Thursday, August 14, 2014 - The Circular Capex Spending Problem

The Circular Capex Spending Problem
by Sinclair Noe

DOW + 61 = 16,713
SPX + 8 = 1955
NAS + 18 = 4453
10 YR YLD - .01 = 2.40%
OIL - .39 = 97.20
GOLD + .70 = 1313.90
SILV + .05 = 19.95

Iraqi Prime Minister Nouri al-Maliki stepped down today, a surprising reversal for a prime minister who a day earlier had assured his supporters that he wouldn’t step down unless forced out by Iraq’s high court.

President Obama says the US operations have broken the ISIS siege of Mount Sinjar. Thousands of Yazidi refugees were stranded on the mountain. Many of those displaced had now left the mountain and further rescue operations are not planned, however US airstrikes against ISIS will continue for now. And Iraqi and Kurdish forces fighting ISIS will continue to receive US military assistance.

Russian President Vladimir Putin said Russia would stand up for itself but not at the cost of confrontation with the outside world, which sounded like a softer, gentler Putin. Trust him about as far as you can throw him. Intense fighting continues as the Ukrainian military kept up its offensive to retake separatist strongholds in Eastern Ukraine.

A new, five-day truce between Israel and Hamas appeared to be holding despite a shaky start, after both sides agreed to give Egyptian-brokered peace negotiations more time. The second extension of the ceasefire, this time for five days rather than three, has raised hopes that a longer-term resolution to the conflict can be found; maybe.

The Missouri State Highway Patrol will take over the supervision of security in the St. Louis suburb that's been the scene of violent protests since a police officer fatally shot an unarmed black teenager.

Earnings season continued to wind down. WalMart reported earnings and revenue that met expectations, but the company cut its forecast for coming quarters. Last night, Cisco Systems offered a weak outlook for its current quarter and announced massive job cuts despite reporting revenue that beat expectations.

We’ve all heard of jobs offshoring; US jobs that once built the world’s biggest middle class, have been sent overseas, and it’s been going on for quite some time. The idea was heralded as free trade globalism and the argument was that it was merely mutually beneficial free trade; but American jobs have been lost and continue to be lost, not to competition from foreign companies, but to multinational corporations that are cutting costs by shifting operations to low-wage countries.

One result of offshoring is lower labor costs, but that also means lower wages. University graduates in the US are just as likely to be employed as bartenders or baristas as they are to get a job as a software engineer of plant manager. And there’s a good chance that recent grads are still living at home with their parents. More than half with student loans are having a hard time paying down student loan debt; 18% are either in collection or delinquent; another 34% have student loans in deferment or forbearance. And if they do find jobs, they find those jobs don’t pay well. Wages have stagnated.

Even though the economy has been adding jobs, it has not been enough to push a recovery in wages. In July, average hourly wages rose a penny to $24.45, a disappointing result after strong gains in June and May. In 23 of the past 24 months, the yearly increase in hourly pay has ranged from 1.9% to 2.2%, or about one-third less than usual during an economic recovery. The 12-month increase in wages as of July was just 2%; and inflation wiped out about three-fourths of that gain. There’s been no change since the start of 2014. While it might seem counterintuitive that wages are flat while jobs are being added, the likely reason is that there are a lot of poor paying jobs plus a few very good paying jobs. According to revised data from the Commerce Department, employee compensation, including wages and benefits, was lower for each year from 2011 to 2013 than previously calculated.

Jobs off-shoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. Between October 2008 and July 2014 the working age population grew by 13.4 million persons, but the US labor force grew by only 1.1 million. In other words, the unemployment rate among the increase in the working age population during the past six years is 91%. Since the year 2000, the lack of jobs has caused the labor force participation rate to fall, and since quantitative easing began in 2008, the decline in the labor force participation rate has accelerated. Clearly there is no economic recovery when participation in the labor force collapses. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends with the result that the economy cannot create enough jobs to keep up with the growth of the labor force.

Some people argue that the problem with economic growth doesn’t start with wages and jobs, but rather with credit, and they point to graphs of the recent rise in auto loans; just as mortgages once fueled a housing boom, now, subprime lending is fueling a boom in auto sales. Credit tightened in the wake of the housing collapse and the housing market remains weak, while auto lenders have become aggressively permissive and US auto sales have made a huge recovery, leading some to argue that consumption depends on access to credit. This is wrong. Access to credit is the lubricant for the engine of economic commerce; it is not the engine. The real driver of the economy is good paying jobs.

There have been magnificent innovations in transportation, medicine, communication, and technology as commerce has spread globally. Credit did not create technological advances, people did. Money and credit could always be used to purchase the tools to make money in business, but money could never produce anything by itself; food, clothing, shelter, cars, and thousands of other worthwhile things were always made by the labor of people, not the sweat and intelligence of a coin or a plastic credit card.

The Federal Reserve just released a report showing that two-thirds of American households have no savings set aside for an emergency, and 40% are unable to raise $400 cash without selling possessions or borrowing from family and friends. Offshoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends for expansion. Corporations are borrowing money not to invest for the future but to buy back their own stocks, thus pushing up share prices.

A new report from Morgan Stanley shows the average age of industrial equipment in the US is now almost 10.5 year old. That’s the oldest since 1938, at the height of the Great Depression. Nonresidential capital expenditure; in other words, spending on equipment, nonresidential buildings like factories, and intellectual property, has fallen short of the long-term trend by 15% per year. That means businesses have pumped into the economy $400 billion less than they normally would have every year. That's $1.6 trillion over the past four years, and it's affecting every sector. Spending has been down 14% on buildings, 16% on equipment, and 6% on intellectual property.

Instead of investing that money, corporations have been hoarding cash; by some estimates, corporations are sitting on a pile of almost $2 trillion. Occasionally they dip in for share buybacks. S&P 500 companies bought back an estimated $160 billion in stock in the first quarter; that would lag only the $172 billion in the third quarter of 2007, shortly before the worst bear market since the Great Depression. Repurchases are all the rage, but are all too often made for an unstated and ignoble reason: to pump or support the stock price. Another corporate incentive for buybacks is that a pumped-up share prices make the stock grants and options held by senior executives more valuable. Occasionally they dip into the cash pile for mergers and acquisitions. North American M&A activity stands at $1.2 trillion year to date, up 83% from last year. This year is almost certain to be the best year for M&A since the crisis. Boosting growth and returns through long-term investment in their business hasn't registered nearly as highly.

The problem then becomes circular: weak demand holds back capital expenditures, which drags on growth, which depresses demand. Productivity growth in the United States, the rate of growth in the level of output per worker, is near a 30 year low. Spending on research, development and technology, would surely improve this trend. Productivity alone does not spur capex spending. Rather, spending increases when demand increases. You don’t buy a new factory or new equipment unless your customers are spending. However if your customers are spending, you will happily invest in the facilities to fill their orders. But real median household income fell 10% between 2007 and 2012. And since the financial crisis, demand across the US economy as a whole has been far below trend.

Several of America’s great cities, such as Detroit, Cleveland, St. Louis have lost between one-fifth and one-half of their populations. Real median family income has been declining for years, an indication that the ladders of upward mobility that made America the “opportunity society” have been dismantled. So, now we face a tipping point, where we either start to reinvest in industrial production or watch the infrastructure turn to rust, and the US becomes a third world country.

The good news is that we are making progress in some areas. We add jobs every month, more than 200,000 jobs per month for the past six months. Capacity utilization is now up to 79%. US exports now top $2 trillion, the highest level in history. Despite the numerous false dawns since the Great Recession, analysts still expect capex to pick up. If it does, then the broader economy should benefit. Factories and equipment will have to be replaced, eventually. It might represent an opportunity; if we’re lucky.

