Wednesday, July 30, 2014
The unemployment battle: structural versus cycle
The key macro battle that will impact all investors and asset allocators is between the view that unemployment is currently still a cyclical problem versus the impression that there is a structural issue that is currently affecting labor market. Now, there is a strong case for each and there are clear signs that there are structural problems but where you place more emphasis between these two views will make a huge difference in your portfolio construction. I will not go through all of the evidence and arguments but focus on the general portfolio implications.
If you believe that current unemployment is still a cyclical problem, then you will also believe that monetary and fiscal policy can be used to push unemployment down. Keeping rates low will not be inflationary since there is still slack in the labor market. In fact, you would want or accept longer and stronger policy action to break through the output gap that still currently exists. Under this view, you will not worry about inflation or the potential for tight labor markets that will force wages up in the near-term. You would construct your portfolio under the view that monetary policy by the Fed will continue and there will not adverse harm to bond markets or equity markets.
The structural view is that much further increases in employment may be limited. There are structural reasons for the lower participation rate and the long-term unemployment. The Fed is pushing on a string and labor markets may be tighter for those who have skills needed by the market. Wage rates can move higher because there is a growing labor tightness. The Fed will be slow to react and there will be higher inflation. The Fed will be late to any policy change. Wage increases could reduce profits and lead to higher inflation.
Call it a cyclist versus structuralist fight. Chairman Yellen seems to be biased to the cycle arguments and this should raise alarm bells with structuralists. If I ask you your view on this issue, I should see a portfolio that has the same appropriate view. The underlying assumptions you have about the economy is extremely critical at this time. Just looking at the data is not enough.