Employment Situation, February 2017

This morning at 8:30 est, the Bureau of Labor Statistics of the Labor Department issued its Employment Situation report for February 2017.

The Bureau estimates the economy added 235,000 new jobs last month.  This is a very strong result.  However,it is most likely influenced by unseasonable warm temperatures in February, which typically allow outdoor construction work to get started earlier than  usual.  So maybe the “real” figure should be 200,000–which would still signal significant economic strength.

Revisions to the prior two months’ data were +9,000 positions.  Most other data–like the labor participation rate, the number of long-term unemployed…–were relatively unchanged.

The unemployment rate fell to 4.7%, a level that twenty years ago would have set off alarm bells warning of incipient wage inflation.  Nevertheless, wages grew at the same steady yearly rate of +2.8% we have been seeing for a while, and are showing none of the acceleration that labor economists fear.

We know from the BLS’s Job Opening and Labor Turnover (JOLT) survey that the number of current job openings is more than 20% higher than at the pre-recession economic peak in 2007.  This makes the lack of wage acceleration look even more peculiar (more about this on Monday).

Nevertheless, the Fed has made it clear that it thinks there’s nothing further that maintaining emergency-room low interest rates can do to stimulate the economy.  That ball in in the court of fiscal policy, the province of Congress and the administration, where it has resided unmoved for several years.

Especially given Mr. Trump’s promises of corporate income tax reform and renewed infrastructure spending, the biggest economic hazards lie in not continuing to normalize interest rates.

So I think we can pencil in three hikes of 25 basis points each in the Fed Funds rate both this year and next.

 

 

the French election?

French elections

As I mentioned yesterday, there’s at least some chance that control of the French government will fall in the Spring to a party that vows to:

–leave the euro,

–engineer a depreciation of the newly-resurrected French franc and

–repudiate euro-denominated French national debt.

This is not just like Brexit, since Brexit didn’t involve government refusal to repay previously incurred financial obligations.  It’s way worse.  This is more like Argentina or Cuba.

Sounds crazy, but so did Brexit and so did Trump.

What to do?

…particularly since it’s hard for me to figure the chances of any of this happening, and I no longer know that much about French stocks.

Two lines of thought:

–avoiding being hurt, and

–trying to make money.

Both will be brief, since I don’t know enough to say any more.

avoiding being hurt

Currency depreciation would have effects much like what’s happened in Japan during the Abe administration.  National wealth and the standard of living of ordinary citizens could take a substantial beating.  Export-oriented industries would thrive.

It’s likely that French companies would have a more difficult time raising money in global capital markets, if France refuses to honor its existing euro-denominated debt.  Companys’ repayment of debt not denominated in francs would become more costly.

Knock-on effects:  my guess is that Italy wouldn’t be far behind France in leaving the euro.  The currency union would likely end up being Germany plus bells and whistles.

The way bond investors are now taking defensive measures is by selling their French government-issued euro bonds for German issues, giving up 0.4% in annual yield to avoid a potential currency loss.

We, as equity investors, can do something similar now, by avoiding non-French multinationals with large exposure to the French economy.  If we want to/need to have some French exposure, it should be in companies that will benefit from possible devaluation–that is, firms with costs in France but revenues elsewhere.  Here the performance of Japanese stocks should be a good guide, except that I’d avoid French companies with a lot of foreign debt.

trying to make money

I consider betting on future political developments to be a dubious enterprise.  If Marine Le Pen makes an unusually good showing in the first round (of two) in French voting in April, and if the French market sells off sharply on that result, I’d be tempted to look for beaten down French multinationals, on the thought that Le Pen would lose in the second round.  I’m not sure I’d actually do anything, but I’d be willing to think about it.  This would imply beginning to study potential purchase candidates, or a suitable ETF, now.

 

 

 

should the US dollar be strong or weak?

This is the question President Trump purportedly called his adviser, Michael Flynn, to ask at 3am one recent morning.  Flynn, to his credit, said he didn’t know.

Perhaps the genesis of the inquiry is the odd position Mr. Trump has put himself in of criticizing Germany (and by implication the EU as a whole) for damaging the US by having a currency that’s too strong while berating China for damaging us by doing the opposite.

