A historical

Luc Synaeghel, CIO 2016-06-10

Last month we wrote about a number of black swan events that could generate financial market volatility over the coming weeks and months. Many of the short-term risks that we are monitoring actually share common roots – roots that reach back several decades. Reflecting on how the world has arrived to the current maelstrom of voter unrest, debt-strapped governments, distressed banks and increasingly impotent central bankers is key in our view to understanding the drivers of future investment returns.

After much “kicking of the can” since the global financial crisis struck in 2008, we feel that the end of the post-war economic road, as we know it, is approaching and that our society is on the brink of profound changes. It is becoming increasingly difficult to mask the uneven distribution of wealth between capital and labour – which dates back to the 1980s – through improved consumer purchasing power, easy access to credit or public sector job creation. Central bank-driven asset price inflation over the past eight years has only served to heighten social inequalities, prompting increasing worker and voter reaction. The middle class has perhaps not yet identified the exact cause of its angst, but it certainly feels wronged and is expressing its discontent in the streets and ballot boxes.
To help gain a longer-term perspective, we thus devote this monthly letter to an outline of the economic history of the past 70 years, breaking it up into three main phases:

  • From the end of World War II to the 1970s oil shocks: a “golden” growth era, the benefits of which accrued relatively equally to corporations, labour and governments (read more)
  • From the early 1980s to the 2008 financial crisis: a period during which income inequalities mounted beneath a surface of generally still “smooth” economic growth (read more)
  • From the financial crisis until today: ever more desperate attempts by policymakers to keep the – broken – system afloat (read more)

The investment world will not be immune to the pending societal changes. Corporations are likely to face more headwinds over the next decade, as increasing regulation adds to the cost of doing business and the tax burden mounts (sometimes even retroactively). Pressure on earnings will translate into lower equity returns. Alongside continued low rates in the fixed income space, investors should thus anticipate modest overall portfolio returns.

Timing such changes is impossible – hence also the importance of being prepared. A case in point could be the ongoing OECD discussions regarding the taxation of multinationals. At some stage, an agreement to close loopholes and tax such companies in the countries where they operate, rather than the (low-tax) countries where they are headquartered, is likely. If that does occur, their richly valued stock prices stand to take a hit. In building portfolios, we thus continue to be very wary of valuation risk, preferring to invest selectively into depressed assets..

1945 – 1974

The post-World War II economic boom, commonly referred to as the “Golden Age of Capitalism”, saw OECD countries post average real GDP growth in excess of 4% during the 1950s, nearing 5% in the 1960s – alongside virtually full employment. This strong economic performance extended to war-devastated Japan, West Germany, France (“Les Trente Glorieuses”) and Italy.

Infrastructure investments were a central feature of this period, the most well-known program being of course the 1948 Marshall Plan for the rebuilding and modernization of Western Europe. Productivity growth was strong, thanks to the deployment of automation technologies in the manufacturing sector and major advances in agriculture processes.

Importantly, under the rule of Keynesian economics, the benefits of this strong growth were distributed relatively evenly between the corporate sector, workers and governments. Rising real wages enabled the emergence of a consumerist middle class, fuelling demand for mass-produced goods (in many ways similar to what has been occurring over the past years in China). Meanwhile, governments had the means to introduce social security benefits, creating what has come to be known as the “welfare state”.

In a 1957 speech to fellow Conservatives, with the best years still ahead, UK Prime Minister Harold MacMillan summarized the golden era as follows:

“Indeed let us be frank about it - most of our people have never had it so good. Go around the country, go to the industrial towns, go to the farms and you will see a state of prosperity such as we have never had in my lifetime – nor indeed in the history of this country.”

This long period of generalized optimism came to its end in the early 1970s. The collapse of the Bretton Woods monetary system in 1971 ushered in freely floating exchange rates and rising inflationary pressures. In 1973 the first oil crisis struck, causing stock markets to crash and western economies to plunge into recession. The second oil shock then hit in 1979.

Failure to restrain inflation and revive economic growth during the 1970s stagflation led to a major change in policy direction, epitomized by the elections of Margaret Thatcher as UK Prime Minister in 1979 and Ronald Reagan as US President in 1981. Demand-management went out of fashion in the Anglo-Saxon world. In came “laissez-faire” (deregulation) and supply-side economics.

1980 - 2008

Continental Europe meanwhile continued down the path of fiscal spending. Unfortunately, not only did these expenditures require the running of substantial budget deficits but their focus also gradually shifted from productive investments to containing unemployment, via the creation of jobs in the public sector.

The underlying problem was that wealth creation was no longer being distributed equally between economic actors. Corporations had begun to reap the greater part of the growth benefits, taking advantage of the cheap outsourcing opportunities brought about by the fall of the Berlin Wall and the emergence of the Chinese economy – not to mention improved export prospects in an increasingly globalized world.

