Has the U.S. Housing Market Recovered? It Depends on Where You Are…

Trulia's Ralph McLaughlin and Wharton's Benjamin Keys discuss the housing market recovery.

It has been almost 10 years since the last big bubble in the U.S. housing market began to pop — the leadoff to what became the Financial Crisis and the Great Recession. In many respects, the U.S. economy has rebounded nicely from that disaster: Broadly speaking, stock indexes are setting record highs, unemployment is back in check, and consumer confidence has returned.

The question of whether the housing market has genuinely recovered, though, is more complex. A recent report complied by real estate website Trulia reveals a wildly uneven housing recovery, in which some parts of the country are seeing prices for nearly all homes above their earlier peaks, while in other areas, most homes are still far below those levels. Nationwide, just over a third of homes have reached pre-recession prices, and the forecast is that pricing won’t fully recover until 2025. Trulia chief economist Ralph McLaughlin and Wharton real estate professor Benjamin Keys, who is also a faculty research fellow at the National Bureau of Economic Research, recently visited Knowledge@Wharton’s SiriusXM show to discuss the housing recovery.

Knowledge@Wharton: Ralph, please go through the report and really break this down as to what we’re seeing, and how far we are from getting back to full pricing on a lot of these homes across the U.S.

Ralph McLaughlin: The highlight of the report is that only a little over a third of homes in the U.S. have recovered to their pre-recession peak values. But that distribution varies pretty widely across space. For example, in places like Denver and San Francisco, nearly 100% of homes have recovered, whereas in areas such as Las Vegas, Tucson or Bakersfield, fewer than 3% of homes have recovered. The secondary takeaway … is that income growth is perhaps one of the biggest differentiators that explains why some places have recovered and others haven’t. A few other factors that are correlated include things like population growth and job growth.

As far as predicting when the housing market will fully recover, if you use our measure of recovery, from a linear perspective it might not be until 2025. But the housing market, as you both know, can take sharp swings upward or downwards, so that could be either sooner than 2025 or much later.

Knowledge@Wharton: What was your reaction to this report, Ben?

Benjamin Keys: The economist in me first wondered if these were in nominal dollars or real dollars; people have this very artificial sense of a nominal value in the housing market. There’s been a lot of really nice research that has shown people are very sensitive to loss aversion. If I buy a house for $200,000, I’m really reluctant to sell it for even a dollar less. Those losses feel much more painful to me than the similar gains would feel in terms of making me feel better.

So there’s an artificialness to this as a benchmark, but I’m thinking of this as something that’s going to resonate in a lot of people’s minds who bought in 2005, 2006 or 2007 at very high prices. But whether these kinds of trends are going to persist, and whether we’re going to see this recovery reach these other markets, I think that’s a much deeper and really important question. The markets that have been left out of the house price recovery are some of the ones that had the most inflated and exaggerated bubbles, where we had the worst behavior in terms of mortgage market discipline, where we had the most teaser-rate contracts and low-documentation loans.

You look at Las Vegas, where almost none of the houses are back to their peak levels, and you really begin to appreciate just what distortions were going on in the market at that time, and how long-lived the recovery has to be to get the market back to a place that looks like it did prior to that bubble period.

Knowledge@Wharton: Ralph, Ben mentions Las Vegas, and it’s a well-documented story about how much trouble that metropolitan area had in terms of the drops in price. You have a list of the top 10 cities that have not recovered to this point, and what I found interesting was there were a couple of markets in there that are, for the most part, considered to be more lower-income cities — Camden, New Jersey, across the river from us here in Philadelphia, being one of them. Those are cities that obviously lost a good bit after the housing bubble burst and the recession hit. The question is whether or not they can regain it to any degree when you think long term.

McLaughlin: There are a couple of interesting points that Ben brought up that relate to this that are important to dive into a little bit more. One, is the pre-recession peak an acceptable benchmark given how inflated some of these markets were? Our measures are nominal, which is the point that Ben makes. We chose to use nominal values because we think that for most homeowners, that’s their benchmark. Most homeowners are not adjusting for inflation in their head, and so it affects the psychology of the market. From a nominal perspective, yes, these markets eventually will recover, at the least just because of inflation.

Second is whether or not really they’re going to recover from an inflation-adjusted standpoint.

