Most nation states are fairly rational actors. Iran. North Korea. Even Libya under Qaddafi and Iraq under Saddam. These are not the kinds of regimes I would like to live under. But they are not irrational in their foreign policy agendas, either. Don’t mistake what a head of state says for what that state will actually do. Even the most vile, tyrannical regimes are first and foremost concerned with self-preservation. It isn’t in their interest to start wars they can’t win.
What they are solving for is the optimal mix of shenanigans to maximize geopolitical power and domestic prestige while minimizing existential risk. If you are the kind of person who thinks only OTHER countries operate this way, you have a lot to learn about geopolitics.
Sometimes rationality does not prevail in international relations. Or, for idiosyncratic reasons (see WWI), what appears to be a series of rational actions when taken in isolation ultimately leads to an irrational outcome.
Hence, in my view we tend to overestimate the frequency of severe geopolitical shocks and underestimate the severity of the shocks that will inevitably occur. In other words, we are really, really bad at handicapping expected values related to geopolitical risk.
The obvious lesson?
QUIT TRYING TO PREDICT GEOPOLITICAL SHOCKS AND IGNORE ANYONE WHO CLAIMS TO BE ABLE TO PREDICT THEM.
Now, I enjoy reading foreign policy think-pieces as much as the next guy. Maybe even more than the next guy. (Fun Fact: Many moons ago I took the FSOT. At the time, you took the exam and wrote the essays separately. I passed the exam but promptly failed the essay section. In retrospect, I was almost certainly disqualified for ideological unreliability) Anyway, the way to read a foreign policy think-piece is as a scenario–a scenario that might play out in a grand strategy game like Hearts of Iron. This is essentially a speculative activity (the parallels with investment research should be obvious). The fact of the matter is that this stuff is useful for getting you to think about a range of possible futures and strategic options. It is NOT useful for actually predicting the future.
In practical terms, the way you manage geopolitical risk is with hedges and rules-based guardrails. Personally, I’d rather ignore geopolitical risk all together than make predictions based on subjective probabilities.
This is relatively simple, process-over-outcome and OODA loop stuff. There are dozens, if not hundreds of ways to adapt a portfolio to geopolitical risk without predicting anything. And 99.99% of what’s written about geopolitics is trash, anyway. Per the above, that’s kind of the point.
The challenge here isn’t identifying the right tools, or even understanding the tradeoffs they entail.
My latest note for Epsilon Theory is about possible futures. And Dune.
One of the recurring images in the book is what we in finance know as a probability tree. In the world of Dune, if you are at least a little bit psychic, and you amplify that psychic ability with a generous helping of hallucinogenic “spice,” you can catch a glimpse of the branching probability tree that is the as-yet-unrealized future.
Here in the investment and financial advice businesses, we, too, seem to have reached an evolutionary crossroads. I don’t claim to know exactly what the industry will look like in ten or twenty years. But like Dune‘s protagonist, Paul Atreides, I think I can peer through the haze of a spice trance to glimpse some of the branching possibilities.
I got a lot of great feedback on this note. In reflecting on it, there are a couple points I wish I’d articulated or emphasized more explicitly.
Non-Linearity In Causal Relationships
The imagery of a probability tree used in the note is oversimplified. In reality, discrete paths do not lead inevitably to particular futures with such-and-such probabilities. Rather, events exert a kind of gravity on one another. (See: The Three Body Problem) For example, if MMT were to become the fiscal policy paradigm adopted by our fiscal policymakers, it wouldn’t “automatically” mean that X, Y, and Z would follow as consequences. Rather, the “gravity” of this event would shift the positioning of events in probability space.
A “better,” but more conceptually challenging way of thinking about this is in terms of the light cone used in special and general relativity.
