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Populists Meet The Cocoon Class – Possible Economic And Investment Implications

Date Posted: August 3, 2018

Populism
The word populism rings loud in many countries today. The overall subject obviously lends itself to a lengthy Ph.D. thesis not this relatively brief commentary. Therefore, this commentary will limit itself to focusing on a limited number of economic forces likely causing the growing populist leanings within the  working class and other sectors of the population.

The Growing Populist Vote
A graph from a Bridgewater Associates study—Populism: The Phenomenon — shows the vote share gained by populist movements and candidates since 1900 (Figure 1). Not since the 1930’s (40%) did populists gain such a substantial share of the vote as they achieved in recent elections (34%.) The study further makes the point that populism today seems less extreme than in the earlier period.
The forces leading to the growth of populism, in our view, go back at least two decades. They reflect the influences of globalism, technology, and innovation. The result of these forces likely ended the golden age of the blue-collar worker that started after the end of World War II.

Figure 1

Source: Bridgewater Associates

Globalization—China Enters The World Trade Organization (W.T.O.)
Globalization represents the first of the major forces that brought pressure on working-class incomes. The most important pressure came when China joined the W.T.O. in December 2001. With that opening, American corporations took advantage of the most important U.S. export–the U.S. dollar—to invest in and move to low cost labor production to China. In return for these investments, China exported its low cost labor in the form of manufactured and assembled products.
The long-term trends from shifting U.S. manufacturing to China shows up in Figure 2. According to a recent Wall Street Journal report, the U.S. represents two-thirds of China’s trade surplus with the entire world. In addition, a recent draft report from the National Bureau of Economic Research (N.B.E.R.) showed Americans lost 2.65 million jobs to China as a result of this change. The study also attributes robotics for an additional loss of 1.4 million U.S. jobs. Most of this total loss came from a manufacturing job base currently totaling nearly 13 million. This job loss from Chinese imports and robotics no doubt contributed to the growth of populist forces in this country and their demands for an answer.

Figure 2

Source: Wikipedia

Declining Labor Share of Income
In addition to shifting production to China, U.S. Corporations outsourced services not directly related to their activities such as building maintenance and food services. By moving production and outsourcing selected services, businesses further reduced the bargaining position of effected workers. With these shifts, corporate profit margins expanded while the labor share of income declined (see Figure 3).


Figure 3

Source: JP Morgan Funds

Not only did labor’s share of income decline sharply in the United States, but it also declined more rapidly than in most other developed countries (see Figure 4). The eroding position for earnings power of American workers compared to the growing profitability of U.S. Corporations added further fuel to the growing populist fire.

Figure 4
International Comparison: Labor Share by Country

Source: The Fall Of Labor Share And The Rise Of Superstar Firms—Autor, Dorn, Katz, Patterson, Van Reenen

Eroding Union Power in Private Industry
The shift of U.S. manufacturing jobs to countries with lower labor costs furthered the erosion of union power in private industry (see Figure 5). This graph also shows income inequality increased at the same time. As a result, workers in heavily unionized industries and crafts experienced a sense of diminished influence on their working conditions and wages. In reaction, unionized workers will likely give increasing support to populist candidates instead of following the political dictates of their union leaders.

Figure 5
Union Density and Inequality Measures—1917-2011

Source: Unions And Inequality Over The Twentieth Century: New Evidence from Survey Data—Farber, Herbst, Kuziemko, Naidu

The Fallout of These Shifts—Wage Stagnation
A National Bureau of Economic Research study shows less than half of Americans born in the 1980’s earn more than their parents did at the same stage of their lives. A recent article in Barron’s, Wage Stagnation, showed American’s total hourly pay grew about 80% above inflation since 1970. However, over the same period, real income for the typical working age male declined about 10% (see Figure 6).
Figure 6

Growing Disparity of Wealth
The increasing disparity in wealth also proves an irritant to many (see Figure 7). The Fed’s policy of Quantitative Easing (Q.E.) likely contributed importantly to this disparity. Q.E. helped to generate greater risk taking among investors resulting in “bubbly” asset markets. Because the upper income own the majority of such assets, they benefitted the most from improved asset markets. Therefore, in our view, faster real wage growth for the working class would do more to dowse the populist fire then trying to focus on wealth inequality. Such faster real wage growth will depend importantly on productivity improvements, in part, dependent on increased capital investment.

