US Workforce Trends Confuse Investors…

We think that today’s labour force participation rate is about right, given observed demographic trends’ – James Bullard, St. Louis Fed President

We’ve seen a burst of volatility in the wake of the US December payrolls data, which ran contrary to just about every piece of bullish recent data and looks like an anomaly in what is a very noisy series. The slump in the labour force participation rate to 62.8% was the most interesting aspect, and it’s a sustained downtrend which has confused many observers. However, it was predicted pre-crisis by demographic models, including research done by the Fed itself. Over the past five years, the US labour force has grown only 0.2% annually, a fraction of the 1% plus pre-crisis trend. In principle, there are roughly 10m potential workers ‘missing’ from the data. If they were to suddenly reappear and actively look for a job, the unemployment rate would be closer to 11%.  The share of Americans either working or actively seeking work in December was the lowest level since 1977, before the female participation rate began to soar through the 1980s and 1990s. 

 As I’ve highlighted previously, the trend is largely structurally demographic rather than cyclically economic. Much of the decline was eminently predictable; indeed a 2006 paper by Fed economists accurately predicted that participation would fall to 62.9% by 2014. There is far too much focus on the demand side of the equation i.e. employment growth, and too little on the supply of labour which is slumping because of demographics and the end of Mexican immigration (the latter partly because of the high tech fence now blocking the border). Meantime, the US economy generated 2.2m new jobs last year, an impressive outcome set against substantial fiscal headwinds and the ever growing impact of productivity boosting technology in the service sector, adding to a similar gain in 2012.

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. 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 62.8%. Recent studies have validated the 2006 predictions (and of all the data economists torture into submission, demographic trends are invariably give the most reliable answers). According to an analysis last November by an economist at the Philadelphia Fed, the aging of the American population accounts for most of the decline in labour force participation since 2000.

The head of the SF Fed pointed out back in September 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. While I’d expect the participation rate to bottom on a cyclical basis in Q1, and gradually pick up by a point by year-end, the fact remains that there is less slack in the US labour market than widely assumed on a ‘mean reversion’ basis for the participation rate because of structural headwinds.

For example, teenagers are spending longer in education, and male participation rates for most age groups have been declining continuously for several decades (possibly because of the evolution of the economy away from manual blue collar occupations, notably in manufacturing). The downtrend accelerates during recessions but only partially reverses during subsequent recoveries. It is very difficult for the Fed to distinguish between a permanent, structural change in the participation rate and one which will be reversed if there is a stronger recovery in the jobs market, but recent comments suggest they are leaning toward the former explanation. If the CBO/Fed estimates of the non-inflationary unemployment rate (NAIRU) are right at about 5.5%, then labour market slack will be pretty much eliminated within a couple of years even with a slight pick-up in participation, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance.

US Recovery Awaits Corporate Investment Rebound…

26th October 2013

‘First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no, no and no.”  Incoming Fed Chair Janet Yellen speaking in 2005

Dovish comments like that from Ms. Yellen as well as the soft September payrolls report are driving investors to assume Fed tapering has been postponed toward Q2 next year, if not the indefinite future. The key issue remains very low levels of investment in the US economy, which correlate well with job creation – if private investment remains moribund, escape velocity for the labour market and wider economy will prove elusive. As covered in previous notes, overall investment as a share of GDP is trending down over time for demographic reasons as the economy matures and also as it becomes more IT driven; sustained deflation trends in computer software and hardware give companies more bang for their investment buck, while faster inventory turn via ecommerce has reduced the need for warehousing etc. (think Amazon versus WalMart sales per square foot). Nonetheless, we are several percentage points short of trend investment levels and a key issue for 2014 is whether corporate boards from the US to Japan decide that they have sufficient visibility to justify capacity replacement and/or expansion. Markets face a pivotal moment in coming months; either the unprecedented stimulus since 2009 has failed to ignite a self-sustaining recovery, despite the energy windfall, in which case the Fed is pushing on a monetary string and earnings momentum   will roll over in a manner painfully familiar to GEM investors.   Alternatively, we finally get the last cylinder of growth firing and corporate investment pushes US growth toward 3% (and the fiscal drag will ease considerably next year), in which case the Fed will have to expedite its balance sheet normalization. I’d still bet on the latter outcome, but  either way as the S&P grinds toward 1800, it would be wise to finally begin paring US exposure. Record net cash levels for the S&P  500 certainly support an investment rebound thesis, with the caveat that  the tech companies who are the clear winners in the new ‘asset lite’  economy are generating the bulk of that cash, and hoarding it overseas out  of reach of the IRS.

It was odd that the Nobel Prize in Economics was split three ways this year and focused on market theory; most market observers are oblivious to a bubble inflating around them, but none  more so than academic economists with their beloved general equilibrium models. Among the winners, the one you might trust with your money based on  his track record is Prof. Shiller (of US house index fame) who suggests that prices are currently “high” in the US equity market at current levels of his estimated cyclically adjusted PER. This implies that objective measures of the risk premium (expected returns) are lower than average that is, expected  risk premia must inevitably rise. 1990’s, when of course Alan Greenspan  echoed Janet Yellen’s housing comments in relation to the tech boom   although he has since partially recanted). The real  contrast between Shiller and his co-winner Prof. Eugene Fama, originator  of the Efficient Market Hypothesis, is that he remains agnostic about what  risk premium is sustainable. In other words, he doesn’t accept that  there is a ‘fair value’, and so has no room for the prediction that prices  will fall. In the current circumstance, he might say that investors are  highly tolerant of risk i.e. they are willing to accept low expected  returns for taking on US equity risk.

