Category: Chart of the Week

Labor Costs and Inflation

This week’s Chart of the Week shows the percentage changes in the Consumer Price Index and Unit Labor Costs (the average cost of labor per unit of output) since 1950.

With the recent surge in commodity prices and inflationary pressures beginning to take hold in many emerging market countries, inflation has once again become a major topic of discussion in the United States. This week’s Chart of the Week shows the percentage changes in the Consumer Price Index and Unit Labor Costs since 1950. As the chart illustrates, over the past 60 years, there has been a very strong correlation of 0.825 between changes in labor costs and changes in inflation (a correlation of 0 indicates there is no correlation and a correlation of 1 indicates a perfect correlation).

Given the strong correlation between labor costs and inflation, it makes sense to look at current labor market conditions to get a more accurate picture of the inflationary pressures currently affecting the United States. The U.S. currently has an unemployment rate of 8.9% and an underemployment rate of 15.9% (the underemployment consists of the unemployment rate plus individuals working part time who would prefer full time employment and individuals who are not working or actively seeking a job but would want to have a job.) In addition, capacity utilization is currently 76.1%, which is well below its historic average of 80%, and worker productivity, which increased at a rate of 2.6% in the fourth quarter of 2010, has been steadily increasing over the past several years. The amount of slack currently built up in the labor market makes it very unlikely that the U.S. will see significant upward pressure on labor costs in the near term. This makes it unlikely that the U.S. will see significant upward pressure on inflation in the near term.

U.S. Peak Employment

This week’s chart examines the peak employment level (total number of people working in the U.S. labor force), along with the time taken to return to that peak level after a recession.

The unemployment situation in the U.S. has been a major concern for economists when considering an economic recovery from the “Great Recession”. This week’s chart examines the peak employment level (total number of people working in the U.S. labor force), along with the time taken to return to that peak level after a recession. The chart looks at peak employment in percentage terms, so 100% indicates the U.S. is at a peak employment level, while anything below 100% indicates the employment level is lower than the previous peak employment.

The U.S. hit a peak employment level in November 2007, and has yet to make much progress towards reaching that peak again. Since 1948, this is the longest time period the peak employment level has remained under its previous high after a recession. Growth in the U.S. labor force (total number of people working or seeking work) has leveled off over the last few years while more than 1.7 million civilians have dropped out of the labor force since mid-2008. The nearly 14 million unemployed people that remain in the labor force average nearly 37 weeks of being unemployed.

Several economists, including those that authored a working paper at the San Francisco Fed, have noted that the natural unemployment rate, long considered to be 5%, may have increased over the last several years to stand as high as 6.9% today. After examining variables such as labor market skill mismatches, extended unemployment benefits and growth in productivity, these studies have concluded that the increase in the natural rate of unemployment is most likely temporary, though may last for several years.

Divergent Sources of Inflation

As commodity prices around the globe continue their steady march upward, convention would suggest that inflation in the U.S. isn’t far behind. However, as many developing nations have already felt the sting of rising costs, inflation in the U.S. remains largely absent.

As commodity prices around the globe continue their steady march upward, convention would suggest that inflation in the U.S. isn’t far behind. However, as many developing nations have already felt the sting of rising costs, inflation in the U.S. remains largely absent. Headline CPI rose only 1.6% in December over the previous year despite surging costs for oil, gold, cotton and many other commodities.

The cause for the divergence is a split between the pace of increases in the prices of goods and those for services. Producers, largely unable to absorb further increases in input costs, have begun to signal to consumers that price increases are inevitable. Thus the red line on the graph, which represents the cost of goods, has recently risen and is above its long term average, therefore adding inflationary pressure to the economy. Goods included in this metric include commodities and non-durables, less food and beverages. Meanwhile, the costs for many services (such as rent, electricity, and medical care) in the U.S. have grown at a much slower pace since the beginning of the crisis as high unemployment has stifled wage growth. The cost of services is shown by the blue line on the graph; the most recent values sit well below the long term average, therefore lessening inflationary pressure on the economy. At the end of January, inflation for goods registered an increase of 2.2% over the previous year while prices for services only advanced 1.2%. On average over the past 20 years, prices for services have grown 1.75 times faster than those for goods, but cheap labor from developing nations has kept prices for goods in check. So while rising commodity prices can be a driver of inflation here in the U.S., it will likely take acceleration in the prices of services before headline inflation can take off.

