The Case for a Pickup in US Inflation

“Given the right economic conditions, business will make substantial efforts to train workers. When the economy is moving along at a healthy pace and firms are eager to hire additional personnel, individuals with few qualifications begin to find opportunities.”

“Labor is the largest cost of the business sector. It has two determinants: employee compensation rates and worker productivity. When employee compensation rates increase, labor costs increase. When worker productivity increases, business pays less to get a job done. Both rising compensation rates and stagnating productivity in the United States have made critical contributions to inflation.”

– Excerpts from Profits and the Future of American Society, S Jay Levy and David A. Levy (1983)

 

“[I]nflation will remain rather limited as long as bad money, here the vellon, is still driving out the good silver money. For this means that the total money supply is scarcely changing.”

“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”

– Excerpts from Monetary Regimes and Inflation, Peter Bernholz (2003)

 

Inflation principally comes in one of two forms:

  • Rising resource prices; or
  • Wage growth outpacing productivity growth.

Given the services-biased structure of the US economy, wage growth outpacing productivity growth has a far greater and more sustainable impact on US inflation than do rising resource prices. With wage growth in structural decline, inflation has remained tepid in the US despite the best efforts of policymakers.

Services as a Share of GDPServices ShareSource: The World Bank

During the recent Fed meeting, the Federal Open Market Committee downgraded its 2017-18 inflation forecasts lower. Despite this, Fed Chair Yellen argued that weak pricing pressures are transitory. We are in agreement with Janet Yellen and find that US inflation is on the cusp of turning sustainably higher.

To assess the prospects of US inflation on a look forward-basis we analyse the relationship between inflation, wage growth and productivity growth. As proxies, we use the annual change in US CPI for urban consumers to represent inflation, the US unit labour costs for the nonfarm business sector to represent wages and US output per hour for all persons for the nonfarm business sector as a measure of productivity.

Comparing inflation to wage growth less productivity growth, we find the relationship to have moderately positive correlation. The R-squared using quarterly data from Q4 1997 to Q2 2017 is 0.52. This relationship is much stronger during periods the two measures are trending, either positively or negatively.

Change in the Consumer Price Index vs. Wage Growth less Productivity GrowthCPI vs WG less PGSources: Bureau of Economic Analysis, Bureau of Labor Statistics

The differential between wage growth and productivity growth has been trendless since 2011, swinging from negative to positive and back on an almost quarterly basis. No wonder then that the inflation environment has remained benign, much to the frustration of the Fed, who has pulled out all the stops to fight deflationary tendencies within the economy.

Despite the seeming absence of inflation, we find that inflationary forces have been gathering steam since 2014. This has failed to show up in the headline data due to the outsized impact of a handful of industries caught up in downturns.

Based on data provided by the Bureau of Labor Statistics, wage growth has outpaced productivity growth across a majority of industries from 2014 through 2016. However, workers in the oil and gas extraction, media related and retail focused industries have suffered from declining wages and this has kept a lid on overall wage growth.

Annualised Wage Growth less Productivity Growth by Industry (2014 to 2016)WG less PG IndustrySource: Bureau of Labor Statistics

As the base effects of the negatively impacted industries unwind, we fully expect, headline inflation measures to turn up and begin to exceed consensus expectations. Giving further credence to our assertion is the tightness in the US labour market. The jobs opening rate and the number of small businesses identifying job opportunities as hard to fill are either at or near their highest levels since the turn of the century. At the same time, US U-3 unemployment is at its lowest level since 2000.

