Lockhart Capital Q1 2019 Outlook

“Context is everything”; so, what is the backdrop in 2019 to advising on generational wealth, and where do we see the risks and investment opportunities?

“The fall of Rome seemed unthinkable to people at the time, but inevitable to historians reflecting on it with the benefit of context” – Mary Pilon (author)

Globalisation is on the back foot.  Voters in the Western world are aggravated by a stagnation or even retreat in their standards of living.  History shows how, from the Roman Empire to the Mayans, regimes can lose the confidence of their end “clients”, who feel remote from the centre of power, and question whether what they get back is worth what they put in. The risk is a dwindling interest in supporting the status quo as an ongoing concern.

A more tribal mentality usually emerges and running out of funds often paves the way for such an eventuality.  To that end, today sees the world with $500trn of debt, vastly more unfunded liabilities, and no way of paying for it.  The UK has £11trn just of unfunded pension liabilities, which is five times its GDP.

Developed countries are struggling to cope with the demise of “the demographic dividend” (c.1960-2010), given its outsize impact on pay-as-you-go models. Our rule of thumb assumption from twenty years ago was that State mandated retirement ages can only ever go up, and the level of public services, (likely) down.  Poverty is easy to create, wealth less so.

Fig. 1.

Source: Pinterest

The catalyst for the current rise in populism has proven to be the response to the Great Financial Crisis of 2008.  Quantitative Easing has been excellent at raising asset prices (and QT will likely do the reverse), but not at providing the” trickledown” effect that central bankers expected, in terms of increased economic activity and (ultimately) that improved quality of life.

An unintended outcome has been the elevation of levels of Wealth versus GDP, and the outperformance of “Capital” versus “Income”.  Essentially asset owners were the huge winners of this process.  Now these ratios tend to be mean reverting over time but could be explicitly helped on their way by policy intervention, the consequences of which will be important for Wealth Advisers.

In any event, so-called austerity fatigue, as perhaps most recently seen with the “gilets jaunes” has become widespread even in the expansion phase of this economic cycle.  We have been wondering what then it is going to be like in the next serious downturn.  Would one expect such an environment to lead to reduced trade barriers or more protectionism?  One assumes the latter, unfortunately.

Fig. 2.

Source: Hermes

Much as protest votes have been “anti-elite”, there has been equal disregard for globalisation.  The globalisation gamble was to trade-off cheap consumer goods versus well-paying bluecollar jobs, to be exported to the emerging world (also actually displaced by technology). 

Whether this was indeed of net financial benefit to Western middle classes is questionable, but what is less in doubt has been the negative impact on social cohesion and human dignity. This was underestimated, and the current opioid and suicide epidemic in the US is at the sharp end of this scenario, although does also have other drivers.

In sum, and to quote Jason DeSena Trennert, Chairman of Strategas Research Partners, “Sadly, in the final analysis, it seems that a generation of broken political promises about the benefits of globalization have resulted in a growing sense of tribalism in the developed world. The Achilles Heel of social engineering to promote globalism, it would seem, is democracy.” What next?

The ability of governments to meet voter expectations and demands, is challenged at best. They have arguably painted themselves into a corner after thirty years of Corporatism masquerading as Capitalism, and tending towards being probusiness (big, not small), more than pro market. 

This has led to more barriers to entry, low productivity, regulatory capture, and capital monopolising returns at the expense of income. Amongst the consequences that we see today, is a decline in the size of new business creation (impacting potentially well-remunerated jobs and the chance of a more vibrant economy).

Fig. 3. Net change in U.S. business establishments

Source: Washington State Wire

The economic populism of both the left and the right, sees each wanting to hijack political power and “the illusion of abundance” for their own ends, and for greater perceived certainty of outcome, rather than possibility. 

Markets have, optimistically, tended to give an initial benefit of the doubt to right-wing populists, if we can generalise and throw the likes of Trump and Bolsanaro in together; while they remain warier of the left-wing variants (perhaps the debacle in Venezuela suffices for recency bias).  Of course, in Italy the administration is, for now, a mix of the two. 

At the same time there has been a shift back towards “strong man” leadership, as we see in the likes of the Philippines and Hungary, and with various “Presidents-for-life”, be it Erdogan in Turkey, Putin in Russia, naturally, and Xi Jinping in an increasingly totalitarian and autocratic China (for example the right of free assembly was prohibited last year, and Presidential term limits removed).

