Uncharted Waters

Britain after Brexit

Now that Britain is sailing alone, Boris Johnson needs a lodestar. Liberalism offers one

NOT MUCH will change at 11pm on January 31st. Some 50p pieces proclaiming “peace, prosperity and friendship with all nations” will go into circulation to mark Britain’s departure from the European Union, but people, goods and services will continue to move freely between Britain and the EU, for the difficult business of making a deal on trade and migration has been left to the transition period that lasts until the end of this year.

Yet leaving the EU is a huge moment. Britain will be quitting the institutional structure that governs Europe’s single market, which will necessarily imply more friction in its trade relations with a club that takes almost half its exports. Britons will lose the automatic right they now have to live and work across the EU.

Brexit has also administered a shock to the country. The nation has argued long and bitterly over the issue, and its ruling elite has suffered a blow. The unarguable outcome is the most powerful government in a generation, under Boris Johnson. Much now depends on how he responds.
The Economist did not advocate this outcome. Most of the changes that Mr Johnson’s government favours could have been accomplished without leaving the EU. System-wide shocks are usually a costly way to bring about change. Yet now that Brexit is definitely happening, the country should make the most of the chance to recalibrate the economy and reset its priorities.

The last couple of times Britain pressed the reset button, in 1945 and 1979, the programmes that it put into place to create the welfare state and replace socialism with Thatcherism had been long-planned. This time is different.

Mr Johnson was focused entirely on leaving the EU and is now being buffeted by the storms that brew up swiftly in the affairs of state: he had to decide this week whether to bow to American demands that Britain keep Huawei, a Chinese company, out of its mobile-phone network (he did not), and must shortly make a call on whether a high-speed rail project to link the north of England to the south (HS2) should go ahead (it should).

Mr Johnson grasps the excitement of the moment, but so far he has shown himself no more than a brilliant opportunist. If his premiership is to leave its mark, it needs to be founded on a strategic vision, not tactical campaigning.

That vision should be based on liberalism. The belief in freedom as the underpinning of civilisation, in the state as the servant of the individual rather than vice versa, and in the open exchange of goods, services and opinions, arose in Britain. It fits naturally with a national character which suspects authority and tends towards pragmatism rather than idealism. It underpinned the country’s progress in the 19th and 20th centuries and spread to become the world’s dominant political philosophy. But it is now under threat, not least in Britain.
Brexit was born in part of the instincts to throw up barriers against the world. But within it was an ultra-liberal strand, which regarded the EU as too statist and parochial. Mr Johnson needs to unite the liberals and to persuade sceptics that a system based on free markets and free trade can work for them, too.

Abroad, liberalism means using Britain’s still-considerable muscle in the service of free trade and individual rights, whether in backing the World Trade Organisation or holding China to account for abuses in Xinjiang. Mr Johnson’s decision that the country should use Huawei’s equipment was, thus, right: liberalism means not going along with President Donald Trump’s attempts to drive China out of global technology supply chains.

Liberalism may also on occasion mean diverging from how the EU regulates business. In many areas, like manufacturing or food safety, following standards set in Brussels may be sensible even after Brexit, not least because the EU market is so valuable. In others it may be a bad idea to accept the EU’s rules.

In financial services, competing EU financial centres may seek to use regulation to handicap the City. In science and technology, Britain’s instinctive approach to regulation, which tends to be principles-based rather than relying on precaution, may be better suited to fostering innovation than the EU’s.

At home, liberalism means making the system open to all comers. Beneath the Brexit vote lay discontent that sprang from the sense that an economic system which pretends to be open is actually based on cronyism, run by and for a glossy, overpaid London-based elite impenetrable to those who are poor, provincial and without a foot on the property ladder.

