Unctad, pg. 26
From GFC I to GFC II ... namely, from Global Financial Crisis to Global Fiscal Crunch; from bank meltdowns to country meltdowns; from the year of the bail-out to the year of the problem budget deficit. The world continues to move on. But one conclusion seems sure: The legacy of the GFC will remain with us for some time, though in changing forms. Complacency is again rife with the belief that the Great Recession has safely passed.
We argue to the contrary. Sizable challenges remain ... not to mention the high chance of a double dip (our Stop/Go/Stop scenario). Moreover, if anything, we remain faced with higher uncertainty than usual, probability-weighting against a wide range of outcomes ... all of them with significant potential volatilities and varied portfolio challenges. Our list of scenarios that require monitoring have expanded to a total of 7.
We are of the view that the prevailing complacency is underpinned by several erroneous premises. We will briefly mention some of these in our conclusions. However, the main objective of this issue is to argue one conclusion that will offer at least one concrete, long-term strategy bias that we expect will offer relative reward over the next years. It is the emphasis of the relative safety of the global MNC (multinational corporation, or transnational corporation, TNC, as Unctad -- United Nations Conference on Trade and Development -- likes to call them).
This may strike readers as surprising coming from the perspective of global macro risk management. Actually, it is for that very same reason that we are warming up to this longer-term bias. Indeed, equities as an asset class have historically had higher risk than sovereign government bonds (at least, according to the definition of risk promoted by the Market Portfolio Theory [MPT] adherents). But higher volatility is not alone a reliable indication of whether you may lose 50% or more of the real value of your capital.
In the same way, just because equities have sported higher volatility (and supposedly therefore also higher returns over the past century) this says nothing about the relative safety of government bonds. In fact, these statistics really provide the ultimate example of survivor bias distorting the conclusions about basic asset mix. There really only have been 2 major equity markets in the world that have survived relatively uninterrupted for a period of longer than 100 years -- that of the UK and the US.
A prime reason why this is so is because the financial systems of more than a few countries have been destroyed by profligate governments, debt explosions and/or subsequent inflations (among other reasons). These stock markets were therefore interrupted by debt crises. The valid conclusion from history would therefore be that sensible government borrowing policies need to be pursued by countries as a priori to the long-term wealth-creating opportunities of stock markets. The evidence of history suggests that government bonds are more vulnerable than certainly stocks of well-run companies in oligopolistic industries.
The big "head-adjustment" is this: By default (no pun intended), the securities of large, solid corporations ... namely MNCs/TNCs ... are now the prime financial credits in the world. Why? The government debt-paper of many nations is destined to head to the confetti factory.
The Great Government Debt Sweepstakes
When economic historians write the books on this era of global policy, it will document the greatest of follies ever perpetuated upon a supposedly advanced financial world. Gauging from the apparent current state of high complacency, it seems that very few even know that such a history is unfolding right now ... with toxic impact for the future. Actually, even to the contrary. In some quarters, current policy developments are mistaken for brilliant policy responses to the less than brilliant policies that illumined the way to financial crisis in the first place. The same shamans that failed to foresee ... and avert ... the financial catastrophes of the past few years are still in their oraclean posts.
Step back for a moment, and consider the epic spectre playing out right at this very time. As the respected team of Kenneth Rogoff and Carmen Reinhardt point out in their recent papers, the volume of government debt of the 5 key crisis nations (US, Ireland, Iceland, Spain and the UK) rose by 75.1 percent over the past two years. While this statistic will not surprise any analyst that has been watching the global scene these past few years, it will chill the spine all the same. It is no ordinary statistic. It is a catastrophic event that should send investors screaming ... protesting the sacrifice of our future generations on the fire-pyre of debt. Consider that this statistic is not in reference to some group of remote despotic banana republics. However, there are more casualties to come ... in fact, perhaps many more.
Earlier last year, the IMF in its annual revisions actually produced a forecast that government debt for the advanced nations, assuming that trends stay on present course, would reach a level of 3.0 times that of GDP by the year 2050. Stunning. Were current dynamics to continue, such a prediction would only seem logical. However, rest assured, this unpleasant scenario is not likely to unfold. Why? Financial structures and current wealth distribution in the world will have been completely upended well before that time. Not only are past financial crisis and current stimulus efforts the culprit, but also the global aging phenomenon which the IMF estimates will cost 5 times that of the Global Financial Crisis.
Even government economists (i.e. the US Congressional Budget Office) are resigned to forecasting federal budget deficits as far as the eye can see. No pretty Rosy Scenario sufficient to solving this dilemma could be found.
