Addressing inequality would be good for the whole economy

Addressing inequality would be good for the whole economy

by | Oct 19, 2020 | Financial Planning, Investments, Wealth Management

Inequality of incomes and wealth continues to be a well-deserved point of focus across the developed world. The US produces the best data, and by 2016 the top 1% of households held 29% of the country’s wealth, while the entire middle class owned 21% and real median income has fallen over the past 40 years. This inequality of wealth and income is actually reducing growth for the overall economy.

The chart below uses a simple, but insightful, method to argue inequality really took root under the ‘neo-liberal’ economic era. If it’s correct, that premise throws up some suggestions as to how it can be addressed.

First, what is the chart telling us? It effectively traces the relative strength of labour versus capital. When the line is trending upwards, share prices, as measured by the US’s S&P 500, are rising faster than the average wage. That means there is a greater share of the economic pie going to the owners of capital than to labour.

After WW2 the US became the world’s factory and there was a relative scarcity of workers, so wages were strong. The next bottom in the chart, around the 1970s, was when unions were throwing their weight around and the US and UK lost a record number of days to strikes. Wages were commonly indexed to inflation, which created the classic wage-price spiral: as wages rose, so did prices, which again caused wages to rise, and so on.

Then came the era of Thatcher and Reagan, and the wholehearted embrace of neo-liberalism. This philosophy, which was largely founded on the work of Milton Friedman, argued markets are best at determining the allocation of resources so the best thing governments can do is get out of their way. It coincided with the crushing of unions, and the highest interest rates ever recorded as central banks around the world followed the US Fed Chairman, Paul Volcker, in his efforts to stomp out inflation.

Neo-liberalism is also called ‘supply side economics’, the premise of which is that reducing regulation and government interference would enable markets to flourish and encourage economic growth, and the benefits of all that growth would trickle down and be shared broadly. Indeed, Paul Volcker predicted that “wages for all Americans will improve as we achieve greater productivity and moderation in the demand for nominal wage increases.”

Well, that hasn’t happened. In his terrific book, The Economists’ Hour, Binymain Applebaum writes that “the median income of a full-time male worker in 1978, adjusted for inflation, was $54,392. That number was not matched or exceeded at any point in the next four decades. As of 2017, the most recent available data, the median income of a full-time male worker was $52,146. Yet, over those same four decades, the nation’s annual economic output, adjusted for inflation, roughly tripled.”

Likewise, economist Thomas Piketty argues that, in fact, the whole of the US is worse off under the neo-liberal model: between 1910-1950 national income per capita grew at 2.1% per year, from 1950-1990 it was 2.2%, and 1990-2020 only 1.1%.

In other words, as income and wealth inequality has worsened, so too has overall economic prosperity.

The solution? On the face of it, economies would be collectively better off if there was some equalisation of power between labour and capital. It also suggests there is indeed a role for government in areas like regulating labour markets and controlling corporate power.

No, US shares have not gone up because of cheap money

No, US shares have not gone up because of cheap money

by | Jan 13, 2020 | Industry News, Investments, Markets and Economy

When we get told something often enough, especially by so-called ‘experts’, it’s easy to accept it as a given. We’re all guilty of falling for the ‘narrative fallacy’ at times, sometimes through blind trust, sometimes because it appeals to our in-built biases.

The financial industry is plagued by this; someone gets asked to explain why something happened, they reach for the simplest explanation and before you know it that story gets accepted as gospel.

One such narrative fallacy we’ve all been told for ages now is that share markets have risen for the past several years because of super easy monetary policy pumping untold amounts of cash into the system that’s largely gone to chasing up asset prices, and without it the house of cards would come crashing down. This is supposed to be particularly true for the US, which has been the best performing global market in the post-GFC period, and where the Federal Reserve led the way in aggressive post-GFC monetary policy, such as the Zero Interest Rate Policy, fondly known as ZIRP, and Quantitative Easing, also frequently referred to as printing money.

You might be surprised to learn that narrative is wrong, baloney, a load of codswallop. The US market has gone up because of good old fashioned earnings growth.

John Bogel, the legendary founder of Vanguard, came up with a disarmingly simple formula for analysing why a share market has gone up or down. A market’s movements can only come from the combination of three things: dividends, earnings growth and the change in the price to earnings ratio (PE, which is really a measure of sentiment).

If share markets have risen because of all that freshly minted money chasing up asset values, then that would be reflected in a higher PE ratio.

A US blogger, Ben Carlson, recently worked out that since 2010 to the end of September this year (so three months shy of 10 years), the US market has returned 12.9% per year. Of that, dividends have contributed 2%, earnings growth 10.5% and the change in PE just 0.5%. That means the two ‘fundamental’ factors account for almost 97% of those annual returns. Not cheap money, not central bank market manipulation, just companies doing what they do.

The next thing you might think is ‘Hah, those earnings have been goosed by companies borrowing all that cheap money and buying back their shares’. Once again, believe it or not, this is just another popular narrative fallacy.

