WW3 or a Grand Bargain?

VIDEO TRANSCRIPT

The former head of MI6 said that Europe is already in "an actual war” with Russia. 

US officials quoted by the New York Times suggested Washington is considering sending nuclear weapons to Ukraine. 

Donald Trump said this week the world has never been closer to WW3 and accused the US foreign policy establishment of trying to drag the US into a war with Russia on a lie. 

He says he is the only one who can stop WW3 

Is he right? What does game theory tell us? 

What are the investment implications? 

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I am in the business of making predictions.

My only concern is being right.

This is why I try very hard to make sure that my personal bias, political, moral, or otherwise, does not enter my calculation.  

For this reason, I love game theory

The future is shaped by people’s actions today.

Game theory is a powerful tool for predicting the outcome of strategic interaction among rational decision makers

They key assumption behind game theory is that people are rational.

I don’t think this is such an unreasonable assumption, especially about the world’s movers and shakers.

Movers and shakers become movers and shakers because they are cold, calculating, ruthless, and self-interested

Don’t get me wrong. This is not a criticism of movers and shakers.

In game theory and in my predictions, there are no good or bad people.

There are only good or bad players.

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Good players, in game theory and in real life, know how to bluff and cheat to get their way

The great insight from the famous Prisoner Dilemma game is that even when people would be clearly better off if they choose to cooperate with each other, the only stable equilibrium is an outcome in which they choose not to. 

This prediction seems to explain very well the state of the world today.

Since the start of the Biden presidency, wars have replaced peace, and geopolitical fracture has replaced international cooperation.

As a result, global trade has slowed (Chart 1), global foreign investments are down (Chart 2), fiscal deficits have widened around the world, and global economic growth remains below the pre-COVID levels

To the extent that US policies have been the main driver behind the global geopolitical fracturing, it is not too surprising that the US economy and the US stock market have gone better. (Chart 3)

But with the US budget deficit at 6.4% of GDP, the highest ever outside a recession (Chart 4), the US equity valuation near the dot.com extreme (Chart 5), and core inflation uncomfortably above 2%, the decoupling of the US from the rest of the world over the past 2 years is unlikely to be sustainable.

In my view, some recoupling is not only very likely in 2025, but inevitable, at least relative to market expectations.

The only question is the form that the recoupling will take.

Will the convergence be the result of the US doing worse or the rest of the world doing better?

Ironically, the answer depends on whether Trump can deliver on his promise to bring peace to the world.

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Peace has only one meaning for the world and financial markets.

Whether the US under Trump and the rest of the world will decide that they are better off by cooperating.

Given where the RMB, the euro, the Russian ruble and the Mexican peso are trading against the US dollar right now, I would say Wall Street is attaching a relatively low probability of peace under Trump.

I am no Pacifist but I think the market may be underestimating the incentives for cooperation around the world as Trump gets ready to take office.

This is why I don’t advocate a long USD position right now.

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One of the great insights of game theory is that players are more likely to cooperate in repeated games than they are in one-shot games.

This is because in repeated games, players are forward looking.

COVID encouraged short-term thinking.

The extended closing off of borders gave people a false sense of self sufficiency.

But COVID is long over.

I think many global leaders, whether they would admit it or not, see Trump 2.0 as an opportunity for a reset

And moreover, failure is not an option, given the world is on the precipice of WW3.

The fact that we can no longer take peace for granted is an important reason for my optimism.

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But my optimism about 2025 has mainly to do with what the increase in incentive for cooperation right now:

Let’s take the US as an example:

Trump has promised to make permanent his 2017 tax cuts that are set to expire at the end of 2025.

However, his decision to nominate Scott Bessent, a fiscal hawk, as his Treasury secretary, over the objection of Elon Musk, suggests that he understands the danger of adding to the national debt at a time when annual interest payments are well over 1 trillion dollars. (Chart 7)

This is likely also why Trump has charged Musk and Vivek Ramaswamy with identifying $500 billion dollars worth of annual spending cuts.

Trump understands that to keep the bond market calm and the Fed on its interest rate cutting path, he needs to do more than pay lip service to debt sustainability.  

But as I said last week, with defense spending accounting for more than half of federal discretionary spending, it would be difficult to cut $500 billion dollars without reducing defense spending.  

To go after defense spending, Trump has to end the Ukraine war that has become a gravy train for the military industrial complex.

Ending the Ukraine war is not only a foreign policy goal for Trump but it is central to his economic plan.

But ending the war is easier said than done.

