Adjusting to Disruptive Change
Two conclusions emerged from the Benchmark Lunches this year. The first was that the world was condemned to a prolonged period of slow growth unless vigorous fiscal spending took place in the major industrialized economies. Monetary policy had been helpful in the recovery after the 2008–2009 recession, but its effectiveness as an economic stimulus had diminished. The second was that considering the uncertainties caused by margin compression, limited revenue growth, the U.S. political outlook, terrorism, Brexit and other factors, the fact that the U.S. equity market is making an all-time high is remarkable.
Every year I organize four Friday lunches for serious investors who spend their summer weekends in eastern Long Island. These sessions have evolved over the past thirty years from a single lunch for five people to four lunches in different venues for over 100. Participants include billionaires and academics, hedge fund managers, private equity leaders, corporate chiefs and real estate titans. Leading Republican and Democrat fundraisers interact with each other. The lunches are not social affairs; I actively moderate a discussion of the key issues for almost two hours at each session.
As you might expect, the conclusions of a group like this might serve as a contrary indicator, and sometimes they do. But in August 2001, one participant had warned of a major terrorist attack in the United States during the following year, and last summer a number of attendees thought the appeal of Donald Trump’s message was underestimated and he had a good chance to be the Republican nominee. In any case, those who came to the sessions this year were sufficiently confused that they listened carefully in search of an insight that would help them find clarity in the outlook.
There were three major narratives threaded through the four lunches. The first was how important a factor populism was in the United Kingdom referendum that resulted in the decision to “leave” the European Union. The movement also played a significant role in Donald Trump’s ascendency to the Republican nomination and Bernie Sanders’ surprisingly strong showing in the Democratic primaries. The second was low world productivity, which improved at 1.8% in the 1964–2014 period and was expected to increase .9% over the next fifty years, but was only up half of that recently. In the U.S., productivity was actually down .4% in the second quarter of this year. Profit growth and standard of living increases depend on productivity improvement. The third was “secular stagnation” caused by technology and globalization that has resulted in the slowing of the growth rate of the United States from more than 3% in the period 1945–2007 to a struggling 2% now.
While the initial investor reaction to the Brexit vote was negative, two months later the impact appears to be largely local. The pound has declined more than 20%, asset values in the U.K. are down by 10% and the prospects for a recession in Britain have risen significantly. In Europe, the risk of contagion would appear to have diminished somewhat, although there were some recent murmurings out of Italy, but right after the U.K. referendum, Spain added seats to the establishment party. The French and German elections next year will be important. Overall, the group at the lunches believed that the slow European recovery would continue in spite of Britain’s vote to leave the EU. One knowledgeable observer said that the impact on the world economy may be unnoticeable several years from now. It will take two years from the invocation of Article 50 of the Lisbon Treaty to implement the departure and during that period Britain will negotiate trade treaties that will soften the negative effect of leaving. Both sides will be practical; Europe has too much to lose by trying to punish the U.K. economically. The big issue is immigration. Britain will now be able to make it harder for Middle Easterners to settle and work in their country. Europe will make it harder for British citizens to travel in Europe, but there may be special visas to ease the border difficulties.
We had an extensive discussion at all the lunches about the productivity question. Prominent executives from West Coast technology institutions were participants. Everyone knew that the productivity numbers were disappointing, but many questioned the way productivity was being measured. It was hard to believe that the smartphone with all of its new applications wasn’t adding to productivity. There were a million Uber drivers earning or supplementing their income by providing on-demand transportation; you could do your job from remote locations with great effectiveness; there was almost no information you could not retrieve instantaneously. On the downside, everyone acknowledged that millions of manufacturing jobs had been eliminated through robotics and other forms of technology. The employee attrition problem was likely to get worse as artificial intelligence becomes more prevalent as a tool in the white collar workplace, eliminating jobs in law firms, healthcare and elsewhere. Where will these displaced workers go?
