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# The Rising Gap between Rich and Poor

Our recent megatrend restructuring

Only a couple of months ago did we restructure the list of megatrends that drive everything we do at Absolute Return Partners. For a long time, it had bothered me that:

• we do not mention climate change explicitly anywhere;
• baby boomers are only part of the story on changing demographics;
• declining spending powers of the middle classes are only a sub-theme under the head-theme which is about the rising gap between rich and poor; and
• mean-reversion of wealth-to-GDP is not really a megatrend but rather the aggregate result of all the other megatrends.

Consequently, we boiled our list of eight megatrends down to six, renamed some of them, and the last megatrend on our list – Mean-Reversion of Wealth-to-GDP – is now presented alongside the six megatrends but as the aggregate result of the other six. The new, revised list looks as follows:

• The End of the Debt Supercycle
• Changing Demographics
• The Rising Gap between Rich and Poor
• Rise of the East
• The Age of Disruption
• Climate Change
• Mean-Reversion of Wealth-to-GDP

I never produced a comprehensive paper on Declining Spending Powers of the Middle Classes so, what is to come next is brand new, although I have leaned against old Absolute Return Letters when putting this paper together.

One final point before I begin. Absolute Return Partners is a member of UN PRI, a United Nations organisation that works to understand the investment implications of environmental, social and governance (ESG) factors. PRI stands for Principles for Responsible Investment, and PRI defines responsible investment as a strategy that incorporates ESG factors in investment decisions. PRI is the world’s leading proponent of responsible investment and we are proud to be a member. How do we incorporate PRI’s investment principles in practice? Think of PRI as an umbrella over and above the six megatrends. An investment opportunity will not pass the needle’s eye if it goes against the investment principles set by PRI.

## Issues to be addressed in this paper

According to the World Social Report 2020, published by United Nations earlier this year, inequality is a growing problem, affecting more than 70% of people on this planet. And, unlike what many think, it is not only a problem that affects people in EM countries. As you will see later, hundreds of millions of workers in the wealthiest part of the world (OECD) are also affected.

The rising gap between rich and poor has many implications. The spending powers of ordinary people are under pressure, which affects GDP growth negatively. As those spending powers continue to decline, the overall level of anxiety in society rises which affects social stability. Even worse, populists in the political elite take advantage by making many (mostly empty) promises. About 25% of all Europeans vote for a populist these days (Exhibit 1). I probably don’t need to remind you that, last time populism was in vogue, we ended up with a problem called Adolf Hitler.

In the following, I will look at the different implications, and I will assess how investors should position themselves to take advantage of this megatrend. It is a massive issue, hence I cannot cover every single aspect, and for that I can only apologise. At least, in these coronavirus times, it gives me an excuse to write a follow-up note relatively soon.

We publish investment strategies and opportunities in our research papers. This research paper is available to professional investors as part of ARP+ subscription.

## The naked facts

Total wealth in society is defined as the sum of household wealth plus the wealth of charitable organisations. In the following, when I refer to total wealth, I refer to the sum of the two.

Through much of the 20th century, as living standards in most countries improved, the number of middle class families grew rapidly. The net effect of that, wealth-wise, was that the wealthiest in society accounted for an ever smaller slice of total wealth. Particularly working class people, who had struggled for centuries, were better off as total wealth got distributed more evenly. As we entered the Great Equity Bull Market in the mid-1980s, the gap between rich and poor had never been smaller (Exhibit 2).

That said, the extraordinarily benign financial market conditions of the last 35-40 years have reversed that trend. The extraordinarily good performance of both bonds, equities and property since the mid-1980s has resulted in significant wealth creation amongst the already very wealthy, causing the gap to widen again. The wealthiest 1% began to grab a bigger slice of the pie when Reaganomics in the 1980s changed the economic landscape, and they have managed to do so ever since. Even if the poorest 99% are wealthier than ever before when measured in absolute terms, many of them feel poorer as they can see the wealthiest 1% building their wealth much faster.

