What follows is an edited version of the original Citibank report suggesting that many nations including the United States have become, in a rather witty neologism, Plutonomies, but you might recognize more commonly as a plutocracy or plutarchy (learn more on the wiki). I have removed much of the financial analyses and ostensibly objective elements of the report leaving behind a social commentary from the perspective of the wealthiest 1% and those who would strive to become a part of that group. In this report the author states: “We should at this point make clear that we have no view on whether plutonomies are good or bad, our analysis here is based on the facts, not what we want society to look like.” Though I object to the earnestness of the statement, I have done my best to edit the document in such a way that did not skew the original message and perhaps made it more accessible to those with short attention spans whose eyes glaze over when they see too many numbers and industry jargon they don’t understand. I have added nothing but merely omitted much of the financial speculation and charts.

If you are in a hurry you might just read the summary and skip to DEATH OF A PLUTONOMY in the last third of the report and read to the end. If you still read books, you should just read the original report. In all there isn’t any thing particularly new or mind-blowing here. I merely find it terrifying and refreshing when we can experience first hand how those who foster inequality perceive inequality. Of course bearing in mind that my world view is based somewhere in the lower 10% of the 90% of the rest of US.

Citigroup Equity Strategy Social Commentary
Plutonomy: Buying Luxury, Explaining Global Imbalances
August 23, 2010

Summary

• The World is dividing into two blocs – the Plutonomy and the rest. The U.S., UK, and Canada are the key Plutonomies – economies powered by the wealthy. Continental Europe (ex-Italy) and Japan are in the egalitarian bloc.
• In plutonomies the rich absorb a disproportionate chunk of the economy and have a massive impact on reported aggregate numbers like savings rates, current
  account deficits, consumption levels, etc.
• There is no “average consumer” in a Plutonomy. Consensus analyses focusing on the “average” consumer are flawed from the start.

WELCOME TO THE PLUTONOMY MACHINE

In early September we wrote about the (ir)relevance of oil to equities and introduced the idea that the U.S. is a Plutonomy – a concept that generated great interest from our clients. In researching this idea on a global level and looking for stock ideas we also chanced upon some interesting big picture implications. This process manifested itself with our own provocative thesis: that the so called “global imbalances” that worry so many, is not as dangerous and hostile as one might think. Sometimes kicking the tires can tell you a lot about the car-business.

Well, here goes. Little of this note should tally with conventional thinking. Indeed, traditional thinking is likely to have issues with most of it. We will posit that:

1) the world is dividing into two blocs – the plutonomies, where economic growth is powered by and largely consumed by the wealthy few, and the rest. Plutonomies have occurred before in sixteenth century Spain, in seventeenth century Holland, the Gilded Age and the Roaring Twenties in the U.S. What are the common drivers of Plutonomy? Disruptive technology-driven productivity gains, creative financial innovation, capitalist friendly cooperative governments, an international dimension of immigrants and overseas conquests invigorating wealth creation, the rule of law, and patenting inventions. Often these wealth waves involve great complexity, exploited best by the rich and educated of the time.

2) We project that the plutonomies (the U.S., UK, and Canada) will likely see even more income inequality, disproportionately feeding off a further rise in the profit share in their economies, capitalist-friendly governments, more technology-driven productivity, and globalization.

3) Most “Global Imbalances” (high current account deficits and low savings rates, high consumer debt levels in the Anglo-Saxon world, etc) that continue to (unprofitably) pre- occupy the world’s intelligentsia look a lot less threatening when examined through the prism of plutonomy. The earth is being held up by the muscular arms of its entrepreneur-plutocrats, like it, or not.

Fixing these “global imbalances” that many pundits fret about requires time travel to change relative fertility rates in the U.S. versus Japan and Continental Europe. Why? There is compelling evidence that a key driver of current account imbalances is demographic differences between regions. Clearly, this is tough. Or, it would require making the income distribution in the Anglo-Saxon plutonomies (the U.S., UK, and Canada) less skewed to the rich, and relatively egalitarian Europe and Japan to suddenly embrace income inequality. Both moves would involve revolutionary tectonic shifts in politics and society. Indeed, it is the “unequal inequality”, or the imbalances in inequality across nations that corresponds with the “global imbalances” that so worry some of the smartest people we know.

4) In a plutonomy there is no such animal as “the U.S. consumer” or “the UK consumer”, or indeed the “Russian consumer”. There are rich consumers, few in number, but disproportionate in the gigantic slice of income and consumption they take. There are the rest, the “non-rich”, the multitudinous many, but only accounting for surprisingly small bites of the national pie.