Global GDP Comparison

This week’s chart shows the relative economic size (measured as a percentage of U.S. GDP) of the top nine countries during each time period compared to the U.S. economy.

This week’s chart shows the relative economic size (measured as a percentage of U.S. GDP) of the top nine countries during each time period compared to the U.S. economy. Back in 1980, the economic giants of the world were Japan and developed Europe, with only two emerging nations near the top (China and Argentina). Moving ahead 30 years to 2010, China surpassed Japan as the second largest economy in the world, and a few more emerging nations (India and Brazil) are now considered two of the largest economies. Japan and the European nations lost relative economic size to the United States from 1980-2010, while Canada remains the same relative size. Projecting out to 2020, China jumps off the chart, with GDP equal to 99% of the U.S economic output. Japan and the developed European nations are estimated to lose more relative size to the United States while more emerging nations will be considered among the largest economies, most especially Russia and Korea. Clearly, the unprecedented growth in emerging economies is a trend expected to continue through the next decade.

Cumulative Outperformance of SMB and HML

This week’s charts show the cumulative outperformance of the two Fama-French Factors, SMB and HML.

This week’s charts show the cumulative outperformance of the two Fama-French Factors, SMB and HML. SMB stands for small minus big, and is the excess performance of small market cap stocks minus large market stocks controlling for value. HML stands for high minus low, and is the excess performance of high book to market stocks minus low book to market stocks controlling for size. Graphs are shown on a log scale to highlight relative change. A change in relative size on a log scale chart is the same visual distance, which enables the viewer to more easily compare different fluctuations over time. For example, on an absolute scale graph, a price change from 50 to 100 appears much smaller than a price change from 100 to 200, even though both represent a doubling in price. On a log scale graph, these two changes appear the same.

As shown on the graphs there have historically been excess returns to small stocks and value stocks over the long term. While the volatility of both of these factors has been high (11.53 for SMB and 12.41 for HML), the value factor has earned a much higher premium over time than the size factor. This has led to long periods during which small cap stocks underperform large cap stocks, as highlighted on the graph.

While it is impossible to say given the data here, it is certainly plausible that there are business cycles that are more or less favorable to small companies compared to large companies. In fact, some academic research suggests small companies are more susceptible to shocks in profitability, which explains some of their underperformance starting in the mid 80’s. See Hou and van Dijk (2010) for more details.

The takeaway for investors is that while small caps may outperform over the long term (30 years or more), there can be extended periods during which they underperform large cap stocks. Small caps have certainly been a good bet over the past decade, but their strong performance versus large caps may or may not continue for the next.

Dow Breaks 12,000 for First Time Since 2008

On Tuesday, February 1, the Dow Jones Industrial Average (“Dow”) closed above 12,000 for the first time in two and a half years; the index was last above 12,000 on June 19, 2008.

On Tuesday, February 1, the Dow Jones Industrial Average (“Dow”) closed above 12,000 for the first time in two and a half years; the index was last above 12,000 on June 19, 2008. The Dow then dropped 46%, bottoming at 6,547 on March 9, 2009. With Tuesday’s close above 12,000, the index has risen 184% from its bottom, clearly rewarding investors who rebalanced into equities when the market was falling. Although the market has not reached its high water mark of 14,165 (achieved on June 9, 2007), hitting 12,000 was seen as another positive trend in the recovery process.

Impact of Oil Price on Inflation Expectations

This week’s Chart of the Week compares inflation expectations (measured by the breakeven rate) with oil prices, to see if there really is a strong correlation between the two values.

In the last four months of 2010, the price of oil rose from $72 as of August 31st to $91 as of December 31st, an increase of 26%. Over that same time period, the breakeven rate (the difference in yield between the ten year TIP and ten year nominal treasury) increased 34%, from 1.68% to 2.25%. Because the breakeven rate is commonly used as a proxy for inflation expectation, it is not a stretch to think that the run up in oil prices was driving inflation expectations (and inevitably, stories of “rising inflation” always seem to appear shortly after the price of oil shoots up). This week’s Chart of the Week compares inflation expectations (measured by the breakeven rate) with oil prices, to see if there really is a strong correlation between the two values. The blue bars represent the price of oil at the end of each month, and the red line chronicles the breakeven rate at each month end; data is used going back to 2003. Between 2003 and 2007, there seems to be a loose connection between the two, but it is not very tight, as the price of oil slowly creeps up but the breakeven rate is relatively static. From late 2008 through the end of 2010, the graphs seem to mirror each other more closely, most especially in late 2010. In total, however, the correlation is only .18, thus we conclude that the price of oil does not have a strong impact on expected inflation values, in spite of what we hear and read when oil prices rise dramatically.

