The Distribution of Pain

When you write about economics, you learn very quickly that the economy doesn’t care what you say about it. The forces that drive it are beyond any one person’s comprehension, much less control.

But at the same time, the economy doesn’t work like a law of nature. Unlike gravity, for instance, the economy responds to human choices and preferences. We influence it, even if we don’t understand exactly how.

In last week’s “Fragmentation of Society” letter, I wrote about the coming technological changes that will replace many human jobs and disrupt society. Some of the disruption will be good and necessary. Much of it will be painful, too, and the pain won’t be evenly distributed.

That is a problem whether you personally feel any pain or not. People don’t like pain and will change their behavior to avoid or relieve it. Like the drowning who desperately seek something to hold onto, they will vote for politicians who say they can relieve that pain, regardless of whether they actually can. And if those who suffer see that you don’t share their pain, they will wonder why not and seek to gain whatever advantage you possess. And then it gets ugly.

That’s not a moral statement but simply a fact-based observation of human nature.

Whether we like the facts doesn’t really matter: We have to face them. Presently we are not handling them very well.

We have engineered society so that we at the upper end of the financial spectrum have little interaction with or knowledge of the people who feel the most pain. I wrote about this chasm between classes last year (see “Life on the Edge”) as the US elections made the split in our nation harder to ignore.

Peggy Noonan talks about the “Protected” class that makes public policy and the “Unprotected” who must live with those policies. The gulf between those classes continues to widen. The changes I wrote about last week will probably make it worse over the next 10–15 years.

Today I want to delve a little deeper into this widening split and consider where it may take us. As you’ll see, the possibilities range from “not so bad” to “very, very bad.”

The Two Economies

Ray Dalio is no stranger to my readers. The billionaire founder of top hedge fund Bridgewater Associates got where he is by having keen insight into both human nature and economic trends. Occasionally he shares some of his wisdom publicly. I featured his reflections on the then-forthcoming Trump presidency in Outside the Box last December.

Last month Dalio posted a new article, “The Two Economies: The Top 40% and the Bottom 60%.” He believes it is a serious mistake to think you can analyze or understand “the” economy because we now have two of them. The wealth and income levels are so skewed between top and bottom that “average” indicators no longer reflect the average person’s experience or living conditions.

Dalio launches with this chart:

The red line is the share of US wealth owned by the bottom 90% of the population, and the green line is the share held by the top 0.1%. Right now they are about the same, but notice the trend. The wealthiest 0.1% has been increasing its share of wealth since the 1980s, while the bottom 90% has been losing ground.

Looking back, we see a similar pattern in the 1920s – which dramatically reversed in the following decade. Then there was an almost 50-year period during which the masses gained wealth and the wealthy lost ground.

(Important note: This doesn’t mean the 0.1% ceased being wealthy. It just means they owned a smaller portion of the total wealth. An economy in which 0.1% of the people own 10% of the wealth is still skewed, just less so. But more on that later.)

In the big picture, we see about a half-century when the net wealth gap widened in favor of the bottom 90%, followed by another 30 or so years in which the wealthiest gained ground while most of the population lost it.

It’s not a coincidence that populism emerged as a political force in both the 1920s–1930s and the 2010s. In each case, people at the bottom could tell the economy wasn’t working in their favor. The best tool they had to do something about it was the vote, so they elected FDR then and Trump now – two very different presidents but both responsive to the most intensely angered voters of their eras.

That previous, roughly 10-year period in which the green line was above the red line included the Roaring 20s, the 1929 market crash, and the first part of the Great Depression. For the 0.1%’s share of the wealth, 1929 was roughly the high point. Wealth lost in the crash sent their share plummeting. It has not fully recovered to this day, but it’s getting close.

Thinking about this situation, I can’t help but correlate it to my friend Neil Howe’s idea of a historical “Fourth Turning” every 80 years or so. It fits well with Dalio’s data. Neil said at my 2016 Strategic Investment Conference in Dallas that we are in the middle stages of that Fourth Turning, and he expects conditions to worsen from here. He repeated that warning this year at SIC in Orlando. As he points out, for almost 500 years the last half of Fourth Turning has always encompassed the most tumultuous times in Anglo-Saxon history.

(A Fourth Turning is a time when society’s foundational institutions are challenged. The generation who are young adults at that time must face the challenge, and hopefully overcome it. The so-called Greatest Generation did so by persevering through the Great Depression and fighting World War II. It may not be a war, but the Millennial Generation will face a similar test.)

Back to Dalio’s article. He goes on to quantify the 60/40 split with some startling numbers. Just a sampling:

• The average household in the top 40% earns four times more than the average household in the bottom 60%.

• Real incomes for the bottom 60% have been either flat or down slightly since 1980.

• In 1980, the average top 40% household had six times more wealth than the average bottom-60% household. Now it is 10 times as much.

• Only about a third of the bottom 60% saves any of their income.

Dalio also found some very useful data I had never seen before: household income adjusted to show the impact of taxes, tax credits, and government benefits. This adjustment gets closer to the resources people actually have available for living expenses, savings, and investment.

