Machiavellian Investing, Part II – Trends

May 22, 2011

Last week’s blog made the case for Machiavellian investing, outlined its skeptical investing assumptions, and drew the following important generalization.  Corporate management can do great harm, but little good.  When companies succeed, it is not due to dynamic leadership, but to external factors, such as political, and technical trends.  Here is a brief description of the most important trends that I believe will operate over the next several years.

Virtual slave labor

The world population is critically high and growing rapidly in the developing world (especially in India, Southeast Asia, China, North Africa, and the Middle East).   Employment will increase (perhaps dramatically in absolute numbers), but it will not keep pace with exponential population growth. Consequently, labor (skilled and unskilled) is cheap and getting cheaper.

In an area of over population and no employment laws, people must work at wages that are just above subsistence.  They are slightly less well off than slaves, because their employers are not required to feed them through slow periods in the business cycle.  If we over dramatize to have a concrete picture in our mind, we can think of this as virtual slave labor. 

The developed world will benefit.  Instead of importing the slaves (as America did before the Civil War) the developed world can leave the slaves in place and import the goods (both material and information products).  We in the developed world will benefit from cheap products, but we will also see higher unemployment and downward pressure on wages.

Political instability

Virtual slave labor will not be content labor.  The developing world, especially where populations are young, will likely see severe labor and political unrest for two reasons. First, as employment and consumption increase, food, energy, and basic material cost will skyrocket. This will hit the poor hardest.  At the same time, the infrastructure in the developing world will break down under the strain of the environmental effects of growth and the increased demand for infrastructure (such as, road, rail, sewer, and water).  Second, development will be inequitable.  Wealth will stay in families or benefit only the technical elite.  The lower class will sink into meager and arduous poverty. 

Asian nations will have prosperous economies that will function like the southern states in America before the Civil War.  Asia will be the major supplier of items produced by virtual slave labor.  These items will not be products of labor intensive agriculture, such as cotton, but mass produced industrial goods.  The profits will accumulate in the pockets of the ruling elites, but this will not bring political stability unless these national economies can achieve something approaching full employment. 

The Muslim Middle East will have a population that is so large, young, and unemployed that it will probably become chronically unstable.  Africa will likely stay mired in corruption.  Eastern Europe and South America will be better off but will not be as prosperous as either the old western economies or the new virtual slave labor economies.

Europe and North America will become the major consumers of Asian products and major exporters of integrated value added products.  Trade will flow between Asia and the West.

Because they are the beneficiaries of stable political systems and have advanced infrastructures, European and North American economies will likely continue to enjoy political stability.  However, they will probably be stressed by a decline in the standard of living. 

Deregulation

Deregulation will continue to increase in most national economies.  This trend has two causes: (1) the collapse of the Soviet Union as a political force and of Marxism as an intellectual force, (2) big-money politics in the first world. 

The demise of the Soviet Union led to an economic power grab that saw the rise of gangster capitalism in the former communist countries.  In Russia and the old East Block, the largest industries are now in the hands of former communist apparatchiks. 

We have big-money politics in the first world because we have rapidly increasing costs for political campaigns and increasing wealth concentration.  This means that the people who control big money control the U.S. government. These are not the big stockholders, but the people who manage those corporations. In America, both political parties have to beg for handouts from the same few hands. The people handing out the money want deregulation and are likely to continue to get it regardless of which party is in power.  For example, no new regulations were enacted after the Gulf Oil Spill.  Reforms that followed the 2007 financial crisis were superficial and even those reforms are under attack by the new Republican-controlled House.

Hijacking of the Fortune 500

Senior management is running America’s biggest corporations not for the long-term benefit of their shareholders, but for the short-term benefit of themselves. Hijacked corporations include not just those whose management has actually run their companies into the ground, but include most of our large cap companies, which are no longer globally competitive.  High labor costs are partly to blame, for the sorry state of America’s airlines, auto manufacturers, steel producers, and textile companies.  However, all these industries have failed to meet high labor cost with automation, and have failed to make even specialty products that consumers (even U.S. consumers) want to buy.  In addition, U.S. manufacturers are less competitive than some of their European counterparts who have to cope with stronger unions and more socialistic employment laws.

Fraud-plagued U.S. economy

The U.S. economy is plagued by deception and dishonesty at every level. Events leading up to the recent financial crisis illustrate the problem.

The Federal Reserve propped up the U.S. economy during most of the Administration of George W. Bush by keeping interest rates artificially low.  Low interest rates stimulated the housing market and encouraged consumer debt.  Conmen in the real estate and banks began to sell ignorant, envy-driven consumers mortgages that they could not afford.  Banks sold large numbers of bad mortgages to the financial services industry, who created dodgy bonds, collateralized debt obligations (CDOs). 

Regulators did not curb these practices because of the antigovernment stance of the Republican Party.  Republicans have consistently promoted deregulation, opposed new regulations, and underfunded the enforcement of existing regulations.

Standard and Poor’s and other rating agencies, had a massive conflict of interests between honest ratings and high fee income. They chose the fee income and gave even the CDOs backed by many bad mortgages high ratings. 

Finally, financial institutions inflated their fee income by creating structured investment vehicles (SIVs) to buy the CDOs. To finance their purchases, the SIVs borrowed at cheap, short-term rates in the money market and thus pocketed the difference between their borrowing cost and the high yielding CDOs. 

