The tiny economy
The economy as we measure it mostly ignores most people and things
We say ‘The Economy’ but we analyse “The money flows associated with the economy” and can’t tell the difference
The money flow impact of riots is negligible - which is why they’re happening
The risk on narrative will change if we see bankruptcies within the tiny economy - the small sphere of activity responsible for most money flows
As citizens in the worlds biggest economy take to the streets to protest excessive policy violence, the claims on the output of that economy represented by stocks are pushing ever higher in value. Some have remarked that this means that stock prices have little to do with ‘The Economy’.
I reject ‘The Economy’. When people say it, they mean “the production and consumption of goods and services”. But we don’t analyse it like that. The quantity of money that accompanies the transactions that measure the production and consumption of goods and services is the only measure that we have, and has become identified with ‘The Economy’ everywhere. This is an analytical disaster. It leaves us unable to trace the consequences of the changes we observe in reality. We think the Economy is much more representative of reality than it is.
By way of example, consider the current police riots in the US. Huge numbers of people are affected, whole commercial districts of cities gutted by looting. But consider the absolutely tiny slice of ‘The Economy’ that is actually affected by them. Retail trade made up approximately 5.5% of GDP in Q4 2019. What we think of as the driving force of the economy, the consumer, is not driving the economy by going to the shops - but by passing money from one hand to another as they “consume” essential services (Real estate, 13% of GDP. Health and Education, 10%).
Then consider the tiny slice of national income that the affected have to spend. The wage share in GDP is in the low 40%’s, so the majority of income is not from employment but from assets or from the government. Then, in 2018, only 60% of that employment income accrued to the bottom 90% of earners. So that’s 24% of the income to be split among more than 90% of the people - poorer families tend to be bigger. Then, consider the wage divide between black and white families. Black families’ median and mean incomes are in the low 60%’s of those of whites. So as an upper bound, the approx 11% of the population that is black and outside the top 10% of households lives on 1.75% of the national income. By contrast, the top 1% of households by income earn around 22% of wages, and hold something in the region of 40-50% of measurable wealth. Macroeconomic aggregates give huge consideration to this tiny segment of the population. ‘The Economy’ is very small indeed. The fact that it barely registers those in the streets is a large part of the reason they are in the streets.
At the end of April, I thought another month of risk off would be consistent with historical experience. In the sense that this rally is getting a bit longer in the tooth than I expected I’m surprised, but the fact it’s continuing whilst city centres are sacked and people suffer en masse is not surprising at all. The economy in the sense of the flows of income and expenditure that support the valuations of financial assets is mostly unaffected by such things. It’s not that stock prices are divorced from the economy, it’s that the economy is not a representation of everything that’s happening. A Tesla will set you back around $45,000 for a cheaper variant - around the median income of a black household. When we talk about the economy, we’re talking about a frame of reference that equates the entire production and consumption of a family for a year with the purchase of a car. That’s a huge emphasis on a tiny slice of reality.
The purpose of this post is not a moral lecture, but an analytical point. What matters for financial analysis is what happens to flows of money - and only that. The things that cause big changes to flows of money are not necessarily the same things that cause big changes in peoples’ lives. Covid19 has been exceptional for the coincidence of the two - but it is not the rule. Indeed, the impact of Government action has been to sever the links between money flows, production and consumption. The re-opening of economies currently being cited as the reason for the endurance of this risk rally is barely having any impact, by itself, on money flows. Indeed, data on money flows - promptly available from the Fed - show contracting credit for businesses and consumers even as “real” measures of economic activity improve. Risk rallied yesterday with stronger than expected ADP employment print, and China’s services PMI printing in expansionary territory. The problem with this narrative is that expansion from a low level of activity won’t necessarily restore money flows - even with record levels of money stocks. The stock of money is not the money supply.
The problem with stories like “The Riots are hurting the economy” or “Re-opening will help the economy” is they don’t ever have to collide with reality. In this moment, it’s easy enough for the former to be believed because of widespread unemployment and covid19 misery. The latter can be believed so long as the first derivative of the data is positive - which is almost guaranteed after such a huge sudden stop. The market has embraced the latter narrative over the former, but in reality neither are likely to be true. The tiny economy is barely impacted by the riots at all, and government policy has severed the link with Coronavirus. Only interruptions to investors’ cashflows can disturb the narrative. So far, every effort has been made to prevent this. Bankruptcy is the only thing I can see changing the story. Not bankruptcies in the real world, but in the tiny economy - the few firms that attract and disburse the biggest money flows. Until that happens, a reflation and recovery narrative can drive prices as far away from so called fundamentals as you can imagine - and then some more.
NB: This post is not investment advice and is not a trade recommendation. The views expressed here are my own and do not reflect those of my employer.