Stocks continued higher amid great economic and corporate earnings news last week, while interest rates remained within a trading range.
If you are an equity investor, it is hard to question the direction of earnings. They are headed higher, a lot higher. With all the stimulus from both the Fed and Congress flowing through the economy, and more to come, it is hard not to be optimistic. If you have a longer memory than I, the two-year Spanish flu epidemic of 1919-2021 was followed by the Roaring 20’s. Get out those flapper dresses, it’s party time!
As I point out frequently, stock prices aren’t just a function of earnings. They are a function of earnings and interest rates. Interest rates are tied to inflation, or at least inflation expectations. The Federal Reserve recognizes inflationary pressures but treats them as transitory. Transitory means ignorable. Commodity price spikes (think lumber and gasoline) will disappear quickly, as higher prices bring more supply. It’s just a matter of time. Other pressures come from supply chain disruptions. Post-pandemic, demand has risen faster than supply. But according to the Fed’s view, it is only a matter of time before that catches up as well. Those empty car dealer lots will get replenished before too long, and ketchup packets will reappear soon. The Fed is probably right, although “before too long” may be question to some debate.
If you look at inflation, there are two dominating components. One is shelter cost. That doesn’t mean home prices, but rather the cost of occupancy. That means rents and interest rates. Rents are starting to rise in reaction to the sharp increase in home prices, but it isn’t excessive. As for interest rates, they remain low.
The other factor is wages. That is what I want to talk about this morning. I am a numbers guy. I am going to throw at you a series of numbers to make a point. The point suggests higher inflation. How much I will leave to persons smarter than me. According to the Census Bureau, our population is going to grow from 332.6 million in 2020 to 355.1 million in 2030, an increase of 6.7% or slightly lower than 0.6% per year. That is a projection, not a fact, but it isn’t likely to be far off unless there is a collapse in the birth rate or a major change in the level of immigration. Any change will be in the tenths of a percentage point. But beneath that number, there are some stark differences. The core working age group, 18-44 years old, is going to grow less than 4%, or a bit over 0.3% per year. 16-24 will grow even less. In other words, few will be entering the workforce. However, 65+ will grow by 30%. As a group, they are less than half the 18-44 age adults, but 75%+ will retire over the next decade.
Put all this together and it is clear the labor force over the next decade will barely grow unless there are a lot of non-working 18-44 years old not now in the labor force who decide to go to work. In the meantime, GDP growth this year will be 7-10% if you ignore changes in inventories, and it will likely grow close to 4% next year. This is in real terms ignoring inflation.
Now we get to the math. Supply, the number of workers available over the next several years, will barely grow. The 18-44 age group will not grow greater than 0.4%, while the baby boomers will be retiring in increasing numbers. While low interest rates have minimized retiree income, rising stock valuations and increased home prices have increased wealth and accelerated retirements. The net is a very low increase in supply. At the same time, demand is likely to grow at a greater-than-average rate for an extended time. Let’s say at least 2-4 years.
That alone would suggest rising wage pressure. We are just starting to see that. There is an offset, however. It’s called productivity, the output per man hour. Post-recession, productivity rises sharply. That isn’t a generalized statement, it happens all the time. Quite simply, demand rises fast and employers are reticent to hire additional workers until they are sure recovery is assured. But that productivity spike doesn’t last, it persists for maybe a year. Right now, we are in a productivity spike, therefore, there are few signs of inflation.
For the last 50 years, there has not been sustained productivity gains above 2%. While we always hear “this time is different”, that’s a speculation. If your inflation target is 2%, productivity rises 2%, and wages rise 4%, everything is OK. But if wages rise by more or productivity rises by less, there is a problem.
I don’t have an answer. But demographics suggest a slowing growth in the labor force at a time when growth, accelerated by both fiscal and monetary stimulus, is higher than average which yields increasing inflationary pressure.
Demographics and productivity are the secret sauce(s) of economic growth. You can fool with everything else but policy won’t change demographics or productivity. If policy exerts undue pressure, the response is likely to be higher inflation. We’ll see what happens, but we know that higher inflation is the enemy of this bull market. I don’t want to predict, but I remain watchful. Enjoy today’s good news but watch the sources of pending inflation, particularly wage pressure.
Today, Bono is 61. Happy Birthday today to my daughter-in-law Elaine, and to my grandson Jarett tomorrow.
James M. Meyer, CFA 610-260-2220