Splitting that data by the top 40% and bottom 60%, we see a sharply growing difference in the percentage changes since 1980. The top saw its after-tax net household income grow almost three times faster than household income for the bottom 60%, even including government transfer payments.

And note something in the right-hand side of the chart, which depicts income changes for the bottom 60% only, divided into three segments. There is a significant difference in the income growth of the middle 40–60% segment and the bottom 40%, too, and that difference accelerated during and after the Great Recession. Think about that in the context of recent political trends.

You see the problem here? The bottom 60% know their own experience. Thanks to the Internet and social media, the bottom 40% are particularly aware of it and increasingly resentful.

Note also that the lower ranks of the top 40% are not “wealthy” by any stretch. Anyone below the 80th percentile is probably struggling to some degree.

Since the 1980s most of us at the top have believed that a rising tide would lift all boats. We were half-right: It has lifted all the boats but not at the same rate, and a good many boats have sprung holes and are taking on water. We’re now near the point where our differences in income and wealth are too great to ignore.

Think back 30 years. None of us would want to go back and live with that same technological base. All of our lives have dramatically improved. From health care to communications to entertainment to transportation and a host of other things, we are all better off.

But the key here is that no matter how much better our lives have become, those in the bottom 20 or 40 or 60 or 80% notice the relative differences between where they are and where the top 10% or 1% reside, and they can see those differences growing.

While the majority of those living in Africa, in some parts of Asia, and in the slums in Latin America would see the lives of what we call the poor in America as vastly superior to their own lifestyles, that is not who the bottom 20–40–60% of the income strata in the US are comparing their lives to. It is simply human nature that we compare ourselves to those who have more, and that we want more for ourselves.

Leveraged Stress

Last week the American Psychological Association released the results of its latest “Stress in America” survey. Not surprisingly, it revealed we are not happy campers.

A big majority (59%) think we are now at “the lowest point in our nation’s history.” To me, that seems a stretch, given that we killed each other in staggering numbers in the Civil War. And the 1820s was not a decade of great civility either. But then, people didn’t watch the fighting on their phones. Now we do, and it fills us with anxiety.

I look back on my youth and realize that the late ’60s was the first time when the reality of war confronted my generation in our homes, on our TVs and in our newspapers, every day. What we experienced with media coverage of social turmoil in that era was a harbinger of what the internet and social media have created today: instantaneous analysis of almost everything. Now, social media have become a monstrous breeding ground for conspiracy theories of all kinds. It is most disheartening.

The specific issues that worry people are interesting:

First on the list is health care, by a pretty wide margin. That concern can cover a lot of territory. Maybe you or a family member are seriously ill, or maybe your health is fine but buying insurance causes financial stress.

Just over a third of respondents reported that the economy causes them stress. That seems a little low, but I remind myself that most people don’t observe the economy the way I do. “High taxes” are well down the list, at 28%. That’s surprising but probably reflects the fact that a small number of people pay most of the income taxes.

“Unemployment and low wages” is also near the bottom with 22% of respondents stressed about it. Maybe that figure reflects today’s low unemployment level, or maybe people are just glad to have any sort of job.

One source of considerable stress that isn’t on the list but probably should be is household debt. I talk a lot about government debt and pension debt, but for most people the more immediate concern is probably their mortgage, auto, credit-card, and student loan debt. There is a mountain of it.

Here’s an interesting Deutsche Bank chart on that point:

We see here household leverage ratios spanning 1992–2016, broken down by income quintiles. Focus your attention on the 1992 (darker blue) and 2016 (rightmost black) bars. In that 24-year interval, leverage more than doubled for the lowest-income 20% and rose significantly for the lower-income 80% of the population. It dropped slightly for the 80–89.9th percentiles and even more for the top 10% income group.

Now recall Dalio’s data on household income, adjusted for taxes and benefits. The top 20%, whose incomes grew the fastest, managed to reduce their leverage. The lower groups, whose income was up slightly or flat, added large amounts of debt, with the poorest adding the most, percentagewise.

This data doesn’t tell us what specific kinds of debt create these leverage ratios. Maybe some of the debt is productive, like mortgages on reasonably valued homes or student debt that helps borrowers eventually raise their incomes. But I’d bet much of the money that was borrowed is simply gone with little or nothing to show for it.

This likely-unrecoverable debt also appears as an asset on some lender’s balance sheet. It ends up being sold as asset-backed securities, possibly to a mutual fund or pension fund near you. And it’s generally in the high-yield category, with leverage on it.

At the risk of repeating the obvious, debt that can’t be repaid won’t be. Somebody will eat the loss; the only question is who. Banks managed to socialize much of their losses in the last recession. I’m not sure that plan will work a second time.

I started off talking about pain and how we distribute it. It may not be physical pain. Financial and employment-related pain are very real. Boredom, too, can be painful, as can loneliness or the feeling that no one needs you. We’re on the verge of many medical breakthroughs, but we won’t cure every disease or heal every kind of wound. People will still suffer, and it’s clear we need a lot of societal as well as personal healing.

