As the world recovers slowly from the Great Recession of 2008, employment has lagged, particularly youth and new graduate employment. Why is this? Employing new graduates and the young is a longer term investment involving money, time and resources towards future productivity. Employing older, experienced workers is an investment in current productivity. Any future productivity must be subject to discounting by variability depending on general business conditions. In times of uncertainty, it is rational to invest in fixed capital, for which there is ownership over a potentially transferable, marketable asset, and experienced workers. Only when there is less uncertainty, or sufficient comfort from current success will businesses invest in future productivity, which incidentally may be mobile with the benefits accruing to the employee, not the firm. Business investment is likely to be a leading indicator, therefore, for a recovery in youth and new graduate employment. Evidence supporting this conjecture can be found in the recovery in part time employment, while full time employment has lagged. The thesis that education derives more value as a signaling device is also supported here. Employers prefer a hard signal, that is, actual and relevant work experience over an indirect and soft signal carried by a college degree. This does not suggest that a college degree is unimportant; workers without a college degree with similar years of (in)experience fare even worse.

Nothing happens without enterprise. Nothing happens without labor. There is at least the perception, that in the past few decades, and certainly accelerating into the past few years, enterprise has had the upper hand. 3 decades of falling interest rates have certainly helped enterprise through cheap funding while returns to savers have steadily diminished but funding costs are a side show. A paradigm shift is behind the steady rise of inequality. Under a purely capitalist, market economy, the strong thrive and the weak do not. Social security and welfare are socioeconomic band aids cobbled together to address the survival of the weak, or the unlucky. It takes an exceptionally enlightened capitalist elite not to over-exploit labor. Post the Great Depression, with the rise of labor unions and the rise of Communism, the capitalist elite were circumspect in dealing with labor. The fall of Communism has, among other things, removed the need for any pretense by removing Capitalism’s nemesis and alternative. It has also contaminated the capitalist model but that is another story. On purely mathematical grounds and importantly ignoring important limitations and behavioral phenomena, a pure free market economy is efficient. However, it implies that the strong will thrive and the weak may not survive. The world has by and large adopted the free market, with modifications for political imperatives, and added an element of basic social welfare to address the social tail risks. That social welfare is tail risk management is fair enough, however, the neglect and mismanagement of social welfare, such as healthcare and pensions is illustrative of their importance in the grander scheme of things. Income and wealth inequality have increased steadily all over the world to a point at which cracks are beginning to appear. Gini coefficients have risen in Communist, Socialist and Capitalist economies. Labor’s share of GDP has also steadily fallen across most countries in the world. It is interesting to note that while wealth and income inequality has worsened within countries, they have improved between countries. The likelihood of tensions between countries is therefore likely to have diminished while the tensions between different strata within the same country is likely to have increased.

Recent political protests which have arisen independently across the world have been attributed to various grouses such as the rising costs of living, environmental issues, corruption, austerity measures and poor employment prospects. Very often an event is precipitated by one issue and evolves towards other issues. It is possible that the people are protesting inequality in general but struggle at defining their true complaint. Perhaps the issue is sufficiently broad and Ill defined and as a result the manifestations are sufficiently diverse as protesters struggle to focus. Be that as it may, there is a serious underlying problem that will eventually seek a solution. Is enterprise the only road to wealth? Is labor sufficiently compensated for its efforts?

The market will be awaiting Bernanke’s pronouncements this Wednesday in his monetary policy report to Congress. Ben will likely have prepared two speeches, one hawkish and the other dovish. Almost a month ago Bernanke telegraphed the Fed’s intention to eventually taper off QE. Since then the Fed has prevaricated and indicated that monetary policy would be accommodative. Bernanke himself talked a dovish position as recently as a week ago. Today, Bernanke is likely to be hawkish in his report to Congress. 

Employment, manufacturing, capacity utilization, personal income are all up. The stock and bond markets were initially roiled by his June 19 comments about QE tapering but have since taken this eventuality in their stride. The market is therefore well placed to tolerate another hawkish signal from the Fed.

The risks are that we are in the middle of earnings season and earnings could disappoint. The market is unlikely to fare well under the cosh of both weaker earnings and tighter monetary policy. Also, inflation is perking up, ever so slightly, but it is perking up.

On balance, however, conditions are sufficiently benign that Bernanke can deliver a hawkish signal at this turn. It will be a sequence of hawkish and dovish signals yet before the Fed actually moderated asset purchases. If the market becomes sufficiently desensitized, the. QE tapering may go ahead as planned in September.

