The Macro Trend of Asset Prices in the Age of Common Prosperity

Abstract

How does a widening or narrowing income gap across society affect asset pricing and asset allocation? The focus on the wealth gap in recent years has led to an increasing number of academic studies introducing “heterogeneous individuals” (individuals who differ in certain respects, such as income or wealth levels) to the traditional “homogeneous individuals” analytical framework (in which only identical representative individuals are considered) to explore the impact of changes in income distribution on asset pricing. Most analyses agree that widening of income distribution and the wealth gap tends to make the risk-free rate fall and the risk premium rise. Also, under the assumption of institutional endogeneity, a widening wealth gap leads to a reduction in systemic stability, which also pushes up the level of the risk premium. The analysis of the historical experience of income distribution and asset prices in the US and Japan also provides insights into investment in the context of China’s move towards inclusive growth. The long-cycle history of changes in income distribution in the US shows that corporate profitability (e.g., return on net assets) does not appear to be affected by income distribution policies. Compared to past periods with relatively large income disparities, the average stock market valuation and volatility are relatively low, and sector valuation divergence is relatively small, during periods of relatively small income disparities. China’s current internal and external environment is somewhat similar to Japan’s in the 1970s. Japan’s historical experience of successfully upgrading its industries through technological innovation led to relatively balanced income growth and thus consumption upgrading. This also provides more insights into China’s current policy initiatives and investment trends, which could help the country achieve the goal of common prosperity. The drive toward more inclusive growth by China as well as the rest of the world could have far-reaching implications for global asset prices and asset allocation. From an investment perspective, there are a number of points to consider: (1) The “new paradigm” of investment: Around the world, the increased focus on equity over efficiency has objectively led to a more “inward-looking” policy orientation and a greater focus on versions of “ESG” that are unique to each country. Although regional frictions have increased, a number of countries have also used antitrust laws to target tech firms in their own markets, while also pursuing financial inclusion and concessions in other sectors. All of them have direct investment implications. (2) The global low interest rate environment is likely to change gradually. (3) A more balanced income distribution is expected to mitigate barriers to China’s development and further unleash China’s growth potential. (4) China’s mass consumption market could expand further and improve against the backdrop of more balanced income growth. (5) China’s domestic demand potential could be further unleashed. The country’s sizable domestic demand could help bring about the most substantial benefit as a result of economies of scale since the Industrial Revolution, and the trend in China towards industrial upgrading could be further strengthened. In addition, the trend towards inclusive growth, which may impose medium- to long-term constraints on finance, real estate, and related sectors, is also a cause for concern.

Authors: Hanfeng Wang, Kaisong Huang, Dong Wei.

The central theme of this chapter is how income distribution and inclusive growth could affect asset pricing and asset allocation. This chapter, starting from a literature review, explores the link between income distribution and asset pricing. We attempt to analyze how changes in income distribution affect asset pricing, as well as the income distribution under different policy regimes and historical patterns of asset prices. We also explore asset prices and allocation in the context of the trend towards more inclusive growth in China and around the world.

8.1 The Stylized Relationship Between Asset Price Movements and Changes in the Wealth Inequality

Does the widening or narrowing of the income and wealth distribution gap affect asset pricing? We have observed a clear phenomenon: Around the world, the gap between the rich and the poor has gradually widened over the last four decades, while global risk-free yields have fallen and the risk premium has risen.

More studies have shown a trend of a widening of income distribution and the wealth gap in most major countries around the world in the last four decades or so.¹ In the US, for example, the gap between the rich and the poor has gradually widened since the late 1970s, with the richest 1% of the US population holding a steadily increasing share of the total wealth of the country (Fig. 8.1). The level of excess wages in particular industries has gradually increased. At the same time, the middle-income group’s share of wealth in the US has continued to shrink, and the time it takes for the average household to accumulate the same wealth has gradually increased. Furman notes that from 1943 to 1973, the average household income doubled approximately every 23 years. However, projections based on data from the past nearly 50 years suggest that the time it will take to double the income may extend to 100 years.² The impact of the COVID-19 pandemic and policy responses since 2020 may have further exacerbated the disparity in wealth distribution in the US among different classes and sectors. The US distribution of wealth published on the Federal Reserve’s website³ shows that the total wealth of the top 1% of Americans with incomes as of the second quarter of 2021 was US$36.4 trn. This number accounts for 60% of the total, thereby exceeding the total wealth of middle-income households (US$35.9 trn) for the first time since data became available in 1989.

Fig. 8.1

Source Datastream, CICC Research

The share of society’s wealth held by the richest 1% of the population in the US, the UK, and France continues to increase.