Mr Johnson’s mantra is “levelling up” by boosting growth in the regions. He should be talking about “opening up” to give everybody the opportunity to share in prosperity. That means encouraging social mobility by spending more money on children’s early years, allowing the construction of more houses so that younger people can have decent homes, running an energetic competition policy to keep incumbents on their toes and building roads and railways in areas that have been short-changed. HS2 should be part of that: although its estimated costs keep rocketing, the gains from boosting rail capacity and speed across Britain will outweigh them.

Neither should the agenda be purely economic. Self-determination is central to liberalism, but over the past 150 years, power has slowly leached away from the English regions to Westminster. Scotland and Wales were given considerable autonomy in 1999, but England is highly centralised.

Brexit was England’s revenge on Westminster for giving special privileges to Scotland and Wales but ignoring the regions; and the consequence may yet be the break-up of the union. But whatever the fate of the union, a liberal government needs to decentralise power, not just because decisions are best made as close to the action as possible, but also because people need to feel they have power over their own destiny.

Britain’s future is full of uncertainty. No longer part of one of the great global blocs, it has to find a new role in the world. Pulled apart by the tensions within the union, its nations need to find a new accommodation. Shaken by the bitter arguments over Brexit, it has to mend its frayed social contract. The difficulties should not be underestimated. But when Britain previously reset its course, in 1945 and 1979, the choices it made helped reshape the world. It should aim to do that again.

The fallacy behind the rise of passive fund management

Ultra-low charges created an industry that hitched a lucrative free ride on the backs of stock pickers

Jonathan Guthrie

web_Passive fund management
© Ingram Pinn/Financial Times

Passive fund management is a big success built on a big fallacy. The late Jack Bogle’s sales pitch encapsulates it: “Don’t look for the needle in the haystack. Just buy the haystack.”

That line is still highlighted in marketing by Vanguard, the mutual fund business Bogle founded. BlackRock and State Street, two other big US fund managers, have their own variants. The implication: funds that track stock and bond indices immunise their clients against human error.

That is impossible. Someone has to build the haystack in the first place. In this case, it is active managers, who select securities they believe will outperform. But Bogle’s reassuring line, combined with ultra-low charges, has created an industry that has hitched a lucrative free ride on the backs of stock pickers. It is so successful that index funds will soon face the issue that confronts all titans, from Standard Oil to Facebook: their outsized impact on business and society.

Vanguard and its two peers manage assets worth $15tn, most of it passively. That compares with a world stock and bond universe whose value is estimated at about $190tn by the US Investment Company Institute. Growth rates have been breathtaking. BlackRock, the largest of the Big Three, has increased client assets 20 times to $7tn over 15 years, according to S&P Global data.

There are no signs of let-up.

The global value of regulated index funds powered past the $10tn mark recently. The reason?

“Fees are infinitesimally small because index funds have spawned competition hugely beneficial to the investor,” says Ben Johnson of Morningstar, the fund-ratings group. Charges may be less than 0.1 per cent annually for the exchange-traded index funds in which he is an expert.

Private investors previously paid five to 10 times more to hold old-school mutual funds. Too often, traditional fund managers were rentiers, charging clients steeply to own the stock market.

Index funds have blown a hole in that business model. But stock pickers still control about four-fifths of world equities. Besides, there is no reason to believe equity pricing would seize up, even if active managers owned far less.

That is good news for compilers of capitalisation-weighted indices, and the passive managers who use them. The Big Three’s economies of scale will continue rising for years, luring more assets.

At current rates, the Big Three will control over a quarter of S&P 500 equity by 2028, up from one-fifth in 2018, according to a paper last year from the National Bureau of Economic Research in the US. Their propensity to vote shares held for clients is above average, noted Lucian Bebchuk of Harvard Law School and Scott Hirst of Boston University. The Big Three are on course to control 40 per cent of the votes in American corporations in a couple of decades.

In a similar scenario, about a dozen people would set the agenda for US public companies, according to John Coates, another academic. That would be a dangerous concentration of power. Vanguard’s Jim Rowley argues “there is no monolithic index fund gobbling everything up — instead there is a very diverse set of index funds [run by each passive manager]”. This seems disingenuous.

