Wage increases haven’t made a dent in profits

Average hourly earnings growth continues to rise, albeit at a leisurely pace. Average hourly earnings for all employees in the private sector grew at 2.92% over the last 12 months, while production and nonsupervisory employee earnings grew at 2.80% over the same period. The Fed is likely to adopt a more restrictive stance if hourly earnings growth, representing underlying inflationary pressures, exceeds 3.0%. So far the message from Fed Chair Jerome Powell has been business as usual, with rate hikes at a measured pace.

Average Hourly Earnings

Rising wage rates to-date have been unable, up to Q2 2018, to make a dent in corporate profits. Corporate profits are near record highs at 13.4%, while employee compensation is historically low at 69.5% of net value added. Past recessions have been heralded by rising employee compensation and falling corporate profits. What we are witnessing this time is unusual, with compensation rising, admittedly from record low levels, while profits rebounded after a low in Q4 2016. There is no indication that this will end anytime soon.

Corporate Profits and Employee Compensation as Percentage of Value Added

Weaker values (1.17%) on the Leading Index from the Philadelphia Fed reflect a flatter yield curve. A fall below 1.0% would be cause for concern.

Philadelphia Fed Leading Index

Our surrogate for real GDP, Total Payrolls x Average Weekly Hours Worked, is lagging behind recent GDP growth (1.9% compared to 2.9%) but both are rising.

Real GDP and Total Payroll*Average Hours Worked

Another good sign is that personal consumption expenditure, one of the key drivers of economic growth, is on the mend. Services turned up in Q2 2018 after a three-year decline. Durable goods remain strong. Nondurables are weaker but this may reflect a reclassification issue. New products such as Apple Music and Netflix are classified as sevices but replace sales of goods such as CDs and videos.

Personal Consumption

There is no cause for concern yet, but we will need to keep a weather-eye on the yield curve.

Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.

~ George Soros

Bullish US GDP numbers

The Bureau of Economic Analysis (BEA) reports that real gross domestic product (real GDP) increased at an annual rate of 4.1 percent in the second quarter of 2018. This is an advance estimate, based on incomplete data and is subject to further revision.

Real GDP for Q2 2018 Annualized

While the spurt in quarterly growth is encouraging, I find annualized quarterly figures misleading and prefer to stick to the annual rate of change from the same quarter in the preceding year. Annual growth still reflects an improving economy but came in at 2.8 percent, more in line with the estimate of actual hours worked on the chart below.

Real GDP for Q2 2018 YoY

Personal consumption figures tend to decline ahead of a recession, so an up-tick in all three consumption measures is a positive sign for the US economy. Expenditures on durable goods is especially robust, suggesting growing consumer confidence. Non-durable expenditures are holding up, while services, which had been declining since a large spike in 2015, are maintaining at still strong levels.

US Personal Consumption

There is no sign of the US economy slowing. Continued growth and positive earnings results should encourage investors.

S&P 500 and Nasdaq relief

June average hourly earnings growth came in flat at 2.74% for Total Private sector and 2.72% for Production and Non-supervisory Employees. This suuports the argument that underlying inflation remains benign, easing pressure on the Fed to accelerate interest rates.

Average Hourly Earnings Growth

The S&P 500 rallied off its long-term rising trendline. Follow-through above 2800 would suggest another primary advance with a target of 3000.

S&P 500

The Nasdaq 100 respected its new support level at 7000, signaling a primary advance. The rising Trend Index indicates buying pressure. Target for the advance is 7700.

Nasdaq 100

The Leading Index from the Philadelphia Fed is a healthy 1.51% for May. Well above the 1.0% level that suggests steady growth (falls below 1.0% are cause for concern).

Leading

Our estimate of annual GDP growth — total payroll x average weekly hours worked — is muted at 1.91% but suggests that earnings growth will remain positive.

Real GDP Estimate

Personal consumption figures for Q1 2018 show growth in consumption of services is slowing but durable goods remain strong, while nondurable goods are steady.

Consumption to Q1 2018

Declining consumption of nondurables normally coincides with a recession but is often preceded by slowing durable goods — below 5.0% on the chart below — for several quarters.

Consumption to Q1 2018

Conclusion: Expect further growth but be cautious of equities that are vulnerable to escalating trade tariffs.

We live in a global economy, but the political organization of our global society is woefully inadequate. We are bereft of the capacity to preserve peace and to counteract the excesses of the financial markets. Without these controls, the global economy, is liable to break down.

~ George Soros: The Crisis of Global Capitalism (1998)

Is GDP doomed to low growth?

GDP failed to rebound after the 2008 Financial Crisis, sinking into a period of stubborn low growth. Economic commentators have advanced many explanations for the causes, while the consensus seems to be that this is the new normal, with the global economy destined to decades of poor growth.

Real GDP Growth

This is a classic case of recency bias. Where observers attach the most value to recent observations and assume that the current state of affairs will continue for the foreseeable future. The inverse of the Dow 100,000 projections during the Dotcom bubble.

