In our 2Q 2017 quarterly commentary, we highlighted what we saw as a “Goldilocks” environment: a belief that a buoyant stock market could continue to be reinforced by a US economy with just the right balance between modest GDP growth and surprisingly tame inflation. Our thinking was: ‘This could go on a while.’ In the third quarter, it did. The S&P 500’s +4% return exceeded even optimistic expectations.
The length of the current economic expansion, now in its 9th year, has a lot of pundits, and many of our own clients, in a mistrustful state of mind—thinking the other shoe is about to drop in stocks. Ironically, that same mood was in evidence in 2015 and again at the end of 2016. Attempts at market timing by selling a portfolio out of stocks and completely into cash or bonds at those junctures would have proven very costly. Stocks have continued to climb against the backdrop of an unpredictable US political climate. A newly divisive issue surfaces almost weekly while geopolitical tensions, natural disasters or terrorist incidents make headlines on a regular basis. And yet, the market has shown few signs of volatility. It shrugs its shoulders, and seems to digest news with a “What, Me Worry?” attitude.
By all accounts, at this point in any prior US economic cycle, stock returns typically run into headwinds, usually soon after the US economy reaches full employment (check) and the Federal Reserve begins hiking interest rates (also check). What gives? For one, corporate earnings have resumed growth at a decent clip after nearly 8-9 quarters of flat growth. This growth has certainly helped, as has the fact that stocks, while certainly not cheap, are not exorbitantly expensive when contrasted against other asset classes with their dim prospects for appreciation. But, we also think the unusual calm around wage growth and inflation has played an underappreciated role in this “Goldilocks” era in the market.
The US Fed has now raised its benchmark interest rate 5 times since 2015. This is the 15th Federal Reserve tightening cycle since the end of WWII. In all but three of those cycles, a recession followed. Monetary tightening is a tough job to get just right. Many economists have likened it to landing a jumbo jet on a coffee table—it’s very easy to overshoot—either the Fed raises rates too quickly, or inflation accelerates too fast and takes corporate profits down with it. Or both occur.
We believe that this recovery has consistently fooled many investors with its longevity because there’s no historical corollary for what is happening. It was not a ‘normal’ recession, nor has it been a ‘normal’ recovery. What’s different this time is that inflation has been missing. Wage growth is a linchpin for spurring economic growth and increasing salaries have been absent from the current recovery.
We believe the severity of the recession changed the composition of the labor force. Post 2008, there was an almost doubling in the number of people re-entering the work force in part-time jobs. Corporate reluctance to hire, or invest was sky high after a near-death experience for many companies that was unlike prior run of the mill downturns. The pool of part time labor grew so large, wage growth for full-time, low-skilled jobs was literally cut in half. Moreover, as full-time wage-earners finally began to get jobs again several years after 2008, many had to settle for re-entering the workforce at below-average pay. The combination of these two effects is estimated to have produced a 1-2% point negative drag in median wage growth.
The second explanation for slower wage increases relates to demographics. Job mobility in this recovery has been well below normal. Typically, when people switch jobs readily, it is for a higher paycheck. Job mobility has declined due to slower job creation and the reluctance of job holders to risk a move. The number of baby boomers 55 years and older has grown at more than 3x the rate of millennials entering the workforce. Workers 55 years and older had seen +3-4% annual wage growth prior to the recession, that number is now running closer to flat. A telling indicator: the employment rate for prime-age workers (25-54 yrs. old) remains almost 2.5 million jobs below its pre-recession peak. It turns out many boomers are putting off retirement, however, on a per capita basis, those that are sticking around are paid more than the millennials. It’s possible this phenomenon may have temporarily monkeyed with the Fed’s definition of “full employment.” Additionally, the ‘Gig Economy’ has meant a proliferation in the number of younger, part-time workers for firms like Uber, Amazon, Etsy and others where pay/benefits are relatively low, and workers are categorized as ‘self-employed.’
These dynamics have restrained wage growth in the US for an extended period. We believe the last piece of this tame inflation/low interest rates story in the U.S. is productivity growth. Productivity measures workers output per hour or worker efficiency. It’s important because it serves as an offset to companies raising wages which in turn raise income and living standards. But productivity growth has been uniquely slow in this recovery, running at approximately half its normal rate. Higher productivity would allow corporations to raise wages at a higher rate.
Only recently, we’ve seen some evidence that the sluggish era in wage growth might be ending. Target Corp recently announced an increase in its minimum wage for all employees to $11/hr. Several state legislatures are examining a meaningful hike in mandatory minimum wage. The US economy continues to add between 150-200k jobs per month. The recent move in wages bears watching as it’s directly tied to the 70% of the US economy that is driven by consumer spending. What we would root for here is a virtuous circle wherein rising wages spur higher economic growth which in turn increases inflation which allows companies to raise prices.