Australia, Canada, and Scandinavia: The Safest Bets in an Unsafe World

Australia, Canada, and Scandinavian countries share two important traits that should make them excellent places to invest/store capital in the coming years.  First, they boast strong and entrenched middle classes, which will guarantee a kind of political stability that can't be relied upon in other parts of the world. And second, their governments are in far less debt than their developed world counterparts (e.g. the U.S., U.K., Japan, European "peripherals").

Here are two fascinating charts to illustrate these points.

The first is a map of the world with countries colored according to their GINI coefficient.  The GINI coefficient is a measure of income inequality where 0 is complete income equality (everyone makes the same amount of money) and 1 is perfect inequality (all the country's income accrues to a single earner).  The higher the number, the greater the income inequality.  This map is interesting in that Europe, Canada, Australia, Scandinavia, and parts of central Asia (the green parts of the map) are really the only places in the world where one could say that a strong, practically unassailable middle class exists.

The second is a chart from Pimco's web site showing the debt-to-GDP ratio of a number of countries.  Notice that Australia, Canada, and a handful of Scandinavian countries look downright safe compared to the powder kegs represented by the U.S., U.K., Japan, and the so-called "peripheral" countries of the EU.

A third trait Australia, Canada, and Scandinavia share is that they are all major commodity producers, which makes them good plays on the commodity super-cycle that we are likely in at the moment.

Given all this, I would argue that if you're looking for places where debt defaults and political unrest are least likely to be a problem in the future, then Canada, Australia, and Scandinavia are what you seek.  This doesn't mean that those regions won't be affected at least somewhat by a sovereign default or political turmoil elsewhere in the world.  But, the odds are that they will be affected less than most.

A stronger dollar might be right around the corner

The conventional wisdom is that the latest round of quantitative easing by the US Federal Reserve (QE2) will weaken/debase the US dollar, drive up the cost of commodities, and fuel potential bubbles in overseas markets.  If this comes to pass, then buying gold and other commodities, emerging market equities, and the currencies of major commodity producers should be a very lucrative trade.  And, in fact, this was the case in the months leading up to QE2 and continued to be so in the days immediately following the Fed’s announcement (see this excellent chart). 

However, the past couple of days have erased some of those gains (and in some cases quite dramatically) as the US dollar has strengthened, commodities like sugar, silver, and cotton have come crashing back to earth, and stock markets around the world have shed value, including a 5% one-day drop in the Chinese market. 

What is going on here? Well, this article in the Financial Times explains a lot.  It’s impossible to know what really moves markets, but this article deftly calls into question the rationale given by people pursuing a dollar-debasement trade and offers reasons to believe that, contrary to popular belief, dollar strength may be in the offing in the near future.  Some of the key points are:

1) The bulk of QE2’s effects have already been priced into the market.  This isn’t difficult to swallow given that commodities and emerging markets have been on a tear since intentions for QE2 were first announced at the end of August, and the dollar has been weakening steadily ever since.  It’s hard to believe that such moves haven't already discounted most, if not all, of QE2’s effects, in which case the immediate post-QE2 rally may have been a blow-off top, the culmination of a “buy the rumor, sell the news” dynamic.

2) The US economy may actually strengthen, which will be positive for the US dollar.  Any future strengthening of the US economy – and especially any real improvement in employment – should cause the dollar to strengthen, which would be a drag on commodities (which are priced in dollars) and attract foreign capital into our markets, presumably eroding the premium that foreign markets currently enjoy.

3) Any increase in the use of capital controls by foreign governments will be positive for the US dollar and negative for emerging markets/commodities.  This is something we’ve already seen.  On Friday, Chinese equities experienced a 5% drop caused by a rumor that the Chinese government is going to have to raise interest rates over the weekend in order to stem the flow of hot money from the US and to dampen its troubling inflation rate.  There’s almost no doubt that other countries will soon have to follow suit, tightening their money supply just as the US is loosening theirs.  Further use of capital controls by emerging economies was even officially sanctioned during the recent G20 meeting - a not-so-tacit acknowledgment that more capital controls are probably on the way.

Although not mentioned in the FT article, I would add one more reason to be skeptical of the weak-dollar trade post-QE2: the evidence we already have from Japan’s attempts to use the same approach.  As this excellent post and this follow-up post detail, Japan’s attempts at quantitative easing earlier in this decade managed neither to weaken the yen nor to strengthen the Japanese stock market.  In fact, the opposite occurred; the yen strengthened further against the dollar, and the stock market continued its gruesome slide. 

It’s something of a truism that one should never "fight the Fed," but it's also an old Wall Street saw that savvy traders position themselves in the opposite direction from government intervention in currency markets (unless that intervention is extremely aggressive).  And, in the case of QE2, which is tantamount to government intervention designed to weaken the dollar (despite Obama’s ridiculous claims to the contrary), one may do well to fade the Fed, so to speak.  A stronger dollar may, much to many people’s surprise, be just around the corner.

QE2 Disproportionately Benefits The Rich

This is an extremely crude exercise, but it makes the point.  Here is a table showing how much money each of six hypothetical investors made today off the QE2 inspired rally in the S&P 500.  Just for argument's sake, I assumed each investor's capital was invested entirely in the SPY (a proxy for the S&P 500) and that today's gain was exactly 2% (it was actually 1.94%).  As you can see, a 2% gain for someone with a $10,000 portfolio is an awful lot less than a 2% gain for someone with a $10,000,000 portfolio.  I've also added a crude graph to show the exponential nature of these relationships.  Is it any wonder there's income inequality in America when the government is essentially giving away vast sums of money to people who are already unbelievably rich?

For a much more in-depth look at the relationship between Fed-driven asset inflation and income inequality in America, please see my previous post here.

If Ben Bernanke is worried about income inequality, then he should stop quantitative easing.

Recently there’s been a lot of attention paid to the enormous wealth/income gap in the United States and to the disappearance of the middle class. In fact, the success of Republican/Tea Party members in this week’s elections was probably fueled at least in part by working (or unemployed) people’s sense that they are being left behind, while Wall Street “fat cats” are enjoying government bailouts and lavish pay packages. This political backlash is likely to manifest itself in many ways, one of which is increased scrutiny of the Federal Reserve and its behavior. Many newly elected representatives have been pushing to audit the Fed- or worse, abolish it- for a while, and they will undoubtedly take up those battles with gusto once they are sworn in. The question is, are they just peddling populist outrage?  Or, is there a legitimate reason to blame the Fed for income inequality and other distortions in the US economy?

Before digging into that question, some background is in order. First of all, here’s a brief primer on the problem of income inequality in the US. 

The best survey of income inequality in the US is on Slate’s web site. Timothy Noah’s series on the issue covers all (or almost all) the important bases and provides some background on the essential points, which are:

1) Income inequality in the U.S. has increased dramatically since 1979.  In 1979, 8.9% of total income went to the top 1% of earners, while in 2007 the top 1% took home 23.5% of the total.  Meanwhile, real wages for the average worker have essentially remained flat in the neighborhood of $20/hour since 1964 with minor fluctuations along the way.

Source: Institute for Policy Studies, Executive Excess 2009, p. 2.

Source: Bureau of Labor Statistics, Current Employment Statistics, Average Hourly Earnings in 1982 Dollars. Converted to 2008 dollars with CPI-U.

2) Income inequality is usually explained mostly by differences in educational attainment, with the gulf between income for earners with advanced degrees and earners with only high school diplomas widening recently to unprecedented levels.

Source: Bureau of Labor Statistics

3) Income inequality is not generally believed to be the result of an upper class of “landed gentry” who simply live off their wealth while the rest of us toil.  Instead, the new rich derive most of their wealth from income they receive from work.  But, as we will see (and Noah doesn’t mention), it’s the specific nature of their compensation that reveals one of the key reasons the top 1% brings home so much more than the rest of us.

Another critical point about income inequality is that it is persistent and tends to be passed on from one generation to the next.  This runs directly counter to the idea that America is an ever-changing land of opportunity where rags-to-riches stories can come true.  In fact, as this article from the Economist points out, an individual’s prospects for social mobility in America are worse than they are in Europe, which is ironic, since -in the mind of the average American- Europe is a bastion of calcified Old World social structures that limit upward mobility.  This lack of mobility in the USA is presumably due to the fact that rich families tend to pass on educational and other advantages to their children, which they then use to land high-paying jobs, hence perpetuating the cycle.

So, what does all of this have to do with the Federal Reserve? Well, before I get to the ways in which the Federal Reserve supports and perpetuates this situation, I should point out that Ben Bernanke is well aware of it and has a sophisticated understanding of the issues, as this speech from 2007 demonstrates.   Bernanke clearly is concerned about income inequality, but what's interesting here is what he believes to be its causes.  Bernanke enumerates all the usual suspects- both for why skilled workers at the top make such outsized gains and for why people in the middle and below can’t seem to get ahead.  Differences in educational attainment along with the effects of technology and the “superstar effect” are all given as explanations for gains at the top, while the leveling effects of globalization, immigration, etc. are considered as reasons why the middle and below aren’t getting anywhere.

