STEVEN KACZMAREK GENE D. BALAS, CFA 631 574 2474 [email protected]www.EastEndWealthManagement.org A S LOW E CONOMY, THE M IDDLE C LASS AND N EW I DEAS INTRODUCTION I f one were a physician and the economy its patient, before prescribing a prescription for its ills, the first steps would be separating the disease from its symptoms and identifying cause vs. effect. Certainly, a doctor might ease the suffering from the symptoms. However, without treating the underlying cause of the disorder, recovery may be prolonged before health returns. We want to examine the economic themes and the cause of slow growth and clarify what catalysts exist to return the economy to a higher long run trajectory of growth. We all know the economy needs to grow faster; otherwise, we will not be able to hire the unemployed, reduce our federal budgets deficits or provide a social safety net to the less fortunate. How we do that is the trillion dollar question. Record low interest rates and massive government spending have been tried, to little avail. While they may have helped at the margins, perhaps treating some of the symptoms, the root cause of the disorder is of a more fundamental, deeper nature that is resistant to these antibiotics. New, more powerful medicines must be creatively considered, introducing what has been lacking in political debates: education, innovation and entrepreneurialism. We can see these more fundamental issues manifest in areas such as structural unemployment and low wage gains. is argues for workers with different and better training. We can point to decreased innovation in the form of lower productivity enhancements. is is needed to provide for both higher corporate profits and worker wages simultaneously, instead of an either/or decision. ese factors explain why monetary policy and stimulus spending programs have not delivered hoped-for results. Let’s explore further. T HE LONG T ERM DECLINE OF THE MIDDLE CLASS On inauguration day, President Obama mentioned revitalizing the middle class. We are glad that he has taken notice. e middle class represents the biggest component of consumer spending power in this country, which in turn is the biggest component of the economy, at around 70%. Since wealthy consumers tend to save more of their incomes, and lower income consumers don’t have as much spending power, we need a healthy middle class for a healthy economy. A healthy middle class is vital to a healthy economy for providing mobility on America’s socioeconomic ladder and powering the engine of consumer spending. Middle class consumers buy more discretionary goods – which tend to provide jobs – while spending by lower income consumers tend to be more on basics, such as food, shelter, utilities and energy, which tend not to provide additional jobs in areas such as manufacturing. February 2013
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STEVEN KACZMAREKGENE D. BALAS, CFA631 574 2474Info@EastEndWealthManagement.comwww.EastEndWealthManagement.org
A Slow Economy, thE middlE clASS And nEw idEAS
introduction
If one were a physician and the economy its patient, before prescribing a prescription for its ills, the first
steps would be separating the disease from its symptoms and identifying cause vs. effect. Certainly, a doctor might ease the suffering from the symptoms. However, without treating the underlying cause of the disorder, recovery may be prolonged before health returns. We want to examine the economic themes and the cause of slow growth and clarify what catalysts exist to return the economy to a higher long run trajectory of growth.
We all know the economy needs to grow faster; otherwise, we will not be able to hire the unemployed, reduce our federal budgets deficits or provide a social safety net to the less fortunate. How we do that is the trillion dollar question. Record low interest rates and massive government spending have been tried, to little avail. While they may have helped at the margins, perhaps treating some of the symptoms, the root cause of the disorder is of a more fundamental, deeper nature that is resistant to these antibiotics. New, more powerful medicines must be creatively considered, introducing what has been lacking in political debates: education, innovation and entrepreneurialism.
We can see these more fundamental issues manifest in areas such as structural unemployment and low wage
gains. This argues for workers with different and better training. We can point to decreased innovation in the form of lower productivity enhancements. This is needed to provide for both higher corporate profits and worker wages simultaneously, instead of an either/or decision. These factors explain why monetary policy and stimulus spending programs have not delivered hoped-for results.
Let’s explore further.
thE long tErm dEclinE of thE middlE clASS
On inauguration day, President Obama mentioned revitalizing the middle class. We are glad that he has taken notice. The middle class represents the biggest component of consumer spending power in this country, which in turn is the biggest component of the economy, at around 70%. Since wealthy consumers tend to save more of their incomes, and lower income consumers don’t have as much spending power, we need a healthy middle class for a healthy economy. A healthy middle class is vital to a healthy economy for providing mobility on America’s socioeconomic ladder and powering the engine of consumer spending. Middle class consumers buy more discretionary goods – which tend to provide jobs – while spending by lower income consumers tend to be more on basics, such as food, shelter, utilities and energy, which tend not to provide additional jobs in areas such as manufacturing.
