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How to Play Emerging Markets Now

By Reshma Kapadia

How to Play Emerging Markets Now
Photo: Pomme Chan


America first? Not when it comes to world stocks.

In a year full of political and economic drama, emerging markets have outpaced an aging bull market in the U.S. over the last 12 months. Still, the prospect of Beijing wielding a heavier hand in Chinese companies and economic reforms in India potentially slowing near-term growth means that investors who take a closer look now will need to pick their spots carefully.

The MSCI Emerging Markets Index is up 34% so far this year, beating the 16% advance in the Standard & Poor’s 500 index and last year’s 9% gain, as emerging markets crawled out of a three-year slump on the hope of an economic and earnings recovery.

That recovery materialized this year as China, Russia, and India found firmer fiscal footing and weathered developments that would have derailed them before. President Michel Temer of Brazil narrowly dodged prosecution on corruption charges in the latest political scandal that

Rajiv Jain of the GQG Partners Emerging Markets Equity fund sees more gains ahead in some emerging markets. Plus, why he is more optimistic about Russia, is decreasing his positions in India and the risk he is monitoring in Chinese tech stocks.

Hit about a year after his predecessor, Dilma Rousseff, was impeached. Russia pushed on despite another round of U.S. sanctions, and India made unprecedented reforms, like a demonetization that took 86% of the country’s cash out of circulation last fall and sent the cash-dependent economy into chaos—yet markets were resilient.

Investors who haven’t paid much attention to emerging markets since they were last this hot in 2009 are taking notice. About $85 billion has poured into emerging market stock funds so far this year, the biggest net flows since 2010, according to EPFR Global. The draw is valuations: Even after the sharp gains, the MSCI Emerging Markets Index still trades at 12 times forward earnings, far cheaper than U.S. stocks’ 18 times, or Europe’s 14 times.

Investors may want to rethink their strategy. Betting on the consumer is still a good strategy, but not via old standbys like luxury-goods makers and companies selling beer or soap. India, a favored market in recent years, is now expensive and facing near-term challenges as it pushes through major economic reforms. And Chinese internet stocks—like Tencent Holdings (ticker: 700.Hong Kong), which recently surpassed Facebook (FB) in market value, and Alibaba Group Holding (BABA)—that have powered the market higher could face the risk of government intervention.

We gathered four emerging market stock fund managers in New York to discover the best spots to invest and identify which risks they are monitoring. Our experts are Taizo Ishida, co-manager of the $812 million Matthews Asia Growth (MPACX) and the $439 million Matthews Emerging Asia (MEASX) funds; Rajiv Jain, who earned a stellar record at Vontobel Asset Management and left last year to start his own firm, where he runs the $454 million GQG Partners Emerging Markets Equity fund (GQGPX); Howard Schwab, co-manager of the $1.8 billion Driehaus Emerging Markets Growth fund (DREGX); and Leon Eidelman, co-manager of the $4.8 billion JPMorgan Emerging Markets Equity (JFAMX).



How to Play Emerging Markets Now
Photo: Matt Furman for Barron’s 


How to Play Emerging Markets Now

Barron’s: What a year! What have been the most notable events?


Leon Eidelman: We had plenty of drama. South African President Jacob Zuma ousted the finance minister in a cabinet reshuffle that sent the currency tumbling; there was an attempted Turkish coup; and the political scandals in Brazil. But what matters most to markets is earnings. Last year, investors began to anticipate an earnings recovery as currencies and commodity prices recovered. Earnings growth had been absent for the past seven years, but now we are seeing it—and it is widespread. That is a positive signal for the next couple of years.

Rajiv Jain: Emerging markets are seeing synchronized pickup in economic growth across the board. That revival is the fruit of good policies born out of bad times. Brazil, India, Russia, and even China implemented reforms after their heavy borrowing during the good times caught up with their currencies. Now, current account deficits have narrowed sharply in many of these countries, budget deficits have fallen, and currencies are sensibly valued. That has led to better earnings growth.

What were some of those reforms, and do they make emerging markets more resilient as the Federal Reserve raises interest rates? In 2013, the hint of the Fed reducing its bond buying sent markets into a tailspin.

Howard Schwab: Emerging markets are less fragile than in 2013. Now, about two-thirds of the bonds of listed companies are denominated in local currencies, not dollars, making them less vulnerable to a U.S. rate hike. India implemented reforms to get its balance sheet back in order; Brazil has begun to privatize its electric utilities and overhaul labor rules; Russia’s central bank has been far more conservative in setting monetary policy. The Chinese government has been taking measures to stem speculative activity in some property markets, including banning resales within a specified period of time. That should help dampen risk.

