There’s No Need to Be Brave (Yet) in This New World

I work in a building with several other macro hedge fund managers. We generally avoid one another, and on those rare circumstances we find ourselves in close proximity we tend to talk about anything but markets. This is primarily to avoid the affliction that plagues our east coast brethren, the dreaded “macro group think”.

Macro Group Think: On Their Way to Short the Euro!

The other day I found myself discussing business unrelated to markets with some macro managers from my building. At one point, the conversation turned to markets. “So…do you think volatility can go any lower?” one of them asked. I shifted uncomfortably in my chair, trying to stifle a response. It was a lost cause.

“Well, when you have every major central bank either buying or about to be buying every debt security in the market, you are going to stifle volatility. If anything goes bad out there, it will be met with a forceful central bank response, fueled by the proverbial “free lunch” of being able to print money in a deflationary environment,” I blurted out. To prove my point, I showed the yield volatility on US, European and Japanese bonds since the crisis. A relatively steady decline.

I’m Surprised JGBs Have Any Vol as They No Longer Trade (source: BBG, Cabezon)

I then showed the VIX. The last time volatility was this low was…well…right before the crisis. But this time is different (famous last words, I know). We’re coming off a crisis, with the Fed ready to pounce on the first signs of economic malaise or financial markets stress, augmented by the ECB, PBOC and BOJ playing by the same rulebook. Unfortunately, the Bank of England seems to be striking their own path that looks to include rate hikes in the near future. But if the FTSE underperforms maybe they’ll wise up and fall back in line.

How Low Can it Go? Technically, to Zero (source: BBG)

El Erian coined the term “New Normal”, but unlike Huxley’s Brave New World, there is little need to be brave when sovereign printing presses stand ready to buy any and all assets to maintain calm. Why wouldn’t you want to be levered long equity in this environment? What can go wrong?

In thinking about that question, I’m drawn to the US consumer. There are three charts that I find interesting and worthy of discussion. The first is the growing gap between wages and consumption since the crisis.

(source: BBG)

Consumption is clearly outstripping wage growth. Given that consumer credit is declining, we know the difference has to be some combination of investment income and government transfer payments.

The next chart shows the overlay of median household income and labor force participation rates.

(source:BBG)

While the decline in labor force participation has been discussed ad nauseam in the media, the decline in median household income has not. Total household income has surpassed pre-crisis levels, but median household income has fallen every year since the crisis. This chart makes it easy to identify labor force participation as the culprit. The common thesis is that old people are retiring, moving from wages to savings/transfer payments and that is driving down median income and supporting the growing gap between wages and consumption. But that doesn’t foot with the next chart.

A Tale of Two Generations (source:BBG)

Folks who should be retiring – age 65 and up – are actually entering the workforce. Their participation rate has risen 2.5 percentage points since the crisis. Prime earners – age 25-34 – are leaving the workforce. Their participation rate has fallen nearly 3 percentage points since the crisis. This should be surprising to anyone who has bought into the dogma that the decline in labor force participation is entirely driven by demographics and purely coincidental to the events of 2008.

So what does this all mean? I think the following:

1. Quantitative easing reduces asset volatility and encourages asset inflation – great for anyone wealthy and invested.
2. Since the crisis, wealthy families have benefited from quantitative easing, and poor families have benefited from government transfer payments, allowing consumption to outstrip wages.
3. Middle class families have not benefited from either quantitative easing nor transfer payments, and have seen their household income decline since the crisis.
4. The decline in the unemployment rate is being driven by an exit of 25-34 year olds, and an influx of those 65 and over. This doesn’t bode well for productivity and potential output.
5. This system will persist until inflation ends quantitative easing or the middle class rebels.
6. Given the exit of 25-34 year olds post crisis, there is probably considerably more slack in the labor market than the unemployment rate suggests, implying inflation is still some ways off.
7. Despite the much-publicized Google bus attacks in San Francisco, there isn’t any sign the middle class is ready to rebel.

So the net is, things will likely stay the same for a while longer. Likely low volatility, low rates and a risk-asset melt-up. However, unless those 25-34 year olds get back into the labor market, the days of 3% annualized US GDP may be a thing of the past.

I’m Back in the Workforce, Baby!