MARKO PAPIC: What does China want? What does China truly want? I think what China truly wants is a regional hegemony. I don't think he wants a global hegemony, and in a way, it's like professional wrestling. He's in a ring, and he's taking that plastic chair, he's beating Xi over the head and whispering, burst the ketchup thing, just burst the ketchup in your face and it looks like you're hurt.
One thing we do know, Mike, is that Chinese policymakers have made massive mistakes over the last 18 months. I don't know who advises them, but whoever does, has been telling them fairy tales.
MIKE GREEN: Mike Green for Real Vision. I'm here in Los Angeles. We're going to sit down with Marko Papic. Marko's with the Clocktower Group. He's formerly with BCA Research and he's one of my favorite young strategists. In particular, he brings a framework of thinking about constraints, what are people forced to do, which in a world of macro in which there's so much going on and there's so much you can possibly know, normal people can't do tends to be the most powerful information. Can't wait to sit down with him. I hope you find the information as interesting as I know I will.
Mike Green, I'm here in Los Angeles with Marko Papic of Clocktower Group. Marko, you and I have known each other for many years, first at BCA and before that, you're actually at Stratfor, although I wasn't aware of that. Let's talk a little bit about your background. Starting on that point. You're not from the United States or even Canada for that matter. You're a Serb, and so on all matters of death, we can discuss these things. How did you get out of Serbia? Tell me about your childhood.
MARKO PAPIC: Well, first of all, it's great to be back on Real Vision. I think we did a hit on Brexit couple years ago, so thank you for having me back on. Yes, my background is different. I was born in Yugoslavia. I'm one of the few people who at six years old, had to have their father explain to them what it means to be something else. When you're born in a country that has identity, that has a sense of self, and then that evaporates, that's a really interesting moment in your life, because then you have this moment when you have to be told that you're something else.
I was born in Yugoslavia, it became Serbia. Lived in Iraq for a very brief period of time. When the country started to fall apart, we actually moved to Jordan. Of all the places in the world, we moved to Amman, Jordan and so I think that I'm one of the very few people who escaped war by going to the Middle East, not from it. It was great three years there, then three years in Switzerland. Things were starting to get better and better, if you will.
I remember being in Jordan, in Amman, in American community school there. It was hilarious, because my first day, I said I don't care to one of my friends. He said, well, you can't say that, you get a detention for saying I don't care. I was like, are you serious? Where I come from, eighth graders have guns. That was my childhood.
And then I went to school in Canada, University of British Columbia. If I don't have a lot of time to explain to people where I'm from, I just say I'm from BC. Then I went to University of Texas. That's where I was doing my PhD, and got a job at Stratfor in 2007, and then ended up at BCA Research in 2011.
MIKE GREEN: Stratfor is known for their geopolitical analysis. One of the things that you brought to BCA was a viewpoint, and this is where I first started reading your stuff-- was a viewpoint on constraints and that the world is governed by this idea of what can't people do? You talk a little bit about your theories on how constraints matter and why they matter and why that's what you follow.
MARKO PAPIC: First of all, I believe that in order to add value, to people who don't speak your language, you have to show up with a framework. When I was hired by BCA Research, the premise was that I was going to be able to help investors with political and geopolitical analysis. How do you do that? Well, you have to give them a framework with which to think. I don't think this is anything groundbreaking. I think a lot of investors share this framework, whether they know it or not, but a constraint based framework is really useful because it allows you to focus on the material reality that constraints policymakers.
You don't just throw up your hands and say, like, I can't predict what policymakers want. Because that's true, you can't. You can't get inside their head, but you can forecast, what are the material constraints that are going to force them to do stuff that they don't want to do, necessarily. What I always say is that constraints are not optional, and they're not subject to preferences. But preferences are optional, and they're subject to constraints.
What do you want to focus on? Something that's optional, and subject to something else, or constraints, the material reality, not the ephemeral preferences? The basis of this framework is basically that Niccol? Machiavelli was wrong, that no matter how much virtue the prince has, he or she will never be able to survive the vagaries of Fortuna. Focus on Fortuna, focus on the material reality.
MIKE GREEN: When you say a constraint, most people tend to think about that meeting something like, well, you can't do that. Yet we say that often in finance, we talked about a debt to EBITDA level, or we talked about evaluation level, we'd say that can't possibly happen, that can't make sense. But a lot of things have happened that people say can't, so how do you avoid identifying false constraints, i.e. interest rates can't go below zero?
