of the countries will take (with the exception of Japan, whose path is now clear) is open for boisterous debate, but the longer there is inaction, the more disastrous the remaining available choices will be. If you think the Greek problem is solved (or the Spanish or the Italian or the Portuguese one), you are not paying attention. Greece will clearly default again. The “solutions” have so far produced outright depressions in these countries. What happens when France and Germany are forced to reconcile their own internal and joint imbalances? The adjustment will change consumption patterns and seriously impact the flow of capital and the global flow of goods.

This breaking wave of economic changes will not be the end of the world, of course – one way or another we’ll survive. But how you, your family, and your businesses are positioned to deal with the crisis will have a great deal to do with the manner in which you survive. We are not just cogs in a vast machine turning to powers we cannot control. If we properly prepare, we can do more than merely “survive.” But achieving that means you’re going to have to rely more on your own resources and ingenuity and less on governments. If you find yourself in a position where you are dependent upon the government for your personal situation, you might not be happy. This is not something that is going to happen all of a sudden next week, but it is going to unfold through various stages in various countries; and given the global nature of commerce and finance, as the song says, “There is no place to run and no place to hide.” You will be forced to adjust, either in a thoughtful and premeditated way or in a panicked and frustrated one. You choose.

I should add a note to those of my readers who think, “I don’t have to worry about all this because I am not dependent on Social Security.” Wrong. A significant majority of the retiring generation does depend on Social Security and also on government-controlled healthcare, and their reactions and votes and consumption patterns will have an impact on society. Ditto for France, Germany, Italy, and the rest of Europe. The Japanese have evidently made their choice as to how to deal with their crisis. If you are a Japanese citizen and are not making preparations for a significant change in your national balance sheet and the value of your currency, you have your head in the sand.

There’s no question that the reactions of the various governments as they try to forestall the inevitable and manage the crisis will create turmoil and a great deal of volatility in the markets. We have not seen the last of QE in the US, but Japan is going gangbusters with it, and it is getting fired up in Europe and China.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures