The world is undergoing paradigm shifts on multiple fronts: political, geopolitical, generational, and technological. What these changes are and their implications for the future are beyond the scope of this book. Instead, I present a framework that has helped me make sense of the world over the past decade. I hope it will prove helpful to navigate the paradigm shifts to come.
I use the term “framework” because it is less deterministic than a theory and not as prescriptive as a method. It is messy, full of contradictions, and much more art than science. It fits with forecasting geopolitics and politics because forecasting is similarly messy. There is nothing parsimonious about the constraint framework I present.
In the past 25 years, geopolitics and politics have switched from being tailwinds to the global economy and markets to being headwinds. For many in business and finance, it feels like a rug has been pulled out from under them. I know the feeling; I saw it happen to my family firsthand when I was eight years old.
In 1986, my 36-year-old dad joined General Export (Genex), the crème de la crème of Yugoslavia's corporate world. For my dad, it was the equivalent of landing a job at IBM in the 1950s-era United States.
Dad had made it. His life – and by extension my life – was going to be pure kajmak.1 Step one: a four-year stint in the London office (“so you and your sister can learn English”). Steps two and beyond: an upgrade to our 505-square-foot “condo,” then maybe a car with more than two cylinders, a house on the Dalmatian coast, a year at a foreign university … culminating in an entrée into the upper echelons of socialist society.2
What was so great about Genex? At the end of 1989, the conglomerate controlled 12–13% of Yugoslav foreign trade and nearly a third of Serbian trade with the rest of the world.3
What did it manufacture? What services did it export?
Nothing and none. What Genex “manufactured” was pure geopolitical alpha.
The Soviets did not believe in running a trade deficit. So, every year, the USSR would produce a list of goods that it was interested in exchanging for barter. Because Yugoslavia was a promiscuous communist country – it played both sides of the Cold War – a company like Genex would sell Yugoslav and foreign goods to the Soviets in exchange for what the USSR was willing to export (mainly commodities). Genex would then sell the Soviet commodities in the global market, pocketing a hefty profit in hard currency.
Unfortunately for Genex, but fortunately for almost everyone else on the planet, the Berlin Wall fell on November 9, 1989. Two years later, the Soviet Union disintegrated. The geopolitical gravy train ended and Genex's edge with it. The firm's entire corporate strategy was leveraged to the geopolitical status quo. In fact, my homeland was basically living off the Cold War. When the geopolitical winds shifted, the end was nigh for both Genex and Yugoslavia.
Thanks to the combination of a massive geopolitical paradigm shift and epic mismanagement, Yugoslavia in the 1990s was worthy of a chapter in Jared Diamond's Collapse. The near-first-world life that my family built in Belgrade descended into hell in weeks.
The country's currency, the dinar, was devalued 18 times in seven years, with 22 zeros erased from its value.4 The monthly rate of inflation peaked at 313,000,000% in January 1994 – at the time the second-highest recorded rate of inflation.5 Between February 1992 and January 1994, the price level in Yugoslavia rose by a factor of 3.6 × 1022.6 I have an academic footnote to prove it.7
My hometown of Belgrade came fourth in the 1986 vote for the 1992 Summer Olympics. But by 1992, it had descended into an episode of The Walking Dead. In May 1994, my family left Belgrade with two suitcases. Destination? Amman, Jordan.8
Thankfully, my dad saw it coming, so he quit Genex a few years before the deluge. He got a job in a direct sales company selling cooking pots. He went from faux IBM to essentially Tupperware.
Many years later, whenever I fretted about my grades or school in general, he told me, “Relax. Why are you stressed? Do you know what Marx and Engels have to say about direct sales? Nothing. All my university exams and work experience are useless for the damn job I do today.”
If you are a CIO of an institutional investment fund, a portfolio manager in an asset management firm, or a C-suit executive, you also face geopolitical paradigm shifts that will, at best, make your work more challenging. At worst, they will collapse your civilization like they collapsed my father's. In this book, my intention is to offer you a framework with which to prepare yourself for the former possibility. For the latter, I've got nothing.
