The television will be revolutionised

Netflix is moving television beyond time-slots and national markets

It may make screen-based entertainment a winner-takes-most business

IN THE heyday of the talkie, Louis B. Mayer, head of the biggest studio, was Hollywood’s lion king. In the 1980s, with the studio system on the wane, “superagent” Michael Ovitz was often described as the most powerful man in town. Now the honour falls to someone who used to run a video store in Phoenix, Arizona.

Ted Sarandos joined Netflix, a DVD-rental firm, in 2000. In 2011, when Netflix was first moving into streaming video, he bought “House of Cards”, a television drama starring Kevin Spacey and Robin Wright and produced by, among others, the film director David Fincher, for $100m. The nine-figure statement of intent was widely derided as profligate, showing that Netflix might be a source of cash but scarcely offered serious competition. A mail-order video store could hardly be expected to take on networks and studios which took decades to build and were notoriously difficult to run.

Instead it has become an industry in and of itself. Mr Sarandos, Netflix’s chief content officer, and his colleagues will spend $12bn-13bn this year—more than any studio spends on films, or any television company lays out on stuff that isn’t sport. Their viewers will get 82 feature films in a year when Warner Brothers, the Hollywood studio with the biggest slate, will send cinemas only 23. (Disney, the most profitable studio, is putting out just ten.) Netflix is producing or procuring 700 new or exclusively licensed television shows, including more than 100 scripted dramas and comedies, dozens of documentaries and children’s shows, stand-up comedy specials and unscripted reality and talk shows. And its ambitions go far beyond Hollywood. It is currently making programmes in 21 countries, including Brazil, Germany, India and South Korea.

Mr Sarandos buys quality as well as quantity with his billions. From Mr Fincher on, he has hired directors both famous and interesting, including Spike Lee, the Wachowski siblings and the Coen brothers. He is building a bench of established television hit-makers: Ryan Murphy (creator of “Glee” and “American Horror Story”) and Shonda Rhimes (creator of “Grey’s Anatomy” and “How to Get Away with Murder”) both recently signed up. David Letterman has come out of retirement to do a talk show. Barack and Michelle Obama have signed a production deal, too. The money helps: Mr Murphy’s deal is reportedly worth $300m; Mr Letterman is said to be getting $2m a show. But so does the company’s growing reputation. “They want to be on the channel that they watch,” Mr Sarandos says.

In the first quarter of this year Netflix added 7.4m net new subscribers worldwide. That gave it a total of 125m, 57m of them in America. With an average subscription of $10 a month, those customers represent some $14bn in annual revenue which the company will plough straight back into programming, marketing and technology—along with billions more that it will borrow. Goldman Sachs, a bank, thinks that it could be spending an annual $22.5bn on content by 2022. That would put it within spitting distance of the total currently spent on entertainment by all America’s networks and cable companies.

Enticed by such prospects, the market values Netflix at $170bn, which is more than Disney. Some analysts see this as outlandish for a company yet to make a profit, which has $8.5bn in debt and hasn’t even had that many hit programmes. Its competitors, though, see it as a call to arms. It was the prospect of building a similarly integrated producer, purchaser and distributor of content that led AT&T, a wireless giant, to buy Time Warner for $109bn. If Comcast, America’s largest broadband provider, buys most of 21st Century Fox from the Murdoch family for more than $70bn, it will be to a similar end—and if the Fox goes to the mouse house instead, it will be because Disney knows that to compete with the new giant it needs to own even more content than it already does.

Amazon, Apple, Facebook, YouTube and Instagram are all developing programming efforts of their own. “The first thought on everyone’s mind is how do we compete with Netflix?” says Chris Silbermann, managing director of ICM, an agency that represents a number of people who have signed huge deals with Netflix, including Ms Rhimes and the comedians Jerry Seinfeld (another $100m deal) and Chris Rock (two comedy specials for a reported $40m). “Apple wouldn’t even be thinking about this business if it wasn’t for Netflix,” says Mr Silbermann. “Neither would Fox be in play.” Rupert Murdoch chose to break up Fox to get out of Netflix’s way. Jeff Bewkes, the former chief of Time Warner, acknowledged after agreeing to sell his company that Netflix’s direct connection to the consumer gave it a huge advantage.

Nobody can watch everything...

For Mr Bewkes that was quite a reversal. At the beginning of this decade he poured scorn on the idea that Netflix could be a competitor, comparing it to the “Albanian army”. “He did not believe that the internet was going to be material for a very long time,” Reed Hastings, co-founder and chief executive of the Albanian forces, recently told The Economist in Amsterdam, Netflix’s European headquarters.

