I just saw this interesting article in Econbrowser called “New estimates of the effects of the minimum wage.” It is both good news, and bad news.
It is good news because it clarifies a debate about the effect of the minimum wage which has been raging for a long time, but without much actual data. This article summarizes a clever approach by a couple of academic economists to examine the actual effects of increasing the minimum wage. The research produces solid numbers and confirms some theories about the effects of the minimum wage.
The bad news is that the effect of the minimum wage is just what theory says it should be, but liberal politicians have insisted isn’t true in practice. And that’s a net negative effect on overall welfare, albeit divided between winners and losers. However, even that ought to be good news, because this analysis also means that we can reverse the policy and reap immediate gains in consumer welfare.
First, the theory: microeconomics tells us that an increase in the minimum wage, if it is above the equilibrium wage for some types of labor, should decrease employment while increasing the wages of those who actually retain their jobs. (The usual argument for increasing the minimum wage is that the people who earn minimum wage aren’t making enough to live on, and supporters tend to forget that if people lose their jobs because the minimum wage is raised, then those people are making even less.) We often say things are “Econ 101,” but this really is Econ 101 in the sense that it is taught in every introductory economics class. There is no excuse not to know this:
In the chart above, the supply of labor is S and the demand for labor is D. In the absence of a floor (minimum wage), the clearing wage and quantity of jobs is at the intersection; at a minimum wage of a, however, there is a shortage of jobs equal to c-b. If the minimum wage is raised to a’, then the shortage of jobs increases to c’-b’. The question for society is whether the increase in joblessness is an acceptable cost to accept, in order to increase the minimum wage from a to a’. (Of course, the political calculation might also include the fact that people who become unemployed will be supported by the welfare state, and potentially vote to preserve and expand those public institutions that constitute it).
The problem for those who argue against the minimum wage, or for it being increased, is that they can point out this economic truism until they are blue in the face, while the other side simply says “nuh-uh” and denies it is true with the same fervor that they insist that Obamacare has actually lowered premiums and deductibles. The façade only cracks, maybe, when actual data is presented that shows the argument to be bankrupt.
This academic study does that cleverly, by examining changes in employment and wages in states where the federal minimum wage was binding (because the state minimum wage was lower, or non-existent) and states where it was not binding (because the state minimum wage was higher, so the federal minimum wage didn’t matter). Their conclusion:
“Over the late 2000s, the average effective minimum wage rose by 30 percent across the United States. We estimate that these minimum wage increases reduced the national employment-to-population ratio by 0.7 percentage point.”
That’s the sterile conclusion. Now let’s count the cost. Between July 2007 and December 2009, the national employment-to-population ratio (which is similar to, but not the same as, the labor force participation rate) declined from 62.7% to 58.3%; it has since risen to 59.2%. As the chart below (source: Bloomberg) shows, the labor force participation rate (in yellow) shows a more gradual decline but no recovery – as has been well-documented.
Now, some numbers. In November, the Civilian noninstitutional population (the denominator for the employment-to-population rate) was reported by the Bureau of Labor Statistics (BLS) to be 248,844,000. That means that if the authors are correct, the minimum wage has boosted the wages of unemployed workers at the bottom of the scale at the cost of about 1.74 million jobs (0.007 * 248,844,000).
Imagine what having another 1.74 million workers would do for GDP? Do you think it could make a difference for one of the worst recoveries on record?
It probably isn’t fair to assume that all of those 1.74 million workers is currently “unemployed” by the BLS definition. Many of them are likely not looking for work, in which case they would not be counted as unemployed. It is interesting to note, although surely spurious, that the series “Not in Labor Force, Want a Job Now” is about 1.7 million higher than would be expected given the unemployment rate (see chart, source BLS).
Alternatively, we could consider what it would mean to the Unemployment Rate if those 1.74 million workers were employed. This means they would also be in the Civilian Labor Force, so the participation rate (see above) would be 63.5% rather than 62.8%. If instead of coming from the “Not in Labor Force, Want a Job Now” group they came from the “Unemployed” group, the Unemployment Rate would be 4.7% instead of 5.8%. (Personally, I think that most of them are probably in the former category, as the Unemployment Rate has declined at approximately the rate we would expect from past recoveries, despite tepid GDP growth.) That is not inconsistent, of course, if GDP growth is lower because the labor force is simply smaller than it should be – and that is exactly the implication of this bit of research.
