Where Have Six Million Missing US Workers Disappeared To?

18th September 2013

Are the unemployment statistics giving a seriously misleading indication of the timetable for Fed policy normalization? Back in the 12th June weekly on this topic, I noted that: ‘The Fed has no idea how many of those workforce exiles have left for structural/demographic reasons rather than cyclical ones; if the latter is the key factor, then unemployment would probably rise in the initial stages of an accelerating recovery, as discouraged potential workers began actively looking again, and thus prolong easy policy. We won’t get a clear answer until y/y employment growth accelerates to 3-4% for several successive months, and then see if there is a strong participation rate response.’  The head of the SF Fed has recently pointed out that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures derived from other sources such as private employment surveys/job openings etc. As it likely tests the 7% level by early 2014, the  Fed’s hand will be forced on exiting extreme monetary stimulus…

While markets have been cheered by Larry Summers having dropping out of contention as the next Fed Chairman, inspiring hopes for a slower QE exit, the bigger issue is the underlying state of the employment market and whether it will prompt the Fed to lower its 6.5% unemployment threshold for a rate hike, which on current trends looks likely by H1 2015. A key issue for global investors to watch is the falling participation rate but also rapidly slowing workforce growth. If the same percentage of adults were in the workforce today as in January 2009, the measured unemployment rate would be 10.8%, and the Fed would be launching QE4. Over the past three months, the US has averaged 148,000 new jobs, a slower pace than the previous six months and yet the unemployment rate dropped to 7.3% in August, the lowest since December 2008, because over the summer a further 312,000 people dropped out of the workforce.

Between 1960 and 2000, the proportion of Americans in the workforce surged from 59% to a peak of 67.3% of the population before dropping to the current 63.2%, driving overall economic growth and household incomes. That was largely due to women entering the labour force while improvements in healthcare allowed working lifespans to be extended.  For the Fed and investors, the question is how much of this downshift is cyclical (the still weak employment market discouraging potential workers) versus structural (i.e. demographic trends).  If the same trends in employment/population growth were in place as pre-recession, total employment would by now be about 6m higher.

The employment/population ratio has hardly changed at all since 2009, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio. Since 2000, the labour force growth rate has been steadily declining as the baby-boom generation has begun retiring and under-25s enter the workforce at a later age. Bureau of Labour Statistics and Chicago Fed researchers have forecast the participation rate to trend even lower by 2020, regardless of how well the economy does in the interim. The extent to which this workforce shift is cyclical rather than structural has huge implications for trend US wage inflation, productivity and GDP growth.

According to the February 2013 CBO estimates, potential growth of the labour supply has been slowing from 2.5% annual growth from 1974-1981 to only 0.8% from 2002-12 and is projected to slow further to only 0.6% over the next five years. At current levels, working-age population growth is at multi-decade lows. Part of that decline in working-age population growth reflects lower immigration to the US as a massive post 9/11 increase in border security spending since 9/11 has curtailed Mexican illegal immigration, and tougher visa rules have slowed legal migrant flows.

The CBO has estimated that the non-inflationary unemployment rate (NAIRU) has risen for temporary reasons to 6% of the labour force, but in the long term it will drop back to 5.5%. At the rate of jobs market progress seen recently, this implies that slack will be wholly eliminated in about 24months, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance. The standard way of estimating the number of people who have temporarily  withdrawn from the jobs market until it improves is to compare the actual participation rate to that predicted if the demographic composition of the workforce had remained unchanged after 2008. This method implies that about 1.3% of the labour force has dropped out since 2008, but should come back if the jobs market improves and that the amount of slack in the labour market might be at least a percentage point higher than implied by the unemployment rate. However, for several important demographic groups, there appears to have been a long term downtrend in participation rates for structural reasons unconnected to the economic cycle, while the potential supply of labour is now constrained, leaving a lot less lack in the system than many assume.

 

China Rebounds, But Can it Rebalance?

China’s economy is bottoming out on schedule (albeit from something closer to 6-6.5% growth than the official data), as the lagged impact on activity of infrastructure announcements since late Q1 is felt. In real terms, retail sales were up 13.5% y/y (helped by the Golden Week holiday), industrial production growth accelerated from 9.2% y/y in September to 9.6% y/y in real terms while the closely watched ‘reality check’ metric of electricity output growth rebounded significantly to 6.4% y/y after staying in low single-digits for the whole of Q3 (see below re coal implications). The recent export rebound (and exports were worth about 31% of GDP in 2011) is impressive considering that the RMB has appreciated by 2.4% against the USD since August, and the euro zone remains grim. However, despite the recent pick- up, China will miss its target for 10% export growth in 2012; exports have increased just 7.8% YTD. There is the risk of a strong base effect flattering the H1 numbers next year, but total planned investment in newly started projects, a leading indicator of FAI, accelerated to 35.2% y/y in October from 31.3% in September.