10-Year Government Bond Yields in PIIGS

This week’s Chart of the Week deals with the sovereign debt crisis in Europe.

This week’s Chart of the Week deals with the sovereign debt crisis in Europe. Over the past several weeks the fiscal situation in Portugal has received a significant amount of attention, and there has been speculation that Portugal will be the next country to require a bailout package from the EU. Yields on Portuguese government bonds have been steadily rising throughout the course of the past year, and in recent weeks the yield on the Portuguese 10-year bond has been trending towards 7%. The 7% threshold is significant because both Greece and Ireland were forced to request a bailout package from the EU shortly after yields on their 10-year bonds exceeded 7% (based on a rolling 10-day average). The yield on Greek 10-year bond broke through the 7% threshold on April 16, 2010, and Greece requested a bailout package on April 23, 2010. The yield on the Irish 10-year bond broke through the 7% threshold on November 15, 2010, and Ireland requested a bailout package on November 21, 2010. Portugal had a successful bond auction on January 12, 2011, and yields on their 10-year bond have backed away from the 7% threshold. However, Portugal is still facing major fiscal issues over the near term. They have a significant budget deficit (9.3% of GDP as of 12/31/09), a high debt to GDP ratio (80% as of 9/30/10), a high unemployment rate (11% as of 11/30/10), and a low growth rate (1.4% as of 9/30/10). In addition, Portugal has over €20 billion (approximately $26 billion) in funding needs in 2011, and unless the market perceives a material improvement in Portugal’s fiscal situation, it will be difficult for the yield on their 10-year bonds to stay below the 7% threshold.

Nonfarm Payroll Employment Revisions

“Jobs” and “unemployment” have garnered a lot of attention during this economic recovery, mostly because the headline numbers have been disappointing.

“Jobs” and “unemployment” have garnered a lot of attention during this economic recovery, mostly because the headline numbers have been disappointing. However, it is important to realize that while the headline number, which is reported the first Friday of every month, gets most of the media attention, it is subsequently revised twice and it is the final number that gives the more accurate picture of job creation in the US economy. This is important for two reasons. First, as this chart shows through 2010 net revisions have been consistently positive (with June the only month showing a negative revision). Over the course of year net revisions have shown that 409,000 more net jobs were created than the headline numbers would lead one to believe. Second, the direction of revisions is indicative of the overall health of the job market and economy. As this chart shows, net revisions were strongly negative during the depth of the financial crisis in the fourth quarter of 2008 but as the economy began to improve net revisions turned positive. Given these trends it is likely that both the November and December job numbers will be revised higher in the coming months and revisions are like to remain positive in 2011.

Corporate Bond Market Picks Up

This week’s chart(s) of the week show the exposure that German, French, and UK Banks have to the debt of Portugal, Ireland, Greece, and Spain (PIGS).

This week’s chart(s) of the week show the exposure that German, French, and UK Banks have to the debt of Portugal, Ireland, Greece, and Spain (PIGS). The top chart shows the Total Exposure that the German, French, and UK Banks have to debt of the PIGS countries. This includes Government debt, Private debt (both household and Corporate), and the value of any derivative contracts held by the banks of the respective countries. The middle chart shows the exposure that the German, French, and UK Banks have to the Government Debt of the PIGS countries. The bottom chart shows the exposure that the German, French, and UK Banks have to the Government & Bank Debt of the PIGS countries.

These charts help to explain why Germany, France, and the UK (the 3 biggest Euro area economies) were so eager to help bail out the governments of Greece and Ireland (thus far). Had the EU not stepped in to help Greece and Ireland, they likely would have defaulted on their debt, which would likely have required the German, French, and UK governments to bailout their banks (the “stress tests” that the European banks recently went through did not include the possibility of a sovereign default).