Chapter 9
The Art of the Net Assessment

In the first section of this book, I presented the theory behind the constraint framework and why geopolitics matters for investors. Chapters 48 introduced the constraints that really matter, those that sometimes matter, and the weakness of the framework. In the next three chapters, I operationalize the framework. How do investors put it to work and generate alpha?

The first step is to learn the art of the net assessment. The term comes from the US Defense Department's work on long-term strategic analysis, produced by the Office of Net Assessment (ONA).

A net assessment nets out the conclusions of competing analytical approaches. Normally, it is US military forecasters who apply net assessments to adversaries or critical risks over a long-term period. For example, the ONA may produce a net assessment of risks posed by North Korea or climate change.

I left the operationalization of the constraint framework for Chapters 911 because investors cannot produce net assessments without understanding what assessments are being netted. Chapters 48 focus on the material constraints that influence policymaker behavior – the very factors that an investor or C-suite executive needs to net out in analysis.

The different time horizons, or lenses, for geopolitical forecasting each require a different kind of net assessment. So before diving into examples, I will define the purview of each lens.

Three Lenses of Geopolitical Forecasting

“Geopolitical forecasting” is a catchall term that many investors use to describe a factor not sui generis to the market or macroeconomics. This broad label obfuscates what is and is not in the wheelhouse of geopolitical analysis.

The constraint framework can be used to analyze any number of challenges across different time horizons. The US's targeted killing of Major General Qasem Soleimani? Yes, there is a market-relevant, constraint-based net assessment for that. Prospects of a leftward turn in the US elections? There is a market-relevant, constraint-based net assessment for that too. Climate change as an investment thesis? Yes, there is even a market-relevant, constraint-based net assessment for that.

There are three lenses of forecasting that investors have to become comfortable with:

  • Discrete Event: The targeted killing of Major General Qasem Soleimani is a great example of a nonmarket, non-macroeconomic event that an investor has to deal with at a moment's notice – in a reactive and tactical manner. Hopefully you, a newly indoctrinated constraint framework analyst, are “ready” for it by already having an off-the-shelf net assessment. In this chapter, I illustrate the constraints keeping the US and Iran at arm's length. If you are caught with your geopolitical pants down on a particular issue, you can enlist consultants to cover you. Frame your questions so that the answers they provide inform your constraint framework: “Yes, we all know that the Quds force are ideologues who hate America, but what can they do about it, given X, Y, and Z (the constraints)?”
  • Cyclical: The second type of net assessment is focused on the cyclical time horizon. To produce this analysis, know the geopolitical calendar over the course of the next 12–18 months. Assign someone on your team to produce a calendar of all political and geopolitical events that may be market-relevant: elections, summits, referenda, budget deadlines, fiscal cliffs, notable military exercises, etc.1 If you see an important election ahead, produce a net assessment of that country in advance of the event. Monitor the mutability of constraints on policymaker preferences as they enact policy decisions that could move markets, either positively or negatively.
  • Around the Curve: For long-term forecasts, I like to focus on themes, not country- or region-specific economies. In my past life as a sell-side strategist, I produced forecasts on several long-term themes:
    • Will the Euro Area survive and European integration continue? My forecast was a 2011 analysis titled “Europe's Geopolitical Gambit: Relevance Through Integration.” Will US–China tensions escalate into a market-relevant conflict? I responded in 2013 with “Sino-American Conflict: More Likely Than You Think.” Is globalization sustainable? I analyzed the question in 2014, penning “The Apex of Globalization – All Downhill from Here.” Will laissez-faire economics survive? I tried to answer in a 2015 net assessment titled “The End of the Anglo-Saxon Economy.”2

      These forecasts were products of theme-based net assessments well outside the view of investors. Few investors in 2013 cared about US–China tensions, not when Europe was falling apart. In 2015, nobody wanted to talk about political risks in the US when Hillary Clinton was presumed to succeed President Obama and Greece was playing a high-stakes game of chicken with Germany. But it is useful to purposefully focus on the themes that are out of sight, especially if they have lain dormant for a while. Their expiration date may be closer than the consensus thinks.

To prepare for each of these geopolitical lenses, investors looking to be proactive should follow these three steps:

  1. Discrete Event: Focus on several topical risks that could upend markets where a reactive analysis may be required. Every January, while the world is still recovering from New Year's Eve, I like to sit down and write the five risks likely to require a reactive net assessment.
  2. Cyclical: Develop a constraint-based net assessment of major economies that you are invested in or would like to invest in. Starting with the G20 is a good idea. In this chapter, I illustrate what such a net assessment may look like with a close examination of India.
  3. Around the Curve: Write down five assumptions about today's investment environment taken as gospel by most of your peers. One in 2020 is the idea that the world is weathering secular stagnation, a deflationary environment characterized by low interest rates. How confident are you in this forecast? Does it make sense to produce a net assessment? In the fallout of the COVID-19 recession, will secular stagnation be confirmed, or will governments' overwhelming economic stimulus signal the end of the stagnation thesis?3

Net Assessment: The Bayesian Prior

A solid net assessment sets “priors” ahead of any forecasting exercise. It creates the initial probabilities of an event occurring or of a relevant economy outperforming some benchmark (either arbitrary or set by its peers). In early 2016, I penned an analysis on the coming Brexit referendum that correctly ascertained that the odds of a Brexit event were higher than the market assumed.