A detailed exploration of the light cone concept is beyond the scope of this post (A Brief History of Time by Stephen Hawking offers a good, in-depth introduction if this topic piques your interest). For simplicity’s sake I’ll rip the relevant principles regarding causality straight from the light cone Wiki:
Because signals and other causal influences cannot travel faster than light (see special relativity), the light cone plays an essential role in defining the concept of causality: for a given event E, the set of events that lie on or inside the past light cone of E would also be the set of all events that could send a signal that would have time to reach E and influence it in some way. For example, at a time ten years before E, if we consider the set of all events in the past light cone of E which occur at that time, the result would be a sphere (2D: disk) with a radius of ten light-years centered on the position where E will occur. So, any point on or inside the sphere could send a signal moving at the speed of light or slower that would have time to influence the event E, while points outside the sphere at that moment would not be able to have any causal influence on E. Likewise, the set of events that lie on or inside the future light cone of E would also be the set of events that could receive a signal sent out from the position and time of E, so the future light cone contains all the events that could potentially be causally influenced by E. Events which lie neither in the past or future light cone of E cannot influence or be influenced by E in relativity.
As events “fire” in space-time, they dynamically shape the geometry of possible futures. Of course, when we think about this in the context of politics, geopolitics, or economics, it is important to acknowledge that events/signals “fire” with different levels of intensity–they create proportionally greater or lesser perturbations in probability space.
If someone were to shoot me dead tomorrow it would not even cause a ripple in global probability space. The event would really only impact probability space in a way that is localized to me and my immediate personal connections. Maybe my local community.
If the President of the United States were to be shot dead, however, the event would “shock” global probability space. A much wider range of possible futures are impacted, distorted, and/or brought into play, and on a much larger scale.
The concept of “blowback” is interesting to consider in this context. The term is used in the intelligence community to describe unintended consequences resulting from covert ops. For example, you arm and train some Islamic fundamentalist religious groups to fight communism during the Cold War. Decades later, the same fundamentalists are using their arms and training to commit terrorist attacks against you. Blowback results from our inability to precisely forecast changes in the geometry of probability space.
We are not Paul Atreides.
And for what it’s worth, if you’ve read Dune: Messiah, you know that even Paul’s prescient vision lets him down in the end.
Some Thoughts On Permabearishness
On a completely unrelated note, I think it’s worth making a few comments on bearishness and permabearishness in particular. If you are not familiar with the term “permabear,” it refers to someone who is constantly calling for the end of the world and therefore refuses to put capital at risk in the equity markets, or is chronically short equities. Sometimes people mistake me for a permabear because I spend a lot of time thinking and writing about economic and investment risks.
There is an important difference between spending a lot of time and energy thinking about risk and refusing to put capital at risk, or being chronically short equities.
Why do permabears exist? Some are cynical charlatans who are permabears because they make a living as permabears. Other permabears get one bearish call right and it leads them down a path of perpetual bearishness as a result of overconfidence in their own prescient vision (there is a Dune reference for everything).
In my view, the core failing of permabears is confirmation bias. They become so myopically focused on justifying their perpetually bearish stance that they lose sight of the fact that you don’t actually make much money (any money?) as a permabear.
The core tenets of my personal investment philosophy these days are the following:
Minimax Regret > Utility Maximization
My affinity for barbell-type portfolios is the result. Rather than create “muddy” blends of fixed income and equity, strive for a convex risk/return profile. Use some method (simple annuity, permanent portfolio, T-bills) to create a kind of “floor” for a portfolio. Then take the remainder of your capital and place your high risk, high reward, high convexity bets. The goal is to create and maintain an asymmetrical risk/reward profile. Skewed to the upside, obviously.
It is not okay to be a permabear. In fact it is dumb to be a permabear.
It is okay to be a nervous bull.
It is okay to view the world through the lens of minimax regret instead of utility maximization (though you must acknowledge potential opportunity costs).
#2. The US financial/political/industrial complex cares deeply and passionately about inflationary pressures and what they might mean for the future path of interest rates, is irritated that the Saudis prefer a higher oil price, and has lucked into the perfect issue with which to needle Riyadh.
Forgive my cynicism, but this all strikes me as by-the-numbers geopolitical gamesmanship.
Update (10/18/18): A more robust analysis can be found here and here. As this story has evolved it seems clearer that this is less about the US using this as leverage and more about plain old-fashioned virtue signaling.
The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.
Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.
It involves the coyotes that “skirmish” with the residents of his town:
What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.
For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.
The layers/ games are:
1. The Security Selection Game
2. The Asset Allocation Game
3. The Economic Policy Game
4. The Socio-Political Power Game
Each of these games is connected to the others through various linkages and feedback loops.
This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.
While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.
Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.
At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.
The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.
I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.
Like it or not, we’re all playing the Asset Allocation Game.
