My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about. ... central bank action has had the effect of de-linking equities from the global growth cycle, as equity investors have chosen to blatantly ignore the fall in global trade in favour of more risk-taking at the back of accommodating central banks. Risk-on, risk-off has miraculously turned into risk-on, risk-on. “Don’t fight the Fed”, as they say, and equity investors have obviously chosen not to. ... First and foremost, returns are going to remain subdued because GDP growth will stay low for a long time to come. Demographic factors, productivity factors and mountains of debt in the majority of countries all point in the same direction, and that is towards below average economic growth. ... The most structural of those factors – demographics – will remain a negative for the U.S. economy for another 10-15 years, whilst economic growth in the euro zone and Japan will be negatively affected by demographics until at least 2050. This does not imply that there cannot be extraordinarily good years every now and then, but the average growth rate will almost certainly be low, causing interest rates to stay relatively low for a lot longer than most expect and corporate earnings to disappoint as well.

Today we have the highest living standards in human history that co-exist with an ability to destroy our planet ecologically and ourselves through nuclear war. We are in the greatest period of stability with the largest probabilistic tail risk ever. The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe from the risk of devastating conflict on our own soil? ... Peace has a dark side. Peace can exist due to hidden conflict in the Prisoner’s Dilemma. ... Global Capitalism is trapped in its own Prisoner’s Dilemma; forty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior. The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, are creating a dangerous ‘shadow convexity’ that will fuel the next hyper-crash. Central banks in the US, Europe, Japan, and China now own substantial portions of their own bond or equity markets. We are nearing the end of a thirty year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razors edge of risk. Do not fool yourself - peace is not the absence of conflict – peace can exist on the very edge of volatility. ... Since 2012, the Federal Reserve have been engaged in a pre-emptive war against financial risk, and other central banks are forced to follow suit in a self-reinforcing cycle of devaluation and a mad game of Prisoner’s Dilemma. This unofficial, but clearly observable policy has the unintended consequence of socializing risk for private gain and introduces deep ‘shadow’ risks in the global economy. ... At this stage, absent continuous intervention, a large deflationary crash in the global economy is inevitable. The greatest risk is that if central banks continue a policy of competitive devaluation and hyper-asset bubbles the end result will be an even more devastating crash, followed by sovereign defaults, and then class warfare. The next Lehman brothers will be a country. The real ‘shadow convexity’ will not come from markets but political unrest or war. ... History shows us that economic recovery from a depression has never been successfully engineered without major debt reduction, devaluation, default, hyperinflation, political revolution, or world war.