The fancy term for the method I used is finding the Bayesian prior, or Bayesian probability. A net assessment sets the “prior probability”: the subjective process through which the analyst assigns the probability of an event occurring based not on the historical record but a thorough net assessment.4

Take the 2016 Brexit analysis example. To assign a probability to the “Leave” campaign winning, I did not look at previous independence referenda or the frequency with which they produced a secessionist outcome because my sample size would be too small to be statistically significant. There is no natural law of secession, and similar events are not similar enough upon closer examination. The 1995 Quebec independence referendum is far from a referendum on EU membership. The 1975 UK referendum on European Community membership was a different time, different context. Neither the quantity nor the quality of available historical data was enough to be statistically significant. Had I applied this frequentist inference approach, I would have assigned 10% to Brexit occurring, as only 1 in 10 noniterative referenda go against the established, consensus view.

A net assessment approach allows the analyst to net out all of the constraints identified in Chapters 48. The result produces a subjective prior probability of an event occurring. But, even more crucially, the net assessment produces a fulcrum constraint on which to focus. It can suggest the critical pieces of data to monitor that would indicate a change in the net assessment, requiring the analyst to adjust probabilities. These “data streams” give investors a sense of what they need to monitor to keep their probabilities up-to-date and accurate. To keep track of those “data streams,” I suggest keeping a checklist.

In the case of the Brexit analysis, polling is an obvious data stream to monitor. In the case of 2017 tax cuts passing, it might be statements of fiscal conservatives in the House and the Senate. In the case of the 2020 COVID-19 crisis, where median voter opinion is the fulcrum constraint, a critical data stream might be the number of op-eds lamenting the economic costs of curve-flattening policies, coupled with Google Trends mentions of “depression,” “back to work,” or “why is my internet slow.” Or, as discussed in Chapter 8, it may be the growing gap between new cases rising in a slew of second waves and a flatlining number of deaths, a gap that ultimately leads to the daily new cases no longer leading the market.

It is useful to call this part of my framework Bayesian, as that is precisely what the net assessment is designed to do.5 The net assessment is not where constraint-based analysis ends, but where it begins. Yes, the assessment provides some prior probability to help gauge whether there is any geopolitical alpha to harvest. But the real key is that it identifies the data streams that will impact the fulcrum constraint of any given geopolitical activity. If the data flowing through those streams change, probability should change with it, as illustrated in Figure 9.1.

Now that you have a more complete knowledge of how to integrate the net assessment into a constraint-based analysis, here are some examples.

Framework of the Bayesian process that describes the beginning of a constraint-based analysis which provides some prior probability to identify the data streams.

Figure 9.1 The Bayesian process.

India Net Assessment: An Investment Thesis Built on Mean Reversion

The defining feature of India is that it is difficult to define. Its history, diversity, geography, and size make generalizations – and thus pithy net assessments – unsatisfying.

As of 2020, many investors embrace India as the “next big thing.” The sweeping 2019 general election has produced even more political capital for Prime Minister Narendra Modi's reformist administration. And yet, the past five years of structural reforms – which would otherwise produce optimism – had a mixed impact on macroeconomic data.

My net assessment of India focuses on investment opportunities over the medium and long term. It concludes that there is strong support for the thesis that Indian consumers should continue to lead the way for the economy, but there is mixed support for the thesis that the country is on the cusp of a breakout à la the East Asian “Tigers.”

What Is Keeping India from Mean Reverting?

India's typical geopolitical narrative is that its ethnic diversity and geography make it a difficult country to control, no matter who is in charge. As such, India's nation-building has been massively delayed by its heterogeneity and added complexity of its democracy, leading to the fractured and regionalized polity of 2020.

But India is not the only heterogeneous country in the world, a fact that the typical narrative does not account for. There is a simpler explanation for India's relative modern poverty: imperialism.6 India and China were the two largest economies for much of the past two millennia. This position changed with the Age of Discovery, which kicked off European military, economic, and technological domination.7 For India, that domination began about a century earlier than it did for China.8

In the wake of imperialism, centralized and socialist government played a role in delaying India's catchup. Whereas China shifted its focus to free-market reforms in 1978, India did not let go of the command economy until the early 1990s.

The promise of India, therefore, is in mean reversion (Figure 9.2). With the command economy of the twentieth century and the extractive rule of European empires in the rearview mirror, both India and China have had much of the past 75 years to re-establish their previous trajectories. China is well on its way to accomplishing mean reversion. India, however, only arrested its decline in the share of global output in 1985, and it remains well below China in terms of global GDP share.

Chart depicting how India's investment thesis is built on mean reversion, which arrested its decline in the share of global output in 1985, and it remains well below China in terms of global GDP share.

Figure 9.2 India's investment thesis is built on mean reversion.

Chart depicting that prior to the election of the reformist government in 2014, gross fixed capital formation – investment in fixed assets by the business sector, government, and households – reached a peak in 2007, as did the gross national savings rate.

Figure 9.3 Why the dropoff in investment amid a reformist government?

