requiem for a jumbo jet

In the third quarter it was reported that Boeing will cease production of the iconic 747 ‘Jumbo Jet’ after the last few orders come off the production line. Designed in the late 1960’s and entering service in 1970, the 747’s large capacity and lower per unit costs democratized trans-continental travel and helped catalyze the second age of globalization.

The first age of globalization occurred from 1870 to 1914 under the aegis of the British empire and the gold standard. A study by the Brookings Institute shows that at its height in 1913 merchandise exports as a percentage of global GDP peaked at 8% and U.S. migrants peaked at 14% of the population while the level of foreign capital invested in developing countries hit its apogee at 32% of GDP in 1914. From that point the U.S. migrant population followed a downward trend to reach just 5% by 1970. The level of merchandise exports also fell and only attained that 1914 level again starting in the year 1971.

The year 1970 was important for another reason. In that year the International Organization for Standardization set the specifications for shipping containers, allowing the launch of the first containership capable of carrying 758 twenty-foot equivalent (‘TEUs’) containers by the NYK shipping line of Japan. Between the Jumbo Jet and containerships trans-continental trade and travel took a quantum leap forward from 1970.

We mustn’t forget lower tariffs. A large driver of the increase in world trade since the Second World War was due to the successive rounds of lower tariffs negotiated through the GATT process (General Agreement on Tariffs and Trade). The average tariff levels for major GATT participants was 22% in 1947, but had fallen to as low as 5% by the end of the Uruguay round in 1994 when the WTO was formed.

Data from the WTO shows that the value of merchandise exports rose from $2 trillion in 1980 to $18 trillion in 2017, a rate of 6.1% growth per year – nearly twice the rate of output growth.

By the year 2008 merchandise exports were nearly 20% of global GDP. By 2015 foreign capital invested in developing countries was once again 30% of GDP and in that same year the migrant share of the U.S. population was back above its 1914 level of 14%.

There is no rule that says these levels mark some kind of upper limit to globalization. But even before the disruptive political events of 2016 the data were showing a slowdown in the momentum of globalization.

According to the UN Conference on Trade and Development (UNCTAD) growth in foreign direct investment had slowed to just 1% per year since the 2008 crisis, down from a rate of growth of 8% in the early 2000’s and over 20% in the 1990’s. The Brookings Institute points out that by 2015 merchandise trade had already fallen nearly 5 percentage points from its 2008 peak to around 15% of GDP. And data from the WTO shows that the ratio of trade growth to output growth had slowed to 1.1 times starting in 2012.

Then the political events of 2016 hit: Brexit and the election of Donald Trump. Both seem to confirm a powerful backlash against globalization.

The theory of free trade that underpinned globalization was premised on the concept of mutual benefit according to Ricardo’s theorem of comparative advantage. But for ever larger segments of society in many developed countries the promised benefits lacked a ‘mutual’ component.

Ricardo’s theorem says that if you can do X better than you can do Z, and there’s a second person who can do Z better than he can do X, but can also do both X and Z better than you can, than an economy should not encourage that second person to do both things. You and he (and society as a whole) will profit more if you each do what you do best. At a country level, even if country A has an absolute cost or production advantage in both products X and Z, it is still better off concentrating on product Z where its relative advantage is highest and letting country B do X. Each country should focus on its highest relative advantage and then engage in trade.

P.J. O’Rourke put it best when he wrote:

The Japanese make better CD players than we do, and they may be able to make better pop music, but we both profit by buying our CDs from Sony and letting Courtney Love tour Japan. And if she stays there, America has a definite advantage.

Ricardo’s theorem is one of the most powerful insights in economics, but the acolytes of comparative advantage routinely gloss over a couple of very important caveats.

According to Professor Charles Murdock, Ricardo’s proof of mutual benefit is conditioned upon 1) capital being loyal to the country of origin and 2) the value of a country’s currency being a function of the relationship between imports and exports.

Given one country’s absolute advantage in production of both X and Z, why wouldn’t the owners of capital, instead of switching resources at home, simply move all production to the country with the absolute advantage? Ricardo’s primary argument was that capitalists are loyal to their home country:

Experience, however, shews that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and intrust himself with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most amount of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.

Recent experience certainly doesn’t shew such a natural disinclination. Today capital is not just disloyal to any one country, it is thoroughly peripatetic.

