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MV Weekly Market Flash: Inflation, Economists and the Rest of Us

September 22, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Where’s the inflation? That question has lurked behind most of the major headline stories about macroeconomic trends this year. Jobless rate falls to 4.3 percent. Where’s the inflation? GDP growth revised up to 3 percent. Where’s the inflation? The Fed has an official dual mandate of promoting price stability and the maximum level of employment achievable in a stable price environment. By all available measures, our central bank policymakers would appear to be living up to their mandate in spades. Inflation has remained subdued for pretty much the entire run of the recovery that began in 2009. Over the same time, unemployment has come crashing down from a post-recession high of 10 percent to the gentle undulations of 4 percent and change from month to month. And therein lies the problem, or rather the riddle that neither the Fed nor the rest of us can answer convincingly: why hasn’t a robust jobs recovery reignited inflation?

Math, Models and Markets

Those of us who do not hold Ph.D. degrees in economics from the nation’s most prestigious universities at least have one advantage over those maven economists on the Fed Open Market Committee: we can freely speculate about the perplexing absence of inflation. Here at MVF we have our own views, largely proceeding from the larger issue of long term growth that has been the central subject of our in-depth research for much of the past three years. The catalysts that drive growth over successive business cycles – productivity and labor force participation – have both chronically underperformed for many years. Quite simply, we may have reached a point of diminishing returns on the commercial innovations that powered a historically unique run of growth through the middle and mid-late portion of the last century. Without that growth, we shouldn’t expect wages and prices to do as they did before.

Which is fine for us to say, because – see above – we are not doctorate-level trained economists. But Janet Yellen is, and so are most of her colleagues. And unlike us, they do not have the freedom to brainstorm and speculate about what’s keeping inflation from showing up. All they have are models. Models with months, quarters and years of data providing quantitative insights into the relationship between the labor market and consumer prices. Models written in beautiful mathematical formulations, the legacy of giants who inhabited the “freshwater” (University of Chicago) and “salt water” (MIT and Harvard University) centers of economic research in the years after the Second World War. Models premised on the hyper-rational choices of economic actors, models that do not actively incorporate variables about capital and financial markets but that assume that money is just “there.”

Follow the Dots…Not

The models say that a higher uptrend in inflation is consistent with where the labor market is. Accordingly, the “dot plot” predictions by FOMC members continue to assume one more rate hike this year (most likely December) and three more next year. This despite the fact that the core personal consumption expenditure (PCE) rate that the Fed uses as its inflation gauge remains, at 1.4 percent, well below the Fed’s 2 percent target. Fixed income markets, though, continue to largely ignore FOMC dots (despite some of the usual post-event spasms after Wednesday’s press release). There remain about 100 basis points of difference between what the Fed thinks is a “normal” long term trend for the Fed funds rate (closer to 3 percent) and what the bond market thinks (closer to 2 percent).

In a nutshell, the bond market, and analysts such as ourselves, look at inflation trends and say, why rush? The Fed says, because the models say we have to act. If the models are right, there could be some very nasty shocks in fixed income markets that spill over into risk assets like equities. But for the rest of us, with our parlor game speculations about how the relationship between prices and jobs today may simply not be as statistically robust as it used to be, it is difficult indeed to spot the hard evidence supporting a major bout of inflation on the horizon.

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MV Weekly Market Flash: Popular Data, Invisible Data

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It’s Jobs Friday, always a fun day for financial pundits as they craft ways to put a defining, click-friendly metaphor on the latest signal of health (or lack thereof) in the labor market. This month’s winning metaphor is that staple of kids’ birthday parties, the bouncy house. “US jobs growth bounces back” says the Financial Times. Adam Samson, the FT reporter whose byline is attached to that article, appears to be on the same cosmic wavelength as Patricia Cohen of the New York Times, whose lead headline today reads – wait for it – “U.S. Job Growth Bounces Back”. The style manuals of the FT and NYT – U.S. or US? Jobs plural or singular? Caps or no caps in the headline? – were on full display. Over at the Wall Street Journal they seem to have quietly retired the “Jobs Friday Live Blog” of times past, but the WSJ’s team of economists nonetheless has a massive “Everything You Need to Know” section on the April jobs report. Indeed, to the credit of those featured, that is one exhaustive parsing of the BLS release.

If Productivity Fell and Nobody Heard It, Did It Still Fall?