MARKO PAPIC: I think in politics, that's also the case as well, but I think what you always have to gauge is constraints versus the power that policymakers have to overcome their constraints. You have to really think about. You have to know a lot empirically about the world. That's the part where giving this framework to someone is one thing, but actually, having them use it properly is difficult. It's like taking a lesson from a tennis coach. He can show you how to hit the backhand real well, but you may not be able to do it.
What do I mean by this? Well, let's take the trade war. A lot of people would have used constraint-based framework to say that President Trump would never pursue a trade war because American companies don't want it. Because the CEOs don't want it. Because farmers don't want it or because he doesn't have the authority to do that.
That would all have been wrong, because if you actually looked at the reality, you would have known that Congress has passed-- now we all know this, several pieces of legislation since 1971 to basically reverse engineer presidential authority when it comes to tariffs so not only do you have to have a framework and a systematic approach to political analysis, you also need to know a lot about politics and geopolitics, you need to focus on the right constraints.
MIKE GREEN: One of the things that I find that people struggle with this framework, and as we've discussed, I have a similar view, is that we're in a dynamic system that has very little information you can extract from it, but if you can know where something can't go, you can actually start to articulate behaviors. One of the things that I find is that people use constraints to articulate their existing bias-- government spending must be constrained, government debt is bad, and people will have to pay higher interest rates for the penalty of engaging in bad things. There's this huge tendency to exert your bias associated with it.
I think one of the things that's interesting about you is-- and I would argue, in part, it's because of a childhood spent in many different places, you're far less willing to say can't. It takes a lot for you to articulate that this can't happen. What do you think's out there right now that can't happen?
MARKO PAPIC: That's a great question. First of all, I agree with you 100%. I think that you have to meditate on your biases. I think that's literally meditate, spend time washing yourself with your biases, and being aware of them. I think it is easier for me to not do that, because I just care less about the things that other people care about. You have to adopt a nihilist attitude. When you walk through the door, and you put yourself in your office and you're doing your job as an investor, you can't care about things too much.
That's the first issue and I think that goes for both the investing and analyzing politics and geopolitics. In terms of what can't happen right now, I think that what cannot happen is you are likely not going to go back to the last 30 years. That's what can't happen, and that can't happen because the structural underpinnings of the last 30 years, which I would characterize at three things-- one, American unipolar moment in terms of preponderance of American power. That's being eroded, not for any reason to blame any administration, not because of any mistakes, just because of rise and fall of empires, it's just a natural occurrence.
Second, the dominance-- ideological dominance, intellectual dominance, laissez faire as a concept, I think we're not going to go back down that path either because of 2008, because of the pain over the last 10 years, because of income inequality. Finally, I think this globalized world that's based on an assumption that absolute returns to trade are more important than relative gains, which is very dangerous because of course, when countries go away from thinking in absolute terms and to relative, that's a cognitive switch that once it's turned on, it's unlikely to be turned back on by any administration.
What I can say with certainty, and I know this is a cop out to your question, but I can say that we're not going to have another moment of 30 years where investors don't have to worry about geopolitics. It's a very self-serving statement, too.
MIKE GREEN: Why do you say that's self-serving?
MARKO PAPIC: Well, I think it's self-serving because I've made a career out of trying to make sense of geopolitics for investors.
MIKE GREEN: Other people have described this as a bull market in politics, that this is the type of framework that we're in. I think that what you've said is a very astute observation. We can't go back in time for two reasons. One is, the arrow of time only goes in one direction. The second is if you think about it, the difference between potential and kinetic energy, really 40 years ago, we were near a high point. Prior to the Reagan Thatcherite Revolution, we're at a high point in terms of government intervention and action.
You've now seen that go to it's somewhat logical conclusion, and it started to climb back. I think one of the things that's so interesting about China is an ascendant China represented an alternative. It functionally took the American model and said, you don't have to do this. Other regions have done something similar like Singapore, Japan, et cetera, but the scale was so much smaller that they didn't represent the same type of dynamic. When you think about China, in this period, you can only go forward, what does it look like to you over the next couple of years and on the shorter term?
