ADER’S MUSINGS, 2.9% - 2.9% = 0

September 7, 2018 

* Trump flirting with a “good” government shutdown in October to fight for his wall?!?  -- brilliant strategy to distract public from Woodward book, Deep Throat Op Ed. * 10 years after…debt levels at forefront of economic risks. -- debt levels reaching pre-crisis peaks. * Health care costs enter wage narrative,   -- Contingent jobs responsible for 94% of new job creation?   * Repatriation post tax reform surges, boosts buybacks vs. investment. * Fine NFP requires math -- YoY AHE up 2.9 minus 2.9% CPI means 0% real gain.

We’re about to hit the 10th anniversary of Lehman’s demise which I suspect will be the subject of some dubious nostalgia. Bear in mind, that the economy and markets were well under pressure long before this benchmark event -- the S&P 500 had peaked a year earlier. (For context, I rebased the S&P 500 to 100 at the peak and the day before Lehman’s demise it was just under 80 on its way to 43.6 in March. Today it stands at 185.)  

Let me go over my perspective of what’s changed with an eye to new, or renewed risks, suggesting that history can repeat itself.

In these last 10-years there was a reduction/consolidation of Primary Dealership with a consequent reduction in liquidity providing that was offset by the simple demand for the instrument in question, Treasuries, and then bouts of QE here and overseas that soaked up the supply. Then, between the expansion of the crisis to Europe’s peripherals, the Greek thing, and broad derisking that kept growth and inflation subdued, interest rates ran, still do, remarkably if somewhat artificially, low. Negative rates became a new phenomenon, even as they failed to provoke the sort of recovery they were intended to provoke.

Bank regulations, capital going to risk taking positions and the need to hedge the massive mortgage portfolios and pipelines of the agencies and big mortgage banks went away, as did the jobs that went with that activity.  New product creation, especially from mortgage related areas, has really dried up, not necessarily a bad thing.

Central banks and algo funds have filled a liquidity void left by a diminished primary dealer community and even there I sense that a handful of firms are dominating. A conference I attended a couple of years back named some of the biggest ‘traders’ in the Treasury market and they were firms I’d never heard of. A few large banks cited internalizing activity, like deal hedging, implying that more peripheral firms were scrambling for smaller and fewer scraps. One day there will be a need of more liquidity depth, especially with rising Treasury issuance, but that will happen at an economic/market turn and for now, relative stability warrants complacency. 

US households have gotten themselves into much better shape (looking at Debt Service Ratios) even if we consider that a lot of that was forced; people lost their homes, went bankrupt, lending standards tightened, and the aging population may have gotten religion. Oh, he’s not going to talk about that again, is he? Yes, he is. In 2007 the median age here was 36.7. Today it’s 37.9 and going north of 40 in, hopefully, our lifetimes. Meanwhile, the 55+ cohort was just 30.6% of the population before the crisis against 35.2% today and 36.5% in 10 years. Older people need less, so spend less and borrow less. The experience of 2008/9 surely scared them to follow a path that, demographically speaking, they would have followed otherwise. Just with more vigor.

Have no fear, people are catching up. Credit card debt is about $830 bn today vs. $870 bn at the peak while all revolving credit is $1.04 trillion over the 2008 peak of $1.02 trillion. And student lending is doing wonderfully unless you’re the student at $1.4 trillion, nearly triple the level from 2007, and today 30.5% of Consumer Credit from 4.5% in 2007.

Overall debt in the US is 249% of GDP. When Lehman went under it was 235% rising to 250% at the peak of the recession.  The rise, of course, is largely about Federal debt at 77.4% of GDP (or 105.7% if you use the broad measure) from 40.4% 10 years ago (69.6% with that broad measure). That doesn’t take corporations off the hook. Corporate debt is 45.2% of GDP, a bit higher than where it was when Lehman went bust and a tad higher than just before the Y2K bubble burst.

This is all to say, that when we look back at the next recession, it surely will be this level of indebtedness. I wonder how the recent corporate tax breaks, which will further boost the Federal deficit, will stand with the household public when that happens. I will be called on this, I know, but “Make America Great(ly) In Debt Again” could be the legacy of the last few years.

To be fair, it wasn’t Trump’s fault before this tax bill. Too, the global story warrants its own note of discontent.  Global debt as a % of the world’s GDP was 286% when we were watching pictures of Lehman employees carrying out their boxes. Today it’s 318%.

