The Altus Insight March, 2016

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: March 31, 2016
FR: Forrest Jinks
RE: Divergence, Politics in economics, and Unwinding the Wealth (trickle down) Effect

Divergence: In December’s Altus Insight (to revisit click here) we discussed the polarization not just in politics but possibly more concerning in the voting populace. Evidence of this on edges of the right and left is obvious with the way the election cycle has been going. Disenfranchised citizens are looking for an opportunity to make their voice heard and moving towards an extreme is a way for that to happen. This is understandable. But my concern around this topic wasn’t the fringes, it was the fracturing of the middle. Experiences this month hammered the point home further.

Even though we are based in a pretty liberal area, I am often in groups of people that lean decidedly red. These are almost always businesses owners struggling to maintain or grow their businesses from a standing of upper middle or lower upper class. This past month I was in an all-day meeting in San Francisco with several business owners/CEOs that ran businesses larger than the business owners I am typically around. Prior to the meeting I didn’t know any of them but they all knew each other well. As it turned out the entire group was decidedly blue leaning. Business owners and executives, whether red or blue, would historically be expected to be more measured in their opinions than most of the voting public since making non emotional decisions is a key to running a business. That forebearance could be assumed to create moderate, measured viewpoints. This was not at all my experience. Both the reds and the blues act/speak as if they are perfectly moderate and sitting directly on the center line. However, the opinions they hold as dear about their platform are considered as extreme and not negotiable by the other “moderates”, and vice versa. There was a conversation that the Affordable Care Act wasn’t working because of the Republicans, even though Democrats controlled the House, Senate, and Presidency at the time of its passing. Conversely, Republicans point to Democrats efforts to block George H.W. Bush’s Supreme Court nomination as justification for blocking the current administration’s nomination forgetting that they overrode the attempt and seated a judge anyway. Guns? Right to bear arms is a core part of Republican’s protection of Constitutional rights but is considered extreme by most Democrats. Conversely, most Republicans went all in on the Patriot Act which Democrats opposed as imposing on our Constitutional right to privacy. That the parties pull different directions is not unusual, it is that the people who used to be in the middle able to have grown up conversations now consider those with whom they used to converse as extreme. Without the middle the pendulum will continue to swing to more and more extremes. Hillary/Bernie on one side, Trump/Cruz on the other.

There is little to add to the December’s article from an investment standpoint as pertains to this fracturing of the political middle other than to reiterate its seriousness of the condition. There are always winners and losers in investing but many of us, myself certainly included, usually associate those wins and losses with the fundamentals of the investment itself. Winning and losing outcomes will become more and more dependent on the tides of political world. If Donald Trump were to win the election wall building companies would have huge opportunity. Importers of consumer items from Asia or Mexico would be facing the opposite.

Politics in Economics: After labor groups obtained enough signatures to put a minimum wage increase to $15/hour on California’s November ballot, Democratic State leaders sat down with union leaders this past weekend and hammered out an similarly structured increase that can instead by passed by the Legislature and signed by the Governor, avoiding the messiness of the increase going before the general population for vote. A statewide $15/hour minimum wage is terrible idea. No, I am not making an argument against minimum wage. What is ludicrous about this proposal is that we are about to apply a one size fits all solution to an economy that would stand alone as the 8th largest economy in the world covering enough area to be the 60th largest country in the world, roughly the same size as Sweden, but with four times as many occupants.

My wife and I own a piece of property out in the country a couple hours north of Sacramento. The closest town has roughly 8,000 people and is not unlike dozens (or hundreds) of similar size or smaller towns spread across the state. The town is clean, people are friendly, and there is complete lack of anything that could be considered a ghetto. Roughly 25 Mil people live in the San Diego, LA and Bay Areas. Several million more are spread throughout coastal towns and cities like Santa Barbara, San Luis Obispo and Santa Rosa. These are expensive places to live. Most of the rest of the state is decidedly not. Over ½ the working population in this town makes less than $15/hour. A travesty right? Decidedly not! You see, it is affordable to live in this town. A married couple making the current minimum wage can qualify for a house that costs 50% more than the median house price in the town. And remember, median means just as many homes sold priced below the median as above. Even a single person making minimum wage can qualify to buy a home. The cost of living in San Francisco is 150% higher than that of the town near our country property. 150%! Does this town (and all the others like it) need a 50% minimum wage increase? Has anyone considered the impact this increase will have on the 10 Mil people spread through the cheaper parts of California? Nearly all the businesses in this town are locally owned. Again, over 50% of the town’s population makes less than $15/hour.

This is going to blow up local economies and destroy one of the few advantages that towns like this have in competing in the largest economy. Cost of living, the very thing the prophets of higher minimum wage are complaining about, is going to skyrocket. Are you invested in companies that may be affected? How about real estate?  A large contingent of the people that will obtain the wage increase are renters and, at least until the cost increases flow through system/economy, those renters will have more to spend on housing. Without an economic shock rents move up more easily than the come down, possibly setting a new and higher bar for residential rents moving forward.