Murdock also asserts that Ricardo’s analysis was predicated upon the existence of something akin to the gold standard, or what we might refer to today as the ‘market equilibrium’ view of exchange rates. If a persistent trade imbalance were to occur Ricardo recognized that gold or silver money might be transferred from one country to another representing a gain or loss of wealth. Today economists assume that the market will adjust freely-floating fiat currencies to levels that will address persistent imbalances in trade.

But as O’Rourke wrily observed, ‘fiat’ money is derived from the Latin word for being forced to drive a cheap, unreliable car.

Floating exchange rates have been manipulated by mercantilist regimes to prevent any adjustment that would restore balance in the trading relationship. The real loss of wealth caused by persistent deficits shows up not as a transfer of gold or silver, but as rising foreign central bank holdings of U.S. treasuries or other domestic assets.

So the predicates for mutual benefit under Ricardo’s theorem are not in place: capital is not loyal and exchange rates don’t adjust to reduce persistent trade imbalances. Persistent net importers suffer a real loss of wealth.

There is a third and equally powerful criticism of Ricardo’s math. Taking Ricardo’s original example of English manufactured cloth traded for Portuguese wine, economist Joan Robinson pointed out what actually happened to Portugal under this arrangement. In 1974 Robinson wrote:

investment in expanding manufactures leads to technical advance, learning by doing, specialisation of industries and accelerating accumulation, while investment in wine runs up a blind alley into stagnation... for England, exports of cotton cloth led to accumulation, mechanisation and the whole spiralling growth of industrial revolution.

Where one country gains an advantage in manufacturing, the accumulation of industrial plant, machinery, skills, know-how and financial capital have a compounding effect over time. Lessons are learned that can only be gained from actual production (learning by doing). New manufacturing innovations are developed. Technologies are evolved and applied to new products. This is broadly the process of industrialization.

East Asia’s massive gains in manufacturing export share and concomitant levels of wealth since the 1980’s were not the product of free trade policies (at least not when it came to their own markets), but on the protection and nurturing of strategic industries, increasingly advanced levels of manufacturing and a rigorous discipline of export competitiveness.

The pursuit of free trade and globalization over two generations has delivered headline economic growth and created vast amounts of wealth, but the benefits were anything but mutual, certainly not within developed countries. In a number of developed countries it contributed to a loss of manufacturing competitiveness, the offshoring of production to low wage countries, the enormous rise in capital’s share of income, a decline in living standards, grotesque levels of income and wealth inequality, increased levels of debt and financialization of the economy, the perversion of incentives towards borrowing and speculation over thrift and savings and ultimately to political and social polarization.

To suggest that things are coming apart no longer seems like hyperbole. Just look at Twitter. Actually don’t...

Your Stock Portfolio is a Sociopath

None of this would come as a surprise to an observer like Sir Jamie Goldsmith. Goldsmith attempted to warn the developed world prior to the signing of the 1995 GATT accords that led to the creation of the WTO. In an interview with Charlie Rose in November of that year, Goldsmith told Charlie:

All of a sudden, by creating a global marketplace for labor; by creating circumstances where people making the same product, with the same technology and the same capital and the only variant is cost of labor, you are shattering the way you share the value added, and that means that you are destroying the basis on which we have been able to create an equilibrium and have a stable society.

The full interview is remarkably prescient. Goldsmith was no Marxist academic. His German Jewish ancestors rivaled the Rothschilds in the 16th century Frankfurt merchant banking scene and Jamie knew a thing or two about the cutthroat world of modern shareholder capitalism.

The free traders had promised two things: 1) more jobs as American or European firms gained access to new markets overseas for their products, and 2) lower consumer prices. But as Goldsmith rightly points out, even when trading partners play by the rules (and many don’t), given the relative cost of labor, U.S. or European firms won’t export to those markets but will instead open up new factories in those markets to supply them from there. The product will sport an American brand, the company and its executives will share in the enormous profits, but their American workers won’t benefit.

The second promise has been fulfilled. Imports from the developing world have lowered consumer prices and that has been a bonanza for American consumers. At least for those with good paying jobs. Yet we are now faced with the extraordinary situation where inflation is too low. In response the Fed continues to push interest rates lower and print new money resulting in ever higher debt levels and rising asset prices, pouring kerosene on the bonfires of inequality.

Goldsmith cuts to the heart of the matter:

Who benefits from this? Who benefits? I’ll tell you who benefits. Let me give you the facts. The facts are the people who benefit are the major corporations. There is a divorce between the interests of major corporations and of society. When one used to say, and believe, and probably rightly, what is good for General Motors is good for the United States, that is no longer true... Today the transnational corporations have sales of $4.8 trillion, the top 100 alone account for one third of all foreign direct investment. Now how do they operate?

