June and July Summer Newsletter: Examining Brexit

Posted by Alex Frey (@alexhfrey )

When the financial markets coin a new term, we feel obliged to at least address it. So it is with "Brexit." 

Like most financial commentators, we expected Britain to, in the end, vote to stay in the EU, so we were surprised when the majority of the citizens in the country voted to leave. The financial markets were also clearly taken by surprise. World stock markets reacted by dropping sharply. The British pound and the Euro (the currency used in much of the EU, but not Britain) also dropped, and the dollar rose in value. Though the stock market has since made back most of its initial losses, treasury bonds have hit an all-time low in the process, indicating that markets are still jittery. Had the markets correctly anticipated the outcome, they would have “priced it in” in advance and you would not have seen these dramatic price swings. 

The standard question when a news event like this drives a quick dislocation in prices is whether this is the start of a trend (“a big deal”) or a short-term blip (“a buying opportunity”). Reacting to the news in isolation, there is a strong case to be made that it is the latter, unless you live in Britain.

For Britain (more properly, the United Kingdom), withdrawal is certainly a big deal. The United Kingdom (UK) depends on exports for almost 20% of its gross domestic product (GDP) and half of its exports go to the EU. Also, many companies locate in Britain because it provides easy access to the Europe. Now those exports may be in danger unless the UK can negotiate a good trade agreement with the EU, and companies may wish to locate in the EU, which will not include the UK in the future. 

The answer is less clear for the U.S. and for most of the rest of the world. There is a danger that other countries in Europe may follow the UK lead, and the EU could dissolve. This would be bad for the world and certainly bad for European stocks, but we don’t think it is likely. Also, the higher dollar, if it persists will make U.S. exports more expensive, but of course it will also make imports cheaper. We expect that any influences on the U.S. economy will be modest. And Britain only accounts for roughly 4% of the world's economy, so we don’t think anyone should panic about Brexit. Whatever happens will play out slowly over the next two or three years, and we think a diversified portfolio will continue to be the best course. 

So why have the markets been so jittery lately? Perhaps because they are not just reacting to the news in isolation, but as part of a broader theme or trend. What could that broader theme be?

That brings us to the somewhat-controversial topic of this month's newsletter. It's one that we had picked before Brexit, but one that we also think both partly explains why Brexit happened and also why the markets have reacted to it as they have. It's a topic that was once confined to the realm of economics and political science, but which investors are going to have to start taking more seriously. The subject is income inequality. 

This topic has been and will be discussed extensively in the political arena. We would like to stay out of the political discussion and look at the issue from an investor’s point of view: How has income inequality changed over the years and how is it likely to affect investors in the future?
As dangerous as this statement is starting to sound in the politically charged environment we live in, let's start with the basic facts about whether income inequality has been increasing or decreasing. 

There are two major sources of data on incomes. One comes from the Census Bureau and is based on questionnaires that are given to selected respondents as part of the American Community Survey. This data has the obvious shortcomings of any such approach. Some people may refuse to respond (even though they are required by law to respond) and some may deliberately or accidentally give erroneous answers. Nevertheless, it probably captures accurate trends. The Census Bureau data is reported in two ways. In one report, they give the percentage of total income earned by each fifth of the population (top fifth, second fifth, etc.). In another report, they compute the Gini coefficient. We don’t need to define the Gini coefficient in detail here; it suffices to say that a Gini coefficient of 1.0 means that one person in a society earns ALL of the money, and a Gini coefficient of 0.0 means that everyone earns the same amount of money. Obviously, neither of these extremes ever happen. Small changes in a Gini coefficient can indicate rather large changes in income inequality. Figures 1 and 2 show the Census Bureau data on how income inequality has varied from 1947 to 2014.

Fig1Figure 1: Census Bureau data on U. S. income distribution. The curves give the percentage of total income earned by each fifth of the population.

Fig2Figure 2: Census Bureau data showing how the Gini coefficient has varied from 1947 to 2014. 

The Census Bureau data shows that income inequality was fairly constant in the early years after World War 2. From 1947 to about 1970, inequality may have decreased a little. However, since about 1970, there has been a slow but steady increase in inequality. During that time, the top fifth of the population has been getting a steadily increasing share of the total income while the four lower fifths have all been getting a smaller share. Nevertheless, one should not assume that the lower fifths are actually getting poorer; they are just getting smaller pieces of a growing pie. 

