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. 

Synopsis:

• 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!

Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor

Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:

"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."

Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies

The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia

 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 

"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017

Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporations in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:

Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 

So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:

"In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp.

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds. Also the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality.

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 this year 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.

While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":

"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017

There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

Synopsis:

• Macro and Credit - The wage / productivity paradox
• Final chart - International trade and Nash equilibrium

• Macro and Credit - The wage / productivity paradox

While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":

"Employers and employees deaf to government's calls for wage rises

No sign of a pickup in the rate of wage rises from New Year events

Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.

Deep-seated reluctance of employers to increase fixed costs

While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.

The unions are also cautious about demanding wage rises

A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).

Limits to how far working practices can be reformed without freeing up the market for regular employees

In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura

Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:

- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 

On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":

"The biggest medium-term macro surprise?

We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.

Tackling Japan’s wage paradox

The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.

Approaching full employment

However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.

Wages growth to double in FY17, reach 2% in FY18 

The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold

Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.

However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch

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.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:

"Disconnect between job growth and wages

Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).

Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).

But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.

That being said, structural factors may be in play as well. 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.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).

Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.

Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).

Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.

Reasons for optimism

The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch

The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":

"Robert Lucas argued that 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, 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.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

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." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

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." - source Wikipedia 

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

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety 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. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

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 mattes 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.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

• Final chart - International trade and Nash equilibrium

Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:

"International Trade game

Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.

However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.

What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch

If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Macro and Credit - The Grapes of Wrath

"When anger rises, think of the consequences." -  Confucius

Looking at the impervious performance of credit markets and in particular US High Yield since this year lows while noticing no doubt a rise in global discontent and populism, it seems to us appropriate this time around for our title analogy to steer towards John Steinbeck's 1939 masterpiece "The Grapes of Wrath". In recent musings we have been pretty vocal about our pre-revolutionary mindset, not because we are of the revolutionary breed but, as we noted in our conversation "Empire Days", there is in Europe growth in disillusion / social tensions which can be ascertained for instance in France with the daily demonstrations of the French police and growing discontent hence our title. The Grapes of Wrath was set during the Great Depression and focuses on a poor family of tenant farmers which when they reach their Californian destination finds out that the state is oversupplied with labor, wages are low and workers are exploited to the point of starvation while big corporate farmers are in collusion and smaller farmers suffer from collapsing prices. When preparing to write the novel, Steinbeck wrote: "I want to put a tag of shame on the greedy bastards who are responsible for this [the Great Depression and its effects]."

The intensity of the US presidential election is indeed resonating with Steinbeck's work as it is representative in similar fashion to the growing global discontent with "elites" and the rising disconnect given the rise in inequality thanks to soaring asset prices courtesy of central banks "wealth effect" policies. It might still be goldilocks period for asset prices and in particular credit with additional melt-up but, no doubt in our minds that political clouds are lining up, while the tide is slowly but surely turning for the credit cycle.

In this week's conversation, we would like to look at the relationship between inflation, wages and labor growth, which would entice us to "buy" the recovery mantra of some sell-side pundits. Furthermore, we believe that for the "stagflation" story to play out it is conditional on a continued rebound of oil prices and an overall surge in commodity prices.

Synopsis:

• Macro and Credit - Is inflation truly rearing its ugly head? A look at the United States, Japan and Europe
• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

• Macro and Credit - Is inflation truly rearing its ugly head?

With the intensification of the use of the dreaded "stagflation" word and in continuation to our most recent musing, we continue to believe that rising 10 year US breakevens have been mostly driven by the change in oil prices as illustrated by the below Bank of America Merrill Lynch chart from their CMBS Weekly note from the 28th of October entitled "Still neutral for now":

- source Bank of America Merrill Lynch

In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp we think.as reported in the Wall Street Journal on the 4th of October:

"Rents in San Francisco declined 3%, while they fell about 1% in New York and edged lower in Houston and San Jose, Calif., the first drops in those markets since 2010, according to apartment tracker MPF Research. Across the U.S., rent growth was 4.1% on average." - source WSJ

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds as posited by Société Générale in their American Themes note of the 19th of October entitled "Equilibrium fed funds: how low and for how long? Demographics the answer!":

