War Gaming – Part 1: Nukes & Terrorism

Submitted by Bill O’Grady via Confluence Investment Management,

One of the key elements of global hegemony is the ability of a nation to project power. Ideally, this means a potential hegemon needs local security. In other words, a nation that faces significant proximate threats will struggle to project power globally. As a general rule, it’s easier to attack via land compared to the sea.

Rome’s power base was the Italian peninsula. It only needed to defend the northern part of the land mass. Spain had a similar situation. The Netherlands was the global hegemon for a while but was always facing a land threat from France. Britain, being an island, was geographically ideal for superpower status; the last successful invasion of the British Isles was in 1066. Finally, the U.S. has managed to create an island effect on a larger land mass giving America more access to natural resources compared to Britain, making the U.S. a nearly ideal hegemon.

In Part I of this report, we will examine American hegemony from a foreign nation’s perspective. In other words, if a nation wanted to attack the U.S. to either replace the U.S. as global superpower or to create conditions that would allow it to act freely to establish regional hegemony, how would this be accomplished? This analysis will begin by examining America’s geopolitical position. As part of this week’s report, we will examine the likelihood of a nuclear attack and a terrorist strike against the U.S. In Part II, we will examine the remaining two methods, cyberwarfare and disinformation, discussing their likelihood along with the costs and benefits of these tactics. We will also conclude in Part II with potential market effects.

America’s Geopolitics

The Americans are truly a lucky people. They are bordered to the north and south by weak neighbors and to the east and west by fish.

— Otto von Bismarck

(Source: Wikipedia)

Although Bismarck’s quote is accurate in terms of borders, this circumstance was less due to luck than design. Successive presidents took great care to expand U.S. territory in such a manner as to leave Canada and Mexico with less hospitable border environments. This can be observed on a map of North American population density. The map below shows population density in North America. Note the low density along most of the Canadian/U.S. frontier as well as the lack of density along the Mexican border.

(Source: Wikipedia)

The U.S. pushed its northern border into areas that were less conducive to human development. Canada’s population mostly rests along the border with the U.S. and rapidly declines the further north one travels. The U.S. population is over nine times larger than Canada’s; Canada has 9.4 persons per square mile compared to 85.6 persons per square mile in the U.S. The opposite situation occurs with Mexico. Most of Mexico’s population lives in the southern parts of the state, with the northern desert region relatively unpopulated.

Essentially, the U.S. is surrounded by two neighbors that are no military threat and two oceans. Any nation attempting to launch a conventional military attack on the U.S. would not have any element of surprise. Attacking through either Mexico or Canada would be relatively easy to see coming and force the invader to cross difficult territory on the way to the battle theater. Coming by sea requires a long voyage that would likely be detected as well.

Since 1812, the U.S. has been able to engage the world without significant concern about an attack on the mainland. Japan was able to successfully attack Hawaii and also capture islands that were part of Alaska. But, neither event was enough to seriously threaten the mainland. In the two world wars, the U.S. was able to launch sustained military operations against its enemies with little fear that its industrial base would be attacked.

The isolation of the U.S. makes it an ideal superpower. The U.S. can focus on power projection and use fewer resources for homeland defense. This gives America great power to influence the world and reduces potential enemies’ ability to prevent the U.S. from becoming involved in thwarting their goals.

So, if a foreign power wanted to dethrone the U.S., or, probably more likely, establish itself as a regional hegemon without U.S. interference, what attack options are available to such a power and what are the odds of success? We will examine four different options, assuming that a conventional attack isn’t possible, at least for the foreseeable future.

#1: Nuclear Strike

Since the U.S. used atomic weapons on Japan at the close of WWII, no other power has launched a similar attack. The world came close on a few occasions to a nuclear war—the Cuban Missile Crisis was a near miss—but, for the most part, global leaders have refrained from using these weapons.

During the Cold War, nuclear war doctrine evolved into one where the weapon became purely defensive. Essentially, nuclear powers can never be forced into unconditional surrender. If a nuclear power was facing defeat in conventional warfare, it could prevent complete capitulation though a nuclear attack.

The primary concern of nuclear powers was to ensure that they had systems that would allow for a “second strike” capacity. Thus, if a nuclear power found itself facing a first strike, the goal was to have the ability to retaliate in kind. This model, known as “Mutually Assured Destruction,” required that no side could reliably win a nuclear exchange.

Nuclear powers usually have at least two of three delivery systems: missiles, submarines or bombers. A nation relying solely on land-based missiles could be vulnerable to a first strike. Usually, if a nation only has land-based missiles, they develop mobile launch systems that make conventional attacks on nuclear facilities more difficult.

The key deterrent to a first strike nuclear attack is the second strike response. At the same time, a full-scale nuclear exchange could have catastrophic effects on human life. The spread of radiation could poison the atmosphere. Some scientists theorize that even a modest exchange could trigger a nuclear winter that could have serious effects on the climate; recent studies have suggested it might even trigger a “little ice age.”

The decision process for an American president is fairly straightforward if facing an attack from a major nuclear power such as China or Russia. One would expect a first strike of such magnitude that the ill effects would be global; thus, the damage to the global ecology would probably already be done, prompting an American president to retaliate in kind. In addition, the desire for revenge would be very strong and likely bring a retaliatory second strike. Where the decision becomes difficult is if a minor nuclear power launches a limited nuclear strike on the U.S. The most likely candidate for such an attack would be North Korea. If the Kim regime launched a limited strike on the Western U.S., would an American president risk ending human life on the planet to retaliate, especially if he feared that China or Russia would defend North Korea? On the other hand, allowing the U.S. to be attacked without retaliation seems unlikely due to the loss of American lives and the precedent it would set that may encourage other smaller nuclear powers (e.g., Iran) to engage in their own limited strikes.

Overall, any foreign power attacking the U.S. with nuclear weapons is probably ensuring they will face retaliation that ends the existence of the attacking nation. Thus, this isn’t a likely option.

#2: Terrorism

Terrorism, a form of asymmetric warfare, is a constant threat. However, it has serious limitations as a strategy if used by a foreign nation state. Although terrorism can take many forms, the goal is to “terrorize” a population. If successful, the fear paralyzes a power and renders it incapable to respond to a foreign threat. In other words, a terrorist act can force a nation to focus inward, spend resources on security and perhaps change its foreign policy.

However, this tactic for a foreign government is risky. It can be a bit like bringing a knife to a gunfight. Terrorism generally won’t lead to a regime change. It harms the target and often can force the target nation to retaliate strongly. In other words, a nation can launch a terrorist strike against the U.S. only to then find itself facing a significant conventional attack.

This is why terrorism tends to be the preferred tactic of non-state actors. Al Qaeda’s attacks on the U.S. were a clear tactical victory. In fact, they probably succeeded far beyond expectations. However, the Bush administration reacted strongly with both conventional warfare and Special Forces, severely restricting the group. President Obama eventually attacked Osama bin Laden’s compound, killing al Qaeda’s leader.

There is a temptation for nation states to support non-state actors in attacking a superpower. However, even this cover has hazards. First, the state supporter of terrorism has to take great care to ensure that it has no obvious ties to the terrorist group. Otherwise, it invites retaliation by the superpower. Second, terrorist groups can be difficult to control. They usually have their own agendas which may not coincide with the state sponsor’s objectives. Even Iran, who sponsors Hezbollah, has tried to guide the group into fewer terrorist acts and toward a focus on political control in Lebanon and more conventional fighters in the Syrian conflict. This adjustment has not always been smooth.

Attacking the U.S. using terrorist tactics is a viable option. However, it has two serious drawbacks. First, it could invite a disproportionately harsh response. For example, we doubt the Taliban anticipated that the U.S. would oust its government because it didn’t turn over Osama bin Laden. Second, it is highly unlikely that terrorism would either lead to a regime change in the U.S. or deter America from a key foreign policy goal.

In Part II, we will examine the two remaining tactics for attacking a superpower, namely, cyberwarfare and propaganda.

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Syria opposition await action from Trump on safe zones, Damascus silent

Syrian opposition forces urged President Donald Trump to fulfil a pledge to create safe zones in their country, but analysts doubted he would proceed with a step that could drag Washington deeper into war, hasten Syria’s fragmentation and risk conflict with Russia. Trump told ABC News on Wednesday he “will absolutely do safe zones in Syria” for refugees fleeing violence and that Europe had made a mistake by admitting millions of refugees from Syria. President Bashar al-Assad’s opponents have long demanded safe zones to protect civilians who have fled government air strikes and bombardment of opposition-held areas. But reflecting uncertainties about the announcement, representatives of the insurgents voiced only cautious optimism. “We’ve seen no result on the ground from (US) […]

After Steve Bannon Calls Media “Opposition Party,” NY Times Frames As Nazi Attack On Freedom Of Press

The NY Times – owned by a Mexican Billionaire and full of pedo apologists and slanderous cucks, was granted a rare phone interview with top Trump advisor Steve Bannon, who in no uncertain terms made it clear that the MSM is chock full of…

The post After Steve Bannon Calls Media “Opposition Party,” NY Times Frames As Nazi Attack On Freedom Of Press appeared first on crude-oil.top.

Trump administration debates designating Muslim Brotherhood as terrorist group

A debate is under way in the Trump administration about whether the United States should declare the Muslim Brotherhood a terrorist organization and subject it to US sanctions, according to US officials and people close to President Donald Trump’s transition team. A faction led by Michael Flynn, Trump’s National Security Advisor, wants to add the Brotherhood to the State Department and US Treasury lists of foreign terrorist organizations, the sources said. “I know it has been discussed. I’m in favor of it,” said a Trump transition advisor, who declined to be named because of the sensitivity of the issue. The advisor said Flynn’s team discussed adding the group to the US list of terrorist groups but said it was ultimately […]

Avocados, Beer, Chilli Peppers And Tequilla: Expect Soaring Prices Under A Mexican Border Tax

While the White House floated, then quickly backed off, a proposal for a 20% tax on Mexican imports to “pay for the wall”, in addition to collecting an approximate $10 billion per year in tax revenues, there would be a notable flipside to a tax that would raise prices on Mexican imports by up to 20%, and would immediately affect a wide range of agricultural goods. Mexico exported $21 billion of food and drink north of the border in 2015, according to data from the U.S. Department of Agriculture, making Mexico the 2nd largest supplier of agricultural imports to the US.

Of note, Mexico is by far the biggest supplier of avocados to the US. A trade war with Mexico would mean guacamole could become more valuable than gold.

Some other examples:

  • Fresh vegetables — Imports of tomatoes, onions, chili peppers and other vegetables totaled $4.84 billion. That’s more than four times what was purchased from Canada, the next biggest importer.
  • Fresh fruit — $4.28 billion of shipments, including raspberries, strawberries and avocados. Mexico sells more than twice as much fresh fruit to the U.S. as the No. 2 importer, Chile.
  • Wine and beer — Hold that Corona? Mexico led this category, importing $2.7 billion, almost $1 billion ahead of its biggest competitor, Italy.
  • Snack foods — With $1.72 billion of imports, Mexico is No. 2 here, although Canada sells roughly twice as much into the U.S.

In total, in 2015 Mexico exported some $316 billion in goods and services to the US, among which vehicles ($74 billion), electrical machinery ($63 billion), machinery ($49 billion), mineral fuels ($14 billion), and optical and medical instruments ($12 billion). Under a border tax, US based buyers of any Mexican imports would seen almost instant 20% passthru surcharge.

On the other hand, food exporters to Mexico would benefit from not paying taxes. As Bloomberg notes, despite running an overall trade deficit with Mexico, U.S. food and drink exports to its southern neighbor don’t lag far behind, at $17.7 billion for 2015. The U.S. typically carries a trade surplus with its southern partner in years when grain and oilseed prices are high, as they were for most of the previous decade. Mexico was the biggest buyer of U.S. corn, soybean meal, rice and dairy products in 2015.

