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Outlook 2018: The Bull Market’s Next Act

By Vito J. Racanelli



Wall Street’s eight-year love affair with stocks kicked into overdrive this year, spurred by a stronger economy, the likelihood of tax cuts, and a lack of compelling investment alternatives.

Donald Trump’s election as president in 2016 turned a bull with a midlife crisis into a high-powered charger, as investors cheered the Republicans’ pro-growth agenda and bid up anything that might benefit. Stocks have produced an 18% price gain, and a 21% total return year to date, as measured by the Standard & Poor’s 500 index, with low volatility and nary a trading session in which the popular benchmark closed down for the year. As for the market’s last big selloff—a 15% decline in February 2016—it seems a distant memory. On Friday, the S&P 500 index ended at 2651.50.

Given synchronized global growth and rising corporate profits, 2018 could be another good year for stocks, notwithstanding the bull’s advancing age. The S&P 500 could gain about 7%, mirroring similar gains in corporate profits, according to the consensus forecast of 10 investment strategists at major U.S. investment banks and money-management firms surveyed by Barron’s each December. The group’s predictions range from 2675 to 3100, with a mean estimate of about 2840.

The outlook isn’t entirely rosy: Interest rates are headed higher, stocks are expensive, and a tax overhaul could still stall or fail. But so long as corporate earnings keep climbing and the Federal Reserve raises rates in a measured way, the strategists see more room for gains.

“Rational exuberance is the stock market’s theme for 2018,” says David Kostin, Goldman Sachs’ chief U.S. equity strategist, harking back to the well-known but ill-timed “irrational exuberance” comment made by Federal Reserve Chairman Alan Greenspan in late 1996 about the rollicking bull market of that era. The market doubled after Greenspan’s veiled critique, only to lose about 50% from its top in the 2000 dot-com bust.

A rapidly expanding price/earnings ratio, or market multiple, drove the 1990s bull, but “it’s the earnings this time,” says Kostin, whose view is shared by his peers.

 
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OUR PROGNOSTICATORS EXPECT S&P 500 earnings to climb to $145 in 2018 from an expected $131.45 this year. Most estimates assume that global growth will spur earnings gains, with an additional boost coming from U.S. tax cuts. Depending on the final tax bill, they figure that lower corporate taxes could be worth 5% to 10% of earnings growth, or anywhere from $7 to $14 a share. But in the unlikely event that no tax cuts are passed, the market could drop sharply.

Industry analysts forecast S&P earnings of $146.20 for next year, not including tax cuts. If analysts revise their estimates higher in coming months to account for the positive impact of lower taxes, stocks could get a further boost.

Market strategists are divided on whether stocks’ P/E ratios will expand. The S&P 500 trades for 18 times the next four quarters’ expected earnings, up from 17.1 times 12 months ago. While the most bullish forecasters look for P/E multiple expansion to help propel stock indexes, others worry that 2018 could be a “peak” year for P/Es.

The strategist got a few important things right last December in looking ahead to 2017. They predicted that stocks would rise this year, speculative activity would revive, and financial stocks would do well again after gaining 20% last year. Indeed, financials are up 20% this year. The strategists were too timid, however, in their market forecasts; their mean prediction put the S&P 500 at 2380 at the end of the year. That now seems highly unlikely, barring a sudden last-minute rout.

Financials, once again, are Wall Street’s favorite stocks for the new year. The industry should be helped by higher interest rates, lower taxes, and an economy growing by nearly 3% a year. The sector trades for about 15 times next year’s expected earnings, below the market multiple, and banks are some of the nation’s highest corporate tax payers.

Consumer staples, real estate, and utility stocks, on the other hand, are expected to underperform in 2018, due to rising interest rates. Because of their relatively lush dividend yields, all are considered bond proxies. The stocks are this year’s laggards: Utilities are up 14%; staples, 10%; and real estate investment trusts, 7%.

TECH STOCKS LED the market for most of this year with a gain of 35%, helped by an even more powerful rally in the so-called FANGs: Facebook (ticker: FB), Amazon.com (AMZN), Netflix (NFLX), and Google, owned by Alphabet (GOOGL). Market watchers now are neutral to positive on the foursome and the sector. At 17.7 times next year’s estimated earnings, tech valuations aren’t cheap, but they’re well below valuations in the dot-com era, and underlying earnings growth is strong.



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Investors worry that next year might see a move toward greater regulation of large tech names, which, some strategists fear, could play havoc with their shares and the market. Despite its Republican pedigree, the Trump administration seems unafraid to pursue antitrust actions against giant corporations, as AT&T (T) can attest; the Department of Justice has sued to block its $85 billion takeover of Time Warner (TWX). Social-media giants such as Facebook and Google have been caught in the crosshairs of congressional investigations into possible Russian involvement in last year’s election, while some critics decry the allegedly monopolistic tendencies of Amazon.

Led by Bitcoin, up 1,500% this year, to $15,232, cryptocurrencies are likely to stay in the spotlight in 2018, gaining even more investor attention. Some market strategists—and plenty of other people—worry that the virtual coins are merely a fad, however, whose trajectory will end in tears and rattle other assets, including stocks.

With interest rates still near historic lows almost a decade after the financial crisis of 2008-09, stocks have had plenty of runway for growth. Most strategists expect rates to rise in the next year, but not to levels that would imperil the bull. Our panel looks for the Federal Reserve to lift its federal-funds rate target on Wednesday by 0.25 of a percentage point, to a range of 1.25% to 1.5%, and follow up with three rate hikes next year that would take the federal-funds rate, on which other interest rates are based, to a range of 2% to 2.25%.

Jerome Powell, successor to Fed Chair Janet Yellen, is expected to continue her easy monetary policy, but could be inclined toward less regulation. That is another reason why financials are favored in 2018.


