What We’re Reading (Week Ending 02 October 2022) - 02 Oct 2022
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 02 October 2022):
1. Engaging With History – Morgan Housel
To me, the point of paying attention to history is not the specific details of certain events, which are always random and never repeat; it’s the big-picture behaviors that reoccur in different eras, generations, and societies. People were dealing with greed and fear 100 years ago the same way they’re dealing with now and will be 100 years in the future. The more you see a behavior throughout history, the more you realize how ingrained it is in human behavior, which makes you more confident that it’ll be part of our future. It’s the only way to forecast with accuracy.
I thought about this after recently reading a paper by philosopher Hanno Sauer.
He criticizes philosophy’s obsession with ancient thinkers – Plato, Aristotle, etc. – because they lived in a world of relative ignorance.
Not only were the ancient philosophers blind to most of science, which hadn’t yet been discovered; they knew little about other civilizations, which were often closed off from the rest of the world. Aristotle knew nothing about Chinese culture or biological evolution; Socrates never saw a modern democracy or had heard of social media.
Sauer writes:
We have good reasons for thinking that historical authors were deeply wrong about almost everything, we have statistical reasons for thinking that the best philosophers live now rather than in the past, and we judge historical authors by much too lenient standards …
Given that we could be studying contemporary philosophers who are much less likely to be wrong about much fewer things, that we must rationally assume that more of these philosophers live today than in the past, and that we judge currently working philosophers much more harshly than historical authors, I suggest that, when it comes to satisfying the epistemic aims of philosophy, we ought to spend much less time studying the history of philosophy.
I can appreciate part of this. There are topics an average person today knows more about than an expert did 100 years ago.
But this gets back to what you can learn from history.
What’s great about reading old writers is not necessarily the wisdom of what they said, but comparing what people believed then vs. what they believe today and seeing what overlaps.
Marcus Aurelius said, “We all love ourselves more than other people, but care more about their opinion than our own,” which to be honest sounds like something you’ll find written on an $11 IKEA poster today. Part of the value of reading an Aurelius quote like that is that he said it almost 2,000 years ago. Its age is the important part. If it was true then, and it’s true today, then it’s a fundamental part of how humans work and of course it’s going to be true for the rest of my life. So I should pay close attention to it.
A dull observation can become important when you realize it’s an enduring trait of human behavior. On the other hand a current thinker might say something complex and brilliant about, say, the midterm elections, but even if it’s true it has the shelf-life of a banana.
2. The Great Progression, 2025-2050 – Peter Leyden
In the next 25 years, the world arguably will deal with climate change and transition the bulk of our core energy sources from carbon to clean. We will transition our transportation systems from the internal-combustion engine to electric mobility as part of an even larger process of reinventing cities. We will scale up brand new industries and build a much more environmentally and socially sustainable society. We very likely will reform capitalism around new economic priorities that counter the current imbalances and inequities. And we can be expected to revitalize our democracies and push back on authoritarianism around the world. People in 50, 100, or even 500 years from now may well look back on our era and marvel at the transformation that we’re about to go through.
This is not just a nice utopian scenario, but a story of speculative journalism about what’s actually starting to happen, and most likely will play out over time. We’re up against world-historic challenges that require transformative and not just traditional solutions. America has pressed through historic junctures like this before, and we’re poised to do it once again. We need rapid progress along many fronts, and we are fully capable of meeting the moment this time too.
“We’re arguably at the beginning of a transformation that is going to change the world in profound and largely positive ways.”
We have mind-boggling new tools like artificial intelligence, and unprecedented knowledge like the ability to understand and engineer the genomes of all living things. The evidence and material for this extraordinary story is all around us.
This essay is going to lay out in broad strokes the world-historic story of the next 25 years of our lives. I’m going to explain the much more positive, pro-progress story of what lies just ahead. Hear me out because I’ve been through this drill before, 25 years ago, and that story proved to be very prescient.
I worked with the founders of WIRED magazine in the mid-1990s, and we found ourselves in a situation that was very similar to today. We were at ground zero of the digital revolution and talking to many of the early technologists, entrepreneurs, and innovators who were super-excited about the progress being made with the new digital technologies — and beginning to see the vague outlines of what they could probably do in the coming decade, and what was possible to achieve in the next 25 years.
