Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. - Marko Papic, Geopolitical Alpha
I read the incredible 270 pages of Marko Papic’s Geopolitical Alpha in just three sittings over the holidays. It was refreshing to be so engrossed in a book after a long time of skimming or reading random bits and pieces of recommended reads that I never became addicted to. I started reading the book as I was working on Opus 10, the first part of this series, and the timing could not have been better. As quoted above, Marko’s framework provides clear signage as to where we are headed from here in regards to the new paradigm of capital. It was certainly fun to read the following passage from the book, which reinforced my stance, almost verbatim:
When all is said and done, decades from now, investors will look back at 2020 and realize that it was the beginning of a new paradigm. The most important macro chart of 2020 will not be the epi curve of COVID-19, but rather Figure 8.12, a chart that visualizes the transition from the Washington Consensus to the Buenos Aires Consensus:
The first part of this New Paradigm series was an explanation of the things we see today both in the public and private markets, along with the economist’s concern and the technologist’s reasoning for this new era. But, the present is only second to the past in its uselessness for investors. What has happened and what is happening is little concern to capital. The future is what we really care about, and the policymakers will unilaterally drive the future of capital, its availability, cost, and mechanics. The days of laissez-faire markets are coming to an end.
Constraints Matter, Policymaker (and your) Preferences Do Not
Policymaker incentives have been up for debate since the beginning of representative democracy. The only well-argued conclusion I have heard and agreed with is that policymakers are incentivized by reelection. Financially, this aligns with the best outcome for the policymaker: the longer a policymaker is in office, the more senior their compensation becomes and the more lobbying, speaking, etc., relationships they can garner. Being a bit less cynical, the longer they are in office, the more policy they can put in place and actually do what they said they would do, a novel idea for most. I have yet to meet or hear of a policymaker that has said otherwise to the above. I doubt there is one out there that wants to only be in office for a single term and would do it on a volunteer basis.
With that in mind, policymakers, both those within the government and those within the monetary bodies, are incentivized to make their current constituency as happy as possible. Note the bolded “current” text in the previous sentence. Academics, economists, and “rational” pundits can say certain policies are detrimental to the future people - i.e., kicking the fiscal debt down the road. But, policymakers have no regard for the future constituents, and neither would you if you were in their position. Policymakers must cater to the needs of the current populations.
Therefore, their constraints are well defined: policymakers are constrained by their current constituents' wellbeing and will enact policies that do just that.
You can see this in action over the last few financial crises. The capital responses have had a single direction of evolution towards more involvement. Volker selected the interest rate lever in his inflation battle but left money supply and liquidity alone. Bernanke paired the inflation lever with the QE hammer in 2008 during the financial crisis. Jay Powell has now utilized both those tools at more extreme levels and moved into new territory with the emergency Fed lines, ETF purchases, and other novel ways to support the financial markets and, arguably, the broader economy. So far, these actions have been applauded, and Jay Powell has been seen as one of the successful policymakers. The reaction to the next financial crisis will include mechanisms we haven’t even thought of yet.
So far, this has shown no signs of stopping even in the current crisis as politicians are already pushing the narrative around even more upside on stimulus:
And even the monetary policymakers are crossing the line into fiscal activities:
Unlike most crazy things, this is not just an American thing. Marko provides a more colorful description of the evolution across the pond:
When it comes to the ECB’s economic Band-Aids, looking back at the Euro Area crisis from the the thick of the COVID-19 pandemic is like looking back at the medeval Europe from the twenty-first century. Draghi’s successor, ECB President Christine Lagarde, is not just using a bazooka.
She is throwing in the kitchen sink, a clawfoot tub, and all sorts of other household appliances at the economy. Within days - not months or weeks - the ECB crossed any remaining lines that may have existed on the use of unorthodox monetary policy. And with the Macron-Merkel consensus on a mutualized fiscal backdrop, the EU has crossed the ultimate red line.
Applying Marko’s constraint framework here provides a clear picture of the road ahead of us. According to Geopolitical Alpha, policymakers operate under the following constraints: political, economic, geopolitical, legal, and temporal. These constraints, not the policymaker’s preferences, are the most powerful forces in the world.
Politically, I explained above the incentive structure that policymakers, which are all politicians by definition, are constrained by.
Economically, a similar pattern emerges. All policymakers must react to situations that are best suited to the economic wellbeing of the current population. Future constituents do not vote today. Additionally, policymakers are humans too, and they will naturally act in their best self-interests.
Turning to geopolitics adds a layer of complexity for monetary bodies that are supposed to act independently in relation to their domestic fiscal counterparts and their international peers. In practice, this does not happen as the world's economic centers are participating in a never-ending dance. The two largest monetary bodies, the Fed and the ECB, communicate regularly and enact policy together. The US and EU sit in unique positions in that they both issue debt in their own currency. Most countries do not have this luxury, and they must issue debt in dollars, euros, and yen. All of which they have no monetary control over. The MMTers will immediately raise their hands and point to how powerful, and arguably limitless, this makes the US debt and, therefore, government spending. We can create the money we pay back our debt in.
As Marko illustrated above, the legal constraint in this context is weak and usually can be ignored in practice. New laws are usually contested on their way in and easily move out of the way in the time of crisis. Look at the FASB-157 ruling during the financial crisis, which was restructured within days as a way to save failing banks. In the last year, the Fed has mostly ignored existing laws and congressional guidance in its effort to keep the markets afloat.
Finally, the constraint of time sits across all others. Policymakers operate within their current term, which is short on the scale of economies and longer-term cycles.
I often think back to a dinner I had with a prop trader friend of mine in Chicago. In his mind, his job was not to predict events, it was not to even react to those events. His job was to move to the third-order effect and try to predict how others, including the market and the policymakers, would react to events. We saw this across the board in 2020. The biggest down and up days in the equity markets were not the days of the highest Covid deaths or infection rates, they were the days that the Fed, Treasury, or other stakeholders announced their reactions to the Covid numbers.
This is known as an upside-down market, as Jesse Livermore of Osam puts it:
An upside-down market is a market in which good news functions as bad news and bad news functions as good news. The force that turns markets upside-down is policy. News, good or bad, triggers a countervailing policy response with effects that outweigh the original implications of the news itself.
Most investors are familiar with upside-down markets as they exist in the context of monetary policy. Bad news can function as good news in a monetary policy context because it can cause central banks to lower interest rates. If the boost from lower interest rates outweighs the negative implications of the news itself, then the overall effect on the market can be positive.
The Future Effects
What does this new era mean for the future of the everyday economy and financial markets?
Starting with the economy, especially the consumer-driven American one, consumption will continue its dominance as an economic driver as fiscal stimulus continues. The government will outsource its spending with the direct stimulus it is providing to consumers and companies. People in my personal circle laugh off the potentially negative implications of direct stimulus checks in the grand scheme of things and are already asking about the next one. As I called it in Part 1, this addiction will not go away, and the policymakers will need to continue feeding it.
Switching to the markets, how does this endless flow of capital drip down to different investment ecosystems? The continuation of the Fed’s drip of QE-based capital into the bond markets will create additional trillions in liquidity and risk-taking will increase because of the buyer of last resort being present. As credit yields somewhat recover with growth from the stimulus, the Fed’s indefinite place in the market will allow buyers to adjust spreads permanently.
Moving to equities, cheap leverage, more liquidity, and a new buyer of last resort will further push valuations. In turn, private market investors will be comfortable in their comps and continue to fund companies within and even beyond the status quo of the last few years.
The divergence from reactive capital to the new paradigm of proactive capital began at the start of the Trump presidency, as shown below with the fiscal budget balance diverging from the unemployment rate, it will continue to widen from here:
For capital allocators, this means a Roaring 20’s. It will be a jubilee unlike any seen before because of the floor that has been put in by policymakers. Holding cash will be criminal in the eyes of the monetary bodies. The narrative around shorting will become “anti-American” much as it has in India, and rational investing will be outsmarted by irresponsible risk-taking.
Marko provided similar thoughts on how to act in this new era:
The answer right now is to be irresponsible. Being responsible is precisely what policymakers are looking to punish. That’s the irony of today’s moment. The only way to profit from it is to throw out precisely everything we learned from our profs. The first step is to lever up.
After reading Opus 10, many people may think I am a perma-bear after my extended rant about the monetary landscape as it stands today. I want to readjust that potential view. As mentioned in the original post, from an economist’s perspective the new paradigm of capital - that is, the uncapped capital supply being provided by a cooperative force of both fiscal and monetary bodies - is scary to any Friedman believer and probably most Keynesians even. But, it is something that is happening regardless.
I, much like Marko in his book, take a stance of nihilism. I can opine on the potential dangers of this new shift in money creation, distribution, and interaction, but it would be about as effective as me talking to a wall. A single market participant like myself has little to no effect. I am nowhere near popular enough (yet!) to have a following large enough that subscribes to my belief system to make a difference either. A more appropriate use of my time would be to identify the constraints within which policymakers will operate and adjust my opinions, and therefore allocations of capital and time, on what will happen, not what should.
It’s a Bubble; Everything is a Bubble
Anyone can point to fundamental data and assert how things must converge back to reality - and more than enough people have done this. But reality and price are two very different things. The reality (I will reference Opus 8 here where I argued that there is no such thing as “reality” both within the financial sense and narrative sense) can be shrouded by the policyholders that must support price to make their constituency happy. Usually, time is the force functioning mechanism that makes reality and price converge. But, that clearly has not happened. Or, maybe, we have to make a readjustment to reality.
For the bubble believers among us, it is important to understand that bubbles sometimes pop in reverse order than one would think. Corry Wang notes that in the 2001 dot com bubble, the market fell 9 full months before fundamentals started their degradation:
When the equity cost of capital is incredibly low, companies can continue to fund growth with it, and they will be encouraged by the market. Pile on the fact that capital allocators must allocate and you get a limitless faucet. Fundamentally, the revenue growth will continue for consumer companies as stimulus continues to enter their wallets, as argued above. It will continue for B2B companies because of the feedback loop of cheap capital - B2B customers are just other companies that can raise cheap capital to fund growth and expenditures.
Reflexivity works in the opposite direction too. If the policymakers can artificially keep markets and the economy afloat, participants will be able to take risks. The payoffs from these risks (entrepreneurship, CapExp projects, hiring, etc.) will allow fundamentals to eventually converge with the markets, providing a safe escape for the policymakers to drop out of the market. At least, that is their plan.
Upside-Down Markets - Jesse Livermore (an anonymous alias) of Osam wrote this incredibly in-depth, 100-page exploration of the markets today. If anything in this New Paradigm series has been interesting, I highly recommend taking two hours and reading this document.
Gresham’s Law, a finance concept which states that bad money drives out good money until only bad money is left. Gresham’s Law can explain why the median consumer reads low-quality information online. On the Internet, low-quality content drives out high-quality content, as the most wide-read articles are polarizing and emotionally jarring. First, they distort the truth by eliminating nuance and adding emotional charge to important topics. If you check almost any major publication, the most popular stories are opinionated and fear-inducing. They draw us in because they sway our base-level instincts in irresistible ways.
Today I wanted to focus on Fabrizio Paterlini, one of the great modern composers of today. I have fallen in love with his music and its simplicity. The quality of his instrumentation and recording is also tangible which is a rarity today.
A few of my favorite pieces: