Sunday, 30 October 2016

Macro and Credit - The Grapes of Wrath

"When anger rises, think of the consequences." -  Confucius

Looking at the impervious performance of credit markets and in particular US High Yield since this year lows while noticing no doubt a rise in global discontent and populism, it seems to us appropriate this time around for our title analogy to steer towards John Steinbeck's 1939 masterpiece "The Grapes of Wrath". In recent musings we have been pretty vocal about our pre-revolutionary mindset, not because we are of the revolutionary breed but, as we noted in our conversation "Empire Days", there is in Europe growth in disillusion / social tensions which can be ascertained for instance in France with the daily demonstrations of the French police and growing discontent hence our title. The Grapes of Wrath was set during the Great Depression and focuses on a poor family of tenant farmers which when they reach their Californian destination finds out that the state is oversupplied with labor, wages are low and workers are exploited to the point of starvation while big corporate farmers are in collusion and smaller farmers suffer from collapsing prices. When preparing to write the novel, Steinbeck wrote: "I want to put a tag of shame on the greedy bastards who are responsible for this [the Great Depression and its effects]."
The intensity of the US presidential election is indeed resonating with Steinbeck's work as it is representative in similar fashion to the growing global discontent with "elites" and the rising disconnect given the rise in inequality thanks to soaring asset prices courtesy of central banks "wealth effect" policies. It might still be goldilocks period for asset prices and in particular credit with additional melt-up but, no doubt in our minds that political clouds are lining up, while the tide is slowly but surely turning for the credit cycle.

In this week's conversation, we would like to look at the relationship between inflation, wages and labor growth, which would entice us to "buy" the recovery mantra of some sell-side pundits. Furthermore, we believe that for the "stagflation" story to play out it is conditional on a continued rebound of oil prices and an overall surge in commodity prices.

  • Macro and Credit - Is inflation truly rearing its ugly head? A look at the United States, Japan and Europe
  • Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

With the intensification of the use of the dreaded "stagflation" word and in continuation to our most recent musing, we continue to believe that rising 10 year US breakevens have been mostly driven by the change in oil prices as illustrated by the below Bank of America Merrill Lynch chart from their CMBS Weekly note from the 28th of October entitled "Still neutral for now":
- source Bank of America Merrill Lynch


For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp we reported in the Wall Street Journal on the 4th of October:
"Rents in San Francisco declined 3%, while they fell about 1% in New York and edged lower in Houston and San Jose, Calif., the first drops in those markets since 2010, according to apartment tracker MPF Research. Across the U.S., rent growth was 4.1% on average." - source WSJ
As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds as posited by Société Générale in their American Themes note of the 19th of October entitled "Equilibrium fed funds: how low and for how long? Demographics the answer!":
"Historic observation: Labor demographics key driver of real long-term fed funds rate
An equilibrium fed funds rate—or interest rate—can depend on many factors that vary over time. The biggest driver under consideration is the inflation rate. Inflation is a straight-forward driver, and more scrutiny is placed on movement in the real interest rate. Economic growth and demographics are key. The perception of equilibrium is an issue too. In the current environment, we believe 2.0% inflation is achieved in balance. In the post-war period, the US economy has operated mostly out of inflation equilibrium with an average inflation rate of 3.64% (CPI) since the 1950s. So far in the 2010s, inflation is averaging 1.53%, just about the closest the US economy has been to a sense of equilibrium, and we are generally worried about deflation risks. The 2.0% inflation-equilibrium may be a challenge for a fed funds equilibrium rate, but we use it.
Drivers and rules of thumb for the Fed Funds rate
Old rules of thumb for determining the fed funds rate have lost prominence over the past decade as the rules appear to have changed. The fed funds rate is substantially lower than these rules of thumb might have suggested. Yet an examination of why they may have worked in the past but fail today is insightful. There are two key rules of thumb:
  1. Fed funds rate should equal nominal GDP. Traditionally, nominal GDP has exceeded fed funds, yet the components of GDP are all the same and influence long-term GDP, namely inflation and real growth. Real growth is determined by demographics, productivity and investment. These latter variables are all the key variables contributing to a dynamic real fed funds determination.
  2. Fed Funds equal 2% plus inflation. This rule coincides with the Taylor rule (In appendix) which originally had 2.0% as a real component. If output gaps and inflation gaps zero out over time, then the fed funds rate rule would be 2% plus inflation. Since the original formulation, however, the 2.0% is now in question. The rule was dependent on the time period examined and later updates used a lower real rate as the time horizon expanded or shifted. We can select a different fixed rate. Yet it is the dynamism of the real rate that is now in question. A different time period could yield a different fixed rate and we could fit the data but gain no insight into an evolving real rate. Today, we assume the real rate component is lower than the past but don’t know how low. Also important, if the real rate turns higher again, will we observe or be aware of the upturn?
The real short-term rate can depend on a large set of factors. In fact, the number of variables that can influence the real rate, and the inability to observe these variables, renders many ambitious under-takings to model the real rate useless. The potential growth rate, or GDP, is likely a top choice as a variable determining the real interest rate. However, the real potential GDP can only be estimated. Further, changes in potential GDP growth are difficult to detect and often require a period of time before a consensus can build on what the potential GDP growth is and how it has changed.
Historically, the nominal GDP averaged a rate significantly higher than the fed funds rate. Nominal GDP is composed of two easy parts, inflation plus real GDP. Like the fed funds rate, it suggests that the real fed funds would over time be equal to real growth. Over the six decade period of examination, nominal GDP exceeded the fed funds rate by 1.55%, and the standard deviation of that spread was 4.45%. Historically, we conclude that nominal GDP has not offered an appropriate guide.

