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!

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.

What is happening on the battlefield in Ukraine left aside a second war (not military this time) in the monetary sphere. Roles are reversed. The Western world pushes hard to collapse the ruble, and thus destroy the Russian economy, and so, Russia retaliates. In both wars, resistance seems to be much stronger than expected. In three weeks’ time, we’ll see if Europe yields to President Putin’s requirement to pay Russian gas in rubles, or not.

The outcome could be a monetary game-changer.

US CPI at 7.5% YoY and 5% in Europe, oil at more than $100 a barrel, Ukrainian refugees by the millions, wheat prices up 30% this year revealing possible food shortages to come in the Maghreb, European governments over-indebted by the management of the Covid crisis which, therefore, can only mean minimalist support measures in the face of the energy shock – a shock that will lead to stagnation in the next six months (likely recession), and FED raising rates by 0.25% this month – the first in an expected series of ten successive hikes – which cannot contain inflation as real interest rates will remain deeply negative… Despite the warlike rhetoric of Mr. Powell, central banks have lost the upper hand.

We are back to the real world.

For 150 years, investment cycles have been mostly controlled by the balance between efficiency and scarcity. Efficiency when primary energy is abundant and cheap; Scarcity when primary energy is scarce and expensive. In efficient times, the stock market thrives; In times of scarcity, it trembles.

Historically, expensive energy cycles tend to last a full decade. What if history repeated itself?

The S&P 500 can be danced like a 3-count waltz: 1 (corporate profits), 2 (price of primary energy), and 3 (interest rates).

Last week, we analyzed the market sensitivity to rising interest rates, all other things being equal. However, rarely are all other things equal.

This week, we integrate the three rhythms, with the conclusion being the cost of primary energy is growing too fast.

Nobel laureate Harry Markowitz's Modern Portfolio Theory (MPT) will celebrate its 70th anniversary this year. It has revolutionized the finance industry by formalizing the principle of diversifying an investment portfolio and taken up much of the computing time of the world's powerful financial computers and the minds of managers for decades. It’s the free lunch of finance.

Today, we tackle this mountain by proposing a new slope in which to climb it: The Intelligence Portfolio Theory (IPT).

The difference between MPT and IPT is ontological. The first focuses on the statistical effects of randomness; the second focuses on the self-organizing intelligence of interacting systems.

Randomness, as we shall see, is a mathematical convenience of ignorance, and this convenience presents many false noses.

Cette lettre est la première d’une série qui prolonge, étape par étape, la Théorie Moderne du Portefeuille. Elle s’adresse aux gérants de portefeuilles financiers et aux risk managers.

Nous commençons par un morceau de choix : la corrélation interne d’un portefeuille. C’est la variable clé qui détermine le risque de crash financier.

Depuis Harry Markowitz, les gérants de portefeuille pensent connaître la solution pour leurs investissements. Choisir des titres les plus diversifiés possibles. En d’autres termes, zéro coopération, zéro corrélation.

Mais comment mesurer la corrélation ? Et surtout, comment la mesurer en temps réel ?

This letter is the first in a series extending step-by-step the Modern Portfolio Theory. It is aimed at financial portfolio managers and risk managers.

We start with a choice piece: the internal correlation of a portfolio. This is the key variable determining the risk of financial crash.

Since Harry Markowitz, portfolio managers think they know the solution to their investments: choose the most diversified assets possible. In other words, zero cooperation, zero correlation.

But how do we measure the correlation? And furthermore, how do we measure it in real time?

Last Friday, the COVID-19 omicron variant from southern Africa awoken loudly under the horns of the media, and European stocks lost nearly 5% in the day. Bad surprise!

The financial market seems to have been invented to surprise managers, more specifically to dispel the surprise, and managers generally do not like this too much.

What are the market consequences of surprises?

In a stable regime where finance and economy grow in parallel, cash and oil are two forms of free energy which, in theory, should be fungible. Since early 2020, however, the central banks from the US, Europe, and Japan, issued 40% excess cash on average out of the blue to fight the deflationary consequences of the pandemic.

Cash and oil are unlikely to remain fungible: you can print cash, but you can’t print oil.