5) Since we think the plutonomy is here, is going to get stronger, its membership swelling from globalized enclaves in the emerging world, we think a “plutonomy basket” of stocks should continue do well. These toys for the wealthy have pricing power, and staying power. They are Giffen goods, more desirable and demanded the more expensive they are.

RIDING THE GRAVY TRAIN – WHERE ARE THE PLUTONOMIES?

The U.S., UK, and Canada are world leaders in plutonomy. Countries and regions that are not plutonomies: Scandinavia, France, Germany, other continental Europe (except Italy), and Japan.

THE UNITED STATES PLUTONOMY – THE GILDED AGE, THE ROARING TWENTIES, AND THE NEW MANAGERIAL ARISTOCRACY

Let’s dive into some of the details. The top 1% of households in the U.S., (about 1 million households) accounted for about 20% of overall U.S. income in 2000, slightly smaller than the share of income of the bottom 60% of households put together. That’s about 1 million households compared with 60 million households, both with similar slices of the income pie! Clearly, the analysis of the top 1% of U.S. households is paramount. To continue with the U.S., the top 1% of households also account for 33% of net worth, greater than the bottom 90% of households put together. It gets better (or worse, depending on your political stripe) – the top 1% of households account for 40% of financial net worth, more than the bottom 95% of households put together.

Was the U.S. always a plutonomy – powered by the wealthy, who aggrandized larger chunks of the economy to themselves? Not really. For those interested in the details, we recommend “Wealth and Democracy: A Political History of the American Rich” by Kevin Phillips, Broadway Books, 2002.

Characterizing the U.S. Plutonomy: Based on the Consumer Finance Survey, the Top 1% Accounted For 20% of Income, 40% of Financial Wealth and 33% of Net Worth in the U.S. (More Than the Net Worth of the Bottom 95% Households Put Together) in 2001. The Income Share of the Top 0.1% of U.S. Households Has Risen from Under 2% in the Early 1970s to Over 7% in 2000, Based on Tax Data

Clearly the fortunes of the top 0.1% fluctuate the most. Indeed, the fortunes of the top 5% (or even top 10%), or the top 1%, are almost entirely driven by the fortunes of the top 0.1% (roughly 100,000 households).

With the exception of the boom in the Roaring 1920s, this super-rich group kept losing out its share of incomes in WWI, the Great Depression and WWII, and till the early eighties. Why? The answers are unclear, but the massive loss of capital income (dividend, rents, interest income, but not capital gains) from progressive corporate and estate taxation is a possible candidate. The rise in their share since the mid-eighties might be related to the reduction in corporate and income taxes. Also, to a new wave of entrepreneurs and managers earning disproportionate incomes as they drove and participated in the ongoing technology boom. While in the early 20th century capital income was the big chunk for the top 0.1% of households, the resurgence in their fortunes since the mid-eighties was mainly from oversized salaries. The rich in the U.S. went from coupon-clipping, dividend-receiving rentiers to a Managerial Aristocracy indulged by their shareholders. The Metamorphosis of the Highest 1% of Income Earners in the U.S.: from Rentier Rich to a Managerial Technocratic Aristocracy.

EGALITARIAN JAPAN, CONTINENTAL EUROPE AND THE PLUTONOMIES OF CANADA AND THE UK

How did the Plutonomy fare in other countries over time? The UK and Canada, pretty much follow the U.S. script. Japan, France, and the Netherlands are a bit different.

These were all plutonomies before the Great Depression, but the War, taxation, and new post-War institutional structures generated much more egalitarian societies, that hold even today. Only Switzerland remained unchanged. Neutrality through the wars saw its capital preserved, the lack of a progressive income and wealth tax regime, and low taxes helped.

The Income Share of the Top 1% Has Risen Dramatically Since the Late 1970s in the U.S., the U.K., and Canada. Of Egalitarian Bent: The Income Share of the Top 1% Is Much Smaller and Is Not Rising as Much, If at All, in Switzerland, the Netherlands, Japan, and France. Plutonomy in the UK: The Income Share of the Top 0.5% Rose from Under 4% in the mid 70s to Over 9% in the Late 1990s. Return of Plutonomy in Canada: The Income Share of the Top 5% Is at the Highest Level Since the 1940s. Switzerland Benefits From Neutrality: Remarkably Stable Income Share of the Very Rich Over the Past 60 Years. France: The Income Share of the Rich Fell During WWII But Stayed Stable in the 1980s and 1990s. The Netherlands: Decline in the Share of the Top 5% and the Very Rich Until 1980. Share Relatively Stable in Recent Years. Japan: The Income Share of the Top 0.1% and the Top 1% Remarkably Flat in the Post-War Period.

