For many years, economists have been puzzled about the persistence of ultra-low wage inflation in the advanced economies (AEs), despite a rapid tightening in the labour markets in the US, Europe and Japan. Viewed in the context of the health of the overall macro-economy, low wage growth has usually been described as a “problem”, since it has led to subdued growth in consumer demand and to price inflation well below central bank targets.
For equity investors, however, low wage inflation has not so much been a problem as a driving force for the long bull market in stocks. With wage inflation running well below price inflation, real wages have declined relative to productivity growth and profit margins have risen strongly. Furthermore, low wage inflation has encouraged the central banks to cut interest rates sharply. Rising profits have therefore been capitalised at very low discount rates, increasing equity valuations still further.
All this now seems to be changing. Recently, there has been an unmistakable rise in wage inflation in the advanced economies, and market economists have started to warn about the risks to equities from higher wages, declining profit margins and more hostile central banks.
These warnings seem appropriate – in fact, far more appropriate than the dire language routinely used to describe the threat from trade protection. However, the rise in wage inflation is still very gradual, and it could take another year or two for the problem to inflict major damage on investor sentiment.
Economists usually analyse and forecast wage inflation through the lens of a Phillips Curve (see below). Using this approach, we would expect US wage inflation to rise earlier than in many other countries, because the American labour market is now operating at over-full employment and price inflation is slightly above the 2 per cent target. Sure enough, we are seeing clear signs that wage inflation is on the way up.
Our preferred measure of the underlying trend in US wages is the change in average hourly earnings, smoothed by the Stock and Watson method that is used widely in data analysis.
This shows clearly that wage inflation bottomed at 1.9 per cent in 2012, and then rose fractionally to just above 2 per cent in 2014. Since then, it has been rising a little more rapidly, and now stands at 2.73 per cent, only about half a point below the peak rates seen at the top of the last two economic cycles.
This result is in line with many other estimates of underlying wage inflation in the US, most of which are hovering around 3 per cent, and are clearly still rising as the labour market continues to tighten. See, for example, the Atlanta Fed wage growth tracker.
More surprisingly, wage inflation also seems to have risen recently in the Eurozone, even though unemployment there has not yet fallen below consensus estimates of the “natural rate” or NAIRU. Part of the recent jump may be due to one-off factors, but ECB president Mario Draghi confirmed last week that the central bank believes that wage inflation is rising. The same is clearly true in the UK and many other smaller advanced economies.
As usual, Japan is something of an exception, with wage inflation rising only slightly to about 1.5 per cent, despite over-heating in labour-market indicators.
The Phillips Curve is the workhorse model that macro-economists use to explain and predict wage inflation. In the labour market, wages are explained by expected price inflation, productivity growth and the tightness of the market, measured by the gap between unemployment and the natural rate or NAIRU. (See this recent IMF analysis of the Phillips Curve for the US and the Euro Area.)
The “puzzle” in the AEs during the recent economic recovery has been that wage inflation has responded much less to the decline in unemployment than would have been expected, based on the Phillips Curve in earlier periods (see this ECB discussion).
The IMF has concluded that this undershoot in wage inflation has occurred because low rates of productivity growth, involuntary part-time working and very low price inflation have held down wages as unemployment has fallen. These structural factors may now be abating.
Since 2017, wage inflation has increased more normally in response to the tightening labour markets. This seems likely to continue, at least until unemployment stabilises.
If wage inflation continues its upward path, as seems probable, then some of the fuel that has supercharged the equity markets will begin to ebb. But it could take a while for higher wages to lead to an outright bear market.
The outcome will depend on the relationship between real wage inflation (ie, wages less prices) and productivity growth in the corporate sector. If real wage inflation rises, but only in line with productivity growth, then profit margins would remain intact and the central banks would not need to raise interest rates on an accelerated timetable. This would not deliver a death blow to the bull market.
Daan Struyven of Goldman Sachs forecasts that, on this type of scenario, profit margins in the US national accounts would reach peak levels around 9.7 per cent early in 2019, and then edge lower as wage inflation rises gradually next year.
However, Struyven also considers a darker scenario in which wages rise at 4.3 per cent per annum, a percentage point above the central forecast, forcing the Fed to raise rates twice a quarter, instead of once a quarter, next year. This would reduce profit margins by a percentage point in 2020, and also increase the interest rate applied by the equity market to discount future profits. Overall, that would probably be enough to cause a moderate bear market in US equities.
While it is too early to sound the alarm bells, rising wage inflation in the advanced economies is likely to cause major problems for investors within the next 12-18 months.