A Tale of Two Debts

It is an understatement to say that the weekend of the 5^th July will be a watershed for democracy and politics on both sides of the Channel. It seems that for once since Brexit, Labour might bring a dull calm to British public life, whilst the contagion of political chaos has spread to Paris.

But, as Britain moves left politically and France appears ready to shift rightwards, there is more at stake than politics. Both economies are burdened with huge debt loads, and the ways in which politicians navigate these will determine the geo-economic future of these two UN security council members, and serve as a lesson to other indebted nations.

The economic cases of Britain and France are worthy of attention in at least two respects. The first is their long, often shared economic history. This is the third time that debt levels in both countries have spiked to extreme levels – ominously the previous episodes were the aftermath of the world wars and the period after the Napoleonic Wars. Then, the actions, principally of Pitt the Younger in reforming the economy and financial system meant Britain leapt ahead of France as the power of the 19^th century.

The second is that unlike other high debt economies such as the USA, the French and British economies are barely growing, and appear to have lost the means to do so. Neither do they enjoy the exorbitant privilege that the dollar permits. To that end, the high debt challenge posed to London and Paris is a precarious one, with broad implications. At this stage, at least three of those are clear.

The first of these relates to the ways in which high deficits and debt loads will condition politics. Neither country has much fiscal space and this may well tilt the political debate further towards topics like identity, immigration and values. This has been the case in France (and Italy) for some time.

In Britain, it’s hard not to feel that the recent Labour manifesto is ‘boring, boring’ like Keir Starmer’s favourite football team, reflecting Labour’s desire to tiptoe around the fiscal risks facing Britain. Consistent with this, it would not be a surprise that a prospective Labour government could choose to kick-off its term in office with a focus on institutional reform (Houses of Commons and Lords) and accountability in public life.

The second challenge for new governments in Britain and France will be growth, and this is where the real policy lessons will be learnt. As neither country has the scope to enact a hefty fiscal stimulus, new growth must be endogenous to reforms in both economic systems. In this respect Labour, whose keenness to halt policy uncertainty and desire for foreign investment, are in a much easier place.

In France, the strong likelihood is that the aftermath of the July 7^th vote is accompanied by an economic shock, driven by the entire lack of transparency and credibility that the far-left and far-right bring to economic policy, as well as their antipathy to foreign investors and corporates.

The third question is who might help France and Britain soften the impact of their debt loads. In financial markets there is a growing view that central banks will need to be deployed to recycle the debt loads of the economies they oversee. This is effectively the case in Japan, though the Bank of England may be loath to be seen to cap gilt yields (especially after the Truss debacle) and the ECB’s Governing Council would be badly split on the issue of ‘rescuing’ France.

The more likely avenue is greater collaboration with private investors (private equity, very large pension funds and some sovereign wealth funds) where projects that would ordinarily be funded and run by the state, are instead jointly capitalized and managed by private institutional investors, and some corporations. This is a likely avenue for Britain on green infrastructure and could continue to be the case for France in sectors like artificial intelligence.

As July approaches, investors are already starting to vote, gilts and the pound are calm, but there is a budding crisis in the French bond market.

Michael O’Sullivan is co-author of ‘L’Accord du Peuple’ (Calmann-Levy) and the BBC 4 radio documentary ‘Waking up to World Debt’.

Boring, boring …

One of the more ‘colourful’ habits in the otherwise sensible life of Sir Keir Starmer is that he is an Arsenal supporter, to the extent that he has been quizzed on this in media interviews, and cruelly asked if, like Arsenal, he will ‘bottle’ the premiership. For those non-football fans amongst you, even Arsenal fans like to chant ‘boring, boring..Arsenal’).

Consistent with his devotion to Arsenal, ‘boring, boring’ seems to be the guiding light of Starmer’s policy playbook, launched formally on Thursday in the form of the 23,000-word, 134 page Labour manifesto.

The subset of individuals who peruse political party manifestos is small, and I have heroically dug into it to save readers the trouble. It is worth paying attention to because of the likelihood that Labour will form the next government in the UK.

My first take is that the manifesto is very conservative, with a small ‘c’, in the sense that it emphasises Starmer’s reluctance to change many elements of existing fiscal policy (corporate tax stays at 25% for example) and effectively ventures very little in terms of dramatic policy moves. The headlines stress no ‘austerity’ but it is also hard to see this package producing a durable expansion and return to productivity. The manifesto is accompanied by a laborious compilation of the costs of the Labour programme, the object of which must be to convince markets that Labour are on top of their fiscal ‘game’.

My sense is that the manifesto is characteristic of a party that wants to avoid any kind of policy hiccup before the election, and confirms my sense that the big policy moves, if there are any, will come in the autumn or early 2025, once the government has been bedded in.

