Chief Investment Strategist
Slow job and wage growth have been fixtures of the U.S. recovery from the global financial crisis, but investors are beginning to assess the costs and benefits of better wage gains ahead. Wage gains in this cycle have so far been characterized by a higher-than-normal weighting toward lower paying industries, such as retail, hospitality and temporary help. In addition, part-time employment has been stubbornly high in this recovery period. While overall wage gains (including supervisory workers) have been very steady at around 2% for the last three years, beneath the surface there are signs of improving wage trends among the roughly 80% of workers who are non-supervisory. Average hourly earnings gains among non-supervisory workers have accelerated to 2.7% from 0.8% since October 2012. What does the potential of further wage gains portend for inflation, growth and financial assets? To address these questions, we looked at a nearly 50-year span of economic data (1965-present) and analyzed the three most recent wage cycles, depicted in aggregate in Exhibit 1, in depth. Our research indicates wage gains that are accompanied by strong productivity growth (what we call good wage gains) have not created inflation in the past, and have coincided with good earnings growth and equity markets. With a constructive view on continued productivity gains and a continued elevated level of unemployment, we do not see rising wages over the near to intermediate term as a risk to inflation or the financial market outlook.
EXHIBIT 1: WAGES ON THE RISE (UNLESS YOU ARE A SUPERVISOR)
Source: Bloomberg, Bureau of Labor Statistics, Bureau of Economic Research, Northern Trust. Data through 3/31/2014, three month smoothing. Unemployment gap = unemployment rate full employment level based on the Organisation for Economic Co-operation and Development (OECD) estimate.
To understand the impact of wage gains on the economy and markets, we examined the relationship between wages and inflation, real GDP, earnings and equity prices. Over the nearly 50 years since 1965 (the blue bars in Exhibit 2), wages correlate highly with inflation (0.78) but show little correlation with real GDP (0.00), equity earnings (-0.07) or equity prices (-0.19). All wage gains, however, are not equal. We have data on unit labor costs starting in 1988 (the hashed red bars in Exhibit 2), and they show that wage gains that are accompanied by good productivity gains are noticeably more market friendly than those with rising unit labor costs. When the economy is generating good wage increases (wage increases in excess of unit labor costs), there is a clearly positive relationship between wage gains and growth, earnings and stock prices. In addition, the positive correlation with inflation disappears. This contrasts with the experience over the entire period since 1988, where all wage gains (both good and bad) were positively correlated with inflation and actually had a negative correlation with earnings and the S&P 500.
EXHIBIT 2: "GOOD" WAGE GAINS AREN'T INFLATIONARY
Source: Bloomberg, Standard & Poors, Northern Trust. Full data from 1965 March 2014. "Good" wage gains are wage increases in excess of the change in unit labor costs.
To further our understanding of the impact of wages on the economy and financial markets, we examined the last three major wage cycles (1987-1990, 1992-1998 and 2004-2007). For each of these cycles, we plotted wage growth over the trailing year for production and non-supervisory workers, as well as inflation and the unemployment gap. We also include the cumulative performance of the stock and bond markets, and the Appendix includes additional economic and market performance data.
At the onset of the first wage cycle (as shown in Exhibit 3), firms paid production and non-supervisory employees an average of $9.08 per hour, which grew at a 3.3% annual rate through August 1990. While wages accelerated through the cycles end in 1990, real GDP grew at a 3.5% compound annual growth rate (CAGR). We inverted the unemployment gap in Exhibit 3 to depict the way in which it typically moves with wage growth. As the economy grew, the postulated inverse relationship between inflation and unemployment (the Phillips Curve) held true: as price levels and hourly earnings increased, the unemployment rate fell 1.7%. In fact, inflation increased at a 4.8% CAGR over the period of acceleration. The increasing cost of labor for employers during the period was compounded by increasing unit labor costs with productivity only growing 1.1% per year, unit labor costs increased 1.6%. These wage gains would fall in to our bad wage gain bucket as they were accompanied by rising unit labor costs the highest increases in our three cycles under review. This was certainly contributory to the higher inflation and muted stock market performance during the period.