In the 1990s it was erroneously thought that liberal democracy was the inevitable winner as a political solution – see Francis Fukuyama’s “The End of history?” (1989) – and then through allowing China into the World Trade Organisation in 2001 (by fudging the entry requirements) this would be ensured, as political liberalisation would surely follow economic. 

Fukuyama himself now sees the “identity politics” of today as a poor substitute for social policy, and an ideological threat to that liberalism, and “the common ideological heritage of mankind”.  The almost primal desire for recognition and respect is proving mighty difficult to sate. 

A sense of self and (equality of) recognition can be gained through meaningful labor, and hence we are back to that offshoring of manufacturing industry/jobs. 

The reason that this is so important, from a money manager perspective, is three-fold.  Firstly, “governance is everything”, as we rarely tire of saying (especially when questioned on the emerging market du jour, over the years).  As minority shareholders it is therefore our strong preference that any State has an independent judiciary and a free press. 

Secondly, and related, established rule of law and a tradition of property rights is also helpful, from an investment perspective, but also when considering that more populist regimes are arguably likely to be attracted to one’s wealth and assets as well as one’s income.  Finally, respect and support for an innovative and entrepreneurial class also goes a long way to creating successful capital formation and investment opportunity. 

We want to invest in human ingenuity and endeavour.  Yet the argument to best support these is not being made, the world has moved away from peak globalisation, and trade barriers have risen.  This started even prior to President Trump, incidentally, although it is true that he doesn’t seem to understand the division of labor, let alone debates around Ricardian theories of comparative advantage (surely his advisers do though?). 

The US is ditching the post second world war Bretton Woods global system and focusing more on bi-lateral deals and immediate national interest.  It is unusual, for the US, as were the two terms of President Obama, to be “leading from behind” and continues this move to a seemingly more fluid and less secure world, and where we must consider appropriate risk premiums and margins of safety.

One obvious result is increased “friction” as capital, jobs and labour try to cross borders, and this results in a net (and opportunity cost) loss for investors.

“It is better to have a permanent income than to be fascinating.” – Oscar Wilde

None of this, however, impacts how we at Lockhart Capital view Wealth.  We see it not as a static possession but a constantly fluctuating purchasing power, and a means to an end.  For us it is not residing in isolation but as part of a lifetime plan, fully engaged with key variables from tax efficiency to changing personal circumstances to generational security. 

Essentially, we observe wealth as constantly under “assault” from tax, inflation, and the fluctuating world, to which we must adapt, and optimise strategy. If your inflation rate is, say, 3% per annum then the pound in your pocket will have lost almost half of its purchasing power in just 20 years.  It is not at all easy, if history is any guide, to instead preserve and grow this value, and in a sensible manner, but this our North Star.

We use financial markets and tradeable assets as tools to address the problem, within the broader gamut of planning and trusted advice.  However, we don’t exist to increase that wealth as far and as fast as we can, to take large bets, or even to beat the market in any given year.

Instead we simply seek to avoid the worst-case scenarios, whereby we and our clients fail to reach stated financial goals, or wealth loses its original purchasing power.  These are the key risks which must be minimized.  To that end, we don’t necessarily mind a short-term loss of real capital if we think we can recover it relatively quickly/easily, as this is capital for longer term liabilities.  We do, however mind a tempering or loss of the opportunity to generate that long term aboveinflation return. 

“Take calculated risks. That is quite different from being rash.” – General George Patton

To assess the investment opportunities of today, let’s start with infrastructure, focus on Asia, weave demographics back into the story, and add in some Impact Investing.

The need to finance infrastructure projects, globally, will continue to open up opportunities for investors, both in equity and debt.  This ranges from replacing old decaying roads and bridges in the developed world, to implementing new renewable energy projects, to supporting ongoing urbanization across Asia.

To that last point, the rise of the middle class in Asia is extraordinary both in terms of size and the speed at which it is growing:

Fig.4 EM Asia’s Rising Middle Class

This has created, as if from nowhere, a substantial brand-new market to be served, and that is not going to go away. In fact, it could double in size over the next ten years or so, according to Citigroup. The growth in consumption will include the expected branded goods, cosmetics et al, and associated services including financial products, as well as other areas such as education.

Leaps in productivity and quality of life are not uncommon in such scenarios, and just last year we saw the impact of India moving to (even only) 4G.  Additionally, more than 90% of that population now has their own reference number, linked to their biometrics, which, apart from anything else, allows the poor (who generally don’t have a passport or driving licence) to prove their identity and access benefits, apply for loans, open bank accounts etc.