Investors are all in the same predicament that my dad faced at age 36. The training, certifications, and experience of the past 35 years have woefully underprepared the West's financial and corporate communities for the paradigm shifts that are occurring.
Politics and geopolitics have shaped investment and business decisions for centuries. In his seminal work, The House of Rothschild, Niall Ferguson describes how the Rothschild family – well-versed in geopolitical analysis – became the richest and most powerful family of the nineteenth century. Adam Smith named the bible of economics An Inquiry into the Nature and Causes of the Wealth of Nations. Not people, not companies, nor corporations, but nations. And while John Maynard Keynes is most renowned for The General Theory of Employment, Interest and Money, he showed the range of his genius in The Economic Consequences of the Peace (1919), where he correctly forecasted the rise of the populist right, the Second World War, and even the European Union.9
For centuries, success in business and investing required the skills of both long division and sensitivity to political and geopolitical change. Yet today the curricula of most MBA programs – and the CFA curriculum in its entirety – ignore the latter.
For the better part of a quarter-century, between 1985 and 2008, election results in most large markets made little difference to the price of assets or company earnings.10 For the vast majority of investors, politics and geopolitics were worthy of a one-hour meeting at the start of the year or, at most, a small expense on the research/consulting budget.
Politics and geopolitics still played a role, but in the background, working as a tailwind in the sails of investors. Events and paradigm shifts played out into the hands of the multinational corporate and financial communities. As a result, a new crop of investors emerged out of this Goldilocks Era who were overquantified, while the gray-hairs and their cautionary tales receded into neglect.
Since the collapse of the Soviet Union, American hegemony meant that wars either occurred in investment-irrelevant countries – Rwanda, Armenia, Azerbaijan, Moldova, Somalia, Bosnia and Herzegovina, Lebanon, etc. – or were finished quickly, such as the First Gulf War or the 1999 North Atlantic Treaty Organization (NATO) air war against Serbia.
By the time I entered the financial industry in 2011, few if any of my clients and colleagues had ever had to make an investment decision based on geopolitics. The world's premier political risk consultancy – Eurasia Group – announced in its very name that its focus was on the fringes of the corporate world. By “Eurasia,” Ian Bremmer – the firm's founder and a visionary in the field of political risk analysis – meant the frontier markets of the former Soviet Union. In 1998, Bremmer's vision was that political risk analysis would matter for “the Stans” and few others.
The answer lies in Mikhail Gorbachev's 1985 “Leningrad speech” – the one where he lambasted the Soviet leadership and launched perestroika (“restructuring”).11
By the late 1970s, the Soviet Union was in the midst of a deep economic malaise. Living standards had stopped improving throughout the decade, and the Soviet Union fell far behind the US in terms of technological advancement. Gorbachev threw in the proverbial towel in the contest between a statist-planned economy and a free-market one.
By conceding the defeat of communism in the Soviet Union, Gorbachev undermined it in the rest of the world. The consequence of this ideological capitulation was the Third Wave of democratization and the adoption of free-market policies across the globe. Within a decade of Gorbachev's speech in Leningrad, free-market capitalism became “the only game in town,” and within two decades, 90% of the global population was living in capitalism (Figure 1.1).
The strategic victory of the US over the Soviet Union complemented the ideological victory of the free market. With the dissolution of the Soviet Union, the US became the sole superpower capable of enforcing norms of state behavior on a global scale.
The US did so by challenging revanchist regimes that were willing to challenge the new status quo, such as Saddam Hussein's Iraq and Slobodan Milošević's Yugoslavia/Serbia.12 It also supported the new capitalist orthodoxy by encouraging international economic institutions to promote macroeconomic reforms, dubbed the “Washington Consensus.”
