Should we worry about recent rises in capacity utilisation?

Posted on 28 March 2013 by Wolfgang Bauer

In recent years the use of capacity utilisation (CU) as a leading indicator for inflation, and hence for interest rates, has fallen somewhat out of favour. The large amount of spare capacity in the developed world in 2009-10 failed to translate into the substantial deflation that many had anticipated. Most economists and investors are eagerly focussing on U.S. labour market data instead, given that the Federal Reserve has tied its interest rate policy to an unemployment rate threshold of 6.5%. So, is it time to throw CU into the dustbin of economic history once and for all? This might be premature; ignore CU at your own peril.

Every month the Federal Reserve Board produces a CU percentage figure for industries in manufacturing, mining and utilities by essentially dividing actual output by capacity, i.e. a maximum sustainable output level. In general, capacity figures are derived from physical product data from government and trade sources or, if actual product data is unavailable, from responses to the Bureau of the Census’s Quarterly Survey of Plant Capacity. The basic rationale behind using CU figures as a leading inflation indicator reads as follows: in economic boom times factories tend to bring their output closer to full capacity, which places growing strains on their goods-producing capital. Excess demand and lack of supply, in combination with failure of stressed equipment, can lead to product shortages, sparking price increases and inflationary pressures. A more detailed explanation can be found in chapter 4 of Richard Yamarone’s book “The Trader’s Guide to Key Economic Indicators” from 2012.

Prior to the financial crisis in the late 2000s, the Fed apparently followed this line of argumentation. As the first chart shows, major hikes in the Federal Funds Rate, e.g. the January 1994 and July 2005 rate hiking cycles, marked by white dotted lines, followed periods of rising CU numbers. However, from 2008 onwards this relationship has clearly broken down. Although CU has risen by more than 11 percentage points from 66.9% in June 2009 to 78.3% in February 2013, the Fed Funds Rate has been kept close to zero. One could argue that despite this remarkable CU growth, i.e. reduction in spare capacity, in recent years the absolute CU level is still below the psychologically significant 80% threshold. For instance, the 1994 rate hike, and the subsequent “death of the bond market”, began at a considerably higher CU level of 82.4% (January 1994). However, I do not find this argument particularly convincing, considering that the Fed’s most recent major rate hiking cycle started at a CU level of only 77.9% (July 2004), 0.4% below the current figure.

Another aspect worth exploring is the relationship between CU and business investment spending. Maybe U.S. companies have simply slashed their investment plans and decided to run down their plants and equipment after the financial crisis, scared to invest their cash safety blankets. In this case, rising CU numbers would merely be an artefact and no indicator for economic recovery and inflationary pressure. The second chart shows both CU and quarter-on-quarter (qoq) changes in non-residential fixed investment for 2009 onwards. With increasing CU figures, investment changes get less negative in 2009 before they enter positive territory in Q1 2010. Throughout the following three years, business investment has grown in 10 out of 12 quarters. Slightly negative qoq changes of -1.3% and -1.8% were recorded in Q1 2011 and Q3 2012, respectively. It should also be noted that the decline in qoq investment changes from Q3 2011 to Q3 2012, which was addressed in a Wall Street Journal article from November 2012, has come to an end by jumping to +8.4% in Q4 2012. Considering this pattern of investment spending, recent CU increases cannot be explained by cut backs in business investment. Therefore, I believe that the rise of CU is indeed a strong sign for an ongoing recovery of the U.S. economy.

In conclusion, although at the moment the Fed seems to be preoccupied with the unemployment rate, I believe it is worthwhile keeping an eye on CU. If CU continues to rise, while being backed up by growing business investments, this would indicate inflationary pressures too strong to be forever ignored by the Fed.

Why we love the US dollar, and worry about EM currencies

Posted on 16 January 2013 by Mike Riddell

The US dollar has been one of the worst performing currencies in the world in the last decade, but we think it is ripe for a rally. We expect the US dollar’s correlation with risky assets to steadily change (in fact this is already happening). We believe that the US monetary policy transmission mechanism is actually working fine. We are bullish on US growth, particularly in relation to other regions. The Federal Reserve appears behind the curve, but a number of policy makers are increasingly realising this. And following a prolonged period of big underperformance, the US dollar is looking fundamentally cheap, especially in relation to some emerging market currencies.

The main push back we hear regarding our bullish US dollar view is that by being long US dollar you’re basically being short of risky assets. Lately this has been true; the US dollar has tended to rally sharply when large banks are blowing up or the Eurozone is threatening to fall apart, and has tended to perform poorly when everything looks alright again.

However the US dollar has not always had this risk on/risk off (“RoRo”) characteristic. The first chart below plots the US Dollar Index (a general international value of the US Dollar) against the MSCI World equity index, and the chart immediately following shows the rolling two year correlation of the two indices with some rough annotations (usual causation/correlation disclaimer applies).

It’s noticeable that the RoRo qualities of the US Dollar have weakened in the last two years, presumably on the back of a broader risk rally at a time when investors and central banks have been dumping/diversifying away from euro denominated assets. Going further back, it’s also apparent that the US dollar has not always been a ‘risk off currency’, where a major factor appears to be Fed Funds rate cycles.