Income distribution statistics do not paint a much different picture. Across the world, the top 10% income earners have increased their share of national income significantly since 1980 (Exhibit 3).

Back in November 2017, I covered this topic for the first time in an Absolute Return Letter, and I introduced work conducted by World Bank in 2013. The now (in)famous elephant chart that I introduced you to (which you can find here), has since been updated (Exhibit 4). If you compare the elephant chart from 2013 to Exhibit 4 below, you will see that the gap between rich and poor is even bigger now than it was not that many years ago.

As you can also see, the top 1% of income earners worldwide captured no less than 27% of the total growth in income between 1980 and 2016. Meanwhile, the bottom 90% got squeezed – at least in the US and Europe – and that is consistent with World Bank’s 2013 findings.

Exhibit 4 is global in nature, but the International Labour Organization, ILO, and OECD both collect data on real income growth on a country-by-country basis. As you can see in Exhibit 5 below, several large OECD countries have experienced virtually no growth in real income since 2008 and, in the case of the UK, the average annual growth rate is -1%. Within the OECD, only Greece has fared worse since the Global Financial Crisis.

## What happens when the gap between rich and poor grows?

All over the world, the middle classes underwrite economic and political stability. Hence, when the middle classes are unsettled, so is society at large. In November 2016, the Americans chose a political outsider (Trump) as their next President. Earlier the same year, the British had chosen an uncertain future outside the EU and, only the previous autumn, The Italian comedian Beppe Grillo had appointed himself to run Movimento 5 Stelle, the biggest political party in Italy. The middle classes of those three countries sent the following message to the establishment:

We are not happy with the state of affairs. Something needs to change. We want a better life!

I am not even sure people knew precisely what it was that must change, but something needed to, they said. Every now and then, a populist shows up on the stage, seeking to take advantage of such discontent and, from that point, the political establishment loses control. When people are unhappy, they start to look for scapegoats, and sometimes the choice of scapegoat defies all logic. If the middle classes of the UK feel increasingly squeezed (which is a fact that one cannot deny), perhaps they should zoom in on the super-rich, or even better, on the various tax rules that has allowed the exceptional accumulation of wealth, instead of blaming the EU – an institution that has nothing whatsoever to do with the rising gap between rich and poor.

Apart from the obvious socio-economic implications (a growing number of divorces, suicides, etc.), the rising discontent amongst ordinary people has the effect of starting a highly unfortunate chain of events that will lead to ever lower GDP growth (Exhibit 6). I should stress that robust GDP growth not only creates widespread wealth – i.e. it is important for the feel-good factor in society – but, without respectable GDP growth, we wouldn’t be able to service the mountain of debt we have created – a mountain which is not exactly getting any smaller with the coronavirus doing so much damage to the global economy.

Talking about the coronavirus, the topic of our next corona-webinar scheduled for Monday the 4th May at 15:00 UK time will dig into this topic – i.e. how much will national debt rise as a consequence of this crisis? Could that significantly affect sovereign risk? How will it affect wealth more broadly? Are your pension entitlements at risk? As a warm-up, I suggest you read this.

For a better understanding as to how Exhibit 6 works in practise, I suggest you go the appendix where more detail is provided. For now, I will jump straight to one of the worst consequences of a rise in populism – a dramatic increase in misallocated capital. Before going any further, allow me to point out that “misallocated capital” is a term used by economists to describe capital that is deployed unproductively.

As is pretty obvious when you look at the hard facts (Exhibit 7), this is not exactly a small problem and is a significant part of the reason why GDP growth continues to disappoint. Exhibit 7 is based on US data, but the US is far from the only economy suffering from this problem. I do not have updated data from other parts of the world, but the latest data I have on Japan, Germany and the UK suggest that this is a widespread problem.