Figure 7

Source: World Inequality Data Base

Technology and Growing Market Power
Earlier, the commentary cited the growing influence of globalism as one of the changes contributing to the rise of populism. Now, we examine one other force, technology and its influence on the changes already outlined. First, many companies appear to be gaining market power (see figure 8). The growing use of advanced technology likely contributes importantly to this trend. Note that advanced economies show more rapid increase in markups than do the economies of emerging and developing markets. This difference likely result from developed economies making greater use of leading edge technologies.

Figure 8
Evolution of Estimated Markups Across Economies
(Sales weighted mean for all publicly listed firms)

Source: The Rise of Market Power and The Macroeconomic Implications—De Loecker And Eeckhout

The Rise of “Superstar Firms”—Employing Greater Technology Intensity
A recent study, The Fall Of The Labor Share And The Rise Of Superstar Firms, cites the “winner takes most” effect of the “superstar firm.” These dominators successfully exploit economies of scale attributable to the network effect. Their rising industry concentration also comes from exploiting their rapidly developing technological capabilities. Figure 9 suggests the disproportionate concentration of industries comes from their faster technology development as measured by “patenting intensity.” Bottom-line—increasing industry concentration comes from taking advantage of faster technological development. Once again, the labor share of income may fall from faster technological development but average wages do not fall. This offset reflects the increasing premium paid for greater technical skills. At the same time, those unable to meet the job requirements of these “superstar firms” will likely see their wages continue to stagnate.

Figure 9
Change in Concentration in U.S. Manufacturing and Change in Industry Characteristics

Source: The Fall of the Labor Share and The Rise Of Superstar Firms—Auto, Dorn, Katz, Patterson, Van Reenen

Wage Premiums and Discounts
As the result of technological demands for increased worker skills, not all workers suffer from wage stagnation described earlier in this commentary. More so, than late in the last century, workers with growing levels of skills earn an increasing premium (figure 10). In contrast, lesser skilled workers face an increasing discount. As technology increases in its importance to the economy, compensation of those with the skills to advance its use will benefit. Those left behind will likely remain frustrated without the necessary training to supply these new skills. However, if additional training can supply skills in demand, then wage premiums may narrow as they did in the 1970’s.

Figure 10
College Graduate and High School Graduate Wage Premiums: 1915-2005

Source: The Race between Education and Technology—Goldin, Katz

Populism’s Influence on the U.S. Election and Its Aftermath
The Cocoon Class and Parenthesis States
The financial community, as did the political savants, missed the rise of populism. One reason reflects that many political commentators, those in the financial community, as well as other so-called elitists live in their coastal cocoons. The late author Tom Wolfe described the coastal cocoons with the following quote: “They’re usually called blue states—they’re not blue states, the states on the coast. They’re parenthesis states—the entire country lies in between.” The Electoral College vote demonstrated the truth of those words.
The Retreat from Globalism and Open Borders
During the campaign, both presidential candidates spoke in varying fashion about the negative influences brought about from globalism. Both promised to withdraw from the Trans-Pacific Partnership. No doubt, candidate Trump spoke out in a stronger fashion. The rise of populism in this election led to a retreat from both globalism and open borders. The U.S. result also parallels similar results in the U.K. with Brexit and in Europe with limits on immigration.

