Opposing Forces

THIS IS NOT INVESTMENT ADVICE.

The constant theme which runs through all Utopian thought, Christian and pagan alike, is that once upon a time there was a perfect state, then some enormous disaster took place: in the Bible it is the sin of disobedience — the fatal eating of the forbidden fruit; or else it is the Flood; or wicked giants came and disturbed the world, or men in their arrogance built the Tower of Babel and were punished.

Isiah Berlin, The Crooked Timber of Humanity, 1947

Last year’s market moves unfolded against two notable shifts—populism and productivity, or AI.

Technological disruptions and swings between rule of law and away from it have been constant for the last 100 years, creating cycles of economic and market instability. Often, a technological shift disrupts both relative geopolitical power and cash flows, rapidly shifting the “haves” and “have nots.” Those on the losing side of the change seek to regain what they perceive as lost, clamoring for the previous “perfect state,” paving the way for a populist shift, be it in Weimar Germany, Communist China or the UK and US today.

Typically, economics drive politics. But not always. When these political shifts become extreme, they add an extra layer of complexity in pricing assets, which is what we are living through now. In addition to the criteria I always must apply to an investment—pricing, flows and catalysts—one needs to properly calibrate the shift in political currents.

For instance, one consequence of Trump’s rise is the attack on the Fed’s independence. But the consequences of this attack were curious. They manifested more in a rally in gold than a decline in the dollar. And while 30-year bond yields rose in the US, also likely due to both these attacks combined with a large budget deficit, 10-year bond yields rose more abroad and fell in the US. This was also due to US policy shifts. Germany, stripped, with little warning, of a US security guarantee, rushed to boost defense spending, boosting their fiscal deficit and driving 10-year German bond yields higher. Tariffs in the US were fiscal tightening, driving 10-year bond yields lower. The point is, politics mattered.

While the tech shifts can seem independent of this dynamic, they aren’t. Voters are simultaneously fascinated by technology and terrified of it and they are voting for politicians who they believe will “contain” the disruption, fearing automation of their jobs even as they cherish almost instantaneous Amazon deliveries.

Against this dynamic, here are some predictions.

1. There is no inflation. No central banks will tighten this year and some, like the Fed, will ease. The components of inflation—labor, oil, housing—are weak. The only area of inflation is medical costs which, so far, have proven immune from creative destruction. If AI makes any inroads into even the administrative side of health, prices will fall. I know of several start ups related to just this. I wish them luck. So inflation will be weak. Short term interest rates will remain where they are or fall.

2. Government borrowing is out of control and won’t decline until there is a crisis. In places like the UK there has been a crisis, so they are being forced to change. But there is no crisis in many other countries, yet. The only solution to big deficits is higher taxes on the rich and less services for the poor and no politician can get elected with this message, so the crisis brews. A crisis will be long-term interest rates rising fast enough to drive stock prices lower.

3. Savers will reduce their financing of the US. Globally, there are savers and there are borrowers. The US is a borrower. Germany, Japan and China are the lenders. The lenders will find the US increasingly unpredictable and won’t want to lend the money and increasingly have things to spend it on at home. Five-year US interest rates are 3.7% and five year Japanese interest rates are 1.5% when they used to be below zero. The gap is closing. This means their currencies go up.

4. With no tightening and margin-enhancing technology, earnings will be stronger than discounted. Stocks go up but likely at some point during the year there is a freak out and stocks trade sharply down. The critical issue in the pricing is the embedded assumption that AI might be truly revolutionary. But no one knows when that revolution will manifest. If there is any doubt about it manifesting in the very near future, stocks will trade down, perhaps violently. If that happens, of course, their expected returns go up and you are supposed to buy.

5. In essence, two things are happening at once. First, companies that make money are going to make a lot of money, bolstered by this new technology. Second, the fundamental agreements that underlie Western civilization—rule of law above all—are giving way. This is creating a crisis of confidence that will result in some combination of rising gold, falling dollar and rising yields on long-term debt. These two themes are at war with one another, that’s the fundamental tension in markets.

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