The S&P 500 price/revenue ratio of 1.6 is now 2x its pre-1990s historical norm; the 1987 peak occurred at a price/revenue ratio of less than 1x, but of course margins are considerably higher now. A key support remains LT interest rates at historically low levels and share buybacks as companies use record net cash flow relative to GDP to shrink their equity base. Back in the 4th September weekly, which looked in detail at the CAPE and other long term valuation methodologies, I noted that: ‘Some investors take a macro view of corporate profits using the Kalecki equation (Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends) and thus argue that the large US deficit has been the big source of (excess) corporate profits. With the deficit now declining and both earnings growth and sales growth on the S&P decelerating, there will be a  double whammy of less fiscal stimulus on demand and a shrinking source of profits that needs to offset that impact, preferably by corporate investment. Overall, after the outperformance seen YTD, US equities no longer look compelling, although a push to my original 1800 S&P year-end target is still feasible on inflows from bond/GEM fund refugees.Those inflows as much as the rally in 10-yr Treasury yields are a key support near-term; data from EPFR Global shows that $69.7bn was withdrawn from money market funds in the week ending 16th October while equity funds captured net inflows of $17.2bn as the debt ceiling crisis was resolved.


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.


Fed Creating Inflation with QE3+, But Also Market Distortions…

The rather discredited Philips curve taught in Econ 101 classes relates the inverse trade-off of unemployment to inflation; the Fed seems to have decided that if lower unemployment can cause inflation, higher inflation expectations can create employment. Spain’s equity market is up 40% since the late July low, the S&P 500 technology and financial sectors are up 23% this year (with Bank of America up 70%), and the euro has rebounded above 1.30 versus the USD, while medium term US bond market implied inflation expectations have broken 3%, versus just 2% last autumn. Back in early June, the smartest brains in the investment world would have confidently bet against most if not all of those developments, as reflected in the underperformance of hedge funds since, with the benchmark Bloomberg index up just 0.7% last month and lag the MSCI World YTD by over seven percentage points on a total return basis. The Fed’s previous QE efforts were flawed in that they removed safe asset collateral from a financial system chronically short of them and left markets convinced that 2% was an inflation target ceiling. Last week, we got a clear signal that it won’t be.

The Fed was most always likely to act via the mortgage bond rather than Treasury market this time, but the open-ended nature and ‘acceptable’ employment target have raised the stakes considerably. The Fed hopes to generate more economic activity per dollar of balance sheet expansion because the program is open-ended, even though $40bn a month is smaller than QE1 or 2, via faster bank mortgage origination and hence boosting a promising early stage housing recovery. One reason banks have been hesitant to step up that origination capacity (which has been running at just $4bn a month net YTD) was that they didn’t believe the low-rate environment would last. As the policy wonks at the Fed might put it, the portfolio balance channel (i.e. goosing asset prices) works better when accompanied by use of the expectations channel (i.e. low rates indefinitely). As ever, things are likely to prove more complicated than those neat econometric models predict…

One risk with relentless monetary expansion via bond purchases is that a false market developing in US fixed income, such that the global risk-free benchmark rate is distorted. We are certainly in an unprecedented situation as regards price discovery because as well as MBS, it’s quite possible that the Fed will continue to purchase longer-term Treasuries ($10-15bn a month) simply to prevent the stock effect of its previous purchases leaking back to the market, but probably without the short-end Treasury sales that to this point have been neutralising the impact on the monetary base, as its supply of these Treasuries to sell will be close to exhausted. The Fed has become the dominant buyer of Treasuries, accounting for almost 50% of 7-year and over 60% of 10-year new issuance. Over the next few months, it will be the dominant buyer in the market for agency-backed mortgage securities, where gross issuance totals about $130bn per month but accounting for securities that reach maturity, the Fed’s purchases will actually shrink overall supply. Unsurprisingly, the yield on the commercial MBS index tumbled to a new low of 2.26% last week and MBS spreads over Treasuries fell to their lowest level in over 20 years.

Junk bond yields are already seeing a ‘displacement’ effect along the risk curve. All of this activity will take its balance sheet toward $4trn by 2014, but will also squeeze fixed income market liquidity even further.   I’ve often noted that the essential investment implication of QE is to artificially suppress macro tail-risks and the Fed has been selling volatility into the markets to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk). Economist Hyman Minsky’s brilliant insights into the impact of low volatility (ignored pre-crisis, and still only grudgingly accepted among policymakers) on speculative behaviour suggest we’re setting ourselves up for another ‘Ponzi finance’ bubble and the only question is where it will inflate this time (aside from bond markets). For China, even if its trade surplus has fallen sharply from 11% of GDP to say 3%, recycling even $300-400bn annually into Treasuries will be a nightmare competing with the Fed as buyer of first resort.

The slowdown overseas is beginning to cut into US corporate profits, which had benefited in the last few years from exports/foreign affiliate earnings outpacing domestic demand. Analysts expect earnings in the S&P 500 to decline 2.2% in Q3 y/y, according to Thomson Reuters, the first annual drop since Q3 2009; earnings are expected to be down 3% from Q2 while the Shiller CAPE is now almost 23x. Certainly, GEM equities have underperformed DM this summer as the BRIC slowdown hits earnings momentum and valuations look far less stretched that in the US and some euro zone markets. EM USD debt has surged further with the desperate global hunt for income, and focusing on stable cash flow, high dividend equities has been a successful investment strategy just about everywhere. That trend looks well supported by the latest Fed move, but having gone back to a long risk stance back in June, I’m weighing up the implications of these cross currents for this month’s Q4 portfolio strategy note. I’d suspect that the ‘washboard’ ride for markets isn’t over just yet.