We have just had a fascinating election here in the UK. Around this time many in the industry are asked, or simply feel the need, to comment on what the outcome means for investors. More often than not this comes down to short-term forecasts: ‘equities will like it if the Conservatives win,’ ‘Sterling will benefit from greater certainty,’ ‘money is on the side-lines waiting for the result.’
Such observations and rules of thumb are often partially valid. However, they often ignore the real reasons why politics matter for investors, reasons that were writ-large in the latest UK election and which dominate the debate in Europe and beyond.
The reality is that politics cannot be ignored, not because you get ‘increased uncertainty’ around elections, but because the way society is run dictates asset returns significantly for long periods.
When most people describe the benefits of investing in equities they talk about participating in growth. More specifically though, equity returns are determined by the share of this growth that goes to companies as profits.
In many developed countries the share to companies has increased over recent decades. Figure one shows the US (for which we have the best data) since 1980.
This hasn’t always been the case. Although today many consider the US to be the ‘high altar’ of capitalism, in the 1970s and early 1980s the share of growth going to companies was far lower.
The reasons for the shift are heavily debated, with ideological preferences often colouring the argument. A more efficient globalised economy, domestic de-regulation, and de-unionisation all seem to have played a significant role.
A common feature of all these forces is the extent to which companies were freed up to generate profits. It is not just about capital winning at the ‘expense’ of labour, but includes changing attitudes to corporate governance; generating profits for shareholders rather than for executives or their friends.
The chart below shows the performance of the US equity market relative to GDP between 1960 and 1980, and from 1980 to 2000. While GDP grew by about the same amount in both periods the differential returns to shareholders are massive.
This societal shift is not limited to the developed world. In many Asian economies, the crisis of the late 1990s drove material changes in organisation of the corporate landscape of many countries. Unsurprisingly, this was mainly focused on reform of the financial sector but more generally there has been increased competition and improved corporate governance, as well as ongoing integration with the rest of the world.
The chart below shows the impact of this regime shift in Korea. Prior to the crisis corporate profits failed to keep up with Korean GDP for extended periods, before a huge divergence in the new millennium, following the Asian crisis.
There are a range of complex forces at work here, currency moves will have certainly played a role, but couple such political and social developments with the highly attractive valuations that were the legacy of the Asian crisis and the impact on investment returns is telling. The chart below shows the performance of the Korean equity market versus that of Japan.
Cross-country comparisons can be very misleading and should always be taken with a pinch of salt. Japan differs in terms of demographics, a lower level of growth throughout the period, and the extent to which it was already a more capital friendly regime.
However, in the case of Japan, equity managers around the world have long been challenged by the inability of the corporate sector to generate profits for shareholders. A simplistic look at profits and GDP seems consistent with this (see figure 6, note the difference in scale).
Interestingly there are indications that as part of ‘Abenomics’ there are positive developments, both in the form of structural reforms and changing behaviour that suggest that the corporate sector is becoming more effective at extracting profits. However, the long-lasting impact remains to be seen.
Spotting regime shifts
The types of changes in political and social structure that I’ve discussed above take place over many years and in ways that are not obvious. They cannot easily be traced in financial ratios or even necessarily looking at the policies of governments. But that does not mean they should be ignored.
The rising share of growth that companies can capture as profits, and the corresponding decline in that going to labour, has been an enormous area of social tension in recent years. It lay behind almost every aspect of the debate in the UK election, the popularity of Piketty’s ‘Capital,’ the emergence of the Occupy movement, and dominates the political agenda around the world. Whatever your personal politics, how these tensions are resolved is crucial for investors.
The balance of opinion in favour of free markets can be thought of as a pendulum which has been shifting meaningfully around the world. Growing social disquiet with the ability of companies to grow profits, the emphasis of many in anti-austerity movements in Europe upon taxing business, the rise of nationalism and protectionism in economies like Russia, and more redistributive and anti-business approaches in South America are examples of forces that could shift this pendulum.
This would mark a change in the direction of for much of the last thirty years. However, we need to remember that the path of least resistance has ultimately been for greater freedom in markets, not less.
In a recent survey conducted by the Pew Research Center, when people were asked whether they agreed with the statement that: ‘ More people are better off in a free market economy, even though some people are rich and some people are poor,’ the strongest agreement seemed to be in some emerging and Asian economies (see figure 7).
Such surveys are merely asides. What is more important is watching what companies and societies actually do at points of stress. Do they act in the interests of shareholders or are they more populist? Assessing these forces is often overlooked in favour of the comfortable certainty of analysis of financial statements, but is a more critical driver of returns over the medium term.