The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.
If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).
The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.
A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.
This is no different than Darwin’s finches evolving in response to their environment.
Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?
Insolvent is where Uber and Tesla would be.
In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.
However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.
The Sociopolitical Power Game
Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.
This game really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).
You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.
Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)
It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!
I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.
Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:
“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”
If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.
I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.
Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.
The Most Important Thing
There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.
In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.
When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?
In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.
And that tribal competition game is probably the most important meta-game of all.
One thing I like to do on this blog is engage in some “live” analytical exercises. So here is one in the vein of my reasoning from first principles post. I will play a round of Socratic Solitaire to examine Russia’s belligerence on the geopolitical stage. This is not a trivial exercise to me. I have real dollars on the line (see disclosure at bottom).
In general I think people do a poor job of analyzing geopolitical risk. There are many reasons for this. Availability bias is probably the most significant issue, especially in emerging markets. Also people do not put themselves in the shoes of the person on the other side of the table. Investment analysts especially tend to be quantitatively oriented people. They struggle to price the “squishy” stuff. So what I am really challenging myself to do here is think like Vladimir Putin.
What Motivates Me?
This is tough. But anyone who enters the political arena does it for some combination of the following three things:
To make the work a better place
Given Russia’s behavior on the geopolitical stage I would say we can safely rule out “making the world a better place.” That leaves me with money and power.
If I am Vladimir Putin, and I am motivated primarily by money, the smart thing for me to do is straightforward: play nice with the other Great Powers (US, China, EU) and simply focus my energy on looting the Russian economy. Without some overriding desire for political power, things like backing Bashar Al Assad and invading Crimea make no sense. They introduce catastrophic risks into the equation. Namely: a large scale military conflict I might lose.
Thus, on a weighted average basis I think it is safe to say that power is the most significant driver for my behavior. The relevant question from the perspective of an investor in Russian securities is: to what extent am I willing to put constraints on my drive for power?
Why Would I Constrain My Desire For Geopolitical Power?
All else equal I would simply work to swallow up the world. What would stop me?
As mentioned above, catastrophic downside risk might give me pause. That happens in a couple of different ways:
1) lose a war,
2) villagers with pitchforks revolt, and
3) a coup.
How Do I Protect Myself From Catastrophic Downside Risks?
In the short term, Risk #3 can be addressed in straightforward fashion with political repression and violence. Indeed, this appears to be the current game plan. The Financial Times recently published an interview with the Russian oligarch Vladimir Potanin. Potanin is notable for being one of the only old guard oligarchs who is still alive and wealthy.
“Why did we survive, [Mikhail] Fridman and myself? Maybe because we never tried to dictate to the government, to the Kremlin,” he says. He recalls a meeting where he and Fridman told Khodorkovsky, “Mikhail, the problem is you are trying to play political games. The perception is you are trying to buy power. It is unacceptable, not just for you but for all of us — we will all look dangerous.”
In Russia, it is perfectly okay to loot. It is not okay to play politics. A meta-reading of the interview suggests Potanin is addressing Putin and Russian state security directly. “I am not a threat,” he is saying. “I am not interested in political power. No need to bump me off or confiscate my wealth.”
Risk #2 is trickier to manage as it requires balancing economic and social considerations. The CIA World Factbook gives excellent high level macroeconomic data for Russia. We can slice and dice Russian GDP in several different ways but there are a couple of data points that stand out. Agriculture, energy and heavy industry play significant roles in the Russian economy. Russia also runs a trade surplus. Its top trade partners are China (22% of imports; 10% of exports); Germany (11% of imports; 7.8% of exports); and the United States (8% of imports). Heavy industry and energy are both intensely cyclical industries. The Russian economy is thus extremely sensitive to trends in global commodity prices, and subject to dramatic boom-bust cycles.
Unsurprisingly then, Vladimir Putin is acutely aware of “villagers with pitchforks risk.” In October 2017, The Financial Timesreported on a 2009 incident where the Russian president publicly shamed oligarch Oleg Deripaska over unpaid workers:
In June 2009, in the depth of Russia’s previous sharp recession, Putin gave aluminium magnate Oleg Deripaska a public dressing-down after workers in the northern town of Pikalyovo, where his company is the main employer, took to the streets over production stoppages and unpaid wages.
