What I learned from “Geopolitical Alpha: An Investment Framework For Predicting The Future”, by Marko Papic

According to former geopolitical consultant Marko Papic, the benign geopolitical backdrop of the past 35 years has left investors “woefully underprepared”.

Ever since Mikhail Gorbachev’s 1985 “Leningrad speech”, capitalism became the only game in town. Geopolitics has continued to play a role, but only really in the background, as US hegemony provided a dividend in the form of globalisation, an expansion in the global labour supply and free-market policies.

That changed after the Great Financial Crisis of 2008, as the world has moved towards a multi-polar world in which there is no single centre of power. The book, Geopolitical Alpha: An Investment Framework For Predicting The Future is Papic’s framework for helping people understand and prepare for the geopolitical power shifts underway.

Geopolitical Alpha: An Investment Framework for Predicting the Future:  Amazon.co.uk: Papic, Marko, Drobny, Steven: 9781119740216: Books

Ironically, despite the use of the word ‘Alpha’ in the title, Papic contends that it is very difficult to generate an investment edge based on geopolitical insights gained from inside information. Especially, the type of insight only gleaned from talking to ‘former intelligence analysts’ sitting in a smoke filled room. This is the type of information that even the wealthiest, most professional of investors eagerly pay to lap up. Papic’s position is that this ‘inside view’ of geopolitics gains far too many headlines and looms far too large in the minds of investors.

Instead, Geopolitical Alpha focuses on the ‘outside view’. For example, most investors reach for gold when the shit hits the fan. Yet Papic illustrates that other than the 1973 Yom Kippur War, few geopolitical events since WWII have been disastrous for markets. Instead Papic suggests, “When something blows up, buy everything.” Backing up this recommendation is that the average 12 month return from the S&P 500 after a significant geopolitical event (e.g. wars, terrorist attacks, missile tests, etc) has been around 10%.

Geopolitical Alpha outlines Papic’s three pillar framework for developing geopolitical alpha: ‘The Materialistic Dialect’, ‘The Diagnosticity of Constraints’, and ‘The Person versus the Situation’.

‘The Materialistic Dialect’ (constraints versus preferences)

Instead of focusing on the narrative of the personalities performing on the geopolitical stage, its much better to focus on the wider context in which decisions are made. It’s only there that you can see the constraints that limit the choice of options. For example, political leaders may say they want a certain political outcome, but constraints limit their ability to actually deliver:

“Material conditions create human reality. Thought systems (philosophy, religion, political parties, etc.) develop around this material condition and are therefore a derivative of it. People cannot “think” or “prefer” their way out of material constraints.”

Herein lies the maxim that underpins the book and is forever bolded: Preference are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.

‘The Diagnosticity of Constraints’ (better data, rather than simply more data)

Seeking out more and more data only serves to increases conviction after all, it doesn’t necessarily improve accuracy. Rather than gathering more and more data, much better to collect better quality data, especially when a complete data set is impossible to find.

The key determinant of quality is diagnosticity, or “the extent to which any item of evidence helps the analyst determine the relative likelihood of alternative hypotheses.” This determinant illustrates the crucial difference between preferences and constraints:

“Preferences are not diagnostic variables because they are optional; the policymaker chooses whether to act on them… In contrast, constraints are the gatekeepers that determine whether preferences affect the outcome. Constraints have high diagnosticity because preference based outcomes are subject to them.”

‘The Person versus the Situation’ (avoid the “fundamental attribution error”)

Finally, while the media and others tend to focus on the personalities of the leaders as a predictor of how they will act. Investors should be extremely careful about giving undue weight to the psychological profile of a leader. This is where the final pillar of the geopolitical framework comes in.

Also known as the “fundamental attribution error”, analysts place undue weight on the character or mood of the political characters, rather than the external context in which they are constrained by. As investors, this means that we should focus less on the media narratives of the unhinged, aggressive political leader, and focus more on the environment that determines the decisions they ultimately take.

The constraints

Papic identifies four main constraints that geopolitical watchers need to keep an eye out for.

  • First, the political economy. This is by far the most important as without political capital the politician is powerless. Key factors to gauge political capital include popularity, time in power, legislative maths, economic context, special interest group support and global momentum. According to Papic, the preferences of the median voter (known as the median voter theorem) is a sound, yet underappreciated way of approximating hard to quantify political constraints.
  • Second, the macro-economy and the financial markets. Macroeconomic constraints include the unemployment rate, levels of inequality, the degree of protectionism afforded to certain industries and the current account deficit. Financial market constraints on the other hand relate to the degree to which markets are quick to discipline policymakers. For example, financial markets may initially give a political leader the benefit of the doubt. However, after a certain point confidence may begin to crumble, upon which the political leadership will be on a tight leash by the markets.
  • Third, geopolitics is a powerful constraint. States must make calculated estimates of the impact their actions have on other states, which is a combination of both internal constraints (domestic politics and macroeconomics for example) and external constraints (how others will react, given their own domestic constraints).
  • Fourth, constitutional and legal positions, an example of historical preferences that have become constraints. For a political leader to sidestep this final form of constraints weakens his or her position with the other constraints.

Papic also includes two further wildcard constraints: terrorists and pandemics.

Papic warns that there are three things the book does not aim to do. It cannot teach you about the world. It will not tell you about the future. It will not tell you what should happen. According to Papic, “To competently use my framework, meditate on your biases and bathe yourself in-indifference. If you are not up to it, you should not be in the forecasting business, let alone finance.”

Geopolitical Alpha provides a framework for freeing yourself from the linear, reductionist framework that dominates the media narrative and pervades almost every other aspect of our lives. Whatever the issue (politics, business, environmental), and whatever the scale (personal, local, global), adopting a constraints based framework for analysing the world enables you to avoid the dangers, and if you wish make the change you seek.

Related article: What I learned from “Capital Returns: Investing Through The Capital Cycle”, by Edward Chancellor

Related article: What I learned from “Mastering the Market Cycle: Getting the Odds on Your Side”, by Howard Marks

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Related article: What I learned from “Principles for Navigating Big Debt Crisis” by Ray Dalio

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