ED YARDENI, PRESIDENT of Yardeni Research, is no stranger to Wall Street but a newcomer to our panel—and its most exuberant bull. He sees the S&P 500 ending next year at 3100, which would reflect a gain of about 17% from current levels. Just don’t give all the credit to tax relief, he says; a second year of global economic growth could ignite fresh enthusiasm for stocks. Corporate earnings growth remains a relative novelty for investors. In the three years prior to 2017, S&P 500 profits were flat at about $118.

John Praveen, chief investment strategist at PGIM Global Partners, has a 2018 year-end target of 2925. His 2017 forecast was closest to the mark, at 2575. A longtime bull, Praveen cites falling cash levels at money-management firms as a sign that institutional investors are finally embracing the rally.

While the Street’s seers believe the market has already discounted about half of the expected tax relief, the tax bill, if passed, could be a gift that keeps on giving. Dubravko Lakos-Bujas, JPMorgan’s chief U.S. equity strategist, says the impact on corporate earnings “will resonate in the first and second quarters of 2018…and continue to be a positive tailwind [for stocks] into the first half of 2018.”

With the S&P trading well above its historical average of 15 times earnings, “it is accepted wisdom that the market is expensive,” says Stephen Auth, chief investment officer for equities at Federated Global Investment Management. But he argues that’s not the case, given the economic and interest-rate backdrop, a pro-business administration, and unattractive fixed-income alternatives.

Auth has a year-end target of 3000, derived by applying a P/E of 20 to his 2018 earnings estimate of $150. For all the talk of investor exuberance, he says, “we haven’t gotten to the point where taxi drivers are giving stock tips.” JPMorgan Chase (JPM) is one of his favorite stocks; the bank could earn $10 a share next year and deserves to trade at 15 times earnings, he says. That implies a stock price of $150, compared with Friday’s $106.

WHILE ALL OUR STRATEGISTS expect stocks to head higher in 2018, some see a yellow light, not a green one, suggesting that the bull’s days are numbered. Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, anticipates a “below-average year,” with the S&P 500 up about 4%, to 2750, compared with a roughly 13% annual gain since 2012. Although earnings will rise next year, he says, this is a “late-cycle environment for the American economy and equity markets.”



The market’s price/earnings multiple could contract later in 2018 as earnings growth peaks and investors sniff out potentially lower growth in 2019, he adds.

Rob Sharps, chief investment officer of T. Rowe Price’s equity group, and another newcomer to our group, agrees. He expects market leadership to narrow in 2018, which is typical in the later stages of a bull market. Sharps calls the current environment “about as good as it gets” for financial assets, with investors buying every pullback. “You have elevated asset prices, high expectations, and aggressive positioning for ‘risk on,’ ” he says.

Unemployment has been around 4% for a while, he notes, adding that when the labor market is at full employment, the economic expansion typically is 60% to 65% complete. That suggests a recession could start in late 2019 or 2020, which investors would anticipate next year. Sharps likes Signature Bank (SBNY), a high-quality bank whose shares have dropped 16% from its peak, to $137, as the bank has had to pay more for deposits. He expects these headwinds to recede, and thinks the New York banking company could become an acquisition target.




Tobias Levkovich, chief U.S. equity strategy at Citigroup’s Citi Research, argues that investors shouldn’t look to tax cuts to keep the market roaring. They are a “one-shot deal” in boosting year-to-year earnings comparisons, and might not even be permanent. “The Street doesn’t believe that the Democrats could take the House of Representatives in 2018, but they could,” he says.

Levkovich, one of the least bullish strategists, has a year-end 2018 target of 2675 for the S&P 500. Should investors accord the same multiple to tax earnings as to operating profits? “I don’t think so,” he says.

Moreover, any gain from a tax cut could be diluted in part through research, development, and capital spending, says Savita Subramanian, head of equity and quantitative strategy at Bank of America Merrill Lynch. It isn’t clear how much corporations will get to keep and return to shareholders directly, she says. The strategist, who has a 2018 year-end target of 2800, sees positive sentiment and momentum driving stocks higher in what she calls a potential “year of euphoria.” She favors the materials sector, noting it tends to perform well in the later stages of a bull market, and likes DowDuPont (DWDP), the global chemical company.

SOME INVESTORS EXPECT a reduced tax on companies’ overseas earnings to produce a cash windfall at home. But Goldman’s Kostin warns that might not be the case. He estimates that U.S. companies have $2.5 trillion in untaxed earnings overseas, of which $922 billion is in cash. About 85% of that cash belongs to only 20 companies, chiefly in the tech and health-care sectors. Kostin, with a 2018 S&P target of 2850, favors the industrials sector, which will benefit from solid capital-spending trends and global growth. Deere (DE), in particular, is investing for growth, he notes.

While Federated’s Auth expects the FANGs to take a breather, especially with stronger growth in gross domestic product and lower taxes lifting other boats, he considers the stocks to be big growth compounders longer term. He looks for Facebook and Alphabet to get an additional lift from higher profits by the middle of 2018.

For another view, there’s JPMorgan’s Lakos-Bujas. He downgraded tech to Underweight last Monday; the sector is flat since then. He bases his negative assessment primarily on “tactical” factors—namely, a conviction that value stocks are set to outperform growth stocks, the bucket in which tech stocks fall.

The spread between value and growth has reached a point historically associated with a reversal; the Russell 1000 value index is up 9% this year, against a gain of 27% in the comparable growth index. Tax reform is a catalyst for a rotation into value stocks, as value companies generate almost 80% of their revenue in the U.S. and are subject to an effective tax rate of 30.3%, the strategist observes.



Market strategists expect U.S. stocks to outperform bonds again in 2018, especially with interest rates rising. The Bloomberg Barclays U.S. Aggregate Bond index is up only 3% this year, and 10-year Treasury yields have fallen to 2.38% from 2.45%, although they have rebounded from a low of 2.04% earlier in the year. (Bond prices move inversely to yields.) The strategists’ 2018 year-end consensus forecast for the 10-year Treasury yield is 2.8%. “It’s hard to like bonds,” says Yardeni, summing up the prevailing view.

