Markets start to face the prospect of a Trump victory
Sep 16th 2016, 13:34 BY BUTTONWOOD
STOCKMARKETS have tended to perform a lot better under Democratic than Republican Presidents. A 2013 paper found the S&P 500 had delivered a return more than five percentage points a year higher under the former party than the latter (since 1948). Growth of GDP, employment, real wages, profits and productivity were all better under the Democrats as well.
Despite that trend, investors are generally assumed to favour the Republican candidates, on the grounds that they favour a low tax, less-regulated economy. But this is an unusual election. A Bank of America poll of global fund managers found that a Republican victory is one of the two great tail risks facing the markets, along with EU disintegration.
Of course, that is because Donald Trump is the candidate. In some respects, his approach resembles that of previous Republicans; he favours tax cuts and reductions in non-discretionary public spending. But in others, he diverges significantly, particularly on free trade. Most of all, the problem lies with his tone; he has made some wild statements about foreign policy, the Treasury bond market and the Federal Reserve. Hence SocGen, the French bank, has found that Treasury bond yields tend to rise when Mr Trump gains in the polls while emerging market currencies (and the Mexican peso in particular) tend to fall (see chart).
This has become a much more serious issue in recent weeks. The markets have tended to assume that Hillary Clinton would win the election but the polls have narrowed and some have Mr Trump ahead. The 538 website’s nowcast model has seen the Republican’s chances of victory rise from 3.6% on August 8 to 42.4% at the time of writing; its less-volatile “polls-plus” model has seen a jump from 20.5% to 40.5% over the same period.
As yet, there has been remarkably little in the way of detailed analysis of the likely consequences of a Trump victory—one exception has been a detailed and level-headed analysis of tax policy by Morgan Stanley. One reason is the fluid nature of Mr Trump’s proposals, and his lack of the kind of academic “brains trust” that supported Mitt Romney or George W Bush. The “make it up as he goes along” nature of his policy approach was shown in the recent visit to Mexico, where his emollient words in front of the foreign audience was followed by a return to his nativist approach at an Arizona rally on the same day. When he talks about buying back Treasury bonds for less than face value, or muses about the political motives of Janet Yellen, he may simply not know what he is talking about.
The benign interpretation of all this is that wiser heads will prevail once Trump is in office, either among the Cabinet members he appoints or in Congress. (Another “benign” interpretation is that he doesn’t mean anything he says.)
As the Morgan Stanley note points out, a Trump victory would almost inevitably mean complete Republican control (the Senate and House are already in their hands). So President Trump would have quite a good chance of getting tax reform of some kind through Congress. That would mean lower tax rates (for both companies and individuals) in return for the abolition of some “loopholes”—one aim would be to get companies to repatriate overseas earnings, for example. These plans will assume (historical evidence notwithstanding) that these lower rates will lead to increased revenues via faster growth.
Veteran observers will note that it is much easier to cut tax rates than to close the loopholes (which are defended vigorously by lobbyists), just as it is easy to announce the intention to cut public spending in aggregate but much more difficult to eliminate specific items. The Committee for a Responsible Federal Budget, a bipartisan group, estimates that Mr Trump’s savings plans will cover only a small part of his tax programme. The deficit will likely rise; hence perhaps the weakness of T-bonds when his poll numbers rise.
When it comes to the dollar, the picture may be mixed. Mr Trump’s trade stance may well be bad for emerging economies. In foreign policy terms, his more aggressive tone towards China and in some parts of Middle East policy (recently promising to blow Iranian boats “out of the water”), combined with his dismissive attitude towards NATO and other alliances, mean that his election would lead to a surge in geopolitical risk. Paradoxically, such surges often lead to the dollar doing well, as US investors repatriate money from more risky places such as emerging markets. But other developed currencies such as the Swiss franc and the Japanese yen might be popular.
For the stockmarket, it seems likely there would be an instant sell-off on the news given the Bank of America poll. But there is a two-month gap between election and taking office and Wall Street may recover its equilibrium. The question would be whether “tax-cutting Trump” was in the ascendant or whether “trash-talking Trump” (on the foreign policy side) took the helm. The former would be positive for share prices, at least in the short term; the latter uniformly negative. One final thought; your blogger has not always been a great enthusiast for gold, but if there ever were an argument for buying bullion, a Trump presidency would be it.
Stealth socialism
Passive investment funds create headaches for antitrust authorities
Sep 17th 2016 | From the print edition
THERE is a contradiction at the heart of financial capitalism. The creative destruction that drives long-run growth depends on the picking of winners by bold, risk-taking capitalists. Yet the impressive (if not perfect) efficiency of markets means that trying to out-bet other investors is almost inevitably a losing proposition. Algorithmic punters trade away the tiniest of arbitrage opportunities near-instantaneously. Active investment strategies therefore amount to little more than a guessing game: one in which, over time, the losses from bad guesses eventually top the gains from good ones. Betting with the market—through broad index funds, for instance—is therefore a good way to maximise returns. Yet where does that leave capitalism, red in tooth and claw, and its need for bloody-minded nonconformists?
“Passive” investment vehicles, like those low-fee index funds, now soak up enormous amounts of cash. In America, since 2008, about $600 billion in holdings of actively managed mutual funds (which pick investments strategically) have been sold off, while $1 trillion has flowed into passive funds. So the passive funds now hold gargantuan ownership stakes in large, public firms. That makes for some awkward economics. Research by Jan Fichtner, Eelke Heemskerk and Javier Garcia-Bernardo from the University of Amsterdam tracks the holdings of the “Big Three” asset managers: BlackRock, Vanguard and State Street. Treated as a single entity, they would now be the largest shareholder in just over 40% of listed American firms, which, adjusting for market capitalisation, account for nearly 80% of the market (see chart). The revolution is here, but it was not the workers who seized ownership of the means of production; it was the asset managers.