Real GDP for Q1 2018 recorded 2.9% growth over the last 4 quarters. Not exactly shooting the lights out, but is the recent up-trend likely to continue?

Real GDP Growth and estimate based on Private Sector Employment and Average Weekly Hours Worked

Neils Jensen from Absolute Return Partners does a good job of summarizing the arguments for low growth in his latest newsletter:

The bear story

Putting my (very) long-term bearishness on fossil fuels aside for a moment, there is also a bear story with the potential to unfold in the short to medium-term, but that bear story is a very different one. It is a story about GDP growth likely to suffer as a consequence of the oil industry’s insatiable appetite for working capital, which is presumably a function of the low hanging fruit having been picked already.

In the US today, the oil industry ties up 31 times more capital per barrel of oil produced than it did in 1980, when we came out of the second oil crisis. ….Such a hefty capital requirement is a significant tax on economic growth. Think of it the following way. Capital is a major driver of productivity growth, which again is a key driver of economic growth. Capital tied up by the oil industry cannot be used to enhance productivity elsewhere, i.e. overall productivity growth suffers as more and more capital is ‘confiscated’ by the oil industry.

I am tempted to remind you (yet again!) of one of the most important equations in the world of economics:

∆GDP = ∆Workforce + ∆Productivity

We already know that the workforce will decline in many countries in the years to come; hence productivity growth is the only solution to a world drowning in debt, if that debt is to be serviced. Why? Because we need economic growth to be able to service all that debt.

Now, if productivity growth is going to suffer for years to come, all this fancy new stuff that we all count on to save our bacon (advanced robotics, artificial intelligence, etc.) may never be fully taken advantage of, because the money needed to make it happen won’t be there. It is not a given but certainly a risk that shouldn’t be ignored.

….For that reason, we need to retire fossil fuels as quickly as possible. Ageing of society (older workers are less productive than their younger peers) and a global economy drowning in debt (servicing all that debt is immensely expensive, leaving less capital for productivity enhancing purposes) are widely perceived to be the two most important reasons why productivity growth is so pedestrian at present.

I am not about to tell you that those two reasons are not important. They certainly are. However, the adverse impact the oil industry is having on overall productivity should not be underestimated.

I tend to take a simpler view, where I equate changes in GDP to changes in hours worked and in capital investment:

∆GDP = ∆Workforce + ∆Capital

Workers work harder if they are motivated or if there is a more efficient organizational structure, but these are a secondary influence on productivity when compared to capital investment.

The chart below compares net capital formation by the corporate sector (over GDP) to real GDP growth. It is evident that GDP growth rises and falls in line with net capital formation (or investment as it is loosely termed) by corporations.

Net Capital Formation by the corporate sector/GDP compared to Real GDP Growth

A quick primer (with help from Wikipedia):

  • Capital Formation measures net additions to the capital stock of a country.
  • Capital refers to physical (or tangible) assets and includes plant and equipment, computer software, inventories and real estate. Any non-financial asset used in the production of goods or services.
  • Capital does not include financial assets such as bonds and stocks.
  • Net Capital Formation makes allowance for depreciation of the existing capital stock due to wear and tear, obsolescence, etc.

Net Capital Formation peaked at around 5.0% from the mid-1960s to the mid-1980s, made a brief recovery to 4.0% during the Dotcom bubble and has since struggled to make the bar at 3.0%. Rather like me doing chin-ups.

Net Capital Formation Declining in the Corporate Sector

There are a number of factors contributing to this.

Intangible Assets

Capital formation only measures tangible assets. The last two decades have seen a massive surge in investment in intangible assets. Look no further than the big five on the Nasdaq:

Stock Symbol Price ($) Book Value ($) Times Book Value
Amazon AMZN 1582.26 64.85 24.40
Microsoft MSFT 95.00 10.32 9.21
Facebook FB 173.86 26.83 6.48
Apple AAPL 169.10 27.60 6.12
Alphabet GOOGL 1040.75 235.46 4.42

Currency Manipulation

Capital formation first fell off the cliff in the 1980s. This coincides with the growth of currency manipulation by Japan, purchasing excessive US foreign reserves to suppress the Yen and establish a trade advantage over US manufacturers. China joined the party in the late 1990s, exceeding Japan’s current account surplus by 2006. Currency suppression creates another incentive for corporations to offshore or outsource manufacturing to Asia.

China & Japan Current Account Surpluses

Tax on Offshore Profits

Many large corporations took advantage of low tax rates in offshore havens such as Ireland, avoiding US taxes while the funds were held offshore. This created an incentive for large corporations to invest retained earnings offshore rather than in the USA.

The net effect has been that retained earnings are invested elsewhere, while new capital formation in the USA is almost entirely funded by debt.

Net Capital Formation by the corporate sector/GDP compared to Corporate Debt Growth/GDP

Donald Trump’s tax deal will make a dent in this but will not undo past damage. The horse has already bolted.