What Mr Bewkes missed, but Mr Hastings did not, was not just that the wireless internet would become a reliable conduit for high-quality video, but that in doing so it would change the rules of television. There would be no time slots and no channels, no waiting until next week to see whom the Lannisters betray or the Good Wife sleeps with. Given big enough pipes—in September 2017 Netflix streams were taking up 20% of the world’s downstream bandwidth, according to Sandvine, a network-equipment firm—a company would be able to offer every one of its customers something he wanted to watch, whenever and wherever he wanted to watch it, for as long as he wanted to.

That company would need two things: a big, broad, frequently renewed range of programming; and an understanding of its consumers deep enough to serve up to each of them the morsels most likely to appeal. This mixture of breadth and depth, of content and distribution, of the global and the personal, is the heart of Netflixonomics—the science of getting people to subscribe to television on the internet.

One of the reasons that Netflix is spending in such haste is that Netflixonomics is a winner-takes-most proposition. People can only spend so much time being entertained by television. If you can provide them with entertainment they genuinely enjoy for that length of time, they will have little reason to pay anyone else for further screen-based entertainment—though they may splash out more for sport, and put up with adverts for news, real or fake. Being big early thus constitutes a first-mover advantage. And the dash towards size has the helpful side-effect of driving up rivals’ production costs at the same time as it eats into their revenues. Netflix is “intentionally trying to destroy us, the existing ecosystem,” says one Hollywood executive.

Todd Juenger of Sanford Bernstein, a research firm, says Netflix could have 300m subscribers by 2026, with revenues per subscriber of $15 a month; that suggests $24bn in earnings before interest, taxes, depreciation and amortisation and an enterprise value of at least $300bn, Mr Juenger argues. With investors expecting further growth on top of that, its market value would be a lot higher.

One far-reaching effect of Netflixonomics is that it has changed the calculus of whether a show or film is worth making. The company has identified some 2,000 “taste clusters” by watching its watchers. Analysis of how well a programme will reach, draw and retain customers in specific clusters lets Netflix calculate what sort of acquisition costs can be justified for it. It can thus target quite precise niches, rather than the broad demographic groups broadcast television depends on. Decisions about what projects to pursue, and whether to make them, are up to the executives in Hollywood; Mr Sarandos has 20 people working for him who have the coveted power to “green light” a project. But the boffins at headquarters in Los Gatos help set the budgets.

Once a show is ready for delivery, it is up to executives in Los Gatos like Todd Yellin, vice-president of product, to work out how to get it to the appropriate users and check that they are, in the corny parlance of the company, “delighted” by it. Netflix customers will scroll through 40 or 50 titles on their individualised homescreen, he says, before they choose a title. The choice can come down to details like the poster art, which Netflix tweaks algorithmically according to the aspects of a film or show that would appeal most to a given user.

The combination of personalisation and reach makes the Netflix homescreen the most powerful promotional tool in entertainment, according to Matthew Ball, a digital-media analyst. It lets the company get better results for a lesser-quality show than its peers can by showing it only to those who will like it. Most readers of The Economist will not have heard of “The Kissing Booth”, a romantic high-school comedy released in May. Critics hated it. But it has been seen by more than 20m households; millions of teenagers targeted by algorithms seem smitten by its leads, Jacob Elordi and Joey King.

Its quantitative understanding, and personalised marketing, of niche projects has seen Netflix revive cancelled shows with loyal fan bases, such as “Gilmore Girls”, and take up shows others turned down, such as “The Unbreakable Kimmy Schmidt”. It has got Emmy nominations for the A-list cast of a show about a pair of elderly women, jilted by their gay husbands, making sex toys (“Grace and Frankie”). Documentaries like “Wild Wild Country” became hot not just by word of mouth, but by being pushed on the homescreen, poster by individualised poster.

...but everybody can watch something

Netflix can take risks on such projects because failure costs it less than it does others. It does not shepherd users towards shows their co-clusterers have hated, so few come to distrust the brand because of seeing things they really do not like. Stinkers do not impose the opportunity costs of a poor performer in prime-time; no other shows have to be cancelled because the network could not programme Wednesday nights. The stuff for which there is no market just disappears.