Not every macroeconomic headline gets the popular-kid treatment of the monthly BLS release, of course. Consider the financial headlines just yesterday, May the Fourth (insert nerdy Star Wars reference here). Yesterday was Productivity Thursday. Ha-ha, of course it wasn’t, because there was basically no coverage of the only economic data point that actually has the capability to deliver sustained growth. What did yesterday’s headlines focus on? Postmortem commentary on the FOMC’s meeting pointing to a June rate hike…the final pre-election debate between Macron and Le Pen over in France…the sausage makers on Capitol Hill hastily throwing together a gambit on the 18 percent of the US economy represented by health care. Important stories, all. Meanwhile, nonfarm labor productivity fell 0.6 percent for the first quarter, well below the consensus expectation of 0.1 percent and yet another lackluster contribution to a chronically underperforming long term trend.

Stop Us If You’ve Heard This One Before

Everyone talks about growth; the notion that the economy will be stronger in the future than it is today is literally the single animating notion behind the capitalist impulse to defer the benefits of a dollar today for the payoff of that dollar’s growth over a defined period of time. But talking about growth without focusing on productivity is like talking about why you just came down with a nasty cold without considering the fact that you recently went out for a walk in the snow barefoot, in shorts and a t-shirt. That is what makes the absence of Productivity Thursday so conspicuous, and why the obsessive focus on monthly payroll gains appears so misplaced.

If anything, the leading number of Jobs Friday should be the labor force participation rate. That nudged down to 62.9 percent from last month’s 63 percent. It remains far below the peak of more than 67 percent reached at the end of the 1990s. Why is this number important? All together now…long term growth is a function of three variables: overall population growth, growth in the number of people working as a percentage of total population, and productivity (how much gets produced for every hour of effort invested).

For most of human history the only variable that mattered was population growth. If that were still true, we would have to content ourselves with annual GDP growth around 0.7 percent, which happens to be the most recent annual rate of population growth. We have little reason to believe that labor force participation is going to improve anytime soon: both demographics and job-replacing technology will see to that. Which leaves productivity, and which is why Productivity Thursday deserves its rightful place at the cool table in the cafeteria of macroeconomic data. Yes, those payroll numbers are useful. But with the unemployment rate at 4.4 percent one might wonder why participation remains stagnant and wage growth is still relatively subdued. Productivity Thursday could help shed some light here.

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MV Weekly Market Flash: The Hard, the Soft and the Ugly

April 28, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Another Friday, another “hard” piece of data that comes in shy of expectations. The Bureau of Economic Analysis released the first estimate of Q1 2017 real GDP growth, and the 0.7 percent quarter-on-quarter growth rate was a bit below economists’ consensus estimate of one percent. As a standalone data point this does not tell us very much. There will be two further revisions that could increase (or reduce) this first estimate. Q1 is notoriously subject to seasonal factors; for example, a warmer than average winter resulted in lower utility consumption by households, which in turn had a slowing effect on personal consumption expenditures. The first quarter of 2016 also produced sub-one percent growth, but that perked up to more robust levels as the year played out. As always, one data point doth not a trend make.

Sentimental Journey

That being said, today’s release will do little to shed light on the mysterious “hard versus soft” debate that has been a staple on the menu of financial gabfests this year. The GDP number comes on the heels of two other underwhelming “hard” macro releases of recent Fridays past: headline inflation below the Fed’s two percent target, and March payroll gains falling short of 100,000. By contrast, a number of “soft” numbers reflecting sentiment among consumers and small business owners have being going gangbusters; by some estimates consumer confidence is higher than it has been any time since the tech bubble peak in 2000. The upbeat sentiment has served for many in the commentariat as an easy go-to explanation for the stock market’s bubbly performance in the year to date (our own take on the market is a more mundane assessment of momentum feeding on itself, more or less impervious to outside catalysts).

Hard, Hard Road

The sentimental bullishness may yet converge into the subdued hard numbers, but it’s not a given. Take retail sales, which posted a modest gain in February and then fell in March. Now, with consumer sentiment being so jazzed up, shouldn’t some of that effervescence be showing up in the actual spending numbers? You can’t blame the weather for this one: those balmy February days should have been mall and DIY store magnets. In fact, the poor showing of retail sales throughout the first quarter was as good a sign as any that GDP might come up short. Seventy percent of growth in output is driven by consumer spending. If consumers aren’t walking the walk, then all the happy talk in the world isn’t going to move the growth needle.

