Overview
Inflation has been a central component in our investment narrative over the past two years. Back in summer 2016, our inflation Nowcasters clearly signalled the end of the deflation that was plaguing the world and Chart 1 illustrates how this trend has evolved. Phase one was reflation; we believe we are now entering phase two – a phase that will prove more complex to navigate.
Our indicator over the period has been driven by every macro trend except wage growth. Producer prices, imported inflation and supply-side inflation have all firmed; wage inflation has been the missing element. Although wage growth has been positive, it has lacked the momentum to be a serious contributor to inflation. Across the developed world, wages are growing around their historical level, but have not yet improved enough to create significant inflation surprises.
For instance, wage growth in the US should be around 3%, below the historical average of 3.6% (Atlanta Fed Wage Growth Tracker). UK labour costs are growing at 1.3%, slightly below the 2% long-term average. In the eurozone, those costs were growing at a relatively lacklustre sub-1% rate last year.
We believe that this issue has become central; inflation typically lags growth, partly because of the time it takes for wages to adapt themselves to improving macro conditions. Nevertheless, when unemployment stays low enough for long enough, wages start growing. This is the central tenet of the “Phillips curve”.
Chart 1: World inflation Nowcaster
Source: Bloomberg, Unigestion as at 30.03.2018
In our view, the principle of the Phillips curve is particularly relevant in the current climate. Simply put, this theoretical relationship binds the unemployment rate with inflation. As unemployment falls, workers take advantage of a tightening labour market to negotiate for higher wages. In turn, this wage increase generates additional demand that pushes up prices, driving up inflation. Similarly, during periods of high unemployment, wage growth is close to zero (if not actually negative), fuelling deflation.
Chart 2: Unemployment vs. inflation in the US over the 1960-1968 and 1974 – 1984 period
Source: Bloomberg, Unigestion as at as at 30.03.2018
Does the relationship stand up?
Over specific periods – especially between 1960 and1968 – the relationship stands up, as shown on chart 2. It even looks non-linear in some ways: as unemployment gets very low, inflation can increase disproportionately. Central banks fear the start of a wage-to-inflation loop that can only be derailed by pushing the economy into recession.
Over the longer term in the US, however, the data clearly rejects the relationship depicted on Chart 2. For some time, the stability of the Phillips curve has been debated by academics, including Nobel Laureate Edmund Phelps, who has questioned the existence of a long-term relationship. Over the shorter term, a Phillips curve can exist for a given structural level of inflation and unemployment.
Meanwhile, when aggregating periods together, structural changes in the economy create conflict between the Phillips curves and the relationship loses its relevance. Chart 3 even shows that, between 1960 and 2018, the relationship is positive: higher unemployment appears to have resulted in higher inflation … or so it might seem.
Chart 3: the Phillips curve over the long run in the US (1960-2018)
Source: Bloomberg, Unigestion, as at 30.03.2018
Eliminating the mismatch
There is a simple solution to this conundrum: by eliminating the changing structural levels of unemployment and inflation, the cyclical element should adhere to the principle of the Phillips curve. Chart 4 shows how the Phillips curve is restored when doing so: the chart illustrates the strength of the connection and the current position.
In fact, the relationship weakened over the past three years, as illustrated on chart 5[1]. One reason is the unusually low goods inflation observed across the world. Commodity prices experienced abnormally high levels of volatility, which helps to explain away some of the mismatch. More recently, goods inflation has stabilised and oil prices have recovered, which should provide support for wage growth and hence inflation.
Chart 4: Cyclical unemployment vs. cyclical inflation in the US; time series (left) and scatterplot (right) over the 1960-2018 period
Chart 5: Rolling inflation’s beta to unemployment
Brown bars stand for US recessions.
Source: Bloomberg, Unigestion as at 30.03.2018.
Focusing on industry sectors
Focusing on individual industry sectors helps to establish the sections of the US job market that are positioned to deliver the largest wage gains. Chart 6 shows the difference between the unemployment rate per sector and how those differences could translate into additional inflation. Most sectors are now positioned to generate higher wages and additional inflation; sectors such as mining or construction are clearly showing signs of running hot. Even the goods sector has unemployment rates that are below their most recent track record.
All this should translate into +40 basis points of inflation over the coming quarters, if the Phillips curve relationship holds. It would not be surprising to see US inflation near 2.6% within the next two years; this would exceed the 2.3% to 2.4% predicted by central banks, suggesting that inflation surprises to the upside cannot be ruled out, although investors appear somewhat ill-prepared for that eventuality.