Cheap, personalised, advertising-free, binge-released video is widely seen as having hastened a decline in audiences for broadcast television, thus doing a great deal of damage to television advertising. It has also led millions of American households to dispense with pay-TV. Americans aged 12-24 are watching less than half as much pay-TV as in 2010, according to Nielsen data; those aged 25-34 are watching 40% less. Networks devoted to scripted entertainment or children’s programming, as opposed to news and sports, have been hardest hit.

To stay in the game, cable networks and other streaming services have commissioned hundreds of hours of high-quality scripted programming, providing an unprecedented glut of good television drama. This has in turn been bad for cinemas. Ticket sales in America and Canada declined by more than 20% between 2002 and 2017—and by 30% on a per head basis. American studios are now either in the blockbuster business—the five Disney films released so far this year have made over $4bn worldwide—or devoted to low-budget offerings best enjoyed with a crowd, like horror.

Netflixonomics is also changing the way shows make money. Netflix usually buys up exclusive worldwide rights to the shows it makes and acquires, paying a mark-up over production costs. Creators forgo lucrative licensing of their shows to secondary markets because, in Netflixonomics, there are no secondary markets. That produces handsome upfront deals, but offers much less to the producers if they make something that outperforms expectations. And the bigger Netflix’s share of the market, the less generous its upfront deals may need to be.

Feel what the community feels

So producers are delighted to see competitors trying to emulate Netflix’s model of integrated production and distribution. Under AT&T, its new owner, HBO is expected to accelerate its move away from its premium-cable base towards direct-to-consumer streaming. It is investing more in shows developed outside America, too, and unwinding partnerships with foreign distributors so that it can stream its own wares worldwide. It will spend over $2.5bn on content this year—as will Hulu, a US-only streaming service co-owned by four studios and best known for its drama “The Handmaid’s Tale”. Apple has hired Hollywood executives to build out a television offering to which it has committed at least $1bn so far. YouTube—which is more watched than Netflix, but accounts for less of the internet’s bandwidth because of its lower definition—also has a subscription service alongside its much larger free-to-view business. Disney is pulling its films off Netflix and launching its own streaming service next year, hoping that its roster of Pixar, Marvel and “Star Wars” movies, not to mention copious princesses, gives it a must-have edge.

Amazon seems perhaps the best placed to compete globally. Its video service is already available pretty much everywhere Netflix is. Amazon Studios will spend more than $4bn this year on content. The company’s boss, Jeff Bezos, has said he wants Amazon to have hits as big and buzzy as HBO’s “Game of Thrones”. To that end the company paid $250m for the rights to make a “Lord of the Rings” TV show. But for Amazon, video will always be part of a bigger strategy. For Netflix it is everything.

Netflix’s investments beyond America give it an edge over all its competitors that goes beyond sheer size. It has started turning non-English-language shows into hits: “Money Heist”, a Spanish crime-caper series, and “Dark”, a piece of German science fiction about missing children, have both been watched by millions in the US, Mexico and Brazil. Nine out of ten people who watched “Dark” were from outside Germany. Upcoming releases include “Sacred Games”, Netflix’s first series in Hindi, and “Protector”, a Turkish superhero story. This summer “Jinn”, a supernatural teen drama in Arabic, will begin shooting in Amman and Petra. These shows will be dubbed into a range of other languages, as Netflix’s English-language shows are—and that range will include English. Americans are not accustomed to dubbing (outside of 1970s Bruce Lee films). But those watching “Dark” and “3%”, a dystopian Brazilian thriller, seemed to prefer it to subtitles.

By offering shows more out-of-the-ordinary and expensive than companies looking just at local markets can normally afford, these shows are meant to make Netflix an enticing premium product. They also allow it to sniff out the best writers and directors. In June Baran bo Odar and Jantje Friese, the creators of “Dark”, signed up to make more shows for Netflix.

The company’s growth in international subscribers—up 48% in 2016 and 42% in 2017—suggests the strategy is working. Goldman Sachs, which is at the bullish end of Netflix assessments, finds that subscriber growth correlates with the rate at which newcontent is added. But Netflix faces several potential challenges. Its easy-sign-up subscription model is also easy to cancel. Netflix does not discuss its churn rate, but MoffettNathanson, a research firm, estimates it to be about 3.5% a month. That is much higher than pay-TV (around 2%) and wireless providers (closer to 1%). A second problem is its thirst for bandwidth. In markets that lack net-neutrality protections (such as America), dominant internet providers might decide to give their own streaming services precedence over Netflix. Aware of such risks, the company is increasingly persuading internet and pay-TV distributors like Comcast, T-Mobile and Sky to bundle its service with theirs, an about-face for some of these incumbents.

