International Equities

The Brexit Election: What now for the UK and the EU?

Few political earthquakes come as big as this one. Rarely has one issue so dominated a UK election of this importance and scale.
January 2020

Few political earthquakes come as big as this one. Boris Johnson has defied his critics and skeptics, including many in his own Party, and redrawn the political map of the UK. It is no small triumph that will become part of British folklore. It takes the Conservative electoral support back to the Thatcher years whilst wrenching seats from Labour that had, in many cases, been regarded as untouchable since the 1930s.

The back-biting, blame-game and excuses are all being trotted out by the Labour supporters, but, in our view, the reality is very simple. It was an election about Brexit, but the Labour leader, Jeremy Corbyn, simply refused to say whether he was for or against Britain leaving the EU. Big mistake. The Labour heartland in the north of England voted to leave the EU in the 2016 referendum and the only way they could be certain to have that democratic choice upheld was to vote for the Conservatives. Boris did not equivocate – Get Brexit Done – was his mantra over and over again. Rarely has one issue so dominated an election of this importance and scale.

Many in Britain have simply become fed up with the EU. They have begun to question why the EU exists at all. We hear the refrain: “What’s this nonsense about the EU Parliament oscillating between Brussels and Strasbourg each month? Just imagine the travel costs and the duplication of facilities and infrastructure.” Or: “Why should they be deciding what sort of light bulbs are to be used in the UK or how powerful our vacuum cleaners should be?”

Despite the lofty ideals when all of this began it is now a case of bureaucratic overreach that amounts to the steady erosion of national sovereignty. Boris and his team provided the only assured means of restoring the control to the UK.

We have discussed the EU at length in these pages in the past so we will not go over old ground other than to e-state our view that the departure of the UK from the EU will, in the long-term, be beneficial for the UK. Now (after a year of ‘transitioning’) the UK can strike out as an independent force without the encumbrance of the low-growth bureaucracy that the EU has become.

Will others choose to leave the EU? It could be that Britain represents the first crack in the wall and others may elect the independence route. Certainly, there is evidence of much voter dissatisfaction within Europe. Additionally, the eurozone could, once again, come under pressure. Regular readers will be aware of our view that the fundamental construction of the eurozone is fatally flawed and nothing that has occurred since its creation twenty years ago has caused that view to be shaken.

Trade

It seems that there has been some degree of rapprochement between the US and China over the trade war. Details are still sketchy, but the official release refers to “structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.” None of the additional tariff increases will now take place. This is referred to as Phase-One.

Nevertheless, the US will be maintaining 25 percent tariffs on approximately US $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately US $120 billion of Chinese imports.

We applaud any moves to roll-back the US attack on China’s trade as the initiatives have had a deleterious global impact whilst increasing prices and reducing choice for US consumers. World exports are now exhibiting negative year-on-year growth (in US$ terms) whilst the ratio of trade growth to GDP growth is at the weakest level in years (trade is a strong “puller” of GDP – see chart below).

Global trade is weak relative to historic norms

The Brexit Election - Global trade is weak relative to historical norms

Source: OECD, November 2019

In China both imports and exports have tumbled to negative year-on-year growth. This compares with average annual compound growth of around 13% over the last 30 years.

Another reflection of the trade skirmish is the impact on global industrial production.

Global industrial production growth

The Brexit Election - Global industrial production growth

Source: OECD Economic Outlook, November 2019

The world economy is grinding along slowly enough without additional impediments. China, India and other emerging nations are endeavoring to duplicate the growth and standard-of-living surge that the (now) advanced countries enjoyed over the last 70 years but it is becoming increasingly difficult. They cavil, for example, at the emission targets that the West is endeavoring to impose on them and understandably complain that Europe, the US and others had no limitations when they went all-out for growth after WW2.

The playing field has changed. It is worth a reminder that the wealth of the advanced countries has largely been built on three pillars over the post-WW2 period: rapid population growth (and thence, work-force growth); increasing leverage and, the exploitation of fossil fuels. The first of these three has ended; the second – leverage – can go little further without threatening a financial calamity and the third has quite suddenly morphed into a social and political no-go zone.

Pensions

It has always made sense to us for financial reserves to be accumulated during one’s working life in order to make the post-working life affordable and less government dependent. Statistics indicate that most people have difficulty in saving for their retirement, so the pension mechanism was created to essentially force savings into the system – either through employee or employer contributions or, preferably, both.

Now that we are in an ageing world and the ratio of those who are retired to those still working has reached an all-time high – and, according to UN calculations, is set to almost double in the next 40 years – it is worth reflecting on how well we have saved for the future.

If we take a look at total assets in public and private pension plans as a share of GDP in 2018 the gap between the relatively well funded and the others is striking.