Thursday, May 29, 2014 - First Quarter GDP and Extreme Weather

First Quarter GDP and Extreme Weather

by Sinclair Noe

DOW + 65 = 16,698
SPX + 10 = 1920
NAS + 22 = 4247
10 YR YLD + .01 = 2.44%
OIL + .79 = 103.51
GOLD – 2.70 = 1256.90
SILV + .02 = 19.14

The economy was worse than expected in the first quarter. The first estimate of first quarter gross domestic product showed 0.1% growth. Today, we got the second estimate and it showed 1.0% contraction. We figured the second estimate would show contraction but most estimates were calling for just 0.1% to 0.6% contraction. The newly revised estimate incorporates additional economic data released in recent weeks. Higher-than-expected imports and slower-than-expected inventory growth dragged the economy into negative territory.

US based corporations posted slightly lower, after tax, seasonally adjusted, first quarter profits of $1.88 trillion for the quarter, down from $1.905 trillion in the fourth quarter; but those numbers were not adjusted for inventory valuation and capital consumption adjustments; we know corporations are still holding bloated inventories. A big buildup in private inventories boosted economic growth in the third quarter of 2013, but left a hangover that weighed on growth in the first quarter of 2014. Inventories subtracted 1.62 percentage points from GDP growth, compared with an initial estimate of 0.57 percentage point subtracted from growth.

Business investment declined at a 1.6% pace, revised from an initially estimated decline at a 2.1% pace. Spending on structures fell at a 7.5% pace and spending on equipment fell at a 3.1% rate. Investments in intellectual property, like research and development, rose at a 5.1% pace.

Consumer spending grew at a 3.1% pace in the first quarter, revised up from an initial estimate of growth at a 3% pace. Spending on services, like health care and household heating, grew at a 4.3% pace while spending on physical goods rose at a more modest 0.7% pace.

The housing market was a drag in the first quarter and the revisions didn’t create much change; residential fixed investment contracted at a 5% pace, a little better than the original estimate of a 5.7% decline, and that subtracted 0.16% from GDP.

Exports fell at a 6% pace in the first three months of the year, not as bad as the initial estimate of 7.6%, but imports, which are subtracted from the GDP calculation, rose at a 0.7% pace, compared with the initial estimate that they declined at a 1.4% pace. Net exports subtracted 0.95 percentage point from GDP growth.

Total government spending subtracted 0.15 percentage point from GDP for the quarter, compared with an initial estimate of 0.09 percentage point subtracted from growth. Federal spending added to GDP, state and local government spending subtracted slightly from GDP.

So, it was a nasty GDP revision but don’t worry, be happy because it was weather related and the winter storms and polar vortexes have passed; gray skies have cleared up, put on a happy face. One headline today tries to tell us: “Why the GDP Drop Is Good for the US Economic Outlook”; the thinking is that there is pent-up demand; consumers and businesses will brush off their cabin fever and rush out to buy and sell. Another headline tries to maintain perspective by reminding us that: “The US Economy Had a Hiccup, Not a Heart Attack”; which is almost a valid point; this wasn’t a heart attack, but it wasn’t a hiccup either. That article says, “This isn’t a recession or even the beginning of a recession though.” True, but this is how recessions start, with economic contraction, but this isn’t a recession.

The economy changes slowly, even though economic numbers jump up and down, and the numbers can be tricky. For example, in October 2008, the numbers on the economy showed GDP had dropped 0.3%, not nearly as bad as today’s number. Back in 2008, Lehman Brothers collapsed and the politicians said we faced a global financial meltdown.

Back in May 2007, the markets looked a lot like they do today, very low volatility, troubling signs for housing stocks, and a stock sector rotation that suggested the bull market was long in the tooth. That bull market ran for 5 more months. Whether investors knew it or not, they were incurring a large risk for only a few percent reward.

The numbers don’t always reflect the scene on the street. Maybe they do, but more than likely, this is not the start of a new recession. This is how recessions start and the strange part is how most economists are just glossing over this as if it were nothing but a hiccup, when it actually represents billions of dollars; one percent of a $17 trillion dollar economy; some hiccup.

