Editor's Note: Below is a Hedgeye Guest Contributor research note written by our friend Doug Cliggott. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst.
A brief note on our contributor policy. This column does not reflect the opinion of Hedgeye. In fact, in this instance we disagree with Cliggott. That's what makes a market. Cliggott has a keen eye for the markets and economy and, in the very least, is worth reading to challenge our own deeply-held views.
American consumer price inflation is running at about 1.0 percent so far in 2016. A year ago, it was zero. Six months from now, it will likely be around 3.0 percent and trending higher. Here’s why.
Inflation is now 1.0 percent because energy prices are lower than they were a year ago. Energy commodity prices – gasoline and heating oil – are down about 14 percent from where they were a year ago. Energy services prices – electricity and natural gas – are down about 3%.
But oil prices have bounced since February, and are now right where they were in November 2015. So if oil prices don’t change much, on balance, between now and November 2016 (not a bad bet I think) then energy will shift from being a lever pushing down on inflation to one that is pushing up on inflation next winter.
The longer-term, more-important story is what is going on with prices of services. Rents folks are paying for a house or an apartment are rising by a bit more than 3% now, and look to be trending higher. And prices of all types of services that we buy (except for energy) – like medical care, travel, going to restaurants or the movies, using the internet – they are rising by a collective 3 percent. Maybe price increases for services slow in the next 6-12 months, but I doubt it.
The reason is most of the services we buy involve quite a bit of labor. And the cost of labor is going up in America – not quickly, but at a slow and steady rate of ascent, kind of like the climb out of Keflavik Airport in Reykjavik Iceland. No need for a steep climb out of that place when there is nothing but water for hundreds of miles in all but one direction.
So-called “unit labor costs” moved up by 2.0 percent in 2014, by 2.1 percent in 2015, and by 2.3% in the first quarter of 2016. This soft trend higher isn’t because hourly compensation is accelerating – that has been growing at an unbelievable steady 2.8 percent per year since the end of 2013. What is happening is growth of labor productivity – the holy grail of economic activity – is grinding down towards zero.
No one really knows exactly how labor productivity works. We know you need good tools, good workers with the right training, good organization and management … but there also seems to be a really important role for something intangible like “chemistry” or “team spirit” in organizations that are experiencing strong growth in productivity.
Robert Gordon, in his excellent new book The Rise and Fall of American Growth, tells us about the amazing improvements in productivity that occurred in the Kaiser shipyards in Oregon and California in the early 1940s. When the yards began production of Liberty ships in 1942, the scheduled production time was eight months per ship. A year later, production time was down to a few weeks.
Gordon writes that the stunning productivity gains were "made possible in part by letters from more than 250 employees suggesting ways to make production more efficient". Gordon creates an image of an amazing team spirit in these shipyards, a spirit that seems to have been shared in many factories and work places in America during the war.
That was then. Things are different now.
Since the end of the 1970s, we have had a well-documented divergence between productivity and a typical American worker's pay. Seventy years removed from the second World War, we now have a generation of American workers who have seen very little relationship between their collective productivity and what they are paid. And the compensation numbers really have become extreme.
Think of corporate America as an American football team with twenty-two players. Twenty-one of these players earn between $15,000 and $125,000 each year, with half the team earning less $50,000 or less. But one player – the quarterback (or CEO) – earns $16,000,000 each year. Despite a pretty good won/loss record for many years, the only players' salaries that have gone up in a measurable fashion are those of the quarterback, and maybe one of his favorite receivers.
In this scenario, we really shouldn't be surprised that most "team members" are now simply showing up on game day and going through the motions. And so the team’s performance (measured productivity) has deteriorated in dramatic fashion. This may be an important part of the profound slowdown in productivity – there may not be a lot of "team spirit" in many American work places these days, but there is a whole lot of selfish behavior going on in the "quarterback fraternity".
We can see the unprecedented shares of cash flow being deployed to increase dividends and buy shares back, all in an effort to inflate stock prices and boost the compensation of those that are paid in stock. What we can’t see is the investments in new tools and training that are not being made, nor the dinner discussions of all those families that keep getting essentially the same pay check, no matter how profitable their company is.
But back to inflation – if I’m right and US inflation is on its way to about 3 percent in six months, and maybe higher than that in twelve months time, owning a 10-year US Treasury yielding 1.75% does not seem like a good idea. But perhaps owning some TIPs is a pretty good one.