Recent economic data on wages, retail sales, and oil and other trade prices have severely undermined the blind confidence of equity markets that prevailed in 2014, and present market conditions are not likely to reverse themselves soon.
2014 was the battle of the cyclicalists vs. the secularists, in both markets and economic data, and that battle ended in a draw. The bond market, with interest rates falling literally from the first days of 2014, voted decisively for the view that the U.S. and the entire global economy are beset by a fundamental secular change and global imbalances resulting from significant shifts in the division of benefits of production between labor and capital, as well as the insufficiency of global demand relative to the huge increase in production emanating from the developing world. Equity markets, on the other hand, appeared to believe that the past seven years’ slump was the result of a cataclysmic collapse in the business cycle, and that the cycle was about to turn to the upside. Both markets had support for their points of view, although I am a secularist myself.
This year will be different, as every year is. 2015 will see a battle between the closed-economy theorists, who believe that, as U.S. exports are a mere 13% of GDP, the U.S. economy can go it alone without worry over contamination from its global competitors (after all, just look at the robust levels of job creation in the U.S., however lousy the wage picture); versus the globalists who believe, as I do, that severe weakness in Europe and Japan, and slowness throughout emerging markets, will be felt painfully in the United States. It appears that equity markets are beginning to take note of this global view―as well as the domestic data―and are beginning to comprehend that the imbalances referred to above have been there through and after the Great Recession but have been masked, to a large extent, by central bank mega-easing. The mask has been removed and the markets are reacting accordingly.
The fact is that the world―and not just the portion of the developed world with weak economies―disinflated during 2014 and is now experiencing price deflation that threatens to keep wages from recovering in the U.S. and elsewhere. And threatens earnings via a decline in unit pricing.
Ironically, this phenomenon will not necessarily depress standards of living for most―at least not for the time being―as accelerating disinflation and deflation will lower the cost of goods for those who have seen what little inflation we’ve experienced since the Great Recession further erode real incomes, that have been declining for over 15 years. If nominal wages don’t begin to actually fall in the U.S. and the core of Europe and the U.K., and they have thus far tended not to, the middle class (especially the non-propertied middle class) might actually enjoy the benefits of recovery in per capita purchasing power…and wouldn’t that be nice?
But underlying this premise―which is at this point more likely than not, in my view―rests a severe economic reality that equity markets are beginning to recognize: that prices of goods and services are, at least for the time being, are going to fall (along with industrial inputs which have already collapsed), that nominal wages will remain flat or actually decline a bit, and that, ultimately, the value of assets―both financial assets such as stocks and real assets (real estate) will fall into line with prices and wages. An unwelcome warning of this is that aggregate payroll indices are already beginning to stagnate, despite the job creation in the U.S., as new jobs are being created at significantly lower wages.
Sure, we may see a boost to equity markets as the European Central Bank responds to what is fast becoming an emergency situation in the Eurozone with its own version of quantitative easing. And economic statistics fluctuate, despite prevailing trends. But if I am correct the U.S. economy will not be on a “go-it-alone” trajectory in 2015. And if you were paying attention to what the bond market was screaming in 2014, perhaps it never was.
The above was originally published as an op-ed on cnbc.com on January 14, 2105: