There are many differences between the current business cycle and a typical cycle. One notable difference is the muted wage growth after years of strong job growth. In the chart above, we can see the minimal income growth throughout this recovery. Many other wage growth indicators tell the same message. But why?
Low productivity growth, higher-paid baby boomers leaving jobs while lower-paid millennials join the labor force and corporations using mergers and acquisitions as a new form of capital expenditure instead of bidding up labor costs are all good explanations.
However, there’s one explanation that takes the cake. As machines become more and more capable, it has allowed corporations to move between capital spending and labor. When labor is inexpensive, corporations use labor to meet the demand; when the labor market tightens, corporations can easily increase capital spending to use machines/automation to meet new demand. This flexibility dramatically enhances the corporations’ ability to manage labor costs.
The progress of machine learning and big data is exerting a strong disinflationary influence in the economy. In the investment industry, quantitative funds are by far the most popular funds. In the last few years, we saw ETFs and factor-based investment disrupt the asset management industry. Now, applying big data analytics and machine learning on alternative data sources like credit card transactions, satellite images, posts on social media and allowing algorithms to make their judgment about macro economy and micro companies is the new cutting edge.
This quantification of everything will impact market structure and the financial industry in three key ways. First, the market will become even faster because machines react to new information more quickly than ever before. Second, the market will become more crowdedly positioned and self-reinforcing because algorithms can quickly identify the new strategies that work and replicate them. Third, the impact of traditional economic data releases will be slowly reduced because the higher frequency alternative data sources will provide more real-time information about the economy and corporate earnings.
We are already seeing the impacts from these changes. Last Friday’s tech wreck is likely driven by rotations out of “quality” and “momentum” factors and into “value” factors. Learning how quantitative strategies behave and affect markets will become more and more important in the future.
Further, the market priced in yesterday’s rate hike, but has only priced in 1.5 hikes until the end of 2018, despite the dot plot showing four more hikes. This dovish hiking trajectory in the market is one reason that we have both equities and bonds doing well today. Because there are so few rate hikes priced in the market, 2 year and 3 year treasuries look rich and are vulnerable if the Fed sticks to the dot plot.Key Takeaways:
The progress in technology will allow corporations to manage labor costs more efficiently for years to come. Low wage growth can allow the Fed to stay easy. Lastly, the new quantitative investment will change the financial industry in the next several years.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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