1. The Hollow Alliance: The trans-Atlantic partnership has been the world’s most important alliance for nearly seventy years, but it’s now weaker, and less relevant, than at any point in decades. It no longer plays a decisive role in addressing any of Europe’s top priorities. Russia’s intervention in Ukraine and the conflict in Syria will expose US-European divisions. As US and European paths diverge, there will be no more international fireman—and conflicts particularly in the Middle East will be left to rage.
2. Closed Europe: In 2016, divisions in Europe will reach a critical point as a core conflict emerges between Open Europe and Closed Europe—and a combination of inequality, refugees, terrorism, and grassroots political pressures pose an unprecedented challenge to the principles on which the new Europe was founded. Europe’s open borders will face particular pressure. The risk of Brexit is underestimated. Europe’s economics will hold together in 2016, but its broader meaning and its social fabric will not.
3. The China Footprint: Never has a country at China’s modest level of economic and political development produced such a powerful global footprint. China is the only country of scale today with a global economic strategy. The recognition in 2016 that China is both the most important and most uncertain driver of a series of global outcomes will increasingly unnerve other international players who aren’t ready for it, don’t understand or agree with Chinese priorities, and won’t know how to respond to it.
4. ISIS and “Friends”: ISIS is the world’s most powerful terrorist organization, it has attracted followers and imitators from Nigeria to the Philippines, and the international response to its rise is inadequate, misdirected, and at cross purposes. For 2016, this problem will prove unfixable, and ISIS (and other terrorist organizations) will take advantage of that. The most vulnerable states will remain those with explicit reasons for ISIS to target them (France, Russia, Turkey, Saudi Arabia, and the United States), and those with the largest numbers of unintegrated Sunni Muslims (Iraq, Lebanon, Jordan, Egypt, and across Europe).
5. Saudi Arabia: The Saudi Kingdom faces a growing risk of destabilizing discord within the royal family this year, and its increasingly isolated status will lead it to act more aggressively across the Middle East this year. The threat of intra-royal family strife is on the rise, and a scenario of open conflict, unimaginable prior to King Salman’s January 2015 ascension, has now become entirely realistic. The key source of external Saudi anxiety is Iran, soon to be free of sanctions.
6. The rise of technologists: A variety of highly influential non-state actors from the world of technology are entering the realm of politics with unprecedented assertiveness. These newly politically ambitious technologists are numerous and diverse, with profiles ranging from Silicon Valley corporations to hacker groups and retired tech philanthropists. The political rise of these actors will generate pushback from governments and citizens, generating both policy and market volatility.
7. Unpredictable Leaders: An unusually wide constellation of leaders known for their erratic behavior will make international politics exceptionally volatile this year. Russia’s Vladimir Putin and Turkey’s Recep Tayyip Erdogan are leaders of an unruly pack that includes Saudi Arabia’s Deputy Crown Prince Mohammed bin Salman and – to a lesser but important extent – Ukraine’s Petro Poroshenko. These unpredictable leaders make our list for 2016 because their interventions overlap and conflict. One powerful, erratic leader spells trouble; four spell volatility with major international implications.
8. Brazil: President Dilma Rousseff is fighting for her political survival, and the country’s political and economic crisis is set to worsen in 2016. Contrary to hopes among pundits and many market players, the battle over Rousseff’s impeachment is unlikely to end the current political stalemate. Should the president survive, her government won’t gain the political boost necessary to move on the economic reforms needed to tackle the country’s growing fiscal deficit. If Rousseff is ousted, an administration led by Vice President Michel Temer won’t fare much better.
9. Not enough elections: Emerging markets underwent a historic cycle of national elections in 2014-2015, but this year there are relatively few opportunities for EM voters to make themselves heard at the ballot box. As slower growth and stagnating living standards stoke popular discontent, governance and stability will suffer. Historically, markets have been less volatile in non-election years, but this time will be different. By raising popular expectations, the massive income growth that most EMs enjoyed over the past 10 years has created conditions for a rude awakening.
10. Turkey: After a decisive victory for his AK party in late-2015, President Erdogan will now push to replace the country’s parliamentary system with a presidential one. He’s unlikely to reach his goal in 2016, but his aggressive electioneering will further damage an already battered Turkish business and investment climate. On the security front, there is little prospect of an imminent end to PKK violence, and unrelenting US pressure on Ankara to clamp down on the Islamic State will produce only modest results while making Turkey more vulnerable to new attacks by ISIS.
* Red Herrings: US voters aren't going to elect a president who will close the country to Muslims. China’s economy isn’t headed for a hard landing, and its politics will remain stable. Continued strong leadership from Japan's Shinzo Abe, India's Narendra Modi, and especially China's Xi Jinping will keep Asia's three most important players focused on economic reform and longer-term strategy, reducing the risk of conflict in Asia’s geopolitics.

An accelerating field of research suggests that most of the artificial intelligence we’ve created so far has learned enough to give a correct answer, but without truly understanding the information. And that means it’s easy to deceive. ... Machine learning algorithms have quickly become the all-seeing shepherds of the human flock. This software connects us on the internet, monitors our email for spam or malicious content, and will soon drive our cars. To deceive them would be to shift tectonic underpinnings of the internet, and could pose even greater threats for our safety and security in the future. ... Small groups of researchers—from Pennsylvania State University to Google to the U.S. military— are devising and defending against potential attacks that could be carried out on artificially intelligent systems. In theories posed in the research, an attacker could change what a driverless car sees. Or, it could activate voice recognition on any phone and make it visit a website with malware, only sounding like white noise to humans. Or let a virus travel through a firewall into a network. ... Instead of taking the controls of a driverless car, this method shows it a kind of a hallucination—images that aren’t really there. ... “We show you a photo that’s clearly a photo of a school bus, and we make you think it’s an ostrich,” says Ian Goodfellow, a researcher at Google who has driven much of the work on adversarial examples.

