The US Labor problem: What markets are missing

The US economic expansion is brittle, and the Federal Reserve knows it. Recent exuberance over an uptick in wages is misfounded when you look closer at the data. US wage growth remains weak -it has been weak for years -and the US recovery cannot continue unless wage growth picks up. Contrary to recent signals in equity and fixed income markets, the concern is not overheating: the concern is a collapse in consumer spending.

The Labor market looks tight, and the US unemployment is at 4.1%. Since mid-2014 there have been more job openings than new hires – a rather clear sign that firms are having difficulty finding workers. This should presage wage growth, as firms compete to pull workers back into the workforce or to attract workers away from other firms. But the evidence points to a much more problematic issue – firms are having difficulty finding the right type of workers, in the right places. There is a skills and geography mismatch.

This is seen in survey data collected by the Federal Reserve but it’s also evident in the wage data. There has been hardly any increase in total average wages since 2015. The bottom 82% of workers  – non supervisory workers – have seen even lower wage growth than average. This is because firms are chasing after scarce workers, the top-18% of workers, who have seen a strong positive trend of wage growth since 2014.  Markets incorrectly interpreted a spike in average hourly wages last week as signs of a stronger recovery, but when you look at the disaggregated data, you see that average wages was pulled up entirely by a big bump in wages paid to the top 18% of workers, possibly just year-end bonus payouts.

The US is a consumption economy. Seventy percent of GDP comes from consumption growth. Since 2011, consumption growth has exceeded average wage growth.

Consumer spending has been solid, despite the lack of real wage gains. In 2017 consumer spending grew at 2.7%, well above average wage gains. This deficit has been made up by a drop in the savings rate to its lowest level in a decade, and an increase in consumer credit to all-time highs, back above levels recorded during financial crisis. This is unsustainable. Without real wage growth picking up, consumers will be unable to spend at these levels going forward, which will lead to lower levels of GDP growth.

We believe the US will grow at 2.8% in 2018. We expect high fixed investment and solid consumer spending. Some additional consumer spending is enabled by the recently passed Tax Plan, which provides more income for low income households. But alone, this isn’t enough. This economic expansion will not endure unless real wage growth for the bottom 80% increase above consumption growth, but this has several direct implications for multinationals firms:

  • For the economy as a whole, the price paid for strong topline growth in consumer segments is inextricably linked to margin pressures from increased labor costs. Without strong wage growth, consumers will not be able to maintain consumption growth. Bottom-line targets may need to be revisited to take into account this relationship between revenue growth and operating margins.
  • A lack of wage growth will lead to lower consumption, as consumers exhaust available means of continued financing of consumption via drawdowns on credit and savings. This leads to a slower path of rate hikes than is currently being forecast by FSG and by markets. This would reduce US imports and lead to more dollar weakness.

The Fed is watching wages, and the price paid for misinterpreting the wage data has been paid by the markets since Friday. If you have to choose only one macroeconomic indicator to monitor the health of the US economy and earnings growth, it is wage growth.

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