An activist in the VC woodpile signals MPT is on its way

Paul Singer, the billionaire activist investor, just announced that his Elliot Investment Fund has taken a 20% stake in Masayoshi Son’s Softbank Ventures.  Activist investors make a living out of forcing efficiencies on inefficiently run companies. Softbank is a legend in VC-land, yet it trades at a 50% discount to NAV.  Masayoshi Son is a superstar investor amongst VC’s yet, were he a mutual fund manager, he would be a laughing stock with a fund trading at such a discount.

What do we make of Singer’s initiative? The simple answer is that Singer is going to pressure Softbank to take steps to narrow the discount by adopting best practice investment principles. But Masayoshi Son is a superstar, the VC investor that every VC investor wants to be – in VC-land he is doing nothing wrong, this is how VC operates.  Singer and Softbank are shaping for a Titanic clash of – well- Titans.

Modern Portfolio Theory has forced major changes on the investment portfolios of institutions and individuals.  Index funds never existed 50 years ago but now they make up more than 50% of the market.  In the 1950s, investors were all stock-pickers, stitching together portfolios of 50-odd stocks or buying 20 of the 30 constituents in the Dow Jones Industrial and Transportation Indices.  JPMorgan’s ‘Nifty-Fifty’ was the staple investment for US Corporate Pension Funds back then and the investments were ‘actively’ managed.  Indexing had not been thought of.

Modern Portfolio Theory made two important observations that has shaped portfolios ever since the field emerged in the 1960’s,

1. Every security return can expressed as the sum of its market exposure (its beta) and a company component (its alpha).  The beta : alpha mix for a listed security is about 30% : 70%
2. Passively managed Index funds outperform the average active investment portfolio

These two simple observations are related.  From 1., since every security contains a market exposure and a company specific return, a portfolio of securities builds up its exposure to the market and a collection of ‘alphas’.  By 2, the only way to beat the index is for the collection of ‘alphas’ to sum to something that is greater than zero (after transaction costs and fees).

The result of this thinking turned portfolio management on its head.  Previously, portfolio managers had constructed portfolios by starting with a collection of stocks that they liked and the return that they received was a mixture of market and alphas.  Today, the modern approach is to start with the market return and then step out into individual securities that appear cheap (ie have a positive alpha).  The difference is subtle but completely transformed the investment industry.  The starting point for an investor is to buy the market where possible and to only concentrate in individual securities when you have a good reason to.  For most investors, the likes of institutions and individuals, there is never a good reason to take bets on stocks – markets are informationally efficient and the likes of Paul Singer are all over those opportunities when they arise…

So what does all this mean for VC?  Just as there are undiscovered tribes in the Brazilian Amazon and the Mountains of Papua that have yet to be touched by civilisation, VC is one of the last bastions of investment management that has yet to be touched by Modern Portfolio Theory.  Having only recently been exposed to the practices of VC-land I am appalled at the near-absence of science with which investors and managers alike approach this market.  The typical VC investment portfolio holds 20 or fewer companies, risk-control is driven by draconian rules of thumb (“…we only invest in series A or later …”) rather than portfolio diversification principles and qualitative instincts drive decisions rather than quantitative objectivity.  This is all the more surprising when it is recognised that VC returns are almost 100% alpha driven as opposed to the 70% alpha exposure for listed equities.  The volatility of the sector is gut-wrenching, highly skewed toward complete failure (95% of startups lose 100% of their capital) and informationally asymmetric.

That said, the VC sector as a whole has delivered some eye-popping returns with the Thomson-Reuters VC Index delivering 22% pa since 1996. Investors are increasingly attracted to these returns however the industry is so antiquated that the only way to get exposure is through old style stock picking which is expensive, unnecessarily risky and a shark tank for the uninitiated.

The Singer-Son clash may change the VC dynamic.  Effectively arbitraging the 50% discount of Softbank to its Net Asset Value requires Softbank to (i) liquidate some of its investments and pay out the proceeds to shareholders, or (ii) open-end the fund thereby allowing for subscriptions and redemptions at NAV, or (iii) buying Softbank and hedging its components by shorting the underlying[1].  The Singer-Son clash, however, may get the VC market thinking about how to deliver VC returns in the Modern way.  That is, finding a way to deliver diversified market index type returns to investors who want VC beta and then specialising in stock picking to generate alpha.