India has a young population, but negative demographics mean that, conversely, Japan is sometimes rather unkindly referred to as “the world’s largest nursing home”, although this will soon be China. Much of the world ex sub Saharan Africa has long been on a similar trend, as we have seen, with many countries operating at below replacement rate levels of fertility.

Not only are countries structurally skewing forwards in median age, longevity has also been increasing.  For investors the consequent opportunities within the Healthcare and Biotechnology sectors are clear, with the latter actually leading the post-Christmas rally.  As an example, the “wearable devices” (such as, currently, smartwatches) market is set to grow by 16.5% per annum (according to ResearchandMarkets) over the coming years, with the intention of enabling the elderly to remain in their own homes for longer, and creating a new industry around monitoring and servicing these clients.

Reductions in fertility rates, worldwide, are arguably a result of higher incomes and increased urbanisation (or in China’s case, also policy).  However, the advantage of consequently slower growth and subdued inflation is lower interest rates and hence higher potential valuation multiples on equity markets and asset prices in general. 

Furthermore, a reduction in the number of available workers encourages innovation and more technology-led solutions, better productivity growth, and ultimately better wages and investment opportunities.  This is already happening in Japan.

Fig. 5

So, we do continue to expect a lower growth and lower return world, but with higher market volatility, and so one must have a strategy to cope with that, and even benefit.

The consensus was too pessimistic about economic growth in 2017 and compounded this error by then being too optimistic about 2018 (as we noted at the start of the year).  Where is it for 2019 then?  Well, we suspect that it is too optimistic again.  Expectations for US economic growth sit at about 2.6%, with only JP Morgan at 1.8% suggesting something closer to our own view.

The consensus call for 1.5% GDP in the UK looks a touch too high to us as well, although of course the economy is likely to be dominated by Brexit outcomes, either way.  We do note AXA’s bullish 1.8% call. They have taken the view that Europe will suffer more than the UK in 2019, which is a left-field opinion.  Admittedly there is over-optimism from most others, including the IMF, on Europe, especially given that Germany is on the brink of recession, and given its dependence on exports, especially to China.

Our own stance is that current soft levels of global economic growth will remain through the first couple of quarters, possibly even worsening a little.  The second half of the year though is even more opaque than normal as we expect fiscal easing (and the political necessity of moving away from austerity policies), to come through, especially in Europe, India and China.  The ECB may “reverse thrusters” with monetary policy as it did in 2015, and in fact Italy and France are already loosening fiscal policy.

This combined with the now weaker oil price, and a potentially more dovish US Federal Reserve, might support better rates of growth in the second half of the year. However, at a guess we would suggest that this won’t happen to any great degree. US Recession is a larger possibility in 2019 than the consensus expects – if still not probable – and would likely lead to another down year for equities.

This does though have us excited about the opportunities that could be revealed for our strategies (there is less to do when our view instead aligns with consensus), and we will also continue to arbitrage our investment time horizons versus those of the dominant algorithms, most of which have a trade horizon of a day at most.

Our ESG portfolio will increasingly focus on Impact Investing, where there is the chance to make a measurable difference (as well as competitive returns), including anything from desalination plants to micro financing to medical technologies, with that Healthcare theme particularly resonating again.

Risks include (overdue?) regulation of the internet technology giants, which seems to have bi-partisan and cross-Atlantic support, and whether China can save itself from recession.  In the case of the latter, it has started to act, but perhaps too little and too late. It tends to use very blunt levers at the best of times, and where the cure may be just as bad as the original disease, so investors need to keep a close eye on this.

A so-called soft-landing (rarely seen!), i.e. no recession at the end of the cycle, for the US economy is actually still possible. The question is whether the Federal Reserve has already tightened policy too much, or whether their belated recognition of deteriorating conditions will lead to a pause in rate hikes in time to prolong the economic cycle and avoid a technical recession in 2019 or 2020.  Such an outcome will rely on last year’s US tax reform having a larger impact than seems to be anticipated in 2019 (mainly due to substantial tax refunds).  This doesn’t seem to be on many investors’ radar at the moment, but does carry some weight we think.

“Money is made when you buy”, is the old saying, of which we were reminded by our associates at Troy (who manage global equities for us) in their January investment report.  This is the key for the 15% we currently hold in cash for the portfolios of our core strategies. As investors we do get to choose at what valuation levels we wish to buy and sell, and which give us the greatest chance of success.  As Benjamin Graham first put it “the margin of safety is to render the forecast unnecessary.”

Andrew Wilson, Chief Investment Officer January 2019

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