Place Your Wagers
by Brian Pretti CFA, Contrary Investor. June 5, 2009
To the point, I want to take a very quick look in this discussion at the complexion and rhythm of US household wages and salaries, and broader personal income circumstances of the moment. The important issue to forward investment actions and thinking being, in a world where corporations have taken a literal machete to employment costs all in the interest of preserving nominal profits and profit margins, are they essentially destroying the very source from which future aggregate demand will be driven within the context of a macro household balance sheet deleveraging environment that continues for some time to come? Moreover, have we entered a bit of a vicious cycle in terms of labor market pressure feeding into wage pressure, feeding into consumption pressure that further constricts corporate profits, ultimately leading to even further pressure on labor costs? Current circumstances are very much unlike any prior US economic cycle of the last thirty to forty years at least. Let me try to tie together a number of broader themes I have been discussing for a while now.
The concept that deleveraging is a big macro construct of the moment. We see it directly at the household, corporate and financial sector levels. As a counterpoint, it’s the government who is leveraging up to try to maintain price and broader economic stability as an offset. Directly to the point, in an economy very much dependent on consumer spending, absent households releveraging their balance sheets (which is absolutely not occurring, nor will it), the character of wages, salaries and broader personal income growth becomes the key driver of a potential forward consumer spending and broader economic recovery. US economic recoveries in recent decades have shared three identical character traits – pent up demand for houses goosing purchases and ultimately new construction, pent up demand for autos goosing purchases and ultimately new production, and consumer credit balances taking off northward in an environment of renewed optimism. For now, these three character traits are missing from the broader economic equation. The deleveraging process occurring directly before our eyes at the household level tells us that the character of wages, salaries and personal income takes center stage in the potential for a consumer led US economy recovery, or not. Could this very set of facts and the eventual broader realization of these facts be the basis upon which another potential leg down in the economy and markets occurs? For now the financial markets have a head of steam. Momentum and the gravitational pull of the markets upon those underweight their asset allocation mandates is driving the short term. Important to realize just what we are looking at.
Before taking even one step further, in all sincerity, I am not walking through this discussion to incite pessimism. Far from it. We all very much need to respect the power and magnitude of money being thrown at the US economy and financial markets at the current time. If the Fed/Treasury/Administration make good on their current promises of borrowing, printing and guaranteeing (forward liabilities), we’re talking about roughly $13 trillion dollars here. Make no mistake about it, there simply is no precedent at all in the entirety of US experience for this type of stimulus as a percentage of GDP being thrown at the financial sector, credit markets, economy and financial markets. Will it have a positive impact on both the economy and financial markets for a time, both in real terms and perceptually? Without question. Our interests should be to look past stimulus at the then underlying sustainable character of the economy, or otherwise.
In the importance of looking ahead and trying to anticipate and develop a game plan for all potential outcomes, we need to at least address the scenario of a failed consumer response to stimulus. How would that come about and what would it mean to the markets? The financial markets appear to be responding just fine to stimulus, but what about the heart of the US economy that is consumers? Further, it’s important to at least think about potential outcomes with a bit more seriousness right now given that the equity markets have come an incredible way in terms of price appreciation based on the conceptual ideas of “less bad” and “green shoots.” I fully expect macro economic stats to continue to get less bad ahead as the stimulus money increasingly presses into the real economy and financial markets over the summer and fall of this year. But, as is always true in our investment thinking at all points in time, we also need to be on the lookout for what could hurt us. What might change the trajectory of consensus thinking? Secondly, the equity market will soon transition from celebrating conceptual “less bad” toward beginning to actually assess the quality and character of supposed “good.” It’s in this transition period to come where we’ll really need to keep our eyes and minds wide open.
Although both labor market conditions and employment, and salary and benefit trends have been lagging indicators in past economic cycles, it’s the nature of the US credit cycle that is the big “it’s different this time” issue. While the world seems obsessed with focusing on the supply and availability of credit, I strongly suggest it’s the demand side of the equation for credit in aggregate that is the key focal point in a household balance sheet deleveraging environment. So if indeed deleveraging at the household level has just gotten started and is in no way even close to a conclusion, then that leaves the character of wages and salaries as a key forward driver for aggregate demand (and clearly by definition retail sales). Has the green shoots crowd thought this one through? Could this set of dynamics, or the perceptual realization of these dynamics be potential catalysts for further pressure on the real economy and financial markets ahead? Again, stimulus will have its day and produce some type of results. But in terms of the non-stimulus character of the real economy, the wage and salary issue is simply critical as we try to anticipate forward demand. In an environment of deleveraging and deflation, employment trends and monthly labor numbers become leading indicators as opposed to lagging. The more folks that lose jobs, the lesser the potential for forward consumption when the need of households to pay down debt still exists. Less forward consumption means lower corporate profits, which means more forward pressure on wages and employment counts. And that cycles right back into further subdued consumption. We'll explain more below and look at supporting data. Our current circumstances are so unlike any period in recent US history that economic signposts and markers of the last three to four decades may be quite misleading in the current cycle. Although it may sound crazy, part of our thinking must at least allow for some possibility that everything we've learned about past economic cycles of the last half century will be wrong in this.
