With leading indicators like per-capita initial claims edging into the top 30% of all desirable readings (figure 1), the unemployment rate at a post-recession low of 7.8%, and the S&P 500 now less than 10% from its pre-bust peak, the question we now have is: what now?We have been waiting for the labour, asset and home markets to clear for three and a half years.
For most of it, the United States seemed like it was slipping into the same class of economic malaise that Japan had suffered, and a close cousin to that of The Great Depression.
The policy response, both fiscal and monetary, seemed to only stem the tide to provide relief from the most acute effects, while the underlying economy was left in the muck.
It takes time for markets to clear after great disequilibrium. “Green shoots” began to appear in early 2010: inventories had been drawn down to unsustainably low levels, and governments internationally, having learnt something from studying The Great Depression, had prevented a death spiral. Overtime increased to compensate for the low inventory levels. Production rose. Then payrolls began to return. The corporate cash hoards began to invest, if not in new capacity, in greater efficiency. Lending standards incrementally eased with employment fundamentals.
While the United States saw asset markets clearing with progressive improvement, the labour, credit and housing markets had been stubbornly over-supplied.
The past few months have provided a strong indication that those markets are finally clearing.
The principal question now is whether the US economy will continue to muddle through, or whether the pace of market clearing will lead to more a more virtuous cycle.
We examine auto sales and new home starts (figure 2) because they provide evidence of spending with multiplicative effect, which is the favoured fuel for the virtuous cycle fire.
F2: New Privately Owned Housing Unit Starts %-y/y vs Real GDP %-y/.
The next step in recovery is for the pace of wage-growth to recover. As we’ve already established, consumer price levels are governed by wage levels (figure 3).
F3: Inflation converges on Wage-growth
We previously observed that the rate of wage-growth actually falls in the first leg of a recovery. Our hypothesis is that the first group of employees to be hired back have minimal bargaining power.
The relative bargaining power labour has to command higher wages may be on its way to increasing. The percentage of labour force which was laid-off & discharged is presently at historical lows. At 1.05%, only 11% of readings are lower (figure 4).
F4: Layoffs & discharges as % of the civilian labour force
Indeed, the skills gap which exists in that unemployed buffer stock may in fact slow down employment growth at the same time as the already-employed command higher wages.
Examining the relationship between unemployment and wage-growth (figure 5), we observe that (Wg = -Ur) is not true, but rather that (Wg = 1/Ur). This is a significant observation: the convexity of wages in price/wage spirals behave like any other commodity against supply limits with short-run inelastic demand.
F5: The relationship we observe between the unemployment rate & wage-growth is not Wg = -Ur, but rather Wg = 1/Ur
To view this relationship between payroll growth, we normalise Non-farm Payrolls %-y/y and Personal Income %-y/y, and observe a leading relationship. The result is somewhat surprising – is indicative of much higher Personal Income growth (figure 6).
F6: Normalised payroll growth and personal income growth
It may be even more surprising that the bond market is also predicting somewhat higher wage-growth and inflation than at present.
This is not reflected in the absolute yields, or real rates net of inflation or wage-growth, but is visible in the 1s2s5s10s Treasury curve (figure 7).This curve is one of the few things that has forecasting value over future wage-growth. The sharp decline in wage-growth looks very much like the mid-80s, and the temporary deviation between wage-growth and the Treasury curve was followed up by a strong increase in wage-growth pace.
The recovery portion of this economic cycle has been dreadfully slow. For some time after the recession officially ended, it appeared we would never see growth again.
Swinging into a higher pace of wage-growth will close out the first chapter of this economic cycle. Demographics and capital structure will probably make for unimpressive mid-cycle growth, but so far, we really have been following the script of a recovery — just very slowly.
There is still political risk. Japan attempted to cut back government spending, and combined with the Asian financial crisis, it set them back a decade. The analogue between the United States and Japan, however, diverges in two key places: the demographics of Japan are far grimmer than in the United States, and the bubble was much larger.
It still may take some more clearing in employment, credit and housing markets, but the table has been set to transition from recovery to mid-cycle. Wage-growth climbing back up above the 2% level will be the sign I’m looking for to turn the page.