Altus Insight: March, 2017
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: March 31, 2017
FR: Forrest Jinks
RE: Sea Changes
To my way of thinking, the most important thing in investing is the asset I am buying itself. Maybe the opportunity comes because the asset is undervalued compared to current market prices, maybe there is hidden upside that we feel we can unleash using our industry expertise, or maybe the structure of the deal itself provides returns outsized for the risk of the investment. But it all starts with the investment itself. Beyond that we look at larger economic forces, first on a local level – Is this neighborhood increasing in value?, Is there a shortage of industrial space in this market?, etc. -- and then on a broader scale -- How do a change in interest rates impact the returns of this investment?, What are construction cost trends?, etc. Lastly, we look at long term changes to the structure of society as we know it. These are the slow-moving tectonic plate-like shifts that could increase or decrease demand for a product ten, twenty, or thirty years down the road. Demographic changes, such as the baby boomer wave, is such a societal impact. Personal computing is another such an impact.
If we don’t make the appropriate changes to our investment portfolios, these changes can steamroll us; but slowly, so I want to be aware of what can be coming, even if it is far out in the future. What makes noticing, acknowledging, and adjusting our actions to these changes difficult is many of them affect not only our investment portfolio, but also the very paradigms we use to view the world.
There is a such a change that has been brewing for quite some time but has really only manifest itself to the world over the past 12 to 18 months. Despite the many missteps of the actors in the play, the momentum seems to be growing. There has been a huge change in the political structure of the western world that I don’t see as temporary. Since politics determine winners and losers in the economy, and our investments are in the economy, we need to be able to understand the changes that have occurred, and in my opinion, will continue to occur. I will start globally and then bring it back to the USA, since that is where I assume most of the investments of readers of Altus Insight are located.
The headlines after the Dutch election earlier this month all blared the defeat of populist Geert Wilders of the Dutch Freedom Party (PVV). For those unfamiliar, Mr. Wilders ran on a platform of anti-EU, anti-immigration, and anti-ruling class. It is true, Mr. Wilders did not win the election, and I think most of the populations of the western world are thankful of this fact. However, the positive headlines gloss over the fact that his party secured the second highest number of seats in the Dutch Parliament, an event unfathomable even a couple years ago.
Going back farther, Italian Prime Minister Matteo Renzi, a member of the political establishment, was destroyed in a referendum held in early December of last year. The winners in the referendum? Populist (and even fascist) parties such as the 5 Star Movement.
In France, populist National Front Party leader Marine Le Pen is expected to win the first round of the upcoming French presidential election after finishing with only 18% of the vote in the 2012 elections (though she still appears to be a long shot to win the run off).
This, of course, is after a 2016 in which British voters bucked the establishment in voting to leave the European Union. Last year also saw the election of Rodrigo Duterte in the Philippines who, while not an outsider to politics, won considerable popularity by saying things most establishment politicians would never dare to say, and running on a platform planning to do things most establishment politicians would never dare to do.
Geopolitical Futures, a geopolitical consulting firm I have referenced before, released an article in November discussing this phenomena. The article’s key point was that left and right are no longer the true issue, it is globalism and nationalism. However, in Europe, globalism focuses on the European Union while nationalism isn’t necessarily tied to national borders, but rather historical “tribes” that may exist within borders or across borders. People tend to associate with others that think like them, talk like them, live like them, etc. Historically, this was the tribe, and pride in the tribe was needed for the survival and growth of the tribe. This tribalism/nationalism became an issue once the tight-knit groups had to survive in and around other tight-knit groups, and cooperate with those groups. This can be workable over long periods of time, but occasionally, and more often during time of economic disruption, some members of these now larger groups will revert back to the original tribal/national identities for support and protection; if psychological more than anything else. An extreme example was the Croatian/Bosnian conflict in the ‘90s. More recently, this is evidenced in Brexit, Catalonia and Scotland’s ongoing efforts to gain independence from Spain and Great Britain respectively, and numerous other cases of growing political momentum behind various European Union withdrawal efforts. (As an aside, nationalism shouldn’t be viewed as all bad. Liberal democracies only exist because of nationalism and the willingness to rise up again the ruling royalty – think the French or American Revolutions.)
