As the threat of an impending trade war grows, what will be the impact on global growth? Bill Priest, CEO & Co-CIO, Epoch Investment Partners, talks to Kim Parlee about how a trade spat could disrupt the global economy, tech regulation and what stocks investors should watch.
Welcome to the show, I'm Kim Parlee. It is great to have you with us.
China will take countermeasures of the quote, "same proportion and scale" if the US slaps more tariffs on Chinese goods. So says China's ambassador to the United States as the threat of an impending trade war grows. What will be the impact of an all out trade war on global growth, which has been doing quite well? And who are the potential winners and losers from this kind of thing?
Joining me from New York to dissect this is Bill Priest, Chief Executive Officer and Co-Chief Investment Officer of Epoch Investment Partners. Bill, it is always great to see you. Just thrilled that you're here to talk about what's going on. Not thrilled about what's going on, but at least you get to give us some insight. How serious is this trade spat between the United States and China?
Well, I think the trade spat, it makes little sense. If you go back to what's the heart of trade, trade is a win-win. And roughly 200 years ago, a very famous economist, David Ricardo, came up with the law of comparative advantage. It was really about trade between Portugal and Great Britain.
He basically demonstrated how it's a win-win when you trade. And it has everything to do with relative competitiveness. If there are two products in the world, if you and I were two countries, Kim, and it took you one hour to make a good and it took me two hours. And it took you two hours to make clothing and it took me four, we have nothing really to trade. On the other hand, if you have better productivity than I do in everything, but not relative productivity superiority, we can trade and it will be a win-win.
So this whole idea of a trade war is potentially quite damaging to the global economy. Supply chains have been in place now for more than a decade. To unravel some of these supply chains will be very, very costly to the global economy.
So we'll wait and see. But this is one law in economics that's lasted for 200 years. These laws don't last for 200 years unless it is a win-win. And unfortunately, this could be a lose-lose.
Well, let me ask you that. Because you and I were chatting a bit before the show started. And if we just kind of focus a bit on this idea of comparative advantage. And anybody who's taken economics is going to perk up and understand what this is about.
It's a win-win if you have countries trading. Again, everybody wins, even if one country is better at doing everything than the other country. But it requires both countries to have people in place who make sure that everyone has a quality within their country, which is not what's taking place right now.
That is correct. As we went through globalization-- and globalization really began in earnest in 1989 with the fall of the Berlin Wall-- when the Berlin Wall fell, we had lots of countries join what amounted to the West. There was a huge influx of labor from China and the East, so to speak. And they brought no money.
So the way to think about it, the labor pool roughly doubled but the capital and technology for the most part lay in the West. So over a decade, two decades, this kind of sorted itself out. And the returns to labor did not go up much at all, but returns on capital and technology went up.
The consumer benefited from this in the sense that literally every consumer in America benefited from global trade. But think of it as being a mile wide and an inch deep. The problem is there were some people in some industries that were badly hurt. It was only an inch wide but it was a mile deep.
And one of the things that the West failed to do, but particularly the United States, we did a poor job at reeducating the dislodged workers. And we didn't do a very good job with supplemental income either. So those people rightly feel wronged by globalization.
But it was a huge win. We should attack those losses with individual policies, not a trade war. That trade war is, frankly, silly and completely unnecessary.
Let me ask you, President Trump tweeted out within the last few days, quote, "when you're already $500 billion down, you can't lose." True, false?
He's looking-- it's false. He's looking at it the wrong way. He's looking at a game where if I win, you lose. Almost every economist in the United States or, frankly, in the world will tell you that global trade is a win-win. Where there are dislodged individuals or industries that are harmed in a particular country, you need specific policies to address that. But global wealth goes up with trade. It's a good thing. And if you start to try and unwind this thing, it could be catastrophic.
We'll see what happens. That's probably too strong a word. But it is not good. You do not want to see global trade unwind.
Well, let me ask you this then, because I think the market reaction to this has been quite fascinating. I mean, we've been seeing a tit for tat going back and forth between the United States and China. Tariffs are levied and China comes back with the exact same amount. Not escalating, just matching the same amount. It looks to me as though there's a bit of testing the waters right now.
But what do investors do with this? I mean, when does this become more of just a OK, we're negotiating and they're going to make it through to OK, no, this is impacting economic growth?
It could impact economic growth. In the very, very short run, the US in particular is growing quite rapidly. Virtually, the economy in the US is doing extremely well right now. But lurking in the background is another problem, which is how are you going to finance the deficit. And we're going from quantitative easing to quantitative tightening.
My own prediction is by the end of the year, you're going to see the VIX double in the stock market. We will have twice the volatility in the stock market this year as last year. Much of that is attributed to QE.
And QE, central banks are buying bonds all the time, every day, and basically supporting a very low cost of capital regime. That's over within in the United States. That simple switch from QE to QT will increase volatility.
Add this trade war discussion-- and that's all it is right now, it's a lot of hot air, but it could have real clout-- put those two things together and you're going to have a lot of volatility. So I'm not sure what the individual investor does except be sure you wear a seat belt.
And Bill, we've talked about trade, the impact that that could have on things. Let's talk about technology. And the FAANG stocks are in retreat. The NASDAQ now has erased all its gains for 2018.
You know, Facebook's having issues. You know, Apple, Amazon, Netflix, I mean, they're all selling off. Some specific company issues, some in the larger picture. But how concerned are you about the sell off that we've been seeing in tech, given that they're the sector that has led the market's up for so long?
