Checking Back in on the Big Inflation Picture
Halfway Through the Year, We See Little Has Changed. Yet Everything Has
Heraclitus of Ephesus, the pre-Socratic Greek philosopher, is supposed to have given us the title of today's Fieldnotes. It reflects a recurrent theme in his philosophy--or what is handed down to us as his philosophy--that the world is constantly in a state of flux, which is to say it is in no state at all. Thus, no one can ever step foot in the same river twice. The critical insight here is not just that the river is constantly in change--that much is obvious--but that the river stepper is, as well.
Just as I was starting to get warmed up for a good metaphysical discursion, Reality intruded with her customary matter-of-factitude to demand that we relate this momentary indulgence to the world at hand. So, I relent. But first, more philosophy.
The philosopher of epistemology Karl Popper wrote in 1957 in The Poverty of Historicism about the idea of Reflexivity. Plainly stated, it is the proposition that our predictions regarding future events influence the course of those events. In this way, what is expected can become a self-fulfilling prophecy. The prophecy that he will kill his father and marry his mother sets Oedipus on the path to murder King Laius on the road to Thebes and wed Queen Jocasta there. Popper's pupil, the investor George Soros, famously adapted this concept by applying it to the financial markets in his 1987 work The Alchemy of Finance.*
Efficient Market Hypothesis holds that the Market is a discount machine. It takes in all available information, assesses probabilities and outcomes, and then publishes prices that summarize the total of market participants' various viewpoints on probability and outcome. These prices are then incorporated into the body of available information, and so inform the discount machine of which they are also the product. Reflexivity, therefore, holds that our expectations about the future (qua prices) influence and shape that same future.
If this sounds familiar to goodsteaders, that's because it is essentially the same argument that we have made before with regard to inflation: expectations about future inflation drive inflation much more so than does any real supply-shock or demand-shock cause. The expectation of future price rises causes workers to demand a higher wage in exchange for their labor. The price of labor increases, causing the price of the goods and services they produce to increase, assuming stable profit margins. The increase in the price of goods and services not only validates the worker's belief that prices in the future would rise, but their rise also serves as justification to demand yet further increase in wages; and so on, and so forth, in what is typically referred to as the 'wage-price' spiral. It's a self-reinforcing positive feedback loop that contains within its own dynamics no mechanism to curtail its own increase. Some exogenous interruption to curtail the vicious cycle is required. That said, we still don't see a lot of evidence that workers anticipate long-term price inflation. Consumer expectations about long-term price inflation seem to remain anchored.
So, while inflation expectations for the next year are high, longer-term expectations are for declining inflation. One of the big differences between the US economy today and in the 1970's about which we've been hearing so much lately is that far fewer American workers belong to a labor union:
In 2021, the number of wage and salary workers belonging to unions continued to decline (-241,000) to 14.0 million, and the percent who were members of unions--the union membership rate--was 10.3 percent, the U.S. Bureau of Labor Statistics reported today. The rate is down from 10.8 percent in 2020--when the rate increased due to a disproportionately large decline in the total number of nonunion workers compared with the decline in the number of union members. The 2021 unionization rate is the same as the 2019 rate of 10.3 percent. In 1983, the first year for which comparable union data are available, the union membership rate was 20.1 percent and there were 17.7 million union workers.Workers bargaining together have a lot more negotiation leverage than do workers bargaining on their own. About half as many workers as a percentage of the labor force belong to a union as did in the early 1980s. Below we show wage growth data going back to 1997. As you can see, wage growth has steadily declined through the aftermath of the Great Recession, then moderately recovered before spiking in the Great Reopening. Workers seem to have more bargaining leverage than in decades.
Nonetheless, although workers have been more successful of late in bargaining for higher wages, those wages still represent a declining share of corporate earnings. Below we show the share of corporate income that accrues to labor going back to 1979. This is reflective of Labor's inability to demand higher wages over the long term. When the Labor Share of Income does increase, it's during recessions, when income falls but worker wages do not. The overall downward trend is clear.
Wages have risen recently due to economic expansion, increases in the general price level, and a declining labor participation rate. It's the fall in the Labor Force Participation Rate that is most puzzling and remains without compelling, evidence-based reasons. With fewer workers in the workforce, the supply of those willing to sell labor is lower. Lower supply without commensurate lower demand results in a higher clearing price for labor.
