Leaked from Citigroup: Plutonomy, Part 2 (2006)



Equity Strategy
Revisiting Plutonomy: The Rich Getting Richer
March 5, 2006


➤ The latest Survey of Consumer Finances, for 2004, has been released by the
Federal Reserve. It shows the rich continue to account for a disproportionately
large share of income and wealth in the US economy: the richest 10% of
Americans account for 43% of income, and 57% of net worth. The net worth to
income ratio for the richest 10% of Americans increased from 7.4x in 2001, to
8.4x in the 2004 survey. The rich are in great shape, financially.
➤ We think this income and wealth inequality (plutonomy) helps explain many of
the conundrums that vex equity investors, such as why high oil prices haven’t
seriously dented growth, or why “global imbalances” are growing along with
the equity bull market. Implication 1:Worry less about these conundrums.
➤ We think the rich are likely to get even wealthier in the coming years.
Implication 2: we like companies that sell to or service the rich – luxury goods,
private banks etc. Favored names include LVMH and Richemont.
The latest Survey of Consumer Finance data was released Friday 24th of February. It shows that the rich in the US continue to be in great shape.We thought this was good time to bang the drum on plutonomy.

Back in October, we coined the term ‘Plutonomy’ (The Global Investigator, Plutonomy:
Buying Luxury, Explaining Global Imbalances, October 14 2005). Our thesis is that the rich are the dominant drivers of demand in many economies around the world (the US, UK, Canada and Australia). These economies have seen the rich take an increasing share of income and wealth over the last 20 years, to the extent that the rich now dominate income, wealth and spending in these countries. Asset booms, a rising profit share and favorable treatment by market-friendly governments have allowed the rich to prosper and become a greater share of the economy in the plutonomy countries. Also, new media dissemination technologies like internet downloading, cable and satellite TV, have disproportionately increased the audiences, and hence gains to “superstars” – think golf, soccer, and baseball players, music/TV and movie icons, fashion models, designers, celebrity chefs etc. These “content” providers, the tech whizzes who own the pipes and distribution, the lawyers and bankers who intermediate globalization and productivity, the CEOs who lead the charge in converting globalization and technology to increase the profit share of the economy at the expense of labor, all contribute to plutonomy. Indeed, David Gordon and Ian Dew-Becker of the NBER demonstrate that the top 10%, particularly the top 1% of the US – the plutonomists in our parlance – have benefited disproportionately from the recent productivity surge in the US. ( See “Where did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income”, NBERWorking Paper 11842, December 2005).

By contrast, in other countries such as Japan, France and the Netherlands (read much of
continental Europe), egalitarianism has kept the rich to a similar share of income and wealth

See page 15 for Analyst Certification and Important Disclosures

that they accounted for in the 1980s – in other words, they haven’t really gotten any richer,
in relative terms.

We believe that the plutonomy thesis helps explain some of the conundrums that vex so
many equity investors, such as why high oil prices haven’t slowed the global economy, why
consumer confidence might be low yet consumption remains robust in the US, why savings rates are low, and why the dollar depreciation hasn’t done much for the US trade deficit.

Why as equity investors do we care about these issues? Despite being in great shape, we
think that global capitalists are going to be getting an even greater share of the wealth pie
over the next few years, as capitalists benefit disproportionately from globalization and the
productivity boom, at the relative expense of labor. As we believe plutonomy explains away
some of the conundrums we highlighted above, we are very relaxed about these issues.

Indeed, if the rich keep getting richer, as we suggest, savings rates might get even worse in
the plutonomy countries. If plutonomy explains away many conundrums that our equity
clients worry about, then this suggests the risk premia ascribed to equities might be too high.

Furthermore, if the rich will be getting even richer in the coming years, this bodes extremely well for businesses selling to or servicing the rich, be it for example luxury goods stocks or private banks. The rich are a growing and captive market, who have the nice habit of relatively little price elasticity. The plutonomy basket of luxury goods stocks, private banks etc. has handsomely outperformed the S&P500 index since 1986, and we expect similar outperformance from these types of stocks in the years to come. In the last 3 months alone, these stocks have outperformed the MSCIACWorld index by 7%.

For these reasons, the recently released US Survey of Consumer Finances, which confirms
that the rich continue to get wealthier and account for a disproportionate share of income and wealth in the US, is important. It confirms that the dynamics of plutonomy are still intact.

