Capitalism works because companies are free to enter and leave businesses. Labour is also free to move from one activity to another. Returns on capital, human and physical, are then mean reverting in that more competition and capital enter attractive businesses and vice versa. The modern version involves government regulation and redistribution but the principles are roughly the same. We would argue that the last 20 years has seen too much government and government agency involvement, and it is that encroachment, including too many rounds of quantitative easing, that is a primary cause of the wealth and income inequality which is in turn the source of so much dissatisfaction.
The natural state of affairs in capitalism is for prices to fall. These falls in prices drive companies to create new products and to do existing things better to maintain returns on capital. Falling prices are good for consumers since their incomes go further. The drive to create new products is beneficial for all because the capital expenditure and R&D, to create new products and services, drives employment and productivity. Real, or inflation adjusted, growth in productivity is strongly associated with dividend growth from equities. Investors receive dividends and should like them to grow in real terms. In summary the whole thing hangs together and while it has occasional problems it has created significant advances for everyone. To mis-quote Winston Churchill, “Capitalism is the worst possible system for an economy, apart from all the others”.
At the moment though there is a desire, by central banks, to create inflation as though this is going to suddenly produce stronger, more equitable and sustainable, growth, more wage increases and generally lead to a much improved future. The argument is that higher nominal growth facilitated by this inflation, will allow us to reduce the burden of the debt relative to the size of the economy.
The truth however is that if inflation returns, and there are clear signs that inflation expectations have returned in asset prices in some countries, then we are actually in for a rough time. It is arrogant to assume that exactly the right amount and the right sort of inflation can be achieved through constant tinkering.
Let’s try and bring some myths about inflation down to earth first.
1 - Deflation is bad...
The first myth is that deflation in goods and services prices is bad. Not true. In a paper from economists at the Bank for International Settlements in March 2015, (Borio et al) they conclude that:
“…once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the post war era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.”
There are other papers out there from existing and former BIS staff and, since they are truly independent from central banks, we believe they are having a prod at what they believe is poor policy.
In short, deflation in goods and service prices is not a problem, but asset price deflation is very dangerous and asset bubbles need to be avoided. Guess what endless rounds of QE have done? Yup that’s right – created a variety of asset bubbles which are now dangerous to prick. You couldn’t have got a worse response to the GFC than a decade of zero interest rates and central bank interference in capital market prices! Well done lads, you have brought about the very condition which under no circumstances should you allow to occur. Not only have you allowed it to occur but you were cheerleaders for it. Enjoy academia and the lecture circuit while we pick up the pieces from the results of your unelected experimentation.
2 - Deflation hurt Japan
The second myth concerns deflation and economic performance in Japan. We have endured endless ‘animated discussions’ about how Japan has ‘suffered’ from years of deflation and it has been a lost 25 years since their equity market bubble popped. All they need in Japan is a little more inflation? This is another myth to be dispelled. Japan has actually been one of the better performing economies when adjusted for demography – it’s not the price deflation that is the cause of low levels of nominal economic growth, it is demography. Once you bother to adjust for demography and for inflation, then Japan has been one of the better performing economies. There have been mistakes but it’s not deflation at fault. Do the same adjustment for the UK and Australia and you get a rather less impressive picture of economic performance. Adding to population will of course grow nominal GDP since that is how the statistics are calculated, but in per capita terms it is not quite so good. You need productivity growth. In the immortal words of Michael Caine “Not a lot of people know that”. Using Japan as an example of the perils of deflation is mistaken.
3 - There is no inflation...
The 3rd myth we want to dispel is that there is currently no inflation. There is and worryingly it is in the form of inflation expectations for asset prices, especially in those countries most burdened by debt. Once inflation expectations are rampant then it typically requires a nasty recession to bring them back. The places most indebted are also most likely to have a problem if things go ‘phut’ since their currencies are also likely to come under downward pressure which will trigger further inflation. They really actually do not want inflation expectations to build further! Many official inflation indices exclude property and asset prices and consequently central banks and politicians turn a blind eye to clear evidence that asset bubbles are forming because there is no visible evidence of a problem. It is always ‘someone else’s problem’ and asset bubbles get ignored. Thankfully this time round USA banks are going to be better at self-regulating and we applaud reductions in auto loans as an example but really, you do want your civil servants to be better, smarter, and braver. More of that when we refer to Thomas Hobbes later.
So why do we have a problem with Amazon, or rather the system that has allowed Amazon to flourish? It has been responsible for driving down prices and driving a lot of physical retailers to the brink. It has been a spectacular success and all credit to them. If we believe goods and services deflation is a healthy aspect of capitalism then why does Amazon concern us? “OK”, says almost everyone, “so you like price deflation then why is the price deflation threatened by Amazon so bad in your eyes, and the stock prices of supermarket companies is justifiably walloped when Wholefoods, now an Amazon supermarket, cuts prices?” If Amazon did indeed create a better strategy, then other companies need to learn to fight back or, replace management who can or, be replaced by companies which can. This is true.