On balance it is a manifesto for workers rather than capitalists. The message for workers is that income tax, national insurance contributions and VAT won’t change, but we will see small groups (private equity execs for instance) treated more severely. Also, with the abolition of generous non-dom tax status, the international wealthy will feel the fiscal pain, added to which private education fees will be charged VAT. These measures are expected to raise GBP 6bn, which is small in the context of the economy and deficit. More efficiencies in spending are expected to bring ‘new’ fiscal boost to GBP 8.5bn

From the point of view of companies and investors, there is not yet much here to worry about, but neither much to be excited for.

We also have a little more colour on the landmark innovation of the manifesto, GB Energy – the brainchild of Ed Miliband (one of the most experienced Labour ministers and the most ‘policy ready’ one). GB Energy will be based in Scotland and will invest in renewables (co-invest with the private sector in new green technologies and help scale up startups in segments like solar and wind and help to invest in the installation of green energy infrastructure). It will take on existing state-owned stakes in energy projects like GB Nuclear, and the aim is to capitalise it (likely in 2025 to the tune of GBP 8bn). One element for the energy sector is the flagging in the manifesto of much tougher regulation of the energy sector (in terms of consumer prices).

On healthcare, my first impression is that the improvements flagged for the NHS are not transformative and as a trend, point towards more outsourcing of services, away from hospitals. Finally, there are some interesting comments in the ‘serving the country’ section of the manifesto (reform of the House of Lords and a focus on ethics in public life). My expectation is that Labour will lead with these reforms once in power.

In more detail, I think Labour will win the July 4^th election, their immediate accession to power will be marked by a number of high-profile foreign affairs events (i.e. NATO summit) where Starmer will be able to look ‘presidential’. August will be quiet, and I think the early policy moves will come, as above, in the area of institutional reform.

As we move into the autumn, the focus will turn to economics, and I suspect Labour will lead this with a series of announcements on inward investment. The launch of GB Energy and the national wealth fund will follow.

This manifesto is deliberately ‘boring’ in the sense that it will ease Labour’s passage through the election campaign with little policy friction. Voters’ disdain for the Tories will be enough for Labour to win handsomely, and they may well be helped by the damage that the Reform party will do to the Tories.

With the economy in mind, the absence of chaos that should accompany a Labour government (as opposed to the Tories) should help, and a great deal will depend on international factors. However, the manifesto, in my view, is not a convincing plan in terms of kickstarting productivity in the UK economy. ‘Boring’ will not be enough to satisfy the economic challenge that has been left to Starmer.

Have a great week ahead,

Mike

Re-emerging Risks

I started the week chatting with one of the leading experts on globalisation, or deglobalization’ as it is now. He is a little older than me (he won’t mind me saying) but we share much the same formative experiences, notably an internalising of the way the world worked in the 1990’s and 2000’s.

Back then, the big project was the construction of the euro, to the chorus of debates on global imbalances, fiscal strength (Hans Tietmeyer the former Bundesbank chief would be horrified by Western economic policy today). Elsewhere in the late 1990’s forward guidance of monetary policy consisted of analysing the size of Alan Greenspan’s briefcase and there was a healthy debate on whether central banks should act to burst asset bubbles (today central banks seem to trade those bubbles).

The point of this reminiscence is twofold.

The first is to demonstrate that compared to previous decades (and indeed the long-run of economic history) today’s economic landscape is an aberration, out of kilter with most long-term expectations of how economies behave.

The second point is to illustrate that for very long periods, economies follow regimes of behaviour where very different norms can endure for some time. It is often the correction of these norms that triggers large scale shifts in asset allocation, and volatility. One marked echo of market behaviour today, with the early 2000’s is that the equity risk premium (the benefit of owning equities over bonds) has fallen to its lowest level since 2000, and the performance of smaller companies (to very large ones) is the weakest it has been since 2001.

In general, the 1990’s and 2000’s were periods of rising expectations, whereas today that is not generally the case across countries. A notable feature of the sense that ‘things were on the up’ in the 1990’s was the growth of emerging markets.

Indeed, that period has given us at least two economic miracles – the rise of China as an economic and geostrategic power, and the rise of small, emerging states (Singapore and the Emirates). Neither of these ‘miracles’ is given enough credit by the West for what they have done in such a short space of time.

Specifically, last week was highly instructive in the case of emerging economies – three elections registered high market volatility. Mexico has elected a new president amidst fears that the institutions of the state, and its democracy will be further undermined, combined with a leftward tack on economic policy. The peso reacted badly.

India surprised most commentators (the consensus view on Modi has been far too bullish) by failing to ‘ordain’ Modi’s third term in office with a wholesome majority. While this may be positive from the point of view of India’s democracy, it means that the Modi economic steamroller has less momentum.

Then, the failure of the ANC to regain their majority in South Africa should not be a surprise given the failure of that economy to grow much in the last fifteen years (GDP per capita is at the same level as it was in 2010).

In the cases of India and Mexico, markets appear to be pricing democracy very differently – less of it in Mexico is bad, but the checking of Modi’s near absolute power is also bad (at least for the notion that he could have forced through another round of government spending).

Similar to governments across many emerging countries, investors appear to be torn between the strong man model and the Western oriented rule of law one. This is just one parameter where emerging economy governments will be forced to choose – another is between the US and China, and a further one is how to build an economy (and cities) around new technologies and in a more efficient way.