The risk that faces the Fed today is that it will not be able to taper of its asset purchase program. All indicators point to a sustainable, albeit weak recovery. It is only reasonable that if this were true, the Fed would at some stage be well advised to reduce its balance sheet, if nothing else so that it would have the means to address the next crisis whenever that might be. By maintaining its current policy the Fed would have few other policy tools to deal with another recession or financial crisis. QE tapering is therefore a good thing and the markets appear to have come to that conclusion. Attention needs to turn now to economic fundamentals. A slowdown from here would not allow the Fed latitude to moderate its asset purchases. A climbdown by the Fed on QE tapering might come to be construed as a sign of weakness.

It is useful to consider the possibilities. A climb down from QE tapering would be negative for US risky assets if coupled with a slowdown in earnings growth, an re-emergence of financial crisis in Europe or a stronger deceleration in China. If markets are driven by both a slowdown and a postponement of QE, one would expect fixed income to rally or at least outperform. Duration would outperform and credit would underperform. Thus Treasuries would outperform investment grade, which would in turn outperform high yield. Floating rate senior loans would underperform. There would likely be a knock on effect to international and emerging markets equities and possibly their corporate bonds. The USD will generally be weakened, unless Europe or China were also sources of weakness in which case the USD might actually strengthen.

If QE tapering proceeds as planned in September, the impact on US risk assets is likely to be muted. The Fed has prepared the market for this eventuality and its execution will have been priced in. Equities will likely continue to rise, and will outperform high yield, which in turn will outperform investment grade. Floating rate non agency MBS will outperform agency MBS. Credit will generally improve even as duration underperforms. The relative exposure to credit and duration in each debt instrument will drive their performance. What if the Fed tapers but earnings slow down? This is an unlikely combination but an interesting one. It would indicate an improving labour market and economy but not generally an improvement for corporate America. How could this combination arise? The US might exhibit this phenomenon if the world is adjusting towards a less globalized, more trade protectionist, more insular state. There are reasons why this might occur which we will not discuss here. However, this might result in an internal rebalancing of the US economy towards a less export driven, more domestically driven, self sufficient economy. The predominance of global companies in the stock market, coupled with weak emerging market and European economies might result in slowing earnings growth while domestic US output continues to improve. If this held true then the asset allocation will need to be more specific. In a sense this scenario might be the most difficult to navigate since both credit and duration would underperform together.

As expected the Fed is prevaricating over its plan to slow the pace of QE. The Fed was always going to telegraph its intentions well in advance and to prevaricate publicly until the market was weaned off the idea of perpetual QE before they actually taper it off. 

The fact is that the US economy is now on the path of self sustaining growth and therefore not in need of further QE. It is therefore rational for the Fed to slowly reduce the size of its balance sheet. Consider the analogy of a person in intensive care. This was the US economy in 2008. The Fed quite rightly prescribed morphine. Most analgesics are addictive, yet when there is recovery, the continued administration of morphine is not only unnecessary, it is harmful. And there is no way the patient can get up and walk out until it is weaned off the morphine. That the doctor feels that the patient is ready to go off the drug is good news not bad.

The markets have yet to come to grips with the Fed’s withdrawal from QE and elevated volatility is to be reasonably expected. But he prognosis is positive. While equilibrium GDP growth may not revert to pre 2008 levels of 4%, a real recovery is underway evidenced by improvements in manufacturing, the labour market, household income, consumption and confidence. The post crisis equilibrium rate may have halved to 2% but corporate earnings have continued to be robust on higher productivity.

There will be threats to the new growth. Trade is likely to fall globally as each country tries to export their way to growth. Other regions in the world continue to see slowing growth from China to Europe. Asset markets reflect similar trends with the US and Japan bucking a trend of tepid returns and sometimes outright negative returns. China is a significant risk as its economy slows beyond expectations. Being the largest external holder of US treasuries is not very reassuring. The strong USD is also a brake on US exports. Fortunately much of the growth in the US appears to be domestically led.

The past few decades saw a surge in growth driven by credit and globalization. The bursting of the credit bubble has reset matters and to an extent rolled back globalization. The search for growth may now take a more insular and domestic turn. While the US is self sustaining threats remain from without, as the global economy readjusts to a less globalized state. The inequality between countries that converged in the past few decades may begin to widen once again. But if the inequality that has diverged to so long within countries is not reversed, the political and social stability of many a government may be challenged.