You just got a raise. Congratulations. You helped cause the October stock-market correction. And your pay hike will be what limits market gains from here. It might even spark the next recession and bear market for stocks.
Thanks a lot.
How can your pay raise finish off a bull market — and even the economy?
Two ways. At the company level, wage pressures are now either limiting profit growth or leading to price increases. Either way, stocks and the economy are in trouble. Here’s a closer look at the double disaster your beloved pay hike is causing everyone else.
Pay-hike disaster scenario No. 1: Peak margin
The extremely tight labor markets and subsequent pay hikes now have market strategists worrying we’re at “peak margin.” When profit margins crest, that’s typically the beginning of the end of a bull market.
Wages rose 3.1% in October, the most since 2009, thanks to an extremely tight labor market that has unemployment at 3.7%, the lowest level in 49 years.
This is a problem for companies because employees are typically their biggest cost. And there are more pay hikes to come, since unemployment is well below the equilibrium or “structural” rate of 4.5%.
Thus JPMorgan Chase global economist Joe Lupton expects wage strength to continue through 2019. “And that’s going to be a big source of downward pressure on margins, which does suggest we are at the late stage of the cycle. This is part of traditional late-stage dynamic.”
Moody’s Analytics chief economist Mark Zandi is on the same page.”Margins are as wide as they are going to be and they are going to compress,” he says. “It is just a question of how much. I think it is going to be a slog for stocks, for sure.”
Zandi isn’t forecasting an imminent bear market. He guesses that a recession starts in the middle of 2020 because that is when the fiscal stimulus dissipates. Bear markets typically start three to six months before a recession.
Of course, companies can use price hikes to offset margin erosion. Indeed, they already are. But if companies work the price lever too much to cover your pay raise, this will trigger the second disaster scenario.
Pay-hike disaster scenario No. 2: Rising interest rates
Higher prices, aka inflation, spook the Federal Reserve. So inflation makes the Fed hike rates more aggressively. And probably more importantly, bond investors “hike” rates, too. They sell when they see inflation on the way. since inflation erodes the value of bond payouts (the coupon). This pushes up interest rates set by the bond markets, including the all-important benchmark yield on 10-year Treasurys
Higher rates spook the stock market. They also raise borrowing costs at companies. This puts more upward pressure on prices, as companies charge their customers more to offset higher interest costs, in a kind of feedback loop.
A lot of investors are lulled by the persistently low inflation of the past several years. They think there’s no way it could rise fast enough to spook stocks, the Fed, and bond investors. But don’t be too complacent. It doesn’t take much of an increase in inflation for disaster to strike.
We’ve actually had fairly low inflation for the last 35 years. Throughout this time, inflation only had to rise modestly during recoveries to wreak havoc for stock investors, says Leuthold Group chief investment strategist Jim Paulsen. During this time, the inflation “spikes” that contributed to sharp stock-market selloffs were merely in the 0.4 to 1.4 percentage-point range. The average was 0.9 percentage points.
The bottom line: Given that wage hikes will continue and companies will keep raising prices to protect profit margins, it’s not hard to imagine inflation, which stood at 2.3% in September, going up at least another percentage point.
The productivity promise
One way out would be gains in worker productivity that justify that higher pay. “The fountain of youth in late-cycle situations is a productivity miracle,” says Paulsen.
Let’s be clear, this isn’t about you working harder and checking your Facebook page less often. It’s all about your boss spending more on technology and equipment to help you do more. This saved the bull market in the late 1990s. Back then, a long phase of higher capital spending and productivity gains supported a long economic expansion. “If we have anything like the late-1990s productivity boom, we set back the clock, and wages don’t matter,” says Paulsen. “And we elongate the cycle.”
This is unlikely to happen. Sure, there’s hope. Business confidence is sky-high, as executives respond to a more friendly environment under President Donald Trump. And we’ve all been waiting for this to translate into higher capital spending.
So far, no luck.
And even if capital spending kicks in now, it may be too late. Productivity gains normally lag capital spending by one to three years. “Capital spending has been pretty punk for three years. This suggests punk productivity over the next three years,” says Paulsen. “It is nothing like the 1990s when we had a major capital spending boom for years.”
Trump may actually be part of the problem. Historically, higher government spending has “crowded out” private investment. You can see this in data which show a hit to productivity trends one year after government spending hikes, points out Paulsen.
Why does this happen? Government borrowing sops up capital. It drives up interest rates which makes capital more expensive for companies. Increased deficit spending can spook business leaders, since they wonder what the government knows that they don’t as it lays on the stimulus.
There’s one more reason to be skeptical that executives will turn on the capital-spending spigot soon, points out Lupton. While business confidence in “current conditions” is indeed high, the expectations component has been slipping sharply.
This has JPMorgan Chase economists trimming expectations for capital spending and productivity growth. “We think we are about done there,” says Lupton. “You put all of this together and it does suggest in the developed markets (DM) margins are going to roll over here over the coming year. And that sets up the potential for late-stage dynamics,” says Lupton.
“Late stage” is code for a struggling S&P 500 with limited gains, followed by recession. Click here for a guide to how to invest in this market phase.
Different this time?
There’s one other way out of this. It could be that productivity gains now come more from investments in technology like artificial intelligence, and breakthroughs like driverless cars, drones, and DNA sequencing.
Since all of these cost less than the heavy equipment that used to drive productivity gains, traditional capital spending measures wouldn’t pick up the potential for productivity gains from new era investments. We could be underestimating some of the benefits of new technologies.
“It’s possible,” says Zandi. “But I wouldn’t count on it. That wouldn’t be my baseline forecast.”
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.