On the point of Fed Funds rate cycles, we think that the Federal Reserve continues to be behind the curve, or following the Federal Reserve’s change in communication, it’s perhaps more accurate to say that the market is behind the curve. We spent much of last year discussing how the US housing market was starting to take off (eg see here), which is evidence that the monetary policy transmission mechanism is no longer broken. But it’s interesting to consider the chart below – wherever the Fed Funds rate has gone in the last four decades, unemployment eventually follows. The shock to the US economy in 2008 was obviously huge, but this cycle doesn’t actually look that different to previous ones.

The current trajectory suggests that the US unemployment rate could hit 6.5% sometime in the middle of next year, an eventuality that would surely see US Treasuries sell off violently. There are eerie echoes of 1994, when the Fed hiked rates from 3% in January 1994 to 6% in February 1995 with very little prior warning; investors were caught with their pants down and markets were given a jolly good spanking (the 10 year US Treasury yield had fallen to 5.2% in late 1993 but a year later peaked at 8%).

It’s likely that the US dollar would appreciate as US yields jumped if you assume that hikes in the Fed Funds rate won’t be replicated around the world. This seems a relatively safe assumption given the Japanese devaluation rhetoric and continuing mess in Europe (Eurozone unemployment recently hit a record high of 11.5%, while the UK is likely to have experienced negative growth in Q4). That said, the US dollar surprisingly depreciated versus the Japanese yen and a number of European currencies in 1994, prompting then Fed chairman Alan Greenspan to state that the US dollar was weaker than it should be – Greenspan’s wish was granted from 1995-2000 though, as the US dollar was supported by factors such as high relative real interest rates, a US productivity surge, EM crises and Japanese stagnation.

Another plus point for the US dollar is that the horrendous performance of the currency over the last decade has left the US economy looking competitive. Last February I wrote about how some manufacturers were moving operations from China to Mexico to take advantage of the dramatic increase in Mexico’s relative competitiveness (see here). I’ve since heard a number of anecdotes – admittedly the weakest form of evidence – about manufacturers also relocating back to the US.

The conclusion from the chart below is that such behaviour makes a lot of sense. It shows the relative performance of real effective exchange rates, which is a measure of a country’s trade weighted exchange rate adjusted for inflation. Real effective exchange rate measurement is imprecise since inflation data can be unreliable (eg Argentina) and calculations can vary depending upon the particular measure of inflation used (eg CPI, PPI, export price indices, core inflation, unit labour costs). The starting point can also make a lot of difference when using a time series – I’ve chosen 1994, which is immediately after China’s 50% devaluation*, but before the Latin American and Asian financial crises.

But while the absolute level of some of the exchange rates in the chart below need to be treated with a pinch of salt, the direction of travel should give a relatively unbiased view. The US dollar (thick red line) is looking very competitive versus the majority of emerging market currencies.

Meanwhile a surprising – and worrying – aspect of the last year has been that emerging market FX reserve growth appears to have stalled. Part of this can be explained by weaker global demand resulting in weaker EM exports. Part of this can be explained by EM countries gradually rebalancing their growth models away from exports and towards domestic consumption, the result of which means a narrowing of the global current account imbalances.

However, lower FX reserve growth is not at all consistent with EM countries continuing to receive large Foreign Domestic Investment (FDI) and record portfolio inflows – you’d expect to see reserves jump. And neither is lower FX reserve growth consistent with the US dollar’s performance over the past year – a slowdown in FX reserve accumulation is typically synonymous with US dollar strength because FX reserves are typically measured in US dollars, and non-US dollar denominated assets would fall in value when measured in US dollar terms. Yet the US dollar has been broadly flat and if anything weaker over this period.

It is a very dangerous combination to have flat or falling export growth (see previous blog) combined with flat or falling FX reserve growth combined with a significant appreciation in real effective exchange rates. In a study of prior academic literature, Frankel and Saravelos (2009) find that measures of FX reserves and real effective exchange rates stand out as easily the most important lead indicators of financial crises. Note that other lead indicators with strong predictive powers were found to be credit growth, GDP and current account measures, and a number of EM countries are looking shaky on these measures too.

Concerns around stalling FX reserve growth are tempered by the fact that reserves in many countries are at or close to record highs. But while high levels of FX reserves do act as a cushion for the individual country during a crisis, FX reserve accumulation can also have significant downside risks for the individual country (eg real estate bubbles, credit bubbles, misallocation of domestic banks’ lending – sound familiar?). Much has also been written about the risks to the global financial system** as a whole and I’d recommend this 2006 ECB paper for a good overview. I’d add that while countries with high levels of FX reserves allow countries to weather crises better, they don’t make countries immune to crises; despite high levels of FX reserves, Taiwan still saw its currency slump 20% against the US dollar in 1997.

When is the US dollar likely to appreciate, or EM currencies depreciate? EM debt crises since the 1980s have tended to follow periods of rising Fed Funds rate and/or US dollar strength, so this would suggest it’s not imminent. However I was presenting at a conference last month and found a kindred spirit in CLSA’s Russell Napier, who has near identical concerns about EM debt, and his view is that there have been many examples where bubbles have burst before the risk free rate rises – domestic overinvestment, lending to poor credits, commodity price declines and capital exodus can cause debt crises independent of external factors.

Either way, the reason that EM FX reserves are not increasing (see charts below) at a time when EM currencies aren’t strengthening seems most likely to be because EM currencies are at best no longer cheap, and at worst have become overvalued. Which is another reason to like the US dollar right now.

* China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade now than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way? A counterargument could be that a big yen sell off would encourage Japanese savings to flood into its trade partners’ capital markets – capital controls meant this wasn’t possible following China’s devaluation.