There are other ways to stumble. Entertainment companies are exposed to public concerns about behaviour at the top. Netflix dropped Mr Spacey from “House of Cards” after allegations of sexual misconduct and recently got rid of a senior executive over his use of a racial slur; there is no way to insure against future scandals. And if the economy were to turn, reducing both consumers’ appetite for paid entertainment and investors’ appetite for junk bonds, a company which is valued entirely on the basis of putative profits after 2022 would be badly hit. Such a setback would slow Netflix’s growth—and give deep-pocketed competitors like Amazon or Apple time to eat into its leads in inventory, tied-up talent and personalisation.

Some think that, even without such a setback, Netflix’s prospects are being exaggerated. In April MoffettNathanson declared that it could not justify Netflix’s share price “under any scenario”. It did not advise selling the stock, though, noting that investors believed in the Netflix story. Shares have risen by 38% since then, as Netflix reported one of its strongest-ever quarters of subscriber growth.

Sitting in Amsterdam, Mr Hastings appears unconcerned about competition. He argues there is room both for competitors to succeed and for Netflix to continue winning more screen time. He is instead looking towards the challenges of success—those that will arise when Netflix becomes a large presence in societies around the world. “What happened when Televisa used to be like 80% of the Mexican television market, what was it like then? What was their relationship with government, with the society?” Mr Hastings asks. Or Globo, a Brazilian media powerhouse. “How did they get along with their societies when they’re so strong? You have to be gentle obviously as you get that big. How did they pull that off?”

The world’s first global television giant may yet get to find out.

Don’t Expect the Fed to Pause for a Trade Fight

With the economy strong and jobs market tight, investors shouldn’t expect the central bank to bail them out if trade tensions start to bite

By Justin Lahart

Federal Reserve Board Chairman Jerome Powell on Tuesday told Congress ‘the best way forward is to keep gradually raising’ interest rates. Photo: Alex Wong/Getty Images

The Federal Reserve will keep raising interest rates until it thinks it has a reason to stop. The danger for investors is that they believe that the Fed will be stopped by rising trade tensions when its focus is elsewhere.

Fed Chairman Jerome Powell on Tuesday told Congress that with a strong economy, solid job growth and inflation warming up, the central bank believes that “the best way forward is to keep gradually raising” interest rates. That makes sense: With the unemployment rate at 4% and inflation lately reaching their 2% target, policy makers don’t want to run the risk of the economy running too hot. 

It is all in keeping with projections policy makers offered up last month, showing they expect to raise rates by a quarter point two more times this year, and to keep on raising them after that. One thing that might upend that plan is escalating trade tensions that threaten to damage business investment and confidence enough slow the economy. 
But the Fed may not react as quickly as investors might like to rising trade skirmishes.

First, the impact of trade troubles will take time to show up in the economy. Not only do economic data come with a lag, but there is some evidence that companies are ramping up activity to avoid tariffs—something that could give the economy a short-term boost. Moreover, because the effects of tariffs and trade restrictions on the economy are so hard to model, the Fed might opt to take a wait-and-see approach before deciding to alter course on interest rates.

Second, as Mr. Powell noted in an interview last week, while tariffs could slow the economy, they could push inflation higher. Ultimately, the Fed would probably be more worried about growth, especially since the tariff-induced increase in inflation would be temporary. But even a temporary pickup in inflation could complicate the Fed’s response. Politics also could come into play, since the Fed might not want to be viewed as monetizing a trade battle.

Investors hoping for a Fed bailout could argue that if trade does become a real problem for the economy, the stock market would likely tumble and put a nervous Fed on hold. But with stock prices still looking richly valued, the drop would probably have to be fairly steep before the central bank changes its plans—a mere 10% wouldn’t cut it. By the time Fed gets worried about trade, investors could be downright alarmed.

Tariff Troubles for Germany Won’t Stay in Germany

Germany’s role as an anchor for Europe makes its export engine a risk for the continent

By Richard Barley

Germany's current account balance as a share of gross domestic product 1980-2017

Source: International Monetary Fund

Note: a positive reading indicates a surplus

Germany has become the focal point of troubling questions about Europe’s political fragility and the decline of globalization. But investors may be better off focusing on the country’s neighbors.

