Asset prices are a function of two things: 1) the size of future cash flows attached to an asset; 2) the discount factor attached to these cash flows. This is a useful tautology to bear in mind when looking at the way in which changes in economic developments have affected asset prices.

 

Global economic growth has been strong. It has, if anything, been stronger in the period since 2000 than in the two decades preceding it. However, economic growth of the advanced economies – a category that includes the United States, the eurozone, Japan and the United Kingdom – has weakened over the same period. And this is despite – some would say because of – rising levels of debt as well as lower monetary policy rates that might serve to reduce future growth for present growth.

 

What we have witnessed is a change in the composition of global growth, which looks like a trend decline only from the perspective of the introspective developed market observer.  The past thirty-five years was an extraordinary time in the global economy during which we saw the fall of the Berlin Wall, barriers in the global trading system torn down, and the associated rise of China.

 

Real income gains amongst the world’s poor have been startling: more people have moved out of poverty more quickly than at any time in human history. But while the world economy has grown markedly, the gains of globalisation have not been shared with uniformity. Four features are striking: firstly the biggest winners have been the ‘global middle’ which is largely accounted for by China’s meteoric rise; secondly, the very top of the income spectrum has done almost as well as the global middle; thirdly, there is a hard core of poverty that has not been touched by globalisation at the very bottom of the income spectrum; fourthly, and most interestingly, there is a large section of people who are well-off in global terms who have largely not participated in global growth over the past twenty years. That section is populated largely by the Western lower middle and working classes.

 

Why have Western lower middle and working classes been left behind? I would suggest that it is part of the global labour market arbitrage/convergence trade that has fuelled income developments at the top and the middle of the income distribution. Marxist-Leninists would call this section of the global population the ‘Labour Aristocracy’: these are people who probably don’t feel well-off in their home countries.

 

There has been a convergence trade - a rolling avalanche of labour supply over the 20 years to 2008 – and the extraordinary move out of poverty on the part of developing country populations, with the modal real income per household increasing from just under $400 per annum to just under $700 per annum. Under globalisation, location becomes less relevant to household income, while skills and endowments become more important. When is this convergence trade over? If we need to wait until people’s incomes are associated with their skills we probably have a long way to go.

 

In the Nineteenth Century dying of hunger was not the preserve of those in the less developed world. You could do it anywhere. Karl Marx’s Das Capital, the first volume of which was first published in 1867, resonated with people in a way that it doesn’t today. This was because class/endowment largely determined your place in the global income hierarchy; location was less important.

 

Things have changed, and radically so. The main determinant of your income at the beginning of the twenty first century is the country in which you were born. The huge ‘citizen’s premium’, enjoyed by citizens of rich countries, has been more recently challenged by globalisation, particularly since the fall of the Iron Curtain and advent of China to the global trading system. Understanding the importance of this challenge is central to understanding asset price and debt stock developments over the past thirty-five years and taking a view as to where we are on the journey to globalisation is crucial if we are to peer into the future. How might the future world look if this were to continue? Let’s compare the World in 2000 to the US in 2012. The US is typically thought of as a very unequal place – and it’s true that the Gini and Theil coefficients of inequality are higher in the US than almost anywhere else in the developed world. But compared to the world at large, the US has very low levels of inequality.

 

Within the US there are rich states and poor states. But in disaggregating the Theil coefficient of inequality we can see that location plays a very small role in your likely level of US household income. Things like inheritance (broadly defined), and the skills you acquire are much more important. If globalisation is to succeed, the world should look a lot more like the United States – and the mission to make it so is an amazing one.

 

The future could look, politics permitting, a lot like America, but we are a long way from getting there. A couple of quick examples: the poorest Danes are better off than the richest sub-Saharan Africans; most of India’s higher earners earn less than the minimum wage in the United States. This becomes tested in a globalised world.

The globalisation story to date has had two huge implications for asset markets. The first is in relation to how firms have responded to these changes. This is well known, informing pretty much every stock analyst report written in the past thirty years, so will not be covered here. The second is about the impact on the real rate of interest. This is less well understood, but much more important for asset allocators.

 

As central bankers have frequently reminded us, the neutral real interest rate is set by the economy, not by the central bank. The globalisation of the economy and labour market convergence trade has been associated with a collapse in labour power in the West. When labour had power, the marginal costs of labour were high. As such there was a big incentive to invest in capital to substitute labour for capital, and this brought the cost of capital higher. As labour lost power, wage pressures in the West collapsed. This led to a falling labour share of GDP, and this has been especially the case away from the top 20% of Western households. With lower labour costs, a reserve army of global workers whose size grew as trade barriers dropped and emerging countries developed, companies have increasingly been incentivised to substitute capital for labour, reducing the requirement for capital, and bringing the cost of capital lower in the West.

 

In a globalised world the vestiges of geography are being challenged, leaving developed countries with a quandary: should they drop the safety nets that they have spent decades constructing to ensure domestic harmony and allow wages to collapse at the bottom of their own income distributions, or should they invest more in education to equip their populations to be the middle and upper management of the globalised world? It could be argued that the cosmopolitanism of globalisation attacks the State’s communitarian raison d’être, and that the increase in government debt and political heat around economic immigration is the result. As income inequality in the West has increased so the role of the State has changed: in 1980 a median quintile US household would be paying twice the amount of federal taxes as they received in transfers, but by 2010 this ratio had reversed.

 

With the lower middle class and working class in the West comparatively left behind, income inequality in the West has risen. This has in turn informed the politics of protest, and fuelled interest in works such as Thomas Piketty’s Capital in the Twenty First Century – a work that takes an introspective Western perspective in which inequality is increasing rather than a global perspective in which inequality has begun to fall. It furthermore mistakes recent returns to assetholders as proof of structurally high discount rates rather, as we will now see, as a function of falling discount rates.

 

If discount rates will be rising rather than falling in coming years, what does this mean for stocks and bonds?

 

If earnings are strong, the cash flows that are important to asset class pricing will be supportive, although the discount rate tailwinds will turn to headwinds. In an environment in which there are rising (Wicksellian) interest rates, and the starting points for yields is low, it is conceivable that cash will dominate as the efficient frontier becomes less curvaceous: returns to duration may be negative and at such low yields they stop providing portfolio insurance.

 

This was the case in the post-war period leading up to 1980 – a time during which labour power was rising in the West. It is for this reason that we have espoused duration as a strategic position and rotated across asset classes as the valuation case for each asset class has varied.