The widening gap between the rich and the poor can be seen not only in the US, but also in most other major countries. Data from the World Inequality Database (WID) shows that around the 1980s, the proportion of total social wealth owned by the higher income groups in major countries such as the US, China, France, and the UK all showed an upward trend. The data in the WID has also been further examined and revised by scholars, and this trend has been confirmed by comparing the trends in inequality dynamics in major economies such as the US, China, France, and the UK.⁴

In line with the widening global income and wealth gap over the last four decades, the performance of major global asset prices has shown a more consistent pattern in terms of risk-free yields and the equity risk premium in the US, namely a gradual decline in risk-free yields and a gradual increase in the risk premium (Fig. 8.2). Still using the US market as an example, the US 10-year Treasury rate has gradually declined from a peak of around 15.6% in the late 1970s to early 1980s all the way to a record low of 0.5% in 2020, at the height of the global pandemic shock. In terms of the equity risk premium implied by the S&P 500, the equity risk premium has shown a gradual upward trend from the late 1970s to the present (Fig. 8.2). In addition to the US, asset prices in major countries such as Japan, Germany, and France have also exhibited these characteristics.

Fig. 8.2

Source Datastream, CICC Research

The risk-free interest rate and equity risk premium in the US over the last four decades.

These observations have prompted us to consider the following: Has the widening global income and wealth gap over the last four decades been accompanied by a decline in risk-free yields and a rise in the risk premium, or have they been linked to each other? How do they influence each other? What are the mechanisms of influence in between? How do changes in income distribution and the wealth gap affect asset pricing?

8.2 How Changes in Income and Wealth Distribution Affect Asset Pricing

To explore the impact of changes in income distribution on asset pricing, it is necessary to introduce heterogeneous individuals into the traditional theoretical model of asset pricing, which is the focus of current academic research. It is useful to combine this with a discounted cash flow model. Income and wealth distribution affect asset pricing through risk-free rate, risk premium, corporate earnings, and economic growth. A simplified version of the schematic formula is expressed as follows:

$$\begin{aligned} &P\left( {asset\,price} \right)\\ &\,\, = \frac{{D\left( {corporate\,earnings\,\& \,ROE} \right)}}{{r\left( {R_{f} \,\& \,R_{p} } \right) - g(corporate\,earnings\,\& \,equilibrium\,economic\,growth)}} \end{aligned}$$

where R_f denotes the risk-free rate, and R_p denotes the equity risk premium.

We can discuss how changes in income distribution affect asset pricing by examining the role of income distribution or wealth inequality in each channel. The remainder of this section focuses on the relationship between income distribution and asset pricing, whereby we analyze the impact of income distribution on: (1) The risk-free rate and risk premium; (2) corporate earnings and return on capital; (3) economic growth; and (4) the industrial structure.

8.2.1 Impacts of Income Distribution on the Risk-Free Interest Rate and Risk Premium

8.2.1.1 Impacts of Income and Wealth Distribution on the Risk-Free Interest Rate

How does income distribution affect the risk-free rate? Intuitively, the more wealth or income a person has, the higher their savings. That is, the savings rate rises with the level of wealth.⁵ As such, in an economy with a given amount of wealth, the more uneven the distribution of income or wealth, the higher the savings will be, which will correspond to a lower level of interest rates. In this way, a widening gap in income and wealth distribution tends to lower the risk-free interest rate.

The analysis of theoretical studies mostly supports this intuitive conclusion. One of the more commonly cited theoretical papers examining the relationship between income distribution and the risk-free interest rate is Gollier’s 2001 study.⁶ He concluded that wealth inequality would reduce the equilibrium risk-free interest rate if an increase in wealth leads to a decrease in individual risk preference. Additional research studies that looked into this further (much of the literature discusses this issue in the context of heterogeneity models) reached a similar conclusion. Aladangady et al. [2]⁷ note that as inequality in household labor and savings income rises, the risk-free real interest rate falls while risky returns to assets increase; the gap between the risk-free real interest rate and the return on capital widens. The magnitude of the decline in the risk-free rate depends on the source of income polarization: When income inequality arises from returns to risky assets, the magnitude of the decline in the risk-free rate is greater than if it were from income inequality due to labor income. Overall, the impact of income inequality on the risk-free rate depends not only on the degree of income and wealth heterogeneity, but also on the ability of households to manage risk through their portfolio decisions.

In economic terms, when income heterogeneity between households increases and the gap between the rich and the poor widens, households tend to purchase risk-free assets for precautionary motives in response to further changes in future income. The rise in demand for risk-free assets leads to a fall in the risk-free interest rate and an increase in the risk premium required to compensate households for taking on risk. Looking at the empirical data,⁸ as mentioned earlier, the last four decades in the US have also been characterized by a rising wealth gap but a lower risk-free interest rate, which may also justify the conclusions reached by the theoretical studies mentioned. The rise in inequality may have contributed to the widening of the observed difference between risky asset returns and the risk-free interest rate.

