Category Archives: General

Strong and Stable

The impact of the Brexit vote on UK politics was far reaching and the results of the UK general election have shown just how far reaching. In a post last year following the Brexit vote I said “one lasting impact of the Brexit vote is likely to be on the make-up of British politics”. The graph below shows the political allegiance breakdown of the Brexit vote.

 click to enlarge

The Brexit issue meant that the previous political (social class) allegiances of the UK electorate has splintered further by factors such as age and by views on immigration and/or globalisation. This has led to some extraordinary results in Thursday’s election: conservatives winning seats off the Scottish nationalists with swings as large as 16%, a significant number (reportingly 25%) of the collapsed UKIP vote going to Labour, a resurgent left wing Labour winning in some of the wealthiest constituencies in the UK are just a few examples.

Adding to the political volatility is that the Brexit referendum vote has to be implemented by politicians elected under a parliamentary system by a first past the post (FPTP) electoral construct. Given the 4% spread in the Brexit vote, the difference between the seats allocated under a FPTP electoral system as opposed to a proportional representation (PR) one can be material, as the results of the 2015 general election with spreads of +14%/-19% show.

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It is therefore highly interesting to see that the difference between the FPTP and PR systems in Thursday’s election result is significantly less with spreads of +6%/-3%.

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There can be little doubt that the earthquake that the Brexit vote set off in UK politics is far from over and there will be more tremors to come as the Brexit negotiations play out. On the plus side, this election has resulted in a closer parliamentary representation of the UK electorate than the 2015 election. On the minus side, it reflects the uncertainty over the exact type of Brexit that the British electorate wants. And that uncertainty looks set to continue. Strong and stable government in the UK looks to be more aspirational than reality in the coming years.

Risky World

The latest World Economic Forum report on global risks is out today and, as usual, it reflects current concerns rather than offering any predictions for 2017. To be fair to WEF, the top risk for 2012 to 2014 inclusive in their survey was income disparity which is commonly viewed as one of the factors behind the rise in populism.

click to enlargewef-global-risks-2017

The report states the obvious about the impact on global risks following 2016, specifically that “societal polarization, income inequality and the inward orientation of countries are spilling over into real-world politics” and that “decision-making is increasingly influenced by emotions” due to the increase in nationalism. Where this year’s report is spot on, in my view, is in relation to the top 5 global trends that will determine global developments over the next 10 years, as below.

click to enlargewef-top-5-global-trends-2017

The report also states that “although anti-establishment politics tends to blame globalization for deteriorating domestic job prospects, evidence suggests that managing technological change is a more important challenge for labour markets” and that “we are in a highly disruptive phase of technological development, at a time of rising challenges to social cohesion and policy-makers’ legitimacy”.

Among the many risks highlighted in the report is a reduction in geopolitical co-operation which is likely to be detrimental to global growth, action on global indebtedness, and climate change.  It’s particularly depressing to think that even if the commitments under the Paris agreement were delivered, which now looks doomed after the election of Trump, the United Nations Environment Programme (UNEP) estimates the world will still warm by 3.0°C to 3.2°C, still far above the 2°C limit where scary and irreversible stuff happens.

Another worrying risk is the possibility of a new arms race in an era of rapid advancements in a technology which also has a retrograde feel, especially “while risks intersect and technologies develop quickly, too often our institutions for governing international security remain reactive and slow-moving”.

All pretty cheery stuff! And on it goes.

As I write this, I’m watching reports on Mr Trump’s press conference today, and although there is no doubt that our world is riskier as we enter 2017, it will be entertaining to see this guy as the leader of the free world. Hopefully good entertaining, not depressing entertaining!

Farewell, dissonant 2016.

Many things will be written about the events of 2016.

The populist victories in the US election and the UK Brexit vote will no doubt have some of the biggest impacts amongst the developed world. Dissatisfaction amongst the middle class across the developed world at their declining fortunes and prospects, aligned with the usual disparate minorities of malcontent, has forced a radical shift in support away from the perceived wisdom of the elite on issues such as globalisation. The strength of the political and institutional systems in the US and the UK will surely adapt to the 2016 rebuff over time.

The more fundamental worry for 2017 is that the European institutions are not strong enough to withstand any populist curveball, particularly the Euro. With 2017 European elections due in France, Germany, Netherlands and maybe in Italy, the possibility of further populist upset remains, albeit unlikely (isn’t that what we said about Trump or Brexit 12 months ago!).

