Don't Ignore the Anecdotes

By Richard Yamarone
My top three fears for 2014 are: 1) income inequality that erodes the middle class, reducing the income and spending power of the primary engine of the U.S. economy, 2) widespread Chinese economic deceleration and an associated shadow banking crisis, and 3) a possible student loan bubble and widespread defaults amid elevated delinquencies.
After speaking extensively in 2013 and almost every week of this year, I’ve managed to gather a great deal of insight from the ground up – something that economists at big firms generally aren’t permitted to do. Do you think they travel to Conshohocken, PA; Oneonta, NY; San Marcos, TX; or Thibodaux, LA? Probably not. There is a great deal of information to be learned by gathering insights from this grass roots perspective.

Prior to Christmas, sometime around October or November of 2013, while shopping for my wife at the Macy’s flagship on 34th Street in New York, I chatted with the sales associate about how business had been and how she felt about her job. She said: no one buys anything here unless there’s a coupon or a heavy discount. This deflationary mindset remains in place even today. She also noted increased traffic on big discount days.

The comments regarding her employment situation were disturbing. Yes, she has a job – has held it for some 15 years in fact. But her hours worked were getting slashed. What used to be 45 hours, plus occasional overtime, as well as potential “inventory days” (where staffers are asked to stay overnight and estimate stockpiled merchandise) and anticipated holiday hours were reduced to a mere 12 or 15 per week. That’s about a 66 percent decline in hours worked.

Realizing that she wouldn’t be paying any bills with those hours, she was forced to obtain a job at Kohl’s. And since that gig was limited to 12-15 hours, she applied for a third position at Applebee’s. 

Several business people have cited the Affordable Care Act (ACA) as the primary obstacle to hiring and capital spending. Essentially the ACA forces any business with more than 50 employees working more than 30 hours a week to offer some form of health care to its staff. Since reducing staff below 50 is not an option for some restaurant chains, such as Darden Group which employs more than 200,000 people, cutting hours worked is the only viable move. The data support this: hours worked in the retail and leisure and hospitality sectors are below 30 hours a week and hiring has increased in these two industries.

During March, the leisure and hospitality group added 29,000 positions, while retailers increased payrolls by 21,300. Combined, these two industries account for 25 percent of all private workers, so it is a significant percent of the labor market.

The data support this trend of increased low-wage hiring in avoidance of the ACA mandate. When people face certain economic constraints, they don’t roll over, they make adjustments, seek opportunities, and do what is necessary to provide for their families. 

Because the year-over-year growth rate in average hourly earnings for leisure and hospitality is about 1.9 percent – and once adjusted for an inflation rate of 1.5 percent, the real rate is about 0.4 percent – it doesn’t seem likely these workers will be willing to increase their expenditures on health care.
Some companies may be realizing this is a concern for Americans. It may be the reason CVS is beefing up its Minute Clinics presence and jettisoning cigarette sales in an attempt to position itself as a legitimate medical alternative to those that cannot afford health insurance amid stagnant incomes. This insight is out just need to get out and find it.

Affordability has hit all of us, across the entire income spectrum. In order to facilitate spending and subsequently economic growth, there needs to be income. Like gasoline in a car, without the fuel, the engine doesn’t run.
During February, real disposable personal incomes – those adjusted for inflation and taxes – advanced 0.3 percent, or 2 percent from year-ago levels. Historically, this is a very soft pace, one that traditionally has market participants unfurling the recession flags. There’s a good chance that consumer spending will return to a sullen state of affairs, since incomes are essentially the fuel for future spending – you can’t spend what you don’t have – and consumers have cut back on their credit card purchases – consumer revolving debt fell 0.3 percent in January.

The level of total compensation of employees is lingering at a year-over-year pace of 2.9 percent. This is essentially unchanged from the range registered since 2010. More importantly, the post 2007-09 depression recovery has had gains in total compensation below levels associated with previous recessions. Total compensation used to run between 5 and 10 percent, with several spikes above 11 and 12 percent. Today we barely break 5 percent.

