Linkages and Sequences
Linkages and Sequences
“A factor or relationship that ties one thing to another”
“The following of one thing after another; succession”
“It is not possible to look in a different direction by looking harder in the same direction.”
Edward De Bono – “The Use of Lateral Thinking”
“To me, past experience is more compelling than any model.”
“An economist is a man who, when he finds something works in practice, wonders if it works in theory.”
Walter W. Heller, former Chairman the Council of Economic Advisors
“Part of the reason for the extent of the world economic collapse of 1929 to 1933 was that it was not one crisis but, as I describe, a sequence of crises, ricocheting from one side of the Atlantic to the other, each one feeding off the ones before, starting with the contraction in the German economy that began in 1928, the Great Crash on Wall Street in 1929, the serial bank panics that affected the United States from the end of 1930, and the unravelling of European finances in the summer of 1931. Each of these episodes has an analogue to a contemporary crisis.”
Liaquat Ahamed, “Lords of Finance”
The investment world is dynamic and akin to a living, breathing organism. Relationships between elements change, sometimes drastically. Ideas and innovations mature and in many cases eventually become extinct. Sequences are, more often than not, non-linear in outcomes. Economic history is littered with examples of unintended consequences, where obscure linkages create very stark outcomes.
In such obscurity, sequences reveal linkages; whereas many investors think only in terms of linkages predicting sequences through correlation and probability
Sequences can take the form of either a chain or a loop. When economists and investors talk about mean reversion, effectively they are thinking about events which will eventually return to the same situation or scenario as the starting point.
Probabilities and correlations are dynamic and constantly changing. Relationships that hold tight today might look completely different in a year’s time - probabilities and correlations are therefore typically not as dynamic as the relationships (linkages) they are seeking to predict.
Edward De Bono might argue that it helps to distinguish between vertical and lateral thinking.
De Bono expands on this:
“Logic is the tool that is used to dig holes deeper and bigger, to make them altogether better holes. But if the hole is in the wrong place, then no amount of improvement is going to put it in the right place. No matter how obvious this may seem to every digger, it is still easier to go on digging the same hole than to start all over again in a new place. Vertical thinking is digging the same hole deeper; lateral thinking is trying again elsewhere…..
…..Oilmen do not perhaps find it so difficult to appreciate the paradox that sitting about deciding where to dig another hole may be more useful than digging the same hole deeper. Perhaps the difference is that for an oilman, digging costs money. But for scientists and industrialists, not digging is more expensive…..” Edward De Bono – The Use of Lateral Thinking
De Bono takes the above example further. He says that a vertical-thinking scientist researches where a hole should be dug, then proceeds to instruct how to dig the best hole. After it reveals no oil, another lateral thinking oilman proceeds to dig a series of random holes, until one of those holes discovers oil.
The vertical thinker then goes on to explain why that particular “lateral” hole delivered oil.
According to De Bono, vertical thinkers tend to hold on tightly to dominant ideas, whereas lateral thinkers hold onto ideas more loosely, and allow changing circumstances and situations to change their way of thinking.
Marconi was told that because radio waves transmit in a straight line, the curvature of the earth would make it impossible to transmit waves across the Atlantic. There is a clear linkage in the relationship between the curvature of the earth and the direction of radio waves. But the sequence of his experiment proved very different – the ionosphere of the earth reflected the radio waves back to North America. While it could be argued that neither party was wrong, there was a further linkage that existed that sceptics were not aware of (neither was Marconi for that matter).
In Liaquat Ahamed’s excellent book, “Lords of Finance”, the author explores the linkages between the four major economies of the world following World War I, as well as the sequences of responses as three of those economies sought to reconstruct (Germany, the UK and France,) while the fourth ended up in an asymmetrically stronger position (the US).
Prior to WWI, those four economies held nearly all of the world’s gold reserves equally between them, roughly reflecting the respective sizes of their economies, as well as their respective adherence to a gold standard of currency management.
While the economic linkages were self-evident, the sequences of events were far from predictable, which in turn altered the respective linkages between those economies.
By the end of the war, the US held almost 80% of the world’s gold reserves, as the other combatants borrowed heavily against theirs. This created a new set of challenges for each central bank, and their respective responses drastically altered the economic relationships between each other for several generations (Germany completed its WWI reparations on October 3, 2010).
While the three European countries borrowed heavily from the US to finance their respective war efforts, their post-war policy responses differed enormously. Germany for example, chose to inflate away the heavy war reparations imposed on them by the victors, leading to the Weimar hyper-inflation of the early 1920s.
