Political economy, once considered an interesting academic aside, is now front and centre in investment thinking. Decades of ideology masquerading as economic truism have resulted in the predictable polarisation of wealth, and that is now starting to become an unavoidable fact in anticipating the direction of markets. Even the investment bank Morgan Stanley is starting to think of the consequences (must be a little strange, investment banks thinking of consequences). Gerard Minack is arguing that politics is now becoming crucial (“intrusive” he calls it):
Politics seems set to be a more intrusive factor for investors in developed markets. This would represent a major reversal from the trend of the past 20-30 years. Politics seems set to become a bigger factor for investors for a number of reasons:
First, policy makers usually take centre stage in periods of macro stress, and they remain central figures in the extended unwind of the credit super cycle.
Second, and more importantly, the government has moved from being part of the solution – typically, policy makers aim to remedy a cycle problem in the private sector – to being part of the structural problem. As is well known, public sector finances in the developed world are on an unsustainable path, something now reflected in rising stress in sovereign markets.
Third, the Great Recession and the trend increase in income inequality may put a question mark over the 20-30 year shift to laissez-faire policies (particularly in financial markets), and the perceived benefits of globalisation. Deregulation and globalisation were two of the fundamental supports for the long bull market in developed world equities that started in the early 1980s. (The fundamental improvements led to strong trend increase in earnings. The credit super cycle led to a trend increase in valuations. Combined, these factors led to the extraordinary bull market in risk assets – particularly DM equities – that started in the early 1980s.)
It is an interesting situation, because for a long time politicians in developed economies have done two things, each cowardly. They have washed their hands of any attempts to influence markets, because that would be “picking winners” and against the prevailing neo-liberal orthodoxy which says that governments should not “intrude” on the purity of market forces. And then, lacking any vision, they have concentrated on fear as a means of winning elections. The first has been a disaster of regulatory omission that has resulted in the GFC (and possibly GFCs). The second does not augur well for showing any decent direction in markets or social outcomes. This we have the fear driven band aid non-solutions in Europe and the complete failure to bring the banksters to book in America because of the fear they were too big to fail.
So Minack is probably right when he is downgrading developed market equities, although perhaps not for the right reasons. The cycle of the financial system and corporates benefitting from government largesse or collusion has reached its end:
It is not clear how these changes will play out. But it seems likely that politics will become a more important factor for investors. This prospect is another factor that may contribute to a trend de-rating in DM equities.
The particular danger for equity investors is that corporates appear to have been the principal beneficiary of the structural changes of the past 20-30 years. Income to labour has fallen as a share of GDP in most developed economies. This is the flip-side of rising profit share of GDP (that is, profit growth persistently out-stripping GDP growth).
Moreover, not only has labour incomes been squeezed as a share of GDP, but inequality has also increased. Exhibit 1 shows median household income in the US (in constant dollars) by income levels. It seems that globalisation and the use of more cheap Asian labour has depressed returns to relatively unskilled labour in the developed economies.
The second trend is that while wage income was stagnating, voters were counting on the largesse of government to provide another offset. Governments in many developed economies were committing to providing social benefits – notably health and retirement support – that lie behind the structural fiscal black hole. Exhibit 2 shows the IMF’s estimate of the cost of health care and ageing.
Although difficult to quantify, it seems plausible that these two trends took the political sting out of the weak, and increasingly unequal, benefits to labour seen over the past 20 years. The forward looking point is that these two emollients have now proven to be unsustainable. Moreover, the poor macro outlook – lacklustre growth or perhaps recession in the developed economies – is likely to exacerbate pressure on the political leadership to address this income shortfall.
Effectively, policy makers in developed economies are now hemmed in by market pressure to fix the unsustainable fiscal pressure, at a time when political heat may increase from the weak income growth of the median household/voter.
As we have seen in the periphery of Europe, financial austerity is not popular. A long-term study of the political response to austerity confirms that instability increases with public sector cutbacks. Exhibit 3 shows the incidence of political problems (measured as average number of incidents per year per country) tends to rise in fiscal austerity.
No longer are we just governed by markets, it seems. Trouble is, it does not seem we are governed at all.