The Great Transition and the Great Extinction

June 2018
James Anderson
JOINT MANAGER, SCOTTISH MORTGAGE INVESTMENT TRUST

Where does all this take us? As we’ve mentioned before, we fear that our industry is too lost in the combination of the inward looking world of finance and in Anglo-American political angst to be in any way capable of stepping back and considering where we might be structurally and systemically in economic and market development. Is the vocabulary of bubbles, crashes, crushed mean reversion, Trump and Brexit remotely capable of providing a guiding narrative? Of course they aren’t as they are crutches propping up the old world rather than adequate attempts to observe the new.

This critique is expressly designed to be harsh. Practitioners, strategists and mainstream financial economists are lost. Their tools do not function as they once did. But this needs us not just to identify the absence of clothes but to try to provide some new garb to dress our world view. We think that Bessembinder’s practical demolition of the CAPM can also provide such an investing framework.

But this leaves us requiring an economic and political narrative to judge our world by in a similar revolution. The point isn’t that this can be expected to be a full and accurate model in all its details but that it might provide an interpretation that sheds some light in place of complete darkness. A limited road map of the future is better than mental mean-reversion to the world as perceived in the 1950s in Chicago, New York or Washington.

The point isn’t that this can be expected to be a full and accurate model in all its details but that it might provide an interpretation that sheds some light in place of complete darkness.

For some time we have thought that the single most useful interpretation of the trends underpinning the global economy are those of Carlota Perez and her school at Sussex University. In her seminal ‘Technological Revolutions and Financial Capital’ Perez investigated the structural similarities between major waves of innovation and the relationship of finance to underlying progress. This seemed to us to explain why the bubble of the 1990s was a precursor to much stronger technology companies rather than their death-knell. We have been very grateful for this guidance.

More recently we have felt the need for still more help. It seemed to us that there were greater puzzles to be explained. For all the extraordinary power of technological change there was precious little evidence that either our societies were building these out in time honoured ways for the good of most and for productive growth. At the same time within finance the refusal to move on from exhausted business and industrial models to invest fresh capital into ambitious new projects and transformative technologies seemed almost entirely absent. Indeed investors appear preoccupied by the opposite: companies apparently exist to provide cash back not investment promise. Sadly the British stock market for once seems at the cutting-edge. It is hard to identify a single company in the FTSE 100 that actually believes in deploying new capital to create future returns.

So we asked Sussex University for help. We have funded a programme of research into the blocked transitions of our time. The preliminary lines of investigation are coalescing around the hypothesis that what we are seeing is both confusing and critical as it represents not just one more great surge in innovation but potentially a complete re-making of the same significance as a turning point such as the Industrial Revolution. What may be occurring will require us to forge a new set of mental models. For the moment we can just term it a ‘Deep Transition’ that upsets our paradigms.

What is certainly the case is that such a conceptualisation already helps to explain major conundrums of our age. The first is that the struggle to move into a new golden age becomes much more explicable if we acknowledge that what is churning away underneath our economies is the need for a complete re-thinking of our societies and philosophies. The vitriol associated with our current politics and the dysfunction of our financial system both make more sense if the traditional lights are really dying.

This struggle is paralleled by the refusal of the mean to revert or the extreme self-confidence of Value investors (as they modestly term themselves) to find market validation.

It is hard to identify a single company in the FTSE 100 that actually believes in deploying new capital to create future returns.

If what the world is just entering is a wholesale transition to a new order then it’s likely that an era of comfortable mean reversion will be replaced by a quite different but equally credible output of capitalism: the death of the old. After all this has been the logical and visible fate of those businesses in the eye of the early internet storm. Do you remember all those articles preaching how ridiculous the valuation of Amazon was relative to established players such as Borders and Barnes & Noble? Well, they underestimated Amazon but they just as clearly overestimated its supposed peers. These companies with hundreds of other retailers haven’t become ‘cheap’ or ‘value investments’. They have instead declined towards and often into bankruptcy. Deep transitions lead to permanent and catastrophic dislocation not to gentle cyclical ups and downs. Why would this not expand from retail crisis to more general bonfires of the old?

This will only become more central to markets as the Deep Transition moves into more and bigger territories. From retailers and newspapers collapsing to the end of big oil, traditional healthcare and lumbering banks and insurance is but a decade or two in forthcoming disruption. But apparently it’s prudent and risk-free to continually rotate into dying companies and industries because they are ‘cheap’ on current earnings. We shall see although to our eyes this looks like pernicious short-termism. Ironically we think our portfolios and methodology are now providers of diversity and risk limitation. If the old world implodes then we will be useful. We suspect that implosion will occur rather than mean reversion. A corporate ‘Great Extinction’ is probable. Or as Schumpeter wrote it illustrates “the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”. This process of Creative Destruction is the essential fact about capitalism.

...the Deep Transition is highly likely to be associated with major geographical shifts.

Lastly, the Deep Transition is highly likely to be associated with major geographical shifts. The Triumph of the West was the unlikely outcome of the Industrial Revolution and as that world fades into memory so too will our hegemonic interlude. As discussed earlier, the future is already being born in China. The coming age will almost certainly rely on mass adoption by the many of new energy sources and on machine learning that morphs into artificial intelligence. Both will be much more easily accomplished with governmental support and widespread popular goodwill. They won’t be driven by re-opening coal mines, by ever greater inequality, rising deaths of despair or contempt for international co-operation. If the next Deep Transition is to come into being then our narrative needs to begin in China and be focused on China. For all the complexities and frequently unappealing facets of the current order we need to embrace this emergent reality. As Martin Jacques presciently wrote in 2012 “The emergence of China as a global power relativizes everything. The West is habituated to the idea that the world is its world; that the international community is its community, that international institutions are its institutions…that universal values are its values…That will no longer be the case.” China isn’t just one of four BRIC countries, it’s not to be confined in the condescension of Emerging Market limits. It’s the hope for the global economy, for investors and for the much needed Deep Transition.

The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.

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