Tuesday, July 21, 2015

Secular and Cyclical Trends in Production and Non-Supervisory Employment

Playing around with employment stats this weekend, I noticed an interesting pattern.  Non-supervisory employees tend to be laid off more cyclically than other employees.  So, the proportion of employees who are production and non-supervisory tends to be a mirror of the unemployment rate.  I think this ratio might give us a window into the business cycle.  There have, unfortunately, been few times where we have been moving ahead in a relatively calm equilibrium state.  Most of the time, we are moving through cyclical disequilibrium.

This ratio suggests that we have entered a period of calm, where we have re-established economic stability.  (Corporate earnings signal this also.)  Now the question is how long we can maintain this.

I have included short and long term interest rates in the graph because we can see that cyclical declines in non-supervisory employment generally happen when the yield curve inverts.  Before the 1980s, when the Fed was biased to inflation, interest rates would tend to rise after equilibrium was reached, and the Fed Funds Rate would chase long term rates up until they went too far.  Since 1980, long term rates have tended to move sideways, but rising unemployment has continued to coincide with the inverted yield curve.  Unless we see long term rates move up sharply, I don't see any reason why we need to tempt fate here.

I have also included an inverted graph of the unemployment rate, scaled to line up with the ratio of production and non-supervisory workers to total workers.  I think it is interesting that secular shifts in the unemployment rate have moved together with this shift in this ratio.  This also seems to coincide with shifts in the Beveridge Curve.

Interestingly, P&N-S workers appears to have peaked, and has moved to a higher level than the previous recovery.  This suggests that the Beveridge Curve should remain to the left and that the unemployment rate should be lower.  But, recently job openings have been very strong, which suggests that the Beveridge Curve is shifting to the right.

I would associate a lower secular unemployment rate and a leftward Beveridge Curve with less friction in the entry-level labor market.  Either my priors are being overwhelmed by other issues, or we are getting mixed signals.  I think there might be two issues here.  (1) Hysteresis in labor markets which create persistently higher unemployment after extreme corrections (like in the 1980s, where unemployment leveled out for a few years) and (2) the continued categorization of about 1/2% of the labor force, who have been unemployed for more than 2 years, as unemployed instead of marginally attached.  If these are explanations, then we may see unemployment dip below 4%, if we are willing to let it.  (It's already under 5% after adjusting for these marginally attached workers.)

Could the persistent level of unemployment (which is not reflected in continued unemployment insurance claims, either today or in the mid 1980s) be a product of a cyclical correction that was deep and long enough to reach past entry level and low-skill employees?  Maybe firms have made cuts in their organizational capacity, which take longer to re-establish.  Here I have charted unemployment by education, indexed to January 1997 when unemployment was at 5.3%, as it is today.  Unemployment for "less than high school" workers has recovered, but unemployment for high school and college educated workers is still above the January 1997 level (the same goes for the "some college" category).  Again, I think that if these factors are in place, then there is a lot of room for strong top line economic growth, and, in fact, allowing this growth to happen is integral in re-establishing the foundation for future real economic expansion.

In fact, it may be dangerous to use wage growth for production and non-supervisory employees as a signal of Fed policy, because if that category is the one which has recovered, we may need to see some wage inflation there in order to complete the recovery in non-production employment.

Using these indicators, here is a graph which shows the Production Employee/Total Employment Ratio along with a measure of Yield Curve Inversion and a measure of S&P500 corrections (both real and nominal).

In terms of defensive equity tactics, this ratio may be better than the unemployment rate itself because the change in trend looks like it tends to be sharper.  (Red marks show when there is a yield curve signal, green when there is an employment signal, and purple when they both signal a correction.)  This seems like something to make note of.

On the theme of "We are the 100%.",  I think the Real S&P500 measure shown here is informative.  In real terms, from 1968 to 1982, the S&P 500 was down 60%.  High inflation during the period hides the terrible performance of productive asset valuations during the period.  This period of terrible equities performance coincides with low real wage growth and declining employment of production and non-supervisory workers.

Then, in the late 1980s and 1990s, equity values grew in both nominal and real terms and real wages and employment of production and non-supervisory workers also grew.

