For more from Marko Papic, don’t miss his presentation, “Geopolitics for Investors,” with Caitriona MacGuinness, CFA, at the upcoming CFA Institute European Investment Conference on 15 and 16 November 2020
In the turbulent year 2020, Marko Papic’s book, Geopolitical Alpha: An Investment Framework for Predicting the Future provides some reassurance. Papic posits that investors can prepare for upcoming events and beat the market while they’re at it — a bold claim, especially in times like these.
The book’s central idea is a framework for geopolitical forecasting. Papic, who is partner and chief strategist of Clocktower Group, an alternative investment asset manager based in Santa Monica, California, urges us to cast aside information from politically connected people, media reports, and about politicians’ motives. He says these only distract from the real factors determining how events unfold. According to Papic, it’s the measurable constraints facing policymakers that determine the future, and these constraints deserve our full attention.
I emailed Papic for more insight into this approach to geopolitical forecasting and to get his views on current events. What follows are his lightly edited answers.
CFA Institute: Why did you decide to write a book explaining how you analyze geopolitics in an investment-relevant manner? Aren’t you eroding your advantage by sharing your methodology?
Marko Papic: First of all, I never really thought I would have the time to write a book. I have been producing ~4,000 words of macro research per week since about 2009. That leaves very little time to gather your thoughts in a book! However, my partner at Clocktower Group — and an accomplished author of Inside the House of Money and The Invisible Hands — Steve Drobny encouraged me to put all my thoughts on a page. When you have someone who has gone through the process trailblaze the path for you, it is really easy to walk down the road. I mean really easy.
I hear you about “eroding your advantage,” and it is not the first time I’ve heard that question posed. But I’ve always been excited by teaching and sharing with my clients the tools to make them successful. I am very passionate about that. Therefore, it was a real pleasure to put my framework on the page and share it with investors. As it says in the book, the focus on constraints is not a theory nor even a method. It is merely a framework. It works sometimes but, not always. It is not parsimonious (in the methodological sense), it is messy and full of holes. However, it has really worked for me well most of the time. As such, it is one thing for me to share the framework on how to analyze politics in order to generate alpha, it is another to actually use it in real life. I hope that the examples in the book help operationalize how the constraint framework works in real time. But think of me as a skiing instructor or a tennis coach. I can show you how to hit a proper backhand, but when that ball is streaking across the net . . . it’s up to you to make it happen.
How can investors use your framework for geopolitical forecasting?
It comes down to focusing on the observable phenomena of the real world. Yes, ideology, preferences, and policymaker “wants” matter, but ultimately the material world is the rock of reality against which the waves of narrative break. In order to predict the policy path of least resistance, investors have to focus on the material constraints to policymaker action, not their ephemeral beliefs and desires.
The 2015 Greek crisis is a classic example. Sure, the Alexis Tsipras / Yanis Varoufakis government may have had preferences for brinkmanship with Europe. They may have even wanted to leave the euro area. But the Greek median voter did not want to leave the euro area. As such, the outcome was clear and downside risk was far lower than the market expected.
This is not to say that ideology and preferences do not matter. They really do. It is just that they are difficult to operationalize in our profession. If we had all the time in the world and all the resources in the world to make a call, we would use a holistic mosaic approach to forecasting. But we don’t. We are limited in time and resources and therefore must focus on the factor that is the most predictive, most of the time. And that’s the material constraints.
As I repeat often in the book, this gives us the Maxim That Shall Forever Be Bolded: Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. So why would we focus on a factor that is subject to a higher-order variable, given our time and resource constraints?
You wrote that the financial industry is poorly prepared to adjust to geopolitical paradigm shifts. What makes you think that?
I came to finance via a windy road, but my experience working in the industry is my starting point. In countless meetings with investment professionals around the world, I have discovered that we are, as a global epistemic community, over-professionalized. We can quickly analyze a balance sheet or macroeconomic variables, but with politics, we often throw up our hands and claim that “You just can’t predict this stuff.”
With all due respect, if markets could be predicted, then PhDs in finance would be billionaires. They are not. We already work in an eminently unpredictable industry. There is massive uncertainty in the markets. And yet, here we are, trying to make sense of a complex, messy, world.