Again, the good news is that we can help the country and the downtrodden “structurally” unemployed with the same simple policy: reverse all increases in the Minimum Wage that have happened since 2007.
The Employment number these days is sometimes less interesting than the response of the markets to the number over the ensuing few days. That may or may not be the case here. Thursday’s Employment report was stronger than expected, although right in line with the sorts of numbers we have had, and should expect to have, in the middle of an expansion.
As the chart illustrates, we have been running at about the rate of 200k per month for the last several years, averaged over a full year. I first pointed out last year that this is about the maximum pace our economy is likely to be able to sustain, although in the bubble-fueled expansion of the late 1990s the average got up to around 280k. So Thursday’s 288k is likely to be either revised lower, or followed by some weaker figures going forward, but is fairly unlikely to be followed by stronger numbers.
This is why the lament about the weak job growth is so interesting. It isn’t really very weak at all, historically. It’s merely that people (that is, economists and politicians) were anticipating that the horrible recession would be followed by an awe-inspiring expansion.
The fact that it has not been is itself informative, although you are unlikely to see economists drawing the interesting conclusion here. That’s because they don’t really understand the question, which is “is U.S. growth unit root?” To remember why this really matters, look back at my article from 2010: “The Root of the Problem.” Quoting from that article:
“what is important to understand is this: if economic output is not unit root but is rather trend-stationary, then over time the economy will tend to return to the trend level of output. If economic output is unit root, then a shock to the economy such as we have experienced will not naturally be followed by a return to the prior level of output.”
In other words, if growth is unit root, then we should expect that expansions should be roughly as robust when they follow economic collapses as when they follow mild downturns. And that is exactly what we are seeing in the steady but uninspiring job growth, and the steady if not-unusual return to normalcy in the Unemployment Rate (once we adjust for the participation rate). So, the data seem to suggest that growth is approximately unit root, which matters because among other things it makes any Keynesian prescriptions problematic – if there is no such thing as “trend growth” then the whole notion of an output gap gets weird. A gap? A gap to what?
Now, it is still interesting to look at how markets reacted. Bonds initially sold off, as would be expected if the Fed cared about the Unemployment Rate or the output gap being closed, but then rallied as (presumably) investors discounted the idea that the Federal Reserve is going to move pre-emptively to restrain inflation in this cycle. Equities, on the other hand, had a knee-jerk selloff on that idea (less Fed accommodation) but then rallied the rest of the day on Thursday before retracing a good part of that gain today. It is unclear to me just what news can actually be better than what is already impounded in stock prices. If the answer is “not very darn much,” then the natural reaction should be for the market to tend to react negatively to news even if it continues to drift higher in the absence of news. But that is counterfactual to what happened on Thursday/Monday. I don’t like to read too much into any day’s trading, but that is interesting.
Commodities were roughly unchanged on Thursday, but fell back strongly today. Well, a 1.2% decline in the Bloomberg Commodity Index (formerly the DJ-UBS Commodity Index) isn’t exactly a rout, but since commodities have been slowly rallying for a while this represents the worst selloff since March. The 5-day selloff in commodities, a lusty 2.4%, is the worst since January. Yes, commodities have been rallying, and yet the year-to-date change in the Bloomberg Commodity Index is only 2% more than the rise in M2 over the same period (5.5% versus 3.5%), which means the terribly oversold condition of commodities – especially when compared to other real assets – has only barely begun to be corrected.
I do not really understand why the mild concern over inflation that developed recently after three alarming CPI reports in a row has vanished so suddenly. We can see it in the commodity decline, and the recent rise in implied core inflation that I have documented recently (see “Awareness of Inflation, But No Fear Yet”) has largely reversed: currently, implied 1 year core inflation is only 2.15%, which is lower than current median inflation – implying that the central tendency of inflation will actually decline from current levels.
I don’t see any reason for such sanguinity. Money supply growth remains around 7%, and y/y credit growth is back around 5%. I am not a Keynesian, and I believe that growth doesn’t matter (much) for inflation, but the recent tightening of labor markets should make a Keynesian believe that inflation is closer, not further away! If one is inclined to give credit in advance to the Federal Reserve, and assume that the Committee will move pre-emptively to restrain inflation – and if you are assuming that core inflation will be lower in a year from where it (or median inflation, which is currently a better measure of “core” inflation) is now, you must be assuming preemption – then I suppose you might think that 2.15% core is roughly the right level.
