Economic Thoughts: The main 2016 surprise?

So what is the most likely major 2016 bet turning out different? It is probably not the deepening SA drought condition whose full force is yet to show itself. Or the Zuma policy-factor undermining business confidence and laying low SA growth. Or Chinese repositioning, the commodity supercycle bust, or the Saudi, Russian, Iranian & frackers energy price undershoot, the European migrant strains tearing at her political innards, or the Brazilian or Russian recessions.

 

The one big surprise would be the US economy failing to sustain her growth momentum, keeping the Fed from normalising,  prevent its lifting the Fedfunds in stages, to at least 1% in 2016, 2% in 2017 and 3% in 2018. Instead, faltering with major global repercussions: lower bond yields, Fed going into a new holding pattern, with weaker Dollar, and the re-emergence of risky asset attractiveness, their bonds and currencies and less pressure on commodities.

 

So what could possibly give us such an outcome? The US economy is steadily trundling on, adding over 200 000 jobs monthly to the already 141 million full-time employed Americans (a labour growth rate of 1.7%). Its GDP growth is just over 2%. All that really tells you, on face value, is that American productivity is now growing at about 0.5% annually.

 

That’s low, given that her 200-year average productivity gain is 2.5% annually, according to Alan Greenspan a truer reflection of American society’s innate ability (as she apparently genetically can’t do better on her present human endowment). But clearly at times can undershoot.

 

But this isn’t what this is about.

 

Instead, there is a lot of anxiety about American business profit trends, things slowing down, to the point of recession starting (within 18 months). That would be quite contrary to the path projected by the Fed which is steady growth, steady resource uptake, steady inflation acceleration, warranting steady interest rate normalisation, with Fedfunds rising at least to two-thirds nominal GDP growth (real growth of 2.5% plus inflation of 2% equals 4.5% nominal), with the Fedfunds reaching 3% by 2018 and the 10 year Treasury bond yield 3-4%.

 

So where are the real life pointers as compared to the Fed song sheet? US GDP growth is an anemic 2.2% this year, and US 10yr Treasury bond yield remains stuck at a very anemic 2.2%, as if the Fed hasn’t been signaling her policy normalisation intentions for 30 months now (starting with the bond tapering scare of May 2013 when Fed chair Bernanke cleared his throat in public (“eh, shouldn’t we?”)).

 

There are many people Stateside who question the Fed’s projected path, instead seeing growth weakness, slow resource uptake, no inflation uptick (despite energy base effects about to turn up the inflation heat, although at the very moment spot oil prices are falling away anew).

 

The deeper arguments reside with resource uptake, as much in America as worldwide, and this to many offering poor prospects of inflation revival.

 

Worldwide, there is a lot of excess resource capacity idled by slow growth, and trade and technological destruction/disruption. It isn’t only in energy. There is a lot of surplus labour worldwide keeping a lid on remuneration. This prevents much of an inflation acceleration.

 

This is also observable in the US (though not everyone buys this). Indeed, the most unsettling US labour data concerns the participation rate, which has dropped steadily in recent years, from a peak 66% in 2008 to 62.5% now.

 

Put differently, the new job growth has reduced unemployment to 5%, but gives only a partial picture. When we add the full-time employed (141 million), the unemployed (8 million) and under-employed (another 8 million), we get those participating in the US labour force (157 million).

 

But that 157 million number as a share of the total pool of those that could be working (the so-called noninstitutional population, now 252 million out of a population of 320 million) is the 62.5% participation rate. And that rate indicates some 9 million people (3.5%) have dropped from view since the 66% labour participation peak.

 

This missing 3.5% is seen by some as a hidden reservoir, too discouraged to be participating or self-employed to the point of having statistically disappeared, with the unemployment rate (those actively looking for work) not a full and true indication of the labour slack. This aside of the 8 million doing work below their full capacity. Add it all up, and the US economy is far from its full resource potential, and daily stumbling.

 

Those who don’t buy any of this focus on a few critical realities. The only real weakness in the US economy at present is the energy sector, for understandable reasons. Manufacturing generally could also do better. But the rest is doing fine.

 

As to the participation rate being 3.5% and 9 million people off in a few years since the peak, what was build up (in the 1970s through 1990s) is now being demolished at a comparable speed. It is mainly demographics at work, first adding baby boomers (a post-WW2 baby bulge entering the labour force 20-25 years later) and once they started to reach retirement from 2009 this began to reverse the bulge, while also allowing for more people going back to or spending longer in education.

 

Put differently, the larger pool from which the participating labour (employed and unemployed) is drawn has now started to grow faster than participating labour as mostly straightforward demographic changes inflate this base faster. So relax. For the health of the economy, focus on the unemployed becoming converted into employed and gradually converting the under-employed to full employed, too.

 

Don’t be taken by the drop in the overall participation rate, mostly a red herring.

 

Yes, say those with the worry beads, but the US treasury bond market is seeing something that isn’t fully appreciated (and that is after taking into account foreign central banks selling some of their treasury bonds as their circumstances have deteriorated and the Fed is no longer increasing its holdings either).

 

Private global interests are buying those treasury bonds and keep yields down, indeed eroding them anew towards 2% even as the Fed has blown trumpets it is raising short rates towards 1.4% by end 2016 and nearer 3.5% by 2018.

 

Clearly, both cannot be right (or otherwise putting the US into a mighty recession as its short rates threaten to rise steeply above long rates on a 2-3 year view).

 

So who is right?

 

In favour of the Fed, the US economy remains a mighty, resilient machine that is steadily absorbing labour and capital resources and new technology, warranting higher interest rates when considering 1-2% inflation and 2-3% real growth, translating into 4-5% nominal GDP growth.

 

But the American bond market has shown “conundrums” before, last under Chair Greenspan by refusing to respond to lifting short rates in the mid-2000s, at the time blamed on surplus global cash flows cascading into US treasury bonds (not least because foreign central banks were at the time buying US bonds & Dollars to keep their currencies from appreciating too much when favoured by too high external surpluses).

 

This time, though, isn’t like that (global central banks doing the opposite). But there is a case to be made for excess global capacity preventing inflation liftoff and this weighing on Treasury bond yields, with these also favoured as global safe havens? This aside of any US growth disappointment and lingering labour slack remaining, it not all being baby-boomer demographics explaining the rapid falloff in US participation rate to 62.5%.

 

There does seem to be another conundrum in the works (though not everyone is convinced this is what long treasury bond yields are signaling). The Yellen Fed, like the Greenspan Fed before her, looks determined to lift rates on the theory of sustained modest growth plus a mild inflation comeback requiring a gradually lifting of real interest rates.

 

Somebody may get this wrong. Just monitor the US treasury long bond yield very, very carefully in 2016 to see evidence of market capitulation as the Fed proceeds to tighten (every second meeting, with a break around presidential election time in November?). Alternatively, keep watching the Fed for evidence of hesitation and ultimately capitulation (though likely for very long dressed up as neither), ultimately striking her flag, and going back to even more modest tightening policy or even flat earth in rates for longer (sinking the Dollar anew, a striking buy signal for global risk assets, EMs as much as commodities).

 

At least now you have a better alternative than watching soapies like 7de Laan, or the Julius & Jacob fraudeville act….though admittedly probably not as exciting as watching grass grow & paint dry. For it may take a long time to get any sense out of what may prove a very long, very dry season

2016-01-04T07:31:25+00:00 January 4th, 2016|Uncategorized|