There are very few diversified VC funds offering beta exposure.  We are proud to say that we are associated with the Hatcher+ fund (www.hatcher.com) that is designed to deliver beta for startup tech VC by investing in 1,300 startups over the next few years. Traditional VC investors see this as a ‘radical’ approach to their market and are either intrigued or skeptical.  The truth is that the Modern Portfolio Theory train is heading toward VC-land so either you jump aboard or it will run you down.

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[1] Softbank’s two significant investments are its stakes in Yahoo and Sprint Telecommunications, each of which can be shorted.

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Memoirs of a SARSa

As the WuHanFlu pandemic rapidly takes grip, it is worth recounting the SARS crisis of 2002…

The first I heard about SARS was when a taxi driver picked me up with his car door windows completely open. I congratulated him on his appreciation of the climate and rejection of air conditioning which tends to be frigidly standard in Singapore taxis. Rather than embracing the tropical climate, he brusquely responded “the windows are open cos i don’t want to catch the Cantonese Flu”. I thought he was a weirdo but within a few hours the first hints of crisis were emerging.

At its deepest trough , Changi Airport in Singapore hosted only 10 flights in a single day. Usually they cater for 10 flights every 10 minutes. I recall being at the airport that evening when the entire Terminal 2 departure hall was in darkness with just one trolley-uncle sleeping in a chair. Normally there would have been 28 gates open serving thousands of travellers. I had managed to secure a seat on a flight to Australia to serve a ‘quarantine ‘ period and the only reason that the flight had arrived was to deliver its precious cargo of World Health Organisation professionals establishing a beach head in Singapore to direct the crisis.

As it dragged on the feeling for most residents in Asia generally and Singapore in particular, was will this ever end?

In hingsight, the SARS epidemic was bad but it wasn’t like the plague in the Middle Ages that wiped out 1 in 3 nor the flu epidemic of 1918 that killed 50million people. To their credit, the medical authorities and epidemiologists did a fantastic job containing and ultimately defeating SARS.

However, there was some stupidity from which lessons can be learned as we enter the current WuHanFlu pandemic. Not surprisingly, the banking sector exhibited much of this behaviour.

In banking, mandatory regulation and prudent risk management practices require Financial Institutions to maintain emergency contingency plans.  These plans are quite detailed and once activated are rigidly enforced. My recollection is that Deutsche Bank was the first major financial institution to activate their contingency plan during SARS.  Every other major bank responded within hours by activating their own plans as well.  This was all well and good at the time but as the crisis rolled on, there was one detail that had not been planned…how and when should the contingency be DE-activated?

As the months dragged on, watching the game being played by the major banks in contingency mode was fascinating.  Twice per day, the risk management heads for each institution had a conference call where each would state their position.  If one bank decided to lift their emergency status while others remained in contingency mode then they would be an outlier, risking the industry for their own benefit, thereby attracting criticism. This reinforced the contingency position and the whole sector got stuck.  No-one was bold enough to act unilaterally.  Eventually, the government took the lead by stating Singapore would be SARS-free provided there was no new case reported for 14 consecutive days.  Hopes were raised upon reaching 11 days one month only to be deflated when one poor guy turned up to hospital with SARS and the clock reset.  Finally, the 14 days ticked over and the country was SARS-free and contingency plans were abandoned.

Another key player in the SARS crisis was the United States.  They banned arrivals from Asia very early on and somehow remained SARS-free throughout the crisis.  The USA’s insulation from the disease made them unreasonable to deal with since Asian countries were excluded from travel and trade to ‘protect’ the US economy.  Notably, this time around, the WuHanFlu has showed up in the US very early on in this crisis so the US can hardly dictate terms to the rest of the world.

Finally, the most amusing experience I had was being denied entry to India on the basis that I had come from Singapore which was a SARS affected country.  India is an amazing place but travellers seldom leave without being infected with some undocumented microbe, dysentery or typhus-related disease.  To have India deny travellers entry on health grounds was truly ironic!

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ARAMCO’s direct listing arithmetic

ARAMCO, the Saudi Arabian oil company, issued stock at a  USD1.7 trillion valuation last week  and promptly traded up 18% to top USD2trillion. This was in line with the Saudi government’s initial valuation expectations.

