I will provide a fair warning for potential readers up front. This is not a short article and I've incorporated a number of links to other articles and reports to support my case. For those willing to invest the time, I hope this article provides some insight about how we got here, where we need to go from here, and what we need to do to get there and away from "here".
Where is "here"? The middle class in America has apparently fallen behind financially in both income and assets to such a degree that the middle class in America may shrink significantly or disappear altogether as we know it. Why did I say "apparently fallen"? Because I haven't seen the effects of this fall myself. I've not experienced the financial fall myself and the people we know and interface with, our circle, have not experienced this or are doing a darn fine job of hiding the impacts. Regardless of not being able to see it myself, the data clearly indicates this has and is happening in the middle income group in America.
I'll admit that it has been hard for me to fully buy in or accept as fact that the middle class in America has and continues to fall behind financially. It is not because I've never experienced similar circumstances. I hail from very humble beginnings having spent much of my childhood on my grandparents' small farm where we had no indoor plumbing in the 5 room, 800 square foot farm house. I remember my parents stressing over their inability to provide the $3.00 per week for me to get hot lunch tickets in elementary school. So, I at least know what financial stress should look like.
Today, I don't see the financial stress of the middle class. Regardless of not seeing it, it is real and, if not addressed, it will likely have a negative impact on the US economy in the future. Without a middle class, the consumption and consumerism that drives 70% of our US economy will shrink. We will have lower demand for consumer goods and services in the US, less manufacturing and industry than we have today and we run the risk of having only two significant income groups in the US with most households at the bottom of the income distribution and a few at the top. History has shown that this type of income distribution drives fundamental change by those that govern; in our case, we the people.
This issue will likely be one of the key topics of continued discussion during the current presidential campaign season. Bernie clearly believes that a large part of the solution involves taking money through the tax system from those that have it and redistributing it to those that don't. Hillary, as far as I can tell, has reluctantly joined Bernie's crusade to make the rich pay more. I strongly believe that approach would lead the US down the wrong path with the end result of turning the US into another EU country look-a-like. We can do better.
Where is "Here"?
A picture is worth a thousand words and the one below provides a pretty clear discussion of where the middle class is today.
Well, maybe it's not quite that bad, but it conveys the idea that the middle class in America is not doing well financially. Is this really true? Is the American middle class really in dire straits financially? If you look at the average net worth of US households, you might conclude otherwise.
In looking at the average net worth data above, one could conclude that the average retiree has a net worth close to $844,000 just before heading into retirement. That's not too shabby. The problem with averages is that they can be skewed if the distribution is not "normal". In the case of US household wealth, the distribution is skewed to the high end due to a relatively small number of households having a very high net worth. In this case, it is more instructive to look at the median net worth data.
The chart above gives a very different picture with 50% of the population in each age group having a net worth higher than the median and 50% having a lower net worth. It is also instructive to study the red bars in the chart above which represent the median net worth of US households sans equity in their primary residence. The chart above says that the typical 64-year-old heading into retirement carries a net worth of closer to $27,000, excluding their home, nowhere near enough to provide any appreciable income in retirement.
Another sobering statistic from the Federal Reserve is that 47% of US households could not cover a $400 emergency expense without resorting to a credit card or selling a belonging. I found this factoid to be nothing short of earth shattering. We often look at unemployment statistics, wage growth data, consumer consumption and other data, but none of that data provides any indication of the extent to which American households are living paycheck to paycheck. For a more detailed discussion of how closely American households are to the edge of the financial cliff, the interested reader should peruse Middle Class Shame.
Middle class incomes have not only stagnated, they have fallen in the last few years while productivity has continued to rise.
Real median income for the middle class has fallen from about $54,000 to about $46,000, or nearly 15% adjusted for inflation over the 23 years reflected in the chart above. This would put a crimp in anyone's ability to save for a rainy day or retirement or even cover all the bills of a growing family. For those readers looking for yet more on the state of the American middle class, the article, American Families on Shaky Ground, gives a more complete picture.
