AMERICAN FUTURE

. . . on the fiscal cliff:

According to CBO’s estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013 (with the resulting economic feedback included, the reduction will be smaller). Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.

There’s more evidence of an incipient eurozone recession. From Markit:



The data was collected between October 12 and 24 — before the confidence-eroding Greek referendum announcement.

Further detail:

Conditions in the Eurozone manufacturing sector continued to weaken in October. At 47.1, down from 48.5 in September, the final Markit Eurozone Manufacturing PMI fell to its lowest level since July 2009 and below the flash estimate of 47.3. The PMI has remained below the neutral mark of 50.0 for three months. Signs of weakness are becoming increasingly apparent in the core nations, while the periphery remains mired in recession. German manufacturing, one of the main drivers of the earlier Eurozone recovery, saw its PMI indicate contraction for the first time since September 2009. Rates of decline were the fastest for 27 months in both Austria and the Netherlands, while France signalled deterioration for the third month in a row. Rates of contraction accelerated sharply in Greece and Italy, with the performance of Italy deteriorating significantly compared with the previous month.

New orders declined at Eurozone manufacturers for the fifth month running, and at the fastest pace since May 2009. The sharpest reductions were seen in Greece, Italy and Spain. Weak domestic market conditions and the deteriorating global economic backdrop were the main factors underlying reduced new order inflows.

New export business fell at the quickest pace since June 2009. All of the nations covered by the survey saw new export orders decline, with rates of contraction accelerating in every country except Ireland and the Netherlands. Worryingly, Germany reported the sharpest reduction, as new export orders fell to the greatest extent since mid-2009.

On Italy:

Signalling a marked deterioration in the health of the Italian manufacturing sector in October, the seasonally adjusted Markit/ADACI  Purchasing Managers’ Index dipped from 48.3 in September to 43.3. This was the lowest PMI reading since June 2009, and the third successive posting below the neutral mark of 50.0. October’s decline in overall business conditions primarily reflected a steep drop in new business received compared with the previous month. New orders from both domestic and foreign-based clients were down markedly since September, with the latter centred on weaker European demand. Consequently, manufacturers cut output levels at the fastest rate since April 2009.

On Spain:

The seasonally adjusted Markit Purchasing Managers’ Index posted 43.9 in October, to signal a broadly similar deterioration in operating conditions as seen in September (43.7). The PMI has now posted below 50.0 for six months in a row. Spanish manufacturing production decreased sharply again in October, extending the current period of reduction to six months. Where output decreased, this was mainly linked to falling new orders.

On Greece:

The headline Markit Greece Purchasing Managers’ Index read 40.5 in October, down from 43.2  in September, signalling the fourth sharpest deterioration in the operating conditions of Greek manufacturing firms in the survey’s twelve-and-a-half year history.

Yesterday, the Conference Board reported that the Consumer Confidence Index and the Consumer Expectation Index fell to their lowest levels since the depth of the Great Recession in the first quarter of 2009. The most interesting of the following charts (published by Wells Fargo) is the one in the bottom right-hand corner, which plots the Consumer Confidence Index and the year-year change in retail sales. As can be seen, these two metrics, which are usually positively correlated, now show an historically-wide divergence. Of course, the divergence can be narrowed in two ways. Based on yesterday’s New York Times/CBS News public opinion poll, my bet would be that the narrowing will be brought about by a decline in retail sales growth.

Using data reported by employers on Forms W-2, the Social Security Administration (SSA) has, since 1990, published annual income and employment statistics. Data for 2010 was released on October 20.

The SSA data includes the following:

• The number of wage earners.
• The net compensation of wage earners (defined as compensation subject to Federal income taxes less contributions to deferred compensation plans).
• The average compensation of wage earners.
• The median compensation of wage earners.

The newly-released data paints a dismal picture in three respects: (1) all trends are adverse, (2) the adverse trends are of long-standing, having been underway since the mid- to late-1990s, and (3) income inequality continues to increase. The charts that follow include linear trend lines.

• The number of wage earners declined for the third consecutive year in 2010, and is now 3.3 percent below its 2007 peak (Chart 1). On a secular basis, growth in the number of wage earners has been declining since 1996 (Chart 2).

• Net compensation recovered in 2010 but was still fractionally below its 2007 peak (Chart 3). The secular trend in the rate of growth of net compensation is downward-sloping (Chart 4).

• The average wage recovered last year but was only 0.8 percent higher than in 2008 (Chart 5); on an inflation-adjusted basis,  average wages declined. The rate of growth of average wages has been trending downward since 2000 (Chart 6).

• The median wage rose fractionally in 2010 but is slightly below its 2008 peak (Chart 7). The long-term trend in its growth rate has been declining since 1997 (Chart 8).

• The gap between the average wage and the median wage, which had declined in 2009 for only the second time since 1991, rose sharply — by 6.3 percent — in 2010 (Chart 9). Between 1990 and 2010, the median wage in relation to the average wage fell from 71.9 percent to 66.0 percent (Chart 10). During the same period, the percent of wage earners whose net compensation was greater than the average wage dropped from 37.0 percent to 33.8 percent (Chart 11). The downward trends shown in Charts 10 and 11 mean that income inequality has been steadily increasing.