8.2.1.2 Impacts of Income and Wealth Distribution on the Risk Premium

How do income and wealth distribution affect the risk premium? Intuitively, if the rise in individual risk preferences is marginally decreasing with the growth of wealth, i.e., the wealthier an individual is given a higher amount of initial wealth, the less additional risk he is willing to take: The rise in wealth inequality will push up the risk premium. Most academic research also supports these findings. To investigate the relationship between income distribution and the risk premium, researchers often introduce heterogeneous individuals into traditional asset pricing models. These individuals differ in their qualities, level of patience, and investment skills, among others.⁹

Gollier [19]¹⁰ argues that the impact of wealth inequality on the equity risk premium depends on the nature of the individual’s absolute risk aversion coefficient. Intuitively, if an increase in wealth brings about a decrease in individual risk preference, increased wealth inequality will raise the equity risk premium. This is consistent with the risk preferences of people observed in reality, with low-income individuals being more willing to take risks while wealthy individuals being more risk-averse. If an increase in wealth brings about a decrease in one’s risk preference, i.e., the wealthier an individual is given a higher amount of initial wealth, the less additional risk he is willing to take. This is the point at which rising wealth inequality will push up the risk premium.

The finding that rising wealth inequality will push up the risk premium is consistent with the rise in wealth inequality in the US since the late 1970s, when the share of wealth owned by the top 1% of wealth rose from 21 to 35% of the country’s wealth, and with the upward trend in equity risk premium. Descriptive statistics on income inequality in empirical studies show that the rise in income inequality has been accompanied by an increase in the share of capital income. Research by Karabarbounis and Neiman (2014)¹¹ shows a significant decline in the labor share of income in the vast majority of countries, including the US, since the early 1980s. Markiewicz and Raciborski (2022)¹² find that changes in the equity risk premium may depend on the source of income inequality.

On the one hand, an increase in the labor share of income of capital owners reduces the equity risk premium. This is because labor income is risk-free for shareholders, and an increase in the share of labor income constitutes a hedge against stock market volatility in terms of consumption risk. On the other hand, an increase in the share of income generated from capital usually coincides with a higher equity premium. That is, the higher the share of income from capital, the more exposed shareholders are to additional consumption risk. Thus, the impact of rising income inequality on the equity risk premium depends on the relative change in the share of shareholders’ labor income versus the share of capital income. When labor income grows faster than capital income, the risk premium falls. However, when capital income grows faster than labor income, the risk premium rises. Some studies¹³ also argue that income distribution affects the stability of the system: Higher levels of income inequality are associated with higher risks of social instability, and thus higher risk premium compensation, assuming that the system is endogenous.

8.2.2 Impacts of Income Distribution on Corporate Earnings and Return on Capital

Initial conditions and underlying policies are important when discussing the impact of changes in income distribution on corporate earnings and return on capital. Different conditions may require different policies for promoting inclusive growth. Furthermore, the different policies could have varying impacts on firms’ earnings and return on capital. It is therefore necessary to discuss the impact from changes in income distribution on firms’ earnings and return on capital, in relation to both the initial conditions (stage of production and the group targeted by the policy) and the potential policy mix.

8.2.2.1 Policy Matrix for Inclusive Growth

We use a 3 × 3 policy matrix for inclusive growth, proposed by Rodrik and Stantcheva (2021),¹⁴ as a starting point for our analysis. From the perspective of both the stage of economic development in which the policy intervention occurred and the income distribution of the population involved, a matrix of 3 (pre-production, production, and post-production) × 3 (low-income group, middle-income group, and top-income group) is constructed to classify policies for inclusive growth (Fig. 8.3). To achieve inclusive growth, different policies are used for different income groups and at different stages of production. The impact of these policies on corporate earnings and returns on capital may vary slightly.

Fig. 8.3

Source Rodrik, D., & Stantcheva, S, A Policy Matrix for Inclusive Prosperity, 2021, CICC Research

Inclusive growth and the policy matrix affecting corporate profitability.

Rows of Inclusive Growth Policy Matrix—policies that cover the income distribution of the population. The population can be categorized into three groups: The bottom-income, middle-income, and top-income groups, and the focus of the policy on regulating income distribution differs among the three groups. The overall idea is to raise the low-income group and to strengthen the middle-income group.

Columns of Inclusive Growth Policy Matrix—stages of economic intervention. Hacker (2011)¹⁵ divides the stages of economic intervention into “pre-distribution” and “post-distribution.” Post-distribution is an ex-post policy, i.e., transfers of income and wealth after they are realized (e.g., redistributive transfers, progressive taxation, and social insurance). Pre-distribution refers to policies that directly affect market operations and produce outcomes. Rodrik and Stantcheva (2021) further classify the pre-distribution into two phases: The “pre-production” and “production” phases. Pre-production policies determine the qualities that people bring to the market, such as education and skills, financial capital, social networks, and social capital. Production stage policies are those that directly influence firms’ employment, investment, and innovation decisions.

8.2.2.2 How Do Inclusive Growth Policies Affect Corporate Earnings?

Based on the policy matrix in Fig. 8.3, we analyze the impact of inclusive growth on corporate profitability under different policy combinations.

