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Winner Takes All!

Last week it was reported that real GDP rose at a 2.3% annualized rate in the second quarter.

While that was an improvement over the “doubly seasonally revised” 0.6% pace in Q1, it was

yet again below what the ever buoyant Wall Street economists had penciled in. In addition, the

Bureau of Economic Analysis reported that 2013 GDP was revised lower from 2.2% to 1.5% and

2012 GDP was revised lower from 2.3% to 2.2%.

This latest report all but assures that economic growth for 2015 will, once again, fail to attain the

3% level needed in order for the average American to really feel it. In fact, the U.S. economy

would have to grow at approximately 4.75% in the second half of 2015 to reach 3% for the year.

Even economists believe that is unfathomable.

To give you a sense of how slow the U.S. has been growing, please consider that the last time

America expanded at 3%-plus for a full year was 2005. That means the country’s growth rate

has not been able to pierce the 3% level in over a decade, a first in the post-World War II era.

As shown below, nominal growth is clocking in at a piddling low rate of 3.3% year-over-year

versus a long term average of 6.7%.

U.S. Growth Crawling Along

So despite unprecedented massive stimulus via zero interest rates for seven years and over $3

trillion of quantitative easing, the U.S. economy keeps plodding ahead, more like a tortoise than

a hare.

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Wages Drop the Most Since 1982!

Wage growth just hit a record low. Last week, it was reported that wages grew by 0.2% in the

second quarter, according to the latest Employment Cost Index (ECI) – easily the most

comprehensive measure of wages in the economy. This gauge measures the costs of wages,

benefits and paid taxes, such as Social Security and Medicare

Below in living color is the record-low quarter-over-quarter gain.

The quarterly increase was a third of the 0.6% rise expected and nullifies the 0.7% rise in Q1.

That puzzled a lot of economists who had expected a bigger increase given the steady drumbeat

to boost the minimum wage and anecdotes about the difficulty of finding qualified candidates for

certain jobs, especially in tech. Last quarter’s reading was lower than the lowest economist

estimates... estimates, which ranged from increases of 0.4% to 0.8%. In fact, this was the

weakest U.S. wage growth since records began in 1982.

Over last year, the ECI rose 2% after a 2.6% gain in the first quarter. Economists were looking

for a year-over-year gain closer to 2.4%. This report could increase uncertainty about the

trajectory of wage growth. Of note: this is the final ECI report before the September Fed

meeting, and so this report was expected to take on added significance as the Fed weighs

whether to raise interest rates for the first time in nine years.

Thus, we have another disappointing data point that confounds the “wage growth is looming

and escape velocity is any day now” theme.

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And, given the low wage environment, is it any wonder that the Conference Board’s latest

consumer polling suggested that regular folks aren’t seeing the blue skies portrayed by stock

market averages hovering near records or a labor market consistent with a jobless rate of just

5.3%? Expectations for the future took the biggest hit in the survey, suggesting gathering clouds

over Main Street.

Winner Takes All – Income Inequality

As we have highlighted numerous times in this space, the reason economic growth is below long

term trends and wages constrained is due to the hurricane gales of high debt, excessive deficits,

aging demographics, declining productivity, global competition and last, but not least, rising

income and wealth inequality.

Over the last few years, much academic research shows that the U.S. has become one of the most

lopsided economies in both income and wealth in the developed world. This was not the case 40

years ago. (Please see Thomas Piketty’s book Capital in the 21st Century.)

Between 1981 and 2012, the top 1% of earners more than doubled their share of total pre-tax

income and now account for about 20% of the nation's earnings.

Throw in the rest of the top 10%, and you’re looking at a group that earned 50% of all income

growth the highest percentage since the late 19th century (from the 1870s to about 1900).

Mark Twain called this period the "Gilded Age." By this, he meant that the period was

“glittering on the surface, but corrupt underneath.” The late 19th century was a period of massive

industrialization, greed and corruption. During this period, there was tremendous wealth created

for a few, but most were left struggling to get by as wage laborers, working for someone else in

the factory or on the farm.

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And wealth influenced the government at all levels through unregulated campaign contributions,

vote buying and similar machinations. The parallels with our own time are compelling, where

once again a yawning gap has opened between rich and poor, and political influence is available

for the taking by anyone willing and able to pay.

Is this Healthy?

When you add in capital gains the picture is a lot worse. The top quintile (20% of Americans)

owns 84% of the wealth in this country. The bottom three quintiles (60% of Americans) control

less than 5%!

Where’s Robin Hood when you need Him?

Source: Atlanta Monthly

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Consider this amazing fact, the top 0.1% (one tenth of 1%) of the population. We are talking

about Warren Buffet, Bill Gates and others who collectively own 21% of total wealth, which is

equivalent to the wealth of the bottom 90%”.

