April 23, 2013

What trends on Wall Street, Main Street mean

Posted in Economy, Finance, Uncategorized tagged , , at 6:04 PM by Robert Barone

In trying to make sense of what is going on in the economy, both on Wall Street and Main Street, the most important thing to remember is in the “new normal” paradigm, one cannot use recent historical perspective.
 
Simply put, in the past five years, the structural changes in the U.S. economy have been so dramatic that today’s economy more closely resembles that of Europe or Japan than it does our own of 2007. As a result, to my way of thinking, a return to 4 percent real economic growth and a 5 percent noninflationary unemployment rate virtually looks impossible.
 
The underlying data
 
Despite the disappointing March employment numbers (88,000 net new jobs in the Establishment Survey and -206,000 in the Household Survey), there was a reduction in the unemployment rate to 7.6 percent because nearly 500,000 people “dropped” out of the labor force in March.
 
Based on this data and using the “old normal” paradigm, it is easy to conclude that there still is a lot of slack in the economy. After all, from an historical perspective the unemployment rate still appears high at 7.6 percent, or 13.8 percent, depending on which measurement you look at.
The underlying emerging facts, however, are quite different.
 
• In the April 9 Bureau of Labor Statistics release of the Job Openings and Labor Turnover Survey, the number of job openings rose by 314,000 for the month of February, despite the fact that hires were nowhere near that level. This is the second-highest level of new openings since April 2010, and the level of unfilled jobs now stands at 3.1 million, where they were in 2006. That number is up from about 2.2 million in the middle of 2009.
 
• While volatile month to month, the level of firings is near an all-time low. And, more people are confident enough in their skills and in their job prospects that the level of voluntary quits (an Alan Greenspan favorite) also is at a five-year high.
 
• On a weekly basis, the BLS issues a series called Initial Jobless Claims, a measure of newly fired or laid-off workers. This series shows a marked downtrend from more than 420,000 per week in the middle of 2011 to under 350,000 in six of the past nine reports; 350,000 per week is about the 2004-07 average.
 
Interpreting the data
 
There clearly is a skills mismatch as openings are rising much faster than hirings. The decline in firings and in the Initial Jobless Claims series imply that employers are holding onto their employees. And, the rise in the voluntary quits says a lot about job prospects for those with skills. So, at 7.6 percent, or whatever the actual unemployment rate really is, the labor markets appear to be extremely tight.
 
Implications of the data
 
One would never arrive at such a conclusion using the historical perspective of the “old normal.” For the first time in at least five years, we are about to see rising wage rates. This is really good for Main Street, as it will give the working class more disposable income. But, it is not good for Wall Street. Labor productivity has declined during the past nine months due to a lack of new investment from businesses and the inability to find qualified help. As a result, as the cost of production rises, profit margins will get squeezed, and we will see the beginnings of cost-push inflation, as businesses vie for the few applicants with skills. This will not be good for equity prices.
 
The view from the Fed
 
In December, with the announcement of 0 percent interest rates and quantitative easing until the unemployment rate reaches 6.5 percent, the Fed has returned to the discredited Phillips Curve concept used in the 1970s under the guidance of then-Fed Chairman Arthur Burns.
The concept was that the unemployment rate could be reduced if there was just a little bit more inflation. Sound familiar to the 6.5 percent unemployment rate and 2.5 percent inflation rate now being targeted?
 
In the ’70s, the result of this policy was “stagflation,” a term coined to describe little or no economic growth but high inflation. Inflation (measured more accurately then than now) was more than 13 percent, and many readers might remember that it took Paul Volker as Fed chairman and many months of 20 percent short-term interest rates to stop stagflation.

 
Nevertheless, it appears that today’s Fed is still using the historical perspective of the “old normal” paradigm in thinking that it can get the real economic growth rate back to 4 percent and significantly reduce unemployment without causing inflation.
Emerging facts are telling us that today’s labor and capital market structures are such that real economic growth of about 2 percent and unemployment rates near 7.5 percent are about all that can be accomplished without significant inflation. (Truth be told, the common experience today is that inflation is much higher than the official 2 percent numbers.)
 
What it means
 
The dusting off of the discredited Phillips Curve concept clearly indicates that Ben Bernanke is much closer to Burns in philosophy than he is to Volker. I lived through the Burns and Volker eras, and I am sure that someday, someone will say to Bernanke, “When it came to fighting inflation, you were no Paul Volker!”
 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

April 9, 2013

Inflation could be closer than we think right now

Posted in Economy, Finance, Uncategorized tagged , , at 10:14 PM by Robert Barone

Mohammed El-Erian of PIMCO coined the phrase “new normal” in 2009 to describe what he observed to be a new, slower growth, a paradigm for the U.S. economy.
 