## Declining spending powers of the middle classes

As mentioned earlier, the Rising Gap between Rich and Poor is a megatrend we have only added recently. In fact, we simply renamed the megatrend we called Declining Spending Powers of the Middle Classes. On further reflection, we came to the conclusion that the latter is really a function of the former, hence the change. That said, given the relevance of the declining spending powers, let’s spend some time on it.

At least in Anglo-Saxon countries, across the lower income groups, virtually all income is spent and nothing saved (Exhibit 8). As you can see, at the lowest income levels, spending actually exceeds income. If you then move up the income curve, you will notice that the cushion between income and spending gets bigger, which is only what you would expect.

It is therefore to be expected that, the wealthier you are, the more your spending patterns are influenced by your wealth. In other words, when I talk about the Declining Spending Powers of the Middle Classes, I refer to the fact that ordinary people in mature economies are going through a phase of negative real wage growth.

In the summer of 2016, McKinsey Global Institute published the most comprehensive study yet on falling living standards in mature economies (called Poorer than their Parents?). McKinsey concluded that 65-70% of all households in 25 advanced countries – or 540-580 million people – were in a segment of the income distribution whose real incomes were either stagnating or in decline in 2014 when compared to 2005. By comparison, only 2% – or less than 10 million people – experienced the same between 1993 and 2005.

With respect to the populist agenda mentioned earlier, I also note that lower tax rates and rising transfer payments have reduced the impact. When taking those factors into account, ‘only’ 20-25% have suffered either stagnating or declining disposable income between 2005 and 2014. That also explains why government debt continues to rise and why so much capital is misallocated these days.

Italy has been particularly badly affected by this trend with no less than 97% of the population belonging to households that have suffered from stagnating or declining incomes. The corresponding numbers in the US and the UK are 81% and 70% respectively. Across advanced economies, the average is 65-70%, but the variation is dramatic. Take for example Sweden, where only 20% have experienced anything like that.

I should point out that not everyone looks at absolute numbers when discussing this trend but instead zoom in on ordinary people vs. the financial elite. As you saw earlier, it is fair to say that, when measured in relative terms, ordinary people have lost out to the financial elite in almost all countries over the last 30-40 years. In absolute terms, though, a much more varied picture emerges, as you will see if you take a closer look at the McKinsey study referred to above.

## Falling spending powers in a microeconomic perspective

If we begin from first principles and define GDP in a very orthodox, macroeconomic way, GDP is defined as the sum of consumer spending (C), corporate investments (I), government spending (G) and net exports (exports (X) minus imports (M)), i.e.:

(I) GDP = C+I+G+(X-M)

Now to the microeconomic way of thinking of GDP: Assume there are n companies in the private sector and think of GDP as the sum of the value-added created by those n companies. The value-added can be defined as total revenues (r) less the total cost of generating those revenues (c). Private sector GDP can therefore be expressed as:

(II) GDP_("Private Sector") = Sigma(r_n-c_n)

All one would have to do to arrive at identical numbers for GDP in (I) and (II) above would be to add government spending (G) in (II). Under reasonable assumptions, DeltaGDP_("Private Sector") = SigmaDeltar_n and r=p . q (revenues equal price multiplied by quantity), i.e.:

(III) DeltaGDP_("Private Sector") = SigmaDelta(p_n . q_n)

In microeconomics, the price and quantity that a company can achieve on its goods and services is a function of where demand (D) meets supply (S) which, in geometric terms, is where the two lines cross each other in Exhibit 9 below. The equilibrium (A) is precisely where S meets D, and the shaded area under A equals total output (p.q)

Now, assume both S and D move out as the economy grows, but that S moves out faster than D, which is precisely what has happened in recent years. The shaded area under the new equilibrium (B) is the new p.q, and the difference between the two shaded area equals DeltaGDP in the private sector.

In microeconomic theory, any growth (or decline) in GDP is a function of the S-curve and the D-curve. Mathematically, we can thus express the change in GDP the following way:

(IV) DeltaGDP_("Private Sector") = f(DeltaS_n,DeltaD_n)

I do not want to over-complicate matters so have assumed that they are both linear curves but, in reality, they won’t necessarily be. Two conclusions are straightforward:

1. GDP growth has been so pedestrian more recently because we have allowed the S-curve to move out faster than the D-curve; and
2. we could accelerate GDP growth, if we could somehow find a way to push the D-curve out faster than the S-curve.

