May 2020 Macro Commentary
The Economic Recovery Will Exacerbate the Wealth Gap
The Fed’s tools are limited in this respect...the Government will need to do more
by Sanjay Khindri, CFA on June 2, 2020
It is natural for one to think that an economic recession would disproportionately impact the less well-off. The data supporting that hypothesis is not entirely clear, but what is clear is that the U.S. income gap has continued to expand over the past 15 years, a period which included two recessions (chart below). Considering the subdued trends in real wage growth since 2008, a stronger conclusion may be that at a minimum, economic recoveries have disproportionately supported upper income families.
With regards to overall wealth, data from the Pew Research Center indicates even starker inequality than what income data would show:
Pew Research Center: https://www.pewsocialtrends.org/2020/01/09/trends-in-income-and-wealth-inequality/
This growing wealth gap is consistent with the fact that: over the past ten years (through the end of ’19), the S&P 500 total return and earnings per share have grown at an average annual compound rate of over 10%, while total private sector average hourly earnings have only grown at a 2.4% annual rate. We believe the Covid-19 pandemic will exacerbate this inequality gap, which will have not only social and political implications, but investment implications as well.
The government stimulus enacted thus far has enabled certain small businesses to maintain employment and provided enhanced unemployment support for those laid-off. These measures, however, do not solve a key issue for small businesses: how to manage liquidity and profitability to ensure that they can actually survive. Compared to big business, smaller firms also generally lack the P&L strength to absorb the needed investments in IT and logistics that this pandemic will require. The Federal Reserve, in coordination with the U.S. Treasury, has established “Main Street” lending programs to assist small businesses with access to capital (the liquidity component). But this facility is not up and running yet and Jerome Powell has admitted to the complexities of providing broad capital support to small businesses with varying capital structures and experience in capital raising. These complexities aren’t present in lending to large businesses. In fact, while the Main Street programs aren’t even operational yet, large businesses have been able to raise record amounts of capital year-to-date in the midst of one of the deepest economic contractions we’ve ever experienced (see chart below and our April Commentary on how the Fed has helped to dramatically loosen capital markets).
Another area that is of critical concern are the budgets of state and local governments. The CARES act provided $150 billion of support in this area, but the shortfall is likely to be much greater than that. Moody’s Analytics1 estimates that the additional budget shortfall for state and local governments will amount to $300 billion through June 2021. Importantly, states and localities generally operate under legislatively mandated balanced budget requirements. Without additional government transfer payments, budgets will need to be cut (i.e. jobs lost). Fed-provided liquidity support facilities to municipalities may not make much of a difference.
The bottom-line is that small business and lower-wage workers have been disproportionately impacted by this recession and face the biggest uncertainty going forward2. Policy support, thus far, has been more effective at providing liquidity to large businesses and keeping asset prices high. If these dynamics persist, we can expect the wealth gap to continue to widen.
Investment Implications
First, we note that while U.S. virus case growth has been trending down, the rate of decline has been stubbornly slow, and some states are showing early signs of reacceleration in new cases. The data is difficult to interpret not least because the U.S. has also been ramping up testing, but the data also indicates to us that most businesses that reopen will need to operate at reduced capacities….this will not be sustainable for many businesses. Given the high uncertainty on how demand will recover, we expect unemployment to remain elevated and pressure on overall wages. The Federal Reserve won’t be able to do much in this situation, but economic data and metrics will support highly accommodative monetary policy and we anticipate the introduction of some form of yield-curve control (where the Fed commits to keeping long-term interest rates at very low levels).
We are surprised at the lack of momentum on another government stimulus bill, specifically targeting state and local governments, but we think ultimately more fiscal support will be needed to help bring down the unemployment rate. As we expect high unemployment and wage pressures to be concentrated at the lower-income and lower-wealth tiers, we see increasing political uncertainty going into the 2020 election, in terms of how the administration will choose to respond and how the Democrats will position themselves around this backdrop. We find plausible the application of Modern Monetary Theory to eventually address these expected issues, particularly given how vocal the Fed has been in committing to supportive monetary policy (see here).
With our expectation of the Fed committing to keeping rates low across the maturity spectrum, while also having the optionality of increasing the size of its liquidity support facilities, the technical backdrop remains supportive of asset prices (technical meaning investors are more willing to take risk given the Fed has shown it will step-in to support markets). That being said, the outlook for economic and earnings fundamentals is highly uncertain while equity markets remain near all time highs. We continue to view taking passive market risk (e.g. index buying) as a highly unattractive way of sourcing sustainable returns in this environment. Our approach to deploying capital during this economic downturn continues to rely on bottoms-up company level analysis with a heavy focus on valuation.
1Mooy’s Analytics Capital Markets Research, Weekly Market Outlook, 5/21/20
2We note as data evidence: the rebound in new home sales for April, mortgage applications, Google searches for “new homes” and the spike in average hourly earnings as lower wage laid-off workers dropped out of the sample
Gallatin Capital Management, LLC
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