PLUTONOMY WAVES – TECHNOLOGY, IMMIGRATION, FINANCE, COMPLEXITY (AND DOPAMINE) DRIVEN?

The reasons why some societies generate plutonomies and others don’t are somewhat opaque, and we’ll let the sociologists and economists continue debating this one. Kevin Phillips in his masterly “Wealth and Democracy” argues that a few common factors seem to support “wealth waves” – a fascination with technology (an Anglo-Saxon thing according to him), the role of creative finance, a cooperative government, an international dimension of immigrants and overseas conquests invigorating wealth creation, the rule of law, and patenting inventions. Often these wealth waves involve great complexity.

“One explanation of …increasing polarization of wealth comes from considering these great transformations as surges of complexity – waves of economic, political and commercial change – profound enough to break down old vocational and price relationships, greatly favoring persons with position, capital, skills, and education” (page 259, author’s emphasis).

Clearly, a speculative instinct is key to generating and sustaining these complex and risky transformations. Here, a new, rather out-of-the box hypothesis suggests that dopamine differentials can explain differences in risk-taking between societies. John Mauldin, the author of “Bulls-Eye Investing” in an email last month cited this work. The thesis: Dopamine, a pleasure-inducing brain chemical, is linked with curiosity, adventure, entrepreneurship, and helps drive results in uncertain environments. Populations generally have about 2% of their members with high enough dopamine levels with the curiosity to emigrate. Ergo, immigrant nations like the U.S. and Canada, and increasingly the UK, have high dopamine-intensity populations. If encouraged to keep the rewards of their high dopamine-induced risk-seeking entrepreneurialism, these countries will be more prone to wealth waves, unequally distributed. Presto, a plutonomy driven by dopamine!

Interesting that Kevin Phillips also mentioned the role of immigrants in driving great wealth waves (oblivious to the role of dopamine, though). He emphasizes the role of the in-migration of skilled and well-capitalized refugees and cosmopolitan elites in catalyzing wealth waves. Being the son of refugee parents from the India-Pakistan partition in 1947, and now a wandering global nomad, I can see this argument quite clearly. (Also, I need to get my dopamine level checked.) Phillips talks of the four great powers – Spain in the fifty years after 1492, the United Provinces (Holland) in the sixteenth century, seventeenth century England, and nineteenth century U.S., all benefiting from waves of immigrants, fleeing persecution, and nabbing opportunities in distant lands.

WHY THE PLUTONOMY WILL GET STRONGER WHERE IT EXISTS, PERHAPS ATTRACT NEW COUNTRIES

We posit that the drivers of plutonomy in the U.S. (the UK and Canada) are likely to strengthen, entrenching and buttressing plutonomy where it exists. The six drivers of the current plutonomy: 1) an ongoing technology/biotechnology revolution, 2) capitalist- friendly governments and tax regimes, 3) globalization that re-arranges global supply chains with mobile well-capitalized elites and immigrants, 4) greater financial complexity and innovation, 5) the rule of law, and 6) patent protection are all well ensconced in the U.S., the UK, and Canada. They are also gaining strength in the emerging world.

Eastern Europe is embracing many of these attributes, as are China, India, and Russia. Even Continental Europe may succumb and be seduced by these drivers of plutonomy. As we argued in the Global Investigator,”Earnings – Don’t Worry, Capitalists Still on Top”, June 10, 2005, the profit share of GDP is highly likely to keep rising to the highs seen in the 1950s/60s. New markets like China and India, their contribution to the global labor supply, the ongoing productivity revolution, the quasi-Bretton Woodssystem in the U.S. dollar bloc, and inflation-fighting central banks should all help. However, a high profit share like in the 1950s/60s does not ensure plutonomy. Indeed, in the 1950s/60s, U.S. and other key countries did not see increasing income inequality.