While the economy has surpassed its prerecession peak and is 16% larger than it was a decade ago in real terms, real median household income fell by 5% from 2000 to 2009, according to Census data. Additionally, the median household income of $51,006 is less than the median household income in 1997, when it was $51,705. No wonder why people in the typical American household have felt they aren’t getting ahead. They aren’t.
The Pew Research Center cataloged the issues facing the middle class in a report titled, “Fewer, Poorer, Gloomier: The Lost Decade of the Middle Class.”
The middle class has also gotten smaller. Pew defines the middle class as households with incomes from $39,418 to
$118,255 in 2010. With that definition, the middle class constituted 51% of all adults in 2011, down from 61% in 1970. The middle income tier commanded 45% of the nation’s income in 2011, down from 62% from 1970.
Some have moved up, others have moved down. The upper income tier rose to 20% of all adults in 2011 from 14% in 1970, whereas the lower income tier increased to 29% of the adult population, up from 25%. The upper income tier takes in 46% of national income, up from 29%, while the share of national income going to the lower tier was 9%, down from 10% four decades prior. Thus, the nation has become more polarized for income and wealth distribution.
What does this mean for economic growth going forward? From 2000 to 2010, the median income of all three groups fell: lower-income households’ income fell by 8% (not annualized), middle-income households lost 5%, and upper-income households’ income decreased by 6%.
The savings rate has fallen as consumers seek to maintain spending while incomes are constrained, leading to the deceiving portrait of an expanding consumer sector of the economy. Without growing incomes, spending per household cannot grow by much, and total spending is only supported by household creation and credit, not growing household incomes.
Consumption patterns can shift as well. Middle class consumers tend to be, well, consumers. A bigger middle class with growing middle class household incomes means a stronger economy than our reality of a growing upper class with shrinking upper-income household incomes.
conSumErS’ rEAction to StAgnAnt wAgES: dEbt And SpEculAtion
Over the past decade and a half, consumers have responded to a lack of wage growth by turning to gambling in the financial and housing markets to augment their spending power: following the herd in not one, but two, asset bubbles and accumulation of excessive debt.
In the past, up to the recent recession, consumers were able, at least initially, to buoy their spending by speculation in the equity markets. From 2000 to 2002, when the tech wreck occurred, we should have learned our lesson. Historians may well be puzzled why, just a few years later, we had yet another desperate attempt to manufacture “transactional” wealth with no input of capital, labor or innovation.
There was the debt boom, much of it associated with the housing bubble, but much of it not, predating the mortgage boom.
From the 1980s up to 2000, the savings rate steadily fell – even as the population continued to age – and it became apparent that stagnant incomes were supplemented with consumer debt to maintain spending. Up to this point in 2000, baby boomers weren’t yet retiring in large numbers, but still, the savings rate might not have been sufficient to both pay down that debt and save for retirement. A logical action would be for households to maintain more moderate spending, increasing the savings rate and decreasing debt as retirement approached as the Baby Boomer generation aged.
Instead, household debt as a percentage of disposable incomes increased again. From the levels that prevailed from the mid-1960s to the 1980s, consumer debt was around 65% of household disposable incomes. It increased to 100% by 2000, and then by another 40%, from 2000 to 2007, to reach a bit under 140% of disposable incomes at the peak of the housing bubble. The savings rate fell even further – even dipping to nearly zero during the peak of housing mania – and cash-out refinancings and capital gain proceeds were used to fund consumption. In the old adage, what is unsustainable always ends, and usually ends badly, the debt levels were unsustainable, and foreclosures and bankruptcies mounted. This tipped the economy into a deep recession and the bad debts triggered a massive financial crisis.
