Best Measure of Labor Market Shows Disinflation Risk

 

The labor market has become less dynamic, meaning that workers quit and change jobs far less than before because of a weak economy. The quit ratio is a measure of worker’s confidence about job opportunities and is Greenspan’s favorite indicator. This ratio along with other similar ones has collapsed and stayed low since the Great Recession of 2008 despite massive stimulus. The Goldman Sachs Labor Market Dynamism Tracker (see WSJ article) has rarely been below zero but starting in 2007 it went below zero and way down to negative 3 and is now at negative 2 far below it traditional positive 2. Clearly workers were badly hurt by the 2008 crash and have not recuperated. When workers quit then employers are forced to hire those who may have a harder time finding work. As a result of diminished amount of quitting it has become harder for new workers to get a break.

If workers are frozen in place and unable to move up through quitting then it not only slows opportunities for them but it also slows opportunities for new job seekers. Currently today’s younger generation has excessive student debt and a more difficult time finding work than previous generations had. Thus it is harder for young people to buy a home which is a key part of wealth building for someone with no assets. Home buying also is important to trigger consumer consumption. This is a reason to be bearish on the economy and on stocks or at least to assume that growth prospects are so limited that stocks are overpriced and will go down.

The middle-skilled workers have been badly hurt by globalization where employers fled to Emerging Market countries. The trend has not been reversed and will continue. This means lower living standards, less consumption less economic growth and thus low interest rates, lower stock prices. The great phony housing boom of 1997-2007 caused by “Liar’s Loans” easy underwriting had fooled people into feeling prosperous by offering employment in real estate, etc. or offering a chance to get cash from refinancing or flipping of properties. This distraction camouflaged the declining career prospects of workers hurt by globalization and thus it camouflaged the disinflationary nature of the deterioration of the U.S. labor market.

17 years ago the economy embarked a journey of massive credit increases which pushed stocks much higher than the PE10 suggested values and created a massive bubble in 2000, 2007 and now. The result of this credit increase is that it camouflaged weakness in the economy while surreptitiously putting handcuffs on to consumers in the form of excessive debt. Now consumers have woken up and realized that the benefits of excessive debt have been fully tapped out yet they are prisoners of an excessive debt load. The U.S. has 349% debt to GDP which is double the long run average. This rapid increase broke through the historical ceiling about 25 years ago and is far above traditional metrics.

I used to wonder if situations like Baby Boom workers in their peak earnings years in the 1990's or an increase in two-income couples would help to justify the fact that this ratio has gone higher. But since the ratio is debt-to-GDP then as one person becomes begins to earn more and also increases the amount of his mortgage, etc. to get a bigger house, then in theory the ratio should not get bigger. Also the end of the Cold War in 1991 would be a reason to cut debt, not increase government debt. The only possible non-risky use of debt is when corporations borrow so that they don’t have to repatriate offshore profits in which case they are not really taking on extra net debt. But those borrowings are a tiny portion of total debt. They are probably no more than 10% of corporate debt which is roughly a third of total debt, so that would be 3% of all debt is something that is offset by offshore corporate cash.

The combination of a very weak labor market (in terms of quality of middle skill jobs and in terms of a bad “quit rate”), excessive debt (especially student loans carried by young people with minimal work experience) and a slow growth economy all serve to make the current economy antipodal to the inflationary 1970’s. Thus a 30% probability of revisiting the 2012 interest rate lows with the ten year Treasury at 1.38% (as forecast by Jeff Gundlach) is a reasonable estimate. It is too risky to go long on long term bonds in hopes of making capital gains. However one should trim their portfolio’s  credit quality risk on junk bonds as the current recovery is not strong enough for “B” paper creditors to grow their way out of too much debt and thus they could default. Junk bonds could lose 30% in a credit quality crash but if interest rates go up for investment grade bonds they will probably only go up 1.5% which on a 5 year duration portfolio would result in a 7.5% price decline. Thus “B” paper is far riskier than the risk of a sudden spike in risk-free intermediate term debt yields.

Investors need independent financial advice about the risk of bonds in the next crash. I wrote an article “Hidden risk of high yield bonds may damage 401K’s.”

 

 

About the author

Don Martin, CFP®

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