Pre-production phase: Education and training, inheritance tax, and real estate tax

Pre-production stage policies determine the qualities that people bring to the market, such as education and skills, financial capital, social networks, and social capital. Policies for the accumulation of human capital, such as education and training, help to increase the profitability of firms. The development of basic education and vocational education can raise the average educational attainment among the workforce and in turn increase the productivity and profitability of firms.¹⁶ Regions with well-developed higher education have higher rates of entrepreneurship than the average level; for entrepreneurs, their level of education is strongly correlated with positive business outcomes. A good higher education background for professional managers and executives can improve the profitability of firms via the pursuit of among others.¹⁷ Inheritance tax policies reduce the profitability of family businesses, but may be beneficial in promoting innovation in the sector. Inheritance tax policies affect the strength and longevity of family businesses. The French Civil Code restricts testamentary freedom, enforcing the principle of equal inheritance shares and a progressive inheritance tax regime. In this inheritance environment, it is difficult for family business to remain strong.¹⁸ Empirical studies show that family firms are less likely to engage in R&D innovation, especially breakthrough innovation.¹⁹ Dieleman (2019)²⁰ suggests an “ability-and-willingness paradox” of innovation in family firms, whereby family firms are relatively more able to invest in innovation but less willing to innovate for change.

Production phase: Market competition, physical investment, and R&D and innovation policies

Decisions that firms make regarding employment, investment, and innovation under the influence of production-phase policies will directly affect the profitability of firms. In the short term, minimum wage policies may reduce the profitability of firms. However, in the long run, minimum wage policies enhance it. Specifically, in the short term, minimum wage policies may hinder business profitability,²¹ but minimum wage policies are essential to facilitating job creation and increase business productivity in the long run. Setting the minimum wage at a moderate level can induce firms to invest in workers and new technologies, and create well-paying jobs.²² Higher wages may also lead to more innovation aimed at partially replacing labor, thereby increasing productivity across the economy.²³ The impact of antitrust policies on business profitability is unclear. Antitrust policies increase the profits of new entrants at the expense of incumbents. For industries characterized by continuous innovation, antitrust policies that protect new entrants increase the overall efficiency of innovation.²⁴ R&D innovation policies improve the profitability of firms. Policies that encourage R&D innovation increase the expected return on investment in R&D innovation, thereby increasing the productivity and profitability of firms through increased R&D investment.²⁵

Post-production phase: Progressive income tax and property tax

A progressive income tax system indirectly affects the level of corporate profitability by affecting entrepreneurial incentives. In the equilibrium of the firm-CEO matching model, more talented CEOs are matched with larger firms, and they devote greater effort in running them. Taxing CEO income affects the equilibrium pricing of their effective labor and spills over to firm profits.²⁶ When innovation is the driver of economic growth, it limits the top tax rate for revenue maximization and welfare maximization. Using innovation as the driver of economic growth would significantly reduce the optimal marginal tax rate on the top-income group.²⁷

In summary, initial conditions and potential policy mixes are important when discussing the impact of changes in income distribution on firms’ earnings and return on capital. For inclusive growth, the optimal policies could potentially be different for the various income groups and different stages of production, and these policies have different impacts on the profitability of firms and return on capital. In the pre-production stage, policies for human capital accumulation such as education and training help to increase the profitability of firms. Furthermore, while inheritance tax policies reduce the profitability of family firms, they may be beneficial for promoting overall innovation in the industry. In the production phase, the impact of minimum wage policies on the profitability of firms changes over time, the impact of antitrust policies on the profitability of firms is uncertain, and R&D innovation policies boost the profitability of firms. In the post-production phase, a progressive income tax system indirectly affects the level of corporate profitability by affecting entrepreneurial incentives.

8.2.3 Impacts of Income Distribution on Economic Growth

8.2.3.1 Theoretical Implications

Income distribution and economic growth are important topics of research in economics. Broadly speaking, the channels through which income distribution affects asset prices include both macroeconomic growth and corporate growth. This section focuses on the analysis of the relationship between income distribution and macroeconomic growth to supplement the relevant discussion in the previous chapters. Judging from mainstream research, the impact of inequality on economic growth is inconclusive. Based on Kuznets’ (1955)²⁸ inverted U-shaped relationship hypothesis (i.e., the Kuznets curve), a similar relationship exists between income distribution and economic growth—at low levels of income, economic growth is accompanied by a widening gap in income distribution; once income levels reach a certain level, economic growth moves inversely with income inequality.²⁹ Alesina and Rodrik [5] link inequality and economic growth through political-economic mechanisms (with the introduction of elections), illustrating the second half of the Kuznets curve in an endogenous growth model. Li and Zou [32] incorporated government public spending into the utility function in Barro’s endogenous growth model where the first half of the Kuznets curve is made.³⁰

There are three main channels of influence. (1) Savings-investment channel: As the savings rate of the wealthy is higher than that of other classes, savings and investment mainly come from the wealthy class, and as such, inequality in income distribution helps to increase the savings and investment rate, thus promoting economic growth.³¹ (2) New economic growth theories: In the late 1980s, the rise of new economic growth theories has broadened the channels through which income distribution affects economic growth. There are two main theories that are more far-reaching (i.e., the “big push” theory and the theory of political and economic instability), both of which suggest that reducing income inequality promotes economic growth. The first theory proposed by Murphy et al. [36]³² suggests that income distribution affects economic growth through market size. They argue that industrialization requires sufficiently large domestic markets so that technologies that can generate increasing returns to scale are able to be profitable, and that unequal income distribution and excessive wealth concentration may limit the market size and thus impede economic growth. The second theory suggests that unequal income distribution may lead to social conflict and weak property rights protection, thus impeding economic growth.³³ (3) Government fiscal spending and taxation channels: Among the contemporary income distribution literature, the theory of endogenous fiscal policy³⁴ is relatively comprehensive in discussing the channels of influence. The theory examines the impact of income distribution on economic growth through fiscal expenditure and taxation channels.