This result was achieved essentially by direct listing. I say this since the cap raise was a miniscule 1.5% of market cap. ARAMCO had originally planned to raise closer to 10% of market cap through a network of international banks however the bankers almost unanimously rejected the valuation target that the Saudi’s had suggested. The banks had argued for more of a USD1.2trillion valuation when issuing new shares.

The IPO market is one of the last bastions of financial inefficiency and the Saudi’s determination to stick by their valuation deserves praise. It is well documented that the degree of underpricing in the IPO market is 30% on average, so that investment banks deliberately stuff their favoured clients with cheap stock, which their clients then stag for a quick profit. So when an investment bank quotes $1.2trillion for an IPO they really mean $1.6trillion after factoring in their stag premium.

It appears that this back of the envelope calculation drove the Saudis to dismiss their dealer panel and go it alone. The banking community publicly expressed their criticism of the Saudis based on valuation numbers generated by their captive analysts’ teams but, no doubt, the banks privately bad mouthed the Saudis as crazy and inept in order to keep their clients away from the deal. Depriving the ‘Saudi renegades’ of the international investment community would surely see the direct listing strategy flop, they surmised, thereby exposing ARAMCO as fools and more broadly serving a warning to any other issuer contemplating a direct listing themselves…

…but the fools turn out to be the investment banks themselves. The $1.6trillion inclusive of stag premium is pretty close to the $1.7trillion the stock priced at. This means that the Saudis kept the stag premium for themselves, all $36 billion of it. That is a lot of money…and a watershed victory for the direct listing camp that seems to be growing in importance and actual listing frequency.  In 5 years time my prediction is that direct listing will be the normal approach for any company going public.

One final point on ARAMCO’s decision to go it alone.  The investment banking community seemed to treat ARAMCO as purely a private corporation going public.  In fact, ARAMCO is a sovereign asset ultimately owned by the Saudi people.  ARAMCO therefore had a public duty to their citizens to maximise the value of the asset.  Private shareholders make decisions to go public for many reasons and they internalise the costs versus the benefits as they are the asset owners.  ARAMCO, on the other hand, are stewards of their nation’s natural resources and it is not for them to simply pay a 30% premium of their country’s wealth to a group of international bankers. This point is lost on every commentator that I have read.  Full marks to the Saudis!

A comment on the UK election…

Well, we were correct in predicting a clear triumph for Boris Johnson but the Labour Party route turned out to be deeper than anticipated.  The mischief vote in favour of the Tories sends a clear message to the UK Parliament that the electorate thinks it is an inept institution.  Irrespective of whether they voted for or against Brexit, the UK electorate was aghast at how their representatives cannot follow a simple instruction.

The US Democrats should take note of this dissatisfaction and disenfranchised attitude toward elected representatives.  Our long-range prediction is that Trump and the Republicans sweep the elections in 11 months time for this very reason.

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An FDV threeway: Swinging in Saudi Arabia…plus Our UK Election Special…plus the latest release from DJ Dr Fish

Swinging in Saudi Arabia

ARAMCO officially listed yesterday.  The Saudi owned company is the world’s largest oil producer, world’s largest company … the world’s largest many things.  It has played a political role, a diplomatic role and a world economic role for many years as the ‘Swing Producer’ in the oil markets.  Swing producers have the capacity and substance to stabilise oil markets should there be short term fluctuations in supply.  Swing producers can also act as policeman to a price-fixing cartel such as OPEC.  Swing producers, it is fair to say, may not necessarily act to maximise profits, especially when it belongs to a Sovereign entity with many competing objectives…

…but now that ARAMCO is a listed entity does this change?  The starting point for a public company is to maximise profit and it is not clear that ARAMCO’s activities to date have had that objective.  Cartels, such as OPEC, aim to control the supply of a commodity in order to fix a price that will benefit all members in terms of higher revenue.  That price is typically way higher than the marginal cost of producing the commodity so there are clear incentives for one or more members of the cartel to chisel away at their production quotas, selling more oil than they are permitted for profits at the expense of other members.  Cartels are inherently unstable, therefore, and it is the role of the Swing Producer to bring discipline to its members.  In this way, the Swinger is not acting to maximise their own profit per se, rather they are bearing the cost of policing other members sly activities.

