Be wary of simple narratives: on stagnation and ‘animal spirits’

On Tuesday I touched on how charts can be used to tell overly simplistic stories, and how whether we choose to accept them at face value or dig into the detail often depends on how much they confirm what we already believe. It seems there are a couple of examples of this in finance at the moment.

On Wednesday the New York Fed posted on the contentious issue of US wage stagnation (which is echoed in much of the developed world). Most of us are used to seeing charts like the below, which shows a sharp shift in wage growth dynamics seemingly originating with the spike in the oil price in 1973.

Like so many long term trends, demographics appear to have played a role here. The New York Fed notes that younger people see faster wage growth as they get older, with this peaking in between the ages of thirty five and fifty five.

As a result, as the US population has aged it is reasonable to expect the rate of wage growth in aggregate to slow. An academic paper published in May noted that the growth in wages in earlier stages of life was more pronounced in developed economies. As a result, this slowing in wage growth as the population ages, would be felt more strongly.

This has important implications for investors. Should we see subdued wage pressure since the crisis as a function of cyclical ‘slack in the economy,’ or is it likely to be a more permanent trend?

A belief in the former might suggest that wage pressure should ultimately intensify, meaning a need for interest rates to normalise. A belief in the latter might suggest that that policy can be kept easy for far longer without significant inflationary pressure.

It is important that investors think objectively when looking at these issues rather than choosing the argument that fits their own political or ideological narrative.

Is there a lack of animal spirits? It is very hard to chart attitudes.

Similar difficulties are presented by the related concept of ‘animal spirits.’ Many have a loose subconscious narrative about the state of the world: as developed economy wages stagnate, companies are also disinclined to invest, and global trade has collapsed. These are often tied together as a short-fall in aggregate demand, driven by a lack of confidence in the future.

But just as the wage issue is not as straightforward as it may seem, neither are global trade and business investment. Global trade has declined in US Dollar terms, but volumes have been far more resilient.

Changes in price will not always reflect sentiment, and it is hard to take the above as evidence that animal spirits are weak. Similarly, while there are large concerns about capital spending in developed markets, top down analysis of private investment appears healthy and there are compelling arguments for why increasing amounts of activity may be missing from aggregate numbers.

These examples show that the situation is always more complex than our subconscious narratives may suggest, and however tempting it is to drift to one side of the argument it is worth remembering the following:

“When [experts] are not agreed, no opinion can be regarded as certain by a non-expert”

-Bertrand Russell, Let the People Think 1941

This does not mean that we must abandon analysis, simply that we must try be far more agnostic than is our natural inclination. Our in-built desire to be certain means that it is often uncomfortable to say that we ‘don’t know’ the answer to an issue.

The episode team believe that being prepared to say we don’t know, and trying to maintain an objective view of how others are forming their own judgements can be very useful for investors. Looking for periods where market valuations reflect the overconfidence of others can be key to identifying investment opportunities.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.