One Nation, Two Labor Markets

In a recent column on Bloomberg, Jeanna Smialek and Greg Quinn write:

Goldman Sachs economists agree with Bridgewater Associates’ Ray Dalio: The U.S. economy is running at two speeds.

Headline joblessness may be at a more than 16-year low, but that bullish trend obscures the fact that the labor market is split into two “quite different stories,” Goldman Sachs economists write. A pool of would-be workers remain on the sidelines, and there are reasons to think they can be pulled back into the game. The share of discouraged workers has shrunk, and people are even coming back into jobs from disability. If the labor market gets as hot as it was back in 1999–2000, the economists think participation could climb by a few tenths of a percentage point.

That conclusion is important. Goldman had been skeptical that a tight labor market could push up participation, so this marks a shift in their thinking. If the Fed concurs, it leaves the central bank with a tough choice: should the rate-setting Federal Open Market Committee run the economy hot to attract disenfranchised workers, even if that risks overshooting on inflation amid low headline unemployment? “The FOMC seems to find this trade-off unappealing and is likely to continue to tighten steadily as a result,’’ the economists write. 

While the Goldman analysis focuses on the labor market split, Dalio pointed out that aggregate statistics mask a division in labor, retirement savings, health care and wealth building. The common theme is that uneven outcomes mean the Fed must take underlying details into account when assessing economic progress. 

Working Class Versus Service Class

One final thought, which we will be revisiting in detail in future letters as we think about the future of work. We have had this notion of the “working class.” These are the people who do not own the businesses and are not professionals in the sense of being doctors or lawyers or accountants.

I have spent a great deal of time thinking about the future of work. It is the single most difficult chapter to write in my upcoming book, partly because I don’t like the conclusions I’m coming to. One of the things I am realizing is that there is a distinction between what we have seen as the working class and what I am coming to see as the service class. A working-class person is somebody who has a trade, and because of their skill, they can generally command a decent income.

Then there is the service class – bar and restaurant workers, retail salespeople, general manual laborers, and so on. These jobs are almost plug-and-play. It is not that the greedy restaurant owner doesn’t want to pay his staff more; it’s that competition generally won’t let him do so and still make a profit. So he holds his labor costs down; and he can do so, because in today’s market there are typically more people available for jobs than there are jobs. And because of the Obamacare mandate, if you are a business with more than 50 employees, you simply cannot afford to have full-time employees; so you resort more and more to part-time positions, which do not allow a worker to earn an adequate wage.

Health care being number one of the worry list? I think a large part of that is the fact that young people are required to buy ridiculously expensive health insurance packages in order to subsidize a sick elderly population. And if you’re making $10–$12 an hour working two part-time jobs, trying to figure out how to hold onto a place to live, eat, have adequate clothing, and a bit for entertainment, you’re just not able to spend $400–$600 a month on health care. And then you find out that your taxes are much higher than you thought they would be because now you have to pay the penalty for not having health insurance. Yes, that might stress me out, too.

And yes, I do know young people in exactly that situation. Several of my children literally cannot afford to buy health care, so dad does it for them. But many other friends don’t have parents who can buy them what is essentially ridiculously expensive health care, because the parents are struggling with their own healthcare costs.

We are a nation that is increasingly under stress. Dalio talks about it in terms of the bottom 60% versus the top 40%, but he could have made the same case using an 80–20 model or even a 90–10 model. I am reminded of Pareto’s 80/20 principle, which states that roughly 80% of effects come from 20% of causes.

Our socioeconomic situation is not going to get better, not for a long time. Let’s assume, wildly optimistically, that the US economy and the rest of the developed world grow at a 5% nominal rate for the next 15 years, so that our economies roughly double. Does that mean that the gap between the lower 60% and the upper 40% will be even wider? We will have more than a few people who will be worth more than $100 billion, that’s for sure.

Will the lives of those in the lower 60% be significantly better than they are today? Absolutely. They’ll have improved health care and health spans (if they have access to health care), lower food costs, far more access to services, etc., but the relative differences will be even greater between the top and the bottom.

Unless we somehow figure out how to help people deal with their stress and better manage the yawning differences in incomes and outcomes, we’re going to see increasing tension and fragmentation in our society.
OK, time to hit the send button. You have a great week!

Your thinking hard about the future of work analyst,

John Mauldin


America’s global influence has dwindled under Donald Trump

A presidential tour of Asia cannot hide the fact that America has turned inward, hurting itself and the world

A YEAR ago this week Donald Trump was elected president. Many people predicted that American foreign policy would take a disastrous turn. Mr Trump had suggested that he would scrap trade deals, ditch allies, put a figurative bomb under the rules-based global order and drop literal ones willy-nilly. NATO was “obsolete”, he said; NAFTA was “the worst trade deal maybe ever”; and America was far too nice to foreigners. “In the old days when you won a war, you won a war. You kept the country,” he opined, adding later that he would “bomb the shit out of” Islamic State (IS) and “take the oil”.

