TheAbsolute Return Partnersletter for the month of June 2019, titled, The Cost Of Rising Populism.
Patriotism is loving your country and fellow countrymen. Nationalism is hating your enemy more than you love your countrymen. Baroness Ros Altmann, Member of the House of Lords
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Ros Altmann is a long-standing friend of mine and an ardent supporter of a unitedEurope(like I am). I often think of Ros and the brave battle she is fighting in Westminster these days to keep Europe together.
Having said that, this months Absolute Return Letter is not about Brexit but about populism, although there is a powerful link between the two more on that below. I will look at the costs associated with rising populism and I will argue that one of the biggest costs is plenty of misallocated capital.
Dont get me wrong, though. Populism often leads toa lotmore than rising amounts of misallocated capital, one of the worst being an increased risk of war but, after all, this is a financial newsletter. I am not going to speculate on whether the presence of Donald Trump, Nigel Farage or Boris Johnson (probably the next Prime Minister of the UK) could result in war. I will stick to the financial costs associated with rising populism.
Misallocated capitalis a term I will bring up repeatedly in this months letter, so lets define what it actually is. Economists use the term to describe capital that is deployed unproductively. One example: As society ages, more and more capital will be set aside to service the elderly, and that is, at least in economic terms, an unproductive use of capital, i.e. it is misallocated.
That is only the short answer, though. Here is the slightly longer, and more correct, one. Assume you make a portfolio investment or purchase a business or other asset, and that the return on that portfolio investment or business is below your cost of capital. If that is the case, the capital you deployed in the first place is said to have been misallocated. In order to adjust for the cyclical ups and downs, the capital was only misallocated if the return is below the cost of capital when assessed over a full economic cycle.
A quick word or two onBrexitbefore I begin. Here in the UK, it is virtually impossible to doanythingthese days without Brexit somehow entering the frame. Even at dinner parties with family and friends, if you start the meal by agreeing not to talk about Brexit, sooner or later, it enters the conversation anyway, and I have heard of entire families that have fallen out as a result of the mess in Westminster. Things are not easy in the UK at the moment!
Only a few weeks ago I came across an article in the New York Times, written by Thomas L. Friedman, which sums up better than anything else I have read more recently why the British are getting it so horribly wrong. Friedman argues that the British have totally lost perspective of the big picture. Let me quote what I think was one of the finest passages in a great article:
Trump is fine with a world of competitive European nationalisms, not a strong European Union. So is Vladimir Putin. So, it seems, are the Brexiteers. How quickly theyve all forgotten that the EU and NATO were built to prevent the very competitive nationalism that ran riot in Europe in the 20th century and brought us two world wars.
Nationalism is a key driver of populism, and populism is a key driver of the political agenda in more and more countries around the world. In Europe alone, populist parties have more than tripled their share of the total vote over the past 20 years with populist leaders being in government now in 11 European countries (Source: The Guardian). More than 25% of all Europeans now vote for a populist (Exhibit 1).
Exhibit 1: Populist vote share in Europe, 1998-2018
In what is to follow, I will argue that populism leads to plenty of capital being misallocated. Obviously, both private and public capital can be misallocated but, in the context of this months Absolute Return Letter, which zooms in on populism, it goes without saying that I am referring predominantly to public capital.
The rise of populism in Europe is most definitely a consequence of the middle classes being financially squeezed (more on this later), but it is also a function of the series of crises Europe has been subjected to in recent years serious economic problems in Greece, the war against ISIS and the subsequent stream of refugees from Syria and Iraq, plenty of illegal immigrants, numerous terror attacks, etc.
political ideas and activities that are intended to get the support of ordinary people by giving them what they want.
If ordinary people feel theirliving standardsare under pressure (as they arguably are), a scapegoat needs to be identified so that something or somebody can take the blame for their misery.
Here in the UK, not one but two scapegoats have already been identified immigrants who supposedly take jobs away from ordinary people, and the EU which supposedly runs the country these days. That neither of those two claims are even remotely true is entirely irrelevant to these people.
Populism is far from a new trend. Every now and then, it rears its ugly head, more often than not with devastating implications to follow.
