Macro-Economic Trading

Productivity

Productivity growth has been a major driving force of economic growth in the United States. Productivity matters a whole lot to the stock market. Increasing productivity allows the gross domestic product to expand at a much faster rate without fear of inflation. Generally, for corporations, higher productivity means higher earnings and thus higher stock prices. Increased productivity is also the only way that workers can enjoy increases in their real inflation-adjusted wages. If workers want to see a boost in their paychecks, they must produce more during any given hour. This, of course, has an indirect effect on the stock market. Workers with more discretionary income, will consume more and this consumption leads to more products being produced, which in turn leads to more products sold, thus higher earnings and higher stock prices.

A very astute observation is that the Fed will react very differently to a rise or fall in productivity depending on where the economy is in the business cycle. Productivity will fall when the economy contracts and enter a recession. This happens because businesses will cut back on production at a faster pace and then start to lay off workers. Secondly, businesses operate with much more idle capacity and must therefore spread their fixed cost over a smaller level of output. These two factors drive up costs while production is falling so that the unit costs of labor increases.

This increase in unit labor cost will not be viewed as a symptom of inflationary pressures. The Fed knows that the business cycle would have created this mirage and they would not be likely to raise interest rates.

When the economy is expanding, productivity will lead the expansion as unit labor costs will fall. At this point, factories will increase their capacity and hence they operate more efficiently because the same amount of workers are producing more output. As long as productivity gains rise at a pace that keeps wages from rising – the Fed will be happy to keep interest rates unchanged. However, later in the business cycle, as raw material costs increase and as the labor market gets tighter, the Fed will take a more critical look at productivity and unit labor cost to check inflationary pressures. If unit labor costs outruns productivity gains – then this is a clear sign of wage inflation and the Fed will be more likely to raise interest rates.

Productivity is measured as the ratio of worker output to the number of hours worked. Unit labor cost is compensation per hour per hour divided by output per hour. Compensation includes wages, salaries, commissions, payments in kind and employer contribution to taxes and benefit packages. Unit labor costs will increase as compensation rises. As productivity rises, it pushes up the output per hour and this tends to drive down unit labor costs – hence productivity offsets increases in unit labor costs.

After all that discussion, not many traders look at the productivity report because the data is highly volatile and it is only reported quarterly. However, be aware that strong productivity reports at key points in the business cycle can move the markets.

The Budget Deficit

How does the budget deficit affect the stock and bond market. The government can raise money to finance the deficit by either raising taxes, selling bonds or printing money. Raising taxes is politically risky and so most politicians shy away from this option. The other remaining options are selling bonds or printing money. The government (US Treasury) can sell bonds to the private capital markets and use the proceeds of the sales to finance the deficit. The Treasury is in effect competing in the capital markets, directly with private corporations that may also be selling bonds. To compete, the Treasury typically will raise the interest rate it is offering in order to attract enough funds. This actually crowds out private investment by using money that normally would have been borrowed and spent by corporations and businesses on private investment. This crowding out effect raises the cost of capital for these businesses and corporations. In the bond market, higher interest rates mean lower bond prices.

To avoid the crowing out effect, the government could, buy the Treasury’s securities itself rather than letting these securities be sold in the open capital markets. The government will simply print new money to pay for this expenditure. However, the increase in the money supply may cause inflation. If this inflation drives up interest rates and drives private investment down, the end result of printing money may be a crowding-out effect as well. Hence most traders have a strong distaste for budget deficits.

Ironically, when the government releases the Treasury budget report, there is typically no earth shaking movement on Wall Street – they hardly notice. This happens because the government’s pattern of spending is highly seasonal. Revenues will increase in January, June, September and December because that is when quarterly tax payments are due. The point here is that the data is subject to very large month-to-month fluctuations.

The astute macro-economic watcher will compare the current month’s receipts and outlays to the same monthly data from the year before. This may signal a decline if the numbers for the current month is smaller than the same month’s data last year.

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