“I must say that you’ve made thousands of residents of Pikalyovo hostages of your ambition, your unprofessionalism and maybe your greed,” the president told Deripaska in front of rolling cameras. As the tycoon hung his head, Putin asked why he had “neglected” his factory. Before the president had left town, Deripaska had ordered that all outstanding wages be paid.
“The effect of that show lingers until today,” says Zemlyansky. “After what happened in Pikalyovo, in all Deripaska towns, they keep on a certain number of employees even in companies that should be shut down, just because of the fear of Putin.”
And the Kremlin is keeping a close eye on things. The National Guard, the police force in charge of riot control, monitors social stability in some monotowns. The federal government has also set up a system to collect more comprehensive data on their social and economic state. The statistics are kept secret, making it impossible even for local governments to assess the situation properly.
Aside from economic policy measures, one highly effective way of managing “villagers with pitchfork risk” is through scapegoating. In fact, this tactic can be used to kill two birds with one stone. In China, for example, the Chinese premier (now dictator for life) has used an anti-corruption campaign as cover for greasing squeaky wheels. In the US, there is nothing Donald Trump loves more than making an individual or organization a scapegoat for some real or imagined threat.
The solution to Risk #1, meanwhile, is simple but not necessarily easy: do not lose a war with a Great Power.
If I Am Vladimir Putin, How Far Will I Push The Other Great Powers?
Answer: As far as they will let me.
There are military and economic dimensions to this and we could spend years gaming it all out. The bottom line is that the optimal strategy is a carefully choreographed dance, similar to the Cold War.
The underlying dynamics are similar to those of the Prisoner’s Dilemma in game theory. The Prisoner’s Dilemma, or, rather, the Iterated Prisoner’s Dilemma, is therefore an interesting model to consider. From Wikipedia:
Interest in the iterated prisoner’s dilemma (IPD) was kindled by Robert Axelrod in his book The Evolution of Cooperation (1984). In it he reports on a tournament he organized of the N step prisoner’s dilemma (with N fixed) in which participants have to choose their mutual strategy again and again, and have memory of their previous encounters. Axelrod invited academic colleagues all over the world to devise computer strategies to compete in an IPD tournament. The programs that were entered varied widely in algorithmic complexity, initial hostility, capacity for forgiveness, and so forth.
Axelrod discovered that when these encounters were repeated over a long period of time with many players, each with different strategies, greedy strategies tended to do very poorly in the long run while more altruistic strategies did better, as judged purely by self-interest. He used this to show a possible mechanism for the evolution of altruistic behaviour from mechanisms that are initially purely selfish, by natural selection.
The winning deterministic strategy was tit for tat, which Anatol Rapoport developed and entered into the tournament. It was the simplest of any program entered, containing only four lines of BASIC, and won the contest. The strategy is simply to cooperate on the first iteration of the game; after that, the player does what his or her opponent did on the previous move. Depending on the situation, a slightly better strategy can be “tit for tat with forgiveness”. When the opponent defects, on the next move, the player sometimes cooperates anyway, with a small probability (around 1–5%). This allows for occasional recovery from getting trapped in a cycle of defections. The exact probability depends on the line-up of opponents.
By analysing the top-scoring strategies, Axelrod stated several conditions necessary for a strategy to be successful.
The most important condition is that the strategy must be “nice”, that is, it will not defect before its opponent does (this is sometimes referred to as an “optimistic” algorithm). Almost all of the top-scoring strategies were nice; therefore, a purely selfish strategy will not “cheat” on its opponent, for purely self-interested reasons first.
However, Axelrod contended, the successful strategy must not be a blind optimist. It must sometimes retaliate. An example of a non-retaliating strategy is Always Cooperate. This is a very bad choice, as “nasty” strategies will ruthlessly exploit such players.
Successful strategies must also be forgiving. Though players will retaliate, they will once again fall back to cooperating if the opponent does not continue to defect. This stops long runs of revenge and counter-revenge, maximizing points.
The last quality is being non-envious, that is not striving to score more than the opponent.
If one views Russia’s behavior (or any belligerent nation state’s behavior) through this lens there are elements of the Iterated Prisoner’s Dilemma in play. In particular, some belligerence must be used as a deterrent. Likewise, some forgiveness and cooperation must be utilized to stop “long runs of revenge and counter-revenge” (read: World War III). In this context, seemingly “crazy” actions such as backing Bashar Al Assad are in fact totally rational.