Figure 3, taken from U.S. News and World Report, shows this data in a slightly different way. This chart shows the real (inflation adjusted), after tax income for several income groups, stated as a percentage of their 1973 income. From 1947 to about 1975, incomes increased at about the same rate for each group, but since 1975, the top 5% have been pulling away from everyone else. However, the income for the other groups hasn’t decreased, except at the end of the period (2007 to 2012).

Fig3Figure 3: Changes in real (inflation adjusted) after tax income for three different sections of the population.  

The second major source of income data comes from tax returns. A number of academic researchers have used this data to investigate income inequality. This data goes back to 1913, the year that the U.S. first introduced the income tax. The general picture is shown by figure 4, which was taken from the Economist Magazine and is based on data collected by a British economist, Anthony Atkinson. It shows the share of income going to the top 1% of the population. For the first part of the 20th century, the share going to the top 1% decreased, but starting sometime in the 1970s, the trend reversed and the top 1% started to take an increasing portion of the total income. By 2010, the portion taken by the top 1% was back to where it had been in the 1920s. It is interesting that the trend for the United Kingdom is very similar to the trend in the U.S. In broad outline, the income tax data supports the trends given in the Census Bureau data.

Fig4Figure 4: The share to total income taken by the top 1% of the population in the period from the early 1900s to 2010. 

We should comment that the historical record may not be as clear as one would like. There are many factors that can confound an evaluation of income inequality. For instance, do you include government transfer payments such as food stamps, unemployment compensation, and welfare payments? Also, do you include benefits such as health insurance and disability insurance? And, what do you do about deferred income such as unrealized capital gains? Nevertheless, the data seem to show clearly that inequality decreased during the early years of the 20th century, but since the 1970s, it has been steadily increasing, with the very top wage earners capturing a large portion of the economic gains over the last 30 years. 

So what has caused the changes in inequality that we have seen over the last 100 years? Many factors are probably involved. Some people have focused on government policy, and in particular on tax rates. Colin Gordon (reference 1) notes that inequality and the highest tax rate move in opposite directions. Figure 5, taken from reference 1, shows how inequality and the highest tax rate have varied since 1913. There seems to be a strong inverse correlation between them. When the tax rate is high, inequality comes down, and when the tax rate is low, inequality goes up. 

Of course, one should be careful about assuming that correlation equals causation. At least one economist, Brian Domitrovic (reference 2) has suggested that part of this correlation is due to the fact that high income people shield some of their income from taxes when rates are high (for instance, by not selling appreciated assets or taking income in non-cash form). He suggests that the real change in inequality may be less than the charts above indicate. It is also worth noting that the years of low inequality in the 1930s were the years when Social Security and unemployment insurance were first introduced.

Fig5Figure 5: The share of income taken by the top 1% of the population is shown in blue with scale on left. The top tax rate is shown in red with scale on right. Taken from Colin Gordon, reference 2.

However, other factors that have little or nothing to do with government policy have probably contributed to the recent growth of inequality. Here are some factors that may contribute:

  1. Technology and automation of routine tasks: Technology creates high skill, high income jobs, but it may destroy many low skill jobs. For example, though the US produces more manufacturing output today than it did in 1960, it requires many less people today to do it. 
  2. Globalization: In a global economy, people with special talents, knowledge, or other advantages can compete in a much larger market and earn higher incomes. Those who don’t have special talents must compete with low wage world labor. 
  3. The “winner take all economy”: In a global economy, companies that are successful can grow very large and realize large economies of scale that allow them to out-compete potential competitors. The founders and/or owners of these companies (think Microsoft, Google, and Facebook) become fabulously rich.
  4. Demographics: The rich tend to have fewer children, so each child gets more support in terms of education and inheritance.5) Assortative mating: The rich marry the rich and the educated marry the educated. Either by genetics, or by creating a good environment, they pass their advantages on to their children. 