Investors have been drawn to emerging markets because they’ve been cheaper than U.S. and European stocks. After a 34% run-up this year, they’re still cheaper, but how much further can they run?

Taizo Ishida: We’re in the fourth inning of this rally. We are not going to see the same massive return as last year, but earnings growth is strong against a favorable backdrop of low inflation and low commodity prices. Though the market looks expensive on a price/earnings basis, free cash flow is growing a lot. Two years ago, free-cash-flow yield was an amazingly high 10%; it is still a reasonable 7.5%. Alibaba and Tencent have more than doubled year-to-date, but P/E multiples have been relatively consistent over the past five years because of strong earnings growth. Valuations don’t signal a crisis, but things are not cheap anymore.

How to Play Emerging Markets Now
Photo: Matt Furman for Barron’s 


How to Play Emerging Markets Now


Jain: Some parts of the market are overvalued. A few years ago, investors were willing to pay up for companies with stable growth because earnings growth was so scarce. But now, as earnings growth recovers, that stability is overvalued, especially in consumer staples. Brazilian brewer Ambev’s [ABEV3.Brazil] margins are shrinking and there’s no volume growth, and Indian tobacco company ITC [ITC.India] is also struggling. Yet they trade at much higher multiples than just a few years ago. On the other hand, anything even a little cyclical—but high quality—is more attractive, like Bank Central Asia [BBCA.Indonesia], a classic consumer-oriented bank in Indonesia that is the lowest-cost deposit gatherer, has the strongest balance sheet, and is well positioned as Indonesia’s economy recovers.

Ishida: We picked up Indian skin- and hair-care company Emami [HMN.India] in late 2011 because it was a better value than Dabur India [DABUR.India], the go-to consumer staple at the time. We recently sold Emami because it became very expensive, trading at 60 times earnings. Indian consumer staples are so loved by global investors it is very difficult to find a replacement.

What, then, are you buying?


Schwab: Alibaba, Tencent, Samsung Electronics [005930.Korea], and Taiwan Semiconductor [TSM] have contributed about a third of the market’s gains this year. As many of the more popular stocks, like technology, have gotten more expensive and revenue growth has faded compared with 15 years ago, we are focusing more on companies that can expand multiples or improve margins or returns. Better governance helps, like at Samsung Electronics, which split the CEO and chairman roles and committed to returning cash to shareholders.

Ishida: There are more reasonably priced options in mid- and small-cap stocks. Baozun [BZUN], a $1.6 billion Chinese online retailer, is a cheaper alternative to big e-commerce stocks. Global brands like Nike [NKE] have had a hard time catering to local markets. For a cut of sales, Baozun acts as a middleman, handling warehousing and logistics, and creates a storefront in an online mall that gives Nike direct control over its products and consumer confidence in the authenticity of purchases. That is critical in China, where there is real fear about whether goods bought online are fake.

Eidelman: I still see opportunity in big e-commerce stocks. It is rare to find companies with reach like Alibaba’s, which is the world’s largest online retailer. Alibaba is one of two players trying to consolidate online groceries in China—like what Amazon is trying with Whole Foods.

If successful, Alibaba will penetrate an even larger market. The groceries market is very fragmented; it is not crazy to think that Alibaba will be much bigger over time.

Jain: Alibaba is one of our largest positions, and there is headroom. But the question is where can you find growth that is not appreciated. For that, you have to leave Asia.

And go where?


Jain: Russia. Beneath the headlines about how much of a threat Russia is, the economy is improving and there have been strong reforms. Companies have cut costs meaningfully, which is beginning to pay off. We own Sberbank of Russia [SBER.Russia], which is partly controlled by the central bank and holds half of the country’s retail deposits. The banking system has consolidated dramatically, and corporate governance has improved, with more than 300 banking licenses revoked over the past couple of years. Yet Sberbank trades at just 6.5 times next 12-month earnings and has generated 20%-plus return on equity—in the middle of a recession.

Eidelman: Russia looks cheap, but for a reason. I can’t come up with three Russian companies you can buy today and not think about for 10 years. But we continue to see plenty of room for Alibaba to grow its earnings over the next five years.

Jain: I’m not negative on Alibaba. But the single biggest risk in emerging markets is Chinese government intervention in the technology market. I’m not saying that will happen, but it is something to watch.

How to Play Emerging Markets Now
Photo: Matt Furman for Barron’s 


How to Play Emerging Markets Now


China held its twice-a-decade Congress of the Communist Party last month. What were the major takeaways, especially on the prospects of the government’s intervention in the technology market?


