Is US Middle Class in Secular Decline?

Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution,” Nobel Prize Winner and ‘father of modern macroeconomics’, Prof. Robert Lucas writing in 2004

Lucas was reflecting the consensus view when he made that declaration, but economists have since woken up the destabilizing macro feedback from extreme income inequality after the apparent prosperity of 2003-7 was revealed to be a credit bubble mirage fuelled by the long stagnation of real median earnings growth. Deep structural trends have again been feeding wealth and income inequality, from the disruptive impact of automation technologies to Fed policies focused on asset reflation; S&P companies spending more on shareholder distributions than capex exacerbates income concentration, given predominant equity ownership among the top 10% of households. The US wage share of GDP remains at multi decade lows, and without the rise in government transfer payments post-crisis, real median household incomes would be even more depressed. The growth of the US middle class in the post war years was an historical accident, now being painfully reversed by powerful economic and political trends. The addition of tens of millions of Americans to the middle class in the 1950s and 1960s was a function of America’s dominant position across many industries after the destruction wrought in Europe and Japan and centralized wage bargaining for a workforce that was at its peak 35% unionized which allowed semi-skilled workers to share the gains of world leading productivity growth and live the American Dream. The US also had a highly progressive tax policy on personal wealth (both earned in all forms and inherited) which funded heavy government spending on infrastructure, basic scientific R&D etc. In other words, the sort of interventionist policies (by both parties) to make the average Republican Congressman today hyperventilate and consult his well-thumbed copy of Ayn Rand’s ‘The Fountainhead’ for a bit of ideological reassurance.

While bankers are still under the regulatory cosh for their role in precipitating the financial crisis, it’s remarkable how academic economists who provided the intellectual alibi for some very dangerous policymaking (from ever more extravagant corporate share option packages driving a short term earnings fixation to laissez-faire banking regulation) have escaped unscathed and largely unbowed. Only at the fringes (in areas like behavioural finance) is there an acceptance that the ever more elaborate general equilibrium models are fundamentally flawed. For all the ‘red blooded entrepreneurial capitalism’ espoused by many ideologues in the US, it’s a historical fact that Silicon Valley owes its existence to the Pentagon and CIA while fundamental scientific research in the US, both private and government (the demise of Bell Labs, Xerox PARC etc.), has collapsed since the 1990s and the end of the Cold War.

Over the next decade, we face a surge in algorithm/machine intelligence driven process automation which is now impacting white collar professional jobs and pressuring the incomes of new segments of the population. The ‘cognitive threshold’ required to aspire to a traditional middle class professional lifestyle is rising fast. This will be the defining issue for Western politicians, and indeed central bankers who are still obsessed with plugging GDP output gaps with QE and blind to the underlying structural shifts that render their econometric models obsolete. In a way, it’s a case of back to the future because the key question in economics a century ago was whether capitalism was capable of generating a sustainable distribution of the gains from growth.

Marx’s critique of capitalism was partly that it would ultimately deliver deteriorating growth rates as wealth become increasingly concentrated at the household and corporate levels, and no longer circulated productively in the wider economy but was hoarded. Looking at the level of retained corporate earnings from the UK to Japan and the weak investment impulse globally as well as the rising income and wealth shares of the top 1% of households, there is a strong argument that we are going ‘ex growth’, although demographics is a big underlying factor as much as technology. The core issue is that while technological progress can in theory raise labour productivity and boost wages, it can also without some form of policy intervention make it easier to substitute capital for labour and profits for wages. In that case, even rapid productivity growth may merely enhance capital’s share of income, the return to capital, and the concentration of income and wealth, eventually undermining trend growth rates.

