Inequality: The which of you with patient ears attend
The below chart illustrates the dramatic difference in the reality versus the perception of wealth distribution in the US. The top 20% of the US holds 84% of the wealth, which is quite different from European countries, such as Sweden, which holds closer to 36%. For some reason, Americans have a very skewed perception of how skewed wealth distribution is in the US, and haven’t been able to manage the distribution of wealth to conform to their ideal vision of fairness. The Congressional Budget Office reports that the change in share of after tax income in the US since 1979 has risen 130% for the top 1%, risen nearly 30% for the top 20%, fallen 10% for the second 20%, fallen 15% for the third 20%, fallen 25% for the fourth 20%, and fallen nearly 30% for the lowest 20% of workers. This article examines the dynamics of growth in both income and wealth inequality in the US, and considers the impact such trends could have on US equity markets.
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Since 1947, real median income for the average American family has doubled, while productivity has increased fourfold. Critics point out that this increase on productivity has in fact generated much wealth, though the gains in productivity have manifested themselves in the upper class in the US, which holds larger amounts of US equities as a percentage of their net worth. And equity markets are near record highs, unlike housing prices. Plus, such high levels of inequality also seem to manifest themselves in high levels of social immobility, as generational earnings elasticity in the US stands at nearly 0.5 versus below 0.2 for Norway, Denmark, and Finland, and just over 0.3 for Germany. In other words, your financial future in the US will have a much higher correlation to your parents’ incomes than in Denmark. It would appear that the American dream is becoming less accessible to the average American worker.
Thomas Hungerford of the Congressional Research Service points to capital gains and dividends as the cause. Perhaps the ongoing declines in the capital gains tax rates of closer to 33% under Reagan to 15% under Bush Junior play a significant role in the growth of inequality. The collapse of the housing bubble post-2008 has certainly had a chilling effect on the balance sheet of the average American, and likely overwhelmed the positive impact of lower taxes under the supply-side regime in the near term.
Net income composition: Education is key
The below graph reflects changes in total income in the US from 1967 to date. Adding together the two top 20% brackets, it would seem that the top 40% of Americans have seen their share of total income grow around 5% since 1976, while the lower 60% of Americans have seen their share of income decline around 20%. This data would suggest that the college-degree-and-higher portion of the population has maintained or grown its portion of the total income in the US, as roughly 30% of Americans age 25 or older have college degrees. Essentially, the below data might suggest that the US will continue to be a worse place to live for the unskilled worker. And, unfortunately, Scandinavian countries with generous welfare states are very tight on work visas—even for the most highly educated Americans—thereby keeping even the capitalist barbarians well behind the gate.
Net income: The supply-side era
The below graph reflects the decline in total income of the lower 90% of American workers versus the top 10% of American workers. Since Reagan took office in 1981, the top 10% of Americans have regained the share of total income they had enjoyed during the roaring 1920s, just prior to the Great Depression. The economy has changed much since then, though it’s clear that the top earners have grown their share of total income in the US. As the above chart suggests, education and productivity could also be significant factors in accounting for the growing dispersion in income and wealth in the US.
Net worth composition
With the decline in US housing prices post-2007, the average American has lost a significant portion of his or her net worth, and has been less inclined to spend as freely as they did prior to 2007. The post-2008 crisis has led to a “balance sheet recession” in which the decline in the value of assets hasn’t been offset by a corresponding decline in liabilities and debt. As a result, the average American has been inclined to spend less. Though consumption as a percentage of gross domestic product remains fairly high, and near peak levels, the wealthy have likely borne a growing share of the total level of consumption in the US, as record equity prices have more than compensated for the decline in the value of their real estate holdings.
University of California Professor William Domhoff estimates that the top 1% of Americans hold 42% of the financial net worth in the country, while the top 20% of Americans hold 80% of all financial net worth, which includes stocks and bonds. The top 1% of Americans holds roughly 9.2% of its net worth in the principal residence, and 64.4% of its net worth in financial securities. In sharp contrast, the bottom 90% of Americans holds 59.8% of its net worth in the principal residence, and 6.1% of its net worth in financial securities. So much for the wonderful wealth effect on the average American’s 401k. Yahoo, and thank you, Ben Bernanke.
Monetary policy: Skewed impact
The result of record low interest rates has done a lot to raise equity prices to record highs, and has helped housing prices recover half of their declines post-2008. However, it’s easy to see which part of the US has seen the most dramatic recovery of the decline in net worth post-2008. It’s hoped that the recovery in wealth among the top 20% of Americans will trickle down to the lower 80% via increased investment and better-paying jobs, though the data has been far from robust in recent years. Actually, the data has been terrible, as the charts in the prior articles in this series reflect.
Even with the rise in the capital gains tax from 15% to 20% under the Obama Administration, federal tax receipts as a percentage of GDP have risen less than a percent to just under 16% of GDP in 2012—substantially below the 18.1% historical average and the 20%-plus levels seen during the Clinton Administration, when capital gains taxes were cut from 27% to 20%. As a result, it appears that the US may require more than simply low interest rates and an modest increase in capital gains taxes to restore more robust economic data, which can generate a higher level of tax receipts, and slow or reverse the growth in federal debt. A significant change in this data will likely require a significant change in public policy, and views as to whether to take a sharp turn to the left or sharp turn to the right, have become increasingly polarized, as reflected in the current round of budget negotiations over the debt limit and Obamacare.
