The Three Pillars of Long-Term Macro Equity Investing
Why are some countries better than others at creating wealth (and investment returns)?
Why did Thomas Edison thrive in America while his poor-country counterpart did not?
What are the ultimate macro factors that make a country successful and investable in the long run? We consider three pillars of long-term macro equity investing.
Will America’s historic drivers of prosperity remain strong in the future?
This is the second guest post by S. Joseph Karam, who has been an equity portfolio manager for multiple decades at top fund managers such as Kingdon Capital Management, Soros Fund Management, as well as his own fund Seven Global. Joseph is also active in macro analysis, specifically on topics relating to demographics as founder of populyst.net. His twitter is @sami_karam.
“There is no limit to the ingenuity of man if it is properly and vigorously applied under conditions of peace and justice.” ___ Winston Churchill
OUR FIRST POST on the return of macro argued that recent events have re-inserted macro into the investment process of money managers, including equity managers that had tried to avoid thinking about macro since the Global Financial Crisis.
Now we turn to the question of macro context. Specifically, which macro contexts are most likely to generate strong returns for investors? Why was America a better investment destination for many decades? And how likely is it to retain this enviable position?
To start, consider this brief thought experiment. America has had its Thomas Edison, its Henry Ford, its Steve Jobs. But what about other countries or continents? Are there any equivalents to these innovator-entrepreneurs in other countries? How many Thomas Edisons have there been or are there now in Central or South Asia? How many Henry Fords in sub-Saharan Africa, or Steve Jobses in Latin America? How many are in Ukraine or Russia right now? Or in Yemen or Syria?
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It is fair to assume that there are such talents walking around on every continent. But of course, we will never know how many or who they are. As importantly, they will never know about themselves. In most cases, they will never know their own full ability, will lead lives that are dictated and often stunted by their immediate surroundings, and will eventually pass without having contributed their immense talent to the betterment of life or mankind.
Macro Beyond Economics
Most Americans are conversant in at least some of the factors that have allowed a Thomas Edison to flourish in America while his (for example) African counterpart has not. If we list those factors, we cannot just say that it is only America’s laissez-faire economy because there is some form of laissez-faire in many African countries. Nor can we say that it is only literacy because there is high literacy in many non-rich countries. Nor can we say that it is only US demographics because other countries have had similar or more favorable demographics.
But we could say that it is all of these things, and a few more, combined.
Macro, as it relates to investing, is not just about economics, even if all macro factors eventually impact economics. Economic measures such as inflation, interest rates, deficit and surplus etc. are proximate factors. But they often result from more fundamental ultimate factors that are further upstream in the chain of events.
When I travel to a less rich country, I sometimes pause to think what the chief economic concern in America may be at the time. For example, rising mortgage rates or a sagging stock market. Meanwhile, in other countries, the people you interact with may only get six hours of electricity a day or have to worry about clean water or about imminent political or military upheaval.
Seen from this foreign perspective, America’s more immediate worries, critical as they may be, are downstream from a set of factors that are more fundamental to the prosperity of a place at a given time. For the citizen of an emerging market, getting clean water is a proximate macro factor. But for a US citizen, it is one of the ultimate factors that have been banked and that are taken for granted.
So what are these ultimate factors that have made a Thomas Edison successful in America? We place them in three main categories:
Innovation and Productivity
Demographics and Health
Society and Governance
Countries that do well in all three categories tend to prosper. Others that do well in two out of three could manage to prosper. Others that only do well in one category will struggle. And those that lag in all three tend to remain poor.
We may think of these categories and their sub-categories as levers of prosperity.
When possible or when necessary, the market or the government (more often the market) can act upon the necessary levers in order to create wealth (market) or to facilitate the creation of wealth or limit the downside in a crisis (government), and thereby improve general prosperity.
Three Pillars of Macro
Taking each briefly in turn:
Innovation and Productivity: Innovation is clearly the bedrock of sustainable prosperity. Countries that are more innovative are more prosperous, in particular when innovations can generate high-margin revenues (think patented software or pharmaceuticals). Innovation depends not only on individual smarts and hard work but also on networks of similarly minded individuals and on institutions that can support their endeavors, such as universities, think tanks, a broad and deep finance sector, etc. Not all countries can innovate profitably, but all countries can improve productivity for example by raising levels of literacy or by investing in infrastructure. In such places, rising productivity and strong innovation create a self-reinforcing virtuous cycle of capital formation, saving and investment.