Merrill’s Subramanian worries that yield-hungry institutional investors are “aggressively positioned and over-own” REITs and utilities, which yield more than government bonds. Compounding the problem, utilities tend to carry high debt loads, she notes. “They look like a bond, trade like a bond—and bonds aren’t where you want to be,” she says.

Globally, most market watchers say U.S. stocks are the place to be in 2018 because of earnings expectations. But fans of overseas markets note that many are earlier in the earnings-recovery cycle. Jeffrey Knight, co-head of global asset allocation at Columbia Threadneedle Investments, notes that U.S. equities rank poorly on various valuation metrics when compared with international stocks, which suggests that the rest of the world will catch up. That said, European, Asian, and emerging market stocks are outperforming the U.S. in dollar terms this year. The Stoxx Europe 600 index has returned 23%; Japan’s Nikkei average, also 23%; and the MSCI Emerging Markets index, 31%.

Knight, who has an S&P forecast of 2750, favors equity markets in developing economies, Australia, Hong Kong, and Japan.

IF MUCH IS LINED UP to go right in 2018, a few things could go spectacularly wrong. A recurrence of inflation is one thing many market watchers fear. While it has been quiescent for years—the consumer price index hasn’t met the Fed’s 2% target—stronger economic growth could ignite it. If core inflation, excluding food and energy prices, were to top 3%, it would be a problem for markets, says Federated’s Auth.

The strategists all fear that the Fed could raise interest rates too aggressively, which would take away the market’s punch bowl. There could also be a negative impact on the consumer and the economy. “I worry about the cumulative impact of rising rates on Americans,” says Citi’s Levkovich. “There are people who have financed their lives on low rates for nearly a decade.”

A regulatory attack against social-media companies, or even the hint of one, could also hit the market hard. Earlier this year, as T. Rowe Price’s Sharps notes, the president tweeted negative comments about Amazon, and executives from Facebook and Google were called before Congress to testify about how foreign nationals might have used the social-media platforms to interfere in U.S. elections. A negative policy response to the sector “could knock the legs out of the U.S. market and the rest of the world,” Sharps says.

Then there’s the parabolic rise of Bitcoin and cryptocurrencies generally—and concerns that a fear of missing out also could lead investors to chase stocks with similar desperation. Alternately, a Bitcoin crash could curdle investor enthusiasm for all risk assets.

But investors aren’t worried yet.

So long as earnings are rising, rates are low, volatility is subdued, and every stock selloff is met with more buying, as happened again this past week, the bull will still rule over Wall Street.


Inequality and the Coming Storm

EDOARDO CAMPANELLA


Walter Scheidel,The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century, Princeton University Press, 2017

Branko Milanovic, Global Inequality: A New Approach for the Age of Globalization, Harvard University Press, 2016

Peter Temin, The Vanishing Middle Class: Prejudice and Power in a Dual Economy, MIT Press, 2017

Keith Payne, The Broken Ladder: How Inequality Affects the Way We Think, Live, and Die, Viking, 2017

Chrystia Freeland, Plutocrats: The Rise of the New Global Super-Rich and the Fall of Everyone Else, Penguin Press, 2012


MILAN – The world is becoming increasingly unequal, and at an astonishing pace. According to Oxfam, in 2010, 388 billionaires owned as much private wealth as the poorer half of the global population. By 2016, a mere eight people did. The Great Recession that followed the 2008 financial crisis has hit the vulnerable especially hard, while many of the gamblers who triggered it have grown wealthier.

The accumulation of massive fortunes by a tiny coterie of plutocrats represents the tipping point in a more complex phenomenon. Although China’s meteoric rise to become the world’s second-largest economy (by GDP) has compressed inequality at the global level, the fact remains that disparities within most countries have been expanding rapidly.

In developing economies, the past three decades of globalization have produced a burgeoning urban middle class, but widened the gap between cities and rural regions. And in advanced economies, globalization and technological progress have conferred significant benefits on a small minority of highly qualified professionals, but squeezed the middle class. The standard of living for those not at the top of the income scale has stagnated, owing to the availability of cheap labor abroad and inadequate redistributive policies at home.

The five books under review shed light on different dimensions of this multifaceted phenomenon. The Great Leveler, by Stanford University historian Walter Scheidel, and Global Inequality, by CUNY economist Branko Milanovic, offer long-term historical perspectives. The Vanishing Middle Class, by MIT economist Peter Temin, The Broken Ladder, by University of North Carolina at Chapel Hill psychologist Keith Payne, and Plutocrats, by the former journalist and current Canadian Minister of Foreign Affairs Chrystia Freeland, highlight the diverging fates of those at various levels of the income scale. All of them propose thoughtful solutions for an ailment that has started to seem untreatable.

A BLOODY OLD PROBLEM

the great leveler

For good reason, rising inequality is widely regarded as the defining economic challenge of our time. Yet Scheidel contends that, while today’s levels of inequality are alarming, they are hardly exceptional by historical standards. Income inequality in the United States is just as high now as it was in the years leading up to the 1929 stock-market crash. In the run-up to World War I, the richest tenth of British households held 92% of all private wealth, compared to around 50% today.

Scheidel shows that, from pharaonic Egypt to czarist Russia, Victorian England, the Ottoman Empire, and China under the Qing Dynasty, the pattern has always been the same: wealth tends to concentrate in the hands of a privileged elite. Most of the great temples, royal palaces, pyramids, castles, and other monuments of history are the lasting evidence of past wealth disparities. At the apogee of the Roman Empire, the richest aristocrat in Rome possessed a fortune that was 1.5 million times the average per capita income of that era. That is about the same as the wealth gap between Microsoft founder Bill Gates and the average American household.

But while inequality has been a persistent feature of civilization, it has not been constant. Scheidel chronicles long stretches of high inequality that were followed by bursts of violent compression, owing to cataclysmic historical events – his book’s titular “great levelers.”