The one explanation conspicuously absent, however, is the increasing financialization of our economy and the enormous rise in asset values we have experienced since 1982, for which the Fed can take a lot of credit (no pun intended).  This, combined with the increasingly common use of stocks, stock options, and other asset-based forms of executive compensation is, in my opinion, the real source of income inequality.  And, since the Fed is largely responsible for fueling the asset inflation of the past 30 years by implementing ultra-low (and in some cases negative real) interest rates, quantitative easing, and other inflationary policies, it also bears a lot of responsibility for income inequality. Unfortunately, none of this is mentioned in Bernanke’s speech.

What exactly is the connection between asset inflation and income inequality?  It is, essentially, this: the richer you are, the more your compensation and net worth depends on the value of paper and other assets. For example, a quick look at any disclosure of CEO or top executive pay usually reveals that most of their income comes from stock option grants, deferred compensation tied to stocks, or some other form of asset-based compensation.  The CEO’s actual “salary” is usually only a small percentage of his or her overall compensation.  Remember, for example, that Warren Buffet’s salary is only $100,000 per year.  This chart from the AFL-CIO’s web site reveals that most CEO’s salary is only 1/9^th their total compensation, while well over half their total pay comes directly from the sale of stocks and/or options. 

This fact explains how a CEO can make $10 million dollars annually even though his “salary” is only $1 million per year. It also implies that without constant asset inflation, the kind of out-sized gains we've seen for top earners would not be possible, since the majority of those gains come from the sale of paper assets.

Another connection between asset inflation and income inequality is the fact that over half of all stock market assets owned in America are held by the top 1% of earners, as the following chart shows.

Source: Author’s analysis of Arthur B. Kennickell, “Ponds and Streams: Wealth and Income in the U.S., 1989 to 2007,” Federal Reserve Board Working Paper, January 7, 2009, Figure A3a, p. 63. Does not include assets held in money market mutual funds or tax-deferred retirement accounts.

This contributes even more to the ultra-rich's sensitivity to asset prices.  Regular working people whose individual paper asset wealth may range from $10,000 to a few hundred thousand dollars aren't affected nearly as much by asset price swings as are the ultra-rich, who typically own millions (or billions) of dollars worth of stock.  Because of this, it’s no wonder that the rich will do anything to keep the asset-inflation party going, even if it means printing money or incurring federal debts that will ultimately be impossible to pay back.  After all, for the average person who lives mostly off his or her salary, a 50% decrease in the stock market hurts but it may only represent a loss of wealth equivalent to one year's salary. For an ultra rich person, however, a 50% drop in the stock market means the loss of many lifetime's worth of earnings from a typical salary- money that could never be earned back unless asset prices re-inflate.

Against this backdrop, one can see why the stock market meltdown of 2008 was so frightening to elites.  For a brief moment- before massive government and Federal Reserve intervention propped up asset prices- the ultra rich had no way of paying themselves and saw their net worth reduced by more than anyone would be able to make in many lifetimes of working for a salary or wage.  Any stocks, options, or other asset-based compensation they owned or were promised weren’t worth enough to convert into the kind of income they had become accustomed to.   Since then, of course, government bailouts have re-inflated asset markets (if not the real economy), and the game continues.

It’s interesting to note that during times of asset deflation, some curious things have happened to compensation for the average worker, who lives almost entirely off of wages and not from assets.  For example, in the following breakdown of average real wages from 1982 to the present one can see that during the market meltdown of 2008 the real wages of the average worker actually increased.  

Source: TheChartStore.com

This momentary increase was quickly obliterated, however, as the market bottomed in the beginning of 2009, and ever since then we’ve been back in a Fed- and debt-fueled rise in asset prices that has made the top 1% very rich and driven the average worker’s real wage back down to right where it was in 1964.

So, what’s the lesson here?  Essentially, the Fed and the Federal Government, by bailing out banks, printing and borrowing money, and supporting asset prices no matter what the cost, is perpetuating the income gap they claim to be trying to eliminate.  Avoiding the specter of deflation at all costs is the justification of all expansionary monetary policy, even though deflation (and especially asset deflation) may, in fact, be the only thing that corrects the imbalances in our economy and restores the average worker’s purchasing power and some sanity to our system.

When Bernanke announces today that he will print even more money to “save us from deflation,” he should know that he’s only perpetuating gross income inequality in America and, by extension, a system that all too many of us have realized is rotten.  It will be no surprise if he is taken to task for it in the near future by our newly elected representatives.

For more on the potentially tonic effects of deflation, see this thought provoking essay.