It may also be economists’ comments that the Republican Congressional proposal to introduce a value added tax on imports could trigger a sharp appreciation in the dollar, thereby making exports from the US that much less attractive.

What is the best strategy for the US?

First of all, we should recognize that there’s no generally accepted economic framework that deals with currency.  There are lots of theories for particular aspects of currency relationships, but no one go-to theory.

Also, the US is in the unusual position of being the only universally accepted reserve currency, making the US is in effect the banker to the world.  So rules that apply rigorously to others may not, for good or ill, hold so firmly for us.

 

In 30+ years of dealing with foreign currencies as an equity investor, I think the issue can be summed up in practical terms to the question:  “If this country were a person, would I feel comfortable lending money to him?”

The factors that have meant the most to me are:  political stability, the rule of law, growth-oriented government policies, no excessive government debt, prudent government spending, and no restrictions on being able to repatriate my funds.  All other things being equal, mild appreciation of the foreign currency would be nice.  But I would trade that away in a nanosecond for assurance I wouldn’t have a currency loss.

All this implies that the value of a country’s currency isn’t determined by a deliberate currency policy.  Instead, it’s the result of overall conditions for doing business in that place, and of the effectiveness of government in providing a backdrop conducive for corporations to locate there.

One instructive recent example of what not to do:  massive government-engineered currency depreciation has been the cornerstone of Abenomics in Japan.  The main results so far have been to revive the fortunes of near-obsolete manufacturers, while retarding innovation and inducing an epic fall in the standard of living of ordinary citizens.

My advice for Mr. Trump?   Press forward on tax reform and infrastructure spending.  Establish meaningful vocational training to replace the VA-like stuff we have now.  Don’t try to weaken the dollar; that’s a recipe for disaster.

 

Trump and the big banks

banks and their social function

Banks aren’t ordinary corporations.  In addition to being private, for-profit organizations, they also carry out important social economic functions.  They’re the primary instrument the government uses to carry out national money policy.  Through letters of credit, they also underpin the workings of the international trade of multinational firms that is increasingly important for economic growth.

This is why the major banks are considered “too big to fail.”

bank failures

US banks have been on the brink of failure twice during the past hundred years–in the late 1920s and in 2007-09.  Both times this has been the result of rampant speculative financial market activity coupled with reckless lending, both driven by the search for earnings per share growth.

Glass-Steagall, and its repeal

In the 1930s, Washington enacted legislation, including the Glass-Steagall Act that barred the banks from non-banking activities (like brokerage, proprietary trading and investment banking).  The new laws ushered in a period of relative stability for the banks that lasted until the late 1990s, when their intense lobbying succeeded in getting Glass-Steagall repealed.

(An aside:  yes, the banks manufactured periodic crises through imprudent lending to emerging economies–the Walter Wriston-led binge of the 1970s being a prime example–but these were relatively tame in comparison.)

Less than ten years later, many big banks were broke.  World trade had come to a standstill as manufacturers refused to accept banks’ guarantees that shipped merchandise would be paid for (the worry was that the guaranteeing bank would file for bankruptcy while the goods were en route, reducing the shipper to being an unsecured creditor).  The deepest peacetime period of world economic decline since the Great Depression began.

This, in turn, spawned Dodd-Frank, the 21st century equivalent of Glass-Steagall.

repeal again?   so soon?

While it took more than half a century for the memory of the Depression to fade enough for Congress to consider removing restrictions on bank activity, we’re now less than a decade away from the 2007-09 collapse.

Despite this, despite campaigning on an anti-establishment platform, and despite warning that Hillary Clinton should not be elected because she would be a creature of the big banks, during his first few days in office Donald Trump is proposing to restore to the big banks the tools of self-destruction they have wielded to devastating effect twice before.

How odd.

 

protecting domestic industry

If his inaugural speech is any indication, a principal tool President Trump expects to use to enhance US economic performance is to help expand sunset manufacturing industries by protecting them against imports.   More useful action would be to emphasize improving the skill level of the workforce and to encourage innovation.  There may be a place for preventing foreigners from selling at below production cost (dumping) designed to stamp out competitors.  But by itself, and as a principal strategy, protection usually ends up making the economic situation worse, not better.

That’s because:

it stifles innovation, as we can see from the current parlous state of the Japanese economy, which embarked on a strategy of protection in the early 1990s.  That country still has domestic industry that’s state of the art circa 1980, but little that’s more recent.  The US auto industry, which Washington protected from foreign competition beginning in the late 1970s from the 1970s onward, is another example.

other countries retaliate when the borders are close to their products.  President Obama placed import duties on Chinese truck tires, effectively barring them from the US market.  China responded by taxing agricultural products sold there by US firms.

protection typically raises costs to local consumers, lowering their standard of living.  Mr. Obama’s headscratching move simply redirected the source of imported tires from China to Thailand–at much higher cost.  Economists estimate that this unintended (I hope) effect alone cost several thousand US jobs.

 

Let’s hope the president sticks to corporate tax reform and infrastructure spending.

 

productivity diffusion

Happy Friday the thirteenth!

The Financial Times has an article today that talks about productivity diffusion, referencing a prior FT article and an OECD study on the topic, both of which I somehow missed.

In its simplest form (which suits me fine), economic growth can be broken down into two components:  having more workers (or having existing workers put in more hours); or being more productive, meaning investing in machines, new business processes or worker training.

One of the bigger economic issues facing the world (US included) is the sharp dropoff in productivity growth over the past ten years or so.  The OECD report that sparked the FT articles argues that the problem isn’t a drop in innovation across the board.  Rather, the most productive firms in the world continue to show strong productivity growth.  What’s changed is that the once-fast followers are only adopting best practices today at a much reduced rate.

Why is this?  The OECD answer, which best fits the EU, I think, is that big banks are protecting low-growth, heavily indebted “zombie” firms.  Their reason?  The banks keep the zombies afloat (mixed metaphor, sorry) so they won’t have to write off the dud loans–calling into question the banks’ own financial viability.  What’s scary about this analysis is that it calls to mind the experience of Japan in the 1990s, the first of that country’s three lost decades.  Given that the Tokyo government actively protects managements from the consequences of failing to innovate, the problem of economic stagnation still afflicts Japan today.

To me the real relevance of the current lack of productivity diffusion for the US is that it speaks to the thrust of Donald Trump’s macroeconomic ideas.  However well intentioned, the effect of dissuading firms from adopting productivity enhancing measures for fear of being publicly shamed and of shielding non-competitive firms from import competition will likely be the zombification of the affected portions of American industry.  That is not a long-term outcome anyone wants.

 

how do tariffs affect selling prices?

The purpose of tariffs on imported goods is to discourage their use and to encourage the development of domestic substitutes.  It sounds good in theory but may not work in practice.

A recent example of the latter is the imposition of tariffs by the Obama administration on truck tires imported from China.  The tariffs made the Chinese tires affected noncompetitive in the US.  But US tire makers regarded this market as not lucrative enough for them to enter.  So trucking companies began to import more expensive tires made in Thailand.  Economists estimated at the time that because the tariffs raised the cost of doing business for truckers it lowered their profits and overall cost the country about 3,000 jobs.  And then, of course, China retaliated by placing an import duty on poultry source in the US, hurting that industry as well.

The key points:

–tariffs raise the cost of doing business for the industries affected.  That extra cost must either be absorbed by the buyer of imported materials or passed on to the customer.  Theory says that if the end product is unique, the burden will be mostly borne by the end user;  if it’s a commodity, the importing company will have to absorb most of the extra expense.  An interesting case in this regard is toys.  Most of the toys bought in the US are made in China.  A tariff on run-of-the-mill imported toys (which probably means 90% of them) would mostly raise the price to consumers, in my view.

–tariffs may not promote domestic industry, and may do significant net damage, as the truck tire example shows.

–in addition, decades of protection against foreign competition did little to protect US carmakers from the long-term threat of imports.  On the contrary, Washington’s protective umbrella shielded shoddy manufacturing and lack of innovation that ultimately ended with two of Detroit’s Big Three declaring bankruptcy.  To be sure, government action forced foreign carmakers to establish manufacturing operations in the US.  However, the sad case of General Motors, which controlled 40% of the US cara market at one time, makes it hard to argue, I think, that government protection of domestic industry against foreign competition is the best thing to do.