The Curious Case of Quiescent Inflation & Negative Yielding Junk Bonds

One of the most important questions being asked in financial media today appears to be, “Is the Phillips Curve Dead?”

Before I go jump into the analysis of whether that is the case and what impact will it have on the future course of monetary & fiscal policy, let me give me a brief explainer about the concept of The Phillips Curve.

A.W. Phillips stated that there was a trade-off between unemployment and inflation in an economy. He implied that as the economy grew, unemployment went down, this lead to tighter labor markets. Tighter labor markets warranted higher wage increases. Companies, in order to maintain their margins, would pass this higher input cost to the consumers which would then be reflected in the CPI (Consumer Price Index- a gauge of inflation) that we refer to.

You could say this was the case before the 1980s, however, since then, the relationship between the two seems to have hit a “rough patch” or flattened out.

Source: Bank for International Settlements (BIS)

The above chart regresses PPI Inflation (%) with the growth in Unit Labour Costs (%). As defined by OECD,

“Unit labor costs (ULC) measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output.

A rise in an economy’s unit labor costs represents an increased reward for labor’s contribution to output. However, a rise in labor costs higher than the rise in labor productivity may be a threat to an economy’s cost competitiveness, if other costs are not adjusted in compensation.”1

Just from the chart, one can infer that the slope of the regression, R2 or the link between PPI inflation and ULC growth has flattened significantly when you compare the data pre and post 1985.

Hence, I would like to devote a major portion of this article on exploring the structural changes in world economies that have led to this compelling phenomenon.

Lower bargaining power emanating from a declining share of income that accrues to labor

  • A June 2018 research paper titled, “Productivity and Pay: Is the link broken”2 suggests, that post-industrialization (or since the 1980s), median compensation grew by only 11% in real terms, and production workers’ compensation increased by a meagre 12%, compared to a 75% increase in labor productivity. Since 2000, average compensation has also begun to diverge from labor productivity.
  • Apart from the weaker link between the above two variables, the continued sluggishness in wage growth can largely be attributed to productivity growth being far weaker than it was before the crisis.3

Globalization & The Threat of Production Relocation

  • The increased integration of production and complex supply chains connecting advanced economies with emerging market economies, outsourcing along with the relatively smooth and easy flow of money and information across borders have forced workers in rich countries to compete with those in poorer ones
  • The IMF World Economic Outlook (2017) attributes about 50% of the fall in labor share in developed economies to technological advancement, with the fall in the price of investment goods and advances in ICT encouraging automation of routine tasks

Declining Path of Unionisation

As unionization declines, the collective bargaining power of employees starts diminishing. For example, in the United States % of employees enrolled in a trade-union membership has steadily declined from 20% to 10% over the past few decades.

This makes it more difficult for the workers to capture a larger share of the productivity gains enjoyed by the firm as a whole.

Hence, we observe that wage growth in real terms has hardly seen a meaningful increase.

The shift from manufacturing to service economies and the era of automation

  • With the heightened contribution of artificial intelligence and automation in the manufacturing process, firms are able to substitute labor with capital and even the high-quality blue-collar jobs are at stake.
  • From an economic efficiency standpoint, it makes sense for a firm to get more work done for the same or lower cost than to waste resources in hiring and training employees. This could partly explain the delinking of productivity and wage growth.
  • With global PMIs crashing into contraction territory across the world economies due to a host of factors such as dollar strength seen in 2018 (80% of global bank trade credit is denominated in dollars), uncertain CapEx or investment environment due to trade wars among others, we have seen consumption stayed relatively resilient.
  • This may be partly attributed to the transition of economies reliance from manufacturing to services, as a result, the share of employment in services has also jumped in recent years.

Quantum Pricing & Long Term Inflation Expectations

  • The traditional theory states that wages are stickier than prices. If so, profit margins should ideally rise if demand increases. However, after studying firm-level behavior we observe that they tend to abstain from margin expansion for the sake of higher market share. Also, firms unable to generate sufficient sales tend not to reduce prices proportionately to avoid losing cash to meet their rising debt and interest burdens (which explains why we saw inflation falling less than expected during the GFC).
  • Firms have since been engaging in “Quantum Pricing” where firms may change the quality or composition of their products to adjust for production cost volatility instead of increasing prices across the board. This, in turn, makes prices stickier while keeping margins stable. It becomes increasingly complex for mainstream macroeconomic models to capture such structural shifts in pricing affecting inflation.4
  • In a nutshell, all the above factors along with weak cyclical pressures drag longer-term inflation expectations lower (as observed by the 5Y5Y forward breakeven inflation, etc). Lower expectations through their negative feedback loop anchor inflation lower to some extent.5

Low Rates, Asset Price Inflation & The Lure of Negative Yields: Glimpse

Markets have set their expectations in stone for rates being “lower for longer” due to the inflation dynamics stated above, secular stagnation going forward and maybe even price level targeting by central banks.

In an environment where markets will pounce on anything with a positive real yield, there may be a real risk of financial instability arising from irrational bidding of risk assets which cannot be more prominently observed than from the negative-yielding junk bonds.

You are essentially paying companies with significant credit risk for (the privilege of) borrowing funds from you!

It may sound absurd but what if I tell you that this negative-yielding Japanese/European debt may in certain cases provide you with a dollar yield that is even higher than the positive yield that you get in treasuries? In other words, (for example) -0.1% (¥) > 2.5% ($)

I shall follow up on the mechanics of how this kind of sorcery is possible (along with the risks associated with the same) in part II of this article.

References:

  1. Retrieved from https://stats.oecd.org/glossary/detail.asp?ID=2809
  2. Stansbury, A. M., & Summers, L. H. (2017). Productivity and Pay: Is the link broken? (No. w24165). National Bureau of Economic Research
  3. IMF World Economic Outlook, April 2019
  4. https://www.bis.org/events/ccaresearchconf2018/rigobon_pres.pdf
  5. IMF Blog “Euro Area Inflation: Why Low For So Long?”
Author
Harsh Shivlani
Team Leader– Fixed Income & Derivatives
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Harsh on LinkedIn
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