The blame is squarely placed on the weather without acknowledging that the weather is undergoing massive change, not just the polar vortex of winter, but let’s look at the wildfires of spring, and the drought of summer. The “weather effect” is not likely a one and done. The United States is currently engulfed in one of the worst droughts in recent memory. More than 30% of the country experienced at least moderate drought as of last week's data. In seven states drought conditions were so severe that each had more than half of its land area in severe drought. Severe drought is characterized by crop loss, frequent water shortages, and mandatory water use restrictions.

While large portions of the seven states suffer from severe drought, in some parts of these states drought conditions are even worse. In six of the seven states with the highest levels of drought, more than 30% of each state was in extreme drought as of last week, a more severe level of drought characterized by major crop and pasture losses, as well as widespread water shortages. Additionally, in California and Oklahoma, 25% and 30% of the states, respectively, suffered from exceptional drought, the highest severity classification. Under exceptional drought, crop and pasture loss is widespread, and shortages of well and reservoir water can lead to water emergencies.

Drought has had a major impact on important crops such as winter wheat. Just 29% of the entire US wheat crop is rated good to excellent; very poor to poor ratings are 78% in Oklahoma, 67% in Texas and 59% in Kansas. And even though much of Texas received rain in the past week, it may be a case of too little, too late. With the crop now heading out, there's not much hope for any recovery as we move deeper into the season. That likely means higher prices for your daily bread. Pasture land across the West is in generally poor shape; that likely means higher beef prices, which you’ve probably already noticed.

In the Southwest, concerns are less-focused on agriculture and more on reservoir levels. In Arizona, reservoir levels were just two-thirds of their usual average. In New Mexico, reservoir stores were only slightly more than half of their normal levels. And Nevada is the worst of all, with reservoir levels about one-third of normal.

The situation in California may well be the most problematic of any state. The entire state is suffering from severe drought, and 75% of all land area was under extreme drought. Restrictions on agricultural water use has forced many California farmers to leave fields fallow. At the current usage rate, California has less than two years of water remaining. And we know California is responsible for about half the nation’s fruit and vegetable supply.

This past February, US food prices jumped 0.4% — the largest one-month increase since September 2011. Then they jumped another 0.4% in March. Then another 0.4% in April. Fruit and vegetable prices rose even faster, at a 0.7% clip in April. The US Department of Agriculture says the California drought doesn’t seem to have affected vegetable prices so far this year and the agency isn’t predicting a catastrophic spike in food prices just yet. The USDA projects that food price inflation will be between 2.5% and 3.5% in 2014. That's higher than the rise last year, but it's in line with the long-term average of 2.8%.

There are a couple of reasons why we might not get hit in the wallet this year: farmers are shifting water use from some crops to others, cutting back on some crops, like corn and alfalfa that might be available from other places. This strategy is tricky; for example, California dairy farms depend on alfalfa for feed; if they have to import feed, it could increase dairy prices in the short term. Also, farmers are pumping groundwater. The problem is the aquifers are being depleted, even sinking in some cases, and losing their original capacity. In the short term, we adapt; but if the drought continues, next year could be a bear.

Commodity markets already have weathered record cold in the US that sent natural-gas futures to five-year highs and severe drought in Brazil that has nearly doubled coffee prices. Now meteorologists are predicting even more abnormal weather, thanks to the return of El Nino, a rapid and prolonged warming of the tropical Pacific Ocean, which disrupts normal weather patterns and would exacerbate the extreme climatic events already affecting many markets this year. Meteorological agencies say there is a 60% to 70% chance of El Nino occurring by the end of 2014, and a more than 50% chance it will arrive earlier, by this summer.

It's a significant event in commodities markets because El Nino affects weather patterns virtually everywhere. Past occurrences brought dry weather to West Africa, damaging the region's cocoa crop, and wet weather to Brazil, delaying the coffee and sugar harvests. India typically sees less rain in its monsoon during an El Nino year, which can mean smaller grain and cotton crops. In the US, El Niño could bring much needed rain to the southwest and California. If it comes.

