Macro Insights/Report: Financial Markets, Macroeconomics and Geopolitics

The world is interconnected

Hey everyone,

I recently wrote out some thoughts on how I think about the intersection of markets and geopolitics. I broke down some of the key principles and mental models I think of while moving through these domains.

For more on this topic, check out the research synthesis that pulls together all the educational articles I have written (link) and also the most recent macro reports (link, link, link, link).

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Financial Markets, Macroeconomics and Geopolitics

Thesis: Financial markets, macroeconomics, and geopolitics are intricately intertwined in their nonlinear dynamics, constraints, and chaotic nature. This paper will show the connection between each of these domains and their characteristics. Furthermore, it will show specific mental models or “principles” to keep in mind while operating in these domains.

The Connection Between Domains: 

The study and analysis of financial markets and macroeconomics are concerned with quantitatively and qualitatively defining all the goods and services in the economy that are represented by monetary units. Furthermore, market or economic practitioners are in a constant state of determining the transmission mechanisms for goods, services, and capital to flow through. For example, the balance of payments represents the flow of goods, services, and capital between countries. This is a direct extension of the domestic output, demand, and monetary/fiscal policy. When specific regulations or actions by sovereign agents are employed for strategic goals, there is a direct transmission to goods, services, and monetary aggregates. Sovereign agents can employ constraints on capital flows, tariffs, or other regulatory directives to conduct offensive action or defensive action in the global arena.

The most prominent example of a sovereign agent actively influencing the flows of goods, services, or monetary aggregates for strategic goals is China pulling the levers of its balance of payments. If a sovereign agent pulls the levers on the “impossible trinity,” they have the ability to artificially shift the supply and demand curves on consumption, investment, and imports/exports. If the sovereign agent is large enough, as is the case with China, it can have an impact across the globe.

The study and analysis of financial markets and macroeconomics are focused on analyzing supply and demand curves of all goods, services, and monetary aggregates across a country. However, these supply and demand curves are directly impacted by the actions of sovereign agents and their specific constraints. This is where the domain of geopolitics has a critical role. While there is a degree of “free markets” in every economy, it is always on a spectrum that connects to the specific goals and constraints of sovereign agents.

Another illustration of how actions by sovereign agents directly impact financial markets and macroeconomics is the position that the US is currently in with it’s debt and obligations. The US has made a commitment to its citizens in the form of entitlements that directly come from its outlays. When government outlays are greater than its receipts, the differential must be funded by debt. Historically, the level of debt in a country would be an important warning signal to investors and economic agents about the risk in a country. However, in the case with the US, the dollar's reserve status mutes a lot of the capital flight risk that is typically seen in balance of payment crises in emerging markets.

The examples of China and the United States illustrate how there are underlying principles governing agents in a complex system. However, there will always be idiosyncrasies in each situation that create continuity and discontinuity from previous historical cases. Inductive and empirical examples are meant to connect with deductive fundamental principles so that practitioners can function with some degree of informational edge in their decision-making.

Principles For Operation: 

When analyzing and operating in this tension, there are five principles that should be kept in mind for taking calculated risks.

The first principle is to start by identifying the constraints of an agent. While hindsight is 20/20 and the history books focus on the single outcome that occurred, this doesn’t imply a deterministic mindset moving forward. In reality, a historical outcome was one of many that could have occurred and was fundamentally path-dependent. When operating with foresight, there is always a distribution of probable outcomes that can occur in the future. Identifying constraints is the starting point for defining the distribution of future probabilities. Constraints begin to define the range of probable outcomes for specific agents, actions, and entities in a system. Constraints in the geopolitical arena can be things such as geography, demographics, natural resources, military capabilities, or other variables.

The second principle is identifying the risk and reward or skew of specific variables within the constraints that exist. The way to identify risk/reward in a system is by being able to interpret signal amongst all of the noise. Within any open, complex, and chaotic system, there will always be a high degree of noise and false signals. The foundation for beginning to identify a signal is by quantifying all the moving parts, systematizing processes, and creating theses that can be falsified and revised. For example, if there is a specific thesis about an action of an economic agent that is supported by a priori or a posteriori evidence, this can begin to reveal the signals that define the risk/reward in a specific scenario.

The third principle directly connects with the first two and it is timing. Within any system, time is never distributed in a linear fashion. There is an old saying “there are decades where nothing happens; and there are weeks where decades happen” exemplifies this dynamic. Many times there can be a compression of risk against constraints where chaos and volatility hit a low before a fat-tailed event occurs. For example, the balance of payments crisis during the late 90s in Argentina showed how an entire country can move from extreme prosperity to complete collapse within a short period of time. The collapse of Argentina didn’t result in a moderate devaluation of the currency but a complete societal collapse where chaos literally ran rampant in the street.

The fourth principle that should be kept in mind when taking calculated risks is path dependency and the destination. When utilizing foresight to view the distribution of probable outcomes, it is easy to forget that the path is just as important as the destination. For example, if the resources for the survival of a specific agent are finite, then the specific type of path can change if the agent even reaches the destination. If a company doesn’t have enough capital to fund a negative carry, or a country doesn’t have enough food and energy to meet a supply chain deficit, then a “short-term” issue can take an agent out of the equation. This further complicates things if the specific agent's actions are a direct input into the actual destination or outcome of a scenario. The main idea is to analyze both the path dependencies and destinations as they dynamically change in real-time. When timing actions in connection with the third principle, both the path and destination must be viewed in their temporal dependencies.

The fifth and final principle for taking calculated risks is synthesizing principles 1-4 and employing risk management with the sober realization that, after all of this analysis is accomplished, being correct 100% of the time is impossible. Risk management is meant to allow an agent to take small losses when wrong and large gains when correct. Additionally, it is meant to function as an information feedback mechanism. Attribution analysis should be conducted on all gains and losses in order to identify any incorrect actions that could have been avoidable within the uncertainty of the moment when the decision was made. This information feedback mechanism is meant to inform adaptation and be conducted in an iterative fashion so that improvements can be made incrementally.

In conclusion, financial markets, macroeconomics, and geopolitics are intricately intertwined in their nonlinear dynamics, constraints, and chaotic nature. In order to operate in confluence with the characteristics of these systems, the principles of identifying constraints, defining risk/reward, timing, path dependency, and risk management should be employed.