Market Thinking - a view from the equity market

Market Thinking - a view from the equity market

28 September 2017
  • The September option expiry and the end of the quarter has combined to put the usual nerves into markets, exaggerated by the German election and the calling of a snap election in Japan.
  • A slowing China ahead of the 19th Party Congress, the possibility of a tightening Fed/rally in the dollar and general geo-politics have combined to trigger a bout of profit taking.
  • Our investment symposium in London last week addressed a number of long term themes around digital innovation and economic growth, looking at productivity and artificial intelligence, all key when assessing the medium term investment climate. 


The last of the big European elections (for now) occurred this weekend, with the German electorate returning Mrs. Merkel to power, albeit as head of yet another coalition government and one that is seen as less stable than the previous one. While this was not a surprise, the markets will now look through this to a likely Italian election next year and worry about the resurrection of the notion of populism - something that was rather too readily written off after the French election earlier this year. I noted last week that the momentum in the euro appeared to be fading and this may well have seen the near term peak. Meanwhile, although the next big political event for Asia remains the Chinese 19th Party Congress in a little over three weeks’ time, the decision by Japanese Prime Minister Abe to call a snap election will provide another diversion for markets. The most likely rationale will be similar to the last time an early election was called there, in order to push through a consumption tax, the second leg of which has been delayed. If previous tax hikes are any guide, this could have the effect of bringing forward consumption ahead of the hike leaving it depressed immediately after, further obscuring the already blurred Japanese economic data. In China, the impact of politics on activity is likely to be more the reverse; a slowdown ahead of the conference, picking up thereafter.  On the one hand this conference ‘disruption’ will likely lead to a spurt of new activity in the wake of the widely anticipated increase in power of President Xi, while on the other there has undoubtedly been something of a steady as she goes/don’t upset things approach in recent months leading to some slowing of activity. We have already seen some slowing in the traditional smokestack industries to help with ‘blue sky days’, although as we discussed last week, other measures such as gas demand (+30% in August and +12% year to date) as well as industrial production data generally continue to undermine the China bear thesis. Nevertheless, for short term traders, the slowing in the last month or so appears to be triggering some profit taking ‘just in case’ before the end of the quarter. Oil meanwhile seems to be showing some surprising strength – particularly Brent relative to West Texas – hitting a two year high – although it is difficult to see how this is sustained. Net speculative conditions have jumped to the long side – echoing a similar switch in sentiment last October with a misjudged enthusiasm over the Organization of the Petroleum Exporting Countries (OPEC) cuts. 

Last week saw our annual investment symposium in London with the theme of Tomorrow: Augmented. As usual there were a number of interesting panels and keynote speakers, but I would highlight a couple in particular, not least because their presentations raised questions that I believe are worth further consideration by investors. The first was the opening keynote speech by Philipe Aghion, a French economist who now teaches at Harvard. Philippe is famous for his theory on Schumpeterian growth, a belief that the creative destruction advocated by Joseph Schumpeter back in the 1940s is necessary for advanced economies to grow today. He highlighted the difference between what he referred to as ‘catch up growth’ of emerging economies, effectively copying the systems and properties of more advanced economies and innovative growth, which is what leading economies need to foster. The former are more suited to a top-down approach in his view and certainly the recent developments in China would tend to fit his thesis, while the latter need to encourage individual actors to innovate and create. To do so he believes that they need to be aware of the tendency of previous generations of innovators to try and set in place rules and regulations in order to preserve their (new) monopoly and earn excess ‘rents’. As such he pointed out that economies with large amounts of lobbying had less growth than those without, for much of the purpose of the lobbying is to prevent innovation threatening existing profits. He showed a very interesting chart linking the amount spent on lobbying with the Gini coefficient of inequality (see below).

Chart 1: The more lobbying, the higher the inequality

Source: Philippe Aghion, September 2017

From a practical viewpoint, certain economies considered to be developed nevertheless had the opportunity to generate some catch up growth in his opinion (he cited as one example his native France). This is a challenge for Macron, but it occurred to me that the institutional ability to innovate may actually have more than a little to do with the nature of the legal system. To my mind it is no coincidence that countries with the system of common law (essentially “if it is not banned it is permitted”) tend to have a better record on innovation than those operating under Napoleonic or Justinian law (“if it is not permitted it is banned”). The difference is both obvious and crucial; under the latter system, an individual risk taker or entrepreneur has to ask permission of a lawyer or a bureaucrat, who is not a risk taker themselves, to grant permission for them to take a risk. Too often the answer is no, as the person responsible has no upside in granting permission. In fact this could be behind the quote from George W. Bush that ‘the French don’t even have a word for entrepreneur’. Under the common law system, so long as the innovation does not contradict existing legislation it can proceed.

