Friday, December 13, 2013

Even more evidence of shifts in labor markets

The following charts are part of December 13's Bloomberg Economics Brief. The top chart is Bloomberg's Economic Surprise Index. As you can probably  notice, the labor market has been surprising significantly to the upside lately. On the bottom, is changes in nominal wages for the month of November by selected industry. The red line represents the Fed's symmetrical target for inflation while the yellow highlight indicates value of the year-over-year percent change in the PCE deflator.  

While wage growth leaves lots to be desired, all but two industries, utilities and Leisure & Hospitality, showed wage increases in excess of PCE deflator increases. This is good news, these are real wage increases and more evidence of labor market tightening, even if very marginal. This is my 3d post in 2 weeks about this and you better get used to them, because there's probably going to be a lot more of them. The tide is changing, and labor is on its way up!

2013-12-12 -- More on labor bargaining power
2013-12-05 -- Profit margins, tax receipts, and labor demand curves

Thursday, December 12, 2013

More on labor bargaining power

Last week I wrote about how a number highly reliable indicators are indicating the bargaining power of labor is increasing and that it will lead to tighter labor markets and wage inflation.

On Nov 26, The New York Times reported that NYU will once again recognize the graduate assistants' union. The voting was scheduled to take place this week, but a search of press releases shows no results yet as  to the outcome. Excerpt below, emphasis mine.
 Some 1,200 graduate assistants at N.Y.U. and the Polytechnic Institute of N.Y.U. in Brooklyn are scheduled to vote on Dec. 10 and 11 on whether to join the union...
An issue that had long prevented agreement between N.Y.U. and the union was whether graduate research assistants in the natural or physical sciences could be included in the union. The university argued that the research those assistants did was an essential part of their academic training, and should not be viewed as employment. In their statement, the union and N.Y.U. acknowledged that they had not resolved their differences over whether the 275 graduate research assistants in the so-called hard sciences had bargaining rights. They will therefore not be included in the union.
NYU's claim that the work (they called it "work") their research assistants do is part of their training, they are acknowledging it is, indeed, work. As with the recent unpaid intern cases, some will argue that this is not valuable enough to be compensated and the benefit of it mostly accrues to the employee/intern/assistant but, if their labor is truly of so little use, maybe they should be free to apply those resources elsewhere. Like in the intern cases, the labor slack as a result of the financial crisis created a large number of people who wanted work and were willing to sacrifice wages in the hopes that experience would be worth something and make it easier to find a paying job in the future. This shift right in the labor supply curve would have led to lower clearing price for labor, the evidence of which is everywhere. Whether this was unfairly exploited or not is up for the judges to decide, but what seems self-evident to me is that the trough in the bargaining power of labor is behind us and, as a result, the labor consumer surplus--in the neoclassical sense. remember, employers are consumers of labor--is about to be redistributed.

At the risk of oversimplifying, but in the interest of avoiding a black-hole, I will skip discussion of dead-weight losses, the welfare state and heterodox theories of economic surplus, and simply say this: If you believe any of the following:
  • welfare initiatives like the Earned Income Tax Credit subsidize low salaries leading to a higher quantity of labor supplied at a point below the incentive-free equilibrium
  • price elasticity of supply of labor flattens significantly on the left side (positive first derivative)
  • some people will agree to work for less to build a resume or gain experience
Then, the logical conclusion is that, as labor markets recover, the lions share of the benefits will accrue to the household and public sectors. Not only on the marginal increase of production (a change in quantity or labor demanded), but on the entire level of production (a shift in the demand curve).

The corporate rent-seekers masquerading as capitalists will argue the corporate sector will simply not hire or invest if faced with rapidly declining margins or increasing costs at the margin, but the truth is that almost 3 decades where productivity gains have disproportionally accrued to capital and record-high profit margins mean that the ability of capital to bring a credible bluff is just about non-existent. This trend is going to be with us for a long, long time.

UPDATE: The NYU vote was overwhelmingly for organization and both parties expect to have completed a contract by the end of the academic year.
UPDATE-2: "Machinists reject Boeing labor contract offer"

Tuesday, December 10, 2013

Corporate Debt / Market Cap as a predictor of forward returns

Earlier tonight, Matt Busigin tweeted a link to the series "Credit Market Debt as a Percentage of the Market Value of Corporate Equities" from the FRB's Z.1 report. After some back-and-forth with some other folks, Greg Merrill suggested that high debt to market cap looked like it it would correlate positively with forward returns. Intuitively, this works because, if we assume creditors are generally somewhat rational about underwriting standards, a sharp increase in Debt / Market Value would signify a sharp decrease in the value of equity from a level at which underwriters thought it was safe to lend. Stepping back, what we would be doing is measuring the "fair value" using debt as a proxy. 

After thinking about it for a few seconds, I decided to plot our the series against annualized forward returns, shamelessly mining for the forward period that offered the best correlation. After starting with 5y (R=0.5985), 7y (R=0.7069), 10y (R=0.8411) and 11.5y (R=0.8677). After peaking at 11.5y (46 quarters) the correlation starts declining again.

