Storm Warning, Part II

What 'The Weather Experiment' can teach us about Risk: Capital & Rates, Labor & Supply, Walls of Jericho, David and Goliath, Miracle of Lights

“Like no other science, meteorology demands faith. For some, such a demand is unscientific. In The Age of Global Warming Rupert Darwall writes at length about the ‘inscrutability of the future.’ What can really be known?… And here we come to the crux. For the good and safety of humanity meteorologists are forced to forecast. Although not falsifiable by Popper’s method or watertight by Bridgman’s standards, the weather forecast is something we generally today have faith in. ”

— The Weather Experiment, Peter Moore

Risk Developments this letter:

• Capital & Rates

• Labor & Supply

• Walls of Jericho

• David and Goliath

• Miracle of Lights

HMS Beagle at Tierra del Fuego by Conrad Martens

FitzRoy’s Redemption

This is part two of the analysis of “The Weather Experiment” by Peter Moore, which began last week. For background, please check out the previous letter.

FitzRoy was born of a time and family that honored noblesse oblige, but he came of age in a vastly different political, philosophical, spiritual and economic world. The Age of Sail, came to a close just as FitzRoy became an adult. It was a period of great patrons and national expenditure on exploration and discovery. Christopher Columbus was funded by Ferdinand and Isabella of Spain, for example. FitzRoy, had the misfortune of living at the end of that era and the beginning of a new one typified by The Enlightenment that changed government, science, religion, and the economy.

It is not a coincidence that the rise of newspapers, stock markets, and railways all took place in the 1840s. The Industrial Revolution had broadly reordered society, creating a middle class, wealthy professionals and a capitalist class that threatened to replace the land-holding aristocracy formed by the Feudal system. With this change, new forms of financing emerged. While the Dutch East India Company was the first company to issue publicly traded stock in 1602, the emergence of a middle class and access to daily information in 1840’s England created speculation on a scale never previously imaginable.

FitzRoy was not made for this new ordering of society. An enlightened man, but not an Enlightenment man, his empirical values and subjective ideas were anathema to the era’s subjective values and empirical ideas. Unlike Darwin or Galton, who borrowed liberally from Lyell, Humboldt, Malthus, Gauss, Laplace and others, FitzRoy was a highly original thinker, unafraid of breaking with orthodoxy, except in matters of religion. This raises, in my mind, the central question of The Weather Experiment:

Do information networks, big data, capital markets, international trade, the modern nation-state, and hegemonic peace, often referred to in aggregate as globalization, encourage or discourage innovation?

Certainly globalization has its benefits. The rapid spread of ideas, efficiencies of scale, greater understanding and coordination between peoples, diversity of natural products and cross pollination of knowledge. There is, however, a dark side. The slave trade rarely gets mentioned in “The Weather Experiment,” nor does Galton’s advocacy of eugenic theory. European explorers brought technology to Tierra del Fuego, but also disease. Not only does globalization carry with it the danger of copying and unoriginal thinking but also the potential for negative reciprocity. In the case of FitzRoy, his financial ruin, ostracism from scientific society and popular ridicule were a personal catastrophe, but the dissolution of the forecasting system for the thirteen years following his death may have cost thousands more lives.

It is impossible to neatly divide globalization into good and bad. Nor is it particularly helpful. Cycles of increasing interconnectedness and decreasing interconnectedness happen throughout history, across domains. In Geopolitics, we call it globalization or nationalism. In tech we call it cloud or distributed systems. In business we call it bundling or unbundling and conglomerates or pure plays. What is more important is recognizing the transitions between phases and riding the trends. FitzRoy failed at this, with disastrous consequences.

In comparison, let us look at Luke Howard, mentioned throughout “The Weather Experiment” for his contributions to the study of clouds, radiation, urban microclimates and windflow. In some ways he was similar to FitzRoy, wealthy, religious, with no formal scientific training and enamored of the weather, but each of these similarities belies their differences. His wealth came from a pharmaceutical manufacturing business, not an estate. His religiosity was progressive. Raised a Quaker, one of the most reform oriented religious sects, his beliefs were too radical even for them. Not a formally schooled man, Howard was however on good terms with many intellectuals and researchers.