So far, Mr Trump’s foreign policy has been less awful than he promised. Granted, he has pulled America out of the Paris accord, making it harder to curb climate change, and abandoned the Trans-Pacific Partnership, a big trade deal. However, he has not retreated pell-mell into isolationism. He has not quit NATO; indeed, some of America’s eastern European allies prefer his tough-talk to the cool detachment of Barack Obama. He has not started any wars. He has stepped up America’s defence of Afghanistan’s beleaguered government, and helped Iraq recapture cities from IS. In the parts of the world to which he pays little attention, such as Africa, an understaffed version of the previous administration’s policy continues on autopilot. As Mr Trump makes a 12-day visit to Asia, it is hard to dismiss him as a man wholly disengaged from the world.

Many people find reassurance in the sober, capable military men who surround him. His chief of staff, his defence secretary and his national security adviser all understand the horrors of war and will stop him from doing anything rash, the argument goes. Optimists even speculate that he might emulate Ronald Reagan, by shaking up the diplomatic establishment, restoring America’s military muscle and projecting such strength abroad that a frightened, overstretched North Korea will crumble like the Soviet Union. Others confidently predict that even if he causes short-term damage to America’s standing in the world, Mr Trump will be voted out in 2020 and things will return to normal.

Reagan, he ain’t

All this is wishful thinking. On security, Mr Trump has avoided some terrible mistakes. He has not started a needless row with China over Taiwan’s ambiguous status, as he once threatened to do. Congress and the election-hacking scandal prevented him from pursuing a grand bargain with Vladimir Putin that might have left Russia’s neighbours at the Kremlin’s mercy. And he has apparently coaxed China to exert a little more pressure on North Korea to stop expanding its nuclear arsenal.

However, he has made some serious errors, too, such as undermining the deal with Iran that curbs its ability to make nuclear bombs. And his instincts are atrocious. He imagines he has nothing to learn from history. He warms to strongmen, such as Mr Putin and Xi Jinping. His love of generals is matched by a disdain for diplomats—he has gutted the State Department, losing busloads of experienced ambassadors. His tweeting is no joke: he undermines and contradicts his officials without warning, and makes reckless threats against Kim Jong Un, whose paranoia needs no stoking. Furthermore, Mr Trump has yet to be tested by a crisis.

Level-headed generals may advise him, but he is the commander-in-chief, with a temperament that alarms friend and foe alike.

On trade, he remains wedded to a zero-sum view of the world, in which exporters “win” and importers “lose”. (Are the buyers of Ivanka Trump-branded clothes and handbags, which are made in Asia, losers?) Mr Trump has made clear that he favours bilateral deals over multilateral ones, because that way a big country like America can bully small ones into making concessions. The trouble with this approach is twofold. First, it is deeply unappealing to small countries, which by the way also have protectionist lobbies to overcome. Second, it would reproduce the insanely complicated mishmash of rules that the multilateral trade system was created to simplify and trim. The Trump team probably will not make a big push to disrupt global trade until tax reform has passed through Congress. But when and if that happens, all bets are off—NAFTA is still in grave peril.

Ideas matter

Perhaps the greatest damage that Mr Trump has done is to American soft power. He openly scorns the notion that America should stand up for universal values such as democracy and human rights. Not only does he admire dictators; he explicitly praises thuggishness, such as the mass murder of criminal suspects in the Philippines. He does so not out of diplomatic tact, but apparently out of conviction. This is new. Previous American presidents supported despots for reasons of cold-war realpolitik. (“He’s a bastard, but he’s our bastard,” as Harry Truman is reputed to have said of an anti-communist tyrant in Nicaragua.) Mr Trump’s attitude seems more like: “He’s a bastard. Great!”

This repels America’s liberal allies, in Europe, East Asia and beyond. It emboldens autocrats to behave worse, as in Saudi Arabia this week, where the crown prince’s dramatic political purges met with Mr Trump’s blessing (see article). It makes it easier for China to declare American-style democracy passé, and more tempting for other countries to copy China’s autocratic model.

The idea that things will return to normal after a single Trump term is too sanguine. The world is moving on. Asians are building new trade ties, often centred on China. Europeans are working out how to defend themselves if they cannot rely on Uncle Sam. And American politics are turning inward: both Republicans and Democrats are more protectionist now than they were before Mr Trump’s electoral triumph.

For all its flaws, America has long been the greatest force for good in the world, upholding the liberal order and offering an example of how democracy works. All that is imperilled by a president who believes that strong nations look out only for themselves. By putting “America First”, he makes it weaker, and the world worse off.

