Chancellor: In praise of slack

Reuters
Reuters

LONDON (Reuters Breakingviews) – In recent decades we have lived through an era of optimisation. In the name of greater efficiency, more and more output has been extracted from a given amount of input. The Oxford English Dictionary defines “optimise” as to “act as an optimist”. The dictionary also notes that “optimism” was “the doctrine propounded by (the German philosopher) Leibnitz … that we live in the best of all possible worlds.” But, like Voltaire’s Candide, we are discovering that isn’t the case. This has important implications for the way companies are managed.

American executives were those who most enthusiastically embraced the move to optimisation. Under the banner of delivering shareholder value, companies contracted out manufacturing to suppliers on the other side of the world, ran down inventories – operating instead on a “just-in-time” basis – and replaced equity funding with debt. Optimisation boosted the components that determine return on equity (ROE): corporate profit margins, asset turns and leverage. U.S. public companies boasted the highest returns in the world, reporting a 17% ROE last year, compared with just 9% for their Japanese counterparts.

But as Nassim Nicholas Taleb pointed out in his 2012 book “Antifragile”, the pursuit of optimisation creates instability. In recent years, we’ve witnessed a succession of what might be described as “optimisation crises”. The global financial crisis of 2008 showed that undercapitalised banks were overly dependent on the capital markets for liquidity. When Covid-19 struck many countries discovered their public health systems had too few hospital beds and inadequate staffing levels to cope with the pandemic. Vladimir Putin’s invasion of Ukraine has further exposed weaknesses in Europe’s energy system. Not only was Germany hopelessly dependent on Russian oil and gas, but the country had also underinvested in its military.

Optimisation has rendered the corporate world more fragile. Companies with too much debt are vulnerable to unexpected downturns. Globalisation works wonders when all goes according to plan. But it’s a complex trading system prone to unexpected breakdowns. As Taleb writes, globalisation “brings fragilities, causes more extreme events as a side effect … in such a complex system, the predictability of consequences is very low.” Recent events have borne out his concerns. 

Pandemic lockdowns disrupted global supply chains, and those disruptions were still unresolved in late February when Russia unleashed the largest military operation in Europe since World War Two. Globalisation has been badly fractured. Earlier this year an American ban on the import of goods manufactured in China’s Xinjiang region caused a pile-up of shipping in the port of Los Angeles. Semiconductors are in such short supply that ASM International, a leading European producer of chip manufacturing equipment, can’t get hold of them. Most of the world’s semiconductors are manufactured in Taiwan, whose independence is constantly threatened by China.

The easiest way to reduce fragility is to build more redundancy, or slack, into the system. For instance, after the global financial crisis regulators required banks to hold more capital. The UK government has announced that it will increase the number of healthcare staff available at periods of peak hospital demand. Germany is looking to construct terminals for imports of liquefied natural gas and has promised to spend more on defence. Slack is the new buzzword.

The corporate world is also seeking to reduce fragility. Having experienced frequent supply disruptions, some companies are turning away from just-in-time production. Others are looking to bring manufacturing back onshore. Chip giant Intel plans to build plants in the United States and Germany.

The era of optimisation sounded the death knell for vertically integrated companies which owned and controlled the entire production process. The tide could be about to turn. In a recent note entitled “The End of Optimisation”, Julien Garran of MacroStrategy suggests that companies will have to bring more key activities in-house. European luxury goods brands are already buying their suppliers, he says. 

The return of inflation exacerbates this trend. Rising prices are often accompanied by supply bottlenecks, but also create uncertainty about input costs. Companies typically respond by hoarding stocks, which requires them to operate with more working capital. Higher inflation and interest rates also raise the cost of operating across overextended global supply chains.

The end of optimisation will produce winners and losers. So-called “platform” companies that have few physical assets face a bleaker future if they are required to invest in their own manufacturing facilities. Taleb observes that small firms are inherently less fragile than larger ones, while large corporations are doomed to break. These factors make it more likely that “value” stocks, which trade at low multiples relative to their underlying assets, will outperform more highly priced “growth” stocks, Garran predicts.

American executives have been the keenest practitioners of optimisation. As a result, U.S. companies sport the highest valuations in the world according to forecasts compiled by Boston-based money manager GMO (my former employer). But these companies have also taken on masses of debt in recent years. In future, it will be harder for companies to boost their earnings per share and stock price simply by borrowing to repurchase their shares. When Howard Schultz, the returning chief executive of Starbucks, announced this week that the company would end buybacks and spend the cash instead on staff and cafés, the coffee chain’s share price fell. As returns on equity decline, the U.S. stock market will lose its premium rating.

The end of optimisation requires fewer financial engineers and more genuine engineers. That should be good news for Japan, one of the few developed economies to have retained its manufacturing base. It’s true that Japanese companies have shifted some production abroad, but they have also been wary of becoming overly dependent on China.

The concept of shareholder value has always been viewed with suspicion in Japan, where companies have given priority to the interests of other corporate stakeholders: customers, suppliers, employees and society at large. Japan’s conglomeration of business organisations, known as keiretsu, also operate with plenty of redundancy. In the past, Japanese companies may have delivered suboptimal returns compared to their U.S. counterparts, but they are less indebted and more robustly designed for uncertain times ahead.

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(Editing by Peter Thal Larsen and Oliver Taslic)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



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