Thursday 18 May 2017

Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author
Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
  • Final chart - Trumpflated

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas
We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:
"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:
"Wage wars
The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.
There is the theory
The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.
The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.
And then the data
We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.
We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch
Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:
"In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017
Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:
"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).
- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":
"Current state of Japan’s labour market
Japan’s labour market is at its tightest level since the early 1990s 
Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."
- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016
We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:
"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages
The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.
Progress until now and further progress on labour reforms should help Japan’s economic recovery continue
The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.
 Back in our January conversation "The Ultimatum game", we indicated the following:
"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.
The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

  • Final chart - Trumpflated
For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:
"The deflating of the reflation trade
As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.
US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse
As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley
Stay tuned!

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