Why Would I Start World War III?
As Charlie Munger says, “always invert.” So, let’s examine the issue of Russian belligerence through another angle. Why would I, as Vladimir Putin, intentionally ignite a global conflagration that could result in my total loss of power and personal demise?
I believe there is a high probability of winning
I am a pure ideologue / religious fanatic (not a rational actor)
Nothing left to lose
At this juncture none of these appear to dominate decision making on the Russian side. There is some level of ideology in play here in terms of a desire to ensure Russia remains a Great Power and a geopolitical player. However, it’s not the type of fanaticism that renders someone an irrational actor, such as Islamic Fundamentalism.
Russian aggression is not irrational. There is a method to it. The method stems from the fact that Vladimir Putin is motivated to expand Russia’s power and influence (and by extension, his own power and influence). This requires a certain level of calculated belligerence so as not to be steamrolled by other Great Powers.
Domestically, the #1 rule for business leaders is to keep out of politics. The #2 rule is to allow the state some latitude for looting. Most investors look at #2 and say “forget it, I am out” (availability bias). I look at SBRCY on forward PE of 5.67 with a 20% ROE, having just announced a doubling of its dividend, and say, “gee, maybe the looting is more than priced into the stock.”
The most controversial asset expropriation in the history of modern Russia is Yukos, which was owned largely by the oligarch Mikhail Khodorkovsky. Russia did not expropriate Yukos for arbitrary reasons. Khodorkovsky had political ambitions. Worse yet (from the Russian government’s point of view), his vision for Russia ran counter to that of Vladimir Putin. Therefore, if you are invested in Russia, an easy qualitative screen to run is whether company management and ownership is aligned with the Putin regime. This is a critical to assessing expropriation risk and ensuring you are taking calculated risks versus stupid risks.
Full Disclosure: Long OGZPY, SBRCY and RSXJ. Short RSX (as a partial hedge)
There is an excellent podcast available through the FT Alphachat Series featuring Matt Klein’s interview of Marcus Noland, a researcher at the Peterson Institute for International Economics who has spent a significant amount of time studying the North Korean economy.
The background information included with the podcast is also worth reading. This section in particular struck a chord with me:
The North Koreans depended on subsidies from the Soviets to survive, particularly the ability to buy oil and refined petroleum products at “friendship” prices. As the Soviet economy creaked under the combined weight of the war in Afghanistan, low oil prices, and the perceived need to match America’s defence buildup, these concessions started to disappear. By the late 1980s the North Koreans were paying more to the Soviets than they were getting.
One of the downsides of the North Korean obsession with self-sufficiency was that the country ended up with the most industrialised agricultural sector in the entire world. The only way the North could hope to feed itself without imports was to bathe the soil in fertiliser and other chemicals. (Of course, that required imports of energy from the Soviets, but apparently that was okay…) The North Koreans also expanded farmland by cutting down trees, which eventually led to soil erosion, silted rivers, mudslides, and floods.
All of this meant that the collapse of the Soviet Union made the North Koreans extremely vulnerable to food shortages. In the mid-1990s these shortages combined with the failures of the North Korean state to efficiently distribute the food they had and secure enough food from abroad through aid and imports. The result was a famine that killed about 3-5 per cent of the North Korean population — around 1mn people. (Regular listeners will think of Cuba’s “special period”, which killed far fewer people but had similar causes.)
Without spoiling the podcast here are a couple of high level takeaways from my POV:
Centrally planned economies do not work. In the cases of the Soviet Union, China, North Korea and Cuba, central planning, at its best, manged to produce substandard consumer goods. At its worst, central planning actively contributed to the deaths of millions through the misallocation of resources. The misallocation of agricultural resources has proven particularly devastating.
These lines from the 1965 film version Boris Pasternak’s Dr. Zhivago are fairly evocative:
Don’t be too impatient, Comrade Engineer. We’ve come very far, very fast […] Do you know what it cost? There were children in those days who lived off human flesh. Did you know that?
Autarky does not work. North Korea is probably the closest thing we have to a true autarky. And yet, even in its much diminished state the North Korean economy is still not a true autarky! Initially it was dependent on the Soviet Union. Now it is dependent on China.
Markets do work. The Soviet Union, China and North Korea each developed market-based solutions to the massive inefficiencies created by centralized economic planning. In the early days of the Soviet Union, Lenin launched the New Economic Policy (later abolished by Stalin). In China, it is the advent of a “socialist market economy” (which, unfortunately, has evolved into a massive kleptocracy). In North Korea, market-based solutions to famine arrived in the form of small scale, informal trading relationships, as well as a black market for food.
There is much more than this in the podcast, however. So do give it a listen.
In the interest of full disclosure, I am long Gazprom ADRs. This post is written for entertainment purposes only and is not a recommendation to buy or sell any Gazprom-related security. Readers should consult a financial advisor before buying or selling any security. An advisor will be able to make a recommendation while taking the investor’s unique circumstances into consideratiom. Now, on to the show…
Gazprom is a fascinating entity for any number of reasons. Chief among them is that it is majority controlled by the Russian state, is a behemoth of an integrated oil and gas company and is therefore an instrument of Russian geopolitical strategy. Here are some fast facts from the 2016 Annual Report:
There is common misconception in the United States that sanctions on Russia somehow really matter. And sure, they matter at the margins. Certainly if you are a Russian oligarch they may impede your ability to make extravagant purchases. Sanctions make it harder and more expensive for Russian companies to do certain things. Project finance wrangling in particular can be a pain.
It is hardly a coincidence that in 2016 Gazprom closed a EUR 2 billion credit facility with the Bank of China (the 2016 Annual Report trumpets this as “The largest deal in the Company’s history in terms of the amount of financing attracted directly from one financial institution”). The company also held investor day events in both Singapore and Hong Kong earlier in 2017. Why? Per a Gazprom press release:
The region is of strategic importance for Gazprom’s development. The Company aims to foster an increased cooperation with its Asian partners and strives to diversify its investor pool and financing sources, with a primary focus on Asia-Pacific’s potential. Specifically, 52 per cent of the Company’s loans in 2016 were provided by Asian banks, which shows that they have a high level of confidence in Gazprom.
Translation: “Ready access to Asian capital markets allows us to reduce our dependence on US and European companies and institutions for financing, just in case we lose access to western capital.”
So here is a lesson in incentives: trade restrictions like sanctions will only bite insofar as no one of means has a strong incentive to violate them. Otherwise someone or some entity is going to come in and arbitrage those restrictions. Critically, ideological incentives do not count. History is replete with examples of people and entities abandoning entrenched ideological positions when it will benefit them economically. In many cases, simple greed will do the trick.
A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel – a pariah state in the Middle East – wanted oil. Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel – so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.
So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it – from the Spanish perspective – Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering – and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff). We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]
[…]And when the Shah fell? Oh well – Pincus Green – an American Jewish businessman – gets on the plane to Iran and does a similar deal with the Mullahs – who – despite their rhetoric will sell oil down a pipeline through Israel – and will allow Israel to skim their take. Trading through the American embargo – well that is just another instance of getting around restrictions and profiting (very) handsomely.
The Gazprom-China relationship isn’t nearly as complex as these Marc Rich & Co. transactions. China has not agreed to the sanctions regime imposed on Russia by western countries. China and the rest of developing Asia simply need cheap and abundant supplies of natural gas. Gazprom is able to meet that need, and will be happy to have the Chinese as a source of project finance.
The political kerfuffle surrounding Gazprom’s Nord Stream 2 pipeline in Europe revolves around similar dynamics. Eastern European states such as Poland, Latvia, Lithuania and Estonia rightly fear dependence on Russian gas as it gives Russia powerful leverage over their economies and therefore their political independence. German industry, meanwhile, would much prefer cheap Russian pipeline gas to more expensive LNG imports.
While today’s headlines herald booming US LNG exports, independent research implies US exports will eventually need to price significantly higher to cover producers’ full marginal costs (including capex, liquefaction & shipping — after all it is not cheap to send tankers full of LNG halfway around the world):
So again economic incentives outweigh any warm and fuzzy notion of European solidarity. The result is a running trade case that has been winding its way through the EU bureaucracy for years.
And meanwhile the Nord Stream pipeline project grinds on…