Global Macro Notes: The Great Compression

February 15, 2011
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Where is all the spending coming from?

We know where the liquidity and the “animal spirits” are coming from. Those are courtesy of Ben S. Bernanke, the golden god of stocks.

But from whence the spending – specifically, the consumer spending (circa 70% of the U.S. economy) that powers earnings and recovery stats and makes this market relentless?

Look at the above chart of XRT, the SPDR S&P Retail Index. XRT has been a juggernaut – a tank. This reflects the strength of retail names, and of U.S. consumer spending in general (at least on the high end).

The refusal of the consumer to roll over has driven bears up a wall (pun intended). You’ve heard the arguments. You’ve heard them pounded into the table, hard enough to make it break.

And then there’s the data: The persistent unemployment; the still-deflating housing bubble; the clear evidences of wage reduction and stagnation; the lessons of financial history; the need of a serious and prolonged deleveraging that keeps getting put off.

Thus far, none of it has mattered. The consumer has powered through, with the ample help of the most reckless Keynesian monetary experiment the world has ever known. And thus, animal spirits have prevailed. But how?

A theory: What has widely come to be called “the Great Recession” is actually,  in many ways, “the Great Compression.”

Via Fortune, “How to Deal With an Invisible Promotion:”

Welcome to the world of invisible promotions, where you can have your job — and your former boss’s too. Productivity is high — but so is unemployment. That’s why across the country, managers and staff now shoulder duties from laid-off managers and peers or positions that were supposed to be filled but never were. The extra work usually brings extra headaches or longer hours, but little or no extra money.

The piling-on of responsibilities is at an all-time high, says Jim Link, staffing agency Randstad’s managing director for human resources. Consider Maura, an interactive designer at a major technology company in Texas who asked that her real name not be used because she still works in the same overburdened department. As the staff shrank, “they kept putting all the responsibility on my shoulders,” she says, figuring she handled the work of three designers in addition to serving as art director on many web projects. Yet a job is a job: Maura kept at it for two years, taking work home and cramming her days full. “I really thought I might explode,” she says.

Maura finally worked up her courage and asked to be recognized for the work she’d been doing. She gave her manager two options: promote her to art director or split up the extra work she’d been handling among several people. She got the promotion, though it took months for her raise, about 2%, to come through. “It wasn’t the pay increase to match the title,” Maura says.

For the sake of debate, let’s call people like Maura the “over-employed.” We can think of the over-employed as a sort of reverse mirror image of the under-employed: Workers who are doing a hell of a lot more work for the same pay (or even reduced pay, given cutbacks in bonuses, perks, etcetera).

Given the above as a backdrop, let’s follow the “Great Compression” logic:

  • The over-employed have dramatically increased corporate productivity.
  • The over-employed still have money to spend.
  • The over-employed have psychological justification to treat themselves.
  • The above factors can feed a virtuous earnings circle.

Howard Davidowitz, of Davidowitz & Associates, has been a consultant to the retail business for decades. Davidowitz has also been a very loud and colorful bear these past few years. When asked to explain how his bearish macro views fit with resilient consumer spending trends, Davidowitz asserted that high-end retailers are driven by the top 30% of consumers. The bottom 70% don’t really matter.

If this 30% assertion is more or less right, it can help explain why the LuluLemon Athleticas of the world can be hopping and popping even as the true unemployment rate skyrockets and “99ers” tell horrible stories of destitution. The bottom 70% are screwed, blued and tattooed – but so what. The spending is being driven by those in the upper strata… those who still have jobs and incomes and the ability to absorb rising grocery and gas prices without blinking an eye.

And again, take into account the psychological profile of an over-employed survivor like Maura. She knows she’s kicking ass for less than stellar pay. And if the company isn’t rewarding her, she is going to want to reward herself with a little spending and splurging here and there. And she’ll be encouraged to do so by the steadily improving stock market and the “green shoots” news she hears in the media, courtesy of Fed Chairman Bernanke.


In some ways, the profile of the over-employed counts as a monetary policy success. After 9/11, President Bush told consumers to go shopping. After the global financial crisis, the Fed told investors to go shopping for stocks. This is all suppposed to feed a positive feedback loop in which “animal spirits” – those famed Keynesian drivers – take us back to a good and healthy place.

But what about that other 70%?

Step back and consider the global picture for a moment.

Inflation is heating up in emerging markets. China is a bubble waiting for a pin. Riots are breaking out in the Middle East, with demands for wage increases one of the drivers. The “E.M. hiking cycle” (as we have dubbed it) is in full effect.

This is, in part, because rising food and energy prices make up a much larger percentage of consumer spending in developing world countries than they do in the United States.

Food and energy prices also make up a much larger portion of budgets for the un- and under-employed in the U.S. – that great swathe of folks the Federal Reserve could care less about.

