Rational Dissent Episode 012. What the 'K' is Going on?

we have to do something about inflation. 3% inflation, being above 2% for 66 straight months, Alex, as you said, is unacceptable, full stop. And this is what's driving interest rates higher, as it should, and this is not something that we cannot The worst answer we could give is throw our hands in the air and say, "I guess we're in a 3% inflation world, and we'll just have to revalue to everything like that." Bottom of the pay will not like that answer, because that means that the it's acceptable for them to continually lose purchasing power, unless you want to start giving them raises. Problem with giving them raises is then you cement a 3 to 4% inflation world. So, we're in a difficult spot right now. >> [screaming] >> Welcome back, ladies and gentlemen, to another episode of Rational Descent. I'm your host, Alex Melitas. My colleague, Greg Blaha, continues to impress with the beard, and Jim Bianco, founder and president of Bianco Research, is back stateside. Every week we try to counter consensus thinking while we discuss the world of markets and finance. And right now, depending on who you ask, the US economy is either the best it's ever been, or it's completely falling apart. Turn on financial TV, and it's record highs. Talk to your neighbor, and it's all about eggs and rent. We've been calling it the K-shaped economy along with everybody else. Part of the country is heading up and to the right. Part is heading down, and both are getting averaged into the same headline number. That's how you end up with data says saying everything's fine while a whole bunch of people are telling you otherwise. So, today, we're splitting the K in half. We're going to look at who's carrying the spending, who's getting squeezed on prices, and where the K shows up. So, Greg's going to start us off with where the spending's coming from. >> Yeah, so if we're going to talk about the K-shape economy, I think we would have to start off with defining the groups that we're looking at here. And for my purposes today, I'm going to kind of break this down by income in the US. So, this first graphic is just going to show a breakdown of incomes in the US by decile. The lowest decile averages just under $10,000 in mean income, while the highest paying incomes average just about $346,000 a year. So, we're going to look at, you know, the lowest decile, the top decile, and maybe even the second and ninth deciles in there in terms of, you know, defining which sides of the K these groups are on. So, with that said, we're going to look at, first I guess, where the income is generated for these groups. And on the lower end of the income spectrum, you're going to see in this next chart these two pie graphs that show on the low end, most of the income is coming from social security retirement, so there's a lot of retirees in this lowest income bracket. And there's also a lot coming from public assistance. There's still about 28% coming from wages and salaries, but it's not that much when you compare it to the highest income brackets where, over, let's see, 81% of income for the highest income brackets come from wages and salaries, and even another almost 11% comes from self-employment income. So, that's a pretty stark difference just in terms of where the money is coming from. Now, it's even maybe a bit more of a stark difference when you look at what these what this money is being spent on. So, the next chart again breaks down the lowest decile of incomes in the US and the highest. On the left, you see the lowest incomes spend 42% of their money on housing. That's in blue, and then another almost 17% in red on shelter. So, your two most basic necessities just food and shelter are going to eat up a large portion of the lowest income brackets uh income. Now, contrast that to the highest income in the US, and they're spending about 29% of their income on housing and um maybe 10% on food. So, it's a much smaller portion of their income is being sent spent on the necessities. Now, what that means is there's also almost 20% of their income that the highest income bracket is able to spend on personal insurance and pensions, which is just a fancy way of saying savings, really. So, these two these two sets of pie graphs show, you know, where money's coming from and where it's being spent on in terms of shares of both of these deciles. But, that doesn't really explain that on a nominal basis, clearly a higher income decile is spending a lot more money than the lowest income decile. So, the final chart I'm going to share here breaks down, according to deciles, how much of the country's spending is being spent by each decile. So, you'll see that richest 10% are spending almost a quarter of all the money in the US, or they account for that much of the spending. And on the lower end, you're looking more like 4% or almost 5% for the second lowest decile of incomes. So, that's a pretty stark difference when you start looking at it, and that kind of starts to bring into focus this case state economy that we've been talking about. Now, the