** Ben Bernanke’s global savings glut hypothesis argues that excess global savings have been responsible for lower government bond yields. The fact that EM FX reserves have stalled suggests that these countries have not been net buyers of US Treasuries in the last year. The baton had been taken on by countries such as Switzerland and Denmark, whose FX interventions to maintain their respective currency pegs resulted in rapid FX reserve increases and strong support for core government bonds, but upwards pressure on these countries’ exchange rates has recently greatly reduced and their reserves are no longer growing either. That really just leaves the GCC countries, whose FX reserves are largely a function of the oil price. Yields on core government bonds would presumably therefore be significantly higher were it not for large scale domestic central bank purchases.

Central Bank Regime Change: an update following the Fed last night, and Carney the day before

Posted on 13 December 2012 by Jim Leaviss

Last night’s move by the Federal Reserve to change its approach to US monetary policy to effectively reduce the focus on the inflation target was just the latest step in an accelerating project by the world’s monetary authorities. In a world where unemployment rates are well above pretty much anyone’s estimate of the natural rate, and in many geographies well above 10%, the need for growth is seen as much more pressing that the fear of missing the 2% inflation targets. So at the latest FOMC meeting the Fed decided that inflation would be tolerated if it nudged higher to 2.5% as long as unemployment remained too high (above 6.5%). You can read the text of the Fed’s statement here.

We call this move by the world’s authorities away from the old idea of 2% inflation targets Central Bank Regime Change. We wrote this blog about it in March. The chart is worth showing again.

The chart from the IMF shows us that in the period post Paul Volcker’s appointment to the US Fed in 1979 (the orange line), the monetary authorities kept interest rates higher than the rate of inflation (they were reacting to the damage that inflation caused in the 1970s). As a result inflation steadily fell – and as well as high “real” rates, the rhetoric was all about inflation (inflation targets, the Bank of England’s Inflation Report, independent central banks). It’s been an awesome 30 years (on the whole!) to be a government bond investor, as yields fell in response to inflation fighting credibility. However, I’ve added another line to the IMF chart (blue), showing how central banks have behaved since Lehman went bust, and the credit crisis was followed by the sovereign debt crisis. It’s a very different story, with sharply negative real yields. Nominal interest rates are near zero in much of the developed world, yet inflation has been sticky above 2%. This is deliberate central bank policy – negative real rates are designed to make it attractive to borrow to invest and stimulate growth (and to deliver gains to indebted consumers), and also to encourage risk taking as investors reach for yield (government bond investors buy credit, investment grade investors buy high yield etc.).

Negative real rates also have an impact which we’ll discuss in more detail another time – debt reduction for bust governments. There are a few ways to reduce debt burdens: strong real growth (seems out of reach for the foreseeable future), austerity (unproven and probably counter-productive, although some point to Canada and Sweden as success stories), default (will be necessary for some Eurozone economies without their own currency to depreciate) and inflation. It’s the last that’s likely to be effective – and as the red line on that chart shows, it’s the method by which the western economies reduced the war debts following WWII.

So whilst we don’t believe the world’s central bankers and finance ministers are sitting high in some Swiss cable car complex, stroking white fluffy cats and cackling maniacally, plotting to generate super high levels of inflation, this is becoming the pragmatic (only?) response to a world without other policy responses (no fiscal flexibility left). Now the Fed’s latest move to target both inflation AND unemployment rates is very interesting – when I was a young student of economics, the idea that you could chose BETWEEN inflation and unemployment was discredited. To quote, er, Wikipedia on that idea, known as the Philips Curve “while it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run”. So the idea that you can choose both is probably even more far fetched.

Anyway, what does the Fed’s action mean? Well watching Bernanke’s press conference last night it struck me that in changing the Fed’s guidance away from the “no hikes until 2015” towards the unemployment and inflation numerical targets should actually be seen as a potential monetary TIGHTENING. After all, we are exceptionally bullish on US housing as a driver for growth in 2013 and 2014, so if things go well we could end up with the Fed raising rates ahead of the old 2015 date.

So I’ve asserted that Central Bank Regime change is taking place, but I thought it would be worthwhile to put together a brief list of the evidence so far. Here it is.

