While the recent trade negotiations between the U.S. and China produced a welcomed truce, it should be quite apparent that this is so much more than a trade war. Greater than trade or tech are the values that will determine the architecture and governance of the global economic order. Epoch CEO and Co-CIO Bill Priest returns to discuss what this could mean for the global economy. (January 09, 2020)
While the recent trade negotiations between the U.S. and China produced a welcomed truce, it should be quite apparent that this is so much more than a trade war. Greater than trade or tech are the values that will determine the architecture and governance of the global economic order. Epoch CEO and Co-CIO Bill Priest returns to discuss what this could mean for the global economy. (January 09, 2020)
Hello, and welcome to Actively Speaking. I'm your host, Steve Blyk. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Welcome to another episode of Actively Speaking, and my guest today is, is our first return guest, I think, in the history of the podcast so far. It's our co c o co-founder, uh, bill Priest, and it's currently CEO as well of Epic. Uh, today we're gonna talk about a white paper we've got up on our website about, it's called Cold War 2.0, uh, the platform, the players and the stakes. And what we're talking about here is the trade confrontation between China and and the West. Uh, welcome back, bill.
Speaker 2:It's good to be back. Steve.
Speaker 1:I thought we could break this discussion down into sort of three parts. Number one, how did we get here? Number two, what are the main areas of contention? And number three, what are the implications for markets and investors? So in terms of how did we get here? After the fall of the Berlin Wall and the end of the Cold War 30 years ago, there was a famous piece by Francis Fukiyama called The End of History, uh, in which he argued that in essence we had tried all the alternatives to democratic capitalism, and they had been found wanting, and that there would be general worldwide agreement going forward from that point, that that liberal democratic capitalism was kinda the only way to go and hasn't really worked out that way,<laugh>. Um, and there there have been, uh, challenges to that view. So talk a little bit about, about those challenges, how we got here, why that was a naive view of, of the world.
Speaker 2:Well, it certainly didn't seem like a naive view at the time. I mean, the Cold War lasted from essentially the end of World War II until 1989. So it was a 40 year period, and I think one of the significant influences of Cold War, I was, um, George Keenan's Telegram, uh, back home. He was a charged affairs in, um, in, uh, Russia at the time. He raised this issue that we needed to contain Russia in a geographic sense, but implicit in that memo was ultimately this regime would fall, uh, fall inward of its own, uh, of its own inefficiencies. Uh, and in the end, we, that was the better way to go than a direct confrontation. Um, and it didn't, and it happened, uh, in 89, but there's something else happened in 89 and, uh, that was Tiananmen Square. It was a different kind of tragedy, uh, and no one fully appreciated that. It was the beginning of what now can be seen as a, uh, a leading factor in, in what I think, or we think is, is Cold War 2.0.
Speaker 1:And, uh, in the paper we talk a bit about how the, um, rise or the accession of, of President G in 2012 seems to have set off some of this, because for a while there was a view prior to that that China was kind of liberalizing economically and was getting more integrated. You know, they joined the wto they were becoming, seemed like they were becoming more a part of the world, uh, system. And I think there was a view that they were going to become more like us in that process. But it, it seems like the opposite has happened in some ways. We've unfortunately sort of become more like them, or we've been forced to accommodate ourselves to their demands in terms of certain values, freedom of speech, et cetera. Talk. Can you talk about these, the, the China 2025 plan and the Belt and Road initiative and what those have meant for the relationship between China and the rest of the world?
Speaker 2:Well, I think when we, when one looks at China, you can even start with maybe a look at Japan after World War ii. Um, we had to rebuild Japan or allow Japan to rebuild itself, and Japan did indeed adopt many Western values in the integrated, uh, well into the global economy, to the point where they were arguably a dominant, uh, player in the late, late eighties. In particular, I think the hope was that China was such a large market, and that seeing the benefits of a democratic capitalism that they would come around to seeing if that was a better way to go, that was a better way to go. Um, and we, uh, encouraged them to join the wto. Now, since they joined the wto, they probably violated more rules than any other signature, and they've really never been called out about it. The whole, the thought probably was that that was a gigantic market. Well over a billion people, you can't ignore a market that big and, uh, let's figure out a way to, uh, to accept some of the imperfections or, uh, um, misbehavior, uh, as they, uh, acclimate to, to western standards. That was naive. Actually, we date the cold, the beginning of Cold War, the vice president's, uh, Pence speech in October, 2018, in which he warned that China was engaged in what he called a whole of government offensive against the us. The vice president was particularly critical of China's MA in China, 25 plans des uh, with the target of dominating advanced industries such as robotics, biotechnology, and ai. And this speech marked a deep shift in America's thinking about China on both the right and the left. This is not one party versus another. This is a uniform view of, uh, the US politics, uh, not since the late 1940s, as the country's mood swung so rapidly behind the idea that the US spaces a new ideological strategic rival. And you'd have to compare that speech to Churchill speech at Westminster College, uh, back in 1946 when he essentially identified that an iron curtain had rung down on Europe. And that speech, along with Keenan's prior note, became essentially the beginning elements of the Cold War.