How Did We Get "Here"?
There is not one boogey man to blame for the middle class financial ills today. I've seen a number of posts on Seeking Alpha as well as other articles laying the blame on corporations and/or banks for, essentially, sucking up more than their share of income. I'm very doubtful of this rationale for explaining the current financial state of the middle class. We don't have a "zero sum" economy in the US such that if one group or sector of the economy pulls in more revenue or profit, other parts of the economy must necessarily take in less. I'd call this the "fixed pie" rationale. The banks took too big a piece and, therefore, I get less is an easy answer but not a credible answer.
Our current crop of progressive politicians are fixated on the concept that the rich and/or our corporations don't pay their "fair share" of taxes. This rationale only has merit under the assumption that government would or should redistribute the additional taxes collected from the rich and from corporations to those who have less income. I am skeptical that taxing the rich significantly more would be a solution. Today, the top 20% of the income earners in the US pay 84% of the federal income taxes collected, the bottom 20% of income earners in the US get a credit (net payment) on their taxes, and 47% of US households pay no federal income taxes (see article here). Are there some fixes needed? Certainly, there are. Should hedge fund managers paid via "carried interest" pay taxes at the long-term capital gains rate? Probably not. But, in general, our current tax structure is already very progressive.
Raising corporate taxes from where they are today I believe to be an even worse fix for the financial malaise of the middle class. Corporations don't really pay the taxes. It is a cost of doing business that is passed through to the end consumer. If we raise taxes on Pfizer (NYSE:PFE) or Apple (NASDAQ:AAPL), the cost of drug prescriptions and your next iPhone will be higher. The US already has one of the highest corporate tax rates compared to the other developed economies of the world.
The US is not and cannot return to being an island nation. We are in a global economy and our corporate taxes are already high enough to cause US companies to move to lower tax jurisdictions or hold profits outside of the US. This is not anti-American, unpatriotic, or criminal. It is simply good business on the part of corporations attempting to lower their costs and increase their profits. It is capitalism.
So, if the rich, the banks, and the corporations are not the boogey men that are pushing down the middle class, who is or what is? As is often the case in the real world, the reasons for the middle class malaise are complex and varied. From the end of WWII through about 1972, most of the goods and services consumed in the US were made or originated in the US. Products made in Japan and god forbid, China, were generally cheaply made and not of good quality. But that quickly changed in the years after 1972. Japanese manufacturers significantly improved the quality of their products, followed by Korea, followed by China, followed by... you get the picture. With improved quality and manufacturing processes combined with cheap and abundant labor, more and more goods were manufactured overseas for sale in the US. Today, cars and trucks manufactured by Toyota (NYSE:TM) have surpassed most other manufacturers in quality surveys and resale value. Today, we have no qualms about buying products made in China, Korea, or Vietnam to name just three. Today, we have a global economy where manufacturing can seek out the highest efficiency and lowest cost producer for their products. Example: My neighbor is an account manager for a conglomerate company that sells all kinds of household products and tools in the US. He is routinely traveling to Brazil, China, Korea and other countries where the company has their products manufactured. The company is doing well, my neighbor is doing well, and the rest of us enjoy the use of those lower cost household items and tools that his company has manufactured overseas. The downside of all this is that many of our middle class manufacturing wage jobs have moved overseas.
Following this period of job migration out of the US to other less expensive locales, we began to automate our remaining manufacturing processes. Assembly and production jobs that were previously performed by people, were replaced by robots. Robotic assembly lines cost more to initially set up but are much cheaper in the long run. Robots don't join unions, don't go on strike, don't require healthcare insurance, and don't need a pension. If we look at just one example, the US auto industry, it will serve to make the point. In 2003, there were 16.4M cars and light trucks sold in the US. In that same year, 228,000 people were employed on the assembly lines making cars and trucks in the US. In 2015, there were 17.8M cars and light trucks sold in the US but only 131,000 people were employed on the assembly lines making cars and trucks in the US. That is almost 100,000 high paying assembly jobs lost in one industry alone. For those interested, I published a more complete article on the long-term outlook for continued automation and robots replacing traditional manufacturing and industrial jobs in the US. That article can be found here.
