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2018-02-15Macro `n Cheese

What just happened?

Strong economy, tight labor markets, nascent signs of accelerating wage inflation, massive unfunded fiscal stimulus, new skipper and helmsmen at the FED… – This week, Roger takes a look at the arguments put forward for a swifter pace (and more) of FED hikes, higher market interest rates and, possibly, lower stock markets.

– Oh, golly, yes, please!

Being one of those hopelessly wrong perma-bears always waiting for the right time to enter asset markets I must admit to expressing a non-negligible amount of schadenfreude seeing financial markets performing a synchronized dive. Condemning myself, as is customary for my subspecies of bear, to eternally waiting on the sidelines I nonetheless asked the unfortunate questions: Why, and, What if?

What actually happened

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Chart 1a & b: Asset markets in FED hiking cycles

The why seems to be about markets realizing that the FED is hiking and will continue to hike. While the initiation of a hiking cycle has historically meant that long term rates have started to drift slowly upwards, it seems as if more recent experiences suggest a phase where long rates initially react negatively (i.e. yields drop) only to start playing catch-up as the hiking phase (business cycle peaks, inflation rises) matures. In that respect, 10y-yields have moved (not level, Nota Bene) well in line, lately even above, what historical experiences indicate. On equity markets, at least after the recent correction, developments are still a bit frothier, perhaps, than what we can infer from historical experiences. Nonetheless, it is quite easy to sketch out a plausible connection, where financial markets switch from a fear of low-flation to a more normal cyclical recovery, pushing yields decidedly upwards. The higher yields prompt a sudden reprising of stocks, as discount rates are pushed upwards. But what was the trigger for such reprising?

Most (equity) market pundits argue that the price action started as the hourly wage growth surprised in the latest BLS labor market reports and was interpreted as a sign that a tight labor market was finally generating the wage inflation seen as necessary to sustainably put PCE-inflation in line with the 2% inflation target. Focusing on equity markets, that might be true, but having a look at bond markets reveals that the main culprit for the price action seen in bonds was probably the realization of additional fiscal stimulus in the US.

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Chart 2a & b: A freak outcome or are wage pressures on the rise?

At 2.9% y/y, wage growth appears to be on the rise. However, there seems to be a lot going on beneath the surface of this particular outcome. Not only does comparing seasonally and non-seasonally numbers point to some remaining noise after the BLS has applied the seasonal adjustment process (in particular regarding the working day adjustment1), but there is also an unusually large discrepancy between the ‘All employees’ outcome and the ‘Production and non-supervisory employees’ suggesting that managers pocketed some hefty wage gains, in particular in a few select industries such as finance (pls open MB-chart for more info).

But more importantly, even at 2.9% y/y, wage growth is not disturbingly high. Historically, only when nominal wage growth has exceeded 4% by some margin, has the inflation target been sustainably attained. Also, assuming the FED will deliver on the inflation target, 2.9% y/y would denote a real wage growth of 0.9% y/y which is pretty much what current productivity growth (0.8% y/y) would suggest. Taking in other parts of recent data, notably a low hours-worked growth (and continued decent growth), higher productivity is also in the offing, which would support an acceleration in wages without necessarily sparking inflationary impulses. Low, but slowly rising wages, are readily visible in our Principal Components Analysis (PCA) of a comprehensive set of wage and labor cost indicators.

1Since the main difference between a seasonal and non-seasonal adjusted series in y/y-terms should – at least in theory – represent the working day adjustment procedure (given, of course, that a calendar adjustment is integrated in the seasonal adjustment procedure). Macrobond Document Note: AHE stands for Average Hourly Earnings; MWE for Median Weekly Earnings; ECI for Employment Cost Index, and; CPH for Compensation per Hour
Chart 3: Wages are increasing on trend, but are below levels compatible with the FEDs inflation target

That said, even if we exclude the most recent outcome, wages seem to be accelerating and without productivity increases it will eventually lead to higher inflation or, if only temporarily, lower profits. Nonetheless, this line of reasoning rests on the assumption of continued decent demand growth and do entail continued rate increases and shrinking of the FEDs balance sheet.

