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Gary Shillings INSIGHT

Economic Research and Investment Strategy Volume XXX, Number 4 April 2014

In This Issue
The Fed CapitulatesAnd For Good Reason The Fed junked its 6.5% unemployment rate target for raising interest rates largely because the declining labor participation rate has artificially depressed joblessness. About 60% of the participation rate drop from its 2000 peak is due to demographics, principally the retiring postwar babies. Forty percent of the decline is due to youths who stayed in school due to poor job prospects. Middle-aged discouraged workers also dropped out but were offset by the rising number of 65+ people who work due to inadequate retirement funds as well as better health. The overall participation rate dropped from 67.4% of those age 16+ in 2000 to 63% this year, and current trends will push it to 60.1% in 2020. Even at the low level, population growth will provide enough people to accommodate the return to rapid economic growth, assuring the proper skill matches and productivity growth at the 2000s rate. How China's Woes Could Shock Investors The ongoing "risk on" investment climate would shift to "risk off" with a substantial shock. Difficulties in China may result in such a jolt, and 8 problems there point in that direction: 1.Slowing Economic Growth 2.Transition from Export-Led to DomesticDriven Economy 3.Rising Militarism 4.Anti-Corruption Campaign 5.Manipulation of the Yuan 6.Shadow Banking Risks 7.Interest Rate Deregulation 8.Botched Bailouts

The Fed CapitulatesAnd For Good Reason

The Federal Reserve finally threw in the towel on its unfortunate targetthe 6.5% unemployment rate (Chart 1) at which it would likely raise the federal funds rate in controls from essentially zero at present. Unfortunate We say unfortunate for two reasons. First, setting quantitative targets is ridiculous in an era when monetary policy is subject to fiscal drag due to higher income tax rates and the expiration of 2009's massive stimuli, uncertain consumer spending, a skittish housing sector, Congressional gridlock and the unknown effects of foreign developments such as slowing growth and
CHART 1 Alternative Measures of Unemployment
Last Points 2/14: unempl. 6.7%; alt. measure 12.6%
18% 16% 14% 12% 10% 8% 6% 4% 2% Jan-00 18% 16% 14% 12% 10% 8% 6% 4% 2% Jan-14

Jan-02 Jan-04 Jan-06 Total unemployed (U-3)




Total unemployed + marginally attached workers + employed part time for economic reasons (U-6)

Source: Bureau of Labor Statistics

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INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. 2014 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ 07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: Web: President: A. Gary Shilling. Editor and Publisher: Fred T. Rossi. Research Associates: Colin Hatton and Tea Gongadze. All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained in this report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not a solicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or short position in any security, option or futures contract of the issue(s) mentioned in this report.

April 20142014 February

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financial problems in China and other developing economies. After the meltdown of the subprime mortgage market revealed its opaqueness, transparency became the goal in Washington and in financial markets. Federal Reserve officials, as mere mortals, caught the bug and have tried to apply transparency to their policy targets even though monetary goals are driven by uncertain data and therefore impossible to quantify with any degree of precision. Even if monetary goals could be precisely and predictably delineated, doing so would remove the uncertainty and mystery from policy. And that unpredictability is what keeps markets honest and speculation in check. Consider the Chinese yuan, which was raised vs. the dollar so steadily in recent years that speculators jumped in to take advantage of a one-way bet, often moving money into China illegally to do so. That induced the government to depreciate the yuan, starting in mid-February, to create uncertainty and punish speculators but with as yet unknown unintended and possibly destabilizing consequences. A Poor Indicator The second reason the Fed's unemployment rate goal was unfortunate is because even though this is the headline number, it is a notoriously poor indicator of labor market conditions. Its the ratio of the jobless, those who say theyve actively looked for work in the last four weeks, to the sum of that group and the employed. So it doesnt account for the quality of jobs. As weve noted in past Insights, leisure and hospitality jobs have risen by 1.53 million since the trough in January 2010 while manufacturing jobs have climbed 622,000 since their February 2010 bottom. But since leisure and hospitality workers are paid less and work fewer hours than in manufacturing, their weekly pay is only 35% as large. Furthermore, the headline unemployment rateU-3 in Bureau of Labor Statistics parlance (Chart 1) doesnt say anything about the leap in the Great Recession in the long-term unemployed (Chart 2) or the widened unemployment rate gaps based on race
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and education levels. Ditto for the leap in part-time employees who would like to work full-time (part-time for economic reasons). And, of course, the standard unemployment rate does not measure the ongoing income polarization in America, which we discussed in detail last month, and the drop in median real income, even in the ongoing economic recovery. Labor Participation Rate Most importantly, the headline unemployment rate doesnt account for the hordes who have dropped out of the labor force and therefore arent counted as unemployed. As discussed in detail in How Tight Are Labor Markets? (June 2013 Insight), if the labor participation rate now were the same as the 67.3% in February 2000, the labor force would be 10.6 million bigger than it is. Since the unemployment rate back then was 4.1%, this implies 14.3 million more job holders. Without that decline and with today s employment, the U-3 unemployment rate would be 12.7%. Furthermore, 88% of the decline in the jobless rate since its peak at 10% in October 2009 was linked to the drop in the participation rate from 65.0% back then to 63.0% in February 2014.......