Ishida: The Congress provides a road map for future economic and foreign policy. While it reaffirmed Xi Jinping as the most powerful leader since Deng Xiaoping, it doesn’t make him a dictator, because there are limits to his power within the party. We are unlikely to see significant changes to economic policy. China will continue to emphasize quality of growth over quantity, entrepreneurship, and reducing risk in the financial sector. Xi also committed to dealing with income inequality, as well as improving health care and education, and the consequences of pollution.

Jain: Xi’s consolidation of power suggests government policies will be much more consistent and ruthlessly implemented. For example, China is going to accelerate shutting down excess capacity at state-owned enterprises in polluting industries, like steel. That will make state-owned enterprises more profitable, which should help banks.

Schwab: Since 2015, reforms have removed about 5% of the coal sector’s capacity, which benefits China Shenhua Energy [1088.Hong Kong]. But the bigger question is how to handicap an indefinite period of Xi. It adds uncertainty for dominant companies like Alibaba, regarding the extent to which they become an extension of the government and are expected to behave in the interest of society’s “greater good.” American internet companies are enduring similar scrutiny in some areas.



How to Play Emerging Markets Now
Photo: Matt Furman for Barron’s 


How to Play Emerging Markets Now


Despite the threat of greater state involvement, Chinese internet stocks are big holdings for many of you. Why?


Ishida: It’s the cost of doing business in China. Unless the government exerts more control by getting seats on the board or otherwise directing future decisions, intervention is unlikely to become a significant risk.

Eidelman: If, say, power utilities were making an enormous profit by overcharging people, the government has an interest in shutting that down. The closer the company is to the consumer, the less likely the government is going to intervene. If you tell a Chinese citizen they can’t use [messaging app] WeChat, that is not going to fly.

China reaffirmed its commitment to infrastructure with One Belt, One Road. What does that initiative mean for investors?

Schwab: China is committing $1 trillion to infrastructure spending in developing countries, creating opportunities for Chinese construction companies, cementing geopolitical alliances, and securing markets for China’s goods—and expanding China’s influence abroad while the U.S. appears to be withdrawing. For some comparison, the U.S. invested $130 billion [in today’s dollars] in Western Europe under the Marshall Plan after World War II.

One Belt should reduce the correlation between emerging markets and developed markets, as trade between emerging countries increases. Already, developed markets account for just 40% of emerging markets’ exports, down from 60% three decades ago.

Eidelman: The Chinese are building three roads that will crisscross Pakistan, helping them access a strategically important port. The ultimate benefits are the fruits of the infrastructure, like increased commerce or the reduction in transport times.

Ishida: Pakistan’s economy is going to benefit. It’s already visible. We own auto maker Indus Motor [INDU.Pakistan], which will benefit from better roads and power grids.

Let’s turn to Pakistan’s neighbor, India, which has been a favored market in the past few years. What now?


Eidelman: I’m most excited about the political change, starting with India’s decision to give everyone a national ID number, followed by a well-sequenced series of moves that included trying to give everyone a bank account and demonetization. Plus, the GST.

The GST is a new goods and services tax put in place to overhaul a tangle of state and federal taxes. That’s smart. But demonetization caused strife for a couple of months as cash was withdrawn from circulation overnight. What is the end result of these reforms?


Eidelman: Eventually, the reforms should cut down on tax avoidance and take the sand out of the gears of commerce. India also recently said it would recapitalize the state banks [to deal with bad loans]. About 70% of the banking sector can’t lend, which has hampered investment in the country, so that is an important step. That said, markets have priced in a decent amount of this.

Which companies will benefit the most from these new reforms?


Eidelman: Take the national ID. It slashes customer-service costs for banks like IndusInd Bank [IIB.India] because now it doesn’t have to send a fellow out to the townships where there are no street names to sign someone up. Now that costs are much lower, the banks can target some of the country’s large, unbanked population.

Schwab: We own jeweler Titan [TTAN.India]. Its shares have more than doubled this year, but the company benefits from the GST, which will force mom-and-pop competitors to pay taxes.

Ishida: Titan is a quality company, but it’s very expensive. PC Jeweller [PCJL.India] is a smaller alternative. Sales growth will pick up over the next five years as it gains market share.

About 70% of the jewelry business is unorganized, which means they don’t pay taxes; that’s a huge advantage. The GST will drive those unorganized mom-and-pops out. I’m not sure Prime Minister Modi wanted to do that.

Jain: That’s an important point. About 90% of Indian employment is unorganized. The idea of everyone paying taxes looks wonderful sitting in an Ivy League tower, but on the ground, business is slowing and affecting corporate earnings.

