October 2003
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Equal Opportunity Inflation?

The Job-Loss Recovery...You may have seen this characterization of current labor market circumstances post the release of recent employment data.  It's fitting for now.  As we look ahead, without question, forward capital spending strength will be a key determinant of whether or not this current recovery is sustainable or otherwise.  The second key determinant is most definitely a labor recovery.  These are really the two missing economic links in the broader landscape over the past three+ years, let alone in the period post the recent official recession to this point.  Without a self sustaining recovery in both cap spending and employment ahead, the broader equity markets just may be making one big mistake in currently pricing in both a significant economic rebound and a meaningful corporate profits acceleration, above and beyond cost cutting, as per the loud and clear message of current valuations.  The fact that labor conditions continue to be weak is self obvious.  The market knows this and is looking ahead.  For now, a potential bright spot in the labor picture is the recent pick up in temp employment.  In fact, we believe we have approached a very meaningful crossroads in terms of the relationship between temp employment and official payroll employment.  But accompanying the current period media discussions of headline employment numbers is a characterization of labor we see being given very little attention - wage inflation.  

There has been a lot of chatter lately about the Fed being amenable to tolerating a higher rate of inflation as we move ahead.  Inflation that traditionally has been a debt laden economy's best friend.  The official tolerance for a weaker dollar professed by the G7 at the recent Dubai conclave also suggests that academically, inflation pressures stateside are set to increase ahead (vis-a-vis the cost of imported goods, services and commodities).  But this go around, we have already lived through the inflating of many a major asset class such as housing and financial assets.  In terms of these two household balance sheet bedrocks, for the large part we may already have seen rate of change peaks.  Moreover, households have been monetizing these assets as they have inflated over time, a monetization process that has gone a long way toward supporting total consumption.  Accompanying this inflation in housing and financial assets has been an acceleration in systemic leverage, primarily driven by household liability expansion.  From the standpoint of labor markets, the most important inflationary trend we need to keep our eyes on ahead is wage inflation.  For without personal income gains outstripping the growth in the real cost of living moving forward, exclusive of debt service obligations, just how else will our supposedly large systemic debt load be "inflated away"?  Importantly, for now, the rate of change in consumption is outstripping the rate of change in personal income growth.  This is not a prescription for inflating away the household leverage burden over time.  In fact, quite the opposite.  We would suggest that absent wage inflation ahead, rate of change in household consumption is at risk.

We know that labor statistics lag in an economic recovery.  We believe it's one of the assumptions the equity markets have leaned heavily upon in having been so trusting as to have bid up stock prices as of late.  August payroll data just recorded the seventh straight monthly decline in head count.  This is an experience that historically has only been reserved for recessionary periods, not periods of apparent economic recovery.  We're now close to two years past the official end of the prior recession.  In terms of "lags", this is now becoming very significant and more than obvious.  Relative to historical post recessionary experience of the last four decades, we're setting a new precedent for the character of payroll employment at the outset of an economic recovery.  The following is simply an update of a chart we have shown you in the past that simplistically indexes payroll experience post recession ends of the last three decades.  The message is clear.
        

The fact that the manufacturing sector continues to take it on the chin in terms of labor headcount month in and month out doesn't even raise any eyebrows anymore.  Folks like Greenspan, as per his recent statements regarding manufacturing, have become numb to this trend, to the point of considering it a non-event for economic growth moving forward.  With the recent payroll employment release, Labor Secretary Chao commented that manufacturing employment has been in decline for decades, implying that it's simply no big deal anymore.  But in the August employment experience, the service sector lost more jobs than did manufacturing.  For a while now we have been suggesting that a contraction in the broader mortgage underwriting employment base was imminent.  Recent data appears to corroborate that we have begun the process.  For now, the "lag time" in labor market recovery continues.

