The Great January Market Sell-Off Is Not Irrational


Many prominent economists seem to be scratching their heads over the recent bout of market turbulence. The consensus is captured crisply by Capital Economics: “The plunge in global stock markets does not seem to be justified by economic developments.” On the other hand, market participants and other non-academic observers are wondering whether this correction will turn into a bear market before the month is out; if it hasn’t already.

The Policy Tensor is usually more sympathetic to rigorous economists than seat-of-the-pants market observers and traders. But in this case, the economists are demonstrating their professional blinders. It is entirely possible to for a market correction to be justified without a fundamental slowdown in the domestic macroeconomy. And this is indeed what is going on.

The US stock market is not a claim on US GDP; it is a claim on US corporate profits. Profit growth can slow without a slowdown in output growth. The profits of US firms have been falling largely due to the strength of the US dollar. Continued policy divergence among the hard currency issuing central banks imply further dollar strength, thus lowering expectations of US profits in the medium term.

Moreover, while exports are only 13.5% of US GDP, the rest of the world contributes half the profits of US firms. Similarly, 97% of employment growth is now taking place in the nontradable sector, whereas the tradable sector accounts for half the growth in gross value added. So, one can have a robust and tightening labor market while profits margins get squeezed due to global disinflation and a rising dollar.

Indeed, as I have argued before, the US economy is much less resistant to an imported disinflation than an imported recession. In particular, this means that the profits of US firms are much less sheltered against global disinflation than the US economy as a whole is to recessionary headwinds from abroad. Therefore, the impact of adverse global developments on the US stock market is bound to be much more serious than on the domestic economy.

Finally, there are purely market developments that have implications for asset prices independent of the real economy. In particular, innovations in systematic volatility imply asset price adjustments regardless of what happens to GDP and inflation.

So what does the market know in January that it did not in December?

First, China: Policymakers in Beijing are clearly floundering and their ability to stem the panic is increasingly coming into question. The renminbi is depreciating faster than anticipated. Capital outflows from China are accelerating to such an extent that the $3.3 trillion cushion — down from $4 trillion — no longer seems invincible. An astonishing trillion dollars of capital has already left the mainland. Meanwhile, the industrial sector is doing even worse than expected.

Second, instead of stabilizing, the commodities rout has exacerbated. This has worsened the outlook for commodity exporters. Moreover, the continued price declines indicate a greater slowdown in global trade and output than previously recognized. To put it bluntly, the world is doing much worse than was realized in the benign aftermath of the Fed’s liftoff; a decision that looks increasingly ill-judged.

Third, it is now being realized that the banks are much more exposed to the oil rout than was assumed to be the case. All the big banks have reported substantial losses on their loan books to the sector. It is clear that these losses will mount since the price of crude is likely to be depressed in the medium term. But it is not clear by how much and that is obviously very worrying given the central role played by financial intermediaries in powering economic growth.

Fourth, market participants can be more confident that market turbulence is likely to persist. The end of the repression of systematic volatility by the Fed and the reduced liquidity due to tighter regulation of broker-dealers increases the likelihood of market turbulence. This means that risk premia will rise since investors must be compensated for greater volatility, in turn implying lower asset prices. In other words: Even if asset prices were aligned with fundamentals before, they would still need to fall even if there was no change in fundamentals.

So, yes, even though expectations for US GDP and inflation have barely changed since the December meeting, the market correction is warranted.


The GOP’s Chickens Have Come Home to Roost



Unless you have been living under a rock, you must have noticed that the Republican presidential campaign has been taken over by demagogues and right-wing lunatics. All establishment candidates are polling in single digits—for a combined total of less than 20 per cent. This has unleashed a panic in the herd.

The clear leader in the polls is a nativist fearmonger who is stunningly unpopular outside his Know-Nothing base. Right behind him, we have an ultraconservative with no less than a perfect rating from the American Conservative Union; the gold standard of conservative Congressional surveillance. Indeed, based on scores for donors, voting record and public statements, Cruz is as far right as it gets in American politics.

The Republican primary calendar is front-loaded with states friendly to the insurgents. Polls in Iowa show the front-runners in a statistical dead heat; while in New Hampshire, the demagogue has a comfortable lead. Trump and Cruz are quite likely to win big in Iowa, New Hampshire and South Carolina. They are also likely to consolidate their positions in the “SEC primary” on March 1, when a dozen, mostly Southern, states go to the polls. Due to the Darwinian effects of 15-20 per cent thresholds for earning delegates in many of these states, the field is very likely to winnow down to three, or perhaps even two, candidates. Indeed, the betting markets are predicting a three-way contest; with Rubio barely making it into the game.

Since these early states award their delegates on a proportional basis, number-crunchers at FiveThirtyEight argue that Rubio could still make a comeback later by prevailing in the winner-take-all primaries in Florida and Ohio that are presumably less sympathetic to the insurgents’ messaging. While this is a mathematical possibility, the Policy Tensor wouldn’t bet on it. The only way for Rubio to realistically make a comeback that late in the game is if Trump and Cruz split the early delegates evenly between themselves. If either acquires a commanding lead by March 1, Rubio is toast. Also toast, would be the GOP establishment. With 3-1 odds, that’s where we are headed.

As I see it, there are two ways to look at the unraveling of the Republican Party. One is from top-down, the other bottom-up. Let’s start with the latter.

MacWilliams finds that support for Trump comes largely from authoritarians. More precisely, people who say they want their kids to be respectful, obedient, well-behaved, and well-mannered are considerably more likely to support Trump than folks who want their kids to be independent, self-reliant, considerate, and curious. But the study does not examine the time-variation in the number of authoritarians or the intensity of their radicalism. Is Trump succeeding because the number of authoritarians has been rising? Or because authoritarians have become more polarized and more suceptible to demagoguery?

I suspect that the radicalism of the Republican base is not unconnected to the slow-motion race death of poor White America. First uncovered by Case and Deaton, who found a half-a-million excess deaths in 1999-2013, the issue has since been further explored by the paper of record. The Times found that the rise in death rates among Whites can be largely traced to drug overdoses. No doubt the narcotics epidemic is itself a symptom of the economic devastation of the hinterland; in no small part a result of the GOP’s policies since Reagan. As the United States rushes headlong into a two-tier society, the losing half is getting angrier and self-destructive. Angry White Americans are clinging ever harder to their guns and bibles. And they are more ready than ever to blame Mexicans, Muslims, and elites for all their ills. Enter Donald Trump.

The top-down picture is not just a story of the GOP moving to the right en masse. What we have is a radical insurgency within the insurgency that is the Republican Party. The insurgents have mounted an unprecedented challenge to the party establishment from the right. As far as I can tell, this has two distinct drivers. First, gerrymandering: The carving out of safe districts by both parties to create a House in which 90 per cent of incumbents get reelected. The flipside of safe districts are more competitive primary races that are decided by the party faithful and tend to push candidates away from the center over time.

Second, and by far the much more important, is the rise of ultraconservative activist billionaries. Campaign spending and lobbying were extremely important even before Citizens United unleashed the floodgates. By now, the GOP has become a billionaires’ free-for-all.

Newspapers speak of the “Sheldon suck-up fest” and the “Koch primary.” This is also manifest in the current campaign. Trump is a billionaire himself, as he never fails to remind us. Incredibly, ninety-five per cent of the $38 million of outside financing for Ted Cruz comes from literally three moneyed interests: A Texas real estate mogul behind Caprock Partners contributed $10 million; hedge-fund manager Jim Simons Robert Mercer of Renaissance Technologies pitched in $11 million; and the secretive Wilks Brothers, who made their billions in the fracking boom, shelled out $15 million. We are well and truly back in the robber baron era.

Of course, these developments pose an existential threat to the GOP itself. In the short run, with either Trump or Cruz at the helm, it cannot hope to prevail in November. More omniously, Business is likely to desert a party that can neither hope to win nor be trusted to govern. What we are witnessing is nothing short of the final denouement of the GOP’s post-Reagan strategy that was based on the premise that angry Whites could be mobilized to support policies in the interests of the business class but otherwise ignored. Now that it takes just four billionaires to mobilize the entire base, it was only a matter of time before the whole strategy backfired.


Dear Powerball Winner: Ignore the Upshot and Take the Lump Sum

The Upshot’s advice to the Powerball winner is to forgo the lump sum and take the annuity. The lump sum payout is $930 million before taxes, while the certain annuity pays you (or to your estate if you die) $22.6 million every year for the next 30 years. That is equivalent to holding an ultra-safe asset with an annualized investment return of 2.843%. That’s around the yield on a 30-year US government bond, so it’s not bad given the tax advantages. The latter is one reason Josh Barro of the Upshot offers in support of the annuity; the other being to protect yourself from yourself. Now, if you are confident that you can control your urge to spend it all away and you are not utterly obsessed with capital preservation, I will show how you can do much, much, much better.

After taxes, the lump sum comes to $561.7 million. Let’s say you spend $61.7 million immediately to buy a mansion and a yacht, leaving you half-a-billion to invest. With such a large investment pool, Thomas Piketty has shown that you can get much larger returns than holding the market portfolio. This is because you get access to sophisticated asset management techniques like leveraged beta strategies. In English, the $500m capital cushion effectively allows you to borrow billions to enhance your returns.

But let’s say you don’t care for actively managed portfolios. What if you invested the entire half-a-billion in the S&P 500? How much would it be worth after 30 years? I ran the simulation over the returns available for the S&P500 in 1928–2015 which furnishes a sample of 58 30-year periods. On average, half-a-billion would accumulate to $13 billion at the end of 30 years.


The histogram above shows the accumulated value at the end of 30 years. You would’ve been worst off if you had invested your money in 1928, right before the world fell into the abyss of the Great Depression. Even so, you would’ve been worth $5 billion in 1958! You would’ve been best off investing in 1969 or 1974, either of which would’ve ended you up at $23 billion. But neither of these scenarios is representative.

Perhaps the most representative is the median performance over the whole sample, which would place your net worth at $11 billion. This is what you would be worth in 2045 if you are luckier than the unluckiest half of the cohorts but unluckier than the luckiest half. Also, as the histogram shows, the distribution has a long tail. This means that you should not be very surprised to end up with a net worth considerably greater than $11 billion.

I did not take inflation into account because it’s an equally valid critique of the annuity: Indeed, more so because equity is likely to outperform fixed-income if we (are lucky enough to) get serious inflation over the next thirty years. Inflation was most serious in the 1970s. If we restrict attention to the subsample of the twenty 30-year periods that include the seventies (starting somewhere in 1950–1970 and ending thirty years later in 1980–2000), the median accumulated wealth comes to $10 billion.

To quote the US President, “it’s not even close.” The Upshot got it so wrong because they somehow managed to ignore the most potent force in the world — the power of compounding.

So, take my advice and welcome to the 0.01%. Don’t forget to invite the Policy Tensor to Davos!

World Affairs

Drama in the Gulf


“Saudi Arabia and Iran are already engaged in proxy wars in Yemen and Syria,” Carsten Fritsch of Commerzbank gravely notes, before throwing up this zinger: “Any direct military dispute between the two hegemonic powers in the Middle East would have grave consequences for global oil supply.” What?

Neither Iran nor Saudi Arabia is a hegemonic power. There is only one hegemonic power in the Middle East: The United States. Saudi Arabia and Iran are regional powers that can push around weak states and intervene in destabilized countries. Neither of them is in any position to impose hegemony. To be sure, Iran could potentially emerge as a regional hegemon if the United States ever withdrew permanently from the Persian Gulf region. But that is not going to happen any time soon: Control over access to the gulf’s immense energy resources gives the US veto over potential challengers (you know who) that rely on imported energy.

The Saudis can be charitably described as primus inter pares among the oil monarchies on the Arabian peninsula. For instance, when the Al Khalifa, the Sunni rulers of Bahrain, felt threatened by unrest among their Shia subjects, they called on the Al Saud. The Saudis promptly sent troops across the King Fahd highway to restore order. Similarly, when the Houthis came down from the hills to kick out the new regime installed by the Saudis, Riyadh invaded with a view to restoring their man at the helm. The Al Saud also became the principal backers of the military junta in Egypt after the ouster of the Muslim Brotherhood government. And, of course, they are bankrolling and arming dozens of Islamist rebel groups against Assad.

The Iranians have their own clients in Baghdad, Damascus, and Beirut. These statelets look to Tehran for help. Iranian forces helped fend off ISIS from Baghdad. And Iran deployed its Quds force to Syria, which, together with Hezbollah fighters, helped Assad fend off the rebels’ advance. Assad’s reliance on Tehran has reduced since the Russian intervention but not markedly so because he continues to lack sufficient manpower to hold on to the territory he still has.

The Iranians and the Saudis have been fighting a proxy war across the ‘arc of weakness.’ The recent breakdown in diplomatic relations began with the execution of a prominent Shia critic in Saudi Arabia. The Saudis had thrown in a couple of Shia faces among the Salafist-Jihadists to be beheaded in order to appear evenhanded. The execution of the cleric prompted a ransacking of the Saudi embassy in Tehran. In response, the Saudis promptly severed diplomatic ties with Iran. Saudi lackeys — UAE, Bahrain, and Sudan — quickly followed suit.

The rapid deterioration in cross gulf relations seems to have rattled oil traders. Some are fretting over the possibility of an open militarized dispute between the champions of competing sectarianisms.

Guys, the probability of a war between the two states is practically zero. The reason is straightforward: The Saudis are relatively too weak to contemplate attacking Iran and the Iranians can be certain that the US would intervene to protect the Al Saud. And if either miscalculates and the two end up coming to blows, Uncle Sam would put an end to it in short order.

There is no trade here yet. If the price of crude jumps up significantly, then there will be a profitable trade: One would short crude on the accurate expectation that any instability premium would get priced out in a matter of days.

World Affairs

Does Kerry have a deal on Syria?


Kerry is on the fast-track to becoming the most influential Secretary of State since Kissinger. The UNSC resolution on Syria is nothing short of a diplomatic breakthrough. The optics of the UNSC action suggest that we may indeed have a deal. Whether or not you think Assad should be ousted, a ceasefire and dialogue in Syria would be cause for celebration.

There are still fairly big outstanding issues before a great power settlement in Syria can be achieved: How long shall Assad stay? And which groups shall be accommodated in the political process? The first is simple, but the second is fiendishly complex.

The hard truth about Assad is that Russian and US interests are largely congruent in the near term: Both require Assad to stick around until a replacement can be secured without destabilizing the Syrian state. Kerry has likely persuaded Putin that no political accommodation is possible in Syria without putting an expiry date on Assad. For a deal, the two must conclude bargaining over the expiry date: Shall it be sixteen months or twenty?

What to do with the hundreds of militias fighting and holding territory in Syria is the hard problem. Which militias shall be recognized politically? Which are to be excluded politically but not hunted down? And which shall be militarily eliminated?

Jordan, a US protectorate, is compiling the elimination list. So far, only two, ISIS and JN, have been included. It is unlikely that small groups that hold little territory will be added to the list. Hanging in the balance is Ahrar al-Sham.

Ahrar al-Sham is a Salafist-Jihadist group that runs Aleppo and is now allied to US-backed groups. It is not exactly a secret that Ahrar is a Turkish client. No doubt the Russians are seeking its inclusion on the list of outlaws.

There are observers arguing that the US should establish a working relationship with Ahrar al-Sham. Even more would likely oppose military action against the group. Others might argue that all Salafist-Jihadist groups should be on Jordan’s list.

It is not clear that the group should be included. Even though Ahrar swears allegiance to Al Qaeda, it has staked a unique position at the dovish end of the spectrum in the Salafist-Jihadist civil war. Whereas ISIS is determined to use an ultra-violent grand strategy to reestablish the Islamic State, Ahrar now shuns attacking civilians and seeks to win hearts and minds instead. It now says that it wants to peacefully persuade people to establish an Islamic state in Syria. And unlike ISIS and JN, Ahrar does not start doling out the harshest sharia punishments as soon as it occupies a town. Ahrar even reached out to the US publicly—by writing an oped in Washington’s leading newspaper!

US intelligence should certainly talk to the group. However, the United States should not think of the group as an ally. It is not. It’s core program remains a threat to US interests. And while it may make purring sounds, its strategies and intentions may change dramatically. Indeed, the right strategy is to oppose the expansion of its influence. In particular, the United States should come up with a strategy to ensure that Ahrar al-Sham does not fill the vacuum left by JN.

World Affairs

Will Anyone Call ISIS’ Bluff?

Any doubt on whether the Islamic State poses a grave threat to global security vanished in recent weeks as ISIS demonstrated an impressive capability to organize large-scale terror attacks very far from home. It was behind the downing of the Russian plane over the Sinai that killed all 224 passengers onboard; the double suicide bombing in a Shia neighborhood of Beirut that claimed at least 43 lives and injured more than 200; and, of course, the gruesome attack in Paris on Friday that killed 129 people and wounded hundreds more. ISIS is bluffing that global powers would not respond in force. 

There is now growing recognition that the nascent outlaw state must be destroyed. Half the world’s air forces already crowd the skies over its territory. The United States, Russia, France, Britain, Turkey, Australia, Canada, the Netherlands, Jordan, Qatar, UAE, and Saudi Arabia have all bombed ISIS; although the Arabs seem to have given up on the project in the past few months. The air campaign has been a predictable disappointment. The Islamic State had largely reached the ethnic limits of its expansion before the air war began; so that even the halt in ISIS’ territorial expansion cannot be honestly credited to the airstrikes.

That the Islamic State cannot be dispatched without landing ground forces is now manifest; as the Policy Tensor predicted more than a year ago. This page argued that Obama’s strategy was based on the Afghan-model of warfare. It was assumed that precision airstrikes directed by US scouts on the ground would allow even untrained allies to rapidly retake territory from ISIS. But on the modern battlefield, air power and ground-force skill are not fungible but rather complementary; so that, as Biddle argued, the viability of the Afghan-model depends on the balance-of-skill on the ground. Once it was clear that there were no competent ground forces available to do the job, the failure of the administration’s war strategy was the baseline scenario. 