Total assets in funded and private pension arrangements

The Brexit Election - Total assets in funded and private pension arrangements

Source: OECD Global Pension Statistics, November 2019

What immediately stands out is that the biggest ‘wealthy’ countries on the European Continent – Germany, France and Italy – have tiny accumulated retirement reserves. This is because they, and many others, operate (mainly) a pay-as-you -go retirement system (that is, a non-funded system). As the liabilities arise, they are financed out of current revenue. Now this is fine in a fast-growing world with dynamic work-force growth but is anything but fine in an ageing environment with anemic or negative workforce growth – precisely the situation in much of Europe. This means that the pressure on government finances in the years ahead will become progressively worse.

No country can relax as retirement costs will become burdensome everywhere, but it is clear that the countries at the left-hand end of the table are far better off than the others. It is inevitable, nevertheless, that average retirement ages will have to increase in all countries.

The actual dollar volume of accumulated pension reserves is shown below. At US $27.5 trillion the US pension reserves are almost ten times the next biggest – the UK. If you are in the business of managing pension assets it is imperative that you have a foot in the US market.

Total assets in funded and private pension plans

The Brexit Election - Total assets in funded and private pension plans

Source: OECD Global Pension Statistics, November 2019

Australia punches above its weight (relative to its population) because it introduced compulsory employer contributions into superannuation (pension) funds back in 1992. They started at a low level but since 2014 have been set at 9.5% of wages with a planned increase over the next few years to 12%. There is no compulsory employee contribution, but voluntary contributions are encouraged. Despite the 28-year head-start the reserves are still inadequate to meet the retirement income goals of most employees. A full working life-time of robust contributions is required. Interestingly, and disappointingly, the OECD calculates that only 27% of the self-employed in Australia made superannuation contributions in 2016-17. This seems to be a failing in most countries.

If we look at public expenditure on pensions (latest data 2015) it is no coincidence that the countries bearing the greatest financial burden relative to GDP are the same countries with the lowest levels of accumulated reserves. Take a look at the Greek and Italian burdens (see below) – hardly something of which they can be proud when both face a struggle to remain financially viable – and that excludes the pension costs.

Public expenditure on pensions

The Brexit Election - Public expenditure on pensions

Source: OECD Pensions at a glance, November 2019

Of the countries analyzed by the OECD only Sweden and Latvia have 100% participation in funded pension plans. In both cases the participation is based upon mandatory personal contributions. Finland, the Netherlands and Iceland have more than 80% participation based on mandatory and quasi-mandatory contributions. At the other end of the scale we have our old favorite, Greece, with just 1.3% of the working-age population contributing to a pension plan. Portugal and Spain also disappoint with percentages of 2.5% and 3.3% respectively.

Governments everywhere are being urged to expand fiscal deficits in an effort to kick-start the economic growth engine but very few commentators take account of the ageing society and the associated costs – not just the pension burden but the significant increase in outgo that will be required to finance health care. In the US, public and private health expenditure per capita already exceeds US $10,000 and amounts to around 17% of GDP. None of this is going to get any easier.

Public and private expenditure on health

The Brexit Election - Public and private expenditures on health

Source: OECD, July 2019

We are bemused when uproar follows any attempt by an advanced economy to increase its immigrant intake. Bemused because the (generally) young age-profile of the immigrants is precisely what is needed in an aging society. Germany’s controversial intake of over 1 million refugees in recent years should benefit the economy although it is difficult to have that view supported within Germany.

The problem with the ageing society debate is that it circular. Spending needs to increase to fund the additional cost burden imposed by an ageing society, but less money is available due to weakening economic growth – thanks to an ageing society.

That is one conundrum we are unable to solve.

US Profits

The corporate tax cuts initiated by Donald Trump helped to supercharge the stock market as, at a stroke, after-tax profits increased and even if the market price-earnings multiple did not move the share prices jumped. However, the price-earnings ratio did move.

At the depths of market and economic despair – March 2009 – the multiple on the S&P 500 averaged around 11. The Trump corporate tax cut – from 35% to 21% – became law at the end of 2017 by which time the price-earnings ratio on the S&P 500 had leaped all the way to 24. By February 2018 it had increased to 26. Today, the multiple sits around 23 so the improvement has largely been retained.

US - S&P 500 price earnings ratio

The Brexit Election - US SP 500 price earnings ratio

Source: Refinitiv Datastream

The closely-followed stocks in the S&P 500 do not replicate the US corporate sector so when we try to figure out just what is going on we prefer to examine whole-economy profit data produced by the Bureau of Economic Analysis (BEA). To remove the distortion of the variable tax rate we utilize pre-tax profits. The story is shown below.