Well, I think it gets back to a couple of points. If a company generates cash flow each and every year and has very little debt, it can never go broke. So as a principle, you want to own companies that can generate cash flow and more importantly, allocate it wisely. To the extent there are tech stocks that do that, they're going to be just fine.
The tricky ones will be Facebook and Google, because that has to do with the privacy issue. And that can be quite serious. We're going to hear something in the second quarter with from the European regulators with regard to this privacy issue. There may very well be fines or sanctions. And there may even be attempts to do some regulation there.
Now, both Google and Facebook generate a lot of cash and it's continuing to grow. But their models are heavily dependent on advertising models. If there's any cut back to those advertising models in any way, it could hurt their cash flow growth.
But with those two, you don't have to worry about them going out of business. Could they be regulated? Possibly. We'll hear more about that in the US. But the Europeans have been in the front on this privacy issue, and we're likely to hear something there.
But you can have a correction in valuation, but the businesses are likely to be OK. They're going to slow down. The growth in both those companies will slow a little bit. But on balance, I think they'll be fine.
When you get to things like Netflix, they don't make any money. They haven't ever made any money. In fact, they lose more and more cash every quarter. Fortunately, they have a Santa Claus in the debt market which, basically, they have been able to borrow money repeatedly to sustain their business model. But it's not a company that we would own, just because they generate no cash flow, no free cash flow at all.
Amazon, they have been able to survive and prosper without a lot of profitability. Now, one of their divisions, AWS, is really quite profitable. But they provide a real service to the economy.
I have no idea how one is going to value Amazon. It's a name that we don't own, but they just don't generate sufficient cash flow for us to merit. It's clearly a successful business and Jeff Bezos has been brilliant in bringing that to market.
But as you go from QE to QT, this sort of free ride you had on cheap money for a long long time, that's over. And that could affect the valuation of Amazon quite a bit.
Bill, let me ask you, you mentioned the fact that if you look at the EU they're probably a little bit ahead, I think, of the United States in terms of privacy and that type of thing. But I mean, do you think the era-- and I think "unfettered" is probably a bit of an exaggeration on my part-- but you know, there hasn't been as much regulation in technology, especially when it comes to people's data as there has been. Is this an inflection point, perhaps, just for the sector to be looked at differently in terms of the way they're able to reap the advertising revenues from their users?
Well, I wouldn't be so-- I wouldn't grade this thing as being a big tech issue. I think it's more of a social media issue. And do consumers-- are they really aware of what they're giving up?
There's an argument out there that you should be paid for the data you give these companies. Right now it's free. And there's a discussion of is data labor. And if you're going to give a lot of information about yourself, should you be paid for it? There's a discussion in the marketplace about that.
You also take it for granted that this information you're giving these organizations are going to be helpful to you. Well, that also is starting to color things. Some of the fake news, some of the ads they're targeting, some of the stories that are coming out on the misuse of social media and how some of these organizations, particularly Facebook, have abetted this misinformation. That's a real concern.
But I do think you'll see the leadership come out of Europe. They are more concerned about the privacy issue than Americans have certainly been so far.
Fascinating discussion. I'm curious, just in light of everything that's going on with tech in trade, I mean, are you seeing opportunities pop up? I mean, is this an interesting market for you with a smile on your face, or an interesting market with a frown on your face?
Well, I guess it's a little bit of both. You have to understand what tech is. And frankly, I would recommend to your readers-- we talked about this once before. If you want to understand what's going on in the tech world, there's an excellent, excellent book called Machine, Platform, Crowd. It's the one book I think that explains what's going on.
We're moving from a world of atoms to a world of bits. And when we go for the world that's made of atoms like the desk or chair that you and I may sit it to a world of atoms where we have a piece of information that can be used again and again and again, that bit has certain characteristics. First of all, if it's information, it's free.
And you can replicate it. Every replication is identical to the first one. So you have perfect replication. And it's instant over the internet. So a bit is free, it's perfect, and it's instant. There's no cost to that, very little cost of that. And to the extent that gets into your system, it's very powerful for profitability.
So to give you an example, let's imagine you have a business. If you can substitute technology for labor and still hold your sales at the same level, your profit margin just went up. And if you can substitute technology for physical assets, if you're in retail, maybe you don't need five stores, maybe you just need one store and you need an internet initiative. Well, all of a sudden-- and you can keep your revenues the same-- your revenues per dollar of assets just went up. So every corporation, in some way, is driving toward what I call a capital light model. That will make profitability better.
There's also a side piece to that. When you look at how organizations are structured financially, if you look at the left hand side of the balance sheet called assets and you look at the relationship with those assets to stockholders' equity, that's called leverage.
Well, if you don't need the physical assets in your business, you don't need all the equity in your business. And you can pull equity out. So this year, you're going to see a record amount of share buybacks. You're going to see rising dividends. It's going to be amazing what happens to capital return to the owners of the business. This will be a record year.
And technology is aiding and abetting that. So when you look at companies to own, there are some technology companies which will do just fine. I think of Applied Materials as one. They're a semiconductor equipment manufacturer. There are a number of companies that should be just fine.
The tricky part will be what valuation will the market put on some of these companies. So you could see a correction in valuation, it's always possible. But the underlying cash flow characteristics of these companies is excellent. And so those are the ones I think you will want to concentrate on this year.
Always good to get the perspective to put the headlines sometimes where they belong, which is always not the most important. Bill, a pleasure. Thank you.
Thank you very much, Kim.