Investment Letter 2016 June privatesector

As the share of corporate profits in GDP grew, that of labour income progressively shrunk. Yet workers did not react, nor perhaps even notice that they were sitting on the wrong side of the income fence. The fact is, two major developments helped mask the growing inequalities.

First, manufacturing outsourcing opportunities also translated into lower prices for consumer goods, particularly brown goods, effectively boosting workers’ purchasing power. The internet breakthrough of the late 1990s added to this trend by offering consumers access to goods anywhere in the world. While not adopted overnight, online shopping eventually came to be a normal fact of life, driving down consumer good prices further.

Second, access to bank credit was rendered much easier, fuelling a massive build up in consumer and mortgage debt. Over time, as we now know, banks became less and less regarding on credit profiles and collateral values, setting the stage for the subprime fiasco.

But until their debt burden became a problem, workers were in effect blinded. What they were not receiving in additional income, they could simply borrow, keeping consumption growth – indeed overall economic growth – afloat.

2008 TO DATE

In retrospect, policymakers’ reaction to the 2008 financial crisis, particularly on this side of the Atlantic but also in the US, was not surprising: attempt to keep the economic engine running, whatever the cost, rather than accept that the system needs radical changes.The past eight years have thus seen governments up their debt load considerably, mostly to finance social security spending. Budget deficits were run, but not in a Keynesian counter-cyclical investment sense. No longer term benefits are to be expected from all the (borrowed) public funds that have been disbursed. And now that public debt levels are unsustainably high, the only way for governments to continue to foot the bills of the discontented middle class (i.e. to maintain the social net) will be to find additional tax revenues. Financial assets are an obvious target, be it through a new/higher capital gains tax rate or increased taxation of financial income and property.
Central banks also participated to the prolonging of the – broken – system. They lowered interest rates massively, all the way down to negative territory, and resorted to “unconventional” quantitative easing (QE) programs (printing extra money) which incidentally appear now to be reaching their limits. While the middle class did see gains initially, as lower rates helped reduce their debt servicing costs, over time it became obvious that most of the benefits were accruing to the wealthy. Liquidity injections did not find much way into the real economy, so reluctant were banks to lend. And financial asset values soared, adding to the wealth of the already wealthy.
The inequalities that have been accumulating since the 1980s are thus now coming to the forefront. The Brexit referendum, Donald Trump’s securing of the Republican nomination in the US and the rise of extremist parties in Europe are but examples of middle class anger. Social media sites, a by-product of technology advances, are also helping give a voice to the people on a global basis.
Moreover, all the borrowing of the past two decades has brought consumption forward and we should not be surprised that consumption is weak and will remain weak during the private deleveraging period that already started in 2008 en still can go on for many years.
And so we find ourselves in a world of low economic growth, zero interest rates, no inflation and a discontented middle class pressing politicians for change.


Higher growth through investments in infrastructure together with a more equitable distribution of future wealth creation (i.e. the recipe of the 1950s and 1960s) seems the way forward.
The developed world is in urgent need of spending on roads, railroads, airports, energy production, telecommunication equipment etc. Everywhere we have reached, or indeed gone beyond, the limits of available capacity. Politicians are of course fully aware of the infrastructure problem that has been created since the 1980s, due to the continuous slashing of infrastructure spending imposed by an ever-expanding “social welfare state”. But already heavy government debt levels and reluctance to cut social benefits (to free up some budget) mean that they are in no position to make the necessary investments.
Appealing to politicians would be a central bank-sponsored solution, whereby central banks decide not to ask for the redemption of the government debt accumulated through their QE programs or, more boldly even, offer to directly finance public spending on infrastructure. The advantage of money-financed versus debt-financed fiscal expansion is that it does not incentivize households to increase their savings so as to offset future tax hikes. Japan is probably the country closest to such an outcome, having also spent the longest time in “no growth” territory. But this solution is not without danger. Printing more money, even if it is used to finance infrastructure investments, could induce serious doubts about the value of “paper money” and lead to (very) high inflation.
Another possibility would be for governments to jointly decide on a one-time exceptional increase of their debt ceiling, involving the issuance of “special” very long term bonds at current near-zero interest rates in order to finance the necessary infrastructure investments – and only infrastructure investments! – as was in fact done after World War II.
A further hurdle to overcome before infrastructure-led higher growth can be possible lies in the current “spaghetti” of administrative rules and laws due to overregulation by an already oversized but ever growing public administration.
Finally, the most difficult part of the solution will be to bring corporate and labour representatives to the bargaining table and find a means to distribute future wealth creation more equally. This would involve higher wages and necessarily imply taxation changes – a complicated subject at any time. Also, with artificial intelligence and robot technology close at hand (e.g. Adidas has just announced its almost entirely robot-run factory in Ansbach), labour may not be the single best way to redistribute income in the future.
All told, there are many rivers to cross before we can again see “sixties style” economic growth and the journey will take several years. In the meantime, all will be done to keep interest rates as low as possible and to tax capital and capital income as much as possible...