The 2009 Great Recession in the US impacted all income classes but hit those in the middle and lower income brackets that hardest. Those in the upper income brackets tend to have more diversity in their family assets, including business ownership, home equity, stock, bonds and other liquid assets. Families in the middle and lower income brackets have a much higher percentage of their assets tied up in home equity and small business equity. During the great recession, most asset classes were negatively impacted, with precious metals being an exception. The liquid asset classes (stock, bonds, etc.) recovered relatively quickly but home equity and small business equity did not. Foreclosures as a result of the 2009 financial crisis are still ongoing in many states. Whatever equity a family may have had in their home or small business that was foreclosed is gone with no chance for recovering those assets. It did not help that the US from about 1998 right up to the crash in real estate prices fostered home ownership through pushing relaxed loan qualifications and lending standards. This resulted in families being more leveraged on their homes than they otherwise would have been and resulted in more foreclosures after the crash in home values. The chart below shows the impact of the 2009 financial crisis on US households.
The table shows that while upper income families' net worth has recovered since 2009, those families in the middle and lower income brackets are seeing their net worth continue to drop.
The headlines say that employment is up and unemployment is near or at the Federal Reserve target. If so many people are employed, why is the middle class still suffering financially. It is because of the way we collect and report our employment statistics in the US. In summary, the US unemployment rate does not count those people who have gotten discouraged and have given up on finding employment, it does not count those people who are working only part time but want or need to work full time, and it does not account for those people who previously had a $60,000 a year job but are now earning only $30,000 a year. The way I view this phenomena is that the quantity of jobs has recovered but the quality of jobs has not. A more complete discussion of today's employment environment is provided in the article, Why America's Impressive 5% Unemployment Rate Still Feels Like a Lie.
Where Do We Go From "Here"?
Maybe the first question for the investment community is "Why does this matter to me?" Take a look at the chart below.
Consumption and consumerism drive roughly 70% of US GDP. Historically, the middle class spends the majority of their income on goods and services in the US. That consumption includes, not only housing, utilities, and food, it also includes autos, cell phones, clothes, restaurant meals, computers, vacations, and all manner of other items. Those families in the upper income brackets typically spend a smaller fraction of their income in consumption of goods and services, choosing instead to save and invest a large fraction of their income. I have no idea where the breaking point is, but it is clear to me that if the middle and lower income brackets continue to see a decrease in earnings, US GDP will be negatively impacted. It may already be occurring and we cannot see it because we are not yet looking for this type of impact. If the middle class consumption in the US falls, fewer cars will be sold, fewer cell phones will be sold, fewer restaurant meals will be enjoyed, and fewer vacations will be taken.
So, where do we go from "here"? How can the shrinkage in middle class incomes be turned around. As I said earlier, the silver bullets being offered up by some of our presidential candidates are duds. Raising the taxes on "the rich" and/or making corporations "pay their fair share" is a band aid at best and increasing corporate taxes may actually make the situation worse as the additional taxes are passed through to middle class consumers.
I believe the solution lies in addressing the issue of the quality of jobs being generated in the US. And no, that does not mean raising the federal minimum wage to $15 or any other number. Raising the federal minimum wage may make some currently poor workers a little less poor but will raise the cost of many goods and services for all. Raising the federal minimum wage is another form of band aid that will not move the needle for America's middle class families.
The US needs to bring back to the US the relatively high paying manufacturing and production jobs that we have lost to other countries. For this to happen, we will need a more competitive corporate tax structure than we have today. We need a more business friendly environment in the US than we have today. To create a more business friendly environment in the US, we will need stable business regulation as well as business taxation. Companies cannot plan and will not commit to growth investment in the US with business regulations and taxation continuously changing. Most of us probably don't know how many regulations are already in place or how changes in those regulations impact the businesses in the US. For a complete picture of why this is important to US business, I recommend reading New Regulations Can Cripple American Business and $22 Billion Savings Cutting Ridiculous Regulations.