The second conclusion above would also explain the prevailing modus operandi, where politicians in many countries have taken the view that constraining S is a great deal easier, and more likely to win them votes short term, than creating conditions that will allow D to move out faster than S; hence why Trump wants to limit Mexicans’ access to the US and why Johnson wants to limit other Europeans’ access to the UK. It is all part of this agenda.

## A special mention of the US

Earlier, I mentioned the risk of populists taking control of the political agenda when the gap between rich and poor gets too big. US median income, when measured in real terms, fell from a peak of about $57,000 in 1999 to$52,000 in 2013 (source: FAS.org). Going into the presidential elections in November 2016, the median American household had just been through 14 years of financial hardship and wanted something to change.

Adding to that point, when measured in relative terms, the bottom 90% of Americans continue to suffer from financial hardship wealth-wise – a trend that was first established in the mid-1980s during the era of Reaganomics. Since then, wealth has concentrated on fewer and fewer hands with the top 0.1% in control of as much wealth now as the bottom 90% (Exhibit 10). As you can see, that hasn’t been the case since the 1930s – another period characterised by a big gap between rich and poor.

## The forthcoming mean-reversion

In the national accounts, national income ultimately ends up in one of two pockets – either labour’s or capital’s. Over the years, even centuries, the split between the two has been remarkably stable, and every time the ratio has deviated from the long-term mean value, mean reversion has kicked in. Every single time!

In economic growth theory, there are some very technical reasons why that is, which is too burdensome for this paper, so let’s not go down that road. Suffice to say, although the mean value varies modestly from country to country, it is long-term stable everywhere.

Globally, about 2/3 of national income goes to labour and 1/3 to capital. Now, after years of capital taking more than its ‘fair’ share, labour is down to 55-60% in most countries. In many of those countries, labour has lost to capital for more than two decades although, in some countries, labour’s loss is of a more recent date. And, in a small handful of countries, labour has actually increased its share since 2011, i.e. the picture is rather heterogenous (Exhibit 11).

What could potentially kickstart the reversal? Nobody knows for sure as economic growth theory provides no guidance, and history little guidance, on that. In one or two instances, war has broken out (e.g. World War II). Every now and then, social unrest has erupted (e.g. the French revolution). Sometimes, new legislation has been introduced. In reality, pretty much anything could happen (even a pandemic), but mean-revert it will, assuming economic growth theory is correct.

As far as ordinary people are concerned, things will most likely get worse before they get any better, and that is a conclusion I have reached entirely independent of the current corona-malaise. Why is that? My logic is relatively simple. As conditions continue to deteriorate, populism will most likely rise further. It always does when ordinary people struggle. And the rise of populism brings a certain brand of politicians to the party who are ill-equipped, or don’t care, to deal with real problems. Going back to formula (IV) from earlier, if we add the public sector to that equation, total GDP growth can be expressed as:

(V) DeltaGDP = f(DeltaS_n,DeltaD_n)+G

In other words, there are only two ways GDP growth can re-accelerate from current lacklustre levels. We either create conditions that will allow the D-curve to shift out faster than the S-curve, or we increase public spending. There is no other way!

As mentioned earlier, the populists (read: nationalists) amongst us believe ∆S should be curtailed, but they are ignoring a small but critical detail – that, with lower international trade, the global economy will reset, so that any future growth will be off a much lower base. International trade is simply too important these days that it can be curtailed without us all paying a very high price.

The other solution populists like to offer is increased public spending. That can be achieved in many ways, but the only responsible way to spend more public money would be to do it in a way that affects productivity positively, and that means a better infrastructure. The current pandemic has taught us how important a robust digital infrastructure is.

