Long-Term Trends

January 7, 2018January 7, 2018Leave a comment

January 7th, 2018

by Steve Stofka

This week I’ll look at a few long-term trends in the marketplace for goods and labor. Millennials born between approximately 1982 – 2002 are now the largest generation alive. Their tastes will dominate the marketplace for the next twenty years at least. In the first eighteen years of the new century, change has been a dominant theme.

Some businesses drowned in the rush of change. A former member of the Dow Jones Industrial Average, the film giant Eastman Kodak is a shadow of its former self after it emerged from bankruptcy in 2013.

Some in the music business complain that the younger generations don’t want to pay for music. Much of YouTube music is pirated material and yes, Google, the site’s owner, does remove content in response to complaints. There’s just so much of it. Album sales revenue in the U.S., both digital and physical, fell 40% in the five years from 2011 to 2016. Globally, the entire music business has lost 40% in revenues since the millennium and is just now starting to grow again (More).

Some in the porn industry make the same complaint as those in the music business. As online demand for porn grew, the industry helped pioneer digital payment security. Now there is too much free porn on the internet. Producers and distributors pirate each other’s content. Who wants to invest in good production values only to see their work ripped off? (Atlantic article/interview on the porn industry) Will the lack of quality reduce demand? ROFL!

An ever-diminishing number of city newspapers struggle to survive. Some complain that people don’t want to pay for local news. Local reporters have long been the bloodhounds who sniff out the corruption in city halls and state capitols around the country. There are fewer of them now. Think that corruption has been reduced? ROFL!

Surviving bookstores glance over their shoulders at Amazon’s growing physical presence in the marketplace. This year Amazon became the 4th largest chain of physical bookstores. The large book publishing houses try to preserve their hegemony as readers turn to a greater variety of alternatively published books.

As online sales grow, brick and mortar stores struggle to produce enough revenue growth to sustain the costs of a physical store. During the past three years, an ETF basket of retail sector stocks (XRT) is down almost 10%.

Hip-hop music was a fad of the ‘80s and ’90 until It wasn’t. Rock ‘n Roll was a fad that has lasted sixty years. In the early 60s, the Beatles were told to make it rich while they could, and they worked hard to capitalize on their success before it fizzled. Never happened.

How are we going to predict the future if it is so unpredictable? Some standards fade while some fads become standards. We face the past, not the future, as the future sneaks up on us from behind.

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Employment

A few notes on what was the weakest employment report of the past year. Job gains were only 150K as reported to government surveyors but the percentage of businesses responding to the survey was particularly low. Expect the BLS to revise those job gains higher next month when more of the survey forms come in. I have long used an average of the BLS numbers and ADP’s estimate of private job gains. That average was 200K – a healthy number indicative of a growing economy.

The long-term trend remains positive. The annual growth of total employment should be at 1.5% or above. We are currently holding that threshold despite the loss of jobs to automation and the growing number of Boomers retiring. Growth in construction jobs remains at or above the growth in total employment – another healthy sign.

ConVsPayemsGrowth

The employment market faces a long-term challenge as the largest generation of workers in history is retiring. In January 2000, 69 million adults were out of the labor force. That figure now stands at 95 million. As a ratio, there were 53 adults not in the labor force for every 100 adults with a job. Now there are 65 adults for each 100 workers.

NotInLabForceVsPayems

Although growth in hourly wages is at 2.5%, weekly paychecks have grown 3% as part-time workers get more hours or find full-time jobs. Look for inflation to approach that growth in paychecks.

WeeklyEarnVsInflation

When inflation rises above paycheck growth, workers struggle more than usual to balance their income with spending. I’ll use that same chart to highlight some stress points during the past decade.

WeeklyEarnStressPoints

As the economy continues to improve, the Fed is expected to continue increasing interest rates either two or three times in the coming year. After a decade of zero interest rates (ZIRP), those with savings accounts may have noticed that their bank is paying 1% or more in interest. It is still a far cry from the 4% to 5% rates paid on CDs in the ’90s and 2000s. This past decade has been particularly worrisome for older folks trying to live off their savings.

