Two weeks ago, Sari and I took a vacation - an extended road trip down the East Coast as far as Charleston and then inland back to New York through the Appalachians. On a long driving stretch on the way back, we stopped at a Jersey Mike’s just off the highway for some much needed nourishment. As we were waiting to pay, a talkative man, in the height of good humor, was ordering behind us. I don’t know if he knew anyone working at the store, but he acted as if he did. He said he’d just got a job after five months searching and he was going to celebrate - by buying two big subs - one for that evening and another to put in the fridge for the next night.
Last Friday, exactly a week later, Sari and I were back in New York, thinking about dinner. There is a nice Italian restaurant in midtown that we like – good food, friendly staff and not at all pretentious – but we’d forgotten to book a table earlier in the week and there wasn’t a chance of getting a reservation for that evening. This is a common problem – U.S. restaurant bookings on OpenTable were up 13% year-over-year in May.
It is a tale of two restaurants and just one more example of the divergent trends shaping the economic and financial environment today. It is the job of economists to trace an average path amidst this divergence and that path still looks supportive for long-term investments. However, as divergence grows across multiple dimensions, so do the risks of something going badly wrong, making it more urgent than ever for investors to diversify broadly across public and private assets.
Dimensions of Divergence
There are many dimensions to the divergent trends playing out across the American economic landscape today. Among the most prominent are the gap between rich and poor, the gap between tech and the rest of the economy, and the gap between attitudes and reality which, in turn, feeds political polarization.
One aspect of the gap between rich and poor is just the income gap. According to research by Thomas Piketty and Emmanuel Saez1, in 2022, the top 10% of American households received 50% of the income of all households. This series, which they have calculated back to 1917, peaked at 46% in 1932, fell back to average 32% between the mid-1940s and the mid-1980s and has since risen in almost a straight line. There is some argument about definitions and absolute levels of inequality here – Piketty and Saez, in this particular calculation, use money income excluding government transfers and capital gains. However, this series, along with a shorter time series produced by the Census Bureau, point to exactly the same trend – the richest households have been receiving a growing share of income and are, not coincidentally, responsible for a growing share of spending in the economy.
A similar trend can be seen in the growth in wealth relative to income. We estimate that, if stock prices and home prices were unchanged between now and the end of this month, the total assets of American households would be $204 trillion, or 630% of GDP, which is a record high if we exclude the collapse in GDP during the pandemic. For comparison, the assets of American households amounted to just 486% of GDP before the Dotcom bubble burst in 2000 and 435% of GDP just before the 1987 stock market crash. The Federal Reserve’s Survey of Consumer Finances shows that in 2022, while the top 10% of households received 49% of pre-tax income (using yet another definition), they owned 62% of the assets. Consequently, the growth in wealth, while very positive for investors, has also increased inequality.
On the flip side, we estimate that average hourly earnings for all workers rose by 3.5% year-over-year in May, trailing a 4.1% year-over-year increase in consumer prices. This will mark a second consecutive month of falling year-over-year wage growth, following 35 months of real wage gains.
A second broad theme of divergence has been the gap between a booming tech sector and the rest of the economy. As we show on page 8 of the Guide to the Markets, the top 10 companies in the S&P500 now account for over 41% of the index and eight of these companies are essentially tech companies, even if two are listed in communication services and two in the consumer discretionary sector. Moreover, the total earnings of these 10 companies accounted for 33% of S&P500 earnings over the past year, continuing a steady upward trend.
Within the economy, the importance of technology investment is becoming increasingly obvious. In the year that ended in the first quarter, while real GDP grew by 2.6%, investment spending on equipment rose 8.9% and real spending on research and development climbed 9.3% with the rest of the economy growing just 1.7%. This partly reflects the boom in hyper-scaler capital spending and, as we show on page 24 of the Guide, this spending is expected to rise by 78% this year, from $416 billion in 2025 to $739 billion in 2026.
And then there is the perception gap. Even as the stock market hit a fresh all-time high at the end of May, consumer sentiment, as measured by the University of Michigan, officially fell to an all-time low. This slightly overstates the gloom, but, even adjusting for a recent change in methodology, this is a lower reading than has been seen 99% of the time over the past 50 years. Meanwhile, on the economy itself, we expect that this week’s jobs report will show an unemployment rate unchanged at 4.3% and next week’s CPI report will show inflation of 4.1%. Adding these together and rounding gives us a so-called “misery index” of 8.5% - the worst reading in over three years but still better than it has been 55% of the time over the last half century.
This particularly dour mood likely reflects growing inequality and is probably exacerbated by the pernicious social media feeds we inflict upon ourselves. However, it also contributes to a particularly intense political polarization, as we are sorted by media algorithms and a broken election system into increasingly monochromatic blue and red states, counties and congressional districts.
