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Deal or No Deal

Don’t let the title of this month’s article trick you into thinking that we are going to write about the popular NBC game show that originally aired from 2005 to 2009, giving away millions of dollars to deserving contestants over the years. This is about the United Kingdom’s potential withdrawal from the European Union bloc and its economic cost amounting to billions of dollars over the years.

On July 29, Boris Johnson moved into his new address on 10 Downing Street as newly appointed Prime Minister of the United Kingdom, succeeding Theresa May as the new leader of the Conservative Party.

Mr. Johnson takes office at one of the most critical moments in Britain’s recent history, and the toughest challenge of his career is to negotiate improved divorce terms and conditions for Brexit with European Union leaders in Brussels. If they don’t agree, which has happened before, he pledges to leave the European Union without a Withdrawal Agreement (no-deal Brexit) by October 31, 2019. Whether he is planning to follow through with an abrupt exit or it is part of his negotiating strategy is unknown. Given the previous pledges and recent rhetoric of Mr. Johnson as well as the clock ticking down to the October deadline, the risk of “no-deal Brexit” increasingly starts to look like a real possibility.

Such a critical decision would produce both financial and political consequences. It would most likely shake up the British economy and could even cause it to plunge into a recession, which would not be welcomed by the global financial markets.

Heightened investor fears are already being reflected in some corners of the financial markets. The British pound, like the proverbial canary in the coal mine, which refers to early warnings of problems, has slumped to its weakest level against the US Dollar in more than 34 years. The currency fell to as low as $1.2091 recently. Some analysts predict it will continue to grind steadily lower toward the October deadline.

There is also the possibility of a political fallout from an abrupt Brexit for the United Kingdom, which could render toxic feelings among its four countries, especially between England and Northern Ireland as well as Scotland which could eventually harm their relationships and damage the bonds that hold them together in the Union.


A disorderly Brexit would also have an economic cost on the U.S. economy albeit a relatively minimal one given that U.S. exports to the UK only account for 0.7% of U.S. GDP. However, negative sentiment could take a greater toll on the U.S. financial markets due to its contagion effect.

All these potential consequences are mostly dependent on the worst-case scenario – no-deal Brexit – which involves a complex process complicated by the fact that conservatives hold a tiny majority, are blocked by a divided parliament, and are confronted with a split country. Therefore, the outcome is uncertain and highly unpredictable even for the most sophisticated statistical models.

Fortunately, an odd phenomenon called the wisdom of crowds may help shed some light upon the chances of a no-deal Brexit. The term was popularized by New Yorker business columnist James Surowiecki, who postulated that a crowd’s “collective intelligence” will generate better outcomes than a small group of experts, even if members of the crowd don’t know all the facts. It produces better results, especially with complex problems and uncertain outcomes like the Brexit deal. A technique called prediction market leverages the wisdom of crowds approach by polling a diverse crowd and aggregating their opinions to form a forecast of an eventual outcome.

With this in mind, we looked at a betting website which aggregates multiple betting exchanges in the UK. We analyzed the current odds placed by gamblers and calculated the implied probabilities on various Brexit outcomes, particularly deal or no deal.

Based on our results, the no-deal Brexit outcome currently has the highest odds of 11 to 5 giving an implied probability of 31.25% compared with the deal outcome.


In order to gain further insight and verify our previous findings about the two outcomes, we also looked at results of the recent July survey conducted by a market research and consulting company in the UK. The results support our previous research. The public (45%) thinks that the UK should go ahead with Brexit on October 31st even if it means leaving with no deal.

It will be interesting to see how much these results will vary as we get closer to the October deadline. Even though it is a rather daunting task to forecast such complex and uncertain outcomes, it still behooves us to try given that the stakes are high, especially when the deadline coincides with the October stock market phenomenon.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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Picking up the Slack

The pace of U.S. economic growth remained robust at 3.1% in the first quarter of the year. The economy has continued to grow for 120 months in a row as of the end of June, matching the longest economic expansion in American history from March 1991 to March 2001 according to the National Bureau of Economic Research. With the Fed as the largest benefactor, stock market investors have enjoyed the unprecedented rally from the depths of the financial crisis lows to new, record highs fueled by long periods of historically low interest rates.

Amidst the 10th anniversary of the expansion, market participants wonder how much longer there is to go before the inevitable relapse into the next recession. To the frustrations of long-time market bears, expansions don’t simply die of old age. However, developments over the past several months suggest the economy may be starting to lose momentum. The following are some important statistical clues in consumer spending and labor-market data:

A Downward revision to consumer spending Consumer spending, which makes up more than two-thirds of U.S. economic output, grew at a 0.9% annual rate in the first quarter, compared with a prior estimate of 1.3% – a sharp slowdown from the fourth quarter, when consumer spending increased at a 2.5% rate.

Declining wage growth In a stable full-employment economy, wages should continue to rise consistently with improvements in productivity. Adding inflation over the past 12 months of 0.8% and average productivity growth of 1 .5%, nominal wages would be expected to grow by 3.3%. However, wages grew only 3.1% over the past 12 months, down from a 12- month high of 3.4% (see: Exhibit I).

Source: U.S. Bureau of Labor Statistics, Average Hourly Earnings of All Employees: Total Private [CES0500000003], retrieved from FRED, Federal Reserve Bank of St. Louis.
Exhibit I

A slowdown in job growth The U.S. is now at or very close to full employment as the unemployment rate dropped to 3.6%, the lowest since 1969. Given the employment rate leveling off at 60.6% (see: Exhibit II) and the working age population growing by about 156,000 a month, the U.S. economy needs to create about 94,500 jobs monthly (156,000 multiplied by 60.6%) to prevail in a full-employment economy. Yet, US Non-Farm payrolls indicated that only 75,000 new jobs were created in May. As can be seen from Exhibit III, the five-month average of Non-Farm payrolls has been steadily declining.