The Federal Reserve recently released their triennial Survey of Consumer Finances (SCF),
conducted in 2004, which looks at the state of household finances in aggregate and by
various sub-categories. The data shows that the gap in incomes and wealth between the rich and the poor in the US shows no signs of significant change, and that the richest 10 and 20% of Americans continue to earn disproportionately high chunks of national income, and own an even higher share of the national wealth.

Figures 1 and 2 show the income and wealth shares of the top two deciles, the next two
quintiles and the remaining 40% of US households.We have lumped the bottom 40% into
one to emphasize how relatively small their income and wealth shares are.


Figure 1. U.S. Plutonomy Remained Intact in 2004: Based on the Consumer Finance Survey, the Top 10% of the Families Accounted For 43% of Income, while the bottom 40%of Families Accounted For Only 10% of Income

Survey 1995 1998 2001 2004
Percentile of income Mean Income in thousands of 2004 dollars

Source: Survey of Consumer Finances, Federal Reserve Board, and Citigroup Investment Research

Figure 2. Little Change in the NetWorth Share in 2004: The Top 10% of Income Groups Account for 57%of Households’ total Net Worth While the Bottom 40% Has 9% of Net Worth

Source: Survey of Consumer Finances, Federal Reserve Board, and Citigroup Investment Research

The top 10%, whose mean annual income level was U$302,000 in 2004 have lost out a little in terms of their share of income, with this falling from a peak of 45% of national income in 2001 to “just” 43% of total US income, in 2004. Meanwhile, the fortunes of the next 10% improved modestly, to 15% of total income. The top 20% account in aggregate for 58% of total income (down from 59% in 2001). By contrast, the bottom 40% account for only 10% of total income. The top 10% earn over four times as much as the bottom 40% combined.

The share of the wealth continues to be even more aggressively skewed, with the top 10%
accounting for 57% of the national wealth, as they did in 2001. In total, the top 20% account for 68% of total income; the bottom 40%, for just 9%.

The overall point here is that the rich continue to be in great shape, in relative terms. Indeed, their net wealth to income ratio (Figure 3) has risen since the 2001 survey was published. It now stands at 8.4, in other words, net wealth is over eight times annual income. In 1995 this ratio was a relatively meager 6.2.We think this rising wealth is the real reason why the rich are happy to keep consuming, and are behaving rationally in so doing. They simply do not


need to save as much to maintain a healthy wealth balance, as they did in prior decades,
because their wealth is growing rapidly.

Figure 3. U.S.: Net Worth to Income Ratio for the Top 10%Is High and Rising. Drives and Sustains High Consumption out of Their Wealth and Income; Keeping Aggregate Savings Rate Low and Current Account Deficit Large

Source: Survey of Consumer Finances, Federal Reserve Board, and Citigroup Investment Research

Another new data point we have is the CLEW (Cost of Living ExtremelyWell) Index from
Forbes Magazine for 2005 (in our original Plutonomy note back in October, we didn’t have
the latest data point for the year 2005).

CLEWI is an inflation index of the cost of luxury goods. It measures such things as the cost
of suite at the Four Seasons in New York (up 15% year on year) and a kilo of Imperial
Beluga caviar (at US$6840, up 40% year on year). In 2005, the CLEWIndex rose 4%, while US CPI rose at 3.6%. Luxury goods still have relative pricing power. The 0.4% gap might not sound all that impressive, but bear in mind that a stronger US dollar, probably helped check this inflation rate (many luxury goods come from Europe, but the CLEWI is a
measure in dollars). At any rate, the year to year fortunes of the CLEWI versus the CPI are
less relevant. The long-term chart says it all (Figure 4). The most recent data point just
confirms that in the search for pricing power, we’d rather be in luxury goods, than low end
consumer businesses.


Figure 4. Forbes “The Cost of Living Extremely Well Index” – Pricing Power for Luxury Goods Much Stronger than Overall CPI Over Time

Source: Citigroup Investment Research, and Forbes

This is a good time, with the release of the latest SCF data, to reiterate our plutonomy thesis, and how when viewed through the prism of plutonomy, many of the apparent conundrums in the world seem less tricky to digest.

➤ 1) Oil and the Consumer.

