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Two-Tier Economies, Two-Tier Markets

FYI | Dec 15 2011

GaveKal offered the following observations this week:

Two-Tier Economies, Two-Tier Markets

It has become conventional wisdom that the 2000s were marked by massive misallocations of capital led by a generalized credit bubble in America and in Europe. This in turn explains why our malfunctioning governments (excuse the redundancy) are now going bust, as they initially tried to absorb the shock once this bubble burst. But the past decade’s large-scale globalization also forced the private corporate sector to spearhead an opposite, more virtuous trend of an efficient re-allocation of its capital. This Ricardian process led to record profitability and net wealth creation of historic proportion. Importantly, these benefits do not seem to have been significantly affected by the economic consequences of the financial crisis.

This double-reality of government misery on one side and corporate prosperity on the other has been one of the most striking features of the advanced economies since the Great Financial Crisis. But does resilient corporate prosperity signal that the effects of private and public deleveraging might prove to be weaker than generally feared, and how can we measure this? And what are the consequences of this two-tier economy for financial markets?

Our initial findings imply a less gloomy (although very uneven) assessment of the economic situation in parts of the western world than what is currently the consensus. We also show how the two-tier economy has provided additional support and acceleration to a longer-standing trend towards a two-tier equity market, in which the Ricardian and Shumpeterian sectors outperform those that are more dependent on governments and finance.

1—The German Precedent

Since the ongoing deleveraging process is necessary and unavoidable in the jobs- heavy sectors of government, construction and financials, it is crucial that the non-deleveraging sectors can provide substantial compensation to the advanced economies. This is as important for Greece as it is for America.

Of course the two parts of the economy are inter-related. Lower government spending induces production cuts in private-sector industrial and service companies; the downsizing of the financial sector might threaten the funding of the economy; and the construction bust creates broader shock waves. Still, the examples of Sweden in the early 1990’s and Germany from 1995 to 2005 suggest that even broad deleveraging processes can be associated with significant gains and improvement in the most productive parts of the economy— which is precisely what a successful deleveraging aims to produce.

The chart below shows how Germany’s unification boom of 1990-1995 produced a huge increase of jobs in the most debt-prone sectors of the economy (public services, construction and finance), while the rest of the economy actually lost more than 2mn jobs, as most East-German companies had to close their doors. Very remarkably, the deleveraging years of 1995-2005 produced exactly the opposite result, with almost 1mn jobs lost in the deleveraging sectors, while the rest of the economy created 1.5mn additional jobs. This painful but successful process was, in time, considerably supported by the large rise of corporate profitability that the enlargement of the European Union to the East produced (see The End of German Deflation). The completion of this successful deleveraging eventually gave rise to a synchronized upswing, starting in 2006—which is still ongoing despite the immense level of uncertainty in Europe.

2—Measuring a Two-Tier Economy

Are some western economies already following the German path, and is there a chance that the process might not have to take a full decade? In an attempt to quantify the two-tier economy produced by the deleveraging process at work in many western economies, we compare total GDP with an adjusted GDP that excludes contributions from construction and government. We also create a ? “two-tiered” employment tracker by comparing the total figure to employment excluding the deleveraging sectors of government, finance and construction.

Applying these measures to the economies that hit the wall the hardest in 2007- 2008, and where the deleveraging process is thus supposed to be already well- advanced, we find evidence of the two-tier phenomenon in some OECD economies—but unfortunately not all.

America presents by far the most compelling evidence of a bullish deleveraging process, as the charts on the following page illustrate:

Both GDP and employment unambiguously show that the non-deleveraging parts of the US economy have been remarkably buoyant since the end of 2009, and that the slowdown of 2011 can be in large part attributed to lower government spending (see USA: A Two-Speed Economy).

In Europe, there are increasing indications that the deleveraging sectors and the non-deleveraging sectors might start to decouple. It must be said, however, that the developments have thus far been less convincing than in the US, and very uneven from one country to another.