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CHART 2 Duration of Unemployment

Last Points 2/14: 27+ weeks 37.0%; avg. weeks 37.1
50% 45% 40% 35 35% 30% 25% 20% 15% 15 10% 5% 0% Jan-48 10 5 Jan-58 Jan-68 Jan-78 Jan-88 Jan-98 Jan-08 30 25 20 45 40

% Unemployed for 27+ Weeks as a % of Total - left axis Avg. Weeks Unemployed - right axis

Source: Bureau of Labor Statistics

April 2014

How China's Woes Could Shock Investors

In last months Insight, we noted that the risk on investment climate persists with robust U.S. equities even though Consumer spending is subdued, even after accounting for inclement weather early this year The housing recovery is slipping and has been driven by rentals, not the solid foundation of new homeowners The Administrations fixation on income redistribution reinforces gridlock in Washington as the 2014 elections loom Tepid labor markets have weakened further and the weather isnt to blame Obamas minimum wage proposal will cut employment by 500,000 while adding a trivial net $2 billion to incomes, according to the CBO While Obamacare confuses individuals and employers alike, the CBO forecasts a 2.5 million job loss as people are paid to not work The Fed is determined to taper despite deflation risks, falling commodity prices and emerging market crises Reduced Fed largess is separating the well-managed developing country Sheep from the poorly-run Goats while global contagion remains a possibility The crisis in Ukraine threatens a slowdown in East-West trade and a revival of the Cold War Shocks This month, well begin to examine the many shocks that would force investors into an agonizing reappraisal and a switch to a risk off strategy. Most investors with long-only equity portfolios dont want to walk away from a winning game. Like most humans, they play until they lose, as was true of the dot com stocks in the late 1990s (Chart 1) and the housing bubbledriven market in the mid-2000s (Chart 2). They prefer to ignore the removal of fuel under the boiling equity pot provided by the Fed since August 2008. They also turn a blind eye to the basis of corporate earnings: the unsustainable leap in profit margins driven by costcutting (Chart 3) and the lack of solid sales volume gains in a slow growth economy and the absence of pricing power in an inflation-less business climate. Its possible, of course, that equity investors enthusiasm will be vindicated. All the problems we just listed may be solved without significant stock market implications. Economic growth may spurt this year and fulfill expectations even though similar hopes in each of the last five years have been dashed. But
April 2014
5500 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Jan-80 Dec-83 Nov-87 Nov-91 Oct-95 Oct-99 Oct-03 Sep-07 Sep-11

CHART 1 Nasdaq Index

Last Point 4/1/14: 4,268
5500 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0

Source: Yahoo Finance

CHART 2 S&P 500 Index

Last Point 4/1/14: 1,886
2000 1800 1600 1400 1200 1000 800 600 400 200 0 Jan-80 Dec-83 Nov-87 Nov-91 Oct-95 Oct-99 Oct-03 Sep-07 Sep-11 2000 1800 1600 1400 1200 1000 800 600 400 200 0

Source: Yahoo Finance

A. Gary Shilling's INSIGHT

absent these salutary developments, the ongoing risk on euphoria will probably be ended by a significant shock. Last month, we listed five potential major shocks: A financial crisis in China if she bungles her attempts to shift from an export-driven to a domesticled economy while opening financial markets; an escalating confrontation between Russia and the West over Ukraine and nearby countries; a spike in oil prices resulting from a blow-up in the Middle East or in Venezuela; and global contagion resulting from developing country woes. Were not forecasting one or more of these shocks to materialize. Nevertheless, in a slow growth world, they cant be ignored since it doesnt take much of a hiccup to turn meager growth into a self-feeding decline in economic activity. Also, the number of possible shocks is important since one can trigger others, just as the subprime residential mortgage collapse, starting in early 2007, spread to Wall Street quickly and required massive financial rescue to avoid a meltdown.

CHART 3 Corporate Profits and Employee Compensation

as a % of national income
Last Points 4Q 2013: corp. profits 14.7%; employee comp. 60.7%
68% 67% 66% 13% 65% 64% 63% 62% 61% 9% 60% 59% 58% 1947-I 8% 7% 1959-III 1972-I 1984-III 1997-I 2009-III Compensation of Employees - left axis Corp. Profits with IVA and CCAdj - right axis 12% 11% 10% 15% 14%

Source: Bureau of Economic Analysis

CHART 4 Problems In China

1. 2. 3. 4. 5. 6. 7. 8.

Slowing Economic Growth Transition from Export-Led to Domestic-Driven Economy Rising Militarism Anti-Corruption Campaign Manipulation of the Yuan Shadow Banking Risks Interest Rate Deregulation Botched Bailouts

Even if all of these shocks are independent of the others and each has only a 20% likelihood, the statistical probability that one or more of them will unfold is 67%! This month, well concentrate on China, and then examine the other shocks in the future. China has vaulted to become the second largest economy worldwide. Shes the 800-lb. gorilla among developing countries even though China is still an economy pigmy in terms of GDP per capita. Her global importance has been magnified in the last several decades as manufacturing shifted there from North America and Europe. So her imports of raw materials and exports of manufactured goods have exceeded greatly her internal demand. This means that Chinas problems are the worlds problems, and there are eight of them that singlyor
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more likely, in combinationcould precipitate a major crisis (Chart 4). Even if only one difficulty surfaces, its far from clear that it can be contained without leading to a full-blown crisis, despite the best efforts of Chinese leaders.......

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April 2014