We at WIRED saw the need to articulate this future that was dawning on the early adopters but not seen by pretty much anyone else. I paired up with Peter Schwartz, one of the world’s premier futurists and co-founder of Global Business Network, a pioneering strategic foresight firm (where I also later worked). We co-authored The Long Boom, a History of the Future, 1980 to 2020, an iconic cover story for WIRED, which later became an influential book in multiple languages.
The Long Boom, in essence, was the pro-progress story of that time that helped catalyze the new zeitgeist of the 1990s with a positive reframe of what was actually happening. We took the historical perspective of how people in the future would explain the big-picture story of the 25 years that still lay ahead of us. We were about to go through two world-historic developments: the digital transformation and the integration of the world economy through globalization. But few really understood what we were heading into.
You must remember that in 1995 almost nobody knew what the digital revolution was, let alone what a digital transformation would be. There were only about 25 million people in the world on the internet, and most folks had no idea how these goofy startup companies with names like Amazon would ever amount to anything. Our story had to fill out the picture of how these technologies would scale, how these startups would grow, and how a digital economy would work.
Likewise, in 1995 the Soviet Union had just recently fallen apart after 50 years of the Cold War, and the Chinese Communists were in the early stages of opening up to the market economy, with rural peasants starting to move to factories in cities.
We had to explain how the global economy would morph into one integrated whole for the first time in history. We projected that we were about to head into a long digital tech boom, a long global economic boom — in other words, The Long Boom.
How did we do? The broad-stroke through lines of that story pretty much played out by 2020. Those 25 million people on the internet grew to 4 billion, or 60 percent of all humans on the planet. The month our cover story came out, Apple begged Steve Jobs to come back as CEO because they were months from going bankrupt — yet Apple later became the first trillion-dollar company. China went from a middling country with less than $1 trillion GDP in 1995 to a superpower with a GDP of $15 trillion, pulling 800 million peasants out of extreme poverty. For that matter, the Dow Jones in 1995 was 5,000 but hit 30,000 by 2020. Another long boom, this time for stocks.
To be sure, we got some specific parts of that future story wrong, as can be expected. We thought we would have made more progress on climate change. We thought humans would make it to Mars by 2020, though that might take another decade or so. And we did lay out 10 possible negative developments that we were worried could disrupt or slow down the larger positive story we laid out. All 10 did actually appear in some form over the course of those 25 years (including a global pandemic), but the remarkable thing is that they still did not stop the overarching story…
…Here’s the other thing about tipping points: They prompt paradigm shifts in understanding what’s really happening and in strategy about what to do. One day the world works one way, like it always has, and then the next day it works a very different way. One day the world had a clear goal, a familiar one, and then the next day, there’s a very different goal. In other words, paradigm shifts set new north stars that rapidly reorient systems.
Some of today’s tipping points — these system changes, these paradigm shifts — are easier to see than others. Take how all the debate and the efforts around climate change have tipped and are now sending out signals about this new north star. This summer’s so-called Inflation Reduction Act, which really is a $370 billion public commitment to accelerate the shift to clean energy and transportation, is only the latest signal to Americans and the world that this transformation has begun. Tesla had already led the entire legacy auto industry around the planet into a historic transition to electric transportation. And global finance had already tipped to massive investments into solar and wind power for utilities and away from coal because renewables are now cheaper — and getting cheaper by the year.
Or take the demographic tipping point between two huge generations that provide the cultural ballast of American society — that’s tipped too. The Boomer generation, now ages 58 to 77, is more than half into retirement and many are dying (the average lifespan of an American happens to be 77)…
…The original Long Boom story we told 25 years ago described the introduction of infotech, meaning digital computers and the internet, as a fundamentally new technology to the world stage. And then we described how it would scale up globally over the next 25 years and create a long tech boom and help drive a long economic boom, as well as a stock boom.
The next 25 years will see the introduction and scaling up of not one but three fundamentally new technologies that will have world-historic impact. One will be in energy tech, one will be in biotech, and one will be the next big stage of infotech, which will be driven by artificial intelligence. We’re heading into a triple-whammy tech boom — not just another Long Boom, but a Long Boom Squared…
…The scaling up of renewable energy, even at the most aggressive pace possible, won’t be enough to get off carbon energy in 25 years. We must have other forms of clean energy and so look to the development and deployment of next-generation nuclear energy. These small-scale nukes will be able to stabilize the grids of massive cities and keep CO2 out of the atmosphere. And they are far safer and the waste much less problematic than what people came to believe with the backlash from environmentalists in the 1970s. Even if we can get all our electrical grid on clean energy by 2050, it’s worth pointing out that some forms of carbon energy will still be needed off the grid, and we will probably need some fossil fuels indefinitely for other uses critical to our civilization, like ammonia.
