Schizophrenic Financial Markets & Policy
David R. Kotok
Cumberland Advisors, September 27, 2014
We will start this weekend missive with three serious quotes and references. They are from thoughtful work by professional and personal friends. And they offer diverse views.
QUOTE # 1.
“We offer new analyses in this working paper of the impact of changes in the US labor force participation rate (LFPR). Right now, many observers of the US economy are attributing much of the historically huge decline in LFPR to demographic factors – despite the fact that the drop in participation is unprecedentedly rapid and coincident with the severe 2008-10 recession. If this attribution were correct, there would be little labor market slack left in the US economy, and the standard unemployment rate (minus the best-guess nonaccelerating inflation rate of unemployment [NAIRU]) would be a nearly sufficient target for that slack. The stakes are high for this assessment, not only because it will be a primary determinant of the timing of Federal Reserve policy tightening; the more one believes that current high long-term unemployment is cyclically (demand) driven rather than structurally (mismatch and demographic) driven, the more one believes workers can be brought back into employment through monetary (or other) stimulus.”
– David Blanchflower and Adam Posen, “Wages and Labor Market Slack: Making the Dual Mandate Operational.” Working Paper Series. Washington, DC. September 2014: WP 14-6. Peterson Institute for International Economics.
QUOTE # 2
“The unexpectedly swift decline in the unemployment rate in recent years has in large part been attributed to a drop in the labor force participation rate. The labor force participation rate has fallen due to cyclical factors such as workers temporarily dropping out of the workforce because of discouragement over job prospects, but also due to structural forces such as the Baby Boomers reaching retirement age and younger workers staying in school longer. But with the labor market finally gaining some traction this year, is the unemployment rate now falling as more unemployed workers are finding jobs?”
– John Silvia and Sarah Watt House, Labor Force Flows: Movement Behind the Headlines (2014) Wells Fargo Securities.
QUOTE # 3
“The income divide in the United States is not a new phenomenon; it has been increasing for several decades. The Gini coefficient is a common statistic used to measure the degree of income inequality within a population…. Viewed in a different light, the top 5% of US households represented 20% of aggregate income in 1960, but by the mid 2000s the proportion rose to around 35%…. Moreover, the US far outstrips the global average for inequality. In 2011, the average income of the world’s richest 10% was nine times that of the poorest 10%. In the US, the ratio was much higher, at 14-to-1.”
– Ellen Zentner and Paula Campbell, “Inequality and Consumption.” Morgan Stanley US Economics (2014, Registration required).
Thank you to Danny and Adam, John and Sarah, Ellen and Paula. You have set the stage for our discussion today and framed the debate for serious readers to consider.
There is a debate in the US about the labor force, employment and wages. That debate takes place internally at the central bank, where contrasting views are regularly articulated by members of the Federal Open Market Committee (FOMC) as our Federal Reserve (Fed) policymakers attempt to steer monetary policy with regard to interest rates.
Opinions and assertions about the condition of the US labor force are also offered by financial market participants, advisors, economists, and academics. The three papers cited above are part of that debate. They were written by skilled professionals who have identified, cited, and articulated views succinctly, eloquently, and usefully for anyone who takes the time to read them. I know some of the writers personally and I respect their work. The coincidence of all addressing labor force issues and income led to this weekend’s commentary. In our view, the result of reading all three papers and others like them leads to a conclusion: we do not know the answers to the major problems the authors raise. We do not have certainty. We do have skilled opinions and assertions.
Those of us in the financial market advising business are trying to grasp how labor force income will rise, at what rate, and in what cohorts, segments or components. We focus on different measures. The data are dependable. It is extensively assembled by means of systems that have been tested over many years. There is reliability in labor force data series. We are counting things well when we consider the margins for error.
But interpretation and, hence, conclusions are difficult to come by. In fact, a large enigma remains unresolved, in that the labor force participation rate has been trending lower for a long time and has returned to levels last seen in the 1970s. At the same time, the unemployment rate may be inching upward. Were it to do so, it would signal that growing numbers of Americans seek a return to the labor force by declaring they have the confidence to find employment. If this phenomenon continued for several months – say, six data points – it would surely warrant a re-examination of many premises. We have yet to see that happen.
Maybe an additional positive sign will appear with next Friday’s monthly employment report. A positive report would read something like 250,000 new non-farm jobs, a slight tick up in the unemployment rate that is the result of a rising participation rate. That is a guess, not a forecast. We will look at the details carefully and the revisions. That is where we may be able to discern some trends.
It would be good to observe sequentially rising income in the monthly employment reports. Higher pay levels broadly distributed among various categories of workers would indicate that income from labor is rising. It would mean that those who have to pay for labor are willing to pay more and those who provide labor (workers) are able to demand and obtain more. We have not seen that happen in a robust way. Where we do see it occur, it is isolated as opposed to broadly indicative.
It would also be helpful if we saw the income inequality divide narrowing. That would say to us that the distribution of income (assumed also to be wealth, although that is not a perfect identity) is broadening. But as Ellen Zentner notes, income inequality in the US has been widening for decades.
If the wealthy become wealthier, do they spend more on consumption? Are there levels at which “trickle down” ends in a drought? The answer is apparently a mixed but qualified yes. On the other hand, can we see some characteristics of the labor force that suggest that it is normalizing? The answer again is a qualified yes.
One of my favorite statistics is pointed out by Jason Benderly, who suggests that households headed by a male adult with spouse present is a sector whose unemployment rate can be most consistently used to determine when wage pressure is beginning to rise. His reasoning is simple. If the head of household is a man, and it is an intact household in the traditional sense, that man is usually motivated to obtain income to support his family. Highly motivated workers are those who will find work and tighten the labor force more quickly. At some point that trend will be reflected in higher labor incomes.
I also like to look at the single mom statistics, since single women who heads a household is part of a growing component of our society. Women who head households are a highly motivated cohort. In our labor force analytics, we observe both series. We see them improving. That says highly motivated heads of households, be they women or men, are seeking and obtaining jobs and gradually raising their incomes albeit at a slow pace.
Will that trend lead to tightening conditions and then inflation pressure? We do not know. We have presented three papers that readers can view at their leisure in order to draw their own conclusions. The policymakers of the US central bank do not have the answers either. They have divided views, opinions, and assertions. Their current data is the same that we have. It goes without saying that the central bank is looking at history and attempting to drive policy forward. All of us know the peril of driving the car by looking in the rearview mirror. But in the present and confusing environment, history is all we have to help us.
So what do we do with markets?
Cumberland Advisors continues to modify duration in its managed bond accounts, either through hedging tactics or through shortening policies. We believe the short-term US interest rate will remain near zero for the rest of this year and well into 2015. Current market expectations suggest that the first Fed hike might occur in the summer of 2015. We are not sure. There may not be a hike for the entire year. Or the first tap on the interest-rate pedal may come earlier. As of this moment, there is no way to know. The result is schizophrenia in the discounting mechanism applied to short term interest rates.
The bond market is schizophrenic, too. One day it forecasts higher interest rates, and bond investors panic. The next day, data suggest the opposite. Resulting bond market disarray ensues and rising bond interest rates seem way out in the future. The market rallies. Schizophrenia prevails in the bond market.
The US stock market struggles with persistently very low interest rates and high liquidity. All of that is due to central bank policy. Meanwhile geopolitical risk rises; headline risk rises; and the new phenomenon of a structurally strengthening US dollar develops. Volatility in stock markets (VIX, SKEW) is reactive. Valuation metrics suggest the market is priced at a high level yet liquidity abounds and its influence is intense. Stocks, too, have schizophrenia.
At Cumberland Advisors, we expect a long stretch of rising US dollar strength compared with most other currencies worldwide. Our portfolio shifts reflect that. We are also aware of the geopolitical risk that is abundant in the world and may precipitate a “black swan” event at any time. That could lead to a correction in stock prices.
Stock, bond and liquidity market agents are evidencing schizophrenia. At Cumberland, we are maintaining some cash reserves in our exchange-traded fund portfolios as this is written. That cash could be redeployed at any time.
David R. Kotok, Chairman and Chief Investment Officer