The defeat of demand-side policies in the Thatcher–Reagan revolution of the 1980s occurred alongside the Soviet defeat. Profligate fiscal policy, politicized monetary policy, and an inflexible regulatory regime had saddled developed markets throughout the 1960s and 1970s, culminating in dramatic inflation that was only exacerbated by the “oil shock” following the 1973 Yom Kippur War.13
In response to this economic malaise, UK Prime Minister Margaret Thatcher instituted her neoliberal shock therapy. While the initial outcome was a recession and elevated unemployment, her policies eventually led to an economic recovery in the late 1980s. Thatcher's tax cuts, privatization, and deregulation became the pillars that would underpin the Washington Consensus – and laissez-faire economics in general – that countries would replicate across the developed and later the developing world.
One country that rejected the supply-side revolution was France. In 1981, in the midst of the rightward policy turn in the UK and the US, France elected socialist François Mitterrand. Mitterrand ran on an unabashedly left-wing policy package called the “110 Propositions for France.” The package of reforms included price controls, reregulation of industries, minimum-wage increases, public works programs, a massive public-sector job program, nationalization of major industrial groups, reduction of the working time, a wealth tax, and an extension of trade union powers. Mitterrand's surprise electoral win led to two major runs on the franc in the year after his victory and the resulting near ignominy of contemplating aid from the International Monetary Fund (IMF).
In the battle of ideas, the Thatcher/Reagan supply-side – laissez-faire – won as decisive a victory over Mitterrand's demand-side –dirigisme – as one could imagine. Voters and policymakers across the developed world took note and adjusted behavior accordingly.14
By the mid-1980s, the twin tailwinds of laissez-faire economics and American geopolitical hegemony created the ultimate Goldilocks scenario for investors and C-suite executives alike.
On the geopolitical front, hegemonic stability – in the words of Charles Kindleberger – prevailed.15 The George H.W. Bush and Bill Clinton administrations enforced that stability when they engaged with the rest of the world.16 The US foreign policy establishment, staffed mainly by foreign policy hawks who cut their teeth on the Cold War, favored an activist and engaged foreign policy, one that ensured the US would continue to provide the expensive global public goods necessary to grease the wheels of economic globalization.
Hegemony sows the seeds for its own decline. America's policing freed up other countries to strengthen their own economic independence. By ushering in stability and globalization, the US allowed countries to set aside their challenges to US hegemony and focus on economic development. But those material gains ultimately allowed these challengers to get to the point where they could challenge the US for hegemony. This is the story of the rise and fall of empires; stability breeds collapse.17
In the wake of the Great Recession, a messy, multipolar world has replaced American hegemony.
Multipolarity is a concept from political science that describes a world in which no single entity (unipolarity) – and no two entities (bipolarity) – possess a preponderance of power with which to impose order in an otherwise anarchic system. Instead, multiple countries pursue their national interests independently, an arrangement that forecasters know – from history and political science theory – produces high geopolitical volatility (Figure 1.2).18
Think of the 2014 Russian annexation of Crimea or China's militarization of the South China Sea since 2012. Both would have been unthinkable during the post-Cold War era when the US was invested in maintaining a global balance of power.
Without a single hegemon to enforce rules of behavior, globalization reached its apex in the past decade. This sequence of events did not require the election of a populist to divine. Deglobalization is structural and thus difficult to reverse. For globalization to persist, one or more states need to bear the high cost of global public goods, such as defense of trade routes, global economic policy coordination, the role of a consumer of last resort, and the continued defense of rules of behavior, such as state sovereignty and noninterference. It was difficult to imagine any country filling this void in the 2010s, and it still is in the coming decade.
Finally, the Great Recession of 2008 and rising income inequality in the developed world undermined the laissez-faire economic system. While globalization lifted billions out of poverty across the world, it also expanded the global supply of labor, weighing on wages for the middle class across the developed world (Figure 1.3).19 Wage stagnation is not the only source of malaise in advanced economies, but it is a powerful one.
That said, the political reaction is not uniform across the developed world. In the US and the UK, the populist backlash was the strongest, in part because the two countries most enthusiastically adopted laissez-faire in the 1980s and 1990s. These policies left their middle classes the most exposed to the winds of change after 2008.