Private equity: Twilight for the buyout barbarians

The founding partners of some of the biggest buyout firms are preparing to hand control to a new generation who will face a more forbidding landscape

by Henny Sender in Hong Kong and Gary Silverman in New York

No one likes to be called a barbarian. A quarter of a century after the 1988 takeover of RJR Nabisco by Kohlberg Kravis Roberts inspired the bestseller Barbarians at the Gate, one of the founders of that pioneering private equity group offered an alternative description of his firm.
George Roberts, the “R” in KKR, told a Financial Times conference in New York that he saw KKR as among the first in a line of activist investors who upset the capitalist order in the 1980s as they engaged in the admirable pursuit of corporate disruption. KKR made companies more efficient. “People forget,” he added, “that RJR had no governance.”
Today, Mr Roberts and the founders’ generation have become the billionaire masters of the financial services universe by purchasing companies and loading them up with debt in an effort to shake up complacent management teams, force cost-cutting and lower tax rates. They easily outshine most of the heads of the Wall Street firms in the profitability they realised, whether for their firms or for themselves.
Now these disrupters are themselves being disrupted. The buyout kingpins of the barbarian era are nearly all past the customary retirement age and are working on ways to hand over firms made in their own image to a new generation of leaders facing a more forbidding landscape.

This new world is marked by the appearance of an increasing number of competitors and resulting pressure on fees. Meanwhile, the end of easy money policies adopted in the wake of the global financial crisis raises the prospect of more expensive debt.
Hanging in the balance are the multibillion-dollar fortunes of the private equity founders themselves. Big buyout firms such as Carlyle, KKR, Blackstone and Apollo have gone public, meaning much of the wealth of their leaders is tied up in the shares of the companies they started. A lot of their money will be riding on the success of their successors.
“The firms have all gone public with the idea that the business model can live forever,” says Roy Smith, emeritus management professor at the NYU Stern School of Business. “But competition, pressure on fees and other factors have reduced some of the joy of the original business models without destroying them.
“So it is tough for the founders to get all their money out,” he adds. “They have to deal with succession to build good teams that will outlast them and add to their marketing connections.”

Carlyle this week became the first of the private equity titans to hand over power to a new generation of executives. Kewsong Lee and Glenn Youngkin, both 51, were named as co-chief executives of the investment firm based in Washington. Founders David Rubenstein and William Conway, both 68, will remain involved as executive chairmen. Daniel D’Aniello, 71, a third co-founder, will become chairman emeritus.
“Carlyle is going about it sensibly, without taking away from the firm the founders’ clout and influence with big investor institutions,” says Mr Smith, a Goldman Sachs partner before he went into academia. “Others will do the same.”
The next generation of leaders includes a fresh crop of entrepreneurs who have built businesses on their own. They are not, in other words, just managers, although management skill has become more essential as the firms — now known as alternative investment managers — grow in size.
For example, all indications are that the next head of Blackstone will be Jonathan Gray, who made his firm’s real estate business a success, with no company coming close to rivalling it. KKR will be in the hands of Scott Nuttall and Joseph Bae. Mr Bae was responsible for building KKR’s Asian business from nothing to the dominant private equity player in the region. All three essentially grew up in the firms they will one day take over.
At Carlyle Mr Youngkin earned his stripes by growing the firm’s energy business and is mostly homegrown — he spent some time at McKinsey. Among his achievements was the Goldman Sachs-led buyout of Kinder Morgan in 2006 in which the firm almost tripled its money.
But Mr Lee, one of the two newly-named heirs at Carlyle, was brought in from Warburg Pincus in 2013 as part of Mr Rubenstein’s quest to find a suitable replacement for Bill Conway, whose reputation as a steady, thoughtful investor with no interest in the limelight is unusual in the private equity industry. Under Mr Conway the flagship Carlyle buyout funds in the US have returned an average of $2.60 cents for every dollar the fund invested since 1987, putting it in the top quartile.
Taking hold of the reins at Carlyle will be a particularly difficult task because of Mr Rubenstein’s high public profile. Along with his day job he also hosts a fortnightly eponymous programme on Bloomberg Television and is chairman of the board of trustees at the Kennedy Center in Washington and co-chairman of the Brookings Institution, among other responsibilities.

He is also the personification of the peripatetic lifestyle of the founders’ generation. That is in part because of his willingness to go anywhere anytime to address audiences of potential investors in Carlyle funds, though he denies ever saying that the most joyous day of his life was when he could make calls from his private plane. “My children were very unhappy when they heard that,” he said.

Mr Rubenstein cut his teeth in US politics, serving as deputy domestic policy adviser in then president Jimmy Carter’s administration in the late 1970s. After Carlyle was founded in 1987, it forged ties across the political spectrum — and across the seas. Frank Carlucci, Ronald Reagan’s defence secretary, was chairman in the 1990s. George H W Bush, the former US president, James Baker, the former secretary of state and Treasury, and John Major, the former UK prime minister, have all served in advisory capacities.

Mr Rubenstein spotted important trends earlier than most of his rivals, predicting more than a decade ago that one day his firm would become as active in mainland China as it was at home. One of Carlyle’s most successful deals ever was the acquisition of a stake in China Pacific Insurance in 2005. But competition is increasing across the Asia Pacific region as well as in the US. Today the most lucrative buyout transactions in China are going to homegrown private equity firms, such as Boyu Capital.

The Carlyle boss was also one of the first in private equity to understand that investing in technology companies would replace the buyout business at the leading edge of finance. Venture capital firms such as Sequoia stole private equity’s thunder, producing even higher returns and generating a greater investor buzz.

