For our quarterly communication to clients we like to delve a bit deeper into current economic and market trends. This quarter we focus on income inequality. Income inequality peaked during the Roaring 1920’s, and was followed by fifty years of steady decline (exhibit 1 below). Since the 1970’s, there has been an upward trend that persists today. While there is no denying that income inequality exists, we believe the proper question to ask is what is its cause and how does it compare to other similar countries? To answer this, we analyzed individual income tax rates in the United States versus other Group of Seven (G7) developed countries. We analyzed both the stated individual income tax brackets as well as actual government tax receipts. We concluded that while the gap in the United States is roughly in line with other G7 countries, the actual tax revenue collected in the U.S. is quite low. This phenomenon is due to smart accountants and attorneys exploiting the myriad of tax loopholes in the US Tax Code reducing the overall tax burden for their clients.
Setting aside social issues, from an investor’s perspective the implications of growing income inequality are relatively straight forward. The first effect is the larger the inequality, the slower the economy. Why? The higher the income level, the more is saved, hence the less is spent. As such, an additional dollar earned by an average wage earner likely gets spent on consumption which is economically stimulative. Conversely, if the same additional dollar is earned by a top wage earner, it is more than likely saved, which, while having some economic impact, is clearly not as stimulative. The currently high income inequality may go a long way to explaining the mediocre GDP growth that most developed countries have been recently experiencing. This may also be a reason for the below average returns for both bond and equity investors (a more robust economy would bring higher interest rates which would be a big plus for bond investors). Some would argue the information age, education differences, globalization, and the decline of organized labor have all had major impacts. The actual causes of the widening gap are a topic for another “Insights”.
Income inequality is roughly the same today as it was in the 1920’s. The increase since 1979 has been quite significant, and both the poor and middle class have borne the brunt of this inequality. In fact, if the distribution of wealth in 1979 existed today, the bottom 80% of US wage earners would have a collective $1 trillion of additional income or $11,000 per person per year!(1)
To be clear, income inequality is not specific to the United States, it is present in developed countries as well. Perhaps the gap is too wide globally. It has been proposed that income inequality in the U.S. can be rectified by a more progressive tax system. Critics of this proposal often cite a 2008 study done by the Organization for Economic Co-Operation and Development which showed that the US has the most progressive tax system among developed countries. The implication is that the United States has already taken substantial steps to address income inequity, yet it continues to grow. So if steps have already been taken, why does income inequality persist and increase? To answer the question, we analyzed both our current tax structure versus the G7 countries along with what the US government actually collects.
In 1912 Italian statistician and sociologist Corrado Gini developed a measure of income distribution within countries that still is used today. The Gini Coefficient measures income distribution from 0, perfect equality to 1 total inequality. While slightly dated (2010 or latest available) the illustrations below show that the U.S. is roughly in line with the G7 average, albeit higher than the OECD average.
As can be seen by these two illustrations, the United States is close to other G7 countries when it comes to income dispersions pre-tax. However post-tax it remains an outlier. How is it possible if our rates are progressive vis-à-vis other countries? The only logical conclusion is it is the impact of all of the deductions and loopholes in our current tax code. Lest anyone assume that these deductions are only for the rich, bear in mind that items such as the deductibility of mortgage interest payments are enjoyed by a large number of taxpayers. It was originally believed that the mortgage deduction would lead to higher home ownership rates. However, data do not support this as New Zealand, Great Britain and Canada all have higher home ownership rates than the U.S without a mortgage interest deduction. A study done by Harvard economists Edward Glaeser and Jesse Shapiro found that the effects are negligible, as deductibility simply increased home prices, crowding out some potential buyers. Recently, there has been some discussion to amend or revoke the mortgage interest deduction. Might it be possible that home prices would decrease allowing for higher home ownership accomplishing exactly what was intended from the onset?
It seems that most agree that the current code needs to be overhauled, so why haven’t our politicians rectified the situation? Most likely, the problem is that they have their pet loopholes with no desire to give them up. Once again, gridlock in Washington. One thing is for sure, the income gap is simply too large at present and measures taken to close it should be expected. Clearly something needs to be done as we are close to all-time highs.
During The First Half Of 2017, Client Portfolio Performance Results Lagged Some Of The Broad Market Indices. However Were In line With Value Indices
US stock market indices were almost up double digits during the first half of 2017 with clients’ portfolios slightly lagging. The S&P 500 showed a total return of 9.3%, the Russell Value 1000 a total return of 4.7%, the Dow Jones Industrials a total return of 9.3%, and the Consumer Price Index was up 1.4%. You can compare your individual portfolio results shown in the attachment accompanying this letter with the summary noted above, and the table below.
Leaders, Losers, And Laggards
The major winning sector in the first half of 2017 was technology. On the whole, we remain underweight the sector since our analysis points to high valuations which we believe will not adequately pay investors for the amount of underlying risk within the sector. Healthcare has been another strong performer this year, after a difficult 2016 campaign. We continue to see value in the Healthcare sector and remain confident in our positioning in this area.
The major detractor to performance in the 1st half was our overweight to the energy sector. While a strong performer in the second half of 2016, the energy sector was down double digits at the end of June. While we have been frustrated by the group, we explained in our last Research Insights publication why we remain overweight. The bear case is we are approaching peak demand and supply continues to grow. We take exception with the first element of this as we do not see demand peaking within our investable time horizon. Yes, someday, we will dramatically decrease our need for fossil fuels, but for the time being, growth from emerging economies will more than offset any decrease from more developed economies. We also disagree with the other part of the bear argument that we are in chronic over supply, as we believe it’s finally coming into balance. The simple reason is price. At today’s oil price levels, the vast majority of the industry is not making money, and we expect that companies will reduce their capital spending which should curtail supply growth as we get closer to 2018.
Granite Investment Advisors News
The Granite family grew by one when Erin Conroy and Dan welcomed their first child Zoë on April 24, 2017. Everyone is doing well. We welcome Zoë to the Granite Investment Advisors family.
Check out our new website http://www.graniteinvestmentadvisors.com/. We are excited about the unique and fresh look that the experts at MESH Interactive created. We engaged MESH Interactive, a full service digital agency here in New Hampshire, to help us position, present, and communicate GIA’s core value to both existing and new clients. We will be posting commentary and blogs on our website and social media sites so visit often.
Due to health reasons, Lemont Richardson, the founder of our Dividend Growth Strategy has now moved to an advisory role here at Granite Investment Advisors. He will continue to follow our holdings, read the news, and take part in investment decisions and discussions. Although Lemont will not be putting in as many hours as he once did, we will continue to lean on him for advice and insight into world events and economic trends. The philosophy and investment strategy that Lemont practiced over his many years with the Dividend Growth Strategy has clearly been proven. As we have said in the past, we will proudly continue with his legacy for many years to come. We all thank him for his contribution.
As always we thank you for the trust and confidence you place in us. Please let us know if you have any questions or concerns.
Scott B. Schermerhorn
Managing Partner and Chief Investment Officer
Past performance is no guarantee of future results. Returns are presented net of management fees. There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors’ recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.