By Reshma Kapadia
Illustration by Doug Chayka
The one-two punch of the worst health crisis and economic downturn in decades has brought to the fore an issue that has been simmering for decades: an increasing income and wealth disparity among Americans. This widening gap has long-term economic implications and threatens the sustainability of the stock market’s recovery.
This isn’t a fringe idea: Federal Reserve Chairman Jerome Powell noted that the current downturn “has not fallen equally on all Americans,” and in congressional testimony this past week he warned that if the job losses and economic fallout seen so far were not contained and reversed, “the downturn could further widen gaps in economic well-being.”
That matters to investors, especially now, as the focus is on the shape of the recovery as the U.S. emerges from the coronavirus pandemic. When a large group of the population is in economic distress, their spending is limited. And spending is what drives the economy, corporate earnings, and, ultimately, the stock market.
Economic disparity also creates deep divides, which increase political risk for investors and opens the door to potential tax and regulatory changes that can weigh on corporate earnings. Economic inequality is nothing new, and the human costs through generations aren’t easily quantifiable. But there is a growing consensus that rising income inequality and the wealth gap will play a crucial role in the strength of the economic recovery.
Markets are notoriously myopic, shrugging off civil unrest, geopolitical flare-ups, and even 9/11. Chronic problems like inequality are even easier to ignore. Indeed, the market’s 40% rebound from its March lows after the pandemic took hold declares “not my problem,” even as 20.5 million people have lost their jobs, the Covid-19 death toll reaches beyond 115,000, and the widespread protests spurred by the killing of George Floyd while in police custody in Minneapolis enter their fifth week.
“It does appear that the markets don’t really care terribly much about these kinds of longer-term, slower-burn issues, but ultimately they create a fragility in the system,” says James Montier, part of the asset allocation team at $60 billion Boston-based money manager GMO.
“Rising inequality is a breeding ground for all kinds of concerning things. You are muting the bottom 90%’s ability to spend. This causes secular stagnation, and that matters for investors because it matters for interest rates, stock market valuations, and long-term returns.”
In recent months, stock investors have been reassured by the federal government, which has taken unprecedented steps to dampen the immediate fallout from the pandemic. The Federal Reserve has supported markets with low interest rates and other unconventional measures, such as expanded bond-buying.
One-time payments of up to $1,200 were sent to roughly half of Americans, and enhanced federal unemployment benefits meant that more than half of households received weekly payments larger than what they were bringing in prepandemic. But the extra unemployment payment is due to expire at the end of July. Meanwhile, many smaller businesses have had trouble accessing the $650 billion in federal loans offered.
“If we don’t have a renewal or another way to get jobs back, we could end up back to near where we started,” says Deutsche Bank’schief economist, Torsten Sløk.
But where we started isn’t where economists and investors want to be. Low-income workers have seen very little wage growth since the last recession: The top 1% of earners now account for a fifth of total income in the U.S., while the bottom half of earners account for just 13% of total income.
Savings rates for the top 10% have risen over the past three decades, while the other 90% has seen negative savings rates, leaving those earners with little to invest and often saddled with debt.
And while a little more than half of U.S. households own some stock, usually through 401(k) plans, just 10% of households own 84% of the stock market, which means a swath of Americans didn’t reap the benefits of the last bull market.
The Covid-19 pandemic exacerbated and highlighted these problems. Some 40% of the people who have lost their jobs were earning less than $40,000, compared with 13% of those earning $100,000 or more.
On its face, income and wealth inequality is a natural byproduct of a healthy capitalist system.
But when inequality of any kind gets exaggerated, it has broad repercussions—and by multiple metrics, wealth inequality has made the U.S. an outlier among developed nations. The U.S. middle class now makes up roughly 50% of the population, putting the nation closer to countries like Russia and Turkey, rather than Japan, France, or Germany, where the middle class makes up more than 60% of the population. The bottom 80% of earners have lost share of total income, wealth, and consumption since 1989, according to the Federal Reserve.
Economic inequality has been building over decades, fueled by structural racism and inequalities in the U.S. educational, financial, and health-care systems. Also at work: a shift toward prioritizing shareholder value over other corporate stakeholders—such as employees and customers—that began in the 1980s, says Robert Gordon, professor of economics at Northwestern University.
The emphasis on stockholders above all else meant that the last couple of bull markets disproportionately benefited Americans who owned stocks—the majority of whom are white and wealthier. (See “Wealth Inequality Doesn’t Show Up in Broad Economic Metrics, Masking the Fragility of Our Current System.”)
Inequality looks even more stark through the lens of race: Black households headed by a college graduate had 30% less median wealth than white families headed by someone with no college degree. The gap was striking even among the top 10% of African-Americans, who had roughly a fifth of the wealth of their white peers.
