Category: Deficit Spending & Employment

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David Woo: Prelude to volatility

The bond market had a heart attack last week. Rising inflation caused a massive back up in bond yields in the short end of the market. The market is now pricing in two rate hikes in 2022. The Fed will have to raise real interest rates in order to tame inflation.

Real interest rates are falling. The stock market is taking its cue from the bond market and is rising. Stock prices represent discounted future cash flows, so negative real interest rates make a big difference to earnings multiples.

The Democrats are determined to spend their way to a mid-term election victory, with a $1T infrastructure bill and $1.75T social spending, both light on tax revenue. The GOP will try to stop them when the debt ceiling issue returns in December but they don’t have much leverage.

Financial conditions will have to tighten a lot more in 2022. The Fed is way behind the curve and is going to have to play catch-up.

Conclusion

Inflationary pressures in the US economy are growing, while the Democrats plan a further $2.75T in fiscal stimulus which is light on tax revenues.

Long-term yields lag far behind inflation, with real interest rates growing increasingly negative. The assumption is that the Fed will tighten sharply in 2022 to curb inflation. We expect that the Fed will taper but is not going to rush to hike interest rates for three reasons:

  1. The Fed would be tightening into a slowing economy, with growth fading as stimulus winds down;
  2. High energy prices will also help to cool demand; and
  3. US federal debt levels — already > 120% of GDP and likely to grow further with proposed new stimulus measures — are a greater long-term threat than inflation. The Fed and Treasury are expected to work together to boost GDP and tax revenues through inflation, keeping real interest rates negative to alleviate the cost to Treasury of servicing the excessive debt burden.
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Job openings flag upward pressure on wages

Job openings fell by 660k in August, from 11.10 million to 10.44 million. Unemployment fell by less, from 8.70 million to 8.38 million (-320k), as absentees return to the workforce. Unemployment declined steeply (-710k) to 7.67 million in September and we expect an even larger decline in job openings as more return to the workforce.

Job Openings & Average Hourly Wage Rates

Job openings in August exceed unemployment by 2.06 million. While this is expected to reduce over the next few months, as stragglers return to the workforce, the persistent gap is likely to add upward pressure to wages. Average hourly earnings growth, currently at 4.6% YoY, is expected to rise in the months ahead.

Small Business - Difficulty in Finding Workers

The number of people who quit jobs voluntarily – to work for another company that offered higher wages and benefits and a signing bonus; to change careers entirely; to stay home and take care of the kids; to spend more time with their money; or whatever – spiked by another 242,000 people to a record of 4.27 million in August, up 19% from August 2019…….This enormous number of quits is the hallmark of a tight and competitive labor market that encourages workers to switch jobs to seek the greener grass on the other side of the fence. (Wolf Richter)

Job Quits

Conclusion

The economy is recovering but the persistent gap between job openings and unemployment suggests that upward pressure on wages is likely to continue into next year. Rising wage rates add pressure on prices of consumer goods and services, adding to the inflationary spiral.

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Beware of the GDP “spike”

Hours worked jumped to a massive 13.5% (YoY) spike in April and GDP is expected to follow.

Real GDP & Hours Worked

Jim Stock’s Weekly Economic Index predicts a similar 12.2% (YoY) spike in Q2 GDP.

Weekly Economic Index

Apologies for being the bearer of bad news but that spike is entirely due to base effects: the year-on-year change is measured from the pandemic low of April 2020.

In real terms, hours worked are still 3.8% below their Feb 2020 level and GDP for Q2 2021 is expected to come in at close to the peak in Q4 of 2019.

Real GDP & Hours Worked

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Labor market turmoil

Pundits are wringing their hands about the poor jobs report, with +266K of new jobs in April compared to 1M estimated. Non-farm jobs recovered to 144.3 million in April, compared to 152.5m in Feb 2020, a shortfall of 5.4%.

Non-farm Payroll

Hours worked has done slightly better, at 5.05 billion in April, compared to 5.25bn in Feb 2020, a shortfall of 3.8%.

Real GDP and Hours Worked

The rate of increase (in hours worked) slowed significantly from March 2021, but that is to be expected. It will be difficult to match the recovery rates achieved at the re-opening and we suspect that the +1m new jobs estimate for April was over-optimistic.

Increase in Hours Worked

Manufacturing

Manufacturing jobs are not fully recovered either, at 12.3m in April, a 4.0% shortfall from the 12.8m in Feb 2020. But manufacturing production in March 2021 (104.3) was only 1.7% below its Feb 2020 reading and is expected to close the gap even further in April. A sign that productivity is improving.

Manufacturing Jobs & Industrial Production

Average hourly wage rates continue to grow between 2.5% and 3.5% (YoY). A sign that employers are able to fill job openings.

Manufacturing Hourly Wage Rates

Job Openings

Outside of manufacturing, job openings are growing. A sign that wage rates are likely to follow.

Job Openings

We suspect that job openings are concentrated in low paid jobs where the pandemic and higher unemployment benefits are likely to have the most impact on participation rates.

Low Participation

Low Participation

Unemployment Benefits

Bond Market

After momentary panic, the bond market seems to have decided that the weak jobs report is a non-event and unlikely to reduce inflation or require increased Fed intervention. The 10-year Treasury yield dropped to 1.525% in the morning but recovered to 1.572% by the close.

