World unrest can't shake optimism

Every summer for the past several decades I have organized a series of lunches for serious investors who spend their weekends on Eastern Long Island where the temperatures are cooler, the scenery is exceptional and ordinarily intense people are more relaxed.  This year about 90 attended the four lunches on successive August Fridays.  Many of the participants are well known and a number are billionaires.  There are hedge fund managers, corporate leaders, activists, buyout specialists, real estate titans, private equity folk and venture capitalists, providing some diversity in terms of their daily activity.  I am adding newcomers to lower the average age.  The group was correctly positive during the past two summer sessions, so I was curious to see if their mood had changed with so much unrest around the world. 

The answer is that the investors almost universally believed that all of the threatening geopolitical problems would somehow work themselves out favorably without significantly disturbing the United States economy or its financial markets.  There were a few with negative views; one raised the possibility that a nuclear detonation from a satellite over North America could release an electromagnetic pulse which would knock out the electricity grid across the United States, causing famine and chaos.  A minority were cautious because of the escalation of geopolitical conflict.  But the majority held a positive view that was untempered by the fact that the Ukrainian unrest has already had an impact on the economies of Europe, with Italy in recession and Germany, the economic driver of the continent, turning down.  If Europe slips back into a recession, the US economy is surely going to feel it in some way.

An impending war with ISIS?

On specific issues, the biggest worry was that the Islamic State of Iraq and Syria (ISIS) had proven so effective militarily that the US would recommit ground forces in the Middle East, with one participant concluding his remarks by saying he was concerned that within the next 25 years the West would be in a major war with the Islamic world.  Another said that he thought the conflict would occur much sooner.  Several believed, as many do, that Iran must be prevented from becoming a nuclear power because that would unleash an arms race in the Middle East which would destabilize the entire region and send oil prices higher.  Others thought Ukraine was the most serious problem because Putin needed to have a victory there to maintain his status as a world leader and to offset the poor condition of the Russian economy, which has been made worse by the sanctions.  Some were concerned that the Chinese were building their military capability and were determined to assert their fishing rights throughout the South China Sea, in defiance of Japan and the Philippines.  China also wants offshore drilling rights off the coast of Vietnam.  Most of the group thought the conflict between Hamas and Israel would be with us indefinitely, interrupted by periodic cease fires. 

All of these issues did not keep the assembled from believing that the Standard & Poor’s 500 would finish 2014 above 2000.  When this year’s lunches started it was at 1930.  Most also thought real Gross National Product (GDP) growth would be about 3% in the second half of this year, with only a few believing 2% was more likely.  Regarding Fed policy, most expected the Federal Reserve to increase short-term rates before June of 2015 in spite of the recent softness in the economy.  No surprise here.

The harm in lower rates

There was some discussion of the fact that the low level of interest rates was doing more harm than good.  While low rates made borrowing by businesses and real estate developers attractive and increased values of financial assets, those living on retirement incomes were hurt because their savings in short-term fixed income instruments were earning less than 1% rather than 5%.  Given that those people are likely to spend 100% of their current income while the top 10% of income earners spend only a portion of their earnings, consumer purchasing has been slowed by lower interest rates.  Because those in the lunch groups benefit from appreciating investments, they were concerned about rising rates, but one attendee pointed out that it usually takes several increases in short-term rates by the Fed before stocks feel the impact, although the market gets skittish at any sign of Fed tightening.  On longer-term rates the group felt that the 10-year Treasury was more likely to be 2.5% than 3% at year-end.  The flood of liquidity seeking safe-haven investments will keep interest rates low. After all, the German 10-year bond yield is below 1%.  Nobody was particularly worried about inflation becoming a serious problem soon, but several private equity people were seeing some wage pressure which, if it persisted, was likely to have an impact on profit margins.

In spite of low interest rates and increasing demand throughout the recovery, there has not been much construction of new commercial buildings and hotels.  Money is being poured into established real estate in the United States from all over the world.  Retail space has not benefited as much and may be held back for some time because of the impact of the Internet.  House prices are rising faster than the data seem to show but that has not yet stimulated an increase in home building.  There has been a notable improvement, however, in multi-family construction.  Younger people want more flexibility in their lives.  They work late, eat out and come home to sleep, shower and change clothes.  Smaller apartments are fine for them.