The 5% rise in the S&P 500 since Trump’s election, accounting for approx half of the overall increase in 2016, has made the market even more expensive with the S&P 500 currently over 60% of its historical average based upon the 12 month trailing PE and the Shiller CAPE (cyclically adjusted price to earnings ratio, also referred to as the PE10). A recent paper by Valentin Dimitrov and Prem C. Jain argues that stocks outperform 10-year U.S. Treasuries regardless of CAPE except when CAPE is very high (the current CAPE is just above the “very high” reference point of 27.6 in the paper) and that a high CAPE is an indicator of future stock market volatility. Bears argue that the President elect’s tax and expansionary fiscal policies will likely lead to higher interest rates and inflation in 2017 which will further strengthen the dollar, both of which will pressure corporate earnings.

Critics of historical PE measures like CAPE, such as Jeremy Siegel in this paper (previous posts on this topic are here and here), highlight the failings of using GAAP earnings and point to alternative metrics such as NIPA (national income and product account) after-tax corporate profits which indicate current valuations are more reasonable, albeit still elevated above the long term average by 20%-30%. The graph below from a Yardeni report illustrates the difference in the earnings metrics.

click to enlargenipa-vrs-sp500-earnings

Bulls further point to strong earnings growth in 2017 complemented by economic stimulus and corporate tax giveaways under President Trump. Goldman Sachs expects corporations to repatriate approx $200 billion of overseas cash and to spend a lot of it buying back stock rather than making capital expenditures (see graph below) although the political pressure to invest in the US may impact the balance.

click to enlargesp500-use-of-cash-2000-to-2017

The consensus amongst analysts predict EPS growth in 2017 in the high single digits, with many highlighting further upside depending upon the extent of the corporate tax cuts that Trump can get past the Republican congress. Bulls argue that the resulting forward PE ratio for the S&P 500 of approx 17 only represents a 20% premium to the longer term average. Predictions for the S&P 500 for 2017 by a selection of analysts can be seen below (the prize for best 2016 prediction goes to Deutsche Bank and UBS). It is interesting that the average prediction is for a 4% rise in the S&P500 by YE 2017, hardly a stellar year given their EPS growth projections!

click to enlargesp500-predictions-2017

My best guess is that the market optimism resulting from Trump’s victory continues into 2017 until such time as the realities of governing and the limitations of Trump’s brusque approach becomes apparent. Volatility is likely to be ever present and actual earnings growth will be key to the market story in 2017 and maintaining high valuation multiples. After all, a low or high PE ratio doesn’t mean much if the earnings outlook weakens; they simply indicate how far the market could fall!

Absent any significant event in the early days of Trump’s presidency (eh, hello, Mr Trump’s skeleton cupboard), the investing adage about going away in May sounds like a potentially pertinent one today. Initial indications of Trump’s reign, based upon his cabinet selections, indicate sensible enough domestic economy policies (relatively) compared with an erratic foreign policy agenda. I suspect Trump first big foreign climb down will come at the hands of the Chinese, although his bromance with Putin also looks doomed to failure.

How Brexit develops in 2017 looks to be much more worrying prospect. After watching her actions carefully, I am fast coming to the conclusion that Theresa May is clueless about how to minimise the financial damage from Brexit. Article 50 will be triggered in early 2017 and a hard Brexit now seems inevitable, absent a political shock in Europe which results in an existential threat to the EU and/or the Euro.

The economic realities of Brexit will only become apparent to the UK and its people, in my view, after Article 50 is triggered and chunks of industry begin the slow process of moving substantial parts of their operation to the continent. This post illustrates the point in relation to London’s insurance market. The sugar high provided by the sterling devaluation after Brexit is fading and the real challenge of extracting the UK from the institutions of the EU are becoming ever apparent.

Prime Minister May should be leading her people by arguing for the need for a sensible transition period to ensure a Brexit logistical tangle resulting in unnecessary economic damage is avoided. Instead, she acts like a rabbit stuck in the headlights. Political turmoil seems inevitable as the year develops given the current state of the UK’s fractured political system and lack of sensible leadership. The failure of a coherent pro-Europe political alternative to emerge in the UK following the Brexit vote, as speculated upon in this post, is increasingly looking like a tragedy for the UK.

