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OPINION

Best is not the worst

Best is not the worst
December 14, 2016
Best is not the worst

It was all very well for the old among them to yearn for a bucolic past of Edward Elgar symphonies and the Cotswold Hills. It was understandable that the younger ones would want a 2015 Ford Focus RS (just one previous owner) parked outside and feel miffed that they had to make do with a ‘59 plate Fiesta. But what happened isn’t a solution.

Meanwhile – on the other side of the divide – there is no sort of anger like the anger you feel when you realise you’ve been duped. You thought that – give or take – the game was fair; that, by and large, you were winning a bit more than you were losing. Then, bit by bit, the game changed. They talked about ‘trickle down’, but it came to be more like ‘put down’. Now you realise it’s all – what do they call it? – a zero-sum game and you’re the one holding the big fat zero. Sorry, that wasn’t part of the deal.

So, Brexit was a convulsive shock to the system. A gloating, bitter yet joyful put-down of the elitist self-serving technocrats of Brussels who disdainfully ignored so many referendums before the UK’s telling vote.

And where Brexit was a blow to the solar plexus, the election of Donald Trump was a knee in the groin. But there was more. Whereas President Trump was implausible, Madame Presidente Le Pen was unimaginable until she romped home in France’s presidential run-off in May 2017.

Then came the inconceivable. While Presidente Le Pen mulled over which should come first – France’s departure from the eurozone or asking the nation: “La France, devrait-elle rester un membre de l’Union Européenne?” – the simultaneous attacks in Berlin and Hamburg on 26 August made the choice irrelevant. The dynamics of Germany’s federal elections swung violently. Germany turned in on itself. As Chancellor Merkel contemplated a coalition of her Christian Democratic Union with a weird alliance of the populist left – Die Linke – and the right – AfD – in effect Germany told the rest of Europe: “Enough. No more. If we can’t persuade you by example then we must leave you to your own devices. Your problems are making life unbearable for us. Meanwhile, we have difficulties of our own to attend to.” The European Union had fallen apart almost as quickly as the Soviet Union had done 28 years earlier. So much for the resilience of western liberal democracy.

Okay, let’s be clear – that was a scenario, not a prediction. However, whereas even two or three months ago it would have seemed ridiculous, today it seems plausible and – depending on your view – either deeply scary or intoxicatingly invigorating.

Which brings me to reiterate a point I’ve made many times but still needs driving home – that in the coming years, perhaps even decades, a new sort of politics will intrude ever more on to the investment scene. In the 30 years 1980-2010, give or take, the political thrust was towards liberality, laissez-faire, deregulation, lower taxation – all the things lumped under the heading ‘Reaganomics’. Since the Credit Crunch of 2009 the force has been in the opposite direction. What began as a renewed need for regulation – especially in the banking industry – has morphed into what we might label ‘exclusionomics’. True, it would be nice to give it an anthropomorphic epithet – and it may yet be called ‘Trumponomics’ – but so far no leader has made it his or her own. It is associated with the global groundswell of protest that we should label ‘The New Populism’ and it will spell lower investment returns.

At its core, the new populism is about the falling affluence of voters. It’s all very well to discuss broken social contracts between governments and the people, the loss of legitimacy of remote technocratic institutions, the unintended consequences of globalisation. These things would not matter if the affluence of voters was still rising at a decent pace; but, as Chart 1 below shows, it isn’t. The years when real disposable income in the UK rose at 2 per cent in a poor year and 3 per cent in a good seem long gone. True, the rate did rise 2.5 per cent in 2015 – the best pace of growth since 2001 – but incipient inflation will soon drag the percentage change back to negative territory and UK families look to be locked into many more years averaging not a lot more than zero.

 

 

Ditto the rest of the developed world – see Chart 2 for different data over rolling five-year periods which tells a similarly depressing story for another four of the world’s major rich economies.

 

 

It is against this inauspicious background that investors have to work. True, it has been going this way for some time, as shown by Chart 3, which, roughly, does for total real returns from UK shares what charts 1 and 2 do for household income. The pace at which real five-year rolling returns were growing peaked as far back as the late 1980s and since the turn of the millennium the downhill trend has been very evident. True, equity returns are often volatile, so a bounceback could be expected. But if companies are battling against what’s increasingly being labelled ‘secular stagnation’, then they are likely to struggle to produce the growth that can drive share prices higher.