The incomes report also identified the continuation of elevated levels of government transfers as a percent of disposable personal incomes. The mere fact that the U.S. economy is so dependent upon assistance from Uncle Sam suggests that this recovery will be considerably weaker than historical periods – in other words, more of the same type of recovery.

French economist Frédéric Bastiat wrote about the redistribution of wealth – or “ plunder” –  in 1850 inThe Law: “There are only two ways of obtaining the means essential to the preservation, the adornment, and the improvement of life: production and plunder…. What keeps the social order from improving (at least to the extent to which it is capable of improving) is the constant endeavor of its members to live and to prosper at one another’s expense.” 

Since the level and composition of incomes are somewhat suspect, expectations for spending should also be called to question. Real consumption expenditures, which increased 0.2 percent, or 2.1 percent since February 2013, are also at a dangerously low level – since this too is a pace that has seen the economy experience a downturn in the past. 

Spending on my “Fab Five” indicators of discretionary spending is not entirely favorable. The ultimate discretionary purchase, dining out, was unchanged in February, and only 0.9 percent higher than 12 months ago. While casino gambling increased 1.5 percent, it was 6.5 percent lower than February 2013. Expenditures on cosmetics and perfumes inched up 0.4 percent, or 0.9 percent year over year, while women’s and girls’ clothing increased 1.55 percent in the month and 0.9 percent year over year. The strongest of the “Five” was spending on jewelry and watches, which climbed 3.5 percent in the month, and is 7.3 percent above year ago levels. This shouldn’t be surprising since they are popular Valentine’s Day purchases.

Essentially the economy is running on an empty tank of very low-octane fuel. Compensation growth is weak, and the reliance on government transfers is unlikely to spark any cylinders. Expectations for a solid recovery should remain reduced until there’s a definitive improvement in the quantity and quality of personal incomes.
The employment situation improved in March as a total of 192,000 nonfarm payroll jobs were added, the labor force participation rate increased, and there was a decrease in the number of long-term unemployed (27 weeks or more). The less welcome components of the release included an unchanged, stubbornly high 6.7 percent unemployment rate, a slower pace of average hourly earnings, and a record level of temporary staffing workers as a percent of total employment.

The 192,000 job increase had a better mix than in recent months, which is encouraging. It isn’t always the total number of positions added, but the composition of those jobs. About 47 percent of those jobs created last month were in the low-wage category – accommodation and food services (33,100), temporary staffing agencies (28,500), retail (21,300), and social assistance (7,600). This is an improvement from the better-than 55 percent registered in recent months.

One frequently cited “improvement” by many economists in their post-release commentaries was the 0.2 hourly increase in the average workweek in March for all employees on private nonfarm payrolls to 34.5 hours. On a year-over-year basis however, this remains unchanged. In fact, looking at the industry breakdown of those 12-month changes, the largest percent gains by industry was mining and logging, a staggering 4.6 percent higher from March 2013 and information, which experienced a 1.6 percent gain. The disheartening issue is that mining and information are the two smallest major categories with 898,000 and 2.6 million workers respectively. The two weakest performers, education/health (minus 1.6 percent) and retail (minus 0.6 percent) were among the two largest employers with 21.3 million and 15.2 million respectively.

Average hourly earnings slipped to $24.30 an hour in the last month, and increased a lowly 2.1 percent during the last year. Once adjusted for inflation of about 1.1 percent, the level of real average hourly earnings was about 1 percent. 

Minimum wage legislation and the Affordable Care Act (ACA) are at the forefront of business concerns. Some of these issues surfaced in this latest jobs report. The use of workers at temporary staffing places as a percent of total nonfarm payrolls climbed to 2.09 percent, the highest level since 1990. 