Using a simple benchmark as nominal GDP for the fed funds rate is clearly an oversimplified approach. Yet much of the modeling approaches to consider the long-term fed funds rate are decomposing GDP and weighting the components.
Inflation is the first component, and in the long term, we expect inflation and inflation expectations to converge. The inflation component is assumed one-for-one in the long-term GDP. The real components to GDP are demographics, productivity and technological change. We can model and weight these components, but the approach is fraught with limited transparency. Productivity and technological change are observed with certainty only in hindsight, and sometimes many years after revisions. Additionally, it takes several years to distinguish between a temporary or a more permanent change in these variables.
Labor force and demographics – a more observable component of real growth.
Examining the different components of real GDP over the long term such as labor demographics and productivity as well as the aggregate real GDP growth rate, the movement in the labor force commanded strong interest. What is most compelling about the labor force growth is that it has some predictability, at least far more so than productivity or real GDP growth. Labor force growth is determined by population growth and retirement. Many of these features we can predict long in advance. On a monthly basis, we find the labor force participation rate (percent of working age population that has employment or is looking for job), but large moves can be predicted by the aging of the population. Another interesting characteristic is that the labor force data is not subject to major quarterly revisions like productivity and GDP.
In the tables above, we created another fed funds benchmark, which is the simple addition of inflation and the labor force growth rate. The aim is to generate a function based upon more readily observable components of potential growth. The goal is also to keep it simple. The two components, labor force and inflation, together offer an easy, dynamic calculation for long-term GDP. Over six decades, such an easy measure posted the narrowest spread to the fed funds rate. Moreover, the standard deviation on the spread was only modestly higher than using a fixed real rate benchmark. Labor force movements appear to be capturing a key, dynamic portion of the real rate movement, and importantly, the labor force variation is more observable, less prone to revision, and easier to project going forward relative to other fundamental explanatory variables.
Labor force growth has slowed appreciably in the 21st century and particularly after the crisis. The slowdown is a chief factor explaining a slowdown in GDP. Since 2009, the labor force has grown at just a 0.5% pace. That was down from 0.8% in the 2000s and 1.3% in the 1990s. Adding to that an equilibrium inflation rate of 2.0% would generate an equilibrium fed funds rate of 2.5% in the 2010s, versus 2.8% in the 2000s and 3.3% in the 1990s. Inflation was higher or lower than 2.0% during the decades and our historical calculation uses the actual CPI inflation measure.
Reasons to use such a simple labor force and CPI construct for considering long-term equilibrium:
  1. Historical accuracy: If we consider a long-term analysis assuming that short-term rates find their needed equilibrium, the simple rate has been accurate. Moreover, the points of departure in the 1970s and 1980s are of interest. Fed funds were arguably held too low in the 1970s, giving rise to high inflation. Conversely, in the 1980s the fed funds was higher than it should have been due to abnormally high inflation expectations. Back testing this simple measure offers intriguing results. Over a six decade history, a simple benchmark of adding the labor force and the CPI inflation rate than GDP that implicitly moves with productivity and technological innovation.
  2. Observable: A black-box model on the real rate can be constructed. Transparency and ease of observations are strong positives. Many important concepts behind a real rate—from demographics, real growth, productivity, potential growth—are not directly observable. Furthermore, the variables can be revised substantially over time. Variables used to fit a model could be materially altered at a later date. Labor force counts and the CPI are less subject to revisions.
  3. Robustness of time varying real rate: Demographics pay a large role in potential GDP growth and additionally on the supply/demand for savings/investment. Having a simple demographic measure such as that has historically had a degree of accuracy, which offers a neat tool for gaining insight. The aging US population and the slowdown in immigration are captured indirectly in the labor force statistic.
There are weaknesses as well that are a narrowly focused driver of the real fed funds and the labor force overall. First, consider the chart on US labor force growth on the preceding page. Volatility argues against using this variable as any short-term guide for the fed funds rate. Second, the swings are numerous enough that deciphering a temporary versus a more permanent change is not straight forward. Yet variation could be minimized with more judgment, given that the aging labor force and the growing participation of women in the workforce were robust elements for change. Labor force gains accelerated into the late 1970s and have been decelerating since.
Estimates of the long-term fed funds rate remain well above current levels and therefore do not offer any short-term guidance for the fed funds rate. Demographics may be suggesting that we have reached a low point. At present, we expect labor force growth of 0.5-1.0%. With an inflation goal of 2.0%, the fed funds rate needs to converge to a 2.5-3.0% range. That range encompasses the Fed’s view and that of many other forecasters as well. It would also allow for further revisions downward. Yet, there is a growing risk that the next step in labor force growth will be faster. We see workers putting off retirement until later and /or the effects of the baby boomers entering retirement fading.
Has the drop in interest rates reached its bottom? 
That is a question regarding most bond maturities. Beyond the inflation question, a bottoming of labor force growth suggests that real rates have reached a bottom. This is an interesting outcome that we stress. The  models now used to explain the persistence of low rates may not yet be ready to determine whether an upturn is underway. Two contributions to slowing labor force growth since 2000  have been the retirement of the baby-boom generation and the slowdown of immigration. The oldest baby boomers are now 70, and the mid-point of the baby boom generation (those born in 1955) reach 62 in 2017.

Meanwhile, we know we have not considered productivity and technological change in this analysis. The question of productivity growth is immensely important, but even more difficult to answer relative to labor force growth as a driver of the economy. In terms of our six-decade view, productivity appears useful in explaining current low interest rates, but not much prior to the current period." - source Société Générale
While Société Générale has an interesting take in relation to demographics, the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality. On top of that we do not agree with Société Générale that real rates have reached a bottom. The effect of ZIRP has in effect pushed many baby boomers to postpone taking their retirement due to lack of returns and until we see a clear change in the Fed's monetary policy, we disagree with Société Générale and do not think workers putting off retirement until later and /or the effects of the baby boomers entering retirement  will be fading anytime soon.

