“Europe’s fundamental values are prosperity, equity, freedom, peace and democracy in a sustainable environment. The EU exists to ensure that Europeans can always benefit from these fundamental rights. If Europe can no longer provide them to its people – or has to trade off one against the other – it will have lost its reason for being”
So says Mario Draghi in the Forward of the long-delayed release of his report “The future of European competitiveness”.
A lot happened in the month of September, not least of which being the Fed’s 50bp interest rate cut, and we will get back to that in due course, but few things will be as worthy of your attention as Comrade Draghi’s report. It is a long slog but, at a minimum, do take the time to click in and read Mr. Draghi’s five-page Foreword.
97e481fd-2dc3-412d-be4c-f152a8232961_en (europa.eu)
It is hard to praise this report enough for its technical construction. It is beautiful. Perfectly constructed in form and representation. Chapters, sections, headings, bold highlights, colours, charts. Precise sentence structures. Consistent proportionality of paragraph sizing. There were, no doubt, some skilled consultants engaged in its construction. Our own editor would kill to receive such well-constructed work.
We jibed last month that Chair Powell and Governor Bailey had used their respectively well-trained versions of GPT to write their Jackson Hole speeches. Along those same lines, one might wonder if Mr. Draghi had pulled in the aid of what we might derogatorily dub Soviet-GPT to aid him in the construction of his content.
The basis of the report is to address the ‘falling behind’ of European (EU) competitiveness, generally defined as growth and productivity, relative to the US and, to a lesser extent, China. Everything is based on what has evolved “since 2000”.
“On a per capita basis, real disposable income has grown almost twice as much in the US as in the EU since 2000.”
We guess it shouldn’t come as a surprise that he never phrases these declines as occurring “since the adoption of the Euro”. In fact, in the classic IYI (Nassim Taleb’s Intellectual Yet Idiot) framework, there is zero recognition that any of the circumstances they are now trying to address could have resulted from second-order, unintended consequences of past centralizing decisions. Quite the contrary, the blame is broadly placed on not doing more centralizing.
The report lays out “three main areas for action to reignite sustainable growth”:
- Europe must profoundly refocus its collective efforts on closing the innovation gap with the US and China, especially in advanced technology.
- A joint plan for decarbonisation and competitiveness.
- Increasing security and reducing dependencies.
Those three items frame the entire report, floating somewhere between ambitions and solutions. The key thing standing in the way is that same old bugaboo – not enough Europe! Not enough “joined-up policy actions”; not enough utilization of “collective spending powers”; not enough “coordination where it matters”.
“The objective of this report is to lay out a new industrial strategy for Europe to overcome these barriers.”
The one thing that is noticeably absent, as a possible solution to improve competitiveness, is competition. It really only gets one mention in the entire report and gets quickly noted as something that they must not let get in the way of their objectives.
“The evidence is overwhelming that competition stimulates productivity, investment and innovation. At the same time, competition policy should continue to adapt to changes in the economy so that it does not become a barrier to Europe’s goals.”
In the end, as we have discussed in several past notes as this report was evolving, the only tangible solution that they arrive at is a need for more borrowing and spending at the central EU level, something in the order of EUR 800bn per year, circa 4.5% of GDP. The report does mention that this could, initially, be inflationary but it will work itself out eventually. As ever, centralized borrowing and directed spending/investment is presented as the unchallenged golden goose.
“Some joint funding of investment at the EU level is necessary to maximise productivity growth, as well as to finance other European public good. The more that governments implement the strategy laid out in this report the greater the increase in productivity will be, and the easier it will be for government to bear the fiscal costs of supporting private investment and of investing themselves.”
Makes one wonder, if it is that easy, why didn’t they think of it before…..
There are a number of other frightening underlying threads throughout the report. Two that standout most clearly – protectionism and financial repression.
Just one of many examples on protectionism:
“…the EU should legislate mandatory standards for public sector procurement, thereby levelling the playing field for EU companies against larger non-EU players.”
There are multiple pieces on how to (force) utilize the pension system to direct savings as desired by the ruling directorate.
“The EU must also better channel households’ savings to productive investments. The easiest and most efficient way to do so is via long-term saving products (pensions).”
The overriding theme, however, is simply more centralisation, more control at the EU level, and they don’t mince words about it.
“To unlock private capital, the EU must build a genuine Capital Markets Union (CMU) supported by a stronger pension. As a key pillar of the CMU, the European Securities and Markets Authority (ESMA) should transition from a body that coordinates national regulators into a single common regulator for all EU securities markets, similar to the US Securities and Exchange Commission. An essential step to transform ESMA into such an agency is to modify its governance and decision-making processes along similar lines as those of the ECB Governing Council, detaching them as much as possible from the national interests of EU Member States.” (Highlights are ours)
We can’t help but fall back on Thomas Sowell’s excellent quote from his book “A Conflict of Visions: Ideological Origins of Political Struggles”.