Intervention

August 27, 2017August 26, 2017Leave a comment

August 27, 2017

Pew Research surveyed four generations of Americans, from the oldest Americans who are part of the Silent Generation, those who grew up during the Great Depression, to the Millennials, those born between the years 1983 – 2002. Pew asked the respondents to list ten events (not their own) or trends that happened during their lifetime that had the most influence on the country. 9-11 was at the top of the list for all four generations. Obama’s election, the tech revolution and the Iraq/Afghanistan war were the other events common on each list. Some differences among the generations were understandable. Some were a surprise to me. The Great Recession/Financial Crisis of 2008 was only on the Millennials list. Many in this generation were in the early stages of their careers when the recession began. Here is a link to the survey results. Perhaps you would like to make your own list. Keep in mind that the events must have happened during your lifetime.

I don’t think that the Boomer generation understands the long-term impact of the Great Recession. In another decade, many will discover how vulnerable the financial crisis left all of us, not just the Millennials. As we’ll see below, the crisis may be over but the response to the crisis is ongoing.

One of the trends common to each generation’s list was the tech revolution, which has reshaped much of the economy just as the last tech revolution did in the 1920s. The widespread use of electricity, radio and telephone in that decade transformed almost every sector of the economy and accelerated the mass migration of the labor force from the farm to the city.

Like today, a small number of people made great fortunes. Like today, the top 1% of incomes accounted for about 15% of all income (Saez, Piketty). The GINI index, a statistical measure of inequality of any data set, has risen significantly since 1967 (Federal Reserve). The GINI index ranges from 0, perfect equality, to 1, perfect inequality. Incomes in the U.S. are more equal than South Africa, Columbia and Haiti (Wikipedia) but we are last among developed countries.

For several decades, Thomas Piketty and Emmanuel Saez have collected the aggregate income and tax data of developed countries. Piketty is the author of Capital in the Twenty-First Century (Capital), which I reviewed here. A recent NY Times article referenced a report from Piketty and Saez comparing the growth of after-tax, inflation-adjusted incomes from 1946-1980 (gray line labeled 1980) and 1980-2014 (red line labeled 2014). I’ve marked up their graph a bit.

IncomeGrowth1947-2014
The authors calculated net incomes after taxes and transfers to determine the effect of tax and social policies on income distribution. Transfers include social welfare programs like Social Security, TANF, and unemployment. Census Bureau surveys of household income include pre-tax income and it is these surveys which form the basis for the calculation of the GINI index and other statistical measures of inequality.

I am guessing that Piketty and Saez used their database of IRS post-tax income data then adjusted for transfer income based on Census Bureau surveys. The Census Bureau notes that people underreport their incomes on these surveys. Is the IRS data more reliable? Probably, but people do hide income from the IRS. Both Piketty and the Census Bureau note that the data does not capture non-cash benefits like food stamps, housing subsidies, etc.

From 1947 to the early 1960s, the very rich paid income tax rates of 90% so that would seem to explain the after-tax income data from Piketty and Saez. The federal government took a lot of money from the very rich, paid off war debts, built highways, flew to the moon and built a big defense network to fight the Cold War. Those infrastructure projects employed the working class at a wage that lifted them into the middle class. So that should be the end of the story. High taxes on the rich led to more equality of after-tax income.

But that doesn’t explain the pre-tax income data from the Census Bureau. The very rich simply made less money or they learned how to hide it because of the extremely high tax rates. In the Bahamas and Caymans, there grew a powerful financial industry devoted to hiding income and wealth from the taxman. In the first years of his administration, President Kennedy, a Democrat, understood that the extremely high tax rates were hurting investment, incentives and economic growth. He proposed lowering both individual and corporate rates but could not get his proposal through the Congress before he died. Johnson did push it through a few months after Kennedy’s death. The rate on the top incomes fell from 91% to 70%, still rather high by today’s standards.

An important component of income growth in the post war period from 1947-1970 was the lack of competition from other developed countries who had to rebuild their industries following World War 2. These two decades were the first when the government began collecting a lot of data, and this unusual period then became the base for many political arguments. Liberal politicians like Bernie Sanders and Elizabeth Warren advocate policies that they promise will return us to the trends of that period. It is unlikely that any policies, no matter how dramatic, could accomplish that because the rest of the world is no longer recovering from a World War.