Regardless of the cause, inequality is becoming a political issue. In democracies, laws, representatives, tax rates, etc. are ultimately determined at least in part by the "will of the majority." Since one person equals one vote, this means the majority of people, not the majority of money or income. Already we are seeing that the majority of people may not be benefiting much, at least in terms of income, from the new kind of economic growth we are seeing. This majority at least theoretically has the power to dramatically change the rules -- overturn trade deals, make tax rates much more progressive, or just thumb their noses at the "global elite."

The rise of an increasingly “anti-elite” strand of politics across the globe is an indication that this is starting to happen in earnest. Peel the onion back on the Brexit vote, and it's clear that two of the strongest motivations of most “leave” voters were protests against immigration, and an open rebellion against a perceived class of “global elites” that was trying to tell them what was good for them. Both of these can largely be explained by stagnating real incomes from those who feel they have been economically “left behind.” “Blame the leaders” and “blame the outsiders” are age-old reactions to economic problems. 

Forget the electorate for the moment, why did the markets react to Brexit as they have? Maybe partly because the anti-elite strain of politics had mostly been simmering beneath the surface until now. Sure, the rise of Bernie-Sanders like figures on the left and Donald Trump-like figures on the right indicated an increasing distaste with the status quo. But up until now the “mainstream elites” have largely remained in power. But with Brexit, an event opposed by nearly all mainstream figures across the world, the “masses” have in a sense seized the reins of power and are using them to unravel a pretty core part of the post WWII world order. In other words, Brexit may be an inflection point that jolts the elites into realizing that they now have a very real problem on their hands. 

What else can investors take from this? It is quite likely that one of the responses to income inequality at some point will be higher taxes on wealthy people, and in particular higher taxes on dividends and capital gains. Investors would be wise to plan accordingly. For instance, if you’re trying to choose between a traditional IRA and a Roth IRA, the Roth is clearly a better choice if tax rates are expected to go up. With the Roth you pay taxes now, but future profits will not be taxed. Likewise, if you’re choosing between an indexed mutual fund and an indexed exchange traded fund (ETF) for a taxable account, the ETF is probably the better choice. An ETF will normally allow capital gains to accumulate without being realized for tax purposes. An indexed mutual fund might accomplish the same thing, but if the mutual fund has significant redemptions, it might be forced to sell assets and realize a capital gain. 

There is another issue that investors may want to think about. The fact that the very wealthy are receiving an increasing portion of the national income has implications for interest rates and investment returns. The very rich provide much of the investment capital that is needed to create new businesses and expand the economy. When the very rich take in a larger portion of the national income, they have more capital to invest, but the market for the new endeavors must come largely from the bottom 90%, whose income may be increasing very slowly or not at all. Thus, there may be a surplus of capital relative to the need. This may be one of the factors keeping interest rates low and driving up asset prices. As we have noted in the past, interest rates are currently very low compared to their historical range, and these low rates have persisted for a long time. Many people would attribute this to the Federal Reserve, but as we have noted in the past, the Federal Reserve really can’t keep rates lower than the “natural rate of interest” for a long time without creating inflation. We have also noted that price earnings (PE) ratios for stocks (especially the “Shiller PE”) are currently quite high and have been so for some time. Both of these trends may be partly explained by the current high level of income inequality. If the current degree of inequality persists, the low interest rates and higher PE ratios may also persist. But, if some action is taken to bring down inequality, it could cause higher interest rates and lower asset prices. 

We may sound like a broken record, but in an unpredictable environment of increasing income inequality, high valuations, and lower-than-average future returns, following core investing fundamentals will be more important than ever before. Minimize expenses by managing your own money and sticking to low-cost and liquid ETFs from reputable fund management companies. Stay diversified to capturethe the only “free lunch” in finance. Consider following a rules-based dynamic asset allocation strategy like the IvyVest model to reduce your exposure to “investment bubbles” and attempt to protect your capital from violent financial market dislocations that might be caused by future political unrest. Take care of what you can, and you can worry about the Brexit's of the world a little less.

Reference 1: Colin Gordon, “Growing Apart: A Political History of American Inequality”, an interactive website at scalar.usc.edu/works
Reference 2: Brian Domitrovic, “The Left’s Dubious History of Income Inequality”, The Laffer Center for Supply Side Economics, July, 2012.

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By Alex Frey