Market Bulletin February 21, 2018 The real story behind wages In brief Nominal wage growth has not accelerated as expected post-crisis, leaving observers concerned. Structural constraints and persistently low inflation will likely curb future nominal wage growth. Real wage growth tells a different story. Wage growth less inflation has trended higher in the last several years, indicating that the real purchasing power of workers has increased. As inflation starts to pick up, nominal wage growth should move up in tandem and the Federal Reserve should continue to normalize monetary policy. As a result, investors should prepare for a changing investing environment. John C. Manley Market Analyst Wage growth worries A steadily improving labor market has been one of the most dependable elements of this expansion. Yet despite the unemployment rate falling for nearly a decade, wage growth has remained elusive: the yearly growth of average hourly earnings has averaged roughly 2.2% since June 2009, compared to 4.6% in the 40 years prior 1. It would appear that the traditional, inverse relationship between the unemployment rate and wage growth has recently broken down, leaving wages to stagnate while the labor market tightens. This has baffled economists and disappointed workers, and at this stage in the cycle has become one of the most pressing concerns for investors. An unusually strong reading in January headline wage growth briefly stoked inflation fears, but seasonal effects may have contributed to the strength.
Weakness in nominal wage growth is arguably structural, rather than cyclical, in nature. Some structural constraints include: The federal minimum wage of $7.25, which has not changed since July 2009. Some state minimum wages have increased, and certain corporations have promised wage increases related to tax reform windfalls, but overall, mandatory wage levels are increasing slowly. The continued decline of labor union participation, which now sits at 6.5% of all private sector employees, down from 16.8% in 1983 2. As a result, employees have lost their ability to collectively bargain. A so-called hangover effect from the global financial crisis. Employees are less confident that they can demand a raise, lest they be laid off in favor of a cheaper substitute (human or machine). Inflationary conditions impact wage growth, too. Periods of high inflation are historically contemporaneous with periods of high nominal wage growth, as shown in Exhibit 1. This relationship is statistically significant: over the past 50 years, changes in headline inflation account for nearly 65% of changes in average hourly earnings. Post-crisis inflation has been weak relative to the longterm average. January s headline CPI reading of 2.1% is nearly a standard deviation below trend, despite nearly a decade of low interest rates and several rounds of quantitative easing. This, coupled with an increasingly tight labor market, suggests that the present U.S. economy is able to absorb more stimulus than in the past. It stands to reason, therefore, that in the post-crisis low inflation regime, nominal wage growth should be suppressed. With only modest upside risk to inflation in the near- to medium-term, nominal wage growth will likely remain low compared to the long-term average for the remainder of this economic cycle. EXHIBIT 1: HEADLINE INFLATION AND WAGE GROWTH Headline CPI and average hourly earnings, percent Average hourly earnings (y/y) 1 8% 6% 4% 2% -4% 4% 8% 12% 16% Headline inflation (y/y) Management. Data are as of February 20, 2018. What s really happening with wages? Structural constraints imply that strong wage growth will be hard to sustain, and the current low-inflation environment is similarly challenging. The lack of wage growth is therefore particularly concerning to many observers, since the market forces that previously encouraged it are now behaving differently. But despite post-crisis weakness in nominal wage growth, concerns around hourly earnings may be overblown. Looking at real wage growth (the nominal figure less headline inflation 3 ), the most recent figure of 0.3% sits just above the 50-year average. This is the ninth consecutive above-trend figure. Indeed, as shown in Exhibit 2, the majority of real wage growth observations have been above the long-term average. This contrasts sharply to the trend seen in nominal wages, which helps to explain recent pessimism: no headline observation has surpassed the long-term average since June 2007. In addition, nominal wage growth has generally been well below trend since the late 1970s, a period characterized by runaway inflation in the face of easy-money central bank policy and skyrocketing global oil prices. 2 WAGE GROWTH
