Covenant Weekly Synopsis for June 1, 2018

June 4, 2018

Last Week Today – Italian President Sergio Mattarella blocked anti-European Union coalition parties; the Trump administration caught the world (and investors) off-guard by imposing new tariffs on steel and aluminum imports from the EU, Canada, and Mexico; these same NAFTA partners retaliated with tariffs on US imports to their respective countries; nonfarm payrolls grew by 223,000 in May (vs. forecast of 190,000), and the official unemployment rate fell to 3.8%; the U.S. / North Korea Summit is back on and scheduled to take place on June 12th in Singapore.

Tracing prices of risky assets last week generated graphs that resembled erratic EKG charts as geopolitical events (mostly negative) and strong domestic economic data releases pushed markets back and forth. The S&P 500 moved a lot with 3 of 4 trading days showing gains or losses of more than 1%, but ultimately the benchmark index closed the week up 0.5%. International equities did not keep pace, with the MSCI EAFE Index recording losses of 1.3% (thank you Italy). US Treasury yields declined modestly, but, here to, the finish belies the day-to-day volatility which saw the 10-year yield close at 2.78% on Tuesday before rising to 2.9% to end the week (only two weeks ago this benchmark had a yield of 3.11%). For the week precious metals declined (gold -0.7%, silver -0.6%), industrial bellwether copper gained 0.4%, and WTI Crude fell 6.9% to $65.81 per barrel (on concerns that Russia and Saudi Arabia intend to boost production levels).

Having closed-out May last week, the table below shows the monthly and year-to-date performance of several broad market indices.


For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.

GDP Update – First quarter annualized, real GDP growth was revised down by 0.1% to 2.2% – the revision was expected, and in fact was smaller than many economists forecast. Overall, the mix of growth improved as inventories were lower and final sales higher than anticipated. Similar to the last several years, it appears that the first quarter will once again represent the slowest pace of growth for the year. The Atlanta Fed’s GDPNow algorithm is forecasting Q2 2018 GDP growth of 4.7%. Keep in mind that this forecast is volatile early in the quarter as the algorithm extrapolates only the currently available reported data into its projections. Hence, the forecast becomes more accurate closer to the end of the quarter. Meanwhile, the NY Fed’s GDP forecast is for Q2 growth of 3.3%, which is likely closer to reality.

Puzzle Pieces – Labor market data has been strong for a long time now, pushing the unemployment rate down to 20-year lows. Despite steady job gains, real wage growth is subdued. The absence of accelerating wage inflation amid historically low unemployment calls into question the veracity of the Phillips Curve — an empirical model that implies declining unemployment generates higher wages — favored by the Fed. This model worked reasonably well from the mid-90’s until the Great Financial Crisis (GFC), but since then unemployment has fallen dramatically (the red line with the inverted y-axis shown on the right) without a commensurate rise in wages (the blue line).


Adherents of the Philips Curve remain faithful, citing that the curve is “kinked.” That is, wage inflation is more sensitive to moving from low levels of unemployment to ultra-low levels of unemployment. If they’re right, we should be seeing wage inflation any day now… Others have pointed out that retiring Baby Boomers, who generally earn higher pay, are being replaced with younger, less tenured workers. These less experienced workers command a lower salary, which on balance, reduces wage growth.

The wage growth picture is indeed a puzzle, so let’s spread the pieces out on the floor, and try to put this together to see the big picture.

  • Over the last five years, monthly job gains have averaged 211,000, equating to 12.6mm new jobs created.
  • The headline (U-3) Unemployment rate is 3.8% (matching the previous cyclical low in April 2000)
  • A broader measure of unemployment (the U-6 rate), which include discouraged workers and employed part-time for economic reasons is 7.6% (the lowest level since May 2001)
  • The May employment report showed that annual hourly earnings increased a muted 2.7% year-over-year.
  • The St. Louis Fed reported in the latest Fed Beige Book that “Some firms have begun relaxing drug-testing standards and restrictions on hiring felons to alleviate labor shortages.”

That last point, though anecdotal, is an interesting one, and certainly supports the survey data that labor is in tight supply. However, if the labor market is tight, why aren’t wages rising?

To this question, economist Paul Krugman offered a potential explanation in a recent NY Times Opinion column. What if the answer is that wages already rose? Said differently, what if wages should have been cut more dramatically in the aftermath of the GFC, implying that employers have overpaid employees since the GFC. Research shows that employers are extremely reticent to reduce wages because of fears of the impact on worker morale. Hence, while employers would cut wages if they could do so without consequences, that option is largely off the table even in a depressed, low-inflation economy like that experienced during the slow recovery from the GFC.

This concept is known as “downside wage rigidity,” and data tracked by the San Francisco Fed’s wage rigidity meter shows this is more than a theory. Because employers did not reduce wages commensurate with reduced demand for products/services in the aftermath of the GFC, they created a backlog of pent-up wage-cuts which must be worked through before meaningful wage increases can gain traction. In other words, employers subsidized laborer salaries through a period of reduced demand (i.e., revenue), and while demand has increased in recent years, it has not yet caught up to the point where employers are comfortable offering raises. Another factor likely weighing on employers’ minds is the memory of the GFC. Even as the economy has largely emerged from that depressed state-of-affairs, employers may be reticent to lock-in higher wages that they know will be problematic to reduce in the next economic downturn.

Be well,