European markets breathed a sigh of relief Tuesday after German Chancellor Angela Merkel struck an agreement over immigration with Interior Minister Horst Seehofer. The threat of a collapse in Germany’s coalition government has subsided. But the issue hasn’t gone away: The rise of populist governments, especially in Italy, has put migration front and center. Europe’s porous borders ensure that any national problem becomes a European problem. 
Meanwhile, the trade dispute raging between U.S. President Donald Trump and China threatens to engulf Germany. The country’s current-account surplus amounts to some 8% of gross domestic product. Car exports to the U.S., which account for 0.7% of German GDP, according to Citigroup, are a particular bugbear for Mr. Trump. That has shaken investors: The Euro Stoxx automobiles and parts index is down 11% this year.

Still, Germany isn’t the best country for investors to bet against. Berenberg thinks a 25% U.S. tariff on car imports would mean just a 0.15% direct hit to German GDP. And the country is well-placed to withstand slower growth. Its economy has been humming and its fiscal position is strong, with government debt down to 64.1% of GDP at the end of 2017. 


German exports of goods and services as a share of gross domestic product 1980-2017

Source: World Bank 

The indirect impact on business confidence throughout the eurozone could be much greater than any direct hit from tariffs. Other countries, like Italy, are far weaker fiscally, and are still posting weak growth. With the European Central Bank still running ultraloose monetary policy, many economists are doubtful about the eurozone’s capacity to react to fresh economic trouble.

Moreover, Bunds are the haven asset in the eurozone, so markets offer Germany respite in times of trouble. While political risk in Italy has sent its bond yields soaring, stress in Germany has helped lower its cost of borrowing. The 10-year Bund yield dipped below 0.3% Monday.

Instead, trouble for Germany can spread quickly through markets to other parts of Europe. 

German Chancellor Angela Merkel and German Interior Minister Horst Seehofer shake hands at the start of a CDU/CSU parliamentary group meeting on Tuesday in Berlin. Photo: john macdougall/Agence France-Presse/Getty Images 

That reflects Germany’s position as an anchor in Europe. Politics and trade may yet cause that anchor to slip. But southern Europe, not Germany, would likely bear the brunt.

Big Tech Is a Big Problem

Kenneth Rogoff

CAMBRIDGE – Have the tech giants – Amazon, Apple, Facebook, Google, and Microsoft – grown too big, rich, and powerful for regulators and politicians ever to take them on? The international investment community seems to think so, at least if sky-high tech valuations are any indication. But while that might be good news for the tech oligarchs, whether it is good for the economy is far from clear.

To be fair, the tech sector has been the United States’ economic pride and joy in recent decades, a seemingly endless wellspring of innovation. The speed and power of Google’s search engine is breathtaking, putting extraordinary knowledge at our fingertips. Internet telephony allows friends, relatives, and co-workers to interact face to face from halfway around the world, at very modest cost.

Yet, despite all this innovation, the pace of productivity growth in the broader economy remains lackluster. Many economists describe the current situation as a “second Solow moment,” referring to legendary MIT economist Robert Solow’s famous 1987 remark: “You can see the computer age everywhere but in the productivity statistics.”

There are many reasons for slow productivity growth, not least a decade of low investment in the wake of the 2008 global financial crisis. Still, one has to worry that the big five tech firms have become so dominant, so profitable, and so encompassing that it has become very difficult for startups to challenge them, thereby stifling innovation. Sure, once upon a time, upstarts Facebook and Google crushed Myspace and Yahoo. But that was before tech valuations soared into the stratosphere, giving entrenched players a massive funding advantage.

Thanks to their deep pockets, Big Tech can gobble up or squelch any new firm that threatens core profit lines, no matter how indirectly. Of course, an intrepid young entrepreneur can still spurn a buyout, but that is easier said than done. Not many people are brave enough (or foolish enough) to turn down a billion dollars today in hopes of much more later. And there is the risk that the tech giants will use their vast armies of programmers to develop a nearly identical product, and their vast legal resources to defend it.

Big Tech firms might argue that all the capital they pour into new products and services is pushing innovation. One suspects, however, that in many circumstances the intent is to nip potential competition in the bud. It is notable that Big Tech still derives most of its revenues from its companies’ core products – for example, the Apple iPhone, Microsoft Office, and the Google search engine. Thus, in practice, potentially disruptive new technologies are as likely to be buried as nourished.

True, there are successes. The remarkable British artificial intelligence firm DeepMind, which Google purchased for $400 million in 2014, seems to be plowing ahead. DeepMind is famous for developing the first world champion-beating Go program, a signal moment that reputedly sparked the Chinese military to start an all-out effort to lead in AI. But, by and large, DeepMind seems to be the exception.