Society and governments need to be amenable to disproportionately allow/encourage the few to retain that fatter profit share. The Managerial Aristocracy, like in the Gilded Age, the Roaring Twenties, and the thriving nineties, needs to commandeer a vast chunk of that rising profit share, either through capital income, or simply paying itself a lot. We think that despite the post-bubble angst against celebrity CEOs, the trend of cost-cutting balance sheet-improving CEOs might just give way to risk-seeking CEOs, re-leveraging, going for growth and expecting disproportionate compensation for it. It sounds quite unlikely, but that’s why we think it is quite possible. Meanwhile Private Equity and LBO funds are filling the risk-seeking and re-leveraging void, expecting and realizing disproportionate remuneration for their skills.

THOSE SCARY “GLOBAL IMBALANCES” – REFLECT PLUTONOMY AND DEMOGRAPHY, QUITE LOGICAL AND UNTHREATENING

We have all heard the lament. A bearish guru, somber and serious, spelling out that the end is near if something is not done urgently about those really huge, nasty “Global Imbalances”. The U.S. savings rate is too low, the U.S. current account deficit is too high, foreigners are not going to keep financing this unless compensated with higher interest rates, and a sharply lower U.S. dollar. The world, being so imbalanced, is about to tip over it’s axis, all hell is going to break loose, so don’t any equities – the risk premium is high reflecting these imbalances and is going to go higher (i.e., lower stock prices) when the earth finally does keel over.

A more balanced view acknowledges these nasty imbalances, but predicts a gentle, gradual dollar decline, a yuan revaluation, and the hope that Asians and European (ex- UK) consumers will embark on a spending journey, righting the world. A tough workout, but she’ll be right.

Almost all the smart folks we know – our investors, our colleagues, our friends in academia, politicians believe in some variant of these two stories. There are very few exceptions who consider these “Global Imbalances” not scary but perfectly natural and rather harmless. (We can think of Gavekal as one of these exceptions, but their repose of comfort is different from ours – they have a new book out “The Brave New World”, elucidating the new business model of global “Platform” companies, etc).

Well, it seems that the plutonomies (the U.S., UK, and Canada together) have deteriorating current account balances; the others are running a combined current account surplus.

How about government deficits? Well, they seem to be equally bad in the U.S., UK, Continental Europe, and very bad in Japan. Hmm. We’ll leave this one alone too.

The Gap in the Savings Rate of Plutonomies and the Others Moves Closely with the Gap in the Current Account Balance. For our purposes, Plutonomies = U.S., U.K. and Canada. Non-Plutonomies = EuroZone, Japan and Switzerland. Missing are the newly industrialized nations of Asia and China.

Our contention: when the top, say 1% of households in a country see their share of income rise sharply, i.e., a plutonomy emerges, this is often in times of frenetic technology/financial innovation driven wealth waves, accompanied by asset booms, equity and/or property. Feeling wealthier, the rich decide to consume a part of their capital gains right away. In other words, they save less from their income, the well- known wealth effect. The key point though is that this new lower savings rate is applied to their newer massive income. Remember they got a much bigger chunk of the economy, that’s how it became a plutonomy. The consequent decline in absolute savings for them (and the country) is huge when this happens. They just account for too large a part of the national economy; even a small fall in their savings rate overwhelms the decisions of all the rest.

There is proof that high income earners, who saw their share of income go up in the U.S. in the nineties,and enjoyed the equity boom, reduced their savings rate as in our example. Indeed, in the real world, it went negative! Since that reduced savings rate was applied to their new enlarged chunk of income, sure enough the total savings rate fell sharply.

Dean Maki and Michael Palumbo, wrote the paper (at Alan Greenspan’s suggestion) that demonstrated this fall in the savings rate of the rich in response to the equity boom (See Maki and Palumbo,”Disentangling the Wealth Effect: A Cohort Analysis of Household Savings in the 1990s”, April 2001). Figure 16 demonstrates the savings rates at different points for different income groups.) The very rich, the top 20%, had a savings rate of 8%, much higher than other less affluent groups in 1992. By 2000 this savings rate had gone from 8%- to -2%! The wealth effect at work. And then this reduced savings rate of the rich hit their huge incomes, swollen by the plutonomy, savaging the U.S.’s overall savings rate. This is our contribution to the debate. Plutonomy plus an asset boom equals a drop in the overall savings rate. (Asset booms by themselves, i.e., the wealth effect by itself does not do the trick, as we will show soon.)

Household Savings Rates of the Rich Fell in the Stock Boom in the 1990s While Those of the Lower Income Groups Rose (Maki-Palumbo Estimates).

