Macro Minute: Inequality and Economic Growth

On a macroeconomic level, inequality can affect economic growth, productivity, and political stability, which in turn has direct implications for corporate profitability.

As with most social science endeavors, there is a healthy debate about the precise impact of inequality on growth. For starters, does it hinder or accelerate economic growth? Economic theory shows that with higher income and wealth come higher savings rates and, therefore, a higher level of investment and gross domestic product. In this case, if marginal productivity is higher for capital than for labor, one can see that more inequality would create higher economic growth. Also, in economies with underdeveloped credit markets, significant investments can only be made if wealth is accumulated. In the presence of imperfect capital markets and indivisibility of investments, an economy with higher levels of inequality may be able to introduce new industries, technologies, and markets and ultimately grow faster than the same economy with lower levels of inequality. Finally, there is an argument that reducing inequality reduces incentives to accumulate wealth through labor, entrepreneurship, and innovation, having, therefore, a negative impact on long-term growth.

However, a healthy debate should not be confused with a balanced debate. The bulk of the literature supports the theory that inequality hurts economic growth. Studies that found a positive relationship between inequality and growth were focused on the short term, and studies that found a negative relationship were focused on the long term. In other words, inequality can produce a small contribution to growth in the short term but will substantially adversely affect growth in the long term. Empirical results have increasingly supported the arguments for impaired economic growth and a negative impact on productivity in the face of rising inequality.

Poor people without access to credit markets often defer health care treatments, cannot procure housing or transportation and lack the means to further their education. This results in missed opportunities and diminished productivity and growth potential. The same applies to poor parents with multiple children compared to wealthy parents with few children. The inability of low-income families to invest in their children’s education, and the inability of poor workers to invest in developing job skills because of either financial constraints or time constraints while working multiple jobs, can result in a reduction in overall skills and knowledge of the potential employee pool. That can have a drag on growth, productivity, and business performance. Finally, there is the problem of the indivisibility of consumption. In the absence of developed credit markets, expensive items can only be acquired by accumulating wealth. If the economy became more equitable, part of the population initially excluded from the acquisition of these goods would enter the market, encouraging the creation of new domestic industries.

Societies with higher levels of inequality also tend to have higher levels of crime, keeping a larger share of the labor force from productive activities and decreasing potential growth. Also, with the increase in social instability, trust and social cohesion can erode, leading to conflict, political crises, and the resulting retraction of investments. One of the potential consequences is the rise of nationalism and the splintering of support for globalization. This scenario has played out in economies around the world over generations. Ray Dalio, the founder of Bridgewater Associates, the world’s largest hedge fund, has warned of the corrosive effects of inequality on faith in capitalism and, therefore, the stability of the institutions and markets in which business operates.*

*This excerpt appeared in the article “Business Risks Stemming from Socio-Economic Inequality” by Todd Cort, Stephen Park, and Decio Nascimento at the Columbia Law School Blue Sky Blog published on April 15, 2022. The article is based on the paper “Disclosure of Corporate Risk from Socio-Economic Inequality” by the same authors published on March 18, 2022. You can find the article here, and the paper here.

Macro Minute: The Reflexivity of Inflation and Conflict

In The Changing World Order, Dalio makes the point that history shows us that empires follow a predictable cycle of rising and decline that he termed Big Cycle. The cycle starts at “The Rise” phase when there is strong leadership, education, character, civility, and work ethic development. Innovation is also enhanced by being open to the best thinking in the world. This combination increases productivity, competitiveness, and income. At “The Top”, the country moves from “growing the pie” to “splitting the pie”. While the country enjoys higher standards of living, people get used to doing well and enjoy more leisure time in detriment of hard work. Financial gains come unevenly, and the elites influence the political system to their advantage creating wealth, value, and political gaps. Borrowing grows to make up for the loss in productivity, weakening its financial health. “The Decline” happens when debt is large and there is an economic downturn leaving the country two choices: default or printing new money. Typically, countries opt for new money. The faster the printing occurs, the faster the deflationary gaps close and worrying about inflation begins.

It is clear that major wars are greatly inflationary, and even minor conflicts can interrupt trade, causing disruptions and increasing prices. But what we’re finding out is, inflation actually precedes periods of war or economic warfare.

