This excerpt, taken from Balentine’s 2017 Capital Markets Forecast, considers how the rising tide of populism shapes the outlook for capital markets.
The previous year was rife with global political surprises. These cycles have become microcosms of a much larger global theme: politics are now increasingly a place for the “have nots” to wage war on the “haves,” rather than a battleground for those aligned with the more traditional liberal vs. conservative party lines. For domestic markets, a Trump victory has, so far, propelled equities to new highs amid the prospect of increased spending, reduced taxes, and pared regulation. The ideas that fiscal deficits may soon begin to expand and that central banks are nearing the limits of their effectiveness have provided a tailwind to rising interest rates as well.
However, much of “Trumponomics” has been devoid of transparent, substantive recommendations, and the resultant policy mix remains vague. Subsequent market reactions will depend on the extent to which a Republican sweep of Congress affords Mr. Trump a carte blanche agenda. This will become more readily apparent as policies are proposed in the months following his inauguration. The political debate occurring in the United States is similar to debates occurring elsewhere in the developed world, especially in Europe. Many are asking whether and how this rising tide of “populism” matters. To address these questions, it is helpful first to understand what is driving voter angst.
Causes of Voter Angst
Unquestionably, developed economies across the Western world have experienced a severe drop in productivity growth since the global financial crisis. From the end of World War II through 1973, labor productivity (as expressed by output per hour of work) grew at an annual rate of 3.3%, and per capita GDP growth nearly doubled. After a dearth of real income growth from 1974-1995 and a resurgence of growth from 1996-2004, we have experienced labor productivity growth at a paltry rate of 1.3% per year. Within economic policy circles, the causes of this retrenchment are debatable; some believe that output mismeasurement is the culprit. Others speculate that we are yet to reap the benefits of new technology and are instead experiencing less productivity either from diminishing returns on recent innovation or suboptimal technological use by existing firms. Economists Robert Gordon and Tyler Cowen argued in their respective books The Rise and Fall of American Growth and The Great Stagnation that today’s innovations are not keeping pace with those of the past because the low-hanging fruit has already been picked. Accompanying this productivity decline has been a widening of income inequality, concentrating wealth in the hands of a select few. The overwhelming theme of the past seven years has been to target the “wealth effect” via higher asset prices in the capital markets as a result of central bank stimulus; bond and stock owners have benefitted at the expense of savers due to central bank policies aimed at asset price inflation, while workers’ real wages have remained stagnant.
Globalization is now being met with skepticism, mainly because the more unattractive effects of the phenomenon were historically masked by strong economic growth and financial well-being.
The signing of NAFTA in 1994 coincided with a period of global economic prosperity that resulted largely from the technological innovation of the Internet. Additionally, China’s 2001 entrance into the World Trade Organization came just before the construction boom in the run-up to the global financial crisis.
An unfortunate reality has surfaced: it is much easier to point to the visible lack of jobs from an abolishment of tariffs than it is to find intangible, indirect benefits of globalization. To be fair, the decline in prime-age men in the workforce that began in the 1960s and the fall in the relative pay that less-educated men receive cannot be blamed entirely on trade deals inked in the 1990s and 2000s. To quote Dartmouth economist Douglas Irwin: “We have a public policy toward trade. We don’t have a public policy on automation.”
This overt observation of financial divergence and the growing class divide is nothing new; a cursory survey of 2016 best sellers includes titles such as Hillbilly Elegy, The Upside of Inequality, and other memoirs and investigative tales that address class dynamism and wage gaps in America and beyond. As Neil Irwin, senior economist at the New York Times, pointed out: “Perhaps the pursuit of ever-higher gross domestic product misses a fundamental understanding of what makes most people tick. Against that backdrop, support for Mr. Trump and for ‘Brexit’ are just imperfect vehicles through which someone can yell, ‘Stop.’”
This backdrop is driving “populist” candidates to argue for bringing about change for the sake of change. A backlash has erupted against any institution presumed to be run by “elitists” or “technocrats,” and skeptics of free trade and financial alchemy have gained a substantial following. Brexit, the rise of the Eurosceptic Alternative for Deutschland (AfD) party in Germany, and the comedian-led Five Star Movement in Italy—and subsequent ousting of Italian Prime Minister Matteo Renzi—immediately come to mind as beneficiaries of such a power rotation in Europe. To make matters even more challenging, a tidal wave of immigrants is exposing the mechanical flaws in a union where policies are set in Brussels, but the implementation is left to the devices of each member state.
The Danger of “Populism” is that it Treats the Symptoms Rather than the Underlying Frustration
Alarmingly, the rising tide of “populist” sentiment has manifested in a backlash against some of the drivers of economic prosperity. Immigration, free trade, and the independence of central banks (both in the UK and in the US) have been called into question. By only addressing these symptoms of voter angst, such attacks may hinder the ability of new governments to enact a policy mix to end the long period of low growth and deflation that has gripped the developed world.
Rather, countries that treat the actual underlying causes of economic stagnation, including weakness in both productivity and real income growth, should be the beneficiaries of higher expected capital market returns over the next cycle. This would promote more sustainable, balanced, and inclusive economic growth and would therefore elevate the potential for earnings growth from corporate sectors. Such prospects would also reduce the equity risk premium for stock markets, which would, in turn, support higher valuation levels.
Treating the Causes of Economic Stagnation
The need for structural reform has been the least-touted ingredient of past economic success throughout this election cycle. While much attention has been paid to changing the emphasis of the current policy mix from monetary policy to fiscal policy and to deregulating industries, the role of structural reform in increasing productivity growth is now more important than ever considering the increased concentration of market share that American businesses maintain.
New firms are entering the marketplace at a slower rate while old firms decay at a slower pace. Those startups that do come into existence are employing fewer workers: in the 1990s, new firms in the US employed, on average, 7.5 workers. Today, that number has fallen to 4.9 workers. A study conducted by The Economist in March of 2016 concluded the total market share held by the leading four firms in each of some 900 sectors covered by the US Census Bureau rose from 26% in 1997 to 32% by 2012. Furthermore, incumbents are engaging in acquisitions of smaller companies before they become independently large and increasingly competitive.
Rather than overstating the importance of low tax rates, increased government spending, and business-friendly regulations, policy can “set the table” for increased productivity growth by promoting greater entrepreneurialism and competitiveness. A January 2014 World Economic Forum survey of more than 1,000 small business owners in 43 countries found that the areas of the “ecosystem” most important to entrepreneurs are funding and finance, human resources, and market opportunity. Through policies that remove obstacles to new business formation and incentivize investment, small businesses are likely to flourish and resume the key role they have played in job creation in the past.
In terms of increasing competitiveness, narrowing the profitability gap across firms could begin with the diffusion of innovative technologies (multinationals) to laggards (nationals) to allow mobility of skilled labor across borders. Small businesses can be incentivized to foster dynamism by pressuring incumbents to adopt newer technologies and practices, thereby increasing productivity. Rather than being simply “business friendly,” deregulation should help market entrants overcome the steep “compliance curve” and in-house regulatory expertise that incumbents enjoy. In fact, a study conducted by the Mercatus Center of George Mason University in May of 2016 concluded that the cumulative effects of federal regulation on economic growth created a 0.8% drag on GDP per year, from 1908-2012.
As the motif transitions from monetary to fiscal policy in the coming years, a swelling tide of “populism” risks encumbering this handoff by treating only the symptoms and failing to produce an actual cure. To decisively overcome secular stagnation, governments must promote productivity growth by cultivating entrepreneurship and competitiveness within their respective economies. Countries that embrace such structural improvement are likely to benefit from higher expected returns in the future.