Against All Expectations

Well, that title makes me think. What are ‘expectations’, anyway? A hodgepodge of judgments on the future based on past experience, perhaps? Or, worse, judgments formed over time by absorbing the opinions by others—the others, most likely, being journalists, broadcasters and commentators? If that’s the case: oh, how terribly those opinion factories have served us!

Let me first deal with monetary policy. Against all expectations, Donald Trump’s outrageous tweet machine, forever demanding lower interest rates, succeeded in coercing the Federal Reserve into quiet compliance? So runs the prevailing commentary, but is that what actually happened? My take is a bit different. The Fed has manoeuvred itself into such an abyss that it has no choice but to re-embrace monetary recklessness. Donald Trump merely recognized that and took advantage. Where we go from here is quite predictable, too. Japan showed the way, Europe followed, and the U.S. is falling in line, too. To prevent a debt collapse, ever more liquidity will be created, while interest rates will stay low and, quite likely, trend even lower.

Turning to financial markets, against all expectations equities continued to soar, making new all-time highs—this despite shrinking corporate earnings and vibrant insider selling. Of course, given the central banks robust support of the stock market (and the politicians’ evident glee over the perceived “wealth effect” that’s not a surprise, either.

Looking back at last year, some would say the same of the economy overall that they said about financial markets. Against all expectations, it muddled along, even though debt levels appear unsustainable, consumer confidence is at best tepid, trade flows are off-again, on-again, and business spending is on hold. Again, I attribute the economy’s refusal to enter recession to central bank largesse. How long the mirage can continue is anyone’s guess.

On the domestic policy front, there are many counts of against all expectations. The U.S. is still caught up in partisan theatrics and likely will be, for years to come. Democrats are stunned that Trump is still the country’s president, while Republicans express disgust over the crass politicization of an impeachment process that appears to be headed for failure. In Britain, Boris Johnson has won with a historical landslide (against all expectations), garnering support from huge numbers of life-long Labour constituents who, this time, voted Conservative. (Well, there is an outcome that shouldn’t have surprised anyone, yet the media completely discounted it). What’s most worrying is how fast domestic discontent is spreading. France, Italy and Spain are all examples of advanced social unrest—far more unhinged conditions exist in various countries in Asia, South America and the Middle East.

When it comes to global politics, the theme for 2019 was, yet again, against all expectations. It was hard to imagine an even more polarized world, but here we are. Populism of the right and of the left has gained exponentially. Used to reporting on the past and rarely considering the future, our clueless friends in the media are searching for a saleable narrative that fits their political leaning. Their offerings are pitifully partisan; the real answers, apparent to anyone with a modest understanding of history, remain ignored. What baffles is that no one talks about the fact that, of a dozen or so key policy platforms, none is sustainable. Whether you look at health care, education, old age benefits, monetary policy, immigration, infrastructural maintenance, energy policy, or military spending—not one of them is on a trajectory that can be maintained much longer. When existing systems crumble unrest ensues, when they crumble at a time of extreme wealth disparity, unrest turns into chaos. I sympathize with the younger generation: our leaders have left them saddled with a dysfunctional world. What we’re passing on to them is far worse than what we inherited.

Three More Things

My wife Caroline jokes that when I set out to compose two pages, I end up writing ten or twelve, then turn to the much harder work of trimming my offering again. I could write a lot more, elaborating on the many other causes that will trigger more and more against all expectations events. To keep this short, let me focus on three of the most important ones.

First is the breakdown into irrelevance of most of the West’s postwar institutions. The dollar’s reserve currency status and America’s dominance of international payments systems are both being challenged. The same is true of the post-war order imposed by the U.S. on the developed economies; by now, institutions like the IMF, the World Bank and NATO are almost universally distrusted. In combination with an endless array of sanctions and tariffs, Washington has used these constructs mainly for its own purpose and, by doing so, has deeply alienated not only its rivals, but also its friends and allies. A typical example are the sanctions imposed on those engaged in building the Nordstream 2 pipeline, which will carry natural gas from Russia to Germany—by any definition, an economic undertaking. The sad reality: the rules-based global order that’s been in place since the end of WW2 is in an advanced state of collapse.

Second is the ascent of China, which is occurring exactly at the time America’s influence over what used to be referred to as “the West” is rapidly waning. There is still vibrant debate of who the most influential economic power is and whose approach to growth will win out: Washington’s power projection via its military, or Beijing’s Belt-and-Road initiative, based on infrastructural development. In the end, what our American or Chinese friends think will matter little; what the world thinks will be decisive. The chart below, produced by the Pew Research Center which interviewed 38,426 people in 34 countries, speaks volumes. It suggests that Europeans, Canadians and the people ‘down under’ are unanimous that China is the world’s leading economic power.

A third major cause of disorder is the demographic challenge. According to the OECD, there were 14 seniors for every hundred persons in 1950. By the year 2000 there were 22, by 2015 the number had risen to 28. In another five years we’ll be at 35. How will the young generate sufficient contributions to support so many pensioners? And how will pension regimes pay already promised payouts, especially if interest rates are kept at low levels? On the surface, the demographic adjustment will hit Japan and Western Europe the hardest. But the U.S., whose demographic profile looks healthier, will suffer too. There are two reasons for this. One is that U.S. policy makers have little room to cut back on social programs or infrastructural initiatives, both of which are at alarmingly subpar levels when compared to almost all developed economies. The other is that America has a much smaller middle class than most of its peers (see chart below). Historically, it is the middle class that can absorb economic shocks the most easily.

It’s impossible to know how exactly the breakdown of the seven-decade old systems we’ve come to rely on will manifest. If I had to make a safe bet, I’d say that ‘against all expectations’ will migrate from last year’s mantra to the leitmotif for the decade ahead. I’ll also join the growing number of investment professionals who predict that, the longer the central banks keep aggressively preventing a recession from taking its course, the harsher and the longer the eventual meltdown will be. Moreover, given the grave social tensions in place, I’ll be surprised if economic fallout will be the only major consequence. A dramatic change in political realities may be in the cards, too.

With best wishes for a joyful and healthy New Year!

Peter Cavelti