Chart 6: unemployment per sectors in the US and estimated inflation contribution
Source: Bloomberg, Unigestion, as at 30.03.2018
Chart 7: Inverted average employment across sectors in the US vs. US CPI
Source: Bloomberg, Unigestion as at 30.03.2018
Making cross-country comparisons
Similar analysis on Japan, the eurozone and the UK generates a similar picture for the UK and Japan; less so for the eurozone. Although the US is clearly ahead of the pack, the UK and Japanese job markets are heading in the same direction. Wage inflation is likely to add a further 15 basis points to both countries’ inflation in the coming quarters, and is likely to have a meaningful impact at macro and market level.
Chart 8: Inverted cyclical unemployment rate
Source: Bloomberg, Unigestion as at 30.03.2018
Impact on bonds and corporate profits
Wage inflation is an all-encompassing phenomenon that poses a widespread risk to bond markets in developed economies, despite recent increases in longer-term rates. We believe the process has just begun and it will take more than a couple of months to play out.
We believe that profits’ connection to wages is twofold. First – and most directly – wages are part of production costs and, as they grow, are likely to weigh on companies’ ability to generate earnings growth. Secondly, from a macroeconomic perspective, wage growth creates demand that is a net positive for profits, although the benefits are hard to gauge as they depend on how and when consumers intend to use this extra wage.
Profits are wage-dependent
Focusing on the most immediate consequence – the reduction of profits growth resulting from higher wages – chart 8 illustrates the strength of this connection in the US: wage growth is proxied using the Atlanta Fed Wage Growth Tracker and correlates relatively well with the year-over-year change in US corporate profits as computed by the Bureau of Economic Analysis.
According to our calculations, current growth momentum in the US would reduce wage growth from its present level of 3% to 4% per year to near-0%. Last time we witnessed a similar growth pattern was in 2007-2008 at the end of the previous cycle. Over the present cycle, the maximum wage growth rate was 3.6% in 2015-2016, which corresponded with a period of a negative profits growth. The current growth situation is much better, which should mitigate the impact of wages on profits. Moreover, higher wages are a necessary step in the continuation of the current economic cycle and should therefore not be feared by investors, provided the global economy continues to exceed its growth potential.
Chart 9: US Corporates’ profits vs. wage growth
Source: Bloomberg, as at 30.03.2018
Commodities and productivity
In our view, two missing factors need to be added to this overall picture in order to gain a full understanding of the inflation backdrop: commodities (an important contributor in 2007) and productivity.
Oil prices played a significant role in ending the previous cycle’s inflation surge: as Chinese demand strengthened, oil prices rose, triggering a worldwide increase in the Consumer Price Index (CPI). Since then, the oil industry has undergone a significant structural adjustment; supply and inventories are much higher and production costs have fallen considerably.
Meanwhile, productivity has risen, but productivity gains are lower in developed markets. In theory, lower productivity gains should imply lower growth wage and consequently a lower inflation growth rate. Chart 10 illustrates how the opposite seems to hold from an empirical perspective: higher productivity gains have usually delivered lower inflation. Strong productivity gains also imply lower production costs and this factor clearly dominates the wage argument.
Figure 10: US CPI quarterly changes (annualized) vs. productivity gains. Long run correlation: -37%.
Source: Bloomberg, Unigestion as at 30.03.2018
Conclusion
To conclude, we believe we have witnessed phase one of the normalisation of inflation. Deflation is well behind us and inflation figures have entered a stabilisation period. The second phase has much in common with the 2006-2007 period of the last cycle: higher growth and falling unemployment should result in higher wages. This cycle has proved somewhat more benign than past cycles and the outlook for wage growth should be no different.
Over the medium term, we remain generally positive towards equities, acknowledging that inflation risks are likely to result in elevated volatility. We believe higher wages are an important piece of the investment puzzle; higher rates – and potentially lower profits growth – are likely to challenge bullishness in equity markets. In the long term, higher wages signal a sound economic dynamic, and this is good news for growth-related assets – as long as your expectations remain realistic.
[1] Central Banks have been actively investigating the time varying nature of the Phillips curve. Patterns of this kind have been highlighted in “Nonlinearities in the Phillips Curve for the United States: Evidence Using Metropolitan Data », Babb and Detmeister, Finance and Economics Discussion Series, Federal Reserve Board, 2017. The time varying nature of the sensitivity of inflation to unemployment rate has also been assessed in “Non-Linear Phillips Curves with Inflation Regime-Switching”, Nalewaik, Finance and Economics Discussion Series, Federal Reserve Board, 2016. On the importance of the taking into account the long run unemployment rate, see “the Phillips curve and long run unemployment”, Llaudes, ECB Working Paper Series, 2005. The instability of the relationship has also been investigated in “Instability and non-linearity in the euro Area Phillips curve”, Musso, Stracca and van Dijk, ECB Working Paper series, 2007.
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Document issued on: 18.04.2018
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