Our thesis is that the higher the share of income going to the top 1%, the lower the overall household savings rate (shown inverted in Figure 17). There is a pretty tight correlation between the two, despite the many other drivers of savings rates (demography, interest rates, financial deepening, retirement security, etc). When the rich take a very high share of overall income, the national household savings rate drops, and vice versa. In a plutonomy, the rich drop their savings rate, consume a larger fraction of their bloated, very large share of the economy. This behavior overshadows the decisions of everybody else. The behavior of the exceptionally rich drives the national numbers – the “appallingly low” overall savings rates, the “over-extended consumer”, and the “unsustainable” current accounts that accompany this phenomenon. We want to spend little time worrying about these (non)issues, neither do we think they warrant any risk premium on equities. They simply reflect the reality of demographic differences between nations, and that some nations are plutonomies, while others are not. Unequal inequality among nations is mirrored in the logical imbalances between them.

How about more empirical verification of the relationship between the household savings rate and the share of the rich in other plutonomies like the UK and Canada? In the nineties, there seems to have been an upward shift in the relationship between the UK personal savings rate and income inequality. There are number of drivers for the savings rate, as highlighted earlier, and the impact of these other drivers could shift the relationship around – our comfort comes from the persistence of the negative relationship in the UK.

In the U.K., A Strongly Negative Relationship Between Income Concentration (Plutonomy) and the Aggregate Household Savings Rate. The Relationship Shifted Upward in the 1990s. Canada Also Shows a Close Relationship Between Income Concentration (Plutonomy) and the Aggregate Household Savings Rate. Canada: High and Negative Correlation Between Aggregate Household Savings Rates and Income Concentration. Similar high correlations are obtained even if we use the income share of the top 10%

Canada also confirms our thesis. A plutonomy begets a lower household savings rate. We have also attempted to put the relationship on a cross border-basis for the eight countries where we have comparable data. Again, plutonomies like the U.S., Canada, and the UK have lower household savings rates than the more egalitarian countries like France, the Netherlands, Switzerland, Spain, and Japan.

Cross-Border Comparison: Countries With Lower Income Concentration (Continental Europe) Tend to Have Higher Aggregate Household Savings Rates High Income Concentration (Plutonomy) Is Associated with Lower Household Savings Rates.

U.S.: It Takes Plutonomy (Income Concentration)a nd Asset Inflation to Lower the Aggregate Household Savings Rate – Asset Inflation Alone May Not Be Enough.

A skeptic, while agreeing with our plutonomy thesis, may still not be convinced about the ability of households to sustain the low savings rate. Surely, even in the brave new world of plutonomies we describe, households cannot forever keep their savings rate low? We have two interesting dynamics in place that should prevent a sharp drop in consumption and so pushing the savings rate higher. One, the difference of the household’s financial assets to disposable income (assets with value of housing stock excluded) and its liabilities to disposable income exceeds its historical average. Households can afford to run down their assets to finance consumption for a while.

Two, as this note has been arguing it is the rich who are driving the low savings rate and high consumption in plutonomies. For the top decile in the U.S., the total net worth to income ratio is exceptionally high at 7.5 times compared to 4.5 times for the rest of the households. The high cushion of net worth of the rich, combined with their gigantic share of income and consumption can sustain the low savings rate (and therefore the current account deficit) in the plutonomies.

U.S.: Net Worth to Income Ratio for the Rich Is High and Rising. Drives and Sustains High Consumption out of Their Massive Income; Keeping Aggregate Savings Rate Low and Current Account Deficit Large.

To summarize so far, plutonomies see the rich absorb a disproportionate chunk of the economy, their decision to lower their savings rate, often corresponding to the asset booms that often accompany plutonomy, has a massive negative impact on reported aggregate numbers like savings rates, current account deficits, consumption levels, etc. We believe the key global imbalance is that some large economies have become plutonomies, and others have not — this imbalance in inequality expresses itself in the standard scary “global imbalances” that so worry the bears and most observers. They do not worry us much. In addition, the emerging market entrepreneur/plutocrats (Russian oligarchs, Chinese real estate/manufacturing tycoons, Indian software moguls, Latin American oil/agriculture barons), benefiting disproportionately from globalization are logically diversifying into the asset markets of the developed plutonomies. They are attracted by the facets that facilitated the re-emergence of plutonomies in the U.S., UK, and Canada – technology, internationalism, the rule of law, financial innovation and capitalist-friendly cooperative governments. This further inflates the asset markets in these plutonomies, enabling the rich there to lower their savings rates further, and worsening their current account balances further. Just as misery loves company, we posit that the “plutos” like to hang out together.