Professor Aghion also pointed out a key problem for economic policy looking at issues such as productivity growth and inflation; that we cannot measure either with any accuracy. If this is indeed the case (and I very much agree with him that it is) then we need to be concerned about policy that pretends that we can. Alan Greenspan raised many of these issues back in the late 1990s under the broader term of hedonics. Unfortunately because of the financial crisis much of his commentary has been subsequently disregarded, which is a great pity as the comments made in the attached link are a pertinent today as they were almost 20 years ago.

Take the current central bank fixation with inflation targeting, whereby interest rates are to be set in response to perceived moves in the observed level of inflation. This approach has been around a long time in places like the UK – albeit not exactly aggressively pursued, probably because systematically targeting an output such as inflation can have unintended consequences. If for example prices rise due to restrictions on supply, or increases in demand in other parts of the world (think oil and commodities in particular), is it sensible that the correct policy should be to increase what is effectively a tax on consumption at home? This is particularly true in developed economies with a large amount of floating rate mortgage debt and was arguably behind the (now widely criticised) moves by Jean Claude Trichet to tighten EU monetary policy back in 2008. Indeed, inflation targeting by monetary authorities is to focus on the symptom rather than monetary cause. If we add in Philippe Aghion’s point that we can’t actually measure the level of inflation properly in any event, this makes the situation even worse. Back in the 1980s we used to focus on money supply growth, which at least had a link between cause and effect - although this too was administered badly in my view, ignoring as it tended to do structural changes in household sector balance sheets, notably mortgage finance in the UK and many of the peripheral European countries. The Bundesbank in particular was obsessed with growth in M3 (the Eurosystem’s broad monetary aggregate), which tended to make monetary conditions there tighter than elsewhere (and the currency stronger) but the general increase in money supply without higher inflation undermined the policy, even though it was missing the fact that there was indeed inflation. It was in house prices, the very place where the increase in the money supply was going to! Post the financial crisis there has been a greater emphasis in some quarters on asset prices, but ironically in getting them higher (a perceived wealth effect) rather than lower. As such this has encouraged loose fiscal policy in areas of lending affecting financial markets themselves.

If we look to today, we see a similar situation of a huge increase in money supply, but no apparent inflation. This is because, rather than increased lending going to the housing market, it has effectively gone into the bond and credit markets, delivering a blow off boost to what has already been one of the longest bull markets in history and badly distorting the behaviour of capital markets. Negative interest rates thanks to quantitative easing (QE) mean that investors are currently paying money to large European corporates to lend to them and said corporates are then using this (more than free money) to buy back their own stock. Thus long term assets are being taken out of circulation, bonds by governments and equities by the companies themselves, leaving long term investors with restricted abilities to match assets and liabilities. None of this is new of course, it is the elephant in the room that is financial repression and QE, but the points that Professor Aghion makes that we cannot even measure the elements on which we are basing policy give important pause for thought.

The third key point that Phillippe Aghion made was that while innovation appears to increase inequality if we focus on the narrow (largely political) concept of the top 1%, for broader measures of inequality such as the Gini coefficient this is not the case. Moreover it also appears to increase social mobility - which is of course linked to the fact that innovation tends to come from ‘outsiders’ while the existing elites try to hold onto power and privilege through legal structures aimed at preserving their monopolies. He contrasted two very different billionaires in Steve Jobs and Carlos Slim. Saying that innovation and technology make people unemployed and only benefit the few ignores the role of the consumer, who tends to derive the most utility from innovation and new developments, not through things we can measure like wages, but through things we can’t easily measure.

Chart 2: Innovation increases returns to the 1% but does not produce inequality generally

Source: Philippe Aighon, September 2017

Matt Brittin from Google was the pre-lunch keynote speaker and he talked in depth about artificial intelligence (AI). As an aside I liked a comment by an earlier panelist that far more relevant right now in practical terms than AI, is IA, or intelligent assistance. This is rather like the subject of co-operative robots (co-bots), robots not to replace humans, but to enhance their efficiency and accuracy, something that the managers of our robotics strategy are always highlighting. Moreover, a lot of this work might be seen as very mundane. For example, the famous AI machine Deep Mind, which just caused a stir by beating a grand master at the previously unbeatable (for a machine) game of GO, was able to use its ‘skills’ to reprogramme all the cooling systems for Google’s server farms and reduce energy usage by 40%.

If data is the new oil, then AI is the new electricity, or so believes futurist Gerd Leonhard, whose keynote speech in the afternoon began with one of my favourite quotes from science fiction writer William Gibson that “The future is already here, it just isn’t evenly distributed”. He used this to illustrate that the ‘near future’ is relatively easy to predict as things are already in place and it is more a question of when the disruption from, say, electric vehicles will happen, rather than if. This is an important part of investment planning as the key part of the value proposition for most stocks is the 3-5 year earnings estimates. Will the company revert to mean or continue to achieve super-normal profits? More important perhaps, what does the consensus think? If as pointed out by Professor Aghion they can lobby to preserve their monopoly then we can predict the earnings more reliably, but equally if competitors can lobby for anti-trust or even for more regulation then the opposite is true. In this way, micro policy is arguably more important than macro policy.