8.2.3.2 Economic Growth Should Balance Efficiency and Equity

In the context of China’s actual situation, we speculate that China has reached a stage at which it needs to balance income distribution and economic growth, as well as efficiency and equity. In the early years of the founding of the country, China’s economic output and growth rate were both low. Since the reform and opening-up policy in 1978, China has achieved remarkable economic development under the idea of “encouraging part of the people to become rich first.” By the 40th anniversary of the reform and opening-up in 2017, China’s real domestic GDP had grown 33.5 × compared to the level in 1978. The annual growth rate of 9.5% is much higher than the average global annual growth rate of around 2.9% in the same period.³⁵ It can be argued that the model of “encouraging part of the people to become rich first” has indeed created opportunities for some people.

All things considered, is the relationship between economic growth and income distribution in China a linear one? Is it true that greater income inequality leads to faster economic growth? The answer is not necessarily. Cheng and Zhang [12]³⁶ constructed a theoretical model of product innovation by companies in an environment of innovation uncertainty, setting up economic growth models under two types of higher and lower inequality (polarized growth between the rich and poor, and inclusive growth). They found through model derivation and numerical simulation that when the level of economic development is low, the widening income gap does not inhibit autonomous innovation and economic growth. However, when at higher levels of economic development, if the income gap does not narrow as income levels rise, autonomous innovation will be inhibited, and economic growth will stagnate. This micro-mechanism explains the “middle-income trap” of many latecomer countries that have reached middle-income levels and have not been able to successfully transition to an innovation-driven economic growth model. In this way, the relationship between income distribution and economic growth in China is likely to be at least partially similar to the inverted U-shape of the Kuznets curve described earlier.

Whether China’s current stage of development is “partially” close to or past the inflection point of Kuznets’ inverted U-curve is subject to empirical analysis. But intuitively, the inequality brought about by imperfect mechanisms (such as differences in household registration, ownership, rent-seeking behavior, etc.), high real estate prices, imperfect social security systems, certain monopoly issues, and inequality in education, among others, are perhaps the key issues that constrain China’s sustainable and stable development. China’s goal of common prosperity creates an opportunity to address these issues and achieve sustainable, stable, and high-quality development.

8.2.4 Impacts of Income Distribution on Industrial Structure

8.2.4.1 The Theory of Structural Change in the Economy with a Balanced Growth Path

Empirical data suggests that when moving towards inclusive growth, even if the economic growth rate remains positive, the impact of inclusive growth on different industries may vary. The various components of the economy may not grow at the same rate, resulting in structural changes within the economy, i.e., changes or transformations in the industrial structure.³⁷ The study of structural change in the economy is also one of the central concerns of modern economic growth theory, but early economic growth theories did not include changes in industrial structural in their discussions. After 2000, a new wave of research on structural change in the economy emerged, which better explains the Kuznets facts and Kaldor facts, and gradually dominated the study of structural change in the economy. Theories on changes in economic structure on a balanced growth path mainly explains the mechanism by which changes in income distribution affect the industrial structure through the demand side and the supply side.

The demand-side explanation is a preference-driven mechanism of income effects. This theoretical mechanism explains the underlying mechanism of structural change in the economy, mainly in terms of demand-side factors. This theory suggests that consumers have different levels of income elasticity in demand for different products. As income rises, demand for superior products increases more rapidly (assuming the income elasticity of demand is greater than one), leading to a flow of factor inputs and consumption expenditures to sectors that produce such products. That is, when the income structure changes, a change in the industrial structure can be deduced given a particular preference (or utility function) setting.

The supply-side explanation is a technology-driven price utility mechanism. This type of mechanism is known in the literature as the “technology-driven” theory of structural change. As long as the elasticity of substitution of demand across products is not equal to one, changes in relative prices will lead to changes in the structure of consumer spending, and consequently, in the industrial structure. There are three types of technological differences among sectors that can lead to price changes: Differences in productivity growth rates (technological progress), differences in factor intensity (capital-labor ratio), and differences in factor elasticities of substitution.