Evidence for Central Bank Regime Change

The level of real rates set by the Central Banks: the best evidence is obviously shown on the graph itself. Are central bankers hitting inflation targets? Not really – for example the Bank of England has only had CPI at or below the 2% target for 6 months in the last 5 years, and for much of that period it’s been above 3% (and above 5% at one point!). On latest data the UK, the Eurozone and the US all have negative real rates of 1.75% or higher. Western central banks are even considering setting negative NOMINAL interest rates. Only Japan of the major economies has positive real rates at the moment – although we think this might change dramatically, as I’ll discuss below.
The US refocus on the dual mandate: after three decades of inflation targeting, the Fed has been moving towards this new objective for a year or so now. First Charles Evans of the Chicago Fed started floating the concept of an unemployment target, then Janet Yellan (Bernanke’s probable successor) of the San Francisco Fed joined him, leading up to last night’s actions. This was pushing on an open door for Ben Bernanke who has written the following in his previous academic life…
Bernanke’s 4% inflation target for Japan: in this paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis, written whilst he was at Princeton in 1999, Bernanke argues that the solution for an economy like Japan with a burst property bubble, broken banks, sluggish growth and deflationary pressures should be to target inflation of between 3% and 4%. Looks similar to the US situation, so why wouldn’t Bernanke think that this is the correct response from the Fed for the US?
Mervyn King’s softening stance on the inflation target: I guess actions speak louder than words, and the lack of actual inflation targeting in the UK for the last 5 years should tell you more than any speech, but I’d never heard the Governor soften his rhetoric until these words in this speech Twenty Years of Inflation Targeting this October. “There may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises”.
New Bank of England Governor Mark Carney talks about a new regime of nominal GDP targeting rather than pure inflation targets: in a speech to the CFA Society of Toronto this week, Carney (who takes over at the BoE next year) suggested that when policy rates approach 0% (the “zero bound”), targeting nominal growth might be more effective than targeting inflation rates. He even used, for the first time from a central banker (?) the term “regime change”. “Under Nominal GDP targeting, bygones are not bygones and the central bank is compelled to make up for past missed on the path of nominal GDP.” Of course, targeting nominal GDP is a very effective way of reducing debt levels in an economy too.
Japanese regime change, the “Abe Trade”: this weekend Japan goes to the polls with opposition leader Shinzo Abe of the LDP favourite to emerge as the new Prime Minister. Japan has yet to recover from its bust, decades ago, and Abe wants to aggressively target growth. With deflation of 0.4% in Japan despite the BoJ’s 1% inflation target, Abe wants the central bank to do MUCH more. This would include raising the inflation target to 2% (or even 3%) and doing whatever it takes (more QE, currency intervention) to achieve that. This is a manifesto commitment that might get watered down at a later date – but having seen a BoJ member in Tokyo recently I get the feeling that a hike in its inflation target is inevitable.
Europe: hard evidence is more difficult to find, but with hawkish German ECB members like Axel Weber and Juergen Stark both resigning in 2011 (“It’s generally known that I’m not a glowing advocate of these (bond) purchases” – Stark) the ECB has been much more open to extraordinary balance sheet expansion (LTRO, SMP, OMT). And to more “traditional” Quantitative Easing at a later date?

So with all of this evidence that the authorities are changing how they think, and act, on inflation, you would expect that bond markets would have reacted badly right? If Ben Bernanke thinks 4% is an appropriate level for inflation in the US, you wouldn’t be lending money to the government at 0.65% for the next 5 years would you? And with Mark Carney taking over at the BoE next year, breakeven inflation rates (i.e. market inflation expectations) would be overshooting the 2% inflation target over the next few years too? Well 5 year Treasury yields are still well below 1% (helped by QE buying of that sector, announced last night) and UK breakeven inflation rates on a CPI basis are below the 2% inflation target. In both cases it feels as if state intervention in these markets (financial repression through QE, capital requirements etc.) will keep yields low despite high inflation. And this is entirely necessary – with half the US Treasury market maturing in the next 3 years or so, if yields ever did adjust higher then western governments, with marginal solvency in any case, could go bust quickly.

The fiscal cliff is bad news, but is likely to be resolved – so don’t ignore the extremely positive developments in the US housing market

Posted on 26 November 2012 by Jim Leaviss

There are some big risks to the US economy, but the potential for the US housing market to surprise on the upside, and deliver massive gains to US employment might well be the bigger story for 2013.

The real damage that the fiscal cliff is causing is mainly psychological at the moment, discouraging both capital investment and hiring. I’m not allowed to use the phrase that involves metal food containers being moved further along transport routes by means of the foot, as we have a “cliché box” at work, and saying it would cost me dearly – but that is both the obvious solution to the problem, and indeed the only solution. The size of the US debt is now too big for any politician to deal with decisively, and some sort of default (against bond holders if a default against the population’s pension or healthcare expectations isn’t possible) or devaluation (currency or inflation) sometime in the future will be likely.

The focus on the fiscal cliff has taken attention away from what we think are extremely positive developments elsewhere in the US economy – and particularly in the housing market, as alluded to in September. US housing became the centre of the global financial crisis from 2007 onwards, when the credit bubble burst as sub-prime mortgage loans started to go bad. Too many houses had been built, and the overhang of unsold inventory together with foreclosures and falling real incomes and unemployment led to a sharp fall in house prices. The banking system went bust, and a huge number of construction jobs were lost in the economy. From a peak of 7.7 million Americans employed in construction in 2006, by the start of 2010 the sector had lost 2.2 million jobs. But we’re now seeing a large number of positive signs in the US housing market, and just as the negative multiplier effects spread through the economy when the sector tanked, the reverse might be true next year.

The chart below was very important to us in 2007, when it led us to expect not just weak growth in the US, but an outright recession with huge damage to the banking sector. It showed that there had been so much overbuilding in US residential property that the supply of inventory had moved from about 4 months to over 7 months. This had historically been a leading indicator of recession. In fact unsold inventory moved much further than 7 months, hitting 1 year in 2008, presaging US GDP falling by 4% year on year. You can see that the available inventory of housing is now contracting sharply, to the extent that US growth should continue positive. It’s also at a level where house-building should resume – and the multiplier effect from that will be extremely powerful.