"Historic observation: Labor demographics key driver of real long-term fed funds rate

An equilibrium fed funds rate—or interest rate—can depend on many factors that vary over time. The biggest driver under consideration is the inflation rate. Inflation is a straight-forward driver, and more scrutiny is placed on movement in the real interest rate. Economic growth and demographics are key. The perception of equilibrium is an issue too. In the current environment, we believe 2.0% inflation is achieved in balance. In the post-war period, the US economy has operated mostly out of inflation equilibrium with an average inflation rate of 3.64% (CPI) since the 1950s. So far in the 2010s, inflation is averaging 1.53%, just about the closest the US economy has been to a sense of equilibrium, and we are generally worried about deflation risks. The 2.0% inflation-equilibrium may be a challenge for a fed funds equilibrium rate, but we use it.

Drivers and rules of thumb for the Fed Funds rate

Old rules of thumb for determining the fed funds rate have lost prominence over the past decade as the rules appear to have changed. The fed funds rate is substantially lower than these rules of thumb might have suggested. Yet an examination of why they may have worked in the past but fail today is insightful. There are two key rules of thumb:

1. Fed funds rate should equal nominal GDP. Traditionally, nominal GDP has exceeded fed funds, yet the components of GDP are all the same and influence long-term GDP, namely inflation and real growth. Real growth is determined by demographics, productivity and investment. These latter variables are all the key variables contributing to a dynamic real fed funds determination.
2. Fed Funds equal 2% plus inflation. This rule coincides with the Taylor rule (In appendix) which originally had 2.0% as a real component. If output gaps and inflation gaps zero out over time, then the fed funds rate rule would be 2% plus inflation. Since the original formulation, however, the 2.0% is now in question. The rule was dependent on the time period examined and later updates used a lower real rate as the time horizon expanded or shifted. We can select a different fixed rate. Yet it is the dynamism of the real rate that is now in question. A different time period could yield a different fixed rate and we could fit the data but gain no insight into an evolving real rate. Today, we assume the real rate component is lower than the past but don’t know how low. Also important, if the real rate turns higher again, will we observe or be aware of the upturn?

The real short-term rate can depend on a large set of factors. In fact, the number of variables that can influence the real rate, and the inability to observe these variables, renders many ambitious under-takings to model the real rate useless. The potential growth rate, or GDP, is likely a top choice as a variable determining the real interest rate. However, the real potential GDP can only be estimated. Further, changes in potential GDP growth are difficult to detect and often require a period of time before a consensus can build on what the potential GDP growth is and how it has changed.

Historically, the nominal GDP averaged a rate significantly higher than the fed funds rate. Nominal GDP is composed of two easy parts, inflation plus real GDP. Like the fed funds rate, it suggests that the real fed funds would over time be equal to real growth. Over the six decade period of examination, nominal GDP exceeded the fed funds rate by 1.55%, and the standard deviation of that spread was 4.45%. Historically, we conclude that nominal GDP has not offered an appropriate guide.

Using a simple benchmark as nominal GDP for the fed funds rate is clearly an oversimplified approach. Yet much of the modeling approaches to consider the long-term fed funds rate are decomposing GDP and weighting the components.

Inflation is the first component, and in the long term, we expect inflation and inflation expectations to converge. The inflation component is assumed one-for-one in the long-term GDP. The real components to GDP are demographics, productivity and technological change. We can model and weight these components, but the approach is fraught with limited transparency. Productivity and technological change are observed with certainty only in hindsight, and sometimes many years after revisions. Additionally, it takes several years to distinguish between a temporary or a more permanent change in these variables.

Labor force and demographics – a more observable component of real growth.

Examining the different components of real GDP over the long term such as labor demographics and productivity as well as the aggregate real GDP growth rate, the movement in the labor force commanded strong interest. What is most compelling about the labor force growth is that it has some predictability, at least far more so than productivity or real GDP growth. Labor force growth is determined by population growth and retirement. Many of these features we can predict long in advance. On a monthly basis, we find the labor force participation rate (percent of working age population that has employment or is looking for job), but large moves can be predicted by the aging of the population. Another interesting characteristic is that the labor force data is not subject to major quarterly revisions like productivity and GDP.