Speaker 1:Okay. Uh, so let's, let's turn then to sort of the middle part of this discussion. What are the main areas of contention? And you could argue that, you know, cold War 1.0, uh, with the Soviet Union was more about control of geography around the world. But that Cold War 2.0 is a, is a really a contest of values, uh, between the West, which has, uh, to vary degrees in different countries, but in general subscribes to ideas of free speech and, and, and market based economies, uh, versus what China is doing, which we are certainly, there is not, uh, freedom of speech or religion. Um, and there is this sort of state controlled, uh, the state seeks to dominate and not not leave decisions to the market.
Speaker 2:Well, yes, I think what China is sponsoring is a form of state capitalism. And, um, it appears there's sign of, at the moment, kind of a deal among the populists and the Communist Party that if you continue to raise my standard of living, I will continue to tolerate intrusion into my personal freedom. That's one way to look at it, um, because China's has, uh, risen in terms of GDP per capita at an amazing rate over the past, uh, uh, generation. Uh, and so there was this trade off, I think, between what the population would accept in a much higher standard of living, but it really does get back to values. And the US is really built around, as you mentioned, the freedom of speech, our bill of rights, the constitution as we see it, the rule of law, uh, that this, this really mattered. And, uh, this is something that's an athema to the Communist Party, and I think they feel quite threatened by the values we express because, uh, in part it's their own history. If you take one step back, for example, and just think about this from another perspective, many, many years ago I was interviewing a management that was a water company in Singapore, and it was a small capitalization company, and we were potentially looking at as an investment medium, and the CEO expressed gleefully that they had just won a contract in China to improve the water. And, uh, Malaysia has a potable water problem. And, uh, her company had, was prominent at the time and solving that problem in China, being so much larger has many, many potable water issues. And she envisioned building dozens of these plants. And in my discussion with her, I said, I think you're gonna get to build two. And she was a bit shocked with that. And I said, well, you're gonna build one, uh, they're gonna want the IP however, and they're gonna want to work alongside of you, and you'll probably get a second one. And after that, I doubt that you are awarded another plan. They will have stolen your ip. They will have, uh, uh, understood how you implemented that ip. And my guess is, uh, you have provided a nice, uh, solution, but you will not financially benefit from it the way you you imagined. Now, I'm not sure how all that turned out, but I'm pretty sure that they may have gotten more than two. But essentially you could see that the whole methodology was they were gonna steal the ip. And in a way, it's not, it's not that, uh, in a way that's actually quite understandable, here's a country of 1,000,000,003 that had not been part of the West and its evolution into this competitive society with its rule of law. And all of a sudden we're telling them, you must honor our laws, our, uh, our patent rights, our copyright laws. You have to honor that. And they're looking at, they had nothing to do with setting it up. So why should I pay attention to your rules and loss? So we're gonna compete and we're gonna invite people in, but they're gonna share their ip, and we'll see where it goes from there. I think that was the attitude they pretty much took when she, he accelerated all of this, and he's kind of a president for as long as he wants to be president. And, uh, he has accelerated this, uh, this desire, uh, to dominate, uh, a number of these, these critical industries. And I think it is correct for the US to stand up and, and, and address this. I don't think this will lead to a hot war in the sense of a shooting war. I don't think China wants that. We don't want it either. Whereas there were proxy wars with communism that both sides participated in. My own personal view is you're not gonna get a hot war, uh, this time around, but you will, you will get these territorial battles in the east battles being verbal and, and, uh, trade. But, um, um, there's, there's a weakness in China as well. Uh, when you look at trade and you look at the number of items that are traded in dollars or defined in dollars, it's quite large. And when you look at China's debt load, if you look at their debt to gdp, it's a very, very big number. There's not a whole lot of price discovery in the Chinese economy. Uh, it's somewhat reminiscent of what happened in Japan when towards the end of their period of growth, there were building bridges and tunnels to nowhere. Uh, it gave lots of employment, but essentially it was dead capital. There was no return on investment, there's no decision making body in China, for example, that takes a look at what is the return on investment and this particular product versus what we think the cost of capital is. No one looks at that gap, and in the end, you have to look at that gap because unless there is a gap, uh, you, you basically are, are, uh, are are spending down the value of your capital. There is a book, uh, written by, um, an am by an American who, uh, lived in China for a long time and wrote for, um, the Wall Street Journal and walks through the debt problem in China and how it came about. Essentially what frequently happened was the land of a peasant was appropriated by the local governments. Uh, they literally would take it over. They would offer housing to that