Underinvestment is the fulcrum constraint that has held India back thus far. Prior to the election of Narendra Modi's reformist government in 2014, gross fixed capital formation – investment in fixed assets by the business sector, government, and households – reached a peak in 2007, as did the gross national savings rate (Figure 9.3). The lack of growth is doubly problematic for a country that has historically underinvested, with gross fixed capital formation lagging behind its Asian peers for half a century (Figure 9.4).

Underinvested: India's Fulcrum Constraint

There are three ways to spur investment in the economy. The government can raise taxes – or capture the profits generated by state-owned enterprises – and spend the revenue on investment. The domestic corporate sector can be incentivized to invest. Or foreigners can invest on their own. All three options face challenges.

Chart depicting the lack of growth is doubly problematic for a country that has historically underinvested, with gross fixed capital formation lagging behind its Asian peers for half a century.

Figure 9.4 India has a lot of catching up to do.

  1. Individuals are undertaxed: India scores poorly in international comparisons of government tax revenue (Figure 9.5). While the introduction of the goods and services tax (GST) in 2017 was a major reform, India still needs a comprehensive reform of property, personal income, and corporate taxes. Only 53 million individuals, just 5.6% of the population, pay personal income tax. For many wealthy families in India, this narrow tax base constitutes “tax terrorism” – as recounted to me by the scion of a particularly wealthy Indian family – that justifies keeping assets abroad. Families keep as much as 70% of their assets outside the country.9 While capital flight has always been the case in India, the unsettling part is that nothing has changed under Modi, despite his pro-market rhetoric. The data does not justify Indian elites' angst. Various tax deductions help the wealthy avoid taxes, as does the lack of a robust real estate tax and the astonishingly low marginal income tax rate relative to EM peers (Figure 9.6). So why the lack of confidence? I suspect that the lack of a redistributive mechanism deepens already-high income inequality and fuels incentive for capital flight, as elites may fear that the gravy train will end due to populist backlash (Figure 9.7).
    Bar chart depicting how India scores poorly in international comparisons of government tax revenue.

    Figure 9.5 India needs to raise more taxes.

  2. Corporates are overtaxed: Given the paltry household tax base, the corporate tax rate in India has traditionally been very high, even by developed-world standards. However, the Modi government managed to reduce corporate taxes for small and medium enterprises to 25% in 2016 and to 22% for all remaining firms in 2019. India's effective corporate tax rate is now around 25%, in line with the rest of the world. However, only about 100 firms, totaling 0.012% of India's 800,000 companies, comprise more than 40% of corporate tax collection.
  3. Foreign domestic investment (FDI) is muted: While the stock of inward FDI has risen nearly four times over the past decade, the pace of inward FDI has slowed since 2008. According to the OECD FDI regulatory restrictiveness index, India remains one of the most restrictive countries for FDI, although it has seen considerable improvement under the Modi administration.
Chart depicting the statutory marginal personal income tax rates by income level for countries such as India, Brazil, China, Indonesia, and South Africa.

Figure 9.6 India: a sneaky-great place to be rich?

Chart depicting that the top 1 percent National Income share in countries such as US, South Africa, South Korea, Taiwan, China, India, and Malaysia.

Figure 9.7 India – a very poor country – is more unequal than America.

Chart depicting that Mauritius is India’s largest source of Foreign Direct Investment/Exports, which is like “round-tripping.”

Figure 9.8 One of these things is not like the others.

Nothing brings all of the above factors together quite like the role of Mauritius in India's FDI “round-tripping.”10 Figure 9.8 shows that Mauritius is India's largest source of FDI … by far! This is astounding given that the tiny island nation is the world's 123rd largest economy, and India is the sixth.

There are several problems with Mauritius being India's largest investor, aside from optics. First, it suggests that some unknown portion of inbound FDI in India is simply a derivative of tax evasion and thus not greenfield investment.11 Second, it means that Mauritius' share of India's 2020 FDI – 30% – had nothing to do with actual foreign investors reflecting an optimistic vision of India's future. Third, this tip-of-the-iceberg figure begs the question of what share of such profits remains outside.

What cements my negative prior bias toward India is that the stagnation of investment – along with a reduced pace of FDI growth relative to GDP – has occurred despite Narendra Modi's reformist government. Since Modi's revolutionary 2014 victory, India's manufacturing as a percentage of GDP and its share of global exports (Figure 9.9) have both either stagnated or fallen. Even more troubling, these trends occurred in the context of rising labor costs in China, a potential tailwind for India. The 2019 US–China trade war was another tailwind, yet it is not clear that India capitalized on it.

Why has India failed to take full advantage of Modi's reformist government and a favorable geopolitical context? Cosmetically, the improvements in the investment environment are substantial. The government often cites that India has moved up 30 spots in the World Bank's Doing Business report, the largest single move in the ranking ever.

Chart depicting how India’s manufacturing as a percent of GDP and its share of global exports have both either stagnated or fallen.

Figure 9.9 Exports have stagnated while manufacturing is collapsing.

The answer comes down to labor and real estate regulation. As for the optimism of the World Bank survey results, they can be gamed by the government. The Modi government focused on the easiest reforms that it could accomplish specifically to move up in the rankings, not to actually fix the underlying problems in the economy. In doing so, Modi transformed India into a good test-taker, but not a learned student of structural reform.