There is an additional adjustment that wasn't important for my trend changing signals here, but is important for long term comparisons, and that is the fact that capital returns through buybacks cause stock price indexes to rise relative to capital returns through dividends.  Buybacks have been utilized widely since the 1980s.  If I adjusted the S&P 500 both for inflation and for buybacks (so that the index price reflected the counterfactual where all capital is returned through dividends), the S&P 500 would still be about 20% below its peak.  In fact, the past 15 years has been a difficult time for equity holders.  Remember that in the 1970s, owners received upwards of 3% to 5% in dividends.  During the 2000s, that level has been more like 2% (the rest coming through share buybacks).  So, real, buyback adjusted returns on equities look much like they did from 1968 to the mid-1980s.

But, during this period, real wage growth has been fairly strong and production and non-supervisory employment has been strong.  Political rhetoric is drowning in class warfare these days, but this has nothing to do with anything that is happening in capital markets.  The story is really closer to the opposite of what our political battles are about these days.  Capital is being left behind.  Or, I should say legacy capital is being left behind.  Some of what is going on is that revolutionary changes in technology are causing much of the gains to capital to be through disruptive capital, so that existing shareholders aren't capturing the gains; Silicon Valley entrepreneurs and key employees are.

Real wage growth has been especially strong when we account for
the supply-side constraints in housing that capture some of those gains.
So, clearly, in both cyclical and secular terms, we are the 100%.  The fortunes of the lowest income workers and of corporate owners move together.  And, if anything, the fortunes of capital are the leading indicator.  That is what makes equity macro-speculation difficult.  Few indicators lead equity values.  And, this is why cynics who spit at the Fed for the "Greenspan put" and who complain about how the Fed is just keeping the stock market from having to take a loss  are so, so damaging for our economy.  There is tremendous political pressure for the Fed to avoid looking like it is just protecting Wall Street.  But, equities are a great leading indicator for what sort of damage is about to hit production and non-supervisory workers.  Equities are a great indicator for whether the Fed is doing its job well or not.

And, in the end, I think this solves a bit of an Efficient Markets Hypothesis problem.  How can the yield curve be such a seemingly good forward indicator?  And, how can equity cycles appear to have such momentum?  It's because the money supply isn't controlled by the market.  It's controlled by a committee which, even though it is somewhat insulated from year to year political upheavals, is nonetheless vulnerable to some public pressure, and that pressure is very strongly pro-cyclical.

And a lot of that pro-cyclical pressure comes from anti-capital and anti-market biases which lead people to promote wholly destructive policies when it appears as if positive policies will benefit capital.

Imagine how absurd it would sound to complain that the Fed was managing the money supply with a "Production and Non-supervisory employment put".  That would be a pretty stupid complaint.  Stable wage growth is, in fact, an ideal target that Scott Sumner mentions.  Guess what.  It's almost exactly the same policy as the "Greenspan put".  People who think we are in bubbles, who equate significant asset collapses with optimal Fed policy might as well be salting our fields.  That policy and its effect is implicitly and explicitly the same and it affects both the top and the bottom of the income scale.

These errors seem pretty mainstream these days.  Of all the anger being aimed at the Fed, little of it is aimed at the fact that they let equity and real estate values drop by shocking amounts or that they were still engaging in discretionary hawkish decisions even after unemployment had been rising for more than a year.  And the two supposedly revolutionary political figures in the current presidential race - Bernie Sanders and Rand Paul - each especially make some of the errors I have outlined here.  So, you say you want a revolution?


Mark Andreessen linked to this graph on Twitter.

It sure looks to me like there tends to be profit from trading momentum in short term interest rates.  Will we ever be able to test this hypothesis?  I'd love to.  But I'm not sure I want to be short forward contracts if the Fed starts to raise rates and the yield curve flattens in our current environment.  I'm not sure there is much room for rates to have positive momentum before they turn back down.

In the Financial Times (the source of the graph), Gavyn Davies discusses the graph thusly:
For about three decades, it has generally paid for traders to assume that the Fed will deliver a path for short rates that is lower than that built into the forward curve for interest rates at any given time. Maybe that partly reflects the fact that a risk premium is normally priced into forward interest rate curves. But, in addition, interest rates have been on a long run downtrend, with the Fed repeatedly choosing to deliver easier monetary policy than the market has expected. “Never underestimate the dovishness of the Fed” has usually been a profitable motto for traders.
This is shocking to me.  Does he really think the Fed has been dovish for 30 years?  What does he think inflation would have done if the Fed had been hawkish?  Where does he think interest rates would be if the Fed had been hawkish?

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