Investors have cheered these reforms, but will they bring problems in the near term?


Jain: I have had as much as 30% of the fund in India in the past; today it is 6%. Earnings growth has slowed dramatically in parts of the market like pharmaceuticals, information-technology services, and staples. And once India recapitalizes the pubic-sector banks, the private-sector banks will see competition return, potentially hurting net interest margins or pushing them to make riskier loans. Another potential risk: Almost all the credit growth is coming from consumer retail. In three to five years, the private-sector banks are more likely to see a credit cycle than not. I still like HDFC Bank [HDB], which is the best of the bunch, but others have already seen nonperforming loans rise.

While growth is slowing in India, it is just picking up in Brazil. What’s going on there?


Jain: Brazil is in the early stages of recovery in noncommodity-oriented companies, and the government there has also begun reforms, notably of its labor market. We own several services companies like Qualicorp [QUAL3.Brazil], which is the dominant provider of insurance and health-care services.

Eidelman: I lightened up a couple of months ago after adding a lot at the end of 2015 and early 2016. The market got expensive and Brazil is not out of the woods politically. We own Kroton Educacional [KROT3.Brazil], which provides vocational education and has good corporate culture and a dividend. Education is a big theme globally; people will pay unlimited amounts to get ahead.

The consumer has long been a big theme in investing in the emerging markets. Has that changed?
 

Ishida: India’s economy is more emerging than China’s. Gross domestic product per capita [a proxy for economic health] is about $10,000 in China, but just $1,500 in India, so the way to benefit from rising consumption differs in these two countries. While a noodle company in China is seeing no volume growth, it is still a good way to benefit in India because incomes are rising from a lower base. A better way to invest in the consumer in China is through e-commerce, leisure, and hotels like China Lodging Group [HTHT]. We also really like health care. Indian generic drugmakers will struggle over the next five years due to increased competition—they did well for years because of their low costs, but Square Pharmaceuticals [SQUARE.Bangladesh] in Bangladesh says they can hire a chemist at a third of the price of the Indians. That’s a big deal.

What about luxury-goods stocks?


Jain: There is a shift away from conspicuous consumption. It’s much more about experiences.

We own InterGlobe Aviation [INDIGO.India], an Indian airline known as IndiGo. It is the lowest cost per seat mile in the world and has grown from nothing in 2006 to controlling 40% of the market.

What other trends are emerging?


Eidelman: Customers are willing to pay up for services and goods—that is new. The Chinese like deep-frying, and if you don’t have an extraction hood, your kitchen doesn’t look so good. Hangzhou Robam Appliances [002508.China] makes range hoods and has the same cachet as Sub-Zero and Wolf. The trend is also playing out with JD.com [JD]. Consumers are going to the online retailer, not because things are cheaper but for customer service and because they know it is reliable.

Ishida: There’s a lot of growth in automation. For example, China has become a high-wage country, and Chinese textile maker Shenzhou International Group Holdings [2313.Hong Kong] has moved operations to lower-wage countries like Cambodia, and recently built a fully automated plant in Vietnam. It’s an excellent company and a critical part of the supply chain for customers like Uniqlo, Adidas [ADS.Germany], and Nike.

For years, China’s soaring debt has loomed over the market. Is it a risk?


Eidelman: It was a black swan event I had been nervous about, but I am more relaxed now that China has allowed its currency to float. By breaking the peg with the dollar, China no longer has to follow U.S. monetary policy and raise rates when its economy is slowing. China has also tightened the limits around taking capital in and out of the country, limiting pressure on the currency.

Ishida: Much of the high debt levels are at state-owned enterprises. Over the past three years, these companies have reduced their debt issuance. That will continue, though very slowly, lowering the risk a bit.

Jain: I’m not as worried about China’s debt creating a global crisis; most of the debt is owned domestically. The Chinese also have a very high savings rate, allowing the country to handle nonperforming loans without being at the mercy of foreigners.

What worries you?


Eidelman: There is some froth. For instance, Tencent’s online publishing platform China Literature [772.Hong Kong] doubled in its recent public offering. I wouldn’t be surprised if we saw a selloff, but we are much more positive on the earnings-per-share trajectory than before. I’d be in the buy-the-dip camp.

Schwab: While everyone thinks of emerging markets as a commodity-driven market, technology stocks make up 30% of the index. Alibaba and Tencent would probably fall in sympathy if there is a big correction in FANG stocks in the U.S., creating a disproportionate impact on emerging markets.