peasant, but they would, uh, essentially take this at a below market value. Um, then they would take that land and they would sell it to a developer. In doing so, they could charge a value added tax that on the property that the developer had. The developer was happy to build it, and at the end, you unwound up with it with a town or an airport. It may or may not have had any real economic value, but it provided a lot of jobs at the time. But the, the debt weight was quite large and is quite large. So the problem is, is that debt gonna ever be paid back? Well, uh, essentially the debt gets transferred to one of the four large banks, and everybody kind of knows this is a game, but they all assume that Beijing with its reserves will be able to bail out the, these, uh, these financial institutions. And that may be, that may turn out to be the case, but there is a rising debt problem inside of China, and it's really unclear how this is gonna play out. China needs access to dollar reserves for a lot of the things that trades in, and that also could be approved to be an issue with, uh, uh, for China. So one of the things that happened in 1989 with the fall of the wall, we saw that this, um, opportunity, uh, to do business with the east in particular, and essentially when you looked at the number of people that were coming into our world was well over a billion, uh, including China. Now, these people that entered our world, they brought no money and no technology, but they brought a lot of labor. So there was a real opportunity for labor ano a labor arbitrage, and indeed that took place. And addition, uh, we also were wa witnessing the bene the benefits of technology in the form of Moore's Law, which says the power of a computer trip doubles every 18 to 24 months. And as that was working into our technology and the way we delivered products and services, these two things were powerful. So you had a huge opportunity. When you look at profit margins, uh, since that time from the late fifties to 1989, profit margins were pretty much flat. They were around five and a half to 6%, but starting in 89, they, they more than doubled over the next 30 years. And they doubled in part for those reason of you had this labor arbitrage, which led to these very sophisticated supply chains. And third, and fourthly, today we have much lower interest rates and much lower tax rates, but that game is probably over because with the Cold War ii starting the trade war being the way in which the battle's being fought, this, we now are going back to what essentially is the law comparative advantage run backwards. And one way to think about it, Steve, is that if you and I were two countries and, uh, we had country ye and country B and let's say we, well, there were only two products. There was, uh, food and clothing and uh, we both wanted, uh, an equal number of units in our respective countries. Uh, and let's assume the only factor of production that mattered was labor. And let's further assume that it took you one day to make a unit of food and two days to make a unit of clothing. It took me three days for food and four days for clothing. So on the surface, you know, why would we even trade with one another? And the critical point here is a relative difference. You're three times more efficient in food than I am, but you're only twice more efficient than I am in clothing. So what's happened here that if one played with a little algebra one can show that over a hundred days, uh, we can figure out what we would have ourselves without trading. But it turns out if you make all the food and I specialize in clothing, we actually wind up with another five, 6% units. And since I have to get something for trading with you and your twice as productive, of those six additional units forward, go to you two would go to me. This is really what drove that margin expansion. It really was a law comparative advantage, wri large with the supply chain, and it was phenomenal with the trade wars we are now entering a lose lose situation. It is literally the movie of the law of comparative advantage run backwards. So we are now returning to a time when you will make all of your own food and clothing units, and I will make all of my food and clothing units and we're gonna fight, fight it out on technology. Some cases we may have, uh, I may have some value, some success relative to you, but it also would be the other way around. But that's the real issue that we're facing. You're facing the fact that global growth is definitely slowing down and you have hyperactivity from the central banks to deal with this. We've got this, this, uh, maniacal obsession of income inequality and it has to be addressed. And all of that leads to a situation where interest rates are gonna be lower for longer. In the meantime, the debt is piling up because the demand for debt is, is astonishing. Uh, virtually every German bun today has a negative yield. Uh, Greek debt sells, I think below, uh, the US 10 treasuries today. Uh, this is someplace we've never been before, but it reflects the activity of the central banks in trying to address this growth issue and the populism issues.
Speaker 1:Okay, so you've gotten us well into the, the third part of the discussion, which is the implications of all this for, of this Cold War for, for markets and investors. So, uh, you've already talked about the impact on growth, which clearly means slower growth. Talk a little bit about what the, what de-globalization will mean, uh, if it does have an impact on supply chains. Do, does it mean companies have to relocate back manufacturing jobs back to the US or can they find other low-cost producers outside of China? What impact would, uh, is, will this have on inflation, on margins, on, on, on, on those areas that matter to investors?