When it comes to Japan and Europe (which is undergoing a clear "Japanification" process), both countries face different inflation expectations than the US mostly due to demographics headwinds as we have pointed out in numerous conversations. Interestingly enough, when it comes to demographics, Japan leading the timing of Europe, it does boast a key advantage compare to Europe which is indeed its much tighter labour market leading to some creeping wage inflation as highlighted by Société Générale Albert Edwards in his latest note from the 26th of October:
"After consolidating around ¥100 for about one year, the yen saw a second step decline in H2 2014 towards ¥125. This additional competitiveness caused Japanese corporate profits to boom. The downside was that household incomes were squeezed as higher import prices pushed up headline CPI inflation - this sounds much like the UK today! Although all this was exactly the intention of government policy, the trick is, like kick-starting a motorcycle, to get this one-off stimulus to profits to fire up the engine into a virtuous wage/price spiral and sustainable growth. And from long experience of kick-starting a BSA 1954 M21 600cc single cylinder, it often takes repeated attempts and bruised ankles to get it fired up - link.
Having driven the yen down towards the key 30-year support level of ¥126 at the start of 2015, the BoJ blew its big chance to drive it down through ¥126. If the yen had broken ¥126, I felt it would have quickly run down to ¥145. But having failed to break below this key support level, this year saw it rapidly head in the opposite direction to peak at ¥100 by June, hence squeezing profits (see chart above) and stalling growth. This led foreigners to take flight by selling a record ¥6tn of Japanese shares in the first nine months of the year. I felt the BoJ had blown their chance of reviving the economy via QE and that Abenomics was doomed.
But I might yet be premature in writing Japan off. One key advantage Japan has in trying to produce inflation is, perversely, its appalling demographics. Why? Because even quite moderate GDP growth has resulted in a very tight Japanese labour market (see chart above), and this has resulted in wage inflation crawling higher. In real terms, wage inflation is now rising above 1% (see charts below – indeed Japan’s real wages are rising faster than the US).
Much to my surprise, despite this year’s H1 yen strength hitting growth badly, the Japanese PMI has actually revived in H2 (see left-hand chart below). But this H2 Japanese PMI recovery may be coming at the cost of the US recovery as PMIs now seem to move inversely (see chart below) – especially with the dollar now surging on expectations of a Fed rate hike).

Leo Lewis of the FT wrote a very interesting Short View, essentially concurring with Andrew’s front page chart, that Japanese companies are heaving with surplus cash. He notes a record high 55 per cent of Japanese non-financial companies now hold more cash than debt, in contrast to less than 20% of the S&P 500. And with valuations where they are (see chart below), which equity market do you think QE has set up to collapse in the next recession?
- source Société Générale

We concluded at the time:

For Europe, the story is as well different, though from a credit perspective, the on-going Japanification means that Europe, in similar traits to Japan has been deleveraging overall (except Italy and Spain) whereas in the United States and as illustrated by Albert Edwards' note the US has been releveraging thanks to cheap credit and buybacks favoring in the process multiple expansion on a grand scale:
"In a low-growth world, debt is dangerous; in a deflationary world, debt is toxic. Japanese companies, through years of experience, probably understand this and have deleveraged as a result; US corporates, perhaps foolishly, have done the exact opposite.” No “perhaps” about it Andrew. This is nuts!
- source Société Générale

Exactly, in a low yield environment, defaults tend to spike as low yields tend to coincide with higher spreads and default rates. Often low yields are associated with slow growth which eventually should evolve towards wider credit spreads when the credit cycle eventually turns but, we are not there yet. If growth eventually picks up while yields stay low then spreads could indeed normalize but it is not our core scenario.

Why inflation matters therefore? Because in low inflation environment, like the one we are going through often tend to be associated with spiking defaults historically (deflation bust of the energy sector earlier this year).