For some of these markets, if they do, it may be decades — and in particular when you’re talking specifically about the markets that tend to be in the Rust Belt — places like New Haven, Connecticut; Lake County, Illinois/Kenosha, Wisconsin; and Camden, New Jersey — those areas are seeing pretty long-term and significant population declines, which are never highly correlated with increases in prices. Usually, population decline leads to decreases in prices.

Now, some of the other markets, in particular, those in the West that may either be fast growing or near markets that are fast growing — think Las Vegas, or in California, Bakersfield, Riverside, and San Bernardino — those markets are probably going to recover, in my expectation, faster than some of those Rust Belt markets.  
Keys: Absolutely. I think one of the things that this highlights is the real divergence across cities in the U.S. That’s something that we’ve seen in the income distribution, and something that we’re seeing across cities as well; there’s a set of stagnant cities that are really struggling, and with housing being such a durable good, it’s very difficult to adjust a city’s footprint or the number of houses that are available. We know that places that have a sizable downturn can be trapped in that state for a very long time, and there aren’t a lot of easy ways to pull out of it. It takes a really active local government and local public policies to turn things around.

Knowledge@Wharton: Ralph, when you bring these numbers forward to people, is there a level of surprise that some of these cities are struggling mightily just to get a little bit of the value back in their homes?

McLaughlin: Yes, this report really was met with a lot of surprise. I think one particular reason is, in general, a lot of the other metrics that we use, that we’re currently using as a society to judge housing market recovery — namely, aggregate measures of prices — really mask what’s going on within individual markets. When you look at the value of individual homes within those markets the story is very, very different. In particular, there was a lot of interest from reporters in markets that have yet to recover, in particular in Florida, but also markets in the Midwest that were outside that bottom list.

Chicago — they were very interested in the fact that fewer homes have recovered. Their big question is, one, when are we going to come back? And two, is this a bad thing? I think that is the important takeaway. Just because your housing market hasn’t recovered to its pre-recession peak doesn’t necessarily mean it’s a bad thing. That’s the emphasis that I’ve been trying to get reporters to focus on. It’s probably a good thing that homes are not back to where they were in Las Vegas and Bakersfield.

Knowledge@Wharton: We saw for quite a period of time a trend of people investing in a lot of these properties, especially the ones that were distressed, and trying to build them back up to a degree, and flip them. That seemingly is still happening, but maybe not to the degree that it was two or three years ago. Based on this information, it feels like there’s still an opportunity for flippers to benefit by finding these properties and turning them around.

Keys: Yes, the single-family rental market is one that really took off in the wake of the crisis, and certainly, some savvy investors scooped up a lot of foreclosed properties at a discount. I think what we’re recognizing now — and what this report really highlights — is that some of the places where we haven’t seen as much of that activity and we haven’t seen prices bounce back are stagnant for exactly the kinds of reasons that we were talking about earlier. In those types of places, the returns that you need to get to make that business model work are really outsized, because there are very high costs to maintain all of those properties. There’s a reason why we think of rental properties as usually being more concentrated and more dense, because it’s just much easier to maintain and monitor. You can have one super take care of the whole building. You don’t have that when you have 50 properties spread across a city.

So I think the returns might not be there in some of those markets. It’s certainly a possibility, and I think there are people who are still pursuing some of these single-family rental plays. But you’re also seeing some of the big players in the market trying to get out. They’re trying to spin these off, and the exit strategies aren’t clean, because you don’t want to unload all of these properties onto the market at the same time, especially in some of the markets where things are still on a bit shakier ground.

So I think it’s still an evolving asset class and kind of a new thing. There’s also the question of whether it’s going to be able to persist in good times and bad, or whether it was just a one-shot deal, and some very savvy investors struck gold at the right time.

Knowledge@Wharton: Ralph?

McLaughlin: That’s a great point. Maybe not so coincidentally, in the home-flipping report we released back in February, several of the markets at the top of the list were markets that are lowest in terms of home value recovery. Las Vegas was leading the country where around 11% of home sales were flipped in 2016. And the other market that was a hot spot was the Greater Miami area — so Miami, Fort Lauderdale and West Palm Beach — that also came up pretty high on that list. So it’s very possible that investors are seeing opportunities, at least to perhaps flip homes, number one, that are undervalued, and number two, maybe that went through periods of deferred maintenance. That’s one thing that anecdotally may be there, that with a large foreclosure crisis, there were perhaps high vacancy rates and removed owners, whether they were banks or other investors, and many of those homes maybe experienced a lot of deferred maintenance. So there’s this housing stock that is ripe for improving, or at least was ripe in 2016. We’re not necessarily saying that that’s going to be the market going forward, but that’s what we observed last year.

Knowledge@Wharton: Looking at the top 10 list of metropolitan areas with the strongest recoveries, the majority were west of the Mississippi. All of them were, in fact, except Nashville. That being said, what is the state of the recovery here in the eastern half of the U.S.? Obviously, there are a lot of areas where housing is still very affordable. I have friends down in the Atlanta area that talk about how you can get a beautiful, big, four-bedroom, three-bath house that would cost you probably $500,000 here in the Philadelphia area for $200,000.

McLaughlin: Yes. Most of the housing recovery as you mentioned has been west of the Mississippi, and we think there really is a delineation between those markets that have recovered. They tend to be either markets that are big economic engines of the country — so places like San Francisco, Denver and Colorado Springs, which is outside of Denver — and markets that really didn’t fall, didn’t crash very much during the recession. Texas is one of those markets, as is that part of the country.

When you’re looking at the eastern half of the country, and comparing areas that have recovered to those that haven’t, there is a similar delineation, but it’s on that second part of the delineation. Markets that really never boomed are the ones that have actually come back. Places like Buffalo, New York, Rochester, upstate New York, never really boomed during the bubble. Other places that fit that bill in states along the East Coast include places like Pittsburgh. On the other hand many other markets that are east of the Mississippi are in the lower half in terms of their level of recovery. In New York, only 26% of homes have recovered.

In Ohio, only about 20% to 23%. Absolutely, in some of these markets there may be a lot of homes that have not reached their pre-recession peaks, but that doesn’t necessarily mean that there’s potential in those markets to get back to that pre-recession peak, as per our discussion earlier.

Knowledge@Wharton: Part of that, as you’ve both alluded to, relates to the economic situation in a lot of these cities. For some of the smaller to mid-sized towns, the loss of manufacturing at whatever level has really hurt these markets. Some of them may not be able to come back because the manufacturing just isn’t there the way that it was, say, 30 or 40 years ago.

Keys: That’s absolutely right. I think you have an employment base that’s really shifting, and it’s shifting quite sharply in the wake of the Great Recession. We saw a lot of people employed in construction, and housing was actually a real engine for growth during that period. But where there really wasn’t much of a boom, those are places where the local economy and the local drivers of the economy are going to be the big factors in determining house prices. And where employment is falling and where the compositional shift away from traditional industries is happening more rapidly, those are places that are really going to struggle.

Knowledge@Wharton: Ralph?

McLaughlin: Yeah. To put some numbers behind that, Buffalo, New York, for example, has had negative 4% job growth – so, employment contraction — since the recession. And the same with Rochester, about negative 2%. It’s very hard for markets to recover when they’re shedding jobs, because you need job growth to support income growth, which supports price growth. We are really seeing very interesting and stark regional differences in where both income and job growth are occurring in the country.

Knowledge@Wharton: Obviously if you flip the scenario and look at a place like San Francisco, it’s just incredibly surging right now mostly because of what we’re seeing in the tech sector. But it’s amazing to me that the median price for a home in the San Francisco area is more than $1 million right now. It’s incredible to think about the growth that you’re seeing, and the wealth that there is in the housing sector in that area alone.

McLaughlin: Absolutely. In San Francisco alone since the recession, they’ve seen about a 30% increase in jobs and about a 25% increase in income. And because housing is a “normal good,” households do tend to put that higher income into their homes in one way or another, either the ones that they’re living in or ones that they use for investment purposes. It’s obviously an outlier. But still, if you compare it to other places that are on that list, job growth in Dallas has been phenomenal, 25% since recession; income growth has lagged a little bit, but it’s still about 11%. But the big difference, at least between those two markets where income growth and job growth are good, is that Dallas actually builds a lot of homes and San Francisco doesn’t. Not only is the San Francisco area booming, but they’re not building a lot homes, so demand is increasing sharply at a time when a supply is pretty stagnant. That’s a situation ripe for increasing prices to, as you said, well over $1 million.

Keys: That’s also leading to an affordability crisis in a lot of these cities. You have this disconnect where the places where the jobs are being created are also the places where it’s difficult to build or there’s not as much building going on. That’s leading to extremely high rental prices, and relatively low homeownership rates. You have this challenge for job mobility. If we’re going to draw people to these drivers of the modern economy, to these engines of growth, but we don’t have anywhere for them to live, this is a real challenge. I think something that we need is policies that do more to encourage affordable housing, and reduce some of the barriers to home construction and more dense construction.