As we heal from the financial crisis in the U.S. (we’ll conveniently ignore Europe, as our focus is on the U.S. consumer), household debt servicing ratios have returned to more sustainable levels. Much of this was through defaults, not diligence. So, even though households, in aggregate, have reduced debt, those with credit histories scarred by defaults or delinquencies may not regain access to credit in the near term to begin to spend again on credit.
Even those with good credit may find it necessary to save more for retirement, as the country ages. Data show that the majority of Americans have insufficient funds for
retirement. Whether due to a lack of access to credit, a need to save for retirement or paltry income gains, many households, particularly the middle class, may find it difficult to accomplish the above goals while increasing consumer spending by a significant amount. The squeeze is on.
thE Economic growth impASSE
Why is the middle class squeezed? Low household income growth inhibits household spending growth, and that in turn limits corporate revenue improvements. This leads to businesses holding the rein on pay raises to maintain corporate profits, leaving workers with few wage gains. The cycle then starts anew. That is the simple narrative.
What we know from Census data is that the real median hourly wage has increased by an average annual 0.6% from 1990 through 2010. (This is adjusted for inflation.) The past ten years show a similar trend, with hourly pay increasing by just 0.7% in real terms on an average annual basis. Certainly, it is hard for individual consumers to spend more when they are not earning more, and these statistics are only for people who are working. Household income, as we discussed, has not increased reflecting smaller percentage of the population working. Aggregate consumer spending has grown faster than this rate for individual households in the past couple decades, but that is because the population is growing and people have been saving less and borrowing more. So, a lack of income gains has been vexing both individual workers and households for a long time.
corporAtE profitS SurgE
At the same time, corporate profits have risen to record highs as a percentage of the economy while wages as a percent of GDP fell in tandem, so we might be inclined to blame “greedy” employers. But it is simplistic to think that employers are necessarily the primary culprit, due to
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a supposed profit motive that deprives workers of wage increases. After all, corporate profitability depends in large part on maintaining a talented workforce.
thE rolE of EducAtion
Employers do value talent: Education matters when it comes to unemployment, wages and income growth and more Americans are pursuing higher education. Americans age 25 and over with a college degree have an unemployment rate of just 3.7%, while 8.1% of those with just a high school diploma are unemployed. For thoese without a high school diploma, the unemployment rate is 12.0%, data from the Bureau of Labor Statistics show.
Which fields one pursues matter, too. Consider that unemployment rates for recent graduates in healthcare and education are 5.4% compared to 9.4% for people who majored in humanities and the liberal arts. To look at it differently, median earnings among recent college graduates vary from $55,000 among engineering majors to $30,000 in the arts. Our economic growth hinges on our entire population’s collective decisions and the majority of our children are taking the less arduous path of liberal arts rather than Science, Technology, Engineering and Math.
The government could make it easier for people to pursue higher education, perhaps by supporting retraining efforts as part of the unemployment insurance program. Such models exist in certain countries in Europe, like Germany, where companies receive a subsidy to hire and train new workers. Rather than pay people to stay unemployed, the government could pay employers a similar amount to hire and train those people. We might borrow some ideas that have succeeded elsewhere to use here.
innovAtion: thE rolE of productivity
A byproduct of education is innovation, which is itself a force in economic development. Investments in research and development, coupled with a sufficiently educated and creative workforce, can turn ideas into economic results. This can both enhance productivity and lead to entirely new industries.
First, though, what do we mean by productivity gains, anyway? Is it a worker producing ever more toasters on an assembly line? No, it is sometimes disruptive new technologies that can enable companies to increase
output with the same inputs of labor. Think of how the internet remade how we shop, bank, travel and obtain information. Then think of the jobs that were created – and lost – as companies that operate on the web became prolific while other jobs, whether travel agents or sales clerks, receded. Consider how much more productive we, as a society, became when businesses
could automate functions or perform other tasks more quickly.
That didn’t happen without some investment. Computer servers needed to be bought, self-service retail checkouts needed to be installed. Expensive robotic assemblies at manufacturers needed different – and fewer – workers to operate them. These all were the makings of higher output with the same, or less, hours of labor. Simply witness the fact that we’ve already exceeded total output, as measured by GDP, from before the recession, but with millions of fewer workers.