But El Nino is not necessarily good news for commodity prices on a global scale; it tends to help soybean crops but harm corn, wheat and rice crops. And also remember that El Nino refers to an extreme weather event. When El Nino hit in 1997 it claimed an estimated 2,100 lives and caused $33 billion damage to properties.

No matter which way you look, the forecast calls for extreme weather, and that means the first quarter GDP wasn’t just a hiccup.

Friday, February 07, 2014 - Jobs Report Friday

Jobs Report Friday

By Sinclair Noe

DOW + 165 = 15,794
SPX + 23 = 1797
NAS + 68 = 4125
10 YR YLD - .03 = 2.67%
OIL + 2.21 = 100.05
GOLD + 9.30 = 1268.10
SILV + .07 = 20.12

The best 2 days in a row for stocks in almost 4 months. For the week the Dow was up 97 points, and the S&P 500 was up 15 points on the week. The VIX, the volatility index slipped back down to 15, indicating a general happy go lucky outlook for stocks, with just the slightest hint that the past couple of days were part of a short squeeze; especially considering the lousy nature of the unemployment report.

This is Jobs Report Friday and I tend to get a bit wonkish with the numbers but I think it is important economic data, so here goes.

The Labor Department reported the economy added 113,000 jobs in January while the unemployment rate dropped slightly to 6.6%. The number of jobs added fell short of expectations; analysts had projected job growth of around 185,000.

While weather was believed to have weighed on hiring in December, it did not appear to be a major factor last month. There were strong gains in the weather-sensitive construction sector, and while a survey of households found 262,000 Americans were unable to work due to the weather, the department said that was in line with historical trends.

This comes on the heels of an even weaker December jobs report. Today’s report included revisions to November and December numbers. November was revised from 241,000 jobs up to 274,000, and December was revised from 74,000 to 75,000.  The past two months of job growth have been the weakest performance in 3 years, even with revisions; and well below the average monthly gain of 178,000 positions over the last six months.

The Labor Force Participation Rate increased in January to 63.0% from 62.8% in December. This is the percentage of the working age population in the labor force.  In the past we’ve seen the unemployment rate dropping as the participation rate drops. It’s a pretty simple idea really; as the pool of working age people gets smaller, it would require fewer new jobs to see the unemployment rate drop. In January, however, the pool got bigger and the unemployment rate still dropped. There are many reasons why the labor pool gets bigger or smaller. The pool of labor gets bigger as the population expands and as discouraged workers look for jobs again. It gets smaller because people give up looking for work or slip into the underground economy or retire; a lot of Baby Boomers are retiring and that has some impact on the labor pool.

Since the participation rate declined due to cyclical and demographic reasons, in other words, the bad economy and an aging population, we can look to the key working age group of 25 to 54 year old workers. The 25 to 54 participation rate increased in January to 81.1% from 80.7%, and the 25 to 54 employment population ratio increased to 76.5% from 76.1%. 

The best explanation I’ve seen for this discrepancy is that there was a benchmark revision going back to March 2013 to include certain service sector jobs, specifically for services for the elderly and people with disabilities, and these jobs had previously been uncounted or undercounted. Or maybe the discrepancy is just that the unemployment rate is based on a separate survey of households, and this whole process is slightly imprecise.

This month there was a huge discrepancy between the two surveys. The less-reliable and much more volatile household survey shows employment shooting up by 616,000 positions, and the employment-population ratio increasing by two-tenths of a percentage point. That’s very good news: It shows a stronger economy leading workers back into the labor force.

The more-reliable establishment survey shows employment growing by just 113,000 jobs. So, in many respects, this report raises more questions than it provides answers. However, one thing is becoming increasingly obvious; the unemployment rate (now at 6.6%) is becoming less and less reliable; and less and less representative of the strength or weakness of the economy. The unemployment rate went down last month but this was a bad jobs report. Unless you look at the household survey, which was very good.

Over time, the two surveys generally move in tandem, but over short periods they can diverge wildly. Over the past three months, the household survey says employment has increased by an average of 580,000 per month. The establishment survey says payrolls have increased by just 154,000 per month. So, we either saw the best 3 month stretch since 2000 or the worst 3 month stretch since 2012.

