Politics: A time for change?
29 March 2017 | Markets and Economy
The election of Donald Trump as president of the United States and the United Kingdom's vote to leave the European Union came as surprises to many. Are these events outliers, or do they portend major shifts in the global order?
Discussing these issues in a recent Vanguard webinar were Jonathan Lemco, PhD, former professor of political science at Johns Hopkins University and senior investment strategist with Vanguard Investment Strategy Group; and Peter Westaway, PhD, former official at the Bank of England, Vanguard's chief economist for Europe and head of our European Investment Strategy Group.
This is an edited transcript of their conversation.
Does the election of Donald Trump reflect a desire for major change in the US?
Jonathan Lemco (senior investment strategist, Vanguard Investment Strategy Group): I think he represents a heartfelt feeling for a significant segment of people in America. Almost 63 million Americans voted for him. It wasn't a majority in the popular vote, or even a plurality, but it was a very big minority.
And who are these people? Well, they come from varying backgrounds and demographics, but what many of them have in common is economic insecurity. They felt threatened by the notion of globalisation; they felt threatened by the perceived prospects of freer trade. Economists will teach us that what's at risk for many of them is less about globalisation and more about massive technological change, but nonetheless it's a broad fear of what trade or immigration can mean for individuals. There was a great deal of that. It's not unlike what we're seeing all over the world, actually.
It's a similar case for Brexit, isn't it? A lot of Britons voted to leave the European Union. Was it all about immigration and globalisation?
Peter Westaway (Vanguard chief economist, Europe): I think in the UK many of the same factors were at work. It's not true that there was a huge populist mandate to leave the EU, as less than 50% of the people actually eligible to vote made that choice, but nevertheless the UK is leaving the EU.
I think anti-globalisation is less of an explicit motivator in the UK. One of the things that really upset people was immigration within the EU – not so much people from outside Europe, but people from Eastern Europe taking some of the lower-paid jobs. That, alongside the concern that somehow Britain has lost sovereignty by giving power away to a supranational organisation. Many people felt they were losing control over what happens in the UK. We're talking about economic factors where things are being decided outside the UK. It was a mixture of hard economics and softer politics.
Jonathan Lemco: Something that's consistent between the US and the UK, and other parts of the world as well, is the growing economic inequality. It's a sense that, yes, the economy is doing somewhat better, but I, as the average middle- or lower-middle-class person, am not actively sharing in the gains of this economic growth. People wonder why they're only now catching up to where they were 10 years ago.
This helps us understand where support for Brexit and populist figures might come from. Politicians in many countries have raised expectations, and in many cases these expectations have not been met sufficiently. Voters are looking elsewhere.
Peter Westaway: Economists have argued for some time that in aggregate, globalisation and migration benefit an economy. But that doesn't mean that those forces can't have negative consequences as well. The same is true for technological progress.
There doesn't seem to have been any real recognition from the powers that be over the last decade that this needed to be addressed. The consequence, I think, is that many people feel they haven't been listened to.
Why is this feeling so pervasive? We're told, for example, that the US and UK are doing well, that we are at or near full employment.
Peter Westaway: It goes back to the point that Jonathan made. If you look at a worker with average income, that person has seen little increase in real income since about 1990. Normally when we see 2% GDP growth per year, we expect individuals' real incomes to grow roughly like that too. The reality is we've had very little income growth in that period, which is astonishing. By contrast, people at the top of the income distribution, who have benefited from the trends towards globalisation and more capital-intensive production, have seen greater income increases. It is a real divergence and people are noticing it.
Jonathan Lemco: That's right. When you survey the world, whether a government's on the left, right or centre, many of these problems of economic inequality are growing. It's less about the particular political philosophy of the country's leadership and more of a worldwide phenomenon.
But the US economy is growing, yes? We've seen steady increases in jobs for many months.
Jonathan Lemco: A lot of them are low-wage jobs that could disappear tomorrow. They're not middle-class jobs for the most part.
Peter Westaway: Another point is that there is less political appetite to use the tax system to offset these forces, whereas in decades gone by you may have seen attempts by governments to shift income towards the people who were losing out. That isn't on the political agenda at the moment. It's politically very difficult to raise taxes to counteract these economic forces.
What next? What does the electorate expect to get from Brexit, and can Prime Minister Theresa May deliver it?
Peter Westaway: Most economists, myself included, think that in the long run Brexit will cause living standards in the UK to fall in terms of GDP. It could be a decline of 5%, it could be 10%; we don't know. As the government appears to be going towards a hard Brexit, it may be towards the more pessimistic end of the spectrum. That doesn't necessarily mean voters are going to be disappointed. One needs to be careful not to be patronising by saying people voted emotionally, but I think there was an emotional element to the Brexit referendum.