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It should come as no surprise then that the global increase in general prices along with a strong price increase of commodities is leading the world to a new era of conflict. Ukraine and Russia are not just material in the global trade of wheat but now also make up close to 20% of the world corn trade. A prolonged conflict can lead to issues this spring when planting starts causing significant productions shortfalls when harvest comes later this year, causing prices to go higher, increasing the risk of an escalation and conflict. This self-reinforcing process we see between inflation and conflict has a name, reflexivity. [1]

[1]The theory of reflexivity in financial markets was proposed by George Soros. Considered by most as one of the best macro investors in history, delivering an average annualized net return of 33% from 1970 to 2020. His work around the theory of reflexivity first appeared in his 1987 book “The Alchemy of Finance”. Soros’ theory of reflexivity is based around human fallibility—human beings can be wrong in their beliefs about the world and therefore act based on misguided knowledge. Heavily influenced by Karl Popper’s account of the scientific method (Popper was Soros’ tutor at the LSE), Soros argues that when the subject of study involves thinking participants, the scientific method must be changed to account for that fact. When thinking participants try to understand a situation, the independent variable is the situation. And when participants try to make an impact on the situation, the independent variable is participants’ views. Reflexivity occurs when the participant’s view of the world influences the events in the world, and these same events will influence the participants’ view of the world. When reflexivity is in play, it can cause boom/bust processes—self-reinforcement that eventually becomes self-defeating. For a detailed description of reflexivity and the construction of social reality, read “When Functions Collide” at https://www.norburypartners.com/nascimento-decio-when-functions-collide/

Macro Minute: Inequality and Monetary Policy

On February 1st, at Credit Suisse’s 2022 Latin America Investment Conference, Enio Shinohara moderated a conversation with Rogerio Xavier from SPX and Luis Stuhlberger from Fundo Verde. In it, Luis made a very interesting remark on the US interest rates curve, which loosely translates from Portuguese to “so far in the United States, the increase in interest rates being priced by the market has simply anticipated a series of hikes, but has not changed the terminal interest rate. In other words, the first probability that appeared during the pandemic was for the first hike to happen in 2023 or 2024. In the past year, these expectations were repeatedly pulled forward. It started with one hike in 2022, and now we are talking about 5 to 6 hikes of 25 bps in 2022. But the terminal interest rate has not changed; the terminal interest rate is around 1.80%. In my opinion, and I agree with Rogerio, this will not be enough.” (I highly recommend watching the entire conversation, especially if you have any interest in Brazil: English LinkPortuguese Link).

Central banks around the world have one big problem today – inflation. This issue is even more apparent in developed markets that are mostly seen as behind the curve. From traditional macroeconomic models, we know that central banks can restrict the supply of money to ease pricing pressures; however, there are a few ways that this can be achieved. The two most common approaches are hiking short-term interest rates and pressuring long-term rates higher, both with meaningful, but different, redistribution effects. Historically, hiking short-term rates has been the method of choice at the Fed. That was also communicated at the last FOMC meeting and markets are pricing for it. Nevertheless, the situation is fluid and central banks, especially the Fed, may conclude that influencing long-term rates might be a better tool for the current environment and their updated mandate that now includes improving inequality.

The traditional way of relying on short-term interest rate hikes to lower inflation has the effect of controlling prices of goods by curbing demand through a flat or inverted interest rates curve, thereby causing a recession that generates the necessary slack to keep prices from rising. This method acts through raising unemployment and having little effect on asset prices. As Luis mentioned, hikes have only been anticipated with minimal impact on long-term rates, which in turn had little effect on mortgage rates and equities. In other words, this method exacerbates inequality. This is what the market is pricing today, with forwards implying an inverted curve in the US and Europe one year from now.

We believe that once this becomes apparent, the Fed will move into a more aggressive posture regarding balance-sheet reduction and steepening of the yield curve. Central banks have tools to control term premia, and by doing so can influence mortgage rates and asset prices. By increasing mortgage rates, they can keep home prices in check and consequently OER, with the added bonus of improving affordability. By decreasing asset prices, they might be able to bring early retirees back into the labor force (due to the decreasing values of their nest eggs), slowing, but not reversing wage growth, and consequently keeping services inflation tamed. Since we are not going through a balance-sheet crisis, central banks can engineer a soft landing without killing growth by pressuring long-term rates higher. This method would potentially have a positive impact on inequality. We hold a strong view that the probability of this scenario is higher than what the market is pricing.