The problem for regulators is that standard anti-monopoly frameworks do not apply in a world where the costs to consumers (mainly in the form of data and privacy) are thoroughly non-transparent. But that is a poor excuse for not challenging relatively obvious anti-competitive moves, such as when Facebook purchased Instagram (with its rapidly growing social network) or when Google bought its map competitor, Waze.

Perhaps the most urgent intervention is to weaken Big Tech’s grip on our personal data, a grip that allows Google and Facebook to develop targeted advertising tools that are taking over the marketing business. European regulators are showing one possible path forward, even as US regulators continue to sit on their hands. The European Union’s new General Data Protection Regulation now requires firms to allow consumers – albeit only those in the EU – to port their data.

In their important recent book Radical Markets, the economists Glen Weyl and Eric Posner go one step further and argue that Big Tech should have to pay for your data, instead of claiming it for their own use. Whereas the practicality of this remains to be seen, surely individual consumers should have a right to know which data of theirs is being collected and how it is being used.

Of course, the US Congress and regulators need to rein in Big Tech in many other key areas as well. For example, Congress currently gives Internet-based firms a veritable free pass in promulgating fake news. Unless Big Tech platforms are held to standards that parallel those applied to print, radio, and television, in-depth reporting and fact-checking will remain dying arts. This is bad for both democracy and the economy.

Regulators and politicians in the homeland of Big Tech need to wake up. The prosperity of the US has always depended on its ability to harness economic growth to technology-driven innovation. But right now Big Tech is as much a part of the problem as it is a part of the solution.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. The co-author of This Time is Different: Eight Centuries of Financial Folly, his new book, The Curse of Cash, was released in August 2016.

Italy’s Slow Recovery and the Millions Left Behind

The 2008 crisis is still haunting Europe.

For millions of Italians, the country’s economic recovery is still little more than a dissonant newspaper headline at odds with their day-to-day reality. New figures released by the Italian National Institute of Statistics last week showed that by the end of 2017, 8.4 percent of Italians and 6.9 percent of all Italian households were living in “absolute poverty” – defined as being unable to purchase a basket of basic goods and services. This is up from 7.9 percent of Italians and 6.3 percent of Italian households a year earlier. Meanwhile, the share of Italians living in “relative poverty” – defined as having a disposable income of less than half the national average – climbed to 15.6 percent of the population, or an estimated 9.4 million people. This is up from around 14 percent in 2016. The release of alarming news about poverty in Italy has become something of an annual tradition in the country since the financial crisis. The number of impoverished Italians has tripled since 2008, and the downward slide has been steady.      

Curiously, however, life is getting worse for many Italians despite that fact that on a macro level, the country’s economic recovery has continued to slowly gain traction since putting a double-dip recession behind it in 2014. Italy’s gross domestic product grew 1.5 percent in 2017 – the economy’s best performance since 2010. As a result, unemployment has continued to tick downward, from a peak of around 13 percent to 10.9 percent today. According to figures released late last year, average family income was actually up by 1.8 percent to 29,988 euros (roughly $35,000) per year, and purchasing power was up by 1.7 percent last year compared to two years earlier. Median income rose 2.8 percent in the same period.

All this, of course, creates some cause for optimism on the poverty front. Economic recoveries, though, never happen evenly; the poorest segments of society are generally the last to enjoy the gains. (According to the National Institute of Statistics, wage and employment gains have been concentrated in the top fifth of Italian society.) Moreover, Italy has been making some progress on issues threatening to drag the economy backward. The country had been wheezing under the weight of nonperforming loans, for example. But the stock of NPLs in banks’ balance sheets has been declining ever so gradually – down 20 percent from its peak – since the government implemented a slew of measures to revive the banking sector, and the NPL ratio has now dropped below pre-crisis levels.

However, Italy’s economy is still among the worst performers in Europe and smaller than it was in 2008. The level of NPLs is still quite high – about 14.5 percent of total loans – limiting lending and investment across the economy. Italy also still has the highest debt of all EU members – about $2.8 trillion in 2017, or more than 130 percent of GDP. Moreover, its recovery may be running out of runway. Exports have been a major driver of Italy’s return to growth, for example, meaning a broader economic downturn in Europe or the U.S. would take the wind out of Italy’s sails prematurely. As it stands, the Organization for Economic Cooperation and Development projects growth to continue roughly at this rate through this year, before decelerating in 2019 to around 1.1 percent due to plateauing job growth, private investment and domestic consumer spending.