The U-6 measure of unemployment dropped to 12.7%, down from 13.1%. U-6 includes the unemployed plus the underutilized workers; people working part-time because their hours were cut back or they weren’t able to find full-time work.

In the January report, one sector holding back payrolls was the government, which shrank by 29,000 jobs in January. State and local governments lost 17,000 jobs; federal lost 12,000. Excluding that loss, private employers added 142,000 positions, a slightly better showing, and is now 291,000 below the previous peak. Total employment is still 866,000 below the peak in January 2008.  It is possible that private employment will be at a new high in March or April. The public sector has declined by more than 760,000 jobs under the Obama administration, and this has been a significant drag on overall employment. A big question is when the public sector layoffs will end.

Education, health care and retail also lost positions. In December and January together, just 2,600 health care positions were filled. By contrast, as recently as November, nearly 25,000 health care workers were added to payrolls. The retail sector lost 13,000 jobs in January; some of that reduction might be related to excessive hiring for the holidays, but the cutbacks are also likely related to weak performances by several retailers. For example, JC Penney and Loehmann’s and Target announced job cuts last month. Manufacturing and construction sectors led overall employment gains in January, adding 21,000 and 48,000 new jobs, respectively.

There are about 3.6 million workers who have been unemployed for more than 26 weeks and still want a job; this is down from 3.8 million in December and this is the lowest level since March 2009. And because off Congressional inaction, about 1.7 million and counting, long-term job seekers are losing emergency unemployment insurance benefits. The Congressional Budget Office estimates that extending those benefits would add 0.2 percent to gross domestic product growth and 200,000 jobs to the economy this year.

According to separate BLS data there are 3 unemployed people for each job opening. The number of people that reported having lost a job involuntarily increased, while the number that reported leaving a job voluntarily and the number re-entering or rejoining the workforce declined. Temporary employment services, often a stepping stone to permanent future employment, added just 8,000 jobs in January.

The average work week remained unchanged at 34.4 hours, and overtime hours notched down to 3.4 hours, meaning that employers have considerable room to increase worker hours before they need to hire additional people.

One mystery arising from today’s report is why employment gains have not kept up with economic growth as measured by gross domestic product, which picked up substantially in the second half of 2013. The annualized pace of expansion was 3.2% in the fourth quarter, and 4.1% in the third quarter. One reason may be that new technologies are allowing employers to make do with fewer workers, for instance the use of automated customer service systems instead of call centers, or Internet retailers’ taking over from brick-and-mortar stores. In other words, the robots are taking over. Maybe.

Or maybe technology has just passed over certain parts of the country. In many cities in central California, unemployment remains about 10%, while on the coast of California the unemployment rate is about the lowest in the nation. In the rust belt regions of Illinois, Michigan, and Ohio, unemployment is very high and may be stuck at high levels as business and industries that supported those jobs in those regions are gone and not likely to return; especially as skill levels erode for the long-term unemployed.

Another possible explanation might be found in a report yesterday on the labor share index. In the fourth quarter of 2013, the labor share index dropped to 95.5, its lowest level since the 1940’s. This might indicate higher demands on worker productivity per unit produced, or labor cost per unit, resulting in a gap between  the work done and the compensation paid. Even though productivity was soft for last year – up just 0.6% last year, the Labor Department reported productivity rose at a 3.2% annual rate in the fourth quarter after increasing at a 3.6% pace in the third quarter. Unit labor costs, a gauge of the labor-related cost for any given unit of output, fell at a 1.6% rate in the fourth quarter, showing weak wage-related inflation pressures in the economy.

This almost certainly should be considered a positive for corporate profits. According to Thomson Reuters data, of the 343 companies in the S&P 500 that have reported earnings through Friday morning, 67.9% have topped Wall Street expectations, slightly above the 67% beat rate for the last four quarters.

