What is the k-shaped economy?

Every few weeks, the financial news likes to throw a new catchy phrase into the mix, leaving the rest of us to figure out what it means. The ‘k-shaped economy’ seems to be the latest one that’s stuck.

But what is it, and is there anything to it?

The k-shaped economy is the theory that as a nation recovers from economic hardship, its wealth splits in two directions -either you ride the upper part of the ‘k’ to more and more wealth, or the lower part of the k, whose struggle gets more intense with time. It splits the population into these two groups, leaving a hole where the middle class would have been. A ‘fork in the road’ of economic growth, so to speak.

Economists create this ‘k’ in graphs through a variety of methods. Some show the stocks of companies that are used by each of those groups. Others, analyse the stock market against a metric like labour statistics or consumer sentiment. It helps in some instances explain why the market might be strong while the economy stays weak.

The term became popularised in the US, prompting conversation in the UK as well. But the evidence on whether it’s taking place here is less clear and one reason for that is that the UK stock market is extremely international, especially among the biggest companies.

Around 80% of revenue from the FTSE 100 comes from outside of the UK. Applying this to the k-shaped theory and it means that the UK large caps will perform semi-independent on whether the country is experiencing positive or negative economic growth so they provide arguably less relevant data.

Another is that many of the stocks that would typically represent this k-shaped split, like grocery stores or cafe chains, are owned by private equity companies, so there’s no public share price to follow the trend with.

But a few companies do seem to be following this trend. For example, Greggs, a popular cafe option for much of the working class, has dropped 38% in the last five years. M&S has risen 149% in the past five years, as of 30 June, according to LSEG. (Of course, this isn’t a perfect way to split companies that only a certain group of people would use. Personally, I enjoy frequenting both!)

What does a k-shaped economy mean for investors?

In theory, the k-shaped economy becomes a bit of a virtuous cycle for investors, until it isn’t. Let’s take, for example, an investor named Henrietta. She has a big pot of money invested in the market, and because her investments have been doing well, she feels comfortable spending a bit more, which feeds money back into the economy, and likely, some of the companies she invests in. Assuming others are doing the same, and the share prices of these companies rise, Henrietta will benefit again from her investments, and the cycle will repeat.

But while Henrietta is doing well, in a k-shaped economy, there’s a much larger group of people that are struggling. As they feel they can afford less, their spending decreases, which starts to take a toll on the companies that rely on them as consumers. This isn’t just limited to a small group of stocks, it trickles through the markets. Eventually, it starts to affect Henrietta’s investments and means that she has less to spend as well, which in turn means less money is going back into those companies, creating a drop in the market.

This, again, is all theory. For the moment, things aren’t looking quite so dire.

Is this happening?

Whether the k-shaped economy is a real worry is the topic of a lot of debate, and at the moment there is not a clear answer. Some data has presented a promising argument for the k-shaped economy fading.

In the US, where the theory has taken a firmer hold, there’s still mixed evidence. The Bank of America's most recent consumer spending checkpoint showed a 5.1% rise in total card spending year on year to June, and that the gap between high-income consumers and low-income consumers was shrinking. But, they do note that the presence of the World Cup could have an impact on this, and there could be a return to the widening later in the year.

In the UK, aside from the aforementioned limits on this theory working here, the evidence is less clear for geopolitical reasons. The ongoing peace talks in the Middle East could ease inflation pressures in coming months if the adjacent oil crisis is resolved as well.

Barclays analysis in May that 70% of UK consumers report confidence in being able to live within their means, which is a one percentage point increase from their April reading. These are helpful numbers to watch, but no single statistic can tell the whole story, which is why economists have found it so difficult to determine if a k-shaped economy is really forming.

How do you protect against it?

Even without a k-shaped economy in the UK, if you invest in the US, there could be some risk from stock market effects. Ironically, while the k-shaped economy presents market risk, one of the most effective ways to fight against it is likely to invest, because it creates the opportunity to grow wealth more quickly.

When it comes to UK markets, there’s some cushion to the economic risk because the top companies in the UK are largely international. For their share prices to take a big hit, it would have to mean that economies around the world were struggling, not just the UK.

For those holding stocks in the US, or other prone nations, diversification is an investor’s best friend. By investing across different regions, you can not only avoid heavy exposure to a single company, but a mix of industries. There’s never complete protection from a market event but spreading assets out can soften the impact.