In the tables above, we created another fed funds benchmark, which is the simple addition of inflation and the labor force growth rate. The aim is to generate a function based upon more readily observable components of potential growth. The goal is also to keep it simple. The two components, labor force and inflation, together offer an easy, dynamic calculation for long-term GDP. Over six decades, such an easy measure posted the narrowest spread to the fed funds rate. Moreover, the standard deviation on the spread was only modestly higher than using a fixed real rate benchmark. Labor force movements appear to be capturing a key, dynamic portion of the real rate movement, and importantly, the labor force variation is more observable, less prone to revision, and easier to project going forward relative to other fundamental explanatory variables.

Labor force growth has slowed appreciably in the 21st century and particularly after the crisis. The slowdown is a chief factor explaining a slowdown in GDP. Since 2009, the labor force has grown at just a 0.5% pace. That was down from 0.8% in the 2000s and 1.3% in the 1990s. Adding to that an equilibrium inflation rate of 2.0% would generate an equilibrium fed funds rate of 2.5% in the 2010s, versus 2.8% in the 2000s and 3.3% in the 1990s. Inflation was higher or lower than 2.0% during the decades and our historical calculation uses the actual CPI inflation measure.

 

Reasons to use such a simple labor force and CPI construct for considering long-term equilibrium:

1. Historical accuracy: If we consider a long-term analysis assuming that short-term rates find their needed equilibrium, the simple rate has been accurate. Moreover, the points of departure in the 1970s and 1980s are of interest. Fed funds were arguably held too low in the 1970s, giving rise to high inflation. Conversely, in the 1980s the fed funds was higher than it should have been due to abnormally high inflation expectations. Back testing this simple measure offers intriguing results. Over a six decade history, a simple benchmark of adding the labor force and the CPI inflation rate than GDP that implicitly moves with productivity and technological innovation.
2. Observable: A black-box model on the real rate can be constructed. Transparency and ease of observations are strong positives. Many important concepts behind a real rate—from demographics, real growth, productivity, potential growth—are not directly observable. Furthermore, the variables can be revised substantially over time. Variables used to fit a model could be materially altered at a later date. Labor force counts and the CPI are less subject to revisions.
3. Robustness of time varying real rate: Demographics pay a large role in potential GDP growth and additionally on the supply/demand for savings/investment. Having a simple demographic measure such as that has historically had a degree of accuracy, which offers a neat tool for gaining insight. The aging US population and the slowdown in immigration are captured indirectly in the labor force statistic.

There are weaknesses as well that are a narrowly focused driver of the real fed funds and the labor force overall. First, consider the chart on US labor force growth on the preceding page. Volatility argues against using this variable as any short-term guide for the fed funds rate. Second, the swings are numerous enough that deciphering a temporary versus a more permanent change is not straight forward. Yet variation could be minimized with more judgment, given that the aging labor force and the growing participation of women in the workforce were robust elements for change. Labor force gains accelerated into the late 1970s and have been decelerating since.

Conclusion

Estimates of the long-term fed funds rate remain well above current levels and therefore do not offer any short-term guidance for the fed funds rate. Demographics may be suggesting that we have reached a low point. At present, we expect labor force growth of 0.5-1.0%. With an inflation goal of 2.0%, the fed funds rate needs to converge to a 2.5-3.0% range. That range encompasses the Fed’s view and that of many other forecasters as well. It would also allow for further revisions downward. Yet, there is a growing risk that the next step in labor force growth will be faster. We see workers putting off retirement until later and /or the effects of the baby boomers entering retirement fading.

Has the drop in interest rates reached its bottom? 

That is a question regarding most bond maturities. Beyond the inflation question, a bottoming of labor force growth suggests that real rates have reached a bottom. This is an interesting outcome that we stress. The  models now used to explain the persistence of low rates may not yet be ready to determine whether an upturn is underway. Two contributions to slowing labor force growth since 2000  have been the retirement of the baby-boom generation and the slowdown of immigration. The oldest baby boomers are now 70, and the mid-point of the baby boom generation (those born in 1955) reach 62 in 2017.

