Volume 79 | Number 5
April job gains at 160,000 were slightly softer than expected – but given the cooling in the economy and previous hiring strength this was hardly a shock. The details of the report suggest that much of the weakness in April came in areas that had been quite strong earlier. Meanwhile, the modest downward revisions of 19,000 actually contained large upward revisions for previously weak industries like manufacturing and big declines for the super strong services sectors. All in all, the combination of higher hours worked and a decent 0.3% gain in average hourly earnings means that wage incomes will continue to support a solid consumer sector despite a slowing of employment. This is the traditional result in labor markets as they approach full employment – which some estimate at 5.1% but Chair Yellen has recently stated was now 4.8%, leaving a bit more room from the current 5.0% rate. The labor force shrank and the participation rate rose after several months of strong gains. However, readings on the number of workers part time for economic reasons and the broader U-6 unemployment rate both indicate that the rough edges of the economy are now enjoying the benefit of a rising tide – however, anemic!
Many are concerned that with wage gains running at 4.4% (1.9% growth in hours worked and 2.5% growth in hourly wages) and profits squeezed by nominal GDP growing at roughly 3%, that an imminent slowdown in hiring is in the offing. We doubt it. Rather we read rising wage pressure as a sign that firms are competing for the best employees. The share of unemployment made up of job leavers is rising, indicating that labor is in the sweet spot of its cycle. While there is clearly a contraction going on in the oil patch, most other industries are willing to share their still wide profit margins with the best and the brightest. Meanwhile, outside of drilling dependent industries, capital investment is grinding higher as firms seek to offset rising unit labor costs.
Bottom line, either collectively all businesses in America are crazy or the labor market data suggest that they are ready, willing and able to compete for the shrinking labor pool. Workers certainly anticipate a long-term expansion as they have re-entered the workforce in large numbers recently – lifting the labor force at a 1.8% annual rate over the past eight months, resulting in a virtually flat unemployment rate. Isn’t this what Chair Yellen predicted a year ago?
It is not the labor market, but the capital markets that remain out of whack – and the most serious threat to the expansion. Productivity continues to founder, rising 0.6% over the past four quarters – matching the three-year pace. Over the past six years, output per hour has risen at an anemic 0.8% annual rate. Add in 0.8% for the long-term growth in the labor force growth and you have an estimate of 1.6% for potential real GDP growth. The current GDPnow forecast from the Atlanta Federal Reserve Bank is for 1.7% growth in the second quarter. Theory tells us that when an economy is growing at potential and both inflation and unemployment are near the FOMC’s targets, monetary policy should remain unchanged. That’s the way the Street sees it despite the ongoing protestations of the professional central bankers. We expect to remain lower for longer on both inflation and interest rates.
With interest rates this low on the expectations of slow growth, it is much wiser to buy existing assets for growth rather than to invest in new ideas. Clausewitz observed that defense is the stronger form of war because it is “easier to hold ground than to take it.” The same is true in business, as an existing firm will fight tooth and nail to defend its current clients – so that gaining share when the pie is fixed is much harder than when a rising tide is raising all boats. As the ancients learned, it is easier to acquire land by marriage than by war. That does not mean that the land was used any more efficiently afterward, just that the owner had a bigger title. Hmmmm….
It is important to understand that low and slow can lead to a paralytic situation like Japan, just as the rules of easy monetary policy led to a dominance of risk taking. When the fractional reserve system was first utilized, the idea was an investor would put their money in the bank and all but a fraction would be lent out safely to others in the area. Over time, financial wizards realized that excess reserves built up in some areas with more savings than places to use them – which drove down local interest rates. Big banks gathered together these underutilized reserves through correspondent banking relationships and lent them more efficiently. Overtime, one bank’s excess reserves could be lent to any taker via the federal funds market – resulting in a national interest rate. This allowed the Federal Reserve to manage the supply of available reserves by manipulating that single interest rate. However, the wizards adapted, realizing that they could expand their balance sheets aggressively knowing that the reserves they needed would be provided by the Fed at the target rate. The most risk adverse lenders lost market share, while those happy with no docs loans and sub-prime auto lending thrived. Ultimately, Lehman’s risk proved too big to bail (or so big it failed, if you prefer).
In the current case, the emphasis on mergers and acquisitions leads to a focus on cost control to generate more profit out of a known stream of income. This is clearly deflationary in the short run. It can be even more so longer run if profit expectations were too high and the “winning” firm finds they are now burdened with financing costs (dividend expectations or interest) that exceed the blood they tried to squeeze from the stone. To pay the investors (at least initially – or face declining stock values) costs are squeezed harder. If the asset value falls, poor performance makes the failing firm a target for someone who is certain they can run the company better – and sees it as cheaper than them starting a greenfield operation.
When the most successful firms are able to absorb their competitors by using the excess savings that they will not use for capital investment, the need for credit diminishes. In economies that mostly depend on fractional reserve banks, monetarist theory tells us that a shrinking money supply is also deflationary. Deflation raises real interest rates, so unless excess savings is driving down nominal rates faster, the credit cycle spirals down. Even if nominal rates are falling, they are hampered by the zero bound (or something close to it as we are learning today in a world of slightly negative rates.)
The merger and acquisition bias leads inexorably to a concentration of income and wealth. When credit is readily available, those being squeezed by declining earning power can delay the inevitable by borrowing. As credit becomes less available, either because banks fail or because they are driven from the marketplace by equity or unleveraged debt financing, the burden of falling incomes will become clearer. In Japan, the government fought this with massive government pump priming to make work and income. In Rome, the government spent on bread and circuses. You get the idea, government redistribution is needed – or revolution is threatened. The leaders of the depressed often negotiate with the elites about just how much money must be paid to the poor to keep them from revolting. This form of government is called fascism (or sometimes benevolent dictatorship). It was common in the 1930s and appears to be making a comeback today. We are on our way to Buenos Aires this week. Argentina was the only nation to survive WWII with a fascist government still in place – until recently. We will discuss next week what (if any) lessons are learned.
Michael Drury is McVean Trading’s Chief Economist and Chairman of the Global Interdependence Center. McVean Trading is a proud sponsor of GIC, a non-profit headquartered at the Federal Reserve Bank of Philadelphia, which holds 15-20 public events each year binging together global business leaders and policy makers to discuss critical issues including monetary policy, energy and trade. In addition, GIC’s off-the-record private roundtables promote frank conversations about often delicate topics and a deeper understanding between participants in our increasingly interdependent global economy. To learn more visit http://www.interdependence.org.