And while China has telegraphed slower economic growth next year as it continues to deleverage, it could still create an air pocket in the market. There are also a slew of elections coming up, including those in South Africa, Brazil, and Mexico, and there’s always potential for volatility. Lastly, the escalation of tensions between Riyadh and Tehran after the Saudis intercepted a missile, and an anticorruption crackdown by Prince Mohammed bin Salman that included arrests of dozens of princes, ministers, and businessmen earlier this month, should not be underestimated as a potential source of volatility.

That’s a long list of worries, gentlemen. Thanks for your time.


For richer, for poorer

American taxes are unusually progressive. Government spending is not

How America does, and does not, redistribute income




AMERICANS are not known for their love of income redistribution. Asked to rank, on a scale of one to ten, how important it is for democracies to reduce inequality, they say only six; Europeans say eight. Yet the country is hardly indifferent to who gets which slice of the economic pie. Three in five Americans say that income and wealth should be spread around more. The most potent charge laid against the unpopular Republican tax plan making its way through Congress is that it is a giveaway to the rich and to corporations—groups that voters, by large margins, think should pay more tax, not less.

This strange amalgam of views manifests itself in fiscal policy. The federal government has no qualms about making the rich pay the country’s bills; it has perhaps the most progressive tax system in the rich world, according to one study from 2009. But it pulls off only half of Robin Hood’s trick, because it funnels very little of the money it raises towards the poor. In combination, its reluctance to redistribute is the stronger force. America’s government reduces inequality by much less than those of other rich countries (see chart).



America’s levies rise with income, but not to particularly great heights. In 2016 the top rate of income tax averaged about 46% once state taxes were included, less than France’s 55% or Sweden’s 57%. So what makes its taxes so progressive? The answer is twofold.

First, America has no value-added tax, a levy on consumption. Because VATs are flat taxes, they are regressive. In any given year VATs cost the poor a higher fraction of their income than the rich, because high earners tend to save more. The average rate of VAT in the OECD, a club of mostly rich countries, is about 19%. Many American states levy sales taxes, which are similar to VATs, but are on average less than 10%.

Second, America’s generous deductions and credits, or “tax expenditures” in the jargon, are good for the working poor. Chief among them is the earned-income tax credit (EITC), a wage top-up for low earners. The child tax credit, a refund for parents, is another. In dollar terms the rich do best from tax expenditures, because of breaks for mortgage interest and employer-provided health insurance. Yet as a percentage of income, the poor benefit most. In 2013 tax expenditures boosted the incomes of the poorest fifth of households by almost 12%, according to the Congressional Budget Office. A single mother with two children earning two-thirds of the average income pays overall taxes of just 13% in America according to the OECD. In egalitarian Sweden the charge is almost 34%.

The Republicans’ tax reform would not do much to alter these fundamentals. The bill that passed the House of Representatives on November 16th expands the child tax credit, leaves the EITC unchanged and limits several deductions that benefit the rich. It preserves the top rate of federal income tax (though it raises the threshold at which it applies). Yet Democrats are still up in arms for two other reasons. First, changes to inflation indexing and the sunsetting of some clauses would hit the poor in the long term. Second, and most important, the bill would cut the corporate and estate (inheritance) taxes.

This would continue a long-running trend. Both taxes have been falling—and incurring more avoidance—for decades. In 1967 they raised a combined 4.4% of GDP; by 2016 this had fallen to 1.7%. Who benefits from lower corporate taxes is a controversial question. The answer is some combination of investors, through higher profits, and workers, through higher wages. The best guess is that about 75% of the benefit goes to rich investors. There is less ambiguity about who pays the estate tax, which kicks in above about $5.5m.

In any country the left would surely oppose such tax cuts. But it is not clear whether, over the long term, America’s left should focus on keeping taxes progressive or on boosting spending.

The international comparison suggests expenditure is more important. For all America’s tax progressivity, its poor, especially those without children, languish. In a dozen other countries, those in the tenth percentile of household income are better off, according to an analysis by Demos, a think-tank, from 2015. What is more, seven in ten Americans want to boost spending on the poor. A more regressive—but more lucrative—tax system, including a VAT, might enable such spending. Republicans, who normally like flat taxes, tend to oppose VATs precisely because they fear these make it too easy to expand the government.



But if spending on the poor is branded as “welfare”, conjuring up images of layabouts, support for it plummets. Seizing on this, conservatives like to argue that many beneficiaries of programmes like Medicaid, health insurance for the poor, are undeserving. The receptiveness of Americans to their argument explains why raising taxes on the rich is easier than raising spending on the poor.