Risks to jobs

Most believed that the frenetic merger and acquisition activity going on was primarily strategic and would increase the competitive position of the acquiring companies, but a lot of jobs would be lost in the process as duplicate administrative functions were eliminated.  The most worrisome part of the merger and acquisition discussion was that corporations, in reviewing their options, had collectively decided that combining with a strategically positioned company was better than building a new plant and creating jobs. The dim prospects for revenue growth had a major influence on the decision. The result is likely to lead to more structural unemployment. Activist investors were also viewed positively since they generally targeted inefficiently run companies and tried to improve them. There was concern that activists, once in control, were cutting research and development budgets to increase profitability. Some feared that profit margins were at an all-time high and would revert to the mean, but most thought they would remain at present levels over the near term.

We had a useful discussion about the pace of technological change.  There have been so many significant developments since 1980 that I doubted that the next thirty years could match the last thirty. Those whose work involved leading edge innovation strongly disagreed. They said the entrepreneurial activity in Silicon Valley is huge and start-up companies are developing ideas that will change the world even faster than what we have experienced in the past. We will see big improvements in health care, agricultural production, energy consumption and a number of other areas. There will be collateral damage; some of the innovations will result in the loss of jobs and the demands of the workplace will be greater, requiring more education and quantitative competence. There are 4.6 million jobs open right now in the United States and most of those out of work do not have the skills to fill them.

No appetite for gold

There is also the danger of a cyber-attack affecting our quality of life. Knowledgeable attendees said that we have been both smart and lucky in avoiding a major calamity so far. Hackers, many from Eastern Europe and Asia, are trying to break into our banking system, and the inability to conduct business resulting from a major financial institution being shut down would have an impact on the whole economy. The risk is that the hackers get ahead of the people providing cyber-security, and the possibility of that happening over the next few years is consequential.

As for other asset classes, there was almost no interest in gold, in contrast to past years. Some of the younger investors thought Bitcoin would gain in acceptance.  Commodities generally were uninspiring to the group.  They believed that technology in the use of plant nutrients would increase agricultural output.  Most believed that the price of oil would remain around present levels.  Several trillion dollars had been invested in drilling over the past few years and yet production is flat because Nigeria, Iraq and Libya are producing less.  The US and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand. Natural gas, however, could be under $3 per thousand cubic feet (Mcf) next year.

Europe, China and the US

Looking at markets around the world, there was clearly concern about Europe. The impact of the conflict in Ukraine was becoming evident in Germany; Mario Draghi had to provide more monetary stimulus to prevent Europe from falling back into recession.

Most of the investors were optimistic about China. While the new leadership has been committed to reducing corruption, it will take a long time to implement reforms effectively.  There will be some bank failures, but the government will engage in stimulative measures to keep the economy growing at 7%.  I worry that the increase in debt needed to accomplish that goal is unsustainable.  Those positive on China cite the strong foreign currency reserves as an important safety-net.  There were several constructive views on Japan based on structural change and an abundance of attractive stocks.  Some complained that a lack of a strong corporate governance culture was a drawback.

Almost everyone was pessimistic about the US government’s ability to get anything done for the next two years. The polarization of Congress is too extreme. Some thought the situation might improve if the Republicans were to take control of the Senate in November.  A majority expected that to happen. People were baffled by Obama’s unwillingness to develop relationships with either Democratic or Republican law makers. He seemed to operate as if he has all the good ideas and Congress should follow through based on his wisdom. He did not seem to be willing to persuade anyone to respond to his views, as Lyndon Johnson or Bill Clinton did. The Affordable Care Act was viewed as controversial and not a clear legislative achievement. The group felt they had lived through six years of a failed presidency and the next two years were unlikely to be better. Almost anyone – Democrat or Republican – who took over the office in January 2017 was likely to be an improvement

This is an edited version of an article by Byron Wien. As vice-chairman of Blackstone Advisory Partners, he acts as a senior adviser to both the firm and its clients in analysing economic, social and political trends to assess the direction of financial markets and thus help guide investment and strategic decisions.