Should I worry about rising wages?Contributor David Lebovitz
The month of October saw average hourly earnings for production and nonsupervisory workers rise by 3.2% from a year prior, the fastest rate of wage growth since April 2009. Many investors are concerned that if wage growth accelerates further, inflation will pick up in a way that ends up being problematic for the broader economy. While we recognize the impact that higher wages can have on profitability, the current pace of wage gains actually seems consistent with the Federal Reserve’s (Fed’s) 2% inflation target when broader trends in productivity are taken into account.
Wage growth can be deconstructed into two pieces – productivity growth and inflation. Generally, this framework makes sense – any gains I see in my wages should reflect either an increase in the output I generate or an increase in the general level of prices. With wages up 3.2% y/y in October and productivity growth of 1.3% in 3Q18, the implied rate of inflation given this framework is about 1.9%, just below the Fed’s 2% target and nearly in line with the headline consumption deflator, which stood at 2% in the month of September. While any further increase in wages absent an increase in productivity growth will likely lead to higher inflation, a surge in wage growth seems unlikely between now and the end of the cycle, suggesting that inflation will likely remain a bit muted.
That said, rising wages will impact earnings by putting downward pressure on profit margins. With profit margins sitting at an all-time high of nearly 12% in 3Q18, our expectation is that they will begin to come under pressure next year as wages and interest rates both grind higher. Based on our top-down model for looking at margins, a 1% increase in average hourly earnings for production and nonsupervisory workers should cause margins to decline by about 35 basis points. This downward pressure on margins, coupled with our expectation for slower nominal growth in the back half of 2019, suggests that earnings growth is set to slow next year. This will create a more challenging return environment for equities, particularly given rising rates will limit the ability for multiples to expand.
Higher wages will not necessarily boost inflation
Headline PCE, implied inflation*, y/y % change