Echoes of the Gilded Age. Part 1: Economics and investments

It has become fashionable to compare the current rise of populism to the political developments of the 1930s and the aftermath of the Great Depression. In my view, however, investors can learn more from a comparison with the Gilded Age of the late 19thcentury and the years leading up to World War I. In this post and the next, I will try to trace the similarities between current developments and the Gilded Age and what these similarities tell us about the path forward. Today, I will focus on investment trends for the next few years while tomorrow, I will focus more on political trends and their impact on economic developments.

The one economic development that has influenced the last three decades in financial markets and economics more than anything has been globalization. The fall of trade barriers and the reduction of frictions such as transportation and communication costs has been a boon for global business. As emerging markets opened up to the world, businesses in the West benefitted two-fold. First, they could develop global value chains that allowed them to outsource production to countries with lower wages and second, the increased income of consumers in emerging markets allowed Western countries to export more of their goods to these markets. Thus, globalization provided both higher top line growth and lower costs. 

No wonder, equity returns between 1980 and today have been high and setbacks due to recessions or financial crises have become rarer. The businesses of global large cap companies have become more diversified and blessed with lower fixed costs. Thus, corporate earnings were better diversified and if there was a slowdown in demand, companies could cut costs quicker in order adapt to leaner times. 

But this globalization trend is not unprecedented. In fact, the chart below shows that exports as a share of GDP in the US have only now caught up with the peaks of the years immediately following World War I and, in the UK, global trade as a share of GDP remains significantly below the peaks reached during the height of the British Empire. Michel Fouquin and Jules Hugot have demonstrated that starting in the 1840s and culminating in the early years of the 20th century, the global economy experienced a wave of globalization comparable to the current one.

During this first globalization wave, we saw the birth of the large, global corporation which could exploit lower transaction and trading costs. This in turn created the wealth of the entrepreneurs of the Gilded Age both in the US and in the British Empire. Today, large global corporations are again the main beneficiaries of the trend towards globalization. As a result, both today and in the Gilded Age large corporations had a competitive advantage over smaller, local firms. Could this explain, why the small cap premium has declined since the 1970s? In my view, it certainly is a contributing factor but given that there are is no small cap stock data from 1870, I cannot prove it.

However, another investment trend that is visible in both the Gilded Age and today is the impact globalization had on equity valuations. According to Robert Shiller’s data, the average Cyclically-Adjusted PE-ratio (CAPE) from 1880 to 1910 was 17.2. Over the subsequent thirty years from 1910 to 1940 it was 12.6 and the average for the 20th Century was 15.2 – and that includes the massive bubbles of 1929 and 2000. In an increasingly globalized world, growth prospects for companies are getting better all the time and that fuels higher valuations.

Of course, the question now is what will that mean for the future? It is sometimes argued that the globalization of the Gilded Age ended with World War I and the Great Depression, but in my view, the seeds for the demise of globalization were sown even earlier. The rise of global conglomerates and the increase in inequality (something I will address in part 2) led to a political backlash that ended in the increased regulation of large corporations and the introduction of high taxes on the wealthy. In the US, income taxes were introduced in reaction to the seemingly obscene wealth of the robber barons and in the UK and Europe the rise of the socialist and communist movements lead to the introduction of social safety nets that in turn had to be financed with higher taxes. In both countries, a concentration of profits in the hands of large corporations led to a backlash that eventually curbed the profitability of these corporations.

Today, we are witnessing the beginnings of a similar trend. Calls for increased regulation of the large IT companies as well as increased taxation of high-income households and corporations to finance redistributive government spending are getting louder by the day. And the barriers to trade that are erected by the US President and China as well as Brexit can trigger another wave of deglobalization similar to the one we have seen in the 1930s and 1950s. 

The potential impact of such a period of deglobalization on investments would be manifold. First, we should expect equity valuations to decline as growth prospects deteriorate. This, in turn, should lead to overall lower equity returns as multiple compression eats up much of the earnings growth contribution to total returns.

Second, it seems likely to me that the winners of such a deglobalization process would be the companies that are anchored in their local economies and have little to lose from higher trade barriers. These are typically smaller companies as well as service providers that do not rely on cheap imports from foreign countries. Thus, I would expect the small cap premium to re-emerge in such an environment as well as a premium for service-oriented sectors over manufacturing-oriented sectors. 

Furthermore, in a lower growth world quality earnings and a high profitability achieved with little financial leverage should come at a premium. Thus, the quality factor should continue to do well. But there is a “but” there. One common metric for the quality factor is high Return on Equity (ROE). I don’t think that earnings generated with the help of high financial leverage will be sustainable in a deglobalizing world. Rather, organic earnings growth is what will count. Thus, my guess is that Return on Assets (ROA) is likely going to be a better measure of profitability in this scenario than ROE.

Finally, as I have mentioned in a previous post, deglobalization could lead to a wave of onshoring of production and services which could lead to entirely new areas of (local) growth that are untapped today.

Overall, a deglobalizing world would lead to a reversal of market leadership. The large IT companies such as the FAANG stocks that benefit from global value chains and cheap debt are likely to have a harder time than small service providers in the area of healthcare, consumer services and real estate – three industries that are intrinsically local in nature. 

Of course, for these scenarios to materialize we need to experience an extended period of deglobalization and that is not necessarily a given. Instead, this will depend largely on politics and the development of economic policies going forward – something, I will discuss in my next post tomorrow.

Trade as a share of GDP

Source: Fouquin and Hugot (2016).