by Byron Wien
The Smartest Man in Europe Sees a New Industrial Revolution
People often ask me if I have a mentor, someone who has influenced my thinking over my career. I have had many, but over the past thirty years I have learned a great deal about investing from the person I have come to refer to as The Smartest Man in Europe. The most important lessons he taught me were (1) that the primary force behind good performance is recognizing important changes before or just as they are starting to happen, and (2) when something significant is happening, put a lot of money behind it. Concentrate on the big ideas; don't over-diversify.
The Smartest Man earned his title over the years by recognizing important shifts early. He saw the rise and fall of Japan in the 1980s and he was early in recognizing the investment significance of the reforms Deng Xiaoping was putting in place in China. He saw opportunities and then risks in emerging markets and technology in the 1990s and he was among the first in my sphere to see the coming of the break-up of the former Soviet Union and its meaning for investors. He has a mercantile background and hundreds of years ago his ancestors sold food, supplies and weather protection to travelers along the Silk Road. He grew up hearing talk of investment opportunities around the dinner table. He received a European education and, after an apprenticeship in New York, returned home to take advantage of the post-war recovery taking place there. I have written annually about his views since 2001.
"There is a new industrial revolution taking place around the world based on innovation. It is centered in California but there are pockets of it elsewhere in the United States and in a few places abroad. There are creative new companies being formed every day. Investors underestimate the significance of this change. It is not only in Internet-based technology, but also in biotechnology. Over the next few years you will see blockbuster products being approved for cancer and heart disease. Alzheimer's and Parkinson's are proving harder to deal with. In information technology the primary beneficiaries will be Google, Facebook, Salesforce.com, Microsoft, Amazon, LinkedIn and a few others, but not Twitter, which I view as a company feeding off the primary companies driving the change. These new companies are making IBM a corporate leader of the past. The drivers are changing the way manufacturing is being done, inventories and transportation are being handled and all forms of communication are taking place. The earnings for these companies are open-ended. In biotechnology the new products will extend life and reduce invasive surgery, and who can say how much that is worth? This is all very exciting and should be the focus of every investor's attention. You can invest in an industrial or consumer company where the earnings are growing 5%–10% annually, but these companies based on technological breakthroughs should do much better than that, and their valuations are still reasonable, in my opinion.
"Overall I see the United States growing at about 2% in real terms. To grow at 3% you would need another building boom and I don't see that happening anytime soon. The use of robotics will improve the productivity of industrial companies and profit margins will stay high, but it will be hard to bring down the unemployment rate. Technology is good news for the world because everything can be done more efficiently, but the bad news is that this means it takes fewer workers to perform the services or make the goods, and the only way to create jobs is through faster growth, which is hard to achieve in a mature economy. Take the banking industry, for example. Thousands of jobs have been lost there and the staff reductions aren't over. We have to learn to live with a higher level of unemployment and there are social and political issues associated with that.
"There is a further problem in that the broader use of technology has made the skills necessary to get and hold a good job more demanding. You will need a fine education and even then it will be tough to find a satisfying job. Many young people are not working in the areas they were trained for. Those who are employed in their desired field will find their wages going up very slowly. As for the inequality problem, I am not hopeful. It has been a part of society since the beginning of time, and now that business is increasingly knowledge-based, it is likely that the problem will get worse and I don't think much can be done about it.
"The broad market will probably not have a major move over the intermediate term, but the innovators will do well. From time to time there will be surges in certain sectors. The homebuilders had their day, now energy and oil service stocks are doing better, but the secular move higher will be accomplished by the innovators. Everyone is worried about interest rates increasing, but that is not likely to happen. Rates may go up slightly in the developed countries from present low levels, but there is so much money looking for a safe place to wait until the outlook becomes clearer that I don't expect yields on quality sovereign or corporate debt to move substantially above present levels.
"Germany is a curse. Europe needs more money to stimulate its growth. Europe is out of the deflationary recession that was caused by the austerity programs that Germany supported, but it is only growing at 1% now. It needs a dose of quantitative easing to grow faster, but Mario Draghi, the head of the European Central Bank (ECB), refuses to provide it. He has been encouraged by his German advisers to be wary of inflation, but more people in Europe are worried about deflation than inflation. The inflation rate in Europe is less than 2%. Monetary easing would be good for the economies across the continent. A few weeks ago the ECB announced some minor accommodative steps, but they were insufficient to have any profound impact. There is one circumstance that could cause the ECB to ease monetary policy in a major way and that would be if the economy of Germany starts to slow down. I think that is likely to happen in the next year, and then you could see Angela Merkel prevailing on Mario Draghi to liberalize monetary policy.
"As for the other countries in Europe: I think François Hollande will be re-elected in France. I do see Europe shifting somewhat to the right politically, but I don't think France will elect a far right candidate. It is basically a socialist country and probably will remain so. I have some renewed hope for Italy. They have a new reform-minded prime minister there and he is determined to restore growth to the economy. He hopes to do this by reducing regulation and removing the barriers that prevent workers from entering certain trades, thereby increasing labor mobility. I hope his program will work. Spain is clearly coming out of its housing collapse–induced recession. The industrial economy is doing well, foreign capital is coming back and sun-seekers are returning to the resort areas. Tourists are also going to Greece; hotel bookings there are up 45%. Portugal is benefiting from the economic recovery in Spain. Of them all France is the most unpredictable. The United Kingdom is surprising us by doing so well, but it is primarily because of the housing boom taking place there. Eventually the Bank of England will have to raise interest rates to slow housing down and that will have a dampening effect on the whole economy. The big real estate boom in London is fueled mainly by Russian and Middle East buyers, as everyone knows.
