Tuesday, November 18, 2014

Falling inequality = Bear market?

Gavyn Davies wrote a fascinating FT article this weekend about the long-term outlook for stock prices. In essence, he attributes much of the current secular bull run to rising inequality in the developed economies:
Thomas Piketty’s work has shown that a rising wealth/income trend is not a “natural” state of affairs in the very long run. He argues that, in many economic growth models, the wealth/income ratio is broadly stable in equilibrium, and his data suggest that this has been the case in the UK and France for several centuries

The opposite has been true in recent decades. Two factors are primarily responsible: the long term decline in the global real rate of interest, and the continuous rise in the share of profits in national income.

This combination has led to rising expectations of future profits, discounted at ever lower real interest rates, a recipe for surging equity prices. Lower inflation has also reduced the inflation risk premium, which has further exaggerated the gains in both bond and equities.

Davies explains that as long as the holders of capital have the upper hand against the suppliers of labor, equity returns will continue to be elevated:
Charles Goodhart and Philipp Erfurth at Morgan Stanley suggest that these factors are directly linked. All of them are basically caused by a long term decline in the ability of labour to maintain the growth of real wages in line with productivity. Until this is reversed, the very long run trends in asset prices may survive intact.

It is obvious that the inability of workers to maintain their previous trend growth in real wages would tend to increase the share of profits in GDP, and therefore be beneficial for equities, but why has this also led to a decline in real interest rates? The reason given in the Goodhart/Erfurth paper will be familiar to readers of recent work by Lawrence Summers and Paul Krugman on secular stagnation.
Fiscal and monetary policy are then caught in a bind and their response has had the unintended effect of further raising returns to capital (emphasis added):
Essentially, the argument is that lower real wages have increased inequality in the western economies, and this has depressed aggregate demand by redistributing real income and wealth away from the relatively poor towards the rich. Since the poor have a higher propensity to consume than the rich, this redistribution reduces consumer demand.

The decline in demand is then addressed by policy makers, either by fiscal expansion (reducing taxes and increasing subsidies on the poor) or by reducing interest rates set by the central banks. Since the fiscal response results in bigger budget deficits and higher public debt/GDP ratios, more and more of the burden of policy adjustment eventually falls on the monetary authorities. It is likely that this feedback loop will tend to increase both asset prices and inequality from one cycle to the next.

A pernicious additional consequence of this loop is that private sector debt/GDP ratios are also likely to rise through time. Falling real interest rates increase the incentive to borrow, while rising asset prices, especially in the housing market, increase credit worthiness and therefore the ability to borrow.

Debt ratios rise until they cause a crash, which of course is what occurred in 2008. This causes even greater and more permanent declines in real interest rates, which adds another twist to the cycle.
Davies warned investors that this trend cannot continue forever:
In the very long run, investors should also be looking at the fundamental driving force for the entire long term process of rising wealth, i.e. the drop in the labour share in national income. If this were to reverse, demand would rise more rapidly and real interest rates could be allowed to increase, bringing down the rate of growth in private debt. Although this would be healthy from many points of view, it would also deliver a double blow to equities by reducing expected profits growth and raising discount rates.

Global vs. local inequality
By way of illustration, here is a fascinating gif chart of the evolution of American inequality which depicts the share of wealth of the top 0.1% (red line) compared to the bottom 90% (blue line, via Vox with data from The Economist). The top 0.1% share of the pie is roughly equivalent to their share roughly 100 years ago, before the emergence of the affluent middle class that began about the time of the Second World War.

As well, here is a chart of inequality by country, as measured by Gini coefficients (via Business Insider). The highest levels of inequality exists in EM countries in Africa and Latin America. Of the developed economies, northern Europe had the lowest level of inequality, while American inequality is roughly equivalent to the levels found in China and Turkey.

If the investment thesis outlined by Davies is correct, it brings up a number of interesting questions:
  1. What would it take for the suppliers of labor to regain more bargaining power?
  2. If labor compensation were to rise, which would result in falling inequality, does that mean necessarily mean that the returns to capital would have to fall?

The best of both worlds?
I would contend that 1) Inequality is being lessened now; and 2) Falling inequality does not necessarily mean lower returns to capital.

In a recent post (see How inequality may evolve over the next decade), I outlined research by Branko Milanovic showing the winners and losers of the globalization drive of the past few decades. The chart below shows how global inequality has progressed. The winners were the rising middle class of the EM economies and the suppliers of capital (rightmost group in chart) as they were the main beneficiaries of globalization. The losers were the people in subsistence economies who were too poor to benefit from globalization (leftmost group in chart) and the middle class in the developed economies.

Fast forward to today. China is facing its Lewis turning point and the low hanging fruit from globalization is gone. There are no Chinas in the world with a similar population size that could cause the same kind of disruptive change to the global economy.

As I pointed out in my previous post, the decision to offshore is no longer a no-brainer for multi-national companies. In fact, China is no longer the low-cost supplier of labor and onshoring is becoming a viable possibility for many companies.

Now consider the following scenario for the coming decade. Onshoring becomes a trend as the economics of offshoring jobs to low-cost countries becomes less attractive. The suppliers of labor in the developed economies then gain more bargaining power because of increased demand. Developed market economic growth improves because of higher propensity of the DM middle class to spend. 

In a Piketty framework, the owners of capital lose ground. I would contend, however, that the Piketty framework is overly narrow in that it only analyzes local (within country) inequality without paying attention to how global inequality evolves. Under the scenario that I outlined, the relative winners of the onshoring drive would be the DM middle class, the relative losers the EM middle class. But since the owners of capital directed the re-allocation of capital from one region to another, it is hard to believe that they would lose ground on a relative basis.

In effect, I would expect an American (and developed market) Renaissance over the next decade, where middle class incomes grow again but without significant impairment of returns to capital.

1 comment:

Mark Wyand said...

following your DM renaissance logic, can you comment on the affects of slowing global demand considering us large caps derive ~40% of demand from other regions...