And so here is where “The Great Compression” puts us on a path to disaster:

  • U.S. companies have expanded productivity through a “Great Compression” of the workforce. Fire half or two thirds of the staff; get the remaining staff to do all the work at the same or reduced pay.
  • The over-employed, and the top 30% (give or take) of U.S. consumers in general have driven recovery expectations. Those who still have money, and the psychological impetus to spend it, are the ones that matter to Wall Street. Their habits show up in the earnings and the stats. Everyone else can go pound sand.
  • The same speculation-enabling monetary policies, designed to boost the stock market, are destroying the economic well being of the bottom 70% — both globally and domestically. Because rampant stimulus is inflationary in respect to “non-core” areas, with the main beneficiary of stimulus being paper assets, those with the right job profile and paper asset exposure get the benefit, while those without get the pain.

Look around and you can see this “Compression” phenomenon everywhere. Companies are compressing productivity into the output of fewer workers. The Federal Reserve is compressing the discretionary income of the bottom 70% (and especially the under-employed) by ignoring the inflationary impact of its policies. China, a long-time veteran of exploiting its own labor force, is compressing the earnings power of workers through mercantilist trade policies and fudged inflation statistics. Dictators in the Middle East compress the well being of their subjects by running kleptocrat regimes that siphon wealth out of the system… and so on.

It’s quite remarkable really. Under the management of a liberal Democrat U.S. President and (until recently) liberal Democrat congress, we have seen perhaps the most lopsided wealth-transfer effort in decades – not from rich to poor but vice versa. It’s like LBJ’s Great Society in reverse.

Bottom line: The stealth-inflationary asset-propping monetary policies of both the Federal Reserve and China, to the extent they drive paper asset returns and optimism among those with means, are simultaneously brutalizing the silent majority without adequate means of saving (or even paying the bills). As the U.S. equity market soars, we are in real danger of creating an institutionalized underclass.

The Fed’s great hope, of course, is that the love trickles down before the experiment goes bust. In Chairman Bernanke’s world, the healing power of rising nominal asset prices will eventually console not just the top 30%, but the bottom 70% as well.

But why should this happen? If we can correctly identify the current earnings and data recovery as a “Great Compression” phenomenon in which the many are sacrificed for the few, is there any logic for justifying things will change?

Not really…

  • If a spending resurgence among the top 30% is linked to the feel-good factor of rising equities, there is no way to slow down the merry-go-round. Those of us with means feel good while “QE” is in full effect. But what happens when it stops? And where do we go when long rates begin to rise in earnest?
  • If corporations have found a path to higher profits through increased productivity, why should they go back? When the jobs go away, where are they likely to crop back up? Will the 2,000 workers laid off in Peoria, Illinois see their jobs return… or are those jobs more likely to show up in Bangalore or Shenzen or Kuala Lumpur?
  • We can’t really go back, but nor can we go forward forever… Another type of compression, margin compression, is beginning to show up in corporate earnings statements. FedEx was the most recent bellwether name to cite rising fuel prices as a factor. Sanguine investors have forgotten, for the moment, that the ravages of inflation were the driver behind BusinessWeek’s “Death of Equities” cover in 1979.
  • If investors are both financially and psychologically invested in a trend of rising hard asset prices, what happens if that trend reverses? The dollar is going to go down forever… hard assets (like oil and copper) are the place to be… we all “know” these things now, and large leveraged bets have been placed. What happens if the bets go sour?

Some time back, Jeremy Grantham of GMO Advisors –- one of the most accurate forecasters of the past few years — warned that the worst thing that could happen would be a successful reflation campaign. Were the Fed to succeed in their bid to reflate the asset bubble, Grantham opined, we would be on the path to an even greater disaster when it popped.

And look where we are now…

As flexible Mercenaries, we are making most of our hay on the long side these days (as are most traders with P&L still intact).

If the above is true, however, the ultimate outcome of “the Great Compression” could wind up being brutal, not just for the stressed and strained underclasses from America to China to Egypt, but for investors too – in the form of swiftly collapsing P/E Ratios on the other side of a 1987/1929 style denouement.

Winston Churchill: “There is no worse course in leadership than to hold out false hopes soon to be swept away.” We still submit that, via the non-sustainable nature of the Great Compression, and the eventual exposure of the bankrupt thinking behind it, the scale and scope of Bernanke’s failures will be far more spectacular than his successes in the end.

JS

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One Response to Global Macro Notes: The Great Compression

  1. Alex on February 19, 2011 at 1:28 pm

    Too true about the 30/70 split. The 70% really only have one option left and that's to take to the streets. But not yet in the US as their minds are still being diverted by cheap TV shows plus they're too busy texting each other. Their time will come though.

    As for the next 'reflation', well that's here for sure and as ever it's going to pop even bigger than last time. Who knows when, could be this year or in 5 years but it's going to happen. But don't worry everyone because the good old Fed will be there to 'save' us all from their mistakes once again……..

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