Market meltdown post-mortem and some comments on wage growth
The short vol trade may now be over. Bond yields will again reach levels that causes angst for equity markets. And equities will tumble. Rinse and repeat.
The past few days of market volatility have made it easier for me to put out mono-thematic posts. But this one is going to be a classic daily roundup — designed to be a potpourri to tie some post-market meltdown threads together.
The first thing on my mind is the narrative and economics behind what’s just happened. AT a very base level, I agree with Cullen Roche about why we saw a correction.
Everyone wants a fancy sounding reason for why the stock market goes down, but sometimes it’s as simple as ” because it went up a lot”.
— Cullen Roche (@cullenroche)
People are always looking for a reason that things happen. So they invent one. But sometimes things just happen.
But, of course, we’re talking about proximate causes. From a bigger picture perspective though, the market meltdown fits my view that bond yields have been rising due to a newfound appreciation of Fed hawkishness in the face of positive economic data. It stands to reason that the uptick in yields became so acute that there was a collective gasp from equity markets — and that sent the algorithms on their merry way. Voila, market correction.
A lot of this market madness was driven by speculators though — people actively betting against volatility, thinking the market could continue its upward climb for the foreseeable future. Interactive Brokers CEO Peterffy says the ‘short volatility’ trade is akin to what caused the ’87 crash. These people have been chastened. I suspect the short vol trade won’t be making a comeback.
But if the volatility speculators do maintain their fervour, they are likely in for a rough ride. If I am right about the macro situation — decent economic numbers, strong corporate earnings, low unemployment — lasting, angst about future Fed rate increases will continue. And bond yields will resume their climb as soon as the next piece of positive economic data hits our screens. At some point, bond yields will reach a level that causes angst for equity markets. And equities will tumble. Rinse and repeat.
Eventually, one of two things will happen. One, the data will break decisively away from the present path — either to the downside or the upside. Two, the credit cycle will show signs of weakness as credit growth slows and defaults increase. This is when markets will be tested— and the Fed along with them. In the last cycle, house prices peaked in 2005 and 2006 and sector credit began to deteriorate given the number of Ponzi investors in the space. Yet, the Fed kept tightening and disregarded that signal. For me, this is where the danger lies.
As an aside, I wan to point out that Bitcoin has done horribly as a store of value here. When the market meltdown was at its worst, there was a huge bid for US Treasuries and the Japanese Yen and US Dollar were safe havens. In Asia, all currencies were down against the US Dollar except for the yen. Bitcoin was melting down, along with equities.
Back to the underlying economy though — yesterday I wrote a positive note saying this market correction reduces the risk of over-tightening. Yet the economic fundamentals remain intact. So I want to drill down on one part of the economic dataset here – wages.
Early in January I noted that data from the tightest labor markets in America showed encouraging signs of wage increases. And the latest jobs report seemed to confirm rising wage growth throughout the US. But if you look underneath, there are two problems with that narrative.
First, the rise in average hourly earnings trails the 1990s and the 2000s. That says that the 2.9% number we saw on Friday really isn’t enough to think wages are rising briskly. Moreover, 2.9% isn’t the real number for 80% of workers. The real number is 2.4%, as I pointed out last week. It’s the 5% rise in manager and supervisor — double the rate for everyone else — that pulls the numbers up. And this is a volatile number that could go down next month.
And if you think about it logically using the Fed’s Phillips Curve mentality, it undermines the case for raising rates quickly. In the 1990s and 2000s, real wages rose at a much faster clip than today. Yet, there was no increase in inflation. So it stands to reason that unless something has changed between then and now, we should be able to grow at near that same pace without a fear of stoking inflation.
If you look at the video I posted last week of former Fed chair Greenspan, he makes the case for what has changed as being productivity. His theory is that the lower levels of productivity growth today will mean a quicker pass-through of wage growth into inflation. And so he thinks we are on the verge of an inflationary spiral and warns of stagflation. I don’t share that view, but I thought I should point it out.
Another view that sounds much more plausible comes from Dan Alpert at Westwood Capital. He wrote a book called “The Age of Oversupply” in which he argues there is a chronic supply/demand imbalance that will suppress inflation for the foreseeable future. With this backdrop, he says that the exogenous constraints on not just inflation but also bond yields are worth considering. The dollar cannot fall far enough to offset the global tendency towards endemic oversupply-induced deflation. And so, yield spreads between the US and other hard currency sovereigns can’t get as wide as they once did. So, there is no global tendency towards higher interest rates. That’s almost verbatim what he told me.
Let me also point out that wage growth does not equal inflation. Even if wage growth were to accelerate here, it doesn’t have to translate into actual consumer price inflation, especially if there is still slack in the labor market due to a low participation rate and a large bucket of unwanted part-time employment. It’s hard for most American economists to believe we’re not at full employment yet with the base rate at 4.1%. Nevertheless, I point out that baseline employment levels are lower in a host of countries like Switzerland, Japan, and Germany without it translating into consumer price inflation. And our broadest definition of unemployment just ticked up to 8.2% in January.
Here’s another perspective on wages. I am just now reading a post by Variant Perception’s Jonathan Tepper on wages. Here’s what he says:
Workers are productive and helping the economy grow, yet unlike previous economic expansions, we are hardly seeing big increases in wages. Instead, companies are sitting on their cash or giving it back to their shareholders through dividends and share buybacks.
The answer of why wages are not growing mattered a lot to me. A few years ago, some friends and I started Variant Perception a company that predicts the ups and downs of the economy using leading indicators. Before growth or inflation turn up and down, there are generally clues that tell you what is coming. For example, building permits provide a good warning sign that growth will turn up or down. When the US stopped building as many houses in 2005-06, it predicted the recession of 2007-08.
Our leading indicator for wages normally provides a 15 month advanced warning of changes in wages. It is pretty good and all the ingredients are the same ones that have accurately worked for decades, yet the relationship has broken down.
I don’t want to take his thunder. So I’m not going to quote the full piece here. But the gist of what he has to say is that ‘market power’ relationships have changed decisively. And he has a lot of data in support of this thesis. Please do read his piece in full here.
Some fantastic charts on workers’ wages I put together in a post
Why American Workers Aren’t Getting A Raise: An Economic Detective Storyhttps://t.co/CQmKs0s8fU
Retweet if you like it. pic.twitter.com/IBAaKfmVLu
— Jonathan Tepper (@jtepper2) February 7, 2018
So what’s the conclusion here? This is a daily post; there doesn’t have to be a conclusion!
But seriously, if I did wrap this discussion up, I would say this: I am optimistic.
I think we are in the sweet spot of this economic cycle. And the only thing preventing this sweet spot from lasting is us. When I say us I mean the collective us in the sense of the Fed making policy errors and companies using their increased market power and depressing wage growth. Middle-class wage growth is the bedrock of sustainable long-term economic growth simply because, in modern societies, the majority of economic output is created by the middle class and the majority of spending is done by the middle class. If we want economic growth that’s long-lasting, its going to come from that source — middle class wage growth. And right now, we’re just getting started on that score. The longer this lasts, the longer we can stay in the sweet spot.
P.S. – Data out yesterday seem to confirm a secular decline in job openings that I flagged last month. The peak for openings was 6.17 million back in July. The latest numbers are for December and they show a continued decline, with the number now at 5.81 million. Seasonality? Maybe. At this time last year, the number of job openings was 4.9% lower. Still, it bears watching this data set for signs of weakness.