A growing number of critics reckon this cannot be good for capitalism. Some argue that because such funds take investors out of the role of allocating capital the outcome does indeed resemble Marxism (or worse, since communists at least dared to suggest that some activities were more deserving of capital than others). In August analysts at Sanford C. Bernstein, a research firm, thundered: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market-led capital management.” This is over the top. Passive investment pays because active investors rush to price in new information. If passive investors took over the market entirely, unexploited opportunities would abound, active strategies would thrive and the passive-fund march would stall.
Others worry that concentrated ownership will lead to managerial complacency. Actively traded mutual funds might sell a stake in a poorly managed firm; passive funds lack that option. Captive shareholders could allow management to run amok. Yet that worry, too, seems overstated. Passive asset managers can still be active shareholders. Most have signalled their intent to push executives for good performance. Rather, the big problem with concentrated ownership may be that firms are too mindful of the interests of their biggest shareholders. A fund with a stake in just one firm in an industry wants that firm to out-compete its rivals. Big asset managers, which take large stakes in nearly all of the dominant firms in an industry, have a somewhat different view. From their perspective, the best way to generate portfolio returns might be for rivals to treat each other with kid gloves.
In a series of recent papers, Martin Schmalz of the University of Michigan and a cast of co-authors work to detect the anti-competitive effects of concentrated ownership. Their results are striking. Institutional investors hold 77% of the shares of the companies providing services along the average airline route, for instance, and 44% of shares are controlled by just the top five investors. Adjusting measures of market concentration to take account of the control exercised by big asset managers suggests the industry is some ten times more concentrated than the level America’s Department of Justice considers indicative of market power. Fares are perhaps 3-5% higher than they would be if ownership of airlines were truly diffuse. In theory large asset-management firms might be quietly instructing the firms they own not to undercut rivals. But the writers suggest nothing so nefarious need occur to cause trouble. Fund-appointed board members could simply refrain from urging conservative CEOs to compete aggressively, or CEOs might anyway conclude that their big shareholders would prefer peace and profits.
Buy low, sell high
A similar analysis suggests bosses are rewarded handsomely for playing along. The authors note that large funds often approve generous pay packets for executives whether or not they are performing well. Indeed, in industries with highly concentrated ownership, bosses receive relatively less pay than peers when their firm does well, and relatively more when competing firms do well. The authors reason that a weaker link between executive pay and firm performance makes CEOs lose interest in aggressive competition, boosting profits across the portfolio as a whole.
Such findings should trigger alarm bells among regulators. There are no easy fixes, however. Limiting the ownership stakes of the large, passive asset managers might boost competition, but it would undercut the cheapest and most effective investment strategy available to retail investors. Forcing asset managers to be entirely hands-off, on the other hand, might also boost competition, but neuter shareholder oversight of management.
Yet despair is premature. Common ownership is not the only barrier to competition in the American economy. Corporate giants are all too good at buying up troublesome rivals and lobbying for privileges. As evidence of the side-effects of growth in passive funds accumulates, the best remedy might be for Washington to take its antitrust responsibilities more seriously.
The age of stagfusion
Sep 12th 2016, 14:12 BY BUTTONWOOD
TRADERS are now back at their desks, and markets are getting active again, after a somnolent August. Friday saw the first significant sell-off (in both bonds and equities) for a while and the trend continued on Monday morning. German ten-year yields have “soared” to 0.03%.
The proximate cause seems to be central bank action and inaction. The Federal Reserve looks more likely to increase rates this year while the European Central Bank (ECB) failed to add any stimulus last week. The narrowing presidential polls in America (and the health scare for Hillary Clinton) can be thrown into the mix; there is not the usual investor enthusiasm for the Republicans, given the nature of the nominee. (Indeed, fund managers polled by Bank of America see a Turmp win as the second biggest risk after EU disintegration).
But the underlying problem needs a new word—stagfusion. Investors have become used to low interest rates and bond yields since central banks started to loosen policy in 2008. They have prospered from it, since asset valuations have risen and corporate profits have held up well, particularly in America. But they also grumble about it from time to time. Hedge-fund libertarians dislike the amount of official intervention in the market; pension funds and insurance companies have seen their liabilities rise because of lower yields; strategists and economists worry about the prospect of secular stagnation, a prolonged period of slow growth.
So investors are confused. They recognise that a world of zero interest rates and negative bond yields is inherently strange and problematic and fear it can’t last forever. But they worry what will happen when they cease to benefit from all that central bank support. Perhaps stagnation is better than the alternative? Hence “stagfusion”.
And judging by the comments of the central bankers, investors aren’t the only ones to be confused. Many central bankers seem to worry that monetary policy has done as much as it can, and that economies need structural reform (and fiscal stimulus) if they are to prosper. They are also conscious of the fact that they are getting dragged into the political arena—and this makes them uncomfortable. But they have mandates to meet, and if the other reforms do not happen, what else can the Bank of Japan, the Bank of England and the ECB do but stimulate? Meanwhile the Fed is clearly terrified of making the kind of premature move that sabotaged the 1930s recovery (or Japan’s in the 1990s). As we have seen, big market moves may cause them to think again.
So we have what therapists might call an “unhealthy relationship” between the central banks and the markets in which each is nervous about the other might do and the latter is terribly dependent on the former. And divorce is out of the question.
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