Down Under Daily, 3 August 2014

How Slack?
Rate markets, rightly, are focussing on the labour The out-sized fall in unemployment reflects two
market as the key to Fed policy. The degree of factors. First, labour demand has been unusually
labour slack will be a big influence on how soon and strong given GDP growth (Exhibit 3).
how fast the Fed tightens. As a result wage and
unemployment data are now critical. I expect both Exhibit 3

to convince markets to price a more hawkish Lots Of Jobs For Little Growth
HOURS WORKED AND GDP GROWTH
outlook for rates next year. That adjustment will 6 8

likely stall the PE-led equity rally. 4 6

2 4
The US recovery has been unusually weak but

4 QTR %
12M%
0 2
unusually stable. Core growth final sales to
-2 0
domestic purchasers (GDP less inventories and net
-4 PRIVATE HOURS -2
exports) has averaged just 2%, with Chinese-like GDP* (RHS)
-6 -4
constancy, over the past 4 years (Exhibit 1). (As an * LEADING BY 3M
-8 -6
aside, the variability of growth on a rolling 3 year 19901992199419961998200020022004200620082010201220142016

basis is now the lowest ever for final sales data Source: BEA, BLS, NBER; Minack Advisors
from 1947 and near the lowest-ever for real GDP).
Put another way, labour productivity growth has
Exhibit 1 been lower than usual. This is important.
Core Growth Weak But Stable Regardless of how much spare labour remains, the
8
REAL FINAL SALES TO DOMESTIC PURCHASERS decline in productivity has put a floor under unit
labour costs (wage payments less productivity).
6
Unit labour costs are the single biggest influence on
SAAR %/4 QTR %

4
profit margins. Signs that unit labour costs have
2
troughed suggest margins have peaked (Exhibit 4).
0

-2 Exhibit 4
-4 QUARTERLY CHANGE Labour Share Bottom, Profit Share Peak
4 QUARTER CHANGE
-6 US PROFIT SHARE AND LABOUR WAGE SHARE OF GDP
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 11 51
PROFIT SHARE* (LHS) LABOUR COMPENSATION [INV]
Source: BEA, NBER; Minack Advisors 10 52
* AFTER-TAX PROFITS WITH IVA/CCA

9 53

Unemployment has fallen in a more normal fashion

% OF GDP
% OF GDP

8 54

despite the unusually weak recovery. The jobless 7 55

rate has been falling at pace historically associated 6 56

with 5-6% GDP growth (Exhibit 2). 5 57

4 58

Exhibit 2 3 59
1950 1960 1970 1980 1990 2000 2010
Low GDP Growth But Falling Unemployment Source: BEA, NBER, Minack Advisors
GDP GROWTH AND CHANGE IN UNEMPLOYMENT RATE
-3 10
UNEMPLOYMENT CH* The second factor behind the large fall in
-2 8
GDP** (RHS)
unemployment is the well-known decline in labour
12M POINT CH [INV]

-1 6
participation (the proportion of the working-age
4QTR%

0 4
population in the labour force). The unemployment
1 2
rate would now be at 9.9% if the participation rate
2 0
was still at its 2009 average.
3 -2

4
* 12M POINT CHANGE INVERTED ** LEADING BY 4M
-4 Consequently, the big issue is how much of the
1950 1960 1970 1980 1990 2000 2010

Source: BEA, BLS, NBER; Minack Advisors

decline in labour participation is structural versus

Page 1 of 3
Sunday, 3 August 2014
cyclical. To the extent it is cyclical, the Fed can keep That adjustment has started. Exhibit 7 shows the
policy easier for longer because growth should implied yield on Fed funds futures has increased
draw discouraged workers back into the workforce. over the past six weeks. The market, however, is
If it is structural, the decline in unemployment still on the low side of the FOMCs dots.
should start to force wages growth higher.
Exhibit 7
The data over the last week were mixed. However, Rate Markets Move Towards Fed Forecast
there are signs that labour costs will start to rise 4.0
FED FUNDS TARGET, MARKET AND FOMC FORECASTS

through the current half year. The employment cost 3.5

LONG-RUN FOMC MEDIAN

index is showing signs of gentle increase (Exhibit 5). 3.0

MEDIAN FOMC
MEMBER
FORECASTS
2.5

%
Exhibit 5 2.0 FED FUND FED FUND
TARGET
The Potential For Rising Wages 1.5
FED FUND
RATE
FUTURES
NOW
3M LIBOR
WAGES AND NFIB PAY EXPECTATIONS 1.0
5.0 25 28 MAY

4.5 0.5
20
4.0 0.0
3.5 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
NET BALANCE

15
Source: Federal Reserve, Bloomberg; Minack Advisors
12M%

3.0
2.5 10
2.0
5
This adjustment will likely put more pressure on
1.5
1.0 WAGES* NFIB PAY (RHS)
short-end rates than long-end rates, implying that
0
0.5 * WAGE & SALARIES FOR CIVILIAN WORKERS % PLANNING TO
the yield curve will flatten. This flattening has
INCREASE COMPENSATION LEAD BY 9M. 3M AVERAGE
0.0
1986 1990 1994 1998 2002 2006 2010 2014
-5 started, but remains well behind what occurs in a
Source: BLS, NFIB, NBER; Minack Advisors usual cycle. Exhibit 8 shows how the spread
between 10 year and 2 year Treasury yields is
Hourly earnings are starting to accelerate. This has normally correlated with unemployment. Exhibit 8
occurred as the unemployment rate has fallen also shows how the curve will continue to flatten,
towards its natural level (Exhibit 6). based on current forward rates.

Exhibit 6 Exhibit 8
Nearing NAIRU Flatter Forwards
US JOBLESS RATE AND CHANGE IN HOURLY EARNINGS US UNEMPLOYMENT RATE & 10 YEAR-2 YEAR SPREAD
3 * 2 YEAR CHANGE IN 12M% GROWTH IN HOURLY -4.0 3 10
10 YEAR-2 YEAR TREASURY
EARNINGS UNEMPLOYMENT LESS CBO NAIRU
CHANGE IN 12M% OVER 2 YRS

SPREAD (LHS)
2 -2.5

2 8
1 -1.0
% PT GAP [INV]

0 0.5
%

1 6
%

-1 2.0
SPREAD IMPLIED BY
-2 3.5 FORWARD RATES
0 4
HOURLY EARNINGS CHANGE* US UNEMPLOYMENT
-3 5.0 RATE (RHS)
EXCESS JOBLESS [INV] (RHS)
-4 6.5 -1 2
1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: BLS, CBO, NBER; Minack Advisors Source: BSL, Bloomberg, NBER; Minack Advisors

Fed commentary still leans to the dovish view. My view has been that QE was an over-rated factor
However, there are hints that the Fed is moderating for equity markets, but I think the yield curve
its view. If, as I expect, data over coming months remains an important indicator. As Ive noted
continue to show the unemployment rate falling before, equity valuation tends to decline when the
and labour costs rising, then it seems likely that Fed yield curve bear-flattens (short rates rising faster
rhetoric will continue to shift. That, in turn, will than long). In my view, this will increase the risk of
force markets to adjust their policy expectations. a correction in the current half year.

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Sunday, 3 August 2014
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Sunday, 3 August 2014