Specifically, Scheidel designates mass warfare, violent revolution, state collapse, and lethal pandemics as the “Four Horsemen of Leveling.” His most prominent examples are the twentieth-century world wars, the Russian and Chinese Revolutions, the fall of the Roman Empire, and the Black Death, respectively.

Scheidel traces the problem of inequality back to the First Agricultural Revolution more than 10,000 years ago. The Holocene epoch marked the beginning of the first interglacial warm period, and created a favorable environment for economic and social development. The domestication of plants and animals led to huge production surpluses, which the dominant members of society then accumulated as property and heritable wealth. Next came coercion, submission, and predation; with that, humanity’s Great Disequalization took off.

Over time, ownership rights became a source of political power or even spiritual authority. Social structures beyond the household started to form, giving rise to clans and tribes, and eventually empires and states. At the same time, disparities between the powerful and the helpless were enshrined in rigid sociopolitical hierarchies. Absent any external interference, like invasions or natural disasters, ruling elites enjoyed long periods of stability and rising economic prosperity, and offered little redistribution to the subordinate majority.

But, as Scheidel argues, all societies eventually reach a demographic, political, or technological limit to the level of inequality they can tolerate. Once this pain threshold is breached, peaceful democratic interventions have no purchase. Only carnage, chaos, and destruction can restore fairness in the system, by disrupting the established order, reassigning social roles, and destroying physical assets and other forms of accumulated wealth. When that happens, the rich and the powerful are suddenly nothing of the kind. Scheidel concludes that there can be no middle ground: extreme inequality yields only to extreme equalizers.

THE EBB AND FLOW OF INEQUALITY
global inequality

Over the last 2,000 years, the world has reached two peaks of inequality: in late medieval Europe, on the eve of the Black Death, and in modern times, on the eve of World War I. The plague boosted the value of labor relative to landed wealth by decimating the fourteenth-century European workforce.

The twentieth-century world wars, similarly, devastated the physical and financial assets of the wealthy, and led to higher taxes on property and income.

During the Great Compression of the 1940s, the modern welfare state emerged. But, since then, traditional economic theory has struggled to explain the persistence and recurrence of income inequality, particularly in advanced economies. In the 1960s, the Nobel laureate economist Simon Kuznets argued that wealth should be more broadly distributed in advanced economies.

As Kuznets saw it, inequality should rise during the period of industrialization when workers are plentiful and wages are low, but then fall when the slack in the labor market is absorbed.

Needless to say, this picture is at odds with what has been happening in the West. In Global Inequality, a must-read, Milanovic updates mainstream theory by introducing the concept of “Kuznets waves” into the study of the subject. According to Milanovic, inequality is cyclical: it waxes and wanes continuously, owing to interconnected economic, demographic, and political forces. Inequality rises as a result of nominal GDP growth, technological progress, and special-interest lobbying activities, and falls as a result of wars, diseases, and redistributive policies.

In the pre-industrial era, according to Milanovic, these waves were governed by Malthusian (demographic) dynamics. Inequality would rise with population and income growth, then decline when wars or famines reduced the population and brought the economy back to subsistence levels.

The difference in modern times is that, instead of population growth, technological change and globalization have been the main drivers of inequality.

The first modern Kuznets wave started at the end of the nineteenth century, when industrialization and economic integration created new wealth disparities. But by the 1970s, inequality had reached new lows, owing to the two world wars, the political upheavals of the 1960s, and the growth in the number of college graduates in Western countries. Since then, however, the world has been riding a new Kuznets wave, powered by advances in information and communication technologies (ICT) and Washington Consensus policies advocating capital-flow and trade liberation. And the technologies of the Fourth Industrial Revolution – artificial intelligence (AI), robotics, and so forth – are further widening the gap between the highly skilled and everyone else.

The similarity between the two inequality-increasing waves is striking – and appalling. Before the First Industrial Revolution in the late eighteenth century, a hereditary class structure was the main source of inequality around the world. Then, when GDP growth took off in the West, location replaced class, such that, 70 years ago, a poor person in Germany was rich by Indian standards. But now that other countries are catching up to the West, the income gaps associated with location are closing, and the centrality of social class has returned.

SEPARATE AND UNEQUAL

the vanishing middle class

To understand how a modern “classist” society functions, look no further than the US in 2017. Social status there has never been denoted by noble titles; prestigious academic degrees fill that role. Still, one’s origins, far more than merit, determine one’s chances for success in life. Being admitted to an Ivy League university depends largely on one’s family background. Wealthy, well-educated parents have the means to raise ideal college applicants, and to afford rising tuition costs. And, because the top employers seek recruits from the top universities, class privilege is perpetuated from generation to generation.

If this sounds to you like the end of the American Dream, then you will find much to agree with in Temin’s The Vanishing Middle Class, which describes the socioeconomic mechanisms that are preventing an ever-larger share of the American population from enjoying the benefits of economic growth. In Temin’s view, the US is regressing quickly toward the status of an emerging economy, where the system works well for a select few and poorly for everyone else.

In the US, a small, predominantly white upper class holds a disproportionate share of money, power, and political influence. Its members, who make up 20% of the American population, are highly educated, well-paid, tech-savvy professionals who work primarily in finance and technology. At the other end of the spectrum is the majority: low-skilled, low-wage workers whose economic situation – substandard education, dilapidated housing, precarious employment – resembles that of workers in developing countries.

As Temin reminds us, American’s class divide has a clear racial element. There is just one African-American on the Forbes list of the 400 wealthiest Americans for 2017. At the same time, African-Americans comprise nearly 40% of the US prison population, but less than 15% of the total population; among African-American men, one in three will serve jail time at some point in their lives.

Still, racial minorities are not the only Americans living as second-class citizens. A large chunk of the white population in the Rust Belt and elsewhere has also been marginalized – precisely the demographic segment that put US President Donald Trump in the White House.