We actually think that Amazon is a great business but that its success lies less in its skill and strategy and more in its tax planning and the inadequacies of the current corporation tax system. Amazon pays a fraction of the corporation tax that its competitors pay and consequently has more retained and free cashflow available to reinvest back into a price reduction and volume strategy. Its tax policies are common practice and there are many versions, but it is currently legal and produces remarkably low rates of tax relative to headline rates and to what their competitors pay.
It is the absence of a level and fair playing field that concerns us. Once the high street retailers decide they can’t compete and close, then local municipalities lose their revenues from the tax base and the multiplier effect means other business on the high street suffer too, such as cafes and restaurants. Amazon is the Death Star in retailing propelled by clever tax planning and the tacit support of bureaucrats who need to wake up and be braver in changing and uniformly applying policy.
Until this anomaly in taxation is removed there will be no level playing field and the creative destruction of capitalism will be mostly destruction because of the inability of competing firms to fight back while hampered by unequal taxation and less retained cashflow. A global arbitrage whereby larger companies can pay minimal tax hampers smaller companies which cannot do this and the importance of smaller companies in providing employment is well documented. We are on the way to a monopoly in certain areas of economic activity because our civil servants haven’t woken up to the need to bring accounting and policy into the internet era; if they are awake they aren’t brave enough and they are not performing their part of the bargain in what is known as the Social Contract. This will also be referred to later under Thomas Hobbes.
We would actually prefer all companies paid less tax but if you do want to raise tax from corporate activity, at least make it roughly equal and then companies compete on innovation, service, value for money, and execution of strategy? That is capitalism but what we have right now is biased.
We find it bemusing that Australian investors can be so keen on Socially Responsible Investing Principles (SRI) and see no problem with divesting from coal mines, that provide employment, on the basis that is anti-social, yet remain invested in companies that are frankly anti-social in their active and complex planning to avoid paying what everyone else does. This non-payment of course places a burden on either others to pay more or services to be cut. Does no one else find the Google BHAG “Do no evil” ironic?
Governments love bribing you with your own money and so like raising lots of it. We suspect that governments desperate for revenue, will be looking at non payment of tax in quite a lot of detail. We would prefer they went after companies rather than individuals because we as individuals already pay quite a lot, but that requires bravery. This is a serious risk to Amazon and other companies, and let’s hope our bureaucrats and politicians wake up to the internet era, and to their role in the Social Contract.
So finally, who was this Thomas Hobbes fellow we have referred to above, and what did he say? What is this Social Contract? He was a philosopher who lived in the 1600’s which in the UK was quite a time of political change when the King was beheaded and Parliament declared supreme; to be followed by the restitution of a reduced monarchy. His argument was that individuals should cede some of their rights to a collective, the State, in exchange for sensible regulation and protection. This came to be known as a ‘Social Contract’ and the idea was developed by others such as John Locke and even by a Frenchman Jean Jacques Rousseau in the 1700s. (The latter had the quaint notion that ordinary people didn’t know their real will and required a supreme Legislator to tell them what they really wanted. And there you have the source of the clash between the French and the Brits today over the EU, the EU Commission, and Brexit and what democracy really is!)
The point about the Social Contract is that it is a deal whereby citizens believe that their elected (and unelected) legislators will be looking out for them. No one likes to feel they are stranded at the bottom and especially not that their children will not be better off than they. If this social contract continues inviolate then the system of capitalism will carry on with the occasional hiccup as it has for a few hundred years. If this contact is broken and the bureaucrats stuff up with very poor policy and/or become beholden to the corporations, then we are in for a problem. We fear this contract is at risk and this is the source of the political changes (or ‘populism’ if you are a ‘liberal’ and want to sneer). We believe folks have been quite patient but have finally snapped and that we could see either a return to sensible policies or something more dangerous. We currently look at the capital markets, wealth inequality; economic and social policy and give the bureaucrats and politicians a ‘Fail’ grade. We wish them to stop trying to set asset prices. We wish them to bring corporate regulation and policy up to date so we have a level playing field. We wish them to reduce social engineering and create equal opportunity but not equal outcomes. Once they have done that - we wish they would then make themselves invisible. As Ronald Reagan said “Government isn’t the solution, it’s the problem.”
And that is how we managed to mix our views on myths about deflation, Amazon and Socially Responsible Investing, and some folks that died a few hundred years ago.
Robert is the head of Global Equity Strategies at TAMIM Asset Management and is also the manager of the TAMIM Global Equity High Conviction IMA. Robert has worked as a fund manager in the investment industry for over 30 years. Before API & TAMIM...
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Well said there's hope for us yet when we move away from the herd mentality of growth, growth grwth and that ugly word - globalisation (translate as monopoly for the biggest)