INFLATION IS NOT WHAT INVESTORS SHOULD WORRY ABOUT.

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The New York Times

The New York Times reported that the recent wild swings in the stock market are rooted in economic fundamentals, these are the fundamentals to fear: that the already strong economy may overheat, inflation may spike, and the Federal Reserve may then raise interest rates more aggressively to try to combat that higher inflation.

The kernel of evidence that supported those fears was a report Friday that average hourly earnings for American workers rose 2.9% over the 12 months ended in January, the highest since the economic expansion began nine years ago.

The New York Times points out that high inflation or deflation is not a good news to the economy and illustrates it with an example of high inflation in the United States in the 1980s, what Japan has experienced in milder forms over much of the last 20 years and Europe since 2010.

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It is true that all these extreme swings significantly affect business activity. However, if I were in shoes of investors, I wouldn’t have worried about inflation as much as they do. Because there are a couple of much bigger issues investors might face in the future.

Society for Human Resource Management indicated that the 2018 pay projections were reported in Planning Global Compensation Budgets for 2018 by ERI Economic Research Institute, a compensation analytics firm in Irvine, Calif. The firm’s projections are based on data from over 20,000 companies and analysis of government statistics, such as the following:

  • Gross domestic product in the U.S. is expected to increase by 2.5% next year, up from 2.3% in 2017 and 1.6% in 2016—an improvement but below the Trump administration’s goal of 3% growth for the economy.
  • Inflation is forecast to slow to 2.4%, down from 2.7% this year but higher than the 1.3% reported for 2016.
  • The unemployment rate is predicted to fall slightly to 4.6%, down from 4.7% this year and 4.9% in 2016.

However, consumer borrowing rose in November by the largest monthly amount in 16 years, according to the Federal Reserve on Monday.

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TrueEconomics

Total consumer credit increased a solid $28 billion in November to a record seasonally adjusted $3.83 trillion, posting an annual growth rate of 8.8%. Economists had been expecting an $18 billion increase.

Year on year, 3Q 2015 growth in total household debt in the U.S. stood at 3.03%. This fell to 2.36% in 2016, before rising to 4.90% in 2017, the highest annual rate of growth for the third quarter period since Q3 2007.

Aggregate household debt in 3Q 2017, relative to 2005-2007 average was:
  • 11.8% higher in 3Q 2017 for Mortgages;
  • 23.4% lower for HE Revolving;
  • 51.9% higher for Auto Loans;
  • 6.6% higher for Credit Cards;
  • 201.2% higher for Student Loans;
  • 6.5% lower for Other forms of debt; and
  • 19.7% higher for Total household debt

TrueEconomics highlights that in the current environment, a 25 bps hike in Fed rate if fully passed through to household credit markets, will increase the cost of household credit by USD32.4 billion per annum. The same shock five years ago would have cost the U.S. household USD 28.3 billion per annum.

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CalculatedRisk

TrueEconomics underlines, to put this into perspective: current markets expectations are for three Fed rate hikes (and increasingly, the markets are factoring a fourth surprise hike) in 2018.

Assuming the range of 3-4 hikes moves to raise rates by 75-100 basis points, the impact on American households of the QE ‘normalization’ can be estimated in the region of USD98-130 billion per annum.

Since much of this will take the form of the non-deductible interest payments, the Fed ‘unwinding’ risks wiping out the entire benefit from the recent tax cuts for the lower-to-upper-middle class segments of the population.

USGDP1
The Balance

It appears that despite Donald Trump’s promises that Tax Bill would improve living standards for American people, the reality displays quite a different picture.

USGDP
The Balance

If household budget is going to be stretched as a result of upcoming rate hikes, it inevitably would lead to consumer spendings’ decline.

According to The Balance, there are four components of the US GDP. Consumer Spending, which is nearly 70 percent of the total.

Consumer spending increased 3.8% in Q4 2017 to $12.028 trillion.  Two-thirds of consumer spending is on services, such as housing and healthcare.

Nearly one-quarter is spent on non-durable goods, such as clothing and groceries.

Interest rates can impact the level of spending on consumer goods substantially. Higher interest rates make purchases more expensive and therefore deter these expenditures. Higher interest rates generally mean tighter credit as well, making it more difficult for consumers to obtain the necessary financing for major purchases such as new cars. Consumers often postpone purchasing luxury items until more favourable credit terms are available.
Perhaps if wages grow proportionately, the impact of rate hikes would not be significant.
The latest reports indicate that average hourly earnings were 2.9 % higher in January than a year earlier. Although i is a hopeful sign that wages might be gaining traction in a tight labour market, it is a mystery why it did not have earlier.

The New York Times reports that besides globalization and automatization, there are a few factors which might have contributed to it.

One of these factors if a collapse in the rate of union membership for private-sector employees — to 6.5% last year from the upper teens in the early 1980s — appears to have played a key role in holding down wages. This is partly because unions benefit workers directly: Average pay for workers represented by unions tends to be higher than for those who aren’t, even after controlling for education and other characteristics. But unions also benefit workers indirectly. In industries and regions where unions have a larger presence, pay tends to be higher for all low- and medium-wage workers, not just those represented by unions.

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The New York Times

“If you work for a nonunion firm and your employer is worried about the possibility of a unionization drive, one way to dampen down that possibility is to pay workers at the union rate,” said Jake Rosenfeld, a sociologist at Washington University in St. Louis.

The New York Times highlights that the effects are especially pronounced for men. A recent study by Mr Rosenfeld and two colleagues estimated that wages for men employed in the private sector who are not union members would have been 5% higher on average — about $2,700 per year — by 2013 if unions had the same reach as in the late 1970s. (The figure excludes senior managers.) For men with only a high school diploma or less, that figure rose to nearly $3,200.

The other factor is contract restrictions, such as noncompete clauses and no-poaching agreements, that prevent workers from quitting their jobs for better ones have grown across the workforce. Once reserved for highly paid, highly skilled employees like doctors and engineers, these contracts have filtered down the ladder to nurses, labourers and even retail clerks.

Virtually every study on the subject shows that these agreements reduce wages in an area since many people get their largest raises when they leave their company or threaten to.

The New York Times indicates that noncompete clauses also tend to prevent growing businesses from hiring as fast as they would like, and that can harm the overall economy by keeping talented employees from joining the higher-productivity companies that move a business forward.

As we can see, slow wage growth coupled with multiple rate hikes suggest a high probability of a decline in consumer spendings. Considering that it represents almost 70% of the total GDP of the United States, it is logical to assume that it could result in negative impact on businesses.

But there are a few more aspects. It is also important to keep in mind that with Donald Trump’s presidency many things have changed dramatically.  It makes a comparison of current political and economic environment in the country with events that took place previously inaccurate.

A few factors make today’s environment very different.

  • The US, #1 global economy, has a dysfunctional president.
  • The government is almost unable to perform due to internal conflicts.
  • What we observed within last 12 months indicate that Donald Trump is beyond unpredictable.
  • So far, Donald Trump did not deliver much. Perhaps it is a good news as what he has managed to deliver is a disaster.
  • Unlike previously,  as of today, most likely, the US debt reached an unsustainable level. This is the time when the country needs very strong leadership and unity within the government. It appears that what the US has today is quite opposite from what is required.

Due to the above, it is logical to assume that we might be facing a perfect storm. Therefore, if I were in investors’ shoes, inflation would have been the least of my worry.

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