About three years ago, Mr Rubenstein began to examine the possibility of acquiring a Silicon Valley company, though ultimately the idea never went anywhere because he could not find a suitable candidate. He is not alone. Blackstone has recently begun telling its staff that when they defend a proposed transaction to the investment committee, they must include a detailed explanation of how technological trends will affect their targets. Meanwhile, other private equity firms, such as General Atlantic and Warburg Pincus, carved out more prominent roles in technology investment.

Failing to keep up could put some of the private equity firms in play. Carlyle, with $170bn of assets under management, lags behind Blackstone, which has $387bn, and Apollo, which has $231bn. And industry participants say a company of Carlyle’s size — it has a market capitalisation of about $7.5bn, one-fifth the size of Blackstone — could be gobbled up by a bigger money manager. Larry Fink, BlackRock’s chief executive, has long aspired to build a thriving private equity business.

In one of his many recent speeches addressing the challenges facing the industry, Mr Rubenstein hinted at the prospect, saying in Berlin in 2015: “Traditional asset management firms will acquire firms previously considered alternative.”

Survival, Mr Rubenstein went on, will ultimately depend on the old buyout executives proving they are indeed corporate disrupters who make global capitalism more efficient — and not the barbarians of the books and Wall Street legend.

“The principal challenge to the industry over the next 10 years,” he said, will be “demonstrating that private equity adds value to companies and economies and is a prudent, safe and productive investment area”.

The Catalan Revolt of 2017

By Jacob L. Shapiro

Catalonia is vying to become Europe’s newest nation-state, but this is a battle Catalonia ultimately can’t win. On Oct. 27, Catalan lawmakers voted to declare independence—barely. Only 51.8% of members in the Catalan parliament supported the declaration. That means even Catalans themselves are divided over whether Catalonia should secede from Spain.

Spain has threatened to do whatever is necessary to maintain the rule of law in Catalonia, and it has both the will and the means to follow through on that threat. Catalonia also has very little international support it can depend on. Even so, the Catalan revolt of 2017 will have ramifications in Spain and in Europe that will be felt for generations to come.

For many observers outside of Europe, the Catalan issue came out of left field. Sure, the Catalan government said it would hold an independence referendum, but it held a similar referendum in 2014 and nothing came of that. Surely, all the Catalan government wanted was a bargaining chip it could use in its negotiations with the Spanish government over taxes and other issues related to the region’s political autonomy. Catalonia has more to gain economically by remaining a part of Spain, so why would it want to embark on the arduous and violent process that usually accompanies declarations of independence?

But no one should be surprised that Catalan independence has become a major issue—it has been for many centuries now. It is a product of Spain’s geography and Catalonia’s unique history. The geography of Spain is immensely diverse. The northwest is rainy and faces the Atlantic. The center has historically been dry and poor. The northeast—where Catalonia is located—is fertile and faces the Mediterranean. The south has its own unique climate and spent many centuries under Muslim rule. These realities helped create unique cultures and political economies that have proven remarkably resilient over centuries, despite best efforts to subsume them under Spanish nationhood.

The Catalan declaration also came out of Catalonia’s history. There has been a uniquely Catalan political consciousness since the Middle Ages. When Ferdinand II of Aragon and Isabella of Castile married, their rule was not absolute. It was a bargain between the monarchs and the regions comprising their dominions, many with their own constitutions. Taxes might well have flowed to the crown, but the crown in turn respected the autonomy of its regional subjects. The players often changed, but “Spain” was always a grand bargain between disparate regions and distinct peoples, not a coherent national entity.
Greater Autonomy

The grand bargain did not always hold, especially in Catalonia. Catalonia has periodically sued for greater autonomy and even independence. In the 17th century, for instance, the Spanish monarchy tried to extract more money out of Catalonia because Castile was carrying too great a share of the tax burden and because the Spanish crown needed money to pay for its wars. The result was the Catalan revolt of 1640–1652. In 1932, Catalonia once more tried to seize greater autonomy, only to be crushed by Spanish dictator Francisco Franco after the Spanish Civil War of 1936–1939. The 1978 Spanish constitution once again returned autonomy to Catalonia, recognizing that Spain could not hope to claim legitimacy among all the people it aimed to rule if it did not also respect the diversity of those very people in the first place.

At first, this seemed to work sufficiently well. But over time, the same issues that for centuries had divided Catalonia from the rest of the country began to crop up again. Even as Spain’s economy grew after 1978, Catalonia remained significantly richer than the rest of the country. Today, the region’s gross domestic product accounts for 20% of Spain’s GDP, and its GDP per capita is higher than the EU-27 average. The 2008 financial crisis hit Spain particularly hard. Youth unemployment spiked to over 50% in 2014 and remains around 40% today. Overall unemployment has been declining but is still over 16%. Catalonia wants more control over its economy and less of its tax revenue going to the central government. And it began reinstituting cultural markers such as teaching the Catalan language in schools. The grand bargain that was reached in 1978 has failed to hold up in a post-2008 world.
Pandora’s Box

This explains why Spain has reacted with such force to the Catalan regional government’s moves—even though only 42% of Catalans showed up for the vote, not exactly a ringing endorsement for the separatists. Catalonia is just one of 19 autonomous communities in Spain. Basque Country, with its own language and unique culture, has also been vying for independence, and as recently as the 1990s, Basque separatists carried out terrorist attacks in Spain in support of their cause. If Spain does not crush Catalonia’s independence movement now, it could open a Pandora’s box, with other regions demanding more autonomy or even separation, and Spain can’t allow this to happen. Madrid, therefore, needs to assert direct control over Catalonia; anything less would give the appearance of Spain abdicating its responsibility to its people and its constitution.