The new models for electric mobility will follow a similar trajectory in the 2020s. The auto industry is clearly on its way with $350 billion in new private investment going into electric vehicles in 2021 alone. The charging infrastructure will need to be built, with a lot of prodding by governments and public investment. How do you charge private cars in dense cities? Millions of questions remain. But it’s all doable and will be done…
…The Biological Age has begun. If you can understand how genomes now work, and then are able to edit the configuration of those genes, then you have crossed the threshold into true genetic engineering. This means that we can now expand human engineering from the physical world of inert materials into the world of living things. But there’s even more to the story, thanks to recent breakthroughs not only in genetics, but also in many subfields of biology, like proteomics. We now understand how living things work below the cellular level, and we are getting better and better each year. We are expanding into a broader notion of not just genetic but biological engineering. This is what people mean by “synthetic biology.”
The new field of synthetic biology can be expected to play a big role in the next 25 years. Like many fields, it will be driven by climate change and the increasing need for sustainable everything. Climate change will probably force the use of much more genetic engineering applied to crops. We are used to hastening the genetic evolution of plants that we eat through classic cross-breeding, and we’ve seen the first wave of genetically modified crops. But we’ll almost certainly need to ramp up changes in most crops to become much more drought resistant, productive, and nutritious…
…The bigger play for synthetic biology will be to take an increasing share of things that have traditionally been made through industrial production and make them through this new form of biological production. This moves synthetic biology into the world of materials. Building materials like steel and concrete account for a significant portion of CO2 that’s released into the atmosphere. Look for things like genetically engineered wood (stronger, heat resistant, faster growing) to replace them in an increasing share of structures — and suck carbon out of the atmosphere in the process. Or consider the plastics that are industrially produced from petroleum and then go into products like bottles and bags that litter our oceans and landscapes and only degrade after centuries. Biologically engineered alternatives could be designed to biodegrade within months after being exposed to salt water or extended sunlight….
…The new game-changer in this next stage of infotech is artificial intelligence. AI in the broad historical context gives humans a breakthrough superpower. Mechanical machines may have given humans the ability to dramatically enhance and extend our physical powers. AI will dramatically enhance and extend our mental powers. We will be able to let computers do things that in all previous eras required human intelligence, and more importantly, we will now be able to do things that human intelligence alone could never do.
This is a new, general-purpose technology that could eventually impact almost all fields over the next 25 years. Right now, we’ve seen early applications of machine learning pioneered by the big tech companies. (Ask any question and search all the information in the world to get an answer in less than a second. Wow. That’s something no human librarian could ever do.) The advanced business world has been applying the still relatively expensive techniques for the last decade to solve their problems. But over the course of the next 25 years AI will become increasingly simple, cheap and ubiquitous. Anyone will be able to take advantage of it through the cloud.
AI is going to enable a mind-boggling amount of innovation. Take just the example of simultaneous language translation, something that AI will perfect this decade. Soon any person on the planet speaking any language will be able to fluidly communicate with any other person in real time, and with nuance, whether through video over the internet or with an earbud walking down the street. This opens up the world’s business and diplomatic conversation not just to the roughly half-billion native English speakers, or the highly educated bilingual elites of other cultures, but to every single human, regardless of culture or class. Innovation essentially comes through the cross-fertilization of ideas and perspectives — and we are heading into a bonanza…
…Consider one final analogy to the past progressive era of the post-war boom: We may be heading into a new Cold War with China. The implications of transformative times do not stop at American borders but are convulsing throughout the world. When old systems start breaking down, and new systems are not yet fully formed, people all over the world desperately look for answers. Authoritarian states provide a sense of certainty in the very uncertain times of transformation.
Their centralized control of power allows them to act quickly and decisively compared to the messy processes of liberal democracies. (Even within liberal democracies authoritarian leaders and parties tend to thrive in these times.) China has been and will almost certainly continue to push big initiatives that will aggressively deal with climate change and other big challenges mounting in the world. China can be expected to showcase a model that will be attractive to developing nations and even any country that wants to emulate their success.
But Chinese President Xi Jinping is doing what almost every authoritarian regime and certainly every totalitarian regime ends up eventually doing. He is hanging onto power and getting the Chinese Communist Party to break with their tradition of rotating leadership at the top every 10 years. And as part of that process, he’s cracking down on all dissent, ramping up surveillance and social control, and fanning the flames of nationalism. The next decade is going to be a dangerous one.
