“Laffer understood perfectly well that his curve didn’t have the power to tell you whether or not any given economy was overtaxed or not. That’s why he didn’t draw numbers on the picture.”
That quote, sourced from one of the best books on quantitative reasoning I’ve had the pleasure of reading (How Not To Be Wrong), comes amid a thoughtful discussion of the benefits and limitations of supply-side economics. One quote in that discussion really resonated with me:
“First of all, maximizing government revenue needn’t be the goal of tax policy.”
Brilliant! After all, one of the more pertinent examples of supply-side economics suggests that lower tax rates may indeed lead to lower revenue:
“When Reagan cut taxes after he was elected, the result was less tax revenue, not more. Revenue from personal income taxes (per person, adjusted for inflation) fell by 9 percent from 1980 to 1984, even though average income (per person, adjusted for inflation) grew by 4 percent over this period.”
Taxes down, income up seems like a pretty decent trade if you’re a U.S. consumer – which is precisely what President-elect Donald Trump has promised.
Back to the Global Macro Grind…
Fortuitously for the Donald, we’re precisely at the point in the labor cycle where wage growth should start to make new highs into its inevitable late-cycle crescendo as highlighted on slide 19 of our Q1 2017 Macro Themes presentation, which we unveiled yesterday afternoon. The DEC Jobs Report certainly confirmed that last Friday:
- Average Hourly Earnings growth accelerated to a new cycle-high of +2.9% YoY; and
- This acceleration comes amid a further deceleration in Nonfarm Payrolls growth to +1.51% YoY, which is down -77bps from its FEB ’15 cycle-peak of +2.28%.
The typical late-cycle progression of slowing employment growth and accelerating wage growth should make a ton of sense for anyone with some familiarity of ninth grade macroeconomics:
- Demand UP: Job Openings accelerated in NOV (the latest data) to 5.52M and remain just shy of their APR ’16 cycle-peak of 5.84M;
- Supply DOWN: The pool of Available Labor fell to a cycle-trough of 13.25M in NOV (the latest data); and
- Market TIGHTER: As a ratio to Job Openings, Available Workers fell to 2.4 in NOV from 2.5 in OCT; 2.4 is just above the JUL ’16 cycle-trough of 2.3.
Q: What happens when the pool of available labor shrinks to new lows in both absolute and relative terms?
A: Employment growth slows because you can’t hire fast enough (i.e. the easy gains have been made) and wage growth accelerates because the negotiating dynamics shift from a buyers to a sellers’ market.
These dynamics likely explain why employers raise wages pro-cyclically, towards the end of an economic cycle. Any firm that wants to grow their business – particularly in the service industry where labor is far and away the most meaningful factor of production – is increasingly forced (by the market) to pay up, not only to retain existing talent, but also to attract new talent.
Obviously such undercurrents vary by industry; you can make the case that in what is likely an oversupplied industry such as asset management, fee deflation may persist, whereas in what is likely an undersupplied industry such as truly independent and thoughtful research, fee inflation may persist. I think this juxtaposition is the #1 reason why prospective clients no longer ask Keith in meetings why he doesn’t want to return to the buyside.
Moving along, I think one question we spent a great deal of time discussing with clients is just how late-cycle is the late-cycle nature of the U.S. economy. As we highlighted in our 12/22 Early Look titled, “CAPE’d Out”:
“Being too early [on the bear side] is the same thing as being flat-out wrong in PnL terms.”
If you recall this time last year, we were keen to highlight the rising risk of recession and called for a Q2 2016 bottom in the sine curve of U.S. growth. In retrospect, one of the big things our team got wrong last year was rolling forward that expectation into 2H16.
To be fair, however, the increasingly late-cycle nature of the labor market was too much to ignore at the time with bond yields crashing to all-time lows in early-July. Kudos to Gundlach and team for booking the #GrowthSlowing trade down there.
All of that is water under the bridge now – especially given our post-election pivot to #Quad2 (i.e. bullish on domestic growth/equities; bearish on bonds and bond proxies).
Now we sit here in Q1 2017 facing the prospect of meaningful fiscal stimulus from the new supply-side regime in D.C. That, in conjunction with the aforementioned labor market dynamics, would seem to portend a shallower retreat in disposable personal income growth, which has been persistently decelerating off its DEC ’14 peak of +4.7% YoY; the latest figures have growth at just half that rate (+2.3% YoY in NOV).
In the context of a personal savings rate that could decline -190bps to its pre-crisis average of 3.6%, a reinvigorated wealth effect for high-end consumers and relatively benign credit gap and debt service ratios for the private nonfinancial sector, it’s not a stretch to suggest the U.S. economy could experience a consumer-driven “recovery” from the aforementioned late-cycle slowdown. We discuss these dynamics in great detail in our 12/7 research note titled, “Is It Early-Cycle, Late-Cycle Or Does the Cycle Not Even Matter Anymore?”.
All told, to the extent you’re still defensively positioned with a late-cycle/rising recession risk view, we strongly urge you to rotate your exposures accordingly on any investable correction in stocks and/or bond yields.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.30-2.53% (bullish)
SPX 2 (bullish)
Nikkei 19001-19656 (bullish)
VIX 10.16-13.39 (bearish)
EUR/USD 1.03-1.06 (bearish)
YEN 113.79-118.25 (bearish)
Oil (WTI) 50.80-54.95 (bullish)
Gold 1143-1215 (bearish)
Keep your head on a swivel,