Knowledge@Wharton: Obviously, it’s a big issue and it’s one that needs to be addressed in Washington, and probably even more so at the state level as well, to open up the door for some of these things to happen. And it does, again, throw us back into that economic debate about what needs to happen to allow some of these things to occur, so that people can have the resources they need to be able to buy these homes. We need to get a lot of these homes, whether they be newer construction or older stock, off the market. To turn them back into assets rather than liabilities hanging on the backs of people.

Keys: That’s right. At the national level, we think about things like federal mortgage policy and federal mortgage finance systems that could potentially alleviate some of the pressure on the rental market, if we could bring more people into homeownership. We’re at a 50-year low for the homeownership rate, which is a pretty astonishing figure. At the national level as well, we can think about support for housing vouchers, support for multifamily construction, and the kinds of things that are going to free up more financing for development that’s denser.

But then we have all these local barriers to development, so those challenges cut across one another and make it really difficult to increase the density in the most desirable neighborhoods and the most desirable cities.

Knowledge@Wharton: Ralph?

McLaughlin: I agree 100% with Ben. You really need a three-pronged approach here. One is to increase market-rate development. I think market-rate development is sort of the elephant in the room, just because a lack of it can put pretty severe affordability pressures on homes that normally, lower-income individuals would occupy. Two, there’s always going to be demand for below-market-rate housing. I think we could do a better job of that. And three — looking at something we haven’t talked about much here – is the inventory problem of existing homes; there aren’t a lot of homes on the market. Some of those may have been bought up by investors and turned into rental units, and investors are holding onto them for good reason; rents have gone up pretty sharply. You could tweak tax codes if you wanted to incentivize owners of existing rental homes to sell. Depending on what side of the political spectrum you’re on, you could either, A, have a one-time exclusion in capital gains tax for those properties — in other words investors could sell them and not pay tax on the capital gains, which might encourage them to sell – or, B, tax rental income at a higher rate. Both of those would have the same effect. Again, depending on what side of the political spectrum you’re on will tell you what side you lean towards, but both should have the effect of freeing up investor-owned properties if there is demand among would-be owner occupiers looking to get back into the market.

Knowledge@Wharton: Ralph, is there a hope that the rental market will ease a little bit in the next couple of years, and that we can flip the script? Can we see more properties purchased, and built as well, to get the new-home market rolling as well?

McLaughlin: I’m much more optimistic about building. I think we’re starting to see upward charges there. On the other hand, I do see signs that rents are starting to moderate a bit, but whether or not they’re going to moderate for long enough of a period for wages catch up and make rents affordable is a question that remains to be answered.

Finding High-Quality Companies Today

We are having a hard time finding high-quality companies at attractive valuations.

For us, this is not an academic frustration. We are constantly looking for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at holdings of investors we respect, talking to our large network of professional investors, attending conferences, scouring through ideas published on value investor networks, and finally, looking with frustration at our large (and growing) watch list of companies we’d like to buy at a significant margin of safety. The median stock on our watch list has to decline by about 35-40% to be an attractive buy.

But maybe we’re too subjective. Instead of just asking you to take our word for it, in this letter we’ll show you a few charts that not only demonstrate our point but also show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, we don’t know either. But this is our point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s demonstrate this point by looking at a few charts.

The first chart shows price-to-earnings of the S&P 500 in relation to its historical average.

The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the1999 run-up to the dotcom bubble burst.


We know how the history played in both cases – consequently stocks declined, a lot.
Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how this journey will look in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it maybe say hello to the pre-dotcom crash level of 164% above average?

Or will another injection of QE steroids send stocks valuations to new, never-before-seen highs? Nobody knows.

One chart is not enough. Let’s take a look at another one, called the Buffett Indicator. Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the whole economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a similar story to the first one. Though neither Mike nor Vitaliy were around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first eleven months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: first, “This time is different” (it never is), and second, “Yes, stocks are overvalued, but we are still in the bull market.” (And they were right about this until they lost their shirts.)

