Investors massively underestimate the importance of political economy. Our financial institutions rely on our political structures, and our political framework only really works because of certain underlying economic relationships. Separating the two realms is impossible. Think about how critical the rule of law, the inviolability of contracts, individual liberty, and an independent judiciary are for the functioning of capital markets. And in the other direction, private property, commerce, and entrepreneurship create the foundations for the liberal political order, meaning the representative democracies of the past two centuries.
Adam Smith might be considered the first modern “political economist.” Karl Marx wrote about political economy in a highly polemical fashion, but in terms of appreciating the interdependence of the two spheres, he was spot on. Friedrich Hayek, Milton Friedman, among many others, continued to intertwine politics and economics in their analysis. In recent decades, Francis Fukuyama has been identified broadly with the market-friendly political paradigm which dominated until just a few years ago. The point here is not to review the history of political economy, but to remind investors who don’t often think of the broader context of investing that political economy is that broader context and that it matters a lot. Finance professionals and politicians tend to “stay in their lane” and thus poorly understand how the highway system works. Moreover, most individuals within a political economy mode naturally assume it will continue in perpetuity. While modes can last for many years, decades or even centuries, they can and do change. We’re in the process of one of those changes.
Why should political economy matter to market participants? Because we are now exiting a period that has been labelled—for better or worse—the “global neo-liberal order” or the epoch of “neo-liberalism.” While there is no canonical definition of neo-liberalism, and the term itself has a long and somewhat convoluted history, there is some consensus that it became dominant in the 1980s and has been characterized by the globalization of trade, labor, and market relationships. It has benefitted from widespread deregulation of financial activity and the privileging of market relationships and market-generated equilibria. The neo-liberal paradigm was bolstered by a generally benign geo-political environment—the Soviet Union had gone away, China had not yet arrived as a political superpower, and US hegemony was clear. Within the US, there was a broad consensus among politicians and business leaders that all of the above developments were in our collective interest. While the decline in interest rates starting in the 1980s in the US is not usually associated with the advance of neo-liberalism, from a more narrowly finance-focused perspective, falling “risk-free” rates clearly lubricated the mechanical parts of the neo-liberal engine.
So what did neo-liberalism bring to the art and practice of stock market investing in the United States? Very high returns. That might sound good, but critics of the development have labelled it the “financialization” of investment. That structural goosing of returns violated Miller & Modigliani’s still wise 1958 invocation that the enterprise value of an investment should depend on the underlying productivity of the assets, not how they are packaged. Financialization brought a lot of fancy packaging. Declining interest rates and the securities law change in 1982 opening the floodgates to buybacks created a straight-forward path for company executives to boost equity returns via leverage. As investors shifted their gaze from cash dividends to screen share prices, every effort was made to boost the latter. Compensation based on share prices rather than dividends paid ensured that executives were incentivized to focus on the stock, not the underly cashflows. New valuation markers such as EBITDA and Adjusted EPS further attenuated the role of cash in the valuation exercise. As Thomas Piketty loudly objected in 2014,[1] returns on “capital” had become higher than underlying economic growth. At least in the case of the US stock market, the leger de main had worked. Growing economic inequality became visible during the process. The gutting of the US middle class and a national de-industrialization have become more obvious in retrospect.
And then came Donald Trump, China and Covid, and Russia invading Ukraine. They did not cause the end of the global neo-liberal order, but they reflected its demise. Visibly from 2016 onward, the consensus in the US evaporated, not only about particular economic or political models, but even about the need to have a consensus at all. A few years later, almost overnight, having tight global supply chains and outsourcing manufacturing to China no longer seemed to be a great idea. And most recently, Russia’s invasion of Ukraine has shattered the Fukuyama-esque notion of the liberal ideal prevailing globally. The return of non-zero interest rates (and therefore genuine investment risk), most evident in 2022, seized up the formerly well-lubricated neo-liberal financial markets.
So where are we heading? It is too early to say for sure, but it is clear enough that the pendulum had swung far in the direction of “capital.” It is now moving back. It isn’t necessarily to “labor,” from a prior paradigm, but it is retreating from the unfettered advance of capital of the past decades. Milton Friedman’s shareholder capitalism is being challenged by a broader European stakeholder approach taking into account factors beyond just capital returns. On-shoring, friend-shoring, and near-shoring mean the model of extreme globalization will have to be altered. Expect to see more local and national, and less global. Expect more regulation rather than less regulation. The only point of agreement of both political parties in the US is their axe to grind against the tech companies that led the neo-liberal stock market for decades. Many other elements of the incoming political economy remain to be determined.
Of those elements, the politics in the US may end up being the most important one for investors. The utter lack of trust in our political institutions right now runs the risk of bleeding over into the investment realm. What’s the difference between, say, Venezuela and Argentina, on one hand, and Switzerland, on the other? The former have vibrant populations, natural resources, and geography. The latter has …. beautiful mountains and a history of fine watchmaking. Yet, assets in the former countries trade at single digit “multiples,” if that, while assets associated with Switzerland trade at sky-high premiums, and have for decades. Why? Because of the trust in the institutions and practices underpinning those assets. US assets trade with a “trust factor” properly closer to that of Switzerland. The US benefits from its status as global hegemon, reserve currency provider, and all the other advantages of incumbency. But given the current precarious state of governance in the US, that trust and those benefits are very much at risk. In short, our political economy matters, far more than investors appreciate.
The trust factor in the new political economy paradigm will play out over years if not decades. In the meantime, from a narrower US stock market perspective, more specific outcomes associated with the end of the neo-liberal order are likely. The first is consistent with the end of interest rates declining, the dominant theme of this work. The resulting return of material risk rates will leave less room for the tricks of the trade that became so common during the final decade or two of the prior order: SPACs, unicorns, and accounting shenanigans to optimize EPS should become scarcer. Some mean reversion in US corporate margins from the advances of the past two decades is also likely. And then there is the cash nexus. The end of declining interest rates on its own will mean assets will need to compete on a more normal cash yield basis. But the new political economy will provide another reason for an improved cash nexus of investment: a different level of trust. The post-neo-liberal order will likely entail less trust in corporate executives, and greater insistence by investors on a tangible return for their capital.
[1] Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Cambridge University Press, 2014).
Draft 4/7/2023