Labor laws are complex and strict, especially for manufacturing businesses. India scores high on the OECD employment protection legislation index, even compared to some developed market (DM) economies (Figure 9.10).12 Firms with more than 100 employees have to obtain government approval to dismiss just one of them. On the real estate front, laws are difficult to amend. They fall under the purview of states and complex communities, not the federal government.

As the 2020 COVID-19 pandemic is hitting India when its GDP growth was already slowing, Modi is unlikely to focus on reforms. Economic performance will become a prohibitive constraint to painful tax and labor reforms. Modi planned but failed to pass such reforms in his first term, as the GST required all of his political capital. To pass, labor and land reforms will need to be watered down by a messy legislative process. Prospects of land reform are even grimmer. It is a prerogative of the states, and the ruling Bharatiya Janata Party (BJP) has controlled 21 out of 29 state legislatures (17 since December 2019) – more than enough votes to enact reforms. If it planned to do so, the BJP would have moved on to land reforms over the past few years. Their absence is a cautionary flag indicating no reforms are forthcoming.

Bar chart depicting how India scores high on the OECD employment protection legislation index, even compared to some developed market (DM) economies.

Figure 9.10 India needs new labor laws.

Why Is Investment the Fulcrum Constraint?

The most optimistic narrative for India is that it could replicate the East Asian miracle. It could “mean revert” to its past glory as a leading global economy.

Three factors underpinned the rapid rise of the East Asian economies in the 1970s and Southeast Asia in the 1990s: high domestic savings levels that translated into high rates of gross capital formation, high productivity growth rates (which followed such investment), and a geopolitical environment conducive to export-oriented industrialization.

On the savings front, India remains behind its Asian peers. Its gross national savings rate is below that of the oft-cited Asian miracles at just 28.5%, compared to China's 45.8%. India's financial system remains underdeveloped, making it difficult for banks to intermediate private savings and investment. Banking assets as a percentage of GDP are half that of other Asian economies. While productivity did break out in the mid-2000s, it has again stagnated despite the reformist government in charge (Figure 9.11).

Chart depicting that productivity did break out in the mid-2000s, but has again stagnated, and Asian Tigers have maintained over 5 percent productivity growth for two decades.

Figure 9.11 Strong productivity performance has stalled.

In addition to less savings, India may have a smaller global customer base than its twentieth-century predecessors. The country is unlikely to enjoy the type of geopolitical tailwinds that helped East and Southeast Asian economies export their way to prosperity. Voters in developed nations are beginning to sour on trade (Figure 9.12). As I discussed in Chapter 1, middle classes in the developed world saw limited gains in real wage growth during the most intense phase of globalization. Given the resultant reduced global demand, India is unlikely to receive the type of welcome China's opening elicited, especially in the 1990s.

India's macro and geopolitical context raises the odds that Dani Rodrik's 2015 thesis of premature deindustrialization may come true before investors' eyes.13 Rodrik – a Harvard economist and notable critic of globalization – argues that due to the combination of automation and East Asia's competitiveness in low-cost manufacturing, developing economies were reaching a peak in manufacturing at a much lower level of wealth.

Bar chart depicting the percentage of respondents who believe that trade with other countries leads to job creation and wage growth, and that the West is souring on trade.

Figure 9.12 The West is souring on trade.

For countries like India, premature deindustrialization “blocks off the main avenue of rapid economic convergence in low-income settings, the shift of workers from the countryside to urban factories where their productivity tends to be much higher.”14

Rodrik argues that services-led growth – particularly IT and finance – could replace manufacturing for India. But such industries “do not have the capacity to absorb – as manufacturing did – the type of labor that low- and middle-income economies have in abundance.”15 Services are difficult to export in large volumes due to their local nature as well as nontariff barriers to trade, which means that their growth is capped at the domestic rate of income growth. As a result, the service industry's real cap is at the rate of India's productivity growth. A high level of productivity growth is a must in such a services-led scenario. Another constraint to service-led growth of exports is that artificial intelligence (AI) and big data may soon replace the global demand for India's back office and call center services.

India is already facing some of the challenges that Rodrik identified in 2015. There is not enough demand for labor in its service sector: out of a population of 1.34 billion, only 500 million people are employed in India, with another 300 million of working age and yet unemployed. Around a third of the labor force is employed in the services sector, where the per-capita income in 2018 was about US$7,900, comparable to countries like Thailand and South Africa. However, the other 70% of India's population is employed in the agricultural and industrial sectors, where per-capita income was much lower and where real rural wages “grew” at –0.3% between FY2015 and FY2018 (Figure 9.13).16

Every month, close to a million youths reach working age in India. It is difficult to see how the services sector will be able to absorb all of them over the next decade. Anecdotal evidence, shared with me by India-based investors, cited numerous examples where the government would post a call for jobs only to be overwhelmed by the demand.17

Bar chart depicting the shocking performance of rural wages - 70 percent of India’s population is employed in the agricultural and industrial sectors, where per-capita income is much lower and real rural wages “grew” at –0.3 percent between FY2015 and FY2018.

Figure 9.13 Shocking performance of rural wages.

Foreign investors constantly hope that reformist Modi will live up to his credentials. Despite two surprising electoral victories, he continues to fall short. From my constraint-based perspective, the investment community is putting too much faith in the man and his preferences, and not enough in the power of the median voter. No matter Modi's preferences, he is constrained by the Indian median voter. And she would not support painful reforms amid a global recession, given rampant income inequality and poor employment prospects.