Offshore Manufacturing

Apart from tax incentives, lower labor costs (enhanced by currency manipulation) led large corporations to set up or outsource manufacturing to Asia and other developing countries. In effect, offshoring capital formation and — more importantly — GDP growth to foreign destinations.

Offshoring Jobs

Along with manufacturing plants, blue-collar jobs also moved offshore. While this may improve the company bottom-line for a few years, the long-term, macro effects are devastating.

Think of it this way. If you build a manufacturing plant offshore rather than in the USA you may save millions of dollars a year in labor costs. Great for the bottom line and executive bonuses. But one man’s wage is another man/woman’s income (when he/she spends it). So, from a macro perspective, the US loses GDP equal to the entire factory wages bill plus the wage component of any input costs. A far larger figure than the company’s savings. As more companies offshore jobs, sales growth in the USA is affected. In the end this is likely to more than offset the savings that justified the offshore move in the first place.

Stock Buybacks

Stock buybacks accelerate EPS (earnings per share) growth and are great for boosting stock prices and executive bonuses. But they create the illusion of growth while GDP stands still. There is no new capital formation.

Can GDP Growth Recover?

Yes. Restore capital formation and GDP growth will recover.

How to do this:

Trump has already made an important move, revising tax laws to encourage corporations to repatriate offshore funds.

But more needs to be done to create a level playing field.

Stop currency manipulation and theft of technology by developing countries, especially China. Trump has also signaled his intention to tackle this thorny issue.

Repatriating offshore manufacturing and jobs is a much more difficult task. You can’t just pack a factory in a box and ship it home. There is also the matter of lost skills in the local workforce. But manufacturing jobs are being lost globally at an alarming rate to new technology. In the long-term, offshore manufacturing plants will be made obsolete and replaced by new automated, high-tech manufacturing facilities. Incentives need to be created to encourage new capital formation, especially high-tech manufacturing, at home.

Stock buybacks, I suspect, will always be around. But remove the incentive to boost stock prices by targeting the structure of executive bonuses. It would be difficult to isolate benefits from stock buybacks and tax them directly. But removing tax on dividends — in my opinion far simpler and more effective than the dividend imputation system in Australia — would remove the incentive for stock buybacks and make it difficult for management to justify this action to investors.

We already seem to be moving in the right direction. The last two points are relatively easy when compared to the first two. If Donald Trump manages to pull them (the first two) off, he will already move sharply upward in my estimation.

Judge a tree by the fruit it bears.

~ Matthew 7:15–20

How long will the bull market last?

US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.

Freight Transport Index

Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.

Bond Spreads

Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.

Real GDP

Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.

M1 Money Stock

The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.

Average Hourly Wage Rate - Annual Growth

Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.

M1 Money Stock and Fed Funds Rate

At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.

Nasdaq and S&P500 meet resistance

July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.

Unemployment below the long-term natural rate

Source: St Louis Fed, BLS

But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.

Hourly Wage Rates

Source: St Louis Fed, BLS

Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.

Hourly Wage Rates

Source: St Louis Fed, FRB

Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.

Real GDP compared to Nonfarm Payroll * Average Weekly Hours

Source: St Louis Fed, BLS & BEA

The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.

Nasdaq 100

The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

US GDP: Where is it headed?

I originally got this from Matt Busigin (I think). Average Hourly Earnings multiplied by Average Weekly Hours (Total Private: Nonfarm) gives a pretty good indication of where GDP is headed, well ahead of the BEA accounts.

Nominal GDP compared to Average Hourly Earnings of All Employees (Total Private) multiplied by Average Weekly Hours (Total Private Nonfarm)

Remember this is nominal GDP, so the latest (April 2015) figure of 4.38% would need to be adjusted for inflation. Inflation is somewhere between 0.5% and 1.75% depending on how you measure it. The GDP deflator looks like it will come in below 1.0% which would leave us with real GDP of at least 3.38% p.a.

GDP Price Deflator compared to Core CPI

GDP, the Dollar and Treasury yields

Interesting to see how Treasury yields and the Dollar reacted — or failed to react — to the sharp fall in first quarter GDP growth. But first a great summary by Matt Phillips at Quartz:

Move along. There’s nothing to see here.

Well, if you must know, US GDP growth fell to a 0.2% annualized rate, which looks pretty bad.

GDP

We told you it would be bad. How did we know? Windows. If you looked out any of them between January and March you were treated to a slush-bound hellscape of icy misery. Thankfully, spring has sprung. And there are all sorts of indications that US growth is bouncing back.

…interpreting the numbers rather than simply informing readers of the latest “bad news”. Good journalism.

Ten-year Treasury Note yields broke resistance at 2.00%. Not what one would expect if the economy was slowing and the Fed planned to sit on its hands rather than raise interest rates. Breakout above resistance indicates an advance to 2.25%. Recovery of long-term yields, however, is likely to be gradual, with much testing of support before we see a breakout above long-term resistance at 3.00%.

10-Year Treasury Yields

The Dollar Index surprised in the opposite direction, breaking support at 96. Not what one would expect if yields are rising. Breach of support suggests a test of the primary trendline at 92.

Dollar Index