Adolf Hitler was the most notorious populist of the 20th century. He took advantage of a desperately poor German populace who neededsomethingto change after years of despair. Deutsche Bank Research runs a populism index (Exhibit 2). As you can see, we are going through a phase now not dissimilar to 1935-39, where a sharply rising gap between rich and poor also led to a monumental rise in populism.
Is the gap between rich and poor really getting bigger or is it just hearsay? Lets turn to the World Inequality Report 2018 which you can findhere. I strongly recommend you download and read this report. It is deeply fascinating.
Spending power is very much a function of income, but it is also a function ofwealth assuming you have any. Through most of the 20th century, the wealthiest 10% lost out to the bottom 90%, i.e. the gap between rich and poor got smaller, but that all changed in the 1980s as we entered the Great Equity Bull Market (Exhibit 3).
The extraordinarily benign financial market conditions of the last 30-40 years have been a major source of wealth creation since the early 1980s. The rich began to grab a bigger slice of the pie and have done so ever since. In other words, even if the poorest 90% are wealthier than ever before when measured in absolute terms, they feel poorer as they can see the wealthiest building their wealth much faster.
Exhibit 3: The wealthiest 10%s share of total wealth (by country)
Switching from wealth to income growth, a similar picture is unfolding. If we rewind to the Absolute Return Letter of November 2017 (which you can findhere), you may recall that I introduced the now (in)famous elephant chart based on work conducted by a research team at World Bank in 2013.
The chart revealed that, between 1988 and 2008, the middle classes of the developed world were the big losers, doing even worse than the poorest people of this world. Themiddle classesof emerging markets fared much better, only surpassed by the global elite who did the best of all in terms of income growth.
Another group of economists have since updated World Banks work from 2013 and have found that the gap between rich and poor is even bigger now than it was only a decade ago (Exhibit 4).(A team led by Facundo Alvaredo, Lucas Chancel, and famous inequality research trio Thomas Piketty, Emmanuel Saez, and Gabriel Zucman updated the elephant chart in the 2018 World Inequality Report.)
Exhibit 4: Global real income growth by percentile, 1980-2016
As you can see, the top 1% of income earners captured no less than 27% of the total growth in income between 1980 and 2016. Meanwhile, the bottom 90% got squeezed at least in the US and Europe and that is consistent with World Banks 2013 findings.
Exhibit 4 is global in nature, but the OECD regularly collects data on realincome growthon a country-by-country basis. As is evident when looking at Exhibit 5 below, the UK comes out as one of the outliers with negative real wage growth (when measured in absolute terms) between 2008 and 2017. Only Mexico and Greece have fared worse than the UK in the last 10 years or so.
Exhibit 5: Real wage growth by country, 2008-17 (%)
All over the world, the middle classes underwrite economic and political stability. Hence, when the middle classes are unsettled, so is society at large.
In the US, they chose a political outsider as their next President. In the UK, they chose an uncertain future outside the EU. In Italy, they chose a comedian to run the biggest political party. The middle classes of those three countries sent exactly the same message to the establishment:
We are not happy with the state of affairs. Something needs to change. We want a better life!
I am not even sure all those people know precisely what it is that must change, butsomethingneeds to. Every now and then, a populist shows up on the stage, seeking to take advantage of the general discontent and, from that point, things tend to get hairy.
As I mentioned earlier, when people are unhappy, they start looking for scapegoats, and sometimes the choice of scapegoat defies logic. If the middle classes of the UK feel increasingly squeezed (as they do), perhaps they should have a go at the super-rich instead of blaming the EU an institution that has nothing whatsoever to do with the rising gap between rich and poor.
As EU governance rules are based on consensus, in effect, the EU epitomises what populists despise. And because of the EUgovernance model, everything takes time, which often makes the EU a scapegoat for problems that have nothing whatsoever to do with it. Many populists argue that the EU is undemocratic. In reality, it is anything but perhaps even a little too democratic sometimes.
Up to this point, my logic has been fairly straightforward a rising gap between rich and poor has led to broad discontent amongst ordinary people which has paved the way for populists. So far so good, but now it gets a tad more complicated. I will now argue that rising populism is at least partly to blame for the slowdown in economic growth that we have been subjected to in recent years.
