2016: The Year of Living Dangerously
As seen in the January edition of Master Investor Magazine.
2016, The Year of the Monkey, will be a capricious, unusually nervous year, full of danger and foreboding, not just confined to the financial markets.
As ever, nothing is foretold, and no outcome is inevitable. Most people have little concept of how much their lives are driven by Chaos Theory. This idea suggests that the same parameters, fed into the same equations, can yield multiple results which are all mathematically correct. (You might have heard of The Butterfly Effect which conjectures that the flapping of a butterfly’s wings in the Amazon rainforest might precipitate, say, a storm in India one month later).
So the same set of circumstances can result in different outcomes. That said, if one could re-run those circumstances again and again in a laboratory, certain outcomes would begin to seem more likely than others. But nobody knows exactly how things will turn out. The medieval theologian, Aquinas, doubted that even God could foretell the future. Though true, some people are better than others at guessing the odds than others.
But let’s keep this practical. In the next 10-15 minutes of your valuable time, I will focus on some key trends that may frame your thinking in the year ahead. Good thinking (instincts, if you will) can save investors from unnecessary losses – and might even make them money. So, without further ado, let me outline six things that you should be concerned about and two things for which you should rejoice during 2016. That makes eight things: the Monkey’s lucky number.
Cause for Concern One: Whispers of war will get louder
Simply put, going into 2016, the world is probably nearer to mass conflict than at any time since the Berlin Wall came down 26 years ago. I am not saying there will be a war soon – but that the risk of a major war between big powers (rather than just a proxy war between two clients) has risen significantly – and that this will become apparent.
Historians who debate the inevitability of the outbreak of WWI in August 1914 often come back to the fact that the conditions for that war had been around for some time. The assassination of the heir to the Austrian throne in Sarajevo on 28 June 1914 was the spark which lit a flame – which then became an inferno. Would the imperial dynasties of Austria, Germany and Russia have survived for decades longer if the Archduke had cancelled his visit that day? That question is called a counterfactual by historians and philosophers alike. The point is that things could have turned out differently, though absolute monarchy was still probably doomed.
Most of the decision-makers of today grew up in the Cold War (1945-91) during which the rivalry between two superpowers created a rigid stasis in the world order. Then they acquired responsibility in the Post-Cold War world in which the USA was the sole superpower and, acting in concert with its allies (collectively known as “the West”), imposed a Pax Americana. (Arguably, the Pax Americana came to an end in Iraq. As Chairman Mao replied, when asked whether the French Revolution had been a success: it is too early to say.)
The global economic and financial architecture set up at the end of WWII – based on the World Bank-International Finance Corporation (IFC), the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade – which morphed into the World Trade Organisation (WTO) in 1995 – has continued to be the foundation stone of the world economy. Until now, that is.
This Post-Cold War era is now under challenge. There is not one single dynamic but several in play, which interact in subtle ways. The first is the inexorable rise of China, the country that will overtake America as the world’s largest economy in about ten years’ time (depending on which forecasts you believe). The second is the attendant rise of revisionist powers like Russia and Iran which simply do not accept an international order which they believe was constructed solely for the benefit of America. The rise of new global institutions – such as the Chinese-backed Asia Infrastructure Development Bank (AIDB) – reflects this. The third is the contamination of Islamic fundamentalist (or more accurately, supremacist) ideology in its many manifestations, not least as suicidal terror cells embedded within Western societies. The fifth is modernist Marxist-oriented critique of the Western economic and social model which I analysed in my essay The Marxists Are Back in the October edition of the MI magazine. This critique is a complex fusion of post-Credit Crunch disgust for financial capitalism and end-of-time environmentalism rooted in the notion that only Greens can save the world. Incidentally, since I wrote that article, an electoral alliance between Mr Corbyn’s Labour Party and Ms Lucas’ Green Party has been mooted openly.
If the American-led West falls it will be partly because of external forces that overwhelm it; but also because it has ceased to believe in its own efficacy. The European branch of the West will lose faith first because it suffers from mass unemployment and its tax-and-spend welfare model will become increasingly impossible to sustain. Uncle Sam, of course, is made of sterner stuff.