Buffalo Wild Wings Vice President Emily Decker spoke at an Analyst Day event last week and noted, “Minimum wage increases are being proposed at the federal level and at the state level, with 11 states significantly increasing their minimum wage in 2014. For issues like this, we are actively working with legislators to explain how changes in the laws affect our business specifically, and the restaurant industry in general.”
Similar concerns regarding minimum wage and the healthcare mandate were mentioned by Panera Bread, Wendy’s, and Jack in the Box. These government regulations are weighing on business decisions to invest and hire. Don’t expect any meaningful improvement in economic conditions until they are altered.
Even with the incessant complaints regarding the crippling effects of the weather on production, sales, confidence, employment and general economic conditions, the comments made during the quarterly earnings conference call season appear to be mostly positive, with the outlooks equally upbeat. Whether the lost business traditionally registered during the first quarter returns is yet to be determined. Issues remain with respect to poor currency translations, deflationary fears throughout Europe, and an uncertain situation in in Russia, Ukraine, and China.
The Bloomberg Orange Book of CEO Comments Sentiment Index has returned to a sub-50 posting in recent weeks, implying a continued sluggish economic recovery. Investors should expect more of the same since this indicator has been mired in a contractionary territory for more than a year-and-a-half.
Some of the comments from the current earnings season include:
Levi Strauss & Co (8089Z) Earnings Call 4/8/14: “We knew the first quarter would be challenging, but it turned out to be even more difficult than we expected. Our focus on our key strategies enabled us to maintain stable constant dollar net revenues, despite unfavorable weather conditions, continuing retail traffic declines, a competitive promotional environment, and ongoing softness in our U.S. women's wholesale business…”
Alcoa (AA) Earnings Call 4/8/14: “Overall volume is slightly higher versus the previous quarter. Improved industrial volumes in Europe were offset by weaker demand in North America. We continue to be impacted by the continued market pressure and unfavorable pricing impacts in packaging. Auto sheet volumes were strong, resulting in record automotive revenues. Improved productivity and cost containment combined with the favorable fixed costs absorption significantly benefited the result.”
WD-40 (WDFC) Earnings Call 4/8/14: “Looking forward, we remain cautiously optimistic about several macroeconomic factors. As per our second quarter and year-to-date results, we expect that growth in EMEA and the Americas will continue to more than offset any lower industrial activity and sales in Asia-Pacific.”
Family Dollar Stores (FDO) Earnings Call 4/10/14: “Our second quarter was particularly challenging, especially considering the significant impact that the severe weather had on our results. There were 18 named storms in the quarter, which resulted in more than 60 days being negatively impacted by winter weather. In addition, winter conditions disrupted merchandise deliveries, and snow accumulation and very cold temperatures resulted in higher than expected store maintenance and utility expenses.”
JPMorgan (JPM) Earnings Call 4/11/14: “Despite a relatively favorable rate environment, the market got off to a slow start in 2014. We're seeing tight housing inventory in some markets, and the purchase market was affected adversely by the severe weather. This led to a challenging quarter for the mortgage business with production of $17 billion, down 27% quarter-over-quarter and 68% over last year.”
Fastenal (FAST) Earnings Call 4/11/14: “The extreme weather that we had caused expenses to go up in more areas than you can imagine, simple things like snow plowing, the fuel, all of those things, heating expenses, but overall it's very challenging with the hard weather.”
Wells Fargo (WFC) Earnings Call 4/11/14: “The housing recovery remained on track, and should benefit from the spring buying season. I'm optimistic about future economic growth, because consumers and businesses have continued to improve their financial conditions. Households have reduced their leverage to the lowest level since 2001 and the burden of their financial obligation is lower than at any time since the mid-1980s.”
Goldman Sachs (GS) Earnings Call 4/17/14: “The first quarter reinforced two consistent themes that we have seen over the past few years: first, the continued uncertainty around the strength of the global economic recovery; and second, the dominant role that central banks play in driving broad economic activity and capital markets sentiment.”