Moreover, five-year rolling cumulative real wage growth has picked up meaningfully since mid-2014. The most recent figure of 4.4% is nearly a standard deviation away from the mean, as shown in Exhibit 3, and rolling real wage growth has trended well above average for almost twenty years. By comparison, nominal cumulative wage growth has been consistently below the long-term average since the mid-1980s, when inflation collapsed under pressure from high Volcker-era interest rates. The data suggest two things: first, that the real purchasing power of the American worker is both healthy and increasing; and second, that employers have been raising wages in real terms despite structural constraints. EXHIBIT 2: NOMINAL AND REAL YEAR-OVER-YEAR WAGE GROWTH Private, seasonally adjusted, percent 12% 1 8% 6% 4% 2% -2% -4% -6% -8% 50-yr avg.: 4.2% 50-yr avg.: 0.1% Real wage growth Nominal wage growth '68 '71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16 2.4% 0.3% Management. Real wage growth is calculated as nominal year-over-year wage growth minus year-over-year headline inflation for the corresponding month. Data are as of February 20, 2018. EXHIBIT 3: CUMULATIVE REAL AND NOMINAL WAGE GROWTH Private, seasonally adjusted, percent 6 5 4 3 2 1-1 -2 50-yr avg.: 0.3% Nominal wage growth Real wage growth 50-yr avg.: 23.6% 12. 4.4% '69 '72 '75 '78 '81 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11 '14 '17 Management. Real wage growth is calculated as nominal year-over-year wage growth minus year-over-year headline inflation for the corresponding month. Data are as of February 20, 2018. The psychology behind wage growth woes Weakness in nominal growth, therefore, is not only warranted given the macroeconomic backdrop, but is also irrelevant from a purchasing power perspective. In fact, inflation and real wage growth are inversely correlated, suggesting that real wage growth is strongest when inflation is low 4. So why has weak nominal wage growth been a persistent concern throughout the expansion? The answer probably lies within the realm of worker psychology: nominal wage growth in absolute terms feels good regardless of inflation levels, perhaps because wage growth sentiment extends beyond purchasing power. For example, nominal wage growth may be seen as a proxy for an improving economy, or as a reward for improving personal performance (a raise). The fact that wage growth is often decried as absent despite evidence to the contrary suggests this. J.P. MORGAN ASSET MANAGEMENT 3
The path moving forward and investment implications As the economy moves later into the cycle, goods and services inflation should begin to materialize, further fueled by fiscal stimulus from tax reform. Beyond this, asset price inflation, such as in homes and stocks, has been consistent throughout the expansion. The subsequent additional household net worth should eventually feed through to higher consumer prices. Alongside inflation, a further-tightening labor market should continue to put upward pressure on real wages, which are more responsive to the unemployment rate than nominal wages 5. This may result in nominal wage growth improving by the end of 2018, though given structural constraints, it may still trend below average, particularly if inflation remains range-bound. This being the case, we believe that the Federal Reserve will continue with its balance sheet normalization program, and that three rate hikes, with upside risk to four, remain likely in 2018. This will challenge fixed income investors, who have enjoyed a decades-long bond bull market. Equity investors may also struggle, as markets adjust to tighter financial conditions, especially if margins compress under pressure from wages. As a result, investors should be aware of their positioning and seek opportunities across regions and asset classes to maximize returns in this evolving investing environment. 4 WAGE GROWTH
References 1 All quoted wage growth figures are for production and nonsupervisory workers only. 2 Bureau of Labor Statistics, Union Members Summary, January 19, 2018. 3 Headline inflation is chosen rather than core to more accurately represent the spending habits of American consumers. Energy and food goods factor heavily Headline inflation is chosen rather than core to more accurately represent changes in the cost of living for American consumers, because while core inflation is likely a better predictor of future inflation, increases in food and energy prices impact worker living standards. All inflation measures use CPI. 4 The 50-year correlation between year-over-year headline inflation and year-over-year production and nonsupervisory hourly earnings growth is -0.74 with an r-squared of 0.55, suggesting a fairly strong inverse relationship between real wage growth and headline inflation. 5 The 50-year correlation between the U-3 unemployment rate and year-over-year real wage growth is -0.16, compared to the 50-year correlation between U-3 and year-over-year nominal wage growth (-0.04). The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions.] For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II / MiFIR requirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research. This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields is not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited (Co. Reg. No. 197601586K), or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd (Co. Reg. No. 201120355E); in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number Kanto Local Finance Bureau (Financial Instruments Firm) No. 330 ); in Korea by JPMorgan Asset Management (Korea) Company Limited; in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919); in Brazil by Banco J.P. Morgan S.A.; in Canada for institutional clients use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan Investment Management Inc. Copyright 2018 JPMorgan Chase & Co. All rights reserved. MI-MB_Wage_Growth 0903c02a8208e3c9