Add to this the dangers arising from global warming, in particular the increased incidence of flooding in some parts of the world and the increased intensity of drought in others. In fact, water shortages will be a major theme in the years ahead. HRH Prince Charles expressed the view, much mocked in the media, that climate change was the trigger that unleashed the civil war in Syria. I think that HRH is right that global warming – though much of the science peddled by activists is highly questionable – will be a catalyst for further geopolitical upheaval going forward.
Consider a litany of just some of the momentous recent geopolitical events.
16 November 2015: President Hollande of France declared that France is at war in response to the Islamic State attacks on civilian targets in Paris on 13 November. The French air force began bombing IS targets in Syria immediately thereafter, joining the American-led operation. Further to a vote in the House of Commons on 02 December, the British joined in too.
24 November 2015: Turkish F-16 fighters shot down a Russian Su-24 fighter bomber which had allegedly made an incursion into Turkish airspace. I explained why I think this was a pre-meditated Turkish provocation of Russia in my MI blog piece of 26 November, War on Terror II: End of Days.
26 November 2015: Russia retaliated for the Turkish attack by deploying S-400 anti-aircraft systems in Syria which analysts consider the most advanced in the world. Russia also imposed export and travel sanctions intended to damage the Turkish economy. Russian tourists spend almost as much money in Turkey as they do in Egypt. Further utterances by President Putin – not least allegations that the Turks are buying oil from IS – suggest that Russia is hell bent on revenge.
26 November 2015 and then 02 January 2016: China announced a comprehensive reorganisation of its military command structure. Moreover, it has sought agreement to establish its first overseas military base. The base will be in Djibouti in the Horn of Africa, where the French and the Americans already have important bases. China is reportedly building a base near the Japanese-controlled Senkaku Islands, which it claims; and reefs in the Spratly Islands (South China Sea) have apparently been weaponised and foreign shipping ordered to stay clear.
21 November 2015: Ukrainian saboteurs blew up power lines to Crimea (now annexed by Russia), causing a power blackout. On 28 November 2015: the Donetsk People’s Republic (a pro-Russian part of eastern Ukraine) cut off coal exports to Ukraine in retaliation. Now, Russia might once again cut off gas supplies to Ukraine. The Ukrainian government in Kyiv still aspires to re-establish control over its renegade Eastern provinces.
23 December 2015: The Taliban took Sangin, Helmand Province, Afghanistan. Helmand, where about 450 British service men and women gave their lives over 2007-2013 to bring the rule of law to one of the most desolate outposts of one of the poorest nations on Earth, is now back to where it was before the US-led invasion of 2001.
02 January 2016: Saudi Arabia executed 47 dissidents, amongst whom Sheikh Nimr al-Nimr, the prominent Shia cleric who was, amongst other things, an opponent of violent extremism. The government of Iran, which has appointed itself the defender of the Shia, foretold that there would be dire consequences. In fact, Iran and Saudi Arabia, which represent opposite ends of Islamic orthodoxy, and which are natural antagonists, have been fighting a bloody proxy war in Yemen throughout 2015. King Salman, who ascended the Saudi throne in January 2015, seems to have racked up Saudi involvement here. Saudi Arabia, of course, is an “ally” of the West, while Iran is an implacable enemy of Israel.
One more spark, one more flame. One such possibility is China-Taiwan. Tsai Ing-wen, the woman about to become the leader of Taiwan, a self-proclaimed Thatcherite, intends to declare Taiwan’s total independence from China when she gets to power. China’s official position is that such a move will be met by force. America is committed to defend Taiwan. So the flashpoint could occur within months – a Sarajevo moment.
But then again there probably won’t be a Sarajevo moment in 2016 – no Archdukes will be gunned down and, in all likelihood, no empires will clash. But, as the plate tectonics of the emerging new world order compress and geopolitical tensions grow, so the significance of apparently marginal events will leverage. What is very likely is that increased political risk will attenuate market returns going forward in a way that has not been apparent before in the Post-WWII era. Consider a defence play in your portfolio. BAE Systems PLC (LON:BA) is already in recovery mode.