Why is that? We know that capital being misallocated leads to falling productivity growth, and we know that productivity growth is one of the two basic drivers of GDP growth. Hence, if populism leads to capital being misallocated, populism will, by definition, lead to slowing GDP growth.
What is it that populists do that cause capital to bemisallocated? Populists do what ordinary people want politicians to doirrespective of the economic rationale.
Example 1: Only a few days ago, Boris Johnson declared that [with me as Prime Minister] the UK will leave the EU in October, deal or no deal. Does that make any economic sense whatsoever? Absolutely not! Could it lead to much more capital being misallocated? Most definitely yes! Is it what (many) people want? Oh yes! In other words, Boris Johnson is a prime example of populism running riot.
Example 2: As society ages, the elderly will have a bigger and bigger say on the fiscal agenda. Most politicians are prepared to do irrational things, just to buy votes. If enough elderly want a spa in their local nursing home (yes nursing home spas already exist), I am sure we will see a few more of those pop up in the years to come.
Rising populism will almost certainly lead to rising public debt levels, as populists are masters at spending public money. That has always been the case and particularly so when money has been cheap. As public debt-to-GDP rises, more and more capital will have to be deployed to servicing all that debt, and capital used to service existing debt is by definition misallocated capital. It is effectively a vicious circle that can only end in tears.
Capital being misallocated in large quantities is one of the most important reasons why GDP growth is as pedestrian as it currently is, and the low cost ofcapitalwe are currently blessed with is the number one reason so much capital is misallocated at present.
When interest rates are low, households buy property they can only afford because interest rates are extraordinarily low. Corporates buy back their own equity rather than making productivity-enhancing investments as that makes earnings look much better than they actually are, and governments (increasingly under the control of populists) spend public money on transfer payments rather than on things that would improve productivity for example by improving the failing infrastructure. All of the above is classified as misallocated capital, and the root cause is cheap money.
It is actually possible to calculate how much misallocated capital each country is saddled with but, to do that, I must introduce the Wicksellian Spread (or Wicksell Spread), named after the 19th century Swedish economist, Knut Wicksell.
Wicksell argued that capitalism works best when the cost of capital to the average business is about 2% higher than nominal GDP growth, and time has proven him right. Economists have since agreed to use the 10-year BAA corporate bond yield as a proxy for the cost of capital to the average business, and the Wicksellian spread is the 10-year BAA corporate bond yield less nominal GDP growth.
Over the years, it has proven to be one of the best probably the best indicator of banks willingness to lend; hence it is a superb indicator of where we are in the credit cycle, and of what can be expected of economic growth going forward.
I note that the Wicksellian spread always climbs as we approach a recession. In the 2001-02 recession, it peaked at almost 6%, in 2008 it exceeded 10%, and it is currently nowhere those levels.
Once you have established how big the Wicksellian spread is, you can calculate the cumulative amount of misallocated capital. You do that by subtracting the Wicksellian spread from 2% and then multiply that result by GDP for the quarter in question. That result is again multiplied by-debt-to-GDP.
Using that methodology, MacroStrategy Partnership (my favourite research shop) has found that the amount of misallocated capital in the US now exceeds the already elevated levels of 2007-08 (Exhibit 6).
Exhibit 6: Cumulative misallocated capital in the US (% of GDP)
Source: The MacroStrategy Partnership LLP, Bloomberg.
Perhaps more surprising to you (it certainly was to me), even if it is bad enough as it is, the US is nowhere near the top of the international league table in terms of misallocated capital. Out in front with so much misallocated capital that it adds up to no less than 77% of GDP is China (all those bridges to nowhere!).
In joint second place with 58% is Australia and (the big surprise) Germany. The membership of a very unproductive monetary union has resulted in the very productiveGerman economyhaving interest rates (borrowing costs) that are way too low for its own good which has led to a huge amount of capital being misallocated (Exhibit 7).
How more precisely that will manifest itself down the road is difficult to say, but there are certainly dark clouds gathering on the horizon in Germany if Knut Wicksells approach still works and MacroStrategy Partnerships calculation methodology can be validated a topic I will return to in a future Absolute Return Letter.
