Bill Priest
Bill Priest, CEO and co-CIO at New York-based Epoch Investment Partners, manager of the Grant Samuel Epoch Global Equity Shareholder Yield Funds, provides an update with two subjects — Epoch’s capital markets outlook and their view of the implications of Brexit; the latter is inextricably tied to the former.
We analyse the potential impact of Brexit by examining three forms of contagion — financial, economic, and political (Figure 1). There should be little financial contagion from Brexit, as the central banks of the world are ready and willing to act. Thus, Brexit does not present a liquidity concern. Also, although we expect there will be some economic contagion, this should be visible early and capital markets should quickly present value it. We expect, however, that Brexit will contribute to political contagion, the impact of which will have a wide reach, most notably in Europe.
(Former) Prime Minister David Cameron led his country into an unnecessary debacle. Ever greater unity has been a cornerstone of the EU since its formation over 60 years ago. Even though the EU was a monetary rather than a fiscal union, its goal and soul were directed toward the unification of Europe. We are witnessing a hiatus of this objective at best and its genuine unwinding at worst. The combination of the travails of the euro, the tide of immigration, and high unemployment have led to a “loss of patience, prudence, and memory,” as one writer recently said. The English economy has been doing well, but this is likely to change. Uncertainty will rise sharply (there is no “Leave” plan), and capital spending projects will be placed on hold or even cancelled as corporate capital allocators adopt a wait-and-see approach. Scotland voted 62% to 38% to Remain and will likely try to leave Great Britain in order to seek EU membership. Similarly, Northern Ireland voted 56% Remain to 44% Leave, and it, too, likely will seek greater independence.
There are undoubtedly many reasons for the 52% Leave vote, including the perception by Leave voters that globalisation is a dark, controlling “bogeyman” characterised by unfair capitalism with tax havens for the rich and no growth in working class wages. Other factors include high immigration, a large hangover from the Global Financial Crisis of 2008, and an expensive and deadly war in Iraq that had no visible purpose or positive outcome.
But the uncertainty surrounding Brexit will negatively impact investment spending plans and commitments. Furthermore, if Britain actually reverses trade agreements and sends workers home, there will be fewer people in the British workforce and, inevitably, lower consumption. A disavowal of trade agreements would reduce the economic benefits of trade, espoused so elegantly in 1820 by David Ricardo, an Englishman, in his treatise on the Law of Comparative Advantage. The “win-win” of trade will become a “lose-lose” if trade agreements are rolled back.
I have always believed the adage that “in the short run politics determine economics, but in the long run economics determine politics.” At the moment, however, social concerns regarding income disparity, job displacement attributable to improved technology, and a perceived disinclination of immigrants to assimilate into their adopted cultures are affecting politics, not just in the UK but elsewhere.
How does Brexit impact our views of global investment? We believe both interest rates and real GDP growth will be “lower for longer.” We have been in the “secular stagnation” camp for some time, believing that the sum of growth in the work force and growth in productivity, the sole determinants of GDP, was unlikely to exceed 2% in the developed world. While emerging markets may have grown faster, their underdeveloped capital markets, the reduction in the wage arbitrage between the developing and developed worlds, and the benefits that manufacturers now expect to gain from being closer to buyers suggest that economic growth will slow for emerging market countries as well. Brexit will not help any of these negative trends.
Furthermore, we are entering a “capital light” world, which is evidenced by the reduction of investment spending by corporations. Manufacturing’s contribution to economies throughout the world is declining. Meanwhile, technology and services have become increasingly important to global GDP. Capital goods have become cheaper. As a result, targeted levels of investment can be achieved with less spending and borrowing, resulting in a correlative reduction in capital investment.
Whereas QE was absolutely essential in 2008, it no longer drives the essential components of growth — workforce expansion and productivity gains. Financial assets have soared in value (see Figure 2) over the past few years but growth in the real economy (Figure 3) has not come close to forecasts by the IMF. Slow growth and fear of deflation have caused monetary policymakers to attempt to prop up inflated asset prices in the hope that real economic growth will follow. History suggests, however, that long periods of negative real rates coincide with periods of anaemic growth. Importantly, low rates encourage capital misallocation, as recent increased M&A activity may suggest.
Excessive money printing has also increased correlations among and within asset classes. One variable, capitalisation rates (think P/E ratios), explains more than 50% of stock market returns over the past four years as illustrated in Figure 2. In other words, beta has been the single dominant driver of returns over this period. QE effectively lowered the range of returns within an asset class, thereby reducing potential rewards from active management. The recent surge of interest in passive investing is partly explained by this effect of QE.
Nevertheless, companies whose managements have a history of wise capital allocation will provide superior returns in the end. Cash flow drives a company’s value and the astute allocation of cash maximises that value. Identifying companies that have these characteristics demands research, analysis and human judgment, and that requires an active management effort.
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