Politics and geopolitics are merely two of the many factors we have to incorporate into our asset allocation and portfolio construction exercise. Unfortunately, it is not easily quantifiable — although we are getting better at doing so. Rather than stick our heads in the sand or, worse, rely on political risk consultants who weave “cocktail party” narratives, we need to roll up our collective sleeves and do the work of analysis ourselves.
This is the real purpose of this book: to empower investors — whether institutional or retail — with a framework for analyzing geopolitics and politics. It can be done in a systematic and repeatable manner.
Many former politicians and well-connected people make a living sharing their expertise with investors. You think their insights rarely translate into alpha in developed markets. Can emerging market investors make better use of this kind of information?
I think that hiring consultants makes a lot of sense. There are obviously things that we, as investors, just don’t know and need to learn from experts. Geopolitical Alpha is not a one-stop-shop to replace your “research budget spend” on political consultants. Rather, it is a way to empower you in your next meeting with some former undersecretary of state, to give you the tools to ask them the right questions and get the most out of their expertise. After you are finished with Geopolitical Alpha, you should never again fall for a preference-based forecast.
An overarching, fundamental, problem is that the well-connected often see the trees, instead of the forest. They also tend to overstate the personal decisions over impersonal forces. After all, they have to sell their own “book of business,” which is quite literally the access to the corridors of power.
In Geopolitical Alpha, I essentially claim that those corridors are not as powerful as we think. This is a very difficult claim for many of us to accept. Especially in finance, where some investors have already written off politics as “unforecastable” and therefore only seek insights from the “wise and powerful men.”
In the book, I claim that it is very difficult to gather insights about developed markets this way, that political systems are too complex and constraints — constitutional, legal, economic, political — too great on those in power. But I am not sure that it is different in emerging markets.
Take the 2019 Argentina fiasco. A large portion of the macro community was enamored by the prospects that Mauricio Macri would be reelected in the general election later that year. Almost universally, the “well-connected” consultants weaved a concise narrative that the country was on the cusp of a massive rerating as Macri’s supply side reforms would be confirmed. They wrapped this narrative into a regional story, with Brazil’s supposed supply-side reforms to rival those of [Margaret] Thatcher and [Ronald] Reagan.
The problem with this “intel-based narrative” was the macro context. China had begun to deleverage in 2017 while the US engaged in a pro-cyclical fiscal stimulus. This led to a policy divergence between the two largest economies that was only accelerated by the trade issues. Chinese demand for Argentine exports sagged while the USD rallied on the growth differential and surging US stimulus, plunging all of EM into a period of underperformance, but particularly Argentina. Macri never stood a chance. And all it would have taken to predict it is one look at the “Misery Index” chart, which was flashing “red.” All the fancy Malbec-fueled dinners in Buenos Aires with the “well-connected” of Argentina could have been replaced by a single macro chart.
Forecasting was criticized a lot after the 2016 US presidential elections when most predictions assigned a small probability to Donald Trump’s win. How do you think the forecasts will fare in this year’s elections?
Pundits assigned very low odds to the Trump election, but actual forecasters did much better. For example, Nate Silver’s FiveThirtyEight — which I highly respect — assigned Trump 29% odds to win the election. That’s less than one-in-three odds. Not great, but decent.
My own analysis ahead of the election was that Trump had 42% odds of winning. If you’re a 40% three-point shooter in basketball, you’re considered a marksmen and have the green light from the coach to fire at will. Now, pundits struggled. The New York Times gave Trump merely 15% odds and the HuffPost gave him laughable 2%!
I would therefore flip the question around. Are investors going to learn the lesson from 2016 and be more discerning about who to rely on for their geopolitical forecasts? If you’re relying on The New York Times to do your geopolitical forecasting, you probably will not do well in the coming decade where predicting politics will become ever more relevant to portfolio construction and to generating alpha. And if you don’t understand that 30% odds present downside risk to a market highly skewed towards the outcome priced with the remaining 70%, you need to learn how to manage risk.
