The macro background matters for shareholders. The last four decades have shown a remarkable shift in the balance of power between capital and labor as a result of the decline of unions and the globalization of the economy. At first glance, it seems obvious that this shift in power balance heavily favors capital, and therefore shareholders. But as the following examples demonstrate, the reality is a little more complex than that.
Countries can, if anything, be too friendly to capital. One could argue that this is the case in the U.S., where the growth and stability of the economy is hampered by that. More familiar are situations where countries are too friendly to labor and too hostile to capital, as the example of Argentina shows. Perhaps the most interesting case is that of China, were growth is very rapid, but neither capital returns nor wages are attractive and the country is geared toward maximizing growth, not capital returns.
The more general lesson is that in the presence of a global savings glut, the role of labor not just as a production factor but as the most important source of demand has been underappreciated. In the end, that will benefit capital and, thereby, shareholders as well.
The U.S.
Here we reproduce what is perhaps the most alarming figure for the U.S. economy from an earlier article, analyzing the weakness of the U.S. economic recovery:
Click to enlarge images.
From the early 1970s onward, median wages started to lag productivity growth, something that we think is perhaps the biggest of U.S. economic problems and responsible for much of what went wrong the last decade. Wage earners increasingly had a hard time sharing the benefits of increased wealth production.
Such a situation simply indicates that employees produce more than they'll be able to consume with wages, and increasingly so. If it endures, it would lead to overproduction. This was only prevented, helped by financial regulation and rising house prices, because employees started to borrow more to keep their spending up. But we know how that ended.
The resulting deleveraging of the private sector would have resulted in a 1930s-style depression were it not for some strong monetary and fiscal policy actions. But the fundamental problem hasn't gone away. Productivity is still growing far ahead of median wages, with the overwhelming spoils of it going to profits and hence a small minority of already very rich people.
These arrangements heavily favor capital over labor, and at first sight they seem good for shareholders. Profits have never been higher, and companies sitting on some $5 trillion in cash. There are proposals to make the system even more in favor of capital by reducing taxes. But when Federal tax intake, at just over 15% of GDP, is already historically very low and corporate tax intake at just over 1% of GDP is at an all-time low, we wonder whether doubling down on this model will achieve much, if anything.
The U.S. economy has experienced great instabilities in the last decade and share prices haven't gone anywhere either. Unless the fundamental misalignment between wages and productivity is repaired, these instabilities are unlikely to go away as overproduction is a serious threat at any time. At present, it's only prevented with 8%-plus public sector deficits and near zero interest rates, but those are no long-term solutions either.
You might think that the low wages (in relation to productivity) enable the U.S. to sell more abroad, but this also makes savings very low, which makes that very difficult to achieve. We think ultimately the system has to rebalance, with wages rising hand-in-hand with labor productivity to keep the system in balance.
Argentina
Going from boom to bust has been the story of Argentina over the past century, and it still is. A century ago, it was one of the richest countries in the world, ahead of many European countries. But it was a long slide backward, accelerated by a host of misguided policies like import substitution.
However, the period between the default and the world financial crisis -- that is, from 2002 to 2008 -- the Argentinean economy outperformed nearly all, growing twice as fast as booming Brazil. The way they did that can be described as "redistributive Keynesianism," rebuilding the domestic market by increasing wages and benefits that restored part of the middle and lower middle classes that were wiped out by the economic crisis and the "coralito," the forced "pesofication" of dollar savings that reduced these by two-thirds.
Basically, this model is the opposite from what happened in the U.S., wages growing faster than productivity. But in a Latin American country that is plagued by staggering levels of poverty and inequality, this strategy was very successful, reducing both poverty and inequality substantially while growing the economy at 8%-plus a year.
That was successful, until the authorities overplayed their hand and doubled down on the model for political, rather than economic, reasons. They did little to improve the supply side, simply bowing to their constituency and inflation became a serious problem. Rather than addressing that, they started to doctor the inflation figures from 2007 onward, and things started going from bad to worse (the first successful years are described here, the downfall here).
At present, it's a shambles, despite record soya prices. There is rampant capital flight and, on the black market, the dollar trades at a 40%-plus premium to the official market. The economy has slowed down to a crawl and the government is turning to ever-more desperate measures. That's why we called our second article "Argentina's Wasted Chances," as the downfall wasn't inevitable out of economic logic, although politicians rarely observe economic logic exclusively, if at all.
