Few Friends for New Trends

For readers who made it through my quarterly management commentary, it should come as no surprise that wage pressure is a growing concern for many businesses. An increase in operating costs, particularly employee related, is a relatively new business trend I noticed earlier in the year. As the trend became clearer in Q2 2017, I began documenting and sharing my observations with readers.

In addition to providing numerous company-specific examples, I continue to collect a growing list of anecdotal evidence from readers and personal experience. For example, after being shocked and awed by our homeowner’s insurance renewal a few days ago, I called our insurance agent to ask for an explanation. The representative blamed higher premiums on the rising cost of home repairs and construction. I informed the agent that she must be mistaken, as the Federal Reserve has been very clear on this subject — inflation is not a problem, and in fact, is inadequate. She laughed and said, “Yeah, yeah, I know, I know, you don’t have to tell me about rising expenses.”

I also noticed more anecdotal evidence of rising wages last week. After our three-year-old dishwasher decided to break down a day before Thanksgiving (I thought quality was improving Mr. Hedonic Adjustment!), I went to the local hardware store to search for a part. While walking into the store, I was greeted by a sign advertising $15/hour positions. That’s pretty good, I thought! But the need for labor didn’t end there.

As I drove home contemplating working for a local hardware store, I drove by a Walgreens with its sign advertising “flu shots” and “hiring”. Shortly thereafter, I found myself stuck behind a school bus with a “drivers wanted” sign taped to its back window. If this wasn’t enough to convince me to write another post on the tight labor market and rising wages, a commercial advertising employment opportunities (included signing bonus!) at a waste management company came on the radio.

In summary, thanks to our broken dishwasher, I was introduced to four job leads all within fifteen minutes. I can’t wait for the refrigerator to break!

And finally, I ended my week with an interesting conversation with an owner of a large lawn service company. He was lamenting on how difficult it was finding workers. In fact, he said his company doesn’t want or need new business, but desperately needs employees. I told him I’d be happy to help as I enjoy mowing the lawn, but wouldn’t be available during allergy season! Given his capacity constraints, I also mentioned raising prices may make more sense than chasing a dwindling pool of available workers. He seemed to like this idea better than putting me on one of his crews!

While signs of rising wages and costs are becoming more apparent, inflation doesn’t appear to be a very popular topic for most investors — including the bulls and the bears. While the bulls love rising asset prices, they’re not particularly fond of inflation spilling over into the real world. In my opinion, rising inflation would be devastating for the bulls, as it would undermine one of their key assumptions used to justify current asset prices. Specifically, the assumption interest rates will remain abnormally low indefinitely.

Bears, on the other hand, aren’t especially open-minded to rising costs and wages either, as it conflicts with certain bearish views on the economy. Many bears believe the economy is weak, saddled with debt, and incapable of generating wage and cost pressures. While I agree the tremendous amount of debt accumulated over the years will have serious consequences, I do not believe the economy is currently weak or incapable of generating higher prices.

And then there’s the policy makers. Despite their own Beige Book stating otherwise, most Federal Reserve members continue to believe wage growth and inflation is too low. In fact, while watching Bloomberg TV last week the following headline appeared, “Yellen Says It’s Dangerous to Allow Inflation to Drift Lower”. Out of curiosity I read the article (link) and discovered Janet Yellen is in fact concerned “raising rates too quickly risked stranding inflation below the U.S. central bank’s 2% target and there’d been ‘some hint’ that expectations for future price increases may be drifting lower.”

While I don’t know the precise rate of inflation, based on the last two quarters of corporate operating results, I’m very confident trends in cost and price are not “drifting lower”. My view on inflation is focused more on trend than a specific rate. Is inflation running at 1%, 2%, 3%, or 4%? I don’t know exactly, but the trend, in my opinion, is very clear – it’s higher. How long and how far this trend goes remains to be seen. However, to say inflation is currently drifting lower conflicts with what many businesses are reporting and openly discussing.

Although many investors and policy makers remain in a deflationary mindset, several investors I know and respect recently contacted me to provide support of my bottom-up views. In effect, they reassured me while my views were in the minority, I was not crazy or alone.

A former fund manager who continues to monitor the markets closely sent me the following chart on the number of times “wage pressure” was mentioned on conference calls. I’m not certain of the sample size, but the trend certainly confirms what I’ve been noticing over the past two quarters.

Another knowledgeable investor sent me an article from The Economist titled, “Blue-Collar Wages Are Surging. Can it last?” As the title implies, the article discusses the generous wage gains blue-collar workers are currently enjoying, further supporting my belief wage pressures are building in many areas of the economy.

In the current job market, finding an MBA to enthusiastically recommend stock buybacks and acquisitions isn’t difficult — they’re a dime a dozen. However, try hiring a skilled worker to wire your house, drive your goods cross country, or nurse your patients back to health. It’s much more challenging.

A shortage of skilled labor would help explain why certain blue-collar wages are growing at a healthy 3-5% rate (per The Economist article). Interestingly, The Economist’s blue-collar estimate is similar to the Atlanta Fed’s 3-4% estimate of median wage growth (link). I found the rate and trend of the Atlanta Fed’s wage growth tracker (chart below) to be informative and similar to my bottom-up view.

In my opinion, current trends in wages should be concerning for investors extrapolating the past to support future asset price assumptions. For example, how would investors respond to an employment report confirming mid-single-digit wage inflation? Where would the 10-year Treasury and stock market trade with wages expanding 3% to 5% a year? I’m not certain, but I believe some very confident and important inflation, interest rate, and valuation assumptions would need to be adjusted.

This isn’t the first time my bottom-up macro views have conflicted with the top-down consensus. Furthermore, business trends have and can reverse, especially in an economy overly dependent on asset inflation (all bets are off assuming a sharp decline in financial markets). That said, based on my current observations and analysis, I believe the deflationary scare popularized throughout the current market cycle is coming to an end.

Will incoming wage data and shifting trends in inflation eventually force bond and equity investors to reconsider their valuation assumptions and long-held beliefs? Current bottom-up analysis suggests it’s possible, but only time will tell if new trends in cost and price will persist or be acknowledged.