Other reasons to be cheerful about US housing? Well house prices have been rising, according to the S&P/Case-Shiller index, since March this year (but remain “cheap”, 30% below the peak in nominal terms, even weaker in real terms). So the negative sentiment around the sector will be fading somewhat – nobody wants to buy into a falling market. And the Federal Reserve has almost entirely moved its Quantitative Easing programme away from purchases of US Treasuries and towards the purchase of Mortgage Backed bonds. This should eventually help get the transmission mechanism working again. In theory American mortgage investors should be able to refinance existing mortgages at high rates into new lower rate loans. This hasn’t been happening – banks have dragged their heels on paperwork (the time from agreeing a loan to it closing has anecdotally risen from a month to three months for example), and lending standards for the new mortgages are often higher than they were for the outstanding stock of mortgages. So new 30 year mortgage rates are around 3.31%, (a record low). But as at 2011 (it’s probably lower now) 28 million Americans had outstanding mortgages with rates over 1% higher than the rate for new mortgages – in theory these are all refinanceable at lower levels. You could read this as bad news – but it represents a possible windfall gain for consumers if the transmission mechanism does start working again (lower interest payments equals more spending power). And the Fed is now focused on making the transmission mechanism work – it will get better.

So if the price of US housing is attractive, and mortgage rates have fallen, and there’s an increasing level of demand relative to low supply, how powerful can this be? Well we saw how powerful the negative impact was post 2007 – the multipliers involved with housing construction and household formation (people starting households for the first time, as a result of population growth and immigration, or moving out of a parental home) are very strong. A new housing construction project might result in a contractor hiring more workers, who buy pick-up trucks and power drills, and have wages to spend in their neighbourhoods. They buy cement (from Cemex hopefully, a high yield company we like!) and wood. And the people who move in buy carpets, chairs and flat screen TVs (is it time to stop saying flat screen when it comes to TVs? Probably). The Australian Bureau of Statistics calculated construction multipliers back in 2002 (the link is here). They found that there was an initial effect (the employment of construction workers and what they produce), a first round effect (the output and employment of those that produce the goods and services to the construction industry needs), an industrial support effect (the extra output impact on the suppliers to that first round effect), and a consumption induced effect (increased spending resulting from the wages resulting from all of those efforts). The ABS calculated that every US$1 million spent on construction output results in US$2.9 million of output in the economy as a whole. And, better still, gives rise to 13.5 jobs in construction and 55.5 jobs in the economy as a whole (I’ve pro-rated the jobs upwards from the Australian example, as their original calculations were using the Aussie $). The ABS did warn about the multiplier being overstated from the theory to the actuality, and Australia is obviously not America – but the numbers show the power of housing and construction, and could make you very bullish on the US economy over the next couple of years.

Which brings me on to my final, and tenuously related point – I had a coffee with George Trefgarne last week, the former economics editor of the Daily Telegraph, and the author of Metroboom, a paper about Britain’s recovery from the 1930s slump. We can debate about whether it was austerity or currency devaluation that got the UK out of depression – but house building was certainly part of the solution. Between 1931 and 1939 we were building from 200,000 to (in 1936) over 350,000 new houses per year. Compare that to the UK today, where despite the much bigger population, we’re building under 150,000 houses per year, whilst rents rise and affordability remains very poor for most. In some ways we are lucky – we have a potential solution to the UK’s weak growth – allow house building to take off (by loosening planning restrictions, incentivising house builders to release land banks). If you are Spain, and you have a huge glut of housing, this is not a way out of the ongoing crisis – but for the UK, or the US, building homes could be the answer.

US income inequalities: Buffett rules

Posted on 2 November 2012 by Markus Peters

In August last year, I picked up on Warren Buffett’s call for a higher burden share for America’s rich in a New York Times Op-Ed and alluded to the heated debate around income taxation and wealth distribution. Since then the US Senate has seen the Democrats proposing and the Republicans opposing the ‘Fair Share tax’, also called ‘Buffett rule’, which would require those with incomes over $1m to pay an income tax rate of at least 30 per cent. Alongside the political debate, academic research has informed and polarised the public debate before and after. For instance, Nobel laureate Peter Diamond and Emmanuel Saez have estimated that the income tax rates for the wealthy should be between 45 and 70 per cent.

Being misguided by today’s environment, the intuitive reflex is to say that a country like the US could never have – or accept – such high income tax rates. High income tax rates are rather perceived to be a European predicament, associated with these countries’ welfare state systems. A look at the historical US income tax bands reveals though that this is actually a clear misperception – and the elder amongst us will even remember these days. US top income tax rates have historically been significantly higher than the last 25 years suggest, although it’s fair to say that they peaked at war-related time periods. The top tax rate didn’t concern a large share of the tax payers back then, but it wouldn’t do so today either.

Admittedly, purely looking at these top and bottom income tax rate bands doesn’t tell you enough about the tax burden that the poor, the rich and the middle class had to bear in the US over this period. So let’s have a look at the chart below. This tells us that over the 44 years from 1960 to 2004, so after the implementation of the Bush era taxes, the average tax rate has actually modestly fallen for the 40% with the lowest income. The lower middle income class has seen a slight increase in their tax burden over the same period. Those who can be described as upper middle income class had seen a rise in their income tax levels throughout the 1990s which were reverted in the Bush era. Most strikingly though, the top 1% income group has seen a sharp decline of its tax burden since the 1960s, initially peaking in the early 1970s and falling subsequently to its lowest historical level in the Bush era.

