Stock sell-off was an accident waiting to happen

Stock sell-off was an accident waiting to happen
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The rollover in the stock market in the past week was triggered initially by an overshoot to forecasters’ expectations for the January wages data.

The rate of growth of average hourly earnings was 0.3 percentage points higher than expected. That doesn’t sound like much, but it’s actually quite a big miss. The wage data also hit a nine-year high at 2.9 percent, year-over-year.

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The surprise was enough to change investors’ perceptions of future inflation risk, triggering a 6.1-percent two-day plunge in the S&P 500 and the biggest-ever point drop in the Dow Jones industrial average. That’s quite a reaction to data that are not very reliable, especially at the point of initial release, and February’s reading is quite likely to return to the range in place since fall 2016. 

 

Markets have become unnervingly sensitive to the rate of growth of wages precisely because the numbers have been so well-behaved — from the perspective of corporate earnings, if not employees’ bank balances — for so long.

Wage growth has been between 2 percent and 2.5 percent for most of the past two-and-a-half years, so a sudden jump toward 3 percent is a significant event — if it lasts. Labor is the biggest cost, by far, for most companies. Faster growth in wages compresses profit margins, other things equal.

It also raises the alarming specter of more aggressive Fed interest rate increases, because most policymakers believe that accelerating wages are the key ingredient in the inflation-setting process. 

In previous economic cycles, the Fed has allowed wage growth to peak at about 4 percent. That’s some way from January’s 2.9 percent, so why the panic? The problem is that the Fed is now much less optimistic about productivity growth, which can offset the inflationary danger posed by faster wage gains.

In the past, the Fed could reasonably assume that productivity would rise by about 2 percent per year, so 4-percent wage growth would generate 2-percent increases in the rate of growth of unit labor costs and, hence, would be consistent with inflation also running at about 2 percent.

But productivity growth has been nowhere near 2 percent in recent years; the average increase since 2011 has been just 0.7 percent.

Recent data have been marginally better, but even if the Fed is prepared to assume, say, 1-percent productivity growth over the next couple of years, that would mean its tolerance for faster wage growth extends only to about 3 percent.

Indeed, former Vice Chairman Stanley Fischer said in early 2016 that “3 percent, I think, is roughly where people would like [the rate of wage increases] to be.” 

This would all be much less important if equity valuations weren’t already so elevated, at all-time highs on some measures, and Fed policy were not so far from normal. The capitalization of the stock market is at a record level compared to GDP, while inflation-adjusted interest rates remain below zero.

The Fed’s balance sheet remains hugely distended, thanks to its money-printing operations, though it is now shrinking slowly.

At the same time, fears that a surprising run of soft inflation numbers last spring and summer were a sign of trouble ahead have faded. The Fed’s favoured inflation measure rose at a 1.9-percent annualized rate in the fourth quarter, only marginally below the target rate.

What's more, the past few months have seen consistently strong economic data as well as the passage of the tax cut bill, which will add more demand in an economy where supply is struggling to catch up. The unemployment rate is now just 4.1 percent, a rate last sustained back in 2000, when wage inflation was heading toward 4 percent.

These conditions, coupled with the S&P 500 having jumped by 5.6 percent in January alone after a 19.4-percent increase last year, meant that investors didn’t need much of an excuse to take profits. Whether profit-taking becomes a sustained correction or, worse, a rout, depends on what happens next in the labor market.

In the good scenario, the upturn in wage growth will be offset by faster productivity growth — because firms finally are spending more on equipment and software — so margins are maintained, and the extra growth in wages boosts revenues.

If the long-awaited upturn in growth pulls people back into the labor force, limiting the downward pressure on unemployment, so much the better. The Fed will continue to raise rates, but no faster than they currently expect, and the rate hikes will not be viewed as a sign of panic over inflation risk. The stock market will be safe. 

At this point, however, there is no sign that labor participation is turning up, and the future path of both wages and productivity growth is uncertain. If the door really is now open to a sustained acceleration in wages, investors will have to factor-in the risk that the Fed could find itself dealing with an inflationary fire later this year.

That risk will be increased if the spending increases under consideration in Congress right now are implemented; they will add more to demand in the economy this year than the tax cuts.

U.S. economic policy right now is not just uncoordinated; Congress is doing exactly the opposite of what the Fed thinks is appropriate, because it is collectively focussed on the midterm elections, not the medium-term outlook for the economy.

Unnecessary fiscal stimulus, coupled with a tight and tightening labor market and a re-awakening of long-dormant inflation fears, are a potentially toxic combination for overvalued markets.

The warning signs have been visible for some time, but investors have been choosing to look away. That’s no longer an option.

Ian Shepherdson is the chief economist and founder of Pantheon Macroeconomics, a provider of economic research to financial market professionals. Shepherdson is a two-time winner (2003, 2014) of the Wall Street Journal's annual U.S. economic forecasting competition.