Both Mike and Vitaliy were investing during the 1999 bubble. (Mike has lived through a lot of more bubbles, but a gentleman never tells). We both vividly remember the “This time is different” argument of 1999. It was the new vs. the old economy; the internet was supposed to change or at least modify the rules of economic gravity – the economy was now supposed to grow at a new, much faster rate. But economic growth over the last twenty years has not been any different than in the previous twenty years – no, let us take this back: it has actually been lower. From 1980 to 2000 real economic growth was about 3% a year, while from 2000 to today it has been about 2% a year.

Finally, let’s look at a Tobin’s Q chart. Don’t let the name intimidate you – this chart simply shows the market value of equities in relation to their replacement cost. If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then Tobin’s Q is 2. The higher the ratio the more expensive stocks are. Again, this one tells the same story as the other two charts: Stocks are very expensive and were more expensive only twice in the last hundred-plus years.

What will make the market roll over? It’s hard to say, though we promise you the answer will be obvious in hindsight. Expensive markets collapse by their own weight, pricked by an exogenous event. What made the dotcom bubble burst in 1999? Valuations got too high; P/Es stopped expanding. As stock prices started their decline, dotcoms that were losing money couldn’t finance their losses by issuing new stock. Did the stock market decline cause the recession, or did the recession cause the stock market decline? We are not sure of the answer, and in the practical sense the answer is not that important, because we cannot predict either a recession or a stock market decline.

In December 2007 Vitaliy was one of the speakers at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was “When are we going into a recession?” Vitaliy gave his usual, unimpressive “I don’t know” answer. The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from six months to eighteen months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the US economy was already in a recession.

We spend little time trying to predict the next recession, and we don’t try to figure out what prick will cause this market to roll over. Our ability to forecast is very poor and is thus not worth the effort.

An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. This argument sounds so true and logical, but – and this is a huge “but” – there is a crucial embedded assumption that interest rates will stay at these levels for a decade or two.

Hopefully by this point you are convinced of our ignorance, at least when it comes to predicting the future. As you can imagine, we don’t know when interest rates will go up or by how much (nobody does). When interest rates rise, then stocks’ appearance of cheapness will dissipate as mist on the breeze.

And there is another twist: If interest rates remain where they are today, or even decline, this will be a sign that the economy has big, deflationary (Japan-like) problems. A zero interest rate did not protect the valuations of Japanese stocks from the horrors of deflation – Japanese P/Es contracted despite the decline in rates. America maybe an exceptional nation, but the laws of economic gravity work here just as effectively as in any other country.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. How about being patient and not taking the poison at all?

You may ask, how do we invest in an environment when the stock market is very expensive? The key word is invest. Merely buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. We don’t do that and won’t do that.

Not to get too dramatic here, but here’s how we look at it: Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as your trying to guess the next card at the blackjack table.

However, valuing companies is not random. In the long run stocks revert to their fair value. If we assemble a portfolio of high-quality companies that are significantly undervalued, then we should do well in the long run. However, in the short run we have very little control over how the market will price our stocks.

Our focus in 2016 was to improve the overall quality of the portfolio – and we did. We will stubbornly continue to build a portfolio of high-quality companies that are undervalued.

The market doesn’t need to collapse for us to buy new stocks. The market falls in love and out of love with specific sectors and stocks all the time. In 2014 and 2015 healthcare stocks were in vogue, but in 2016 that love was replaced by a raging hatred. We bought a lot of healthcare stocks in 2016. In the first quarter, REITs as a group were decimated and we bought Medical Properties Trust (MPW) at less than 10 times earnings and a near 8% dividend yield – more on that later. We also spend a lot of time looking for stocks outside the US, in countries that have a free market system and the rule of law.

The point we want to stress is this: We don’t own the market. Though the market may be overvalued, our portfolio is not.

For a more extensive version of Vitaliy’s thoughts on investing in today’s environment, see “How Investors Should Deal With The Overwhelming Problem Of Understanding The World Economy.”

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).

Wall Street's Best Minds

Weak Job Growth Is a High-Class Problem

A Charles Schwab strategist gives her assessment on jobs, wages and their impact on Fed policy.