According to Temin, inequality is now so entrenched in American society that it might never be uprooted. Only education can ensure that Americans will have a chance at employment in the high-paying, high-skill sectors of the twenty-first-century economy. But for the children of most low-wage families, there are simply too many obstacles. Public schools in low-income areas are too decrepit and underfunded to give their students the qualifications needed to join the elite. Temin, for his part, argues that such hindrances to social mobility are created deliberately by the ruling minority, whose primary concern is its own preservation and reproduction as a privileged class.

HOW THE OTHER 80% LIVES

the broken ladder

As class divides widen, those on the bottom start to have radically different experiences of the world than those at the top. And as Payne shows in TheBroken Ladder, many of those experiences include psychological suffering. For an issue that is dominated by sociological and economic analyses of the factors behind wealth disparities, Payne’s is a brilliant and important contribution.

As a psychologist, Payne is interested in how inequality affects individuals. First, he explains, “Inequality is not the same as poverty,” because it “makes people feel poor and act poor, even when they’re not.” When people perceive vast economic disparities between themselves and others, their decision-making about savings and personal finances, political beliefs, and even their health changes.

More telling than one’s position on the income scale is the subjective process by which one establishes one’s own social status. According to Payne, those who feel poorer than their neighbors, their parents, or some other referent are more likely to suffer from depression, anxiety disorders, cardiovascular disease, obesity, and diabetes – regardless of their socioeconomic situation. Not surprisingly, people with these conditions tend to have a shorter life expectancy than the rest of the population.

In the US, that now describes many middle-aged whites. According to a landmark 2015 study by economists Anne Case and Angus Deaton, midlife mortality rates have improved for all US demographic groups except non-Hispanic whites. As Payne puts it, members of this group are not just “dying of cirrhosis of the liver, suicide … and overdoses of opiates and pain killers,” they are “dying of violated expectations.” Despite the fact that “high school-educated whites make more money on average than similarly educated blacks,” he writes, “the whites expect more because of their history of privilege.” They grew up believing – and constantly being told – that they would be better off than their parents. Instead, they have been condemned to low wages and unstable Jobs.

THE VIEW FROM THE PENTHOUSE

plutocrats

At the other extreme, there is the top 1%, whose lived experience, and thus worldview, could not be more different from those at the bottom. Although it was published five years ago, Freeland’s Plutocrats is still the most incisive and intelligent account of how the world’s wealthiest think and behave. Few have observed the global elite in the wild so closely, and for so long.

The super-rich, as Freeland calls them, are essentially a tribe that lives in a separate world that has neither national boundaries nor time zones. Regardless of where they are from, they all attend the same elite universities in the United Kingdom and the US. After that, they all begin their careers in the same top consulting firms and investment banks, attend the same exclusive conferences in Davos and Dubai, and vacation in the same places in Switzerland and US coastal enclaves. They have no problem spending $3 million – equivalent to the combined average annual income of more than 50 Americans – on a birthday party. And they wash their hands by dabbling in philanthropy.

Of course, despite these similarities, the super-rich are not all the same. Some are entrepreneurs or entertainers who create real value for society. Others run hedge funds, private-equity firms, or other rent-seeking businesses and contribute little to nothing. In either case, most were actually not born rich. They built their fortunes through hard work, talent, and discipline. Starting in nursery school, they embraced the Darwinian classroom struggle to win entry into a top university. And as adults, they work long hours at the expense of their private lives. Having made it to the top, they live with a constant fear of falling from grace.

But even if merit brought many of the super-rich to where they are, they have become so powerful that they can deny meritocratic outcomes to everyone else. Freeland, for her part, points out that this is not unprecedented. The Republic of Venice unwittingly engineered its own downfall when Venetian elites in the fourteenth century created a “Book of Gold” to designate which families would belong to a permanent class of nobility, and thus the oligarchy. An economically dynamic commercial power quickly decayed into a sclerotic, closed city-state.

IN SEARCH OF A CURE

The world is now in a state of limbo. Today’s levels of inequality, as all of these books show, can hardly be regarded as stable or under control. Moreover, as technological innovation accelerates, the casualties will mount. Yet, according to Milanovic, we are still waiting for the current Kuznets wave to crest. Inequality is high, but it is still not as high as in the peak periods just before the Black Death and the outbreak of World War I.

What can be done? Many commentators recommend improving the availability and quality of public education. Others have proposed more effective ways to tax wealth, such as a global tax on capital income, higher marginal tax rates, more aggressive estate taxes, or even a tax on robots. And still others are calling for a universal basic income (UBI).

But none of these will be a panacea. Educational policies take years to gain traction; taxing the global super-rich would require a level of international cooperation that does not exist today; and a UBI is simply unaffordable for most – if not all – governments.

Scheidel would remind us that political reforms usually are not up to the task of tackling inequality.

Yet, even if democratic measures cannot reverse inequality, they may be able to keep it in check, and are thus worth pursuing.

The alternative, of course, could be a cataclysmic leveling in the not-too-distant future. Climate change is already wreaking havoc on some national economies and creating tensions over shrinking resources. Populism, nationalism, and xenophobia are threatening to consume liberal democracies from within. An increasingly ambitious China and a newly protectionist America could end up on a collision course over trade or territorial claims in Asia. And, at some point, self-learning robots might eliminate most jobs, and topple Western civilization itself.

How much more inequality can the world tolerate? Sooner or later, we will cross another historical threshold, on the far side of which await the Four Horsemen of Leveling, eager for another stampede, if we let them have it.


Edoardo Campanella is a Future of the World Fellow at the Center for the Governance of Change of IE University in Madrid.


Buttonwood

After a bumper 2017, will 2018 be kind to the financial markets?

Investors seem to expect more of the same; they may be disappointed


AFTER a bumper year for financial markets in 2017, can 2018 be anything like as good? Much will depend on the global economy. The rally in stockmarkets stretches back almost two years, to the point when worries about an era of “secular stagnation” started to diminish.