Still, it may be that the most consequential impact on inequality of Republicans’ tax reform comes not from its direct effect on incomes, but rather from its knock-on effects on government spending. America would eventually have to pay for the tax cuts, which would add around $1.5trn to total borrowing over the next decade. That would make a bad fiscal outlook worse.

Growing spending on health care and pensions for the retired is already expected to push up the deficit from 3.2% of GDP in 2016 to 5.2% of GDP in 2027.

Even bigger deficits will make it easier for Republicans to justify cuts to entitlement spending, which they frequently say is unaffordable. The Republican plan to repeal and replace Obamacare, which flopped earlier in 2017, would have reduced Medicaid spending by 35% by 2036 (Medicaid spending is the biggest slice of the federal budget that is dedicated to the poor).

The tax bill may eventually allow them to achieve a similar result and more.

In reality, America could afford a bigger state; the question is whether it wants to. This coming fight, over the size and responsibilities of the federal government, will matter more than an argument over precisely who pays for what.


Let the 5G battles begin

There is exponentially more wealth to be made and tech titans are vying for position

Rana Foroohar




The consumer internet revolution of the past 20 years has brought us many amazing things, from online search engines to phones doubling as personal assistants. But as dramatic as that change was, it’s nothing compared with the coming evolution of 5G wireless and the internet of things, which will involve putting data mining chips in everything from your fridge to your car.

This will not only create entirely new businesses, but also allow advertisers to reach you in ever more targeted ways (they’ll know not only where you are, but if your garden needs watering or if you are running out of milk). The economic stakes are high. As rich as big tech companies are, there is exponentially more wealth to be created in this new 5G world. Yet the technology that underpins it all is being threatened by a battle over which businesses and industries will seize which slice of this juicy pie.

Traditionally, companies such as Apple, Google, Samsung and others that make wireless devices have paid the developers of crucial wireless technologies — including Qualcomm, Nokia and Ericsson — a licence fee to use their chips and other essential patented intellectual property (IP). Standard-setting bodies in the US and Europe designated which technologies were essential to building the underlying system, and then allowed innovators to patent them provided they would offer “fair, reasonable and non-discriminatory” access to all market players.

Of course, there are big disagreements about what’s “fair”, particularly as connectivity becomes more widespread across a greater variety of devices.

One of the most contentious issues has been whether the value of essential patented technologies should be based on the price of a chip (which might only cost a few dollars) or the phone it powers (which could be hundreds of dollars). The tech giants, of course, want to locate the licence value in the chip, which would mean they pay less for IP.

Companies such as Qualcomm want it based on the price of a finished product, a phone or even a car, for example. They argue that connectivity needs are very different for a device that, say, monitors water levels in soil once a week versus an always-on autonomous vehicle, and prices should reflect that.

This is all part of a deep and growing divide between the largest consumer brands, such as Apple, which see their ability to put tens of thousands of bits of patented technology together in a beautifully finished product as the biggest contributor to value, versus US and European innovators that argue they have spent billions on research and development creating standards and technologies that actually make smartphones smart — and are now being bilked.

The result, according to one recent survey, is that roughly three-quarters of wireless tech IP holders are refusing to provide assurances that they’ll license their latest technologies, something that could start to undermine connectivity. The epic legal battle between Apple and Qualcomm reflects this stand-off. Qualcomm is refusing to ship its chips to Apple, while Apple is refusing to pay Qualcomm fees for what it is already using.

Both sides have a point. Critics say Qualcomm is charging too much for its technology but also that Apple is wrong to hold out on paying licence fees. “The fact that there’s so much litigation now means that neither regulators in the US or the EU are doing their jobs,” says Elvir Causevic, a managing director and IP specialist at Houlihan Lokey, the San Francisco-based investment bank. Indeed, the regulatory signals coming from either side of the Atlantic have been contradictory.

In 2015, the US standards-setting body, the IEEE, moved towards a position that favours big tech companies. But on November 10, US assistant attorney-general Makan Delrahim, gave a speech indicating that he thought players who “hold out” and refuse to pay licence fees (such as Apple) were a bigger problem than patent owners who “hold up” the system by demanding higher fees.

The European Commission, meanwhile, had been headed in the opposite direction. You’d think it would be a no-brainer for Europe to protect its own telecom players. Yet there is a battle within the commission, with innovation advocates (who fund the research conducted by companies such as Nokia) arguing for the telecoms businesses and those in antitrust seeing patents as a monopoly that should not be protected.

It’s also possible that the antitrust contingent is looking to protect an entirely different group of stakeholders. If cars become phones on wheels, then French, German and Italian automakers will need access to cheap wireless tech, just as Apple and Google do. It may be that the commission will throw telecoms (and the existing patent system) under the bus to give European carmakers a leg up with smart vehicles.