We stress that our analysis of the relationship between income concentration (plutonomy) and the household savings rates is confined to industrialized countries. This relationship in emerging markets is weak or non-existent. As mentioned earlier, the emerging markets’ elites often do their spending and investment in developed plutonomies rather than at home.

WHAT MIGHT CHANGE THIS?

Our view that plutonomy is driving savings and consumption imbalances is all very well. But before examining how to make money from this theme, we want to look at what might cause it to change.

THE DEATH OF PLUTONOMY

At the heart of plutonomy, is income inequality. Societies that are willing to tolerate/endorse income inequality, are willing to tolerate/endorse plutonomy.

Earlier, we postulated a number of key tenets for the creation of plutonomy. As a reminder, these were: 1) an ongoing technology/biotechnology revolution, 2) capitalist- friendly governments and tax regimes, 3) globalization that re-arranges global supply chains with mobile well-capitalized elites and immigrants, 4) greater financial complexity and innovation, 5) the rule of law, and 6) patent protection.

We make the assumption that the technology revolution, and financial innovation, are likely to continue. So an examination of what might disrupt Plutonomy – or worse, reverse it – falls to societal analysis: will electorates continue to endorse it, or will they end it, and why.

Organized societies have two ways of expropriating wealth – through the revocation of property rights or through the tax system.

Capital markets, like human beings, generally strive for certainty and stability. The pricing of assets is easier, projections more comfortable, etc. For this reason, in developed capital markets, governments have learnt the lessons of level playing fields, regulatory certainty, and the sanctity of property rights.

However this does not mean that governments are incapable of revoking property rights. While this tends to be something more often seen in countries with a shorter history of capitalist democracy, such as the Ukraine (attempts to undo prior privatizations), or Russia (where some of our clients believe events surrounding Mikhail Khodorovsky to be a form of nationalization), it can happen in the strangest of places. For example, in 2001, UK government withdrawal of financial support bankrupted Railtrack, the UK rail operator, effectively re-nationalizing railway assets on the cheap.

But these moves are exceptional and generally counter-productive. If the government is willing to be a contestant and simultaneously set and change the rules of the game to their advantage, the rewards of the game must rise to attract other participants.

The more likely means of expropriation is through the tax system. Corporate tax rates could rise, choking off returns to the private sector, and personal taxation rates could rise – dividend, capital-gains, and inheritance tax rises would hurt the plutonomy.

There is a third way to change things though not necessarily by expropriation, and that is to slow down the rate of wealth creation or accumulation by the rich – generally through a reduction in the profit share of GDP. This could occur through a change in rules that affect the balance of power between labor and capital. Classic examples of this tend to fall under one of two buckets – the regulation of the domestic labor markets through minimum wages, regulating the number of hours worked, deciding who can and cannot work etc, or by dictating where goods and services can be imported from (protectionism).

WHERE DO WE STAND TODAY?

In the plutonomies, there seems little threat from the first of these challenges: blatant expropriation of property by governments. There are few examples of governments changing the rules in the plutonomies and engaging in widespread nationalization, or asset re-distribution.

Likewise, if anything, the trends of taxation are positive for corporates, with fiscal competition in Europe forcing rates lower, year by year. Ironically, this is happening most in non-plutonomy countries, like Germany. This is good for the profit share, of which the mega-rich, through their holdings of equity, are “long”.

However, even if the profit share is rising, the fruits of those profits could be taxed before ending up in the pockets of the rich. However, we struggle to find examples of this happening. Indeed, in the U.S., the current administration’s attempts to change the estate tax code and make permanent dividend tax cuts, plays directly into the hands of the plutonomy. While such Pluto-friendly policies are not widely being copied around the world, we have not found examples of the opposite occurring elsewhere.

Protectionism or regulation. Here, we believe lies a cornerstone of the current wave of plutonomy, and with it, the potential for capitalists around the world to profit. The wave of globalization that the world is currently surfing, is clearly to the benefit of global capitalists, as we have highlighted. But it is also to the disadvantage of developed market labor, especially at the lower end of the food-chain.

There are periodic attempts by countries to redress this balance – Jospin’s introduction of the 35 hour working week in France to the anticipated benefit of labor being one example. But in general, on-going globalization is making it easier for companies to either outsource manufacturing (source from cheap emerging markets like China and India) or “offshore” manufacturing (move production to lower cost countries).