The global catastrophic risks in this report can be divided into two categories. Some are ongoing and could potentially occur in any given year. Others are emerging and may be very unlikely today but will become significantly more likely in the coming decades. The most significant ongoing risks are natural pandemics and nuclear war, whereas the most significant emerging risks are catastrophic climate change and risks stemming from emerging technologies. Even where risks remain in the future, there are things we can do today to address them. ... The relative likelihood and urgency of the different risks matters when deciding how to respond. Even though the level of uncertainty is extreme, rational action requires explicit assessments of how much attention the different risks deserve, and how likely they are. The views of the authors on these vexed questions, based on our reading of the scientific evidence, are summarised in the following table. More information can be found in the full version of this report.

Many companies already have the ability to run keyword searches of employees’ emails, looking for worrisome words and phrases like embezzle and I loathe this job. But the Stroz Friedberg software, called Scout, aspires to go a giant step further, detecting indirectly, through unconscious syntactic and grammatical clues, workers’ anger, financial or personal stress, and other tip-offs that an employee might be about to lose it. ... To measure employees’ disgruntlement, for instance, it uses an algorithm based on linguistic tells found to connote feelings of victimization, anger, and blame. ... It’s not illegal to be disgruntled. But today’s frustrated worker could engineer tomorrow’s hundred-million-­dollar data breach. Scout is being marketed as a cutting-edge weapon in the growing arsenal that helps corporations combat “insider threat,” the phenomenon of employees going bad. Workers who commit fraud or embezzlement are one example, but so are “bad leavers”—employees or contractors who, when they depart, steal intellectual property or other confidential data, sabotage the information technology system, or threaten to do so unless they’re paid off. Workplace violence is a growing concern too. ... Though companies have long been arming themselves against cyberattack by external hackers, often presumed to come from distant lands like Russia and China, they’re increasingly realizing that many assaults are launched from within—by, say, the quiet guy down the hall whose contract wasn’t renewed.

Risk scores, generated by algorithms, are an increasingly common factor in sentencing. Computers crunch data—arrests, type of crime committed, and demographic information—and a risk rating is generated. The idea is to create a guide that’s less likely to be subject to unconscious biases, the mood of a judge, or other human shortcomings. Similar tools are used to decide which blocks police officers should patrol, where to put inmates in prison, and who to let out on parole. Supporters of these tools claim they’ll help solve historical inequities, but their critics say they have the potential to aggravate them, by hiding old prejudices under the veneer of computerized precision. ... Computer scientists have a maxim, “Garbage in, garbage out.” In this case, the garbage would be decades of racial and socioeconomic disparities in the criminal justice system. Predictions about future crimes based on data about historical crime statistics have the potential to equate past patterns of policing with the predisposition of people in certain groups—mostly poor and nonwhite—to commit crimes.

Following 17 months of mostly negative equity returns in Europe, very recently, I have noticed an inclination amongst European investors to increase the risk profile in their portfolios. They may not exactly be going for broke (yet), but the willingness to take more risk is clearly on the rise. The rising appetite for risk could be driven by one of two factors. Investors could either be turning more optimistic, or it could be the result of less benign factors, such as a need to generate higher returns, whether they really believe in such an outcome or not. ... In short, I suspect investors are chasing returns that (I think) are unrealistic, and it is not the first time that happens. When investors are under extreme pressure, as I think many are now, they sometimes behave quite irrationally. They do things they would have sworn only a short while earlier they would never do. ... Is there anything else investors could do to raise the overall return level and, in particular, to generate more income without necessarily taking more risk?