The end of American hegemony, multipolarity, the apex of globalization, and the erosion of laissez-faire economics defined the 2010s. These trends also changed the nature of political and geopolitical risk, which had been localized in emerging and frontier markets and thus largely relegated to commodity prices.
When historians look back at the 2020s, they will remark that the COVID-19 pandemic had a dramatic influence on the West, that it was the final nail in the coffin of the Washington Consensus and its mutation into something else … a Buenos Aires Consensus, perhaps (more on this in Chapter 4).
I vehemently disagree. The pandemic has simply accelerated the paradigm shifts that began in the 2010s: geopolitical multipolarity, deglobalization, and the end of the Anglo-Saxon laissez-faire consensus.
When the COVID-19 market sell-off began in February 2020, I was in Miami at a gathering of top macro minds in the industry. Few there expected policymakers to react to the pandemic as dramatically as they did: with unlimited credit lines to businesses, massive quantitative easing (QE) programs, and even “helicopter money” – deficit-financed cash handouts to the public. The consensus at the event was that Speaker of the House, Democrat Nancy Pelosi, would play politics and delay the stimulus to hurt President Trump in the election. Policymakers would be “behind the curve.”
The reason policymakers were not behind the curve when it came to monetary and fiscal stimulus had little to do with the nature of the crisis. They were already primed to respond with extraordinary measures by the paradigm shifts of the last decade, particularly shifts away from the Washington Consensus.
Fiscal prudence? Who cares? The US had already blown the budget deficit under the Trump administration at the top of the economic cycle. Why would anyone worry about the size of the stimulus when they were already past the point of no return?
The COVID-19 crisis may have accelerated the inevitable, but America's turn from a laissez-faire economy into a dirigiste one had begun much earlier. For investors and businesses, geopolitical analysis became more important than ever.
Getting the market right, from here on out, is as much about the politics and geopolitics as it is about valuations, interest rates, and earnings. And yet, our epistemic community of financial professionals has no real framework with which to navigate this new paradigm.
The quarter-century between 1985 and 2010 was a great time to be an investor. With geopolitics and politics on autopilot, running a business or a portfolio became routine, iterative, and mathematical. The Goldilocks Era allowed for the professionalization of the investment industry in unprecedented ways.
But the same skill sets required to conduct financial analysis do not always lead to cogent political analysis. During a quarter-century of self-selection, hiring managers favored industry entrants who were comfortable with quantitative modeling and engineering. As a result, the 2010 financial industry – and the business world as a whole – found itself inadequately staffed for the paradigm shifts to come.
There are three particular weaknesses in the 2020 financial industry that make it poorly prepared for the geopolitical and political paradigm shifts afoot:
Of course, investors should still use quant tools and approach their craft with scientific rigor. But the Goldilocks Era of geopolitical tailwinds allowed investors to become overly focused on macroeconomics and the markets. Investors would benefit from applying that same rigor to politics. There is an empirically driven framework for analyzing politics that does not involve cozying up to policymakers at cocktail parties.
Further, investors were generally blind to a major irony in their own ignorance of politics. It was politics and geopolitics that played a major role in the “Great Moderation,” which saw inflation tamed and economic volatility dissipate. But instead of recognizing the important role of politics, the financial industry universally credited and praised a committee of academics setting interest rates. That such moderation was actually underpinned by globalization, massive expansion of the global labor supply, adherence to laissez-faire policies, and global stability enforced by American hegemony is a heretical view.21
In 2020, it is obvious to most of us in finance that we're not in Kansas anymore. Merely reading the Fed minutes, waiting for the ISM print, and scanning the pages of The Financial Times is no longer enough to do one's job. Unlike academics, investors cannot be rigid. Our performance is measured in real time. As such, finance has picked up on the need to complement understanding of economics and the markets with political analysis. The demand for cutting-edge geopolitical forecasting is rising.
In this book, I present a macro, top-down, framework to analyzing politics. There are other approaches to geopolitical analysis. They all have their time and a place. The difference between my approach and that of the political risk industry is that I think that the constraint-based framework can be replicated by investors on their own time and with their own resources. In fact, there are components of the framework where an investor skilled in macro fundamentals and markets can best a seasoned political analyst.