Macro Minute: US Labor Participation

This week, we will once again touch briefly on labor force participation and attempt to make sense of the US Employment Situation Report from Friday.


US labor force participation has been the subject of much discussion lately. Beginning in the 1960s when more women entered the workforce, it has steadily risen, moving from 59.1% to 66.9% by the year 2000. Since then, it has drifted lower and settled near 63% pre-Covid. A drop of almost 4% on the labor participation rate is equivalent to around 10 million jobs. At first glance this seems negative, but we find that most of this was due to strong levels of enrollment in post-secondary education among those aged 16 to 24. This trend began in the late 1980s, and accelerated into the 2000s, hence a deluge of social science majors and a dearth of truck drivers.

Turning to today, let’s analyze some of the most common arguments for explaining the slow recovery of the labor force participation rate.

(1) Self-employment is keeping labor participation low – One way to try to test for that, is to track the difference between the household and the establishment employment data. The household employment figure captures the self-employed, farm workers and domestic help, something the BLS payrolls survey doesn’t do. Here what we find is that household employment suffered more than payrolls during 2020, and still hasn’t recovered to pre-covid levels.

2) Women have been kept out of the labor force because of childcare – There is some indication this may be true. We saw nearly the same number of exits from the labor force for men and women in 2020 (3.9mm & 4.2mm in April ’20, respectively). Those aged 25-34 were the second most affected at the time, accounting for more than 1mm women exiting the labor force. By September 2021, there were still 550k less women aged 25-34 in the labor force than in January 2020, the largest discrepancy across all age brackets. With schools reopening, that number was cut in almost half to 283k in November.

(3) Retirement is keeping people out of the labor force – It is hard to see that clearly in the data. The age group 55 and over (55-64 & 65 and over), suffered the least in both genders and have the least amount of people out of the labor force (when compared to January 2020 levels). Today there is 100k more men 65 and over in the labor force than at the peak in January 2020.

Macro Minute: Fiscal Cliff vs. Excess Savings

Looking ahead to 2022, much has been written about the pending fiscal cliff and its impact on Real GDP Growth. As the impact of fiscal stimulus dissipates and the federal government mulls tax increases, analysts expect fiscal impulse to shift from positive to negative next year.

Figure 1: Effect of Fiscal Policy on Real GDP Growth (3Q CMA) [Source: Goldman Sachs]

In our estimation, given the levels of excess personal savings reached in the past 20 months, we believe there is enough pent-up savings to compensate for the forthcoming negative fiscal impact on GDP. Using seasonally adjusted personal income minus personal consumption expenditures as a proxy for personal savings, we find that from April 2020 through September 2021, Americans generated over $2.8 trillion in excess savings, amounting to approximately 12% of GDP. That compares with approximately 4% of fiscal drag projected for 2022.

Macro Minute: What’s going on in the US Labor Market?

With job openings, participation rate, and unemployment central to the current discourse on markets, the topic of this month’s memo is the United States labor force.  

Focusing on the four largest sectors (which add up to more than 60% of payrolls and job openings in the US economy), we can see that wage inflation is a pattern that predates the onset of covid. In other words, wage inflation is not simply a result of covid supply shocks, it is based on fundamentals in the economy, and therefore it is not transitory. 

1 – Trade, Transportation & Utilities (19% of total Payrolls, 18% of total Job Openings)  In 2018, demand for work (job openings) started to grow much faster than supply (using payrolls as a proxy). As a result, average hourly earnings growth for this sector has surged from an average of 2.25% percent in 2018 to over 4% today (and 3.35% pre-covid). 

2 – Education & Health Services (16% of total Payrolls, 18% of total Job Openings) Hereto the story is very similar, but it started even earlier. In 2014, demand for work accelerated faster than supply of workers, driving an increase in earnings from 1.5% to 3.4% today (and 2.5% pre-covid).

3 – Professional & Business Services (14% of total Payrolls, 18% of total Job Openings) In Professional & Business Services, we saw two waves. The first in 2014 and the second in 2018, causing an increase in earnings from 1.5% to 2.3% in the first wave, and from 2.3% to 4% today (and 3.3% pre-covid).