Finding an Average Path: No Bump, No Slump
One challenge, in the midst of all this divergence, is to trace out an average path for the economy going forward. For now, this appears to be one of moderate GDP growth, slow job gains, a low and falling unemployment rate and inflation peaking this summer but falling back to a much cooler pace next year.
On growth, real consumer spending continues to be bolstered by the spending of the rich. May light vehicle sales, due out early this week, could come in at an annualized pace of 16.1 million units, comfortably above the 15.6 million units seen last year. This may surprise some, given the spike in gasoline prices. However, over the years, as new vehicle prices have outpaced general inflation, they have increasingly been bought by the richest households. Moreover, because of gains in fuel efficiency and lower long-term inflation in gasoline than in new vehicles, the price of a new vehicle in 2024 was approximately 29 times the annual fuel cost of running it, compared to 11 times back in 1975. Today, if you can afford to buy a new vehicle, you can afford to fuel it, and vehicle sales are consequently far less vulnerable to oil shocks than they were a few decades ago.
Other areas of upper income spending, such as recreational goods and services, are continuing to show momentum. By contrast, real spending on food for home consumption fell by 0.2% in the year ended in April as weak demographics and now negative real wage gains drag on the spending of average American consumers. That being said, we will get some relief from an 18% year-over-year gain in total income tax refunds and we expect real consumer spending to grow by 2.2% annualized in the second quarter, before easing back to roughly 1.5% growth for the rest of 2026 and 2027.
The rest of the economy should show a similar divergence with strength in tech spending offsetting weakness in homebuilding, government spending and inventory accumulation. This should result in year-over-year real GDP growth of between 2.0% and 2.5% for 2026 and between 1.5% and 2.0% for 2027.
As we noted in a recent article, this pace of economic growth should result in steady employment gains of about 60,000 per month, a drift down in the unemployment rate to below 4% in 2027 and inflation falling back to a 2% year-over-year pace by next spring.
Dealing with Divergence Risks
But even if the average path traced out by a divergent economy is one of moderation, the divergence itself carries considerable risks.
First, from the perspective of investors, there is the possibility of a sharp political swing to the left. The election of the current administration no doubt had much to do with many Americans feeling left behind in an unequal society. For a time, voters may blame this on illegal immigration, environmentalism or DEI policies. However, it is quite possible that in the mid-term elections and, more importantly, in the 2028 presidential election, they may decide that the real issues are inequities in the tax system and the political power of the wealthy and corporations. If this occurs, it could result in much higher taxes on corporations as well as estates, property, dividends, interest and capital gains, all eating into the prospective after-tax returns of investors.
The economy’s reliance on the AI boom and stock market gains could also be a point of vulnerability. First, as was the case with the dotcom bubble, while the technological advancements of AI are very real, most AI-related companies will likely fail to achieve anything like their ambitions. It could be that AI capital spending entirely outpaces the ability and willingness of the consumers of AI technology to fund that spending, leading to cutbacks and bankruptcies among many players in the space. It could be that job cuts implemented to fund AI spending so weaken the macro economy as to accelerate this process. And it could be that the stock market sees a major bear market and that, as was the case in the 1920s, so much of the spending in the economy is coming from the richest households and corporate investment, that a stock market crash makes economic retrenchment inevitable.
Or there is simply the threat posed by weak regulation failing to keep pace with ever more powerful technology. It is obvious that we live at a time of immense technological progress – in biotech, financial technology, military technology, AI, robotics and energy just to name a few. It should escape no one’s notice that the great shocks of the 21st century so far, stem, in a broad sense, from a failure to regulate – ranging from not monitoring pilot training in the case of 9/11, to inadequate regulation of sub-prime mortgages and derivatives in the Great Financial Crisis, to a failure to apply the strictest protocols when researching viruses in the case of the pandemic.
Today, we face these and many other threats such as the risk of cyber-hacking, money-laundering via crypto, drone technology and the impacts of climate change. Many of these risks require greater international cooperation and common, non-partisan and well-thought-out regulation. However, in the face of these growing risks, regulation has generally been downsized and has become more fragmented.
For investors, there is a warning in all of this. The average path forward looks comforting, if boring, and capable of supporting further gains in financial assets. However, it is an average built of such divergent trends that there is considerable danger of “something” going badly wrong from an economic, political or technological threat. In such an environment, it is impossible to be sure what that most likely “something” could be and so it is very difficult to hedge against it. But the prospect of some fat-tailed risk does argue for a broader diversification across public and private assets with reasonable valuations so investors can weather whatever storms are eventually unleashed by the divergent trends of today’s society, economy and financial markets.