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.

Biotechnology: Where the Promise of Life Meets the Reality of Markets

The case for investing in biotech and pharma stock








Billy:    So you got a job, where you play with all these toys.

Josh:    Yup!

Billy:    And they’re gonna pay you for that!

Josh:    Yup!

Billy:    SUCKERS!

Big (1998)

“Youth comes but once in a lifetime.” – Henry Wadsworth Longfellow, American poet and educator

“Demography is destiny.” – usually credited to French philosopher Auguste Compte

“The rewards for biotechnology are tremendous – to solve disease, eliminate poverty, age gracefully. It sounds so much cooler than Facebook.” – George M. Church, professor at Harvard & MIT

“Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” – Hillary Clinton


Hollywood movies went through one of their many curious phases during the late eighties. It was a phase in which adults were becoming children and moviegoers treated to cinematic atrocities such as Like Father Like Son, Vice Versa and 18 Again. Big starring Tom Hanks also came out during this time and turned out not to be half bad.

Human fascination with reversing the vicissitudes of old age is nothing new. Tales of magical sources of water that could reverse the ageing process and cure sickness can be found in ancient folklore across civilisations.  Legend even has it that Florida was discovered by the Europeans while searching for the mythical “Fountain of Youth”.

Our search for the elusive elixir that can reverse the ageing process, increase our lifespans and cure all sicknesses known to man continues to this day. Only the means have changed, not the goals. We no longer set out on journeys to far-off lands in search of mythical bodies of water. Instead we have replaced the ships with laboratories, the sailors with scientists and the paddles with test tubes, in the process creating what is now known as the biotechnology industry.

The term biotechnology was coined by Hungarian engineer Karl Ereky in 1919 to describe the process of creating products using raw materials sourced from living organisms. The roots of the discipline, however, can be traced at least as far back as the nineteenth century and to the work of Gregor John Mendel, an Austrian Augustinian Monk. Mendel’s development of the “Laws of Inheritance” is at times recognised as the foundation on which the principles of genetics are built.

Today, biotechnology has become almost synonymous with the application of engineering and biological sciences in pursuit of delivering improvements to human health, the environment and agricultural production. It is a time-consuming, expensive, and risky pursuit that strongly divides public opinion. And one that requires the coming together of engineers, scientists, patient capital, and an accommodative regulatory environment to thrive. Even then success is not guaranteed.

Despite the challenges, the industry has made great strides over the last two decades. In 1997 the industry achieved two major, yet controversial milestones. The first was the cloning of Dolly the sheep and the second was the first set of tests of gene therapy on humans. In 2003 the Human Genome Project was declared complete. In 2015 the Mexican government approved the world’s first vaccine to treat dengue – the world’s fastest-growing mosquito-borne disease.

Notwithstanding all the progress, the need for much more remains.

The developed world, while rich, remains demographically challenged. Needing more effective drugs and better healthcare for its ageing population. While in low income countries, a half dozen or so deadly infectious diseases claim millions of lives each year. The spread of these diseases may be contained by the development of easy-to-use and accurate diagnostic tools.

The prospects for biotechnology are strong as ever, which makes its demand for capital just as strong.


Investment Perspective

At its simplest, money is made in capital markets by either clipping coupons or riding a wave of liquidity to capital gains. With interest rates as low as they are, correctly anticipating where liquidity is headed is critical for the health of investors’ portfolios.

Stock pickers follow all sorts of styles of investing. At their root, investment styles are heuristics for anticipating the flow of liquidity. Value investors position themselves based on price. Growth investors focus on the rate of change of revenues and earnings. Technical analysts search for repetitive behavioural patterns. And so forth.

Our approach to anticipating liquidity movements within equity markets is informed by Richard Bernstein’s earnings expectations life cycle framework, outlined in his illuminating book Style Investing: Unique Insight into Equity Investing. While Bernstein modelled the evolution of earnings expectations, in our opinion, his approach can just as easily be applied to sentiment. For expectations are ultimately fractals of sentiment.