interesting thing though is that if you look historically at these income brackets and what percentage of the nominal spending they account for, they're pretty static. So, I mean, the top decile always spends around 22 to 25% percent of the income or of the spending in the country. And the bottom decile also usually accounts for 4 or 5%. So, if that doesn't change so much, Jim, I guess I would throw it to you as why are we hearing so much about the K-shaped economy now? Why wasn't this an issue maybe a decade ago or no one really talked about it even though the shares of spending were really pretty similar for these different groups. >> Yeah, so I think you're right. You know, you could argue that we've always had a K. So, what's different about this K relative to other K's? And I do think it is about what we refer to as affordability or as spending. So, the first chart I'll show you here is from the weekly YouGov poll. And it shows the uh People are asked the question, "What is the biggest issue in the country?" So, they're given 15 options to pick from and this chart shows you the five largest. And number one and running away at a multi-year high this week, cuz this is the poll that was put out this week, at 37% the number one issue is inflation. The number one issue is affordability. It's even higher than it was in '23 or '22 when we actually had 9% inflation. And if I go to the second chart, it's the same poll but now they ask, "Grade the economy." 47% of the public grades the economy as poor. And that's a two-plus year high right now. So, you're right, Greg. If you look at the data, stock market's at an all-time high, GDP is doing fairly well, the unemployment rate is at 4.1%, the retail sales numbers are okay. Um you know, so why is it that half the country thinks that the economy is terrible, um although the headline numbers are not reflecting that? And I think the answer is affordability. The and what you're seeing with a lot of people is they're struggling because prices are running ahead of where they've been thinking. So, I'll go to my final two charts here cuz it fits. Um I want to show the first next chart is the blue line on the chart is the uh the cumulative increase in CPI since the end of COVID. It's up 31%. Orange line is a cumulative increase in wages. They're up 26%. So, wages are lagging behind um prices. Now, for the top of the K, you maybe their wages are lagging behind inflation, too, but they look at their phone and see what Zillow says their home has done or their ETFs have done, and their wealth is going up. And so, they feel wealthier and they're spending more. But, the bottom of the K lives paycheck to paycheck. Uh they don't they rent. They don't own assets. And they're buying less at the store every month. Now, is this always the case? Well, the next chart, the final chart I'll show, same chart from 2009 to 2020, this time the orange line is above the blue line, meaning wages outpaced inflation. So, to use the tennis term, the average person held serve. They went to the store and they keep buying the same things, maybe even a little bit more, not a lot more, but a little bit more, but at a minimum, at a default, they weren't falling behind. So, that's what's changed. That's why you could argue, yes, there's always a K. Always rich people that spend more than poor people. That's That's not That's a truism that will be true for the rest of time. But, why is it such a bigger issue now? I think it really is about inflation. >> So, let's put these two things together here, and I I think you hit on exactly the point I'm trying to make here. But, on Greg's side, right, the people who are spending, these are the people that we see now, obviously, excited about all-time highs, the people you see on financial news, right? What keeps them spending isn't really the paycheck, it's the portfolio, like you said, Jim. The top 10% owns approximately 90% of the stock market. So, when stocks go up, they feel wealthier, they spend, you know, companies earn more, stocks go up again, the loop continues. And that loop is really a big part of why the economy is held up as well as it has. Now, the natural pushback to this is plenty of Americans own stocks. Sure, yes, that's fair. Most people do have some money in 401(k)s or an IRA, but there's a big difference between having a stake in the market and having the market change your life. All right, and that brings us to Jim's side, right, which is your neighbor talking about eggs and rent, like I mentioned earlier. If you don't have much in the market, there's no portfolio or no home quietly working in the background for you. Your paycheck, it it that's the whole plan, right? So, the only way you get ahead is if your raise outruns prices. Now, over the last few years, like Jim said, it mostly hasn't. And you can hear "Inflation is cooling" all you want, but it just means that prices are going up more slowly. Nothing went back to what it used to cost. So, the gap that is that you feel is still there. So, you put those two together, and this chart that you're seeing now, that's what it looks