Corporate profits held up reasonably well, though, as earnings for the S&P 500 grew 11% during the first wage cycle (annualized). Despite healthy corporate profits, equity returns were muted during the period. The second frame of Exhibit 3 shows the performance of U.S. stocks and bonds set to zero at the start of the wage acceleration cycle. The market suffered the 20% crash of October 19, 1987 (tied to market functioning failures, margin debt and computerized trading), and additional 10% corrections in the fourth quarter of 1989 and the third quarter of 1990. However, upward momentum persisted and the market returned an annualized 3.7% during the period. With only modest growth in equity prices, and more rapid earnings growth, price-to-earnings multiples contracted 9% annually during the cycle, falling from 19.3x to a below-average level of 14.1x, which set the stage for the historic bull market of the 1990s. While equity prices failed to surpass inflation, investors who held onto high-grade bonds enjoyed stronger returns. Despite a rise in yields on U.S. sovereign debt (yields on the 2-year and the 10-year increased 175 and 169 basis points, respectively), investment-grade fixed income, as measured by the Barclays U.S. Aggregate Bond Index, exhibited a return of 7.3% at an annualized rate. We think this is a fine example of the diversifying benefits of investment-grade fixed income despite rising rates it was beneficial to portfolios in both mitigating volatility and boosting returns.
EXHIBIT 3: WAGE GAINS DROVE INFLATION IN THE LATE EIGHTIES
Source: Bloomberg, Bureau of Labor Statistics, Bureau of Economic Research, Northern Trust. Upper panel: three month smoothing. Shaded region is recession. Unemployment gap (U. gap) = unemployment rate full employment level OECD estimate. *S&P 500 price return due to data availability.
Turning to our second wage cycle (1992-1998), after a difficult year in 1990 both for the economy and the stock market, output grew faster than 4.5% during the first half of 1992. At the same time, the unemployment rate began to moderate and our second upturn in wage growth began. At the onset of the cycle, production and non-supervisory workers took home $10.72 per hour, which grew at a 3.3% annualized rate over the full cycle. During this cycle, the unemployment gap dipped into negative territory in December 1994, and tightness in the labor market once again fueled wage acceleration that persisted for multiple years until the unemployment rate had dropped all the way to 4.2% in May 1998. Despite the increase in aggregate demand and above-average wage inflation, price levels did not move in tandem, growing at a reasonable 2.6% annualized rate over the full cycle. Rising productivity meant that unit labor costs actually fell at a 1.3% annualized rate during this cycle; as such, these good wage gains did not contribute to inflation.
Amidst a hot economy, corporations consistently posted record profits. S&P 500 earnings per share grew at a 14.9% CAGR from $19.90 per share in the second quarter of 1992 to $44.67 per share in the second quarter of 1998. As the period unfolded, asset prices moved in lockstep with the expanding economy and a historic bull market transpired. The S&P 500 delivered a total return of 21% (annualized) during July 1992 to May 1998. Corporate earnings did most of the grunt work, but valuations did expand at a 3.7% annual rate from a high 20.5x starting point in the second quarter of 1992. Investors in corporate fixed income enjoyed roughly the same performance out of bonds during the second wage acceleration cycle as they did during the first cycle we studied, with the Barclays U.S. Aggregate Bond Index returning 7.4% annually. The Federal Reserve increased its target rate by 225 basis points during the time period (25 basis points more than they had during the first cycle), and the short end of the curve gravitated upwards with the 2-year U.S. Treasury yield jumping 112 basis points. Concurrently, the yield on the 10-year government bond fell 116 basis points as expectations of slowing growth worked their way into the longer end of the bond market.
EXHIBIT 4: NO INFLATION BOOST FROM WAGE GAINS IN THE NINETIES
Source: Bloomberg, Bureau of Labor Statistics, Bureau of Economic Research, Northern Trust. Upper panel: three month smoothing. Unemployment gap = unemployment rate full employment level OECD estimate.
The third wage cycle lasted from February 2004 until September 2007. During the three-and-a-half year period, the pace of wage growth increased until it reached 4.2% in September 2007, when workers took home $17.64 per hour. Prior to the beginning of the third cycle, the economy expanded swiftly after contracting in 2001, growing at a 6.9% pace in September 2003. The economy continuously expanded during this wage cycle, but its growth rate slowed in real terms from 3.8% in 2004 to 1.8% in 2007. The Consumer Price Index moved directionally with wages throughout the first half of this wage cycle, but the relationship broke down again after inflation peaked at above 4% in the third quarter of 2006 and fluctuated in 2007 and 2008 as the recession took hold. Once again, the unemployment gap served as an effective indicator of the degree of tightness or slack in the labor market. The unemployment gap reached its maximum (bottoming on the inverted scale of Exhibit 5) in the third quarter of 2003; as it decreased progressively during the cycle, wages grew faster as employers faced a tighter, more competitive labor market. Unit labor costs only grew at a 0.5% rate during this wage cycle; these wage gains can again be considered good gains, lessening impact on inflation and supporting corporate profits.