But, moving back to Europe and its inflation conundrum, when it comes to wage growth, it could put additional pressure on its inflation expectations due to decelerating wage growth as highlighted by Ban of America Merrill Lynch in their Euro Area Economic Watch note from the 28th of October entitled "Wage growth: potential for worse":
"Wage growth: potential for worse
This is a half-hearted labour market recovery
Employment growth in the Euro area is continuing its relatively steady recovery. The number of employees (excluding self-employed) rose 1.7% and 1.6% in 1Q and 2Q16, respectively, predominantly driven by the services sectors. The number of employees is back at 2008 levels now (Chart 1).

However, robust headline employment growth masks a much shallower recovery in hours worked, which continue to stand nearly 4% below their 2008 level in the economy as a whole (Chart 2). 

Meanwhile, Euro area wage measures, including compensation, wages and salaries, contractual wages, etc, continue a gentle downward trajectory. Wages and salaries per employee, for example, slowed to 1.4% yoy in 1H16 on average compared with 1.5% in 2015 and 2.1% on average since 2001.
Some blame sector composition for slower wage growth – we disagree
A predominantly services sector-driven labour market recovery is not surprising given the composition of the Euro area growth recovery: domestic demand components, public and private consumption in particular, are a lot more service-intense than capex or exports. Services, in turn, are more labour-intense.
Some hawkish ECB council members have cited the sector composition of the labour market recovery as the driver of slowing wage growth, as services wage growth typically underperforms that of industry.
We believe this line of argument is flawed and not supported by the data. On the contrary, our findings suggest that wage-setting behaviour may have changed also in the services sector post-crisis, which would be disconcerting. Even if we assume that wage structures did not change, wage growth prospects would still be rather gloomy and under pressure to decelerate further.
Sector drag on aggregate wage levels? Not if you look at hourly wages
Since 2002, the share of employment in industry excluding construction has fallen by more than 4pp to 17% in the Euro area, while that of the services sector has risen 6pp to 77%. We wanted to know if and how much drag this reshuffle of employment poses to average wage levels. To do this, we calculated a counterfactual wage level measure, assuming the composition of employment and the composition of working hours had remained at the 2002 level. Results are shown in Chart 3.
We find that wages per employee are currently some 1.5% lower than they would have been if the sector shares of employment had not changed. The trend has been very steady, however, lowering wage growth per headcount by 0.1pp every year – hardly enough to justify the wage growth deceleration we have seen post-crisis.
Wage growth per employed, however, does not reflect the rise in part-time employment. So we run the same exercise for hourly wages. We find that, if anything, wage levels today are marginally higher than they would have been (blue line in Chart 3). This would suggest that sector composition cannot really be held responsible for what we see in the recovery.
Wage growth has slowed across most sectorsIf sector composition were solely to blame, we would also expect wage growth to have remained intact across sectors, particularly in those where wage growth is typically lower but employment growth currently faster. Again, data suggests that things are not so simple.
Chart 4 shows hourly wage growth in the industry (excl. construction) and services sectors (including the public sector). In both aggregates, dynamics have slowed from pre-crisis standards (although industry wages have continued to decelerate more quickly recently).

We have equally checked standard deviations of wage growth across 10 different sectors at any point in time (grey area in Chart 4). During 2012-14, wage growth was more harmonious across sectors, but it has started to reflect typical dispersion again (as has the differential between the fastest and slowest sector wage growth). This could suggest the entire spectrum has shifted a gear lower.
Slowing wage growth in response to inflation – even in services
Generally, a lower wage level could be “normal” if it results from a) lower productivity growth and/or b) more economic slack now than before. But again we find that more may be at play here, both in the economy as a whole and in individual sectors.
We replicate an exercise we ran over the summer, when we were warning to be vigilant of second round effects of inflation on wages. As a reminder, we had found at the aggregate level that the deviation in compensation growth from its long-term average could be explained by slack (high unemployment), but also larger and more persistent than usual negative contributions of inflation. These, we argued, were tentative signs of second-round effects."  -source Bank of America Merrill Lynch
So, if wages are a backward looking indicator of inflationary pressures and labor markets continue to weaken in the US and in some parts of Europe such as France and oil prices finally recede, we have a hard time buying the stagflationary story for the time being. We also have a hard time buying the Q3 US GDP at 2.9% but that's another story.

