This is time for reflecting back on the year ending and making resolutions for the new to come. From an investment perspective however, we will end a rollercoaster year close to the levels where we started in many asset classes, what prompts me to look further into the past in order to understand why we are here in the first place.
Some argue the root of the problem is the financial crisis which was triggered by the subprime crisis in 2008, evolved further into a sovereign crisis and later developed into the first stages of an emerging markets crisis. On a different camp, to which I subscribe, are those who would argue the root-cause of the current situation needs to be traced further back into the past. As growth rates trended down since the 70s, the welfare state’s entitlements kept concurrently rising. As increases in the state’s size had short-term beneficiary effects in terms of growth and job creation, it was a sweet too difficult to resist for politicians. The facts speak for themselves. Taking the US as an example – and not precisely the most pro-government country – total government spending at local, State and Federal level increased from a post-war level of 20% to GDP in 1950 to 40% in 2011. Initially this increase was financed by vigorous economic growth and public debt was even reduced. However, since 1980, growth decelerated and total public debt increased from 40% to GDP to about 100% in 2011. In parallel, during this period economies turned to be increasingly dependent on consumption, and less on manufacturing and investments. This on itself is not a bad thing form the sustainability of growth perspective, but was partly achieved through an increase in personal debt. When these two elements are factored into the declining growth rates seen over the past decades, the conclusion is even more somber. GDP growth is not more than a P/L view of the economy where investments can be counted as revenues and interest rates are not deduced as costs, hence, leveraged growth is not differentiated from unleveraged growth. Under this view, 2008 marked the point at which bond markets no longer tolerated leveraged growth, and since then governments, consumers (and banks) had no option than to delever.
With low or negative credit and economic growth, the price of money had naturally to decline. The response of central banks has been to drop nominal rates markedly so that real interest rates remain negative to help economic agents in the deleveraging process. So here we are investing in an environment of historically low interest rates that distort the valuations of all financial assets. The Fed has started its journey towards normalization of interest rates. If they can successfully complete it without having to reverse course, this should be cheered, as this will probably mark a return to a healthier path of economic growth. However, it will also bring a repricing of all asset classes which will turn bad for those with most inherent interest rates risk. If the Fed fails, we will enter a new stage of the crisis with the monetary stimulus already exhausted, leaving policy makers probably no other option than breaking the taboo of debt monetization. Not a bright outlook for any asset class besides physical assets.
On the positive side of the story, globalization has proved to be a tremendous force, acting as the major contributor to global growth over the past decades. The problem is that this growth has accrued to economic agents in a very unequal way. Offshoring and global trade have benefited the capital, emerging economies, as well as exporters and consumers in developed economies, at the expense of workers and producers in developed economies. Another formidable force has been technological change. Even though the benefits of it have been more widespread, similar as happens with globalization, it is creating winners and losers at an accelerated pace, since long-lasting business models get easily disrupted and workers skills turn quickly obsolete. No surprise then that inequality is currently at the top of the political agenda.
Thinking on the year ahead, with this political climate, I am amongst those who see the next stage of the drama to be of a sociopolitical nature, traces of which can be found in the polarization of political options, the rapid rise of populist parties on both sides of the political spectrum, and in the ascent of nationalistic trends, be it of a separatist, protectionist or isolationist nature. I think this will not result in a major social upheaval, as in the end “reality bites” and very few are willing to live in isolation without flat screens, iPhones and the like. Greece offered us this year an example of waking up to reality after an idealist hangover, and North Korea remains a poster-child of how an isolated world could look like. However, even if not traumatic, this will mean social adjustment – hopefully for a better political governance – and a combination of less growth, less trade and a lower return on capital, which are not good from an investor perspective. Even excluding this scenario, in the current environment of depressed interest rates and low growth, we are all facing a terrible time to find where to invest. I find it also a very bad time for placing bold macro bets, as we are at a turning point of reverting to a somewhat normal growth path or falling back into crisis mode, which means changes in macroeconomic variables and investor sentiment can be very pronounced during this period. Probably this is time for paying more attention than ever to the micro factors, mainly conducting a proper risk management, and trying to select investments in companies, sectors or economies that will thrive (or at least survive), no matter what the world does.
Fernando de Frutos, MWM Head of Investment Advisory
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