 To all that I’ll note the rise in populism in much of the developed and underdeveloped world, which has implications I’m trying to fathom. That may prove economically good for a brief spurt to domestic economies (trade), but ultimately economically dampening and politically dangerous. Nationalism leads to economic competition and that can lead to conflicts of another nature. “War,” to paraphrase Von Clausewitz, “is a mere continuation of politics by other means.” That is a new risk we didn’t have 10 years ago.

Too, on a more prosaic level (I pray), we have limitations to traditional policies when we have another financial crisis or simple recession, both of which I can see as debt inspired. Interest rates are still low by historic standards, more so elsewhere in the G7, and debt as posited above, is frighteningly high and all the more so given we’re still in expansion mode when tradition tells us we should be paying down debt, not adding to it. The implication is that we have borrowed tomorrow to consume today and at some point that has to be paid back.

I’m depressed at my own words.

Lehman was a particular moment in time, I get that, but things had turned before then when the markets started to wake up to then debt valuations and balked, got worse with Lehman, forced government and central bank action the likes of which we’ve never seen, and, 10 years on, have put debt very much back into the worry frame. I think we at least know where to look for the cavity in the economic tooth so to speak.

The structure of the market is something I think has gotten too little attention. I refer to 1) the rise in Treasuries and duration in a bond index, 2) the rise in passive vs. active investment making indexes more of a market influence, 3) the lower credit quality on the corporate side of market (the weighting of BBB in that index), and the 4) less ‘defensive’ nature of the S&P 500, with defensive stocks holding a lower weighting. I think we need to focus on structure of markets at least as much as pure economics to guide investment strategy.

I suppose this is a way of saying that history repeats itself. If the state of debt I outline is the cause of the next round of problems, economies will have less ability via monetary and fiscal policies to deal with them in big gun fashion. Thus, I suspect that central banks, certainly politicians, might tolerate some inflation relief on the debt side, but I think bond and equity markets will be quick to respond.  

 CHARTS AND THEMATICS:  A colleague sent me a piece from the Washington Post that warrants attention. It’s not really newsy but I think is part of an ongoing story that helps explain why wages are so stubbornly stagnant, especially on a real basis.  This one is a column by Robert Samuelson and goes hand in hand with the chart that ensues. I’s title? “Where did our raises go? To health care.” The chart I refer to shows the angle which is that Wages & Salaries as a % of Compensation have dropped 3% since 2004 and by more than 7% from the 1990s. Surely, higher health care costs factor into that. Likewise, Wages & Salaries as a % of GDP has slid to 43.1% from an average of 46% from 1980-2000, and 43.4% from 2003 to today. That’s problematic in a consumer society.

Back to the column. The column goes over the dry statistics about the low unemployment rate and new job creation and contrasts that with low wages gains. Samuelson rounds up the usual suspects: well paid retiring workers replaced by lesser paid younger workers, greater concerns with job security post the recession, and mismeasurement of wages. But his emphasis is on health-care costs diverting money that might otherwise have gone to wage gains. The bottom 60% of workers have, he says, seen any wage gains totally wiped out by increased contributions to their health insurance plans. It’s not a surprise per se, but the numbers are eye opening; 1999 to 2015 premiums for a family rose from $2,000 to $5,000 in real terms.  

For more depressing details, read a report from Will Towers Watson entitled “Health care USA: A cancer of the American Dream.” (https://goo.gl/N1hc9A). That study notes that employers allocated 41.9% to health care and 58.1% to retirement benefits in 2001. Today that split is 63.5% to health care and 36.5% to retirement.

There’s also the rising cost of the deductibles. A study a couple of years ago by the Kaiser Family Foundation had it that 80% of workers have a deductible averaging about $1,500 (and more like $2,000 in firms with fewer than 200 people) and that in the last five years deductibles have risen, gulp, six times faster than wage gains.

Then the Council of Economic Advisors chimed in with its recent report saying wage gains have been better than reported because a greater share of remuneration is coming in the form of, for instance, health benefits and parental leave and that should be incorporated into official figures, along with demographic shifts that mean lower wages for young workers replacing retiring ones. To be fair, there is a self-serving element to Kevin Hassett’s admonition of more traditional methodologies. In a WSJ piece, he said, “Consumer sentiment has hit a 20-year high, business confidence is up, and GDP growth has climbed above 4%, but some wage measures seem inconsistent with all of that good news.” Talk to the Fed about that.