Public companies are not meant to engage in price-fixing arrangements, collusive anti-competitive behaviour nor any supply manipulation.  On the face of it, however, ARAMCO’s raison d’etre has been all these things.  Owing to its  ‘strategic global importance’ ARAMCO will get away with all these activities as the global regulators turn a blind-eye to it all.  ARAMCO’s shareholders, however, may think differently.  While the non-government shareholder register represents only 1.5% of the stock, they will want their rewards – as either higher dividends or higher stock prices.  This may force ARAMCO to abandon their Swing activities and, quite possibly, become a source of instability themselves.

UK Election special: Money v Mischief in the UK Brexit Poll

Speaking of cartels, the UK is going to an election om December 12 to break the impasse caused by the UK parliament’s inability to follow a simple instruction.  In 2016, the UK’s electorate decided to leave the European Union, a particularly vicious cartel that favoured members such as France, Italy and Germany over others such as the UK.  Breaking the cartel seemed, on the face of it, the right thing to do.  But the UK’s government has had difficulties letting go of the security blanket and their Whitehall bureaucrats got busy negotiating a ‘Claytons Brexit’ – an expression for the Brexit you have when you are not having a Brexit.

Frequent readers will be aware of my ‘Money v Mischief’ theory of voter behaviour.  Basically, the ‘thoughtful swinging voter’ make their mind up only when they reach the polling booth and they do so based on (i) how much money they expect to make from each party and (ii) how much mischief they can cause within their own parliament.  On this basis, the Labour Party in the UK might well surprise with their pork-barrelling of promises such as free fibre internet for everyone.  The mischief vote goes squarely to Boris Johnson who, despite being a career politician, candidly expresses his impatience with the talk-but-no-action that is modern democracy.  Sadly for the Liberal-Democrats, they offer neither money nor anything other than ‘good policy’ which, irrespective of its content, is pure boredom.

So on this basis, my prediction for the UK elections are

(i) The Liberal Democrats get decimated to the point of extinction

(ii) The Conservatives easily obtain a majority as the electorate send a message to the parliament to just get Brexit done

(iii) The Labour party pick up the Lib-Dems losses

…and finally, check out the Christmas Album from DJ Dr Fish

The latest release does NOT have any of the songs that your DONT want to hear at Christmas.  Just 63 minutes of relaxing, progressive trance.

https://soundcloud.com/stephen-john-fisher/santas-little-fish-mix

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Beware: Libra threatens to stabilise the World’s monetary system!

“We have security concerns with this initiative ” is every IT department’s Ace of trump’s for effectively stopping any project in its tracks. No board of directors will dare challenge said “security concerns ” since their personal liability is too great to risk it.

Those of us old enough to remember the Y2K soap opera know how diligent we all were in cooperating with the legions of consultants allocated to this pending doomsday event, while at the same time thinking what a load of rubbish the entire exercise was. I personally remember explaining to a Y2K vigilante that the computer code THAT I WROTE MYSELF was not exposed to any Y2K risk, only to be told that there were 3 layers of approvals needed to verify what i knew to be fact…rather than rage against the machine I quietly surrendered to the higher powers.

Y2K came and all our private doubts about the security risks were proven correct. Nothing happened. Y2K, it turned out, was an IT pink elephant fabrication (“we see a pink elephant, prove to us that there is no pink elephant “), that no one was game enough to challenge before it became a corporate tamagotchi requiring constant attention.

Rather than confronting the flaws in the global monetary system generally, the collective Governmental response to Facebook’s plans to launch its own ‘currency’ has been to float an array of pink elephants.  Let’s be honest, Libra is nothing more than a prepaid gift certificate that people can deposit with Facebook and use to purchase whatever is being offered by Facebook’s retailers.  Libra does not pay interest nor lay claim to anything tangible.  Instead its a swap from Government issued fiat money into Facebook issued fiat backed by a currency board of the Government issued fiat money that is swapped-in in the first place. If Libra operates in this way, then whatever happens to the Government fiat drives Libra. Libra is a benign translation of dollars/yen/euro/sterling into some gift certificate registered on Facebook…

…but whoa, the pink elephants that have been floated!  Libra will be a haven for terrorists. Money launderers. Drug dealers.  Retail junkies. Libra threatens a nation’s sovereignty and its ability to conduct monetary policy.  Libra will provide Zuckerberg with the means to control the international monetary system.  And so on and so on.  What truth is there to any or all of this?