like. The blue is the S&P 500, the orange is what people say they feel about the economy. For 25 years, those two lines pretty much were were correlated. They went together, right? Stocks dropped in 2008, people felt terrible. Stocks climbed during the 2010s, people were feeling better. Then you get to 2020, which is the break, and it started to split. S&P runs off to a record, sentiment falls to the lowest it's ever been. And that's the K. This is the the perfect example of where the K shows up. One arm has its savings and investments growing on their own, right? Essential with the market. And that spending is what keeps the overall numbers up. The other arm depends on their wages to keep up with prices. And for 5 years it's been really tough since COVID. And then you average those two together, you still get a headline number that says everything's fine. And I think that's a good spot to bring back to what you guys both said, which is that higher earners have always owned most of the assets and accounted for a larger share of the spending. So what's different now? And I think this is exactly what Jim said. I think it's inflation and affordability. But even if inflation [snorts] returns to that 2% mark that the Fed says that they're targeting, even though we're 66 months off of that mark, we're not getting deflation. Prices aren't going back to 2019 levels. So we have to acknowledge that this K-shaped economy is really not ideal for the majority of what we are calling the K, right? So how does this kind of get addressed? What happens here? Greg, I want to start with you. What are your thoughts on that? >> Well, I think it would be easy if we're going to say that the problem is inflation, which I agree that's why maybe now we're talking about the K-shaped economy more than we ever have in the past, despite the fact that this has always existed. If inflation is the problem, it'd be easy to point to the Fed and say, well, you know, that's one of their mandates. They got to control prices. So let's get them hiking and, you know, go about our business. I I see a couple problems with that is and one is that on one end, the Fed doesn't control the long end of the curve. So yields at the long end, you would hope that, you know, they would be affected by Fed policy. That's not always the case. The other kind of issue I see if you want to bring in monetary versus fiscal, I think that if the Fed is going to be counted on to fight inflation, we've seen this in the past where maybe that gives the fiscal side of the government maybe more leeway to run with some of the spending or spending, you know, spending that they've been doing in the past. So, on one end, yes, the Fed can control inflation and that's one of their mandates, but then, you know, if the government's just going to take that as a reason to keep spending more, keep borrowing more, that's not going to work out well. You're going to end up seeing, you know, a continuation of the fiscal problem that we've seen. And until some of these budget problems maybe come back into line, I think the yields at the long end of the curve, you know, they might over the long run could remain elevated. So, again, easy to say, "Okay, Fed, this is you. It's inflation, so fix it." But, you know, at the same time, I think the fiscal side of things, the government needs needs to bring the budget in line and that would, you know, if they both work at the same time, then that'd be all the better, but Jim, I mean, where do you see? Do you agree with that that this is maybe more a fiscal issue than a monetary issue? >> Absolutely, you're right. I mean, one of the problems the Fed has is we're talking about the K that there's two different economies, if you will, driven more so than usual by inflation. But, we set monetary policy and everything on the average of the two. And the average of the two seems to be the top of the K pulling up the economy more than the bottom of the K is pulling it down. So, the Fed has got very limited tools in what they could do. They can raise rates to try and rein in inflation, but you'd be right to yell, "But, doesn't the bottom of the K rely on loans?" You know, if they're going to buy a car, if they're going to finance something on a credit card, if they're all going to try and reach and buy a house, higher interest rates hurt them a lot more than the top of the K. That's true. So, that's why they're they're in a tough spot um right now. Fiscal policy. Now, the problem with fiscal policy is, oh, let's just borrow a bunch of money and throw it at the bottom of the K to try and you know, improve their situation. Here's the issue with this. 9 years ago, almost 9 years ago to the day that we're recording, um Dan Tarullo, who was a Fed Reserve Federal Reserve governor, um we had from 2009 to 2017, uh I stepped down and then he went to the Brookings Institute and gave a speech and in the speech he said that there's the Fed has no working theory for money uh for inflation. And he's right, they don't. And that's not a criticism on the Fed cuz I don't either and a lot of other people don't. We have