Ultimately, generating geopolitical alpha comes down to what the market is pricing, not just the odds. If you make a bet on a soccer match or an NFL game — and lose — will you blame the casino for setting the line wrong? It’s the same thing in the markets. This time around, I think markets remain mispriced. Odds of a Blue Wave are probably understated, given that many pundits and investors have PTSD from the 2016 shocker (which, given polling, should not have been shocker). When I look at assets like the Treasury market, I think that bonds are not pricing in a potential fiscal orgy after the election.
In your book, you write: “The median voter is the price maker in the political marketplace; in the long-term, politicians are mere price takers.” You go on to explain that politicians are hostage to voters’ preferences since they need popular support. Following this logic, is it fair to conclude that it matters little who wins the upcoming US presidential elections in November if we assume that policies are determined by voters’ preferences, rather than the incumbent’s agenda?
In the long term, yes. It does not matter who wins the 2020 election. We have said goodbye to the Washington Consensus — a set of policies that gave us the Great Moderation — and have welcomed something else . . . a Buenos Aires Consensus, I call it.
In the short term, however, any long-term paradigm shift can be challenged. One particular electoral outcome — a Joe Biden presidency combined with a Republican Senate — would be pernicious for the economy and the markets. I know, it’s ironic. The markets normally like “gridlocked government” outcomes. But not today, not when we are already addicted to not just monetary, but also fiscal stimulus.
As such, I actually think downside odds to the market are around 30% (the odds that a Biden victory is paired with a Republican hold in the Senate), which is not negligible, particularly at these price levels. Throughout early September, investors got a little preview of what a gridlocked government would look like, with failure to pass a Phase 4 stimulus package.
How do you think the current pandemic and economic crisis will change geopolitics and the global economy?
They won’t. This is not the first pandemic that humanity has experienced. As such, the half-life of the collective COVID-19-induced panic will dissipate much faster than people think. We, as humans, become desensitized to risks that half-a-year ago seemed egregious.
I would go further and posit that the paradigm shifted much earlier than the pandemic. The pendulum has been swinging since 2008–2009 away from laissez-faire capitalism. The growing income inequality in the US, combined with falling potential GDP growth rates around the world, has led to the intellectual erosion of the Washington Consensus. To the point that everyone from the Catholic Church to the IMF is saying to hell with debt levels. As such, I would vehemently argue that even a shallow recession would have led to the Buenos Aires Consensus, to the re-introduction of fiscal policy and stimulus and the erosion of central bank independence.
Now, of course, I cannot prove this counter-factual. We did not get a shallow recession. We got a pandemic-induced and sharp one, albeit brief due to the stimulus. But that is my view, that the shift from the Washington to the Buenos Aires Consensus was already afoot. The pandemic may have only accelerated it.
What are the main trends shaping this decade and how should investors position their portfolios?
On the geopolitical front, we remain in a multipolar world. Not a bipolar one. In a multipolar world, [two countries] do not get to carve up the planet into two neat camps as the US and USSR did. As such, the Cold War is a poor analogy for the world waiting for us over the next decade.
A multipolar world will be one where “economies of scale” make a return. Think the late nineteenth century, which to me is the much better analogy than the Cold War. You had the acceleration of imperialism in large part because the early globalization — underwritten by the hegemony of the United Kingdom — began to wane. In that macro context, countries will seek strength-in-numbers. The EU suddenly becomes a model to replicate, not a failed setup. China and the US will defend their spheres of influence, but other regional powers will scramble to organize theirs. Russia, Turkey, Iran, Saudi Arabia, India, and Japan — they are the “free radicals” that may clash as they scramble to devise their own “economies of scale.”
On the macro front, the multi-decade low growth environment, combined with “elite overproduction,” will see the pendulum swing away from laissez faire and towards dirigisme.
What does this sort of an environment portend for investors? I think that the US, which is on the frontier of unorthodoxy, will seek reflation through currency depreciation. Investors should position themselves for a USD bear market, and a bull market in everything priced in dollars, especially commodities. Inflation will surprise to the upside, as will growth eventually. Dominance of tech stocks will end in a whimper — not necessarily a bang — with deep cyclicals catching a bid. In terms of regions, I like Europe and Latin America. China should also do well.
Thanks Marko. I’ll be looking forward to your presentation at the CFA Institute European Investment Conference next month.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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