They are no longer linked to the United States, the American ones, or to France or to Great Britain. They operate by farming out their production to whatever country produces the cheapest labor wherever they can get the biggest return on capital and pay the lowest part to labor.

The interests of the major corporations are no longer aligned with the citizens of their respective countries. Those same corporations make up your stock portfolio.

Your equity portfolio is probably a sociopath.

The below chart from the Economic Policy Institute illustrates the extent of this distortion. American labor productivity has continued to increase in line with the long post-WWII trend, but since 1979 compensation for workers has virtually flatlined. The fruits of increased productivity have accrued primarily to owners. Over more than forty years productivity has increased by 70% in real terms, yet workers take home just 16% more than they did in 1979.

Investing in an Era of Industrial Policy

We believe that restoring this link between labor productivity and labor’s share of value added is going to be one of the most important objectives for governments and policymakers in the developed world over the coming decades. We are increasingly of the view that there is a growing political acceptance and desire for some form of industrial policy.

In a recent report by the U.S. Senate Committee on Small Business and Entrepreneurship called Made in China 2025 and the Future of American Industry, the authors argued:

Manufacturing provides better and more stable employment for American workers than financial services. Physical capital deployment makes for more prosperous towns and communities than does digital capital. Knowing how to make a specialized product is a less replicable skill than marketing the product for sale. Research and development expenditures deliver greater benefits to the public than private cost alone justifies. Offshoring jobs to save on labor costs doesn’t often create the equivalent jobs for the workers displaced by it. Worker skills are not easily transferable across industries. Geographic proximity to productive assets like factories increases the prosperity of supplying and local small businesses. In sum, production matters.

The conclusion of the Senate Committee report states that the United States must adopt an industrial policy to rebuild manufacturing capability, particularly in the industries of the future and industries that are essential for national security.

This is not a left versus right debate. As Harvard professor Dani Rodrik states, “industrial policy is now a favored theme at both ends of the political spectrum, from progressives such as Senator Elizabeth Warren to conservatives such as Senator Marco Rubio.”

There are well understood issues with industrial policy such as rent seeking, regulatory capture and the government picking winners and losers, but recent research suggests ways to ameliorate the worst aspects. This new industrial policy might take the form of protection from subsidized foreign competition, tariffs, lower taxes on productive investment, conditioning support on export success, provision of cheap or partially guaranteed loans, risk-sharing, government investment in supporting infrastructure or worker training, or establishment of systems and standards to promote firm competitiveness.

OK, great, but why does any of this matter to investors?

Well, to start with we want our equity portfolio to be someone we would happily invite to dinner. We don’t want our portfolio getting drunk, making a pass at the neighbor’s wife, insulting the cook, kicking the dog and scratching our car on the way out.

More importantly, if some form of new industrial policy is forthcoming, by definition the measure of its success will be the creation of high-paying, highly-skilled jobs, an increase in manufacturing, export competitiveness in a number of key value-added industries and a lower share of value added going to capital.

As an investor in common stocks, that last line should scare you. That means a lower return on capital.

Yet the U.S. and most other developed countries are not command economies. Industrial policy will have to work within broad principles of free, private enterprise and will probably operate by creating incentives for private capital to move into desired activities and disincentives to shift it away from unwanted ones.

For example, according to data from the Bureau of Economic Analysis the average U.S. factory was 16 years old in 1980, but today it is 25 years old. McKinsey Global Institute estimates that upgrading the capital base would require $115 billion in annual investment over the next decade . To get there policymakers will have to reward investment in physical capital and domestic production, while penalizing labor and tax arbitrage and unproductive investment in things like stock buybacks. As the U.S. Senate Committee report concluded:

Free markets can be an unparalleled force for the creation of prosperity and wealth, but they produce in response to the terms they’ve been given. Lately, success by these terms has been defined by the growth of financial services instead of applied research or advanced manufacturing. The conclusion we should draw from this evidence is that we have too often failed to make the well- being of working Americans the terms for market success.

It's not yet clear how this affects our portfolio today, but it could mean that different sectors, industries or even particular firms will see a step change in the rate of return on capital invested, or in the after tax return achieved in the hands of the investor. Analyzing past returns in that sector over the past two decades may not be a good guide to the future.