Slowly rising consumer price inflation may also weigh on growth over the next few years. This speaks to one of many paradoxes inherent to uneven recoveries – and one that may contribute to the rise in poverty rates. Inflation in Italy is still relatively tepid, with monthly figures consistently below the European Central Bank’s target of 2 percent. Nonetheless, goods are becoming more expensive at a time when those being left behind can scarcely afford it. Meanwhile, some of the structural reforms that have been deemed necessary to unleash the recovery (social spending cuts, for example) are likewise leaving the poor at least temporarily in the lurch, all while the country’s elites are doing quite well. This year, the poor didn’t even have a World Cup team to distract from the daily grind.

It should be no surprise, then, that Italian voters have ushered in a populist government, even though the recovery was seeming to pick up steam. Indeed, the new figures on poverty put Italy’s age-old regional disparities in even starker relief. Suffering is most acute in the southern regions that, in March’s general elections, voted overwhelmingly for the Five Star Movement – the euroskeptic and staunchly anti-immigrant bloc that formed a right-wing coalition government with the northern-based League party in late May. According to official figures, 11.4 percent of Italians in the south (including Sicily and Sardinia) are living in absolute poverty, up from 9.8 percent in 2016. By comparison, just around 7 percent of Italians in the north fall into this category, up by 0.3 percent from the previous year. (Poverty rates actually declined in central Italy in 2017, from 7.3 percent to 6.4 percent.) Similarly, poverty rates were higher among Italians below the age of 35 (9.6. percent) than any other age group, and youth unemployment remains above 30 percent. As could be expected, both the League and the Five Star Movement performed particularly well among 18-34-year-olds.

This trend, of course, reflects one seen across Europe and the U.S. since 2008, where recoveries haven’t uniformly healed the wounds inflicted by the crisis – and where the recovery has been felt the least in segments whose living standards were hit disproportionately hard. In Italy, as in many other countries, the employment problems generated by free trade and widening inequality have expressed themselves as hostility toward immigration. When a class is hit by uncontrollable economic forces, the fear of unemployment or surplus labor is immense. (Notably, poverty is highest among immigrants in Italy, which has taken in more than 600,000 migrants since 2014. More than 29 percent of households consisting exclusively of non-nationals are living in absolute poverty, compared to just more than 5 percent for households made up solely of Italian nationals.) And when a political movement gains steam with immigration and resentment of outside institutions as the fuel, its implications are more likely to ripple beyond borders to the point where, in Europe, it’s begun undermining the very foundations of the EU project.

Thus, from a geopolitical perspective, Italy illustrates just how much fixating on economic recoveries misses the point. The crisis exposed and deepened social divisions, and higher growth is proving not to be a panacea. The consequences of 2008 are still becoming fully apparent, and establishment parties may not have the luxury of merely waiting out the political forces they’ve unleashed.

When $1 Trillion Isn't $1 Trillion And A Warning From The Largest Asset Manager On Earth

by: The Heisenberg

- On Monday, BlackRock reported quarterly results and they served as a nice opportunity to pen a followup to one of my weekend posts.

- Outflows from the firm's equity products in Q2 underscore investor consternation with trade frictions.

- Meanwhile, one bank takes a closer look at a flashy buyback headline.

I spent a lot of time over the weekend talking about trade and buybacks and how the former is serving as a persistent source of angst and consternation for investors while the latter is arguably the most important source of support for U.S. stocks (SPY).
On the buyback front, the debate continues to rage about the social utility of corporations using their tax windfall to reward shareholders and inflate bottom lines, as the so-called "tyranny of quarterly capitalism" incentivizes management to prioritize shareholder returns.
That's clearly a contentious issue. As noted on Sunday, a Democratic sweep in November will almost surely mean more pressure on companies to spend on wage growth and capex. While most readers are probably well apprised of my political leanings, I'm not entirely sure it's within politicians' purview to try and dictate how private enterprise spends its free cash. The job of Congress is to legislate and there are ways of achieving the same end (i.e., incentivizing corporations to rethink how they allocate their cash) through legislation that don't involve politicians resorting to the kind of explicit, public exhortations of buybacks, which leave a bitter taste in the mouths of folks who might lean liberal on social issues, but would rather leave decisions about buybacks to the management teams with whom investors have entrusted their capital.
Anyway, that's my take on that and there's something for everyone (i.e., for both sides of the aisle) there.
Speaking of buybacks and people who are actively trying to push companies in the direction of eschewing myopia in favor of a long-term vision, you might recall that back in January, BlackRock's Larry Fink used his annual letter to effectively chide management teams on this issue. To wit, from that letter:
Companies have begun to devote greater attention to issues of long-term sustainability, but despite increased rhetorical commitment they have continued to engage in buybacks at a furious pace. While we certainly support returning excess capital to shareholders, we believe companies must balance those practices with investment in future growth. 
To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.