Cause for Concern Two: The USA will become politically more unstable
Never underestimate the achievement of The American Century. It changed the lives of everyone on Earth through its innovation, technology, dynamism and sheer fun. Not a single inhabitant on this planet was uninfluenced by America, and in my view, that influence was overwhelmingly beneficial.
The American Century began in 1917, with America’s entry into WWI. It is about to end.
America is still the global hegemonic power: by far the Number One economy with a military that enjoys a crushing dominance, in every category of warfare. Right now, America could confidently fight a war against the Bad Boys that I wrote about last year (China, Russia and Iran – in MI’s August magazine, Should We Ever Invest in Bad Boys?) combined, and still not lack hardware. Its military technology is decades ahead of China’s.
So America in 2016 is not the Ottoman Empire in 1916. But as Time Magazine put it in its 2015 end-of-year edition: Abroad, America’s once predominant influence is fading fast. Americans feel this more intensely than anyone else.
This change of mood is having unforeseen consequences. America, once politically-speaking the most stable and conservative nation on the planet, where politics were as staid and dependable as the Office of Management and Budget, has spawned a lunatic fringe. And they might even take power…
Donald Trump makes Nigel Farage look like a mannered, and somewhat nuanced, sophisticate. (After all, Nigel is a kind English gentleman – though possibly a cad; but then some people like cads.) And yet, as I write in the first days of the New Year, Mr Trump is still the favourite to clinch the Republican nomination for the US Presidential Elections of 08 November 2016.
The most worrying thing is that there are kernels of truth in what Mr Trump says. For his supporters in the middle-American white working class, he is a voice crying in the wilderness saying things that need to be said but which no one else has the courage to say. And the heart of his economic programme – increased minimum wage, lower taxes on the low-paid, stealth taxes on the rich – could have been written by George Osborne.
I personally don’t believe that Mr Trump will get the Republican nomination because the mandarins of the GOP know that his candidature would hand over Black America, the Hispanics and liberal White America to Hillary Clinton. But even if Senator Rubio or Senator Cruz takes the ticket (either could mobilise the Hispanic vote), Mr Trump’s voice will continue to be heard in Republican circles. Mr Trump might even get a job in a Republican administration. Homeland Security?
American public opinion is polarising between the Northern urban liberals who broadly support the Democrats and the Southern and Central rural conservatives who broadly support the Republicans. (Of course, politics is never that simple in America.) And this is reflected in the declining consensus in Washington. Expect more government shut-downs, sudden changes of policy, stalemate in Congress and increased confusion as to how America should project its power. All this leaves more room for big-time policy mistakes.
Cause for Concern Three: The Unholy Trinity of Deflation, Zero Interest Rates and Insipid Growth will endure indefinitely
The world in 2015 was delicately poised between inflation and deflation; in 2016 it will gently tip in the direction of deflation. Central banks will have run out of ammunition. Although much fuss was made about the Fed’s decision on 15 December 2015 to raise rates from nothing to a crotchet more than nothing, we are still in a world of near-zero interest rates. If there were a prospect of sustained growth of above-average levels with associated credit growth and moderate demand-pull inflation, monetary policy might be tightened with positive consequences for investment. But that is not going to happen in 2016.
In fact, deflation, and its terrible consequences, will probably be the main economic headache for the rest of my lifetime: especially for debt-laden governments.
Cause for Concern Four: The Debt Time Bomb in the West will finally explode
Debt-to-GDP ratios in the Eurozone countries are still rising. For that matter, the ratio is due to rise in the UK this year to about 83%, although Mr Osborne assures that it will be down to 71% by 2020-21. So after 10 years of Coalition and then Tory governments, the UK Debt-to-GDP ratio will be higher than the 67% bequeathed to us by Mr Brown in 2010!
Actually neither Europe nor the UK, with the possible exception of Greece, has actually endured anything like real “austerity” as yet, whatever Ms Sturgeon says. Structural deficits – that’s the amount by which deficits grow even in years of economic growth – are due to rise in Europe due to unfavourable demographics, for which read the inexorable growth of retired people on generous state pensions. The problem of unsustainable recurring deficits has still not even begun to be addressed.
Greece, anyway, will need another bailout this year. And French national finances are not looking good. Just as one day the Chinese might stop buying T-Bills and the plug will be pulled on the USA, so one day even sooner European pension funds, if they are sensible, will abjure negative-yielding European government debt.
Even modest deflation will quickly destroy the residual credibility of European government finances. Imagine the political fallout when a European government, having run out of cash, begins to pay pensioners with negotiable IOUs. As the Chinese curse goes: may you live in interesting times.
Cause for Concern Five: The EU, beyond reform, will dig its own grave
The real problem with the EU is that its members’ economies have not grown since the Euro was launched in paper form in 2002. It is not growing now, and it is unlikely to grow at anything like the pace of its rivals in the foreseeable future. Yet no one at the EU level and few national governments are prepared to enact the necessary structural reforms to kick-start a new era of growth.
Even the European Commission is talking about an era of Secular Stagnation in which zero-to-low economic growth combines with Thomas Picketty’s increasingly unequal capitalism[i]. And, according to the annual report from the Centre for Economic and Business Research (CEBR) published just before Christmas, both France and Italy, on current growth forecasts, are likely to be kicked out of the G10 by 2030.
Europe is a grand old aristocratic lady – a Lady Violet for you Downton fans – still living in some style, all dressed up and eating formal meals, patronising neighbours with tart put-downs; while her financial standing remorselessly declines relative to the hoi-polloi down the road. She is totally convinced that she is superior in class and culture, that she is wiser and wittier than they, so why should she conceivably change her ways?
Cause for Concern Six: Stock Markets will go nowhere
Consider that the FTSE-100 Index hit its hitherto all-time high of 7,000 on Millennium Eve, 31 December 1999, but then went south for the first three years of the new century, reaching less than half that level during the Second Gulf War in March 2003. It recovered, somewhat, thereafter but was then blown out of the water by the Credit Crunch of 2008 and the nasty recession which ensued. After three or more years of recovery, the London market clambered back to reach the iconic 7,000 mark in March 2015 and spent most of April in record territory, only to fall back to below the 6,000 level subsequently. It finished 2015 at 6,242, about 5% down on the year.
Now you might argue that the FTSE-100 is a rum measure of UK economic success as its performance has been hampered, especially in 2015, by some dodgy foreign miners and commodity companies like KAZ Minerals PLC (LON:KAZ), Glencore International (LON:GLEN) or Lukoil (LON:OAO) and their ilk, the one-year charts of which look like one of those aqua-park death slides.
But the decline in commodity prices, especially oil which continued to decline last year to around the US$40 barrel mark, should have been great news for manufacturers, retailers and consumer staples. Yet they all stalled too.
If one looks abroad there is the extraordinary case study that is the Nikkei-225. Notoriously, the leading Tokyo index reached its zenith of nearly 39,000 on 01 December 1989, whereupon it began a 20-year decline. During the summer of 2012 it began to recover from lows of below the 9,000 mark and at the beginning of 2016 it stands at around 19,000 – still less than one half of its historic peak. Few Japanese investors have retired on their stock market gains.
Equity investors are constantly reminded that past performance is not a guide to future return. But what they should be compelled to baa like sheep is: stock markets do not follow national economic growth metrics. Not even on a lagged or adjusted basis. This is because, for a start, only a portion of the total national economic assets are valued by the stock market. (By the way, with the rise of the private equity sector, more old firms have been de-listed than new firms have been listed in the first 15 years of the 21st Century, so the total number of listed stocks (barring investment trusts) has actually fallen in both London and New York). Second, corporate earnings are much more volatile than national growth statistics. And third, equity itself is only one asset class which competes with others for investors’ cash (not least private equity). There is some evidence, for example, that pension funds have been reducing the proportion of their portfolios allocated to equity.