Demographics and Health: Contrary to the common adage, demographics on their own are not destiny, but they are an important part of destiny. In particular, a large population can help an innovator create a greater amount of wealth. An iPhone with a market of one billion customers will create more wealth than an iPhone with 100 million customers. However, having a large population obviously does not on its own guarantee a higher level of prosperity. There are many countries with large populations that are struggling to climb the GDP ranks. Generally, the demographic variables that are most conducive to prosperity seem to be 1) a falling dependency ratio combined with 2) a growing population. We note that the dependency ratio is typically defined as the number of dependents aged zero to 14 and over the age of 65, compared with the total population aged 15 to 64. Good health in a society is important for many reasons, not least because it allows greater social and professional interaction and because it leads to longer life spans. In poor countries, it was found that better health care for mothers leads to higher literacy and vice-versa, and that both lead to lower infant mortality and lower fertility. This dynamic can create a demographic dividend under the right conditions.
Society and Governance: All countries have citizens who are potential innovator-entrepreneurs. And many countries have favorable demographics and adequate health. But fewer countries have good society and governance metrics. The mission of ESG investing addresses society and governance questions on a micro or company level but these questions are also critical at the macro level. Corruption is an endemic problem in a large majority of countries and cronyism is present everywhere, and it creates inefficient capital allocation and may disincentivize hard work. Society and governance are about the general context of doing business: an independent judiciary, checks and balances, strong contract law, respect for property rights, political plurality, diversity of opinions, respect for women and minorities, protection of the environment etc. A country that does not have these things can be investable every now and then and can prosper sporadically, but not systematically or in the long run.
These three sets of factors represent a big picture approach to macro but we see them as the pillars or origins of all medium- and longer-term macro considerations.
Examples XYZ and the US
Consider for example a random country XYZ today in South Asia or in sub-Saharan Africa. The odds are that such a country does not have these levers of prosperity. Innovation is weak because networks of knowledge are small or shallow, or because financing is not available, or because capital tends to flee to Europe or the United States and the more educated also tend to emigrate. Productivity is low because literacy is low and infrastructure is non-existent or rare. Demographics could be helpful but the population is booming and the dependency ratio is falling too slowly. Health care may be adequate in parts of the national capital but is generally lacking in most other regions. Corruption is high, and cronyism is routine business. There is no political plurality, no checks and balances, no independent judiciary, no concern for pollution. Why would anyone, local or foreign, invest there?
Ideally, a good rule of thumb for portfolio investing (not direct investing) would be to only invest for the medium or long run in a country where a 21-year-old female can travel safely on her own. This rule seems very restrictive as it would exclude a large number of countries that have been desirable investment destinations in the past. However, countries that do not meet this standard tend to sooner or later disappoint and to blow up. So we may ignore the rule of the 21-year-old female tourist and invest in such places if we recognize that the opportunity is temporary and if we remain close to the exit.
Finally, let us consider macro conditions in the United States. As stated previously, these conditions have been very supportive of wealth creation, and by extension of the equity markets, for several decades.
The US has a wide and deep network of institutions that are oriented towards innovation: research universities, startup hubs, investment firms, and even government agencies. And the stock market, notwithstanding all of its flaws, incentivizes companies to improve their productivity and to do so again and again.
US demographics between 1995 and 2008 had a falling dependency ratio and a growing population, an ideal combination for economic growth. But the dependency ratio has been rising since 2009 and population growth has fallen below 0.5% per year. Health care is too expensive by a factor of 2x or 5x. Until recently, it delivered for a large majority of the population. But the Covid pandemic has highlighted the inadequate health care situation of some minorities. And the suicide epidemic shows that we have neglected mental health for way too long. Both of these factors have resulted in a flattening of life expectancy in the United States while other developed countries still manage to eke some gains.
Finally, the US looks less stable than in the past on society and governance metrics. Corruption and especially cronyism are on the rise. Many people, some of them rich and famous, have ignored laws or pushed them to their limits and have done so with impunity. Political plurality has devolved into extreme polarization. Diversity of opinion is under attack by groups promoting purity of thought, on campus, at work and in politics. There is a greater degree of certainty than is healthy for a society that thrives on risk-taking and on the exchange of ideas.
Individual rights are increasingly compromised. The very meaning of a right has become nebulous in the minds of many. From something that is innate and does not require the work of another, it has turned into something that can be obtained through political pressure and that necessitates the taxing of another.
To sum up the US situation therefore, the main factors that have thawed an erstwhile frozen macro context are: deteriorating demographics, impaired access to health care for many, the mental health crisis, falling longevity, rising corruption and cronyism, impunity for the powerful, polarization and intolerance for divergent points of view etc. These factors slowly disable the country’s levers of prosperity. If they continue to do so, it will be more difficult for the US economy to maintain or to achieve the same level of prosperity as in recent decades. And future Thomas Edisons will lose what has been their safest and most fertile ground in history.
What are the more proximate macro factors that weigh more immediately on the markets? We will discuss in a future post.
The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective.
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