The impact of weak earned income growth in the US was partly reflected in and a driver of the rapid growth in consumer credit pre-crisis, as an attempt to maintain living standards. As far back as 2001, median income was already lagging GDP and productivity growth significantly. The long term polarization of income growth is a global phenomenon, with a few relative exceptions such as Japan and the Scandinavian countries. The ratio of corporate profits to wages and salaries has increased steadily since 2000 in the US to hit all-time highs, on the back of record price mark-ups over unit labour costs. With stagnating real household incomes and hence mass market consumer demand in the US (luxury is a very different matter, as reflected in the stellar performance of the Dow Jones Luxury Index, which has tripled over the past five years), it will be impossible for Asia to replicate the mercantilist policies that fuelled export led growth over the past 15-20 years. As the US current account steadily shrinks on the shale energy boom as well as soft merchandise import demand (and the consensus has been persistently overoptimistic in forecasting an imminent Asian export recovery), rebalancing demand toward domestic households as China hikes minimum wages helps, but that leaves much low margin export capacity increasingly uneconomic, perhaps the real driver behind recent ‘shock’ RMB weakness.

Japanese Banks Willing to Lend, But Corporates Awash in Cash…

The two most interesting outcomes from the latest Tankan survey were weak corporate inflation expectations and the highest willingness to lend by banks since 1997. Corporate executives overall see consumer prices rising 1.5% over the next year and barely half the BOJ’s objective at 1.1% for large companies ex the sales tax rise impact. Inflation expectations are lagging BOJ rhetoric and while this survey is a new attempt to capture inflation expectations within the traditional survey, it certainly doesn’t suggest an imminent wage and capex surge. Retained earnings by Japanese companies rose to a record high of 293trn yen in Q4, and those retained earnings have of course been a key support for the JGB market as household savings fell over the past decade. While the proportion of mid-sized companies saying banks are willing to lend rose to the highest level since June 1997, corporate demand for credit remains very limited, aside from pockets of foreign M&A. Indeed, outstanding lending to companies increased by 2.2% y/y in February, but the total outstanding amount of 275trn yen remains below levels in 2009. If inflation expectations weaken further in the next Tankan survey, the BOJ will be well behind the curve and perceived to have repeated its late 1990s error.

In fact, there is a strong case that Japanese companies are overinvesting (at the expense of shareholder distributions), partly for tax reasons. In the US, listed company corporate capex has pretty much matched combined buybacks and dividends in recent years (at $770bn last year) but in Japan capex is running at over 5x dividends plus buybacks, a ratio that has been trending up since 2009. Business investment amounts of 13% of GDP, compared with (a historically low) 10% in the US – the key structural issues are the lack of reform to the gerontocracy running Japan’s leading companies (director term limits, mandatory retirement ages etc.) nor any measures to make activist investing easier, a key factor in forcing US tech companies to distribute their cash hoards.

While the earnings revision ratio has turned negative for most global sectors and markets as detailed previously, Japanese financials have been an exception and yet banks tumbled almost 20% in Q1 – alongside real estate (and the next BOJ buying round will focus on ETFs and J-REITs) there is scope for outperformance in Q2. Loan volume began picking up in late 2012 and y/y credit expansion is now running at just under 3%, and set to grow at 3% – 3.5% in the next two years. Rising mortgage and consumer-loan volume has been a key positive, while demand for corporate loans has been flat to negative. Japanese non-financial corporations had $1.56trn of cash on their balance sheets at end Q4, up 6.4% y/y and half of listed companies are net cash-positive. Meantime, Q1 was a reminder that Japan still trades like an emerging market with foreign investors accounting for 60% of volumes, but relative earnings momentum and valuations support while extreme long positioning back in January has largely reversed.

Japan’s Consumer Confidence Index has been trending down since last May, falling in February to the lowest reading since September 2011. The Tankan survey showed expectations in the retail sector particularly bearish, worrying when the recovery since 2012 has been driven by domestic demand rather that exports. CPI has reached 1.3% y/y but the energy component was large in February, gaining 5.8% y/y and adding half a percentage point to the overall increase. Housing starts are down 12.9% over the two months through February, industrial production, which rose 10.3% y/y through January (partly on expectations that consumer spending might surge before the tax hike) dropped 2.3% m/m in February. In fact, the pre-tax rise consumption boost has proved to be very underwhelming – Japanese household spending fell 2.5% y/y in February. While that may imply a less severe post-tax hike contraction, the BOJ will be lobotomized by the LDP if it squanders the momentum of Abenomics (which depends critically on asset inflation for its wider economic impact). There is enough evidence of deteriorating momentum to see belated BOJ intervention by the end of this quarter, and after their sharp YTD selloff, financials/REITs would lead any consequent rally…