The dilemma is how the labor force adapts to these innovations – and even participates in creating them – without being left behind. These new technologies might drive economic growth, but disrupt livelihoods in the process. There are, after all, very few stagecoach manufacturers left in the world. Nor are railroads among the biggest employers either, for that matter.
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However, one economic theory is that business cycles are caused, at least in part, by technology introductions and their resultant impact on productivity, termed the real business cycle theory. Researchers at the Chicago Fed recently documented this relationship. Beginning in 1973, low rates of productivity gains were associated with a moribund economy in the 1970s. Then, beginning in the early 1980s, productivity began to grow, modestly at first, and economic growth responded upwards in turn. In the mid-1990s, productivity growth took off coinciding with the tech and internet boom, and we had a booming economy.
After 2004, however, productivity growth diminished remarkably – as did the typical worker’s income – and our economic growth would have slowed markedly absent debt-fueled consumer spending just prior to the recession. This slowdown in productivity gains predated the recession, and while the recession was caused by other factors, our slow recovery may relate to lessened productivity gains. Historically, companies have shared productivity gains with their employees by providing pay raises. Increasingly, companies are using productivity gains to enhance profitability, sharing less with workers, given a large supply of labor and competition for jobs. Increasingly, companies share gains directly with shareholders thru stock repurchases and special dividends.
Regardless of why it ebbs and flows, productivity gains help to determine the “speed limit” of the economy. Basically, potential economic growth can be thought of as productivity gains plus growth of the labor force and capital introductions. If the economy grows faster than this rate, inflation can result as bottlenecks emerge from more demand for labor and capital than the economy can provide. Right now, inflation (aside from food and fuel, which are dictated by forces of nature) is unlikely to be a problem because of a large excess capacity of both capital and labor.
Our interest, though, is where economic growth is likely to converge over time, so let’s explore the economy’s longer term potential. Growth of the labor force can be influenced by many things including, birth rates, immigration and demographics. It can also be impacted by how many people decide to seek, or not seek, a job. What interests us, in particular, are productivity gains. When productivity is high, corporate profits tend to increase, and companies may share some of those income gains with their workers. That can increase economic growth.
Going a step further of what influences productivity gains is business’ investment in new technology or equipment. This is what will allow companies to produce more for each hour of labor. Unfortunately, those investments haven’t recovered ground lost during the recession. Consider
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some of the preceding graphs, indicating lower business investment in certain capital expenditure categories:
Orders for machinery have rebounded as manufacturing has enjoyed a renaissance of sorts. However, those things which make businesses more productive, like communications equipment, computers and electronic components, have seen a systematic drop in new orders. These investments have not recovered completely since the recession, and the wide ranging services industries use these to enhance productivity gains.
When businesses make fewer investments into equipment and software, it means a couple of things. One is that businesses might be more cautious about the future, as we see now with the fiscal cliff. Another is that companies have chosen to boost their share prices through stock repurchases, returning cash to shareholders rather than making further investments in their own companies. This can increase earnings per share artificially through fewer shares, not necessarily more earnings or even revenues.
Since these trends have been in place since the end of the recession, it also means that businesses might not expect their output to grow as fast as it had in years past. When businesses don’t expect output to grow as fast, it becomes a self-fulfilling prophecy. The reasons for these lowered expectations are complex, and relate to the many well-publicized headwinds the economy faces. Lower business investment is both a cause and effect of slower growth expectations.
So when policymakers confer to address monetary policy or consider the effectiveness of previous rounds of fiscal stimulus and wonder why the economy is still growing sluggishly, perhaps a large-scale productivity shock is what we need instead. That, however, is a difficult proposition, as one cannot simply create the “next internet” just by lawmakers’ decree or a Fed decision. Instead, the “next internet” will likely be produced by private industry, but policymakers must nurture it along without killing it with excessive regulation. Government could foster new ideas by helping new businesses form and by easing regulatory burdens.
EntrEprEnEurS providE innovAtion
The U.S. provides tremendous support to the goal of home ownership, such as through the creation of Fannie Mae and Freddie Mac, as well as providing a mortgage interest tax deduction. Meanwhile, the Federal Reserve is buying vast quantities of home mortgage securities to depress mortgage rates to allow more people to buy
homes. However, a home, once built, provides no new jobs.