Although not yet as compelling as the US, the most promising developments can be found in Ireland and in Spain, the two European countries that fell the first and the hardest in 2008. Both of these countries are still deflating from construction booms of historic proportions—but excluding construction and government spending, GDP growth has risen back to pre-crisis levels—+3% for Spain since end-2010, and +5% for Ireland:

However, employment data does not yet point towards a two-tier job market, either in Spain or in Ireland (see chart above for Spain). For now, the private sector remains eager to build on higher productivity and profit margins, as the level of uncertainty remains far too high in Europe for contemplating new hiring. Whether this environment begins to improve next year will obviously be
key for the sustainability of economic recovery in these two countries.

The situation is however much worse in two countries that are considered to be in aggressive deleveraging mode—Greece and the UK. In these two economies, no decoupling can be observed, even on GDP data. This is especially disappointing in the case of the UK, since the country should already be benefitting from its huge devaluation of 2008, and from strong corporate profitability. Is it possible that in the UK (as in Greece), the entire economy was pulled into a dependency relationship with government spending and the financial sector during the Blair & Brown era, and that thus the spillover effects of deleveraging on the rest of the economy are larger? Or is it simply that the UK, for all its talk, has not yet really begun its deleveraging?

In the rest of Europe (excluding Germany, Sweden or Switzerland, where deleveraging is less of an issue), the deleveraging process is too recent to judge. But it will be interesting to monitor how things develop in Italy and France from next year (see charts in the Appendix section), as these two countries begin to cut government spending. 

3—Investment implications: A Two-Tier Market

Just as the deleveraging process is (unevenly) giving rise to a two-tier economy, the watershed of 2008/2009 has considerably accelerated a long-standing trend at work since the fall of the Berlin Wall: the two-tier equity market. Very logically, the acceleration of globalization has over the last three decades led to a sustained outperformance of the Ricardian and Shumpeterian sectors (which we call the ? “free sectors”) over those sectors such finance, construction, utilities and telecoms (the network industries) which are either directly run by governments, or heavily regulated by them. As the gap between the balance sheet of governments and that of non-financial corporations began to widen considerably from 2009, the outperformance of the free sectors over the government-related sectors has been pretty astonishing, as the two following charts illustrate:

Of course, in a world of public-sector misery and private-sector prosperity, the biggest risk is that governments, casting about desperately for new sources of revenue, will kill off corporate profitability through punitive tax increases. This would not only hurt financial markets, but endanger hopes of recovery, since it is in large part thanks to solid corporate profits in the most productive sectors of the economy that a deleveraging process can eventually prove successful. As long as these populist attempts, exemplified by a number of recent measures in France (see Will Government Misery Kill Corporate Profitability?), remain relatively modest and mainly affect the equity sectors that are the closest to government activities (finance, utilities, telecoms, etc.), the damage for equity markets is manageable. Investors just need to continue to avoid the government– related equity sectors, and continue to invest in the Ricardian and Schumpeterian sectors of the economy (see also page 44 of The Euro: Staring into the Abyss).

But if the anti-profit and anti-globalization movements strengthen on the back of the rising influence of political extremists, taking the form of broader protectionism, political deadlocks freezing economic policies and ever-higher taxation, and if regional dislocation risks rise further in Europe, risks for investors would become far less manageable. In short, there would be nowhere to hide. Through politics, the deleveraging process would then threaten even the Ricardian and Schumpeterian equity bull markets. This is the bear case.


In the end, our argument is very simple. Although extraordinarily challenging, periods of deleveraging do not necessarily lead to economic decline and equity bear markets a la Japan (see A Crucial Test for the World Economy). The record high level of corporate profitability, along with supportive monetary policies, argues for generally improving economic performance. America, in particular, might have already entered into a bullish deleveraging process. For obvious reasons, we need more time to characterize what is happening in Europe, but even there, some green shoots have emerged (Ireland, and possibly Spain).

As long as we get increasing evidence that the deleveraging process is less and less impairing the growth of the ? “free” sectors of the economy and leading to moderate economic growth, the outlook for equity markets should improve. It would at least appear that that there is good value in the free sectors (which make up some half of market cap in Europe), particularly after the sharp sell-offs seen
since last May.

The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.

GaveKal is a financial services firm that offers institutional investors and high net worth individuals fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.

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