Without investment and productivity growth, India could still grow based on robust consumption, which is set to increase as the population continues to grow. However, such growth will not be high-quality growth that sees the country move up the manufacturing and export value chain. An economy addicted to consumption would also ensure that India's current account deficit remains a persistent constraint to high-quality growth. A rise in consumption without an accompanying increase in productive capacity would therefore either widen the country's current account deficit or increase domestic inflation as domestic demand overwhelms domestic supply.

India Net Assessment: Investment Implications

A global macro manager I spoke with regarding India argued that Indian equities are, from a long-term perspective, a “screaming buy … it is just not clear whether the scream will be due to elation or despair.” Several bullish managers outlined their optimistic thesis in late 2019 as a combination of the following:

  • Trade war insurance: India is insulated from the US–China trade war and from a global trade slowdown in general, as exports are merely 11% of its GDP.
  • Chinese reform insurance: China's move away from fixed asset investment is positive for India because it is a low-income economy that imports almost all of its commodities. As China's demand for commodity slows, India's costs should ease as a consequence.

These fail-safes are no longer factors in 2020. There are long-term constraints to the US–China trade war, as I pointed out in Chapter 5. Meanwhile, the COVID-19-induced recession has reduced prices of commodities for India, but it is not clear that this event is good for the country. A global recession is unlikely to see Indian assets outperform, and the COVID-19 recession has elicited so much epic fiscal and monetary stimulus out of the West and China that commodity prices will probably rise before long, especially food. On the contrary, India may struggle if the long-term consequence of the COVID-19 stimulus is inflation, as I think it will be.

A global recession is bad news for the country's assets. But the fulcrum constraint to a positive performance of the country's markets and economy is its lack of domestic investment. If India struggled to attract foreign investment in 2019, when the twin tailwinds of the US–China trade war and Modi's electoral victory filled its sails, investment stimulus will likely not improve going forward.

Absent these bolstering tailwinds, domestic political risks may actually rise over the rest of Modi's term. Instead of focusing on painful structural reforms, Modi has turned to nationalism and populism. His change in focus is consistent with my suspicion that median voters are not looking for “short-term pain, long-term gain” policies. Although labor and land reforms are languishing, Modi has pivoted to reform the country's citizenship laws – reforms opponents say disenfranchise Muslims. They elicited protests starting in late 2019 that continued into 2020. Ethnic and religious tensions, a structurally impaired investment environment, and an imminent global recession create a toxic brew for India's mean reversion prospects.

Could the sell-off be a buying opportunity? India has a lot of positives going for it. Unfortunately, its policymakers have limited capacity to execute painful reforms. At some point, investors have to stop and ask themselves what those delays suggest. Modi's hesitation to pursue painful reforms may reveal the constraint of the Indian median voter preference.

This net assessment gives investors a road map for investing in India. The first fork in the road is that its fulcrum constraint to high-quality growth, and thus profitable investment, is … the lack of investment. To resolve this constraint, policymakers need to fix land and labor factors. Instead of expending his 2019 political recapitalization on that goal, Modi focused on social policies that elicited unrest that could grow throughout 2020. The global recession in 2020 will probably only cause Modi to double down on populism at the expense of market-friendly policies.

The verdict? As of early 2020, investors should not invest in India yet. Regardless of valuations.

The point of an investment-relevant net assessment is to boil everything known about an economy down to the fulcrum constraint. From there, it is simple to monitor the data streams of that one constraint and use them to gauge when conditions may shift. In the case of India, the net assessment reveals that the country is woefully underinvested. Without investment, India will probably not experience high-quality growth.

On top of that, I identify the key issues to follow the data streams of labor and land reforms. If they occurred, it would indicate a shift in India's fulcrum constraint of underinvestment, prompting me to change my mind about the country's prospects. But, given the government's focus on populist social reforms at a peak of its political capital, I doubt that India is about to embark on market-friendly policies.

I spent little time on India's geopolitical constraints because I am optimistic on this front. America's rivalry with China has made India a valuable US ally, as President Trump's high-profile India tour in 2020 demonstrates. Meanwhile, its traditional rival Pakistan is no longer a match for India's hard power. Future tiffs with China could even prompt Modi to “sell” painful structural reforms as necessary from a national security perspective. As such, the rivalry with China is not necessarily a negative.

Nonetheless, geopolitical risks abound in the long term for India. Climate change represents a global threat, but it is particularly problematic for India. The costs of climate change are not equally distributed. From the evidence gathered by the scientific community thus far, developing economies have born and will continue to bear the brunt of the burden.

Without a meaningful change in carbon emissions over the next decade, which I do not expect will happen, India is likely to see further economic drag from climate change.

War in the Middle East: Net Assessment

Iran's attack on Saudi Arabia's Aramco energy facilities in September 2019 and the American targeted killing of Major General Qasem Soleimani in January 2020 raised the prospects of a US–Iran war. Oil prices spiked both times, 15% following the first incident and 4.6% following the second. Both spikes proved transient due to geopolitical constraints and because global demand was impaired.