Now, bringing us back to the United States: I don’t believe the US follows that same rising nationalism script. Someone living in the U.S. may know they have Spanish heritage, and they may even know they have Catalonian heritage, but they will also know they have Irish heritage…or German, or English, or any other number of nationality heritages. It is hard to identify with a particular “tribe” when most of our backgrounds are so diluted across so many heritages/tribes. The United States is defined instead by its fierce individualism. The growing nationalism isn’t due to groups of people running towards each other, but rather many individuals running away from those who would tell them what to do. Call it a desire for self-governance, as part of a larger desire of self-determination.
This being said, the actions taken in the US and in Europe end up being essentially the same. Britain didn’t want Brussels dictating its immigration policy and continuing to pile on regulations. Catalonia doesn’t want Madrid to syphon tax dollars to be redistributed elsewhere without benefit to Catalonia. Greeks are tired of austerity for the benefit of German banks. And a large portion of the US population is tired of being preached to by the UN, IMF and World Bank. Without acknowledgement on the part of the ruling elite of the underlying issues facing ordinary citizens, we should expect to see more outsiders like Donald Trump and Marie Le Pen come to prominence and have a greater voice in the direction of the society in which their respective groups/tribes reside.
Robert Shiller, the well-known professor of economics from Yale University (and referenced previously as the author of the Case-Shiller Index – used to track home prices – and the Shiller P-E ratio – inflation- adjusted measurement for the pricing of public companies) posted an interesting article on the editorial website, Project Syndicate. The key to the article for me is the thought that despite many of Donald Trump’s campaign promises being beneficial to the large companies and the rich, and very little promised in the way of handouts to those that aren’t, a large part of his voting support came from those who feel economically powerless. On the surface this doesn’t make sense. Shiller captures why:
“Those on the downside of rising economic inequality generally do not want government policies that look like handouts. They typically do not want the government to make the tax system more progressive, to impose punishing taxes on the rich, in order to give the money to them. Redistribution feels demeaning. It feels like being labeled a failure. It feels unstable. It feels like being trapped in a relationship of dependency, one that might collapse at any moment.
The desperately poor may accept handouts, because they feel they have to. For those who consider themselves at least middle class, however, anything that smacks of a handout is not desired. Instead, they want their economic power back. They want to be in control of their economic lives.”
Once read, this revelation makes perfect sense. I know I don’t want handouts, but I do want a level playing field. While questions abound about exactly how level Trump’s playing field will be (as discussed in the December Altus Insight here), he was able to sell the idea that not only would the playing field be level, but the entire field would ascend to new heights. This is a completely different message than the status quo message of redistribution that has been so common. It also tells us that Trump may have the ability to push policy changes that would have previously been considered impossible. (The full Shiller article can be found here.)
Awareness of the sea change is great, but what can we do about it from an investment standpoint? For one, we can make a guess where the political party platforms fall out, and who ends up supporting which new party and platform. We can guess whether the thought proposed by Shiller has legs, and large amounts of the populace will be changing their voting habits, not just within the (new) political party framework (we will likely discuss this dynamic in a future Insight), but even within issues they would have previously held as core beliefs. From our guesswork, we can extrapolate the industries and inter-US geographies that will be winners and losers according to that particular guess. If we guess right, we can do very well for ourselves, but if we guess wrong, we can likewise get hammered.
Many money managers I’ve read recently have been increasingly focused on portfolio construction around passive hedging to guard against an unpredictable future versus depending on making the correct guess of what might occur. This isn’t too unlike the traditional financial planners’ advice to diversify, except with the acknowledgement that diversifying across correlated investment classes is of little benefit. These more intricate portfolio construction suggestions, though highly subjective depending on individuals’ goals and personalities, focus more on investment length, real cash production (adjusted for inflation), and how the portfolio might react against any number of seemingly extreme economic scenarios. They would say to be very short and very liquid, or be very long and able to ride out economic disruption. Make sure you understand the convexity in your portfolio, or better yet, structure your portfolio for positive convexity (for our purposes, we will define convexity as exposure to interest rates in a non-linear fashion). Focus on cash producing assets, but only if those assets, and the cash produced by those assets, can/will withstand economic shock, and preferably adjust favorably to changes within the interest rate environment. In addition, many of these professionals are also saying to increase the amount of a portfolio with direct exposure to real asset ownership. This is obviously self-serving for Altus, as a source of real estate and real estate debt instruments for investors, so take the inclusion of that last piece of advice with a grain of salt.
Will this changed definition of portfolio construction work? Only time will tell, but with an eye on capital preservation, cash flow, and long term wealth accumulation, it seems to make a great deal of sense.