Exhibit 7: Cumulative misallocated capital in Germany (% of GDP)
Source: The MacroStrategy Partnership LLP, Bloomberg.
Finally, let me share the UK picture with you. At about 16% of GDP, it is bad enough as it is particularly as it came from nothing only a handful of years ago but it is still better than elsewhere (Exhibit 8).
Exhibit 8: Cumulative misallocated capital in the UK (% of GDP)
Source: The MacroStrategy Partnership LLP, Bloomberg.
Lets wrap it all up. A grotesque amount of misallocated capital capital that could (and should) be deployed to enhance productivity is an important reason why GDP growth is as pedestrian as it currently is. And, as you have just learned, the emergence of populism doesnt make the problem any smaller.
If misallocations in the private sector are mostly funded by banks, as they were in the years leading up to the Great Financial Crisis, they pose a systemic risk, as we all learned some ten years ago. These days, most private sector misallocations are funded by either private credit or equity (whether private or public). That is bad enough, but it doesnt pose the same level of systemic risk; hence a repeat of 2008 is not as likely as many doomsayers claim.
As far as misallocations in the public sector are concerned, a rather depressing picture unfolds. The rising gap between rich and poor will almost certainly lead to more tailwind for populist parties and, as we have learned from various incidents over the past few centuries, populism often leads to authoritarianism. If we want to protect our democracy, it is therefore critical that we find ways to reverse the trendline expressed in Exhibit 3.
It is in that context you should think of Brexit and the newly held elections for the European Parliament, where populist parties all over Europe gained furthermomentum.
Here in the UK, more people than ever hold a job today, and the unemployment rate is near all-time lows. Average living standard are undoubtedly better than they were when I first moved here nearly 33 years ago. It is almost impossible to find anything thats worse public transport, maybe, but it is hard to blame Brussels for that, even if Nigel Farage tries every now and then.
Yet, over 30% of the UK electorate voted for Nigel Farage and the Brexit Party in theEuro election, and there is an aura of self-destruction hanging over the UK at the moment. That leads me to finish this months Absolute Return Letter with a second quote from Thomas L. Friedmans recent Brexit article in the New York Times:
What were seeing is a country thats determined to commit economic suicide but cant even agree on how to kill itself. It is an epic failure of political leadership.
Investment Theme: Declining spending powers of the middle classes
Article by Niels Clemen Jensen,Absolute Return Partners
The postAbsolute Return June 2019 Letter: The Cost Of Rising Populismappeared first onValueWalk.
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Chinese technology giant Huawei signed a deal with Russias largest telecoms operator MTS to develop 5G technologies and launch a fifth-generation network in Russia within the next year. This is another example of the close Chinese-Russian relationship.
Swiss bank UBS and Japans Sumitomo Mitsui Trust (who has 2.6 trillion under management) have agreed to cooperate to build a one-stop shop for asset management products and services in Japan. The JV will be 51% owned by UBS and is expected to be created by 2021.
The major Asian stock markets had a mixed day today. Shanghai decreased 33.62 points or -1.17% to 2,827.80; KOSPI increased 3.22 points or 0.16% to 2,072.33; ASX 200 increased 60.90 points or 0.95% to 6,443.90; NIKKEI 225 increased 110.67 points or 0.53% to 20,884.71; Hang Seng increased 69.84 points or 0.26% to 26,965.28; and SENSEX increased 86.18 points or 0.22% to 39,615.90.
The major Asian currency markets had a mixed day today. AUDUSD increased 0.0029 or 0.41% to 0.7005; NZDUSD increased 0.0048 or 0.72% to 0.6668; USDJPY decreased 0.3110 or 0.29% to 108.0890; and USDCNY increased 0.0154 or 0.22% to 6.9419.
Gold increased 7.8 USD/t oz. or 0.58% to 1,341.48 and silver increased 0.207 USD/t. oz or 1.39% to 15.0497.