That was not well received in some circles, for obvious reasons, not the least of which is that it came across as something of a threat given how large BlackRock (BLK) is.
In the course of discussing buybacks over the weekend, I cited a recent JPMorgan note in which the bank's Nikolaos Panigirtzoglou took an in-depth look at repatriation following the tax cuts on the way to explaining how buybacks likely helped prop up the market in Q2:
Based on the average divisor change of four US equity indices, a proxy for the share count, we estimate that the net equity withdrawal by US companies overall including both financial and non-financial companies tripled in Q2 ($150bn) vs. Q1 ($50bn).
As it happens, Panigirtzoglou revisits this in his latest note (dated Friday) and in light of my weekend post, I wanted to highlight a couple of excerpts for readers here. JPMorgan makes a critical distinction between "values" and "volumes". To wit:
Announced US buybacks look set to approach one trillion dollars this year if one annualizes the YTD pace, the highest on record. But in volume terms, at 4% of the capitalization of the S&P 500 index, this year’s announced US buyback pace is lower than the 6% record high pace seen in 2007 and lower than the 5% post Lehman peak seen in 2012.
Panigirtzoglou goes on to again emphasize the distinction between "net actual buybacks" and the headlines numbers, where the former is estimated using share count reduction (i.e., taking into account shares issued as part of employee compensation packages). Here are the annualized numbers on that, both in dollar terms (left pane) and in volume terms (right pane):
Panigirtzoglou explains those visuals as follows:
If one looks at net actual US buybacks, this year’s annualized pace stands at just above $300bn which is lower that either 2015 or 2016 (Figure 5). In volume terms, the YTD pace of the share count reduction across major US equity indices is almost half of its 2015 high (Figure 6).

The implication there is that while the $1 trillion figure (the annualized dollar amount of announced buybacks using the YTD pace) is certainly a headline grabber, there's a ton of nuance under the surface. That nuance seems to suggest that the corporate bid, while voracious, might not be as strong a pillar of support for the market as the surface-level data would appear to tip.
I'm not sure that mitigates the type of criticism implicit in critiques of corporate cash usage (critiques like that delivered by Larry Fink earlier this year), but it does paint a more complete picture and is certainly more useful for investors looking to get an accurate read on how much support they can expect their equity portfolios to enjoy from the buyback bonanza.
You'll recall that the overarching point of the post linked here at the outset was to explore who the "marginal buyer of equities" would be in the event buybacks failed to support the market or if, for whatever reason (e.g., trade frictions dent global growth expectations), corporate earnings in the U.S. start to disappoint.
A big part of that discussion revolves around relatively subdued retail sentiment following the avalanche of inflows into equity funds that accompanied the January euphoria. Specifically, I cited another JPMorgan note by the same Nikolaos Panigirtzoglou, who last month observed a "sharp downshifting in equity and bond fund flows" since the first of the year.
Well, BlackRock was out with its quarterly earnings on Monday and guess what? Inflows into iShares products were just $18 billion, the lowest since Q2 2016. More notable was the fact that investors look to have yanked more than $22 billion from the firm’s equity products during Q2:
In an interview with Bloomberg TV, the above-mentioned Larry Fink attributed this to consternation about trade and also to the fact that for the first time since 2008, "cash" is actually a viable option for some investors thanks to rising short rates in the U.S.
While I generally downplayed the "marginal buyer" question here over the weekend (citing the likelihood that buybacks and earnings growth would remain supportive in the U.S.), all of the above tells a bit of a different story or, at the very least, gives you some further perspective.
The buyback bid is optically huge, but the net effect might not live up to the billing. Meanwhile, BlackRock's results suggest that trade tensions are in fact weighing on sentiment.
You can take all of that for what it's worth, but I was delighted to take the opportunity to pen this short (by my standards) followup on Monday as BlackRock's earnings served as a poignant reminder that to the extent the "marginal buyer of equities" question does matter, the largest asset manager on the planet just saw $22 billion in net outflows from its equity funds in the space of three months.