- Income inequality has tended to rise in both developed and EM.
- Companies look across the globe to determine where they can manufacture their products at the lowest risk-adjusted cost.
- We believe that the global unit labor cost arbitrage is likely to continue for many decades.
By Marie Schofield, Chief Economist and Toby Nangle, Head of Multi Asset Allocation
Last week we discussed rising income inequality in developed markets and the degree to which bank lending to lower income households helped create a financially unstable and unsustainable dynamic that culminated in the global financial crisis. We postulated that the lack of willingness on the part of banks to recreate this unsustainable dynamic would deliver a drag to consumption growth in developed markets. This week we consider the degree to which income inequality is a global phenomenon.
Many countries in emerging markets (EM) have high and rising levels of income inequality with attendant social and political risks. On a country by country basis, we observe that income inequality has tended to rise in both developed and EM. We believe that this is associated with higher returns to education and capital that go hand in hand with the process of globalization. Data for consumption inequality and household debt-to-income ratios across income deciles outside developed markets is sparse. But it does not appear obvious that patterns in the U.S. are at all in evidence in countries like China.
Interestingly, despite levels of inequality rising within individual states, the rapid economic growth seen at the overall economy level for EM has seen global inequality — measured at the household level — first plateau and then decline at the margin over the past 30 years (at admittedly extremely high levels).
Exhibit 1: Real income growth at various percentiles of global household income distribution, 1988-2008 (in 2005 PPPs)
Source: Lakner & Milanovic, 2013; World Bank Dataset
Exhibit 1 shows how this has occurred. While the top 1% of global households have seen their real incomes increase by a cumulative 65% in real terms, households at the bottom of the top quartile (seen in the 75th to 95th percentile) have seen only very modest increases in their real incomes (and this is associated with rising inequality in many developed markets). Moving leftwards across the chart, we encounter EM (in the middle percentiles of the distribution). Here income growth for better off emerging market households has outstripped the global one percenters, while conditions among the very poorest have barely improved (and this is associated with rising inequality within and between many EM).
How do we account for this? We associate it with the process of globalization. With international trade and capital barriers falling, the beginnings of a cross-border arbitrage of unit labor costs have been taking place. Put simply, companies look across the globe to determine the locations from which they can manufacture their products at the lowest risk-adjusted cost.
Of course, wages are only one component in the calculus as to where to locate. Integral to the calculation of the cost of doing business are concerns over governance (the cost of managing across multiple legal, regulatory, political, monetary and physical geographies, as well as the level of uncertainties attached to the stability of these considerations). Also, educational and physical infrastructures are by no means homogenous across the world. Put simply, there is a good reason why Silicon Valley has not shut up shop and relocated to the Democratic Republic of Congo despite its much lower wages.
The profits of this process go to both owners of global businesses and to workers employed in EM, with margins at the former boosted by the lower relative unit cost of the latter. So, for example, Apple reaps the majority of the profits from iPhone sales even though China has a virtual monopoly on the assembly and export of iPhones, together with the bulk of the low wage jobs attached to its construction*.
And so when we look at profitability trends in U.S. national accounts data, we can see that while domestic non-financial profits are around 7.3% of gross domestic product (GDP) — around 1.6% above their long-term average — total profits generated by U.S.-based firms outside the United States (shown in Exhibit 2) has risen from less than 1% of GDP to around 2.5% of GDP.
Exhibit 2: Profits generated outside the U.S. by U.S. firms as % of U.S. GDP
Source: Bureau of Economic Analysis, Threadneedle, September 2013
The economic, policy and investment implications are profound but also familiar. With citizens of EM a good deal poorer than their developed market neighbors, and with a slow convergence in political governance and education standards, we believe that the global unit labor cost arbitrage is likely to continue for many decades. This arbitrage is likely to cap developed market lower and middle income household income growth by denying them pricing power (which, all else equal, is disinflationary). And this can be expected to contribute to further falls in income inequality at a global household level, even if it pushes up (or heightens) inequality within individual countries. In so far as this dynamic is disinflationary in developed markets, and with developed market central banks like the U.S. Federal Reserve mandated to target domestic unemployment and domestic inflation, the rates at which global companies are able to borrow are likely to remain low versus historical norms on a medium-term basis, all of which supports higher long-term returns to capital in both emerging and developed markets that global companies should be best able to exploit.
Importantly, this outline is contingent on the convergence of EM from a governance perspective as well as an economic perspective, and an ever-more integrated global economy. The path of convergence is far from smooth, and the background to the latest bout of EM turmoil poses proximate challenges to this convergence story, although the intermediate convergence story remains, in our view, intact.