Implications of Populism

Why the anger? It’s the economy

One of the many notable characteristics of this unconventional presidential race is the broad-base populist uprising from both the left and right.  Across the U.S., pockets of workers are fed up with dead-end jobs and stagnant wages.  This anti-trade theme has resonated across both parties and will likely force changes in government policy, no matter who wins the election.

The primary cause of frustration is that workers across the U.S., especially those younger and less skilled, have faced falling standards of living since the Great Recession.  A McKinsey report[ref] Poorer than their parents? A new perspective on income inequality
By Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap, McKinsey Global Institute, July 2016 [/ref] estimates that 81% of the U.S. population experienced flat or falling incomes from 2005 to 2014.  The report shows similar results internationally with over 65% of households in 25 developed economies facing flat or decreased real income during the same time period. This equates to over 540 million people worldwide whose quality of life has not improved, many of whom are voicing their anger in elections.  As we see in the U.S., these concerns are being integrated into both parties’ platforms.  One only needs to look at Britain’s surprise Brexit vote to understand that these ‘new’ political forces should not be taken lightly.

Main concern – Trade

During this presidential campaign, free trade has been attacked from both parties.  In theory, trade improves a country’s wealth and economic growth by allowing them to focus on their production strengths – what are referred to as comparative advantages.  A comparative advantage is the ability of an individual or group to carry out a particular economic activity (such as making a specific product) more efficiently than another activity.  These advantages allow consumers and countries to benefit by paying less for imported goods and by specializing in the export of goods and services where they are more skilled.

However, many believe trade rules are unfair and put local workers at a disadvantage as the global playing field is not level. Their view is that companies importing goods are at a relative advantage; able to hire lower wage workers, operate outside of the labor standards enforced locally, benefit from local government subsidies and operate with little to no environmental restrictions. Of course, not all imports are produced in this manner, but it is understandable to see why anti-trade rhetoric is increasingly popular given the stagnation in quality of life for many people in developed economies.

Unfortunately, economic trade models did not predict the broad-based stagnation of wages seen across developed countries since the early 2000’s.  The culprit could be that countries who run trade deficits (like the U.S.) may not realize the full benefits of trade.  Trade deficits occur when a country imports more goods than it exports.  Offsetting the incoming flow of goods is a corresponding outflow of capital or money which helps keep borrowing costs low (interest rates).  The benefits of lower interest rates are harder to measure, whereas the costs of lost production are economically larger and more readily identified via lost jobs.

However, the economic argument for trade is still sound.  The U.S. successfully exports $1.5 trillion of goods a year which accounts for over 8% of GDP.  Key export industries are machinery, technology, vehicles, aircraft, medical equipment, drugs and chemicals.  As a country we continue to gain wealth from trade both as consumers of less expensive goods and producers of these exports.

Portfolio effects – lower margins and growth; higher volatility and inflation

Over the next few years, we may see politicians enact restrictions on trade in the U.S.   These restrictions could focus on ‘fair’ production, imposing rules on imports or outright protection of U.S. jobs and wages in the hope that this will increase the U.S. worker’s share of the economic pie.  However, rising wages would be a headwind for corporate profit margins and earnings.  Other by-products may be increased inflation (via higher prices) and greater volatility.

Additionally, tit-for-tat trade restrictions could lower global growth with potentially severe consequences for our export industries.  The last time the U.S. enacted increased tariffs was in 1930 when the government passed the Smoot-Hawley Tariff act; trade fell by over 60% and helped to deepen the great depression.

It is clear that neither the diffusive benefits of trade nor the ramifications of a trade war are well understood by the public. Certainly this was on display when the two most popular Google searches in Britain the day after the referendum were “What does it means to leave the EU?” and “What is the EU?” As we have seen in the aftermath of the vote, UK business activity has already shown signs of shrinking and the UKs Purchasing Managers Index (PMI) has fallen to its lowest level since 2009.

Conclusion

The political environment has not soured our view on the relative strength of the U.S. economy, however the clear message from both parties is a desired shift away from globalization and a move towards protectionism. Our biggest concerns are the ramifications of a trade policy misstep.  Voter anger could translate into government policy that threatens our country’s long-term prosperity via trade wars.

These potential changes highlight the importance of having a diversified portfolio.  Short-term periods of volatility could cause investors to deviate from their plan at the worst time.  Those who sold stocks at the bottom of 2008/9 bear market turned a temporary loss into a permanent one.  A well-diversified portfolio should reduce volatility.  Owning a broad basket of investments that behave differently during market cycles attempts to stabilize your portfolio during periods of market downturns.  At Crestwood, we will continue to monitor these events and manage portfolios with an eye towards diversification.

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