The first pieces of economic data to be published in January—the purchasing managers’ indices (PMI) for the manufacturing sector—were pretty upbeat. In the euro zone the index recorded its highest level since the survey began in 1997. China’s PMI was stronger than expected, and America’s index showed new orders at their highest level in nearly 14 years.

The obvious question is whether the markets have anticipated the good news about growth, and pushed share prices to a level from which returns can only be disappointing. The cyclically adjusted price-earnings ratio of the American market, which uses a ten-year average of profits, is 32.4; it has been higher only in September 1929 (just before the Wall Street crash) and during the dotcom bubble.

A regular poll of global fund managers in December by Bank of America Merrill Lynch (BAML) found that a net 45% thought that equities are overvalued, the highest level in the more-than-20 years the survey has been conducted. But a net 48% of investors still have a higher exposure to stockmarkets than normal. The discrepancy can be explained by their attitude to the other highly liquid asset class: government bonds. A net 83% of managers think they are overvalued.

Given the very low level of bond yields (which fall as prices rise), it is hardly surprising that investors are chary about the asset category; a net 59% of managers have a lower weighting in bonds than normal. But partly because of the better news on the global economy, they are more hopeful about equities: stronger growth should mean higher profits. By the third quarter of this year, investors are expecting S&P 500 companies to show annual profits growth of 11.9%. Another factor is the American tax package just approved by Congress; the BAML survey found that more than 70% of fund managers thought tax cuts would cause shares to rise.

What was remarkable about 2017 was not just that stockmarkets rose. It was that they did so in such a steady manner. The MSCI World index rose in almost every month, and the volatility index, or Vix, stayed at remarkably low levels (see chart). None of the political headlines—the tensions between America and North Korea, the investigation into President Donald Trump’s election victory, the inconclusive German elections—seemed to bother investors for very long.

Politics could still sandbag the markets in 2018, particularly if another war broke out in Asia or the Middle East. But the more immediate concern for investors will be monetary policy. The Federal Reserve has been steadily pushing up interest rates, and the European Central Bank is reducing its monthly bond purchases. The combination of low rates and quantitative easing (QE) has been helpful for markets ever since the financial crisis. Like anxious parents, central banks are taking the training wheels off their children’s bicycles and hoping they won’t crash.

David Bowers and Ian Harnett of Absolute Strategy Research, a consultancy, have a different worry. They fear that investors may be caught out by a slowdown in China. In 2017 Chinese interest rates rose; this may start to have an economic impact in the current year. The effect will not be dramatic (they think global growth will slow to 3.3%) but it will be enough to disturb the rosy consensus.

Messrs Bowers and Harnett conduct their own survey of fund managers, and they find some inconsistencies in the outlook. Though investors expect equities to perform well, they are not enthusiastic about high-yield bonds. Normally conditions that are good for the former also boost the latter. And investors also expect the Vix to rise, an event that usually coincides with poor equity performance.

These contradictions can best be explained by assuming that investors are making the understandable bet that the current year will look much like the previous one. Extrapolating from the past is a well-known bias, and often applies to economic forecasts as well. But that is to ignore the nagging feeling that the events of 2016 may have marked a historic turning-point, and that the new era will be much more turbulent than before. To misquote Mr Micawber: “Something unpleasant will turn up.”


Fragile: Handle With Care

by: The Heisenberg



- Last night, I did two things I normally don't do and one of them involved watching Jim Cramer.

- I was surprisingly pleased with what I heard from Jim, but popular pundits need to do more of what he did on Friday.

- Now let's walk through some charts and have a few laughs (but unfortunately no drinks) along the way.

 
On Friday evening, I did two things I normally don't do: I took two hours away from working to watch a movie, and before that, I watched about 15 minutes of Jim Cramer.
 
To my complete surprise, neither of those two things was a waste of time. The movie was Guardians of the Galaxy Vol. 2 - it was great. And the 15 minutes of Mad Money turned up a pleasant surprise. Jim Cramer actually spent the last 15 minutes (give or take) of his Friday show explaining the "Goldilocks" narrative that's part and parcel of the dynamic driving the now ubiquitous "everything bull market."
 
I've spilled gallons of digital ink expounding on "Goldilocks" where that means decent and synchronized global growth but still subdued DM inflation. The former allows investors to assert the global economy is on sound footing while the latter helps make the case for cautious central banks who, by virtue of still below-target inflation, will be loath to normalize in a fashion that's aggressive enough to force a disorderly unwind of the bond trade.
 
That was notable because millions of retail investors effectively depend on popular pundits who have connections in the financial world to provide color as to what's actually driving asset prices. Cramer is the poster child, but even if you want to take a haughty attitude towards Jim, chances are you follow other pundits who are just like him. One thing that's particularly pernicious (and note that there is a distinction between something that's "pernicious" and something that's "nefarious" where the latter usually entails purposeful deception while the former doesn't necessarily have to) is the echo chamber of financial pundits and bloggers who spend a good portion of the work week parroting manifestly simplistic narratives about what's driving markets at the asset class level. I'm not going to name names because that's not constructive, but a lot of the commentary that emanates from these sources is ostensibly "educational" for the retail crowd but would not be taken any semblance of serious by Wall Street.

Here's an important note for any Heisenberg newcomers: regular readers know I don't talk much about individual stocks. So I am by no means suggesting that you should take a given bank's inherently conflicted calls on individual names in your portfolio seriously. Individual stock analysis is easy for regular investors to do on their own and platforms like this one are hugely valuable in helping retail investors come together and form their own consensus view on individual companies without having to worry so much about whether those views are biased due to investment banking relationships and myriad other conflicts of interest.
 
Rather, I write from the 30,000 foot perspective and I can say definitively, without equivocation, that it is profoundly unrealistic to think that retail investors have a better read on market structure and the dynamics that drive markets at the macro level than professional investors and analysts. For instance, it is (almost by definition) impossible for retail investors to know more about something like volatility than a Wall Street derivatives strategist. To give you another example, it isn't realistic to think that someone writing macro commentary without access to professional research or a direct line to Wall Street can have a better read on what would happen in the event central banks were forced to get more aggressive on normalization than a professional rates strategist.
 