While the period from 2002 to 2008 was favorable to labor, it did manage to grow the economy rather spectacularly because in the context of a poor, crisis-ravaged, and highly unequal Latin American country, it is a workable model. Brazil's boom is a milder, and (crucially) a more capital-friendly version of it in very similar circumstances (minus the 2002 crisis).
Despite being rather capital-unfriendly, the Argentinean stock market boomed in that period:
China
China is a very interesting case because it's a very fast economy despite being a rather unfriendly environment for capital. According to Jim Chanos, a hedge fund manager with a long-time short position in China, nobody in China earns their cost of capital.
There are two answers to this. As we discussed earlier, John Hempton noted that financial repression basically provides Chinese companies (especially the state-run ones with the good connections to banks) with a negative cost of capital. Banks simply pay a paltry interest rate on deposits and deposit holders have very few places to go with their money.
This provide banks with the possibility to provide companies with cheap loans, with negative real interest rates, so these are not too worried about return of capital. In an extremely interesting expansion on that theme, Izabella Kaminska from the FT Alphaville blog discusses at length a note from another Australian analyst, James White, who is quoted as follows:
Falling or negative returns on capital are a sure sign of economic weakness reflecting the end of a period of over-investment, which is naturally followed by a period of under-investment. This is the business cycle. (Source: FT Alphaville.)
Even with a truly staggering 45% of investment/GDP (while in most countries, capital formation is only around some 15% of GDP), and indeed with very low returns on capital (as one would expect),
investment is driving sustainably higher economic growth. This high investment economy has led to some important outcomes that support the economy's growth model. (Source: FT Alphaville.)
How does such growth dynamic work? We have to quote White at length here:
At a micro-level, capital is often very well protected in Western markets, relative to the other pieces on the board. Property rights are an important part of capitalism. While property rights are evolving in China, there seems less desire to protect intellectual property rights in areas where it may discourage competition. China views competition as an important means of raising living standards by lowering the cost of goods and services. This encouragement of a hyper-competitive industry structure drives innovation through the threat of failure; there is no carrot for innovation. Investors understand that achieving scale and productivity growth is the only way to sustain a profitable business model. By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards. (Source: FT Alphaville.)
We have to say that as economists, we marvel at this stuff. Could it be that the Chinese are cleverer than Jim Chanos and designed (or stumbled upon) a new model for economic growth? As far as we are concerned, the jury is still out. We say that especially with Japan in mind.
Japan, too, had stumbled upon a new growth dynamic in the postwar period up until 1990, a model that vexed many Western specialists, unable to explain how Japan could grow so fast while it seems to violate so many laws of textbook economics. In fact, there was more than one dynamic at work, with companies like Toyota adapting Fordism for a much smaller market, which resulted in a form of very efficient and flexible mass production system.
Japanese companies, like the Chinese now, went for growth and market share rather than profits. Both had a more long-term perspective compared to most Western companies, being financed with "patient" capital. We don't think that the mother of all asset price bubbles was the inevitable outcome of the Japanese model, but it nevertheless happened, and Japan has never really been the same since (although having done a lot better than many think after the bubble burst).
Whether the Chinese model is sustainable depends to a large extent whether they manage to avoid creating a bubble like the Japanese. The jury is still out on that. But in the meantime, while the Chinese model is very good for growth, it isn't so good for shareholders:
At a macro-level, the higher allocation of capital in China has led to falling profit growth and lower returns for capital. Compared to its BRIC (the Brazilian share market, Russia, India and China) counterparts the Shanghai Composite has been staggeringly bad. Since 2004 Brazil is up 167%, Russia 176%, India 197% but China is up just 46%, despite higher growth rates. (Source: FT Alphaville.)
Conclusion
Should shareholders always invest in the country most favorable to capital and always support policies that favor capital over labor? Not always, as based on these examples. In the U.S., policies are very friendly to capital but largely neglect labor, creating an unstable economy in the process. Investors in the SPDR S&P 500 ETF (SPY) have seen little returns for over a decade.
In Argentina, policies are the reverse. For a while (from 2002 to 2008) this worked and the economy boomed, and investors in the index (ARGT) experienced high returns. But they neglected the supply side, and that finally caught up with them.
Or they can go for growth at the cost of capital returns like they do in China. However, despite all the spectacular economic growth, for investors in the Chinese markets (FXI) this hasn't been quite so good.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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