The US – the only actor in the region with enough firepower to counter Iran – has geopolitical constraints preventing it from fighting a major war against Iran in 2020. Without troops on the ground in Iraq, there is no sustainable way to counter Iran's growing regional hegemony. These geopolitical constraints not only mean that a prolonged kinetic action between the two countries is unlikely but also that the US will eventually (again) accept Iran's regional hegemony.

The historical context demonstrates why such a forecast is likely.

The Obama administration agreed to the Joint Comprehensive Plan of Action (JCPOA) with Iran in 2015 because the US sought to extricate itself from the Middle East. The US chose retreat to reduce resources committed to the Middle East – where America's national interests were in decline – and to pivot to East Asia, where national interests were increasingly challenged by China (Figure 9.14). While the Obama administration managed to free up resources, it did little with the available maneuvering room as the “pivot to Asia” fell flat.

US national interests were declining in the Middle East for more reasons than just energy independence. True, increasing domestic oil production has a lot to do with it, as does declining reliance on direct energy imports from the Organization of the Petroleum Exporting Countries (OPEC). But in 2015, the US also no longer faced any direct national security threats from rivals in the Middle East, whereas China (and to a certain extent Russia) represented significant regional and global hegemonic challenges.

Chart depicting how the US chose retreat to reduce resources committed to the Middle East and to pivot to East Asia, where national interests were increasingly challenged by China.

Figure 9.14 The JCPOA allowed the US to deleverage.

Iran threatened American allies in the region, but that is much different from a threat to the US homeland itself. Obama's decision to pivot away from the Middle East created the constraint of limited troops in the area.

The other constraints to a US-initiated war with Iran are the domestic and geopolitical contexts:

  • Politics: On the domestic front, the median voter's exhaustion with wars in the Middle East constrains policymakers from engaging a sophisticated military rival like Iran. As of mid-2019, while 82% of Americans have an unfavorable view of Iran, only 18% support military action against it, and 65% are concerned that the US would be “too quick to use military force.” Most importantly, Americans now consider Iran as merely “one of many” enemies, and it is no longer clearly the greatest enemy, as was the case 2008-2013. It is third on the list of enemies behind Russia and China. In 2012, it was literally Public Enemy Number One at 32% (Figure 9.15).18
    Chart depicting the US opinion poll results analyzing which country is the greatest enemy of the United States - Russia, North Korea, US itself, Iraq, China, Iran, and Afghanistan.

    Figure 9.15 Americans do not want a war with Iran.

  • Geopolitics: Since the 2015 JCPOA, the geopolitical context of the Middle East remains unconducive to an American military response. Thanks to the US's own intervention in Iraq – and the subsequent regional imbroglio that followed – Iran has been the largest beneficiary of America's blood, sweat, and treasure.

The collapse of the Saddam Hussein regime – which was dominated by Iraqi Sunnis, a minority in the country – created a power vacuum in the country that Shias filled, some of whom are allied with Iran.

As of 2020, the Iraqi government is made up by a coalition of the Fatah Alliance and Sairoon. Both strengthen Iran's relationship with Iraq and provide political and military deterrents for any kind of US presence in the area.19 While the Sairoon leader Muqtada al-Sadr is mostly moving away from Iran and adopting an Iraqi nationalist position, al-Sadr was hosted in Iran days before the Aramco attack, which the US traced back to Iran's Grand Ayatollah Ali Khamenei and the Islamic Revolutionary Guard Commander Qasem Soleimani.

Iran is cultivating a comprehensive Middle East sphere of influence. In addition to Iraq slipping into Tehran's orbit, Iran also strengthened its influence in Syria and Lebanon thanks to Sunni militancy (i.e., the Islamic State), targeting Shias. Iranian sympathy is present in Yemen, where it is allied with the Houthi militants who claimed responsibility for the Aramco attack and are at war with Saudi Arabia. Iran also gained influence in Qatar, which suffered for its close ties to Tehran in 2017. It was embargoed by its fellow members of the Gulf Cooperation Council.

These are the political and geopolitical constraints that bind the US in 2020, and they put the country in a weak position in the Middle East. President Trump pulled out of the JCPOA so he could leverage sanctions to force Tehran to negotiate a new deal. But geopolitical constraints make an alternative, more advantageous deal for the US impossible. The JCPOA was a “bad deal” because the US was never negotiating from a position of power. Its multiple wars in the Middle East have exhausted Washington's political and geopolitical capital. It can no longer maintain enough troops in the region to deter Iranian influence in Iraq, which is the geopolitical epicenter of the region.

Without the option of re-engaging Iran for influence in Iraq, the US is constrained into reducing its physical presence and settling for a détente with the Islamic Republic. The signing of the JCPOA was not just the Obama administration's dovish politics. It was the optimal path of least resistance, given growing constraints on US maneuvering room in the region. There are simply bigger fish to fry for the US, specifically its budding tensions with China in the South China Sea.

The US faces considerable constraints to an armed conflict with Iran. An attack against Iran would likely invite a Tehran retaliation against Saudi production facilities, which Iran already demonstrated are vulnerable (2019 Aramco drone strike). Iran could also directly target US troops in Iraq and Syria, where the two adversaries have been tacitly allied since 2014 in the war against the Islamic State militants. In January 2020, Iran already demonstrated its willingness to retaliate on US troops in the immediate aftermath of Soleimani's death.