But even there, one would have to assume that policy could affect inflation instantly. Inflation has momentum, and it takes time for policy – even once implemented, of which there is no sign yet – to have an effect on the trajectory of inflation. Maybe there can be an argument that 2-year forward or 3-year forward core inflation might be restrained by a pre-emptive Fed. But I can’t see that argument for year-ahead inflation.
Of course, markets don’t always have to make sense. We have certainly learned this in spades over the last decade! I suppose that saying markets aren’t making a lot of sense right now is merely a headline of the “dog bites man” variety. The real shocker, the “man bites dog” headline, would be if they started making sense again.
If it seems that the frequency of my posts has diminished of late, it is no illusion. There are many reasons for that, many business-related, but there is at least one which is market-related: a three-month-long, 20bp range in real and nominal yields and a year-to-date S&P return that seems locked between +2% and -2% with the exception of the January dip offers precious little to remark upon. Along with those listless markets, we have had plenty of economic data that it was very evident the market preferred to ignore and blame on “severe weather.” And, to the Fed’s lasting credit (no pun intended), the decision to start the taper under Bernanke and thus give Yellen a few months of simply sitting in the captain’s chair with the plane on autopilot has short-circuited the usual rude welcome the markets offer to new Fed Chairmen.
These sedate markets irritate momentum traders (you can’t trade what doesn’t exist) and bore value traders – at least, when the markets are sedate at levels that offer no value. For individual investors, this is a boon if they are able to take advantage of the quiet to pull their attention away from CNBC and back to their real lives and jobs, but for professional investment managers it is frustrating since it is hard to add value when markets are becalmed. Yes, successful investing – which is presumably what successful investment managers should be practicing – is very much about patience, and this is doubly or trebly true for value managers who eschew investing heavily into overvalued markets. I am sympathetic with the frustrations of great investors like Jeremy Grantham at GMO, but I will point out that his frustrations are more acute among less-legendary managers. It is, after all, much easier to pursue the patient style of a Hussman or Grantham…if you are Hussman or Grantham.
Again, I’m not whining too much about our own difficulty in securing good performance, because we’ve done well to be overweight commodities and with some of our other position preferences. I’m more whining about the difficulty of writing about these markets!
But let’s reset the picture, now.
The very weak Q1 GDP figure from last Wednesday (a mere +0.1%, albeit with strong consumption) is old news, to be sure, and investors are right to underweight this information since we already knew Q1 growth was weak. But at the same time, I would admonish investors who wish to patiently take the long view not to get too ebullient about Friday’s jobs figure. Payrolls of +288k, with solid upward revisions, sounds great, but it only keeps us on the 200k/month growth path that we have had since the recovery reached full throttle back in late 2011 (see chart, source Bloomberg).
As I wrote back in August, 200k is what you can expect once the expansion is proceeding at a normal pace, and that’s exactly what you’ve gotten for a couple of years now. Similarly, if you project a simple trend on the Unemployment Rate from late 2011 (see chart, source Bloomberg) you can see that the remarkable plunge in the ‘Rate merely operated as a ‘catch-up’ from the winter bounce higher.
If you believe that inflation is caused when economies run out of slack (I don’t), then the low unemployment rate should concern you – not because it fell rapidly, because it is nearer to whatever threshold matters for inflation. If you rather think that inflation is caused by too much money chasing too few goods, then you’ve already been alarmed by the continued healthy rise in M2 and the fact that median inflation rose to 2.1% this month. So, either way, people (and policymakers) ought to be getting at least more concerned about inflation, no matter what their theoretical predilections. And, in fact, we see some evidence of that. Implied core inflation for the next 12 months (taking 1-year inflation swaps and hedging energy) has risen in the past month to about 2.25% from 1.75%. To some extent, this seems to be seasonal, as that measure has risen and peaked in the last three March/April periods. Investors tend to mistake the rise in gasoline prices that normally happens in the spring to be inflation, even though it ordinarily falls back later in the year. But right now, the implied acceleration in core inflation from the current level of 1.7% is the highest it’s been in three years (see chart, source Enduring Investments).