“There are no solutions. There are only trade-offs.” Thomas Sowell.
If anybody has the access, they should send Mr. Draghi a copy of Mr. Sowells most excellent book. Going back to the Draghi quote that we opened with, the EU’s current circumstances are because of the trade-offs they decided to make along the path of getting to where they are today.
If Mr. Draghi really wants to do something about competitiveness, he should go and start a business. Raise capital in the private sector, from people willing to put their own skin-in-the-game. Hire and train skilled resources. Innovate some new technologies. Produce cheaper more efficient energy resources. Generate products or services that improve the quality of life for the citizens of Europe and generate profits for shareholders. Don’t use the power of government to direct the hard acquired savings of said citizens to pet projects chosen by unaccountable bureaucrats.
In the end, this turns out to be nothing more than some central borrowing power, at the EU level, leaping into the arena of the Hunger Games competition of issuing bonds into an ever-diminishing demand from end buyers.
Whatever it takes.
ECB Mario Draghi: Whatever it takes (youtube.com)
Keep an eye on this space. The issuing of this report was significantly delayed from its original timeline. Its implementation has a fair chance of being delayed somewhat longer (indefinitely?).
Critical as we are about this report, it did raise (though never really delved into) one issue that is increasingly on our radar: that of demographics.
“The EU is entering the first period in its recent history in which growth will not be supported by rising populations. By 2040, the workforce is projected to shrink by close to 2 million workers each year.”
Amazingly, while they factor this in as one of the challenges impacting their hoped-for objectives of greater growth and productivity, they never discuss anything related to trying to do something about it. A bunch of economists and ex-central bankers that think they can control the weather, don’t seem to think there is anything that could be done to address declining workforces.
They show this stunning chart on the projected changes in overall population and in working age population for the EU, US and China.
Figure 1: Long-term population developments and projections
Source: United Nations World Population Prospects 2022. 97e481fd-2dc3-412d-be4c-f152a8232961_en (europa.eu)
As interesting as the blue European line is, it is hard to ignore the implications of what is to come in China. We promise to come back to this broader point in some of our future works.
Speaking of Hunger Games, it is worth having a quick look into the recently released “Office for Budget Responsibility: Fiscal risks and sustainability” report from the UK.
CP 1142 – Office for Budget Responsibility Fiscal risks and sustainability (obr.uk)
The report leads straight in with the usual “the dog ate my homework” deflections of a series of exogenous shocks and a listing of uncontrollable externalities of the usual suspects once again:
- Ageing population
- Climate change
- Geopolitical tensions
“The analysis in this report shows that, based on policy settings in March 2024, these and other pressures would eventually put the public finances on an unsustainable path.”
They show this fairly self-explanatory chart in support of their concerns.
Figure 2: UK projected total government revenue and spending
Source: ONS, OBR CP 1142 – Office for Budget Responsibility Fiscal risks and sustainability (obr.uk)
The UK counterparts to Mr. Draghi’s crack staff in Europe run into many of the same challenges and, likewise, propose some ambitions (again, as opposed to solutions) as to how to deal with them.
- Slow the rise in global temperatures
- Improve the health of the population
- Boost the productive potential of the economy
No small aspirations!
Their work leaves them with this outcome in terms of projections for UK debt/GDP.
Figure 3: UK Projections for public sector debt/GDP
Source: OBR CP 1142 – Office for Budget Responsibility Fiscal risks and sustainability (obr.uk)
Make room for District III in the arena. “May the odds be ever in your favor!”
Checking back over on Katniss and Peeta, we got to see Chair Powell stepping forward in aid, and technically speaking against the rules, of his district companion, Treasury Secretary (Professor) Yellen, with a panic-stations grade 50bp cut of the Fed Funds rate. As we noted last month, this despite the fact that key equity indices were at all-time highs and financial conditions indicators were very much on the loose side of historical averages.
Figure 4: Fed Chicago Financial Conditions Index (white) and Average (yellow). Fed Funds Rate (blue). SPX Index (orange-log scale). Vertical Line July 1995 (white) and Sept2024 (red). Sept1987-Sept2024
Source: Bloomberg, Convex Strategies
Chair Powell made it very clear in his official policy statement that the economy was strong, unemployment was low, and inflation remains elevated. Nevertheless, he cut 50bp.
