A few weeks ago we pointed out something curious [12]: despite the so-called massive "slack" in the US economy - the traditional alibi used by Bernanke & Co. to justify ongoing endless QE, labor productivity has slumped while labor costs have soared at the fastest pace in 11 months. This is a result that is directly at odds with the assertion that the structural unemployment for the US is still at 5%, and indicates that the New Normal baseline jobless rate is more likely well above, perhaps in the mid to higher 7% range (which also means that the Fed will never voluntarily end QE as the unemployment will not drop to 6.5%, and as for inflation, well, there's BLS' Arima-X-12 goalseeker for that).
While the immediate implication of this is that central planning has merely broken yet one more law, that of Okun which maps productivity to GDP, a topic we have covered in the past [13], there is another aspect to what lies in the future, which is the topic of Albert Edwards' letter today. In it, he observes as we do, the rising labor costs, and the inherent inflationary pressures these bring, yet his thesis is that any inflation will be short-lived, and that unlike the mainstream which is advocating for a rotation out of bonds (apparently falling on deaf ears as inflows into bond funds are once more far greater than those into equities), he is suggesting to go long duration now.
On one hand...
Note the recent release of the US Productivity and Cost data shows that the upward charge in unit labour costs is intensifying. Most economists consider unit labour costs to be the principle driver of inflation and we can see from the chart below that core CPI inflation ebbs and flows with unit labour costs (we use a 2y% ch on the labour cost data to smooth excessive volatility ? hence it misleadingly appears that CPI leads slightly). After drifting downward for the last year to below 2%, core inflation may be set to rise more rapidly as unit labour cost inflation drags it higher. This would undoubtedly hurt an already jittery bond market.
[14]
And yet...
The ebbs and flows of the economy have confounded most commentators on both sides of the argument, with regular sightings of a self-sustaining recovery followed by immediate relapse (and of course vice versa). But although the economy has bobbed along just above or below stall-speed, what is clear from the data is that the mini-cycles remain on a general downward (see chart below). And whereas we are clearly in the middle of another mini upturn, the lower lows are accompanied by data that typically precedes recessions (eg new orders ? inventory balance).
And therein lies my bullishness on bonds. Unlike the (equity) bulls who believe that the economy is strengthening and beginning to lift off, I believe we are either in recession already (as the ECRI thinks) or close to the end of the cycle, which it should be noted is already longer than average. The rise in unit labour costs, driven as it is by rapidly stalling productivity growth, is a warning to investors that cyclical gloom lies ahead. Hence in my view any rise in core inflation will prove short-lived and should not be taken as bearish for bonds, but instead the prelude for the next leg down in yields.
And now you know why the SocGen strategist is expecting near-term inflation, yet why he thinks this will be short-lived, giving way to a major drop in yields, and thus yet another deleveraging upcycle.
Of course in a time when the entire capital market and economy are one grand, and luckily terminal, monetarist experiment, all bets are off, and predictions are only made to be proven wrong as soon as they are uttered.