The good news is that authoritarian closed societies always lose to open democracies in the long run — and this next 25 years should be no different. Historical periods of transformation and progress play to the strengths of societies that can correct course through frequent leadership changes. Open societies that encourage free thinking and are tolerant of dissent thrive in these periods dependent on widespread innovation. The process of democracies may be messy and relatively slow but in the long run they inexorably move forward and ultimately succeed. This happened in the last Cold War that ended in the collapse of the Soviet Union, and it most certainly will again if China gets increasingly totalitarian and mounts another Cold War.
One other bonus if a Cold War is forced on America and the West: External threats tend to accelerate social cohesion and progress. Serious external threats coming from a Cold War with a comparable power can be expected to bring Americans together behind a common purpose again and thrust us back into global leadership. A Cold War can be the rationale for channeling massive amounts of resources into research, science, new technologies, new infrastructure, and expanded education — all the elements that historically have led to more progress. An undesirable and unwanted Cold War could be yet another historical development that supercharges The Great Progression.
3. TIP397: The Dollar Milkshake Theory w/ Brent Johnson – Trey Lockerbie and Brent Johnson
Brent Johnson (02:16):
Well, essentially, what the Dollar Milkshake is, is how I think a sovereign debt crisis plays out. There’s a lot of people who, as the dollar has fallen over the last year… Well, actually, the interesting thing is the dollars are at a 52-week high today. But anyway, as the dollar has fallen since March 2020, a lot of people have said that the Dollar Milkshake Theory has been invalidated. And it really hasn’t because we haven’t entered a sovereign debt crisis yet. There’s no question I got the timing wrong. I thought that COVID would lead to a sovereign debt crisis, it didn’t.
Brent Johnson (02:49):
The powers that be have been able to prop up the markets with QE and bailouts and stimulus plans, but essentially what it is, is that I believe once we enter a sovereign debt crisis when debt finally matters and whether that’s tomorrow, next week, or next year, I don’t know the timing. But when we get into a situation where debt finally matters again, I think that the dollar is going to rise dramatically versus all other fiat currencies. And while it will probably in the very short term, be bad for risk assets such as we saw in March of 2020, I think it will evolve into a situation where global capital flows into the US dollar and therefore, it flows into US markets. And I think it will actually push us markets even higher than we see today.
Brent Johnson (03:36):
Now, it doesn’t mean it’s going to be a straight line, it doesn’t mean it’s going to be easy, but I think that’s where it goes. The milkshake name comes from the fact that since the global financial crisis, central banks and monetary authorities around the world have just flooded the world with liquidity, again, the bailouts, the QE, the monetary stimulus, the government help. And so my contention has been that for a number of reasons, the US dollar will have the straw versus all the other currencies. And for better, for worse, like it or not, the dollar will suck up all that liquidity that’s been provided to the markets.
Brent Johnson (04:14):
And sucking up that liquidity denies the rest of the world liquidity. And so I think our markets will be very liquid and the rest of the world will be very illiquid. And that itself, creates this perpetuating effect that pushes the dollar even higher. And so I think we’ll get into a situation where the dollar goes much higher than anybody thinks possible. Perhaps you’ll have asset prices go much higher than anybody thinks possible just as that flow of capital comes in.
Brent Johnson (04:40):
And so we will have a situation where we may have inflationary pressures and in US dollar terms even though the dollar’s going higher, and I think we will outside the United States, we will have inflationary pressures in local currency terms, but deflationary pressures in US dollar terms, which is the worst of both worlds. And so it really does become this self-perpetuating disaster, for lack of a better word. And I’ve always said, this is not a story that ends well. Even if the US outperforms the rest of the world, it doesn’t mean it will be a great place. Again, it’s all relative. And that’s what I always try to explain. It’s all relative.
Brent Johnson (05:16):
And so the dollar may fall in real terms, but against this fiat peers, I think it will dramatically outperform. And so then a lot of people have said to me, “Well then, who cares? Who cares if the dollar isn’t rising in real terms?” Well, it does matter. If the dollar rises just as an example, 20% versus all other fiat currencies, that will have dramatic effects on global markets. You may think it won’t affect you, but I’m here to tell you that you won’t be able to ignore it. And I think that will lead to more volatility. That’s a long way of explaining it, but that is the Dollar Milkshake Theory…
…Trey Lockerbie (34:56):
I want to touch on what you said earlier about this all coming to a head when debt finally matters because it goes to another point you just made about the whole effort between Central Banks being coordinated. They’re all in this together, so to speak. So if they’re all in this together, I would say that debt finally matters when the US loses its creditworthiness. But when you examine the landscape and you say, “Well, look, the entire world is doing this,” as you said, “And everyone’s lost their creditworthiness.” Where are governments then going to lead to? You mentioned China, so maybe we go there next about their digital currency, is that the solution in their mind as to where to go once everyone’s lost their creditworthiness?