The referendum wasn't fought around GDP. It was much more around issues like sovereignty and immigration. In that respect, it may be that some degree of power will indeed be handed back to the UK. But as for the consequences of lower immigration, it's difficult to say. I think about 150,000 people were coming into the UK before, not including EU migrants. The UK government are trying to get that down to 100,000 or less, and that's not going to be an easy target to hit – nor will it necessarily be desirable when if you think about some of the contributions those migrants make, whether they are students, high-skilled workers in the financial services industry, or low-skilled workers in the agricultural sector or the services sector. The government will be aware of these things and will be looking at ways to reduce immigration in such a way that the economy isn't derailed.
In the US, the new administration has an ambitious programme, with deregulation and fiscal reform at the front of the agenda. What is the likelihood of them being delivered?
Jonathan Lemco: With regard to deregulation, the US markets are most focused on things like regulation of the financial services industry under the Dodd-Frank law, especially the big banks. The perception is that if you ease the regulations associated with banking, banks will be freer to do more of what they want to do. Note what happened in the US equity market in the months following the election. The banking sector did well – even better than the amazing returns we saw in the broader markets.
There's also an expectation that deregulation will also make it easier to get a business licence, to do business in general. The United States used to be close to the top in terms of ease of doing business, but it's now falling. It's nowhere close to the top. The sense is if you make it easier to get a licence, if you get rid of red tape, if you unleash the "animal spirits" of American industry, then we'll see meaningful growth in the broader economy, more job growth, et cetera. At least that is the promise.
I think this part of the agenda will wait until 2018–2019. The president can introduce legislation, but Congress is going to play a very important role too, and it's hard to say how it will play out. I personally believe we'll see a relaxation of many regulations, but the extent and the impact remain to be seen. All we do know is that there's a mood for change.
With regard to tax reform, Mr Trump is proposing that corporate tax rates have got to be substantially reduced. At present, US corporations pay a maxmimum 35% tax rate. Relative to other developed economies, that's quite high. What is being discussed now are top rates of 15%, 20%, 25%, take your pick.
Part of this is an effort to encourage US companies that have head offices in places like Dublin for tax reasons to come back home. Also we know that US corporations, particularly the largest ones, are sitting on hundreds of billions of dollars in cash. The thinking here goes that if you reduce their tax load, corporations will have incentives to spend that money in ways that will benefit the broader economy. Again, though, it's hypothetical.
What is the likelihood of a meaningful infrastructure programme for the US?
Jonathan Lemco: I think it's very high, but again many numbers are being thrown about. Mr Trump says he wants to spend $1 trillion, which is a great deal of money. At the low end, it could be as little as $150 billion, in a combination of public and private funds. I think the answer is somewhere in between.
It's certainly true that the United States is desperate for infrastructure building. The thinking is, if you build roads and bridges it will be a boon for construction companies and all sorts of industries that are dependent on building. I think there will be a lot of support from both Democrats and Republicans once they've agreed on how much money should be spent, and on that point there will be controversy.
So the bottom line is, yes, I think in 2018 and 2019, but not before, we will see meaningful legislation regarding deregulation, fiscal reform and infrastructure building, but the numbers at the moment are all over the place. It will be the subject of tough negotiations between the executive and legislative branches of the government.
Let's turn to international trade. What are your expectations for trade between the UK and other countries?
Peter Westaway: That really does remain to be seen. Brexit supporters said that withdrawing from the EU, through which we are currently required to negotiate, will allow us to be more flexible and allow us to strike up better deals with emerging markets, the US, Australia and so on.
The reality is not at all clear. It remains to be seen whether these deals really are going to be easy to strike. It's not going to be quick. Indeed, it's going to take a long time before the UK's relationship with the EU is settled, and until then it's going to be quite difficult for any hard deals to be struck. We might end up with the UK falling back on its World Trade Organisation trading relationships, which are very unfavourable in the first instance.
Most economists that have looked at this say the most important determinant of successful trade is geographical opportunity, and that's why we in the UK currently trade so much with the EU. The idea that you can somehow overturn the rules of economics and trade much more with countries that are farther afield may be a bit fanciful.
Regarding anti-EU sentiment, what are your expectations for the upcoming elections in France and other European countries?
Peter Westaway: There's no question that there's a lot of anti-EU sentiment, but the big question is whether that sentiment, and those votes, will translate into actual economic power.
In France, Marine Le Pen [leader of the right-wing Front National] looks likely to get through to the final round of voting on 7 May. But we've seen Emmanuel Macron [of the Socialists] edge into the lead; opinion polls suggest he could win something like 60% in the final round. Even if François Fillon [of the centre-right Republicans] gets through to the final round against Le Pen, he could win by a large margin.
Of course, polls were similarly confident last year about election results in the US and the UK, and a lot of people ended up with egg on their faces. Even so, I think there's a decent chance that Macron could become president, and far from the EU and the euro unravelling, we would have a very pro-EU, reform-minded government in France, which might, in alliance with Germany, start bringing the EU together more closely.
Could you elaborate a bit on Marine Le Pen?