Lindsay Graham –  who this afternoon reminded Trump that Mexico is America’s third largest trading partner, and that any tariff we can levy they can levy – probably put it best when he said:

Simply put, any policy proposal which drives up costs of Corona, tequila, or margaritas is a big-time bad idea. Mucho Sad. (2)

— Lindsey Graham (@LindseyGrahamSC) January 26, 2017

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Who’s Right? Bonds Or Stocks

With political and economic policy uncertainty at record highs and equity market valuations near record highs, we have one question: which market – interest rates or stocks – is right about ‘risk’ ahead?


We note that Bloomberg pointed out that VIX call volume climbed to ~435k, compared with 393k in the 20-day average and 88k puts traded today. Among notable trades, an opening block of 34k April 20 calls changed hands at the same time as existing blocks of 6k and 4k of the same contract, as well as opening blocks of 15k and 17k April 15 calls. Other opening blocks of 40k April 20 calls and 20k April 15 calls also traded, at the same time as existing blocks of 60k February 20 calls and 20k February 15 calls

Given the surge in VIX Calls…


And SVXY Puts…


And record short VIX positioning…


We suspect the answer will be evident soon.

The post Who’s Right? Bonds Or Stocks appeared first on crude-oil.top.

Who’s Right? Bonds Or Stocks

With political and economic policy uncertainty at record highs and equity market valuations near record highs, we have one question: which market – interest rates or stocks – is right about ‘risk’ ahead?


We note that Bloomberg pointed out that VIX call volume climbed to ~435k, compared with 393k in the 20-day average and 88k puts traded today. Among notable trades, an opening block of 34k April 20 calls changed hands at the same time as existing blocks of 6k and 4k of the same contract, as well as opening blocks of 15k and 17k April 15 calls. Other opening blocks of 40k April 20 calls and 20k April 15 calls also traded, at the same time as existing blocks of 60k February 20 calls and 20k February 15 calls

Given the surge in VIX Calls…


And SVXY Puts…


And record short VIX positioning…


We suspect the answer will be evident soon.

The post Who’s Right? Bonds Or Stocks appeared first on crude-oil.top.

Libyan forces say they found 90 bodies at site of US air strike

Libyan forces have found some 90 bodies of slain militants at the sites of recent US air strikes near the former Daesh stronghold of Sirte, they said in a statement on Thursday. The forces posted pictures of desert hideouts covered with sand and grass and said the sites were being used for training. Shells, suicide belts and booby traps had been recovered there, the statement added. They also said they had arrested two suspected militants and killed four who refused to surrender. The forces are led by brigades from the city of Misrata and ousted Daesh from Sirte in a near seven-month campaign that ended in December. US officials have said more than 80 militants, some plotting attacks in Europe, […]

Grantham’s GMO Asks: “What If Trump Succeeds?”

(For those who wish to skip the wonkish intermediate steps and analysis, please proceed straight to the conclusion)

“The new administration’s plan for a large fiscal stimulus seems poorly designed, oddly timed, and very unlikely to produce the sustained strong growth that Trump claims he will provide. Even in the unlikely possibility that we do achieve the growth Trump is calling for, it is not obvious that it would be the boon to the stock market that investors seem to think. The fiscal stimulus does, however, seem likely to lead to tighter monetary policy and has a reasonable chance of leading to rising inflation.”

This is how the latest letter by GMO’s Ben Inker begins, and by the tone and narrative, it is clear that the author is quite skeptical about the success of Trump’s proposed policies. Inker first goes back to his previous scenario analysis in which the economy ultimately falls into one of two outcomes, “hell” or “purgatory“, and makes it clear that he does not anticipate any notable changes as a result of the Trump administration. For those unfamiliar, here is a refresher:

The key metric that I believe has driven market valuations upward in recent years and could conceivably drive them right back down is short-term interest rates: So much of this comes down to a question of whether cash rates over the next 10, 20, or 50 years will look like the “old normal” of 1-2% above inflation or whether they will look more like the average of the last 15 years of about 0% after inflation. The scenario where they average 0% real is what we have referred to as “Hell,” whereas the other scenario is “Purgatory.” On the eve of the US election in November, the US 10-year Treasury Note was yielding about 1.55%, which suggested the bond market at least was very much in the Hell camp. As of year-end, that yield has risen 90 basis points to 2.45%, which is at least closer to a level consistent with Purgatory.