Those worried about productivity and inequality were perhaps not recognizing changes in the “quality” of life. Technology had definitely made our lives easier even if this isn’t reflected in the productivity numbers. Also, someone living in “poverty” in the United States probably has a residence, a refrigerator, television and other amenities not enjoyed by those in poverty in other countries. While this may be true, I do believe that a substantial portion of Americans go to sleep scared every night. They don’t have a job; they have one but it doesn’t cover all their bills; they have a good job but they are worried that business conditions or technology will cause them to lose it. Sanders, Trump and populism generally are products of an insecure population. They feel that their government’s policies have let them down.
Perhaps the productivity problem is not as complicated as we make it out to be. When the economy is growing reasonably rapidly, say at 3% plus, companies are slow to hire new workers and the existing workers produce more. When the economy is growing slowly, say at 2% or less as now, even though technology enables companies to produce more with fewer workers, managers are reluctant to reduce the workforce and productivity declines.
Adding to this problem are the impressive advances being made in healthcare and surgical procedures. Doctors can now perform operations more effectively and more economically than ever before. The result will be that many people will live longer with a better quality of life than any previous generation. Life expectancy is increasing by several weeks a year in the U.S. When you put all of this together you have a larger aging population being supported by a diminishing number of workers who hold jobs that provide incomes that enable them to have a comfortable middle-class life. The inequality problem has grown in the last two decades and may get worse. Stronger growth would help create more well-paying jobs, but the top brackets may earn even more as prosperity improves, widening the inequality gap even further. Improving our educational system could alleviate the problem, but the progress there seems agonizingly slow. Charter schools have been providing encouraging prospects for part of the population, but on-line education had not gotten the traction everyone had hoped for. It wasn’t enough to have a student sit before a screen working on a well-conceived learning program. Teachers to provide guidance and inspiration and other students to foster an academic atmosphere were needed to enrich the experience.
The third theme was “secular stagnation,” a term developed by Harvard professor Alvin Hansen in the 1930s, to describe the prolonged period of slow growth that he thought would follow the Great Depression. He was wrong, but the term has been resurrected by Larry Summers and others to describe the difficulties economies have when they are trying to come out of a recession in which both an economic and a financial decline occurred, as in 2008–2009. Monetary policy was the principal tool used across the world. The United States and others used selected fiscal measures as well, particularly at the beginning, but monetary policy, which requires no legislative approval, was the instrument used most extensively. In 2007 the balance sheets of the central banks of the United States, England, the European Union and Japan had total assets of $3.5 trillion; today, according to Bianco Research, the aggregate is more than $12 trillion. The slow pace of world growth is troubling when monetary policy has been so expansive. But central banks have had no incentive to stop printing it, because inflation has not followed the enormous growth in money. Milton Friedman must be rolling in his grave.
Terrorism continues to be a threat to world financial stability and periodic incidents are unlikely to end. ISIS can be contained but probably not defeated. The Zika problem reminds us that the uncontrollable spread of infectious disease represents a lurking natural terror. The climate change problem is real, but not immediate and it is hard to get policy makers to focus on it, despite rising temperatures and sea levels. Only 50% of the public think this is a serious problem; 16% do not; the rest are undecided. That’s why it’s hard to get governments to act. According to some climate experts, in 200 years most major cities will be in danger, but there is not a sense of urgency that will get world leaders to deal with this problem now.
Almost everyone agreed that the time has come for more fiscal spending on infrastructure, education, job training, research and development and other programs to improve growth and increase competitiveness. One participant knowledgeable in municipal finance pointed out that state and local governments were now amortizing more debt than they were incurring, thereby not investing enough to reduce the infrastructure problem. The companies that are doing well are the “disrupters” like Amazon, Google, Apple, Airbnb, Uber, Netflix and similar companies. The “old economy” companies will continue to face challenges from margin pressure and foreign competition. Excessive regulation is also a problem that limits growth, as does labor union inflexibility. This may have a dampening effect on the market multiple in the long term, but it sure isn’t evident now. There was a feeling in the group that American consumers had enough “stuff” and their spending money on experiences and services rather than goods was having a negative impact on growth.
