With so much policy ammunition spent in the pursuit of long-lasting growth in the U.S., it is somewhat puzzling that the economy has remained, thus far, stubbornly sedate.
Since the onset of the 2008 – ’09 financial crisis, gross domestic product (chained year-over-year) has grown almost exclusively by rates of less than 3 percent. This is not a pace to alarm the hawks on the Federal Open Market Committee. Indeed, it has resulted in talk of a new normal, in which the upper bounds of the interest rate cycle are much lower. Proponents say that instead of 5 percent being the top end of the fed funds rate cycle, we are likely to see rates peak at 3 percent.
So what is holding the economy back? The chief suspect must be the fiendishly slow pace of wage growth. After five years of economic expansion, the humble U.S. worker has seen hourly compensation rise by just 0.5 percent. This is the slowest wage growth since World War II, a fact underlined by the poor savings rate. Federal Reserve chair Janet Yellen has homed in on faster wage growth as the final hurdle for the labor market’s return to health (see “U.S. Labor Market Offers Mixed Signals on Timing of Fed Rate Hike”). Housing and consumer spending tend to track wages closely, so a pickup in these areas could deliver the self-sustaining recovery that the Fed and the markets so desire.
In the meantime, a less than satisfactory two-tier recovery continues, with asset prices behaving far more enthusiastically than the real economy. Unfortunately, asset-generated wealth has proved to be an ineffective transmission mechanism onto the real economy.
Bond and equity markets have posted strong gains this year, and economic conditions appear largely benign. But as asset managers, we have to ask ourselves whether investor optimism is justified. Although we acknowledge that the markets may have become overly reliant on support in the form of monetary stimulus, we can’t ignore a fundamental shift for the better. For example, major U.S. corporations are enjoying record profits and boast healthy balance sheets. Aside from the positive implications for equities, this is good news for investors in corporate bonds — both investment grade and high yield — for which issuers have taken advantage of cheap borrowing and default levels are extremely low.
But are these gains sustainable? If workers in the real economy are stuck with low savings and low wages, the answer could be no. It appears that there is probably more slack in the economy than the Fed has realized, and that the number of people working or potentially seeking work has risen. The latter may be because more and more, older workers are delaying retirement (see also “The Rising Challenge of Measuring and Managing Longevity Risk”).
The labor market has been at the center of Fed policy since the 2008 beginning of the financial crisis. But with worker growth skewed toward low-skill occupations and part-time work, there is a strong downward pressure on wages.
The economic cycle will run its course. Accordingly, slow wage growth is likely to pass as well, as employment slack resolves itself. But how quickly this happens will depend on how many workers are still waiting on the sidelines to jump back into the workforce — something no one knows, not even the Fed. In the meantime, there is a danger that if the aforementioned higher corporate profits are not shared with the labor market, a lack of consumer spending power would hamper economic recovery.
Until the slack is taken up, however, several factors stand to anchor interest rates — and hence government bond yields. Scarcity is among these points. The Treasury is issuing less debt at a time when demand for risk-free collateral is high. Also weighing on interest rates is the positioning of the market. Those investors expecting rates to rise have already positioned themselves underweight. And of course, there’s the near-absence of inflation. Low wage growth strikes yet again!
Joanne Gilbert is a global fixed-income portfolio manager at Aberdeen Asset Management in London.