What Happened to the American Dream?

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A survey from Luxembourg Income Study Database (LIS) has made headlines this week from an article in the New York Times. The topic was on the lagging pace of income growth for the American middle class compared to the rest of the world. The New York Times stresses the point that its countries like Canada, Britain, and the Scandinavian nations that have vastly outpaced the United States in terms of median income growth over the past decade. It goes beyond a comparison of median incomes in the world’s western nations as the comparison is on a global basis, and that is why the median income in the United States has stagnated verses strong growth in say Canada or Sweden. Also, are the factors that caused median incomes to stagnate in the United States going to change in the near future?

A plausible short answer is that other western democracies median incomes are simply catching up to the United States as smaller open economies benefited from an aversion of capital from the US in recent years. In terms of an outlook for stagnating middle class incomes, particularly in the United States, the answer is much less clear.

The topic of income inequality between the middle class and the upper one percent is nothing new, but has once again resurfaced, and not coincidently to the fact that we escaped the most severe recession since the great depression. This then reasons that regardless whichever country one might chose to examine at the moment, the politically popular topic is on the growing disparity between the top 1or 5 per cent and the middle class. This is because it’s a subject that caters to the masses, and should it inspire enough of the electorate, it’s a winnable political platform. However, taking advantage of the crony aspects that misrepresent a capitalist system and the false belief that a left of center government is a solution to this issue is blatantly mistaken and misguided. Furthermore, it’s a platform that takes advantage of the vulnerable.

As many economists have argued, it is yet to be known whether there is a direct cure or policy prescription for how the American economy will roar back to life. And ultimately, this is what is of most important to a world economy where the United States leads in the areas of growth by innovation and economic advancement in that country. The fear, which looks more and more realistic every day, is that America has entered a period of secular stagnation, replicating the lost decades in Japan where their economy has flat lined since 1990’s. Quite succinctly, it is the threat of getting stuck in this epoch of secular stagnation that will create minimal opportunities for the western world’s middle class, irrespective of the stance of the reigning political power.

To quote Winston Churchill, “The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of misery.” In a capitalist system there will always be a divide of wealth. The challenge is maintaining a system that instills a competitive environment that’s accessible to the majority of the people.

Four Years On

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Does Greece returning to the sovereign debt markets indicate the worst of the euro crisis is now behind us? That question cannot be answered with any certainty. But does the fact that this country was unable to go to the public debt markets since 2010, and now has auctioned 5 year notes below 5 per cent bear any long-term implications? The answer is a resounding no.

To start with background, Greece had their first public debt auction since March of 2010 last week. Only a meager 3 billion euros were auctioned, but demand was so strong the Greek Treasury was able to do fill the orders at a lower than anticipated yield. Some sources had demand at more than 20 billion euros. As interest rates in North America continue to see upward momentum, it might still be safe to suggest that the bull market in bonds isn’t over in Europe.

The Eurozone has advanced significantly from the dark period referred to as the Euro Crises. So much of this is attributed to those oft-quoted words of the European Central Bank President Mario Draghi, insisting to do whatever it takes to save the euro. And to the dismay of many pundits, confidence has been restored in the Eurozone without any market intervention or extraordinary monetary stimulus.

What is also astonishing about the relatively low yields (compared to 4 years prior) of peripheral euro nations’ debt is the unpriced risk in depreciation of the euro measured against the US dollar. The debate still continues as to whether a monetary union of that size and cultural divergence is actually sustainable in the long term. And given a forecasted dire outcome by many that would be associated with a collapse of the currency, the euro continues to defy forecasts and even appreciate in this tepid economic growth environment.

Beyond a low growth environment, there are a myriad of additional factors why Greek debt is attracting such high demand. Foremost, it’s because interest rates will more likely see downward pressure in the Eurozone. The euro denominated countries still sees disinflationary characteristics in many of its markets, and bizarrely it is in tandem with an appreciating euro currency. Both factors contribute to or are associated with downward moves in interest rates.