Now that any lingering hope that the Islamic State could be destroyed from the air has been dashed, the question is this: How long will it take for global powers to come around to landing an army? And just who will do this dirty work? The existing ground forces of Britain, France, and Germany are simply insufficient to the task at hand. The Russians are more interested in defending Assad than taking on the Islamic State. The Turks care more about preventing the Kurds from establishing a statelet in northern Syria than defeating ISIS. The Kurds neither have the mass nor the motivation to protect anyone other than themselves. The Saudis and other gulf monarchies are too busy containing Iranian influence in the region and imposing themselves on Yemen. The Iranians on their part would love to dispatch ISIS but are deterred by the idea of trying to pacify Sunnistan. Which brings us to the only actor capable and potentially willing to do the job. 

President Obama has again ruled out sending ground forces. But US opinion is shifting rapidly. Senators John McCain and Lindsey Graham have been gunning for it. Jeb Bush has come out in support. Even Roger Cohen has come around. Expect more and more people to join the chorus as reality sinks in. Sooner or later, the United States will be leading the conquest of the Islamic State.

The caution of global powers reflects the complexity of the challenge posed by the Islamic State. For the Islamic State is the superposition of three distinct developments. First, ISIS contains the ghost of Saddam Hussein: The Islamic State’s military prowess comes from the reconstitution of the core of Saddam’s army. Second, it is the most virulent manifestation so far (and the clear flag-bearer) of the Salafist-Jihadist movement powered by gulf money; feeding on the disaffection of Arab youth, both in the Middle East (as a consequence of the societal crises of the Arab states) and in the West (a result of their exclusion from national culture). Third, ISIS is riding arguably a much more enduring ethno-political development, the rise of Sunni-Arab nationalism in Iraq and Syria. To put it bluntly, Iraq and Syria are history. Humpty-Dumpty cannot be put back together because the Sunni-Arabs will never again submit to Damascus or Baghdad; not unless they dominate them.

The first development (the reconstitution of Saddam’s army) means that dispatching ISIS requires landing a superior concentration of ground forces. The second means that ISIS will continue to espouse unlimited aims; that it cannot be contained like a regular outlaw state; and indeed must be crushed out of existence. But the third development means that whosoever conquers the Islamic State would be taking up the unenviable task of pacifying Sunnistan. There are only two options here for a global power committed to conquering the Islamic State. Either it can try to reconstitute the Sykes-Picot states or it can forge a brand-new Sunni-Arab state; recognized by the United Nations and ratified by a UN-mandated referendum to boot. One of these leads back to square one; the other to a permanent resolution of the challenge posed by the Islamic State.

An effective US response to the challenge posed by the Islamic State must begin with a reversal of policy in Syria. The United States must drop its counter-productive insistence of Assad’s premature ouster. That will open the way to a great power settlement in Syria. The second step would be to lead a broad international coalition of ground forces to conquer the Islamic State and impose the peace in Sunnistan. A UN supervised referendum would then follow. If a nascent Sunni-Arab state does emerge from this process in Sunnistan, it would remain a ward of international society until it is ready to shoulder the burden of imposing the peace.

The strategy outlined above will be costly in terms of both blood and treasure. But with the Europeans eager for a solution to the coupled refugee and security crises, and the Russians eager to have a seat at the table, the United States can share these costs with other global powers.

It is surely time to call ISIS’ bluff. Or does anyone seriously think that it is a good idea to dilly-dally until the message is brought home in an even more brutal manner?  


Hawks Take Centerstage

ACM term risk premia since 2000

Abstract: The market seems convinced that the Federal Reserve will lift-off in December, 2015. We argue that this expectation needs to be tempered because the economy begs to differ with the hawks. Fatally for the hawks’ case, the Phillips Curve is broken. And since the neutral rate is now exceptionally low and on a downward trend, the Fed’s model risk has increased considerably. The labor market continues to show slack on many indicators including decidedly tepid wage inflation. Moreover, the US economy is not nearly as resistant to an imported deflation as it is to recessionary headwinds from abroad. The baseline scenario continues to be lowflation and stagnation for some time to come. The FOMC is therefore likely to hold fire. And if it does hike in December, it would be running the risk of deflation. A premature exit would harm the recovery that is still underway in the real economy. At the very least, the Fed would be sure to miss its inflation target over the medium term.

Read the research note here (pdf).