we have ideas about how inflation works, but I've often argued, everybody says, oh, inflation is is very simple to understand. It's too much money chasing too few goods. Yeah, I understand we could put those bromides out there about what inflation is, but it's really complicated because the Fed is correct to say inflation expectations cuz it's much psychological as it is anything else. But if there is one thing that seems to correlate with inflation, it is government spending. If the government borrows a lot of money and consumes a tremendous amount of goods and services, it pushes prices higher. So, deficit spending is basically trying to, you know, drink yourself sober. Uh you're you are spending money to try and help the bottom of the K because they're worried their affordability, but by doing that, you're making things more unaffordable at the same time. So, this is a real difficult problem to solve. You go back to 2022, we were talking about this, too. Remember we hit 9% inflation. And we were real worried. We had to do something about inflation. And the Fed Chairman Jay Powell went to Jackson Hole in August of 2022 and gave an 8-minute speech, which was dubbed the will be pain speech. And I was active on social media, like I am now, back then, too. And I was kind of half quipping and half serious, you know, for all of you at the top of the K, do your patriotic duty and lose money in the stock market. Cuz that will soften your demand, that will bring down prices, and that will help the bottom of the K. Dare I say that that might be something we might have to do in order to help the bottom of the K? Is that we've just The top of the K is making too much money, and that the I I mean, I hate saying this. I don't want to believe it. But I'll throw out one statistic for you. Alex, you mentioned that 10% the top 10% own 90% of ass of uh stocks. There's $70 in stocks. So, that's $63 that they own in the stock market. That is something like 180% of GDP uh that the top 10% owns in the stock market. In 1996 was the first time the entire stock market went above 100% of GDP. Now just the top 10% owning is 180%. So, that gap keeps widening. So, this isn't an easy question. I don't think the answer is to punish the top of the K. Oh, we got to raise rates and, you know, kill the stock market. Um you know, the Fed The Fed has to do something about inflation. And the government, if you ask the government, well, they should step in and do something fiscally. The answer is not just we just need to borrow more money. We just need to send, you know, Trump is saying, we just need to send everybody a $5,000 check if Republicans win. That's not going to do That's not going to do it. But, this is I'll throw this before I throw it back to you, Alex. I'll I'll say this is one of the biggest issues and if you look at the polling for the midterm election, which is a little more than 3 weeks away from when we're recording, there is big expectations of big gains by the Democrat Party and largely driven by people's unhappiness about the economy and that's about affordability. Prices are not going down. Sure, we could squibble about the gas prices, the pump prices because of the war, but it's much more than just that. Uh you know, even if we didn't have the war, we didn't have the gas prices, I still think we would still have a big affordability problem. >> So, I want to steer this uh I want to steer the conversation to another question I had here. So, there's a Dallas Fed research that I read that a greater spending concentration makes it makes consumption in the economy more sensitive to asset to to market shocks, right? If the if economic growth is increasingly supported by households, you know, whose spending is tied to these asset values, like walk me through what happens, either of you, Jim, if you want to start. What happens when the market stops cooperating with that, right? Where does the damage appear first? I mean, how does it move from portfolios into spending? I mean, we we recently wrote up internally that, you know, S&P earnings estimates for the next several quarters are two quarters of 20% growth this year, which would make all of 2026 20 plus percent quarterly earnings growth. And then the first two quarters of 2027 above 15%. That's an unbelievable streak of earnings growth. So, with that kind of baked in already to why we're hitting market highs, right? What happens when the What happens when the market start start stop to stop cooperating? Excuse me. >> So, a couple of thoughts for you. Mark Zandi at Moody's.com. He is the chief economist. And he takes the data that Greg showed. Greg, you showed the data by income. And he recasting the data by wealth. You know, how much money do you What's your net worth? And according to his data, the top 20% of wealth It's a It's It's It largely over over intersects with income, but not totally. But the large the top 20% of wealth is now 55 50% of retail sales. And that is the most concentrated it has ever been on the top of the K or the top of the wealth tables largely because of the stock market. Now, I'll throw