Of the three countries, South Africa is a depressing warning to others, and I see very little hope that it can put in place a coherent developmental model. What is more reassuring is that there are plenty of examples of countries that have made the journey from emerging markets to stable economies – Poland, the Czech Republic and the Baltic states are good examples, and the cohort of Vietnam, Indonesia, Thailand and Malaysia is on its way. Other emerging economies like Nigeria and Argentina are ‘experimental’.

What is also interesting is that emerging markets show that investors are becoming more sensitive to political and institutional risks (institutional investors in Turkey have all but given up). In this respect the important question is whether they start to more severely price in the macro risks associated with some of the developed economies.

If my notional 1990/2000’s investor was to return to the marketplace today, he/she would be confounded by valuations, low volatility and miniscule credit risk, and might start to believe that markets should treat the developed world economies with the same mercilessness it has shown to emerging markets this week.

Have a great week ahead,

Mike

Treasure Chest

John Maynard Keynes is very well known for his contributions to economics and policy making, but less so for his investing prowess. In the 1920’s Keynes worked as a portfolio manager for two insurance companies and from 1921 to 1946 ran the endowment (the ‘Chest’) for King’s College, Cambridge. Keynes’ investing performance is the subject of some fascinating research by David Chambers and Elroy Dimson.

Early in his career Keynes was what we might call a macro investor, focusing on commodities and foreign exchange. Later, he became more focused on stocks, and from the 1930’s Keynes beat the (stock) market by over 5% per year despite several close shaves with personal bankruptcy.

Viewed from the point of view of today’s stock market, what was unusual about Keynes’ style was that in the 1920’s and 1930’s equities were very much the preserve of retail investors, and not so much institutional managers.

To that end, Chambers and Dimson remark that Keynes’ early allocation to equities was ‘as radical as the much later move to illiquid assets in the late 20th century by Yale’. Unsurprisingly, Keynes’ investing style, which was driven by strong macro-economic views and focused on a few, large and often concentrated positions (if he was investing today he would likely be heavily invested in mega-cap technology stocks) has influenced modern endowment managers, most notably David Swensen of Yale.

Swensen pioneered the move by large US university endowments towards private assets (notably private equity, but also infrastructure and venture), a strategy that has proven remarkably profitable. The top endowments, generally Ivy League schools and other top ranking universities like MIT, have consistently made double digit returns, spurred by annual §private equity returns in the very high teens.

However, the endowment model is coming under scrutiny, partly because some universities have overinvested in private assets at a time when capital distributions have slowed (my former employer Princeton University has effectively invested up to 40% of its portfolio in private equity and venture), and partly because universities themselves have adjusted their expenditure upwards whilst they have enjoyed generous disbursements from performing endowments.

Endowments in the US originally paid 4% of their value to universities annually but in some cases this has risen to 12% (in turn pressuring endowment managers to produce returns). Broadly, disbursements from endowments amount to close to 30% of university budgets with much of it spent on student financial aid. Given that cash distributions from private equity funds have slowed, the knock on to university spending is being felt.

Anyone who has visited a top-flight US university and witnessed the extent to which laboratories, sports facilities and student bursaries are well funded will appreciate the size of university budgets and the role that endowments play. In Europe, only ETH Zurich can match this level of financial backing.

The debate on endowment investing has been enlivened by the publication in February of the 50^th NACUBO Endowment Study. In general, the nearly 700 endowments surveyed in the report hold less fixed income than I would imagine for a typical ‘balanced’ investor, more ‘foreign’ equities than US (this might explain some underperformance), and nearly 50% alternative assets (including a large slug of hedge funds).

Interestingly from the point of Keynes’ active management stance, nearly 50% of US endowments ‘outsourced’ their investment office function. Reflecting this, allocations to private equity, returns and return distribution tend to be better in the larger endowments that have well-equipped investment teams.

In turn this reflects the reality that private equity and venture are two of the asset classes (unlike equity and bond funds) where returns are highly dispersed (i.e. there is a large difference between the best and worst performing funds). As such, finding the best performing funds and gaining access to them has a cost in terms of investment research resources. To this end, I wonder if many universities have really been following the ‘endowment’ model as pioneered by Keynes and Swensen.

Indeed, one of the secrets of the performance of the Yale and Harvard models is that they have very good networks of alumni in the private investment industry, who willingly proffered the best advice and access to their alma mater.

Supporting this theory, Keynes had a similar network of former students around the world (notably in Africa – think mining stocks and commodities) who offered him advice, information and investment opportunities and he also had access to relatively sophisticated telegram technology, so that in some cases he had access to market moving information before others. Further, Keynes was unlike many investors today in that his colleagues at King’s had great faith in him and gave him enormous freedom to pursue his own investment style.

This ‘freedom’ has been all but quashed by benchmarking and technology in public markets (i.e. equity and bond funds) but still exits in private markets – the trick is to find the Keynes like managers.

Have a great week ahead,

Mike