10-Year Treasury Yields

Conclusion

The labor participation rate has been declining for 20 years and the COVID-19 pandemic may have accelerated the decline. Participation rates may never fully recover to pre-pandemic levels.

Declining Labor Participation

But as long as the difference is made up by rising productivity (output/jobs), boosted by increased automation, then the economy is expected to make a full recovery.

Manufacturing Production/Jobs

Higher unemployment benefits and a lower participation rate are likely to drive up wages for unskilled jobs, while de-coupling from China and on-shoring of critical supply chains is expected to lead to skills shortages, driving up wages for higher-paid employees. The Fed will be reluctant to increase interest rates to cool the economic recovery, allowing inflation to rise.

When the (inflation) train starts to roll, it is difficult to stop. Sharp pressure on the (interest rate) brake is then required, but would cause havoc in bond and equity markets.

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Carmen Reinhart: Financial repression

“These crises are really a form of domestic default that governments employ in countries where financial repression is a major form of taxation. Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payments system, not simply currency. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Citizens put money into banks because there are few other safe places for their savings. Governments, in turn, pass regulations and restrictions to force the banks to relend the money to fund public debt….”

~ Carmen M. Reinhart, This Time Is Different: Eight Centuries of Financial Folly

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Modern Monetary Theory (MMT)

A reader asked me to explain MMT. I am not an economist and will try to avoid any jargon.

The basic tenet of MMT is that government has the power to reduce unemployment by increasing stimulus spending. Government spending in excess of tax revenues (a deficit) is funded by an increase in public debt. Deficits are likely to cause inflation but MMT holds that inflation can be reduced by raising tax revenues.

Problem with Lags

There is normally a lag between an increase in debt and the resulting increase in inflation. If you wait for inflation to rise before raising taxes, underlying inflationary pressures have already built and will be hard to contain.

There is also likely to be a lag between raising taxes and a resulting fall in inflation. This means that authorities will keep raising taxes for longer, causing an eventual contraction in employment.

The second problem is that it is far easier to increase government spending than it is to raise taxes. Voters seldom object to an increase in public spending but are likely to punish any government that increases taxes. This is likely to make the lag between identifying inflation and raising taxes even bigger.

Third, regular increases in government spending followed by tax increases (to subdue inflation) are likely to ratchet up government spending relative to GDP. Rising levels of public spending followed by rising taxes is simply creeping socialism and is likely to slow long-term economic growth.

Finally, sharp increases in public debt no longer deliver bang for buck.

Real GDP & Public Debt

Has inflation been tamed?

The consumer price index (CPI) is nowadays a lot less volatile than producer prices (PPI) which it tracked quite closely in the 1960s and 70s. Some of this can be attributed to better management at the Fed but the primary reason is the offshoring of manufacturing jobs to Asia.

CPI, PPI & Hourly Earnings

The service sector is largely immune from producer prices and fluctuations in offshore manufacturing costs are partially absorbed through a floating exchange rate.

We have witnessed a decline in global trade over the past two years and this is likely to develop into a long-term trend towards on-shoring key supply chains in both Europe and North America. On-shoring is likely to drive up prices.

Conclusion

Inflation is not dead. On-shoring of supply chains is likely to drive up prices. Rapid expansion of public debt is expected to weaken the Dollar, slow growth and fuel inflation. Long-term costs of bringing inflation under control are likely to outweigh the shorter-term benefits of MMT-level stimulus.

Notes

Hat tip to Neils Jensen at Absolute Return Partners and Luke Gromen at FFTT.

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USA: Sales up, daily COVID-19 cases down but jobs still scarce

Daily new COVID-19 cases in the US are clearly falling as the vaccine roll-out takes effect.

USA: COVID-19 Daily Cases

But daily deaths are still rising and may take another few weeks to level off.

USA: COVID-19 Daily Deaths

January payroll figures show the economic recovery has stalled, with total jobs contracting by 6.08% compared to January 2020.

Payroll Growth

Hours worked are down 4.4% compared to last year.

Real GDP & Hours Worked

Average hourly earnings jumped 5.44% for production and non-supervisory workers but these are distorted by strong job losses in the lowest pay grades.

Hourly Wage Rates

Retail sales (excluding food) have also been artificially boosted by government stimulus which added roughly 20% to disposable income.

Retail Sales Excluding Food

Light vehicle sales are similarly boosted.

Light Vehicles

While housing starts are climbing in response to record low mortgage rates.

Housing Permits & Starts

Total unemployment claims (state and federal) declined to a still high 17.8 million for the week ended January 16th.

DOL: State & Federal Unemployment Claims

The proposed Biden stimulus will support households and businesses but employment is likely to remain weak until the COVID-19 outbreak is clearly under control.

Conclusion

Economic activity is expected to remain weak in the first half of 2021. A key determinant will be the length of time it takes to bring the COVID-19 outbreak under control. Subsequent recovery is likely to need strong fiscal support, with federal debt expected to grow faster than GDP in 2021. This will require continued Treasury purchases by the Fed and commercial banks, with interest rates remaining low throughout 2021.

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Jim Bianco forecasts higher inflation in 2021

Jim Bianco from Bianco Research:

“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”

The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.

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