We could enact a network of social support policies that resemble those in Europe but could we get used to a 10% unemployment rate that is customary in France? For thirty years beginning in the early 1980s, even Germany, the powerhouse of the Eurozone, had an unemployment rate that exceeded 8%. At that rate, many Americans think the economy is broken. Despite 17 quarters of growth, unemployment in the Eurozone is still 9.1%. Half of unemployed workers in the Eurozone have been unemployed for more than a year. In America, that rate of long term unemployed is only 13% (WSJ paywall).

The post-war period was marked by high tax rates and high federal spending, a period of robust government fiscal policy. The federal government intervenes in the economy via a second channel – the monetary policy conducted by the central bank. The Federal Reserve lowers and raises interest rates, and adjusts the effective money supply by the purchase or sale of Treasury debt.

The 1940s, 1970s and 2000s were periods of high intervention in both fiscal and monetary policy. The FDR, Truman, Eisenhower, Johnson and Nixon administrations exerted much pressure on the Fed to help finance war campaigns and the Cold War. In 1977, the Congress ensured more independence to the Federal Reserve by setting two, and only two, clear objectives that were to guide the Fed’s monetary policy in the future: healthy employment and stable inflation.

A rough guide to the level of central bank intervention is the interest rate set by the Fed. When rates are less than inflation, the Fed is probably doing too much in response to some acute or protracted crisis.

EffFundsRate-Infation

Let’s look at an odd – or not – coincidence. I’ll turn to the total return from stocks to understand the effects of central bank policies. There are two components to total return: 1) price appreciation, and 2) dividends. When price appreciation is more than 50% of total return, economic growth and company profits are doing well. Future profit growth looks good and more money comes into the market and drives up prices. When dividends account for more than half of total return, as it did in the 1940s and 1970s, both GDP and company profit growth are weak. Both decades were marked by heavy central bank and government intervention in the economy.

Here’s a link to an article showing the total return on stocks by decade. During the 2000s, the total return from stocks was below zero. An average annual return of 1.5% from dividends could not offset an annual loss of 2.4% in price appreciation. Hubris and political pressure following 9-11 led Fed Chairman Alan Greenspan to make several ill-advised interest-rate moves in the early 2000s that helped fuel the housing boom and the ensuing financial crisis. His successor, Ben Bernanke, continued the policy of heavy intervention. Following the financial crisis, the Fed kept interest rates near zero for nine years and has only recently begun a program of gradually increasing its key interest rate.

The price gains of the 2010s have lifted the average annual return of the past 18 years to 7.4%, and the portion from dividends is exactly half of that, at 3.72% per year. It has taken extraordinary monetary policy to rescue investors, to achieve balanced returns that are about average from our stock investments. Some investors are betting that the Fed will always come to the rescue of asset prices. That same gamble pushed the country to the financial crisis when the government did not rescue Lehman Brothers in September 2008.

The financial crisis should have been on each generation’s list. Within ten years it will be. It is still crouched in the tall grass.

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Debt

Happy days are here again. Yes, girls and boys, it’s time to raise the debt ceiling! By the end of September, the Treasury will run out of money to pay bills unless the debt ceiling is raised. This past week, President Trump hinted/threatened that he would not sign a debt increase bill unless it included money to build the wall between the U.S. and Mexico.

The Congress has not had a budget agreement in several years and is unlikely to enact one this year. People may sound tough on debt but a Pew Research study
showed that a majority do not want to cut government programs, including Medicaid.

Liberal economists insist that government debt levels don’t matter if the interest on the debt can be paid. This article from Pew Research shows the historically low rate on the federal debt. However, Moody’s reports that the U.S. government pays the highest interest as a percentage of revenue among developed countries. As a percent of GDP, we are 4th at 2.5%.

River Rafting

July 16, 2017July 23, 2017Leave a comment

July 15, 2017

After a good year of snowfall in the Rockies, the rivers run strong. A popular spot for rafting is the Colorado River as it runs through the dramatic scenery of the Glenwood Canyon in western Colorado. Investing is a lot like rafting. We can’t control the amount of snowfall, the change in elevation, where the rocks are or the streams that feed into the river.

Our individual and group behavior on the river can help or hinder our progress. In a good year, rafting companies charge more for a rafting adventure. As more people come onto the river, we must pause in quiet water at the river’s side to give a safe distance between rafts. This crowding effect is made worse by stretches of river that require more caution to navigate. We can steer right or left to avoid some rocks but we are largely at the mercy of the river and each other.