The bigger spike, on the left side of that chart, corresponds with the significant fears around the time of QE2. But what’s interesting now, of course, is that the Fed is actually tightening (providing less liquidity is the definition of tightening) rather than easing. Some of this is probably attributable to base effects, as last year’s one-off price decline in medical care services due to sequestration-induced Medicare spending cuts is about to begin passing out of the data. But some of it, I suspect, reflects a true … if modest … rising concern about the near-term inflation trajectory.
 Unless, that is, you are overweight commodities…which we are. The DJ-UBS is +8.9% year-to-date.
Is there anything different about the current downturn in stocks, already two whole days old?
It is difficult to get terribly concerned about this latest setback when in one sense it is right on schedule. The modest down-swings have occurred at such regular intervals that the chart of the VIX looks quite a bit like an EKG (see chart, source Bloomberg).
A rise in the VIX to the 19-21 zone happens approximately quarterly, with minor peaks at the same intervals. Eerie, ain’t it?
So is there anything particularly ominous about the current pullback? There is no clear catalyst – I am reading that the selloff is being “led” by tech shares, but the tech-heavy indices look to me as though they have fallen similarly (adjusted for the fact that they have higher vol to begin with. The S&P is down around 3%, and the NDX is down 4.6% over the same period. To be sure, the NDX’s recent peak wasn’t a new high for the year, and it has penetrated the 100-day moving average on the downside, but it doesn’t look unusual to me.
Nor do the economic data look very different to me. The Payrolls number on Friday was in line with expectations, and beat it comfortably when including the upward revisions to the prior two months. The generation of 200k new jobs is not exciting, but it is pretty standard for a normal expansion. My main concern had been that the “hours worked” figure in the employment report had plunged last month, but it rebounded this month and assuaged my concerns (although Q1 growth is probably still going to be low when it is reported later this month, it will be reasonably explained away by the weather).
Two things are different now from previous setbacks, but one is positive and one is negative. They are related, but one is somewhat bullish for the economy and the other is somewhat bearish for risky assets.
We will start with the negative, because it segues nicely into the positive. It is nothing new, of course, to point out that the Fed is tapering, and will be steadily continuing to taper over the next several meetings. Despite the well-orchestrated chorus of “tapering is not tightening,” such Fed action clearly is a “negative loosening” of policy – if you don’t want to call that tightening, then invent a new language, but in English it is tightening.
Now, I never want to short sell the notion that President Clinton taught us all, including market denizens, that if you say something ridiculous often enough, it comes to be regarded as the truth. At times, the market meme clearly has kept the market moving upward even though rational analysis argued for a different outcome. For example, in the early part of the equity bear market that started in 2000, the market meme was that this was a “corporate governance” crisis or a “tech selloff”, when in fact it was a broad-based and deep bear market. In the more-recent credit crisis, it started off as a “subprime” crisis even though it was clearly much more, from the beginning.
So I am loathe to bet about how long markets can run on air before the market meme falters. The challenge, obviously, is being able to distinguish between times when the market meme is correct; when the market meme is incorrect, but harmless; and when the market meme is incorrect, and obfuscating a deeper, more dangerous reality.
“Tapering is not tightening” is one of those thoughts that, while not as serious as “this is a corporate governance problem” or “this is about subprime,” is also clearly mistaken, and possibly dangerous. The reason it might actually be dangerous is because the effect of tightening doesn’t happen because people are thinking about it. Monetary policy doesn’t act primarily through the medium of confidence, any more than gravity does. And, just as gravity is still acting on those aboard the “Vomit Comet,” monetary tightening still acts to diminish liquidity (or, more precisely, the growth rate of liquidity) even when it appears to be doing nothing special at the moment.
The eventual effect of diminished liquidity is to push asset prices lower, and (ironically) also may be to push money velocity higher since velocity is correlated with interest rates.
Now, don’t be overly alarmed, because even as Fed liquidity provision is slowing down there is no sign that transactional money growth is about to slow. Indeed (and here is the positive difference), commercial bank credit has begun to rise again after remaining nearly static for approximately a year (see chart, source Enduring Investments). (As an aside, I corrected the pre-2010 part of this chart to reflect the effect of recategorizations of credit as of March 2010 that caused a jump in the official series).