And Now for the Ugly

Behind all these month-to-month metrics we use to measure the economy’s health is the grim reality that long-term growth remains challenged by three major headwinds: declining population growth, a smaller percentage of the population at work in the labor force, and anemic levels of total factor productivity. Of those three headwinds, the only one that can plausibly deliver growth as we know it is productivity. It was the unique convergence of productivity advances with baby boom demographics that delivered the amazing, historically unprecedented growth rates of the 1950s and 1960s. The demographics are no longer in our favor, so to have any growth at all we will need to see some material evidence that all the technology innovations of the last 10 to 15 years can deliver a new, sustained dose of productivity gains. Until that happens, we should not expect to see the kind of go-go growth being promised by some who should know better (ahem, Treasury Department tax plan crafters). At some point, sooner rather than later, this reality will likely make itself known in the soft data as much as the hard.

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MV Weekly Market Flash: Noise and Signals in the Labor Market

April 7, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Last month, White House press secretary Sean Spicer instructed us that the 235,000 payroll gains recorded for the month of February were a direct and unambiguous consequence of the “surge in economic confidence and optimism that has been inspired since [Donald J. Trump’s] election.” This month it would appear we are back to “fake” job numbers, as the latest batch of data from the Bureau of Labor Statistics not only revised last month’s figure down by 16,000 souls, but the March total of 98,000 came in well below analysts’ expectations of 180,000 new hires.

Equally silly are attempts on the one hand to take credit for one single month’s data point, and on the other hand to point to that of another month as a harbinger of failure (or fake, for that matter). A wave of statistical fluctuation – otherwise known as the “margin of error” – accompanies all economic data releases and means that the variation between what actually happened and what the number shows can be wide indeed. There is no reason to expect that the overall labor market picture is either better off or worse off when considering the two data points from this month and last. More importantly, though, the popular obsession with “The Number,” as the monthly payroll gains figure has come to be known – says little about the real state of affairs in the world of employment.

Who’s In, Who’s Out?

What’s the “natural” rate of unemployment? This is a term economists use to try and define what employment would look like in a theoretically stable economy, i.e. in some sort of harmonious equilibrium between jobs, wages and consumer prices. While nobody can pin down exactly what this rate would be in the messier economy of the real world, chances are that the current unemployment rate of 4.5 percent is not all that far away. The chart below shows the unemployment rate trend over the past 25 years, along with the labor force participation rate, another useful employment metric that adds an important perspective to the longer term structural picture.

The 4.5 percent figure in today’s BLS release is the lowest since the middle of 2007, and the above chart clearly illustrates (green line, left y-axis) the dramatic improvement in overall employment since the 2008 recession. But astute observers will notice something odd about the recent trend. When the unemployment rate skyrocketed during the Great Recession, the labor force participation rate (red line, right y-axis) started to fall sharply. But the participation rate kept falling steadily even as employment perked up, and is still more or less directionless even in the current favorable environment. How should we interpret this trend? In other words, who’s out of the labor market forever, and who’s potentially back in if sufficiently enticed (e.g. by better wages, benefits etc.)?

Back to Work, or Off to the Links

The labor force participation rate reflects several important structural trends. One, of course, is the natural increase in the number of retirees as baby boomers activate their retirement accounts and head off for 18 holes or catamaran vacations or whatever. That this rate has fallen from its peak at the end of the 1990s is not surprising, as the first cohort of boomers hit their sixties shortly thereafter. But the accelerated drop in participation from 2008 obviously includes as well the millions of jobs lost from the recession. The absence of a clear reversal in this trend would seem to indicate that, despite the steady pace of new job creation since 2010 – the longest uninterrupted streak of monthly net payroll gains since the BLS started keeping track of this – a meaningful percentage of those jobs lost during the last decade remain unaccounted for. This is true even when you strip out the retiree cohort on one side and young full-time students on the other. The employment-to-population ratio for the cohort aged 25 to 54 – peak working ages – also remains well below its peak reached in 2000.

Wages and Prices

These structural metrics matter, because an increase in the percentage of working Americans to the total population is one way an economy grows. For that red line in the above chart to become a reliable uptrend probably depends mostly on how much more upside there is in real wage growth. Average hourly earnings grew this past month in line with the recent trend level of about 2.7 percent year-on-year. That’s still higher than monthly consumer inflation, but recent strength in the CPI has narrowed the gap. Real purchasing power increases will continue to depend on wage growth outpacing price growth.