Federal Reserve Board – Federal Reserve issues FOMC statement
“Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have slowed, and the unemployment rate has moved up but remains low. Inflation has made further progress toward the Committee’s 2 percent objective but remains somewhat elevated.”
Not really much to say. As we pointed out last month, he is living up to the asymmetry bias that Arthur Burns laid out in his famous mea culpa speech that we walked through in detail in our December 2021 Update – “Arthur Burns mea culpa” https://convex-strategies.com/2022/01/17/risk-update-december-2021/.
“It therefore seemed only natural to federal officials charged with economic responsibilities to respond quickly to any slackening of economic activity…. But to proceed very slowly and cautiously in responding to evidence of increasing pressure on the nation’s resources of labor and capital. Fear of immediate unemployment – rather than fear of current or eventual inflation – thus came to dominate economic policymaking.” Arthur Burns, 1979.
In February 2022, just going into the first hike, the then Fed Funds rate of 0.00%-0.25% was running circa 6.5% below Core CPI (itself 4.5% above the Fed’s target) and 10.5% below a proxy of the Taylor Rule. In March 2022 that warranted a mere 25bp hike. Going into the September 2024 cut, Fed Funds at 5.25%-5.50% were circa 2.0% above Core CPI and about 50bp below the same Taylor Rule proxy. This warranted a 50bp cut. Asymmetry, or at least so it would seem.
Figure 5: US Fed Funds Rate (blue), Taylor Rule Proxy (white), Core CPI yoy% (orange), Unemployment Rate (purple-inverted). Sept 1987-Sept2024
Source: Bloomberg, Convex Strategies
Katniss should be pleased.
Stanford based economist John Cochrane continues to elaborate on the subject of this interaction between monetary and fiscal policy. We discussed Mr. Cochrane’s excellent paper “Expectations and the neutrality of interest rates” in some detail back in our May 2024 Update – “Polanyi’s Paradox” https://convex-strategies.com/2024/06/14/risk-update-may2024-polanyis-paradox/.
(3) Monetary ignorance, monetary transmission, and a great time for macroeconomics (grumpy-economist.com) John Cochrane
“Monetarist theory is perfectly clear. The Fed must control the money supply. If it does not do so, and either targets interest rates or provides ‘an elastic currency’ meeting demand, the theory does not work. ‘Money’ and ‘bonds’ must be distinct assets. If money pays the same interest as bonds, or if bonds can be used as money, the theory does not work.
It’s a nice theory. It might be a theory of how the Fed could control inflation, or perhaps how money supply (by the Fed, gold discoveries, etc.) did control inflation in the past, even as recently as the 1980s. It might even be a theory of how the Fed should control inflation. (I’m throwing bones to my many monetarist friends.) But it is not a theory of how the Fed (and the ECB, BOJ, BOE, etc.) does control inflation by raising interest rates without any money supply control.”
His point, elaborating on from his original paper, is that without an accompanying fiscal contraction, maybe as a response to the signal of higher borrowing costs, higher interest rates alone will not constrain inflation over time. Sort of his version of the Fiscal Dominance story. It is kind of a sensitivity to initial conditions sort of thing.
This, naturally, brings us back to our ongoing discussions around complex systems and the complexities of nonlinear dynamics. The Butterfly effect. Chaos theory. Bifurcation maps. Self-organized criticality. Emergence.
A chap by the name of George Henry Lewes is generally credited with having coined the terminology around “Emergent Properties”, aka emergence, in his 1875 five volumes works “The Problems of Life and Mind”.
“Every resultant is either a sum or a difference of the co-operant forces; their sum, when their directions are the same – their difference, when their directions are contrary. Further, every resultant is clearly traceable in its components, because these are homogeneous and commensurable. It is otherwise with emergent, when, instead of adding measurable motion to measurable motion, or things of one kind to other individuals of their kind, there is a co-operation of things of unlike kinds. The emergent is unlike its components insofar as these are incommensurable, and it cannot be reduced to their sum or the difference.” George Henry Lewes, 1875, “The Problems of Life and Mind”.
There are many others, going back to Aristotle, that have pondered this concept of emergence, as commonly encapsulated in the catchphrase “the whole is greater than the sum of its parts”. Adam Smith’s “invisible hand” in “A Wealth of Nations”. John Stuart Mill, a contemporary of and a significant influence on Lewes, in his “A System of Logic”. Of course, Friedrich Hayek and the whole school of Austrian Economics. All the modern-day luminaries of Chaos theory, Information theory, self-organized criticality, decision heuristics. On and on.
The simple example used to explain emergent properties is water. Studying hydrogen atoms and oxygen atoms on their own would in no way lead someone to derive the concept of wetness. The complexity extends even more so to such realms as human consciousness or social systems, like economies.
