Investors in developed markets have, in recent years, become accustomed to inflation rates that have been trending down. The graph below illustrates that annual OECD inflation has fallen from around three percent in 2011 to an environment of stable prices today.
Weak commodity and oil prices have had a dramatic impact on headline inflation. In addition the impact of the internet has also had a profoundly deflationary impact. Some industries such as the telecoms and the music industry have seen dramatic structural change. Other industries, such as general insurance, have found the price discovery, and transparency, of the internet has significantly reduced their pricing power. In the future, as the internet becomes more sophisticated, more industries are likely to experience significant change and reduced profit margins. Finally workers have found it very difficult to negotiate pay rises which has intensified the disinflationary environment.
CHART 1: OECD INFLATION
However wage growth looks like it is beginning to increase in a number of key developed economies. Hourly compensation measures in both the UK and US are close to six year highs (see chart 2). Wage growth in Japan has also strengthened, albeit under pressure from a government desperate to make a decisive break from deflation. In both the UK and the US the unemployment rate is approaching five percent, having fallen from a peak of 10 percent and 8.5 percent respectively. This is generally thought of as the threshold that gives workers greater bargaining power over their wages. Indeed UK average earnings have accelerated from 1.1 % y/y to 2.8 % y/y in the last eighteen months (see graph).
CHART 2: UK AND US WAGE GROWTH ARE SHOWING SIGNS OF ACCELERATION
Ordinarily relatively small changes in wages would not be anything remarkable. However the problem for policy makers lies in the fact that productivity (output per person) growth has been weak for over five years in both the UK and US. Quite why this is the case, in the face of a rapid technological advance, is open to discussion. However it is a phenomenon that has been observed in many OECD countries.
CHART 3: UK and US PRODCTIVITY GROWTH
So unless UK and US productivity growth stirs from its current slumber companies could experience a fairly sharp rise in their costs. Remember that the US and UK economies are predominantly service economies where the key input is people. In today’s internet enabled age companies are unlikely to be able pass all these costs onto the end customer. So it is likely to result in some increases in prices but also reduced profit margins as some of these costs are absorbed.
For bond markets the current low growth rate of productivity is a mixed blessing. From a positive perspective it means that the trend rate of economic growth, once all the spare resources in an economy are used up, is low. This in turn means that the neutral interest rate for the economy is also likely to be low (around three percent in the UK and the US). However it also implies that inflation is relatively sensitive to accelerating wages. This might result in UK and US interest rates eventually ending up above their neutral rates.
For equity markets the return of wage inflation would obviously boost purchasing power and therefore company sales. However if it was associated with low productivity growth, and an environment of weak pricing power, it would also mean lower profit margins. Whilst it is certainly some way off the prospect of interest rates rising above neutral, to reduce inflationary pressure in the economy, would be a negative event for the equity market. This is because it would imply a temporary slowdown in economic growth and thus slower profits growth.
The prospect of gently rising interest rates is currently priced into financial markets. So such a scenario would be not necessarily produce significant changes in the prices of bonds and shares. However rising inflationary pressures in the US and UK labour markets could prompt a significant correction in the price of financial assets. Investors should keep at least one eye on the developments in the US and UK labour markets.