That is not how populists think, though. They will spend money on items that are popular amongst ordinary people, and that usually means higher transfer payments. The multiplier on transfer payments is very low, though, and the impact on productivity non-existing; i.e. it is a gigantic misallocation of capital.

One thing that will almost definitely change in the years to come is the use of monetary policy. Sooner or later, policy makers will reach the conclusion I have reached already, namely that monetary policy has no meaningful impact on the D-curve. If anything, access to cheap growth capital has kept inefficient companies alive; hence it has allowed the S-curve to shift out more rapidly than the D-curve.

The obvious solution is to zoom in on the D-curve, i.e. to create conditions that allow the D to shift out faster than S. In that context, my out-of-the-box proposal is to introduce negative tax rates – on earned income only and for the lowest income groups only – and to finance the scheme by further limiting the social benefits low-income, and no-income, earners are entitled to.

## Investment implications

For as long as the gap between rich and poor continues to rise, risk assets will do well. Having said that, the ultimate fallout from the corona-crisis currently doing havoc is nearly impossible to predict, and that is the short-term joker in this game. Things could very easily get a lot worse before they get better, or we could already be past the low point. Hard to say.

The optimists amongst us have chosen to zoom in on the modestly better medical data (infection rates and/or death rates) coming in from most countries in recent days and on the action taken by various central banks (mostly the Federal Reserve Bank) more recently. “That is all correct”, the pessimists amongst us argue, “but economic fundamentals cannot be ignored” and, admittedly, they look pretty awful.

I find it hard to disagree with either side but have, over a long life in the industry, learned never to fight the Fed, so I am leaning towards the bullish side of the argument, although I would favour European over US equities, considering Europe is 1-2 weeks further into the disease cycle than the US is, and given how much better US equities have performed in recent days.

That is effectively my short term disclaimer as, corona-virus or not, once labour begins to take a bigger share of national income at the expense of capital, the nearly 40-year old bull market in risk assets may finally be over. Precisely when that will happen is hard to say, though. Could the corona-virus be the catalyst that starts the mean-reversing process? Maybe. Could capital continue to grab a bigger and bigger share of national income for another ten years? Maybe.

When it eventually happens, several things will happen, though. Corporate profits will drop, and that will most likely lead to an era of value stocks outperforming growth stocks for an extended period of time. Value always outperform growth when corporate profits are under pressure.

Adding to that, European equities will most likely outperform US equities in such an environment. The logic behind that argument is rather complex, so let me explain. With corporate profits under pressure, two of the three key drivers of wealth in society, namely equities and property, will face much more difficult times. If both equity and property prices struggle, household wealth will also struggle. Wealth, when measured as a percentage of GDP, has a well-defined mean value – 380% in the US vs. 420% in Europe – and wealth-to-GDP will revert to those mean values. It is only a question of when.

Now, if I tell you that US wealth-to-GDP is currently about 30% above the mean value, whereas the corresponding number in Europe is ‘only’ about 15%, it follows that US equities will likely underperform European equities in the years to come.

See the appendix for further comments on the various investment themes associated with this megatrend.

Niels C. Jensen

16 April 2020

## The Rising Gap … and its associated investment themes

As we always do, when we identify a megatrend, we zoom in on the associated investment themes that we have identified. In the case of The Rising Gap between Rich and Poor, we have (so far) identified a total of four such investment themes (Exhibit A1).

The Rising Gap between Rich and Poor affects many aspects of everyday life. As mentioned in the main text, it affects overall social stability. It has led to a rise in the number of divorces and to a rise in the suicide rate. One could even argue (but there is no proof of that) that is has also led to a rise in violent crime, in this country mostly knife attacks.

One of the most obvious consequences of the rising gap is the increase in populist agendas that are taking over nearly everywhere (see more on this below). With a rise in populism follows misallocation of more and more capital. Socio-economically, the consequences are therefore dramatic.