4 – Leisure & Hospitality (10% of total Payrolls, 14% of total Job Openings) Leisure & Hospitality is the only sector in the top 4 that has gone through two opposite cycles since 2014. The first was with the demand for work growing faster than supply starting in 2014, increasing earnings growth from 1% to 4% in 2017. The second cycle took place starting in 2018, with labor supply growing faster than demand, and earnings growth falling to 3.5%. Today we are back at 4% growth, last seen entering 2018. It is worth noting that today, the demand for work in this sector is at historical highs while supply is back near the levels of 2010.

Labor Supply Shock

The last point has to do with the temporary labor supply shock that happened due to covid. Comparing jobless claims numbers between states that ended extra unemployment benefits before the September 6th deadline and those that adhered to the target, we see that the states that finished earlier have a much more accelerated and consistent contraction in claims across latter weeks. With this in mind, we expect some of this labor supply shock to normalize as we get farther from the deadline. However, when we look at the pre-covid trend, we believe that this will not be enough to avoid wage inflation.

Foreign Investment-Friendly Policies Could Make Brazil The Country Of The Present

“Brazil is the country of the future and always will be” is a quote often attributed to Charles de Gaulle that I particularly dislike but find hard to dispel.

From the early 1500s to 1930s, Brazilian GDP growth was merely a function of population growth, with annual population growth rates ranging between roughly 0.5% and 2%. It was only when government efforts to industrialize the country materialized in the 1940s that growth rates detached from population growth, with a meaningful increase in productivity that would only end with the hyperinflation period of the 1980s, resulting in a period of GDP per capita contraction. The seeds planted in the early years of industrial policy still pay dividends to this day through companies like Petrobras, Vale and CSN, as well as the National Bank for Economic and Social Development.

Until the 1970s, Brazil’s industrial policy was focused on opening its borders to attract foreign investment, which set it apart from many countries in Europe and Asia. The end of the expansion coincided with the oil embargo of 1973 and pushed the country into stagflation with high levels of debt and interest rates. It was only when the military dictatorship ended and democracy returned that the focus shifted to fighting inflation and economic development. By then, international competition was fierce, with China’s working-age population surpassing all developed markets combined. In many ways, the country was too early to reap the extraordinary benefits that globalization provided to emerging markets beginning in the 1980s. The disparity in emerging markets can be seen by comparing different countries’ economic complexity indexes. From 1998 to 2019, Brazil moved from 24th in terms of economic complexity to 49th in the world, while China impressively leaped from 72nd to 29th. The result was more successful in fighting inflation than implementing an effective industrial policy.

However, all is not lost. True, GDP per capita in Brazil was over nine times higher than in China in 1990, and in 2019 was about 85% the size of China’s, with expectations of decreasing further in the coming years. But, this loss in income has also made the country more competitive. Since 2011, labor costs in Brazil have decreased, and the OECD projects those costs to be slightly lower in 2022. In China, unit labor costs have steadily increased since the Great Financial Crisis and are materially higher than in Brazil at present, with projections implying further divergence between the two countries. When compared to Mexico, although labor costs are also trending down, Brazil still has one of the most cost-competitive labor markets in emerging markets today.

Along with cheaper labor costs, Brazil is in a great place to benefit from sustainability megatrends and international net-zero emissions goals. As the world moves toward net-zero, policies such as a carbon border adjustment tax are increasingly likely. Such a tax would mean that goods produced in countries where most of the electricity is generated from carbon-based fuels will cost more for producers, leading profits-first exporters to search for alternative manufacturing bases. Countries with mostly renewable electricity should benefit from significant capital inflows. Brazil generates 83% of its electricity from renewable energy, most of which comes from hydropower. The government has stated plans going back to 2016 to expand the share of renewable alternatives in its energy mix — wind has the greatest potential in the dry season as a hedge against low rainfall limiting hydropower productivity. Specifically, the 10-year Brazil Energy Plan from 2016 called for 18.5 GW of additional wind capacity by 2026. As of March, there was 17.7 GW of wind capacity installed in Brazil, leading it to be ranked eighth in the world for total wind capacity installed. This compares to China, India and Mexico, where only 29%, 22% and 21% of electricity production are from renewable sources, respectively.