Most of all, Howard was original in his imitation. He became famous for creating the system of cloud classification, borrowing from Carl von Linne’s work in botany and zoology. Using Latin to classify clouds, he made his system accessible to any speaker of Romance languages. Among his other accomplishments, Howard also published “Climate of London,” the first work on the climate of cities, a highly relevant work as London had become the world’s largest city. This piece of original thinking, was highly influenced by his good friend John Dalton’s “Meteorological Observations and Essays.” Compare the similar table of contents’ for their respective works below:

Consciously or not, Howard positioned himself at the forefront of globalization in his works, his beliefs and his acquaintances.

There is a popular belief in certain circles today that globalization is antithetical to technology. In so far as globalization represents a kind of imitation, that may be true. Examples of bad imitation include plagiarism, theft, price wars and many Red Ocean strategies. These examples share one simple, but often overlooked attribute; They are not sustainable. A company may engage in a price war to drive competitors out of business, or steal IP to play catch up, but the strategy depends on its victims. Before going too far down the path of bad reciprocity, let us also note that imitation is also necessary for innovation.

Those familiar with Thomas Kuhn’s Scientific Paradigm understand that a scientific ground truth is necessary for technological advancement within a field. A model, to be copied, advanced and implemented is not just necessary, but the key to development. FitzRoy and Howard both exemplify this kind of positive imitation, Howard was just more successful in his time. Good reciprocity, the kind practiced by Howard and FitzRoy, drew on inspiration. FitzRoy’s storm warning system, still used to this day, is a system of large canvas cones and drums hoisted up flag poles in harbors across the world. FitzRoy was no doubt inspired by semaphore and optical telegraph systems, but was not seeking to replace them. His innovation was sustainable, even if his life was not.

Capital & Rates

Like in previous eras of globalization our era has led to a massive global savings glut, driving down the cost of capital. Leon Lin has a nice writeup on how to respond in this environment. The ultra low interest environment has three main consequences. First, it bails out a lot of unsound businesses, so there are fewer failures. Second, it brings the future closer to the present, since long-term projects no longer cost as much to finance over the years. Third, it drives up asset prices and floods alternative asset classes as investors seek yield wherever they can find it.

Here’s a nice story about the consequences of the Federal Reserve’s actions to bail out the Treasury’s market last spring when traders got so scared they didn’t even want secondary T-bills. It turns out that if the buyer of last resort steps in to support asset prices, the prices go up. Now prices are at an all time high, but might fall, if there’s another sell off. It reminds me of how dictators poll higher than democratically elected leaders, but suffer more catastrophic collapses.

In other low interest rate environment news, insurance companies, who have been some of the hardest hit by low rates, may get a double helping of pain as potential covid-19 defaults trigger renegotiation of terms. Insurers, being some of the biggest bond holders out there, have been increasingly buying bonds in private markets where they get to negotiate terms (covenants) bilaterally. This allows for more creative deal making and a small amount of extra return for the bond holders. Insurers like bonds because they are a safe way to turn their cash into long term assets to match their liabilities.

An insurance company is a bundle of long term liabilities (indemnity) funded by cash (premium). In contrast, a bank is a bundle of short term liabilities (deposits) funded by long term assets (loans). Banks are locked in at one interest rate for assets, but subject to fluctuations of rates for liabilities. This is called the duration gap, and is what makes banks blow up in a rising rate environment. Insurance companies are the inverse of banks, and what rate direction is good for one, is bad for the other. Falling rates mean insurers, who must wisely invest their cash to cover future liabilities, have to take on more risk.

Part of what’s going on here is the world appeared to get safer for a while, until the coronavirus hit. Now insurers may have to waive terms for borrowers to avoid default. The good news is that since these deals were private, they can be settled with a bilateral agreement. The bad news is, as we improve at stabilizing the system with bail-outs, waivers and quantitative easing, the risks that we can’t mitigate are going to get weirder. For more on this and other unintended consequences, check out Paul Orlando’s piece “Is the World Getting Safer?”.

Labor & Supply

Another effect of globalization is the single global market for labor. Some industries, particularly those that are mainly about symbolic manipulation (software and finance), have essentially no friction and shifted instantaneously. Others that exist in the real world (resource extraction) took years of reorienting supply chains. Still, we now exist in a hyper connected world where a strike millions of miles away can affect the price and availability of goods.

The geopolitical risks of labor have long been a concern of financial analysts, and Chile is no stranger to political turmoil. Strikes at the world’s largest copper mine had investors worried. That strike was resolved peacefully, but so far a second smaller strike is ongoing. Another resolved strike in Norway, this time in the oil industry, threatened to take a quarter of the supply of Europe’s biggest oil producing country offline. With oil prices so low, it is not likely to be a problem for global markets, but if these smaller labor actions are any indication of the pushback against globalization, expect labor to disrupt supply chains more in the future.

