We have enjoyed an extraordinary bull market in risk assets since the mid-1980s, following Volcker’s fight with inflation.  Interest rates have collapsed (I am conveniently ignoring the recent rise),  equity markets have done phenomenally well, and so have property markets.  Following the war against inflation back then, it took approximately ten years before wealth began to rise markedly, hence why the rise in wealth in Exhibit 4 is measured from 1995.

As you can see, the bottom 50% of the population worldwide, has only captured 2% of the wealth created since 1995.  Meanwhile, the top 1% has captured no less than 38%.  The implication of that is obvious.  Since 1995, the rich have gotten much richer; therefore the gap between rich and poor has widened significantly and continues to do so.

Why the difference in wealth dynamics between Europe and the US?

Last year, researchers at Imperial College of Business School in London did a study on the determinants of wealth inequality in Europe and the US (you can find the study here).  Their findings were not hugely surprising.  Whilst interest rates and property markets have performed similarly on either side of the Atlantic during the period in question, equity markets have not.  As Clara Martinez-Toledano (one of the authors of the study) points out, “from the 1980s we see a wealth gap start to emerge, where there’s a more dramatic change in the United States. The wealth that the top one percent richest people own in the States has undergone a significantly larger increase than the top one percent richest in Europe – in other words, the gap between rich and poor in the US became much more pronounced as wealthy Americans became even richer.”

Martínez-Toledano continues: “Differences in the composition of these assets across wealth groups is key. The richest people tend to own financial assets such as stocks and bonds, while the middle wealth groups tend to have a house as their major asset. But even with a big growth in house prices in both regions, stock market prices were the standout distinguishing factor, with a huge jump in value of US stocks during those decades“.  The problem, according to Martinez-Toledano, is that “high levels of economic inequality can lead to economic and political instability. This is why action needs to be taken before societies become polarised”.

The impact on life expectancy

Declining living standards affect many things in life, none more important that mortality rates.  As you can see in Exhibit 5 below, the latest longevity statistics coming out of the US indicate that life expectancy over there is now the lowest it has been since 1996 (you can read more about that here).  I am not arguing that the rising gap between rich and poor is the only reason behind declining life expectancy – not at all.  The pandemic has certainly had an effect.  So has the ongoing opioid crisis.  Having said that, when the money is tight, you don’t always go to the doctor at the first sign of problems.  If you don’t think the rising gap between rich and poor has had an effect on mortality rates, I suggest you read this article in New York Times.

What will happen if the gap continues to widen?

Unless political action is taken, the inequality gap will most likely continue to widen.  As the gap grows, more and more problems will materialise.  Not only is extreme wealth and inequality politically corrosive.  It is also socially divisive.  Society is undermined, not necessarily in the short term but definitely over the longer term.  Take for example positions of power whether in politics or elsewhere.  Those from the elite are much more likely to end up in those positions, further entrenching inequality.  And children of the elite will likely follow their parents into positions of power.

Extreme wealth is also economically inefficient.  Wealthier people spend a smaller proportion of their disposable income on consumer goods than poorer people do. Therefore, a concentration of wealth on fewer hands leads to a drop in consumer spending when measured as a proportion of overall economic activity.  Having said that, a concentration of wealth on fewer hands has proven good for risk assets, as wealthy people invest more; hence why financial markets have done so well since the 1990s.

One of the (many) problems we face at the moment is that ordinary people are forced to make sacrifices every day.  The British media call it a cost-of-living crisis, and that is hardly an exaggeration.  Meanwhile, the super-rich continue to get wealthier and wealthier.  According to Gabriela Bucher, Executive Director of Oxfam International, “taxing the super-rich and big corporations is the door out of today’s overlapping crises.  It’s time we demolish the convenient myth that tax cuts for the richest result in their wealth somehow ‘trickling down’ to everyone else.  Forty years of tax cuts for the super-rich have shown that a rising tide doesn’t lift all ships – just the superyachts.”

Unfortunately, it is not as simple as that.  Unless such a tax programme is global in nature, the super-rich – most of whom may have a pretty good track record in terms of finding loopholes in the tax laws – could possibly relocate to various tax havens.  And, quite frankly, I would be stunned if the entire world were to agree to a programme like Ms. Bucher suggests.  The problem facing the rest of us is that the chain will come off at some point.  It could take another 10 years, perhaps even another 100 years, but come off it will, if the gap continues to rise.  How do you think the French Revolution in 1799 came about?  The problem must be addressed before it is too late.

Investment implications

In the original 2020 paper, I argued that, for as long as the gap between rich and poor continues to widen, risk assets will probably continue to do well.  That is still my opinion; however, there are two noteworthy caveats.  First and foremost, as long-term readers of my work will be aware,  I am of the opinion that, at some point, household wealth will begin to mean-revert when measured as a percentage of GDP.  In many countries, particularly in the US, wealth-to-GDP is so much above its long-term mean value that it is unsustainable.  Risk assets won’t do well in an environment where wealth-to-GDP is falling.

The problem I have with this argument is that a significant drop in wealth, which shall be required to restore the long-term mean value, could still be decades away.  The underlying theory provides zero guidance on timing, but I am inclined to think that mean reversion will truly begin when  the mob decide that enough is enough.  A civil war, or a revolution, may never happen, but less can get the mean reversion process underway.  An extreme left-swing in parliament could give the far left sufficient powers to make earth-shaking changes.  Here in Europe, we tend to smile when Americans call Bernie Sanders “an extreme left-wing”.  At least by our standards, he is far from extreme, but he could be the canary in the coalmine.

The other issue you need to take into consideration is inflation.  Although I think the worst is probably behind us now, the journey back to 2% will be long and arduous.  The issue at heart is the strength of the US labour market.  Unless it weakens meaningfully from here, the Fed could be forced to raise its policy rate well above current expectations. The market-implied terminal rate is currently hovering around 5.7%, which is about 1% above the present Fed Funds rate.  If the Fed needs to go much higher to get inflation under control, risk assets will most likely suffer.

Niels C. Jensen

11 April 2023