At this point he makes it clear that GMO, unlike other “fast money” flipfloppers, has not changed its mind:”a number of our clients asked us if we have changed our minds about the likelihood of Hell, as the market seems to have. The short answer is that we have not. If Hell is a permanent condition for markets, it should not be readily changeable by the policy choices of a single US administration, to say nothing of the fact that we do not yet know what those policy choices will be for an administration that has just taken office.

Inker’s point that not only will implementation of Trump’s policies be problematic, it may not achieve much at all, is valuable, even if it remains largely ignored by the market; earlier today JPM warned of essentially the same. He then lays out two discrete theories as to how the US economy got to a point where Trump is in charge, the first focusing on secular stagnation as explaining the slow grind lower in US productivity and output:

“This line of argument can be boiled down to saying that the reason why exceptionally easy monetary policy has not been particularly stimulative and/or inflationary is that the “natural” rate of interest has fallen to extremely low levels relative to history. If this argument is correct (and secular stagnation is a reasonably permanent condition for the developed world, not just a temporary effect of the 2008-9 financial crisis), then we should see that as interest rates rise to levels that are still low by historical standards, they will choke off economic growth.”

The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful.

“This line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous. There is no question that monetary policy affects the financial economy.”

Here Inker explains that no matter which of the two scenarios preventing US growth ends up being correct, he is skeptical US growth can rebound to the Trump promised 4%.

Sustained high growth in the context of a slowly growing population requires fast productivity growth, which the US economy has been particularly bad at delivering of late. Exhibit 2 shows 10-year trailing productivity growth in the US.



The current trend looks to be something south of 1.5%, and population growth is set to add somewhere between 0.2-0.5% to the workforce over the coming decade, absent a change in labor participation rates or a burst of immigration.4 While it is tempting to believe we can return to the 3% productivity growth that we saw for the decade ending in 2005, the reality is that is probably a pipe dream. The overwhelming driver of the spike in productivity in that decade was the extraordinary growth in production of IT equipment, which grew at 10% real per year for the decade ending in 2005, despite a declining number of people employed.


So, A massive reacceleration of productivity seems unlikely. And it’s possible that looking at the trailing 10-year number understates how slow productivity growth has gotten, as productivity over the last 3 and 5 years has averaged 0.7% and over the last 12 months a nice round 0%. Attempting to grow a 1.5-2% economy at 4% is a recipe for inflation, and this is where the Trump effect will help us answer questions much more quickly than we would with a president enacting more conventional policies. Any acceleration of inflation will require far faster interest rate increases than is generally being priced in and we will likely learn relatively quickly whether the economy can withstand those increases.”

But here Inker asks the question that the markets appear to be taking for granted: “What if Trump succeeds?

This line of thought, to the disappointment of stock bulls, does not lead to a favorable outcome for equities. Here are the key points:

if we assume for a minute that somehow the economy really does grow at 3.5-4%, this probably will not be the panacea for equity investors that some are assuming. First, it seems more or less impossible that the right interest rate level for an economy growing at 4% would be 0% real. So Hell, in that case, would seem to be off the table, and with it a big part of the justification for higher P/Es for the stock market. And while the faster growth would seem at first blush to be a big plus for equities – after all, it would mean that corporate revenues will grow significantly faster than they have been – our best guess is actually that faster growth might well be associated with a stock market trading at significantly lower valuations than today. The 1960s and 1996-2005 periods may have been the halcyon days of productivity in the US, but it is the current period that has been best for profitability, as we can see in Exhibit 3.