Hoisington Investment Management Company is a registered investment advisor specializing in fixed-income portfolios for large institutional clients.

On a number of occasions, I’ve noted the worrisome trend in the velocity of money. In its Quarterly Review, Hoisington takes note of the same phenomenon:

Although many measures of economic performance worsened during QE2, the Fed might argue that the recent M2 acceleration may eventually contribute to an improvement in economic growth as deposit growth fuels income expansion. In our opinion, such an optimistic assessment is not warranted.

In the past three months, M2 increased at a rapid annualized pace of more than 20%, and the annual increase in M2 is about 10%, well above the post 1900 average annual increase of 6.6%. This rise in M2, however, appears to reflect a massive balance sheet shift of assets, not a net creation of new assets. Theoretically, if funds are switched from non-M2 assets into M2 assets, M2 velocity would decline and bank loans plus commercial paper would be stable.

This is exactly what has been happening. After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter. Also supporting this idea of asset shifting, bank loans plus commercial paper in September totaled $7.845 trillion, down from $7.906 trillion in June 2010.

PIMCO’s Bill Gross in the economic crisis:

. . . almost all remedies proposed by global authorities to date have approached the problem from the standpoint of favoring capital as opposed to labor. If the banks could just be stabilized, if the “markets” could just be elevated back in the direction of peak 401(k) levels, if interest rates could just be lower so that borrowers would inevitably take the bait, then labor – job creation – would inevitably follow. It has not. The explanation for why not must at least include the rationale that Wall Street and Main Street are symbiotically connected and if one benefits at the expense of the other, then both ultimately can falter.

That there is a current imbalance is obvious from Chart 1, which shows before-tax corporate profits as a percentage of Gross National Income (GNI). It is obvious that “capital” as opposed to “labor” – moving from 8 to 13% of GNI over the past three or even 30 years – has been the cyclical and secular champion. Why one or the other should be policy and politically advantaged is not commonsensically clear. Granted, the return on capital as opposed to the return to labor should logically be higher if only to encourage savings. But once an historical midpoint or range has been established, a relative equilibrium should be observed. Even conservatives must acknowledge that return on capital investment, and the liquid stocks and bonds that mimic it, are ultimately dependent on returns to labor in the form of jobs and real wage gains. If Main Street is unemployed and undercompensated, capital can only travel so far down Prosperity Road. Until recently, economic recovery has been relatively robust if one were a deployer of capital as opposed to the laborer who made that deployment possible. Near zero percent interest rates have allowed profit margins to widen even in the face of anemic end demand. As well, “productivity” has remained high, but only because of layoffs and the production of goods and services with fewer people. While that is a benefit to capital, it obviously comes at a great cost to labor.

Ultimately, however, both labor and capital suffer as a deleveraging household sector in the throes of a jobless recovery refuses – if only through fear and consumptive exhaustion – to play their historic role in the capitalistic system. This “labor trap” phenomenon – in which consumers stop spending out of fear of unemployment or perhaps negative real wages, shrinking home prices or an overall loss of faith in the American Dream – is what markets or “capital” should now begin to recognize. Long-term profits cannot ultimately grow unless they are partnered with near equal benefits for labor. Washington, London, Berlin and yes, even Beijing must accept this commonsensical reality alongside several other structural initiatives that seek to rebalance the global economy. The United States in particular requires an enhanced safety net of benefits for the unemployed unless and until it can produce enough jobs to return to our prior economic model which suggested opportunity for all who were willing to grab for the brass ring – a ring that is now tarnished if not unavailable for the grasping. Policies promoting “Buy American” goods and services – which in turn would employ more Americans – should also be reintroduced. China and Brazil do it. Why not us?

. . . There are no double-digit investment returns anywhere in sight for owners of financial assets. Bonds, stocks and real estate are in fact overvalued because of near zero percent interest rates and a developed world growth rate closer to 0 than the 3 – 4% historical norms. There is only a New Normal economy at best and a global recession at worst to look forward to in future years.

. . . in manufacturing capacity.

In his blog, Paul Krugman goes further: he divides the Federal Reserve Economic Data (FRED) manufacturing production series by the capacity utilization series to back out capacity. This results in the following chart:

What does this mean?

. . . there is a real concern that if the slump goes on long enough, it can turn into a supply-side problem, because investment will be depressed, reducing future capacity, and because workers who have been unemployed for a long time become unemployable. This is the issue of hysteria “hysteresis”.

[...] You can see that there was a mini-version of the current decline in manufacturing capacity after the 2001 recession: capacity basically stopped growing in the face of a protracted weak economy. But this time around, with manufacturers operating way below capacity with little prospect of needing more capacity any time soon, they’re both scrapping equipment and failing to expand. The result is that when we finally do have a real recovery, we’ll run up against capacity constraints much sooner than we would have if there had been no Lesser Depression.