And for the Federal Reserve, today’s jobs report probably doesn’t change their thinking. The unemployment rate went down, even for dubious reasons, and so they can continue with their taper. The Fed has committed to taper, and it would take a big jolt to knock that train off its track; or as Dalls Fed President Richard Fisher said today, the Fed won’t be swayed by a single number. Indeed, the focus on the Fed now shifts to interest rates, as we get closer to 6.5% unemployment, which you may recall, the Fed set as a target for their pledge to hold low rates steady.

For whatever reason, Wall Street shrugged off the jobs report, at least for today. 

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. 

Thursday, December 05, 2013 - 46664

46664

by Sinclair Noe

DOW – 68 = 15,821
SPX – 7 = 1785
NAS – 4 = 4033
10 YR YLD + .03 = 2.87%
OIL + .18 = 97.38
GOLD – 18.20 = 1226.10
SILV - .28 = 19.54

Nelson Mandela is dead. News reports say the former South African President died peacefully at his home. He was 95. Nelson Mandela will be remembered as the person who, more than any other, brought an end to apartheid, the heartless policy of “separate development” in which white, black and South Asian South Africans were obliged to live apart. It is part of his towering achievement that the very notion of racial segregation is anathema throughout the civilized world.

Yes, the stock market was down again today but the economy is doing better than you thought. Third quarter gross domestic product grew at a 3.6% pace, revised up from earlier estimates of 2.8%. Wow, sounds great, until you dig into the numbers. A large part of the revision, almost half, comes from an increase in inventories. Businesses were stocking the shelves. Were they predicting a gang-buster holiday shopping season or were they caught flat-footed by a lack of demand? We won't know with certainty until we get through the fourth quarter, but most indications are that the economy is still slogging forward, and there doesn't seem to be a need for such a large inventory buildup. We know businesses accumulated more than $116 billion in inventories in the quarter, the most since the first quarter of 1998.

Growth in consumer spending, which accounts for more than two-thirds of US economic activity, was revised down to a 1.4% rate, the lowest since the fourth quarter of 2009. That line about consumer spending is a bit misleading, and I always have to issue a caveat, because the economy is about much more than consumers, but still. Consumer spending had previously been estimated to have increased at a 1.5% pace. A sluggish start to the holiday shopping season offered another reason for caution on the economy's near-term prospects. Several big retailers reported disappointing November sales, with some relying on bargains to lure shoppers. And so, there is a strong possibility businesses will still have inventory on the shelves after the holidays, and there will be no need for new orders to replenish the stocks, and that will likely weigh down GDP growth in the fourth quarter and into the New Year.

Consumers are holding onto the purse strings. Some companies that reported sales gains had to offer more bargains to attract shoppers. The need to keep discounting, which stems from sagging consumer confidence and shoppers trained to wait for bargains, will persist through the remainder of the season. Retailers have created this expectation; just check your inbox; I'll bet you're getting more and more promotional e-mails from national chains. Why rush when there might be a better deal next week.

Meanwhile, the Commerce Department reported that after-tax corporate profits in the third quarter increased at a 2.6 percent pace in the third quarter, slowing from the prior quarter's 3.5 percent pace. So profits are still growing, quite nicely, but they are growing slower. Dividends decreased $179 billion in the third quarter, in contrast to an increase of $273 billion in the second; part of that decrease is from dividends paid by Fannie Mae to the federal government in the second quarter.

The knee jerk reaction on Wall Street was that the GDP number was stronger than estimates and Wall Street looks at good news as bad news, based upon the idea that the Fed will taper from Quantitative Easing; that speculation was enough to push treasury yields to 3-month highs, but a closer examination of the numbers shows the GDP numbers to be a little less than robust. Atlanta Federal Reserve Bank President Dennis Lockhart summed it up by saying: "I am not prepared to interpret the revised third quarter number as an indication that the economy is on a much stronger track."

Another number in the report was the price index for gross domestic purchases, which came in at 1.8%, up 0.2% from the second quarter. These measures of inflation are important because the Fed has repeatedly promised not to raise the so-called fed funds rate, now at nearly zero, until the jobless rate falls below 6.5% or inflation rises above 2.5%; those are the thresholds, rather than the targets. The Fed has targeted an inflation rate of 2%; that would be the sweet spot. And as long as inflation remains below target, that provides justification to keep the fed funds target rates in the zero range.

Why is that important? Markets are jittery about the Fed starting the process of ending some $85 billion in bond purchases each month. The purchases of Treasurys and mortgage-backed securities are meant to keep interest rates low and stimulate the economy. The tapering of bond purchases, however, is likely to trigger an increase in interest rates of all kinds and that could dampen economic growth. When the Federal Reserve first hinted during the summer that it would soon scale back, mortgage rates surged and interest rates also rose in many developing countries.

A new research report by the Cleveland Fed indicates that when the inflation rate remains low, it would be justification for the Fed to maintain its Zero Interest Rate Policy. In other words, the Fed will try a balancing act; keeping the fed funds rate lower for longer, to ease the worries of investors and let the economy more gradually acclimate to a future that at some point, might include higher interest rates.

An interesting point to ponder is that inflation remains tame, perhaps even disinflationary, even as the stock market has moved to record highs. Now you might suspect that a rising stock market, even a frothy stock market, even a bubblicious stock market might have an inflationary impact on the economy; then again, maybe not. Here we are in a stock market boom, and deflation is a greater concern, and apparently a guide for Fed policy. Go figure.

Today, the European Central Bank and the Bank of England left interest rates unchanged. Deflation is a big concern in the Eurozone. Producer price inflation (PPI) fell to -1.4% in the eurozone in October. This is how deflation becomes lodged in the price chain. Prices are sticky for a while as you approach zero inflation, but once you break through the ice into deflation things can move fast; an example would be Greece.

We seem to have a glut of things, and you know the old story about supply and demand. China's fixed capital investment over the past year has been $4 trillion; that represents an 8 fold increase in the past 10 years, and it compare with $3 trillion for the entire EU and $3 trillion for the US. China is a vast new source of supply for a saturated global economy. Meanwhile, today's data on GDP suggests US businesses are a bit saturated as well. Europe's slide towards deflation is replicating what happened in Japan in the 1990s at the onset of its lost decade.

Japan is now fighting back with a strong monetary stimulus program called Abenomics, an easy money policy after the abject failure of a tight money policy. The result of tight money was that fiscal policy had to carry the entire burden instead. Budget deficits exploded as Japan battled the slump. Public debt ballooned to 245% of GDP. ECB President Mario Draghi says the central bankers are fully aware of downside risks of protracted low inflation. The ECB has been behind the curve for most of the past three years, needlessly causing a double-dip recession that caused havoc to public finances; so I guess its no surprise they took no action today.

In other economic news, the Department of Labor released its weekly jobless claims report this morning, and these results were also better-than-expected. Seasonally-adjusted claims fell by 23,000 to 298,000, significantly beating the 320,000 claims economists had predicted. Combined with yesterday's ADP payroll report, this would seem to bode well for tomorrow's monthly jobs report, but this weekly claims report was over the Thanksgiving holiday week, and the results might be slightly distorted. Still, it was the third straight weekly drop in initial claims. Not bad.

Look for 180,000 new jobs and the unemployment rate to go from 7.3% to 7.2%.

Regulators are reportedly ready to approve a tough version of what is known as the "Volcker Rule," part of the Dodd-Frank financial-reform act, which prohibits banks from proprietary trading, which is fancy talk for "gambling with their own money." Regulators were originally planning to leave a big loophole in the Volcker Rule by letting banks do what's known as "portfolio hedging”. This is basically proprietary trading by another name, because it lets banks claim that any kind of trading they do is hedging against losses somewhere in their massive, multi-trillion-dollar portfolios.

One reason why the Volker Rule might actually have teeth is the London Whale. Remember the $6 billion loss that was, according to Jamie Dimon, a portfolio hedge? Not exactly. Bankers warn that this version of the Volcker Rule means mega-banks will not be able to protect themselves from future economic calamities, which means they have no choice but to get smaller and take fewer risks.

Sounds about right.