Frenemies

“If you put tariffs against what are your allies, one wonders who the enemies are”
-Mario Draghi

Suppose you are an emergent corporate chieftan in a closed economy.

And as it so happens, you specialize in helping industries affected by quasi-random, politically motivated trade polices manage input cost related margin pressure …. along with the confused fallout related to the rhetorical rescission of those proposals following the orchestration a sufficiently chaotic global foreign policy tantrum.   

You also happen to sub-specialize in speculating whether protectionist policies steeped in political short-termism will result in a stronger currency due to the prospects for higher inflation and rising interest rates or a weaker currency resulting from an expectation for lower interest rates against a backdrop of declining exports, flagging growth, retaliatory tariffs and a not so implicit weak dollar policy out of the Treasury.

Back to the Global Macro Grind…

Your proclivity for presciently engineering optimal leverage to an unlikely cluster-mess of conditions, however, is actually not the point. 

The point is this:

Because business conditions are currently favorable you want to add headcount. 

As manna from heaven (or perhaps China) would have it, an influx of workers equal to 120% of the current labor force has just entered the labor supply pool.

Initial conditions matter and prior to this massive influx in labor, productivity has been generally weak so labor demand in the aggregate has been similarly sluggish. 

Now comes this deluge in labor supply, which has two primary first order effects:

1. With labor demand flattish and supply way up, any guesses on what happens to price (i.e. the real wage paid to labor)?
2. There are two basic ways to increase output.  Hire more people or invest in productivity enhancing technology.  An excess supply of labor means it costs less to use labor to generate small increases in output and disincentivizes investment at the margin, particularly if there exists significant excess capacity.  This results in a decrease in the marginal productivity of labor which, in turn, also drags on wages.

Now, alongside those shifting labor market conditions have been significant shifts in global demographics.

A period of strong population growth was followed by a combination of falling fertility and rising longevity, resulting in sizeable decline in the dependency ratio (the ratio of the working age population relative to the dependent young and the dependent old) – a development that saw desired savings rise relative to investment.   

The influx of new, cheaper labor in combination with large-scale shifting in global demographics should result in the following:

1. Lower wages paid to labor (stagnant real wage growth)
2. An excess of savings relative to investment (declining real interest rates)
3. Increase in inequality within countries and a decrease in inequality between countries.  

That, at least, is the idea posited by BIS researchers. 

To make the generalized discussion above more tangible, here are the metrics of consequence referenced in the research:  

• The working population in China and eastern Europe (aged 20–64) was 820 million in 1990 and 1,120 million in 2014, whereas the available working population in the industrialised countries was 685 million in 1990 and 763 million in 2014 (Graph 4). That represents a one-time increase of 120% in the workforce available for global production.
• China’s share of world trade increased from slightly less than 2% in 1990 to almost 12% by end-2014 with its entrance into the World Trade Organization in 2001 being the primary catalyst.
• Imposing strict capital controls and pegging the currency allowed monetary policy to remain extraordinarily easy for a long time in order to maximise internal growth. As a result, there was a shift of overall investment out of the rest of the world and into China. Furthermore, the savings ratio was boosted in China through corporate/state-owned enterprises (SOEs) and household savings, especially owing to the lack of a social safety net and the collapse of the family safety net as the “one child” policy took hold. Thus, despite an already high investment ratio, the savings ratio climbed even higher, creating a savings glut that channelled back into the US Treasury bond market.

In short, the authors contend that the integration of China and eastern Europe into global economic markets (the effective introduction of 820 million people into the global labor force) is critical to understanding wage and interest rate dynamics across advanced economies.  They argue that prior analysis around demographic and labor force dynamics fail to take a truly global approach and thus fail to fully consider the import to interest rates, real earnings growth and inequality dynamics observed globally.   

Their conclusion is that the constellation of factors described above – and global demographics, in particular - conspired to drive the disinflationary and low interest rate environment observed in recent decades.  And, importantly, those same dynamics are all set to reverse as global demographic trends reverse and the disinflationary forces of globalization ebb and potentially inflect. 