In the absence of access, retail investors depend on pundits with connections to help them understand markets at the asset price level and pundits aren't doing a very good job of that lately, which is why I was glad to see Jim discussing "Goldilocks" on Friday evening - even if he only spent a few minutes on it.
 
Well, one thing that pundits have not done a good job of is helping to communicate why the ubiquitous "buy the dip" mentality continues to work (and again, I mean that broadly, not in the narrow context of this stock or that stock). Note that "buy the dip" in the volatility context translates roughly into "sell the spike."

There is a demonstrable tendency for popular pundits to try and explain this by way of earnings or the synchronous upturn in global growth. The problem with those simplistic explanations is that they do not explain what they purport to explain. And in employing those explanations, pundits fail to communicate the actual dynamic at play and thereby fail to convey what the risks are.
 
Obviously, robust earnings and synchronous global growth are good reasons to take a bullish view on risk assets like stocks (SPY). And indeed you can make an argument that those factors (combined with a few more fundamental drivers) can serve as the foundation for a bullish view over the near, medium, and long term. But what you cannot do is explain this chart with those arguments:
 
(BofAML)
 
 
You can read the literal fine print there, but the gist of it is captured in the description of the yellow dots which, as BofAML notes, represent "the speed of mean reversion of VIX spikes."
 
The rapidity with which fleeting volatility (VXX) spikes are collapsing is unprecedented.
 
Obviously, it makes little sense to attribute that entirely to optimism about earnings and global growth. You don't see a VIX spike and think "gosh, I better sell some vol. right now, this second, because I'm optimistic about earnings growth in 2018." Even more absurd is the idea that anyone sees a VIX spike and thinks "gosh, I better sell some vol. immediately because I really like the trajectory of the German economy and man, how about that November Chinese trade data?!"
 
Here's another visualization of the same dynamic using the S&P:
 
(BofAML)
 
 
The reason that's happening is because the two-way communication loop between policymakers and markets makes taking a long-term view impossible. I'm going to excerpt a few passages from Heisenberg Report that regular readers will recognize. To wit:

Thanks to near-daily speeches and media appearances by Fed officials, this is quite literally a real-time information exchange between markets and policymakers. No one can see outside of this information exchange, and if you’re a trader, there’s really no utility in trying. 
In this way, transparency introduces risk in a paradoxical way. As Deutsche Bank's Aleksandar Kocic wrote more than two months ago, “transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it — it is a tactics of delaying, rather than reducing risk.” 
Everything thus becomes short term. Taking a long-term view of the Fed (or of the ECB for that matter) is effectively impossible. You can try – you can “do the right thing”, as it were – but you will be drowned out. The status quo cannot change unless you are joined in your dissent by others. If you are alone in your rebellion, your efforts will almost invariably result in foregone carry and underperformance. Thus, change becomes for all intents and purposes imposible. 
This is the controlling dynamic for volatility. This, as I put it a few weeks, is why things are the way they are.
 
This has become so deeply ingrained that the market "no longer fears shocks, but loves them, as it is an opportunity to predictably generate alpha" (to quote the BofAML note from which the charts above are taken).
 
This has become a self-fulfilling prophecy. Because no one believes that these vol. spikes will be sustained, vol. sellers immediately re-engage. Now think about what that means for the people who take the other side of those trades. Here's the above-mentioned Kocic again:
Dealers, who take the other side of that trade, through their hedging, reinforce local stability making resistance even more futile.

Have a look at this chart:
 
(Deutsche Bank)
 
 
See what I mean? This is a loop. But inherent in that loop is the idea that the market is becoming more fragile. The buildup of rebalance risk from levered and short VIX ETPs creates the conditions for a turbocharged vol. spike that could then spillover as it forces the hands of vol.-sensitive systematic strats. And on the dealer side, consider one more quote from Deutsche:
The short-dated, strike-dependent nature of the gamma profile means this phenomenon can disappear quickly. Slowing option selling following a large expiry or a spot move away from the current strikes could reduce net gamma significantly over just a few days.
That would mean the buffer that effectively works to contain outsized drawdowns could evaporate and in the event those vol. spikes stop mean reverting so rapidly, the chances of a systematic unwind occurring increase.
 
The other thing you need to keep in mind here is that in addition to the communication loop described above (i.e. forward guidance), central banks are still actively driving risk premia compression. The especially maddening thing about a lot of the commentary from popular pundits is that they demonstrate a truly remarkable (and quite disconcerting) propensity to say things about global QE that simply are not true. Central banks added $2 trillion to their balance sheets this year.
 
Have a look at one last chart which plots the 12-month change in central bank assets with 12-month realized vol. on the MSCI World:
 
(Deutsche Bank)
 
 
Coming full circle, it is incumbent upon popular pundits to convey all of this to retail investors.

Do note, by the way, that when I say "popular pundits" that is not a cheap shot at random commentators who, like me, just enjoy healthy debates about markets. I'm talking about pundits who have tens and hundreds of thousands of social media followers (in one specific case, nearly a million). I'm talking about the people you see writing Op-Eds for Bloomberg and the people who are fixtures on CNBC shows. People whose blogs are regularly listed by mainstream financial media outlets as being the go-to sources for free information. In other words, people who reach millions upon millions of retail investors each and every day of the work week. In short: I'm not talking to anyone writing for this platform, so if the shoe doesn't fit, don't try to wear it fellow contributors, because I'm not criticizing you.
 
Now you might very fairly say this: "ok Heisenberg, and how do you suggest someone convey everything you said in this article to retail investors in a way that's easily digestible?" The answer is: "dude, I have no idea or I'd be on CNBC wearing my sunglasses and my Heisenberg hat rather than writing blog posts."
 