One of our current heroes, Stephen Wolfram, released yet another fantastic note on his website. This one is specifically on the mother of all challenges – time. He reflects on this across his theory of the ruliad and computational irreducibility. We discussed this in last month’s Update – “Unknowable” https://convex-strategies.com/2024/09/19/risk-update-august-2024-unknowable/. This, inevitably, aligns his thoughts with the concept of emergence. The only way to know what will happen is to get there.
On the Nature of Time—Stephen Wolfram Writings
“There is no way to ‘jump ahead’ in time; the only way to find out what will happen in the future is to go through the irreducible computational steps to get there.”
Mario Draghi, to go back to the above example, doesn’t know what the future holds and he is unlikely to get the “resultant” outcomes that his simplistic sums imply. To put it bluntly, he has no idea what his initial conditions are, nor what the emergent properties will be.
From a risk and investment management perspective, we know what the answer is – add convexity to your portfolio. Turn the mathematics of compounding to your benefit. Get away from the volatility drag and negative return-skew of traditional Sharpe World investment strategies and get on the compounding-train of good convexity-bias and positive return-skew. Stop trying to optimise expected returns (Modern Portfolio Theory) and start optimising actual returns.
For just a simple example of the transformation, we can take a good old fashioned 60/40 portfolio (represented in red below), in this case MSCI World Total Return (GDDUWI Index) for the 60%, and the Global Bond Aggregate (LEGATRUU) for the 40%. The simple form transformation of that into a hypothetical convex portfolio entails getting rid of the bonds and splitting that 40% allocation equally across explicit loss mitigation, in the form of the CBOE Eurekahedge Long Volatility Index (EHFI451 Index) at 20% of the entire portfolio, and the other 20% into more equities, so increased to 80% on the MSCI World allocation, ie. an 80/20 Barbell (represented in blue below). Both portfolios assume annual rebalancing.
Readers, by now, will be very familiar with the results.
Figure 6: Barbell 80/20 (blue) vs Balanced (red) 60/40. March2009-Sept2024. Hypothetical Scattergram and Return Distribution
Source: Bloomberg, Convex Strategies
Even with the naked eye one can see the moderate improvement in convexity and return skew. That “moderate” improvement has significant impact on capital appreciation.
Figure 7: Barbell 80/20 (blue) vs Balanced (red) 60/40. March2009-Sept2024. Hypothetical Compounding View
Source: Bloomberg, Convex Strategies
As we always like to point out, the above pictures only show you what did happen, not all that could have happened. What risks were you taking, or not taking, that you just managed to avoid through per luck of circumstance? The Barbell, throughout, always had more potential upside participation, than was realized, and more potential downside protection, should it have been needed. The portfolio with the greater convexity has its own element of positive emergent properties. As realizations diverge from expectations, the convexity bias of the portfolio rewards the investor with compounding greater than the sum of its parts. Investing should not be about “guessing” what is likely to happen, it should be about improving risk-adjusted returns.
As we noted last month, we are far from the only people that have figured this out. We refer you again to the wonderful report on Total Portfolio Approach generously put out by Singapore’s own Government Investment Corporation (GIC) in coordination with JP Morgan Asset Management (JPMAM).
GIC-ThinkSpace-Building-A-Hedge-Fund-Allocation.pdf
As another little teaser to the results from this excellent piece of research, we show below their chart that results from their optimization (unfortunately we think that they are essentially optimizing to Sharpe Ratio, standardizing things to a consistent volatility as opposed to a useful measure of risk like drawdown, downside volatility, or negative beta) after breaking down their universe of Hedge Funds into their relevant factors.
Figure 8: GIC/JPMAM Return an underlying composition of Standalone vs Integrated hedge fund portfolios.
Source: GIC-ThinkSpace-Building-A-Hedge-Fund-Allocation.pdf
As discussed last month, it turns out that, when optimising to the hedge fund portfolio on a standalone basis, circa 60% goes to their subset of Loss Mitigation strategies. Optimizing across the integrated portfolio, the entirety of the hedge fund allocation, right up to their 20% maximum constraint, goes into Loss Mitigation strategies and it allows some risk appetite left over to allocate some of the bond-capital to holding even more equities. Just like our above hypothetical Barbell example, their Integrated portfolio has the best overall return.
This outcome, as you would rightfully guess, gets even more significant if you include explicit loss-mitigating strategies, eg Long Vol, and if you do your optimisation based on some sort of effectual measure of risk-adjusted performance, eg. Sortino Ratio, Convexity Ratio, Drawdown, etc.
Happy to discuss how this looks if anybody wishes to.
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