Wealth (trickle down) Effect – After years of lambasting the trickledown economic theory of the 1980s, the intelligentsia embraced the Federal Reserve’s attempt at creating a Wealth Effect coming out of the 2008 recession. Whether or not the hypocrisy of such embrace was ever realized, even when Reserve governors used specific trickle down language, is not known. At closer observation, the apparent hypocrisy is likely not so as the 1980s trickledown economics and the 2010s wealth effect theory were similar only in the broad strokes of simplification. In reality there is a different effect on the economy based on whether it (the trickledown or wealth effect) is due from asset price appreciation versus cost of business cost reduction (earned income tax rate reduction). January’s article (here) discussed that the tightening by the Fed would/should lead to the unwinding of the wealth effect/trickle down economics pursued by the Fed over the last several years. What if the wealth effect, at least as defined/pursued by the Fed, didn’t really happen? There is ample evidence to believe that it did not and plenty of reasons why, especially when compared to the country’s previous wealth effect/trickle down economic time period. I believe the following bullet points can bring clarity to the discussion:

  1. When the tax rate is lowered on business income more cash is produced. The holder of that cash, who is also the owner of that business, has incentive to invest more money into the business so it will produce more cash at the lower tax rates (the goose that lays the golden eggs). That reinvestment is into PP&E or labor, both of which have a positive impact on the economy through the multiplier effect.
  2. Business owners are different than financial engineers. In general they are much more likely to invest into things that will grow their company (or other companies) as opposed to purchase financial instruments.
  3. There are roughly twice as many companies in the USA that aren’t Corporations as there are Corporations. The income from those companies flows to the owners (investors) in those companies. Business income is taxed at the same rate as earned income while capital gains are taxed far lower and according to more than 50% of passed through business income is taxed at the top individual tax rate (over 50% in California). Lowering the business income tax rate relative to capital gains tax rate increases the incentive for investment into income producing companies, generally the same companies that need PP&E and labor.
  4. Conversely, asset price increases don’t have the same impact on the economy:

i.People generally don’t sell winners. Thus raising asset prices may make a person feel richer and lead to an uptick in consumer spending but doesn’t create cash that can be invested into the real economy.

ii.Tax structure incentivizes investors NOT to sell their winners, further locking up that increase in value from being turned into cash to be invested into the real economy.

iii.As mentioned above, because of the differences in tax rates between capital gains and business income investors are incentivized to invest more in capital appreciation than income production, which is exacerbated when capital appreciation is rampant. Other than the notable exception of investing in start up or early stage companies, investments made for capital appreciation do not have a direct real economy investment impact.

iv.Investments into financial assets do not benefit the operations of the companies of which the financial assets are being traded. It doesn’t matter if I sell you 1000 shares of Apple at $1 or $1000, Apple sees no increase or decrease in cash available for investment back into the real economy.

v.Intuitively people understand that actions taken to encourage the wealth effect through asset appreciation are out of the ordinary in an open economy. It then follows that additional change will be coming in the future as those actions are reversed, but since the original action is out of the ordinary the resulting corrective action will also be unordinary hence creating uncertainty. In uncertainty people migrate to greater liquidity in their investments. Financial assets are far more liquid than real assets. A reduction on investment in the real economy hurts the real economy.

vi.Note: One notable exception to the claim that financial asset investments don’t hold a benefit for the company itself is when the company itself makes the direct investment. This has been prevalent over the past 6 – 7 years as companies executed massive stock buy backs. Unfortunately this eventually cannibalizes the very companies making the investment (and the economy). Roughly half of the per share income growth since the recession was due to stock buybacks. Stock buys backs can’t continue forever. Either a point is reached where there are no more stocks to repurchase or there is no more money to buy the stocks (which in part could be due to increasing stock prices from the increasing EPS). When this happens income growth falls. We are already seeing this with Q3 and Q4 2015 corporate income falling back to 2011 levels. This is not supposed to happen during an economic expansion but points to two things; One, companies are feeling the effect of not investing in the growth of the company, and two, incomes were overinflated by the accommodative money policy.

What this means to us as investors largely depends on each of our investment focuses and personal investment rules. If there was no true wealth effect on the economy maybe it means unwinding the accommodative monetary policy in place to encourage the wealth effect won’t be as negative on the economy as might be thought. But because this is all new practice of monetary theory no one really knows what the outcome might be. Uncertainty is often scarier than risk because risk can be quantified as a probability. This is an uncertain situation. Looking at it from another viewpoint, uncertainty, while possibly stressful and potentially damaging to our portfolios, can result in opportunities of a life time. This happened in the time period coming out of the recession. It will happen again, we just don’t know where (yet).


Happy investing.


Forrest Jinks

Altus Equity Group, LP

off: 707/932-5887

fax: 707/544-2972