Straws in the Wind
We count ourselves in the somewhat crowded camp of forecasters who believe we will not see a recession in 2020, but we believe economic growth should slow to an even lower growth rate than we experienced in 2019. We are calling for overall economic growth (real gross domestic product (GDP) growth) of 1.5 percent for 2020.
In addition, we are forecasting a slight uptick in inflation in 2020. Wall Street is littered with the bodies of economists who erroneously forecasted a strong uptick in inflationary pressure. Except for asset prices, our economy hasn’t seen a rise in general prices in years. Depending on the measure that you use, inflation has been rising at a rate of less than 2 percent for sometime. Compare this low pricing pressure to inflation rates of the 70s and 80s. Some suggest inflation is essentially nonexistent and that our main pricing concern should be deflation.
Assets are priced by the market on factors reflecting expectations and known reality. When “everyone knows” that something is going to happen in our economy, like inflation remaining low, then the risk to asset classes exists if inflation starts to rise unexpectedly.
Currently, it seems “everyone knows” rising inflation isn’t going to be a problem. We count ourselves in that camp. However, we need to consistently monitor inflation pressure and the factors that drive inflationary pressures. Why? We have long argued that inflation pressure, be it high or low, is probably the most important single determinant that affects an investor’s capital allocation plan. Rising inflation tends to usher in rising interest rates. Rising interest rates are the stuff that erodes bond prices and business profit margins. Rising interest rates tend to negatively affect both stock and bond returns. So keeping a tab on inflation is important for all capital allocators.
Wages and Inflation
Most economists recognize the historical trends that suggest rising inflation isn’t sticky, or sustainable, unless it is accompanied by rising wage growth rates. Why? Inflation tends to be unsustainable if people can’t afford to pay the rising price for goods and services. Under this pressure, price increases tend to reverse.
So wage growth needs to occur for rising inflation pressure to hold. The chart above from the St. Louis Federal Reserve highlights the historical fact that wage growth and inflation rates have tended to be positively correlated, as the upward sloping trend-line attests.
Wage Growth Accelerating
Along with persistent, low inflationary pressure, a consistent mantra of the current business cycle has been low levels of wage growth. This has indeed been the case as illustrated in the chart below, which highlights wage growth since 1998. The shaded areas represent the last two recessions. As you can see, wage growth has lagged behind growth rates of the previous two business cycles.
But, as the chart also shows, wage growth has accelerated to close to 4 percent over the last year. This level of growth is close to the growth in wages that occurred prior to the onset of the 2008-2009 recession. So, the days of very low wage growth rates, and the stickiness of low inflation may be coming to an end (chart per Atlanta Federal Reserve).
Another significant development in wage growth pressures is the fact that lower-paid workers’ wages are now growing more rapidly than higher-paid workers. This is typical of what happens in late-stage economic cycles when demand for workers accelerates above available supply of workers. When this occurs, wage rates start to rise. Note the chart below, which shows the annual gains in wages for the lowest quartile of paid workers relative to all wage earners. While all wage earners’ pay increase has been a little lower than 4% over the last 12 months, the lowest wage quartile workers’ pay has increased by almost 5% over the same period. Over the last 20 years, it has been rare for the lowest quartile workers’ pay to increase by an annual rate of 5%. That is now starting to occur.
Those who share the view that our economy is somehow broken and has left the lower-paid workers behind do not like to quote this information, which is provided here by the Atlanta Federal Reserve.
Other Straws in the Wind
One of the benefits of working in the investment field is the ability to be associated with great people. I have known and associated with clients, associates and others in the investment business who, by and large, are much smarter than me. Richard Bernstein is one of those people.
In the past, Rich and I have shared a speaking stage and TV time. A few years ago, we were both interviewed by Barron’s to discuss bond market alternative ideas. I respect Rich’s acumen in this business and consider him to be one of the brightest minds in my business.
In the December 2019 edition of the Richard Bernstein Advisors newsletter, Rich highlighted a view that inflation will be a stronger variable over the next 10 years than it was over the last 10. He highlighted these facts:
- The world seems to be moving away from strong globalization trends. The rise we saw in globalization – where productive capacity has moved from high-cost, less efficient geographic areas to low-cost, efficient production – is coming to an end. Nationalism is on the rise in Europe, China and the United States. The major driver of low inflation seems to be slowly vanishing.
- Current monetary policy is pro-inflation. Since unemployment is now 3.5%, the Federal Reserve’s policy moves last year (reducing interest rates) occurred, not to spur the jobs market, but to add support to pricing.
- Government fiscal policies are inflationary. Deficits that run too far spur inflationary trends. Tariffs, by definition, are inflationary in their impact.
- The five-year trend in inflationary pressure is rising at the fastest pace in 30 years.
And, lastly, in concert with our wage growth theme:
- The current NFIB survey shows that U.S. small businesses are planning on raising wages the more rapidly than they have in the last 30 years.
What All This Means – Good and Bad
Rising wages are a good thing, right? By and large, yes, rising wages are a good thing. At least up to a point. Like most economic issues, there are few solutions and many tradeoffs. Along with stronger growth in take-home pay comes building pressure on corporate profit margins…unless prices rise to offset these increased cost pressures. Inflation means rising prices for goods and services.
Rising inflation normally isn’t a bad thing by itself. Some degree of pricing flexibility is good for business and helps cover a number of management inconsistencies. That being said, an upward shift in inflationary pressure is much less harmful to the economy if people expect the inflationary push to occur. When they don’t, the rise in inflation tends to be harmful.
Some people ask me what unexpected economic event or development may occur in 2020. We suggest an upward push in inflation may indeed be that unexpected development. Frankly, most believe inflation will do nothing but remain very low, and even decline, in 2020. If inflation rises, to challenge the 2 percent level, people will be surprised.
Remember, capital market asset pricing reflects consensus view. If that consensus is proven wrong, asset prices tend to react, at times, somewhat violently.
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