Intergenerational transfers of wealth—not just inheritances but also paying for college or down payments for homes—drives much of that gap, says Trevon Logan, an economics professor at Ohio State University.
Wealth provides a safety net. It allows people to take risks—with their investments or their careers. “Wealth begets wealth, and if you don’t have it, you don’t have means to withstand a shock,” says Andre Perry, a fellow at Brookings Institution.
What Inequality Means for the Economic Recovery
Inequality matters to investors trying to gauge whether the economic rebound will have a V shape, or a U, or a W. The latest entry to the recovery alphabet is the confounding K. Some economists see a two-pronged recovery: first, a strong, almost V-shape recovery among the haves, who can work from home and are spending on furniture and cars now, and will resume further spending once the health concern has subsided.
For those who have lost jobs or income—the other leg of the K—it could be a much more difficult road ahead. Layoffs have hit lower-income workers hard; about half have lost their jobs or had their wages cut. Hard-hit sectors like leisure, transport, and retail are filled with part-time and lower-wage jobs that generally don’t come with safety nets like paid leave, health care, or work-based 401(k) savings plans—and many of those jobs might not come back.
Lower-income workers face another threat. Many are on the front lines, processing meat, caring for the elderly, delivering packages, and stocking grocery stores, so that others can shelter and work from home. What’s more, recessions have seen a surge in low-skilled men dropping out of the workforce—a trend that persists and contributes to elevated earnings inequality long after a recession ends, according to a paper by Jonathan Heathcote, a monetary adviser at the Federal Reserve Bank of Minneapolis.
In a consumer-driven economy, lower-income households are a critical source of growth because they are more likely to spend any additional money they get. According to a working paper by the Chicago Fed in May, those who lived paycheck-to-paycheck spent more than two-thirds of the recent $1,200 relief checks within two weeks, while those who save much more of their monthly pay spent less than a quarter.
“Economic history clearly shows that the strongest, most durable periods of economic expansion in most countries occur when the middle class expands,” says Abby Joseph Cohen, senior investment strategist for Goldman Sachs.Indeed, investors have made lucrative returns investing in such companies as Nike(ticker: NKE) and Nestlé(NSRGY) that have benefited from expanding middle-class spending in countries such as India and China.
But the middle class in the U.S. has shrunk, accounting for a smaller share of the population than other rich countries. It’s also getting harder to move up the income ladder: It takes five generations for a person born to a low-income family to get to their society’s median income levels, according to simulations run by Deutsche Bank and the Organization for Economic Co-operation and Development.
Covid-19 could reduce social mobility further: Early data from Zearn, a math program used by some schools for distance learning during the pandemic, showed children in high-income areas experienced a temporary reduction in learning but soon recovered, while children in lower-income areas have remained 50% below baseline levels, according to a paper co-written by Harvard economist Raj Chetty, who is also a director of nonpartisan data project Opportunity Insights.
The Fed allowed interest rates to stay low even as the economy started heating up a couple of years ago, in an effort to get more people working and to improve mobility, and that’s why rates will probably stay low for the foreseeable future. That provides a safety net for stock investors and could keep the market afloat for a while. But the bill will come due—literally, as policy makers grapple with the national debt passing $25 trillion, and figuratively, as the stimulus, at least in its current form, doesn’t do much to address the fractures created by inequality.
“We are hearing the overall social fabric in the U.S. tearing in many different ways—racial injustice, poverty, income, and wealth inequality,” says Daniela Mardarovici, who oversees $15 billion as co-head of U.S. multisector and core plus fixed-income strategies at Macquarie.
So what’s the solution? In a word, taxes. “It’s hard to see where things change without taxes. The pendulum on inequality swings to revolution or tax policy. It’s a short menu,” says DataTrek Research co-founder Nicholas Colas. He doesn’t expect a revolution; civil unrest usually stems from a combination of a high Gini coefficient (a gauge of inequality) with a low average population age, he says. “The U.S. has high inequality, but also a high average age, so you probably get some political problems, but not massive unrest.”
Many other strategists and economists agree that the biggest risk is political. “If a bigger and bigger group is losing out in terms of health, income, or wealth inequality, there’s a rising probability that the average voter will begin to have different views on how society should be organized,” says Deutsche Bank’s Sløk. “Tectonic plates are shifting underneath.”
A social reckoning could increase calls for more-redistributive policies, such as rolling back the 2017 corporate tax cuts that juiced the market, or higher taxes on the wealthy, such as higher income or estate taxes, though few expect a wealth tax.