Consumer inflation eased to its slowest pace in nearly three years in October, with the 1.7% y/y rise below consensus expectations, and surprisingly food prices down m/m, allowing scope for further policy action into Q1 if required. More significantly, corporate deflation pressures eased; PPI fell 2.8% y/y, from September’s 3.6% drop, a marginal boost for companies struggling with falling margins and lengthening receivables. As I’ve highlighted in previous notes, no ‘V’ shaped recovery back to near double digit growth rates is plausible on any sustained basis, given the structural headwinds from low industrial capacity utilization, weak corporate cash flows and  inevitable systemic deleveraging. Near term, the PBoC has used aggressive reverse repos to stabilize liquidity conditions, while the effective lending rate floor is now as low as 4.2%, as the discount rate on the lending rate floor was also widened from 10% to 30% at the same time as the last interest rate cut in July. Since May total social financing has been rising y/y, led by the non-bank sector. In fact, China’s trust companies, with more than $1 trillion under management, provided 755bn RMB worth of new funding to infrastructure projects over the course of the first nine months of the year. Local government financing vehicles (responsible for funding most of the country’s infrastructure construction) raised a further 716bn RMB from bond issuance, according to CICC data.

The trend marks a transfer of default risk from the state (in the form of implicitly central government backed policy bank lending to LGFVs) to private investors, at a time when local government finances are in a very bad shape (with revenues in many large cities typically up 10% y/y and spending up 25-30% YTD). It seems that not only have the banks stepped back from taking the primary role in funding the latest round of infrastructure expansion, but that a portion of funds raised from trusts and bonds has gone toward repaying older bank loans. Xiao Gang, chairman of Bank of China, writing in the China Daily last month, noted that: “It is shadow banking activities that have allowed many projects to obtain fresh funds and hence avoid default …this could be one of the major reasons why the formal banking system in general is still enjoying declining non-performing loan ratios, despite the weakening repayment capabilities of some borrowers”. Despite the pick-up in high frequency data, the quality of incremental credit is a concern.

Overall, Armageddon scenarios were never plausible at this stage, but a decline to 4-5% growth remains feasible by mid-decade if deep reform measures to boost trend productivity growth from current levels at about half of wage growth are not pushed through in 2013. The next couple of quarters should be bullish for Chinese risk assets, but the challenges and inevitable upheaval of the looming economic transition will be the key investor focus by this time next year. It’s clear that China’s new leadership must be comfortable with “the new normal”, and focus on efficiency enhancing reforms. During his opening speech of the 18th People’s Congress, Chinese President Hu Jintao stated that GDP must double by 2020. That implies an annual growth rate in excess of 8%, which is implausible given demographic headwinds without a much larger role for the private sector and radical structural reforms.

The debate is raging in policy circles about now to halt the trend known in Chinese as guojin mintui, roughly translated as ‘the state advances while the private sector retreats’, a trend since 2008 which has driven productivity growth lower and led to diminishing capital returns across the economy. Reformists generally see the growing power and share of  GDP held by state-owned  companies  as  the biggest structural risk facing the Chinese economy. Private SMEs are blocked from investing in sectors such as oil and shipping, over which the government asserted ‘absolute control’ six years ago, and they have limited access to nine other sectors including autos and construction in which state companies were granted ‘relatively strong control’, leaving cash surpluses from the export sector  to  be  reinvested  unproductively  into  real  estate.  Opening  these  key  sectors to both FDI and local SME activity will be an important signal of intent in coming months.

Meantime, a new hukou (residence pass) policy was announced in February 2012, allowing migrants in small cities to apply for local residence if they have a stable job and a place to live. Migrants in medium-sized cities can do the same if they have worked and lived in the same city for three years. This policy, if it is implemented, will greatly boost domestic consumption as rural migrants save much of their income because they have to prepare for going back home someday and China’s household consumption would increase by 3-4 percentage points as a share of GDP if the consumption level of rural migrants were increased to the average level of urban Chinese citizen. Migrants will bring their children and parents to the city once they get the urban hukou (a key factor behind the opposition of urban residents worried about competition for social services like schools). However, this reform in conjunction with a wider social safety net would provide a larger market for services, a sector still hugely underdeveloped and with the potential to offset the falling share of manufacturing in the second half of this decade.