Both sides have been hurling accusations of illegal conduct at each other. The Spanish constitution is silent on the issue of independence referendums, but the Spanish government and Spain’s Constitutional Court view the Catalan regional government’s activities as illegal. The Catalan government viewed the violent Spanish response to the vote as illegal. The Catalan government also thinks what it is doing is in keeping with the spirit of the European Union, founded as it was on the idea of national self-determination. The situation has progressed to the point that the legalities and illegalities are irrelevant. The rule of law exists only in a political community in which all, or at least the vast majority, accept it. When there is a fundamental disagreement about what the law is and who gets to enforce it, the stability that law imposes breaks down, and life goes back to being nasty, brutish, and short, with victories determined not by persuasive argument but by monopoly of force. 

This is where things get complicated for the European Union. On the one hand, the EU remains steadfastly in support of its member state, Spain. But Spain will now have to use force to maintain its writ in Catalonia. That will put the EU in a lose-lose situation: It can either support a member state using force to quell a political rebellion that seeks the very thing the EU was designed to protect—national self-determination—or it can support the right to self-rule for the people of Catalonia but, in so doing, completely undermine the position of the Spanish government.

Eighteenth-century Irish statesman Edmund Burke famously said that Spain is “a great whale stranded on the shores of Europe”—as if, at the end of the day, there was something fundamentally un-European about Spain. That may have been true back then, but the 2017 Catalan revolt shows that Burke’s view of Spain no longer holds. Spain will now be a model for Europe. Catalonia is the first major secessionist movement to take concrete steps toward achieving independence in post-Maastricht Western Europe, but it won’t be the last. How Spain and the EU respond to Catalonia will set the tone for how the EU will respond to separatist or autonomy movements in places like Scotland, northern Italy, or other regions with dormant nationalism that may bubble to the surface.

2017 will be the year that the EU supports a government in putting down a movement for national self-determination on the European continent. Most, if not all, EU countries will support the use of force this time, since no country wants its own territorial integrity challenged. But condoning the use of force in this context takes the EU to a dangerous place. The EU was built around economic prosperity and was designed to ensure peace for Europe’s nations. If the EU can guarantee neither of those things, it will become irrelevant or unrecognizable. Slowly but surely, Europe is returning to history—and the suppression of Catalonia is a recurring chapter in that history.

The everywhere stores

Online retail is booming in China

Alibaba demonstrates the benefits of breadth

ON AN AVERAGE morning a young urban professional anywhere in the world might wake up, check her social-media feed and order a cab on her mobile. While sitting in traffic, she might use her phone to purchase groceries and watch a video, and later to pay the driver and buy a coffee. Once at work, she might make an online payment to reimburse a friend for a concert ticket. So far, so normal. But if that young urbanite were living in China, every one of these activities could have been powered either by Alibaba or a company in which it has a stake.

E-commerce in China is sweeping the board. Last year online sales in China hit $366bn, almost as much as in America and Britain combined. Growth has slowed from its eye-popping pace of a few years ago, but Euromonitor predicts that online shopping’s share of total retail will rise to 24% by 2020; Goldman Sachs, whose forecast includes sales from one consumer to another, puts the figure at 31%. That will mean selling more to existing shoppers and gaining new ones in smaller cities and towns. About 80% of adults in China’s biggest cities already shop online.

Alibaba, the company leading this transition, makes most of its money from advertising. But it has permeated consumers’ lives in ways not yet seen in America or Europe. Westerners should picture a combination of Amazon, Twitter, eBay and PayPal, but broader. Alibaba’s creation story is well polished. Jack Ma, its founder and chairman, was born in Hangzhou in 1964, the same year as Amazon’s Mr Bezos, and perfected his English by offering free tours of his home town to foreigners. His first visit to America in 1995 inspired him to set up an internet business in China. After a few false starts he founded Alibaba in 1999 to help Chinese manufacturers sell to foreign buyers. He also established Taobao, where independent sellers can list products, and Tmall, an e-commerce site for big brands. Much more followed.

Alibaba’s vertiginous rise was powered by hundreds of millions of increasingly well-off Chinese coming online, and helped along by a dearth of well-established incumbents. For example, its online marketplace required a reliable way to make payments in a country where credit cards were still rare. So Alibaba created Alipay, a digital payments system that held a buyer’s money until he received his order and was happy with it. It was spun out into an affiliate, Ant Financial, in 2014. Alipay is now used by about 520m people, not just to shop on Taobao or Tmall but to pay bills, buy lunch or send money to family. Amazon has nothing of this kind.

