3+1 Baby Black Swans for the end of 2022
Preparing for the unknown
Each year I review my experience gained in the the prior twelve months and adjust the way I work. This year I learned a lot, unwillingly I might add, as the market downturn was worse than expected, setting records that go far back in history. We had a rare visit from the mother of all black swans. Actually, we didn’t have just one black swan, we had (and still have) a flock of them flying majestically above our heads.
You cannot argue with the statement that a black swan event will at some point in time. The problem is you don’t know when. Can you prepare for it? If I learned something from the last pandemic and the Ukraine war is that you can guess the unknown better if you keep track of emerging threats. Of course, you have to see the emerging threats first, but once you see them, make them your constant concern until they are understood and resolved.
I say that from personal experience: I started the new year by placing a post-it note on my monitor that said “Ukraine” as a reminder for me to prepare for a potential conflict. The post-holiday drag and the January market swings erased the sense of urgency I had earlier. I had a hunch, and yet when the conflict finally arrived it found me unprepared.
I promised to myself that I will not let that happen again. The least I can do is to formulate a few ideas describing potential emerging threats and make the tasks of reading and research activities about them part of my weekly routine, work habits. One of these habits is to write about the emerging threats with consistency and perseverance. If the threat pattern changes, so will the list, and consequently my focus. I will adjust once every six months if necessary, unless something drastic happens.
To be clear, I am not trying to predict what will happen, but think about what could happen. In doing so I have a chance to overcome my own bias and tendency to stay anchored into the idea of a continuous and linear world. By actively examining the list of the emerging threats, I am consciously challenge my rational beliefs, and with a bit of luck, save myself from my own biases.
We can often see emerging threats, but we don’t always act on them. Sometimes we see them in numbers, other times we have a gut feeling that something is not right. Nothing clear, but definitely detectable. For instance, in the last days of April last year while I felt the dopamine injected by the jolt of winning, I knew the market will have to fall. I wasn’t worried though. The worst pandemic since the 1918 Spanish flu didn’t make me anxious, except for a bunch of apprehensive days in early 2020 and occasional episodes that wouldn’t last more than a day or two, mostly caused by lack of sleep. Trying to stay up to date across global markets amidst unparalleled events that no one living person ever experienced can be exhausting. Lack of sleep can make you edgy without reason.
Take inflation as an example of an emerging threat. I watched Druckenmiller’s interview on CNBC in April, I think, in which he expressed his concern the Fed is ignoring the threat of inflation at great peril. I absorbed the reasoning, but I wasn’t worried because I believed that Fed will take action if things got worse and the reason for its inactivity must be based on facts we don’t see, but they do. The voices of concern multiplied, yet the Fed did nothing, and neither did I. Big mistake on my part. That baby black swan was right there and I was just staring at it. We should add a new phrase to our lexicon: never trust the Fed. Don’t fight it, don’t trust it. They are as fallible as us mere mortals.
I treated that episode as financial news. In contrast, Druckenmiller treated it as a substantial emerging threat and he acted on it. My view of the markets only started to change substantially in December 2021 when data started to paint a dark picture.
Morgan Stanley chief equity strategist Mike Wilson’s bearish forecast started to gain adopters late in the year, but not enough to stop a big rally early in January. Despite the evidence, the inflation threat has changed its status from emerging to present danger in slow motion. After his re-nomination, Jerome Powell suddenly changed his public stance, and everything started to really go down in a way that made people think of the Great Depression again. What the Fed doin’?
Another example of an emerging threat, is the war in Ukraine. As expected, the worst military secret in history came to the fore and Russia invaded Ukraine. The end of February and March were the most agonising months for me, mostly because of the brutality of Russian conduct in Ukraine. The way the operation has been conducted and the blatant disregard for truth and human life made me realise that we are in for a different kind of challenge. At the same time, while the course of the war is hard to predict in detail, the impact on Europe is something that can be subject to methodical analysis and strategic preparation. This is still an emerging threat. There are many aspects of this unravelling conflict that should be considered as part of the strategic toolset of an investor.
What are the emerging threats?
The emerging threats are like baby black swans. They may look like standard baby swans, but you only get to see how dark they are when they begin to mature. It is worth trying to identify the baby black swans even if you are wrong. It builds the skill of discerning signals in a sea of noise.