It’s Good to be King!

Outside of “voodoo trickle down” economists, it is becoming much widely understood and

accepted that extreme and growing inequality is leading to sub-optimal, below trend growth in

the U.S.

Think about it. It’s common sense. The super-rich getting super-richer would all be fine and

dandy, except that it doesn’t appear the nation’s “wealth creators” are creating much wealth for

anyone else. If the vast majority of the income and wealth is distributed to the elite and the vast

middle class makes little or no progress for 40 years in real wages – as the official U.S. statistics

show – then it should not be surprising if consumption and growth rates have been incessantly

dissatisfying as they have been.

Middle Class is Falling Behind

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A relatively small group of rich people cannot drive the U.S. economy. The rich are NOT job

creators. What creates good paying jobs is a stronger consumer. The more the consumer spends

the more companies will hire to support increased demand. That can only happen if the middle

class of America secures good paying jobs.

Stock Option Culture – Adding to the growing inequality is the practice of rewarding senior

corporate executives with a compensation that is comprised primarily of stock option awards,

which in most cases are NOT tied to the performance of the company or industry.

The combined effect of the stock option culture and Fed policy targeting higher asset prices has

resulted in most of the corporate cash flow being used for stock buybacks – a record $700

billion annualized rate this year at the expense of corporate investments in expansion. As a

result, we have distinctively had no hint of a surge in capital spending; notwithstanding, we are

into the seventh year of economic expansion.

This should not be surprising to any of us. Why would companies not use corporate cash flow to

repurchase shares when lower returns make it increasingly difficult to justify investment in new

plant and equipment? Why take the added risk? Is it any wonder that because of these incentives

and Fed policy – CEO compensation has risen from 40 times the average worker in 1965 to

approximately 300 times today?

It’s Good to be a CEO

The wage-setting mechanism has been broken, but has particularly faltered in the last 10 years

despite corporate profits are at historic highs. The problem is income growth has been captured

by those in the top 1%. Meanwhile, the wage and benefit growth of the vast majority, including

white-collar and blue-collar workers and those with and without a college degree has stagnated.

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While those in the executive suite may be popping bottles of bubbly, this decision reduces

corporate expansion; lower job creation, less GDP growth and hence lower wages. Pretty soon,

Mr. Ford, there will be no one to buy your cars.

Greenspan’s, Bernanke's and Yellen’s trickle down thesis combined with good ole corporate

greed has simply not benefitted the country. You can't lift the economy with artificial monetary

stimulus and rising asset prices to artificially high levels. At best, you can blow a bigger bubble,

which may give the illusion of prosperity for some, but the broader public doesn't get any of the

participation from it, and they get all of the downside.

This country needs to grow more equitably. A wider distribution of income and wealth will lead

to stronger economic growth.

Market Outlook and Portfolio Strategy

Let's review the key data points for the economy:

Employment: During the past year, almost 250,000 new jobs were created each month.

During the past four years, the average has been almost 210,000. Unemployment has

come down dramatically from its peak of 10% in 2009 to 5.3%. Yet there are 93 million

Americans who have left the labor force and the participation rate has fallen to a 30 year

low. A declining labor force greatly explains the rapid descent of unemployment rate.

And many of the jobs created have been in low paying service sector jobs, while higher

paying manufacturing jobs have been in constant decline. To wit: while burger flippers

may be mandated to get $15 an hour, the steady decline in oil patch means the loss of a

significant number of high-paying jobs for skilled workers. It takes four or five

bartenders or baristas to make up for the lost income of a single oilfield worker.

The Federal Open Market Committee said that it would take just “some” improvement in

the labor market to clear the way for liftoff in its federal-funds rate target from near zero.

However, the lack of pay hikes evident in the ECI made markets think that a September

increase is less likely.

Inflation: Forget hyperinflation; even those (including the Fed officials) who have been

forecasting modest inflation have been wrong for many years. Despite zero interest rates

and QE, inflation is still running below the Fed's 2% target. The U.S. dollar is the

strongest against a basket of major currencies in almost 12 years. Thanks to slowing

global demand and a rising dollar, commodities just had their worst month in almost four

years. The CRB commodity index has fallen nearly 18% since its most recent peak in

May of last year. And commodity prices are universally lower by 45% since 2011.

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The price of oil plummeted close to 20% during the month of July. It was the worst month for

the price of oil that we have seen since October 2008, which just happened to be during the

height of the last financial crisis.

All of this makes it very unlikely we'll see a big pick-up in inflation any time soon.

How Low will Oil go?