By Liz Ann Sonders

Here are key points of this commentary:
• Last Friday’s jobs report raised alarm bells about slowing job growth, but perhaps it’s natural at this stage in the cycle.
• Wage growth has been held down by both secular and “math” problems.
• Small business survey data, as well as alternate wage growth measures, suggest wage pressures are on the rise.
After the financial television networks’ typically-breathless countdown to last Friday’s jobs report, the release was a downer, at least as initially diagnosed. My report will attempt to tell a more detailed tale of what’s going on with jobs, wages, and their potential impact on Federal Reserve policy.
Charles Schwab & Co.
May’s nonfarm payrolls report showed a weaker-than-expected gain of only 138,000 new jobs, below both the consensus expectation and the recent trend. And although the unemployment rate ticked down to 4.3%, the details of that component of the release were weaker than expected; as the household survey employment series fell by 233,000 and the labor force participation rate (LFPR) fell 0.2 points.
On the subject of the labor force participation rate, it’s important to highlight that it’s getting harder for companies to attract individuals who are not currently working. The pool of “discouraged” (but still available) workers has been falling precipitously during this expansion. About two-thirds of those not working represent older retirees; while the “other” category—stay-at-home parents, folks on disability, students, etc.—now represents about one-third.
Why job growth has waned
First, there was likely yet again a seasonal adjustment problem. As highlighted by High Frequency Economics (HFE), the May 2016 report was even weaker—payrolls were up only 38,000 —with similarly weak details. Thereafter, payrolls rebounded sharply. The average rise in payrolls so far this year—at 162,000 —is below the 187,000 from last year; but that includes the below-trend May reading. A rebound in the June and July data is expected.
Second, and more importantly, job growth is naturally waning given that we’re already likely at “full employment” and given the fact that we’re entering the ninth year of an economic expansion, showing a six-month average to smooth out month-to-month volatility). HFE notes that even 162,000 job gains per month—1.3% at an annual rate—is more than enough to keep both the headline (U3) and broader (U6) unemployment rates trending down.
More confounding has been the perceived-breakdown between lessening labor market “slack” and wage growth. At this stage in the employment cycle, wage growth should have been stronger based on historical trends and the “Phillips Curve,” which shows that inflation/wages and unemployment have an inverse relationship.
Using average hourly earnings (AHE)—the standard measure of wages—the year/year change was stable at 2.5% in May, slightly down from last year’s 2.6% average. As noted by HFE, and “based on the ‘accelerationist’ theory of the relationship between unemployment and wages, wages don’t accelerate significantly until unemployment drops below the full employment level, and that likely just happened a few months ago.”
There are a few secular reasons for lower wage growth in this cycle; including weak corporate top-line revenue growth, low productivity growth and limited corporate pricing power. But there is also a “mix shift” problem in terms of how average hourly earnings are computed. This is why there are other—arguably more “accurate”—ways to measure wage growth.
Math problema 
Notice how AHE were moving higher during much of the Great Recession. Does anyone think wages were actually moving up during one of the greatest economic contractions in history? Of course not; but that’s the way average math works. During that period, more folks on the lower end of the wage spectrum were losing their jobs; which biased up the average. Conversely, more recently, the sharpest job gains have been concentrated in the younger cohort—they are naturally at a lower wage level than older workers—therefore they bias down the average. In other words, Boomers are retiring from higher-wage jobs, while Millennials and Generation Z folks are getting new jobs at naturally lower wages.
The mix-shift problem is why the Atlanta Fed created their own “Wage Tracker,” which only measures wage gains for those folks who have been in the workforce for the full 12-month measurement period; thereby eliminating the “mix shift” problem of AHE. This measure of wage growth is running at 3.5% —a full percentage point higher than AHE. For what it’s worth, the Federal Reserve has both on its “dashboard” of employment indicators and is part of the reason we, and the market, believe a June rate hike remains firmly on the table.
Skills gap
A budding problem for employers, as well as an explanation for slowing job growth, is a skills/worker shortage. Given that small businesses are the U.S. economy’s largest employers and hirers, the National Federation of Independent Business (NFIB) highlights an important problem—the inability to find qualified workers for what are still high and rising job openings.
The same NFIB survey from which the job openings data comes also has a series measuring firms’ plans to raise workers’ compensation. It’s been trending higher for the past several years. HFE suspects that “some of the increase in compensation is separate from the basic wages captured by the average hourly earnings series.”
In summary
The pace of job growth has slowed, but it’s likely not because the economy is weakening. It may even be because the economy is strengthening. 

Sonders is chief investment strategist with Charles Schwab & Co.