Sonoco Products Co. (SON) Earnings Call 4/17/14: “We're seeing improvement in certain domestic markets as well. For instance, we've experienced growth in dough, coffee, and nuts, which was partially offset by weather impacted categories like fiber, caulk, and snacks. However, both of these sectors are now rebounding. In addition, flexible volume continues to grow and we believe we've turned the corner in our thermoforming and blow-molding operations.”
Chipotle Mexican Grill (CMG) Earnings Call 4/17/14: “While sales were understandably down during days of extreme winter weather. When the weather improved, our sales recovered to a higher level than before the extreme weather for a few days before settling back into a normal sales trend. The comp also benefited from an increase in the average check of about 2% and we benefited by about 1% from an extra trading day as Easter was in the first quarter of last year.”
Sherwin-Williams (SHW) Earnings Call 4/17/14: “Consumer Group got off to a respectable start from a revenue perspective with organic sales up 1.6% in the quarter, but the harsh winter weather over the first two months of the year disrupted raw material deliveries that made it difficult to move finished goods across the northern half of the country and occasionally the southern half for that matter. This drove supply chain costs up, resulting in negative flow-through for the group in the quarter.”
AutoNation (AN) Earnings Call 4/17/14: “Certainly, in the last 10 days of March with the thaw, business was exceptionally strong. We see the same intensity continuing into the month of April, which gives us optimism that in the second quarter we can recoup some of the disruption that occurred in the first quarter because of weather, which gives us the confidence to confirm our forecast for the full year of industry growth between 3% and 5% breaking through 16 million units.”
Kimberly-Clark (KMB) Earnings Call 4/21/14: “I hate blaming weather for anything, and so – because you like to think that our products are more essential. So…people who have – didn't come to work didn't use hand towels, people that weren't able to get to the welding job site didn't use our safety products. And so we really lost hours of work in the first quarter.”
A.O. Smith (AOS) Earnings Call 4/22/14: “We are cautiously optimistic about the developing recovery in U.S. housing. After a very strong water heater industry growth in 2015, helped by improved levels of home completion and significant expansion of the replacement market, we expect residential water heater volumes in the U.S. to be up to approximately 9 million units including tankless, primarily due to an increase in new home construction this year.”
Deltic Timber (DEL) Earnings Call 4/22/14: “…the winter weather conditions that existed for much of the US during the first quarter had a chilling effect on markets for these companies' wood products. These conditions prevented builders from starting new homes, which resulted in decreased demand and lower prices for the dimension lumber used to construct these new homes. With these market conditions, we were forced to reduce our lumber production to meet the market demand…”
Genuine Parts Co (GPC) Earnings Call 4/22/14: “The extreme weather we encountered during the month of January, and even into February in some southern states as well as up and down the Eastern Seaboard, forced numerous store and customer closures and had a negative impact on our business.”
P&G (PG) Earnings Call 4/23/14: “We continue to operate in a volatile environment with uncertainty in foreign exchange, deceleration in market growth rates, and a rapidly developing policy environment.”
Manpowergroup Inc (MAN) Earnings Call 4/23/14: “As I look at the U.S. markets, we could see continued good, stable demand for almost all our service offerings. After some rough weather at the beginning of the year, we have seen demand and volume stabilize and improve across most of our brands.”
Norfolk Southern (NSC) Earnings Call 4/23/14: “The impact of severe winter weather was concentrated in January and February, with March showing a fairly strong recovery. Clearly severe weather in the quarter depressed certain economic activity and shipments in the first two months of the year in particular.”
Six Flags Entertainment (SIX) Earnings Call 4/23/14: “Attendance for the quarter declined by 434,000. As we discussed on our last earnings call, we anticipated a 300,000 decline in attendance in the quarter as a result of the shift of the Easter holiday and related school Spring Breaks at some of our parks into the second quarter this year. Unfortunately, in addition, we saw some very unfavorable weather at our two Texas parks during their Spring Breaks in early March, which accounted for the remainder of the decline.”