Of course, Trump and Brexit are not the only issues facing the world in 2017. China, the Middle East, Russia, climate change, terrorism and cyber risks are just but a few of the issues that seem ever present in any end of year review and all will likely be listed as such in 12 months time. For me, further instability in Europe in 2017 is the most frightening potential addition to the list.

As one ages, it becoming increasingly understandable why people think their generation has the best icons. That said, the loss of genuine icons like Muhammad Ali and David Bowie (eh, sorry George Michael fans) does put the reality of the ageing (as highlighted in posts here and here) of the baby boomer generation in focus. On a personal note, 2016 will always be remembered by me for the loss of an icon in my life and emphasizes the need to appreciate the present including all of those we love.

So on that note, I’d like to wish all of my readers a prosperous, happy and healthy 2017. It looks like there will be plenty to write about in 2017…..

Age of Change

As if we all needed proof that the people across the so called developed world are troubled about the future, the election of Donald Trump to the US presidency last Tuesday is still a shock and unfolded in a spookingly familiar manner to the Brexit vote. “Wrong!” as Alec Baldwin has so aptly mimicked could be the call to the pollsters and commentators who are now scratching around despondently for reasons.

Why, we again ask, could an electorate so recklessly vote against conventional wisdom. I think the answer is in the question. Although the factors behind Trump’s vote are multi-faceted and reflect a bizarre coalition that will be impossible to satisfy, the over-riding factor has to lie at the door of an electorate that is troubled by future prospects and rejects the status quo. Why else would they vote for a man that polls suggests a majority acknowledge as been unqualified for the job? Aspects such as the worry of aging baby boomers at the diminishing returns on savings, the insecurity of the middle and working classes over globalisation, and the realisation that the technology from the shared economy is a cover for unsecure low wage employment have all contributed. Like in the Brexit vote, Trump tapped into a nostalgia for times past as an easy answer to the complex questions facing the world we live in.

The age profile of the Brexiteers in the UK and Trump voters in the US is interesting in that it highlights that Trump’s surprise victory is slightly less of a factor of age than Brexit.

click to enlargetrump-brexit-vote-by-age

Aging demographics in the developed world has been highlighted by many as a contributor to the current low growth. I last posted on this topic before here and the graph below is a reminder of one of the current predictions by the UN.

click to enlargeunited-nations-population-projections-2015-to-2100

The impacts of aging on future dependency ratios can be seen below, again from UN predictions.

click to enlargeglobal-dependency-ratios

A fascinating report from the research department of the FED last month, entitled “Understanding the New Normal: The Role of Demographics”, argues that demographic factors alone in the US account for 1.25% decline in the nature rate of interest and real GDP growth since 1980. The report concludes that “looking forward, the model suggests that low interest rates, low output growth, and low investment rates are here to stay, suggesting that the U.S. economy has entered a new normal”.

There was an interesting article recently in the FT called “The effects of aging” which included the graph below from UBS which strikingly highlights the changes in demographic trends and financial crises.

click to enlargefinancial-crisis-demographic-turning-points

Whatever disparate concoction of economic policies that Trump will follow in an attempt to tap the ghost of Reaganomics, it is clear that lower taxes and increased US debt will be feature. Trump may surprise everyone and use debt wisely to increase productivity on items such as rebuilding infrastructure, although it’s more likely to go on wasteful expenditure to satisfy his motley crew of constituents (eh hello, a Mexico wall!).

I constructed an index to show the relative level of debt dependency of countries using the 2020 debt level predicted by the IMF and the average 2020 to 2050 dependency ratios by the UN. Both the US and the UK are above the average based upon current forecasts and really can’t afford any debt laden policy cul-de-sacs. One only has to look at Japan for enlightenment in that direction. We have to hope that policies pursued by politicians in the US and the UK in their attempt to bring back the past over the next few years don’t result in unsustainable debt levels. Maybe inflation, some are calling the outcome of Trump’s likely policies trumpflation, will inflate debts away!

click to enlargedebt-dependency-index

In his recent book, “A banquet of consequences”, Satyajit Das articulated the choice we have in terms of a choice of two bad options by using the metaphor of the ancient  mythical sea monsters, Scylla and Charybdis, who terrorised sailors. Das said “Today, the world is trapped between Scylla, existing policies that promise stagnation and slow decline, and Charybdis, decisive action that leads to an immediate loss in living standards.