Brent Johnson (35:41):
I think that’s probably right. I think that they realize… The first thing I’ll say is this whole de-dollarization idea. There’s no doubt that the world wants to de-dollarize, it’s just not as easy as many people think it is. And we can get into why that is, but as it relates to China, I think China especially would love to get out from underneath the dollar because they realize to a certain extent, the dollar is a prison. It’s a prison not of your own making. And without a doubt, China has ambitions to become the global hegemon. And even if they don’t outwardly say it, anybody that lives in China has that in the back of their mind that, “This is our time, we’re ascending, the US empire is descending. It’s just a matter of time before we take over and dah, dah, dah.”
Brent Johnson (36:22):
And that’s aspirational, it doesn’t have to be a negative thing. I would say that that’s a common theme over there. And so for them to do that, they’ve got to get out from underneath the US dollar. They just can’t do it with the dollar yoke around their neck. So I think then rolling out the digital yuan is their plan for how to try to do it. And perhaps what they say is they convert the regular yuan into the digital yuan. And then they say anybody that wants to do business in China, you have to own digital yuan. And then with the digital yuan, maybe it’s easier for them to bypass the dollar payment system. Maybe they don’t have to be part of the SWIFT and transfer money, if they want to do business with Russia, it doesn’t have to go through a US bank.
Brent Johnson (37:07):
Well, maybe that’s not a good example, Russia and China do some business directly with each other, but the world as a whole, whenever they do business, they go through a US correspondent bank because of our payment system. There’s no question in my mind that countries around the world, not just China, but these countries around the world are going to continue to try to de-dollarize. I just think it’s too little too late. And here’s the problem that a lot of people, I think miss, maybe they don’t, but it is my impression that they miss is that it’s not as easy to walk away from two things.
Brent Johnson (37:41):
One is all these countries have US dollar reserves. So if you’re walking away from the dollar, that means you’re blowing up some of your reserves. Now, even if you are, let’s use Bitcoin as an example, I know a lot of people that watch your program are heavily into Bitcoin. Let’s pretend that 80% of your net worth is in Bitcoin and 20% in US dollars. Well, even though you like Bitcoin better, and even though you think Bitcoin you own a lot higher, you don’t go home, throw gasoline on your pile of dollars and throw a match on it. You still want that 20%, you don’t want to just go up in flames.
Brent Johnson (38:17):
That’s the same thing with countries’ reserves, they have a lot of money in dollars. And so for them to go to a system that doesn’t use dollars, potentially decreases the value of their reserves. And so it’s a tug of war for them to a certain extent. For them to leave the dollar, they’re going to have to cannibalize some of their assets. So it can be done, but it’s hard. The other thing that I think many people miss is the Eurodollar system itself. And now this is when entities outside the United States borrow in dollars. So if a manufacturer in Brazil wants to issue some bonds in order to buy some machinery, a lot of times they’ll do it in dollars. Or another country will issue bonds, China’s issued a lot of bonds in dollars.
Brent Johnson (39:10):
And the reason they would issue in dollars is two things. One, they get paid in dollars, so now their liabilities and their assets are matched. But secondly, as they get a lower rate. If you issue a bond in dollars, you pay a lower percentage rate. Well, in another case, that’s the case if they issue a bond, but they can also go to a bank and get a loan. Turkey has a lot of dollar loans. And I think a lot of people think, “Well, these will just get defaulted on and that will hurt the US dollar, it will hurt the United States, and then all these other countries will move to a different currency.”
Brent Johnson (39:43):
But what they’re missing is that those dollars aren’t owed to the United States, the dollar debt that Turkey owes, a lot of it’s owed to France or Italy, or Spain, the European banks. In other words, entities outside the United States loan in dollars, that’s the Eurodollar market. And that dollar market is bigger than the US dollar market. So these loans that would get defaulted on don’t hurt the US, it hurts the rest of the world who’s defaulting on their own assets. So again, I’m not saying it can’t be done, it’s just a lot harder to do than many people realize.
