Wednesday, August 2, 2017

Where Did the Inflation Trade Go?

Over the past month, Crude Oil, Gold, and the US 10-year Treasury have all been advancing higher. On the surface the feedback from the price action is conflicting. I'll start with higher oil prices, as I believe it is leading the group, indicating higher producer and consumer prices down the pipeline.

According to the December 2015 Dallas Fed Economic Letter titled, 'Cheaper Crude Oil Affects Consumer Prices Unevenly', the pass-through time for the non-energy components of the Personal Consumption Expenditures (PCE) Index can be severely delayed. The Economic Letter highlights that though non-energy categories make up 95-percent of the PCE weight, it can take up to six months for 50-percent of the long-run pass-through of price changes in oil to materialize. And more than two years for consumers to realize the complete price adjustment.

For purely technical reasons, I see the price of a barrel of crude oil advancing and remaining above $50. The fundamental rationale will become apparent in time. With this assumption as my anchor, I can turn my attention to Gold, and the US 10-year Treasury. With Crude Oil trending higher over the interim, I would expect the price of Gold to also reflect the sentiment, driven primarily by demand from inflation hedging. The US 10-year Treasury then seems to be the odd-man, as its value is eroded by both realized and expected increases in consumer prices.

The last month's higher prices for the US 10-year Treasury also contradicts the rationale of a fixed-income market that is facing dual headwinds of explicit monetary tightening through FOMC rate increases, and implicit monetary tightening through balance sheet reductions via asset roll-offs. I interpret this to mean the trend of buying that has become apparent in the US 10-year Treasury market in the past month will be relatively short-lived, as there are macro-economic fundamentals that are working to push that market in the opposite direction.

My context for the Inflation Trade is Crude Oil leading Gold higher, and the eventual return to a sell-off in the 10-year Treasury market, especially as the Fed stops re-investing proceeds from maturing instruments.

Thursday, May 18, 2017

US Labor Market Disconnect - Productivity vs Compensation

The US labor market has been at the center of economic debates since we all realized that the Fed would not be able to generate positive inflation in line with long run expectations through monetary interventions. With the official unemployment rate at levels associated with full employment, one can reasonably expect to see consistent upward pressure on wages. This is not the case however. Basic reasoning would suggest that as workers become more and more productive relative to hours worked, they would be compensated more, but again, that’s not the case. Per Bureau of Labor Statistics data, since the Great Recession the divergence between labor productivity and labor compensation has been exacerbated.

The productivity-compensation gap—defined as labor productivity divided by labor compensation.

In the almost decade since the onset of the Great Recession, the issue of compensation not keeping up with productivity has been becoming more pronounced. Because so many workers got displaced during the Great Recession many people had to completely re-tool themselves for the labor market. With elevated levels of new entrants with limited levels of work-specific experience, wage pressures turned negative. This trend in conjunction with a rotation away from baby-boomers and towards millennials also means that technological adoption and implementation has been set on an accelerated path. 

The longer-term trend in labor compensation versus labor productivity was one of tandem movement, until about the mid-70s. This period reflects a macro shift away from manufacturing as the industrial base of the US economy to a more services dominated base. The shift also means that corporate productivity measures depend less and less on the input of labor, and more and more on the input of technological innovation. The decade covering the late 70s to the late 80s would have also been marked by large numbers of workers being displaced and having to re-tool themselves for the new labor market.
Its seems like the adage “History repeats itself…” rings true in this instance. Except for the caveat, that intrinsic problems in an economy left unattended for thirty years will only get worst over time.  This brings to mind one of the tenets of finance, compounding does work.

Sunday, April 30, 2017

To Tax, or Not to Tax? Is That Really the Question?

When tax reform is discussed, it is usually in terms of who gets a new tax cut and who loses a tax subsidy. This time around, individual taxes are (sort of) on the table. Looked at from an isolationist viewpoint, both individual and corporate taxes should be susceptible to increase or decrease going into the negotiation, as the end-goal in any tax reform debate in the US at this point, should be to increase revenue. But more realistically, in a globalized world only one of the two tax bases are mobile.

With that guiding principle, an ideal tax reform proposal should include both individual and corporate tax rates being realigned with the times. No politician wants to stand on the platform of higher taxes, so maybe America’s first non-politician president might want to give it a try. Point blank, individual tax rates in this country need to go up. Yes, people will complain, but the ones that use more of the services will be right here paying their taxes. Corporate tax rates on the other hand need to be lowered to bring them in line with other developed economies. The goal is to incentivize multinational and international businesses to setup shop in the US. An ideal outcome would be to see a reversal of the corporate tax inversion trend in the US, and eventually to see foreign companies inverting to be domiciled in the US.

The primary objective of corporate tax policy in the US is to drive private sector spending of cash that would otherwise be held and/or spent outside the country. To do this, companies need to be incentivized, and the path of least resistance for spending and investing for large multinational companies is the lowest tax rate jurisdiction. The potential for a net shortfall in corporate tax revenue should be outweighed by the potential social benefit of a sustained increase in both domestic and foreign corporate spending within the United States. Paired with an increase in individual income tax revenue, the social benefit from increased private sector spending should put marginally less strain on the Federal government budget.

Of course, no conversation about US tax reform is complete without at minimum a mention of entitlement spending. Lowing corporate tax rates and even increasing individual tax rates short of draconian levels will at best have a marginal effect on the overall fiscal position of the US Federal government. Real, tangible efficacy does not come into play until you start pairing net tax rate increases with decreases in entitlement spending. Not just cosmetic cuts, but deep slashes in social security and medicare spending. The burden will inevitably fall onto the states which would have to in-turn increase tax rates to cover the additional costs of providing social safety nets.

Private sector spending in increasing productivity needs to be met with a better educated, more flexible workforce. Which again the burden falls on the Federal and state governments to bolster the education system. There aren’t two ways about it, tax rates need to be increased in the United States. Of tax rates in general, individual tax rates need to be increased on a disproportionate scale to corporate tax rates, which need to be decreased to become more competitive on a globalized stage. This is a tall order for even the most agile, and well-versed politician, damn near impossible for someone relying on on-the-job-training. On the other hand, maybe this is the one time in American political history that the motives of a self-serving businessman align with what is best for the country. After-all, despite being the richest person to every run for President of the United States, Donald Trump managed to be most relatable to some of the poorer parts of American society. Good luck Mr. President.