Since the budget crisis in the late summer of 2011, the stock market has enjoyed a fairly strong run, more than doubling since that time. The financial crisis nine years ago was like a winter of extraordinarily deep snowfall. The Fed has kept interest rates abnormally low to thaw that snow, and equity investors have had a wonderful ride.

The Federal Reserve has committed to a series of gradual rate increases. Despite the low rates, people continue to pour their extra money into savings accounts and CDs. Wells Fargo is paying almost 1% below the Fed discount rate on their savings accounts. Why? As long as their customers are willing to accept savings rates of .3%, Wells Fargo has no incentive to raise rates. Discover, Goldman Sachs, American Express, Ally and Synchrony are paying about 1.15%, the Fed rate. (Bankrate) Savings account balances are near $9 trillion, more than double the balances in late 2007 before the recession began. The fear lingers. Many people stand on the shore, too cautious to ride the river’s tumble and flow.

Until 2015, retail sector stocks (XRT) have been on a fast raft, quintupling from the market lows of March 2009. Over the past two years they have drifted into a side pool, losing about 20%. This year the stocks have been quite volatile as investors gamble on the future of the retail industry. Will Amazon continue to take sales from traditional brick and mortar stores?

June’s retail sales (RSXFS) were disappointing. Year over year growth was 3%, less than the 5 year average of 3.3%, and far below the near 5% growth of the 1st quarter. Excluding auto sales and auto parts (RSFSXMV), annual growth was only 2.4%, a 1/2% below the five year average and half of the 1st quarter rate.

The Trump administration and the Republican Congress have aimed for 3% real – inflation adjusted, that is – GDP growth. In an economy that depends so heavily on consumer sentiment, slowing retail sales will make that growth goal difficult to achieve.

For now, the sun is shining, the river is running strong and I am enjoying myself. As long as I don’t look around the next bend in the river, everything looks fine!

Investment Declines

September 4, 2016January 27, 2017Leave a comment

September 4, 2016

The market seems awfully quiet leading into September, a month that is the most consistently negative for the past century. LPLResearch notes that it has been about 35 years since the market was this quiet for this long. It has been 30 trading days (at the end of August) since the SP500 had strayed more than 1% from its 10 day average. A year ago in August 2015 the market spent 17 trading days in this quiet zone then fell 6% in 3 days. In September 2014, the market acted like a sailing ship in the horse latitudes before sinking 6% over the following ten days. We wish the market went up after these long quiet periods, but the trend is usually down.

Investment

Let’s look at a disturbing long term trend – a decline in private investment in housing (residential), as well as factories, equipment and office buildings (non-residential). What is private? Non-government, i.e. companies and individuals in the private market.

First, let’s look at private investment as a whole before we look at the parts. As a percent of GDP, we are near post-WW2 lows.

“Oh, that was the housing bubble and financial crisis,” we might say. Everytime we think we’ve got it figured out, that is the beginning of the journey of learning, some Zen master probably said at some time. Be humble, little tree frog, or wax on, wax off. Something like that.

Only this year has the economy surpassed the 2008 level of inflation adjusted private investment. To get a sense of the damage done by the financial and housing crisis, the chart below is a rolling 5 year sum of investment and covers most of the post-WW2 period. Look at the historic dip – not a pause, not a flattening, but a genuine crater in investment growth. Here we can see the over-investment during the tech bubble of the late nineties when the 5 year sum climbed at a 60 degree angle, followed by the 45 degree climb as the housing bubble climaxed. Even scarier is the possibility that we may still be above the growth trend of the 70s, 80s and early 90s – that there is still a bit of correction left.

Housing Investment

Seven years after the official end of the recession, ten years after the height of the housing bubble, investment in residential housing is still near all time lows. As a percent of the economy (GDP) it has been rising but from a great depth.

Slow household formation after the financial crisis, i.e. Johnny and Mary staying home or moving back in with Mom and Dad, has contributed to the slow recovery in housing investment. The millennial generation, bigger in numbers than the aging Boomers, doesn’t have the same preference for owning their own home. Census Bureau data shows that the home ownership rate in the under-35 crowd has declined from 39% in 2010 to 34% in 2016. While it may be more noticeable in the millennial aged cohort, the data shows a decline in all age groups, and across incomes (page 10). Competition for a dwindling stock of apartment rentals has caused a sharp rise in median rental rates across the country.