Election Leads to Early Effort to Protectionist Measures—Initial Economic Impact
While a retreat from globalism may prove long-term, this election produced an immediate result. The administration moved to raise tariffs. The so called “trade war” creates a number of direct and indirect investment and economic consequences. For example, meaningfully raising U.S. tariffs, all things being equal, will likely lead to a stronger U.S. dollar. This increase would dampen U.S. export growth. At the same time, the translation effect from a stronger dollar would reduce U.S. corporate global earnings.
The stronger economy will likely permit many U.S. companies to raise prices thus offsetting their increased import costs from higher tariffs. The resulting higher inflation could force the fed to pursue aggressive normalization steps compared to its current orderly steps.

Playing Bully in the China Shop—A Negotiating Bluff?
Will threatening higher U.S. tariffs simply turn out to be a short-term negotiating bluff? Most investors initially assumed that to be the case. Now, we see even more aggressive U.S. trade threats against China. In our view, playing bully in the China shop—so to speak–unfortunately, could lead to our bluff being called. Even if this then leads to full implementation of higher U.S. tariffs, many economists and investment strategists project only a modest negative impact on U.S. economic and earnings growth. Yes, just massaging the numbers might bring that answer. However, with full implementation of higher tariffs, we would expect the tone of business expectations and planning to turn more negative. If this reaction proves correct, this will likely cause a greater economic pullback than the number massaging alone would project. In reaction, investors would likely shift their focus back to those companies with primarily domestic earnings. Corporate managements might reduce their capital investments in plant and equipment. Instead, managements could use their freed up cash flow to buyback their stock and perhaps look to acquisitions to shore up their growth.

Short-Term—China’s Response
Because of the imbalance of trade with the U.S., China must use other tactics in addition to tariffs to fight the trade war. As an example, China did not approve Qualcomm’s acquisition of NXP by both parties agreed deadline. Another example, up to recently, American products could be shipped overland into China from Vietnam duty-free. With the onset of the trade war, China cut off this special duty-free provision. No doubt, China will likely make it even more difficult for U.S. firms to operate in China. Finally, the Bank of China could continue to let the Renminbi/Yuan fall.

What Might Bring A Truce In The Trade War With China?
The administration may expect the relative performance of the two economies will determine when truce negotiations begin. The U.S. economy continues to show strength. This will likely give the administration confidence to maintain its aggressive U.S. trade posture towards China. In comparison, China showed manufacturing and non-manufacturing weakness in June. Both production and new orders fell from the previous month. To counter this slowdown, China indicated it will step up fiscal and monetary stimulus to recharge growth.
Most governments in the world do not react positively to public pressure. Even more so, that applies to Asian countries. If so, the administration may need to try some more moderate outreach to the government of China in order to get truce talks rolling.

The Election—Immigration and Open Borders—Meaning For Economic Growth
Beyond trade, the impact of populism focused at least one candidate on re-establishing firmer borders—build the wall–and stricter control of legal immigration. A simple equation shows economic growth depends on the increase of employment plus productivity. Employment growth remains sluggish in the United States. Therefore, less legal immigration could potentially reduce economic growth barring a sudden spurt in productivity.

Investment Conclusions
In the end, the overall economy will not benefit by retreating from global trade. Even if settled quickly, trade wars will leavemuch damage to global confidence. With a possible truce, investors still should not return to their prior period of complacency. Next year the economy will likely see reduced benefit from this year’s dual fiscal stimulus. As a result, most economists look for slower economic and earnings growth beginning sometime in 2019. If the trade wars linger, then next year’s economic growth will likely be even slower and inflation higher. Finally, with the fed continuing to raise rates, economic growth moderating, and the trade war simmering, we continue to favor a balance of growth stocks, short duration fixed income paper and, considering the more uncertain outlook, alternative investments.

A Side Observation—Political Confidence
Beyond the usual investor focus on the economic and investment outlook, financial markets require political confidence. Without speculating on the impact Russian meddling played in the U.S. elections, no doubt it undermined America’s confidence in the political process. It will probably take some time to reestablish such political confidence. This would prove particularly troublesome if we suffer from an economic slowdown, in part, related to the forces of populism.