23 Oct 2017
Economic cycles dominate investment outcomes but only over the short- to medium term. Over the long term, relentless demographic and structural mega-trends drive investment performance.
This is the second of a two-part series where we cover megatrends which have driven performance over the last 50 years and highlight the changes occurring right under our noses.
" Lack of demand is at the core of most of the world's current growth problem."
In part one, we looked at two major demographic changes and tax rates. In part two, we examine debt, trade and inequality.
Long-term trend four: rising inequality
Rising inequality has been a feature in the West for 40 years. It’s particularly prevalent in the US, where President Donald Trump's proposed tax cuts could see it become an even bigger issue as the 1 per cent take an even larger slice of income.
Economically there are two main effects:
• Lack of demand is at the core of most of the world's current growth problem. Give poor people more money and they spend it, give rich people more money and it is usually saved.
It’s hard to see any reversal in inequality in the short term. Things will possibly need to get worse before they get better.
• Political instability has been a feature of most elections over the last few years. Voters know something is wrong and change is needed – they are just not sure what is wrong, which leaves them vulnerable to con men and demagogues. This could get worse before it gets better.
Long-term trend five: debt growth
The best medium-term way to raise demand when a small group of the population (the 1 per cent) are taking the lion’s share of the economic benefits is for the 1 per cent to lend the money to the 99 per cent so they can spend. That is what has happened.
So, when does this end? No one can say but we don’t seem close.
The saying ‘you go broke slowly and then all at once’ is probably instructive. There are two key ways to resolve over-indebtedness:
• Inflation: With lots of wage inflation, workers get more money, which reduces the real value of their debts. This is relatively painless for most involved and it is how central banks would like the transition to occur.
The reality is the methods tried to date haven’t created inflation - and Japan is a 20-year example of trying to create inflation but failing.
In practice, central banks have lowered interest rates to try to spark inflation and in doing so they have increased the value of assets, which has increased inequality. And we are largely back to square one…
The irony is we know exactly how to create inflation: print money and give it to poor people.
Economists generally don’t want this to happen because in the hands of politicians it gets out of control (Zimbabwe, Weimar Germany) and causes hyperinflation.
What central banks are currently trying to do is create inflation in any way possible without actually printing money. They are failing.
• Debt forgiveness/write-offs: There have been lots of opportunities to do this – basically if a rich person lends to a poor person who can’t pay then the rich lose the money. It’s a great way of transferring assets out of the hands of the rich.
Unfortunately, what happened instead is governments everywhere bailed out the banks. The decision was made to ‘extend and pretend’ in high-profile over-lending cases like Japan (zombie companies in the 1990s), the US (housing loans in 2008), Europe (Greek and peripheral debt in the last seven years) and China (the housing market in the early 2000s and probably the housing market plus a range of state-owned entities again in the not-to-distant future).
It looks like governments will continue to take a lot of pain over a long period of time rather than let lenders take responsibility for mistakes.
In the short term, what could give us a burst of inflation is if a populist leader was voted in (say in the US) and decided to dramatically increase government debt (say by giving massive tax cuts and/or spending on infrastructure).
If the policies were designed so the 99 per cent benefited more than the 1 per cent, then a lasting solution might be achievable. Instead, it looks as if most of the benefits of any US tax reform will accrue to the 1 per cent, solving nothing.
Long-term trend six: increasing global trade
I am a huge believer in the magic of trade. A buyer and a seller come together and both leave the transaction thinking they got the better deal.
Comparative advantage, specialisation, relative productivity – it all makes sense in terms of improving global wellbeing.
Where trade falls down is in jobs. For instance, if you had a bunch of states in the US which specialised in manufacturing and then you outsourced the manufacturing to Mexico and China but didn’t get the manufacturing workers into new jobs, you suddenly have got an army of unemployed who are enraged enough to vote for, say, a reality-TV star as president.
You will get into the same strife if you sacrificed the bulk of your manufacturing workforce at the altar of a never-ending Chinese boom, only then to realise that it wasn’t never-ending.
For companies in general, and multinationals in particular, growth in trade leads to growth in profits – companies are much better placed than individuals to exploit cost differentials across countries.
It’s hard to estimate how much profit growth has come from increased global trade - my estimate is it is significantly greater than zero.
The danger over the next few years comes from the following chart – this shows how far trade fell in the 1930s when the world turned against trade during the Great Depression.
Now, I don’t know how much of Trump’s anti-trade rhetoric is real and how much is hot air. With Trump’s tax cuts he has the support of most of the Republican party – I’m reasonably confident they will go through.
Republicans are generally pro-trade and so there will be difficulties getting a trade war through Congress. It is also hard to tell how much of Trump’s rhetoric is about taking an extreme position and then negotiating back to something more reasonable.
However, I do think it’s safe to say there will not be increased globalisation. The risk to investors is trade wars break out and damage both world growth and company profits.
Bringing it all together
So, the last 40 to 50 years saw five key tailwinds: female participation in the workforce, favourable demographics, increasing debt, increasing trade and reducing taxes. These have more than offset the headwind of increasing inequality.
• The baby-boomer tailwind is about to (or has already) become a headwind;
• Inequality is still growing;
• Female participation and trade are no longer tailwinds;
• Debt is still increasing but levels are elevated and there is probably not much room left on this front; and
• Corporate taxes are still a tailwind.
We are at an inflexion point. The long-term mega-trends which carried markets from strength to strength over the last 50 years are ending – and while you won’t see the effects tomorrow or the next day, you will over the next decade.
Damien Klassen is Head of Investments at Nucleus Wealth
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
23 Oct 2017
12 Feb 2016