Lets first deal with the terrorists/launderers/druggies/spendthrifts.  Entering the Libra system should require hard fiat to begin with.  Either the t/l/d/s uses, say, USD to exchange directly for Libra with the Central Repository of FaceBook (CRFB) or they elect to buy existing Libra from Facebook’s loyal supporters.  Libra does not just drop out of the air nor does it get funneled or produced by the t/l/d/s crowd.  In fact, it is hard to imagine a scenario where the bad guys have managed to earn their money other than in the official hard currency system – that is, the current system is to blame for the bad guys having access to Libra.

Next, the scaremongering that Libra will invalidate or compete with a nation’s monetary policy is also vacuous.  Just like Hong Kong’s peg to the USD, Facebook has elected to peg Libra to the existing official currencies in operation (a basked peg where the weights reflect the inflows to Facebook’s system).  Technically, an exact peg backed by a currency board (that is one USD is held for every USD represented in Libra) outsources monetary policy to the original currency issuers.  This means that the US Federal Reserve, the ECB, the Bank of England etc etc control the monetary conditions inside the economy of Facebook and not vice versa.

Finally, can Zuckerberg take over the monetary system?  This is challenging for the Zeitgeist would need to decide to break the strict link between Libra and its currency board, for example by issuing Libra without the hard currency to support it, and the holders of Libra would need to refrain from converting back to hard currency.  This is the Argentina problem – in the 1990’s Argentina famously pegged its currency to the USD without holding any USD to back the promise – and the trick did not last long.

Zuckerberg could, however, offer something tangible to back Libra in place of Government issued fiat…gold, oil, digital assets… something that an owner of Libra could confidently switch into should the supply of Libra become excessive and switch out of if Libra became more scarce than the physical assets.  That, Ladies and Gentlemen, would be a true threat to the official currency markets since it would represent a stable, convertible, medium-of-exchange …something that doesn’t exist in the current world of official fiat.

For some reason, however, none of the Government officials has mentioned this ‘threat’ to the world’s financial system.  The true threat of Libra is that it STABILISES the World’s monetary system!

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CB Libre

The Cuba Libre (Rum and Coke) became the symbol of Cuban independence during the Spanish-American war.  What will symbolise the take-no-prisoners war about to erupt between Facebook and the world’s Central Banks over Libra?

I recently attended a meeting of senior Central Bank and Academic researchers in Singapore. The discussion quickly focused on the effectiveness of Monetary Policy – to be more exact, it was all about the ineffectiveness of Monetary Policy. The mood amongst the Central Bankers was that of capitulation- interest rate targeting had failed even with negative interest rates in place and QE in all its forms had failed to either influence prices or output. All is lost…

To be honest, while Central Bankers are no longer rock stars in the eyes of the markets or businesses or the general public, they should not be surprised. The writing that monetary policy is ineffective has been on the wall (and in the volumes of empirical evidence that modern economics has generated)  for decades and decades. The Real Business Cycle literature made this point elegantly 30 years ago by simply omitting money from its analytical framework altogether! Critics of RBC at the time dismissed the framework completely, arguing that a theoretical economy without money could not generate realistic predictions. Three decades later, the ‘money doesn’t matter ‘ chorus is being sung by those critics themselves.

Reluctantly admitting that current approaches to monetary policy are ineffective, radical approaches were proposed and contemplated. One idea is to ‘helicopter drop ‘ money directly into people’s bank accounts. Radical as it may sound, this is probably the purest expression of the classical monetary injection…but while increasing the money supply might bring joy, reducing the money supply means confiscating cash from bank accounts and would lead to riots.

Another idea is to give Central Banks the right to tax. The argument here is that tax policy is quite powerful (true) and that elected governments cannot be trusted to tax properly (also true) while independent Central Banks can be trusted to tax correctly (not true, but less not true than the truth that elected governments cannot be trusted).