Average Cash Earnings (YoY) increased from -1.3% to -0.1%
Household Spending (YoY) (Apr) decreased from 2.1% to 1.3%
Household Spending (MoM) (Apr) decreased from 0.1% to -1.4%
Overtime Pay (YoY) (Apr) increased from -3.10% to -1.10%
Foreign Reserves (USD) (May) increased from 1,293.5B to 1,308.0B
Coincident Indicator (MoM) (Apr) increased from -0.4% to 0.8%
Leading Index (MoM) (Apr) increased from -1.2% to -0.2%
Finlands Nokia is emerging as a winner in 5G contracts, as the scrutiny has increased on Huawei. Nokia has reportedly signed 12 new 5G contracts in the last two months compared to just 3 for Huawei.
The German Parliament approved NATOs accession protocol yesterday with North Macedonia. They were expected and failed to discuss supporting the launch of the European Union accession talks either with North Macedonia or Albania. Meanwhile, EUs Junker approved and backed Croatia by joining the open border Schengen Zone.
In the UK, the High Court dismissed an effort to prosecute Boris Johnson over claims he lied during the 2016 referendum campaign by saying the UK gave the EU 350m a week. Regarding Brexit, the government is said to have spent 97 million GBP on consultants.
The major European stock markets had a green day today. CAC 40 increased 85.63 points or 1.62% to 5,364.05; FTSE 100 increased 72.09 points or 0.99% to 7,331.94; and DAX increased 92.24 points or 0.77% to 12,045.38.
The major European currency markets had a mixed day today. EURUSD increased 0.0065 or 0.58% to 1.1339; GBPUSD increased 0.0045 or 0.36% to 1.2744; and USDCHF decreased 0.0049 or 0.49% to 0.9862.
German Exports (MoM) (Apr) decreased from 1.6% to -3.7%
German Imports (MoM) (Apr) decreased from 0.7% to -1.3%
German Industrial Production (MoM) (Apr) decreased from 0.5% to -1.9%
German Trade Balance (Apr) decreased from 20.0B to 17.0B
French Current Account (Apr) increased from -2.30B to -0.80B
French Exports (Apr) decreased from 43.1B to 42.3B
French Imports (Apr) decreased from 48.6B to 47.3B
French Industrial Production (MoM) (Apr) increased from -1.1% to 0.4%
French Trade Balance (Apr) increased from -5.5B to -5.0B
Mays disappointing jobs report was ironically viewed by many as a welcome surprise, hoping it increases the chances of a near-term rate cut by the Federal Reserve. According to the official report released today, the U.S. economy added approximately 75,000 new jobs in May, which fell about 100k short of analysts expectations. Unemployment remained low at 3.6%, unchanged on a MoM basis, and hourly earnings rose by 0.2%. On a YoY basis, average wages have grown by 3.1%.
Similarly, in Statistics Canada released a favorable jobs report as well, noting that unemployment has dropped to its lowest level since 1976. Canadas unemployment now stands at 5.4% after the economy added 27,700 new jobs in May.
Looking back to the U.S., President Trump announced this Friday that the U.S. is taking in billions from the tariffs imposed on China. Furthermore, the President stated that China has been forced to subsidize many of their products and companies are beginning to leave China to avoid the additional fees. Although he is known to often overstate the benefits of his administrations policies, he may not be too far off in some cases. The American Chamber of Commerce surveyed 250 firms in Shanghai last month and ~40% stated that they were considering or have relocated manufacturing facilities outside of China.
Contradictory, the poll also noted that manufacturing companies (35.3% of respondents) have begun to adopt In China, for China policies whereby their new focus is to sell goods to Chinese consumers. As stated numerous times on the Armstrong Economics blog, the U.S. gained the title offinancial capital of the worlddue to its strong consumer economy. Also previously noted on our blog, Countries line up to sell products to Americans. If China shifts to consumerism, countries may soon line up to sell their products to the Chinese.
In any event, Wall Street closed the first week of the month in bullish territory. The Dow posted its strongest week of 2019 after climbing 263.28 points this Friday (+1.02%) to 25,983.94. The SP 500 increased by 29.85 points (+1.05%) to 2,873.34. The Nasdaq rose 126.55 points (+1.66%) to 7,742.10. The Russell 2000 bounced back, gaining 10.85 points (+0.72%) to 1,514.39.