When I first highlighted this paper last year, reflation’s rollover was ascendant, domestic yields were looking to breach 2% to the downside, QE cessation was but a twinkle in Mario’s eye and the Japanese stars were still faithfully aligned in the cooing Kuroda formation. 

In other words, the consensus inflation narrative was antithetical to what it is currently and the paper only received a fleeting acknowledgement.  If you’re in need of a sirenic macro song to underpin a secular price growth narrative, the linked paper should suffice. 

This is all relevant, of course, because we’ll get the February payroll data this morning and everyone will be myopically focused on whether January’s AHE (average hourly earnings) print can show some wage inflationary follow-through … and thus whether the prospects for 5 rate hikes in 2018 becomes a risk that requires discounting.    

Here’s the obligatory quantitative context for this morning’s data:

1. Payroll Growth:  Anything less than +203K on the headline will = sequential deceleration in year-over-year payroll growth.  Consensus is sitting right on the Mendoza line at a +205K estimate. With initial claims at multi-decade lows and the employment related series in the ISM,  Small Business and Fed regional survey data all still strong that’s not an unjustified expectation. 
2. Hourly Earnings Growth:  Consensus is looking for a modest backslide to +2.8% Y/Y (down from +2.9% Y/Y in January, the strongest print since May 2009).  Is that reasonable?  Recall, extreme weather conditions characterized the early part of January and the BLS’s measure of “Those not at work due to weather”  was roughly double the average January reading over the last decade+.   Employees out due to weather would serve to reduce hours worked and inflate average earnings with lower-paid hourly wage workers working less due to those conditions.  This would manifest as an outsized gain in Total Private Sector hourly earnings growth (which includes both salaried manager positions and hourly earners) relative to hourly earnings growth for non-supervisory and production workers.  This is exactly what we saw in January.  And if that was the marginal dynamic of consequence in January then February would then show some modest backslide in AHE growth as lower paid wage workers are again fully incorporated in the averages.  

That’s certainly plausible, but who knows …..

What we do know is that what needs to happen for the late-cycle expansion to progress durably remains unchanged:

1. Payroll growth will continue to slow on a trending basis.  
2. Wage inflation needs to accelerate and will need to continue doing so to offset the payroll slowdown.  
3. Accelerating wage growth and decelerating payroll growth need to net positive such that Aggregate Income Growth can accelerate and the baseline, forward view on consumption can remain favorable - particularly as the tailwind of a falling savings rate progressively diminishes. .  

As Keith highlighted yesterday, if the wage growth data is “hawkish enough” we’ll get a short-covering opportunity in bond yields and bond proxies as they hit the top and bottom ends of their respective of the risk range.  If it’s not hawkish enough, the next catalyst will be the disinflationary print in the February CPI report next week and the continued emergence of global divergences in growth and inflation. 

Oh …. and after threading the disinflationary needle and traversing the hardest CPI comps in February/March we get to manage the reflationary impulse of lapping trough comps in some of the componentry that drove reflation’s rollover mid-year last year – namely, all-time lows in healthcare inflation and the step function decline in wireless pricing associated with the cellphone price wars.   But that’s a discussion for another time. 

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:

UST 10yr Yield 2.81-2.93% (bullish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 7175-7489 (bullish)
Biotech (IBB) 107-114 (bullish)
Energy (XLE) 65.15-68.95 (bearish)
REITS (RMZ) 1007-1054 (bearish) 
Nikkei 207 (bearish)
DAX 111 (bearish)
VIX 14.86-22.91 (bullish)
USD 89.25-90.74 (neutral)
EUR/USD 1.21-1.24 (neutral)
YEN 105.36-107.47 (bullish)
GBP/USD 1.37-1.40 (bullish)
Oil (WTI) 59.58-61.99 (bullish)
Nat Gas 2.61-2.83 (bearish)
Gold 1 (bullish)
Copper 3.05-3.16 (bearish)
AAPL 172.62-179.94 (bullish)
AMZN 1 (bullish)
FB 174-187 (neutral)
GOOGL 1063-1150 (neutral)
NFLX 280--333 (bullish)
TSLA 316-357 (bearish)

For today …. Keep Springing Forward, let the competition Fall Back.

Christian B. Drake
U.S. Macro Analyst