The final option for countries willing to consider it, is to in-source labor. It interests us that the Plutonomy countries (U.S.A, UK, Australia, and Canada) all have – generally – a welcoming attitude to skilled immigration.

So, property rights look as if they are being protected, tax policies helpful, and the profit share should continue to rise, through globalization and the productivity/technology wave.

Our conclusion? The three levers governments and societies could pull on to end plutonomy are benign. Property rights are generally still intact, taxation policies neutral to favorable, and globalization is keeping the supply of labor in surplus, acting as a brake on wage inflation.

IS THERE A BACKLASH BUILDING?

Plutonomy, we suspect is elastic. Concentration of wealth and spending in the hands of a few, probably has its limits. What might cause the elastic to snap back? We can see a number of potential challenges to plutonomy.

The first, and probably most potent, is through a labor backlash. Outsourcing, offshoring or insourcing of cheap labor is done to undercut current labor costs. Those being undercut are losers in the short term. While there is evidence that this is positive for the average worker (for example Ottaviano and Peri) it is also clear that high-cost substitutable labor loses.

Low-end developed market labor might not have much economic power, but it does have equal voting power with the rich. We see plenty of examples of the outsourcing or offshoring of labor being attacked as “unpatriotic” or plain unfair. This tends to lead to calls for protectionism to save the low-skilled domestic jobs being lost. This is a cause championed, generally, by left-wing politicians. At the other extreme, insourcing, or allowing mass immigration, which might price domestic workers out of jobs, leads to calls for anti-immigration policies, at worst championed by those on the far right. To this end, the rise of the far right in a number of European countries, or calls (from the right) to slow down the accession of Turkey into the EU, and calls from the left to rebuild trade barriers and protect workers (the far left of Mr. Lafontaine, garnered 8.5% of the vote in the German election, fighting predominantly on this issue), are concerning signals. This is not something restricted to Europe. Sufficient numbers of politicians in other countries have championed slowing immigration or free trade (Ross Perot, Pauline Hanson etc.).

A second related threat, might come from productive labor no longer maintaining its productive edge. Again, we find Kevin Phillips’s arguments in his book, Wealth and Democracy, fascinating. Phillips highlights the problems in the late 1700s Netherlands, where an increasing obsession with financial speculation (sound familiar?) caused non- financial skilled labor that had built that country’s wealth, to seek their success in other countries. Likewise, Britain’s failure to keep its educational advantage in what were then high-tech areas caused them to lose their competitive advantage that had been maintained until the First World War. Are there similarities with Asian economies, versus the plutonomies, today?

A third threat comes from the potential social backlash. To use Rawls-ian analysis, the invisible hand stops working. Perhaps one reason that societies allow plutonomy, is because enough of the electorate believe they have a chance of becoming a Pluto- participant. Why kill it off, if you can join it? In a sense this is the embodiment of the “American dream”. But if voters feel they cannot participate, they are more likely to divide up the wealth pie, rather than aspire to being truly rich.

Could the plutonomies die because the dream is dead, because enough of society does not believe they can participate? The answer is of course yes. But we suspect this is a threat more clearly felt during recessions, and periods of falling wealth, than when average citizens feel that they are better off. There are signs around the world that society is unhappy with plutonomy – judging by how tight electoral races are. But as yet, there seems little political fight being born out on this battleground.

A related threat comes from the backlash to “Robber-barron” economies. The population at large might still endorse the concept of plutonomy but feel they have lost out to unfair rules. In a sense, this backlash has been epitomized by the media coverage and actual prosecution of high-profile ex-CEOs who presided over financial misappropriation. To this end, the cleaning up of business practice, by high- profile champions of fair play, might actually prolong plutonomy.

Our overall conclusion is that a backlash against plutonomy is probable at some point. However, that point is not now. So long as economies continue to grow, and enough of the electorates feel that they are benefiting and getting rich in absolute terms, even if they are less well off in relative terms, there is little threat to Plutonomy in the U.S., UK, etc.

But the balance of power between right (generally pro-plutonomy) and left (generally pro-equality) is on a knife-edge in many countries. Just witness how close the U.S. election was last year, or how close the results of the German election were. A collapse in wealth in the plutonomies, felt by the masses, and/or prolonged recession could easily raise the prospects of anti-plutonomy policy.

We should at this point make clear that we have no view on whether plutonomies are good or bad, our analysis here is based on the facts, not what we want society to look like.

