Authored by Huw van Steenis via WEForum.com,
The mood at Davos was the most upbeat for over a decade. Synchronous global growth, surging markets, ultra loose monetary policy and some pro-business policies are unleashing animal spirits. In fact, so good was the sentiment some were giddy it may be getting too good.
Whilst Trump, Macron, Modi naturally captured the headlines, it was the nature of the big transitions - the implications of AI, Blockchain, Big Tech power, quantitative tightening, rise of impact investing and the populist revolt against globalisation -which dominated business and investor debates
1 The End of Easy Money?
Central banking is meant to becoming boring - and yet for many investors and financiers, how central banks may tighten financial conditions always came up. As most investors are bullish on public and private equity, they wanted to explore whether there could be a sharper repricing of the expectations on rates. Will $7.3trillions of bonds with negative yields get repriced smoothly? And if the positive correlation that asset prices have had with central bank expansion on the way up, may play outa on the way down as central banks start to reel in their $15trillion expansion. The debate pivoted on 3 issues:
Most chemical reactions can be hastened with an accelerant -and there was much discussion about two possible accelerants: US fiscal policy and the financial channel. The potential impact of US fiscal expansion at a time when the business cycle is already long on historical yardsticks was hotly aired. Economists were the more fearful, US business folk more optimistic - at least til mid 2019. With US two year treasuries touching their highest level in 7 years, the market is starting to factor this in. Looking international as Euro-phoria is breaking out and Chinese growth motors on, the reflexively of US fiscal reform and pro-business agenda to how the Chinese and Europeans may in turn may respond was a rich seam of discussion. It left the bulls hoping above trend growth could improve further and increase the upswing, but also that further yield curve repricing may be likely.
Could the banking system go from having been a huge drag on economies to a catalyst was the other topic. Central banks have played a pivotal role in effecting a far smoother deleveraging of the banking system and private sector. This was the first time in 9 years where I didn"t hear a single critic of the banking system at Davos. So it was a minority who tested whether the banking system could reinforce the cycle on the upside. Whilst there are risks - for instance the ECB is still offering Euro 0.8 trillion of free loans to prompt Eurozone banks to lend - the lacklustre returns on equity for banks means bank credit growth is unlikely to break out vs market based finance.
The second big debate is whither inflation - and why inflation consistently undershot economists’ expectations. A meaningful pick-up in inflation would be very consequential for monetary policy and asset prices given market expectations. Many investors are far more persuaded that technology has crushed inflation, or at least the way inflation is recorded, than most policy makers. The official sector strongly assumes the Philips Curve will, eventually, kick in, and inflation could spike in coming years. This said, those holding that view fail to then explain why Japanese inflation hasn"t followed this logic.
The base case for many investors is that central banks will be slow to tighten given there is a strong asymmetry in payoffs for a central banker. If inflation proves to be 0.5% worse than central bankers predict, they would on the whole be tolerably happy as inflation is below targets and they feel they have the tools to combat this. But if inflation was 0;5% lower, then the tool box is largely used up. History is our database but we have no precedent for money printing on this scale to assess the impact of unwinding a proportion of the $15 trillion os stimulus. Central bankers are all feeling their way through the fog. So it is not surprising that investors still remain doubtful about the pace of official rate rises.
Bottom line, public and private investors I met remained constructive on markets on a 12-24 month basis, but are very sensitive to a much larger repricing of the discount rate or anything which may derail the economy. Bank stocks, as a hedges to higher rates, are also getting more share of voice.
2 Big Tech vs Big Finance?
Bitcoin and blockchain were on everyone’s lips but also on the streets. Digital Davos was entertained at a new “Crypto HQ” cafe and the curiously named “Blockchain Central” (surely an oxymoron?). Whilst most were bullish about the long term potential of Blockchain - even if some financial services bosses struck a note of caution that the technology was still way to slow to deal with most payments or pricing functionality. But bitcoin divided opinions sharply. Tech entrepreneurs were intrigued by the success of bitcoin; central bankers wanted to regulate it whilst some simply saw a speculation. Bob Shiller suggested bitcoin is a "classic investing mistake" and some buyers have been drawn in by "the existential meaninglessness of life when you"re not invested in anything”, according to James Mackintosh of the WSJ.
There has been a sea change in the perceived threat, and opportunity, of technology for financial services in the past yeas at Davos. Near the top of the list is whether Big Tech may encroach into parts of financial services. The success of the Chinese giants in payments gives everyone pause for though. China now has $15 trillion of annual cashless transactions in 2017 - as increase of 10x in only 2 years, and forecasts are for a tripling in the next 3 years.