Meanwhile, we know we have not considered productivity and technological change in this analysis. The question of productivity growth is immensely important, but even more difficult to answer relative to labor force growth as a driver of the economy. In terms of our six-decade view, productivity appears useful in explaining current low interest rates, but not much prior to the current period." - source Société Générale

While Société Générale has an interesting take in relation to demographics, the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality. On top of that we do not agree with Société Générale that real rates have reached a bottom. The effect of ZIRP has in effect pushed many baby boomers to postpone taking their retirement due to lack of returns and until we see a clear change in the Fed's monetary policy, we disagree with Société Générale and do not think workers putting off retirement until later and /or the effects of the baby boomers entering retirement  will be fading anytime soon.

When it comes to Japan and Europe (which is undergoing a clear "Japanification" process), both countries face different inflation expectations than the US mostly due to demographics headwinds as we have pointed out in numerous conversations. Interestingly enough, when it comes to demographics, Japan leading the timing of Europe, it does boast a key advantage compare to Europe which is indeed its much tighter labour market leading to some creeping wage inflation as highlighted by Société Générale Albert Edwards in his latest note from the 26th of October:

"After consolidating around ¥100 for about one year, the yen saw a second step decline in H2 2014 towards ¥125. This additional competitiveness caused Japanese corporate profits to boom. The downside was that household incomes were squeezed as higher import prices pushed up headline CPI inflation - this sounds much like the UK today! Although all this was exactly the intention of government policy, the trick is, like kick-starting a motorcycle, to get this one-off stimulus to profits to fire up the engine into a virtuous wage/price spiral and sustainable growth. And from long experience of kick-starting a BSA 1954 M21 600cc single cylinder, it often takes repeated attempts and bruised ankles to get it fired up - link.
Having driven the yen down towards the key 30-year support level of ¥126 at the start of 2015, the BoJ blew its big chance to drive it down through ¥126. If the yen had broken ¥126, I felt it would have quickly run down to ¥145. But having failed to break below this key support level, this year saw it rapidly head in the opposite direction to peak at ¥100 by June, hence squeezing profits (see chart above) and stalling growth. This led foreigners to take flight by selling a record ¥6tn of Japanese shares in the first nine months of the year. I felt the BoJ had blown their chance of reviving the economy via QE and that Abenomics was doomed.

But I might yet be premature in writing Japan off. One key advantage Japan has in trying to produce inflation is, perversely, its appalling demographics. Why? Because even quite moderate GDP growth has resulted in a very tight Japanese labour market (see chart above), and this has resulted in wage inflation crawling higher. In real terms, wage inflation is now rising above 1% (see charts below – indeed Japan’s real wages are rising faster than the US).

Much to my surprise, despite this year’s H1 yen strength hitting growth badly, the Japanese PMI has actually revived in H2 (see left-hand chart below). But this H2 Japanese PMI recovery may be coming at the cost of the US recovery as PMIs now seem to move inversely (see chart below) – especially with the dollar now surging on expectations of a Fed rate hike).

Leo Lewis of the FT wrote a very interesting Short View, essentially concurring with Andrew’s front page chart, that Japanese companies are heaving with surplus cash. He notes a record high 55 per cent of Japanese non-financial companies now hold more cash than debt, in contrast to less than 20% of the S&P 500. And with valuations where they are (see chart below), which equity market do you think QE has set up to collapse in the next recession?

- 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 this year 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".

For Europe, the story is as well different, though from a credit perspective, the on-going Japanification means that Europe, in similar traits to Japan has been deleveraging overall (except Italy and Spain) whereas in the United States and as illustrated by Albert Edwards' note the US has been releveraging thanks to cheap credit and buybacks favoring in the process multiple expansion on a grand scale:

"In a low-growth world, debt is dangerous; in a deflationary world, debt is toxic. Japanese companies, through years of experience, probably understand this and have deleveraged as a result; US corporates, perhaps foolishly, have done the exact opposite.” No “perhaps” about it Andrew. This is nuts!

- source Société Générale

Exactly, in a low yield environment, defaults tend to spike as low yields tend to coincide with higher spreads and default rates. Often low yields are associated with slow growth which eventually should evolve towards wider credit spreads when the credit cycle eventually turns but, we are not there yet. If growth eventually picks up while yields stay low then spreads could indeed normalize but it is not our core scenario.

