By Joanne Gilbert, Fixed Income Investment Specialist, Aberdeen Asset Management
With so much policy ammunition spent in the pursuit of long lasting growth in the US, it is somewhat puzzling that the economy has remained, thus far, stubbornly sedate.
Gross domestic product (GDP chained year-on-year) has posted almost exclusively sub-3% readings since the onset of the global financial crisis (GFC). In our view, this is hardly a pace to trouble the hawks on the Federal Open Market Committee. Indeed, it has resulted in talk of a “new normal” where the interest rate cycle has a much lower upper bound. Proponents say that instead of 5% being the top end of the federal funds rate cycle, we are likely to see rates peak at 3%.
So what is holding the economy back? We believe the chief suspect must be the fiendishly slow pace of wage growth. After five years of economic expansion, the humble US worker has seen the real value of his or her hourly compensation rise by just 0.5%. This is the slowest rate of increase since World War II, a fact underlined by the poor savings rate.
Federal Reserve (Fed) chair Janet Yellen has honed in on faster wage growth as the final hurdle for the labor market’s return to health. Housing and consumer spending tend to track wages closely, so a pick-up in these areas could deliver the self-sustaining recovery the Fed and the markets are looking for.
In the meantime, a less-than-satisfactory two-tier recovery continues, with asset prices behaving far more enthusiastically than the real economy. Unfortunately, asset-generated wealth has proved to be an ineffective transmission mechanism onto the real economy.
Bond and equity markets have posted strong gains this year, and economic conditions appear largely benign. But as asset managers, we have to ask ourselves whether investors’ optimism is justified. Although we acknowledge that the markets may have become overly reliant on support in the form of monetary stimulus, we can’t ignore a fundamental shift for the better. For example, America’s major corporations are enjoying record profits and boast healthy balance sheets. Aside from the positive implications for equities, this is good news for investors in corporate bonds—both investment grade and high yield—where issuers have taken advantage of cheap borrowing and default levels are extremely low.
But are these gains sustainable? If workers in the real economy are stuck with low savings and low wages, the answer could be no. It appears that there is probably more spare capacity or “slack” in the economy than the Federal Reserve realized, and that the number of people working or potentially seeking work has risen. This may be because older workers are remaining in the labor force for longer.
The labor market has been at the center of Fed policy since the onset of the GFC. Its record on jobs looks impressive: it has achieved a decline in unemployment of around 1% for each of the past four years. But with jobs growth skewed toward lower-skilled occupations and part-time work, there is a strong downward pressure on wages.
The economic cycle will run its course, and this means the phenomenon of low wage growth is likely to be transitory as the slack in the labor market extinguishes itself. But how quickly this happens depends on how many workers are still waiting on the sidelines to jump back into the workforce—something no one knows, not even the Fed.
Meanwhile, there is a danger that if the aforementioned higher corporate profits are not shared with the labor market, a lack of consumer spending power will serve to hamper the strength of the recovery.
Until the slack is taken up, however, interest rates—and hence government bond yields—could be anchored by a multitude of factors. These include: scarcity (the Treasury is issuing less debt at a time when demand for “risk-free” collateral is high); the market’s positioning (those investors expecting rates to rise have already positioned themselves underweight); the moderate pace of economic growth; and, of course, the absence of inflation (low wage growth… again!).
About Aberdeen Asset Management
Aberdeen is an independent asset management company. Formed out of a management buy-out in Aberdeen, Scotland, in 1983, it is now a FTSE 100 company operating on the ground in 25 countries across Europe, Asia and the Americas. Aberdeen established its North American headquarters in Philadelphia in 2005.
Defined by a focus on asset management, including equities, fixed income, property and multi-asset portfolios, Aberdeen’s investment solutions are driven by commitment to straightforward, transparent investment approaches that stress intensive, first-hand research and a long-term view. As of July 31, 2014, Aberdeen manages over $546 billion in assets.
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PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS
Foreign securities may be more volatile, harder to price and less liquid than US securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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