Hand in hand with soft payroll experience of the moment is the supposed miracle of productivity growth.  Productivity growth in 2Q was simply a moon shot.  We just don't see numbers like this very often.  But one thing is for sure, we do see them during periods that can be characterized as witnessing significant stimulus being brought to bear on the total economy in a focused and narrow period of time.  The last time non-farm productivity was as high as was recorded in 2Q was 1Q of 2002 and 4Q of 2001.  A period directly following the heavy monetary and fiscal stimulus unleashed post the 9/11 tragedy.
       

As you can see above, its now been thirteen straight quarters where hours worked have either been down or flat.  Surely a good part of the recent gains in productivity are built on the back of labor market weakness.  Again, this is nothing new relative to the prior three years.  It just corroborates the fact that labor market weakness is not some type of aberration at the moment.  To the point, unit labor costs declined (2.8%) in 2Q.  Yes, output is improving, but macro labor conditions are still deteriorating.  The combination of these two phenomenon have made for gangbusters productivity.  For now, we expect more of the same in 3Q given that hours worked remained weak in the August employment report.

Assuming continued expansion in business output over the quarters ahead, it sure seems a good bet that improvement in labor market conditions will be forthcoming.  But, as we mentioned at the outset, what about wage gains (or wage inflation)?  The productivity numbers alone tell us that labor isn't exactly in a perfect position to extract meaningful wage increases.  Hours worked remain weak.  The average work week is scraping the lows of the last half century at least.  And Greenspan's favorite productivity measures remain an ominous sign for potential wage gains moving forward.  As you might be aware, Greenspan's favorite view of productivity in America is non-financial corporate productivity.  Here are some fun facts.  In 2Q, total non-financial corporate unit costs experienced the second largest one quarter drop in forty years.  The largest drop was seen in the fourth quarter of 2001, when the airlines and other businesses shed bodies so fast the ink wasn't even dry on the pink slips.  The reason this happened in 2Q is that the unit labor component of total costs experienced its third worst quarterly decline in forty years.  Suffice it to say that corporations continue to keep labor costs more than in check.

Taking The Temp-erature Of Labor...If you have been watching the ISM reports as of late, you're aware that in the past few months the non-manufacturing (service sector) ISM employment component reading has stepped very modestly into expansionary mode.  In terms of the ISM manufacturing sector report, employment has been in contraction for years.  But as was acknowledged by Ralph Kauffman of the ISM, recent modestly increasing employment conditions in the services sector is being driven by temp workers.  This brings up a key anecdotal point for labor both now and looking ahead.  As is almost common sensical, strength in temp employment usually precedes ultimate strength in payroll employment during each economic recovery cycle.  Yes, payroll employment is a lagging indicator and so is temp employment, but changes in temp employment are going to be your first clue as to potential directional change in payroll employment over subsequent periods.  And during this most recent cycle, we'd put special emphasis on temp employment as the annual rate of change in temp employment literally collapsed over the past three years.  Far worse than was seen in the early 1990's.  There's one heck of a lot to recover from in temp land.  Here's a little view of the past decade plus as it applies to temp employment.
        

As you can see in the graph above, we've only just crossed back into positive year over year rate of change territory in terms of temp employment during the last few months.  For now, either the demand for labor is beginning to turn incrementally, or the recent spurt was related to summertime employment.  Trying to give labor the benefit of the doubt as we move forward, we need to keep in mind that the directional change in temporary employment experience and macro payroll employment experience is very highly correlated historically.  The following graph is clear on the subject.  Meaningful directional turns in these two labor series usually occur no further than six months apart, if that long.  As you can see below, the current annual rate of change in temp employment is moving out ahead of payroll employment change at this point.  From our perspective, the labor markets have arrived at a crucial crossroads.  If temp employment continues to improve without a corresponding uptick in payroll employment rate of change, it will be a huge statement on business confidence.  Confidence among the very corporate insiders who are currently blowing out of their own shares at near historical peak rates.  If there is any bright spot in the labor markets of the moment, this is it:
      

Equal Opportunity Inflation?...Although we may be seeing the beginnings of incremental change in the labor market as per the recent temp employment data, what about the wage component of the total labor picture?  The two charts above tell us that the temp body count is increasing as of late, the but chart below is emphatic regarding the message that companies who are choosing to hire temps to fill their incremental labor needs do not have to pay up for this privilege in the least.  In fact, quite the opposite.
          