Britain, on the other hand, chose a more austere approach, wanting to preserve its status at the time as the world’s financial and banking capital. Accordingly, it restored what at the time was a disinflationary gold standard, one that led to severe unemployment and diminished global economic competitiveness. France’s policy responses were somewhere in between, and in the early 1920s saw much of the gold they traded during wartime financing come flooding back into the country (at least for a while).
In due course, the three European nations settled their respective debts to the US at various amounts. The UK went first at 80 cents in the dollar. France went next at 40 cents in the dollar, and Germany eventually at 25 cents in the dollar. So, linkages led to a variety of sequences, and those various sequences again altered the original linkages.
In the recapitalising of Germany, US banks lent very aggressively to them on more favourable terms than they could lend within the US. The Federal Reserve did not stand in the way of these capital flows, as they believed their excess gold holdings of themselves could cause a monumental credit boom within the US (this eventually happened in the late 1920s as capital flows and interest rate policies again changed between the four economies). The problem for Germany was that much of this capital flow was short-term in nature, and therefore unstable.
French capital, especially gold flows from the US, were also redirected into Germany, which prompted cynics at the time to compare such investment to the French capital flows into Tsarist Russia prior to 1914.
The United Kingdom, as well intended as it was, could not maintain its mantle as global financial capital, ceding its pre-WWI status to New York.
It is easy to look back on this period between the wars as a very unstable time, and while none of the major four economies wanted to re-engage in combat, many policy mistakes were made that had major economic consequences in the face of good intentions. (That is not to say there were not “robust discussions” between the powers).
As the 1920s rolled on, the sequence of events through that time revealed a number of linkages that were difficult to maintain, as those European economies had differing challenges. At a private meeting of the four central bankers in 1927 in New York, the Head of the Bank of England, Montague Norman, wanted his US counterpart, Ben Strong to lower US interest rates in order for the UK to increase its relative competitiveness on its self-imposed draconian gold standard. The French wanted things to remain pretty much as they were, and the Head of the Reichsbank, Hjalmar Schacht, wanted capital controls on the flow of easy money into Germany, which he feared could never be repaid.
One of the key lessons from seeking to understand the importance of that time in history, where linkages were changed irrevocably by sequences, is that there are certain periods in history where sequences matter more than others, and alter history. There is mounting evidence that we are in the midst of an era where sequences matter more than they have for many generations.
The situation of the 1920s has more than a passing relevance to today. Niall Ferguson wrote on December 14, 2020:
“In advanced economies public debt relative to output has increased as much since the late 1970s as it did between 1914 and 1945. Together, the global financial crisis and the pandemic have had roughly the same doubling effect as World War II.”
He further says
“The pandemic’s financial cost also looks similar to a world war.”
Remembering that Germany chose inflation, the UK chose deflation and they both ran into economic difficulty (France, choosing a middle ground, was not spared longer-term economic fallout).
He goes on to discuss US fiscal policy:
“Fiscal policy can support growth with ongoing deficits as long as real debt service (i.e., interest payments adjusted for inflation) does not rise above 2% of GDP over the coming decade.”
Developed world central banks are intending to create inflation with a very blunt instrument, being more public debt, and however successful they may or may not be, there will be a new set of sequences that will alter existing relationships and economic correlations.
Ferguson adds the following;
“Even so, my Hoover Institution colleague John Cochrane has history on his side when he expresses concern. As he argued in the National Review last week, the situation is very different today from the situation in 1945, the last time the US had a debt mountain this big. By 1945, the war and its spending were over. For the next 20 years, the U.S. government posted steady small primary surpluses, not additional huge deficits. Until the 1970s, the country experienced unprecedented supply-side growth in a far less regulated economy with small and solvent social programs. … [Today] we are starting a spending binge with the same debt relative to GDP with which we ended WWII.”
To give an idea the contrasting starting point today, in the US, for example, economy-wide debt to GDP is 370%. Ten years ago it was 350%, and twenty years ago it was 265%. Thirty years ago, 227%, forty years ago 158%, and fifty years ago it was 144%. Unlike in 1945 where the spending binge stopped, it continues to increase unabated (Source: David Rosenberg). First and foremost, the effectiveness of the credit multiplier is diminishing as debt increases, whereas within five years of the New Deal, the US budget was back in balance, and Roosevelt did not during that time run a deficit exceeding 7.5% of GDP (last year it was in the order of 20% of GDP).
So why is it so important to understand the post-WWI landscape today?
Because back then, the major economies all traded with each other outside of wartime. When the United States was engaged in the Cold War with Russia, there was little trade between NATO and the Warsaw Pact countries. This is in stark contrast today, with the relationship (ie. linkages) between China and the US far more complex.
When the world is re-evaluating the advantages of “just in time” inventory management systems compared to “just in case” inventory management, some clear challenges for these governments and central banks are laid out below.
This first chart is interesting for a number of reasons. For most of the past 25-odd years, in concert with the greatest bond bull market in recorded history, China has been exporting deflation to the rest of the world, through cheapening the global supply chain. Not only has that changed since the COVID outbreak, but China’s credit impulse is turning downwards:
…at the same time as the Federal Reserve’s balance sheet has expanded to an unprecedented $8.1 trillion (see chart below). Remembering that in 2009, the Bank of China played a significant role in reviving the global credit system. Now these sequences have changed.
It is important not to understate the size and prominence of passive/index investing in today’s investment landscape. When China was expanding its credit system in 2009, providing a “shock absorber” to the global financial system, passive investing comprised around 10% of US equity investing. That total is in excess of 40% today, together with China’s credit impulse now going in the opposite direction (source: Michael Green). At the same time, the amount of algorithm trading since 2009 has exploded.
Added to the unprecedented levels of global debt, these changed linkages mean that it is much harder today for markets to re-set themselves. There is an increasing amount of global capital that, in the event of a crisis, would be a victim of selling begetting selling.
So, global supply chains are likely to be in a secular reconfiguration phase, at the same time as;
- The Fed’s balance sheet is at unprecedented levels
- Global deflation is no longer being exported by China
- Credit conditions tightening in China, as opposed to 2009
- Passive investing and algorithm trading at unprecedented levels
- Banking and finance is a much larger component of the global economy than it ever has been, and has never been more concentrated and interconnected
- Developed world interest rate policy starting the next economic phase at zero and negative levels
- Food and energy prices rising around the world
- And at some point, retirees might need to draw down capital (sell assets) if interest rates remain near zero
- Any “on-shoring” of reconfigured global supply chains could be viewed as a variation of capital controls
- As bond yields around the world have gravitated on either side of zero, benchmark bond indices have dramatically increased in duration due to increased debt issuance – this cannot normalise without disruption
It is a very different mix of linkages today, and the next sequence of events will be telling.
In terms of cyclical valuations, there is much commentary that can be accessed. However, the following chart reveals the number of S&P stocks that are trading in excess of 10x sales:
Added to this, and despite the zero interest rate policy of the Federal Reserve (and other central banks), approximately 30% of the US Russell 3000 Index constituents cannot cover their interest payment obligations with earnings, rendering them “zombie companies”. Until now, corporate profitability could be assisted reasonably quickly by lowering official interest rates. Now that fiscal policy is the dominant instrument of governments around the world, such profitability stimulus is slower and less precise - another linkage that has been changed by the sequence towards zero interest rate policy now being largely exhausted.
Policymakers continually seek the path of least resistance. That is, seeking to resolve economic excesses at the cost of minimal economic pain. Niall Ferguson expresses in very simple terms how easy it is to become trapped by such an ideal:
“The problem is that for there to be a free lunch, financed by borrowing that pays for itself, secular stagnation has to continue: in other words, interest rates have to stay at their present low levels, which isn’t what the CBO [Congressional Budget Office] expects. In its most recent long-run forecasts, nominal and real rates rise over the course of the 2020s. That means that net interest payments would rise above 2% of GDP from 2030 onward and hit 8.1% in 2050.”
In other words, governments and central banks need circular linkages and circular sequences to succeed, where debt levels continue to increase through ongoing deficits (unlike the post-WWII environment of small surpluses), higher inflation and borrowing costs that remain no higher than 2% of GDP in real terms.
If the interests of the major economies are aligned, the economic challenges today are still great. Even though it was in everyone’s interest to resolve their economic differences in the 1920s, it could not be achieved because their problems and challenges were different, and it proved impossible for the leaders at the time to create a set of sequences which preserved the relationships and linkages that existed at the time.
That is to say nothing of the challenging geopolitical environment of the time.
Each cycle varies in terms of idiosyncrasies and amplitude. But sequences do not always revert to the mean. Linkages are becoming more complex as time goes by, due to technological advancements and globalisation. It is unlikely that the next phase of financial history will be circular or mean reverting. Global debt is too large to be resolved in an orderly fashion, just as it was in the post-WWI era (and the numbers are several quantum’s larger today).
This will require a different mindset to grasp and understand that which might seem intuitive.