CIO Blog: Inequality Bubble
In this month’s CIO blog we study the idea of an inequality bubble and ask what the potential implications are of this spreading uncertainty for financial markets
A bubble can be defined as any system that is unsustainable and leads to catastrophic events that are largely unpredictable. It is a fragile state that presents risks and uncertainty. In this note, we examine the presence of an inequality bubble. Does the current wealth distribution in the global economy present a risk to investors and what are the implications for financial markets?
The rise of political uncertainty globally has been largely attributed to inequality. Several countries have been transformed by populism in the last 12 months. Whether it is in the United States with the meteoric rise of outsiders such as Bernie Sanders and President-elect Donald Trump, or the United Kingdom with the Brexit vote, a new political order is taking root. Anti-establishment movements are also brewing in Europe. In Germany, the right-wing Alternative for Germany is now a potent political force. In France, Marine Le Pen of the Front National is a near certainty for the second round of the 2017 elections. In Italy, the Five Star Movement has surged in popularity, particularly in light of December’s referendum. And in Spain, the two traditional parties garnered 50% of the vote collectively, while Podemos, the populist party, won 25%.
This is not a coincidence: the political upheaval is reflective of an emerging paradigm which separates humans less by country, culture or religion, but more by income, education and social mobility. In financial markets, as in life, it pays to be aware of tectonic shifts to evaluate their impact. One such shift is undeniably developing here.
The penny drops
As recently as between 1993 and 2005, 98% of households in 25 advanced economies saw real incomes rise. However – in the decade that followed – real incomes fell, or were flat, for two-thirds of households in those countries. This equates to 540 million people. It bears repeating. 540 million people. Our calculations show the UK is no exception. Median disposable income was over twice as high in 2015 as in 1977. But, over this same period, mean household income increased at a much faster pace as high-income households took an increasingly large share of the pie. Indeed, the top fifth of incomes grew 25% faster than those in the bottom fifth since 1977, with the distance between the top and bottom income quintiles far above that in the 1970s and 1980s.
Benjamin Friedman of Harvard University, in his book The Moral Consequences of Economic Growth, said that while most people do not read income statistics, they draw internal conclusions about the economic progress that they see in their lifetimes. Discussing Friedman’s work, Robert Shiller, the eminent economist, summarised “if people can’t see themselves and others in their cohort as progressing over a lifetime, their social interactions often become angry, resentful and even conspiratorial.” In a recent survey we conducted in collaboration with YouGov, about half of the British population felt their wealth was “about the same” or “less” than it was ten years ago (48%). Of those who felt “less wealthy”, nearly one-third thought “themselves” responsible (32%); 55% thought “someone else” responsible. And thus, one begins to piece the puzzle of public anger which is so vividly transforming global politics.
There are innumerable reasons behind something as complex and structural as global income inequality. They include: aging; slowing global growth; declining productivity; higher household debt for those with lower incomes; globalisation; automation; education; capital gains; and taxation.
Each topic is worthy of an individual paper, but it is worth focusing on three key trends.
Aging and myriad effects: Following World War II, a perfect storm of industrialisation, rapid population growth and urbanisation led to a “golden age”. However, this effect began to fade through the 1970s. Advanced economies received a major boost to growth with falling trade barriers and rapidly increasing demand from emerging markets. This allowed the “golden age” to be reignited in some ways for a few more decades. However, both of these factors were one-offs.
Today’s advanced economies, and many key emerging ones such as China, have a reversing demographic dividend. Trends such as aging, falling fertility rates and a rising ratio of dependents to working age adults is leading a decline in total income earned by households, which in turn is leading to less demand for everything. Adding to this picture is, perhaps, a more important factor. In advanced societies, income is disproportionately accruing to those who are least likely to consume, but most likely to save. Simply put, the marginal propensity to spend your millionth pound is less than your twenty-thousandth.
Capital Gains: Nearly all major investable assets class – stocks, bonds, credit, real estate – have done phenomenally well over the last few decades. Even cash, barring the last few years, has usually delivered positive, real returns. Therefore, those who have owned assets have generally increased their wealth, while those who depend solely on wages for wealth creation have become relatively poorer, and more insecure. In 2014 in the UK, capital income amounted to 33% of disposable income for the richest quintile of households. That compared with just 7% of disposable income for the lowest quintile.
Leverage: The Great Depression of the 1930s and the Great Recession of recent times had their origins, in part, due to increases in borrowing by low and middle-income people, who used debt to maintain standards of living. Income earned is mostly spent on immediate consumption and debt servicing, leaving very little to invest in education. This is no trivial matter. Education is the biggest single factor to higher income. Richard Reeves, a senior fellow at the Brookings Institute, cites data showing that 56% of heads of US households in the top quintile have college or advanced degrees, compared with 34% in the third and fourth quintiles and 17% in the bottom two quintiles.
Following the Trump victory and Brexit – combined best described as “Brump” - a shock populist outcome is no longer a shock. These are harbingers of long-term, structural forces reshaping the landscape in which geopolitical events will evolve. Against that uncertain backdrop, our advice to clients is threefold: be optimistic, be selective and be disciplined.
First, be optimistic. There are lots of causes for concern in the current macro environment. Whether it is the swing in politics or the fragile economics, the mood can at best be described as one of pessimism and scepticism. Often those are the ripe conditions to invest. Over the past five years alone, there has been a mood of negativity and uncertainty. That prevailing sentiment was punctuated by the Eurozone crisis, US debt shutdown and downgrade, slowdown in Chinese growth, and lately Brexit and Trump, yet the global equity market is up 71 per cent (or 11.4 per cent per year). Throughout history periods of negativity breed opportunities. It is when everything looks rosy that one should be cautious. That is when risk is often at its highest.
Second, be selective. Not too long ago, cash in a savings account yielded 5%; today, equities may well struggle to achieve that. One of the key changes as a result of aging demographics and skewed income distributions is likely to be perpetually lower equilibrium interest rates. Give that the conditions for a “golden age” of growth are unlikely to materialise again in our lifetimes, we must be ready to accept a lower return for each level of risk than we have historically. There is no getting past this trade off. Still, opportunities are ever present; when they arise, one should maximise them. Therefore, it is prudent to have some defensive assets such as government bonds and cash, as they offer the “dry powder” to invest in opportunistically. And, although equity market valuations are higher, by some measures, they still offer some value. Moreover, within equities, some sectors and regions still present the potential to harvest good long term returns. As such, being selective in the current environment is increasingly important, particularly as a monetary tide will decreasingly lift all boats.
Finally, be disciplined. We live in a world where events unfold very quickly and markets can move with staggering speed. It is therefore easy to want to react. Often, that emotional impulse is wrong. A disciplined and robust investment process that seeks to evaluate the long-term fundamentals rather than focus on short-term movements is key to navigating the uncertainty. It is critical to eschew the “noise” which inevitably surrounds period of great change. By focusing on indelible drivers of long term asset returns such as valuation, momentum and sentiment, the short-term movement and uncertainty can be prudently managed.
 McKinsey Global Institute, Poorer Than Their Parents? Flat Or Falling Incomes In Advanced Economies (July 2016)
 All figures, unless otherwise stated, are from YouGov Plc. Total sample size was 2232 adults. Fieldwork was undertaken between 25th - 28th November 2016. The survey was carried out online. The figures have been weighted and are representative of all GB adults (aged 18+).