They may also decide to punt and see which direction the US goes in, not only in terms of wireless standards but patent rights in general. This week, confirmation hearings will begin for the presidential nominee for director of the US Patent Office, and the Supreme Court will hear the “Oil States” case that could shift the entire patent system in the US. Corporate lawyers of the world, rejoice — the 5G battles are only just beginning.


Germany, Coalitions and Social Earthquakes

By George Friedman


Germany has been the stable center of the European system for decades. It has the fourth-largest economy in the world and the largest in Europe. Its society has been relatively cohesive within the framework that has defined Europe since 1989. Its political system has been solid during that time, with the country’s two main parties, the Christian Democratic Union and the Social Democratic Party, forming a governing coalition for much of the past 12 years. While the interests of European Union members have diverged since the 2008 crisis, and social and political tensions have torn at the fabrics of other nations, Germany has been the solid rock on which Europe has rested. It is not an overstatement to say that if Germany destabilizes, European institutions and the European Union as a whole will not survive.

Germany has not destabilized, but it is wobbling. One sign is the inability of German parties to form a new government since elections in September. A reason for this is that the political reality of Germany has shifted: Both the CDU and the SPD lost roughly 20 percent of their seats in parliament in the election; the Christian Social Union in Bavaria, the CDU’s long-time partner, lost about the same; and the two left-wing parties, the Greens and the Left Party, gained hardly any. Meanwhile, the right-wing Alternative for Germany, or AfD, gained 93 seats to become the third-largest party in parliament, taking most of its votes from the CDU and the SPD. In addition, the Free Democratic Party, a traditionally liberal party dedicated to free markets with a minority euroskeptic faction, became the fourth-largest party after failing to win any seats in the previous election. 
Germany parliament Bundestag Angela Merkel
German Chancellor and leader of the CDU Angela Merkel (L) speaks with Martin Schulz, leader of the SPD, on Nov. 21, 2017, in Berlin during for the first session of the Bundestag, the German parliament, since the collapse of government coalition talks. MICHELE TANTUSSI/Getty Images
 
This is not an earthquake, but the ground has shifted. The CDU and the SPD can still form a grand coalition, but to date they have been unable to do so. There are, as in all political matters, many reasons for this, but the deepest reason is that the CDU and the SPD have evolved into effectively the same party. They have governed together, sharing the same Europhile ideology and holding similar views on the role of Germany and the manner in which German society should be run. The two major political parties have failed to provide the German public with different visions of the country’s future, and different views on the matters that concern Germans, like the EU, immigration and social programs.

As a result, other parties have emerged. These parties are too small to expect to govern, and therefore they don’t necessarily need to hold positions that have broad appeal. Instead, they have carved out niches with views designed to bring together fragments of German society. The left has been doing this for years, and now the AfD has stepped up to represent the nationalist right, while the Free Democrats represent a vaguely libertarian position. None of these parties will rule, but together they constitute the only opposition to what are called the mainstream parties. The problem is that the mainstream consists of many lesser streams, and the subtleties of even the governing coalition have been forgotten. This is one factor that has led to resentment toward this political hegemony. The marginal parties attract not only fellow ideologues, but also those who are repelled by the decline in debate between the major parties. The SPD therefore is being very cautious in accepting a place in another coalition government. Germany needs mainstream parties that debate and disagree, not a hegemonic center that generates revolts from the margins.

Politics is, for the most part, uninteresting from a geopolitical perspective. Watching the personal ambitions of various players getting cloaked in useful principles rarely reveals the underlying social realities. But we live in a time when politics in the United States, the United Kingdom, Germany and other countries reveal the deep social tensions that must be addressed. The anger between factions is real, and bringing them to light is the only way to address them.

Germany is not Angela Merkel, although she has skillfully built a political center that claims to speak for the whole country. But Merkel has also created an opposition that is now challenging the center on a range of issues. When a grand coalition ignores the dissenters or pretends that they are merely cranks, the ground under the coalition weakens. There is in fact a great debate in Germany over the country’s future on issues from the role of German culture to the welfare state. A grand coalition brushes these matters aside, and the more it does that, the more the political system and social reality will diverge, until the earthquake inevitably arrives.


Inheritance tax

A hated tax but a fair one

The case for taxing inherited assets is strong



NO TAX is popular. But one attracts particular venom. Inheritance tax is routinely seen as the least fair by Britons and Americans. This hostility spans income brackets. Indeed, surveys suggest that opposition to inheritance and estate taxes (one levied on heirs and the other on legacies) is even stronger among the poor than the rich.