The employees of any company share common values — passive fund governance wonks included. The greater the dominance of a few investors, the worse for shareholder democracy.

Lobbying pressure on the Big Three will also grow. Following pressure from activists, BlackRock joined Climate Action 100+, which chivvies energy companies to cut emissions and announced new green funds. Some see that as good stewardship. But can investors whose votes are increasingly pivotal in takeovers and top appointments credibly claim to be passive? Not really. By voting, they are picking winners, or trying to, just like active managers.

You could say the same of a range of index funds that are investing in everything from modish green ventures to marijuana companies. Here, compilers at index groups such as MSCI make bigger subjective calls on inclusion than they would for purely capitalisation-weighted benchmarks.

Even these old warhorses cause distortions. Businesses included in popular indices have lower financing costs than others. Companies from the former Soviet Union listed in London partly for this reason.

In the US, index funds stand accused of a far more incendiary anti-competitive impact. Their concentrated ownership of industries such as airlines and pharmaceuticals may push up travel and drug prices, some academics argue.

The validity of such concerns matters less than their growing currency. As huge businesses, the Big Three will provoke growing hostility from politicians and regulators. Modern capitalism’s crisis of legitimacy is a function of its scale and disengagement.

Groups that have accumulated trillions by outsourcing investment decisions look like a prime example of the problem. It is no longer enough for them to point out how low their charges are.

Before he died last year, Bogle wrote that if index funds owned more than 50 per cent of the stock market it would not “serve the national interest”.

That is one quote you will not find displayed prominently on Vanguard’s website.

Avocado crime soars ahead of America’s Super Bowl

Gangs muscle in on Mexico’s lucrative ‘green gold’ fruit business

Jude Webber in Mexico City and Emiko Terazono in London

Farmer Alfonso Trujillo looks at avocados at his orchard in the municipality of Uruapan, Michoacan State, Mexico, on October 18, 2016. With the United States buying most of the Mexican avocado production and the domestic demand constantly growing, the price of avocados in Mexico is suffering frecuent increases. / AFP / Ronaldo SCHEMIDT / TO GO WITH AFP STORY BY JENNIFER GONZALEZ COVARRUBIAS (Photo credit should read RONALDO SCHEMIDT/AFP via Getty Images)
Avocado growing in Uruapan, Michoacán state, Mexico. Parts of the state have become no-go areas, even for the police © AFP via Getty Images

As Americans prepare to tuck into their guacamole, a staple of Super Bowl viewing parties, ahead of this weekend’s football championship, avocado growers in Mexico are guarding against criminal gangs eager to cash in on a fruit dubbed “green gold”.

With about a dozen trucks an hour setting off from the avocado belt in Mexico’s western state of Michoacán for the US, armed robbers are zeroing in on the fast-growing, multibillion-dollar industry. The rise in avocado-related crime has turned parts of the state into no-go areas even for the police.

“We’ve tried to work with the government [to combat crime] but even they are afraid in some areas and don’t dare go in,” said Juan, whose family has two farms near Uruapan, the city at the centre of the state’s avocado production. He did not want his real name published for fear of retaliation.

Demand for avocados jumps ahead of the Super Bowl, America’s biggest sporting event, with Mexico shipping a record 127,000 tonnes to the US for the occasion.

Overall production is rising, hitting 1.09m tonnes in the 2018-19 season, up nearly 4 per cent from the 1.05m produced in 2017-18.

Exports last season rose 5.4 per cent. Sales to the US, the largest importer of Mexican avocados, bring in almost $2bn a year, much of it going to smallholders.

“Where there’s money, that’s where the bad guys go. With all the publicity that it’s going so well for us — this will be the sixth year that Mexican avocados have [been] advertised in the Super Bowl — it draws attention to us,” said Juan.

The criminal activity around avocados bears striking similarities to “conflict minerals” such as tantalum, tin, tungsten and gold, said Christian Wagner, Americas analyst at risk consultancy Verisk Maplecroft. “Because the degree of enforcement in Mexico is so low, if they see an opportunity they [the criminal groups] will start doing it. Avocados could become a conflict commodity,” he said.

Line chart of US imports from Mexico ('000 tonnes) showing US appetite for Mexican avocados is on the rise

Until recently, Mexico’s organised crime groups’ main source of revenues from avocados centred around extortion — demands for protection money from farmers. But the sharp fall in the price of Mexican opium paste has forced them to diversify, according to analysts. Increasingly they have started hijacking truckloads of fruit for export. “What motivates them is profit margins. They have an impressive capacity to invest and go into new areas of activity,” said Mr Wagner.

The rise in avocado crime is thus indirectly linked to America’s opioid crisis. Americans’ increased use of fentanyl, a synthetic opioid used for pain relief, pushed down the price of heroin, which in turn slashed the price of Mexican opium, according to Nathaniel Morris, a researcher of Mexican modern history at University College London, and a co-author of a report on the US fentanyl boom and the Mexican opium crisis.

Line chart of Reported incidents showing Violent crimes rise in Michoacan, Mexico

Column chart of Price of opium in 4 states ($ per kg) showing Mexican opium prices plunge

Opium prices in Mexico collapsed between 2017 and 2018, with the price per kilogramme falling to a quarter in some key producing areas, according to Noria, a research network. “[The fall in the opium price] is helping drive the further expansion [of criminal gangs] in the avocado industry and the negative side effects around it,” Mr Morris said.

Rising violence has even threatened to disrupt avocado flows to the US. The US Department of Agriculture last year temporarily suspended inspections in the Uruapan area after repeated threats to its employees.

Future security breaches or physical threats could result in suspension, the USDA wrote in a letter in September to Apeam, the Mexican avocado producers and packers association.

So dangerous has the avocado business become that several municipalities have armed private security guards to protect towns, said Juan.

“In Uruapan, there are only 130 policemen. [They] aren’t sufficiently trained and there aren’t enough of them,” he said.Still, for smallholder farmers in Michoacán, avocados provide much-needed income.

“If it weren’t for the 30,000 small avocado producers, Michoacán would have a very serious problem with migration, crime and poverty,” said one official at an avocado production company who did not want his name published.

“Buying avocados helps families and small producers. Without that, they are at the mercy of criminal groups.”

How Developing Countries Create Industrial Champions

Japan, South Korea, and other Asian economies achieved high-income status through strong state interventions that helped domestic firms venture into sophisticated high-tech sectors and compete globally. By applying these lessons, today’s developing countries can provide similar opportunities for their companies, as well as good returns for global investors.

Reda Cherif , Fuad Hasanov, Sabine Schlorke

rcherif2_In Pictures Ltd.Corbis via Getty Images_chinatechnologyworker

WASHINGTON, DC – For many firms in emerging and developing economies, emulating the success of the likes of Samsung and Hyundai may seem like an impossible dream. But the rapid economic growth of Japan, South Korea, and other Asian countries in the second half of the twentieth century shows how it can be done.

Japan and South Korea, for example, were once poor countries striving to reach high-income status as quickly as possible. They each achieved that goal through strong state interventions, such as industrial policies that helped domestic firms venture into sophisticated sectors and compete globally. By applying these lessons, today’s developing countries can provide similar opportunities for their companies, as well as good returns for global investors.

The “Asian miracle” was largely the result of a three-part strategy. First, the state set ambitious goals and achieved them by encouraging and supporting private firms to set their sights on breaking quickly into high-tech industrial sectors.

Next, governments understood that their countries had to develop strong export sectors in order to vault into the top echelon of high-income economies. Finally, policymakers needed to encourage a culture of robust corporate competition, as well as strict accountability for the support that businesses received.

The resulting symbiosis between the state and the market proved highly successful and has become a model for other developing countries to follow.

Exports became the gauge of success for Asia’s miracle economies. Throughout the region, firms systematically evolved from low-tech domestic concerns into global high-tech manufacturers of cars, ships, and electronics. Because they had to justify the support they received, they adapted quickly to changing market conditions. The firms that managed this transformation well became hugely successful, while those that underperformed were eventually restructured.

A vivid illustration of this can be found in the contrasting fortunes of South Korea’s Hyundai and Malaysia’s national car company Proton. The Malaysians had an ambitious plan to create a local supplier cluster. But although the venture succeeded in many respects, Proton was protected in its domestic market, and lacked the incentive to export in substantial quantities and face international competition. As a result, Malaysia did not develop an innovative automotive cluster.

Hyundai, on the other hand, built a global brand and developed cars that were key to South Korea’s export success – an accomplishment due in large part to government policies. The South Korean state bet on several family-based conglomerates, known as chaebols, to develop the country’s automotive industry. But that did not preclude restructuring these firms when warranted, and only a few of them eventually succeeded.

Hyundai was originally a family-owned construction company focusing on the relatively modest domestic market. But starting in the mid-1960s, with strong state support and incentives, the firm started operating abroad and entered high-tech sectors such as shipbuilding and automobile manufacturing, even though it had no previous experience in those areas.

The pressure to export and compete forced Hyundai to speed up research and development and upgrade its technologies. By 1991, the company had designed and produced its first car engine. (Likewise, Samsung, also from South Korea, traded food products such as noodles before pivoting to electronics.)

The successful development of the Taiwanese electronics sector further highlights the potential for developing-country firms to become leading global players in high-tech fields. Moreover, this technological leapfrogging took place very early on, when the economy’s GDP per capita was about 20% of the level of the United States – roughly where Tunisia stands today.

The state essentially acted as a venture capitalist to catalyze the fledgling sector. Public institutes established in the early 1970s, such as the Industrial Technology Research Institute, spearheaded a huge R&D effort, along with investment in skills training and building relationships with foreign multinationals.

These institutes spawned numerous electronics startups, and their staff initially headed the new firms. Some of the spin-offs, such as UMC and TSMC, have grown to become large multinationals in the global semiconductor industry. A focus on innovation and exports enabled these and other firms to achieve a level of success they could not have attained serving only the domestic market.

The earlier rapid growth of Asia’s miracle economies underscores the importance of the role of private firms in a country’s economic development. Although the state’s “leading hand” was instrumental in the initial stages, firms such as Hyundai, Samsung, and TSMC had the ambition to become global players in sophisticated sectors.

Many companies in developing countries today could borrow this recipe and attempt to create economic miracles of their own, in the process providing attractive returns to their countries and investors alike.

Reda Cherif is a senior economist at the International Monetary Fund.

Fuad Hasanov is a senior economist at the International Monetary Fund and Adjunct Professor of Economics at Georgetown University.

Sabine Schlorke is Global Manager for Manufacturing at the International Finance Corporation.

Rising Tide Lifts Some Banks’ Boats

The best-performing U.S. banks put their chips on Wall Street and credit cards, but investors should look past current pockets of strength

By Telis Demos

Goldman Sachs Group was among the banks to boost trading revenue in the latest quarter. Photo: lucas jackson/Reuters

When it came to American banks, the trend was your friend in the fourth quarter.

The parts of the sector best suited to the current environment stood out as big growth drivers: credit cards and trading. Consumers are healthy, enjoying rising wages and home values. And many trading clients were much more buoyant than a year earlier amid improving risk appetite and a renewed hunt for yield in fixed-income markets.

Trading was a huge factor at Goldman Sachs Group, GS -0.18%▲ JPMorgan Chase JPM -1.50%▲ and Citigroup. C -0.83%▲ Those banks’ trading revenues were up 41%, collectively.