China Rebalancing Trends Deteriorate in Q3…

While the consensus obsesses over GDP growth, the key issue for investors in China and the incoming leadership remains the quality and sustainability of incremental activity. We introduced the China Rebalancing Index back in the February monthly note, and updated it in a July weekly; it’s an equally weighted diffusion index taking a standardized composite measure of seven key economic trends to act as a statistical summary of evolving structural trends, rather than looking for contemporaneous or lagging correlations or cyclical turning points as with a composite leading/coincident index approach. The components offer an insight into whether the Chinese economy is evolving in a sustainable direction toward greater household consumption/private sector service growth or further structural imbalance by experiencing incremental growth driven by SOE/heavy industry/fixed investment activity.

Readings  above  50  represent  trend  imbalance,  and  readings  below  50  represent  trend rebalancing. The methodology follows that used in constructing a Purchasing Managers’ Index (PMI). Quarterly data is used as a default rather than the usual and dubious linear interpolation to create a monthly series; where monthly data is available, the end of quarter data point is selected. Broadly, significant trend shifts in the CRI as seen in 2002/3 and 2009/10 lead the relative consumption share of GDP growth by 9-12 months, which is in line with the real economy lagged impact of factors such as the real deposit rate and REER in terms of metrics like the savings ratio/consumer purchasing power.

The CRI components are:

1. The real (CPI deflated) 1-year bank deposit rate deviation from neutral (defined as 100bps positive i.e. a level at which monetary policy is neither expansionary or restrictive) – every 1% rise in the real interest rate will reduce the savings rate by 60bps on IMF analysis, and vice versa – a positive in Q3 as the decline in average CPI outpaced the cut in deposit interest rates.

2. The Real Effective Exchange Rate (REER) y/y change i.e. the trade weighted and relative inflation adjusted change in the RMB rate as calculated by the Bank of International Settlements – an accelerating REER trend will be positive for rebalancing by boosting domestic retail spending power/curtailing marginal industrial activity –negative contributor in Q3 on relative inflation rates and RMB volatility, as the y/y growth rate fell to 3.5%.

3. The differential between real per capita household income growth (rural and urban, weighted by the annual urbanization rate) and real GDP growth. This is a proxy for wage growth in the absence of direct statistics – positive in Q3 with per-capital real urban incomes rising 9.8% and rural by 12.3%, well ahead of GDP growth.

4. The differential between Secondary (industrial) and Tertiary (service) shares of incremental GDP growth – acceleration in SME service activity is crucial to several positive trends from reduced energy intensity of incremental GDP to absorbing underemployed graduates. Small positive in Q3, as manufacturing industry suffered disproportionately from the policy led slowdown, and services activity accelerated slightly to 7.9% from 7.7% in Q1, both on a YTD y/y basis.

5. The % change in the quarterly Entrepreneur Confidence Index for SOE dominated sectors versus private to capture trends in private SME momentum; the Shibor interbank rate is a useful proxy for funding stresses in this sector but the history only extends to 2006 and this index correlates positively with revenue growth and negatively with funding cost trends. Largest contributor to imbalance in Q3 as SOE/heavy industry confidence stabilised amid on-going weakness in SME sentiment (notably in the social services sector, down from 131.5 in Q2 to 122).

6. The differential between real Fixed Asset Investment (deflated by 6mma Building & Construction PPI) and real Retail Sales (deflated by CPI) growth rates (note as discussed in previous notes that FAI includes land values, which creates distortions in drawing international comparisons, but not in terms of broad GDP trends). Falling inflation helped China’s retail sales rebound to a real growth rate of 12% y/y in Q3 but the 6mma construction PPI slumped far faster than CPI, boosting the real FAI growth rate to 22%, so marginally negative contributor.

7. The differential between heavy and light industry output growth (on a VAI basis) within the Secondary sector of GDP – heavy industry such as cement and steel is capital and energy intensive, and dominated by SOEs with preferential funding access. Light industry is predominantly consumer demand focused, although the category is also exposed to construction activity. Value added of industry = gross industrial output – industrial intermediate input + value added tax; the growth rate is calculated at constant prices. Value-added of Industry refers to the final results of industrial production of industrial enterprises in money terms during the reference period. Neutral in Q3, as the decline in value added output growth for heavy industrial sectors like steel was matched by light industry suffering from softer consumer demand growth.