Using their method, the CEA’s, shows a 1.34% YoY gain during Trump’s era, but below that of 2015-16. The chart in WSJ is at the end of this section.

Let’s add some more to the low wage story to understand why it’s happening.  An NBER working paper with the thrilling title, “The Rise and Nature of Alternative Work Arrangements in the United States, 1995-2015” by Lawrence Katz and Alan Kruger (https://goo.gl/gZjfUi) says that contingent workers rose from 10.7% of the workforce in 2005 to 15.8% in 2015. Contingent workers, i.e. the gig economy, don’t qualify for benefits or unemployment insurance. (The latter is one reason I believe that Claims figures can’t compare with similar levels on a historical basis; as a % of the total unemployed, those who are insured has come down sharply because so many more simply are not included in the ranks of the Continuing Claims.)

This all may come across as so much dry humdrum, but get this; if the figures that Professors K and K came up with are accurate, than a massive number of job gains are in the contingent category. They write, “A striking implication of these estimates is that 94 percent of the net employment growth in the U.S. economy from 2005 to 2015 appears to have occurred in alternative work arrangements.”

Perhaps that warrant some challenge, I mean, 94% of net job gains are labeled ‘contingent’? But they have data they come up with and the wage growth story as anecdotal evidence to say they’re in the right direction.  

IN OTHER NEWS:  The FT offered an opinion piece on topic by Michael Goldfarb, called “Fear and debt lurk behind the mystery of stagnant wages.” (I would like to believe that what follows is not really new information to readers of my musings.)

Goldfarb says the best-trained minds in economics and public policy are stumped, and suggests if such pundits had ever been unemployed, like Goldfarb, they’d get it. To wit, his ideas are sound explanations; 1) Fear. People know that cutting jobs is a prime way of hitting profit targets and so folks don’t ask for a raise hoping that staying under the income radar will protect them in the next layoff. We all know someone, our age or abouts, who lost a job, and it rattles us even if we’re still working. 1a). When a middle class, and middle aged or late middle aged, person loses a job the next one will likely pay less. Interview for a job when you’ve been unemployed for a while ask yourself if the person you’re talking to isn’t factoring that in. 2) Credit card debt and low savings has been a substitute for low wages gains to keep lifestyles up with the Joneses. A steady income simply to handle that debt keeps the wage demand down. Finally, 3) less pressure from Labor Unions and fewer people in them, though that can’t be separated from the decline in US manufacturing and the jobs that went with it.

Funny, but with all of that no one mentioned my bugaboo, simply, that older workers are simply more content to stay employed and, too, are happy with health benefits at the expense of wage gains.

And then there was this interesting teaser from The Fed, under FEDS Notes on U.S. Corporations’ Repatriation of Offshore Profits (https://goo.gl/jizrFf). The upshot of the work is that at least in Q1 a surge in corporate cash repatriated from overseas was associated with “a dramatic increase in share buybacks” but little of that’s been used for capital expenditures. They note it’s perhaps too early to say this is a trend or won’t happen, but I’ll hint that with a decade of low rates behind us, that it hasn’t happened yet remains the best indicator of the future.

The study looked at the top 15 firms with cash overseas. Those account for 80% of cash held outside the US, which tallies to about $1 trillion held mostly in short-term US securities. (The latter was sold, the evidence shows.) A bit more than $300 bn of that came back here in Q1. Think about that. Thirty percent was repatriated already and mostly used for buybacks vs. investment; given the high level of corporate indebtedness noted above, it seems to make sense that this sort of cash would be used for buybacks, a favored investment decision heretofore, vs. tapping deeper into debt markets.

Given that these 15 have 80% of the cash overseas, it follows that they were the bulk of Q1 buybacks (dividend payment were little changed so that wasn’t what the money was used for).  In Q1, buybacks rose to $55 bn from $23 bn in Q4, with the top five cash holders taking 66% of the overall share buybacks. NB the overall debt of the firms they looked at did decline so some of the cash may have been used to pay down debt. That may sound encouraging until you look at the dollars in question: $15 bn, or just 2% of their total debt.

The article mentions the tax holiday in 2004 which gave a full year’s respite on the repatriation tax rate. $312 bn of $750 bn came back in 2005, and most of that, the Fed says, was used for buybacks. Again, I think this is evidence of corporate behavior suggesting it won’t be used for investment in conventional terms and, let’s note, now is somewhat more late cycle than 2005.

