“It’s not whether you win or lose, but whether you win!”. Source: Reddit
Nobody has any real idea what President-elect Donald Trump has planned.
It is quite possible he himself doesn’t know.
As President-elect we are all forced to take him seriously, but the consequences of taking him literally or not are so wide that most are in a state or confusion.
However, if we look at the situation more closely there may be method to the madness and some potential hints on where we go from here.
Candidate Trump was incredibly successful in covering up his weaknesses by, in effect, making the US election a referendum.
The election was a referendum on the status quo and a vote for Trump was a vote for change, not a vote for the huge range of messages and proposals he put out.
Indeed, by putting out so many messages and controversial statements he attracted different voters for different reasons. So the blue collar worker may have voted against free trade, but the Pennsylvanian Latino may have voted against health insurance premiums jumping 50%. The extreme proposals echoed his negotiation style as he made a bold first step, then walked it back, also allowing voters to justify ignoring his more odious statements.
The opponents of Trump preferred to take him at his word, ignoring the real passions his grievance narrative and promise of a better (different) tomorrow stirred up, looking to fight him on topics his supporters found ephemeral.
This strategic ambiguity in his message changed the game and was a key component of his ability to beat Clinton by going outside the system and making it a game of persuasion over politics. The falsehoods leading to furious fact checking were also reminiscent of the theoretical foundations of non-linear war put in place by the Russians, building on the work of prior autocrats. We can expect this to continue with Trump TV and direct communication through social media.
The normalization of Candidate Trump has occurred faster than anyone could have imagined as the world is now forced to take him seriously as President-elect.
The narrative has moved quickly to a positive one of a structural change with decreased regulation, lower taxes and huge infrastructure spending. Leading figures are overlooking extreme statements and focusing on President Trump as a more reasonable, settled and somewhat magnaminous chap after he ‘won’ the negotiation.
However, little is certain and this presents an interesting situation to look at through the lens of game theory.
The USA has been the global superpower for decades, much to its own benefit and that of the rest of the world (overall).
Free trade and globalization trends combined in a cooperative game where participants benefited, although some, like global multinational organisations and owners of capital, gained more than others such as domestic blue collar workers. These trends also helped pull hundreds of millions out of poverty worldwide and trade in a truly positive sum outcome.
The most recent cooperative equilibrium has been the gospel belief in the power of Central Banking that has dominated markets and investment moves in recent years. This has been the primary narrative around the market and most price moves have been described in relation to Central Bank actions as opposed to more idiosyncratic factors.
Cooperative equilibria like this are slow to form, but relatively stable.
Until they aren’t.
Political factors and a slowing of global trade has been placing increasing pressure on this narrative and the election of Donald Trump into the most powerful position in the world has accelerated this process, with a key flip in the dominant narrative towards fiscalism and stimulus spending over austerity and low rates.
More importantly, the role of the USA has changed sharply in terms of its likely behaviour under a Trump administration as it will no longer be a cooperative player, but a competitive one.
This moves us into a different class of competition, such as the familiar games of chicken and the prisoner’s dilemma, where there are drastically different equilibrium conditions.
Competitive players in competitions where there is a key enforcer and dominant player such as the USA can be handled through a variety of means, but when the dominant player changes its tack to claw back some the shared gains for itself, the game can rapidly change to a zero-sum or even negative-sum one.
This is where the fear of trade wars comes in and, looking at prior instances, the narrative is likely to rapidly shift across a spectrum of outcomes as each player in the game makes their competitive moves to get “ahead” of the game.
The “pricing for perfection” of the current narrative is fragile in this environment given the difficulty of implementation and the probability of continued extreme comments from the President-elect and his transition team. Curiously, the likely continued impact of these statements means the US will likely trade in a similar manner to autocratic Emerging Markets, unsurprising when Trump’s executive Presidency has more power than even rulers like President Erdo?an.
The uncertainty created by the dichotomy between the outcomes of Candidate and President Trump also add an additional wrinkle to this, placing the new normal into a category known as competitive games under uncertainty.
The most prominent recently example of this is OPEC and Saudi Arabia’s decision not to cut. A number of classical models can be employed to understand OPEC (generally a Stackelberg competition given Saudi’s role is a good starting point), but the presence of US shale changed the equation.
In this case, a cut, for example, of 1mbpd by Saudi Arabia (say 10% of 10mbpd of production), would be sensible if they expected the price to rise 10%, particularly if everyone else chipped in, something other players are not incentivised to do due to lack of enforceability by OPEC.
This would cost Saudi Arabia $18bn in forgone production revenue over 12 months if oil prices stayed at $50. If US shale output was elastic as oil prices rose however, with rigs firing up once more and stabilising the price, US shale would make $18bn at the Saudi’s expense.
This uncertainty changed the game and equilibrium conditions until we headed into the recent Saudi bond issuance and in the next period ahead of a potential Saudi Aramco IPO as this completely changes the payoff structure. OPEC is still an unstable competition, but there are alternative oil balancing approaches that are not.
Going into the OPEC meeting at the end of the month the optimised structure would have Iran being included once more in the exclusions and an overall cut target announced but flexible country quotas. The negotiating position of Saudi Arabia simply is not very strong given the changing conditions. This may not be enough to push oil prices above $60, but a failure in the deal would push prices well into the $30 range. I remain very bullish for 2017.
As he has a huge popular mandate having eschewed using the GOP power structure, the rational approach for President Trump is to continue with his classical negotiation tactics in bringing the House, Senate and foreign powers in line with his long-term wishes under an environment of competition and uncertainty to gain an edge.
The proximate impact of this shift is to increase the probability of market-altering moves such as a Chinese currency free float, with a periodic shifting between multiple unstable equilibria as each side tries to get ahead. We are already seeing this with the Yuan drifting to multi-year lows and JP is very bearish on the potential for a Q1 shock in China as outlined here.
The world seems a very uncertain place at the moment as the foundations of many of our political, economic and market models shift underneath us.
However, this may be a feature, not a bug of the new regime and it may be possible to adapt and understand where we might be headed if we build the right structural models in a methodological way. The likely path to a new stable status quo is likely to be a rocky one, with plenty of opportunities and dangers to keep us on our toes.
Bonus: Learn how to play the game