Changing Dynamics of an Evolving Economy

In March of 2013, I had a short post titled “Entrepreneurship and the Small Business is going to be the Saving Grace of the US Economy”. Well a couple weeks back, I’m reading an Economic Letter from the Federal Reserve Bank of San Francisco, published July 7^th, titled “Slow Business Start-ups and the Jobs Recovery”, and it seems to be carrying the same theme as the March 2013 post, albeit more quantitative by design.

The Economic Letter was highlighting the relationship between housing values as a primary source of financing for entrepreneurial endeavors, and the level of new job creation experienced post 2008-2009 recession compared to previous (deep) recessions. 

Things were coming along smoothly until the topic turned to juxtaposing the rates of job creation post-recession for start-ups versus mature firms over time. Comparing cross-sections of the data, we see that indeed start-ups have been responsible for a disproportionately larger share of new job creation versus mature firms when compared to their relative shares of the overall labor market. An observation which has held true for many previous recessions. 

But when the dots are connected over time, a trend starts to emerge, and not a pretty one at that. That ‘Saving Grace’ that I alluded to in the March 2013 post has been losing its luster. Now, being that there are two aspects to this statistic, it’s only fair to consider them both to pinpoint the culprit. Granted both start-ups and mature firms have been – over the same period of time – creating marginally less jobs post-recession, the start-ups seem to have had an exacerbated decline in growth rate.  The overall resulting effect has been a downward trend in the spread of the growth rate of jobs created post-recession by start-ups over that of mature firms. This is of course worrying, as start-ups have historically been the predominate source of job creation growth.

 

Getting back to the relationship that the Economic Letter was initially highlighting between home equity values and the level of entrepreneurial activity; home equity values have not been reflective of the trend in the growth rate of start-up job creation. Instead, when looking at historical comparisons, home equity values have been trending higher, and this even includes the housing market crash that was associated with or caused (depending on how you look at it) the 2008 Global Financial Crisis. 

In my opinion, the increase over time of home equity values is a function of the continual increase in the housing stock. Even during the deepest and darkest of recessions, we never stop building homes, we just reduce the number that are built. As well as, the US has not had an outright deflationary cycle where asset prices on a broad base fall over time, represented by negative inflation measures.

That being said, the driver of the observed trend in the job creation growth rate of start-ups has to be more fundamental than depressed home equity values post-recession. Little to no real (inflation adjusted) wage growth, paired with increasing labor productivity over the past almost two decades, speaks more closely to what is being observed with start-up job creation.

In a capital-intensive economy like the United States, investments in technology as well as the pernicious death of manufacturing and heavy industrial production, paired with the simultaneous expansion of services and other less labor intensive sectors of the economy is resulting in less marginal demand for labor. Less marginal demand is being represented by a decline in the growth rate of the more sensitive source of job creation, and less of a premium for labor represented in stagnating wages over time, even as labor has been increasing in productivity this entire time.

Here’s [an opportunity for] a silver lining, as waves and waves of baby boomers retire and leave the workforce, and we continue to see the effects of a falling birth-rate on the supply of labor, there may be some upward and well needed pressures on wages. However, technological development does tend to occur at an exponential rate, and I am yet to see a model that forecasts marginal declines in labor supply at an exponential rate.

No doubt, labor productivity will continue to increase-- driven predominantly by technological development-- while the marginal premium placed on that labor will continue to move in the opposite direction.

Best argument I can make for investing in education.

The Tale of Seven Banks

There once were seven central banks (that I follow), that each had an economy and an actively traded currency, and all was well in the world. Fast forward through a global financial crisis to today and the world economy is recovering, being led by the US.

The US economy being shepherded by the Federal Reserve, is doing OK. Growth is slow but steady, and inflation, as monitored by the Fed, is trending below its long-term averages. Both the previous Fed Chair Bernanke, and the current Fed Chair [and Bernanke disciple], Janet Yellen, have stated that the Fed will be willing to accept inflation above its long-term trend as long as employment and GDP lag behind.