8.2.4.2 Channels of Income Distribution Influencing the Change in China’s Industrial Structure

Modern economic structural change theories and empirical studies demonstrate that China’s industrial structure is changing. Overall, in the last two decades, along with rising incomes, the service sector—in response to changes on the demand side, coupled with support at the policy level—has gradually become a new engine of development. China’s service sector, represented by the internet and other sectors, has developed and expanded rapidly in recent years; the tertiary sector’s contribution to GDP exceeds that of the primary and secondary sectors combined. The changes in market capitalization of listed companies also reflect China’s industrial transformation and upgrading. By the end of 2021, the total market capitalization of “new-economy” sectors such as information technology, healthcare, consumer staples, consumer discretionary, and telecoms reached approximately Rmb54.5trn, accounting for over 50% of the market capitalization of all Chinese stocks, including A-shares, H-shares, and Chinese concept stocks (based on the Wind database).

From the perspective of changes in income distribution, the demand structure of the Chinese population changes in line with changes in income structure, which in turn drives consumption upgrading and industrial upgrading. Therefore, a reasonable and natural path of influence is change in income disparity → change in demand structure → change in market size → change in industrial structure. That is to say, due to the different preferences of different income groups, the narrowing of income disparity will bring about changes in the country’s demand structure, which will lead to changes in industry size and gradually lead to changes in the industrial structure. Under these assumptions, we simply use two models to present the process of industrial structure change influenced by income distribution.

One is a partial equilibrium model that assumes exogenous changes in income structure. We find that on the demand side, when the income distribution gap narrows, the low-income group receives more income relative to the top-income group. In this case, the demand characteristics of the low-income group are dominated by high-end products, and the demand for high-end products in society rises rapidly. When the income distribution gap widens, the top-income group receives more wealth relative to the society. Thus, the overall demand characteristics of the top-income group—that is, the demand for high-end products—will slow down or flatten out. On the supply side, as we assume that other variables exogenous to the factor model will not change, the overall production capacity is fixed. At this time, manufacturers will allocate according to the demand. When the income distribution gap is narrowed, the overall demand for high-end products in society rises. In this case, manufacturers allocate more production capacity to high-end products. Therefore, the output of high-end industries is increased and eventually realizes the upgrading of consumption and the change in industrial structure.

The other model is a general equilibrium model that simulates the value of the industrial structure. To visualize the potential changes in the industrial structure amid the goal of inclusive growth, we use standard New Keynesian and CGE models to simulate industry fluctuations or future changes in industrial structure undergoing shocks. We find that following a shock of increasing income disparity, the total capital stock in the economy rises, and the return on capital falls while real estate prices rise. Conversely, when the income disparity decreases, the return on capital and non-housing consumption both rise. We can also simulate future changes in the industrial structure (Fig. 8.4). As the income distribution becomes more balanced, the trend towards a higher share of services and equipment manufacturing suggests that the economy evolves from an upgrade in demand led by rising incomes among low-income group to consumption upgrading and high-end manufacturing upgrading.

Fig. 8.4

Source Wind, CICC Research

China’s industrial structure is changing.

8.3 Empirical Analysis of the Income Distribution and Asset Price Performance

In this section, building on the theoretical analysis we have previously discussed, we further analyze the link between changes in income distribution and asset price performance at different stages of development of representative economies such as the US and Japan. Empirical analyses will provide insights into the implications of future investments under the broader context of the shift towards more inclusive growth both in China and around the world.

8.3.1 The US Experience: Low Interest-Rate Environment, Lower Volatility of Financial Asset Valuations, and Convergence of Valuations Between Industries

In the long-cycle history of the US, the cut-off point for a significant shift in income disparity, with the income gap first narrowing and then widening, was around 1980. The economic growth and asset price performance exhibited different behaviors in periods before and after this point (Fig. 8.5). Changes in income distribution do not appear to have systematically affected the profitability of US firms (as measured by ROE). In addition, we observe the following salient features

Fig. 8.5

Source Wind, Bloomberg, CICC Research

The performance characteristics of global asset classes differed markedly around 1980.

First, the impact of changes in income distribution disparity on the overall valuation level and volatility is quite significant. During the period before 1980, when the US income disparity narrowed, economic growth was significantly more volatile. Each economic cycle, from recovery to recession, occurred within relatively short intervals, leading to frequent peaks and troughs in economic growth. Interestingly, during this period, volatility in asset price valuations was relatively low. Despite the oscillating and upward trend of the risk-free interest rate, the standard deviation of the risk-free interest rate from 1950 to 1980 was only around 2.1%. Also, the average P/E valuation of the S&P 500 was low, and fluctuations were within a relatively small range. After 1980, when the income gap in the US widened, the economic growth rate in the country slowed and was less volatile. Each recovery lasted longer, with longer intervals between recessions. However, at the same time, US asset prices became much more volatile. The risk-free interest rate oscillated downwards, with its standard deviation rising to 3.3%. The average market valuation became higher than before 1980, and the volatility in the market increased. The economic and financial reasoning behind this contrast may require further consideration.