Economic Report Card

Overall, the economy has grown at one of the slowest rates ever during a recovery. From 2012

through 2014, the economy grew at an all-too-familiar rate of 2% annually, significantly below

the 2.3% reported previously.

Since the recession ended in June 2009, the economy has advanced at a 2.2% annual pace

through the end of last year. That's more than a half-percentage point worse than the next-

weakest expansion of the past 70 years, the one from 2001 through 2007. Overall the economy

has failed to break out of its roughly 2% pattern for six years. The Fed has never raised rates

when the economy was growing at such a slow rate and inflation was this low.

The world’s most populous country and second largest economy is heading for trouble.

China appears to be slowing rapidly and its stock market bubble is popping. The Shanghai

Composite took another tumble of some 8.5% last Monday, but managed to pull out of that

nosedive into a mere downward glide. But despite the billions pumped into the market through

monetary easing and direct injections into equities, the Shanghai benchmark still ended the week

down 10% and off 14% for July, the biggest drop since August 2009.

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Indeed, the equity market “is only one of many excesses that make up a Chinese bubble

economy. China also suffers from severely overextended export capacity, real estate markets,

bank debt, and shadow banking debt. These balance sheet stresses virtually guarantee that,

sooner or later, China will undergo a crisis at some time.

And in Europe, the euro zone is an endless debacle; even as there are signs that the Greek debt

crisis may be resolved in some manner, nobody (myself included) truly believes this isn't going

to erupt again in a year or two. The International Monetary Fund (IMF) is indicating that it will

not take part in the new Greek debt deal. As a result, the whole thing may completely fall apart.

Leaked minutes of the fund’s latest board meeting, which took place on Wednesday, showed

staff “cannot reach agreement at this stage” on whether to take part in the new €86billion

bailout for Greece. The document said there were doubts over the capacity of the Athens

Government to implement economic reforms, as well as the over the sustainability of the

country’s sovereign debt pile, which is now projected to hit 200% of GDP.

The German Chancellor, Angela Merkel, only sanctioned a new Greek deal earlier this month on

the condition that the IMF takes part.

And Italy is going down the exact same path as Greece, but Italy is going to be a much larger

problem for Europe because it has a far, far larger economy. This week, we learned that youth

unemployment in Italy has reached a 38-year high of 44%, and Italy’s debt to GDP ratio has now

hit 135%.

Bottom Line: When looking at the economic report card above, it is simply difficult to argue

that the Fed should or will be raising interest rates in September. That of course does not mean

that they won’t!

As I have opined previously, the “real economy” may not be the Fed’s primary concern. Instead,

they have to do deal with the fact that they have and are blowing a monstrous credit bubble that

is filtering through to both higher-end housing (but leaving middle-class and lower-income

housing untouched!), corporate buybacks and M&A activity, which are creating a third equity

bubble in 15 years.

“The BIS emphatically avers that there are substantial medium term costs of ‘persistent

ultra-low interest rates’. Such rates they claim, ‘sap banks’ interest margins… cause

pervasive mispricing in financial markets… threaten the solvency of insurance companies

and pension funds… and as a result, test technical, economic, legal and even political

boundaries. The reason [the Fed will commence rate increases] will be that the central

bankers that are charged with leading the global financial markets – the Fed and the

BOE for now – are wising up; that the Taylor rule and any other standard signal of

monetary policy must now be discarded into the trash bin of history.”- Bill Gross

Further, the Fed has effectively no tools available if and when the inevitable business downturn

comes.

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Finally, the Fed would most likely not want to have to begin raising rates during an election year.

Will they or won’t they raise the fed funds rate? Your guess is as good as mine. Incoming data,

especially retail sales and employment data, will likely be the deciding factors in whether or not

the Fed raises rates in September.

In terms of relative value in the fixed income markets, please click here for the Weekly Relative

Value Analysis report.

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More Information

For more information about credit union investment strategy, portfolio allocation and security

selection, please contact the author at tom.slefinger@balancesheetsolutions.org or (800) 782-

2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and

Registered Representative of ISI, has more than 30 years of fixed income portfolio management

experience. He has developed and successfully managed various high profile domestic and

global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually

all types of domestic and foreign fixed income securities, foreign exchange and derivatives in

institutional environments.

At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated

with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily

involved in analyzing portfolios, developing investment portfolio strategies and identifying

appropriate sectors and securities with the ultimate goal of optimizing investment portfolio

performance at the credit union level.

Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general

information only. This information does not consider the specific investment objectives, financial situations or particular needs of

any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes

an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are

subject to change without notice. Investors should understand that statements regarding future prospects might not be realized.

Please contact Balance Sheet Solutions to discuss your specific situation and objectives.