 

Exhibit II

Source: U.S. Bureau of Labor Statistics, All Employees: Total Nonfarm Payrolls [PAYEMS], retrieved from FRED, Federal Reserve Bank of St. Louis. Exhibit III
These economic indicators suggest that economic slack has almost been eliminated since the 2007-2009 recession. Stock market participants are closely watching this data as recessions are usually accompanied by declines in stock prices. Of the 12 recessions since WWII, the average corresponding drawdown in the S&P 500 index has been close to -29%. Since the beginning of 2018, the U.S. stock market has been displaying periods of increased volatility as investors become more wary of an impending recession.

Now, all eyes are on the Federal Reserve. Recently, the Fed signaled that it would start to lower interest rates if the economic climate doesn’t improve in the coming months. Up until late 2018, the Fed was determined to keep raising rates through all of 2019. This recent shift in the Fed’s policy stance underscores the conundrum that policy makers face: prolonging growth without overheating the economy and preventing the current full-employment situation from turning into the next recession.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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Fed’s Predicament

The recent escalation of the U.S. trade disputes with China and Mexico is putting Federal Reserve policymakers in a bind. This comes at a time when global economic growth is losing its momentum, and the effects of President Trump’s tax cuts are wearing off. The International Monetary Fund projected that the current and threatened U.S.-China tariffs could slash global GDP by 0.5% in 2020. This slow-down is most noticeable in the Eurozone and Japan. As for the Chinese economy, the outlook for growth is becoming less certain.

The Fed has held its benchmark rate steady so far this year in a range between 2.25% and 2.50%. However, with risks to the multi-year U.S. expansion rising, Fed officials recently started debating whether and when to cut the rates. They already expect the economy to slow down by 1% to around 2% growth from last year to this year. Any forecast of a sharper-than-expected decline would fuel concerns of recession.


The change in sentiment has already convinced bond investors that a rate cut is likely as bond yields have pushed lower in recent weeks. The 10-year Treasury yield was down to 2.142% at the end of May, and it currently sits well below yields on three-month Treasuries. This represents a so-called yield-curve inversion (Exhibit I) which often precedes rate cuts and recessions as investors prefer to lock in higher rates.

Futures markets provide further evidence that a rate decline is expected. As of the time of this writing, the CME FedWatch tool places about a 25% chance of a 25-basis point rate cut at the Fed’s June meeting and an 80% chance of at least a 25-basis point decline from current levels at their July meeting. The CME FedWatch tool computes probabilities for future interest rate levels based on Fed Funds Futures prices. Market expectations are factored into these prices. As can be seen from Exhibit II, the probabilities of a rate decline have been trending upwards since the start of May with expectations spiking at the end of the month.


Fed policymakers have always had a challenging task. Congress maintains three key objectives for the Federal Reserve: to maximize employment, stabilize prices, and moderate long-term interest rates. For example, the Fed must encourage low unemployment while also monitoring nominal wage increases to make sure that inflation does not grow out of control. They must also ensure that in the long run, interest rates are not too low or too high. And now, the United States is only recently coming out of a period of unprecedented quantitative easing, complicating matters further for current policymakers. The bottom line is this: Fed officials must balance the risks of easing too soon with the costs of waiting too long; and a wrong decision may have far reaching consequences.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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The Power of Al: How Does It Work?

Artificial Intelligence (Al) is far from a new concept. Cars, cell phones, fraud detection and prevention technology, ad recommendations that pop on the side of your Facebook page, etc. are all forms of technology that utilize artificial intelligence in one form or another. Within the larger field of AI, there are various subsets such as robotics, computer vision, and perhaps most famously machine learning (ML). Machine learning is a sophisticated extension of Al that is rapidly advancing the efficiency of the modern world, and in fact, you probably use ML-powered technology on a daily basis.

Coined by A.L. Samuel in 1959, machine learning is a process whereby a computer system learns and adapts to data it is fed, essentially training itself. Instead of humans programming the technology to do or know something, the technology is programmed to teach itself based on its experiences

There are three primary categories of ML: :Supervised LearningUnsupervised learningReinforcement learning.

With supervised learning, the model is provided with a known, desired outcome. The model then trains itself to best achieve that outcome. The challenge, of course, is then feeding new data to the existing model. Often, the model is “overfit” on the data that it was trained on and is useless in making decisions with new data.

In unsupervised learning, the model is not provided with any target outcome. Often, unsupervised learning is used to identify similar clusters, or groups, of observations. Recommendation systems are a famous use case of unsupervised learning.

Finally, reinforcement learning is quickly gaining momentum. In this approach, the model learns from feedback it is given throughout the learning process. For example, when training a dog to sit, the dog is rewarded with a treat once it performs the task it is commanded to do. After the dog is praised and rewarded for its accomplishment, the dog will know to do the same thing when asked to execute the task again. Reinforcement learning uses the same idea, but without the dog treat, of course.

You may be wondering what an every-day example of Machine Learning is. The truth is that ML is embedded in multiple forms of technology that you more than likely use regularly. For example, the spam filter in your email is one common application of ML. Based off what you have opened and responded to in the past, ML will sort what it thinks you will find important from unimportant. It is important to consider that the more information it is fed, the more accurate it will be.

Al was created to simplify our lives as well as take on larger and more complex feats that human error inhibits us from accomplishing, and ML is precisely the resource that will continue to innovate the world. Industries all over the globe are beginning to utilize forms of Al to enhance performance, efficiency, and general way of life.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.