Most American and European consumers have stuck with their tried-and-trusted credit cards.

Last year Alipay had 2.5 times as many users as PayPal and more than 11 times as many as Apple Pay. And new services are still being added.

Alibaba’s online marketplaces are also expanding. The company not only sells all manner of goods but has now moved into health care and services. Ali Health sells medicines online. Mr Zhang, Alibaba’s CEO, recently announced a partnership with Marriott, the world’s biggest hotel chain. His company has also bought or taken stakes in other firms to extend its reach. It owns Youku, a video-streaming site, and has invested in Weibo, a Twitter-like social-media company with 361m users, as well as Didi, a ride-sharing service. If a consumer likes the dress worn by an actress seen on Youku, she can instantly buy it through Tmall.

But if China reveals how broad one company’s scope can be, it also shows how a rival might emerge. Alibaba has two main competitors, JD and Tencent, which have recently joined forces.

Tencent began as a gaming and messaging business. Its “Honour of Kings” is estimated to be the world’s top-grossing video game; its popular messaging app, WeChat, has 963m monthly users. Whereas Alibaba began with e-commerce and payments and then expanded, Tencent began with gaming and messaging and has moved further into commerce. Tencent’s mobile-payment app, WeChat Pay, had 40% of the market in the first quarter of the year, compared with Alipay’s 54%. Tencent started investing in JD three years ago; it now owns about one-fifth of it and is its biggest shareholder.

We know what you want before you want it

Unlike Alibaba, JD sells its own inventory and that of third parties, and has its own distribution system. Shoppers can buy goods from JD within WeChat’s app. In August JD announced a partnership with Baidu, China’s biggest search engine. This blurring of boundaries between digital activities provides Alibaba, JD and Tencent with a vast amount of information about its customers’ lives. “We will know you as well as you know yourself,” says Zhang Chen, JD’s chief technology officer. Tencent can gather data from social-media feeds and payments both online and in stores, and Alibaba recently introduced a “unified ID”, which collects data on individuals across Alibaba’s many businesses. These data give companies greater insight into what consumers want so they can adjust their marketing accordingly. Big Brother, it turns out, is a capitalist who wants to sell you blue jeans.

“The most important thing is not meeting the demand but creating the demand,” says Alibaba’s Mr Zhang. His company, JD and Tencent have ambitions beyond e-commerce. They are also after the 85% of the retail trade that still takes place offline, either by bringing more spending online or by serving customers in stores. WeChat Pay and Alipay are already widely used for physical transactions. Pass a clothing store and you may receive a personalised coupon on your phone. JD and Alibaba cast themselves as potential partners of bricks-and-mortar retailers, not just helping with delivery but providing tools to transform the way stores operate.

JD is using its logistics business to supply goods to small convenience stores, cutting out parts of the supply chain. Alibaba has invested in grocery and department stores. In Hema Xiansheng, its growing supermarket chain, prices on electronic tags can be changed throughout the day.

Mr Ma says he wants to use technology to change Chinese manufacturing. Alibaba already provides services such as advertising and cloud computing and hones those services continually, based on the data it gathers. Mr Zhang wants to use such “data-driven infrastructure” to support other businesses. In China, Alibaba has achieved some of that. But as it invests abroad, it is coming up against Amazon and others, who are eager to do so with infrastructure of their own.

IMF warns volatility products loom as next big market shock

Assets invested in such strategies estimated to have risen to about $500bn

by Miles Johnson

Fund believes that sustained low volatility increases incentives for investors to take on higher levels of leverage

The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets.

In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.

“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” he said

Equity market volatility has plumbed to its lowest level in a decade, with the Chicago Board Options Exchange’s implied volatility index, also known as the Vix, sitting at a level close to 10 compared with an historical average of about 20.

The IMF believes that sustained low volatility increases incentives for investors to take on higher levels of leverage while causing risk models that use volatility as an important input to understate real levels of risk participants may be taking on.

“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,”

Mr Adrian said. Mr Adrian’s warning comes amid increasing evidence that pension funds and insurance companies are venturing into riskier types of investments to gain income. Some are also effectively writing insurance contracts against a market crash to pocket premiums.

Last year the $14bn Hawaii Employees Retirement System said it was writing put options to boost its income, while other US pension schemes such as the South Carolina Retirement System Investment Commission and Illinois State Universities Retirement System have also hired outside managers to use option writing strategies.

The IMF estimates that assets invested in volatility targeting strategies have risen to about $500bn, with this amount increasing by more than half over the past three years.

Marko Kolanovic, head of macro, derivative and quantitative Strategies at JPMorgan, last month warned of “strategies that sell on ‘autopilot’”, and how risk management models that use volatility could be luring investors into taking on too much risk. “Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” he wrote in a note to clients.

With equity implied volatility continuing to drop over the course of this year investors who have bet that markets will remain tranquil have been rewarded. Yet the true quantity of complex products being sold that are linked to volatility of various assets is hard to ascertain due to such deals mostly being done in private. Regulators therefore find it difficult to map out the risks in the event of an unexpected market shock.