The Canadian indices remained relatively unchanged from yesterdays session. The TSX Composite added 3.16 points (+0.02%) to 16,230.96, and the TSX 60 added 0.38 of a point (+0.04%) to 973.47.
In Brazil, the Bovespa finished strong, inching closer toward the 100,000 mark that (optimistic) analysts have been anticipating. The index added 616.41 points (+0.63%), closing at 97,821.26.
Saudi is expected to extend the output cut deal as oil has just endured the worst run since 2008. Today, however, the market shot up 3.88% as a reaction to the dismal run of form.
The oil markets had a mixed day today. Crude Oil increased 1.16 USD/BBL or 2.21% to 53.6782; Brent increased 1.34 USD/BBL or 2.17% to 63.1153; Natural gas increased 0.015 USD/MMBtu or 0.65% to 2.3418; Gasoline increased 0.0143 USD/GAL or 0.84% to 1.7237; and Heating oil increased 0.0293 USD/GAL or 1.64% to 1.8147.
Top commodity gainers: Crude Oil (2.15%), Brent (2.09%), Cocoa (1.94%), and Heating Oil (1.67%). Top commodity losers: Cotton (-4.07%), Oat (-1.75%), Orange Juice (-1.49%), and Soybeans (-1.44%)
The above data were collected around 12:54 EST on Friday.
Japan -0.12%(-2bp), US 2s 1.81% (-5bps), US 10s 2.06%(-6bps), US 30s 2.57%(-7bps), Bunds -0.23% (-1bp), France 0.08% (-4bp), Italy 2.36% (-14bp), Turkey 18.12% (-4bp), Greece 2.83% (-9bp), Portugal 0.62% (-6bp), Spain 0.55% (-6bp) and UK Gilts 0.81% (-2bp).
If you lack the time and resources to research individual companies, then investing in a stock index could provide a substitute.
CNBC Exclusive: CNBC Excepts: Billionaire hedge fund manager Stanley F. Druckenmiller onCNBCs Squawk Box Today
The following are excerpts from the unofficial transcript of a CNBC EXCLUSIVE interview with Billionaire hedge fund manager Stanley F.Druckenmiller, the founder of Duquesne Capital, on CNBCs Squawk Box (M-F 6AM 9AM) today, Friday, June 7th. The following is a link to video of the interview :
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Stanley F. Druckenmiller On Trump Tweets/US-China Trade War:
JOE KERNEN: And that is Stanley F. Druckenmiller, Duquesne Family Office CEO. Hes the founder of Duquesne Capital and you managed that as well as a lot of Soros money. All at the same I dont know how you did so much at the same time. If you dont know this mans record and Im not even talking about being the biggest philanthropist in in the world, in I think when was that, 2009, Stan, at 800 million dollars? But
STANLEY F. DRUCKENMILLER: I cant remember.
JOE KERNEN: Yeah, alright. Anyway, thirty years without adown market.
JOE KERNEN: Yeah, 39. But an average 30%
STANLEY F. DRUCKENMILLER: 30 years competing. We dont really talk afterward but yeah it is 30.
JOE KERNEN: And I think after 30 years of not having a down year or getting 30% a year, you couldnt do it anymore. I dont see how you could do it. You would get up every morning worrying, I think, wouldnt you? And thats too much for anyone to try and
STANLEY F. DRUCKENMILLER: There was a lot of luck in there. I had a lot of big draw downs inner year. Its just the way the calendar came out. So, there was a lot of luck involved with that.
JOE KERNEN: Ive talked to you in recent days and you had an interview that got a lot of play at The Economics Club and so well start by saying: so, a thousand points today Im sorry 100 points today would bring us up almost a thousand for the week. So, weve had a snap back. And I asked you, you sold everything and you said, you know these headlines dont really necessarily cover the nuances of what youve done in the last couple of weeks. Right? I mean they said youve sold everything and got inTreasuries. Was that thats not exactly what you did, is it?
STANLEY F. DRUCKENMILLER: No, but I did do a lot. So I was over 90% invested. Fat and happy. Fed look like they were going in the right direction.