Now with a look at Buffett’s opinion piece, you could point out that he’s not only been referring to the low income tax burden, but that he and many of his peers make a lot of their money – different to those belonging to the lower and middle income class – from capital investments. Therefore, it’s important to have a look at the historical development of the maximum tax rate on capital gains as well. Supporting Buffett’s assessment, the chart below demonstrates that the current tax rate level for capital gains is the lowest in the past 50 years.

So let’s put all this into perspective. The previous charts suggest that the “mega-rich”, as Buffett has previously described himself and his peers, as well as the ordinary wealthy currently face one of the lowest income and capital gain tax burden since these figures have been reliably recorded. At the same time, their share of the total income has doubled since the 1980s. While income inequality fell after World War II until the 1970s, the so-called ‘Great Compression’, this trend took a u-turn in the following decades. Today Warren Buffett and his peers, represented by the top 1% income category, earn around 20% of total income.

But is this exclusively an American phenomenon? It is not, but the magnitude of this development seems to be particularly high in the United States. I’ve picked three more countries to demonstrate this. One of these, the UK, follows a similar economic and social model as the US, whereas Sweden and France represent the European welfare state model. While the UK has seen a comparable increase in the income share of the top 1%, this development in France and Sweden has been rather modest, and is only at around the long-run average. It’s particularly interesting to think about the below chart in the socio-economic context. Instantly, the recent talks about the feasibility of tax hikes for higher incomes in the UK come back to mind. At the same time, Hollande’s unpopular demand for higher income taxes for the rich, and their potential effect on government revenue, might have been put into a less favourable perspective by this chart.

What do I make of all of this? First of all, it doesn’t look like a healthy development for a society when the gap between poor and rich widens disproportionately. In the US, the income share of the wealthiest part of the society has reached close to all-time record levels. The financial crisis didn’t revert the trend seen since the 1980s, it was only briefly interrupted. Inequality is currently at the highest level since the Great Depression. It might be even more reasonable to be worried about such a development since there isn’t a proportionate burden share, as the evolution of the tax burden across income classes in the US suggests. Ultimately, this might have contributed to what appears to be a much divided society these days. That’s a development that doesn’t sound too unfamiliar to me in the UK. It might also partly explain today’s toxic political climate in the US where parties and individuals have become strong lobbyists for rather limited parts of the society. It seems to be clear that a situation in which tax burden and income distribution are historically rather exceptional, but have been taken as the new norm by one side at the negotiation table is difficult to resolve. The argument that it might only be a correction of a previous exaggeration is then easily overheard. And there’s an economic side to it. The IMF actually concludes in a paper that fighting income inequality and fuelling growth might be two sides of the same coin in the long run. Therefore, Warren Buffett rules. He’s given this debate visibility. And I believe that he’s got a fair point. Surely, the higher taxation of the highest incomes will not make a fundamental difference to the US government revenues in the short term. But it certainly helps to create the feeling of a shared burden across society and to revive the inspirational thought of unity. Apart from this rather philosophical note, it might also have implications for the bipartisan negotiations around the fiscal cliff. When I look at the expiring Bush era taxes that will be brought to the negotiation table, then I may conclude that all this public debate – and the factual evidence presented – make it more likely that both sides can ultimately agree on the expiry of the Bush era tax cuts for the wealthy rather than those for the middle incomes. That would be a sensible thing to do

5 years on

Posted on 10 October 2012 by Richard Woolnough

On the 9th October 2007 the totem pole of capitalism, the S&P 500, peaked at 1,565. Last night it closed at 1,441. So, five years into the crisis, where are we in terms of clearing up the banking crisis?

There’s good news in the US. We have commented on the initial driver of the crisis in the world’s largest economy – the boom and bust of the housing market – on many occasions. Recently, we’ve noted that we’re beginning to see improvement here. This is an important sign that the US is moving on from the financial crisis. Although unemployment remains stubbornly high, it is moving in the right direction and the financial system is looking sound once again. The government’s combination of supportive measures – such as taking equity stakes in banks – and allowing some pain to occur – in the case of Lehman Brothers and housing repossessions – seems to have been largely successful.

The UK economy and financial system have not yet returned to the same state of health and the government still holds legacy stakes in some of the bigger banks. It appears that the problems the country faced five years ago remain, even though they are not as severe as they were. These difficulties are highlighted by today’s Financial Times where the two headline stories relate to the FSA easing bank rules further to encourage lending and help the financial system, and the governor of the Bank of England’s speech at my old university last night where he talked about giving central banks greater flexibility with their inflation targets to help avoid financial crises.

Europe, the third major western financial system, faces its own particular problems. Five years on from the peak we had the strange situation of the German chancellor being taken in a convoy of cars through Athens past illegal demonstrators to try to sort out the continued funding of the Greek state. We have written many times about the questionable sustainability of a politically motivated single currency and the funding of states, individuals and corporates remains difficult in many parts of this system.

We believe financial systems need to be mended by a combination of government intervention and private sector responsibility. The US has led the way in this regard and the UK is trailing, hopefully successfully, behind it. However in Europe the problems have been exacerbated by the single currency regime, where the need for political intervention to solve the problem is relatively large versus the need for private sector adjustments. We are still concerned about whether the necessary political intervention will occur. So, five years on, it appears that the western world is still coming out of the credit crisis, albeit at different speeds and with different levels of success.

Americans are inconsistent in how they believe the budget deficit should be tackled. But growing signs of pragmatism?