## The Rise of Populism

Populists always prevail when ordinary people struggle. In the last 120 years, we have only experienced two big spikes in the Populism index as compiled by Deutsche Bank. The first one was in the dark days of the 1930s with Adolf Hitler – the most notorious populist of the 20th century – taking advantage of a desperately poor German populace who needed something to change after years of despair. The second one is now (Exhibit A2).

With a rise in populism follows misallocation of more and more capital (see Exhibits 6-7 in the main text). The classic populist agenda is to promise the electorate things they want rather than things they need, i.e. transfer payments such as unemployment benefits and other social expenditures rise whereas investments in productivity-enhancing infrastructure decline. In the private sector, the biggest source of misallocated capital in recent years is property investments. As the gap between rich and poor has grown, more and more wealth has been tied up in property all over the world – capital that could (and should) be deployed in productivity-enhancing projects instead.

## Declining Spending Powers of the Middle Classes

See the main text for a discussion of this investment theme.

## Currency Wars aka QE

The first country to experiment with QE (Quantitative Easing) was Japan in the early 2000s. In the West, QE was first applied in late 2008 by the US Federal Reserve Bank in response to the Global Financial Crisis.

These days, QE is an active part of monetary policy in both Japan, Europe and the US. More recently, governments around the world have been criticised for not bringing QE to an end, potentially even replacing it with QT (Quantitative Tightening) as the Americans did a few years ago – although half-heartedly, I hasten to add.

Governments around the world have noticed the German export success story of recent years (well, at least before the trade war and the outbreak of the coronavirus) and believe it is, to a significant degree, based on a very competitive currency. All other things equal, QE weakens the currency in question, but governments all over the world are facing the dilemma that nearly everyone is doing QE these days; i.e. governments/central banks are afraid of putting a stop to it as the currency could rally and make the country in question uncompetitive.

In the context of the Rising Gap between Rich and Poor QE is relevant, because the discontent amongst ordinary people can be kept under control as long as they don’t lose their job. And, in an economy where competition is increasingly global, a relatively simple way to protect jobs is to ensure your currency is competitive, hence the continued appetite for QE.

The tricky part is to identify investment strategies that stand to benefit from this investment theme. In principle, CTAs should be able to benefit, but their systematic approach has not worked particularly well in the aftermath of the Global Financial Crisis (with the exception of 2019) – mostly due to low volatility in financial markets but also due to far too much equity exposure going into the coronavirus crisis. Consequently, I think this investment theme is most effectively adopted at the tactical level, i.e. how the currency risk should be managed (hedged or not).

## Out-of-Control Public Deficits

Economic theory prescribes that GDP = C + I + G + (X-M), but if neither C (consumer spending) nor I (corporate investments) will grow much in the years to come, governments will probably seek to affect DeltaGDP, either through increasing G (government spending) or through affecting X-M (via tariffs or otherwise).

There are (at least) three reasons why public deficits will expand in the years to come. Firstly, populists (and the political arena is overloaded with populists these days) always spend loads of public money, and populists will most likely gain in popularity for as long as the middle classes struggle.

Secondly, when GDP growth is low or negative, even responsible governments increase public spending. It is called fiscal policy, and one shouldn’t expect government not to use fiscal policy ‘just’ because we are already drowning in debt – at least as long as interest rates are as low as they currently are.

Thirdly, after I began to write this paper, the coronavirus pandemic broke out, and that changed the world overnight. As these lines are written, we do not yet know the magnitude of the economic impact, but there can be no doubt that it will be massive, encouraging governments to spend (much) more. How that will all pan out, only time can tell but, from where I sit, one of the more likely scenarios seems to be a return of more troublesome inflation down the road.

With the world already drowning in debt, central bankers will be aware that we may soon be in for a period of debt destruction. Now, debt can only be destroyed in two ways – though default (like in 2008) or through inflation. According to my source in those circles, pretty much any central banker would prefer the latter, i.e. it is not inconceivable that central banks deliberately choose to stay (a little bit) behind the curve once we have the first signs of healthier economic conditions.