If you look carefully at this chart, by the way, you will see something curious. Notice that during QE2, as the monetary base rose commercial bank credit stagnated – and then began to rise as soon as the Fed stopped buying Treasuries. It rose steadily during late 2011 and for most of 2012. Then, commercial bank credit began to flatline as soon as the Fed began to buy Treasuries again (recall that QE3 started with mortgages for a few months before the Fed added Treasuries to the purchase order), and began to climb again at just about the same time that the taper began in December.
I don’t have any idea why these two series should be related in this way. I am unsure why expanding the monetary base would “crowd out” commercial bank credit in any way. Perhaps the Fed began QE because they forecast that commercial bank credit would flatline (in QE1, credit was obviously in decline), so the causality runs the other way…although that gives a lot of credit to forecasters who have not exhibited much ability to forecast anything else. But regardless of the reason, the fact that bank credit is expanding again – at an 8% annualized pace over the last quarter, the highest rate since 2008 – is positive for markets.
Of course, an expansion and/or a market rally built on an expansion of credit is not entirely healthy in itself, as to some extent it is borrowing from the future. But if credit can expand moderately, rather than rapidly, then the “gravity” of the situation might be somewhat less dire for markets. Yes, I still believe stocks are overvalued and have been avoiding them in preference to commodities (the DJ-UBS is 7.3% ahead in that race, this year), but we can all hope to avoid a repeat of recent calamities.
The problem with that cheerful conclusion is that it depends so much on the effective prosecution of monetary policy not just from the Federal Reserve but from other monetary policymakers around the world. I will have more to say on that, later this week.
The following is a summary and extension of my post-Employment tweets. You can follow me @inflation_guy (and tell your friends!)
- 175k +25k revisions, nice jobs figure. Oh, but Unemployment up to 6.7%. Love how these seem to always provide opposite surprises.
- One of my favorite labor charts. Want a Job Now, versus the Unemployment Rate:
- 1 way to add more jobs is to have em all work less. Is this an Obamacare effect since part-timers don’t count?
- …regardless, fewer hours worked –>lower output. Expect more downward revisions to Q1 growth ests. Q2 too, if this is ACA.
- If we all end up with jobs, but we’re all working only 30 hours per week, is that better than if only 93% have jobs, working 40?
It will be interesting over the next few months to see if the Hours Worked figures are weather-related (as will be claimed). I suspect that for the most part, they are not. Notice that if there was any weather effect over the last few years, it is not noticeable in the data (nor is it apparent in the unrevised data, incidentally). So, while this year’s weather was colder and snowier than usual, I am skeptical that this can account for more than a small downtick in the hours worked figures.
I rather suspect that the drop is more likely to be attributable to the definition of what constitutes a “full time worker” under the Affordable Care Act. And the question I asked rhetorically above is actually worth thinking about seriously because, looked at one way, the ACA is a jobs program: it will tend to cause businesses to cut back on full-time work and replace those people with more part-time work. The effect should be to cause the Jobless Rate to decline along with Hours Worked. But is that a good thing (because more people have some job) or a bad thing (because people who formerly had a full-time job now only have a part-time job)?
That’s a normative question, not a positive question. But I would think that one effect would be to push more people from what we think of today as “middle class” to lower-middle class, while perhaps raising some who were previously in poverty to be also lower-middle class. I don’t think this was one of the purposes of the law – because frankly, it doesn’t seem that much economic thought went into the design of the ACA – but it is interested to reflect on.
I don’t know what to make of the “Want a Job Now” chart. Let me explain that series, first. “Not in the Labor Force” implies that these people aren’t even looking for jobs, because if they were then they would be counted as unemployed. But, despite the fact that they are not looking, they would like to have a job and would take one if it was offered. While the Unemployment Rate is falling, almost as many people are in the “not in labor force but want a job now” category as were in that category at the beginning of 2011. Why aren’t these people looking?
A fair number of these workers, some 2.3mm of them, are described as “marginally attached” because they’ve looked for work in the last 12 months, and want a job, but haven’t looked in the last 4 weeks so that they aren’t counted as part of the work force. And those are the ones who are holding the category up (see Chart, source Bloomberg).
Some of those workers are not looking because they are “discouraged”, but that only represents about 750k of the 2.3 million or so in this category (and discouraged workers have fallen from about 1 million in 2011, so the decline is consistent with the Unemployment Rate).
So, we are left with a category of people who have looked for work in the past, and would take a job if it was offered, but haven’t looked in the last month. Or the month before. Or the month before. But, at some point, they had at least done a cursory search of the wanted ads.