Brent Johnson (40:17):
And so if you were loaning somebody money and you found out that their reserves or the money in their bank were quickly falling and that their brokerage account assets were quickly falling, you might change the lending terms a little bit. And so that’s what a number of these countries would be facing. If they started blowing up their dollar reserves, funding for them doesn’t get easier, it gets harder. Anyway, that’s a long ramble, I apologize.
4. The reason the BoE is buying long gilts: an LDI blow-up – Toby Nangle
OK, so we all know the story about why short-end rates have soared in the UK.* But what about the long-end? Well, basically pension plans appear to have been caught in doom-loop of margin calls on interest rate derivatives that forced them into dumping longer-maturity UK gilts, and spurred the Bank of England into intervening today…
…But my suspicion is that to understand why you need to look at plumbing issues coming from “Liability Driven Investment” (LDI) strategies in the UK.
I wrote about these back in July for the main paper, but to recap, pension plans are BIG investors, and they have shifted massively into LDI over the past two decades. Just in the UK they represent about £1.5tn of assets, which is about two-thirds of the UK’s GDP, or the size of the entire gilt market. They’re huge, in other words.
UK defined benefit pension liabilities don’t change with bond yields: they are a function of the number of pensioners living (present and future), perhaps their salaries, and maybe inflation (different employers promise different inflation-related uplifts).
But the estimated present value of pension liabilities do change with bond yields. Think of these pension promises as debt owed by employers — this is how accountants (FRS 102, IAS 19) think about it, and this is pretty much how the Pensions Regulator thinks about it.
So if you, a board member of a company with loads of pension obligations, want to avoid reporting wild swings in your pensions funding status to both markets (in your reports and accounts) or the Pensions Regulator (and maybe have to submit a recovery plan, as well as pay a higher risk-based PPF levy), you want a pension scheme that aligns its assets with the way your liabilities are measured – LDI in other words…
…All right, so — as explained in the midst of this brilliant thread from Dan Mikulskis, LDI commonly isn’t just shifting assets to mirror liabilities. It also uses leverage:
This 2019 Pensions Regulator report that looked at the top 600 UK pension schemes, with total assets of around £700bn. It found that “the notional principal of schemes’ leveraged investments totalled £498.5 billion; interest rate swaps were held by 62% of schemes and accounted for 43% of all leveraged investments” and that “The maximum permitted level of leverage ranged from 1x to 7x”.
1x to 7x!
Many schemes using derivatives like interest rate swaps will just be smoothing out cash flows, but a good portion will be gaining exposure to long interest rate risk through these derivatives. They will essentially be buying long fixed and paying floating. When you’re deploying leverage you need to think about your collateral — essentially initial margin plus variation margin.
This, again from the 2019 Pensions Regulator survey of the top 600 schemes, asks what method they were using to monitor collateral. Schemes use a variety of ways. I’ve highlighted basis points to exhaustion because it seems pretty intuitive: how many basis points rise in yields before your collateral is gone. The answer back in October 2019 was 291 basis points.
Long yields have since risen by 400 bps.
5. Everyone Relax, The Bank Of England Keeping Bond Markets ‘Orderly’ Is Normal – Nathan Tankus
What has finance Twitter all excited is the United Kingdom. Their new right wing (“Tory”) government has announced a “mini-budget” just a handful of hours after the Federal Reserve’s interest rate hikes, and got caught up in the reaction to that. The exchange rate depreciated and interest rates rose across the yield curve of government securities. Since these factors don’t typically go together in the U.S., western europe or Japan, there was much speculation that this signaled the U.K. was now being “treated as an emerging market”. That concept is something that deserves unpacking elsewhere. For now I’ll say that I think pundits were far too quick to underestimate how much financial traders were still processing the Federal Reserve interest rate hikes, and their forward guidance…
…Nonetheless, there clearly was a specific reaction to the announced fiscal policies. Why would that be? There are two main reasons. First, there is the consideration of what monetary policy will do. Remember that in the current monetary policy operating frameworks across dozens of countries, monetary policy is supposed to manage aggregate demand. Thus any factor that will increase demand can potentially lead to the central bank raising interest rates to prevent demand (and thus incomes) from growing faster than they desire. The report I wrote earlier this year was about the potential monetary policy tools available to offset rising aggregate demand—that don’t involve raising interest rates. It is strange how quick punditry commentary is to forget this core fact about how our current economic policy frameworks work.