American allies in the region may take the retaliatory heat off of a shrinking US military presence. But Saudi Arabia and Israel do not have the capacity to mount a successful attack on Iran and take matters into their own hands.

Israel has no strategic bomber force that would make an air war against Iran feasible. It would have to use fighter jets (F-15E Strike Eagles, F-16 Fighting Falcons, and 18 F-35 Lightning IIs) to reach Iranian targets, and they require complicated refueling operations.20 The Israeli air force is capable of conducting such an attack but would likely require around 50–70 fighter jets to both conduct suppression of enemy air defense (SEAD) operations and hit enough Iranian military and industrial targets to make the attack worthwhile.

While the Saudis have enough jets to conduct a similar attack and are geographically closer to Iran, they have never conducted anything so sophisticated. The only experience that the Saudi air force has had in striking ground targets is against the hapless Houthi rebels.

Iran is not hapless. It possesses the Russian S-300 air-defense system, operational since 2017. While the S-300 is less sophisticated than the S-400 – which Russia refuses to sell to Iran – it is sophisticated enough to handle most of the fighter jets that Saudi Arabia or Israel would be able to throw at Iran. Iran also possesses a competent air force, including 20 MiG-29s. It is not good enough to deter an attack, but it guarantees casualties in any non-US-conducted raid.

The US is therefore constrained from taking the conflict to the kinetic level due to domestic politics and geopolitical logistics. Because of its reduced ground troops, the US is unwilling to support air strikes with a commensurable military ground force in Iraq. Such ground troops would be necessary to prevent a potential Iranian counterattack against Saudi territory. Meanwhile, American allies in the region do not have the military force to attack Iran without US aid. If they had, Israel and Saudi Arabia would have already collaborated on a joint attack in 2011, when Israel came very close to doing so on its own (but backed off, likely due to an analysis similar to this one).

Despite the rhetoric and the passive-aggressive back-and-forth between the US and Iran throughout 2019 and 2020, my forecast is that thanks to geopolitical constraints, in the long term, the US has to come back to a détente with Iran. As long as the US keeps the focus on China and Russia – two global powers – it has to make peace with Iran. That peace will necessarily include giving Iran some influence in the Middle East. What of America's allies in the region, Saudi Arabia and Israel? They will simply have to learn to live with a suboptimal outcome. However, thanks to their sophisticated military forces and an overall security guarantee from the US, they will be fine. Angry. But fine.

However, a risk to this forecast does exist. There is some non-negligible probability that the US and Iran engage in tit-for-tat retaliation that gets out of hand, crosses some undefined red line, and produces a prolonged kinetic action. As the example of the Islamic State in Chapter 8 demonstrates, the threat of terrorism is a powerful mover of the median voter and, as a result, could also spur on policymaker action.

When producing a net assessment of a discrete event – in this case a US–Iran conflict – it is useful to organize the various possible scenarios into a decision tree. The diagram gives investors a visual representation of the constraint-defined path of least resistance to policymaker actions. It formalizes choices available to policymakers and offers the investor a chance to apply conditional probabilities to a succession of policy options.21

I show a simple decision tree in Figure 9.16. I produced it in early 2018 to illustrate the limited – but still meaningful – odds of a US–Iran war due to the reimposed oil embargo. The first step of the forecast was the physical loss of Iranian oil exports. There was some possibility that Europeans would not comply with the embargo or that Iran would open back-channel negotiations with the US to avoid the sanctions. To these two outcomes, I assigned only 5% and 15% probability. The greatest probability went to the scenario where the rest of the world complied with US sanctions, severely reducing Iranian oil exports (80% subjective probability).

That 80% probability, the main scenario, then split into three possible paths: Iranian retaliation via rhetoric, concrete kinetic action somewhere in the Middle East, or both kinetic retaliation and a full restart of its nuclear program.

  • Step I: The US reimposes sanctions against Iran.
  • Step II: Iran retaliates against US sanctions.
  • Step III: The US retaliates against the Iranian retaliation.22

Scenario 1 (36% conditional probability): An uneasy status quo emerges, where Iran benefits from a geopolitical risk premium on oil prices but suffers the loss of exports.

Scenario 2 (24% conditional probability): The US ratchets up military and economic pressure on Iran.

Scenario 3 (20% conditional probability): Scenario 2 fails to move Iran, and it continues to use kinetic actions to retaliate against sanctions, drawing the US (or Israel) into an attack against its nuclear facilities.

Scenario 4 (5% probability): There is a trade war between the US and the EU because Europeans failed to implement the US oil embargo.

Scenario 5 (15% probability): The US and Iran negotiate a détente.

Given this analysis was produced in May 2018, the time line at the bottom of the diagram and the ultimate probabilities were not far off from what actually took place. An all-out US–Iran war was correctly assigned a non-negligible, but not the highest, probability. The actual outcome – put in motion by Iran's attack on Aramco facilities and US targeted killing of Soleimani – was somewhere between the first two scenarios. An “uneasy status quo” emerged, but the US did also “ratchet up military and economic pressure on Iran.”

A simple decision tree to illustrate the limited odds of a US–Iran conflict due to the reimposed oil embargo, in early 2018.