The character of Charybdis is said to be the personification of a whirlwind. Remind you of anyone….?

Anarchy in the UK

Uncertainty reins and the economic impacts of Brexit on the UK and on Europe have yet to become clear. And a big factor in the uncertainty is the political path to Brexit. The UK political class are now trying to rally around newly agreed leadership of their respective parties (assuming Labour MPs eventually manage to get rid of their current leader) and craft policies on how to engage in the divorce negotiations.

A unique political feature of the UK is their first past the post (FPTP) electoral system. The graph below of the 2015 general election shows how the system favours the larger political parties. It also shows how parliamentary representation under FPTP can be perverse. The Scottish SNP, for example, got 4.8% of the vote but 8.6% of the members of parliament (MPs). The right wing little Englander party UKIP, whose rise in popularity was a direct cause of the decision to have a referendum on Brexit, got 12.6% of the vote but just 0.26% of the MPs. Despite its obvious failings, the British are fond of their antiquated FPTP system and voted to retain it by 68% in a 2011 referendum (albeit with a low voter turnout at 42%).

click to enlarge2015 UK General Election Results

One lasting impact of the Brexit vote is likely to be on the make-up of British politics. Much has been commented on the generational, educational and geographical disparities in the Brexit vote. A breakdown of the leave-remain vote by the political parties, as per the graph below, shows how the issue of the EU has caused schisms within the largest two parties. Such schisms are major contributors to the uncertainty on how the Brexit divorce settlement will go.

click to enlargeUK Brexit Vote Breakdown by Political Party

Currently both sides, the UK and the EU, have taken hard positions with Conservative politicians saying restrictions on the freedom of labour movement is a red line issue and the EU demanding that Article 50 is triggered and the UK agree the divorce terms before the future relationship can be discussed.

Let’s assume that all of the different arrangements touted in the media since the vote boil down to two basic options. The first involves access to EU markets through the European Economic Area (EEA) or the European Free Trade Association in exchange for some form of free movement of labour, commonly referred to as the Norway or the Switzerland options. The second option is a bilateral trade agreement with a skills based immigration policy, commonly referred to as the Canadian option (although it’s interesting to see that there is political uncertainty in Europe over how the Canadian trade deal, which has been agreed in principle, will be ratified). I have called these option 1 and option 2 respectively (commonly referred to as soft and hard Brexit respectively).

Let’s assume the negotiations on Brexit in the near future will be conducted in a sensible, rather than an emotive, manner whereby the economic impacts have been shown to be detrimental albeit not life threatening. And both sides come to realise that extreme positions are not in their interest and a workable compromise is what everybody wants. In such a scenario, I have further assumed that the vast majority (e.g. 98%) of remain voters would favour option 1 and I have judgmentally assigned political preferences for each option by political party (e.g. 90% and 75% of Conservative and Labour leave voters prefer option 2 respectively). Based upon these estimates, I calculate that there would be a 56% majority of the UK electorate in favour of option 1, as per the graph below.

click to enlargeBrexit Options Breakdown by Political Party

Now, the above thought experience makes a lot of assumptions, most of which are likely to be well off the reality. Particularly, I suspect the lack of emotive and divisive negotiations is an assumption too far.

What the heck, let’s go one step further in these fanciful thoughts. Let’s assume the new leadership in the Conservative party adopt option 2 as their official policy. Let’s also assume that the Labour party splits into old labour, a left wing anti-globalisation party, and a new centre left party whose official policy is option 1. In a theoretical general election (which may be required to approve any negotiated deal), I guesstimate the result below under the unpredictable FPTP system.

click to enlargeTheoretical post Brexit General Election Result

This analysis suggests a majority government of 52% of MPs with option 1 as their policy could be possible with a grand coalition of the new centre party (Labour break away party), the Liberal Democrats and the SNP. The Conservatives and UKIP could, in this scenario, only manage 35% between them (the old labour party at 9% of MPs wouldn’t tolerate to join such a combination no matter what their views on the EU). The net result would be a dramatic shift in UK politics with Europe as a defining issue for the future.

Yea, right!

Back to today’s mucky and uncertain reality….

 

Follow-up: I thought I was been clever with the title of this post and I only realised after posting it that the Economist used it in their title this week! Is there nothing original any more….