Now, El-Erian, A. Gary Shilling and others are forecasting an end to the “new normal.” One can presume that means a return of the “old normal,” where the non-inflationary level of unemployment is about 5 percent and potential economic growth is 3.5 to 4 percent.
 
Return of ‘old normal’
 
We have experienced the weakest recovery from a recession in the post-World War II era with average growth since mid-2009 of 2.2 percent versus a 4.2 percent average for the previous seven recoveries.
 
The unemployment rate is 7.7 percent (U.3); if short-term discouraged workers are included, it is 14.3 percent (U.6). During the past five years, the growth rate of the private capital stock has been the slowest of any five-year period for the past six decades.
 
Thus, it appears easy to infer that there is plenty of slack in the labor markets and that firms do not see any need to expand capacity. So, to return to the “old normal,” all we need is an increase in demand, something the huge federal budget deficits or 0 percent interest rates have failed to produce. But, if demand were to rise, because of excess capacity, we will then have a period of rapid growth with little or no inflation.
 
What if ‘new normal’ is permanent?
 
I always thought that “new normal” meant we simply couldn’t rely on pre-great recession historical perspective to tell us where we might be headed.
 
Can we really expect the unemployment rate to return to 4.5 percent like it was in 2006-07? What if labor shortages and inflationary pressures begin to appear when the unemployment rate is between 7 percent and 7.5 percent? What if the industrial base in the U.S. already is using its most efficient means of production, and rising demand means using older, less efficient productive processes or having to go to more expensive second shifts?
 
Labor, capital market conditions
 
The National Federation of Independent Business recently found that from the lows of about 10 percent of survey respondents, the trend of those not able to fill positions has been upward such that today about 20 percent of respondents cannot find qualified applicants.
 
In the pre-recession period, that number hovered around 25 percent. The Capacity Utilization rate, at 79 percent, is equal to the pre-recession peak. That indicates that any rise in demand will be met with capacity issues.
 
Potential economic growth
 
Looking at markets today, even at the so-called anemic post-recession economic growth rates we have experienced, both labor and capacity appear to be constrained.
 
So, maybe in today’s “normal,” the potential noninflationary growth rate of the economy is closer to 2 percent-2.5 percent.
 
Last year, the Congressional Budget Office put out a missive estimating that potential GDP growth was 2.9 percent, a number that the markets, the media and most economists simply ignored. If that is correct, then the 2.2 percent average post-recession growth in this recovery is not all that shabby. Released on March 15, the Economic Report of the President also argues that potential GDP today is much lower than what we might otherwise consider “normal.”
 
Is inflation close?
 
If the “new normal” conditions of the past four years apply, both labor markets and capacity constraints could mean that we will begin to see inflationary pressures if economic growth approaches even 2.5 percent.
 
It is likely that labor shortages will first appear (and, remarkably, we already see these in the construction industry) which will rapidly translate into rising wages. On the industrial front, rising wages, the need to employ older capital, second labor shifts, or to hire and train less-than-qualified candidates reduces profit margins and puts upward pressure on prices.
 
Fed stuck in the ‘old normal’
 
Will the Fed recognize this and take away the spiked punch bowl?
 
There is that possibility, i.e., that interest rates will soon begin to rise in anticipation of higher inflation. But the Fed’s own history of mishandling the yield curve says “no.”
 
Federal Reserve Chairman Ben Bernanke himself missed the recession when the economy was already in it, and, of course, he told us that the “sub-prime” housing issue had been contained. Under “new normal” conditions, the 6.5 percent unemployment rate target that must be met before the punch bowl is removed and the Fed tightens may very well be much lower than the noninflationary unemployment rate.
 
There is even a movement on the Federal Open Market Committee to lower that unemployment objective to 5.5 percent. In addition, Bernanke’s likely replacement, should he decide to retire in 2014, is Janet Yellen, whose views on money printing might be even more liberal than Bernanke’s.
 
So, there is clearly no thinking at the Fed that the “new normal” is permanent. Either that or the Fed never embraced the “new normal” and has continued to use “old normal” guidelines to set policy.
 
Conclusion
 
It is, therefore, a good bet that if the economic paradigm is still governed by “new normal” guidelines, inflation will be well-entrenched long before the Fed recognizes it.
 
Let’s hope that El-Erian and Shilling are right and the “old normal” soon returns. But, I would caution: “Hope” is not a good investment strategy.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.