What the Paris Agreement Doesn’t Say About US Power

By Jacob L. Shapiro

U.S. President Donald Trump’s decision to withdraw from the Paris climate agreement is indicative of a problem that has hampered his presidency since he came to office. There are two factions within the administration that have mutually exclusive foreign policy goals. One, centered around chief strategist Steve Bannon, advocates “America First” strategies that align with Trump’s campaign promises. The other, centered around Secretary of Defense James Mattis, wants the U.S. to continue to work with the very international institutions the America First faction is trying to get out of. The result is an inconsistent American foreign policy that strains relations with allies and causes even greater friction with enemies.

Opposing Factions

The America First faction believes that participating in international institutions and agreements weakens U.S. power. Members of this faction want the U.S. to withdraw from the Paris Agreement, get tougher on trade with China, renegotiate NAFTA, and insist that NATO and other American allies pay their fair share of defense costs. If the U.S. decides cutting carbon dioxide emissions is in its interest, then it should do so, but cutting emissions only because a multilateral agreement obligates it to is a slippery slope and could infringe on U.S. sovereignty. Withdrawing from the Paris Agreement is a major symbolic victory for this faction.

Dozens of Connecticut residents converge along a bridge at a vigil and rally for the environment and against President Donald Trump’s recent decision to withdraw the United States from the Paris climate accord on June 4, 2017, in Westport, Connecticut. Platt/Getty Images

But it was a major disappointment for the second faction, which promotes international agreements and cooperation. One of the more prominent members of this group is the defense secretary, who has supported NATO and has focused his strategy to combat the Islamic State on a 68-member coalition assembled by the State Department. In a speech just last week, Mattis emphasized the role of international institutions such as the United Nations, the Association of Southeast Asian Nations and the International Monetary Fund in promoting prosperity in Asia and protecting countries from Chinese ambitions.

These are mutually exclusive worldviews, and they generate mutually exclusive foreign policies.

On the one hand, Trump is pulling the U.S. out of the Paris Agreement. On the other hand, his secretary of defense and secretary of state are relying on multilateral institutions to pursue U.S. strategic interests. Neither faction appears strong enough to defeat the other. The result is inconsistency in American strategy and confusion among allies and enemies. In some cases, this undermines U.S. power abroad, and in other cases it creates an opportunity for countries like China to make the U.S. appear weak and self-absorbed.

What the Critics Are Missing

The media and Trump’s political opposition have focused on certain aspects of his decision, arguing that it will diminish the United States’ global leadership position. In focusing on these points, the critics have missed the bigger picture of U.S. power in the world.

First, the U.S. has always distrusted international institutions, but this has not destroyed U.S. power in the world. The U.S. has at times advocated their necessity, but it always made sure to preserve U.S. sovereignty, even at the expense of the efficacy of these institutions. The U.N. has been rendered powerless many times by the veto power of the Security Council’s permanent members. Its weakness is, in part, by American design.

Withdrawing from the Paris Agreement is, moreover, not unprecedented; many international treaties have failed to get through the American political system. For example, the U.S. Senate rejected the Treaty of Versailles, which established the League of Nations. Bill Clinton signed the Rome Statute in 2000, committing to join the International Court of Justice, but failed to get it ratified by Congress.

The Paris Agreement’s predecessor, the 1997 Kyoto Protocol, was another agreement Clinton signed but couldn’t get ratified. George W. Bush announced his unwillingness to implement Kyoto just a year into his presidency. In each of these cases, the decision to withdraw from an international agreement was met with much criticism from people claiming it meant the U.S. had lost its standing as a global power. Each time, it wasn’t true.

Second, the Paris Agreement is unenforceable as written. The countries that have ratified the deal have agreed at the broadest level to cut carbon dioxide emissions. The quotas for these cuts, however, are to be decided country by country, and nowhere in the agreement is the issue of enforcement raised. There is no guarantee that the ratifying countries will cut emissions to the levels promised in the agreement, and there is no accountability for any country that decides to cheat. The best way to judge the efficacy of an international agreement is to look at the consequences for a signatory that fails to live up to it. By this standard, the Paris Agreement is a toothless initiative.

Last year’s OPEC agreement to cut oil production and boost oil prices is a prime example of why enforcement is a huge problem for such agreements. OPEC and non-OPEC oil exporters, including Russia, have every interest in keeping oil prices high, which is why they agreed to cut production. But despite their shared interest in abiding by this deal, Russia has fudged its numbers, claiming to have met its obligation when, in reality, it raised crude production in January and March 2017 compared with the previous year. This is a much smaller group of countries with a far more tangible goal (increasing oil prices) – and even they can’t stick to the terms of their agreement. The Paris deal apparently includes an unwritten suspension of the laws of human nature that allows it to avoid the prisoner’s dilemma inherent in the agreement’s framework.