The second element is more complicated. Over the course of the 2010s monetary policy was implemented in the context of weak demand. In that context, central banks were desperately searching for ways to increase demand by any means. Quantitative Easing (which I am not going to do a full overview of here) was meant to show a commitment to keep interest rates lower for longer. That was in order to try to induce a little more spending from lower long interest rates. Its success is, famously, extremely debatable. But it’s clear that the “plumbing” of monetary policy took a backseat over this period. The New York Federal Reserve trading desk practically went dark, when it used to engage in repo agreements on an hourly basis (a point to which I will return later). In that context, forward guidance about future monetary policy was able to cleanly shape the yield curve without much trouble. With indefinite Zero Interest Rate Policies, there were no day to day market movements. Bond desks even shrank because of the lack of volatility (and thus opportunities to trade).
Now however, plumbing is back.
There are new leverage-based capital requirements and unique liquidity requirements associated with Basel III. In the context of a “tightening” cycle, where interest rates are rising quickly and central banks commit to “shrinking their balance sheet” (i.e. net selling government securities) things have changed. Financial institutions, institutional investors etc. may not have the willingness (or even ability) to expand their balance sheets to purchase more government securities. Even worse, as the volatility of bond prices increases those using government securities (especially long maturity government securities), as collateral need to come up with more “cash” which pressures them into selling assets. This can easily become a classic fire sale dynamic. The spike in interest rates that were always going to come in this kind of economic environment seems to have interacted with these plumbing issues, leading to interest rates out of line with plausible Bank of England interest rate hikes.
In short, in the 1990s and 2000s central banks relied on private balance sheets which could expand cheaply, and easily in order to absorb “risk free assets” to implement monetary policy. This meant they didn’t need large scale asset purchases. After 2008 they engaged in large scale asset purchases for reasons other than financial market plumbing, averting problems in that arena as an unintended side effect. In late 2019 and during March 2020 those plumbing issues came to the forefront—forcing the Federal Reserve to engage in bond purchases for explicitly plumbing reasons. To act, not as a lender of last resort, but as “dealer” or “purchaser” of last resort. Up until yesterday, the United Kingdom in 2022 was experiencing similar issues, as bid-ask spreads began to widen on long maturity government securities. Interest rates on “Gilts” (British government securities) seemed to get somewhat out of line with monetary policy forward guidance.
As a result, yesterday the Bank of England announced long maturity government securities purchases in order to make markets “orderly”:…
…This sparked a new round of takes. Concerns about “debt monetization”, “fiscal dominance” and even government collapse were bandied about. People treated the idea of purchases to bring “order” to government securities markets as very extraordinary and unprecedented. In short, many pundits are talking as if this is the end of central bank independence.
In reality, these kinds of purchases are, while infrequent, normal. In the 20th century they happened periodically as dealers’ inventories swelled and couldn’t absorb much more. Preserving orderly markets through time limited purchases to reduce interest volatility was not the “end of central bank independence”—but actually one if its core innovations. It’s not clear to me who at the Federal Reserve coined the term, but it was certainly a Federal Reserve idea to explain how government securities markets would work without the Federal Reserve directly fixing interest rates at every part of the yield curve as it was doing up until the Fed-Treasury Accord of 1951…
…Bond traders, financial journalists and commentators more generally are not used to thinking about monetary policy, in a world where central banks have to periodically make purchases in order to “maintain order” distinct from overall monetary policy. The fears some commentators have is clearly based on the idea that these purchases mean that the Bank of England “must” reverse itself about interest rate increases. That is not the case. In fact, it tends to be a sign of the opposite.
These kinds of purchases are meant to make raising interest rates more viable. Just as greater discount window borrowing was usually a sign of monetary policy tightness not ease (a subject I will return to another day). An unfortunate element of post-2008 monetary policy for present circumstances is the tying of asset purchases to forward guidance. By teaching financial market participants that forecasted bond purchases are the way you interpret the future path of interest rate policy, it makes it difficult to make purchases in order to smooth market functioning. There is clearly a contradiction between “quantitative tightening” and “financial stability” purchases to make bond markets more “orderly”. But so much the worse for quantitative tightening (though it might still continue). Both central banks and financial market players will need to get used to bond purchases and interest rate increases coming together.
6. A Safe Place to Hide – Chris Mayer
I heard a friend say there is “no safe place to hide.” It got me thinking. What’s safe?