Brazil still needs to improve its economy if it wants to compete with these countries to attract capital flows effectively. In 2020, the World Bank ranked Brazil 124th out of 190 countries regarding ease of doing business, compared to 31st for China and 60th for Mexico. Brazil ranked in the bottom third when it comes to registering property and starting a new business. The country was only better than six out of 190 countries when it comes to paying taxes, and ranked 170th for dealing with construction permits. By making even minor improvements, the region could be much more appealing to international investors. One place to start could be in reducing the administrative burden and time for companies to solve issues across these metrics, as this was a recurring theme in the data.

Historically, high interest rates have curtailed investments in Brazil. With rates materially lower, greenfield projects should be easier to pencil in the nation as companies look to diversify supply chains and protect their margins. This lower interest rate environment also opens new possibilities for industrial policies. Brazil could borrow a page from the Self-Reliant India playbook. The Indian government will spend $28 billion to subsidize manufacturing in the country by allowing manufacturers that hit investment and production targets to apply for cash back worth 4%-6% on incremental sales above their turnover for up to five years. This policy encourages foreign businesses to move manufacturing to India, produce goods for export and earn an incentive. This is not unlike the path China took to build its manufacturing base — initial Chinese export success relied heavily on foreign investment in clusters where domestic operators could grow alongside foreign competitors. Companies such as Apple, Amazon and a Foxconn subsidiary have already announced production plans in India. Such a foreign investment-friendly policy stance from Brazil could be monumental for the country’s manufacturing base and allow the country to emerge as a critical piece of a diversified, green global export regime.

If the country can seize this opportunity, it would finally put to rest the idea that success is an ever-moving target and make Brazil the country of the present.

Article also submitted to Forbes

2021 Annual Report

When observing macroeconomic trends, we separate our thinking between short-term credit cycles and the impulses impacting them versus slower-moving, long-term credit cycles and the prevailing policy drivers for their behavior. A tertiary layer that has been gaining steam for the better part of the past decade and is now firmly entrenched as a key driver of economic activity, market behavior, and our investment theses is sustainability. As we look ahead into 2021, we believe that we are at, or very near, a rare inflection point involving each of the three aforementioned factors that will reshape the landscape for investors globally. In the subsequent sections, we will discuss at length our views on each of these three pillars, but a summation of the key points can be found below:

  • The coronavirus pandemic caused the sharpest contraction of United States GDP and rise in unemployment of any recession since the Second World War, which resulted in an unprecedented level of fiscal and monetary support in most developed markets.
  • A combination of vaccination rates and the effects of the policy response has created an environment where cyclicals and services could benefit from the large increase in excess household savings and the most pent-up demand since the 1920s.
  • Commodities will play an important role in all of our investment horizons. In the short-term, supply-demand mismatch and supply chain disruption could provide upward pressure on the asset class, while rising oil prices might stymie consumers ability to spend on goods and services. In the medium-term, large increases in money supply used to finance government deficit spending could cause inflationary pressure to further increase commodity prices and in the long-term, government net-zero policies might result in higher carbon costs, which could raise soft commodity prices, as well as greatly increase demand for a new set of commodities integral to developing a clean energy complex.
  • Globalization has been driven by global demographic trends and trade policies since the 1980s that are slowly reversing due primarily to the working age population in China peaking last decade.
  • Labor market integration caused lower wage inflation which led to lower inflation globally. Central banks responded by progressively lowering interest rates, driving asset prices higher and causing balance sheets to expand rapidly relative to income.
  • Economic inequality across generations as voting demographics change in developed markets could lead to a redirection of capital and will influence the rate at which balance sheet issues are resolved.
  • Recent growth in sustainable and responsible investing strategies has been parabolic but encompasses a wide range of implementations. Limiting one’s investable universe through exclusion or negative screening reduces potential Sharpe ratios, while integrating material sustainability information as part of a holistic analysis of individual companies, countries, and commodities boosts them.
  • Given current government positioning, climate change mitigation and adaptation will likely be a key driver of secular trends for the coming decade. Large investments will be required to increase end-use efficiency and electrification of transportation and buildings, generate and transmit renewable energy, develop bioenergy and other carbon-free fuels, capture and store carbon dioxide, reduce emissions, and increase land sinks. Each of these verticals can shape the future path of equity, credit, and real asset prices if net-zero goals are to be met.

To arrive at these views, we have done extensive research that involves proprietary information and third-party data. If you are interested in a full copy of the report, please contact ir@norburypartners.com.