in another statistic. Eric Balchunas at Bloomberg did a a piece a couple months ago talking about the stock market. And it was about whether or not the Fed would intervene in this in in a stock market sell-off. And he did make an interesting statement, which I believe to be true. It's And the statement is the stock market is now more important to Americans' retirement than Social Security. Uh So, you hear politicians, we're in the election season, right? What what are we going to do about Social Security? And how are we going to make sure that everybody gets their Social Security? Well, actually, stock market might be more important. And so, you're right that this is the driver of everything is this massively large well over 200% of GDP stock market that we've never seen. And you're correct that not only does the stock market uh if it stumbles and it it goes down does it affect people's outlook for retirement? It's going to affect their spending habits. It's even going to impact the government's budget because there's a bigger share of the government's budget the taxes the government raises now from capital gains than we've ever seen. And it's the you know, it's a minority part, but it's a significant minority. What happens if we have a couple of bad years in the stock market and there are no capital gains? There are no capital gains taxes. The stock market goes sideways to down. If you think the budget deficit's big now, wait till you see what it becomes afterwards. So, yes, I I mean I don't have an answer for you, but I could just say it really is about the financial markets and it really is about you know, them driving everything right now and that is why your chart Alex was was spot-on. The K is the S&P going up and the vast majority of people as measured by consumer sentiment which don't own stocks or own not enough stocks to matter. I mean they probably have they probably have some brokerage account with something in it, but it's not enough to change their life like the top half of the K is going down. And so, you know, the the the stock market is the driver on the way up and if it ever does peak, it will be the driver on the way down. >> Yeah, so so the question the question I wanted to bring us back around to was you know, we we we saw in 2008 a lot of the Occupy Wall Street movement and things like that where the bottom half of the K essentially revolted against the top half of the K in a way. I mean, you you you had protesters essentially saying that you Wall Street guys are stealing our money, which is which is not the case, but you had the sentiment reach a boiling point that didn't work out well uh in that period of time. So, I'm curious following on what happens when, you know, the market stops cooperating, what does that do for, you know, this for the actual sentiment indicator? If the top half of the K does, you know, have to lose money in equity land, right, to to bridge this gap a little bit, doesn't it also lose money for the bottom half of the K that they were also making even if it was a modest amount? You know, why would that then drive sentiment any higher than any of anything else? Any thoughts on that? >> Yeah, it won't. You're right. I mean, the the argument you're giving is what if the top half of the K were to lose in the stock market, they would demand less, that would bring down inflation. I Yes, that part is true, but the bottom half of the K is going to be reliant on the top half of the K for their job, uh for a lot of other things, and that could they could be in adversely impacted as well. That's why you never want to let your economy bifurcate as much as we've seen now. To your question about what happened in 2011, you know, we had two part Remember, we had two protest movements at the same time. We had the Tea Party movement, and we had Occupy Wall Street. And they all came as a response to the housing crisis, which led to a 50% decline in the stock market. And it was kind of interesting because the way I looked at them was they were both complaining about the same thing. Asset values went down a lot. Uh the Tea Party movement blamed the government and Occupy Wall Street blamed Wall Street. But they were all in agreement as to what was the catalyst that they were complaining about was falling prices, uh falling asset prices. And now asset prices are bigger. They're They're a bigger part of the economy. Um and they're getting to be even bigger when you consider the big rush in AI. So this is going to be the issue as we move forward from here. We have to do something about inflation. 