Despite a modest deceleration in the economy amid a period of increasing labor expenses, corporate earnings maintained upward momentum, growing at a 12.8% CAGR during the third wage cycle. The growth of labor productivity did decelerate throughout the cycle, from 6.3% at the onset to 1.7% in 2007, but this endpoint is a solid level of productivity for the end of a cycle. If this cycles wage growth was not as good as the second wage cycle, the stock market did not mind, as the S&P 500 chugged along at a 10.3% annualized rate toward its pre-recession peak in October 2007. Meanwhile, U.S. investment-grade bonds climbed at a more modest 3.6% rate amid a rising rate environment. The highest yield that the 10-year U.S. Treasury bond reached during the 10 years ended this March was 5.3% in June 2007 toward the end of the wage cycle.
EXHIBIT 5: WAGE GAINS SUSTAINED BY TIGHT LABOR MARKET
Source: Bloomberg, Bureau of Labor Statistics, Bureau of Economic Research, Northern Trust. Upper panel: three month smoothing. Shaded region is recession. Unemployment gap = unemployment rate full employment level OECD estimate.
The current wage cycle started in October 2012, when wage gains for non-supervisory workers fell to a 25-year low of 0.8%. Since then, wages have grown to $20.57 per hour (as of March 2014), a rise of 2.7% over the prior year. Price inflation has remained muted despite historically expansive monetary policy, so these wage gains are having a real effect. Clearly, for non-supervisory workers (80% of workers on nonfarm payrolls), a turnaround is underway. However, the broader measure of earnings is more reflective of the total labor force and has been in a tight range of 1.9% to 2.2% since the end of 2012. As shown in Exhibit 6, the traditionally strong relationship between the unemployment gap measure we used and the timing of wage cycles deteriorated during the last five years. The unemployment gap reversed its course in 2010 after reaching its highest point in the 28 years we studied. In other words, there was a significant lag in the amount of time between the peak in the unemployment gap and the trough in the wage growth measure for 80% of workers, while for the broader measure of wage growth, a change in direction has not clearly emerged. However, the largest gap in our previous three cycles was less than 2% in 1992, so the depth of this labor market downturn is historic and has had a suppressing effect on overall wages.
With unit labor costs falling so far in this cycle (down 0.5% annualized), corporate profits have been supported. In the April jobs report issued on May 2, there was little sign of increased wage pressures as average hourly earnings in April were unchanged from March and slowed to 1.9% on a year-over-year basis. The participation rate was much lower than expected at 62.8%, down from 63.2% in March, which does raise the prospect of an earlier tightening of labor supply than previously thought. However, we still expect productivity gains to offset incremental wage gains and to alleviate inflationary pressures in the economy.
EXHIBIT 6: UNEMPLOYMENT GAP SHOULD TEMPER INFLATION RISK
Source: Bloomberg, Bureau of Labor Statistics, Bureau of Economic Research, Northern Trust. Data through 3/31/2014, upper panel: three month smoothing. Shaded region is recession. Unemployment gap = unemployment rate full employment level OECD estimate.
Rising wages have historically led to increasing inflation, rising interest rates and eventually the risk of recession as interest rate hikes put a brake on economic growth. However, our research indicates that not all wage gains are the same. As long as productivity gains help offset the impact of wage increases, inflation can be contained and corporate profits can keep expanding. One of the causes of weak job creation this cycle has been the substitution of capital for labor (through automation, for example). This has boosted productivity, and we see no changes in those incentives or reason to believe that will suddenly dissipate. So, while we will continue to carefully monitor the trends in wages and job creation, our view is that continued productivity gains will help offset the inflationary impact of further wage gains in this wage cycle.
Special thanks to Jonathan Williams, Investment Analyst, for data research.
APPENDIX: DETAILS OF THE CYCLES
Souce: Bloomberg, Bureau of Labor Statistics, Northern Trust. Data through 3/31/2014. Unemployment gap = unemployment rate full employment level OECD estimate. Growth rates annualized. *First cycle: as reported earnings, second, third and current cycles: operating earnings.