MARKO PAPIC: I think China is going to struggle, because there's a lot of inconsistencies inside of China. There's an inconsistency between China that's on the coast, and that's in the interior. There's an inconsistency in China that is looking to maintain state champions in China that desperately wants entrepreneurialism and creative destruction to move up the value chain with the US. There's a China that wants to open up its domestic markets to foreign investors, so that it becomes a challenge to the dollar as a reserve currency, but there's also a China that wants to control the outflows.
I think those consistencies are going to have to be resolved, and I think that that's going to create a lot of volatility inside China. I think the China over the next 10 years is not going to look like China today. In particular, what that means is that if China truly wants to challenge the US, and I think they do. They want to become a regional hegemon at the very least, if they're not there already. What China is going to have to do is going to have to create a sense domestically that you as a foreign investor wants to be in China, you want to store maybe some of your wealth there. I mean not all of it, but a proportion of it. It's not going to be crazy to diversify your reserves by having a little bit inside China, they want that.
They want to be able to deal with their current accounts. They want inflows, not just outflows. They are going to have to make a case for the rest of the world why China is also part of the reserve currency world. To do that, that's going to check some of their ambitions, and that's why I do think we're on a trajectory towards a secular conflict between US and China. It's something I articulated in 2012 and 2013 while at BCA Research. I firmly continue to believe that, but I also believe the constraints on both countries are such that we're not just going to linearly end up in a Cold War, because China itself has a high degree of desire and need to continue to be part of the global financial and trading system.
MIKE GREEN: Can China do that, though? Can China make the choices, or is China too far down the path in terms of a need to depreciate their currency because of the pressure on the financial account for example? If they were to lift capital controls and tried to open the country, which seems like it would be a requirement for somebody to consider placing a significant fraction of their wealth in their MSCI reallocations notwithstanding?
MARKO PAPIC: Absolutely, yeah, they're getting into trouble. At some point over the next decade, they're going to have to make a decision on how to do this, and it could be a very violent transition, where there are some massive outflows. Can they do it? I think they can, but the first thing they're going to have to do, I think, before they open up, is they're going to have to recapitalize their banks. They're going to have to do what they did in 2000s, which requires a lot of domestic pain. Why?
What they did in '97-'98 is they went through their industrial overcapacity, something like 60 to 90 million people lost their jobs in Northeast China. It was a very painful event, but it was a necessary event to clean out the rot in the industrial part of China. It was necessary in order to then recapitalize the banks, only after that was resolved. MPLs basically jumped from nothing to like 15% in a matter of weeks.
China will have to go through I think one of more of those events, and to do that, they're not going to be able to open themselves up before they do that. They do have the ability to recapitalize, the banks basically print more money, purge the SOEs that are not competitive, and then only open up after that. To do that, they can't do that in in a constant state of panic and conflict with the US, which is why I think what's happened over the last two years is they understand this the tradeoff.
That's why China's been deleveraging since 2017, since after the Party congress actually even began before the 2017 Party Congress. It surprised a lot of people, they haven't really stimulated as much as they have in the past. They're aware of the problems with just recycling the same SOEs that are uncompetitive, but there'll likely be more volatility ahead.
MIKE GREEN: If I look at China circa 1997-'98 and the recapitalization of the banking sector that happened at that point, by and large, what occurred in that time period was a reorganization of China from servicing internal demand in a very inefficient way, and opening up and freeing up resources that could be applied to servicing the West. And so they were able to absorb that relatively easily largely because FDI is storming into the country. How do they do that without debt? How did they do that with the surplus of labor, the urbanization process now being gone? How do they do that with both that and demographics starting to work against them?
MARKO PAPIC: I think it's all about domestic consumption obviously. They themselves think that that's the path and so one of the ironies of that is that they will have to focus on domestic consumption of domestically produced goods, which is why when I've thought about this in the past, I always thought there was a China that was going to be protectionist first, not the other way around. Of course, it has been, but it did a lot of consumer goods from the West to come into the economy and to be sold. You can buy Johnson and Johnson shampoo, you can buy a Buick.
I think that China will have an incentive over the next 10 years to favor domestically produce goods. I think in a way, what's happening right now, is helping them because they have like a patriotic reason to abandon Apple and focus on Huawei sales domestically. That is the only way to make this shift to focus on consumption domestically of domestically produced goods