Why inflation matters therefore? Because in low inflation environment, like the one we are going through often tend to be associated with spiking defaults historically (deflation bust of the energy sector earlier this year).

But, moving back to Europe and its inflation conundrum, when it comes to wage growth, it could put additional pressure on its inflation expectations due to decelerating wage growth as highlighted by Ban of America Merrill Lynch in their Euro Area Economic Watch note from the 28th of October entitled "Wage growth: potential for worse":

"Wage growth: potential for worse

This is a half-hearted labour market recovery

Employment growth in the Euro area is continuing its relatively steady recovery. The number of employees (excluding self-employed) rose 1.7% and 1.6% in 1Q and 2Q16, respectively, predominantly driven by the services sectors. The number of employees is back at 2008 levels now (Chart 1).

However, robust headline employment growth masks a much shallower recovery in hours worked, which continue to stand nearly 4% below their 2008 level in the economy as a whole (Chart 2). 

Meanwhile, Euro area wage measures, including compensation, wages and salaries, contractual wages, etc, continue a gentle downward trajectory. Wages and salaries per employee, for example, slowed to 1.4% yoy in 1H16 on average compared with 1.5% in 2015 and 2.1% on average since 2001.

Some blame sector composition for slower wage growth – we disagree

A predominantly services sector-driven labour market recovery is not surprising given the composition of the Euro area growth recovery: domestic demand components, public and private consumption in particular, are a lot more service-intense than capex or exports. Services, in turn, are more labour-intense.
Some hawkish ECB council members have cited the sector composition of the labour market recovery as the driver of slowing wage growth, as services wage growth typically underperforms that of industry.
We believe this line of argument is flawed and not supported by the data. On the contrary, our findings suggest that wage-setting behaviour may have changed also in the services sector post-crisis, which would be disconcerting. Even if we assume that wage structures did not change, wage growth prospects would still be rather gloomy and under pressure to decelerate further.

Sector drag on aggregate wage levels? Not if you look at hourly wages

Since 2002, the share of employment in industry excluding construction has fallen by more than 4pp to 17% in the Euro area, while that of the services sector has risen 6pp to 77%. We wanted to know if and how much drag this reshuffle of employment poses to average wage levels. To do this, we calculated a counterfactual wage level measure, assuming the composition of employment and the composition of working hours had remained at the 2002 level. Results are shown in Chart 3.

We find that wages per employee are currently some 1.5% lower than they would have been if the sector shares of employment had not changed. The trend has been very steady, however, lowering wage growth per headcount by 0.1pp every year – hardly enough to justify the wage growth deceleration we have seen post-crisis.

Wage growth per employed, however, does not reflect the rise in part-time employment. So we run the same exercise for hourly wages. We find that, if anything, wage levels today are marginally higher than they would have been (blue line in Chart 3). This would suggest that sector composition cannot really be held responsible for what we see in the recovery.

Wage growth has slowed across most sectorsIf sector composition were solely to blame, we would also expect wage growth to have remained intact across sectors, particularly in those where wage growth is typically lower but employment growth currently faster. Again, data suggests that things are not so simple.

Chart 4 shows hourly wage growth in the industry (excl. construction) and services sectors (including the public sector). In both aggregates, dynamics have slowed from pre-crisis standards (although industry wages have continued to decelerate more quickly recently).

We have equally checked standard deviations of wage growth across 10 different sectors at any point in time (grey area in Chart 4). During 2012-14, wage growth was more harmonious across sectors, but it has started to reflect typical dispersion again (as has the differential between the fastest and slowest sector wage growth). This could suggest the entire spectrum has shifted a gear lower.

Slowing wage growth in response to inflation – even in services

Generally, a lower wage level could be “normal” if it results from a) lower productivity growth and/or b) more economic slack now than before. But again we find that more may be at play here, both in the economy as a whole and in individual sectors.

We replicate an exercise we ran over the summer, when we were warning to be vigilant of second round effects of inflation on wages. As a reminder, we had found at the aggregate level that the deviation in compensation growth from its long-term average could be explained by slack (high unemployment), but also larger and more persistent than usual negative contributions of inflation. These, we argued, were tentative signs of second-round effects."  -source Bank of America Merrill Lynch

So, if wages are a backward looking indicator of inflationary pressures and labor markets continue to weaken in the US and in some parts of Europe such as France and oil prices finally recede, we have a hard time buying the stagflationary story for the time being. We also have a hard time buying the Q3 US GDP at 2.9% but that's another story.

What we are seeing we think, is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand. The illustration of buying essential items is clearly shown by Visual Capitalist.com Jeff Desjardins on the 28th of October:
"Prices Are Skyrocketing, But Only For Things You Actually Need

"The average price increase, as shown by the CPI (Consumer Price Index), is 55% over the last 20 years. Meanwhile, the prices of individual sub-categories have a much wider variance." - source Visual Capitalist, Jeff Desjardins.

Of course the consequences of central banks meddling with interest rates is in our mind seeding "The Grapes of Wrath" and is causing biflation to some extent. This is leading to not only rising cross asset correlations as of late between stocks and bonds, but, leading to wider variances and larger standard deviation moves. Instability is not only brewing in financial markets but is leading as well towards instability in various countries and risks of social unrest.

Whereas the United States, Japan and Europe face different situations when it comes to dealing with inflation expectations and wage pressure in conjunction with different demographics, back in October we recommended (a little bit early) to look at US TIPS  in our conversation "Sympathetic detonation" from a great diversification perspective:

"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

In March again in our conversation "Unobtainium" we commented that we continued to like US TIPS:

"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016

So from a biflation allocation perspective, US TIPS still remain particularly attractive particularly given their embedded deflation floor. While "balanced funds" are getting "unbalanced" by recent correlated move downwards for both bond prices and stocks, what is not to like about the lower correlation offered between linkers and equities/sovereign bonds? Inflation-linked bonds still provides you with very interesting diversification benefits. For instance the Ishare TIPS bond ETF exposed to US TIPS has delivered you a total return of 6.53% so far. For the long duration braves out there Pimco's 15 years + ETF has LPTZ has rewarded them with handsome year to date total return after fees of 18.70%. Who said there wasn't sometimes some "embedded" actionable ideas in our musings? We rest our case.

In our final chart, while we have been monitoring the credit cycle as it is slowly turning in this "overmedicated" central bank meddling environment, we continue to look at the slow but evident deterioration in credit fundamentals particularly in the US which has been "releveraging" thanks to cheap credit.

• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

While the relentless liquidity provided to the credit markets thanks to Japanese NIRP and the ECB and now BOE being competing with investors in the credit investment world, when it comes to default in a low yield environment, leverage matters and so does credit fundamentals. Our final chart displays US debt growth relative to EBITDA and comes from JP Morgan's Credit and Market Outlook and Strategy note from the 20th of October:

"The ongoing deterioration of credit fundamentals remains the key market risk, however. Debt issuance continues to grow much faster than EBITDA, even if the expected uptick in revenue growth this quarter materializes. Investors are aware of this, but are focused on the strong technicals outweighing these risks. This has been the right view since 1Q of this year. However, our sense is that some investors are uncomfortable with market valuation given these technicals, and if there is a catalyst for a risk off market, this concern about fundamentals would reassert itself.
Fundamental credit metric deterioration is not itself likely to be a catalyst as it occurs slowly and it is difficult to define a red line for specific metrics that causes a problem. A renewed trend of rating downgrades, as occurred in 1Q in the Energy sector, could refocus markets on these risks, but if and when this will happen is difficult to predict." - source JP Morgan

While the party has been running strong "uphill", mostly to the bond market that it, courtesy of the "wealth effect", and not downhill to the real economy, if real assets are positively correlated with inflation and deflation fears are subsiding, we believe that some commodities could stage a comeback, US TIPS will be as well one of the beneficiaries rest assured. Meanwhile, our politicians and central bankers alike have indeed sowed "The Grapes of Wrath", putting financial assets at risk of heightened political backlash from the have not of the real economy namely "Main Street" versus "Wall Street". 

"You will not be punished for your anger, you will be punished by your anger." - Buddha

Stay tuned!