El-Erian: Is Piketty right about investment strategies?

May 28, 2014, 8:37 PM UTC
<<enter caption here>> on April 23, 2014 in Berkeley, California.
Justin Sullivan 2014 Getty Images

FORTUNE – Having surged to the top of best-seller lists, Thomas Piketty’s Capital in the Twenty-First Century continues to attract attention, and rightly so. With the initial flurry over its conclusions now giving way to an intensifying debate over the underlying data, the interest will continue to grow for quite a while yet, as will analytical work on inequality – a topic that is capturing greater public awareness.

Yet there is one related area that, until now, remains under, if not unexplored: The extent to which the book can and should inform investment strategies.

Piketty’s analysis of several countries over history highlights how the return to owning capital (what he labels “r”), be it financial or real estate, tend to exceed the rate of economic growth (“g”). As such, income inequality rises; and it does so until the social fabric erodes excessively and/or the rich recognizes it is in their self-interest to capture less of the country’s wealth.

Piketty’s numbers-driven analysis, while subject to counters, reinforces what some others have documented using other data sources. Moreover, and quite counter-intuitively considering it has only been six years since the financial sector almost tipped the world into a Great Depression, increasing inequality has been a notable feature of the much-shorter post-financial crisis period.

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Turning to market implications, well-off households have been richly rewarded in recent years by taking significant exposure to capital markets. Luxury brands serving the rich have out-performed, as have activities aimed at supporting vulnerable segments of the population – that is to say, at the two extremes of the income and wealth distributions. The average returns to labor services have been disappointing as reflected in the protracted sluggishness of wage earnings and unusually high unemployment.

Taken at face value, Piketty’s analysis would suggest a deeply engrained nature to these market tendencies, suggesting that investors can exploit them further, especially on market pullbacks. Moreover, he is among those that acknowledge that effective measures to counter increasing inequality – in his opinion, a wealth tax – are political non-starters.

Meanwhile, there is little to indicate that the U.S. is anywhere near a tipping point when it comes to factors that would stop and reverse growing inequality – be they economic, political and social. And the rich appear in no rush to counter a trend that, left unchecked, would eventually result in an excessive level of inequality that would harm their own well-being.

But before investors rush to market insights from Piketty’s analysis, they would do well to remember a few things regardless of whether you agree with his analytical approach or not.

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First, the recent surge in U.S. inequality has also been fueled by a monetary policy approach that is highly supportive of asset markets. This is not because central banks favor inequality. Rather, they have been compelled to rely on an inevitably narrow policy tool kit in carrying the bulk of the policymaking burden – whatever it takes to boost financial asset prices as a means of stimulating economic growth.

This policy support is now being gradually withdrawn in the U.S., the most systemically important economy. Few can predict how quickly the changed conditions would eat into the wedge between market valuations and underlying fundamentals, particularly if economic growth fails to attain the desired lift-off.

Second, increasing inequality is but one of several secular/structural forces that influence returns. Others include ageing demographics, re-regulation, a new globalization phase, inadequate governance, a changing institutional landscape in finance and fluid geopolitics.

Third, the Piketty sectoral influences pale in comparison to the impact of advances in disruptive technologies, particularly those enabled by the powerful mix of the Internet, social media and innovation. These, as well as what is happening in energy, have the potential to upend whole segments and companies, giving rise to particularly bimodal investment outcomes.

Finally, the “r-g” phenomenon encourages financial leverage overshoots, particularly when “g” appears to be stuck in a stable low-level equilibrium, when policy intentions are well-telegraphed, and when investors are wedded to their forward-looking return targets regardless of how much valuations have moved.

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This is the case today judging from the extent to which over-crowded trades have compressed virtually every risk premia – be they credit, default, liquidity, or volatility. The result is an increased risk of credit bubbles and, with that, sudden market corrections that can be quite indiscriminate in their scale and scope.

Piketty’s book is an important contribution to a broadening and timely debate on a key challenge facing a growing number of societies around the world. It also suggests interesting investment insights, though they do not aggregate into a playbook for markets.

Mohamed A. El-Erian is chief economic adviser to Allianz, chair of President Barack Obama’s Global Development Council, and author of ‘When Markets Collide.’ He is the former CEO and co-CIO of PIMCO. Follow him @elerianm

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