In the early 1990's, rate of change in temp wages bottomed in spike experience fashion after the official recession end.  We're seeing much the same thing at the present.  But whether we have seen the ultimate bottom yet is still open to question.  The latest monthly experience in average weekly temp earnings was the worst year over year rate of change showing of the current cycle so far.  At least as of now, we believe it's fair to say that wage inflation is really nowhere to be found.  The same wage inflation that is going to be a necessary ingredient in hopefully "inflating away" total systemic leverage. 

As we look ahead, the consensus is coming to believe that the Fed wants inflation stateside to proactively prevent potential global deflationary pressures from washing up on our shores, at least any more than they already have.  Moreover, the effort to reflate economies is really a global theme at the moment as opposed to being specific only to the domestic economy.  The Fed and Administration have chosen to reflate via creating the circumstances necessary for abundant and cheap liquidity availability as well as having a certain tolerance for US dollar weakness.  Both of these efforts have not been lost on the commodities markets over the past few years.  Although energy is a big driver of the CRB index, you can see below that recent year over year rate of CRB change has been as great as anything seen since the original oil crisis days of the early 1970's.  Moreover, the CRB index itself appears to have recently broken a declining tops line that goes back to the early 1980's.  The CRB is telling us that efforts to reflate via dollar depreciation and excess liquidity are succeeding.  The cost of things are going up (at least in nominal dollar terms).
      

But, as always, we are on the lookout for potential unintended consequences of monetary and fiscal policy at any point in time.  Especially as these consequences might relate to the financial markets.  Over the very short run, could it be that the incredible economic stimulus the Fed and Administration is unleashing (really on the planet) truly causes the cost of "things" to continue to rise, but may also have very little to no influence on wage inflation domestically?  It seems relatively reasonable to assume that what is truly the global reflationary effort of the moment will continue to lift the price of global commodities and, in turn, the price of goods and services whose input components are those very commodities.  Moreover, continued credit inflation, especially in the US, will continue to exert upward pressure on those items financed by easy credit - housing, cars, etc.  But what about wages?  Just what aspect of the current stateside reflationary effort will support necessary domestic wage growth ahead?  We're having a very hard time identifying just what will drive that wage growth from a longer term perspective.  Especially given the changes in the nature of global business capital movement over the last few decades in terms of labor outsourcing opportunities.

For now, there is very little wage strength in sight, despite improving economic stats all around us.  Given that nominal temp wages have not even yet made a rate of change turn, it's close to intuitive that wages and salaries in the broader economy remain decidedly weak at the moment.  Below is a chart showing system wide nominal wage and salary history over what is close to the last half century.  Certainly nominal wages continue to trend a bit higher on an absolute basis at the moment, but it is the rate of change characterization of this data that is most important.  
          

Excluding very weak nominal wage and salary annual rate of change experience over the last few years, current quarterly year over year rate of change rests near a low not seen since the late 1950's.  As you can see, it is very interesting to notice the ascending rate of change lows in the above data from the mid-1940's through to the early 1980's.  At that point we move into a period of continuing rate of change lows with each passing economic cycle.  It's this latter period that is characterized by heightened global trade and capital liberalization.  Of course this data is surely picking up the extreme weakness in the domestic manufacturing sector during this cycle as being a big rationale for aggregate wage growth weakness.  But this phenomenon of very subdued wage growth is by no means specific to manufacturing.  As you'll see below, current annual wage and salary growth in the US service sector rests quite near a three decade low at least.  Only two other quarters of the last three+ decades have seen year over year rate of change lows in wage growth as low as was experienced in 2Q in terms of the services sector.  And this is now six quarters after the conclusion of the most recent official recession.  The current quarterly reading is a new low for this cycle.
          