Selling political analysis is not new. Henry Kissinger set up Kissinger Associates soon after he got out of government, in 1982. The aforementioned Eurasia Group has been around since 1998, and Stratfor, the shop where I began my career, opened its doors in 1996.
In my experience, the political consultancy business is dominated by advocates of the “intelligence model.” The major consulting firms hire former technocrats and occasionally former policymakers. While such professionals can provide good context and background to most of the world's problems, they are rarely analysts or researchers. They do not personally get down in the trenches of research. Furthermore, the moment political consultancies hire them, they disconnect from the network of classified intelligence and analysis provided in their previous posts. They can also overemphasize their own expertise – say epidemiology in the case of the COVID-19 pandemic – and misunderstand how policymakers will react to such crises.
The intelligence model suffers from two additional weaknesses.
The first is the “statistical significance” problem. To make a reasonable forecast or net assessment, public (government) agencies rely on signals from electronic and human signals (data points), creating a mosaic of information and sources that approaches some reasonable level of statistical significance. This massive data collection is beyond the scope of any political consultancy, which, by definition, is a for-profit business that cannot rely on endless state resources to collect intelligence. Instead of a mosaic of intelligence, the investor quite often gets an over-the-hill technocrat looking to cash out. The technocrat sits across from them in the boardroom, at best giving them useful background on a particular issue, at worst regurgitating Wall Street Journal and Financial Times op-eds.
The second limitation of the intelligence model is that today's geopolitical and political risks are no longer only investment-relevant to frontier and emerging markets (EMs). An intelligence-led model of political analysis might work in a simple political system, where access to the key decision-makers is all that one needs. Similarly, getting (legal!) policy intelligence on a particular regulatory matter may indeed generate alpha. But in complex political systems of the most liquid markets – the US, China, the EU, India, and other large EM economies – access to power does not guarantee insight. This is because power is diffuse and checked by constitutional and bureaucratic constraints.
I will spend a lot more time on this question of “supply” of political analysis – and how to talk to “experts” – in Chapter 3. The political analysis community – including experts and political consultants – has enormous value for investors. The point of this book is not to get the reader to cancel their political research providers and put seasoned analysts out of business. But the only way to make an investment decision in 2020 is to think of political analysis as part of the investment process itself, not to merely outsource it to external research providers.
For now, the point is that investment-relevant political and geopolitical analysis is not something that should be outsourced to a former State Department deputy assistant secretary of European and Eurasian affairs.22 Political and geopolitical analysis is not exogenous to the investment process. It is inherent to it.
This book provides investors – and anyone else interested in political and geopolitical forecasting – a framework with which to conduct their own analysis. Yes, you can and should still read newspapers and rely on outside political analysis (and I'd love to give you tips on which consultants to use), but my goal is to share a simple precept that has worked for me (most of the time). By using this framework, you can make better use of the outside advice and research and, hopefully, get better at separating the signal from the noise in the news.
But let's get something out of the way right at the top. The fact that I, Marko Papic, have a job in finance is conspicuous. None of my four university degrees are in finance, business, economics, or any mathematical science whatsoever. In my eight years studying at the university level, I spent maybe forty hours in total begrudgingly learning math.23
That I am now a chief strategist of an alternative asset management firm is a foreboding outcome for the world of finance. It means that we are no longer in the Goldilocks Era, where the twin tailwinds of American hegemony and globalization allowed investors to ignore the messy world of geopolitics.
Just because politics and geopolitics are not easy to quantify does not mean that they are (complete) voodoo. At the core of the constraint framework that I present in this book is my belief that investors should focus on the material world of constraints, rather than the ephemeral word of policymaker preferences and beliefs.
The world of constraints is measurable and quantifiable whereas the world of preferences is not. It is the constraints that are ultimately predictive, actionable, and alpha-generating.
This is because of the Maxim That Shall Forever Be Bolded: Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.