The harshest critics of Trump’s decision to pull out of the Paris Agreement believe climate change is destroying the planet. That is a serious issue, but if meaningfully cutting carbon dioxide emissions is the goal, this deal is not going to achieve it.

Third, withdrawing from the Paris deal does not preclude the U.S. from cutting emissions if it so chooses. The previous administration pledged a 26-28 percent cut in greenhouse gas emissions from 2005 levels by 2025, and there’s no reason the U.S. can’t still meet that target. If major U.S. companies support emission cuts, they can reorganize their businesses to achieve them. If individual U.S. states want to cut emissions, they can implement measures to do so.

And if a majority of the American population wants to reduce emissions, they can elect representatives who support such reductions. Other countries will cut emissions if it is in their interest to do so, and the same is true of the U.S.; a piece of paper printed in Paris doesn’t change that reality.

Fourth, President Barack Obama bypassed the Senate to enter the agreement in the first place.

The legality of this action is questionable at best, but it certainly violated the spirit of the Paris Agreement itself, which stipulates that it must be approved by states, not heads of states. The agreement’s supporters in the U.S. also point out that even major energy corporations like Chevron and BP support the deal. The irony that environmentalists and liberal internationalists are taking their lead on climate change from a company like BP is lost on them.

Fifth, some have argued that withdrawing from the Paris Agreement cedes the future of the world order to China. This notion coincides with Beijing’s other supposed successes: It is working on the hugely ambitious One Belt, One Road initiative, constructing islands in the South China Sea and building aircraft carriers, and it will soon have a middle class exceeding the population of the United States. Withdrawing from the Paris Agreement is just the cherry on top – now, China will also become the world leader on climate change (even though it won’t be cutting its emissions until 2030, if it lives up to this pledge at all).

But this perception is not accurate. China is not on its way to challenging U.S. global supremacy, and the above examples indicate why. It’s not clear how China is going to fund One Belt, One Road. The U.S. has 11 aircraft carriers; the Chinese have two. China may have a burgeoning middle class, but it also had more people living on less than $3.10 a day in 2010 than there were people in the United States. The U.S. has become somewhat inept at communicating its position, but its power relative to other countries remains overwhelming.

The Bigger Picture

The media has made the case that the U.S. has abdicated its global responsibilities by leaving the Paris Agreement. This view acknowledges one aspect of American foreign policy while missing several others. The U.S. is the primary country in the world gearing up to deal with a North Korean regime that seems bent on developing nuclear weapons at any cost. The U.S. is leading the fight against the Islamic State. American soldiers are deployed in Eastern Europe to hold the line against potential Russian aggression. The specter of a U.S. recession is casting a heavy shadow on many of the world’s largest economies, because when the U.S. sneezes, the rest of the world catches a cold. The U.S. has chosen not to participate in an international agreement of limited importance, but that doesn’t mean that the U.S. has withdrawn from the world.

U.S. power is not waning; it’s maturing. One man’s isolationism is another man’s self-reliance.

Maturation, however, is not a linear process. The battle raging within the Trump administration is a microcosm of an old argument that has been reanimated across the country between those who want to focus on domestic issues and those who want the U.S. to be a global leader.

What makes this different from previous iterations of this argument is that isolationism is not a viable way for the U.S. to conduct its foreign policy in the long term. The U.S. is the only global power in the world, and other countries look to it for leadership. They praise the U.S. when the U.S. lives up to their ideas about what it should be, and they castigate the U.S. when it disappoints them. Often this has very little to do with the U.S. and everything to do with what those other countries think about themselves.

In this case, though, the world sees the U.S. as it is: in a state of confusion. The U.S. insists that national interests are and ought to be the organizing principle of global politics, while simultaneously insisting that multilateral institutions are needed to help combat global threats to the liberal world order it helped build after World War II. The U.S. is trying to figure out how to be a global power.

Withdrawing from the Paris Agreement will be consigned to the dustbin of similar moves in U.S. history. But the unpredictability of U.S. foreign policy has the power to reshape geopolitics, and it will do so for years to come. That is a marker of just how powerful the U.S. is. Its self-doubt is not contained by the oceans.