The outlook for equity markets in 2016 is not dire; it is just insipid. I foresee some scope for solid gains on the back of good earnings data (aided not least by cheap oil), but that all of this will be attenuated, if not asphyxiated, by increased geopolitical risk, by firming expectations that we are nearing the downturn in the economic cycle, and by (probably unjustified) fears that interest rates are about to rise.
When the FTSE-100 reached 7,000 on 31 December 1999, the Bank of England Repo Rate (as Bank Rate was then called) stood at a historically “normal” 5.5%. When it breached 7,000 in the spring of last year, the Bank Rate was still at 0.5%. In orthodox economics, lower interest rates, all things being equal, should imply higher stock prices, since the opportunity cost of capital – the discount rate used to derive the present value of future dividend pay-outs and capital gains – will also fall. Yet here we are, super-low interest rates notwithstanding, sitting on a loss over 15 years! Something has gone seriously awry.
Ah, but some savvy investors will say: no one has ever made money with a long-term buy-and-hold strategy – successful fund managers buy winners and sell losers, so who cares about the index? Except that as we all know deep-down (don’t we?), no fund manager can outperform the market in the medium to long-term. Sooner or later, outcomes regress to the mean. (Ask Warren Buffett). On the basis of the evidence, we have to face up to the fact that stock market returns in the 21st century will far underperform those of the 20th century. And, arguably – statistics are tricky – 20th century stock market returns underperformed those of the 19th century. I’ll speculate on why this might be so another day.
Reason to Rejoice One: We are getting healthier and are living longer!
You are probably going to live longer than you think. That is good news – even if you have to postpone retirement. But you will hopefully be fit enough to work, at least part-time, well into your seventies and beyond, so why not share your accumulated wisdom and skills? (Actually, most people will “work” (as defined by time spent in the office) no more than 20-hour weeks by then, except politicians, investment bankers and other workaholics.)
By one estimate, life expectancy is rising so incredibly quickly, that for every day that you survive from today onwards, your life expectancy will be extended by another hour. That is amazing! Of course there may be snares: dementia/Alzheimer’s for one. But some scientists are cautiously optimistic on the dementia front. I am not qualified to judge on this: just Google, if you are so inclined, “Astaxanthin”.
Data mining in healthcare has hardly even begun: soon most of us will have smart watches which are wired up to a central processor which monitors our blood pressure, cholesterol, the lot. Here in the UK, our beloved National Health Service would save a lot of money and get better results if it deployed Cortana[ii]-style personal nurses who recorded our most intimate health parameters. (OK, there would be confidentiality issues – there always are.) A world in which prevention trumps cure is now within sight.
Reason to Rejoice Two: Technology is making us wiser, richer and more efficient
Expect Artificial Intelligence (AI) to loom larger in 2016, but in my view, there is nothing to worry about, and much to hope for. There will be some really clever machines in your household very soon, and they will be no more likely than your spell-checker or your satnav (both basic forms of AI) to harm you.
Note that in the tech sector, companies which have articulated a commitment to AI have fared better. So Microsoft (NASDAQ:MSFT) was up 18% in 2015 and Google/Alphabet (NASDAQ:GOOGL) up nearly 60%; while Apple (NASDAQ:AAPL) was broadly flat on the year. For clever people who understand technology and biotech, there are still great opportunities out there.
Facebook (NASDAQ:FB), up nearly 25% in 2015, is bringing people of very different cultures together only to discover that, despite all, they share much in common. Yes, I curse the tendency of guests to gaze into their hand-held devices during dinner. But, within seemly boundaries, let’s share our thoughts and prayers across the oceans.
Despite all the doom and gloom, expect to hear much more during 2016 about man’s future conquest of space. A final prediction: this is the year when the big space agencies, working together, will announce a target date for a manned mission to Mars. I hope that I will live to see the day that they land on the Red Planet. And it’s entirely possible.
[i] See: When ‘Secular Stagnation’ meets Piketty’s capitalism in the 21st century: Growth and inequality trends in Europe reconsidered, by Karl Pichelmann, Economic Papers 551, June 2015.
[ii] Users of Windows 10 will be familiar with Cortana.
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