Secondly, the impact of changes in income distribution disparity on industry valuation levels and on the discrepancy in valuation levels between industries has become more noticeable. When the income gap narrowed in the US before 1980, the volatility of industry valuations and the valuation difference between industries increased. Since 1980, the major industries of the US stock market—similar to the overall US stock market—have been characterized by an increase in average valuation levels and greater volatility. There was also greater divergence in valuations between different industries, especially in the downstream consumer, technology, and cyclical upstream and midstream industries. In addition, the fundamentals and performance of a number of industries have also further diverged since 1980. The average medium- to long-term US equity ROE has remained relatively stable. However, the ROE of the downstream industries has been higher than that of the upstream and midstream cyclical-industries since 1980. Share-price performance has also shifted from equilibrium to divergence, with the downstream industries clearly outperforming the midstream and upstream cyclical industries.

Third, the performance of global asset classes also differed markedly around 1980. Before 1980 when the wealth gap was narrowing in the US, the performance of US and global asset classes were ranked as follows: Commodities, gold > stocks, bonds > real estate. In the period following the 1980s, however, financial assets as a whole outperformed physical assets, with stocks > bonds > real estate > commodities, gold. Stocks became the best-performing assets during this period.

Asset prices in the US at around 1980 may have been correlated with changes in the income gap. Widening income and wealth disparity in the US after 1980 may have led to a greater divergence between different structural parts of the economy. It also, to some extent, had the effect of lowering the interest rate as the savings rate in the US has generally risen since 1980. In lower interest rate environments, investors may hold assets for longer periods, leading to greater volatility in asset prices. Moreover, the market is more willing to pay a premium for growth amid lower interest rates, and as a result, downstream sectors with better growth tend to enjoy higher valuation premiums. Thus, it is in this long-term, low interest rate environment that the growth style has outperformed the value style in global equity markets since 2010 (Fig. 8.6). Moreover, when prices of financial assets rise and outperform that of real assets, the wealth gap widens as wealthy people generally have a higher allocation for financial assets. However, the opposite was generally true prior to 1980. Going forward, with the goal of moving towards inclusive growth and drawing from the experience of the US, we may need to start thinking about the possible implications of a change in the low interest rate environment and a decline in the volatility of financial asset valuations, as well as the convergence of valuation levels between industries.

Fig. 8.6

Source Bloomberg, FactSet, CICC Research

Global market growth outperformed value overall in a low interest rate environment.

8.3.2 Japan’s Experience: Inclusive Growth Through Economic Transformation and Structural Upgrading Under Internal and External Challenges

In the face of internal and external challenges, Japan gradually embarked on a long period of inclusive growth during the 1970s through economic transformation and structural upgrading. Although Japan was affected by a combination of factors such as the energy crisis, demographic changes, trade frictions between Japan and the US, and economic restructuring in the 1970s, GDP still grew at an average rate of around 4% between the early 1970s and 1990. The income disparity in Japan remained relatively low for a long time, and the capital market responded relatively positively. Despite the stock market bubbles that occurred periodically, and the real estate bubble later on, there was no significant expansion of income disparity, and relatively healthy, inclusive growth was achieved.

One of the core factors of Japan’s inclusive growth may have been the technological innovation that drove industrial upgrading, which led to consumption upgrading and promoted internationalization. Amid the growing trade frictions with the US, rising domestic labor costs, and the oil crisis, Japan began to seek technological innovation and industrial upgrading in the 1970s. The growth rate of the old economy and its share of the whole economy declined. The increase in trade specialization coefficients and the higher share of exports of high-value-added products manufactured in Japan during the 1970s to 1990s are evidence of industrial upgrading and globalization in Japan (Fig. 8.7). At the same time, industrial upgrading led to an overall increase in income levels, with workers’ earnings as a percentage of GDP starting to trend up around 1970. Thus, higher-quality products and services were consumed by the population. Consumption’s share of economic value added rose substantially, accompanied by a noticeable shift in the consumption patterns towards more high-end, branded products (Fig. 8.8).

Fig. 8.7

Source Yukio Noguchi, Economic History of Postwar Japan (translated by Ling Zhang), April 2018, CICC Research

During the 1970s–1990s in Japan, industrial upgrading created more added value, drove income growth, and led to consumption upgrading. Note Trade specialization coefficient (TSC) = (exports − imports)/(exports + imports); JPY-denominated and production indices are from 1958.

Fig. 8.8

Source Datastream, CICC Research

In Japan, rising income as a percentage of GDP accelerated consumption growth, and consumption upgraded during the transition period of national economy.

In the context of inclusive growth in Japan, industrial upgrading and consumption upgrading were the main themes of investment. During the period of structural transformation of the economy, Japan introduced supportive industrial policies and leveraged its own factor endowments to achieve industrial upgrading and raise the income levels of the overall population. To some extent, Japan is a role model for balancing the wealth gap and economic development in developed economies. While the performance of the Japanese stock market index from 1973 to 1983 was relatively flat as it was dragged by traditional sectors, the structural opportunities related to industrial upgrading and consumption upgrading were outstanding. Five sectors, namely support services, pharmaceuticals and biotechnology, technology hardware and equipment, media, and electronics and electrical equipment, posted gains of over 150% in the stock market. The 100 best-performing stocks in the Japanese market during this period also came from sectors related to industrial upgrading and consumption upgrading. Japan’s development during the transition period can shed light on how China can achieve high-quality development and sustainable growth. Meanwhile, China’s own industrial upgrading and consumption upgrading have been the main areas of investment over the past decade. We believe that they are likely to remain the drivers of economic growth and contribute rich investment opportunities in the context of inclusive growth in the future.