Importantly, investors are convinced that Mario Draghi and the European Central Bank stand ready, and potentially will act in the near future to unleash their own version of Quantitative Easing. Should this be the case, a weaker euro will ultimately prevail and create the sudden selloff many are anticipating, but the mere fact that investors are still convinced the ECB will act and be effective means there is already some level of assistance being provided to the markets through instilled confidence.

The final factor is all about austerity. The euro crises was about debt, and governments are all implementing policy with the focus of fiscal rebalancing and restraining public spending. This is not a bullish call on Europe, but highlighting that EU member governments are relatively sounder from a fiscal standpoint (thus, this is damning with faint praise given recent history).

Greece’s return to the bond market was extremely well welcomed, but for the investment opportunity in an environment that will continue to see downward pressure in European interest rates. This is not to minimize that Greece still has a painful road ahead. Following six straight years of recession, the Greek economy now produces 25 per cent less output. Public debt is still 175 per cent of GDP, which essentially requires Greece to seek outside funding should their economy hit another speed bump. And not forgetting a tragic scene of unemployed youth, there’s no reason to believe they’re close to being back to normal just yet.

What the Markets are telling us about the Economy

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Friday’s US payroll numbers revealed a key milestone for the US labour market. Private employer payrolls surged to 116.09 million positions, a level not surpassed since January of 2008. That confirms two key factors about the economy. One, the US labour market continues on its path of modest gains as more Americans rejoin the labour force each month. Two, the slump through the first quarter of this year was in large part weather related and looks to be short-lived. In essence, this is exactly what the markets have told us as the S&P 500 gained a modest 1.3 per cent in the first quarter of 2014 verses 10.03 percent in the quarter a year prior.

SPX q1-13vsQ1-14

The US labour market however, isn’t on a clear path to prosperity just yet. Population growth alone has seen an increase of 2 million American workers since 2008. And given the budget cuts and trimming of positions at government agencies, private payrolls are yet to pick up the slack created by the public sector. Although its easy to find optimism each month as the broader market shows signs of improving, there are the unavoidable facts that 3.7 million of 10.5 million unemployed Americans have been out of work for 6 months or longer, and 7.4 million Americans are working part time, but would prefer full time hours.

It’s the structural problems of the US economy that continue to exhibit investors’ uncertainty, and that is what is leading to the volatility of these markets. As many leading analysts seemed to suggest, 2014 would be a much more volatile year than 2013, and as the chart indicates, the first quarter of 2014 was rather directionless. Moreover, it was with that forecasted volatility that the market finished the quarter within a per cent of where it started.

The real question going forward this year surrounds what path policy makers, particularly at the US Federal Reserve, but also in Washington, will take. Without doubt accommodative monetary policy has been what directed these markets since 2009. Recent developments at the Fed, however, indicated Janet Yellen’s direction to be slightly unclear as her message has wavered between being hawkish to dovish. Furthermore, one of the leading voices on financial stability, Harvard’s Jeremy Stein resigned his seat as a Fed Governor this week. This is the third vacancy to be filled at the US Fed this year, and certainly opens up the possibility for a more accommodative tone, as it is the Fed Governors that dictate policy as they carry the majority of the votes on Federal Open Market Committee.

To make investors jobs more difficult, Washington kicks into campaign mode for the 2014 mid-term elections, and there are two probable outcomes. One is where Obama continues his lame duck presidency with strong Republican opposition, or a Democrat majority that support his anti-business agenda. Either scenario doesn’t really provide optimism for robust economic growth. Instead, more of the same moderate advances should be expected from the economy.

And this returns us back to the likely scenario of stock market volatility. The Fed has played a role in maintaining a steady hand for their unconditional support for the US economy. That is now being questioned. If the Fed choses to subside their proactive role in providing a predetermined level of assistance, investors may very well lose confidence in these markets, and they shouldn’t expect Washington to fill that void.