I think the story of these “marginally attached” workers is worth studying. Are these structurally-unemployed people, who should be counted as such? Are they incentivized to remain out of the work force due to governmental benefits they receive? Or are they, and the decline in the labor force participation rate generally, telling us that the jobs aren’t coming back (or that the newly-created jobs are of lower quality than the old jobs)? I don’t know, but none of the answers is good. We want to see this number decline.
The story of the declining hours worked is potentially much more serious, though – partly because it is a new effect. The nation’s total output is number of employees, times average hours worked, times output per hour. If the number of employees is rising, but they’re working less, then unless productivity rises the total output (that is, GDP) won’t grow very quickly. This could be an early recession sign, or it could be a consequence of the ACA…or it could be a sign that the ACA is pushing a fairly non-robust economy towards the recessionary tipping point. Again, none of these things are good.
So, while the stock market roars its approval about this Employment number, I growl my displeasure. But this is normal.
In normal times, by which I mean before actions of the Federal Reserve became the only data point that mattered, the monthly ISM report was important because it was the first broad-based look at the most-recent month’s data.
Now that the Fed’s taper has begun – right about the time that the uncertainty of the impact of Obamacare implementation was at its peak, curiously enough – the ISM data seems to have taken on importance once again. I must say that I did not see that coming, but since guessing at the Fed’s actions every six weeks and ignoring all intervening data was so all-fired boring, I suppose I am glad for it. Looking at economic data and trying to figure out what is happening in the economy is more like analysis and less like being on The People’s Court trying to rule on a he-said, she-said case where the hes and shes are Federal Reserve officials. And that is welcome.
That being said, the January ISM report isn’t one I would necessarily place at the head of the class of importance, mainly because it is January. Still, it was an interesting one with the Manufacturing PMI dropping 5.2 points, matching the steepest decline since October 2008. The New Orders subindex plunged to 51.2 versus 64.4 last month, and Employment and Production indices also declined significantly. It’s clearly bad news, but I would be careful ascribing too much value to any January number – especially one based on a survey.
Also standing out in the report was the increase in the (non-seasonally adjusted) “Prices Paid” subcomponent, to 60.5. the jump was initially somewhat surprising to me because as the chart below – which I tweeted shortly after the number – seems to show, we have had a jump in Prices Paid that is not being driven by a concomitant jump in gasoline prices – and Prices Paid is predominantly driven by gasoline prices.
However, as I noted in that tweet, the Prices Paid index is measuring the rate of change of prices (the question posed to purchasing managers is whether prices are increasing faster, slower, or about the same as the month before), so just eyeballing it may not be enough. The chart below plots the 3-month change in gasoline prices versus the ISM Prices Paid subindex. What you can see is that the first chart is slightly deceiving. The change in gasoline prices has accelerated – back to zero after having been declining since February of 2013. And “unchanged” gasoline prices is roughly consistent with about 60 on the Prices Paid indicator. So, this isn’t as much of a surprise as it looked like, initially.
Still, whether it was the data or because of continued concern about emerging markets (though the S&P fell nearly as far in percentage terms as did the EEM today, leaving open the question of which is following which), stocks didn’t enter February with much cheer. But never fear, I am sure there is “cash on the sidelines” that will come charging to the rescue soon.
The past week has given a great illustration of one important difference between the price behavior of equities and commodities. That is that stocks are negatively skewed and positively kurtotic, while commodities are positively skewed and negatively kurtotic. That is to say, in layman’s terms, that stocks tend to crash downward, while commodities more frequently crash upwards. This happens because what tends to drive severe movements in commodities is shortages, where the short-term supply curve becomes basically vertical so that any increase in demand pushes up prices sharply. Exhibit one is Natural Gas (see chart, source Bloomberg), where inventories were above normal as recently as October and now are the lowest in a decade.
Exhibit two is Coffee (see chart, source Bloomberg), where drought in Brazil has lifted coffee prices 8-9% today and 35% from the five-year lows set in November. There’s an awful lot of coffee in Brazil, I understand, but there may be less this year.