8.4 Investment Trends Amid the Pursuit of Inclusive Growth

China and other major global economies are gradually becoming more focused on efficiency and equity, as well as inclusive growth and more balanced income distribution. In this context, what are the likely medium- to long-term trends in the investment environment, and what are the main investment trends to focus on? This is the topic of discussion in this section. We believe the following points are worthy of attention from an investment perspective.

First, the “new paradigm” of investment: Under the context of widening internal income disparities, policy orientations around the world are favoring equity over efficiency. This may have a number of macro and sector implications. (1) There is a more inward-looking policy orientation across regions, with a higher probability of regional conflict and greater volatility in economic growth, perhaps somewhat similar to the US experience and around the world from the post-World War II period to the late 1970s. (2) There is a greater focus on social responsibility and sustainability across the globe, with each country advancing its own version of “ESG.” In a certain sense, the goal of “common prosperity” in China also aligns with the concept of “ESG” in the Chinese context. (3) There is a greater focus on anti-monopoly policies, which, to a certain extent, promote financial inclusion and encourages financial institutions to support the real economy more. (4) The regulation of technology and internet platform companies will also receive increasing attention globally. All of these changes have direct investment implications.

Second, the global environment of low interest rates is likely to change gradually. In the previous section of the theoretical analysis, we explored the impact of changes in the income distribution gap on the risk-free interest rate. The gradual decline in global nominal interest rates over the last four decades has raised concerns and has had a large impact on asset allocation. There have been various explanations for the decline in global risk-free rates, including the “global savings glut” (as observed by former Federal Reserve Chairs Alan Greenspan and Ben Bernanke) and capital inflows attracted by the US’s efficient and competitive financial system,³⁸ among others. Our previous analysis suggests that the widening gap in global income and wealth distribution may also have been one of the drivers of the nearly four-decade decline in global risk-free interest rates. If this holds true, as more equitable income distribution advances across the globe, it may gradually change the persistent downward trend in risk-free rates in the medium to long term. In addition, the increase in consumption expenditure as a percentage of GDP and rising costs due to “inward” regional policies may also raise global inflation to some extent in the medium or long term. These factors may lead to an end to the long-term downward trend in nominal interest rates globally over the last four decades. This could be one of the most important trends in the future global asset allocation space. Higher nominal interest rates will generally be accompanied by lower asset valuations, shorter investment durations, a lower growth premium, and potentially a smaller difference in valuations between sectors, among others.

Third, more balanced income distribution will mitigate the barriers to China’s development and further unlock its growth potential. China’s rapid economic development over the last 30 years is one of the most important events in the global economy. Its share of the global economy has risen from around 2% to around 15–20%. China is currently facing issues of unbalanced development and insufficient development. A better balance between efficiency and equity, and the promotion of more balanced income distribution, may help to correct some of the imbalances in China’s development. It could also mitigate the barriers to development, thus further unleashing China’s growth potential. In particular, initiatives to reform and improve basic systems and mechanisms (including establishing a long-term mechanism for the smooth functioning of the real estate market, improving the social security system, and encouraging financial institutions to pass on benefits in order to provide greater support to the real economy) will have the effect of correcting developmental imbalances in the medium to long term.

Fourth, China’s mass consumer market is expanding and its quality is improving (Table 8.1). Although China’s GDP per capita has reached around US$11,000, the consumption expenditure as a percentage of GDP is not high. Promoting a more balanced income distribution and improving social security may have the effect of expanding the scale of domestic demand and raising consumption expenditure as a percentage of GDP in the medium to long term. The mass consumer market, which includes clothing, food, housing, transportation, recreation, and entertainment, may enter a stage of expansion and quality improvement. The trend of branding, increasing industry concentration, and internationalization in China’s consumer sectors is likely to be further strengthened. This is likely to be similar to the trend achieved in Japan between the mid-to-late 1970s and the 1990s in terms of the steady income growth and the structural transformation of the economy.

Fifth, China’s sizable market for domestic demand will continue to unleash the largest benefit from economies of scale since the Industrial Revolution, and the trend of industrial upgrading in China will be further strengthened. This will contribute to the trend of technological innovation and industrial upgrading in China (Fig. 8.9). China will move from low-end to high-end, from small to large, and from large to strong in many manufacturing sectors with comparative advantages.

Fig. 8.9

Source Wind, CICC Research

China’s industrial upgrading and consumption upgrading—from the previous bull market in commodities to a structural bull market during industrial upgrading and consumption upgrading.

It is also worth noting that the trend towards inclusive growth may create constraints in the financial, real estate, and related sectors in the medium to long term.

Table 8.1 Potential trends in the consumer sub-sector amid the pursuit of common prosperity