The US has opened up its market to the global economy and has very few restrictions, quotas, or limits on what products can be imported for sale in the US market. But, other countries have not opened up their markets fully to US goods and services. Take for example Japan. Japan has essentially full access to US markets for the products they produce. But, Japan has a plethora of restrictions and limits on the importation of US goods and services, including fruits, vegetables, beef, and lumber. Many of those Japanese limits and restrictions are hiding behind tall barriers to entry in the form of paperwork, permits, inspections, etc. Nonetheless, in the end they are import restrictions with the intent to limit the importation of products from outside of Japan and to protect Japanese producers. Free trade and open markets must be so in both directions to allow US companies to compete on a level playing field.
The middle class in America has been suffering financially for many years and, likewise, there is not a quick fix for their malaise. I do not believe in our government's ability to directly fix these issues. Government jobs are temporary, tax cuts are temporary, retraining takes a long time and there is no guarantee a job will be available after retraining, and redistribution of wealth only works until you run out of other people's money. I believe that only private enterprise can solve the issues impacting the middle class and that the next administration and congress must understand the necessity of providing a stable pro-business environment for US business to compete and grow in our global economy. This is the only way America's middle class will regain their financial health.
What Is An Investor To Do In the Meantime?
If the next administration and congress are smart enough to understand that a more stable and accommodating business environment is needed in order to compete in today's global market and the US starts moving in that direction, the changes won't happen overnight. It took many years for the financial health of the middle class to sink to where it is today and it will take several years to regain that financial health. What is an investor to do in the mean time?
I find it interesting that out of the 12 sectors that CNN/Money tracks, Consumer Non-Durables performance is dead last and Retail Trade is second to last. I am, by nature, a very conservative investor. I don't pursue momentum stocks or the latest quarter's hot stock. I generally look for what I refer to as macroeconomic trends that provide tailwinds to a particular sector or industry.
Example: The baby boom generation is now starting to retire in mass; by some estimates at a rate of 10,000 per day in the US alone. The trend of boomers retiring will last for the next 30 years and we are just now on the leading edge of that trend. That is a major macroeconomic trend that will provide a strong tailwind for both health care stocks and real estate investment trusts (REITs). I'm long a number of stocks and REITs to try to capitalize on this trend. My holdings include Allergan (NYSE: AGN), Physicians Realty Trust (NYSE: DOC), Welltower (NYSE: HCN), Omega Healthcare Investors (NYSE: OHI), Sabra Health Care REIT (NYSE: SBRA), Ventas (NYSE: VTR), Pfizer (NYSE: PFE), and the Vanguard Health Care Fund (NYSE: VGHCX). For a more complete discussion of the boomer impact on the healthcare sector, the reader is directed to previously published SA articles, These REITs Will Profit and Riding The Age Demographics Wave.
I believe that the poor financial health of America's middle class is already having a negative impact on retail trade and consumer discretionary purchases. Rather than a positive tailwind, I view lack of a robust and growing middle class as a negative headwind on retail and consumer non-durables. Add to that headwind the competition that traditional brick and mortar retail outlets have from online internet sales and it becomes clear why traditional retail and consumer discretionary stocks are lagging. As a consequence, I own exactly zero individual stocks in either of these sectors. I also own exactly zero REITs that focus on shopping mall properties or shopping center properties. There are plenty of other industries and stocks that have positive tailwinds available.
I am optimistic that future administrations and congress will see that the middle class is suffering financially, will understand what changes in US policy are needed to reverse the slide in middle class incomes, and will implement policies to move us in that direction. When that happens, I'll be trying to determine what sectors and industries will benefit from the macroeconomic trend of a robust and growing middle class.
Disclosure: I am/we are long AGN, DOC, HCN, OHI, SBRA, VTR, PFE, VGHCX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.