Why a dwindling number of rental units? As home ownership rose in the 2000s, the investments in new apartment building began to decline in 2007, then fell abruptly during the crisis. Only in 2011 did it finally start to rise up from its trough. The drop in investment was so huge that just posting a number doesn’t do it justice. Millennials are now being squeezed by a lack of rental housing stock. Sharply rising home values in popular areas like Denver make it more difficult for millennials to shift preferences to home ownership.

The business Side

Now let’s look at investments in office buildings, equipment and factories. These can be somewhat cyclical but the long term trend is down. Since China was admitted to the WTO in 2001, the highs in the cycle have been trending lower. During the 2000s Americans were not saving enough to fund business investment growth and our economy increasingly relied on foreign investment dollars. Today we are on the decline in that investment cycle and we can expect further declines.

Does low inflation hurt investment?

It makes sense that a stable environment of low inflation should encourage business investment. Low interest rates should encourage lending to business, etc. This is the conventional narrative that has guided policy making at the Federal Reserve. Stop an economist on the street and ask them if low interest rates encourage business investment and they will probably say yes. Here’s a quote from an economics course “If the expected rate of return [on the new investment] is greater than the real interest rate, the investment makes sense.”

Makes sense but what if it is partially wrong? Is it possible that low interest rates could, in some cases, discourage investment? This is the opposite of the conventional narrative but let’s walk this path for a bit. We often think of interest rates as a dependent variable, a response to something indicating a demand for money. What if it is also an independent variable, a cause affecting the demand for money? Yep, it’s one of those interdependent cyclic things that might make you want to meditate on the universality of love and being, but stay with me 🙂

Interest rates can be a heuristic for investors, a signal of the demand for money, a weather vane of the underlying strength of the economy as seen by the top economists in the country, the folks at the Federal Reserve. Low rates could be seen as a cautionary warning to investors. If the economy were really getting stronger, would interest rates remain low? Of course not, an investor might reason. They would rise in response to stronger demand for money. But they are not rising so better to be cautious, the investor reasons. The dog chases its tail.

Do low interest rates cause reckless borrowing?

Are low interest rates prompting companies to borrow excessively? Well, yes and no. Yes, they are borrowing more but the growth trajectory, the rate of growth, is about the same as it has been since 1990. As we can see in the chart below, each recession is a pause in the growth of corporate debt. After each recession, the level rises again on approximately the same slope. The “pause” in this last recession lasted a whopping four years, during which corporate debt declined as much as $600 billion, or about 5.6%.

The problem is what they are borrowing it for. Companies typically buy back their own shares at their hghest, not lowest value. By lowering the number of shares outstanding, buybacks raise the earnings per share even if there is no real growth in earnings. Instead of buying low, selling high, companies tend to buy high, sell low. FactSet gathers and crunches a lot of market data. Their mid-year analysis of share buybacks shows that total dollars spent on buybacks is approaching the highs of 2007. Investment in real growth, in productive plants, equipment and office buildings, has declined the past three quarters but share buybacks, the appearance of growth, have increased.

A simple example

How could low inflation hurt investment? If predicted inflation is rather low, about 2%, sales growth will not get that extra kick from inflation. Let’s say that a company’s sales are $1000 and the owners have an extra $50 to invest. They are considering a plan to invest $50 and borrow $50 from the bank to expand in the hopes of making more sales.

First they consider the return by not expanding. They put their $50 in the bank and make 2% interest or $1. At 2% inflation, $1000 sales grows to $1020. Let’s say that the company has a 30% gross margin, which gives an extra $6 profit on the extra $20 in sales. The combined extra return to the owners is $7, a $6 profit and $1 in interest income.

