Thursday, January 30, 2020

Second-Order Effects: The Unexpectedly Slippery Path to Dow 10,000

Dow 30,000 is "unsinkable," just like the Titanic.
A recent Barrons cover celebrating the euphoric inevitability of Dow 30,000 captured the mainstream zeitgeist perfectly: Corporate America is firing on all cylinders, the Federal Reserve's god-like powers will push stocks higher regardless of any other reality, blah blah blah.
While the financial media looked elsewhere for its amusement, the coronavirus epidemic in China just poured fentanyl in the Dow 30,000 punchbowl. The mainstream continues to guzzle down the punch, oblivious to the fentanyl, confident that the coronavirus will quickly fade and China will soon return to its winning role of growth chariot pulling the global economy to ever greater heights.
As I noted in Could the Coronavirus Epidemic Be the Tipping Point in the Supply Chain Leaving China?, there's a factor few of the sublimely confident Bulls consider: second-order effects: first order, every action has a consequence. Second order, every consequence has its own consequence.
The media's focus is solely on the first-order consequences: the number of infected people and fatalities, government responses such as quarantines, and so on. The general expectation is these first-order consequences will dissipate shortly and life will return to its pre-epidemic status with virtually no significant changes.
If we consider second-order effects carefully, we draw a much different conclusion: China will experience social unrest and economic dislocation that will unleash self-reinforcing chaos in global markets. This is not a mainstream opinion, of course, because the mainstream assumes second-order effects simply won't matter, i.e. they don't exist. As I describe in my latest book, Will You Be Richer or Poorer?, acting as if inconvenient realities don't exist doesn't make them actually vanish. Ignoring realities that are difficult to measure or that don't fit the happy story is ultimately suicidal.
Though China Bulls will never admit it, China's economy has become increasingly fragile in a process of diminishing returns reflected in the chart of China's S-Curve below. What worked in the boost phase (picking the low-hanging fruit of development) no longer works.
The conventional view in the West is that the Chinese people are docile and obedient, obeying the central government's edicts without question. The idea that the working class in China could refuse to comply is not even on the margins of Western understanding.
But if we consider the thousands of spontaneous protests and wildcat strikes against authority that have occurred in China in recent years, we realise it's Americans who are docile and obedient, slavishly worshiping at the altar of the Federal Reserve / Dow 30,000 while their "billionaire betters" pile up fortunes and political influence, reducing the vaunted American middle-class to passive, beaten debt-serfs and tax donkeys.
Despite the paper-thin veneer of official Communist rhetoric, the social contract in China is entirely financial: you (the ruling elites) make us more prosperous every month and we'll obey. Prosperity is of course financial--higher wages, more social benefits, higher real estate valuations, and so on-- but it also includes intangible forms of capital such as greater security, cleaner air and water, wider avenues of social mobility, etc.
The official mishandling of the coronavirus epidemic from the top down tells the Chinese people the unfortunate reality: you don't count, you don't matter. All that matters is the leadership saving face, and if millions of working-class Chinese people are sacrificed or needlessly put in harm's way to save the leadership's face, then the masses should quietly accept their completely needless losses and suffering.
This is a complete abrogation of the implicit social contract China's people have come to expect of their leadership. The masses have accepted systemic corruption that enriches the few (Party leaders and crony developers, etc.) at the expense of the many because the many were gaining greater prosperity and security. But that advance has stalled in recent years as the costs of essentials have soared and wages haven't kept pace.
The favored elites have of course kept pace, and since they control the media and machinery of governance, the unhappy slippage has been successfully buried beneath bogus official statistics and relentless suppression of any leakage or dissent.
(Note that doctors who attempted to go public with their fears of the coronavirus in early January were reportedly arrested to shut them up--par for the course for anyone who doesn't comply with face-saving official prevarication.)
But being exposed to a potentially fatal virus because it pleased the leadership to suppress the facts will trigger second-order effects that will not dissipate. The same can be said of economic and financial second-order effects that will disrupt supply chains and China's precariously over-leveraged shadow banking system.
Those expecting the Chinese workers to be cowed by 100,000 security cameras will be surprised when workers tear down every single camera and the police and People's Liberation Army soldiers decline to kill their fellow citizens.
Nobody expects China's social order or economy to unravel as a second-order effect of the epidemic, and that in itself is a sound reason to not dismiss the possibility too readily. Second-order effects: consequences have their own consequences.
Meanwhile, back on the Corporate America Ranch, Second-order effects may upset all the happy-story assumptions of Chinese suppliers magically being unaffected and workers whose jobs have vanished accepting their downward mobility without complaint.
U.S. companies may find their products are not available in the expected quantities and at the expected prices. Since 90% of American wage-earners have stagnant incomes, Corporate America has no pricing power, i.e. ability to raise prices and make them stick, so profits will be slashed as sales stagnate along with wages.
The hubris-soaked fantasy that the Fed will jack up stock valuations forever regardless of sales and profits will run aground on the unforgiving shoals of reality and all the hidden fragilities in America's economy will emerge: too much leverage, too many zombie companies kept alive by debt, too much debt and not enough collateral, too many small businesses one tiny tipping-point away from closing for good and laying off all employees--the list is nearly endless.
Once all the second-order effects have erupted and triggered their own chaotic consequences, we'll look back at the complacent euphoria that America is both dependent on Chinese labor and production yet magnificently detached from any consequences of China's downward spiral and marvel at the herd's self-congratulatory hubris, willful blindness and unforgivable negligence.
Down this slippery path lies Dow 10,000. Dow 30,000 is "unsinkable," just like the Titanic.