Central Bankers have all this misery and introspection to deal with, only to be sucker punched by the rise of crypto and private money. Admitting your own ineffectiveness is one thing, being challenged by your serfs is another. There was uniform agreement amongst all the Central Banks that everything that has to be done to prevent crypto from dominating traditional fiat money will be done! As a contingency, Central Banks globally have crypto currencies of their own, ready and waiting to challenge the potential threat of a private currency…

…and then came Libra. Facebook, the internet phenomenon with the world’s largest privacy waiver, announced their plans to issue a crypto-currency for online payments within the Facebook ecosystem…

Libra is planned to have full backing from the underlying mix of currencies represented by the official fiat currencies used to purchase it. This is a trade-weighted valuation reflective of the proportion of Facebook online shoppers’ currency sales.(If 50% is USD and 50% Yen, then Facebook will hold the subscribed currency in cash-like securities in a 50-50 proportion). While most trade weighted baskets reflect a nation’s external business transactions, Libra will reflect Facebook’s demographic consumer mix.

Reading the description of Libra from Facebook’s press release it becomes quite clear that the currency has been constructed quite intelligently. Zuckerberg must have decided to ignore the dreaming of the crypto-zealots and hired some quality monetary theorists to design Libra…

The big problem, however, is that any interest earned by Facebook on its deposits of traditional fiat money is kept by Facebook. Very greedy and very dumb. Even the Central Banks don’t favour themselves that much when it comes to paying interest on reserves. By construction, therefore, the Libra is designed to fail as an alternative to USD or Euro since it has no value other than to trade online with Facebook merchants.

Mark Carney, the Bank of England’s Governor, told parliament that the BoE and other major Central Banks would have ‘oversight’ of Libra to prevent money laundering and terrorism usage. Beyond that the Central Banks collective silence on Libra has been deafening.

So even though Libra will fail initially, eventually the Central Bank of Facebook will wake up to their self-imposed handicap. Central Bankers know this and war rooms have been set up around the world readying for a fight. A massive coordinated attack on Libra is being prepared for launch at any moment.

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Money v mischief in the Australian election

There is less than 2 hours until voting finishes in the Australian federal election. My money v mischief theory is difficult to determine a winner. The Labor party is a clear leader in the money category, promising everybody everything…but my suspicion is that mischief will decide this election…

The current global trend is to protest against the elitist elements in both the media and politics. Labor has siddled up to the elitist vision of utopian socialism, much as the US Democrats have done. The natural mischief vote is to reject the chardonnay socialist set to piss them off.

As voters stand pencil in hand, a vote for the boring liberal party is really going to stir up the anger of the left who are already claiming victory.

I think the liberals will be handed an upset win precisely because the losers will be very upset!

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Private is now the New New-Private not the Newish Public

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The speech

Last Thursday evening, First Degree hosted a Launch Party for our manager platform. Everyone was having such a pleasant time that we decided against puncturing the enjoyment with a boring speech…

…for those of you who are curious about what I would have said, here it is!

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Walls

The Great Wall of China took several thousand years to build and was primarily a method for stopping Mongolian invaders from expanding into China. As a piece of military technology it dominated all-comers however it was rendered entirely useless with the advent of the flying machine. The 20th Century was not a good one for the Chinese military defenses…Walls work until someone finds a way to bypass them completely.

So it is astonishing that the political agenda in Europe and the US is currently fixated on walls.

First, Europe. The pantomime that is Brexit has been derailed by the wall that may have to be built in Ireland to keep out cheap imports from a trade-liberated UK crossing into Europe. “Fancy a pair of these fine Italian shoes or these Chinese ones fresh in from Northern Ireland this morning at a quarter of the price?”  The reality is that this is the least of the worries for the EU who stand to have their service sectors decimated by liberal UK policies in the Finance, Legal and even Medical sectors. The City of London can easily attract companies and investors by simply cutting trading taxes or liberalising listing rules. No wall can stop this arbitrage.

Second, the US. The US Democrats have cut off funding the Government until President Trump abandons his promise to build a Wall along the Mexican border. If you had have asked Donald Trump “What do you think about shutting down the Government?” before he became President he would have said “Great idea!”. Not much has changed since becoming President. The irony of this tale is that the Democrats are the BIG GOVERNMENT believers and the shutdown is primarily at odds with both their philosophy and their constituency. Trump on the other hand, is in a win-win position and I suspect he would rather keep the Government shutdown than build his wall anyway!

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