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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This weeks AMCA healthcaredata breachhas highlighted the importance of vendor selection and management for businesses of all sizes and across industries. In response to details that have emerged, the National Cyber Security Alliance has put together a statement with best practices for businesses.
June 7, 2019 This week, both Quest Diagnostics and Laboratory Corporation of America Holdings (LabCorp) announced related data breaches that may impact up to 20 million customers who used their services between August 1, 2018 and March 30, 2019.
While details are still being confirmed from third party medical vendor American Medical Collections Agency (AMCA), the compromised customer data is thought to have included personal, financial and medical patient data such as first and last name, date of birth, address, phone and credit card or bank account information.
Healthcare companies have increasingly become a target for hackers and other bad actors given the vast amounts of information that is collected and stored across the medical ecosystem, said Kelvin Coleman, executive director of the National Cyber Security Alliance. Businesses and organizations that accumulate data must operate with a deep understanding of the value of that data to cyber criminals and employ a comprehensive approach tocybersecurity, including robust vendor management strategies.
eSentire recently commissioned asurveyof IT and security decision-makers, which found that nearly half (44 percent) of firms had experienced a significant, business-altering data breach caused by a vendor.
The National Cyber Security Alliance (NCSA) recommends that employers and IT teams take the following steps to secure their business and work with third-parties and vendors to secure their customers data:
Crown jewels are the data without which your business would have difficulty operating and/or the information that could be a high-value target forcybercriminals. When assessing your vendor network, the IT team needs to map out not only who your vendors are, but who their vendors are who might have access to your data or systems. This includes working with your vendors to confirm the data they collect and whether or not they have formal and robust cybersecurity programs in place.
Ultimately, your goal is to build a culture of cybersecurity that includes employees knowing how to protect themselves and the business and understanding the cyber risks as your business grows or adds new technologies or functions. When creating third-party contracts, include non-negotiable document data ownership andmanagementprocesses, including how company data is handled, who owns the data and has access to it, how long the data is retained and what happens to data once a contract is terminated. Only people who need access to your data should have it. You should also have a lawyer look over any vendor agreements to ensure they take proper measures to protect data assets and grant appropriate access controls.
We have fire alarms in our businesses and homes that alert us to problems. In cybersecurity, the quicker you know about an incident, the quicker you can mitigate the impact and get back to normal operations. For vendor contracts, establish processes within your agreements that enable you to verify compliance with the negotiated terms. Third-party intelligence providers can also offer independent, unbiased inputs on the status of vendors. If a vendor is hit by a cyberattack, these third-party intelligence services will report back to you in a time-critical way.
Having a recovery plan created before an attack occurs is critical. Develop and practice an incident response plan to contain an attack or incident and maintain business operations in the short term.
The goal of recovery is to move from the immediate aftermath of a cyber incident to full restoration of normal systems and operations. Like the response step, recovery requires planning.Recoveryis not just about fixing the causes and preventing the recurrence of a single incident. Its about building out your cybersecurity posture across the whole organization (not just the IT person or group), including increasing the focus on planning for future events.
NCSAs CyberSecure My Business holds events across the country and monthly webinars that shed light on how small and medium-sized businesses can protect themselves, their employees and their customers against the most prevalent threats. For more information on these events and locations, visit
Major breaches like these remind Americans that it is critical for internet users to remain diligent about practicing good cybersecurity habits. NCSA recommends that consumers potentially impacted by the AMCA breach protect their accounts by following these steps to stay safer and more secure online, including:
Monitor activity on your financial and credit cards accounts.
If appropriate, implement a fraud alert or credit freeze with one of the three credit bureaus (this is free and may be included if credit monitoring is provided post breach). For more information, visit the Federal Trade Commission websiteidentitytheft.gov.
. Scammers and others have been known to use data breaches and other incidents to send out emails and posts related to the incident to lure people into providing their information. Delete any suspicious emails or posts and get information only from legitimate sources.
For additional cybersecurity resources and tips, visit
Learn more aboutbest practices in vendor selection and managementfrom this National Institute of Standards and Technology resource.
The postNational Cyber Security Alliance Tips Amid Massive Quest Leakappeared first onValueWalk.
You keep stating that the center of Finance will move to China. However, the world distrusts China, rightly so. How can they become the Financial Center if no one trusts them?
ANSWER:That will come only after 2032. Keep in mind, the West will be tested and the failed system of continually borrowing is why the confidence in the West will break. After that, it will become the lesser of two evils. The financial capital of the world always migrates. The British never saw how America could take their crown. Throw in a world war, and capital moves. I have dealt with this issue in detail. That report is available (see theStore for China on the Rise). It is available in printed form or in digital format.
Dont play favorites and put all your resources into bottom-of-the-funnel efforts; make sure every consumer interaction makes your brand more compelling.