All I can do is convey the message in the best way I know how, which is by mixing in humor and cynicism in an effort to keep readers engaged with challenging material. That was my goal with this post, and as usual, I sincerely hope it was useful.
 
Oh, and as a highly amusing side note, CNBC's Fast Money e-mailed me the other day asking to find out more about Heisenberg (true story). I said I'd be glad to talk to them, but it would have to be off the record. They never responded.
 
Yours truly on a disappointingly chilly weekend here on the island,
 


The High Cost of Denying Class War

YANIS VAROUFAKIS

Visitors and volunteer at the Salvation Army

ATHENS – The Anglosphere’s political atmosphere is thick with bourgeois outrage. In the United States, the so-called liberal establishment is convinced it was robbed by an insurgency of “deplorables” weaponized by Vladimir Putin’s hackers and Facebook’s sinister inner workings.

In Britain, too, an incensed bourgeoisie are pinching themselves that support for leaving the European Union in favor of an inglorious isolation remains undented, despite a process that can only be described as a dog’s Brexit.

The range of analysis is staggering. The rise of militant parochialism on both sides of the Atlantic is being investigated from every angle imaginable: psychoanalytically, culturally, anthropologically, aesthetically, and of course in terms of identity politics. The only angle that is left largely unexplored is the one that holds the key to understanding what is going on: the unceasing class war unleashed upon the poor since the late 1970s.

In 2016, the year of both Brexit and Trump, two pieces of data, dutifully neglected by the shrewdest of establishment analysts, told the story. In the United States, more than half of American families did not qualify, according to Federal Reserve data, to take out a loan that would allow them to buy the cheapest car for sale (the Nissan Versa sedan, priced at $12,825).

Meanwhile, in the United Kingdom, over 40% of families relied on either credit or food banks to feed themselves and cover basic needs.

William of Ockham, the fourteenth-century British philosopher, famously postulated that, when bamboozled in the face of competing explanations, we ought to opt for the one with the fewest assumptions and the greatest simplicity. For all the deftness of establishment commentators in the US and Britain, they seem to have neglected this principle.

Loath to recognize the intensified class war, they bang on interminably with conspiracy theories about Russian influence, spontaneous bursts of misogyny, the tide of migrants, the rise of the machines, and so on. While all of these fears are highly correlated with the militant parochialism fueling Trump and Brexit, they are only tangential to the deeper cause – class war against the poor – alluded to by the car affordability data in the US and the credit-dependence of much of Britain’s population.

True, some relatively affluent middle-class voters also supported Trump and Brexit. But much of that support rode on the coattails of the fear caused by observing the classes just below theirs plunge into despair and loathing, while their own children’s prospects dimmed.

Twenty years ago, the same liberal commentators were cultivating the impossible dream that globalizing financialized capitalism would deliver prosperity for most. At a time when capital was becoming more concentrated on a global scale, and more militant against non-owners of assets, they were declaring the class war over. As the working class was growing in size worldwide, even though its jobs and employment prospects were shrinking in the Anglosphere, these elites behaved as if class were passé.

The 2008 financial collapse and the subsequent Great Recession buried that dream. Still, liberals ignored the undeniable fact that the gigantic losses incurred by the quasi-criminal financial sector were cynically transferred onto the shoulders of a working class they thought no longer mattered.

For all their self-image as progressives, the elites’ readiness to ignore widening class divisions, and to replace it with class-blind identity politics, was the greatest gift to toxic populism. In Britain, the Labour Party (under Tony Blair, Gordon Brown, and Edward Miliband) was too coy even to mention the post-2008 intensification of the class war against the majority, leading to the rise across the Labour heartland of the UK Independence Party (UKIP), with its Brexit parochialism.

Polite society seemed not to give a damn that it had become easier to get into Harvard or Cambridge if you were black than if you were poor. They deliberately ignored that identity politics can be as divisive as apartheid if allowed to act as a lever for overlooking class conflict.

Trump had no compunction to speak clearly about class, and to embrace – however deceitfully – those too poor to buy a car, let alone send their children to Harvard. Brexiteers, too, embraced the “great unwashed,” reflected in images of UKIP leader Nigel Farage drinking in pubs with “average blokes.” And when large swaths of the working class turned against the establishment’s favorite sons and daughters (the Clintons, the Bushes, the Blairs, and the Camerons), endorsing militant parochialism, the commentariat blamed the riffraff’s illusions about capitalism.

But it was not illusions about capitalism that led to the discontent that fueled Trump and Brexit. Rather, it is the disillusion with middle-of-the-road politics of the kind that intensified the class war against them.

Predictably, the embrace of the working class by Trump and the Brexiteers was always going to arm them with electoral power that, sooner or later, would be deployed against working-class interests and, of course, minorities – always the penchant of populism in power, from the 1930s to today.

Trump has thus used his working-class support to usher in scandalous tax reforms, whose naked ambition is to help the plutocracy while millions of Americans face reduced health coverage and, as the federal budget deficit balloons, higher long-term tax bills.

Similarly, Britain’s Tory government, which has espoused Brexit’s populist aims, has recently announced another multi-billion-pound reduction in social security, education, and tax credits for the working poor. Those cuts are matched exactly by reductions in corporate and inheritance tax cuts.

Today, establishment opinion-makers, who scornfully rejected the pertinence of social class, have contributed to a political environment in which class politics was never more pertinent, toxic, and less discussed. Speaking on behalf of a ruling class comprising financial experts, bankers, corporate representatives, media owners, and big industry functionaries, they act exactly as if their goal were to deliver the working classes into the grubby hands of the populists and their empty promise of making America and Britain “great again.”

The only prospect for civilizing society and detoxifying politics is a new political movement that harnesses on behalf of a new humanism the burning injustice that class war manufactures.

Judging by its callous treatment of US Senator Bernie Sanders and Labour leader Jeremy Corbyn, the liberal establishment seems to fear such a movement more than it does Trump and Brexit.


Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.