Kudlow versus Reich: The top 40% versus the bottom 60%
Larry Kudlow’s recent tweet of guest commentator James Pethokoukis’s article addresses the inequality issue. August 19, National Review, “Obama is obsessed with the Wrong 1 Percent.” Pethoukis cites University of Chicago Professor Steven Kaplan’s analysis of the top 1% being driven by “superstar” economics—much like star athletes in the US. These are truly outlier observations, and not descriptive of the broader population base. Pethokoukis duly mentions the decline in real GDP growth in the US, as reflected in the graph in the first article in this series, with real GDP growth at 1.8% in the past decade versus 3.3% since 1929. This growth data is likely the real culprit of the broader population base in the US relative to a small number of highly paid executives. The US has bigger problems, such as weak investment data, which tower over the issue of a few overpaid CEOs.
Pethokoukis mentions that the apparent decline in social mobility is a potentially misleading statistic, as social immobility varies widely among different US cities and geographies. As suggested above, for Americans who have kept up with the educational and skill requirements of the modern US economy, real incomes have remained stable to positive for the educated and highly skilled—with some of the fortunate or exceptional individuals in the top few percent hitting real home runs in income and wealth.
The Robert Reich camp seems to focus more on the bottom 60% of Americans who have been the net losers since 1981—the rise of the supply-siders and financial deregulators. While much wealth has been created in the US equity markets, the bottom 60% have not participated in this period of wealth creation in a statistically significant and direct manner, and have thereby seen their income and purchasing power decline quite drastically. While Robert Reich does not seem to begrudge the financial home runs of the top earners in the US per se, he does object to the excessive inequality growth which has developed. He suggests that such economic home runs are, at least in part, being hit with the baseball bat of the less fortunate, and possibly even being hit by Republicans wearing his Davy Crockett cap.
Equality of outcome: Un-American?
The differences between Larry Kudlow and Robert Reich on the growing inequality in the US reflect fundamental differences in what constitutes proper public policy. Essentially, the differences focus on what constitutes a reasonable, fair, and economically viable, inequality of outcome. Given the change in wealth dynamics as described above, Robert Reich argues that the inequality of outcome between the top 40% of American’s relative to the lower 60% of Americans has gone too far. Of course, these dynamics of inequality of outcome become increasingly severe as we climb the income and wealth ladder. The election of President Obama seems to have vindicated Robert Reich’s beliefs on this matter.
Inequality of outcome: Inherently American?
The above graph would suggest that this was not always the case. The FDR Administration taxed the wealthy very heavily after World War II, and middle America received a much larger share of the income pie. However, post-Reagan, the data has reverted to the pre-FDR levels, when the US was primarily an agricultural and manufactural economy. As the American economy has shed both agriculture and manufacturing in its transition to a services-oriented economy, wealth inequality has once again grown to the levels seen in 1927.
The question remains: is this outcome the best of all possible economic worlds, or is this simply bad policy? In other words, would additional wealth transfer to the lower 40% of Americans push real GDP growth levels above the current 1.8% level back toward the historical averages above 3.3%, or would growth rates fall even further in an environment of widespread and debt-financed entitlements? Plus, as the world economy has become increasingly globalized and competitive post–World War II, does the US now require a permanent, low-tax regime—especially in terms of capital gains—to simply keep itself in the game of global economic capitalism? Views remain sharply divided on exactly these points, which will be considered in the next and final article in this series.
Investors in the US equity markets will need to monitor the budget debate very carefully. While the growth in debt is one issue, the bigger issue of the future trajectory of public policy toward the less fortunate 60% of Americans is a much more central issue associated with more aggressive redistributive economics under the current administration. Significant growth in and ideological commitments to future entitlement-related spending will move the debt needle and equity markets much more than a single-budget bill. A rapid transition to an entitlements-heavy federal budget and step back from the post-1981 supply-side tax ideology would represent a major shift in public policy. It also would likely have a major impact on equity valuations in the US. Taxes could eventually go back to the 1993 Clinton Era level, or even go back to the pre–Reagan Era levels much more quickly than the uninformed investor might realize. Caveat emptor.
S&P Price Earnings Ratio
The Shiller P/E ratio of the S&P 500 reflects a mean level of 16.5 times earnings, and current levels at 23.6 times—thanks to record corporate profits and unprecedented monetary policy post-2008. In the history of the US, the current level of price-to-earnings was touched briefly in early 1900s, then briefly right before the 1927 crash, then briefly in the mid-1960s. The market has remained at this level or higher since the mid-1990s, with the exception of the 2008–2011 recession. In other words, the price-to-earnings levels have been extremely high by historical standards post–Reagan and Bush. With the potential growth in debt and a step away from supply-side tax policy, a reversion to the average 16.5 multiple would suggest a 30% decline in the S&P 500 valuation (but try to think about the decline in inequality this would create).
The US debt ceiling debate: Democrats versus Republicans and a Russian joke
Igor is unhappy. He goes to visit the local mayor to complain. He says to the mayor, “Alexander, I am so unhappy. It is not fair that Boris has ten goats and I only have five!” The mayor says, “I see, Igor. What would you like me to do? Would you like me to speak with Boris? Maybe I can convince him to give you a few of his goats. Would that make you happy?” Igor replies, “No, that would not make me happy!” “Then what could I do that would make you happy, Igor?” asks the mayor. Igor answers, “I want you to kill five of his goats.”
Shutdown investing: Outlook
Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.