Even while knowing the risk of an accident, we often drive too fast with the hopes of getting to our destination sooner.

Portfolio managers today are faced with the same dilemma. The stock market is moving fast. First it plummeted 25%, then rebounded 10%. Is it time to buy?

The Sharpe ratio provides the answer. And the Sharpe, well, is sharp!

The Fed is very vocal in reaffirming its objective to bring US inflation down below the mandatory level of 2%. If history is of any help, we show evidence that such a target is no coincidence.

Furthermore, if the Fed misses the target and manages to bring inflation back down to 3.5%, the S&P 500 will most likely not protect investors from persistent capital destruction.

This note continues on the GDP accounting model introduced by Gavekal-IS in August 2022, by analysing and comparing the place of energy in the GDP production of the European Union, Germany, France and Italy.

In the context of the 2022 Russo-Ukrainian conflict, the model is able to provide estimates of the potential impacts of energy price spikes or volume shortages on the GDP output, which is a particularly salient issue for the economy of the European Union.

In particular, in the year ahead, with a 1 in 3 chances, the model reports that, even in the absence of any shortage in energy supply, the whole European Union, Germany, France and Italy would go into recession at rate of -1.2% to -0.3%.

The economy having the highest exposure to recession because of primary energy price spikes and volume shortages is Italy.

Is Italy today all about politics?

In August, we developed our first econometric model about economic growth, applied to the European Union. There were two innovations:

This week, we provide simulations to compare Germany, France, and Italy. This letter is published together with the model in full detail for quant teams.

Beware of Italy!

The 80/20 rule tells us that 20% of your customers – the VIPs – accounts for 80% of your revenues. It is derived from a fundamental law – the Pareto Law – driving ecosystems towards a stable and efficient form of self-organization.

In 2000, developed countries accounted for 70% of world GDP and 80% of world GDP growth. In 2021, developed countries produced only 53% of the world's wealth, and less than 20% of world GDP growth.

The economic and political world is undergoing a transition phase, which destabilizes the Pareto distribution. Yesterday's VIPs may not be tomorrow's.

In this reconfiguration, Japan is a pivot country in need of scrutiny. Japan is at a geopolitical crossroad, which could lead it East or West, as shown in the newfound volatility of its currency (the worst performing one among main currencies this year) and its stock market (the best performing one).

Introducing the first econometric model of Gavekal-IS, about economic growth, as summarized in our previous publication, “Economic Value-at-Risk”. This time, with full transparency, mathematical, data construction, and simulation details.
Our goal here is to track the economic Value-at-Risk of the European Union facing the unprecedented combination of primary energy scarcity, primary energy massive inflation, and secondary inflation.

The first econometric model of Gavekal-IS, about economic growth.

For almost 40 years, financial institutions have developed sophisticated risk measures of investment portfolios, such as Value-at-Risk, and numerical simulation tools, not just central scenario estimators, namely the expectation of return. And surprisingly, economists have done little to no follow-up on this major innovation.

But today, the question of growth in the European Union deserves more than a central scenario. The current political decisions could very well cause the economic trajectory of the European Union to drift dangerously.

Just how far dangerously? And what probability?

Western leaders have spent trillions of dollars in resources to address the Covid crisis.Primary reason? A model.

Two years later, facing uncharted inflation levels for fifty years and energy shortage, Western leaders, especially European leaders, procrastinate. Primary reason? A model.

What if the models were wrong? The first one predicting apocalypse, and the second business as usual. Here, we discuss the second one, i.e., the GDP consequences of primary energy shortage.

Corporate bond yields share a rare property among financial assets, that of being like cruise ships whose trajectories are difficult to change.

Any icebergs in sight?

Within the Gavekal 4 Quadrants’ framework there is no discussion today that the world economy has moved up the chart from the disinflationary lower quadrants to the inflationary upper ones.

The next question thus becomes: right or left? In other words, boom or bust? The answer to this question has historically paved the way for reasonable hopes or disasters.

Occasionally, Gavekal-IS publishes a seminal paper when deep financial instabilities light up from our quantitative research. For instance, February 2021’s “US PE Expansion: Game Over!” based on the statistical evidence that US inflation was about to kill equity multiples, as well as July 2021’s “Risk Off” on the statistical evidence that equity value for risk was shrinking. Today’s “World Crash Ahead” is the third of this trilogy.

Five conditions are met for a global market collapse.

You take this route in your car every morning. It is second nature to you, controlling the risk of any collision. And then one day, a bike suddenly steers too far to the right. Your adrenaline kicks in, you brake, you swerve, and just barely escape an accident.

Here is my first bet: You will drive very carefully the rest of your route and the next day and even the days following that, until, gradually, you return to your usual habits.

And my second bet: The same thing occurs on the VIX and all volatility indices. The way our memory of stress amortizes gives the price of the VIX – and gives it better than the consensus.

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