3% inflation, being above 2% for 66 straight months, Alex, as you said, is unacceptable, full stop. And this is what's driving interest rates higher as it should. And this is not something that we cannot The worst answer we could give is throw our hands in the air and say, "I guess we're in a 3% inflation world and we'll just have to revalue to everything like that." Bottom of the K will not like that answer because that means that it's acceptable for them to continually lose purchasing power unless you want to start giving them raises. Problem with giving them raises is then you cement a 3 to 4% inflation world. So we're in a difficult spot right now. Stock market doesn't see it that way. Stock market is operating under a small part of 20 or 20 or 30% of the public, but the other 70% of the public being felt left out. That's the bottom of the K and they're not They're not seeing the same economy. Witness the YouGov polls I showed. >> Yeah. I want to ask you guys one last question here as we as we wrap this up. If you were Kevin Warsh or if you were Scott Bessent, I mean, where where do you How do you go and tell the president, regardless of who the president is, that this is what the country feels, this is what's happening, and this is how we have to address it. Where if you were Kevin Warsh sitting at as the chair of the Federal Reserve, I mean, do you just throw your hands up and say there's nothing I can do because it's a fiscal issue? Greg, what do what are your thoughts on that? >> Well, you're exactly right, and that just shows what a pickle this is that the Fed can raise rates, but again, if we're talking about, you know, one of your questions was what happens during the next financial crisis or next time something goes wrong, you need to have some dry powder to, you know, help ease the situation. And in 2008, you know, going into 2009, we kind of had that, and, you know, we went through QE, all of the different iterations of QE, and then again, like by the time the pandemic came around, it was again, okay, we're going to spend more money, but now it's getting kind of to a point where, okay, fiscally, this is getting maybe a bit much. We haven't really the deficit hasn't really come down as a percentage of GDP much since then. So, then the question is, you know, what happens the next time? The Fed, you know, can only raise rates or lower rates. That's not going to fix the problem with the deficit, and then particular, maybe having some dry powder ready waiting on the sidelines for the next, you know, financial crisis. So, to answer your question, I don't know what Kevin Warsh could really do. I mean, he needs to just stay in his lane and do what the Fed is supposed to do. Right now, he has, you know, very little leverage, I guess, over whatever else happens with the rest of the government. >> You know, I'll throw in just a a follow-up to what Greg said. Uh the Tuesday, October 13th, the government's going to report the or the monthly Treasury statement will come out. We'll get the final 2026 uh deficit numbers because the government uses a September 30th fiscal year-end. Uh the deficit GDP is expected to be about 6%. Double Scott Bessent's 333 3% deficit, you know, uh uh 3% growth and uh 3 million barrels of oil is where his 333 was. 3% of the deficit, so we're going to be double that. There's only been six times in American history that we've had 6% deficits. And those have been the Civil War, World War I, World War II, the global financial crisis, COVID. Those are five of the six. And those were all a response to an existential crisis in the economy, maybe even the existence of the country, if you want to talk about the Civil War. Um which is why forget the deficit, we just have to do what we have to do in those five. The sixth one was 1983. We got a 6% deficit to GDP, and the bond market rioted in 1984, and it went to 14%. And it forced the government to rein in and pull back that deficit. We're doing that now without an existential crisis to the country. So, we're spending as if there's a crisis, and there isn't a crisis. And I think that that therein lies the problem. Remember, I said if there's anything that seems to fit with inflation is massive government spending, massive consumption of goods and services by the government through its spending that is pushing up inflation. And the problem is what I fear is is that on the next downturn, oh, we'll just spend more. We'll go to 10%. We'll go to 12%. Yeah, you're just going to create more inflation. And all you're going to and you're going to push everybody in the bottom of the K further behind. So, while the sun is still out, while we don't have a problem, we need to get the deficit under control. And unfortunately, I'll come back to something I said earlier. President wants to reward everybody by voting Republicans for $5,000 checks, and the Democrats are mad at them cuz they didn't think of it first. So, neither party is really in the mood to try and pull back on government spending, the American public isn't going to elect people that are going to be fiscally responsible. And I think it really kind of starts there. You know, the uh famous H.L. Mencken line, you know, uh elections are the idea that you vote what you want, you should get it good and hard. And maybe if we continue to vote people that just recklessly spend, we run the risk that we're going to get it good and hard from all that reckless spending. >> What a pickle we're in. And that about does it for today's episode. Make sure you like, subscribe, and leave any comments you have below, and we'll see you guys next week. Thank you, Jim and Greg.