Figure 9.16 Iran–US conflict decision tree (May 2018).

This net assessment would have correctly given investors a conservative bias following both the Aramco facility attack and the targeted killing of Iranian general. Both times, the correct call was to short the spike in oil prices. The global macro context of the subdued demand for oil also helped.

Net Assessment: The Takeaway

The purpose of a net assessment is to identify one or several fulcrum constraints that define one's forecast. In the case of India's cyclical net assessment, assigning probabilities would not have produced a helpful frame of analysis. Rather than setting a probabilistic prior, the assessment sets my prior bias: to remain bearish India until its policymakers resolve underinvestment via land and labor reforms.

In case of discrete events, such as a possible US–Iran war, investors should try to produce a net assessment that concludes in a set of scenarios that analysts can apply probabilities to. A decision tree becomes a highly useful tool, as I have found visualizing scenarios and their probabilities is the best way to operationalize the constraint framework. It illustrates the concept that constraints lead policymakers down a “path of least resistance.”

In Expert Political Judgment, Tetlock posits that forcing forecasters to think in probabilities improves forecast performance. Investors should assign subjective probabilities to their forecasts because the more specific the subjective probability, the better the forecast is likely to be.

In my experience, Tetlock's directive and theory prove true, especially when combined with the decision-tree tool.

The combination of conditional probability and decision trees can sometimes have interesting and unintended outcomes – which skew toward a more accurate assessment. Following a net assessment analysis in late 2019 of a no-deal Brexit outcome, I thought that my subjective probability of Brexit was 15%. But when I visualized the scenarios through a decision tree and applied conditionality to several decision paths, I came to a probability of just 4%. The process of visualizing the various paths increased my confidence that a no-deal Brexit would not happen.

Net assessments are meant to be changed. The point of a net assessment is to produce the Bayesian prior – a probability or a bias – that is the starting point of the forecast. However, as information changes, that probability or bias changes with it. As such, the net assessment is the netting of all the constraints at hand. It does not conclude the hard work. In fact, the hard work has only begun.


  1. 1   Or, you can rely on the geopolitical calendar by my former teammates at BCA Research, the best in the business.
  2. 2   All of these analyses are available on request, courtesy of the fine folks at BCA Research.
  3. 3   My high-conviction view is that it will lead to an inflationary environment over the next decade. Secular stagnation will be vanquished, but at a cost.
  4. 4   There are many books to read on Bayesian probability. But if you want one that will not drown you in math, I recommend The Signal and the Noise by Nate Silver.
  5. 5   Still, I hesitate to call it so because it describes only the beginning of constraint-based analysis.
  6. 6   Shashi Tharoor, Inglorious Empire (London: C. Hurst & Company, 2017).
  7. 7   David Abernathy, The Dynamics of Global Dominance (New Haven, CT: Yale University Press, 2000).
  8. 8   The British East India Company established a trade monopoly over India at the conclusion of the Carnatic Wars (1746–1763) against the French East India Company and various independent rulers. The British Crown did not formally take over the East India Company until 1858. In contrast, British domination of China began with the First Opium War (1839–1842) and only became entrenched with the 1858 Treaty of Tientsin, which concluded the Second Opium War.
  9. 9   Families avoid capital controls by designating one family member as a nonresident Indian, enabling them to take more wealth out of the country.
  10. 10 Adrienne Klasa, “Round-tripping: How Tiny Mauritius Became India's Main Investor,” Financial Times, October 30, 2018,
  11. 11 An Indian corporation looking to avoid prohibitive domestic corporate taxes will invoice its exports to Mauritius, where it does not have to pay any taxes. Some, but not necessarily all, of the proceeds are then imported back to India, recorded as FDI.
  12. 12 The OECD index of employment protection is a synthetic indicator of the strictness of regulation on dismissals and the use of temporary contracts. Data range from 0 to 6, with higher scores representing stricter regulation.
  13. 13 Dani Rodrik, “Premature Deindustrialization,” National Bureau of Economic Research Working Paper No. 20935, February 2015,
  14. 14 Rodrik, “Premature Deindustrialization,” 23.
  15. 15 Ibid., 24.
  16. 16 A big thank you to Ritika Mankar for her help with this analysis.
  17. 17 The most jarring of the anecdotal examples was a posting for 63,000 jobs in the national railway service that saw 19 million applicants. Apparently getting a job with India's national railway is less likely than getting into an Ivy League university.
  18. 18 “Iran,” Gallup, July 15–31, 2019,
  19. 19 The Fatah Alliance is the political arm of the Iranian-backed Popular Mobilization Forces (PMF). Sairoon, or the Alliance Toward Reforms, is a political alliance led by the Shia cleric Muqtada al-Sadr, whose militias fought a bitter insurgency against the US.
  20. 20 Refueling operations would not just be complicated logistically, but also diplomatically as the refueling would likely take place in Saudi airspace. The idea that Israeli jets would refuel in the skies over Mecca on their way to strike targets in a Muslim country is an interesting thought exercise.
  21. 21 Conditional probability is dependent on other events happening first, while subjective probability is derived from the forecaster's personal judgment.
  22. 22 Yes, this decision tree is starting to sound an awful lot like the plot to Romeo and Juliet. But all's fair in love and (trade) war.
..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.