We have heard constantly that oil will slow consumption down as it eats into disposable
income. But it remains a conundrum to many that consumption has remained robust, despite oil prices remaining high. What’s going on? We don’t see a conundrum. As we wrote about in September (The Global Investigator, Is Oil Relevant for Equities, September 2 2005), in the plutonomy countries, the rich are such a massive part of the economy, that their relative insensitivity to rising oil prices makes US$60 oil something of an irrelevance. For the poorest in society, high gas and petrol prices are a problem. But while they are many in number, they are few in spending power, and their economic influence is just not important enough to offset the economic confidence, well-being and spending of the rich.

➤ 2) Consumer Confidence and Consumer Spending

A second related conundrum, and one that ex Fed Vice–Chairman Roger Ferguson spoke of as long ago as 2001, is why consumer confidence and spending have not moved in sync with prior patterns. As Mr. Ferguson put it “A somewhat puzzling feature of the recent period has been that, despite the sharp weakening in sentiment, household spending appears thus far to have held up well. How these apparently conflicting signals will be resolved going forward is not at all apparent from today’s vantage point, and will bear close scrutiny.” Remarks to the University of North Carolina School of Law, Feb 27 2001. This thesis came up again last year in relation to Hurricane Katrina, when consumer confidence fell sharply, yet consumption (ex autos) was just fine.

Again, we see this as being a lot easier to understand if viewed through the prism of
plutonomy. While the average consumer might not be feeling great, the important consumers – the richest 20%, who account, as we’ve shown, for 58% of income – are in good shape.

Rather than focus on consumer sentiment indicators like the Conference Board sentiment
index, we highlight our own February Citigroup Smith Barney/CNBC Affluent Investor Poll.

Affluent investors appear quite optimistic about the future prospects. Indeed the more
affluent they are, the more upbeat they are about future prospects. “Projections for the next year are positive among all investors. About two in five believe they will be better off
financially in the coming year and 39% foresee things being no worse. An even brighter


outlook for their financial status over the next 12 months is evident among the wealthiest
group of investors (assets of $1 million or more), with 46% saying they will be better off
financially in the coming year”, (see Appendix 1 for the background and methodology of the survey which was first released in January 2006).

The point here, again, is that the rich are feeling a great deal happier about their prospects,
than the “average” American. And as the rich are accounting for an ever larger share of
wealth and spending, it is their actions that are dictating economic demand, not the actions of the “average” American.

➤ 3) Low Savings Rates

The “disaster waiting to happen scenario” we hear about most from our clients, is the low
savings rates in countries such as the UK and US.Well, we disagree that this is such a big
problem in the near term, the time horizon that matters for most equity investors. As we
showed in our note on Plutonomy back in October, using data from a paper written by two
(then) Fed economists, the low savings rate in the US (and we believe the same holds true in the other plutonomy countries like the UK, Canada and Australia) is a function of the
savings habits of the richest 20%. Figure 5 shows the savings rates split down by income
quintile in the US. The richest quintile are primarily to blame for the overall fall in the
savings rate in recent years – although there low savings behavior has likely been joined in
the past few years by the housing-pumped non-plutonomist US consumer.

The rich are being perfectly rational. As their wealth/income ratios have been rising, and as we highlighted earlier, the latest SCF data suggests wealth/income has grown even larger, why should they not consume from their wealth rather than just their income? The more rich people there are in an economy, and the more affluent they feel (as they do right now), the more likely we believe an economy will be to experience falling savings rates.

When your wealth has soared, the need to save diminishes. Rational, but apparently a conundrum and an accident waiting to happen, according to the perma-bears. Not to us.

Figure 5. Household Savings Rates of the Rich Fell in the Stock Boom in the 1990s While Those of the Lower Income Groups Rose (Maki-Palumbo Estimates for 1992 and 2000)

Source: Maki, Dean M. & Palumbo, Michael G. “Disentangling the Wealth Effect: A Cohort Analysis of Household Saving in the 1990’s”. Board of Governors of the Federal Reserve System & Putnam Investments. April 2001.

➤ 4) Global Imbalances and the US Dollar

Finally, the dollar. The perma-bears told us that the current account deficit in the US was too high. It could only be lowered by raising the savings rate of the household sector which in turn would only be accomplished by rising interest rates and/or a dollar collapse.We
disagree. To us plutonomists, the current account deficit is largely a function of the savings


rate, which is a function of the propensity to save by the rich. As we highlighted above, they are rationally consuming out of their stock of wealth (which incidentally, keeps going up) as well as from their incomes. To them, dollar devaluations are a mild inconvenience, but not a reason to change their spending and dis-savings habits. Here’s the real conundrum: if a dollar collapse is the primary way to adjust global imbalances, we would have expected the bilateral trade deficit between the US and Eurozone to have moderated following the dollar’s more than 50% devaluation against the Euro between Nov 2000 and Nov 2004. Did that happen? No. The bilateral trade deficit (on a rolling 12 month total basis) nearly doubled from $47.5 billion to $83.6 billion. The bottom line to us is that plutonomics is a better explanation of these ‘nasty’ deficits, and currency manipulation just doesn’t change the habits of plutonomists enough to make a difference.