Much of the chatter in financial markets recently has been about the notion that the same animal spirits gripping investors of late will motivate business owners and management teams to sweeten the pot and attract scores of new hires, in anticipation of some wonderful new era of growth. Every month we get a new read from the BLS on the state of things (with the statistical variabilities mentioned above), and each data point gives us another piece of a giant and complex puzzle. What we do know is that none of the measures of long term growth – not the rate of population growth, not the percentage of the population actively in the labor force, and not the productivity rate –validate the assumptions behind those animal spirits. Until they do, we must remain skeptical. And see what goodies next month brings.

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MV Weekly Market Flash: Crunch Time for “Secular Stagnation”

March 10, 2017

By Masood Vojdani & Katrina Lamb, CFA

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One of the great debates among the economic literati in recent years has been whether the subpar growth trends of late are cyclical or more long term in nature. The bearish long term view goes by the name “secular stagnation,” with advocates including former Treasury secretary Lawrence Summers making the case for a world stuck in a rut of anemic capital investment and lackluster demand. Two years ago, secular stagnation seemed like a pretty good theory to explain the deflation trap threatening to ensnare the Eurozone, zero-bound interest rates in the US, and many former growth darlings in emerging markets falling into low single digit or negative growth.

Macro headlines today tell a rather different story. In the US jobs, wages, prices and consumer confidence are all trending uniformly higher, as indicated in the chart below. 

Meanwhile, Eurozone inflation has bounced back and even Japan is enjoying a relatively unusual run of positive growth. Most Asian economies are performing decently, if not necessarily spectacularly, while erstwhile basket cases Brazil and Russia seem to have gotten through the worst of their travails. Is it time to put a fork in the secular stagnation theory and call it done? Asset markets certainly seem to think so; today’s valuation levels can only appear reasonable if premised on the imminent resumption of historical-trend growth. But before we read last rites and sing Psalm 23 over the corpse of secular stagnation, we need to supply an answer to the question of what forces are present to drive that historical-trend growth.

1938 Calling

The term “secular stagnation” is not new; it was coined in 1938 by prominent US economist Alvin Hansen. If you are familiar with US economic history you will recall that 1938 was the trough year of the second sharp pullback of the Great Depression: not as deep as the earlier one that bottomed out in 1932 but still painful, with unemployment at 20 percent and a steep decline in US population growth. Hansen looked around him and saw no way out; the world was locked into that dreaded feedback loop where businesses invest less because they expect continued lower demand, and households spend less because there are fewer jobs. Secular stagnation, in other words.

As we know now, of course, the world didn’t turn out that way at all. Instead, the onset of the Second World War unleashed a torrent of economic growth to supply the war effort, and after the war the US, as the sole economic superpower, ushered in a glorious thirty year period of steady and sustainable growth. The secular stagnation theory was laid to rest, until its resurrection by Larry Summers et al in the 2010s.

Attractive Economy Seeks Feisty Catalyst for Growth, Good Times

The headline economic data shown in the chart above are promising, but they are not yet sufficient to return secular stagnation to the box where it rested from 1939 to 2010. While the circumstances that produced the magnificent growth from the late 1940s to the early 1970s are complex and varied, the growth drivers themselves are easy to pinpoint. First, a return to population growth after the anomalous decline of the Depression years. Second, growth in labor force participation as returning war veterans went into a booming job market (and were later joined by a rising level of participation by women). Finally – and most importantly – was growth in productivity, or efficiency gains in how much output businesses could produce for each hour worked.

Are we on the cusp of another productivity boom? The data do not yet point to one. The chart below shows US productivity trends, along with the labor force participation rate, for the last thirty years. Both of these growth indicators remain decisively below-trend.

Some argue that the innovations of recent years will be that much-sought catalyst desired by the global economy. Expansive pundits talk of the Holy Trinity of the Three Industrial Revolutions: the steam engine of the late 18th century, electricity and the internal combustion engine a century later, and the smartphone in the early 21st century. Perhaps history does move in such well-tempered cycles; alternatively, perhaps the culture of growth that grew up around the first two Industrial Revolutions will be seen by future historians as a delightful anomaly rather than an inevitable forward march of progress. Time will tell whether this third iteration can deliver the goods.

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