Speaker 2:Well, nothing's gonna stay the same, and tariffs have significantly hurt us households. Uh, the entity putting on the tariffs always suffers more than the other, which is something most people don't realize. Uh, corporate pro capital spending will be restrained. It's also gonna be restrained because of the substitution of technology for both labor and bricks and mortar. So you're not gonna see cap spending, uh, be much of a factor going forward. In, in, in my view. You've also exacerbated, uh, what's called the Global Uncertainty Index. It's, uh, it's an index by Bloomberg. It's at a 20 year high. This uncertainty starts to say, you know, we're getting to the point where volatility, there's, there's gonna be fragility in the capital markets, even though at the moment it doesn't appear that it's very large. But I think we're setting ourselves up for a fair amount of volatility. Um, we are gonna have lower global growth, we are gonna have lower interest rates and some global value chain can be reconfigured and they will if it makes economic sense. But that takes time and I think there will be a desire to kind of make more things in the us but ultimately, uh, we won't make up all of what we've lost through the de-globalization that we're facing. Uh, one of the things that is woven into this is, is the fact that digital technologies are very, very deflationary. And the way to think of that from a conceptual standpoint is, uh, the so-called DuPont return on equity formula, which basically has profit margins, times asset turnover, times leverage algebraically. Some of these things cancel out to where you had profits divided by equity. So return on equity, well, technology is, comes to you in the form of bits and labor comes in the form of atoms, bricks and mortar comes in the form of atoms as well. But if I can substitute technology for labor and hold, my revenue is constant, my margins go up. And if I can, uh, substitute technology for bricks and mortar such as a retail store and sell my goods over the internet, I can do that as long and it will be beneficial to me as long as my revenues are there. So we have this run to what is called a capital light model. And virtually every company we speak to is engaged in some form of a capital light model. The key question for them is, uh, not what is my digital strategy. The right question is what is my business strategy in a digital age? Cuz we have transitioned to a new age. So not only are we doing with Cold War 2.0, but we're dealing with this, this shift in age to a a digital age. And every company has to come up with what they think is the, the business solution to this digital age problem. What it's going lead to, I think is a surprisingly, uh, higher level of payout ratios in companies. They simply do not have to reinvest the capital in the same way they used to because you've had the substitution effective technology for labor and bricks and mortar. So I would expect, uh, yields, dividend yields and the growth rate underlying dividend yields to actually remain quite high. And my guess is that it will become, uh, a sustainable and more important contributor to total return in the markets. Albeit the price volatility will dominate any dividend yield.
Speaker 1:Okay, so, so Cold War 1.0, uh, as you pointed out, lasted over 40 years. If you date it from 1946, it arguably ended in 1989. Uh, it did have some hot proxy wars, most notably in Korea, in Vietnam. Your your, uh, view is that, uh, cold War 2.0 will, will not be, will not lead to those sorts of hot proxy wars. But you would you care to speculate at all on, on how long this is gonna last and, and what the, um, cold War 1.0 ended pretty well for the West. Uh, how long do you think Cold War 2.0 might last and and what might the outcome be for the West? It's certainly not the case as President Trump said a few years ago that, uh, he liked trade wars. They were easy to win. That that's not true. But, uh, so how do you think this might play out over the years?
Speaker 2:Well, I'm not sure how I see the end game. There's two end games. Um, we are thinking that in the end our values are superior to China's values. Well, are they? Um, case in point in early October, uh, the general manager of the Houston Rockets ignited a fewer in China by tweeting quote, fight for freedom stand with Hong Kong in quote, because China's the NBA's most important international market executives quickly distance the themselves, themselves from that sentiment. So self-censoring to make money in China is a longstanding business practice. And China's fierce reaction to that tweet, uh, was certain to induce even more self-censorship in the future. So we may value our values very highly, but if it interferes with business profits, maybe we can make a little sacrifice. I hope we don't go down that path. Uh, I hope we recognize that there is not just, uh, kind of social justice in our rule of law and our Bill of rights and our constitution, but there's also it's good business sense. But it's unclear to me when you look at how companies have behaved, uh, that they're willing to basically, uh, sign on to the essence of, uh, Pence's speech.
Speaker 1:Okay. Well, so, uh, thanks for that discussion Bill. Uh, again, if you're interested in reading more the white papers on our website, uh, at www.eipny.com, it's called Cold War 2.0, the platform, the Players and the Stakes. We hope you've enjoyed this discussion, and if you have, please do us a favor and, uh, go to wherever it is you're getting this podcast from and give us, uh, a good review or a good rating. And, uh, we'll talk to you again soon. Remember to subscribe to actively speaking on Apple Podcast, Spotify, or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.
Speaker 3:The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.
Speaker 4:Stop audio.