Then they consider a second scenario. Let’s say that the interest rate on the borrowed money is 6%, or 4% above the inflation rate of 2%. As in the first scenario, they assume that the savings rate, or opportunity cost, of the invested $50 is about 2%. The owners can expect an extra $4 imputed and actual cost on that combined $100 of investment. If inflation is averaging 2% per year, then they can expect sales of $1020 even if there is no real sales growth. Again, they use a 30% gross margin to arrive at an extra profit to them of $6, the same as the first scenario. If the extra investment does not produce any real sales growth, then the owners will net an extra profit of about $2, much less than the scenario of no expansion. To make the same extra profit as in the first scenario, the owners need to generate an extra $11 in profit. Minus the $4 in costs, the extra profit will be $7, the same as the first scenario. Note that the owners are now trying to break even with the extra profits of not expanding. To do that they must have sales of about $1037, or almost 2% real sales growth in addition to the 2% inflation growth.

Now, let’s consider a higher inflation rate of 4%. Let’s imagine that the cost to borrow money is 8%, or 4% higher than inflation, as before, so that the cost of borrowing the $50 for a year is $4. As before, we’ll assume that the savings rate, or opportunity cost, of the $50 from the owner’ pockets is the same as inflation, or 4%, so that the imputed cost of the owners’ investment is $2. Borrowed and imputed cost of the extra $100 invested in the company is now $6. If there is no real sales growth, total sales will now be $1040, or $40 more. A 30% margin gives a gross profit of $12, leaving the owners with about $6 extra profit on investment.

Note that a doubling of the inflation rate in this scenario has produced a tripling of extra profit even with no real sales growth. Still the extra profits are less than not expanding at all. They must still have a real increase in sales, but it is very small.

So a stable higher inflation rate and interest rate encourages business investment. The key word here is stable. We could keep doing this calculation with higher and higher rates producing more net profits to the owners but…. As inflation gets higher, it becomes less stable, less predictable and this unpredictability actually hurts business investment.

The Federal Reserve has set a target inflation rate of 2%. I think it is too low and the lackluster growth of the economy seems to bear that out. Since the 1970s, prominent economists (Taylor and Tobin, for example) have suggested alternative targets that the Federal Reserve could use to replace the “dual mandate” set by the Congress in 1977.

A prominent alternative is a growth target in nominal GDP, called NGDP, There are several variations but the one most favored has been level targeting, the calculation of GDP targets over the following five years or so based on an agreed growth rate. The Fed would then take action to offset deviations from those targets. Two prominent economists, Robert Hall and Greg Mankiw, wrote a paper in 1993 explaining these alternative targets and the policy tools that the Federal Reserve could employ to help reach those targets. During the period called the “Great Moderation,” from 1985-2007 national income grew at a rate just a bit more than 5%.

Hall and Mankiw noted (pg. 5) that the consensus among macroeconomists at that time was in favor of a targeting of nominal national income because it was a transparent measure, a clear, simple target. The authors commented (pg. 4): “A rule like ‘Keep employment stable in the short run but prevent inflation in the long run’ [the current rule, by the way] has proven to be hopelessly vague; a central bank can rationalize almost any policy position with that rule.”

So the idea of nominal income or production targeting is familiar to economists and policymakers for several decades but has never been adopted. We can only assume, as the Nobel winner James Buchanan posited, that there is a very good reason for that. When an obscure policy remains in place, it does so for a reason. Enough policymakers want the obscurity that the policy provides. I’m reminded of a letter John Adams wrote to Jefferson lamenting some of the vague language used in the Constitution which both of them had helped to craft. Adams noted that the vagueness was necessary to reach consensus at the Constitutional Convention. Efforts to achieve more precision in language or attempts to add specific detail were sometimes met with hardened disagreement. The “general Welfare” wording of the tax and spending clause, Section 8, was one example. Some argued that the lack of precision would give future generations of lawmakers some flexibility in determining what, in fact, was the general welfare of the United States.

Whatever the Fed is doing now is only partially working and a different approach might be in order. The use of the Labor Market Conditions Index, a broad composite of over twenty employment indicators, in guiding monetary policy shows that the Fed is reaching for a broader set of guidelines. As Hall and Mankiw indicated, nominal targeting might give the Fed that broad guide, one that is less influenced by the needs and whims of elected politiciams.

Investment decline and the stock market

Let me finish on a somber note. The year over year growth rate in the SP500 and private investment have both gone negative this year, for the first time since the end of the recession in 2009. The SP500 data is copyrighted so here’s a link to that chart. Pay attention.

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Notes:
If you would like to read more on the relationship of investment to savings, check out this 2006 NBER paper.