Politicians know a vote-winner when they see one. The estate of a dead adult American is 95% less likely to face tax now than in the 1960s. And Republicans want to go all the way: the House of Representatives has passed a tax-reform plan that would completely abolish “death taxes” by 2025. For a time before the second world war, Britons were more likely to pay death duties than income tax; today less than 5% of estates catch the taxman’s eye. It is not just Anglo-Saxons. Revenue from these taxes in OECD countries, as a share of total government revenue, has fallen sharply since the 1960s. Many other countries have gone down the same path. In 2004 even the egalitarian Swedes decided that their inheritance tax should be abolished.

Yet this trend towards trifling or zero estate taxes ought to give pause. Such levies pit two vital liberal principles against each other. One is that governments should leave people to dispose of their wealth as they see fit. The other is that a permanent, hereditary elite makes a society unhealthy and unfair.

How to choose between them?

When the heirs loom

Some people argue for a punitive inheritance tax. They start with the negative argument that dead people no longer enjoy the general freedom to disburse their wealth as they wish—as the dead have no rights. How could they, when they are not affected one way or the other by what happens in the world?

That does not ring true. The logic would be to abrogate even the most modest of wills. But inheritances are deeply personal and the biggest single gift that many give to causes they believe in and loved ones they may have cherished. Many (living) people would feel wronged if they could not provide for their children. If anything, as the expression of their last wishes, bequests carry more weight than their passing fancies do.

The positive argument for steep inheritance taxes is that they promote fairness and equality.

Heirs have rarely done anything to deserve the money that comes their way. Liberals, from John Stuart Mill to Theodore Roosevelt, thought that needed correcting. Roosevelt, who warned that letting huge fortunes pass across generations was “of great and genuine detriment to the community at large”, would doubtless be aghast at the situation today. Annual flows of inheritance in France have tripled as a proportion of GDP since the 1950s. Half of Europe’s billionaires have inherited their wealth, and their number seems to be rising.

However, in 2017, it is not clear exactly how decisive a role inheritance plays in the entrenchment of the hereditary elite. Data from Britain suggest that people tend not to lose their parents before they reach the age of 50. In rich countries the advantages that wealthy parents pass to their offspring begin with the sorting mechanism of marriage, in which elites increasingly pair up with elites. They continue with the benefits of education, social capital and lavish gifts, not in the deeds to the ancestral pile.

Even if the link between inheritance-tax rates and inequality were clear, wealth can pay for a good tax lawyer. In the century since Roosevelt, Sweden and other high-taxers discovered that if governments impose a steep enough duty, the rich will find ways to avoid it. The trusts they create as a result can last even longer than the three generations it takes for family fortunes to go from clogs to clogs.

Armed with such arguments, some leap to the other extreme, proposing, as the American tax reform does, that there should be no inheritance tax at all. Not only is it right to let people hand their private property to their children, they say, but also bequests are often the fruits of labour that has already been taxed. And a large inheritance-tax bill is destructive, because it can cause the dismemberment of family firms and farms, and force the sale of ancestral homes.

Yet every tax is an intrusion by the state. If avoiding double taxation were a requirement of good policy, then governments would need to abolish sales taxes, which are paid out of taxed income. The risks that heirs will be forced to sell homes and firms can be mitigated by allowing them to pay the duties gradually, from cashflow rather than by fire-sales.

In fact, people who are against tax in general ought to be less hostile to inheritance taxes than other sorts. However disliked they are, they are some of the least distorting. Unlike income taxes, they do not destroy the incentive to work—whereas research suggests that a single person who inherits an amount above $150,000 is four times more likely to leave the labour force than one who inherits less than $25,000. Unlike capital-gains taxes, heavier estate taxes do not seem to dissuade saving or investment. Unlike sales taxes, they are progressive. To the extent that a higher inheritance tax can fund cuts to all other taxes, the system can be more efficient.

Transfer market

The right approach is to strike a balance between the two extremes. The precise rate will vary from country to country. But three design principles stand out. First, target the wealthy; that means taxing inheritors rather than estates and setting a meaningful exemption threshold.

Second, keep it simple. Close loopholes for those who are caught in the net by setting a flat rate and by giving people a lifetime allowance for bequests; set the rate high enough to raise significant sums, but not so high that it attracts massive avoidance. Third, with the fiscal headroom generated by higher inheritance tax, reduce other taxes, lightening the load for most people.

A sensible discussion is hard when inheritance taxes prompt such a visceral reaction. But their erosion has attracted too little debate. A fair and efficient tax system would seek to include inheritance taxes, not eliminate them.