Random Thoughts November 5

a) Fitch downgrades Ireland: Yesterday Fitch downgraded the sovereign credit rating of Ireland by 2 notches to AA-. The downgrade reflect "the severity of the decline in nominal GDP and the exceptional rise in government liabilities" However, the agency also notes the vigour of the government's fiscal consolidation response to date and the expectation of further aggressive budget tightening which helped stabilise the outlook for Ireland's creditworthiness. Fitch expects a cumulative fall in the nominal GDP of 14% in between 2007 and 2010! The downgrade and the rationale fit perfectly with my view on the Eurozone peripherals laid down in detail on October 30 in No easy way out for Eurozone peripherals. It also shows that while for example France and Germany are contemplating further fiscal easing measures, Eurozone peripherals' ability to even maintain the current level of fiscal accommodation is severely constrained. Rather the need to tighten fiscal policy is growing sharply which will result in a prolonged recessionary environment, a higher output gap and with that lower inflation pressures and therefore higher realised real yields than in the core of the Eurozone. Again, it will take several years to rebalance the economies and restore competitiveness, not only for Ireland but also for countries such as Spain and Greece. I continue to suggest an underweight stance in these countries for any fixed income investments.
b) US employment report: Expectations for tomorrow's US October employment report are for a loss in nonfarm payrolls of 175k. What is more, the growth in average hourly earnings is forecasted to fall further to 2.2% from 2.5%. It is this combination of falling employment and falling wage growth (amid the rising unemployment rate) which will hold back consumption growth if fiscal support is not increased further. Wage income growth (i.e. essentially hours worked times hourly earnings) grew at a yearly rate of 4.9% at the end of 2007 but has since collapsed to -5.6% yoy according to the Q3 GDP report. Personal income (where wages constitute a bit more than half) itself has dropped by -2.8% yoy with the fall in the sum of wage income accounting for the largest part of this drop. With personal income continuing to fall, it will be difficult to see a significant growth in personal consumption, not even taking into account a likely rise in the savings ratio. As the chart below shows, personal consumption growth and personal income growth are closely related with both having grown by approx. 5.5% yoy in between the start of the 90s and the end of 2007. While employment growth is usually being seen as a lagging indicator, I think that as long as the sum of wages earned (i.e. hourly earnings times worked hours) continues to drop, the underlying dynamic in the US economy will almost excclusively be dependent on the accommodation provided by monetary and even more so fiscal policy. And as long as personal income continues to fall, we need ever increasing fiscal support just to maintain the level of consumption! Therefore, what I will be focusing on in tomorrow's employment report will be the development of nominal hourly earnings and the so-called index of aggregate weekly hours. This is not the same as the data on average weekly hours (which indicates how much an employee has worked on average) as it measures the total of hours worked in the private economy (i.e. it is dependent on the average workweek as well as on the number of people in employment).

The drop in personal income growth bodes ill for consumption growth

Source: Bloomberg