At each lunch I ask the participants for their views on various asset categories. As the lunches proceeded and the market moved higher there were fewer bears. At the beginning, half of the group thought that the S&P 500 might be flat to down for the year by Christmas and the other half thought it would be up by 10% or more. Few saw a recession brewing before 2018. There were many bulls on gold at one lunch and almost none at another. More people expected the dollar to head toward 1.05 against the euro, but there were some dollar bears (at 1.20) as well. Conviction that oil (West Texas Intermediate) would be above $50 a barrel at year-end was high, while almost no one thought it would be below $40. There was a general feeling that interest rates were headed higher, but nobody thought the move would be large or that it would occur soon. The group slightly favored raising the minimum wage to $12. The consensus was that the current favorable but unspectacular performance of equities would continue. The U.S. was still considered the best place to invest in spite of all its problems, but there was nobody who expressed table-pounding enthusiasm about an investment idea.
As for China, the general feeling was that the economy had picked up some strength in 2016 and the fear of a hard landing had diminished. While the non-performing debt problem was worrisome, it was not likely to bring down the whole economy and there was a sizable minority of investors willing to put money there. Chinese consumers were holding back on their spending because of a lack of government-supported healthcare and retirement programs. Some of the macro people were concerned about strained diplomatic relations between the U.S. and China. Part of this was related to disagreements about territorial rights in the South China Sea and the buildup of military bases there and part to confusion about the Trans-Pacific Partnership. India continues to be the most popular Asian investment, but it is ranked very low in terms of ease of doing business. What was surprising was the increasing interest in the emerging markets, including Argentina, Peru and the Middle East. Nobody, however, had an appetite for investing in Africa.
In the past we could always count on the real estate people at the lunches to provide some optimism. This year their comments were more mixed. The effects of the internet on retailing are significant, having an impact not only on shopping malls, but also on urban retail rentals. Office rentals are still okay, and warehouses are doing well, but there has been some overbuilding of residential condominiums. While apartment rentals continue to be in strong demand, rents are softer. The outlook there is good, however, because we are not building enough housing units to keep up with family formations. If interest rates rise, 3% cap rates won’t look so attractive for commercial property.
Since this is a presidential election year a part of each session was naturally devoted to politics. A number of those attending had been major contributors to the Republican Party in the past. Some of them were supporting Donald Trump. Some were not voting for either Trump or Clinton; a few were voting for Gary Johnson, the Libertarian candidate. Many thought a Trump presidency would put the country at risk. One strong Trump supporter suggested that I not take The Donald’s statements literally. He said they were “metaphors” for what Trump believed. When he says he’ll build a wall with Mexico, he means he’ll do something about immigration. When he says he’ll prevent Muslims from entering the country, he means he’ll be very tight on entry screening. There were a few who expected Trump to be president. Most thought he had hurt his brand by running. When he entered the race more than a year ago, he thought the downside was that his brand would be enhanced whether or not he got the nomination.
Some said Trump might do surprisingly well in the debates because Clinton was so vulnerable. He was likely to hit her hard on her personal e-mail server, her failure to protect the Americans in Benghazi, her performance as Secretary of State, her fundraising for the Clinton Foundation while she was a cabinet officer and her relationship with her husband. Most participants believed Hillary Clinton would be the next president and that the Senate would shift to a Democratic majority by perhaps one vote. The Republicans would lose a number of House of Representatives seats as well, but would retain a majority. Clinton would essentially continue Obama’s center-left policies but there would be no drastic changes out of Washington. That’s perhaps another reason the market has been working its way higher.
As I reviewed my notes for the four lunches, I noted a mood of complacency. The setting was pleasant, the food good and the weather agreeable. All of the attendees had done well in their careers. Some truly frightening possibilities were looming out there, but they didn’t seem imminent. The intermediate future was likely to be like the recent past: lower but positive returns. Let’s see if that’s the way the next year plays out.
The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Services L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.