Bernie Sanders was a low-profile U.S. Senator who had been mayor of Burlington, Vt. Further burnishing his national political credentials: He is a proud socialist. These are not the typical attributes of a promising national political candidate. Yet, when running for the Democratic presidential nomination, Sanders won 23 primary contests against deep-pocketed, prohibitive favorite Hillary Clinton.
Meanwhile, at the end of last year, anyone predicting that Donald Trump would emerge as the Republican presidential nominee would have been laughed out of the conversation. He is a career private-sector deal-maker, self-promoter and showman bordering on caricature.
As a candidate, Trump has proven to be thin-skinned, impertinent and frequently uninformed. These aren't the traits normally associated with successful candidates, either.
Yet, barring a coup at the Republican Convention, Trump is the nominee.
Finally, the defeat of the Brexit in the U.K. was considered a fait accompli by bookmakers, experts and markets, and then the Brits voted to leave the European Union with 52% of the vote.
Have we entered bizarro world, or is there some other explanation for Sanders, Trump and the Brexit?
All three are manifestations of the same global dynamic, and there is probably more to come. When public disaffection reaches sufficient breadth and intensity, improbable outcomes can become realities.
But what are the roots of this antipathy toward the status quo?
A disparity in income growth in advanced economies or income inequality hasn't produced social unrest historically. In fact, rising income inequality has often coincided with periods of broad prosperity, which isn't a coincidence.
Income inequality doesn't appear to present meaningful societal problems, provided that lower-earning cohorts' living standards are rising in real terms and there is opportunity for upward mobility out of the lower-income brackets. The stubborn persistence of the bottom quintile of earners representing a small percentage of overall income, which is frequently cited as evidence that lower-income earners aren't participating in the rising tide of wealth accumulation, is largely just a static reflection of young people starting their careers.
The population of adults age 16 to 24 represents about 15% of the overall U.S. adult population. This age group is constantly turning over, yet it ensures structural, significant numbers in low-earning quintiles.
It isn't a group trapped in a cycle of poverty, provided that young people can find quality entry-level jobs to begin their career paths. But both these conditions have moved in the wrong direction over the past decade and a broader population is, for the first time since World War II, being left behind.
The stagnation of median income in advanced economies near late-1990s levels and persistent, historically high youth unemployment are the results of the broader absence of economic dynamism and vitality reflected in low-money velocity, anemic private-sector capital spending and as a result, sluggish gross domestic product growth.
The top quintile of earners increased in share of comprehensive income in the 15 years from 1983 to 1998 (see chart below) and maintained that share in the last 15. Yet, the first period was one of great prosperity, while the latter has yielded the call for radical change at the ballot box.
U.S. Distribution of Comprehensive Income by Quintile
Income inequality is a nearly meaningless metric in the absence of context, notwithstanding the rhetoric of demagogues. What is meaningful is the decline in real household income for the bottom three quintiles of U.S. earners over the past 15 years (see chart below).
This is a stunning trend, particularly when the labor force participation rate among those age 16 to 24 continues to languish at about 55%, compared with 65% in 2000 and about 60% prior to the financial crisis.
Real change in U.S. household income (end-to-end nominal income minus CPI)
In the U.K., the picture has been similarly bleak for earners, as wages continue to languish near 2002 levels.
Median full-time gross weekly earnings in current and constant (2015) prices, U.K., April 1997 to 2015
Source: Annual Survey of Hours and Earnings: 2015 Provisional Results
These protracted trends have made income inequality an issue of real concern for the first time in the post-World War II era, threatening the socio-economic stability of western society and creating the backdrop for radical change. The next economic and market downturn is going to be ugly, and the degree of systemic instability continues to be under-appreciated.
Could the Brexit mark the tipping point?
The longer a market goes without experiencing meaningful downside, the further into the future that market discounts stability. Risk apathy breeds riskier behavior.
Ironically, markets are often at peak confidence in risk-on portfolio configuration at the points of maximum systemic risk. This is the dynamic behind asset bubble formation and market crises that no one saw coming.
The psychology of an overplayed or even false narrative can outweigh economics for protracted periods, but in the end, cash flow prevails.
Was the failure of Lehman Brothers Holdings, an entity with $600 billion in debt at the time of its bankruptcy, the cause of financial crisis in a $240 trillion global market? Of course not.
For starters, the so-called Lehman moment was actually just another falling domino in a sequence. The first event listed in the Federal Reserve's full time line of the financial crisis epilogue is Freddie Mac's February 2007 announcement that it would no longer buy the most risky sub-prime mortgages and mortgage-related securities.
Lehman Brothers filed for bankruptcy in September 2008. Freddie Mac's announcement signaled an end to the government-sponsored enterprise put option, no small factor fueling the reckless suspension of basic credit standards producing the financial crisis.
The dubious narrative driving the financial bubble was suddenly breaking down.
Instability had already metastasized throughout the financial system by the time Freddie Mac decided to dial down its purchases of toxic assets. Years of aggressive, pervasive sub-prime lending, magnified by fractional-reserve banking and derivatives, had created a financial volcano waiting to erupt, hidden beneath the veneer of apparent stability.
When systemic risk reaches such heights, relatively minor catalysts can trigger the transition from prodigious underlying instability to actual crisis.
The biggest risk from the Brexit is contagion and the ratcheting up of uncertainty and actual economic disruption. Other members of the EU or eurozone opting out would likely undermine global growth that already has been decelerating for five years.
It is also possible that the EU will try to make an example of the U.K. to discourage contagion, which could manifest in trade barriers triggering a U.K. recession.
German Chancellor Angela Merkel's post-Brexit remarks demonstrate that she recognizes the continuing importance of the U.K. to European trade and economic stability, but it remains to be seen how the EU bureaucrats choose to respond.
Beyond these risks, the extent to which a relatively minor economic event such as the Brexit could serve as a catalyst for crisis depends on the broader levels of systemic risk. High and rising market instability, after seven years of easy money, has been masked by low downside volatility in risk asset prices directly caused by it.
Symptoms of systemic risk include:
- Third-highest level of U.S. stock market valuation in the past century (distinct episodes, based on ratio of price to trailing 10-year earnings)
- The consumer price index up just 11% since the financial crisis, despite a 4.6 times increase in the U.S. monetary base
- Real wages languishing across advanced economies at late-1990s to early-2000s levels
- Chronically high global youth unemployment
- Higher global debt than pre-financial crisis, reportedly up $57 trillion or 40% from 2007 through the second quarter of 2014
- A massive and still unregulated derivatives market
- Decelerating growth of gross world product and labor productivity
As long as the bubble-forming narrative persists, market psychology can trump economics. As we have argued consistently over the past three years, there is no reason to expect long-term rates to begin rising for years, never mind quarters.
But there is no question that the risk profile across economies and asset classes is elevated by historical standards. Investors need to ask if something else will constitute the Freddie Mac/Lehman Brothers moment, given such high underlying instability.