Professionals in many organizations are assigned arbitrarily to cases: appraisers in credit-rating agencies, physicians in emergency rooms, underwriters of loans and insurance, and others. Organizations expect consistency from these professionals: Identical cases should be treated similarly, if not identically. The problem is that humans are unreliable decision makers; their judgments are strongly influenced by irrelevant factors, such as their current mood, the time since their last meal, and the weather. We call the chance variability of judgments noise. It is an invisible tax on the bottom line of many companies. ... The prevalence of noise has been demonstrated in several studies. Academic researchers have repeatedly confirmed that professionals often contradict their own prior judgments when given the same data on different occasions. ... The unavoidable conclusion is that professionals often make decisions that deviate significantly from those of their peers, from their own prior decisions, and from rules that they themselves claim to follow. ... It has long been known that predictions and decisions generated by simple statistical algorithms are often more accurate than those made by experts, even when the experts have access to more information than the formulas use. It is less well known that the key advantage of algorithms is that they are noise-free: Unlike humans, a formula will always return the same output for any given input. Superior consistency allows even simple and imperfect algorithms to achieve greater accuracy than human professionals. ... One reason the problem of noise is invisible is that people do not go through life imagining plausible alternatives to every judgment they make. ... The bottom line here is that if you plan to use an algorithm to reduce noise, you need not wait for outcome data. You can reap most of the benefits by using common sense to select variables and the simplest possible rule to combine them.

This problem has a name: the paradox of automation. It applies in a wide variety of contexts, from the operators of nuclear power stations to the crew of cruise ships, from the simple fact that we can no longer remember phone numbers because we have them all stored in our mobile phones, to the way we now struggle with mental arithmetic because we are surrounded by electronic calculators. The better the automatic systems, the more out-of-practice human operators will be, and the more extreme the situations they will have to face. ... The paradox of automation, then, has three strands to it. First, automatic systems accommodate incompetence by being easy to operate and by automatically correcting mistakes. Because of this, an inexpert operator can function for a long time before his lack of skill becomes apparent – his incompetence is a hidden weakness that can persist almost indefinitely. Second, even if operators are expert, automatic systems erode their skills by removing the need for practice. Third, automatic systems tend to fail either in unusual situations or in ways that produce unusual situations, requiring a particularly skilful response. A more capable and reliable automatic system makes the situation worse. ... The rarer the exception gets, as with fly-by-wire, the less gracefully we are likely to deal with it. We assume that the computer is always right, and when someone says the computer made a mistake, we assume they are wrong or lying. ... For all the power and the genuine usefulness of data, perhaps we have not yet acknowledged how imperfectly a tidy database maps on to a messy world. We fail to see that a computer that is a hundred times more accurate than a human, and a million times faster, will make 10,000 times as many mistakes. ... If you occasionally need human skill at short notice to navigate a hugely messy situation, it may make sense to artificially create smaller messes, just to keep people on their toes.

Wu believes Opendoor can buy and sell homes, in quantity, by employing the type of data analysis that has powered so many Silicon Valley companies and by targeting the broad middle of the market. It deals in single-family homes built after 1960, priced between $125,000 and $500,000. It has no interest in distressed properties, which require too much work, or in luxury properties, which are harder to value. ... Of course, buying up houses to make a market is capital-intensive, and the risks are great. Opendoor has raised $110 million in equity from Khosla Ventures, GGV Capital and Access Industries, among others, most recently at a valuation of $580 million earlier this year. And it has also raised more than $400 million in debt to buy the homes. To succeed, it has to price the homes it buys accurately, without seeing them, and it has to sell them quickly to minimize the costs of carrying them. ... Opendoor is a big, bold play in a market with $1.4 trillion in annual transaction volume that’s been largely undisturbed for decades. ... the model has yet to be tested by a recession or a market crash, which can catch even the smartest players by surprise. Wu says he modeled the business through the 2008 subprime crisis to understand the risk.