Suffice it to say, that the sovereign government bond in much of the world is on a slippery slope, its supply virtually bottomless. We are less worried about hyperinflationary risks for bonds over the long-term (though hyper-vigilant, nonetheless) than the dangers of default and rising interest rates. While on the one hand, we are looking forward to earning higher real yields someday -- that being the needed antidote for incomestarved retirees, today and future -- we also want to avoid underperforming income assets before that time arrives. If more government bonds are bound to follow the course of Greece in the years ahead, just where should investors turn?
Consider the TNC.
Why the Securities of the TNC?
Just what is a corporation really? Mostly, we are inured to its historical significance. Analysts and economists think of it as a powerful legal structure with many benefits ... including lately, the right to unlimited lobby budgets in the US. However, it isn't just merely a convenient legal structure. There is an attendant trend facilitated by the corporation that is actually quite recent. It is the global TNC itself. Very definitely there have been global multi-national entities much earlier, but actually, the emergence of the TNC as a global and dominating force is a recent phenomenon.
Today's corporation, apart from being a "legal person," has really become a mighty "human obedience" structure. All great human achievement, from Attila the Hun's conquest of most of the Asian continent to Alexander the Great's conquest of the then known world of 4th century BC, all have only been possible through "human obedience" structures. That applies to Francis Loyola's founding of the formidable legacy of the Jesuits as well as to the success of corporations today.
The TNC corporation represents an obedience structure. They have strict hierarchy and highly defined "pecking" orders. Obedience is lavishly rewarded, especially today amongst the higher executive echelons. They get a large share of the booty as did Alexander the Great's senior officers. Failure or insubordination, on the other hand, is met with quick disciplinary action ... perhaps the firing squad. And so, the multinational form of power flourishes, and likely will continue to gain power, some even think to take on government role in the future. Says one law expert, "Tomorrow's state will have as much in common with the 21st-century multinational company as with the 20th century state." This seems spot on.
MNCs today are large and pervasive. They now commandeer a significant portion of the entire world economy, virtually controlling the arena of commerce on earth. The 100 biggest (non-financial) transnational corporations in the world today may account for as much as 8-9% of total world GDP. Employing data from Unctad's annual World Investment Reports over the last decade, all 82,000 TNCs (with some 810,000 foreign affiliates in the world) we estimate contribute between 25% and 45% of world economic activity. The foreign portion of their sales -- growing leaps and bounds faster than their domestic sales -- now represent almost half of the total revenue of the top 100 TNCs. Their exports account for one-third total world exports of goods and services. Overall, total foreign sales (meaning domestic sales of foreign companies owned by all TNCs) now far exceed total world export and import volumes. This is an astounding development considering that MNCs accounted for little more than 3% of world economic activity in the early 1950s.
With their vast global reach, transnational companies virtually transcend the restrictions of borders and the controls of individual sovereign nations. These firms can choose to shift production from country to country, seeking better taxation climates and labor markets. Given the advanced state of concentration in some global industry sectors, they even possess the economic power that can make or break individual national economies, especially so smaller, developing countries. Importantly, they have greater pricing power. Could that be why corporate earnings (we use the US experience as an example) have not fallen more during even the Great Recession of the past few years? The graph on the first page shows that corporation's share of National Income has fallen to a level no less than what was considered the cyclical high of business cycles twenty years ago. Something seems to be changing.
Realism: The Long-term Limits of the MNC Strategy
Historically, equities have indeed always been thought to be the riskier asset when compared against the stalwart government bond. The future looks different. But not for a minute do we think that a preference for corporate securities (both stocks and bonds) is a sustainable investment strategy for the very long-term. We are sorry, but try as we might, we cannot identify today a single, major macro investment idea that can be relied upon to generate solid portfolio growth for the next several decades.
Success in the case of the TNC, as the investment creature most fittest to survive the times, also poses other challenges of which we should not lose sight. The greater number of TNCs are public corporations (publicly-listed); almost all TNCs beholden to maximal profits. They are ideal investment vehicles but not everyone will wish to work for one. As behavioural structures, some of them are as cuddly as a female preying mantis after mating. Companies excessively driven by profits will eventually eat their paramour (i.e. recently AIG, the mortgage brokering industry and other examples too numerous to mention). Given the strong culture of the profit-seeking corporation, (whether or not it has a VP of Ethical Practices or Environmental Sustainability) investors may fail to foresee that too much of a good thing can usurp its very own food supply. Success invariably also breeds eventual demise ... and dangers.
Complicity in this is spread all around. Investors all clamour to buy securities that offer the prospect of outperforming all the rest. Top-performing mutual funds supposedly are rewarded by being most adept at identifying outperforming companies (most of these, measured by market capitalization, being TNCs.) Corporate boards are incentivized to pick executives that will boost profits, and reward them richly for trying. Yet, as rates of return come under pressure due to secular macroeconomic factors -- i.e. progressively widening income stratification, slowing population growth, aging populations, an accumulation of malinvestment and rising debt carry costs ... etc.-- the competition for a finite pool of real profits and wealth intensifies. (Does this sound like conditions today?) It can lead to the high-grading of the ore body, the most flattering definitions of earnings, opportunism, the strategy of industry concentration and other such tactics.
The point we make is that the pursuit of high profits, when at the expense of balanced income distribution between labor and capital or wealth stratification (whether seen in a closed domestic system or one internationally integrated) will eventually impair its hosts if these processes are allowed to carry on to unsustainable extremes. It would be similar to the process that eventually kills the yeast in the wine vat. Yeast happily converts the sugar found in the must into energy and fungal biomass. But the parabolic growth curve of the yeast soon meets up against a hindrance -- the increasing concentration of the prized waste by-product of fermentation, namely alcohol. Eventually, a toxic level of waste kills the golden goose, so to speak.
Shaky Post GFC Premises
Western financial and economic systems, whether euro or US dollar centric, are indeed under increasing structural stress. If a major wealth rebalancing and/or debt reduction does not occur first, the proverbial yeast will succumb to these toxins. In this allegory, this means ever slower economic growth and further government spending imbalances. However, you can survive a set of falling dominos by simply staying ahead of the chain reaction. You can run across the slickest quicksand so long as you do not stop.
In this sense, a greater reliance upon TNC securities is the next tactical step to consider as a tactic to stay ahead of the falling dominos. That said, there will be more opportune times to do so ... not necessarily right now. As mentioned, complacency is again high. We see a number of premises underlying this outlook that are likely to prove false. Consider these two:
1. China's Growth Will Save Us. That China and other emerging countries will pull through the world economy is a comforting thought. We are not so sure about China. Just what has been so outstanding about China recently that is deserving of so much praise? Home to one-fifth of the world's population, this country has virtually immolated itself financially in its quest for geopolitical gain. It has single-handedly produced the most manipulated boondoggle probably in history.
In the space of only two years, it has engineered a gargantuan fiscal stimulus and a loan-induced boom like no other. Since when are such tactics considered the fuel of sustainable long-term growth? Aren't these the same tactics (though arguably much more glacially) that brought the Occidental world to the brink (a.k.a. Global Financial Crisis)? To boot, quoting Simon Johnson, its massive accumulated reserves are the result of "arguably the largest ever sustained intervention in a foreign exchange market." (The Baseline Scenario)
Yet, economists around the world effusively congratulate this nation for having produced above-average economic growth, attributing it to prowess and the innate wealth creation attributes of a fast-financializing emerging economy. Hardly. More likely, China may have shot its wad. We will find out eventually. Like Japan during its heyday of the mid-1980s when this country looked virtually unassailable as a wealth-making machine in real estate and stock market values, China will also again prove that you cannot borrow or inflate your way to sustainable prosperity. We are staying clear of China.
2. Governments Did it Before, Didn't They? Just because government bail-outs and intervention programs bailed out everything from the financial institution to General Motors, and the occasional underwater mortgagee recently, doesn't mean that this insulates investors from further risks in the future. If anything, it is the opposite. It has increased the risk. As mentioned, we are nervously pondering the probabilities of 7 scenarios.
No one would argue that governments can continue to increase their debt loads indefinitely ... except perhaps the policy wonks who always argue that one last, massive, intravenous speed-ball of debt might re-energize the patient out of economic torpor. It has been long recognized by analysts that understand "sustainability" and "causality" that there comes a point where the weight of debt collapses the very pillars of capital markets. And, here the "long-run" and the dawn of the proverbial "tomorrow" has finally arrived for more than a few sovereign nations around the world -- for example Iceland, Greece, Ireland, and possibly Spain.
Amazingly, none of these are non-aligned, third-world countries run by tyrannical kleptocrats. What we see instead are so-called developed, democratic nations, who's citizenry feel it an imposition ... even a Nazi outrage ... that capital markets will wish to discipline them for their profligacy. Harrumph! All of the above, should be taken as a warning; not as an amazement.
The sovereign government bond is increasingly becoming an exercise in treachery and brinksmanship. If the IMF forecasts are right, over the next years the deep blue sea will look better than the devil Occidental government bond. We will therefore leave the sovereign bond to take the hindmost.