And to try to intelligently guess at what may be to come in terms of financial market perceptual turning points ahead, let’s have a quick multi-decade look at the history of the US employment cost index. Please remember that the Employment Cost Index (ECI) that comes to us courtesy of our wonderful friends at the Bureau of Labor Stats (yes, the same folks responsible for the payroll numbers) is made up of two key components – wages and benefits. As you can see below, the current (as of 1Q) year over year change in the ECI is the lowest number in the history of the data. Again, we should not be expecting fireworks, especially in the midst of a deep recession. But in the absence of household credit acceleration, what you see below is the key to future reacceleration of aggregate demand, or otherwise as the case may be.
Very quickly, the history of the two components of the ECI (wages and benefits) is seen below. The year over year change in wages has never been this low in the records of the data. And in terms of growth in benefit costs, we’re pushing historical lows as we speak. What does all of this mean? It tells us labor is under serious total compensation pressure. And since benefit costs to employers are falling rapidly, this tells us one of two things is correct. Either employees are simply losing employer sponsored benefits they will need to make up on their own out of wages or total household resources, or their personal participatory costs in employer sponsored benefits are climbing rapidly (think co-pays, etc.). Either way, labor is under serious wage and benefit pressure, really unlike anything seen over the prior three decades at least.
One last corroborative chart. This is the history of the year over year change in US wages and salaries from the personal income numbers. Drawn in the chart with red bars are all of the recessions since 1960 to show you that the year over year change in wages and salaries has actually been quite the tell tale sign of official recession conclusions over this time. Will it be so again? One more time, never over the history of the data have we seen this type of pressure on wages.
IF you believe that the credit cycle for households is clearly in the reconciliatory repair shop at the moment and not about to reemerge any time soon, then by default wages and salaries become the key to potential forward recovery in macro US economic final demand. Employers have acted swiftly and strongly to attempt to maintain profits and profit margins by attacking labor costs. But it’s these very labor costs that will theoretically allow their and other employees to buy their production. The ultimate Catch-22 in a post credit cycle bubble environment? If there is to be any next leg down for the financial markets, it’s this realization that may be the driver of the perceptual shift, or disappointment in the rate of level of economic liftoff. But certainly as per the character of the financial markets recently, this perceptual shift is not yet upon us. Again, all in the spirit of simply trying to anticipate forward outcomes over the remainder of this year and into early next amidst the celebratory environment of the moment.
Let’s quickly walk through the remaining components of “household financial wherewithal” outside of wages and salaries to get a broader sense of the current circumstances surrounding the character of personal income. As a quick punch line, we believe it’s the Fed and Treasury that are in good part acting to hold up the US credit markets in the current environment. In part although it’s really always this way in meaningful recessions, the Government is also the key support mechanism in upholding personal income as of now. Quite the dual roles – holding up the US credit markets and the character of personal income as it now presents itself. And at least as of yet, Atlas has not shrugged. We’ll roll through these components in rapid-fire fashion to give you a sense of what is going on.
Since we looked at wages and salaries above, no need for extended commentary. Point being, on a year over year rate of change basis, wage and salary growth is negative as of recent monthly data. This has not been seen over the history of the data. Wage and salary growth is not contributing positively to personal income, at least not now.
Next up in the personal income roster of possibilities is proprietor’s income. Simply, non-wage categorized income of folks who own businesses. A good read on the smaller business community? Indeed. As of now we’re at a rate of change contraction low not seen since the early 1980’s recessions. Not a positive contributor to personal income flexibility for now.
Above we looked briefly at employer benefit costs in the employment compensation data numbers. Employers have been cutting back on benefits. Not a wild new revelation by any means and pretty darn easy to do in the current labor market. Within the personal income data, employer “supplements” to wages and salaries also in part measure the issue of benefits, but there are some differences. Included in the supplements data are things like pension contributions. To be honest, employers contribute to pensions only when they HAVE to. As you look at the chart below, the moves up in the rate of change numbers have coincidentally come after declines in general equity market values. In other words, employers needed to reseed underfunded pension obligations. Anyway, in broad terms the year over year change in employer supplements isn’t exactly doing a Herculean job of adding to personal income character at the moment. Plus, as is intuitively clear, "supplements" to wages are not cash in the pockets of households. So regardless of positive or negative rate of change levels, these numbers really never find their way into immediate spendable cash flow.
Quite noticeably the next PI component has reached a record low in terms of now being a rate of change drag on household personal income circumstances of the moment. Below we’re looking at income from assets, virtually 100% driven by household interest, dividend and rental income streams. As described, a record rate of change contraction for the entire history of the data is what characterizes the present.
So in a bit of quick summation, at the current time we have the year over year change in wages and salaries, proprietors income and income from assets all in negative rate of change territory. They are ALL contracting year over year. For now, employer supplements are registering a 2.5% year over year gain, but again this is not current cash in employee pockets (and can even represent higher unemployment insurance payments, which would not surprise us at all as being a current driver of theoretical strength). So just what the heck is a positive when it comes to personal income as these key fundamental components of personal income are all heading south coincidentally?
Positives? Look no further than the final two components that join in the mix of characterizing the totality of bottom line personal income – government social transfer payments and personal taxes. And guess who has the most influence over both of these? You bet, the Government. You can see the longer-term history of the year over year change in government social benefit payments in the chart below. We’re now as high as anything seen since the early 1990’s, excluding the one-shot tax rebates under the Bush stimulus plan a while back.
Remember, it isn’t that this is something bad. Increased social benefits need to occur during recessions, as has exactly been the history of the US for five decades now. We just need to make sure that we are aware of just what personal income character consists of in order to hopefully look ahead and make intelligent judgments regarding the true drivers of the real economy, equity sectors and corporate earnings.
Of course rounding out the field is the character of personal taxes right about now. First, it should be no surprise at all that they are down given the initial effects of the Obama stimulus plan in terms of immediate tax relief at the household level. Secondly, the decline in corporate taxes with the drop in earnings is a given, but that’s not shown below. As you can see in the chart that follows, the year over year decline in personal only income taxes is pushing toward the lows seen over the entire history of this data.
The prior cycle drop in the rate of change in personal taxes during the 2001 downturn was all about the vanishing act put on by capital gains taxation in the wake of the tech/dotcom stock implosion. At the moment, the current impact of the loss of capital gains revenues is minor compared to the loss of non-cap gain related personal income taxes. The current cycle is all about folks losing their jobs, seeing a reduction in interest and dividend income, and the softening in rents due to the home foreclosure issue forcing rental inventories to near historic highs. This is real people losing fundamentally real income that is translating into the big year over year drop in personal taxes. But to the bottom line of the equation that is pretax income less taxes, this is an academic benefit to net after-tax personal income.
By now you get the picture, so I will not belabor the point. As I stated last month in the “Of Fingers And Dikes” discussion, I believe the Fed/Treasury/Administration has had a huge hand in supporting and anesthetizing the US credit markets (inclusive of LIBOR). Without governmental/Fed/Treasury support, there is no way the headline credit market data would be showing us as much perceptual healing as has been the case up to this point. Of course the key question remains, just when can these folks take their collective fingers out of the multiple holes in the US credit market dike? For that, we have no answer. In like manner, at least as per the data above, it sure appears as if the US government is now a major infrastructural support to the character of personal income circumstances of the moment. Again, this is not wrong and this is not bad. This pattern repetition is seen in EVERY recession of the last five decades at least. It’s just that never have we had the annual rate of change in wages and salaries, proprietor’s income, and income from other assets all in negative rate of change territory on a simultaneous basis over the prior five decades. That highlights and reinforces the role of the US government in holding up the current character of personal income.
So as we step back and contemplate the relationship of labor market conditions, consumer confidence, retail sales trends historically and what the equity market is discounting in price in terms of an economic recovery to come, we need to ask ourselves once again, just who (or whom) will fund higher household consumption ahead at the margin absent renewed household balance sheet releveraging? Will it be government transfer payments and lower taxes? Moreover, households have shown us they have begun to increase their savings rates. How can we have much higher consumption ahead accompanied by higher savings rates when the key core components of personal income are all in year over year contraction mode? As I have said in so many discussions recently, I keep coming back to the key forward focal point that is the consumer.
The financial markets are trying their best to discount a typical consumer and/or corporate demand led economic recovery of the type seen over the past half century. Yet when looking at things like the credit markets, personal income circumstances and the complexion of household balance sheets crying out for deleveraging, current conditions are quite different than any recession of the prior half-century, with the government acting as Atlas holding up the world of "demand," per se, for now. Just what type of a valuation multiple do we put on a financial market under these character circumstances? This is a very important question the financial markets will be facing head on during the second half of this year and early next. For now, the key recovery fingerprints of every single economic recovery of the last half century are missing from the current puzzle (housing demand, auto demand and reacceleration in consumer credit growth). Standing in for these classic drivers is the US government. For how long will this be the case and what should investors be paying for this stand in role? Yes, the old market saw is hokey, but I can’t get this one out of my mind. First price, then optimism…then earnings. There can be no break in the chain in cyclical bull market character, and the first two have already gone a long way in terms of playing out. Absent household balance sheet reacceleration in leverage it sure seems a good bet forward corporate earnings are now as dependent on household wages, salaries and broader personal income as at any time in recent memory. And corporations to protect margins and nominal profits are pressuring wages and salaries downward. Time to place your wagers as we look ahead?
© 2009 Brian Pretti