It is simply a fact that from a longer term standpoint, growth in household personal income drives growth in personal consumption expenditures.  And that income variable is largely driven by wages (interest income, etc. also enters the picture).  Like it or not, the consumer is still holding up our current economy.  A consumer dependent on wages and ultimately sensitive to broader global commodity inflation over time.  The following chart is historical testimony to the very strong correlation between personal income growth and consumption growth.  As you can also see, current year over year personal income growth rests near a four decade low.  The same rhythm as broad nominal wage growth.
         

Where we find ourselves at the moment is that the annual rate of change in household personal consumption has been outstripping the annual rate of change in personal income growth.  It's more easily seen below.
       

Consumption growth has been outdistancing income growth on a rate of change basis for two and one-half years now.  It happens to be one of the longer historical stretches of growth rate differential witnessed over the past forty years.  Consumption has clearly been supported by increasing household leverage as well as modest income expansion over the period shown.  Since year end 1999, total household net worth has declined by $1 trillion.  During that same period, total household leverage has increased by $2.4 trillion.  The household debt to net worth ratio stands at a post war high at 2Q period end.  This relationship is simply a reflection of household leverage and lack of savings while trying to maintain consumption.

Although we may still be early in the game as it applies to the full court reflationary press being put on by the Fed and Administration, we want to know how personal income growth currently pushing the lows of the last four decades is supposed to aid the effort of "inflating away" household leverage.  As is clear in the first chart of personal income and consumption growth, inflationary pressures in the late 1960's (to some extent) and surely in the significantly inflationary 1970's did indeed lead to higher rates of change in personal income.  Same deal for wages.  By the late 1970's, year over year changes in personal income growth were in double digit territory.  But labor and capital variables were quite different at that time.  No one was moving manufacturing production to then a close economic system that was communist China.  Technology support, data processing and software engineering were simply unthinkable in terms of being outsourced to a then near third world country such as India.  Even moving production to Mexico was still just a dream in many a manufacturers head at the time.  There was no giant sucking sound as was so popularized by folks such as Ross Perot only a decade later.  At the time, domestic inflationary pressures, that were in good part the result of global oil related pricing strength, ultimately drove personal wage inflation.  Simply put, will this be the case looking ahead if indeed broader domestic inflation once again picks it head up off the mat?  Has the Fed and the Administration thought through what life might look like here in the US if their efforts to reflate are successful in terms of the general level of domestic prices, but unsuccessful when it comes to wage inflation?  It's a potential outcome at the front and center of our thinking.  Especially given the current ability of the global corporate sector to redirect labor input across the planet in the blink of an eye.  It's a potential unintended consequence regarding which we hear little to no commentary.  Is it at all being discounted as a possibility in current financial asset prices?

Alongside capital spending of the moment, there is no larger an issue for the financial markets to digest and try to make sense of.  The falling dollar over the last year plus has been a very significant factor in rising commodity prices that will ultimately directly affect the total ability of households to consume.  And this pressure may increase post the Dubai meeting.  Coincidently, unprecedented domestic liquidity has kept the cost of big ticket household items such as cars and housing either firm or creeping higher.  The non-seasonally adjusted twelve month rate of change in the CPI is running at 2.1%.  It's a good bet it's headed to 3% or above over the next six months.  It appears that the financial markets are beginning to sense the same.  But for now, what we cannot see is how wages will participate in this inflation.  Is this to be the big spoiler issue in the supposed recovery as we move ahead?  Can the Fed and Administration really create an environment of equal opportunity inflation inclusive of wages?  If not, they will have created a problem much greater than they might have imagined or intended.  It's a new era for labor and wages.  A new global era - ready or not.