At Goldman, overall fourth-quarter revenue was up 23% from the prior year as global markets revenue makes up more than one-third of its business.

JPMorgan’s and Citigroup’s total quarterly revenues were up 9% and 7%, respectively.

Bank of America BAC -1.84%▲ is certainly a very big Wall Street player, but just not quite as much of one relative to the overall size of the company.

Its quarterly trading revenues rose by a more modest 7%, making it more vulnerable to the industrywide pressure on net interest income.

Total revenue fell 1%. Revenue at U.S. Bancorp, a big lender but not a big Wall Street house, was down 3%.

Then there were credit cards: Cards are among the highest-yielding products banks offer. JPMorgan Chase and Citigroup grew their card loans outstanding by 8% and 5%, respectively, in the quarter, when counting Citigroup’s roughly equivalent U.S. branded-card business. Bank of America, meanwhile, shrank its card loan book slightly.

But is the latest quarter any kind of guide to longer-term performance for these institutions?

Wall Street trading is one of those businesses that can make a bank look stronger in good times and weaker in bad ones. Take the fourth quarter of 2018, when bond trading sank. Banks are trying to use technology to make markets businesses steadier, but it is difficult to escape the underlying cyclicality of financial markets.

Credit cards aren’t a one-way street, either. Of course consumer-credit risk is still seen as being very low right now. Bank of America, for its part, explained that it is trying not to court people just seeking rewards or cheap introductory borrowing rates, instead favoring the most profitable long-term customers. “Generating new customers who are surfing is not exactly the strategy,” Bank of America Chief Executive Brian Moynihan told analysts.

Frustratingly, the right answers in banking are most evident in hindsight.

Underlying returns are best measured over the course of a cycle, not quarter to quarter.

With a long-running U.S. economic expansion and an election looming, longer-term investors should look past those lenders lifted by a temporarily rising tide and instead pick banks that they are confident will hold up best when benign trends end.

Gold Mining Stocks Broaden Their Appeal — With Dividends

No one interested in current income buys gold mining stocks because those stocks are traditionally all about capital gains. As ‘leveraged plays on the price of gold,’ the miners work this way:

Let’s say gold is $1,000 per ounce and a hypothetical miner produces a million ounces annually, eking out a net profit of $10 million, or $10 per ounce produced. There’s no money here for dividends, obviously, and virtually nothing for capex. Someone hoping for current income would have zero interest in such a stock.

But let the gold price rise by $100 per ounce, or 10%, and the miner’s profit jumps by 900%, to $110 per ounce. In most market environments the stock of such a company will rise, which is the outcome most capital gains-oriented investors want.

But something else happens at the same time. Most of this torrent of found money will no doubt go towards our hypothetical miner’s expansion. But some, assuming management is reasonably enlightened, will flow back to investors in the form of rising dividends.

And just like that, a speculative capital gains vehicle becomes an income play, attractive to a whole new segment of the investing public.

With gold now up by several hundred dollars in the past couple of years, the above dynamic is playing out across the sector, as marginal operations become free cash generators, giving managements a chance to reward their long-suffering investors with monthly income.

Leading the way is industry giant Newmont, which raised its dividend by 79% (from an admittedly modest base) in the most recent quarter. Its stock now yields around 2%, comparable to Treasury paper but with a lot more upside potential.

Mid-tier miner Yamana, meanwhile, doubled its dividend in July of last year and then added another 20% bump at year-end.

This trend is just getting started. If gold’s price holds up in the coming year, most gold miners will see rising cash flow, making dividend increases the norm going forward.
The prospect of 2%-3% yields on high-quality gold and silver miners and, by implication, rising yields on ETFs like GDX and GDXJ that own them, might draw the interest of people who care about current income.

And since there are way more income investors than mining stock speculators, even a small shift of capital from bank accounts and bond funds into the miners will make a huge difference.