If the government were to support new business formation the way it does homeownership, we would likely have more jobs created. Instead, the government provides comparably little support for new businesses. Yes, many new businesses don’t succeed, but some of them turn into the next Facebook, a multibillion dollar company that is less than a decade old.
The government can also rethink regulation. Much of it is onerous and hinders business creation and thus, job formation. Of course, there is a reason for some regulation, to keep our employees, customers and environment safe. However, unnecessary hurdles for businesses to clear, aside from public or worker safety, keep many would-be entrepreneurs from starting their own company.
Small businesses that do succeed often do so because they have new ideas. Those new ideas are what provides them a profit, pays their employees, and benefits society. While many big businesses do have large research and development labs that lead to patents, individuals with big ideas need to be nurtured, too. And that is where policymakers can lend a helping hand. New businesses and new ideas often lead to new technologies and perhaps even new industries.
innovAtion lEAdS to nEw induStriES
In that vein, innovation, whether it comes from entrepreneurs, academia or a large corporation isn’t just about improving productivity; it can produce entirely new industries. One example is related to shale oil and natural gas extraction, or fracking, and that can lead to new jobs in different fields, revitalizing regions of the country where fracking is being deployed. Along with other petroleum extraction, such as oil sands in the Dakotas, the U.S. can perhaps achieve energy independence and may even become a net petroleum exporter. Pipeline construction from these sites, and possibly Canada, can provide for jobs and budding industries all along the construction routes. Retooling truck fleets to run on natural gas would also increase our energy independence.
It is early, and we don’t know the full potential of America’s new energy industry revolution. We do have to address potential environmental concerns that some lawmakers (and their voters) might have. We don’t know how many jobs this might provide yet. Still, it is an excellent example of how new industries can develop from new technologies that spring from innovation. This is how education begets innovation, which in turn begets new industries and jobs.
East End Wealth Management
This information is intended to describe a general investment strategy and is not a recommendation to buy or sell any specific securities. The strategy discussed does not and should not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. Any investment carries risk, including the loss of principal. Any investment strategy discussed here or available through East End Wealth Management is not an obligation of a bank and is not guaranteed by the FDIC and may lose money. Some investments are not suitable for all investors. Past performance is not indicative of future results. We cannot guarantee that this information is accurate or complete. As with any investment strategy, you should thoroughly discuss your particular investment situation and with your financial representative and understand any investment recommendation that might be made before investing any money.
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concluSion And invEStmEnt thEmES
In the meantime, we believe the economy will grow only moderately, at a rate insufficient to reduce unemployment substantially as the population grows in tandem. Remember that in the long run, economic growth is dependent on growth of the labor force plus productivity gains. If we assume that productivity gains may be underwhelming, and the labor force is not quite adapted to the needs of employers, our potential growth rate now may be less than it once was. Perhaps 2% is the new normal.
There are however, plenty of reasons to be optimistic. America is a country of innovators and entrepreneurs; we just need a way to foster the transition of a new idea into new technology or a new industry. We need to invest more in education so that we have a talented workforce and innovative entrepreneurs able to translate an idea into jobs. Policymakers can start by helping new businesses form and by reducing unnecessary regulations. These are entirely doable action items. If we can educate our youth and encourage innovation, we can help our economy grow.
For more information on East End Wealth Management please visit our website: www.eastendwealthmanagement.orgOur most recent performance results through January 2013 are located here.
Steve is the President of East End Wealth Management. He has over 30 years of experience in trading and risk management in a wide range of markets. Most recently, Steve held the position of Managing Director at Legend Merchant Group. His background also includes the positions of Partner at Schonfeld Securities; a proprietary trading firm, NYMEX floor trader and Lieutenant, United States Army Reserve. Steve graduated New York University with a degree in Economics.
As an active member of the investing, planning and trading community, Steve is a member of NAIFA and the Financial Planning Association. Locally, he is the Chairman of the Southampton Youth Board, focused on youth issues on the East End of Long Island.
Balas has over twenty years’ experience in investment management. He currently writes economic commentary for TheStreet.com’s RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop investment strategy, He also headed the firm’s manager due diligence efforts. Prior to GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in 1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.