The actionable value of this exercise is questionable given the small sample size but, in my opinion, probably reflects the rational behavior of lenders and CFOs regarding debt levels.  The average Debt / Market Value ratio for the sample is 57%, which is 9.1% higher that the latest (Q3) reading of 47.9%. Since the end of Q3 the Wilshire 5000 has risen 6.84%, representing a market-cap increase of $1,229 billion. We currently have no estimate for net corporate debt issuance since the end of Q3 but, if we extrapolate Q3's 2.2% increase, we get an estimate of a current 45.8% debt to market-cap ratio, which would correspond to a pretty average 7.8% annualized forward return for the next 11.5y. This expected return stands in sharp contrast to much lower expected returns obtained with similar methods by John Hussman using non-financial market cap as % of GDP and the Price/Sales ratio of the S&P 500  as predictors. I should note here that this expected return also lies significantly above my own 10y expected return of just 4.5%.

Of course, the current Debt / Market Value lies in a particularly dense zone with significant dispersion, which--when combined with the 2.45% standard error of the linear regression--should give us pause as to the reliability of any such measure. In this particular casse, the expected total holding period is 132% and the -1 and +1 sd  bands would lie at 82% and 207% respectively--not exactly a Swiss watch.

Thursday, December 5, 2013

Profit margins, tax receipts and labor demand curves

Much has been made of the record levels of corporate tax profits over the last two years. From GMO's warnings of an 1100 "fair price" for S&P 500, to Hussman's forecast of 10y of negative nominal returns, to the economics "It" girl of the moment, the Kalecky-Levy profits equation. Real median household income, in my opinion at a cyclical bottom, is back to early-to-mid 90s levels and as ZeroHedge (the best indicator of policy bear zeitgeist) reports, wages are at an all-time low relative to profits. Meanwhile, it seems like the entire Very Serious Old Guy complex is warning of mean reversion in a laundry list of ratio measures, but nobody wants to talk about whether it will be the nominator or denominator that will change. It is my intention to illustrate exactly how these measures will mean revert in a simple, common-sense way accessible to anyone with a cursory understanding of supply and demand curves and lay out what I expect to be a way to make investments guided by this thesis.

Corporate profits are high because effective tax rates are low, real wages are low, and debt to large companies is cheap, a point I've previously made. They are about to start shrinking. When? Like right now. Maybe last month, or last quarter, even. What led me to write about this is, believe it or not, is public sector employment. Employees of State, Local and Federal governments are not many, they peaked at 14.68% of the labor force (not including the census high) exactly as private payrolls hit bottom, and hit a trough in June and July 2013 at 14.01% representing 21,826,000 employees. In other words, fiscal drag added 0.67% to the unemployment rate.

But this summer we had three important developments:
  1. The labor force stopped growing
  2. The number of public sector employees stopped shrinking and may be growing
  3. Real average hourly earnings growth of non-supervisory employees accelerated to a level coincident with the last expansion
Public (blue rhs) and Private employment as % of labor force
In economic parlance, we can translate the first one as a change from a marginal pressure right on labor supply curve  (curve inching slowly right as labor force grows) to curve shifting slowly left. Ceteris paribus, and assuming a downward slopped demand curve, the consequences would be an increase in the price of labor (coincident with #3) and a slight reduction in quantity demanded at the new price. The second would represent the public sector going from a marginal impulse left on the labor demand curve, to neutral or right maybe a slight force right, which will lead to stable or increasing price of labor (coincident with #3) and an increasing quantity of labor demanded at the new price. The third observation, present since Q1 of 2013, tells us that despite the public sector drag in the first half of 2013, private sector employment growth (demand curve shifting right) has been enough to lift average wages and increase the number of units of labor demanded at the higher price.

With the private sector labor demand growing, public sector stable, or growing, and labor supply (labor force) stable or shrinking, the only plausible answer is wage growth. And, as the marginal unit of labor required to produce a marginal unit of final output goes up in price, so must marginal profit margins fall. But this is not the most interesting part.

Capital expenditures / GDP (blue, lhs)
After-tax profits / GDP (red, rhs)
The interesting part about the position we find ourselves in is that, because of the very low effectivecorporate income tax rate (~16.35% last year), and very low corporate investment rate, the marginal dollar earned by the corporate sector has very little impact on the economy, it just sits as retained earnings. Using Manufacturers' New Orders: Nondefense Capital Goods as a proxy for capital expenditure we can see that even though corporate profits as a share of GDP have increased, capital expenditures as a share of GDP have decreased, meaning the marginal propensity to invest in new capacity is low. This is because of depressed aggregate demand caused by the low labor share of income and previously mentioned low real wages.

