The road that led to Brexit (and where it’s heading)
The UK has voted to leave the European Union, sending ripples through financial markets that had anticipated a vote to maintain the status quo.
The media has been awash with opinions on the near-term implications for financial markets. We do not intend to add yet another view on the effect on financial markets; the red on our terminals provides a succinct summary. At Schroders we have prepared for the possibility of an Exit vote and believe others in our industry have done so as well.
Rather than speculate on future political decisions, we focus here on the underlying issues that led us to this point and their implications for the future. Those trends stretch far wider than the UK’s continued membership of the EU and we believe remain underappreciated by financial markets.
Although characterised by the media as a vote on immigration or bureaucracy, a closer examination of the reasons voters gave shows a broader, more conventional list of concerns. It appears less a vote about borders and red tape and more a judgement on our economic and political system.
The Brexit vote reflects growing social tensions that have resulted from rising inequality, moribund income growth and falling job security, and discomfort with the political systems that have caused them. This is a global trend that is as evident in the US presidential elections as it is in demonstrations in Hong Kong or impeachments in Brazil.
It is a trend that is reflected in the continued decline in trust in political institutions across major economies. Eurobarometer finds that trust in national EU governments has fallen by one-third since the mid-2000s. EKOS, an economic and social research consultancy, finds an even larger drop in the US, where the percentage of respondents saying they trust their government to do what is right most or all of the time has fallen from over 70% in the 1960s to under 20% most recently.
Tensions are building and will lead to more political “surprises” in the future. We focus here on three drivers we believe underpin the tensions that have led us to this point, and examine their implications for businesses and investors.
More protectionist, domestically-focused policies
For decades, globalisation has been a dominant political theme across developed and emerging economies, and has generally been very successful. Growth in global trade has outstripped GDP more than two-fold over the last 30 years, international migration is up 40% since the start of the century and the stock of foreign direct investment is a three times larger share of global GDP than it was 20 years ago.
While those policies have generally achieved what they set out to deliver, they have exacerbated social tensions within countries. Economies are becoming more global but societies are still national. Globalisation may raise overall economic growth but its speed has left many unable to adjust. Consequently, whereas global incomes have risen and inequality fallen, the opposite is true within most countries.
The result has been rising tensions in many societies, which see (in many ways correctly) globalisation as the cause of their problems, and are looking for solutions that will shield them from those forces.
While it is doubtful protectionism can work given the extent to which globalisation has permeated economies and societies – disentangling the “good” and “bad” bits is virtually impossible – there is likely to be support for politicians that promise to try.
Global businesses need to operate locally
Societies are still defined at a local level and while large companies have become more international, the most successful are doing so through locally defined tactics. Companies that focus on understanding the environments they operate in and tailoring their strategies will be better able to meet the diverse needs of customers, employees, regulators and other stakeholders in the markets in which they compete.
Companies in more global sectors will typically face both greater challenges and opportunities adapting to an environment in which local expectations and regulations are unique and require distinct strategies. The chart below plots the share of revenues European companies in each sector generate outside their largest market, based on reported geographic sales. Those towards the left of that chart will typically face a wider range of markets.
More political and social instability
Disillusion has spawned a search for alternatives. Change has become a more attractive choice than maintaining the status quo. This is not restricted to the left or right of the political spectrum; both ends have benefited from disappointment with the middle ground. Movements like Occupy gather the headlines but the rise in voter turnout over the last decade is a far more powerful force.
Insofar as we are doubtful any single solution exists to the challenges voters face, it’s likely that hopes for a panacea will be passed from one party to another, leading to potentially significant swings in political tendencies in short periods.
Flexibility and adaptability are key
Effective corporate strategy is becoming less about forecasting the future and plotting a course towards it, and more about building the organisational resilience to adapt to unexpected change. Culture, oversight, incentives and structure are more important and durable strengths than forecasting abilities or deal making skills. Effective corporate governance is an important element of that flexibility, as is the ability of managers and employees to engage stakeholders to identify pressures at a local level.
Companies that operate in industries in which change is common and where governance is typically stronger, should be better prepared to meet the challenge of more fluid regulation, political pressures and social expectations. In contrast, those which are typically less attuned to change, may be less prepared, particularly where governance is weaker.
More pressure to ensure workers and societies benefit
The failure of most people to benefit from the globalisation and global economic expansion of recent decades lies at the heart of much of the disquiet. Median incomes in the US have not risen since the mid-1990s, allowing for inflation. Since the financial crisis, the average worker in OECD countries has seen their standard of living fall 5-10%. Meanwhile those who own financial assets have seen their value rise, buoyed by quantitative easing, and media headlines are filled with stories of CEO pay packages and corporate riches.
That perception is supported by evidence. Corporate profits have been a rising share of GDP for decades, mirroring the declining payout to workers. CEO remuneration has continued to escalate far faster than employee wages. We believe the pendulum of power is likely to swing back towards workers going forward. Accelerated by the events of 2008, trust of big business has been in long-term decline and governments have been given a clear mandate to regulate for social benefits.
Compounding the social pressure, governments cannot afford to continue supporting employed workers unable to get by on the wages they receive; their responses are already evident in the social and political focus on living wages, tax avoidance, pension and healthcare reform and other “subsidies” from the public to private sector.
Investing to strengthen stakeholder relationships
Long-term success ultimately stems from companies’ abilities to attract talent, engage customers, manage supply chains and establish strong relationships with the spectrum of stakeholder they rely on. Companies that ensure stakeholders – in particular employees – benefit from those relationships, through adequate wages and reasonable working conditions, will be better able to withstand mounting pressures without suffering margin squeezes, compared to those that continue to see stakeholder investment as a trade-off to profitability.
Companies operating in industries where wages are typically lower will face the greatest pressures, while those which also contend with low operating margins will have less room for manoeuvre. Higher wages across a sector are ultimately likely to push prices up, leaving the industry’s overall profitability broadly unchanged, but with potentially significant shifts in value from those businesses that rely on low wages and those that do not.
The strongest companies will address the causes rather the symptoms
While every company faces immediate challenges in the aftermath of Brexit, those that recognise and adapt to the underlying trends the vote reflects will be in a stronger position for the long term. We have focused on three trends here, although the challenges and opportunities are likely to be more complex and diverse:
- More protectionist, domestically-focused policies: global businesses need to operate locally
- More political and social instability: flexibility and adaptability are key
- More pressure to share rewards with workers and societies: investing to strengthen stakeholder relationships
Whereas these considerations are typically far better understood in the corporate world than in financial markets, differences remain between companies and present investment opportunities for those investors able to understand them.
We need a better tool kit
As investors, the Brexit vote highlights the growing need for new models and tools. The fundamentals of markets are constant. In the long run, earnings drive equity returns and in the shorter term, fluctuations in sentiment and valuation multiples force variations around those longer term trends.
However, the lenses markets have conventionally used to examine these issues tend to assume maintenance of the status quo and are becoming increasingly exposed as inadequate. Our industry has built short-term earnings models based on analysis of current operations, recent financial trends and near-term economic forecasts. We have compared the earnings that emerge from that modelling to share prices and based decisions on companies’ relative attractions. The effects of changing social pressures – while often recognised and accepted to be important – do not fit that model.
As a result, we are convinced new tools are needed. At Schroders, we are focusing on building analytical models and tools that reflect companies’ abilities to adapt to the changing social and environmental trends they face. This means analysing industries and the ways social trends impact business models, competitiveness and profitability. It means focusing on how companies are run, rather than just on how much money they make. And it means thinking about investments as companies not symbols.