My recent books:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.
NOTE: Contributions/subscriptions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, Robert M. ($5/month), for your superbly generous pledge to this site -- I am greatly honored by your support and readership.
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Posted by Charles Hugh Smith at 9:29 PM

Wednesday, January 29, 2020

Has the Global Economy Finally Exhausted its Good Luck?

All of these guarantees and redundancies are as illusory as the "unsinkable" technologies of the Titanic.
The past three decades of global growth are rarely attributed to luck: it's all the result of our brilliant fiscal, monetary and trade policies. Those in positions of wealth and power are delighted to take credit for this tremendous success, but as a general rule, the more knowledgeable you are and the higher up the food chain you are, the greater your awareness of the role of luck in any unbroken chain of success.
There are various moving parts in what we call luck. One is what we don't know but think we know, or put another way, we know enough to be confident everything will work as intended and expected.
I described how this worked in the Titanic disaster in Why Our Financial System Is Like the Titanic (March 15, 2016).
The technologies of the early 1900s enabled shipbuilders to construct enormous steel-hulled ships almost 900 feet in length capable of steaming at 24 knots, transporting passengers across the Atlantic in comfort. The technologies that made such ships and transits low risk were largely already present but in forms that were deeply flawed in ways that were not readily visible or understood.
Unbeknownst to the era's designers and shipbuilders, the Titanic's hull plates were brittle due to high sulfur content in the steel, especially at cold temperatures (the water was near freezing at the time of the collision with the iceberg).
Rather than deform as the iceberg scraped against the hull, the plates and rivets fractured, opening the irregular gash that sank the ship.
The watertight bulkheads appeared to make the ship "unsinkable," but this was only true if the hull was compromised across no more than four watertight compartments. The bulkheads may have actually accelerated the sinking, as later studies found the ship would have stayed afloat an additional six hours without any watertight bulkheads, as the ship would have settled evenly rather than sinking bow-first as the forward compartments filled.
The presence of lifeboats seemed to offer a guarantee of safety, yet outdated regulations only required enough lifeboats for half the crew and passengers.
The new technology of radio ("wireless") seemed to provide a reliable way to call for help, yet regulations did not require all ships to staff wireless stations 24 hours a day, so nearby ships never received Titanic's distress calls.
Assuming that human lookouts could detect icebergs soon enough to change course seemed realistic, and favoring the first class passengers in lifeboat access was unquestioned until after the sinking.
After the disaster, all these inadequacies (except the high sulfur steel deficiencies) became obvious, but this "obviousness" only manifested because of the disaster: if the Titanic had narrowly missed the iceberg, everyone would have continued to be resolutely confident that the ship and all the life-safety systems were not just adequate but beyond adequate.
The fact that large ships and powerful engines could be built created the illusion of low risk, because the risk factors were invisible until after the fact. The high confidence in the technologies of the day now seem quaint: the flaws in the steel plates and rivets would remain invisible until the technologies of steel production finally caught up with the other shipbuilding technologies, and better detection and tracking of icebergs would have to wait for radar and better navigational technologies.
But how different is our current extreme confidence in our healthcare technologies?
Much of what we take for granted as essentially guaranteed by our fabulous technologies and systems is more akin to the Titanic than we care to admit. That the world has avoided seriously disruptive global pandemics for a hundred years is more luck than most people understand. RNA viruses mutate at a very high rate (i.e. they replicate with imprecision, generating a high rate of mutations). Whether these mutations end up being "good" or "bad" for the human hosts is a function of randomness, i.e. luck.
The global economy has been astonishingly lucky for 30 years--or even 75 years. Like the passengers on the Titanic, we have unquestioned confidence in our technologies and systems because they appear so "guaranteed", so resilient and so redundant.
All of these guarantees and redundancies are as illusory as the "unsinkable" technologies of the Titanic. The irony is that the more knowledgeable the individual, the more they understand the role of luck in avoiding failure or catastrophe. The less we know, the more trusting we are in compelling illusions of safety and security.