HOW TO PLAY PLUTONOMY

So, Plutonomies exist, and explain much of the world’s imbalances. There is no such thing as “The U.S. Consumer” or “UK Consumer”, but rich and poor consumers in these countries, with different savings habits and different prospects. The rich are getting richer; they dominate spending. Their trend of getting richer looks unlikely to end anytime soon.

How do we make money from this theme? We see two ways. The first is simple. If you believe, like us, that the Plutonomy exists, and explains why global imbalances have built up (for example the savings rate differentials), and you believe there is no imminent threat to plutonomy, you must in turn believe that the current “end of the world is nigh” risk premium on equities, due to current account deficits, is too high. Conclusion: buy equities. There is however a more refined way to play plutonomy, and this is to buy shares in the companies that make the toys that the Plutonomists enjoy.

To test this, we built a basket of companies that serve or sell to the rich, the beneficiaries of Plutonomy. The companies – not all followed by Citigroup Investment Research – fall into a number of areas, from Private Banking (for example Julius Baer), to traditional luxury goods like Bulgari, through art auction houses (e.g., Sotheby’s), and of course luxury toys, such as Porsche. We emphasize that a stock’s inclusion in this basket in no way makes it a recommended buy, from Citigroup Investment Research, unless rated so by our respective analyst. The basis for inclusion was that a majority of the company’s revenues were/are derived from the “rich”. Hence Bombardier, the manufacturer of Lear Jets, did not make the list, though clearly that product is a typical plutonomy “toy”.

So how did it perform? Since 1985, our starting point for this plutonomy basket, it has generated an annualized return of 17.8%, handsomely outperforming indices such as the S&P500.

Compared to standard indices, we nevertheless find what we expected: that the plutonomy basket performed exceptionally well.

So well in fact, that our fashion-loving colleague Priscilla pointed out the obvious – “wow, I can get rich by owning the plutonomy stocks, and then spend my money on these products”.

Up, Up and Away: Plutonomy Basket Outperforms World Equities Handsomely

This is hardly a major surprise; given that the Plutonomy is fuelled by an equity market boom, and threatened by a bust, given the rich are disproportionately long the equity market.

The average person, by contrast, tends to have a disproportionate amount of their wealth tied up in housing. While a stock market boom should help the rich, a housing boom should help the average Joe.

Belsky and Prakken’s paper suggests that housing booms tend to get reflected in spending more rapidly than stock market booms – in other words, the wealth effect from house price rises gets turned on more quickly than from equity prices rising.

It is interesting when we look at the performance of the stock market relative to the housing market, and compare this to the performance of the Plutonomy basket relative to the broad equity market, we find that during periods of house price appreciation relative to stock market appreciation, our plutonomy basket moves sideways.

If like us, you believe that attempts by the UK, U.S., and Australian authorities to cool the housing market is likely to work, and you believe, like us, that equities are likely to perform well in coming years, this is a good time to switch out of stocks that sell to the masses and back to the plutonomy basket.

Conclusion

We are not often shocked. But shocked we were, when we published our note on the Irrelevance of Oil, several weeks ago, and discovered just how significant the rich were in terms of income, wealth and consumption in the U.S.

Looking into this in more detail, we have found that the U.S. is not alone. Un-equal societies abound in the Anglo-Saxon world. This income inequality, we have called Plutonomy.

Outlandish it may sound, but examined through the prism of plutonomy, some of the great mysteries of the economic world seem to look less mystifying. As we showed, there is a clear relationship between income inequality and low savings rates. In turn, those countries with low/negative household savings rates tend to be the countries associated with current account deficits.

It is both intellectually fashionable and elegant, apparently, to attack “the crazy American consumer, and his/her overspending”.

This has of course, from a portfolio perspective, been a costly trade to run-with, over the last 10 years. Those “crazy American consumers” seem to be in rude health. Their imminent demise has been a long time imminent.

If we are right, that the rise of income inequality, the rise of the rich, the rise of plutonomy, is largely to blame for these “perplexing” global imbalances. Surely, then, it is the collapse of plutonomy, rather than the collapse of the U.S. dollar that we should worry about to bring an end to imbalances. In other words, we are fretting unnecessarily about global imbalances. In turn, the risk premium on equities is probably too high.

Secondly, we hear so often about “the consumer”. But when we examine the data, there is no such thing as “the consumer” in the U.S. or UK, or other plutonomy countries. There are rich consumers, and there are the rest. The rich are getting richer, we have contended, and they dominate consumption.