The military-industrial complex is so invested in the war that we can expect it to try to sabotage any effort to ending the war

Trump knows that any plan he comes up with will be immediately accused by the military-industrial complex, the neocons, not to mention Zelensky, as a sell-out to the Russians.

This is why he needs concessions by Putin to make it a balanced and politically viable deal that he can sell to the American people.

But is Russia ready to make concessions to get a deal?

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What is Putin’s reaction function?

It is reasonable to think that Putin wants to end the Ukraine war as much as Trump

The Russian economy is starting to show clear signs of strain

Inflation is running at 8.5% (Chart 11) and the central bank recently hiked interest rates to 21%

Meanwhile, the ruble has plummeted. (Chart 12)

It stabilized this week only after the central bank was forced to intervene in the market.

But with most Russian foreign reserves frozen by western sanctions, it is not clear that the central has the ammunition to conduct sustained interventions.

If Putin has managed to maintain strong public support through-out the war it has been because he has been able to insulate the economy from the war

But harder times are ahead, especially if oil price continues to slip into 2025.

As much as Putin would be open to a deal, he also needs to be able to sell it to the Russian people.

After nearly three years of fighting during which at least 70,000 Russian soldiers have died (Chart 14), Russia has the clear upper-hand in the battlefield right now.

Putin might think that if Russia keeps up the pressure, his troops may reach the Dnipro River by next summer.

Does Putin have an incentive to make the kind of concessions that Trump needs to end the war right now?

Does Putin even trust Trump?

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This is why Trump might need Xi Jinping to help him bring Putin over the line.

China is Russia’s largest customer and most powerful ally

If anyone has any leverage on Putin it would be Xi.

It should be in China’s interest to help Trump end the war in Ukraine

It might help prevent another round of bruising trade war with the US

The Chinese economy will barely grow 5% this year despite fiscal and monetary easing

More concerning is the fact that China is sinking further and further into debt

The grim reality is that China’s total debt as a share of GDP will likely exceed that of the US this year. (Chart 14)

I think the time is ripe for a serious dialogue between the two biggest economies in the world

China and the US will remain strategic rivals for the foreseeable future (thumbnail: how trade war helps China), but this should not preclude attempts at exploring overlapping interests.

The fact that Trump’s former chief trade negotiator Rob Lighthizer has not yet landed a job in the Trump cabinet is a strong indication that the Trump team and Beijing may have started informal talks.

They don’t have to start from scratch.

The Phase 1 agreement signed by the two in early 2020 should serve as a starting point for any new trade negotiation.

At the time Trump called the deal “the biggest deal ever seen”.  

It didn’t get implemented only because of COVID.

Trump no doubt remembers that under the deal China committed to spend an extra 200 billion dollars on US goods which it never did because of COVID.

Trump might decide it is more productive and less risky to hold Xi to his promise than to start a new tariff war.

My predictions:

Trump wrote in Art of the Deal: “Deals work best when each side gets something it wants from the other.”

In other words, a good deal is when it is a win-win.

My prediction is that the start of the new Trump administration will usher in a flurry of deals.

No doubt, some deals will be easier than others.

For example, a deal with Mexico should be relatively straightforward given Trump needs all the help he can get from Mexico to solve the illegal immigration problem.

It will be tricker with Canada but given the next Canadian election is less than a year away and Justin Trudeau is trailing in the polls, his Liberal Party might decide that it does not want to slug it out with Trump before the election.

Deals with China and Russia will be more difficult.

Especially given it will almost certainly be the case that the two deals will have to be negotiated simultaneously.

Doing a deal with China and Russia will require thinking big.

The good news is that both Trump and Elon Musk have that in them.

This is another reason for my optimism.

What is less clear to me is where Iran comes in.

Trump has promised to tighten sanctions on Iran that tried to assassinate him

It would be easier if he has the cooperation of China and Russia

But Iran is an ally of both China and Russia and a member of the BRICS

I don’t see Xi and Putin turn their back on Tehran

Or the price for them to turn their back on Iran would be too high for Trump

This is why Trump might decide it is easier to take Iran off the negotiating table.

The easiest way to do so is to simply give Israel the greenlight to take out Iran’s oil and nuclear infrastructure.

What are the biggest risk to my optimistic view about the geopolitical outlook for the world and the US fiscal outlook in 2025?

Sabotage by the Neocons and the military-industrial complex that thrive on endless conflicts.  

They won’t make it easy for Trump.

 That much I am sure.

As for what this meants for the market, I recently went from being long the USD against the RMB to short the USD against the Mexican peso. 

I also went from being short US treasuries to long US treasuries. 

I am hedging these positions against sabotage by owning a put spread on S&P 500 that expires before the inauguration.