Figure 6. Example of A Conundrum We Believe Plutonomy Sheds Light on: Euro/US$ Exchange Rate Appears Unrelated to the Increasing U.S. Trade Deficit with Europe

Source: CEIC and Citigroup Investment Research

There are, in our opinion, two issues for equity investors to consider. Firstly, if we are right, that plutonomy is to blame for many of the apparent conundrums that exist around the world, such as negative savings, current account deficits, no consumer recession despite high oil prices or weak consumer sentiment, then so long as the rich continue to get richer, the likelihood of these conundrums resolving themselves through traditionally disruptive means (currency collapses, consumer recessions etc) looks low. The first consequence for equity investors who worry about these issues, is that the risk premia they ascribe to equities to reflect these conundrums/worries, may be too high.

Secondly, if the rich are to keep getting richer, as we think they will do, then this has ongoing positive implications for the businesses selling to the rich.We have called these
businesses “Plutonomy stocks”.We see three reasons to take another look at those
plutonomy stocks.

1) The Survey of Consumer Finances continues to show the robust health of the richest
consumers in society. The rising net wealth to incomes ratio (now standing at over
8.4x) is an indication of just how robust the balance sheets of the rich are. While we
have concerns about the spending power of the middle-income consumer in the US
in the event of a housing slowdown, the richest 10% are less exposed to a housing
slowdown, as their wealth is more diversified. They are rich, feeling good about
their wealth (as our Citigroup Smith Barney Affluent Investor poll points out) and
likely to spend.


2) While not as impressive as in some previous years, nevertheless the Forbes CLEW
Index once again shows what pricing power really is. Once more, inflation in luxury
goods rose faster than general CPI as we highlighted earlier. The CLEWIndex has
doubled relative to overall CPI over the last 29 years. Not only is demand for luxury
goods likely to be strong in the near future, but pricing power is good too. A rosy

3) Emerging markets. It doesn’t take a genius to have spotted that emerging markets
are doing well. The recycling of commodity price liquidity is not only benefiting the
emerging markets themselves, but is creating a new breed of brash, confident
millionaire consumers. This is a boon to the Plutonomy stocks. Short of buying UK
football clubs to play the recycling of these cash flows, we can see a much easier
way of playing this strong demand theme in buying the plutonomy stocks.

So what are these plutonomy stocks? Figure 7 shows the names that we used to create our
Plutonomy basket back in October. This is not an exhaustive list.

Figure 7. Basket of Plutonomy Stocks

Source: Factset and Citigroup Investment Research

These stocks have done very well over the last 20 years. Figure 8 shows the performance of
the Plutonomy basket relative to the MSCIACWorld Index since 1985. The cumulative
annual growth rate of the basket is a cool 17.8%, handsomely outperforming the MSCI
World Index.


Figure 8. The Plutonomy Basket Has Handsomely Outperformed the Global Equity Market Since 1985, on Average by 7.3% a Year

Companies in the Plutonomy Basket: shown in figure 7.
Source: Citigroup Investment Research

Critics will rightly argue, that the Plutonomy stocks are not cheap.We agree – they are
currently close to a 15 year P/Book multiple relative high (1.4), compared to the MSCI
World Index (figure 9). However, we find there is very limited predictive power in this
valuation metric as a sell signal. A better metric for outperformance is relative pricing power – as figure 10 shows, the plutonomy stocks have tended to outperform when they exhibit relative pricing power, as we think they do right now.

Figure 9. The Plutonomy Basket’s P/Book Looks Expensive Relative to MSCI World Index But This Has Little Predictive Power For Future Performance

Source: Citigroup Investment Research, Worldscope and MSCI


Figure 10. The Performance of the Plutonomy Basket Relative to the MSCI World Index Moves In Line with The Pricing Power of the Plutonomy Companies

Source: Citigroup Investment Research, Forbes and MSCI

If we are right, that the rich are going to keep getting richer over the coming years, then this outperformance should, in our opinion, continue. In the short term, we also think them attractive. Of these stocks, we would highlight two in particular – Richemont and LVMH are in our model portfolio.