My recent books:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.
NOTE: Contributions/subscriptions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, Kenneth B. ($10), for your most generous contribution to this site -- I am greatly honored by your support and readership.
 
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Posted by Charles Hugh Smith at 8:19 PM

Coronavirus and the "Unsinkable" Titanic Analogy

Unthinkable doesn't mean unsinkable.
As we all know, the "unsinkable" Titanic suffered a glancing collision with an iceberg on the night of April 14, 1912. A half-hour after the iceberg had opened six of the ship's 16 watertight compartments, it was not at all apparent that the mighty vessel had been fatally wounded, as there was no evidence of damage topside. Indeed, some eyewitnesses reported that passengers playfully scattered the ice left on the foredeck by the encounter.
But some rudimentary calculations soon revealed the truth to the officers: the ship would sink and there was no way to stop it. The ship was designed to survive four watertight compartments being compromised, and could likely stay afloat if five were opened to the sea, but not if six compartments were flooded. Water would inevitably spill over into adjacent compartments in a domino-like fashion until the ship sank.
We can sympathize with the disbelief of the officers, and with their contradictory duty to simultaneously reassure passengers and attempt to goad them into the lifeboats. Passengers were reluctant to heed the warning because it was at odds with their own perceptions. With the interior still warm and bright with lights, it seemed far more dangerous to clamber into an open lifeboat and drift off into the icy Atlantic than it did to stay onboard.
The evidence was undeniable, but humanity's first response is denial, regardless of the evidence. The evidence that the coronavirus is contagious is undeniable, as is the evidence that carriers who have no symptoms can transmit the virus to others.
Just as the eventual sinking of Titanic could be extrapolated from the basic facts (six watertight compartments were flooding), so the eventual spread of the coronavirus can be extrapolated from these basic facts.
But the official global response is "these facts don't matter," and so hundreds of airline flights continue to leave cities swept by the disease. That once the virus spreads globally it will impact the global economy is easily extrapolated, but few want to consider the sinking of the unsinkable, so they don't.
As a result, the first lifeboats left the doomed ship only partially full. Only when it became undeniable that the ship was doomed did people attempt to get on a lifeboat, but by then it was too late: the lifeboats had all been launched.
This may be an appropriate analogy to the U.S. stock market, which is widely considered "unsinkable" due to the Federal Reserve's unlimited ability to create "liquidity" (cash) out of thin air.
The stock market just had a minor collision with the coronavirus, and few are heeding the warnings, preferring to heed the reassurances that thanks to the omnipotent Federal Reserve, the market is unsinkable, and the party in the First Class deck will continue indefinitely.
The lifeboats are already leaving, but few have escaped the doomed ship, i.e. sold all their equities.
When the crowd partying in First Class awakens to the inevitability of the stock market sinking, it will be too late to get on the lifeboat, i.e. sell out at the top.
A half-hour after the fatal collision, the reassurances are so comforting and credible: how could this great ship sink? Indeed, how could a stock market racing so confidently to Dow 30,000 sink to Dow 20,000 or even 10,000? It's unthinkable.
Unthinkable doesn't mean unsinkable.
Here are some informative science-based links on the coronavirus, courtesy of longtime correspondent Cheryl A.:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.
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Posted by Charles Hugh Smith at 2:56 AM

Tuesday, January 28, 2020

Could the Coronavirus Epidemic Be the Tipping Point in the Supply Chain Leaving China?

Everyone expecting a quick resolution to the epidemic and a rapid return to pre-epidemic conditions would be well-served by looking beyond first-order effects.
While the media naturally focuses on the immediate effects of the coronavirus epidemic, the possible second-order effects receive little attention: first order, every action has a consequence. Second order, every consequence has its own consequence.
So the media's focus is the first-order consequences: the number of infected people and fatalities, government responses such as quarantines, and so on. The general expectation is these first-order consequences will dissipate shortly and life will return to its pre-epidemic status with virtually no significant changes.
Second-order effects caution: not so fast. Second-order consequences may play out for months or even years even if the epidemic ends as quickly as the consensus expects.
The under-appreciated dynamic here is the tipping point, the imprecise point at which a decision to make fundamental changes tips from "maybe" to "yes."
These tipping points are often influenced by exhaustion or frustration. Take a small business that's been hit with tax increases, additional fees, more regulatory compliance requirements, etc. When the next fee increase arrives, the onlooker might declare that the sum is relatively modest and the business owner can afford to pay it, but the onlooker is only considering first-order effects: the size of the fee and and the owner's ability to pay it.
To the surprise of the onlooker focusing only on first-order effects, the second-order effect is the owner closes the business and moves away. Invisible to everyone focusing solely on first-order effects, the owner's sense of powerlessness and weakening resolve to continue despite soaring costs and declining profits has slowly been moving up to a tipping point.
Beneath the surface, every new fee, every tax increase and every new regulation has pushed the owner closer to "I've had it, I'm out."
When the owner shuts the business, onlookers can't understand how one little extra fee could trigger such a fundamental change. The observer is only looking at the new fee as a single cause with a single consequence. In the real world, each new fee, tax increase and regulation was another link in a causal chain of consequences generating consequences.
Turning to the possible second-order effects of the epidemic in China, let's start with the decision to keep supply chains in China. The reasons to keep supply chains in China have been dwindling for years: wages and other costs have been rising, the central government has increased demands for technology sharing, the general sense that foreigners and foreign companies are no longer needed or wanted, and the trade war, which is more or less in a truce phase rather than over.
One common belief is that it's "impossible" to move supply chains out of China. This is a classic first-order effect analysis. When the supply chain gets disrupted for one reason or another and alternatives must be found, alternatives are found. What becomes "impossible" isn't moving the supply chain from China but keeping it in China.
The mistake made by those only considering first-order effects is that a modest effect "should" only generate modest consequences. For the observer focused solely on first-order effects, if the coronavirus epidemic blows over as expected, then supply chains "should" be unaffected because the effect is quantitatively modest.
But once we start considering cumulative second-order effects and potential tipping points, then the disruption of supply chains caused by the epidemic, no matter how modest, could be "the last straw" to those who had beneath the surface already shifted from "never leave China" to "maybe leave China." The epidemic could tip the decision process into "must leave China."
Consider two executives, one who looked at the longer term consequences of being dependent on production in China and began establishing alternative suppliers at the start of the trade war 18 months ago, and another exec who looked at the first-order hassles and expenses of moving out of China and stayed put to minimize short-term expenses.
Individual decisions add up to trend changes, and these charts reflect a trend change in globalization and China's share of global exports. Globalization and China's share of global exports have both plateaued and are now entering the stagnation / decline phase of the S-Curve.
Everyone expecting a quick resolution to the epidemic and a rapid return to pre-epidemic conditions would be well-served by looking beyond first-order effects and easy assumptions that the consequences of the epidemic will be near-zero.
Here are some informative science-based links on the coronavirus, courtesy of longtime correspondent Cheryl A.:
Money and Work Unchained $6.95 (Kindle), $15 (print) Read the first section for free (PDF).


If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com.
NOTE: Contributions/subscriptions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, John D. ($50), for your magnificently generous contribution to this site -- I am greatly honored by your steadfast support and readership.
 
Thank you, Robert S. ($50), for your superlatively generous subscription to this site -- I am greatly honored by your steadfast support and readership.

Read more...
Posted by Charles Hugh Smith at 9:41 AM
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