The battle between every start-up and financial institution comes down to whether the start-up gets distribution before the incumbent gets innovation, as venture capitalist Alex Rampell likes to say. Consultants Oliver Wyman had their WEF panel on what banks learn from Big Tech - particularly around the challenges of innovating at scale. Whilst many banks are spending in scale to harness technology for productivity and customer service, many worried its they were agile enough to respond to disruptive tech change.
And yet none of the Western Big Tech seem to want to become a bank today with all the regulatory hassle and capital that this implies. Instead, talking with several Big Tech bosses, there is a keen ambition is to reduce friction - with a big focus around payments and subscriptions, and a secondary battle ground around warranties and insurance. This is the battle ground where the Big Tech vs Financials Waris likely to be fought.
3 Artificial Intelligence - bigger than Fire or Electricity?
The challenges that AI and robotics pose to businesses was perhaps the single hottest topic of Davos this year. The CEO of Google suggested AI was bigger than fire or electricity in terms of business impact. Such a large number of use cases were presented that the Q&A always turned to the impact on society, the requirement for digital reselling and the role human vs machine. To reassure, one tech CEO said in his view there are four things AI can’t meaningfully do today: creativity, complexity, dexterity or empathy. And many will be delighted to have jobs with less drudge. Put another way, people need to develop soft skills to compete and complement AI.
There was standing room only in the session of Artificial Intelligence in financial services. There was broad consensus that applied machine learning could be very helpful in say fraud detection or targeting prospects. But the use in investing was far more hotly debated. For most, trend following quant hedge funds have a huge opportunity in market making or to ride on trends in markets. To mine the short term market, the machines have an advantage. But the use of AI for long term investing was less obvious: machine learning assumes the future will be the same as the past - which simply is not true. Whether it be the extraordinary value creation in Big tech over the last decade or the implications of the unprecedented great monetary experiment on asset classes. Whilst good investors always learn much from history, it is less obvious whether AI will have an edge on this.
The potential power of AI only served to heighten the case for those calling for regulation of Big Tech. In part from their high market shares: Google drives 89% of internet search; 95% of young adults on the internet use Facebook product whilst Amazon now accounts for 75% of electronic book sales. In part due to concerns on fake news and the impact on democracies. But also from the concerns of the addictive and harmful properties of social media which means to Marc Benioff, CEO Salesforce told CNBC that Facebook should be regulated like a cigarette company. Whilst the markets are not pricing in any major regulatory dislocation, it added support from recent activist investors discussions. For more on this, well worth thumbing Tom Keene’s book of the year The Four by Scott Galloway.
4 Business with a social purpose
Business is more than the bottom line was a popular theme - in response to many societal issues and the rise of impact investing. Bosses were keen to engage on what they could contribute to society and their stakeholders well beyond just financial metrics. But how to do so given the constraints of quarterly earnings was much discussed. As i discussed at last years Davos, initiatives around spelling out a firm’s long term strategy and how it hopes to achieve are key, but how each management team decides the balance of shareholders vs stakeholders is a delicate balance which will vary across firms. Practical and policy steps can be taken to reduce excessive short-termism but there will always be a tension as firms find their feet at the fire of regular reporting.
Activist and engaged investors which can be an important catalyst for change, i’ve argued before. The best academic study on activism suggests activists as a group are not myopic. Harvard’s Lucian Bebchuk and colleagues looked at 2000 interventions by activists which showed that five years after activist intervention, their operating performance was materially improved.That is not to say there aren’t short-term activists, or that all engaged investors proposals are good. There are virtues and vices in short and long-termism. Rather the devil is in the detail and idealism needs to be married with deep pragmatism. But more engaged - impact focussed - investors is likely to be part of the answer.
5 The Populist threat to global trade
With global growth strong and accelerating, the fear of many bosses was not the traditional business cycle checklist, but rather political discontinuities. The threat to global trade through US trade policies, particularly for China, was uppermost in folks minds. The fear is we are moving towards greater protectionism and fragmentation. It was noteworthy how much Modi, Macron and Trudeau argued the benefits of globalisation.
How populism manifests itself in the coming years in trade policy is likely to be a critical drivers of markets. But it is striking how populism or “economic nationalism” in the West has not, on the whole, played out the way many had feared or from the emerging market playbook. It has not proven to be as infectious in Europe as feared. Nor has it proved as inflationary. Political institutions have proven more resilient and trade policies in the main have not yet been touched. This no doubt will be one of the biggest questions for the next 12 months.
Conclusion
No cycle or bull market lasts for ever. Investors will need to weigh risk and reward carefully. But the message from Davos last weekend was optimistic: the growing breadth of global growth, gradualist central bank policies and improving corporate investment are supportive of a longer cycle.
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