Tuesday, October 24, 2017

America's Dangerous Dual Economy?

Abby Joseph Cohen, a senior investment strategist at Goldman Sachs, wrote a comment for Yahoo Finance, The last 8 years of labor market improvement have been disturbingly uneven:
The deep recession triggered by the financial crisis technically ended in the summer of 2009. Despite eight years of economic growth, the labor market improvements have been disturbingly uneven.

Several factors are contributing to the wide range of outcomes which, in turn, have led to stark contrasts in how different groups of consumers and business owners view the current economic environment. I’ll briefly discuss only three of the factors: education, technology and geography. This last category can also be described as “location, location, location” and hasn’t received adequate attention from policymakers.

Declines for high-school educated Americans

Even before the financial crisis, some workers and their families were falling behind, with an ever-widening gap in household incomes linked to level of education. In 2000, for example, the median household income in which the head of household had a high school diploma was about $50,000. A household headed by someone with a college degree was about $100,000. Since then, on an inflation-adjusted basis, the high school-educated family has experienced a decline of about 15% in household income to $43,000. The decline for a college-educated family was about 3% to $97,000.

Technology causing shifts in how workers do their jobs

Long-term structural changes have also had dramatic effects on individual earners and their families. Much has been written about the job losses in the manufacturing sector. Although some politicians point to the role of imports, by far the larger factor has been the use of technology and increased productivity of workers in this sector. Studies have suggested an 80/20 split, that is, 80% of the job losses can be attributed to enhanced productivity, and much of the remainder to global competition. Of course there are variations based on the specific industry within the manufacturing sector.

Throughout the economy, increased use of technology is causing shifts in how businesses interact with customers and how workers do their jobs. There have been pronounced changes in many sectors, including retailing, media and some professional services. The growth in STEM-specific jobs has outpaced the rest and wages, at about $95,000 per year, are roughly double those for the overall private economy. But only 7.2% of US workers are in STEM jobs.

Location, location, location 

Geography is a critical factor which is often overlooked. The attached chart clearly shows the wide gap in job creation by location in the US (click on image below). Since the peak of employment before the financial crisis, the overall economy has created jobs at an anemic pace. Between 2007 and 2014 the aggregate increase was 1.1%. But we need to look below the surface of the national averages. There have been sustained job losses in rural areas and in smaller towns and cities. But, the nation’s largest cities experienced a sharp 8% increase in jobs during this period. The areas surrounding these primary cities also benefited as being part of the regional ecosystem.

Courtesy: Abby Joseph Cohen

The success of communities can be linked to multiple factors. These include the presence of growing industries, higher levels of education, welcoming of newcomers, and the magnetic appeal of public infrastructure and cultural institutions. It is worth noting that broad policy tools, such as monetary and fiscal stimulus, may not be sufficiently targeted to help the communities that are currently struggling. Instead, the “business models” of the cities that are currently thriving show that long-term public investment in education, infrastructure (roads, schools, communication, etc.), and health care can pay long-term dividends in the form of job creation and wage growth.
A very interesting comment indeed from Abby Joseph Cohen, Goldman's former superstar permabull strategist during the tech bubble years. I wonder if she agrees with Greenlight Capital's David Einhorn who recently told clients that the market may have adopted an "alternative paradigm" for calculating the value of stocks.

It's a very bullish Tuesday on Wall Street. In early afternoon, the Dow is up over 200 points reaching another record-breaking high driven primarily by great earnings reports from Caterpillar (CAT) and 3M (MMM).

In the last four trading sessions, the Dow is up almost 500 points (click on image):


This is great news for Bill Koch and his expensive counterfeit wine collection and for his fellow billionaires which include tech innovators, indusrialists, entrepreneurs and a handful of banking, hedge fund and private equity titans who are reaping massive gains no thanks to global central banks continuing to pump massive liquidity in the system (click on chart):


Cohen doesn't discuss the financialization of the economy and how it has permanently and irrevocably exacerbated the wealth gap in the United States.