What we are seeing we think, is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand. The illustration of buying essential items is clearly shown by Visual Jeff Desjardins on the 28th of October:
"Prices Are Skyrocketing, But Only For Things You Actually Need

"The average price increase, as shown by the CPI (Consumer Price Index), is 55% over the last 20 years. Meanwhile, the prices of individual sub-categories have a much wider variance." - source Visual Capitalist, Jeff Desjardins.
Of course the consequences of central banks meddling with interest rates is in our mind seeding "The Grapes of Wrath" and is causing biflation to some extent. This is leading to not only rising cross asset correlations as of late between stocks and bonds, but, leading to wider variances and larger standard deviation moves. Instability is not only brewing in financial markets but is leading as well towards instability in various countries and risks of social unrest.

Whereas the United States, Japan and Europe face different situations when it comes to dealing with inflation expectations and wage pressure in conjunction with different demographics, back in October we recommended (a little bit early) to look at US TIPS  in our conversation "Sympathetic detonation" from a great diversification perspective:
In March again in our conversation "Unobtainium" we commented that we continued to like US TIPS:
So from a biflation allocation perspective, US TIPS still remain particularly attractive particularly given their embedded deflation floor. While "balanced funds" are getting "unbalanced" by recent correlated move downwards for both bond prices and stocks, what is not to like about the lower correlation offered between linkers and equities/sovereign bonds? Inflation-linked bonds still provides you with very interesting diversification benefits. For instance the Ishare TIPS bond ETF exposed to US TIPS has delivered you a total return of 6.53% so far. For the long duration braves out there Pimco's 15 years + ETF has LPTZ has rewarded them with handsome year to date total return after fees of 18.70%. Who said there wasn't sometimes some "embedded" actionable ideas in our musings? We rest our case.

In our final chart, while we have been monitoring the credit cycle as it is slowly turning in this "overmedicated" central bank meddling environment, we continue to look at the slow but evident deterioration in credit fundamentals particularly in the US which has been "releveraging" thanks to cheap credit.

While the relentless liquidity provided to the credit markets thanks to Japanese NIRP and the ECB and now BOE being competing with investors in the credit investment world, when it comes to default in a low yield environment, leverage matters and so does credit fundamentals. Our final chart displays US debt growth relative to EBITDA and comes from JP Morgan's Credit and Market Outlook and Strategy note from the 20th of October:
"The ongoing deterioration of credit fundamentals remains the key market risk, however. Debt issuance continues to grow much faster than EBITDA, even if the expected uptick in revenue growth this quarter materializes. Investors are aware of this, but are focused on the strong technicals outweighing these risks. This has been the right view since 1Q of this year. However, our sense is that some investors are uncomfortable with market valuation given these technicals, and if there is a catalyst for a risk off market, this concern about fundamentals would reassert itself.
Fundamental credit metric deterioration is not itself likely to be a catalyst as it occurs slowly and it is difficult to define a red line for specific metrics that causes a problem. A renewed trend of rating downgrades, as occurred in 1Q in the Energy sector, could refocus markets on these risks, but if and when this will happen is difficult to predict." - source JP Morgan
While the party has been running strong "uphill", mostly to the bond market that it, courtesy of the "wealth effect", and not downhill to the real economy, if real assets are positively correlated with inflation and deflation fears are subsiding, we believe that some commodities could stage a comeback, US TIPS will be as well one of the beneficiaries rest assured. Meanwhile, our politicians and central bankers alike have indeed sowed "The Grapes of Wrath", putting financial assets at risk of heightened political backlash from the have not of the real economy namely "Main Street" versus "Wall Street". 

Stay tuned!

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