US Jobs Opening RateUS Job Openings RateSource: Bureau of Labor Statistics

 US Small Business Job Openings Hard to FillJobs hard to fillSource: National Federation of Independent Business

US U-3 Unemployment RateUS UnemploymentSource: Bureau of Labor Statistics

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WGSources: Bureau of Labor Statistics, National Federation of Independent Business

Once again, the relationship is seemingly impaired at the headline level due to the outsized impact of a handful of industries. Based on data provided by the Bureau of Labor Statistics, wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

Annualised Wage Growth by Industry (2014 to 2016)Wage Growth IndustrySource: Bureau of Labor Statistics

Going forward, the oil and gas extraction industry should no longer be a drag on headline wage growth and may even have a positive impact on it if oil prices continue to increase. We therefore expect wage growth to pick up as businesses increasingly pay up or hire lower skilled labour and train them up to fill outstanding job openings.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex PlansSource: National Federation of Independent Business

The effects of the structural deflationary forces of globalisation, migration / labour mobility and declining trade union membership are also abating. The lion’s share of gains from outsourcing has already been realised. Politicians are increasingly pandering to populous movements and turning to protectionist policies, making labour migration far less frictionless. Trade unions have held very little appeal to younger workers that entered the workforce in recent years.

The inevitable corollary is the rising labour share of corporate profits will place increasing pressure on businesses to improve productivity. We therefore expect capital expenditures to pick up. Businesses will increasingly invest in automation and robotics to overcome the challenges of wage inflation and labour market tightness.

Small Business Capital Expenditure Plans vs. Productivity Growth (Lagged One Year)Capex plavs vs PGSources: Bureau of Labor Statistics, National Federation of Independent Business

Increased corporate spending will not only lead to improvements in productivity but to an upturn in the overall US business cycle. Capital investment has been the one missing ingredient in the US economic recovery since the Global Financial Crisis.  As businesses spend more, corporate profitability will pick up, which will lead to increased hiring and higher wages, which will feed into further investments into automation and robotics.

Our base case is, therefore, that the current US economic expansion will be the longest ever recorded. And the business cycle will only come to a turn after unemployment levels fall below 4%, inflation exceeds prevailing expectations and policymakers begin to respond to the unexpected consequences.

 

Investment Perspective

US median household income has been rising and we expect it to continue to rising as wage growth accelerates.

US Median Real Household IncomeUS Median Household IncomeSource: US Census Bureau

At the same time, US household balance sheets have been repaired with the household debt to disposable income ratio in decline since the Global Financial Crisis. More so, the debt service to disposable income ratio is at comfortable levels for US households. There is ample room for households to take on more debt, especially for the poorest households who are the likeliest to benefit as wage growth picks up.

US Household Debt to Disposable IncomeUS Household debt to disposable incomeSource: Bloomberg

 US Household Debt Service RatioUS Household DSRSource: Bloomberg

As poorer households’ disposable income increases, this cohort is more likely to increase consumption as opposed to increasing savings, especially when compared to upper-middle and upper class households. Poorer households shop at Walmart not Whole Foods. They eat at McDonald’s not Shake Shack. We expect retailers and quick service restaurants catering to lower and lower-middle income households to be amongst the greatest beneficiaries of higher wages. We are particularly bullish on the prospects of Walmart ($WMT).

Consider the relationship between US wage growth and $WMT revenue growth lagged by one year. The revenue growth measure does not adjust for store openings, corporate actions and other extraordinary events that may have occurred during intervening periods. Despite the lack of adjustments, this dirty measure has shown a strong relationship with wage growth.

$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential and rotate out of Amazon and into $WMT.

US Wage Growth vs. Walmart Revenue Growth (Lagged One year)WMT vs WGSources: Bureau of Labor Statistics, Bloomberg

A derivative of accelerating wage growth and labour market tightness is business’ increasing investment in automation and robotics. We are at the beginning of a long-term secular trend towards automation. Rather than picking winners at this early stage in the trend, we recommend positioning in a basket of automation and robotics related companies. The most obvious way to play this theme is the ROBO Global Robotics and Automation Index ETF ($ROBO).

Lastly, another derivative of accelerating wage growth is that the Fed is likely to increase interest rates at a faster pace in 2018 than currently anticipated by the market. We expect the short end of the curve to rise faster than the long-end, resulting in a classic bear flattening.

US Wage Growth vs. Effective Federal Funds RateEffective FFR vs WGSources: Bureau of Labor Statistics, Bloomberg

We are long $WMT, $ROBO and looking to get short the short-end of the Treasury yield curve.

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