The Bank of Canada is dancing to a similar tune, as wages and other drivers of core price inflation in Canada remain stymied. The same can be said for the Bank of England, and the Bank of Japan where again inflation targets are quantified by the central banks and reflected in their monetary policies . Wages in the US are not increasing because of slack in the labor markets, but that problem is slowly fixing itself. In the United Kingdom, wages are not increasing for a similar reason, but, they are however, dealing with real estate prices that are growing faster than incomes (especially in London) being driven by foreign buyers. The Bank of Japan is in the process of undoing almost 20 years of economic stagnation, and price deflation. Prices, wages, and interest rates have been falling since the early 1990s, but now monetary and fiscal policy are both being aligned to support the intended shift in the macro-economy.

The remaining three banks are the Reserve Bank of Australia, the European Central Bank, and the Swiss National Bank. Each one with its own set of ‘personal’ problems to contend with. In Australia, the issue is the slowdown in Chinese growth in manufacturing, for which Australia exports the bulk of the raw materials it mines. The slowdown is rippling through the Australian labor market which happens to be heavily weighted in the [you guessed it] mining sector. On the European continent, Germany is starting to show signs of exhaustion as its customer -- the rest of Europe -- is not doing so well. The other major players including France, Italy, and Spain and some minor ones are focused on government bond yields while economic growth stagnates and prices fall. In Switzerland, where money goes to hide when there is risk afoot on the continent, the Swiss National Bank has to guard its economy against capital flight from the Euro area to their little haven.

Each of these banks has ended up in a unique position, stemming from global rebalancings due to half a decade plus of emergency monetary policy, but none more precarious than the Fed. Central Bankers around the world are taking their cues indirectly from the Fed; as Chinese domestic consumption is not yet able to replace the shortfall in US consumption. The rest of the world is waiting for someone to step up and buy. Europe needs time to find a new economic equilibrium, as debt and low productivity work their course, while the US, who is on a similar path just has a head-start and a more resilient economic base.

Central Bankers were able to co-ordinate monetary policy stimulus in response to the global financial crisis; but the panic was universal. The timing of the undoing is not so universal now that it’s safe to call an end to the crisis. The Banks must now normalize their policies and let the (somewhat) free markets get back to the tedious work of setting prices from wages, to interest rates, to gold, and real estate.

Summer 2014 Part 2

Bond investors have enjoyed the first part of a rollercoaster ride over the past five or six years. Anyone that has been holding onto a portfolio of bonds and other debt instruments that were issued “pre-crisis” have seen their portfolio benefit from interest rates around the world racing to the bottom.

As all good things must come to an end, so must the bull market for debt. Monetary cycles across the globe are normalizing, with the exception of the mainstays of the developed economies. But they too, as growth begets growth, will begin to normalize as well. Leading the way is the Federal Reserve with its hand firmly on the short end of the yield curve holding short term rates low. It is playing the role of buyer of last resort in the long end of the curve as well, to help stimulate the housing market by restraining mortgage and other long term borrowing rates. The Fed has begun consistently tapering its long maturity debt buying and will soon give up its active influence over long term interest rates. At which point, I think it’s safe to assume long term interest rates will start drifting higher.

The next step in the normalization process, would be to raise short term rates. If the Fed lets the long end of the yield curve drift higher and continue to hold short term rates this low, the market might start pricing in higher inflation expectations. If this happens, and the Fed does actually need this to happen, they can raise short term rates to stem price inflation.

As this plays out, bond portfolios will see price depreciation as the securities are re-priced to match the rising interest rates or inflation expectation.

Best course of action for a bond investor sitting on a portfolio of securities that have appreciated; take profits. Starting with the longest maturity securities and work your way backwards. There really isn’t much in the way of hedging the interest rate risk that the average debt portfolio faces from this point going into the next five years. But, since the Fed should not be under any undue pressure to raise short term interest rates until the summer of 2016, the short end of the yield curve (3 – 6 month maturities) would be a safe place to shelter the fallout from the monetary normalization cycle that is in a nascent stage in the US, and a growing list of economies around the world.