Walls of Jericho

What are the military implications of low rates and the single labor market caused by globalization? There are at least two big shifts going on right now. The first is an emphasis on retooling militaries from the Cold War arms race dynamic of a bipolar world to a cheaper, more sustainable, and lower maintenance military of a multipolar world. Think of it this way, the old world was a single point of catastrophic failure, the new world is death by a thousand paper cuts. The second is a shift online. Low rates and global labor mean it’s harder to deal a death blow to competitors in business. Similarly, in great power conflicts, the game has shifted to wearing down your adversary through a war of attrition.

We see this playing out in the new vehicle platforms that the U.S. military is buying. The Air Force just awarded BAE Systems a contract to develop low-cost autonomous vehicles to increase the air combat power of manned vehicles. Similarly, General Motors’ defense focused subsidiary delivered the first lightweight, commercial off-the-shelf, troop mover vehicles to the Army just 120 days after winning the contract. These are both examples of “attritable” (i.e. able to undergo attrition) vehicles. They are also both features of a whole system, dependent on complicated infrastructure. In security studies, this is referred to as perimeter defense.

Speaking of cyber, the money the military is saving on hardware isn’t exactly going to tax cuts. Continuous IT overhauls are necessary as the military gears up to fight information wars across the globe. The Southern Command, responsible for Central and South America, as well as the Caribbean, awarded a contract to upgrade its IT systems. On top of that, the world’s biggest office building, the Pentagon, is getting an IT modernization as they add 3,000 more wireless access points. The failure of perimeter defense for cybersecurity has led to defense in depth.

David and Goliath

Another effect of low rates and the single market is turning losers into winners, debts into profits and weak into strong. Cheap money bails out overly ambitious bets, accelerates changes in technology investments and can encourage wanton risk taking, bordering on fraud. Big bets getting a second chance and more rapid maturation of IT investment are pretty good things on net, but there are casualties. Risky, possibly illegal, behavior is the epitome of bad reciprocity and unsustainable “innovation.”

The first category describes the turmoil in the semiconductor industry. We talked about edge computing in the first installment of Storm Warning. One of the consequences of cloud and edge computing is that it turned the chip making hierarchy upside down. Intel, the king of semiconductor manufacturing has fallen from its peak market share of 70-80% in 2011, and looks to be poorly positioned for the coming wave of IT investments in cloud and edge. Bad news for Intel, but probably good for IT purchasers, and companies like AMD, who stand to gain market share (thanks to Mule whose substack provides excellent commentary on the semiconductor industry that helped me understand the industry).

The second category describes this crazy story of NAC Foundation founder Rowland Andrade trying to have the SEC’s case against him dismissed. His argument is essentially, “I told investors they would lose all your money if you buy the tokens I’m selling, so it can’t be fraud.” The icing on the cake is the involvement of Jack Abramoff, disgraced former lobbyist. And the cherry on top is the fact that the pitch was an “Anti-Money Laundering BitCoin” token. If your argument is essentially, “Don’t invest in this! It’s a scam! I’m telling you it’s a scam!” I suppose it helps your credibility to involve shady people and make your pitch trigger random fraud associations?

Miracle of Lights

Finally, low rates and a single labor market have profound consequences in the energy industry. Not only are rates shifting IT investments forward, but also energy, and, like other resource extraction industries, the single market for labor has created complex extended supply chains. The combination of these two factors is causing some big shifts, as energy buyers seek protection from overextended supply chains, and energy investors see opportunities to meet that demand.

Three examples are the Department of Energy’s continued support of demonstrations of new types of nuclear reactors, record breaking consumption of renewables in the United States, and big bets by oil majors on low probability, but high impact fuel sources like hydrogen. All of this signals that globalization has run its course. What started as good reciprocity, in the beginning of the current era of globalization, turned to bad reciprocity, inverting the direction of feedback loops as IP theft, free riding and fraud become the norm.

Gratitude

Thank you to all those who helped edit parts I and II of this piece. Writing workshop members:@Simone Keelah, @Reza Saeedi, @Roger Farley, @SachinMaini, @Vinit Shah and@Tom White. Also thanks to @LeonLin, @Paul Orlando,@mule, and others for inspiration and teaching me through your writing.