This, finally, gets me to my much delayed points:
  1. If the marginal effective tax rate of the household sector is higher than that of the corporate sector, which we know is true because FICA on its own is 15.3% (split by employer and employee), a marginal dollar that moves from profits to wages will increase tax receipts
  2. If the marginal propensity to consume of households is larger than the marginal propensity to invest of corporates, a marginal dollar that moves from profits to wages will increase aggregate demand
  3. If the marginal propensity to consume or invest of the public sector is greater than the marginal propensity to invest of the corporate sector, the increase from #1 will increase aggregate demand
  4. Any savings by households and/or government in excess of investment will be coincident with lower profits, all else equal.*
  5. Any increase in demand for labor by the public sector in response to #1 (in the form of bigger budgets) will be a marginal pressure to the right in labor demand which, all else equal, will lead to an increase in both the price and quantity demanded at the new price of labor. 
  6. Increases in employment and household income will reduce the cyclical deficit and reliance on government assistance programs like medicaid and "food stamps." This is, once again, an increase in government savings which is negative for profits. 
I will stop here, as you are likely seeing the self-reinforcing cycle that will be triggered. Because payroll and individual income taxes make up the lions share (~ 80%) of federal tax revenue, this will lead to a very strong self-feedback loop that will ultimately pressure corporate profit margins down and real wages up, reducing both the income and wealth distribution skew (the proverbial labor/capital divide) while redistributing corporate savings to the household and public sector.

10y treasury yield minus %YoY change in CPI (blue)
%YoY change in average non-supervisory hourly wage
minus %YoY change in CPI (red)
If the past is any indication, a real increase in wages will lead to higher nominal and real rates of interest for long term securities (thanks to Matt Busigin for this one) which, if you recall earlier discussion, is one of the primary reasons for the elevated levels of profit margins. As liabilities mature and reprice at higher rates, this will be a direct hit to profit margins, especially so if the increase in the rate of financing is not only nominal but also real. Given the very low present financing rates (without even mentioning qualitative measures like easy covenants) any future liability repricing is likely to increase the cost of capital and, once again, pressure profit margins.

Grantham, Hussman, Gross and many other investment managers have expressed concerns over elevated profit margins. To my knowledge, none of them have chosen to describe exactly how and why profit margins will fall and who will benefit and how. In this analysis, it is obvious that the beneficiaries of the sectoral rebalancing will be wage-earning households and tax receipts. The losers will be the labor-intensive employers, especially those that are highly leveraged because the cost of debt capital and cost of labor will rise at a speed greater than final demand or price inflation. It should also be clear by now the role of low investment (capital formation) and high unemployment (and associated cyclical deficits and low household savings rates) have had in the final sharp impulse upwards of corporate profits during a struggling economy and that, as labor markets recover, the household and government savings rate will gradually recover as corporate savings decline. Perhaps ironically, the same lack of investment that has helped prop-up corporate savings and holding unemployment high and kept inflation low will, as real wages increase, be the cause of any future increase in inflation. As, Matt Busigin has shown before and you can see to the right, this analysis is not only theoretically sound, but also empirically true.

Net Investment / GDP
This is likely to be very, very long cycle, even if it hits small cyclical snags along the way. Wages just started growing, the public sector just stopped being a drag on employment and net investment just turned positive. To anyone who missed the historic stock market rally, it may feel like it is too late, but this is just the beginning of the real economic recovery. It is also the beginning of inflationary pressures, but it will benefit wages more than prices. If you are wondering, "what's the play?" it is to favor being exposed to credit risk backed by public sector and household incomes and avoid being exposed to credit risk being backed by corporate incomes, especially those that are labor-intensive or highly indebted. Because the Federal government is considered a credit-risk free entity, this would mean the credit risk of state and local governments (which are ultimately backed by incomes of the residents) and of households, either directly through securitized obligations or indirectly through institutions that have a large exposure to households as creditors. Using extreme examples, you would want to own a company that insures mortgages and consumer ABS securitizations as well as municipal bonds, and avoid the lower tranches of any recent vintage CLO.

Is this a doomsday sign for stocks? Maybe not. It is possible that aggregate demand growth is enough to let profits fall as GDP increases and profits rise more slowly, however, it is not likely in my opinion. Assuming a reversal to mid 2000s effective corporate tax rates of 22% after tax profits as % of GNP to a generous 7% (median is 6.10% and mean is 6.34%) and a NGNP growth rate of 6% (mean 6.11%, median 6.7%, current 3%) over 10 years the CAGR of after-tax corporate profits would not amount to more than 1.65%. But it is also not terrible. GMO likes to flaunt their 1100 "fair value" number and Hussman is partial to his price-to-sales ratio chart, but there is no reason for stocks to fall to their fair value, and every day that passes, their fair value will close in to their present value, and at an accelerating pace. This would make selling short equity a trade with a short lifespan, while other trades--especially those where time works in your favor, like being long high-grade municipal bonds, an asset class which happens to be offering remarkable value--offer much more attractive ways to play the thesis.

Shorter version
Marginal head-winds for employment and wages are turning into marginal tail winds as the economy recovers. These same factors posses self-reinforcing properties and are likely to continue to be positive impulses for, real wages, employment levels, tax receipts, and aggregate demand and negative impulses for corporate profit margins and corporate savings. Favor the liabilities of the household and public sector over those of the corporate sector.

*Going back to Kalecki's Profit equation we can remember that:

Corporate Saving = Profits - Dividends
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends