3 Big Structural Forces To Watch: Tech Cold War, Diesel Car Collapse, Liquidity Illusion.

I recently gave a speech on 3 key themes many investors are neglecting . Here’s the summary:

1)      US-China tech cold war. The essence is that the US establishment led by the US Department Of Defense (DoD) has deemed China’s tech development as a national security issue. The view has been publically articulated by US Vice President Mike Pence in his  Hudson Institute speech last October, where he talked about “using stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale”. Meanwhile, the DoD’s venture capital unit, the DIUx, has described in a white paper that a key dimension of China’s technology transfer strategy is to invest in US start-ups, which had to be curtailed. On top of all of this, Congress has taken an increasingly hawkish stance to China.

Ironically, this leaves the US President Donald Trump as the China dove in contrast to the hawkish establishment. Trump’s focus is more on trade tariffs and stock market performance, rather than the multi-decade technology strategy that the DoD/establishment is taking. The full implications of this are difficult to determine, but at the very least Chinese funding of the US (and possibly European) tech sector will be heavily curtailed, and the roll-out of 5G infrastructure could be complicated. It also means that Trump-related news on trade is not the thing to focus, but rather the implementation of the strategic view by the establishment (DoD, Congress).

2)      War on diesel cars (and environmental policy). Climate change is here whether one looks at extreme weather patterns, societal awareness or the shifts in government policy. The battle-ground is currently around cars – diesel cars are bad, electric cars are good. Europe is in the process of rolling out policies at the national and city level to curtail the use of such cars.

This notably impacted Euro-area growth last year through protests in France and cuts in auto production in Germany. The trouble with such policies is that it runs counter to the concerns on inequality. Raising the environmental standards of products, especially cars, makes them more expensive, which in turn hurts the lower income segments of society.

The political scientist Ed Luttwark wrote an excellent article on this in 2017 to explain the rise of Trump. He argued that years of new regulations under Obama had made new cars out of reach for many, who then either had to do without cars or buy older lower quality cars. And given poor public transport options, not having a car, severely hurts the ability of the poor to get to their jobs (or to move to other jobs), especially in the US. 

The yellow vest protest in France, around introducing a tax on diesel cars, is another expression of this. It waes a tax on the poor, just as President Macron removed the wealth tax on the rich. Whether Europe continues to push this line without measures to support the poor, could determine the fate of various populist movements as we enter European election season.

Before one thinks that it is better to give up on environmental policy, we know that without adequate climate change policies, there are poor responses to natural disasters, which typically hit the poor (who are less mobile). This would lead to lower potential growth as investment gets directed to fixing old infrastructure. Moreover, transitioning to a less carbon intensive economy could create new types of jobs, which could provide a boost to the economy.

3)      It’s the liquidity cycle , not the credit cycle,  that matters. While there has been much focus on a credit crunch, defaults and recessions, many could be missing the bigger story. We have to remember that the next crisis will not look like the last one. Indeed, the 2008 financial crisis was very different to the dot-com collapse or the Enron credit unwind, and the 2012 European sovereign crisis was very different to the 2008 financial crisis.

Today, many are looking for a repeat of the European crisis or the 2008 financial crisis or even the China 2015/6 crisis. Instead, the bigger story could be unravelling of the market liquidity illusion. Put simply with the rise of electronic trading, the disintermediation of banks and the presence of central banks in financial markets, the structure of markets has changed and there is an apparent endless supply of market liquidity. That is, it seems easy to buy and sell any asset – spreads are tiny and counterparties are falling all over each other to provide prices.

The trouble is that central banks are slowly withdrawing their bid for risk assets, political risk has increased and electronic trading algos disappear when market volatility spikes. That’s the recipe for flash crashes. We saw it with the collapse of USD/JPY at the start of the year (how can TRY/JPY move USD/JPY?!) and we saw numerous instances last year from the VIX spike to the absence of Italian bond bids after Italian elections.

The way market microstructure has evolved is that in “normal” times liquidity is abundant and much better than when humans were price makers, but in “abnormal” times liquidity disappears as algos don’t trust each other, which results in flash crashes. The challenge for markets is to correctly price liquidity premium on all assets, which is not an easy task. It also means that market moves could be less reflective of the credit cycle (or business cycle) and more a repricing of liquidity. This suggests that we need to be wary of connecting price action to economic fundamentals. 

Anyway, these are my evolving thoughts and I’d love to hear what you think.

Bilal

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