Without knowing the causes of this decline, it is difficult to say whether it will be sustained in the future and result in higher wage growth rates or not. Historically, it was secular factors that exerted negative pressure on wages--offshoring, automation, worker immobility, and the shift from goods to services production--all contributed to depressing wages. Their effects likely won't be as pronounced going forward: offshoring resulted in fragile supply chains that are largely responsible for the supply shocks that we're now experiencing, and the advent of remote work gives workers access to a far greater pool of demand than was ever available to them before. As we're closer to the end of the business cycle than the beginning, our bet is that workers' newfound wage negotiation leverage will be short-lived. Higher unemployment due to a contraction in growth will be enough to pause wage growth rates this time around. The next business cycle, however, will prove interesting to watch.
US Real Growth Continues to Decline, but Still Strong
We continue to receive mixed signals on the state of growth. American productivity growth had been in decline for much of the past forty years, but has been 2% higher since the second quarter of 2020 when the world shut down to contain the spread of the COVID-19 virus. We continue to expect growth of about 3-3.5% for the near term.
As we mentioned earlier, expectations of the future are more important than current conditions. The market, our discount machine, is forecasting earnings growth of 3% one year out, nearly in line with GDP growth. This indicates that the market, on average, expects corporate profits--earnings--to increase 3% over the next year. (This would be inclusive of inflation expectations.)
So, we're good, right? GDP growth looks good, profitability growth looks good, and the growth rate is the highest that it's been in a couple of generations. The unemployment rate is the lowest it has ever been. How is the consumer reacting to this favorable set of circumstances?
According to the University of Michigan, consumers have never had lower confidence. Never. Not even in 1979 when inflation was raging, and growth was at a standstill. We're not too clear on how this is possible. We are certainly aware that many consumers don't spend as much time looking at data as we do. We are certainly aware that we spend far less than does the average consumer (Note to Reader: Consumer Spending is the enemy of wealth. Save now!) We're definitely more optimistic. But worst ever? It strains credulity.
Without impugning the accuracy or methodology of the University of Michigan's fine survey, we are aware that, if accurate, reduced consumer sentiment will impact how much people save, how much they consume, and what risks they're likely to take in their jobs or in their businesses. We have now come full circle, back to Reflexivity. No matter how healthy the economy is, or how good workers or consumers have it, if they don't feel good about the future, they'll stop doing the things that drive economic growth, and start doing the things that cause the economy to contract. And so their expectations of a decline in growth can become a real decline in growth--and so might the epitaph for the longest economic expansion in the history of the United States written.
It's not just the prices at the grocery store that have consumers concerned--consumers who are the backbone of the American economy. We believe that the most proximate cause of this collapse in sentiment has pretty much everything to do with the rise in interest rates. Money is more expensive than it has been in quite some time. That means that Americans have to pay higher monthly payments to buy the big-ticket items they've had to wait months and months for--houses, cars, durable goods, etc. The consumer has responded by buying far less of these things, and less of things in general. This makes the consumer feel less well off, and has already contributed to a lower marginal propensity to spend.
It is this change in sentiment, more than the change in a food-, energy-, and housing-price heavy, backward-looking index level, that the Federal Reserve should look at today when they consider how much to hike interest rates. On the table is another rate increase of .5%, or a more aggressive increase of .75%, presumably to "maintain its credibility". This is wholly unjustified on the data, and wholly already priced into the market.
As we believe that the Federal Reserve Bank will answer the hawks' cries, and consumer sentiment has already turned, risks of economic recession are no longer balanced, but have instead turned to the downside. Accordingly, we have moved to a portfolio positioned to perform in a low-growth, high-inflation environment. As markets are not currently pricing in economic contraction, it is our belief that equity markets will fall further over the coming months, and will overshoot to the downside as they always do. This creates buying opportunities toward the latter part of the year, for which we will maintain a larger-than-usual allocation to cash. Things are going to start to get really interesting after today.
*He delivered an excellent summary of its basic tenets and their implications in a lecture delivered at Central European University called "The General Theory of Reflexivity". (Similarities in title to the famous works of Albert Einstein and John Maynard Keynes are wholly coincidental.)