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Chart 4: Hard to become bearish on growth

Luckily, there is little to suggest an imminent slowing of the US economy, to the contrary, as both Atlanta and NY FEDs indicators (at the time of writing this piece) point to Q1-growth in the 3½–4% range and the stable measure of domestic demand, PDFP-growth, is strong. Simultaneously recalling the marked deceleration in January hours worked growth it seems a benevolent interpretation is plausible. Indeed, there are many that believe (or hope) we are now washing out the last remains of the financial crisis and that revisions to potential estimates will again start improving.

Market interpretation

How does the analytical exercising above stack up against market’s interpretation of data and events over the past few weeks? – Well, the Fisher-equation can at least take us some way: it = rt + Πt e . Differentiating we get: Δit = Δrt + ΔΠte, implying that we can use the change in real interest rates and break-even inflation (BEI) to at least get some idea (varying liquidity premia etc. are assumed away) on what has driven the reprising of nominal yields.

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Chart 5: Putting the reprising in perspective (performance since all-time lows)

I thought it would be good if we put the recent market sell off in some perspective. Fixed income markets started deteriorating in the run-up to the US elections in 2016, reflecting an increasing chance of additional fiscal stimuli. Of the total reprising in 10yr nominal T-bonds, approximately 1½ percentage points, the contributions are more or less equally divided between real rate and break-even inflation (BEI). Eyeing, instead, the 5yr T-bond, it seems the real rate explains more than ⅔ of the reprising, while inflation expectations account for less than ⅓, hinting of a benign interpretation where higher nominal yields are an effect of improved demand growth, underlining the case for a “Trump trade” also in bonds.

When studying the more recent market traumas I have chosen the dates when the latest fiscal policy package was approved (mid-December) and when the stock market began to tank (end-January).

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Chart 6a & b: A more benign outlook seems to be main driving factors

These graphs are eye-catching and maybe even a bit provoking. Again, it seems the rise in real rates are the main drivers to the rise in nominal yields, while there is little to suggest a considerable change in the inflation outlook. While this goes hand in hand with our “fundamental” analysis above, implying a strong outlook for demand, it is harder to square with professed fears of inflation. And if future growth prospects have improved while inflation is expected to continue on a low side, why all the equity market drama?

The implication is that growth will, if anything, accelerate while cost pressures (inflation) are contained. – Goldilocks! High productivity, but it does not accrue to labor but rather to capital owners2. So, why did really stock markets tank?

Just an overdue response to rising real interest rates?

– Somehow, I get the feeling that stock market might take a cue from fixed income markets when it comes to discount future profits, but not as much when it comes to the general growth outlook. Putting the numbers from Jordá et al (2017) into a simple Gordon growth model (or Dividend Discount Model if you prefer) framework, P = D1 / (r - g) , but allowing the real interest rate to move gives us a crude idea on how the change in interest rates could affect equities3:

2Admittedly, this is a crude interpretation, as e.g. supply issues and other factors could be distorting our analysis, but still…
3Nota Bene, this calculation is not for any other purpose than showing how the rise in real interest rate could affect equities and is just as easily performed (for once) in excel. It is basically assuming a constant equity premium of 5.74%, and real dividend growth of 1.69%. With these assumptions, changing the safe return (10Y TIPS yield) from 0.47% to 0.78% implies a drop in equity prices of 6.4%. In this setting, the ‘D’ is, of course, whatever.

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Chart 7

Hence, the correction experienced over the past couple of weeks must not herald steep drops in leading stock indices but could just as easily be explained as an overdue response to a rise in real interest rates. In that case, the confirmation of (structurally?) higher productivity growth and profits could even lead the indices higher again. More probably, though, we have taken the first steps on a wobbly way forward, where developments are decided in an interplay of growth-, inflation- and monetary policy prospects. As long as none of these three factors deteriorate me and species will remain in the bear pit during this, by now, very long hibernation.

To sum up

  1. During the great moderation, the market action in rates seem to be confined to more mature stages of the business cycle
  2. In fixed income markets, the recent correction seems to be a result mainly of rising real yields as additional fiscal stimuli has been announced
  3. On equity markets, the correction seems to be fear of inflation driving interest rates (too) high
  4. Nonetheless, dissecting recent economic data it is hard to find evidence of an imminent and forceful rise in inflation, why...
  5. Stock market developments could be interpreted as an adaptation to longer (real) yields, and
  6. A more fundamental repricing of fixed income and equity markets, necessitate a weaker demand (and productivity) outlook or an outright policy mistake. Currently, both seem like long-shots

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Disclaimer

We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.