Peter Westaway: She's far right, and hence she's tapping to the anti-immigration sentiment we've been talking about. But the main reason markets are worried about Le Pen is she wants France to leave the euro and the EU, and if that were to happen, I think the game would be up for both of those institutions.
That's why we're seeing spreads between French and German bonds blowing out to 70 or 80 basis points in recent weeks. It's similar to the risk we saw at the time of the Greek debt crisis – that countries would leave the euro or the EU and the whole edifice would start to unravel. Most people in the market don't think that's going to happen, but it's a risk people pay attention to.
In Germany, which also has a national election this year, radicalism isn't as evident.
Peter Westaway: Indeed. There is an anti-EU party, Alternative für Deutschland, but its support is on a much smaller scale. The interesting development in Germany has been the emergence of the centre-left candidate Martin Schulz [of the Social Democratic Party], and it's increasingly possible that he could unseat Angela Merkel [of the centre-right Christian Democratic Union] as chancellor.
On the face of it, given that Mrs Merkel has been the de facto leader of the EU over the last few years, this would be concerning for pro-Europeans, but at the end of the day I think Schulz is as tied to the European project as Merkel is. I don't think we need to place great significance on a change of government in Germany.
Looking more broadly, could you give an outline of the international picture? Are other countries picking up Donald Trump's agenda?
Jonathan Lemco: Some are, in both the developed and developing worlds. I would stress that it's not about emulating Donald Trump per se. Some call what we're seeing around the world a populist movement. I prefer to think of it as more a nationalist movement, whether of the right or the left.
In Europe, Italy, Poland, and Hungary are good examples. In southeast Asia, the Philippines fits this model very nicely. In Latin America, Venezuela has a very strong nationalist movement.
From a market perspective we should pay close attention to Mexico. It's part of NAFTA [North American Free Trade Agreement], which is central to the trade debate. According to the early polls, the leading candidate in next year's election is Andrés Manuel López Obrador, or AMLO, a leftist former mayor of Mexico City. He's talking about dismantling existing NAFTA provisions, among other anti-free-market proposals. As with Mr Trump, it's all about a call for change. Mexican political elites of the recent past have made many promises and yet have not delivered. So, the thinking goes, why not try someone totally different?
When the existing elite lose credibility, when inequality is growing, when people have aspirations to improve their lives yet don't see a way to do it, when people are feeling very insecure, they seek alternatives. That's what we're seeing now in important parts of the world.
Let's turn to China, where President Xi Jinping seems to be consolidating power.
Jonathan Lemco: That's true. Mr Xi is consolidating power in a way we have not seen in many years. He's discouraged opposition, he's rewarded supporters, and he's bringing to himself powers not just over the national government, but with regard to defence and other important ministries as well.
But this is at a time when GDP growth in China is adequate. They're reporting that it's around 6.5%. Even if you don't trust those numbers, if you look at things like electricity sales, energy, transport and so on, you find roughly 6% growth, which is adequate. It's a soft landing, not a hard landing.
Quality of life for the Chinese people continues to improve. They do have serious problems starting with massive fiscal challenges, particularly private sector and bank debt issues, but broadly speaking the economy continues to do reasonably well.
That means that they're buying goods from all over the emerging-market world as well as from developed economies like Australia and Canada. That's good for the world economy. On balance China is doing better than many of us had thought they would be doing at this point. Key, though, will be an upcoming meeting of China's leaders in the next few months and the new policy proposals they bring forward. Even more important at that meeting will be the question of which rising leaders will take on the most important roles. That to us seems most unclear, and we're watching very carefully.
As we wrap up, what is the best response to all of these political and economic risks for a long-term investor?
Peter Westaway: There are a couple of things that have come through very clearly over the last six to nine months in the light of these political uncertainties.
First is that it is very difficult to predict how political events are going to play out. We've been scarred on this. Many investors have been surprised by events. Perhaps the second thing is even more surprising. Even if you can foresee political events, it's not always easy to predict how markets will respond. The huge rallies in the equity markets after the Brexit vote and the Trump election surprised many people.
The simple conclusion we draw is that any attempt by investors to position their portfolios to get the best out of political events is a fool's errand. Sticking with long-term goals is generally a much better strategy. Stay with that diversified portfolio; don't try and be cute in terms of fiddling with your portfolio in advance, because it's probably just not going to work.
Jonathan Lemco: One lesson international investors learn almost from day one is that there's always going to be a civil war somewhere, an economic reversal somewhere else, or a natural disaster – an earthquake, for example, which may be a drag on a nation's budget. There's always something on the negative side – and indeed, on the positive side too. The markets respond to all kinds of inputs.
It's very hard for us to predict events, and as a consequence, I do believe that it's in the investor's interest, as Peter said, to stay broadly diversified, to have a long-term perspective, to keep your investing costs low. You've heard this from Vanguard in the past, of course, but it remains true.
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