LVMH recently announced their 2005 results, which indicated robust demand. The company also reiterated their positive outlook for 2006. In the words of our analyst Constanza Mardones, there is “no sign of a slowdown in any of (LVMH’s) major markets”. Constanza thinks the outlook for earnings looks “highly favorable” with a plausible chance of upgrades to come. The stock trades on 21x Constanza’s forecast 2006 eps, and 11.5x 2006E EV/EBITDA.

Richemont recently announced 3Q results, with comparable sales up 14%. Underlying US
revenues were up 18% (plutonomy at work). Our analyst Bruce Hubbard is bullish on the
Richemont story as operational leverage is leading to margin improvements. Indeed, stronger margins have caused Bruce to upgrade EBIT by almost 25% over the course of the last 12 months. Though in Bruce’s own words, the valuation argument no longer looks compelling, he believes that upgrades to forecasts will continue to give upside to the shares. The stock trades on a P/E of 18.6x Bruce’s 2006 estimated earnings.

Our whole plutonomy thesis is based on the idea that the rich will keep getting richer. This
thesis is not without its risks. For example, a policy error leading to asset deflation, would
likely damage plutonomy. Furthermore, the rising wealth gap between the rich and poor will probably at some point lead to a political backlash. Whilst the rich are getting a greater share of the wealth, and the poor a lesser share, political enfrachisement remains as was – one person, one vote (in the plutonomies). At some point it is likely that labor will fight back against the rising profit share of the rich and there will be a political backlash against the rising wealth of the rich. This could be felt through higher taxation (on the rich or indirectly though higher corporate taxes/regulation) or through trying to protect indigenous laborers, in a push-back on globalization – either anti-immigration, or protectionism. We don’t see this happening yet, though there are signs of rising political tensions. However we are keeping a close eye on developments.

The latest Survey of Consumer Finances for 2004 from the Fed, just released, shows that the richest 20% of Americans have gotten even wealthier since the last survey was conducted in


2001, and continue to enjoy a disproportionately large share of both income (58%) and
wealth (68%).We should make clear that we have no normative view on whether
plutonomies are good or bad. Our analysis is based on the facts, not what the society should look like.

This lies at the heart of our plutonomy thesis: that the rich are the dominant source of
income, wealth and demand in plutonomy countries such as the UK, US, Canada and
Australia, countries that have an economically liberal approach to wealth creation.We
believe that the actions of the rich and the proportion of rich people in an economy helps
explain many of the nasty conundrums and fears that have vexed our equity clients recently, such as global imbalances or why high oil prices haven’t destroyed consumer demand.

Plutonomy, we think explains these problems away, and tells us not to worry about them. If we shouldn’t worry, the risk premia on equity markets may be too high.

Secondly, we believe that the rich are going to keep getting richer in coming years, as
capitalists (the rich) get an even bigger share of GDP as a result, principally, of globalization.

We expect the global pool of labor in developing economies to keep wage inflation in check, and profit margins rising – good for the wealth of capitalists, relatively bad for developed market unskilled/outsource-able labor. This bodes well for companies selling to or servicing the rich. We expect our Plutonomy basket of stocks – which has performed well relative to the S&P 500 index over the last 20 years – to continue performing well in future. From this basket, we would highlight in particular, at the moment, LVMH and Richemont.

Appendix 1. Background and Methodology of the U.S. Citigroup Smith Barney February 2006 Affluent Investor Poll
Greenwald &Associates and Synovate conducted the Citigroup Smith Barney Affluent Investor Poll, done in partnership with CNBC, between January 5 to January 20. Interviewing was conducted online with 561 investors who are members of the Synovate Consumer Opinion Panel. In order to qualify for participation, panel members had to have at least $100,000 in financial assets (excluding real estate and employer retirement plans), a definition that describes approximately one-quarter of all U.S. households. Survey results include 177 interviews with households that have $100,000 to $499,999 in savings and investments, 156 interviews with those in the $500,000 to $999,999 asset range, and 228 interviews with investors who have $1 million or more. Survey results have been weighted by age and asset level to reflect national population norms. The results of the Citigroup Smith Barney Investor Poll have a maximum margin of sampling error (at the 95% confidence level) of plus or minus four percentage points.

[Valuation and risks, Analyst certification, Disclosures etc. redacted for brevity]

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