The Wooden Nickel
The Wooden Nickel
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Author : The BlackSummit Team
Date : February 6, 2024
The Wooden Nickel is a collection of roughly a handful of recent topics that have caught our attention. Here you’ll find current, open-ended thoughts. We wish to use this piece as a way to think out loud in public rather than formal proclamations or projections
1. What If It Reaccelerates? The Economy Reaccelerated
We teased the idea last month that not enough attention or consideration was being given to the possibility the economy would reaccelerate despite the tightening cycle the US has seen. If anything, we should have been more declarative that the economy had or currently was reaccelerating. Because enough evidence is in at this point that the supposed hypothetical has become reality.
Since that publication, we saw the latest GDP report come out with yet another print of real economic growth above the 2% level (long assumed to be the long-term equilibrium level for such a developed economy) and the second straight report above 3%. It’s been easy (and partially correct) to attribute the resilience of the US economy to massive fiscal stimulus. We’ve written pretty extensively about its impact and underappreciated influence on not just the economy but also asset markets. But you could wipe out the entirety of government spending’s contribution to GDP for the last two quarters and you’d still get GDP well above 2%. The reason for this is that the core engine of the US economy has come roaring back: the consumer (Figure 1).
The consumer spent most of 2022 decelerating and digesting the catch-up in incomes in the face of rising prices. With wages still catching up from 2022 inflation-induced wage hikes, nominal income growth has accelerated pricing, leading to acceleration in real consumer spending. And that trend is holding steady, if not accelerating itself. On Friday, we saw the US economy add an astounding 353,000 jobs to payrolls in the month of December, led by the services sector. The report blew away economists’ expectations of 180,000 – 200,000 jobs added. Revisions in the coming months may move that figure down (although the reports for November and December got revised upwardssubstantially on Friday) but nevertheless growing employment plus income growth of 4%-5% per year plus falling prices is a powerful recipe for the consumer and for economic growth. And the number of people participating in the economy’s reacceleration is broadening. The Bureau of Labor Statistics publishes a diffusion index with each month’s job report. Its objective is to measure the number of industries whose employment levels are expanding or contracting. Much like the monthly PMIs, levels above 50 signify improvement over the prior reading. The December report showed the greatest broadening in over a year, another sign of acceleration.
2. Credit Migration
Long ago, Aristotle remarked that analysis, and what we now would call the Scientific Method, was only relevant when studying things that “cannot be other than they are.” Gravity works the same way every day no matter the time of day, where you are in the world, or when in history. Therefore, using past data is contextually relevant and helpful as a means of discovery.
Economists are known for having “physics envy” precisely because the study of the economy does not follow this essential principle of non-contradiction. There are patterns, similarities, and tendencies but human agency and incentives prevent context from being identical. Unlike the laws of physics, what occurs in one environment is not always exactly repeatable. Economics violates the principle of non-contradiction.
This has been apparent in discussing and analyzing just how levered and healthy the consumer is. We’ve highlighted before how most headlines regarding debt at the household level are misleading or disingenuous but more evidence continues to come out (in addition to things like income growth cited above).
A new paper released in January unveiled the extent to which the credit quality of the consumer has improved relative to the pre-COVID era. Specifically, more and more consumers fall under the Prime and Near Prime categories based on credit scores. As a result of their migration up the credit quality ladder, the remnants of the lowest quality Subprime category are not comparable to the pre-COVID period. In other words, what was true about who made up the Subprime category 5 years ago is no longer true. And thus, using the same standard to compare apples and oranges is misleading.
If consumers hadn’t moved up in credit quality category the delinquency rates used as a fear tactic would look very different.
Now this does not purport to suggest that those borrowers who are delinquent on subprime loans don’t matter; the authors of the analysis explicitly make that case. But it does demonstrate how anchoring on past levels of delinquency rates as a harbinger of what’s to come fails to recognize that context is not fungible.
3. Sticky Inflation and Productivity
An interesting dynamic is at play currently within the labor market. As mentioned earlier, growth in wages and income have moved the US economy from stable to accelerating; the most recent estimate for GDP growth in Q1 2024 is over 4%. Wage growth, while having come down from post pandemic highs, still remain comfortably above what the economy experienced for the decade-plus in the post GFC era. In fact, it’s higher than the boom years leading into the Financial Crisis (Figure 5).
Productivity has reverted back to pre-pandemic levels after what has been admittedly a very noisy time period. But upon close inspection, it seems the majority if not entirety of the acceleration in productivity being experienced is due to a decline in the total number of hours worked (Figure 6).
Now this may all be noise and random and not relevant to the future (see point 2) but it does set up a tricky dynamic in terms of inflation getting sticky; going from 4% to 3% CPI will be easier than going from 3% to 2%: A dilemma the Fed is aware of. It also represents a headwind to earnings if it doesn’t resolve with greater productivity growth.
4. Is Deflation Possible?
“I skate to where the puck is going to be, not where it has been” – Wayne Gretzky
There’s a handful of quotes that come from outside financial markets that encapsulate the difficulties with investing exceptionally well and the Gretzky quote is well-known within financial circles for that very reason. In essence, while there are endless examples of idiosyncratic inefficiencies from time to time, to argue that markets never reach a point of having well captured the future is beyond asinine. You don’t get paid for something the market already knows; variant perception and insight are what matters.
This is not a binary or black-and-white proposition. With many more players and far more capital at play having a variant perception today, in my estimation, means more about thinking beyond a standard deviation of thought to find something different. It isn’t illuminating nor insightful if you’re opinion is simply to say that the economy will (or will not) enter a recession. It’s within the bounds of plausibility that a reasonable person could see some merit in portions of either argument. Far too few people late last year and now had the thought that the economy could reaccelerate in the middle (or end) of a tightening cycle. It was outside the range of typical discourse.
Which is why I find the chart below from DoubleLine all the more interesting. We ourselves debated the puts and takes to future CPI in the midst of an energy spike in the fall. But I’ll admit I hadn’t thought that deflation was in the cards. Given the weighting of shelter within the CPI and the huge amounts of housing supply under construction it might be a probability that we underestimated. Do I think it’s likely or probable? No. But is it given its fair share of probability within current market expectations? Probably not.
5. Recommended Reads and Listens