Earnings Expectations Life Cycle

Earnings Expectations Life Cycle.pngSource: Style Investing: Unique Insight into Equity Investing, Richard Bernstein (1995)

An area where we find sentiment, and therefore earnings expectations, at a turning point is healthcare, specifically biotechnology and pharmaceuticals. The sectors peaked in July 2015 and as surely as night follows day, stories of fraud started surfacing after the peak. The bad news did not end there, politicians started taking turns to add to their misery – none more so than Hillary Clinton, whose “price gouging” tweet sent the sectors into a tailspin.

Nasdaq Biotechnology Index and S&P Pharmaceuticals Select Index

NBI Index

Source: Bloomberg

The under performance of the two sectors, since their peak, relative to broader market indices has been noteworthy.  Biotech has under performed Nasdaq by more than 40% while pharma has trailed the S&P 500 by more than 50%. Investor apathy can be brutal.

The under performance of biotech and pharma during 2016 has not been entirely unwarranted. It was a challenging year for new drug approvals, which fell to a six-year low. The US Food and Drug Administration (FDA) only sanctioned 22 new medicines for sale, down from 45 in 2015.

Nasdaq Biotechnology Index / Nasdaq Composite Index

NBI Relative

Source: Bloomberg

S&P Pharmaceuticals Select Index / S&P 500 Index

SPSIPH Relative

Source: Bloomberg

For biotech, earning expectations have duly followed price action as opposed to the other way around. Given recent price action, we expect earnings expectations to start getting revised upwards.

NBI Blended Twelve-Month Forward EPS Expectations vs. Index Level

NBI Index and Earnings Expectations

Source: Bloomberg

Investors have been fleeing the sectors without abandon. That is, until recently. Using the iShares Nasdaq Biotechnology ETF ($IBB) and the SPDR S&P Pharmaceuticals ETF ($XPH) as proxies, we find that investors are rushing back into biotechnology. $IBB shares outstanding have increased by more than 25% year-to-date. Although pharma has lagged, the bleeding has stopped and we expect investor interest to pick up.

 ETF Shares Outstanding


Source: Bloomberg

Although investor interest in $IBB has picked up, the move is still in its early stages. Comparing the annual rate of change of shares outstanding for $IBB and the PowerShares QQQ Trust Series 1 ($QQQ), we find that capital flows relative to stock remain biased towards Nasdaq over biotech. Our models suggest that the trend should be more favourable for biotech over the remainder of 2017 and in 2018.

Annual Rate of Change of ETF Shares Outstanding


Source: Bloomberg

Despite investor interest increasing, we have received significant push-back on healthcare, especially biotech, with one investor citing the adage “Growth under performs value in a rising interest rate environment”. With central banks becoming increasingly hawkish and with biotech squarely in the growth camp, the scepticism may be reasonable. Yet the recent out performance of healthcare stocks is eye-catching.

The current state of markets makes us question if the market is beginning to focus on the world’s need for better drugs and improved healthcare? We also wonder if liquidity will start to rotate out of the increasingly politicised and polarising technology plays such as Facebook, Google and Amazon and into healthcare and the other laggards.

The regulatory environment, despite the Trump administration’s challenges in passing healthcare reform (or any reform for that matter), should almost certainly be more supportive for healthcare than it was under the Obama administration. Ironically, in large part due to President Obama, who gave the industry a parting gift when he signed the 21st Century Cures Act into law in December last year. This legislation is intended to expand medical research and speed up the approval of new drugs and medical devices. Predictably, the pace of new drug approvals has picked up in 2017. By May, 20 new treatments had been approved as compared to 22 for all of 2016.

Reduced regulations around drug approval, especially those that make the process of getting new drugs to market faster and less expensive, can greatly improve returns on investment. Improved returns incentivise management teams to increase research and development budgets and embolden them to pursue mergers & acquisitions. We believe that Gilead Sciences’ decision to acquire Kite Pharma is just the start of the trend of increasing mergers & acquisitions within the biotechnology and pharmaceutical sectors.

If this bull market in equities is set to continue, and we certainly are amongst those that believe that it still has legs, we contend that healthcare will be one of the sectors leading it higher.

In sectors where individual companies are fraught with idiosyncratic risks, we tend to prefer a core and satellite approach as opposed to taking concentrated positions in a handful of stocks. In this case, $IBB and $XPH form our core while a basket of our most favoured biotech, pharmaceutical and healthcare stocks, identified in our trade ideas, makes up the satellites.

We are long $IBB and $XPH.