Arguably the same thing is happening in other sectors of the economy, as the long-term unemployed begin to become unemployable, as the long shortfall in residential construction leads to rising rents (and a small uptick in core inflation) even though demand remains deeply depressed.

Hysteresis can mean that the costs of failing to pursue expansionary policies are much greater than even the direct effects on employment. And it can also mean, especially in the face of very low interest rates, that austerity policies are actually self-destructive even in purely fiscal terms: by reducing the economy’s future potential, they reduce future revenues, and can make the debt position worse in the long run.

Still more evidence, then, of the awesome folly of the current direction of policy in Europe and America.

This chart is from my “Capital and Labor: The Great Divergence” post of September 1:

In that post, I said that “Of course, it’s not surprising that corporate profits are more volatile than compensation. But there’s world of difference between periods of time when both are rising (as in 2003-2006) and those when profits are rising and compensation is not only not rising but is below that of three years ago.”

Fund manager John Hussman, in his latest newsletter, covers the same ground far more thoroughly and persuasively than I did:

To a large extent, the widening of profit margins in recent years reflects two unsustainable dynamics. One is that the increase in profits as a percent of GDP has essentially come at the expense of employees. The spike in corporate profit margins has moved hand-in-hand with the collapse in labor income. As companies cut employment dramatically in recent years, they were able to maintain relatively high levels of output, which was reflected in high productivity growth figures. At this point, however, there is little latitude to expand profit margins through further payroll cuts, and labor tensions are increasing as well. The sequential decline in measured productivity in recent quarters, and the corresponding pickup in unit labor costs, reflects the difficulty in picking much more from the bones of workers.

Figure 1.

But if wage income is falling, how is it possible to maintain the sustained (though not growing) level of demand that is responsible for elevated corporate profits? Simple – add in a second unsustainable dynamic. Government transfer payments are now substituting for wage income to the greatest extent ever observed in history. The majority of the recent surge represents unemployment compensation.

Figure 2.

In fact, 22 cents of every dollar of U.S. personal consumption is now financed with transfer payments. It would be absurd to imagine that this does not fall to the bottom line of corporations. In effect, the elevated level of profit margins is largely a reflection of government deficits that maintain transfer payments, and by extension, consumption demand – even in the face of wage compensation that has never been lower as a share of GDP. While we are likely to see further deficit spending in the event of a full-blown recession, which will provide at least some buffer for demand, it is doubtful that investors should bake the assumption of sustained record profit margins into their long-term valuation of stocks.

Card-carrying capitalist that he is (bear in mind that I’m a retired Wall Street analyst, which allows me to use words like these), Hussman can’t quite bring himself to state the obvious: the public sector (headed, of course, by that quasi-socialist Barack Obama) is subsidizing the private sector. Yes, we have a welfare state. But not the usual kind. It’s corporations that are on the dole. And, indirectly, it’s people like me whose income comes from corporate dividend and interest payments that are the beneficiaries of the public sector’s largesse. If government transfer payments as a percent of nominal GDP were to drop from their current 16 percent back to their pre-crisis 12 percent (which, of course, is favored by some as a way to reduce the budget deficit) , corporate profit margins would collapse, stock prices would plunge, and some corporations wouldn’t be able to fund interest payments on their bonds.

Now take a look back at Figure 1. Remember the good old days of the second Clinton administration? Prosperity was everywhere — people were lifted out of poverty is record numbers, the stock market was booming, and the budget deficit was turning into a budget surplus. This was before the housing bubble created funny money. What was different about that time? Wages income as a percent of nominal GDP was rising, breaking a downward trend that had been in place since the late 1960s.

The people who are the direct recipients of transfer payments certainly aren’t in favor of reducing them. It’s some of the people who are indirectly receiving them — through their dividend and interest payments — that advocate reducing such payments. They should be careful what they wish for.

It’s a holiday weekend, so I’m letting this graphic from the New York Times speak for itself.

Our economy has a severe circulatory problem. While the Fed has greatly increased the amount of available money in its efforts to restore economic growth (Figure 1), the rate at which money has been flowing through the economy — the “velocity” of money — has been plummeting (Figure 2).

Figure 1. M2 Money Stock

Figure 2. Velocity of M2 Money Stock

What does this decline in velocity mean and what can be inferred from it?

• The meaning is that the interval between economic transactions is getting longer, the effect of which is to suppress economic growth.
• A declining transaction rate implies a rising desire on the part of both consumers and businesses to hold larger cash positions. It is a reflection of the deleveraging process which these two sectors of the economy are experiencing.
• For as long as velocity continues to decline, an acceleration in the underlying rate of inflation is highly unlikely, regardless of the rate of expansion of the money stock.
• For roughly a ten-year period beginning in the late 1980s, velocity increased almost continuously. Since then, except for a brief period corresponding to the recovery from the 2000-2001 recession, it has fallen almost continuously. This strongly suggests that the seeds of the crisis we are now experiencing were planted as long as a decade ago, in the aftermath of the Roaring ’90s.

A sustained period of rapidly declining money velocity is still another parallel between our time and the first years of the Great Depression. Until velocity reverses course, it is highly unlikely that we will witness the start of a new period of prosperity.