NEAR-TERM MARKET THOUGHTS:  I get that what’s going on in EM should be supportive for Treasuries ostensibly, but ‘my’ market isn’t doing much with it. I suspect the late bid in August (month end buying? ‘dovish’ Fedspeak? Inversion chatter? Illiquid summer trading?) probably had an impact to create a very tight-range bid so maybe the early September response is about that.  Sure, sure, there’s a bit of firm data on the ISM front, but the negligible change in Fed Fund futures tells you that’s hardly a surprise. No, I think we’re in a tight range, will stay in a tight range and between 2.82% and 2.95% on 10s I simply don’t think there’s much more to say about it.

I believe we’re being held in place, in Treasuries, by full-on odds of a hike this month, reasonably high odds of one in December (negating to some degree the negative impact of strong data like ISM) and then the incoming imponderables of 1) trade stuff, 2) the mid-term elections and the fate of the Trump policies to say nothing of the regime, and 3) the ongoing stress in EM. I think the trade story is a somewhat distant third to other two and Trump isn’t doing anything to turn down the heat on the election process. I mean, a ‘good’ government shutdown? That GOP lawmakers want that to be postponed until after the elections -- when getting a wall might prove far more difficult -- does seem like pandering to the Woodward version of Trump. I know, I know he’s backed away from the shutdown, for now, but the cat is out of the bag. (Whatever that means.)

I need to digress. In recent weeks I got a solitary note suggesting I was a ‘hater’ meaning I was beating up on Trump unfairly, ‘fake strategy’ perhaps, and letting such feelings influence my views. My response is that is not at all accurate. I’m looking at Trump’s policies analytically, the same way I looked at and criticized (or applauded) policies of the five prior Presidents I’ve been privy to write about. Trump’s tweets/attitude/behavior create issues with repercussions which is what I’m dealing with. If they are bad policies, or contain economic risks, that is not hating but what a strategist should shout about.  

Let me say I have no issue with lower corporate taxes conceptually, for example. However, these tax cuts come with borrowed money when the economy was doing just fine. It’s fun while it lasts, but will have to be paid for. That’s an idea I do hate. I really don’t understand how intellectually honest people can applaud the Tax Cuts and Job Acts and ignore the consequences for the deficit. Please, explain that to me; I’ll listen.

But back to EM. So, in the last several days what the headline focus on Turkey and Argentina, expands to Indonesia, South Africa, Poland and Mexico. Rising tide lifts all boats until the high tide ebbs. I hear in the press about EM investors saying things always get exaggerated and waiting for entry points. I hear the word ‘wait’ which means not yet, so I have to follow suit; it’s not my market. That Treasuries are taking it in stride is remarkable to me, though I suppose the firmer dollar helps offset some of the bearish inputs.

I’m intrigued to see technology under some fire here which I attribute to both sheer valuation and the recent accusations them stifling free speech with Sessions planning to meet with AGs on the topic.  If a response to the latter, I’m skeptical about it really hurting, but for now it’s a something to watch especially with a lot of chatter about September being a tough month for stocks. (I used to think it was October.)  

That got me to look at Seasonals. They are relatively stable for 10s and 30s after a bullish phase, and the curve tends to steepen. I like that idea for a trade as it fit the narrative that the next two hikes are largely priced in and so skews the risk that December’s might price in a pause. I DON’T BELIEVE THAT THEY WILL PAUSE, but market valuations are not priced for that potential. Seasonals suggest low risk in shorting 10s or 30s.

Oh, let me rain on the NFP parade a bit. First, there was the real AHE gain, 0% YoY when you add inflation to it. Second, there were the downward revisions. Third, there was the steady 3.9% UNR after a drop in Participation. Fourth, hours worked was steady at 34.5. Also, not getting much attention was the drop in the Diffusion Indexes but then that really gets into dweeb territory. And all that was still good enough to warrant the Fed’s Rosengren say there’s no reason for rates to remain accommodative and push 10s beyond the confines of their recent narrow range top at 2.89%; maybe they’ve got a shot at 3.03% after all?

To be fair, there are some quirks that warrant attention and make the clouds I offer disperse a bit. Did you see the number of people who didn’t work full time due to bad weather? 179k, which is well above the norm. This dovetails with a NYT piece asking “Is the ‘Heat Day’ the New Snow Day?”  

David Ader, Chief Macro Strategist for Informa Financial Intelligence

Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor’s annual survey.

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