Yang Wen-li’s Dilemma – Democracy, Revolutions & thoughts on Financial Markets

In Yoshiki Tanaka’s epic science fiction thriller, ‘The Legend of the Galactic Heroes‘, Yang Wen-li is caught between the horns of a difficult dilemma.

Staring at the vast open space of stars from his flagship’s bridge, the awkward but astute admiral contemplates the never-ending wars between his home planetary system (the democratic Free Planets Alliance) and the monarchic Galactic Empire.

His adversary is the young and brilliant Count Reinhard Von Lohengramm, who commanded the Galactic Empire’s space fleets.

Heartbroken and tormented after his beloved sister was taken away as an imperial concubine and socially ostracised by the nobility, Von Lohengramm swore vengeance. He seeks to obtain supreme power by serving with distinction in the Imperial Navy – to overthrow the old order some day and establish a benevolent government under his authoritarian rule.

As he rose in stature and power, Von Lohengramm became the biggest threat to the Free Planets Alliance. The Alliance’s politicians deployed their most shrewd tactician (admiral Yang Wen-li) to face-off Von Lohengramm’s fleets in response.

However, the peace-loving and humble Yang realises how brilliant Von Lohengramm is. Yang noted that Von Lohengramm’s reforms in the Empire improved the livelihood of their people, and that he was a genuine, charismatic and efficient leader.

And Yang despises the politicians of his home. Incompetent and corrupt, Yang contemplates if the failing democracy of the Alliance is worth saving.

To continue fighting would mean (i) more casualties, (ii) becoming an enemy of a truly brilliant leader that could bring about a better livelihood for all, (iii) but keeping the flame of democractic governance alive. Stop the fight however, and it would mean peace and an end to destruction and bloodshed, but the end of any democracy in the galaxy…

Even as these thoughts ran through his head while his space fleets prepare to warp across the galaxy to battle, Yang subconsciously remained firm in his belief in republican democracy, sighing as he contemplated if the bloodshed is worth it all.

Hence, the war continued.

Remember the 3rd of November

I’m once again breaking my writing sabbath in this fairly wild year to pen my thoughts down in this post. As always, my perspective is limited by my experience and my current understanding of the situation. I’ve got the right to change my views in the future – the world is always more complex than what we presumably believe.

The upcoming presidential elections in the United States is supposedly one of the most widely-watched political events in recent memory. Americans are making their votes at a challenging time. Foreigners will also be quick to note the high degree of polarisation in American society.

This chart from Bruce Mehlman below illustrates the situation clearly.

It doesn’t help that the mailed-votes process and incumbent President Trump’s antics have led to fears of a chaotic transition of power (should Trump lose). Fears of widespread social strife in the event of an unclear outcome are valid given the current backdrop of a highly polarised society.

Many investment professionals have also reduced their risk exposures. According to Financial Times, many are opting to ‘do nothing‘:

‘… many investors are mindful that they failed to predict the shock victory of Donald Trump in 2016 — which triggered market convulsions on the night — as well as the longer-term equities rally that was stoked by his administration’s corporate tax cuts. Other surprises, such as the rise and then historic drop in sterling on the Brexit referendum night earlier that year, have left some investors preferring to just sit back and wait for the result.’

But let us first take a look at the volatility surface of the S&P 500 equity index (SPX). It is basically a 3-dimensional plot of implied volatility of S&P 500 options (the x-axis is the time to maturity, y-axis the implied volatility, z-axis the option’s strike price).

This is the S&P 500’s vol surface on 23 October:

The first thing that you can easily notice is the huge difference in the cost of 10 delta puts relative to 10 delta calls during the first week of November (puts are more expensive). It is indicative of investors’ concerns of the election, as they purchased insurance against potential adverse price shocks.

Contrast the current situation with the S&P 500’s vol surface exactly 4 years ago during the 2016 election:

Back then, expectations were for a Hillary Clinton win, but Trump turned out to be the victor instead on 8 November. Prior to the final outcome, SPX puts did not see the same kind of premium as they did now.

With participants having been bitten once, a case can be made that there’s some adaptation to the current political dynamic (Wall Street portfolio managers anticipating uncertainty and chaos). Of course, that isn’t to say that markets wouldn’t see sharp moves or experience bouts of volatility in November.

I don’t have an opinion on who’s going to win, and I don’t see a need to. To my knowledge, market participants tend to overestimate the direct impact of US political events on financial markets.

Investors should take a step back and assess the bigger picture. They should focus on the ways a political system generally deals with changing socio-economic forces, and not on any individual politician or event at point in time.

The stability of a society depends on the relative size of its middle class

I once had a fascinating discussion with one of my professors back in university. The topic of discussion was the stability of societies (it was an economic geography class).

My professor postulated a simple thesis – the stability of a society depends on the size of its middle class. He said to me:

“Look at the countries and societies that saw violent revolutions in the past. Prior to the breakout of chaos, you’ll find that the ruling class owns a majority of the productive assets of a country and there isn’t any middle class of any sorts – at least in the modern sense of the word.

Medieval societies were generally stable as monarchs relied on lords and barons, and land and serfs were distributed among them. Power and control was fought between monarchs and the Roman Church. In late-Ancient Greece, Tsarist Russia or in Imperial China, there was a huge lower class (as a percentage of the overall population) and a tiny elite ruling class. Revolutions broke out when socio-economic conditions reach a tipping point.

When people feel that they have a stake in a society, they tend to think twice about upsetting the status quo, reaching out for their pitchforks or capturing the local governor and governess and beheading them.”

He then drew the following on the whiteboard, using circles to demarcate the size of various classes within a social-national construct. The diagram below illustrates one that has a high chance of instability:

For societies that have a higher chance of remaining stable, they tend to look like this:

While I pondered over the diagrams, he added that in Singapore’s case, the government pushed for home-ownership and made education mandatory in the early years following independence from the British.

When everyone’s livelihoods improved and they feel invested in a society (owning homes and assets), a virtuous cycle of economic improvement and societal stability kicks in. Of course, being an American, he chuckled and added casually that the Singapore government enforced it in an authoritarian way by restricting civil liberties.

Having studied the history of rebellions and revolutions, this was an interesting thesis that stayed on me. It is true that societies in the past that have seen violent and devastating internal chaos tended to have stark economic disparities between various social classes.

The revolutionaries that rose to power, whether its the Jacobins of 18th century France or the communists in China or Vietnam in the 1940s, were more similar than widely-believed. ‘Liberté, égalité, fraternité‘ is something that resonates with a people when they own almost nothing and feel left out in a society and when conditions force them into a ‘nothing-to-lose’ mentality.

Additionally, the new regimes that came into power also fought for better welfare. The Bolsheviks were shouting for ‘Peace, Land, & Bread‘ in 1917, which is something the workers and farmers desired, not sovietisation, abolishment of stock markets, and confiscation of bourgeoisie property’ (that was in manifestos but who could read them? Who knew what stock exchanges are?).

Very rarely do people solely fight and die for political preferences, unless they believe that is a requisite for a better livelihood and better socioeconomic conditions.

How economic & wealth redistribution occur will matter

With this context in mind, it isn’t all that surprising that social tensions in various countries across the world have risen in recent times. Everyone is aware of the stark divisions in wealth-levels and huge income disparities in the developed and emerging countries. The ‘have-nots’ are rebelling.

With interconnectivity aided by social media, it is increasingly difficult for political systems where power is highly centralised to persevere. I’m of the opinion that political power is breaking down at the highest level, and increasingly transitioning to the individual. Whether the existing political systems as we know it survive or evolve remains to be seen – the key issue is how these political systems deal with current socio-economic issues such as redistribution of incomes.

So focus on those paths and policy actions, and cut away the noise and irrelevant ‘data’ from the 24/7 news cycle flooding all of us.

Authoritarian governments have to cater to the needs of the average commoner to stay in power, and to control and regulate public opinion either by social engineering or by aggressive restrictions of civil liberties. On the other hand, politicians in representative democracies have to be sensitive to the flavour of the season lest they get booted out by the election cycle. Very likely, this means that we’ll see a lot more fiscal spending by democractic governments well through this coming decade.

Politicians of today have Modern Monetary Theory as their ideological banner to justify fiscal spending and various measures such as universal basic income (UBI). I’ve written earlier about MMT and the potential implications (if you’ve not read, you should get up to speed on it. It’s possibly the most important thing to know in the 2020s).

One core theme that I’ve highlighted on keanchan.com that has emerged (COVID-19 has accelerated this) is the priority of infrastructure building and re-shoring of supply chains. This satisfies the goal of job-creation, at least to in the eyes of politicians trying to win over their people. Together, it is a potent force that they’ll push for.

Incidentally, this requires a huge amount of materials, and it is likely that the structural demand for base metals will increase in the months and years to come – regardless of whatever political outcomes.

I like base metals such as copper to play out this theme. The 10-year chart of Copper prices as shown in the chart below is starting to look interesting. After years of the emerging markets slowdown and supply rebalancing, prices have potentially stabilised.

Investment bank Goldman Sachs estimates that a ‘higher share of renewables and EVs could add between 675 and 1050 kt co copper demand from 2019 to 2023 comparing to only 300kt added between 2015 and 2019.’ In my view, other than rising demand in the developed world, demand for is likely to come from EM ex-China.

This area is just one outlet of the many exciting opportunities to come.

Yang Wen-li’s Dilemma is our dilemma

Hence, as we go into the 2020 US presidential election, I’m looking beyond the noise, and focusing on what I can control: my research, risk-taking, composure, and mental wellbeing.

Many will be debating about whether American democracy survives or whether other forms of governance systems (i.e. autocratic rulers) can more effectively deal with the key issues and challenges at hand.

The simple truth is, we’ll never know. Perhaps we’ve yet to devise the perfect political system that can cater to our needs and temperaments across time. Or perhaps there isn’t an ideal or perfect solution at all.

Just as democracy-believer Admiral Yang Wen-li philosophised in Yoshiki Tanaka’s ‘The Legend of the Galactic Heroes‘:

“There are no absolutely evil forms of government (including dictatorship). The point is how you can run it for the benefit of society.”

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