Unfortunately, the SIVs left the institutions vulnerable to a liquidity crisis, but that was a threat to the share holders, not to management, who had already pocketed huge bonuses from stock options that were ultimately based on stock prices that could last only until the inevitable collapse.

The government bailout and stimulus package may have prevented the economy from going into shock, but the prognosis remains bleak.  The mortgage crisis is far from a one-time aberration.  On the contrary, it is typical and the congress has done nothing to curb deceptive financial practices.  Consequently, the U.S. economy is likely to continue to encounter frequent scandals, suffer market crashes, and recessions.

The U.S will also suffer from economic retardation that is the result of inefficient markets.  Each time that Wall Street whips up greed-fueled investment craze, savings flow into bad investments.  During the S & L crisis the bad investments were phony land deals.  In the dot-com crash, they were foolish business ventures like “dog-food.com”.  In the recent crash, they were bad mortgages, CDOs, and SIVs. When these bad investments bust the investment capital becomes, not productive capital or infrastructure, but non-productive junk or toxic assets that are sold at fire sale prices.  Meanwhile, valuable investment opportunities go unfunded.  The only people who profit from these bogus investments are the promoters. 

The hijacking of the Fortune 500 and the fraud plagued economy not only underline the imperative of skeptical investing, but they suggest the need for a a strategy that is actively defensive.

Currency devaluation

High trade and budget deficits are continually undermining the value of the U.S. currency.  Europe runs high budget deficits, but not high trade deficits.  The U.S. has a high trade (current accounts) deficit in part because it is a consumer driven economy and in part because it is now a massive oil importer.

As a result not only the government, but also business and consumers live on borrowed money.  This situation is analogous to removing parts of a building’s foundations and selling them.  We are creating a catastrophe scenario. The U.S. is still the single biggest political, economic, and military power.  We have the world’s largest building.  Consequently, we can borrow and undermine our foundations longer than can anyone else.  However, the longer we do it the greater the risk of a larger currency collapse. 

Fortunately, there are two potent, mitigating factors.

First, devaluation of the U.S. dollar will tend to reduce the real U.S. debt and thus tend to eliminate the causes of devaluation. This is possible because of the unique role of the dollar as the world settlement currency.  Most U.S. debt is denominated in its own currency.  Were it denominated in Euros, real American debt would skyrocket.

Second, dollar devaluation will make U.S. manufactured goods artificially cheep outside the U.S. and will stimulate U.S. exports. 

Because of these mitigating factors, it is in no one’s interest to prop up the U.S. currency and we can expect it to continue to decline.

Free knowledge capital

Knowledge once discovered is free.  Asia will exploit free knowledge capital to develop their economies rapidly.  Therefore, developing economies will compete not just in labor-intensive products, but also in knowledge-intensive products and service.  This will reduce the profitability of U.S. firms that provide consulting services and large-scale, stand-alone, high-tech manufacturing. In these businesses developing economies will be able to leverage free knowledge capital and enjoy a decisive advantage in cheap (virtual slave) labor.

Third world infrastructure problem

Asia, especially India and China, will need to build up their infrastructure in order to get their virtual slave labor products to market.  However, they will not be able to build their infrastructure as did the U.S. with energy from cheap oil.  The U.S. may enjoy a lead in the quality of its transportation, communications, and financial infrastructure for decades.  This lead will provide an advantage to U.S. manufacturers of products that require deep layers of subcontractors an efficient infrastructure to integrate the supply chain.  

Developed economies will specialize in integrated businesses that can thrive where there is a reliable and high speed infrastructure in place.  Developing economies will specialize in isolated businesses that do not depend on the infrastructure and can leverage virtual slave labor.

High velocity trade

Asia and second tier developing economies (such as Eastern Europe and South America) will need to import food, raw materials, and specialty equipment. By specialty equipment, I mean classes of equipment that are necessary for manufacturing and communications, but that developing economies cannot manufacture efficiently.  For example, India may build a highly competitive semiconductor fabricating plant, but it will be most cost effective to buy testing equipment from a supplier in the U.S. or in Europe.  Thus food, raw materials, and specialty equipment, will flow into developing economies, where virtual slave labor will turn them into inexpensive products.

At the same time, in order to maintain an acceptable standard of living, developed economies will have to import the cheap products produced by virtual slave labor.

Expensive energy

Several factors point to much higher energy costs. First, there is substantial risk that the Saudi government has over produced their oil fields, and that Saudi wells are pumping a large fraction of water.  This suggests that the fields are nearing their peak output.  Matthew R. Simmons book, Twilight in the Desert makes a persuasive case for this scenario.

Second, American foreign policy has created a power imbalance in the Middle East by critically weakening Iraq and thereby strengthening Iran.  This will destabilize U.S. allied regimes throughout the region and Saudi in particular. The Saudi government and its oil infrastructure are no longer reliable.

To compound the problem, all regional oil facilities rely heavily on pipelines, which are long, vulnerable, and enticing targets for terrorists.  By a similar logic oil exports from the region depend on ships, which are already targeted by pirates and may also be targets for terrorists.

Iraq may at any time fall into civil war and if it does Iran may make a grab for the Basra oil field.  While American troops are in Iraq, Iran will not be able to move west to seize Basra or to make an alliance with the Shiite government in Syria to attack Israel.  However, once the U.S. pulls out its troops matters may take a dramatic turn for the worse.

Finally, as Asia builds out its infrastructure and its productive capital, it will dramatically increase the demand for oil.

All these factors imply that not only will oil consuming economies have to pay high prices for oil but will have to pay a premium for reliable supplies.

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