Posted on 12 June 2012 by Jim Leaviss

It looks as if we might see a repeat of 2011′s brinkmanship regarding the US budget – remember that this game of chicken between the Republicans and Democrats was a contributory factor to S&P downgrading the US from AAA. Few expect American politicians to make progress on debt matters until after November’s elections – but that doesn’t leave them long to prevent many automatic cuts to spending and hikes to taxes occurring in January 2013. This fiscal cliff on 1 January will cause automatic defence spending cuts, and hikes to income, capital gains, dividends and estate taxes. How big an impact would this have on US growth? The Congressional Budget Office estimates it would mean that the US economy would shrink by 1.3% in the first half of 2013, but Goldman Sachs thinks that the impact could reduce first half GDP by as much as 4%. With China slowing, and much of the Eurozone in recession, it doesn’t feel like a good time to take $600 billion out of a major economy that has at least been growing in recent quarters.

But the inability of politicians to decide how and when to tackle the US’s growing debt problem is mirrored by its population. Here are a few opinion polls to show how it’s possible for voters to want to a) keep social security and healthcare benefits unchanged, but b) cut spending, c) not increase taxes, and d) not increase the US debt ceiling.

Which is more important: taking steps to reduce the budget deficit or keeping Social Security and Medicare benefits as they are?

Reducing budget deficit 32%
Keeping benefits as they are 60%

(Source: Pew Research Center, June 2011)

What is your favored way of reducing the budget deficit?

Spending cuts alone, or more spending cuts than tax hikes 58%
Tax hikes alone, or more tax hikes than spending cuts 23%

(Source: Reuters/Ipsos, April 2012)

In order to reduce the budget deficit do you think it will be necessary to increase taxes on people like you?

Necessary 41%
Not necessary 56%

(Source: NYT/CBS Poll, January 2011)

Would you want your member of Congress to vote in favor or vote against raising the debt ceiling?

Vote for 22%
Vote against 42%

(Source: Gallup, July 2011)

Given that Medicare, Medicaid and social security are already around 60% of government spending, it would be a tough ask to reconcile a) leaving these unscathed and b) cutting spending. Additionally these expenses are growing at a rate far outstripping US GDP growth, so the baseline is for significant increases to these programmes rather than cuts (mainly due to the aging population and advances in medical treatments).

But perhaps there is a growing realisation that these inconsistencies need to be addressed. Having spent a decent amount of time in the US over the past few years, we’ve found recently that it’s become difficult to keep economists, strategists and policymakers focused on our US-centric questions and away from them asking us about the Eurozone’s problems. And with municipalities experiencing debt distress across the States already, the question “Could we be Greece one day?” is crossing into the mainstream.

So it is interesting that a couple of developments recently suggest that American voters are thinking more holistically about the future structure of their nation’s economy. An interview in this weekend’s Financial Times with civil rights lawyer Molly Munger discussed her success in getting a proposed income tax hike onto California’s ballot paper in November. This new tax, currently supported in opinion polls, would boost the state education fund. Another tax hike for deficit reduction purposes is also on the ballot paper. At the same time voters in Wisconsin last week rejected a Trade Union backed recall vote to try to eject Republican Governor Scott Walker from office after he proposed the Wisconsin Budget Repair Bill. The Bill would have increased pension and health contributions for state employees and reduced Union powers in bargaining. Walker actually increased his victory margin in the recall vote compared with his 2010 election, and he is the first ever Governor to keep his seat in a recall vote.

Signs of a changing attitude towards the debt burden? Possibly, and that has to be positive – but we still expect a great deal of turbulence around the debt ceiling issue after the Presidential elections. That turbulence will be exacerbated by a likely split between control of the Presidency and that of Congress, although some have suggested that this would be the best outcome as there will have to be a compromise in the breakdown of long term budget reduction between spending cuts and tax hikes, rather than one or the other taking all the strain.

Finally, there is increasing discussion of a nationwide consumption tax (VAT) in the US. Even a small VAT could make significant inroads into the deficit each year. Is this a popular view in the States? Well when I typed “us consumption tax” into Google, the second automatically generated search is “u.s. consumption tax is tempting vat of poison” so I’m guessing that’s a “no”. However this is a silver bullet still available to the US whereas Europe, with many nations having VAT rates already at 20% has little scope to raise additional revenues through this route.

Explaining low government bond yields (follow up) – maybe it’s not just about Europe, it’s about China too

Posted on 21 December 2011 by Mike Riddell

Yesterday I wrote a comment about how US Treasuries seemed to have decoupled from US economic data, and decided that it must be all about Europe (see here). That could have been a slightly hasty conclusion.

Having spent the last few minutes messing around with Treasury correlations, I was surprised to find just how closely correlated US Treasury yields have been with Chinese equities since the beginning of 2009. Mounting fears about the extent of the slowdown in China saw the Shanghai Composite Index hit the lowest level since March 2009 last week. It’s also interesting to note that while Eurozone economic data has stabilised and US economic data has massively surprised on the upside, Asia Pacific as a region appears to be getting worse. The Citigroup Economic Surprise Index for Asia Pacific shows that data in the region is currently underperforming analyst expectations by the most since the end of April 2009. For those interested, Paul Krugman wrote an interesting piece on the deteriorating picture in China in the New York Times earlier this week (see here). As Krugman rounded off in his piece, the last thing the world economy needs is a new epicentre of crisis.

Alternatively, if you want to see an argument about why economic surprise data is meaningless then see here.

