Quarterly Newsletter July 5, 2017

We are always on the lookout for events or trends which might have the ability to change the market.  There is a great deal written about income inequality.  How often have you seen articles about a CEO of some large company being paid $30 million while some poor guy on the line is making $30,000 a year?  Or perhaps the top 2% of income earners taking 50% of the total income.  Or some proposed tax reduction benefitting the high-tax bracket folks while those who pay no taxes are shortchanged.

Capital In the Twenty-First Century by Thomas Piketty became a best-seller in the last two years.  Piketty is a French economics professor.  The following opening paragraph would lead you to believe there is some question in Piketty’s mind about the issue of income inequality:

“The distribution of wealth is one of today’s most widely discussed and controversial issues.  But what do we really know about its evolution over the long term?  Do the dynamics of private capital accumulation inevitably lead to the concentration of wealth in ever fewer hands, as Karl Marx believed in the nineteenth century?  Or do the balancing forces of growth, competition, and technological progress lead in later stages of development to reduced inequality and greater harmony among the classes, as Simon Kuznets thought in the twentieth century?  What do we really know about how wealth and income have evolved since the eighteenth century, and what lessons can we derive from that knowledge for the century now underway?”

After reading about 2/3 of Piketty’s book, I am of the opinion he started with the conclusion that income inequality is a massive problem and then went about trying to prove it.  His book, like many articles we have read, make a compelling case that some people are grossly overpaid relative to others, and they pass this fortune down through the generations, making it multiple times larger as it moves down the chain.  His solution is an 80% income tax rate and a tax of 2% annually on net worth for high earners.  This would, over time, level the playing field.

While browsing through the bookstore last winter, I found a book titled, Anti-Piketty: Capital for the Twenty-First Century.  It is a collection of 20 papers written by 20 experts in economics, tax, and history, providing arguments against Piketty’s work.  The following is the opening paragraph from Martin Feldstein’s article:

“Thomas Piketty has recently attracted widespread attention for his claim that capitalism will now lead inexorably to an increasing inequality of income and wealth unless there are radical changes in taxation.  Although his book, Capital in the Twenty-First Century (Piketty 2014), has been praised by those who advocate income redistribution, his thesis rests on a false theory of how wealth evolves in a market economy, a flawed interpretation of U.S. income-tax data, and a misunderstanding of the current nature of household wealth.”

Piketty’s book was to be the mathematical silver bullet that proved not only that income inequality exists but that it is becoming a multiple of what it was.  Anti-Piketty provides a convincing argument that not only is Piketty’s math flawed, his assumptions about future generations keeping and enhancing wealth are for the most part suspect.  The vast majority of the wealthiest people today are self-made business people and they are providing the jobs and the benefits to an awful lot of American citizens and families.  Are we sure we want to slap burdensome taxes on them to discourage them from building that next plant in the U.S.?

If you boil down the sources of disagreement, what remains is generally a difference of opinion on the total wealth of the country, also known as “the pie.”  Re-distributionists would argue that the size of the pie either doesn’t change over time, or it doesn’t matter.  To the contrary, most economists believe that innovation, productivity, and competition cause the pie to grow over time.  A couple letters to the editor in The Wall Street Journal summed it up pretty well.  The first:  “You need to ask whether an unequal distribution is better than a more equal one if the total rewards are significantly larger in the unequal one.  Given the relative performance of such ‘equal’ societies as Cuba, Venezuela, and the Soviet Union…I am sure ‘unequal’ would come out far ahead.”  The second:  “Wealth is the residue of hard work, determination, luck and self-denial, none of which is distributed evenly.”

There is no doubt there are income inequalities today and perhaps more than 10 years ago.  I am not sure what the answer is but I do not like Piketty’s solution.  Our economy today is different than any we have experienced.  Instead of fighting to get inflation and interest rates down, we are struggling to get them up.  The graph below pits corporate profits against wages.  The solid line shows corporate profits as a % of GDP.  The dotted line shows labor’s share of corporate GDP.  Basically, this measure serves as a proxy for how much of corporate sales are getting to the workers.  It should be pretty easy to see how the two lines move opposite each other.  In the first half of an economic cycle, profits flow to the corporations and investors.  As the labor market tightens in the second half of the cycle, wages increase relative to earnings.

Inflation has always increased as wages rise.  As wages peak, so does the economy, and a recession normally follows.  While we are in the second half of the economic cycle, there is no indication the economy is about to turn down.  Our core stocks are trading at 17-18 times earnings, which is slightly above their 14-15 long-term average.  The market has managed to climb the wall of worry, but the grade is getting a little steeper.  The yield curve is pretty normal.  The Fed is in the process of normalizing (raising) short-term interest rates.  Over the next year or two, we could have 2-3% short-term rates.  If intermediate and long-term rates also rise, the curve will remain normal.  If they remain stable or decline, we could experience a somewhat inverted yield curve, although at pretty low levels.

For now, we remain fully invested, with no economic downturn foreseeable over the near-term.

Written by David Meyer

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