The Investment Risks of Regime Shifts

January 10, 2021

The below post was originally published in mid-December via the South China Morning Post (pre-this Substack distribution) and because both many readers didn’t receive it and due to of what’s transpired more recently, I’m re-sharing. Since this was published, we’ve crossed the threshold into violence.

Next week’s podcast: Andrew Weiss, a deep Russia expert, explains what makes the Kremlin tick.

Last month, like so many others, I scanned a 21st century tool, Twitter, to see if 18th century rules devised to transfer power from one US President to another would hold. They did, despite the fact that President Trump, with the enthusiastic backing of almost half of those who voted, sought to subvert them. The worst-case scenarios of election violence failed to materialize but the fear was real. After the election, stocks rallied in relief.

For investors, this episode serves as a reminder of a profound truth. The biggest risk is less a market gyration, these normally smooth out over time, and more a disruptive break in the existing order, from which investors may never recover. Wealth is lost permanently. However, in a dynamic economy existing order is always under strain, it’s a question of degree.

The flux in wealth is what makes investing both so interesting and treacherous. As a global macro investor, when I build a portfolio, I am indifferent to national borders. My goal is to assemble a return stream to get the highest return for the risk I endure.

In doing so, I am mindful of the historic record. Yesterday’s hegemon, like Portugal’s colonization of Macau, is today’s has been and vice versa. Germany is now considered a paragon of stability but witnessed both hyper-inflation and a break-down in order less than a century ago. While the US has the oldest constitution still in force, 238 years isn’t that long. The average length of a Chinese dynasty over the last 1000 years is about 242 years.

In regime shifts currencies can implode either due to capital flight (many emerging market crises), printing (Weimar Germany) or capital controls (Soviet Union and China). Capital markets close, sometimes for decades. The Russian stock market closed after 1917, China’s in 1949 and European markets often were suspended trading during their wars.

Yes, you can lose plenty of money without a regime shift, like the 1929 US stock market crash. Stocks fell roughly 90%. Yet, if the system remains intact, the markets will often come back to equilibrium as policy makers are forced to address the shocks that knocked markets out of equilibrium. In the case of the Great Depression, President Roosevelt needed to take the then almost unthinkable step of abandoning the gold standard. It’s also true that some regime shifts can be positive for investors, like the collapse of the Soviet Union, which presaged an opening of global capital markets.

Government structures often break when a protracted, broad decline in living standards is met with inappropriate policy. Given shifting technologies, living standards in certain sectors are always in decline, Detroit versus Silicon Valley. It’s a question of how big the dying sectors are relative to the rising. These disruptive shifts are tied to the very thing that has increases living standards: productivity.

Productivity fuels income growth; economic growth, or spending, is composed of both income and borrowing. Because the economy is always in motion, rules regulating the economy need to keep up, a challenging administrative ballet.

The question raised on election night and during the entire Trump Presidency was whether it was now the US’s turn to experience a fundamental break in rules. A number of pressures motivated Trump supporters, disproportionately rural men with a high school education. One consistent with other periods of institutional breakdown: flat real wages among the lowest quintile income groups for decades. This was in part caused by a shift in technology that created enormous profits in other parts of the economy, reflected in the performance of US technology stocks. An added twist with this technology shift––it changed media to an extent that it altered how citizens perceive reality, precisely how is a conversation for another day.

Going forward, both China and the US have significant economic strengths and substantial challenges that will test their models. Both countries are virtually alone among global economies in that they are large, diversified, mostly internally driven, a structural advantage. Most countries lack this dynamism. China and the US also face diminished competitiveness and high levels of both income inequality and debt.

Their governing models, open versus closed, are obviously different. Neither system is entirely open nor closed, but on a spectrum the US system is more open and the Chinese system more closed. In the West, debates about the merits of either approach go back to at least ancient Greece, where the “open” Athens fought a “closed” Sparta.

An open system holds the individual responsible for navigating an ever-shifting economic landscape. This process is chaotic and flexible. A closed system puts responsibility on a self-selected group of administrators to make appropriate decisions. The system is often (but not always) less chaotic and heightens dependence on the top. By putting limits on the executive, an open system precludes the transformative change China has benefitted from in the last forty years. It also reduces the odds of (but does not prevent) a policy error like the Cultural Revolution.

In the short term, the risks of a more disruptive US institutional break have diminished though the underlying causes of the tension persist. President-elect Biden is a centrist. I am maintaining a long exposure in the US and, given the opening of Chinese capital markets and the likelihood of less bi-lateral conflict, hold the highest exposure to Chinese assets I have ever held. At the same time, I am mindful about the structural weaknesses in both systems and scanning for early signs of trouble. Both China and the US have descended into Civil War in the past. For a few days, the US seemed perilously close to starting down that path.