"One of the problems of Europe beyond its economic woes is that it has limited power politically. It fears Russia and would like to have imposed tougher sanctions on the country, but its economic interests would have suffered a negative impact if they did that. So it stood by and watched Russia take aggressive action in Ukraine and annex Crimea. Putin is only held back from going further in trying to reassemble parts of the former Soviet Union by the awareness that if there is widespread bloodshed there, the world could turn on him. If he were patient, he might get what he wants without a fight. Ukraine is going to need $30 billion to sustain itself over the next two years. It is unlikely that the West is going to put up that kind of money to support a country they didn't care all that much about in the first place. But Putin will put up the money because it is in his direct interest to do so. In the current world, money may be more important than military power in achieving geopolitical objectives. People are tired of fighting and losing lives for other people's causes.
"The United States is an example of that. It is weary of the wars it has been waging in the Middle East for a decade or more with little to show for it in terms of establishing democracies there. The U.S. was naïve to think it could establish democracies in areas that are so strongly tribal in nature. The probable solution for Iraq is that it will be broken into three parts – Kurdish, Shiite and Sunni. The country could only be run as a single entity by a strongman, as Saddam Hussein was and Malaki is not. We see that in Egypt where el-Sisi has virtually destroyed the Muslim Brotherhood that previously was in power. Afghanistan is a lost country. Al-Qaeda is setting up cells there and I don't think the U.S. can stop it.
"I also am not hopeful the Israelis and the Palestinians can achieve a peace accord anytime soon. The hawks are in control on both sides. The Palestinians want all of their territory back, the closing of the settlements and the right of return in order to recognize Israel and the Israelis are not likely to agree to that, so the stalemate is probably going to continue. Israel is one of those places where technology innovation is vibrant. Much of the creative work is coming from people whose basic education took place in Russia. With all of its problems Russia still has the best public education system in the world. You hear a lot about the oligarchs, but the society there is based on status – your education, your job – more than money. The Russian economy is suffering because Putin spent so much on defense and didn't diversify the economy beyond energy.
"I am optimistic that there will be some agreement which will result in Iran pulling back from its nuclear weapons development program. There are too many young people in that country who know what is happening elsewhere in the world and they want to be part of it. The clerics cannot hold them back indefinitely. The sanctions are hurting and everyone but the very top leadership wants them removed. The real story in Iran and throughout the Arab world is that 70% of the population is under 30 and these younger people want change and the prospect of a better life. If the sanctions were lifted there would be enormous foreign direct investment in Iran and a huge boom. I don't have much hope for Syria. Al-Assad and his oppressive regime are there to stay. The northeast could be broken off and become a part of Iraq, however.
"Eventually I see oil production in the Middle East returning to pre-conflict levels and even moving higher. I agree with you, however, that increased production will not be enough to meet the demands of the developing world – especially India and China – and I see oil prices heading somewhat higher. As for gold, it has now been established as an asset class although it is not one embraced in Europe and the United States. It is a part of almost all institutional platforms in India and many other places in Asia. I think it has formed a base here at current levels, but I don't know when it will move substantially higher. I think at least a small amount of gold should be in all portfolios.
"I think the election of Modi in India without a run-off is a very positive development. He appears to be a real reformer, which is what the country needs, but he has to deliver. The market may have already discounted a good part of what he is likely to achieve. I visited China this year and my conclusion is that the size and the diversity of the country present a challenge to how central government rules the country. As a result, the regional authorities have a lot of power and it is hard for Beijing to know if they are always performing in accordance with the intentions of the central government. It is true that China has ascended to the position of second largest economy in the world but that is because of the size of the population, not its per capita income. I don't expect a hard landing, however, because they have enough control over the economy to avoid that. Still, I presently have no investments there. I also visited Japan and I am impressed by what is happening in their economy now. The people need to have more confidence that Shinzo Abe's policies are working. I am making some investments in Japan.
"As for the rest of the world, I am pretty bored. I think Indonesia is basically a commodities rather than industrial market and if commodities do well, so will the country's equities, but I can't predict commodity prices. In Latin America I am bullish on Argentina; Brazil will recover, but it is too early to invest now.
"Everyone seems to be disturbed by the lack of volatility in the market, but volatility is the product of excesses and there are few excesses now. The U.S. stock market is fairly valued, the economy is healing and the U.S. bond market has settled down to a new low-yield level. The Middle East is not likely to blow up. Despite all of this, a lot of people are afraid and because of that the market should to go higher. Europeans are under-invested. Saving the European Union and the euro preoccupied investors over the past two years. As the economy strengthens, there will be more structural change – a banking union and more fiscal convergence in Europe.
"Some final thoughts:
• In the future only creativity will be rewarded and the rewards will be big. California is a magical place for creativity. The rest of the world is an average place.
• The art market is reflective of the inequality problem. It is the most unregulated market in the world. Prices may be topping soon because of wealth taxes.
• After 2012 and 2013, it is proving much harder to make money in equities.
• There is a big boom coming in Myanmar even though the military is still in power.
• Hillary Clinton will win the 2016 election."
We had a lively discussion on almost every point but we were more in agreement than in past years. That, however, may be a worrisome sign. Half-way through his ninth decade The Smartest Man in Europe is still as informed and opinionated as ever. He should be an inspiration to all of us.
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