Change could also come through measures outside of the tax system, like infrastructure spending; giving companies incentives to spend on investments in the parts of the economy that most need jobs to come back; or tying additional government stimulus to commitments to offer paid leave or raise wages for a wider swath of workers, says Ohio State’s Logan.
“We don’t have this magic lever that says, ‘Open the economy back up,’ ” Logan adds. “We now see how interconnected all these things are, and how little the nation has addressed them.”
What Inequality Means for Portfolios
As interconnected as all of these strands are, that connection hasn’t always been clear enough for investors to incorporate into their financial analysis. But smart long-term investors have always paid attention to trends that play out over decades. Whether it is the promise of fifth-generation, or 5G, cellular networks, the disruption of companies like Amazon.com (AMZN) and Tesla(TSLA), or the long-term decline of bricks-and-mortar retail, investors have always factored secular changes into their earnings projections and valuation calculations.
Economic inequality can be viewed through a similar lens. As the U.S. emerges from the pandemic, inequality will weigh on the factors that investors care about most deeply: the scope and pace of the economic recovery, the outlook for corporate earnings growth, and ultimately the political fallout, which could affect tax policy, the regulatory environment, and other systemic changes.
As investors think about how inequality can manifest in their portfolios, the first place to go is taxes. Specifically, they can increase the tax diversification among their accounts, a good move in light of a rapidly growing deficit as well as the increased momentum to address wealth inequality.
Investors should use as many tax-advantaged accounts and tax-efficient strategies at their disposal: 529 plans for education, Health Savings Accounts for medical expenses, and Roth IRAs all allow for tax-free withdrawals, provided all rules are met. Open a tax-deferred retirement account for a side business. Look at tax breaks for solar panels and other home improvements.
A rising deficit could eventually mean inflation and higher interest rates. But for now, rates are expected to stay low. “That has implications for those who need to generate income—whether an institution or a retired couple—because you can’t do that with Treasuries,” says Brian Nick, chief investment strategist at the $1 trillion Nuveen.
It also makes diversification harder, as asset classes become more correlated. That means investors could feel forced to take on riskier strategies. “There is no silver bullet for diversification,” Nick says. Hedging is one option, he says, though that can be costly; adding some real estate is another. This is also when stockpickers should shine, as the outlook for companies diverges coming out of the pandemic.
“This is a small-business Great Depression,” Colas says. “The reason Chipotle’s stock is working is because scores of small Mexican restaurants have closed in urban areas.”
Many of his Midtown Manhattan neighbors have fled, he says, working remotely from second or rented homes, and their spending may be largely unabated as they shop online. But the small businesses that depend on their physical presence in the city have seen business dry up, and business owners are cutting jobs and curtailing spending.
This divergence is showing up in portfolios. “If you want to play momentum or growth, you are inevitably playing wealth inequality,” says Laura Geritz, head of money manager Rondure Global Advisors. Companies like LululemonAthletica (LULU), Peloton Interactive(PTON), Estée Lauder(EL), luxury retailers that cater to the wealthy, and the FANG stocks— Facebook(FB), Amazon, Netflix(NFLX), and Alphabet’sGoogle (GOOGL)—have been the biggest winners throughout the bull market.
If there’s a populist backlash or a push to increase regulation, these companies, Geritz says, are among the most likely to take a hit: “To me, it is a portfolio-risk problem.”
As awareness about racism and inequality grows, the way that companies respond could affect their brands and, consequently, their valuations. As company chiefs talk more about these issues, scrutiny over their practices will intensify beyond just ESG-minded investors—and that, too, will seep into valuations, says Christopher Smart, chief global strategist for the Barings Investment Institute. “Inequality is the defining feature of our economy today,” he says. “That has implications for the kinds of companies and investments that will and won’t do well.”
Some of the stocks that have performed through the Covid-19 lockdowns—such as education technology, telemedicine, affordable-housing investments, financial technology, and digital payments that can help the unbanked—can also work even as people try to address inequality, says Afsaneh Mashayekhi Beschloss, founder of investment manager Rock Creek Group.
To be sure, inequality isn’t an easy factor for investors to model. While the Fed has hundreds of variables that economists and strategists can use to model the U.S. economy—from oil rising a certain amount to the dollar weakening—there’s no lever for widening inequality.
“When there is an unquantifiable risk from a finance perspective, you worry about nonlinear effects—or something suddenly coming out of the blue that can change things that become very important for economic and earnings forecasts,” says Sløk.
Add that uncertainty to current valuations and it contributes to anemic projected long-term returns. If today’s high valuations persist, says GMO’s Montier, stocks could bump along at 3.5% indefinitely. And that’s the optimistic case. “The backdrop of inequality and the fragility it creates,” Montier says, “depresses long-term return projections even further.”
And that is something investors care very much about.
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