It’s been six years since we first wrote about the coming G-Zero world—a world with no global leader. The underlying shifts in the geopolitical environment have been clear: a US with less interest in assuming leadership responsibilities; US allies, particularly in Europe, that are weaker and looking to hedge bets on US intentions; and two frenemies, Russia and China, seeking to assert themselves as (limited) alternatives to the US—Russia primarily on the security front in its extended backyard, and China primarily on the economic front regionally, and, increasingly, globally. ... These trends have accelerated with the populist revolt against “globalism”—first in the Middle East, then in Europe, and now in the US. Through 2016, you could see the G-Zero picking up speed ... with the shock election of Donald Trump as president of the US, the G-Zero world is now fully upon us.
1.   Independent America: Trump rejects the comparative weakness of the presidency, and he wants to more directly project American power in service of US national interests
2.   China overreacts: Xi will be extremely sensitive to external challenges to his country’s interests at a time when all eyes are on his leadership
3.   A weaker Merkel: Could the Europeans have resolved their financial crises without the Germans forcing a solution?
4.   No reform: The reform needle won’t move in 2017. Save for a few bright spots, money won’t know where to flow
5.   Technology and the Middle East: Technology, a force for economic growth and efficiency, also exacerbates political instability
6.   Central banks get political: In the US, there’s risk of an open conflict between the Federal Reserve and the White House
7.   The White House versus Silicon Valley: Technology leaders from California, the major state that voted in largest numbers against Trump in the election, have a bone to pick with the new president
8.   Turkey: Ever-fewer checks on executive power will leave the private sector vulnerable to political whims
9.   North Korea: It’s making consistent progress on an intercontinental ballistic missile capability that would allow it to hit the West Coast of the US with a nuclear weapon
10.   South Africa: South Africa’s political infighting will undermine the country’s traditional role as a force for regional security
Red Herrings: US domestic policy, India versus Pakistan, Brazil

In the summer of 2014, Anthony McGinty and Michelle Sosa were hired by Los Angeles World Airports to lead a unique, new classified intelligence unit on the West Coast. After only two years, their global scope and analytic capabilities promise to rival the agencies of a small nation-state. Their roles suggest an intriguing new direction for infrastructure protection in an era when threats are as internationally networked as they are hard to predict. ... their current operation falls somewhere between a start-up and a think tank. Because she came from an intelligence background, Sosa had an eye for big-picture narratives; McGinty’s 25 years as a street detective and war veteran gave him tactical insights and a deep knowledge of police culture. Together, the two of them have brought classified in-house intelligence analysis to one of the world’s busiest airports ... Their work promises to propel the city’s aging airport to the forefront of today’s conversations about what it means to protect critical infrastructure and, in the process, to redefine where true power lies in the 21st-century metropolis. ... More than 50,000 badged employees report to work there each day, many with direct access to the airfield—and thus to the vulnerable aircraft waiting upon it. More than 100,000 passenger vehicles use the airport’s roads and parking lots every day, and, in 2015 alone, LAX hosted 75 million passengers in combined departures and arrivals.

Financial markets accommodate both prudent insurers and reckless gamblers. They provide investors with an opportunity to diversify their portfolios, and allow gamblers to bet on future movements in interest rates. The coexistence of the two can allow speculators to make profits by stabilising prices—buying when markets are fearful, and selling when they are greedy. But when the gambling motive overwhelms the insurance motive, speculation becomes destabilising and then risk, far from being minimised by careful management, becomes concentrated in the hands of those who understand least what they are doing. And when regulators perceive insurance when they should see wagering, their actions magnify a crisis rather than minimise it. Such destabilising speculation, mischaracterised by regulatory authorities as prudent risk assessment, is what caused the global financial crisis of 2008. ... The coexistence of insurance and gambling goes back to the earliest days of markets in risk, and the interaction of the two has been central to financial history. But it was four developments in the second half of the 17th century that combined to frame the way we think about risk, and the institutions we have for dealing with it, through to the present day.

Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature. I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses. ... Since I’m convinced “they” are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions – it’s time for yet another cautionary memo. Too soon? I hope so; we’d rather make money for our clients in the next year or two than see the kind of bust that gives rise to bargains. (We all want there to be bargains, but no one’s eager to endure the price declines that create them.) Since we never know when risky behavior will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us.