FACTS AND TRENDS: THE BIG WAGER

Average hourly earnings of production employees have been accelerating during the past 12 months. From Q4’11 through Q3’13, wage gains remained below 2.0%, averaging 1.7%. In the last 6 months, wage gains accelerated to 2.3% even though high unemployment and tame inflation would not justify higher wage demands nor higher wage offers.

S&P 500 revenue per share rose 9.4% in 2011, 3.8% in 2012 and 2.2% in 2013. Revenue growth slowed to 0.5% in Q4’13. A margin squeeze thus seems to be underway, unless companies can pass on these higher costs to their customers, something the Fed and the ECB, fearing deflation, are openly encouraging.

Curiously, amid all the headlines and the warnings of deflation, the U.S. CPI has been accelerating from 0.9% last October to 1.5% in March and +1.8% annualized during the last 4 months. Core CPI has been stable at +1.7% Y/Y for 6 months but the median CPI has remained above 2.0% during that period. Lately, food and shelter costs (14% and 32% of the CPI respectively) have been surging and world commodity prices have broken their 3-year downtrend. Gasoline prices have jumped 11% since the end of January and are now up 4.2% Y/Y.

If workers have been able to get more than 2.0% wage increases when unemployment and inflation were respectively much higher and much lower than currently, aren’t they more likely to demand, and receive, even higher wages when food, shelter and energy costs are accelerating and unemployment is declining.

As the chart above shows, upward moves in wage inflation is difficult to stop when it begins, generally requiring a Fed-induced recession.

Interestingly, wage gains hovered around 2.5% for 27 months after bottoming in September 1992. It is only after the unemployment rate declined from its cyclical peak of 7.8% to 5.4% in March 1995 (en route to 3.8% in April 2000) that wage gains definitely broke upwards of 2.5% to reach 4.3% three years later. The fact that a 7.8% unemployment rate failed to trigger wage inflation in 1992 but not this time should be of concern to the Fed.

Ms. Yellen seems unfazed by the debate on the possible lack of labor slack, saying that “I think it’s premature, frankly, to jump to that conclusion” while admitting that the Fed would be alert to “wage pressures that can translate into price pressures and be an early warning indicator of an impending uptick in inflation”.

Being highly conscious of the impact that the Fed’s communications have, Ms. Yellen may be sparing investors after having seen the effect of her “6 month slip” of March 21. Perhaps that slip was a reflection of her real fears that something amiss is actually happening.

The National Federation of Independent Business performs a monthly poll with its members, incidentally the largest employers in the U.S.. A quick glance at poll results may suggest that we remain pretty far from any major cyclical pressures but a deeper analysis reveals tighter conditions. If we accept that the U.S. experienced two unusual bubbles in the late 1990’s and mid 2000’s, these next charts suggest that employment conditions are in the cyclical highs area, matching periods when wages were accelerating as per the first chart above:

Comments from the NFIB April survey are also supporting the tight labor market/margin squeeze thesis:

• Forty-nine percent of the owners hired or tried to hire in the last three months and 41 percent reported few or no qualified applicants for open positions.
• Two percent reported reduced worker compensation and 25 percent reported raising compensation, yielding a seasonally adjusted net 23 percent reporting higher worker compensation (up 4 points), the best readings since 2008. A net seasonally adjusted 14 percent plan to raise compensation in the coming months, unchanged from February and the strongest reading since 2008 as well.
• The reported gains in compensation are now solidly in the range typical of an economy with solid growth. Hopefully this is a good sign. With a net 23 percent raising compensation, but a net 9 percent raising selling prices, it is easy to see why profits remain under pressure.

This next chart also supports the notion that wage pressures are building in the economy (keep relating to the top chart) along with rising challenges to maintain profit margins. 

I have recently been tracking indications of rising prices in the U.S. economy. Some of my recent observations:

• Truckload linehaul rates spiked in March, with the Cass Truckload Linehaul Index surpassing the 120 mark, showing a 6.0% year-over-year increase – the largest in 35 months – and setting a new high. From February, linehaul rates rose 3.7%, displaying an above-normal sequential increase for the fourth straight month. Demand for freight transportation continues to improve while capacity shrinks as carriers continue to exit the marketplace. The cost of intermodal shipping also continues to rise, with March costs reflecting a 1.8% upsurge over the same month last year and a 2.5% increase from February. Like our truckload index, our intermodal index has also reached a new peak. (Cass)
• We think that the ongoing drought in California will pressure food inflation to well over 2% as soon as May. This development is occurring at a time where shelter costs are rising at a post-recession high of 2.7% annually. (NBF) The spot price of US Foodstuffs is up a staggering 19% in 2014.
• Commodity prices are turning back up. The sharp (27%), sustained decline in commodity prices since mid-2011 may have run its course.
• The producer-price index for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% M/M from February, the Labor Department said Friday. It rose 0.6% excluding the volatile categories of food and energy. March’s 0.5% rise in the PPI was driven by prices for services, which rose a seasonally adjusted 0.7% from February, the largest one-month increase since January 2010.
• Total PPI is up 2.4% annualized in the last 3 months, 1.8% annualized last 4 months (December’s was 0.0%). Core PPI is up 2.8% annualized in the last 3 months and 3.0% in the last 4 months.
• Intermediate demand PPI is up 4.5% in last 3 months, 4.6% in last 4 months. Core intermediate PPI is up 2.8% (3 ms) and 2.7% (4 ms). Intermediate production prices lead final demand pricing.
• During the last three months, nonoil import prices rose at a 5.0% annual rate.
• Hotel room prices seem to be rising at a fast clip. Industry revenues per available room rose 5.4% in 2013, 5.3% in January ‘14 and 7.3% in March “aided by limited supply”.

Note that strong demand is not necessarily at play here. Reduced supply is often the reason for higher prices. It is true for labor, trucking rates which impact most of the goods that we consume, food, housing and hotel rooms. 

Ms. Yellen wants more time to get more data before concluding. Looking again at the top chart, we have to wonder how even an “alert” Fed can stop the rising wage tide once it begins. We must also wonder what would be the political response to rising wage/inflation pressures in an environment of still moderate economic growth and high unemployment. Would the Fed be willing to raise rates to slow a nascent wage spiral, and/or inflation accelerating beyond the Fed’s target of 2.0%?

This is the big wager for investors submerged with deflation fears these days. The investment world would turn upside down if the opposite happens. Rising wages coupled with stable inflation mean lower corporate margins. Rising inflation means higher long-term interest rates and lower P/Es. Rising inflation and accelerating wages mean higher short-term interest rates, lower profits and lower P/Es, potentially leading to a Fed-induced recession to stop the spiral.

We can hope for the best, but also be mindful of the worst.