In my view, stocks remain very expensive even after this quick 5.75% loss (-2.3% today). Obviously, less so! Commodities have outperformed stocks by basically remaining unchanged, but remain very cheap. Bonds have rallied, as money has shifted from stocks to bonds. This is fine, except that 10-year notes at 2.57% with median inflation at 2.1% and rising is not a position to own, only to rent. The question is, when investors decide that it’s time to take their profits in bonds, do they go to cash, back to equities, or to commodities? If you are one of the people mulling this very question, I have another chart to show you. It is the simple ratio of the S&P to the DJ-UBS (source: Bloomberg).
I think that makes where I stand fairly clear. If both stocks and commodities represent ownership in real property, and both have roughly the same long-term historical returns (according to Gorton & Rouwenhorst), then the ratio of current prices should be a coarse (and I stress coarse) relative-value indicator, right?
But let’s shift from the long-view lens back to the short view, now that a retreating Fed makes this more worthwhile. I am not sanguine about the outlook for stocks, obviously (and here’s one for the technicians: for the first time in years, exchange volume in January was higher than last year’s January volume). However, bulls may get a brief reprieve later this week when the Employment Report is released. Yes, it’s another January data point that ought to be ignored or at least averaged with December’s figure. And that’s the point here. Last month’s Employment Report showed only a 74k rise in Nonfarm Payrolls. That weakness was likely due to the fact that the seasonal adjustments (which dwarf the net number of jobs, in December and January) assumed more year-end and holiday hiring than actually occurred. But the flip side of that is that if fewer were hired in December, it probably means fewer were fired in January. Thus, I expect that the 185k consensus guess for new jobs is likely to be too low and we will have a bullish surprise on Friday. That might help the bulls get a foothold…but it is a long three trading days away.
Tomorrow’s Employment Report offers something it hasn’t offered in a very long time: the chance to actually influence the course of monetary policy, and therefore markets.
Now that the taper has started, its continuation and/or acceleration is very “data dependent.” While many members of the FOMC are expecting for the taper to be completely finished by the middle of this year (according to the minutes released yesterday), investors understand that view is contingent on continued growth and improvement. This is the first Payrolls number in a very long time that could plausibly influence ones’ view of the likely near-term course of policy.
I don’t think that, in general, investors should pay much attention to this report in December or in January. There is far too much noise, and the seasonal adjustments are much larger than the net underlying change in jobs. Accordingly, your opinion of whether the number is “high” or “low” is really an opinion about whether the seasonal adjustment factors were “low” or “high.” Yes, there is a science to this but what we also know from science is that the rejection of a null hypothesis gets very difficult as the standard deviation around the supposed mean increases. And, for this number and next months’ number, the standard deviation is very high.
That will not prevent markets from trading on the basis of whatever number is reported by the BLS tomorrow. Especially in fixed-income, a figure away from consensus (197k on Payrolls, 7.0% on the Unemployment Rate will likely provoke a big trade. On a strong figure, especially coupled with a decline in the Unemployment Rate below 7%, you can expect bonds to take an absolute hiding. And, although it’s less clear with equities because of the lingering positive momentum from December, I’d expect the same for stocks – a strong number implies the possibility of a quicker taper, less liquidity, and for some investors that will be sufficient sign that it’s time to head for the hills.
I think a “weak” number will help fixed-income, and probably quite a lot, but I am less sure how positive it will be for the equity market.
In any event, welcome back to volatility.
Meanwhile, with commodities in full flight, inflation breakevens are shooting higher. Some of this is merely seasonal – over the last 10 years, January has easily been the best month for breakevens with increases in the 10-year breakeven in 7 of the 10 years with an overall average gain of 15bps – and some of it is due to the reduction of bad carry as December and January roll away, making TIPS relatively more attractive. Ten-year breakevens have risen about 18bps over the last month, which is not inconsistent with the size of those two effects. Still, as the chart below (Source: Bloomberg) shows, 10-year breakevens are back to the highest level since before the summer shellacking.
Indeed, according to a private metric we follow, TIPS are now back almost to fair value (they only very rarely get absolutely rich) compared to nominal bonds. This means that the benefit from being long breakevens at this level solely consists of the value that comes from the market’s mis-evaluating the likelihood of increasing inflation rather than decreasing inflation – that is, a speculation – and no longer gets a “following wind” from the fact that TIPS themselves were cheap outright. I still prefer TIPS to nominal Treasuries, but that’s because I think inflation metrics will increase from here and, along with those metrics, interest in inflation products will recover and push breakevens higher again.