We still don’t fully grasp how significant are the changes brought by the pandemic. It is not clear yet what are the consequences of the rewiring of global supply chains which started when many countries realised how big is the risk of relying too much on China’s manufacturing hubs in a time of crisis. Wasn’t that a wise thing to do, when you see the far reaching economic implications of the zero covid policy in China today?
From an investment perspective there are always two fundamental imperatives to consider: identify the opportunities to help you identify winners, and threats to help you calibrate restraint (aka cash ratio). These two imperatives are two sides of the same coin. The most important concern is that of the threat. If you don’t know the risks, opportunities don’t matter because you may have no money left to put them to work.
I don’t care that much about the short term volatility, but I care about direction. Predicting with high confidence is impossible. However, I can try at least to find direction by identifying key emerging threats, classify them and use them as zonal markers for investment decisions.
The Baby Black Swans
Below are compact descriptions of those threats that could have major impact on large portions of the financial markets.
Baby Black Swan #1: Russia’s dark enterprise
To paraphrase Basil in Faulty Towers, most financial media outlets like CNBC rarely mention the war. The ramifications of the Ukrainian invasion which seems to run its course on a steady rhythm of destruction with diminished interest from the media are felt throughout Europe even in absence of a serious escalation. The winter will arrive in a few months in Northern Europe causing an economic shock in EU that will be felt around the world. To what degree, that is to be seen.
The Russian gambit is desperate. There is not going back, there is no scenario on Kremlin’s war game in which Russia will lose the occupied territories in Ukraine. If that happens, the grandiose strategy will collapse with dire consequences for Putin’s entourage . One thing we learned from the “special operation” is that Russia is willing to do anything no matter how brutal, horrific and dishonourable. That is why I consider the Russian aggression as an emerging risk with potential catastrophic consequences. Russia is far behind technologically compared to the West, and but it has an unparalleled skill at building malignant alliances around the world with governments with similar tendency for using repressive methods.
Final note on this point: Putin’s removal will cause another mayhem. Positive, but mayhem nevertheless. The toy shop must be re-organised. Again.
Baby Black Swan #2: China’s stability
China’s wolf diplomacy with its most aggressive tone at the peak of the Covid pandemic crisis in the first half of 2020 caused many countries to re-think their relationship with China. For the first time, the G-7 and the EU officially labelled China as a “challenger”. Taiwan problem elicits bellicose reactions from China each time another country treats Taiwan as an independent state. The problems arising from a Taiwan conflict are impossible to predict, but it is a well known and feared black swan. I will not discuss them here.
China is not like Russia. Its economic achievements have been astonishing, but what is the most impressive it’s how connected is the economic world of China with the rest of the wold. China has embraced the standards of the developed world not only for competitive reasons, but also because the newfound freedom in the post 1978 era has unleashed a huge creative and productive energy. In stark contrast to Russia, China is the world’s manufacturing hub. Its production capability has been so competitive that it made alternative manufacturing options redundant, thus causing the major supply chains to become dependent on Chinese producers. The pandemic exposed how critical and risky this dependency is.
The forces that propelled China to the top of the world are being challenged by forces of opposite effect. China has undergone a clear political change under Xi Jinping who gradually rebuilt the power and influence of CCP to pre Deng Xiaoping era marking the transition from a quasi free business environment to a vertically controlled decision making system subordinated to political imperatives.
There are three key developments that carry with them an enormous risk: 1) Consolidation of power under Ji Jinping entering a more tense phase of conflict with those opposed to it, especially on the subject of record youth unemployment 2) The private enterprise made subordinated to state enterprises with large consequences on productivity and innovation, 3) The collapse of real estate followed by a deep economic crisis.
The month of October will be moment of historical importance for China, regardless of whether Xi Jinping will be re-elected or not. Two roads are diverging for China and choosing one against the other will make a huge difference. The choice will show which forces have the upper hand at this point in time: political or economic.
Baby Black Swan #3: Mass unfulfilled aspirations
One of the social media’s benefits is spontaneous communication at scale. News travels across the globe like fire spread by influencers with large followings and individuals with sparse connections.