Looking further out is of course even more difficult and in a post conference discussion with a client we touched upon the movie Blade Runner, whose sequel Blade Runner 2049 is due out next month. The original, created in 1982 was set in 2019 and featured the ubiquitous flying cars that have never happened. It also featured what is now termed ‘the curse of Blade Runner’ whereby a number of existing high profile brands featured in the movie – Bell, Pan Am and Atari being the most notable – who were obviously predicted by the writers and producers to still be dominant 37 years hence but in fact collapsed and largely disappeared within a few short years. Some of the technology however, (other than flying cars) was prescient, the scene where the main protagonist Deckard uses voice commands to enhance a picture seemed remarkable at the time, but in a world of digital zooming and Siri/Alexa actually it seems quite normal today. Equally the use of a video phone from the bar looks unremarkable in the context of Skype and FaceTime. Having said that the biggest omission was probably the fact that he used a payphone, the writers having seemingly failed to predict probably the single most important consumer product of the last 35 years, the smart phone. Again, how do we measure the inflation, growth and efficiency of a smartphone?

The central technology of Blade Runner of course was the androids and we are still a long way from achieving anything approaching a ‘replicate’. Developments in household robotics are currently limited to machines that add mobility to their functionality in performing chores. Thus the static ‘robot’ that is a washing machine or dishwasher has evolved to include robotic lawnmowers or window cleaners or floor mops. Meanwhile, the original mobile machine, the automobile, is evolving to become more autonomous in needing less input from the driver. These semi-autonomous cars are more what we would term co-bots, enhancing the human operator rather than fully replacing them, much as computers enhanced basic office productivity for spreadsheets and report writing. On the flight back to Hong Kong I watched an episode of “The Wire” from 2002 and was both amused and shocked to see police reports being written on typewriters with detectives using correction fluid! As far as I can recall in finance we had been writing reports (such as this one) on computers for some time by then, but that was just a future that hadn’t been evenly distributed at that time I guess. Such efficiency enhancements go back to Philippe Aghion’s earlier points about measuring growth, productivity and prices. Extending existing technology from early adopters to the wider population can enhance growth and economic wellbeing in ways that may or may not be captured by the statistics. How do we capture the consumption of movies for example?  Around five or six years ago, I purchased a DVD blu-ray edition of Blade Runner, which cost me around 15 pounds. Today, I could probably buy a copy for around half that or stream it from iTunes for even less. How is that captured in the measurement of inflation? Moreover, it is almost certainly possible to find it online in HD for free, so do we put the price in as zero? One thing for certain is that the fall in the price of me watching Blade Runner is no justification for central banks to try and stimulate household borrowing to reach a target level of inflation!

As with Matt Brittin from Google, Gerd touched upon the concept of robots replacing humans and suggested that they could only replace a certain type of intelligence; they can replace more of the left brain than the right brain. As he put it, technology is not what we seek, but how we seek. Given just how much of what we do is actually at the subconscious level, it stands to reason that if we can’t define it ourselves it will be very hard to code it. We describe our world as a rules based system, but what we define with rules is a very small part of what actually exists. Rather like the concept of chaos theory highlighting that only a very small fraction of what is out there is actually linear, but because that’s the only bit that makes sense to us, we assume it is most of what is there.

This brings us full circle to the question of innovation and my point about common versus Napoleonic law. If our computers are simply enhancing the part of the world that is already ‘permissioned’ then there is always scope to focus on the things that have yet to be defined by lawyers and codified by engineers. In our world, that means that investing algorithms can make us smarter, help us process more information more quickly to replicate things that have been successful in the past but ultimately they are about efficiency and processing that which we ‘know’. As individuals we can find out what ‘the market’ knows more easily. But it doesn’t mean the market is always right in predicting the future, the market prices what it knows and computing simply makes that more efficient. They are a long way off making the sort of judgements needed for assessing longer term growth ideas and making subjective judgements about the future, which brings me back to the subject of recent weeks and the background discussion to much of the conference, the emergence of ‘Internet 2.0’ in the form of the blockchain and the potential disruptions it could bring. The interviewer in the following interview with Vitalik Buterin, the young inventor of Ethereum, describes the blockchain as like a brain virus, once you have started thinking about it, it is difficult to think about anything else. It’s worth the time for a relatively straightforward explanation of the exciting new developments.

Finally it was interesting to notice that having talked to the CLSA Conference in Hong Kong on the Tuesday, Steve Bannon was apparently in Beijing on the Friday talking to Wang Qishan, the close ally of President Xi and his anti-corruption chief. This has fueled speculation that Mr Wang who is widely regarded as the second most powerful man in China after President Xi, will not in fact step down as planned at the upcoming Party Congress, but it also supports the view that I expressed at the time that China and America are working on bi-lateral accommodations over a number of areas. Once the Party Congress is over, I would expect to see more visibility on this new G2 world.

All data sourced by AXA IM as at Thursday 28th September 2017.

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