The US economy is facing an 'impossible trinity' that will be a nightmare for investors

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The US economy is facing a new "impossible trinity" that will likely create major headaches for stock and bond investors alike. 

In a new note out Tuesday, Rineesh Bansal, an analyst at Deutsche Bank, writes that right now the US economy is striving to achieve three outcomes: higher wages, more inflation, and higher profits. 

The problem is that it can only pick two. 

In economics, the classic "impossible trinity" that policymakers face is a two-out-of-three choice on maintaining a fixed exchange rate, cross-border capital flows, and independent monetary policy. 

(The US, for example, allows money to freely flow in and out of the economy, its monetary policy is independent, while the value of the US dollar is not fixed.)

But so the new trinity facing the US economy is that policymakers — read: the Federal Reserve — want inflation to run closer to its 2% target and wages to increase, while investors attribute much of the success of the post-crisis stock rally has been underpinned by high levels of corporate profitability (and, as a result, higher earnings). 

Wages, as DB outlines, are the sum of labor productivity, prices, and labor's share of output.

Slightly more comprehensibly, this formula accounts for how much output a business gets per hour worked by its employees, how much the business gets paid for that output, and then how much of that pay is transferred to employees. 

Here's Deutsche Bank (emphasis mine):

The theory behind this new ‘impossible trinity’ is intuitively simple. If workers’ wages rise faster than their productivity, the companies paying those higher wages face two choices. They can either pass on the extra costs to customers, thereby leading to higher overall prices and rising inflation, or they can absorb the extra costs resulting in lower profit margins. Or in economist speak, increases in nominal wages must equal the sum of productivity improvements, price rises and changes to labour’s share of output (which is the flip-side of profit margins). [...]

For the entire second half of the last century, growth in nominal wages tracked the sum of productivity growth and inflation while leaving labour’s share of output largely unchanged. However, the first decade of this millennium saw nominal wages failing to rise sufficiently to compensate workers for rising prices and their productivity gains. The result was a substantial decline in labour’s share of output through the decade of the 2000s. 

And these two charts from Deutsche Bank tells the whole story.

First we see how labor's share of output collapsed in the 2000s...

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...which leads to a major boom in corporate profitability seen during the same period.

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And so it's the tension between these forces that really gets at the heart of why markets seem so stalled out right now.

Again, the Fed explicitly wants inflation to move higher and wages to increase, and DB argues that Fed officials continually citing less-than-stellar wages increases as evidence of slack remaining in the labor market make this a de facto official reason for keeping rates low. 

Investors, meanwhile, want more profits and earnings. But the Fed also wants investors to be happy — the "third mandate" of the Fed is financial stability, which has come to be taken as stocks not tanking and bond yields not ripping higher — which would potentially be jeopardized by a prolonged and sustained decrease in profits. 

Right now, the US corporate economy is in a profit recession — a year-on-year decline in profits — and the question has become whether or not this will tip the broader economy into recession, too. (Or: will aggregate US economic output decline?)

The problem is that this sort of looks like it can go two ways and there are losers in multiple directions. 

DB again (emphasis mine):

Consider two possible scenarios in this situation. Firstly, the labour share of output, and therefore corporate profit margins, remain constant at current levels. This implies inflation has to rise to 3.5 per cent and would decimate many fixed income investors given current inflation expectations for the next five years are barely over one per cent currently. In some ways, recent signs from the Federal Reserve that it is willing to let the economy ‘run hot’ for a while, that is, tolerate inflation above its two per cent target might signal this is the central bank’s preferred outcome.

Conversely, if the Fed chooses to enforce its two per cent inflation target religiously, the labour share of output would grow at 1.5 per cent per annum. The historical relationship with corporate profit margins would suggest that in this scenario, profit margins would fall by nearly 1.3 percentage point a year from their current levels of 10 per cent. Current levels of the stock market do not suggest that equity investors are prepared for profit margins halving in the next 3-4 years. 

The current political cycle in the US has seen the decline of middle-class working wages get significant play as something that must be addressed. On both the right (Donald Trump) and left (Bernie Sanders), presidential candidates have rallied around this idea and seen success. 

But any pickup in these wages would have to come from somewhere. Namely, corporate profits. 

And it is these profits that have buoyed financial markets, which to an extent have allowed the economy to come as far as it has in the seven years since the recession. 

Something will have to give. Or perhaps nothing will. 

Which, depending on how you see it, is either good or bad. Remember, this is called an "impossible trinity" for a reason: someone loses. 

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