Information that may or may not be true, that may or may not be well understood touches people connected to their own social network triggering reactions shaped by their own inner perspective and situation. The outcome is the generation of a multitude of waves that spontaneously move many people, waves that join or clash, without the assistance of any organising force.
The way people think of their own career is marked by this medium, which in turn affects the labour market, sometimes in unexpected ways. Who would have thought the pandemic will be the catalyst for the Great Resignation? One can argue that this is the result of government generous assistance, but I believe that played only a small role.
I explained in a bit more detail how the workforce has changed in an essay on the incoming intelligent robots (the essay discusses potential scenarios around the Tesla Bot, it looks sci-fi, but it is not). Recent developments caused by the accelerated inflation and Russia’s invasion of Ukraine, or China’s zero Covid policy, show that people around the world expect to live better in a more equitable society with a sense of impatience.
Decades ago, this feeling of injustice was bottled into personal vessels of life, mostly kept private, but now this view is often expressed online hash-tagged in large social aggregates which occasionally could create influential and disruptive trends.
In free societies with high social mobility, people at the lower end of socio-economic ladder, with the aid of fortunate circumstances, were able to move up through arduous effort, individual motivation. Today, in the same societies, there is an increased expectation that social mobility should be virtually regulated by the government with the effect of top-down equaliser.
Some would argue that the government intervention will diminish the promotion based merit, while others would argue that without government many of those who merit don’t have the chance to be promoted. This is a social experiment impossible to accurately test and compare, as with each evolutionary step the system changes irreversibly.
No one knows what is the best way to move forward, but something will change, and that change will big, and not be limited to the Western world. Despite the re-shoring trend and a fragmentation into competing global alliances, for the first time in history people around the world find themselves together, in the same space, increasingly aware of each other. Also, for the first time, life aspirations are open, connected, interdependent.
Leaders who don’t read these signals will pay a price, but at the same time, we can all pay a price if we don’t get things right. These aspirations can magnify significantly in volume and if they they are left to grow unfulfilled as they tend to become movements with unintended social, political and economic consequences.
Baby Black Swan #3+1
This extra baby black swan is crazy, but possible. I want to keep it on my pay-attention list.
Imagine a a power, capable and motivated, with access to advanced artificial intelligence technology, possessing a strong ideological system ready to be activated across the most efficient communication infrastructure in the human history, starting to execute a plan of world domination.
I am not referring necessarily to one particular country, despite the obvious actor in everyone’s mind. One has to remember, that one of the largest empires of all times originated in Mongolia started by one person who relied on no preceding historical tradition. It takes one genius to do it all.
I am referring to the possibility that AI, mixed with metaverse and IoT and edge computing and CGI could be used in conjunction with military means to control large segments of populations. If the current social media platforms could be used to influence opinions to the degree witnessed recently, imagine how powerful would be the impact with these technologies in a medium that mixes print, video, standard 2D online and 3D metaverse with haptic properties.
Powerful innovations promise a better world, if they are used well. Thanks to the technological revolutions and spread of democracy we get used to positive advances. The difficulties that we have overcome made us confident in our future. Yet, I sometimes have an ambivalent feeling about the computational power that increasingly empowers semi-autonomous networked devices and systems.
It may be that we simply go through another cycle of progress, and all these fears will prove to be unfounded, just like those before us, but it also may be that we are on the verge of a crucial test. It is hard to see the difference early on. Rome went from strength to strength with each crisis, until it didn’t when very few suspected the death of the empire is just about to happen. Arnold Toynbee called our confidence in survival “the mirage of immortality”:
“IF we look at these universal states, not as alien observers but through the eyes of their own citizens, we shall find that these not only desire that these earthly commonwealths of theirs should live for ever but actually believe that the immortality of these human institutions is assured, and this sometimes in the teeth of contemporary events which, to an observer posted at a different standpoint in time or space, declare beyond question that this particular universal state is at that very moment in its last agonies.”
— A Study of History: Abridgement of Volumes VII-X (Royal Institute of International Affairs) by Arnold J. Toynbee
Looking from the inside is hard to determine what stage we are in: is it the beginning of a deep fall, like WWIII, or just another climbing step on the wall of worry.
Listening, watching, reading the signals, understand and decide what to do when nothing is certain, always surprising, is what makes investment so amazing.