In both the 1960s and the 1996-2005 periods, profits were about 6.5% of GDP, against an average of 8.5% in the most recent decade. The slowdown in productivity growth certainly didn’t seem to hurt corporate profitability much, so it seems odd to assume that a hypothetical increase in productivity will push it up still higher. In fact, for an economy in which consumption is around 70% of output, one can make the argument that a necessary condition of sustained strong economic growth would be the share of income going to labor going up from here. This would almost certainly require corporate profits to fall as a percent of GDP. And if profit margins fall materially, even a moderate acceleration of revenue growth would lead to falling, not rising, overall profits.

What about the cut in corporate tax rates? Surely that will be a positive for the stock market, Inker muses rhetorically?

It is possible that it will be, but it is neither theoretically clear that it should be nor empirically obvious that tax rate changes have been particularly important to profitability. Exhibit 4 shows after-tax corporate profits versus corporate tax rates since 1947.



It’s hard to see a lot of correlation here. While tax rates are currently at about their lowest levels and corporate profits just off of their highest, tax rates did their falling in the 1980s and the profit spike was a good 20 years later. Given that lag, it strains credibility to argue that the tax rate fall was an important driver of the rising profitability. What you would want to see is a relationship such that when tax rates fall over a period, profits rise. This does not seem to have been the case, as the correlation between tax rate change and profit change as a percent of GDP is positive over 3-, 5-, 7-, and 10-year periods.


This means that tax rate falls have generally been associated with falling, not rising, profits. Your microeconomics professor probably would have taught you that corporate taxes should be a pass-through, just as sales taxes are. Because corporations are interested in their after-tax return on capital, a change in corporate tax rates should generally affect output prices, not profits. That would make a fall in corporate tax rates at best a one-off windfall and possibly a wash. It is easy to imagine that a burst of economic growth might create a stock market bubble, as occurred in the late 1990s. But in terms of what the stock market is actually worth, if faster growth leads to interest rates returning to historically normal levels, the safe bet is that equity valuations will eventually find their way back down to historically  normal levels as well.


So what does a Trump policy “success” mean for various asset classes and prices? As the above lays out, not even a world in which GDP somehow regains 4% annual growth assures the kind of surge to equity prices and valuations that the market has tried to price in. As Inker puts it, “it brings us back to the odd paradox about Purgatory and Hell. If Trump’s policies work or if they otherwise demonstrate that we are not stuck in secular stagnation, it’s bad for stocks and bonds and good for the economy. If we wind up back in recession, it’s good for bonds and not necessarily terrible for stocks because valuations can stay high, buoyed by low cash and bond rates.

Nonetheless Inker, true to his skeptical nature, is pessimistic:

It is hard to be particularly hopeful about the prospects of the incoming administration’s economic policies. Certainly, if they are predicated on an actual belief that the US economy can sustainably grow at 4%, they are more likely to lead to accelerating inflation than anything else. But there is a meaningful plus side to what Trump is doing. Whether he succeeds or fails, we are likely to learn some useful things about the economy and therefore where valuations will wind up in the coming years. While neither Hell nor Purgatory are particularly happy outcomes for investors, either one is arguably better than our current stay in Limbo, where it is difficult to even prepare for whichever future awaits us.


We are still putting the higher probability on the Purgatory outcome, which implies that rising rates will not kill the economy. But our collective confidence in that outcome is not close to high enough that it makes sense for that to be the only scenario we should be preparing our portfolios for. For now, we are still in Limbo and are focusing on making the best we can out of an uncertain investment landscape, building a portfolio that can survive either scenario. This means focusing first and foremost on those areas where we believe either leads to decent outcomes. Emerging market value stocks are first on that list, followed by alternatives such as merger arbitrage. After those come EAFE value stocks and US high quality stocks. At current yields, TIPS are a reasonable holding in multi-asset portfolios whether we are in Purgatory or Hell, although they do look a good deal better in Hell. Credit, while less exciting than it was a year ago by a good margin, fills out the list of assets that seem worth holding in either scenario. Other assets, such as broad US equities or developed market government bonds, seem hard to love in either of the plausible scenarios, and are consequently hard for us to want to hold.

The good news is that unlike any other administration, the jury on whether Trump’s policies have been success or failure will only be out for a relatively brief period of time.

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