I think the answer to the question depends on your investment horizon.
So, cash looks really good if you need two weeks. Maybe you need to buy a new car. Cash gets it done. Not much risk.
Cash looks worse, though, if you look one year out, especially with inflation running circa 8%. And it looks terrible over ten years.
If your horizon stretches ten years or more, then owning a good business is one of the safest places to be. Even better: own a portfolio of such businesses. Thank goodness we have public equity markets, where we can easily buy pieces of some of the best businesses on the planet. (The problem is that we can easily sell them, too, but more on this below…)…
…Alternatively, you could build a portfolio of wonderful businesses yourself and then – this is the key part – leave it alone for a decade and see what happens. This is the “coffee can” idea. I am a big fan. I’ve written about it in different places before, but you can read about the idea, penned by its original creator, Robert Kirby, in a classic article here:
http://csinvesting.org/wp-content/uploads/2016/12/the-coffee-can-portfolio.pdf
The appeal of the coffee can is you protect yourself against your worst instincts. You can’t sell when things are going badly. It’s like Odysseus, when he had his crew tie him his mast to resist the sirens’ calls. He still heard them, but he couldn’t do anything. (His crew stuffed beeswax in their ears).
I quoted Kirby up top. As he implies, in some ways, it is easier to invest when you have a longer-term time horizon. I have have no idea what the stock prices of my favorite ideas will do over the next 5 months. Chance would play a huge role in the outcome. And the odds are decent they could actually be worth less. But over the next 5 years, I’m more confident they will be worth a lot more.
What makes investing hard is that things don’t unfold in an even, or predictable, manner. There are some great runs, there are nasty drawdowns and there are extended periods where you seem to go nowhere. Each presents lots of opportunities for investors to make costly mistakes.
7. Meta’s new text-to-video AI generator is like DALL-E for video – James Vincent
A team of machine learning engineers from Facebook’s parent company Meta has unveiled a new system called Make-A-Video. As the name suggests, this AI model allows users to type in a rough description of a scene, and it will generate a short video matching their text. The videos are clearly artificial, with blurred subjects and distorted animation, but still represent a significant development in the field of AI content generation…
…The clips are no longer than five seconds and contain no audio but span a huge range of prompts. The best way to judge the model’s performance is to watch its output. Each of the videos below was generated by Make-A-Video and captioned with the prompt used to generate the video. However, it’s also worth noting that each video was provided to The Verge by Meta, which is not currently allowing anyone access to the model. That means the clips could have been cherry-picked to show the system in its best light.
Again, while it’s clear these videos are computer-generated, the output of such AI models will improve rapidly in the near future. As a comparison, in just the space of a few years, AI image generators have gone from creating borderline incomprehensible pictures to photorealistic content. And though progress in video could be slower given the near-limitless complexity of the subject matter, the prize of seamless video generation will motivate many institutions and companies to pour great resources into the project….
…It’s also worth noting that Meta is not the only institution working on AI video generators. Earlier this year, for example, a group of researchers from Tsinghua University and the Beijing Academy of Artificial Intelligence (BAAI) released their own text-to-video model, named CogVideo (the only other publicly available text-to-video model)…
…In a paper describing the model, Meta’s researchers note that Make-A-Video is training on pairs of images and captions as well as unlabeled video footage. Training content was sourced from two datasets (WebVid-10M and HD-VILA-100M), which together, contain millions of videos spanning hundreds of thousands of hours of footage. This includes stock video footage created by sites like Shutterstock and scraped from the web.
The researchers note in the paper that the model has many technical limitations beyond blurry footage and disjointed animation. For example, their training methods are unable to learn information that might only be inferred by a human watching a video — e.g., whether a video of a waving hand is going left to right or right to left. Other problems include generating videos longer than five seconds, videos with multiple scenes and events, and higher resolution…
…Meta’s team also notes that, like all AI models trained on data scraped from the web, Make-A-Video has “learnt and likely exaggerated social biases, including harmful ones.” In text-to-image models, these biases often reinforce social prejudices. For example, ask a model to generate an image of a “terrorist,” and it will likely depict someone wearing a turban. However, it’s impossible to say what biases Meta’s model has learned without open access.
Meta says it is “openly sharing this generative AI research and results with the community for their feedback, and will continue to use our responsible AI framework to refine and evolve our approach to this emerging technology.”
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. Of all the companies mentioned, we currently have a vested interest in Apple and Meta Platforms. Holdings are subject to change at any time.