It’s true buybacks have averaged what sounds like an eye-popping US$5-600 billion per year since 2014, with 2018 a real outlier at US$900 billion thanks to President Trump’s tax cuts, however, JP Morgan concludes that between 2006-18, changes in margins and revenues accounted for about 93% of earnings growth, with the change in share count representing less than 7%.

Given the post-GFC monetary easing was ‘unprecedented’, as we are regularly reminded, it’s probably understandable that some would jump to the conclusion that it would have unprecedented effects. But the perpetuation of the fallacy that US share markets have gone up because of money printing is a classic case of people sticking with a narrative fallacy well after its use by date.

The WeWork debacle shows private equity is not a one way street

The WeWork debacle shows private equity is not a one way street

by | Oct 10, 2019 | Investments, Markets and Economy, Wealth Management

The Yale Endowment Fund was an early mover toward big allocations to private equity, which accounted for 40% of the fund’s assets last year. After returning more than 11% per year for the past 20 years, it’s made David Swenson a rock star among portfolio managers and started a movement that’s seen private equity’s share of giant investment funds go from barely being on the radar 20-odd years ago to now being a meaningful and indispensable portion.

Australia’s own Future Fund has 16% of its $160 billion in private equity, most of our big industry super funds include some weighting to it, and over the past five years there’s been an increasing number of vehicles offering private equity exposure to mum and dad investors that have proved very popular. And why wouldn’t they: as an asset class, private equity’s delivered returns that have averaged about 4% per year more than global share markets over the past 10 years or so and usually without the big swings share markets can suffer from. But the recent WeWork debacle and the dismal performance of Uber since it listed have shone a light on some of the risks in the space, risks that all investors need to be mindful of.

Private equity is investing in assets that sit outside public markets, and it can range from backing businesses in the earliest stages of starting up, right through to buying and selling long-established businesses or assets. The asset can be in private hands to begin with, or a private equity firm might buy a company listed on a share market and take it private.

One huge advantage of private equity is that if they’re transacting on a private company there are no insider trading laws, which is fair enough, if you were buying an asset from your neighbour there’s no reason the general public needs to know all the details. That means when a private equity firm does due diligence on buying a company they can insist on getting access to every detail available, information that a fund manager buying shares in a listed company would go to jail for.

Returns have also been less volatile than share markets, which is because the funds are not traded on a public market. When an asset only gets valued once or twice a year, it’s unlikely you’ll see a lot of ups and downs in the price. The downside of that is private equity is usually an illiquid asset, meaning you can’t buy and sell it whenever you want. Instead you’re typically locked into a fund for anything up to five to seven years, and in return you hope to harvest what’s called the “illiquidity premium”.

Because of that illiquidity, returns from private equity can be totally unrelated to share markets, which can be very handy when markets correct and you’ve got a chunk of your portfolio that barely moves. It’s close to the holy grail of “equity-like returns with bond-like volatility” that so many investors dream about.

With the huge rise in popularity of private equity as an asset class for institutional investors over the past 10 years, there’s likewise been a huge rise in the amount of money chasing private assets. It’s estimated there’s US$5 trillion locked away in private equity funds already, and Prequin, an alternative asset analyst, found more than half the large pension funds and family offices it surveyed intended to increase their allocation.

Of that US$5 trillion, US$2 trillion is ‘dry powder’ that hasn’t been invested yet and the intense competition for assets has seen the multiples paid rise by 20% over the past eight years. After the GFC, US regulators guided private equity firms to paying no more than six times ‘EBITDA’ (a proxy measure for how much cash a business spits out), but recently almost 40% of deals have been done at more than seven times.

While that may not sound like much, it’s a 17% rise and the way a lot of firms are looking to maintain strong returns on higher priced acquisitions is by jacking up the debt, which has seen average debt multiples increase 20% over the past few years. In just the last few years, once household names like Debenhams, Toys R Us and Pizza Express, have collapsed under the weight of the debt piled on by their private equity owners.

In January of this year Japan’s Softbank, one of the biggest private equity firms in the world, put money into WeWork at a valuation of US$47 billion. In the build up to listing the company in the US, which is the way many private equity firms cash in to realise their profit, Goldman Sachs and J.P.Morgan valued it at US$50-60 billion, but after closer scrutiny by regulators and fund managers the deal was pulled and the valuation is now estimated at more like US$10 billion.

That came after another private equity darling, Uber, was valued last year as highly as US$120 billion, then listed at US$80 billion, and is now US$50 billion. Likewise, its competitor, Lyft, has seen its valuation fall by 40% since it listed six months ago.

Having an exposure to private equity in your portfolio can be great for returns and can reduce its volatility, but like anything, you really need to know what you’re buying first. There are some companies that run like a Swiss watch, others that grab headlines for what can be the wrong reasons, and others that are clearly trying to jump on the bandwagon and raise money from unsuspecting mums and dads. The low interest rate environment is a double tailwind for private equity: lower yields are encouraging investors to look elsewhere for a return boost, and debt is cheap. Just make sure you don’t get blown off course.