US - Pre-tax corporate profits

The Brexit Election - US Pre-tax corporate profits

Source: Refinitiv Datastream

The pre-tax profit reality is that by Q3 2019 profits were no higher than Q2 2014 – in other words, no increase in 5 years. Over the same period pre-tax profit margins have weakened by around 9% (source: BEA). This is hardly the profit boom that President Trump expected or has so often spoken (or Tweeted) about.

Our sense is that corporate America is finding life relatively tough. The trade war has increased input costs, the world economy has slowed and full-employment in the US is causing real wages to creep up. Business sales growth is flat over the 12 months to October whilst business inventories (relative to sales) have been increasing since 2013 (source: Datastream).

The hook that the market is hanging on is a revitalization of corporate profits and no weakening in the market multiple. It’s a tenuous hook.

Hong Kong

Media boredom has set in with the Hong Kong ructions so they have largely disappeared from the headlines. It would be an error, however, to believe they are no longer occurring.

The Hong Kong Tourism Board has now announced the popular New Year’s Eve firework display will be cancelled. The Board has also announced that tourism numbers are down 56% in the year to November.

Retail sales, by value (see below), are down 24% in the year to October (3 months moving average).

Hong Kong - Retail Sales Value

Source: Refinitiv Datastream

Hong Kong is now mired in a serious recession. GDP growth turned negative in the September quarter (year-on-year) and a further negative can be expected in the December quarter.

We can’t prophesy where this is heading. To some extent Hong Kong is shooting itself in the foot as Beijing will only put up with so much before it takes control. Is there a sub-plot? 2020 should provide the answers.

The Final Word

So, a new decade is upon us. How did investors fare in the 2010s?

The simple answer is that, in most cases, investors in government bonds, equities and property all did well (expressed in local currencies). Less easy to measure are such things as collectible art, fine jewelry, classic motor vehicles etc. but it appears they also performed well.

The price of gold rose by 37% over the 10 years (in US dollars), providing an annualized return of 3.2%. Better than bank interest and the rate of inflation. In the equity arena the key misses over 10 years were the southern European problem children – Spain, Portugal, Italy and Greece – although, in common with most markets, they performed well in 2019.

The MSCI developed markets ‘World’ price index appreciated at an annualized rate of 7.3% over the decade (measured in US dollars). If dividends are lumped in the annualized return mounts to around 10%. None too shabby.

The decade marked the recovery from the financial and economic crisis of 2007-9 and was accompanied by an unprecedented explosion in central bank balance sheets. Interest rates and bond yields fell, equity and property yields remained low and Wall Street rejoiced. In the US the 10-year government bond yield fell by 200 basis points over the decade – to the current level of around 1.9%. Some other countries were even more dramatic. In Australia, for example, the 10-year yield fell from 5.6% to the current level of around 1.3%. In several markets 10-year yields fell below zero.

The US equity market was the king performer among major equity markets in the decade. It was accompanied by a firm US dollar so that a 100% allocation to the S&P 500 index would have reaped generous rewards.

Measured over the 10 years to the end of 2019, the S&P 500, including dividends reinvested, achieved a compound annualized growth rate of around 13.6%. Inflation averaged a touch under 2% over the period so the real return to investors would have remained comfortably in double digits (source: Datastream). These are extraordinary numbers and approximately double the long-term average real return from the US market (50 or more years).

Real annualized GDP growth in the US over the last decade has amounted to around 2.2%. Thus, the stock market has moved much faster than the underlying economy.

So, what next? The best answer is always: “anything’s possible”, but that’s fairly unhelpful. Being realistic however, it is obvious that it is impossible to repeat the balance sheet expansion by central banks or the massive fall in bond yields. Interest rates are already on the floor, or hovering very close, and debt is stretched in all sectors of the economy.

Our view, therefore, is that investment returns in the next decade will, in most cases, struggle to match those of the last. If world GDP grinds along in low single figures that might be about it for market returns.

On that note we wish all our readers considerable success in picking the winners from the losers in 2020 and beyond.

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Pyrford International Ltd is authorized and regulated by the Financial Conduct Authority, entered on the Financial Services Register under number 122137. In the USA Pyrford is registered as an investment adviser with the Securities and Exchange Commission. In Australia Pyrford is exempt from the requirement to hold a financial services license under the Corporations Act in respect of financial services it provides to wholesale investors in Australia. In Canada Pyrford is registered as a Portfolio Manager in Alberta, British Columbia, Manitoba, Ontario and Quebec. Pyrford is a wholly-owned subsidiary of BMO Financial Group, a company listed on the Toronto Stock Exchange (ticker BMO).

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