China is Still Number Two


MAY 5, 2014

CAMBRIDGE – Headlines around the world this week trumpeted a watershed moment for the global economy. As the Financial Times put it, “China poised to pass US as world’s leading economic power this year.” This is a startling development – or it would be if the claim were not essentially wrong. In fact, the United States remains the world’s largest national economy by a substantial margin.

The story was based on the April 29 release of a report from the World Bank’s International Comparison Program. The ICP’s work is extremely valuable. I eagerly await and use their new estimates every six years or so, including to look at China.

The ICP data compare countries’ GDP using purchasing-power-parity (PPP) exchange rates, rather than market rates. This is the right thing to do when looking at real (inflation-adjusted) income per capita in order to measure people’s living standards. But it is the wrong thing to do when looking at national income in order to measure the country’s weight in the global economy.

The bottom line is that, by either criterion – per capita income (at PPP exchange rates) or aggregate GDP (at market rates) – the day when China surpasses the US remains in the future. This in no way detracts from the country’s impressive growth record, which, at about 10% per year for three decades, constitutes a historical miracle.

At market exchange rates, the American economy is still almost double the size of China’s (83% larger, to be precise). If the Chinese economy’s annual growth rate remains five percentage points higher than that of the US, with no significant change in the exchange rate, it will take another 12 years to catch up in total size. If the differential is eight percentage points – for example, because the renminbi appreciates at 3% a year in real terms – China will surpass the US within eight years.

The PPP-versus-market-exchange-rate issue is familiar to international economists. This annoying but unavoidable technical problem arises because China’s output is measured in renminbi, while US income is measured in dollars. How, then, should one translate the numbers so that they are comparable?

The obvious solution is to use the contemporaneous exchange rate – that is, multiply China’s renminbi-measured GDP by the dollar-per-renminbi exchange rate, so that the comparison is expressed in dollars. But then someone points out that if you want to measure Chinese citizens’ standard of living, you have to take into account that many goods and services are cheaper there. A renminbi spent in China goes further than a renminbi spent abroad.

For this reason, if you want to compare per capita income across countries, you need to measure local purchasing power, as the ICP does. The PPP measure is useful for many purposes, such as knowing which governments have succeeded in raising their citizens’ standard of living.

Looking at per capita income, even by the PPP measure, China is still a relatively poor country. Though it has come very far in a short time, its per capita income is now about the same as Albania’s – that is, in the middle of the distribution of 199 countries.

But Albania’s economy, unlike China’s, is not often in the headlines. That is not only because China has such a dynamic economy, but also because it has the world’s largest population. Multiplying a middling per capita income by more than 1.3 billion “capita” yields a big number. The combination of a large population and a medium income gives it economic power, and also political power.

Similarly, we consider the US the number-one incumbent power not just because it is rich. If per capita income were the criterion by which to judge, Monaco, Qatar, Luxembourg, Brunei, Liechtenstein, Kuwait, Norway, and Singapore would all rank ahead of the US. (For the purposes of this comparison, it does not matter much whether one uses market exchange rates or PPP rates.) If you are shopping for citizenship, you might want to consider one of those countries.

But we do not consider Monaco, Brunei, and Liechtenstein to be among the world’s “leading economic powers,” because they are so small. What makes the US the world’s leading economic power is the combination of its large population and high per capita income.

It is this combination that explains the widespread fascination with how China’s economic size or power compares to America’s, and especially with the question of whether the challenger has now displaced the long-reigning champion. But PPP exchange rates are not the best tool to use to answer that question.

The reason is that when we talk about an economy’s size or power, we are talking about a broad range of questions – and a broad range of interlocutors. From the viewpoint of multinational corporations, how big is the Chinese market? From the viewpoint of global financial markets, will the RMB challenge the dollar as an international currency? From the viewpoint of the International Monetary Fund and other multilateral agencies, how much money can China contribute, and how much voting power should it get in return? From the viewpoint of countries with rival claims in the South China Sea, how many ships can its military buy?

For these questions, and most others involving total economic heft, the indicator to use is GDP at market exchange rates, because what we want to know is how much the renminbi can buy on world markets, not how many haircuts or other local goods it can buy back home. And the answer to that question is that China can buy more than any other country in the world – except the US.

Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

US equities: more buyers than sellers

If investors wish to buy more than others wish to sell, share prices will tend to rise. It is therefore sensible to look at who buys and who sells and if any changes seem likely.
Up to 1985 US companies issued shares (ie, they were sellers) and since then they have become by far the most important buyer (chart one). As a result the stock market has tended to go up and down as corporate buying has ebbed and flowed (chart two).
Buying peaked with the stock market in 2007 and slowed a bit before the market peaked in 1999. It was not quite as strong in 2013 as in 2012, but is still running at 2.3 per cent of gross domestic product.
US top managements are receiving huge bonuses which are typically linked to earnings per share or the return on corporate equity. This means that buybacks increase their pay and investing in equipment pushes it down. The result is that companies spend less of their cash flow than ever before on capital investment and have increased their buybacks to near record levels (chart three).
As it is in the interest of their managements, I expect companies to go on buying back shares until their cash flows fall off and I don’t expect this to happen soon.

A futile war on drugs that wastes money and wrecks lives

By George Soros

The scale of human wreckage means nations need to look at their policies, writes George Soros

The war on drugs has been a $1tn failure. For more than four decades, governments around the world have pumped huge sums of money into ineffective and repressive anti-drug efforts. These have come at the expense of programmes that actually work such as needle exchanges and substitution therapy.

This is not just a waste of money, it is counterproductive.

The London School of Economics has just completed perhaps the most thorough account of the war on drugs done to date. The conclusion, backed by five Nobel Prize-winning economists: it has done more harm than good.

Drug prohibition has created an immense black market, valued by some at $300bn. It shifts the burden of “drug control” on to producer and transit countries such as Afghanistan and Mexico. This approach also fails to grapple with a basic truth: drug markets are highly adaptive. Repress the business in one country and it springs up elsewhere.

Consider Colombia. When its law enforcement agencies made progress cracking down on the country’s cocaine trade, much of the criminal business and the violence that goes with it moved to Mexico. The LSE report estimates that after 2007, Colombia’s interdiction policies accounted for more than 20 per cent of the rise in Mexico’s murder ratef drugs

Bogotá had a lot of mayhem to export. The explosion of the illegal drug market between 1994 and 2008 “explains roughly 25 per cent of the current homicide rate in Colombia. That translate into about 3,800 more homicides per year on average that are associated with illegal drug markets and the war on drugs”, according to the report. This type of violence takes a massive economic toll; corporations relocate, foreign investment dries up, industries decline and citizens flee in search of a better life.

The costs are not limited to producer countries; consumer nations suffer as well.

This is especially so in the US, which has less than 5 per cent of the world’s people but almost 25 per cent of the planet’s incarcerated population. Most are drug and other non-violent offenders for whom drug treatment and other alternatives to incarceration would probably prove cheaper and more effective in reducing recidivism and protecting society. Worldwide, 40 per cent of the 9m people who are incarcerated are behind bars for drug-related offences – and that figure is only likely to rise, as arrests of drug offenders in Asia, Latin America and west Africa are increasing steadily.

Despite the epic scale of human wreckage, services that could save lives and cut down on the costs to society go underfunded, or not funded at all.

For years, my Open Society Foundations have supported harm-reduction programmes such as needle exchanges – a proved, cost-effective way to prevent HIV transmission. One country found that for every $1 invested in needle exchange, $27 is returned in cost savings. That is no small matter, considering the billions of dollars spent treating HIV. We have seen similar returns on investment with supervised drug injection rooms and medication-assisted treatment of opiate addiction. Yet despite these benefits, the US Congress continues to block federal funding for needle exchanges.

Several governments around the globe fight to prevent any mention of harm reduction in international forums, lest it clash with the predominant drug war ideology.

Yet change is still possible. In 2016 the UN General Assembly will review the current state of the drug- control system. For too long the UN has worked to enforce a “one-size-fits-all” model around the world, based on a belief that prohibitionist policies alone would solve the global drug problem.

The LSE report, to be released on Wednesday, recommends that governments give top priority to proved public health policies, moving to minimise harm in illicit markets, and mandating “rigorously monitored policy and regulatory experimentation”. I heartily concur.

Governments the world over need to weigh the costs and benefits of their current policies, and be willing to redirect resources towards programmes that work. This will save lives – and save money along the way. We have a once-in-a-generation opportunity to fix a broken global framework for coping with the drug crisis. The costs of doing nothing are too great to bear.

The writer is chairman of Soros Fund Management and a philanthropist