Many people do not understand the way the world works now and how critically important the FIRE (finance, insurance, real estate) industry is. For example, as I recently explained in the coming renaissance of macro investing, the US is becoming more powerful as its current account deficit and national debt widen because the rest of the world is recycling profits right back into Wall Street.

13D Research tweeted this chart on China's growing influence looking at its share of global trade (click on image):


People look at this and think "OMG! China is taking over the world!". But they're not understanding the full story.

Importantly, China, Japan, Germany all running current account surpluses necessarily means the US is running a capital account surplus. In other words, all these profits need to recycled right back into Wall Street so don't read too much on China's growing influence.

And with central banks pumping billions into the financial system using conventional and non-conventional tools, it's a virtual free-for-all for the lords of finance.

In fact, when people ask me which industry receives the most subsidies from governments in the developed world, I tell them it's not agriculture or aerospace, it's the financial sector via money for nothing from central banks that can print at will through a few keystrokes.

Bankers don't like to talk about this dirty little secret. They prefer the mirage that they're real tough capitalists who are innovators and take risks. They do take risks, mostly with other people's money, but when things go wrong, they socialize the losses (as we saw in 2008).

But even on Wall Street, traditional jobs are already being disrupted by technology, and the emergence of artificial intelligence will drastically reorder the role of most humans in finance, according to former Goldman Sachs Group Inc. Chief Technology Officer Michael Dubno.

This is the ruthless logic of banks looking to cannibalize each other, where return-on-investment drives everything with little to no regard on how AI is profoundly disrupting all industries and the very fabric of society (we need more good moral philosophers, fewer programmers!).

And it's not just banks. Their big quant hedge fund clients taking over the world are also investing heavily in AI, trying to gain an 'edge' over rivals. Two Sigma has rapidly risen to the top of the quant hedge fund world and it has been hiring Ph.D.s and other AI experts just like everyone else.

The same thing is happening in Silicon Valley where tech giants are paying huge salaries for scarce AI talent, upward of $300,000 to $500,000 a year for Ph.D.s and people with less education fresh out of school. Pretty soon, we're going to be teaching embryos to code to give them an edge in life.

Go back to read my comment on why deflation is headed for the US where I outlined once again the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

By structural, I mean factors that will be with us for a very long time, as opposed to cyclical factors that are temporary by nature.

All these factors are deflationary because they shrink the economic pie for most, leaving more an more resources in the hands of the prosperous few, the so-called "winners" of this uneven economy.

Some very influential hedge fund elites are taking notice. Yesterday, Ray Dalio, Chairman and CIO at Bridgewater wrote one of his most profound and in my opinion, important comments on LinkedIn, Our Biggest Economic, Social, and Political Issue The Two Economies: The Top 40% and the Bottom 60%. It's not the first time Ray discussed the dangerous divide.

I will let you read his entire LinkedIn comment here as it is long but he explains in detail why you cannot base policy based on averages like average household income. He also explains why the polarity in economics and living standards is contributing to greater political polarity which in turn is fueling greater distrust in government, financial institutions, and the media, which is at or near 35-year lows.

Ray summarizes it all here and shares his policy concerns:
Average statistics camouflage what is happening in the economy, which could lead to dangerous miscalculations, most importantly by policy makers. For example, looking at average statistics could lead the Federal Reserve to judge the economy for the average man to be healthier than it really is and to misgauge the most important things that are going on with the economy, labor markets, inflation, capital formation, and productivity, rather than if the Fed were to use more granular statistics. That could lead the Fed to run an inappropriate monetary policy. Because the economic, social, and political consequences of an economic downturn would likely be severe, if I were running Fed policy, I would want to take this into consideration and keep an eye on the economy of the bottom 60%. By monitoring what is happening in the economies of both the bottom 60% and the top 40% (or, even better, more granular groups), policymakers and the rest of us can give consideration to the implications of this issue. Similarly, having this perspective will be very important for those who determine fiscal policies and for investors concerned with their wealth management. We expect the stress between the two economies to intensify over the next 5 to 10 years because of changes in demographics that make it likely that pension, healthcare, and debt promises will become increasingly difficult to meet (see “The Coming Big Squeeze”) and because the effects of technological changes on employment and the wealth gap are likely to intensify. For this reason, we will continue to report on the conditions of “the top 40%” and “the bottom 60%” separately (as well as on the averages), and we encourage you to monitor them too.
Of course, Ray Dalio's "big squeeze" neglects to mention the big squeeze on fees US pensions had to endure from his fund and other elite hedge funds and private equity funds over the last two decades despite seeing their funded status deteriorate. That's what catapulted them to the top 0.0000001% of the world's rich and famous.

Ray is right however on monetary and fiscal policy. Janet in wonderland or whoever is at the helm of the Fed needs to stop catering to big banks and their big hedge fund and private equity clients and start thinking very carefully about the next downturn and how it will primarily impact the bottom 99%, not just the bottom 60%.

I believe Yellen is starting to worry that deflation is headed for the US which is why she is openly discussing redeploying quantitative easing during the next downturn.

But again, even if the Fed preps for QE infinity, there are serious structural issues that need to be addressed and monetary policy alone will not relieve the major inequities that plague the US and increasingly global economy.

A few months ago, I was talking to my younger brother who is a psychiatrist like our father about rising inequality and he thinks it's only a matter of time before we introduce a basic minimum income for all in our economy like they are now doing in Finland and other Scandinavian countries, realizing that some people will never be able to be part of the labor market.

Even Facebook's Mark Zuckerberg sees the merits of a universal basic income. And he is right to worry because according to one recent study, financially vulnerable millennials could spell disaster for the US economy:
The unemployment rate dropped to 4.2% in September, its lowest since February 2001, and yet consumer loan defaults keep creeping up.

In fact, the divergence between the labor market on one hand, and consumer credit performance on the other is at a record (click on image). What figures?


UBS analysts led by Matthew Mish and Stephen Caprio set out to answer that question, and their findings highlight the financial difficulties many millennials are facing.

According to Mish and Caprio, there are two cohorts that have been left behind by the labor market: lower income households, and millennials.

"The most underappreciated factor explaining consumer stress is the two-speed recovery in US consumer finances," they said.

The two strategists dived into the Fed's latest Survey of Consumer Finances to calculate a bunch of metrics, including the the levels of debt to assets and income across different age cohorts. Those ratios are near record levels, with the millennial debt-to-income ratios in line with 2007 levels (click on image).


And that might not tell the whole story. The Fed survey suggests 38% of student loans are not making payment, while the structural shift from owning a home and paying a mortgage to renting means that more households are paying rent and making auto lease payments. In other words, they might have significant outgoings that aren't being captured in the debt figures.

"We believe this is particularly problematic when assessing the financial obligation ratios of US millennials and lower-income consumers," UBS said.

So what does this mean? Here's UBS:
"Longer term, the two-tier recovery in consumer finances suggests key segments of the US population (lower income, millennial households) are more financially vulnerable than aggregate consumer credit metrics imply. In turn, these groups will be more sensitive to fluctuations in labor market conditions and interest rates ceteris paribus."
That's a touch worrying, especially at a time when interest rates are going up.

For context, millennials hold 18% of debt outstanding, according to UBS, and make up 19% of annual consumer expenditures. Together, the two cohorts "left behind," lower-income households and millennials, make up about 15% to 20% of debt, and 27% to 33% of expenditure.

So if they're struggling, it has the potential to negatively impact the economy pretty significantly.
This research supports Ray Dalio's warning on the danger of looking at averages when making important policy decisions. It also supports my theory that things are nowhere near as strong as these record-breaking stock markets suggest.

Below, Ray Dalio, Bridgewater Associates founder, talks about Federal Reserve policy, interest rates and how an economic downturn would likely impact the US's dual economy (September 19, 2017).

And Goldman Sach's former Chief Technology Officer, Mike Dubno, talks about how traditional Wall Street jobs are already being disrupted by technology, and the emergence of artificial intelligence will drastically reorder the role of most humans in finance.


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