Tuesday, January 28, 2014 - If I Had a Hammer

If I Had a Hammer

by Sinclair Noe

DOW + 90 = 15,928
SPX + 10 = 1792
NAS + 14 = 4097
10 YR YLD - .02 = 2.75%
OIL + 1.50 = 97.22
GOLD - .80 = 1256.70
SILV - .13 = 19.66

The State of the Union is… tonight.

President Obama will describe how he will use his pen and phone to overcome the Do-Nothing Congress, and the Republicans have ironically lined up not one, but three responses to refute the idea they are nothing more than obstreperous obstructionists.

Everybody from the Pope to the big wigs in Davos have been talking about inequality and it will likely be a major theme in tonight’s speech. Job and wage growth has been broken since the 1990s. Median family incomes grew very slowly from 1979 to 1999, peaked that year, and have fallen 13% since. The economy has recovered since the near financial meltdown of 2008, but it has been the weakest recovery since the Great Depression, and one of the reasons it has been such a slow recovery is that the spoils of recovery have been unevenly distributed.

Even though we have seen job growth in the past 54 months, 6 of the 10 fastest growing job categories are in low paying service sector positions, such as retail clerk and home health care aids. Middle class income is sinking; the ranks of the poor are rising; and the economic gains only go to the top, or 95% of all economic gains in the “recovery” have gone to the top 1%. For the fourth year in a row, the real median weekly earnings for full-time workers fell slightly. Profits, on the other hand, have been putting on a show. As a share of national income, corporate profits were 14.6% in the third quarter of 2013, the most recent quarter for which we have data. In the history of these data going back to 1947, there was only one quarter higher than that, the last quarter of 2011.

These trends are moving in opposite directions but they are related. Profit is simply revenue minus expenses, and so there are two ways to grow profits: increase revenue or cuts expenses. Profits have been propelled by squeezing costs rather than growing demand. The strength of profits is directly related to the weakness in hourly wages. In a normal business cycle, you would expect profits to increase before wages. During the good times, we tend to get fat and lazy. During a downturn, businesses get lean and mean and they start running at high productivity again. But that hasn’t happened. Real compensation has grown more slowly than productivity.

One way to look at this is to compare labor costs against the unit profit costs, and even after accounting for increases in productivity, profits have outpaced workers earnings. Compensation net productivity growth is up about 10% since 2000, while profits net productivity growth has doubled in the same time.

In the US, there is no job security. The share of working age Americans holding jobs is now lower than at any time in the last 30 years, and three-quarters of those working people are living hand to mouth. Advances in technology are just going to make job prospects even more challenging. A recent McKinsey Global Institute survey found that 230 million service jobs representing some $9 trillion in salary globally could be transformed by computers by 2025. Forget about outsourcing manufacturing jobs overseas, the robots are coming.

So, there is really nothing to drive wages higher because demand for jobs outweighs supply of jobs. It is hard to demand higher wages when your replacement is filling out an application in the lobby, or when your replacement is a robot.

So, in addition to a pen and a phone, the President has a bully pulpit, and he will use it tonight. It remains to be seen if he will use it to put important ideas in people’s minds by shaping public discourse. We know he's going to talk about economic inequality, as he should. He will probably mention worker salaries, which haven't risen in 30 years.

One of the ideas we will hear tonight is the President will to use an executive order to raise the minimum wage in new federal contracts.  The order about the minimum wage and federal contracts will raise the pay from the national minimum of $7.25 an hour to $10.10 an hour. The change applies only to new federal contracts, and not to renewals of existing agreements. So, he’s using a pen and a phone to raise the minimum wage, but nobody will see an increase in their next paycheck.

And for college age students, who you might expect would raise a ruckus about all the inequality, well they don’t have jobs; they do have mountains of student debt and so they don’t dare take to the streets. Besides, nobody really thinks you can change government anymore. Pete Seeger is dead and nobody can find a hammer, much less figure out how to use a hammer. Cynicism is stifling, not motivating. It’s hard to get people worked up to change something that seems irreparably dysfunctional. Maybe we’ll just have to wait until the whole mess to topple under its own weight. And things right now are pretty lopsided. Even the high rollers at Davos acknowledged that just 85 people now hold as much wealth as 3.5 billion people.

Whatever the economic costs of inequality, the social costs are even greater. Research shows that unequal economies are more fragile and prone to financial crisis and that they have higher levels of social unrest, poor health, anxiety and a host of other problems. Inequality also reduces social mobility—the very foundations of the American Dream—and it’s a voting issue. A new Gallup Poll shows that two-thirds of adults are dissatisfied with wealth distribution in the US. It’s also a global problem and it is certainly at the core of the volatility we’ve seen in emerging market economies in the past couple of weeks.

The problems in emerging markets are not just related to the monetary policy of central bankers, although that is a big part of the equation; the problems are related to economic inequality and subsequent political problems which tend to crop up when there is economic inequality. After 5 down days on Wall Street, you might think the markets were waking up to the problems; then we have a modest gain and we are lulled into a sense of complacency. The financial markets in 2012 and a much of 2013 were moving in lockstep, in a “risk on-risk off” pattern, with high yielding emerging markets as the preferred “risk on” trade. Investors were chasing yield and finding it in emerging markets, where the yield was much higher than here, where the Fed has engineered negative real yields.

And in our complacency, we might have overlooked the similarity in emerging markets today with the similarities of 1997.  In the 1990s Asian crisis, the rapid withdrawal of hot money triggered combined liquidity and exchange rate-regime crises. Then and now, capital flight merely served to exacerbate homegrown problems. The initial flight of capital needn’t be prompted by a crisis anywhere at all. It might simply be a ‘rotation’ of short-term capital from one set of opportunities to others elsewhere: game over, move on. That means that as emerging countries tried to enter into the global economy, they set up to allow capital to flow in with ease, which also meant capital could flow out with ease. Emerging market economies that had nurtured reasonably liquid domestic capital markets were among the worst hit.

Even though the Fed’s taper talk sent a shudder through emerging markets last year, at least as big a culprit has been slowing growth in China, since lower demand for commodities hits many smaller economies hard. China is trying to engineer a transition from an export/investment driven economy to a consumer oriented one, and no country has managed that transition smoothly. Even worse, China’s consumption share of GDP has generally been declining in recent years.

Remember that Lehman, which had a large emerging markets desk, nearly went bust in the 1997 Asian markets crisis. Our big banks now look better diversified, but if a large bank bet wrong on enough trades, it could take a meaningful hit to its balance sheet. And more weakly capitalized Eurobanks are less able to sustain this sort of blow well. So while the emerging markets wobbles may not evolve into a full-blown crisis, it’s likely we’ll have a sustained period of roller coaster volatility before conditions stabilize.

There have been 14 Federal Reserve Chairmen; Janet Yellen is about to become the fifteenth. The transition of the Chair is cause for some trepidation. Market makers rightly wonder about the direction of monetary policy and the markets may act in a skittish manner. The first year of a new Fed Chair is not necessarily bad for the markets. By a 9 to 4 ratio, the first year of a new Fed chair leads to positive gains in the Dow Jones Industrial Average. The most recent and notable exception being the first year under Alan Greenspan (1987), where the Dow tanked more than 30% and finished the year down about 20%. Under Paul Volker, the Dow was volatile, with significant moves from negative to positive territory, but after one year of trading under the guidance of Volker saw the Dow in positive territory. Bernanke took the reins in 2006, which you may recall was a very good year for the Dow. Yellen? Well, time will tell.  Tune in tomorrow.