 

 

There are compensating factors at work – first, corporate profitability is particularly high; second, capital spending is low, in part because secular stagnation reduces the number of feasible projects that are available. As a result, companies are generating elevated amounts of cash, the effect of which is to boost their underlying value while such cash flows are capitalised at record-low interest rates.

Yet investors can’t rely on that forever and need to work these four tactics into their plan:

Diversify more.

Affluent private investors are rarely as diversified as they imagine. That’s especially true of UK investors since they are likely to have too much wealth tied up in their home. Judged by the per-capita output of nations, the British are surprisingly wealthy and that’s thanks to a combination of the UK’s population density and restrictive planning rules. However, there is nothing to say these rules must persist, particularly as it is clear what – mostly intergenerational – distortions they create.

This matters because in, say, a particularly chaotic Brexit the resulting drop in house prices would help to lock the UK into a cycle of decline as falling house prices disproportionately dampened consumers’ spirits and spurred the liberalisation of planning rules that further undermined house prices and so on.

Diversify towards emerging markets.

Emerging market economies have recovered strongly in 2016 after five consecutive years of decline and the International Monetary Fund (IMF) expects them to drive global growth in 2017 and beyond. The IMF reckons that global growth will pick up to 3.4 per cent, thanks to the bigger impact of the developing world, especially China (up 6.6 per cent in 2016 and 6.2 per cent in 2017) and India (up 7.6 per cent in both years).

True, emerging economies come with big risks. Their progress would be threatened by higher US interest rates and they will have to resist the deadweight drag of slowing advanced economies. Such forces will make it harder for companies in emerging countries to address their high levels of corporate debt – the IMF reckons that the average ratio of debt to equity in the corporate sector is 75 per cent.

That financial difficulty might fade into insignificance if – or when – China encounters its first financial crisis in its post-reform era. That credit and financial-sector leverage continue to grow faster than national output and that state-owned enterprises and real estate projects continue to absorb and outsize this credit all point to an eventual bust. Yet the hope must be that it will be China’s equivalent of the crises that, for example, the emerging United States encountered several times in the late 19th and early 20th centuries.

Yet there is little choice but to take on these risks. The only question is how to do it - via active funds, passives exchange traded funds or maybe via shares in the great global profit harvesters; the likes of Nestlé (SIX:NESN), Procter & Gamble (US:PG) or Unilever (ULVR). However, such is the demand to capture the predictable recurring revenues and the presence in emerging markets of these exceptional companies that their shares are all rated far above their long-term average.

Remember dividends. By one reckoning, equity dividends are an artificial construct that can be manufactured by investors anyway. There is something to be said for that. However, in the long run, dividends received will account for over a third of total returns from equity investment; the proportion for the Bearbull Income Portfolio’s 18-year history, for example, is 44 per cent. The reason is simple - dividend payments are far more stable than volatile share prices. On average, share prices will fall one year in four; for mature, well-financed companies a dividend cut is a rarity. Investors forget this fact of life at their peril.

Avoid fixed-interest securities. Talking of peril, currently investing dangers don’t get bigger than holding fixed-interest securities. True, artificial factors – in particular, regulatory rules for banks and life insurers – have helped sustain demand for UK government securities (gilts). That’s hardly enticing for private investors. Meanwhile, interest rates can’t go lower, meaning the best bet is not to lose money by holding fixed interest. One day, however, rates will rise. Impending ‘Trumponomics’ is already having that effect on US Treasury bond rates and something similar may be happening in the UK. For example, the nominal yield on 20-year gilts rose from 1.3 per cent in August to 2.0 per cent by the end of November. Ominous indeed.

And don’t expect too much from UK equities, either. That’s simply because share prices, as measured by the FTSE All-Share index, are within 2 per cent of October’s all-time high and have more than doubled since the post-crisis lows of January 2009. Time for a spot of mean regression, perhaps. And that assumes that something like the scenario outlined at the start does not transpire. Maybe the best we can hope for from 2017 is that the worst does not materialise.