Why you shouldn’t just read the headlines on US unemployment

Posted on 3 November 2011 by Anthony Doyle

Everyone is familiar with the deterioration in US labour market. Figures out today show that the unemployment rate has more than doubled to 9.1% from its pre-crisis low of 4.4% in 2007. The question is how accurately does the unemployment number reflect the true state of the US labour market? To understand this, we need to grasp how the unemployment numbers are compiled.

The Bureau of Labor Statistics (BLS) is responsible for conducting the surveys that inform economists, press, politicians and citizens as to the strength or weakness of the labour market. To do this, the BLS conducts the Current Population Survey (CPS), known as the Household Survey. The CPS has been conducted in the United States every month since 1940.

The BLS calls up around 60,000 households – covering around 110,000 people – every month to find out who is and who isn’t working. To get an even spread of responses, the US is split into 2,025 geographic areas. From the 2,025 areas, 824 are selected every month to take part in the survey. The sample is designed to reflect urban and rural areas and different types of employment. Persons are classified as unemployed if they do not have a job, have actively looked for work in the prior four weeks, and are currently available for work.

There are around 115,000,000 households in America, meaning that there is a 0.05% chance that the BLS will call any individual household. Obviously, the majority of households will never be called. If you are lucky enough to be called up, the BLS will ask you a number of questions including:

Does anyone in this household have a business or a farm?
Last week, did you do any work for (either) pay (or profit)?
Last week, did you have a job, either full or part time? Include any job from which you were temporarily absent.
Have you been doing anything to find work during the last four weeks?
Last week, could you have started a job if one had been offered?

If there is no reason, except temporary illness, that the person could not take a job, he or she is considered to be not only looking but also available for work and is counted as unemployed.

The labour force is made up of the employed and the unemployed. Excluded are persons under 16 years of age, all persons confined to institutions such as nursing homes and prisons, and persons on active duty in the Armed Forces. Everyone else is defined as “not in the labour force”. If you are not in the labour force, the BLS will ask you:

Do you currently want a job, either full or part time?
What is the main reason you were not looking for work during the last four weeks?
Did you look for work at any time during the last 12 months?
Last week, could you have started a job if one had been offered?

From responses to these questions, the BLS will determine whether or not a person is “marginally attached to the labour force”. To be counted as marginally attached to the labour force, individuals must show some degree of labour force attachment by looking and being available for work. “Discouraged workers” are those who are not looking for work because they don’t believe there are any jobs, were previously unable to find work, lack the necessary skills or experience to do a job, or face some form of discrimination from employers such as being too young or too old.

If you are “marginally attached to the labour force” or a “discouraged worker”, you’re out. You are not included in the labour force. When it comes to calculating the unemployment rate, you’ve disappeared. You are not counted in the official unemployment rate, the rate that everyone uses to understand how well the Fed is doing at achieving its dual mandate of stable prices and full employment. This official unemployment rate, which equals the total number of unemployed as a percent of the labour force, is known to economists as U-3. On this measure, it appears the unemployment rate is now trending lower.

For those who think the U-3 calculation is too stringent (like us) to get the full picture of what is going on in the labour market, the BLS produces a broader measure of unemployment known as “U-6”. It basically includes marginally attached and discouraged workers in the unemployment calculation. It also includes those people that are working part-time but would rather be full-time. On this measure, the US labour market appears to be deteriorating once more, and the unemployment rate as calculated by this measure is 16.5%. This suggests around 11.4 million Americans are marginally attached or discouraged workers (from 2001-2008, the number of marginally attached or discouraged workers was on average 5.8m people). According to the BLS, 11.4m Americans do not have an income, do not pay income tax, and do not contribute producing goods and services. Indeed, almost 15% of Americans (45.8m) are now on food stamps. This is a substantial drag on economic growth.In writing this blog, we’ve had an eyebrow-raising moment. According to the BLS, the American workforce (employed plus unemployed people) has actually shrunk since October 2008. It doesn’t seem to make sense, given most estimates tend to suggest the US population is growing at 1.0% per year, in part due to immigration. We would expect labour force growth to slow due to the retiring cohort of baby boomers and peak in the participation of women in the labour force. But it shouldn’t be negative.

The reason it is negative is because the BLS doesn’t count those who are marginally attached or discouraged from entering the labour force (as shown above, around 11.4m people). This has the result of reducing the size of the labour force, resulting in a lower unemployment rate percentage. This is why the official unemployment rate is much lower than the broader U-6 measure and has actually been falling. More and more people are becoming so disenchanted with their job prospects that they have simply stopped looking for a job.

Despite the idiosyncrasies in calculating the unemployment numbers, they are the best we’ve got. If the Fed is really serious about targeting the unemployment rate – as Chicago Fed President Charles Evans has suggested – then it should have a good hard look at including those people who are underemployed, discouraged or marginally attached to the labour force. The official headline rate – which gets the most coverage amongst the financial community – overstates the current health of the US labour market.

M&G Fixed Interest team visits New York – Operation Twist, The Fed and corporate bond markets

Posted on 23 September 2011 by Gordon Harding

It’s been two and half years since our last visit to New York. As you can see in this latest video, the past few tumultuous years in the markets have not been kind to Jim, Richard and Stefan. Earlier this week they visited New York, meeting with a number of economists and strategists, where talk was dominated by developments in Europe. In this latest video update, you can hear the Team’s views on the outlook for the US economy, the Fed’s latest policy moves and valuations in corporate bond markets.

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