Investors have been so fixated on the waves of inflation and monetary policy this year, that other deeper undercurrents have received less airplay in terms of their longer-term potential to affect asset prices. If you wanted to come up with a hypothesis where inflation might stay higher for longer, requiring a higher level of interest rates, then you need a combination of factors that caps or erodes productivity growth, while pushing the pace of wage increases well above that growth.

 

As much as there were a number of economic data points this week that might have unnerved the Federal Reserve going into Wednesday’s FOMC meeting, I doubt none were as unsettling as hearing of a $30 billion agreement between the Teamsters and UPS – days ahead of the end of the current contract. If you wanted evidence as to how a tight labour market can be used as leverage, this was it. Without an agreement, roughly 340,000 UPS workers could have hit the picket lines and brought a sizable chunk of the U.S. delivery network to a halt.

 

 

Considering that this is a five-year arrangement, it is a major achievement for the union since UPS revenues for the past five years to 2023 have been approximately $456 billion.  This deal is a 7% extraction from that revenue pool. The market hasn’t been fazed by this and the stock price actually popped briefly above US$190 on the day the proposed deal was announced. It certainly hasn’t been hit like some would imagine. The main issue is that this agreement, if ratified by the union, is going to pave the way for action against other mega cap companies, such as FedEx and Amazon. This doesn’t mean that similar deals will get done or, in the case of Amazon, that unionization will emerge; but it does represent a signaling device for price setting in the labour market.

 

 

Back in March 2022, U.S. average hourly wage inflation was running at close to 6%.  Outside of the government injections at the time of the pandemic, this was the fastest wage inflation in a long time. There has been some relief in the fact that the pace of increase has slowed to 4.4% as of the last reading in June, but the Federal Reserve believes that only a 3% rate of increase would be consistent with achieving its 2% CPI inflation objective. As you can see from the above chart, the second quarter has seen a plateau in wage growth. If we use the UPS deal as a proxy then this would produce an average annual increase in wages of just under 3%. That is inside the Fed’s window of “comfort” but only just.

 

What about the economic recession?  Isn’t this going to create a void in labour demand and take the wind out of the sails of wage increases?  Well, U.S. real GDP growth clocked in at 2.4% in the second quarter – above what economists predicted and ahead of the 2% pace in the first quarter. The core personal consumption expenditure (PCE) measure of inflation rose 3.8%, which was below the 4.9% pace in Q1, but there seems to be an abundance of demand in the economy to allow retailers to pass on cost increases and potentially for businesses to pass along wage increases to retain or attract staff.

 

 

Canada is in a slightly different situation, as labour supply and demand is coming back closer to balance. There are still a large number of job vacancies out there, but they have subsided from the peak in 2022 when they surpassed one million positions. In previous commentaries I have discussed how the labour market dynamics this cycle are so unique, from the distortions created by the pandemic and the policy responses enacted, to the fact that some jobs (technology in particular) are more easily ported to other sectors to the massive immigration boom that Canada is in the middle of. The latter definitely speaks to the help wanted statistic since an increase in available labour will tend to bring this number down, all other things being equal. That should lead to a slower pace of average hourly wage increase and, therefore, less stress for the central bank. Indeed, the annual increase in wages dipped below 4% in June for the first time since May of last year there appears to be no signs of plateauing – at least yet.

 

 

While Canada is showing a different trajectory on wage growth than the U.S., the issue is that there is another element at play in terms of opposing the market’s desired disinflationary path. Let me say that there have been enough studies done that have shown that wage inflation does not normally create higher consumer price inflation. The problem is that these studies were run in periods of time that did not carry the same characteristics of today’s environment. This runs both ways. Today, we are dealing with stickier unemployment, created by easier labour migration across sectors, but we are looking at a longer-term possibility of increased labour-technology situation, especially with growth in AI. That will work against the potential for sustained wage growth due to labour shortage.

 

Let’s move away from labour economics and look at something more global, and that is the obvious trend towards more nationalistic industrial strategies. Like it or not, the world is watching the largest economy (the U.S.) do whatever it can do to preserve its place on the podium against China, the second largest. Party colour has nothing to do with this, which is a little scary, as subsidized and targeted fiscal investments in industries deemed essential are now becoming the norm. Other countries watching this battle have no choice but to see the bid and sometimes raise. We are moving away from a (in my opinion) successful experiment in competitive advantage, that led to decades of improving global growth to one where we are going to try to make chips, batteries and EVs better than the next country. The problem is that we all can’t be the best (I suggest a morning coffee read of David Ricardo).

 

 

At the start of the 1970s, world trade accounted for about 25% of total global economic output, as shown in the chart above. By the early 2000s, the share had doubled and at the start of the great financial crisis, world trade was worth more than 60% of global output. It has trended lower since then, falling to about 52% at the time of the pandemic, before rebounding in 2021 to above 55%. Undisturbed, this trend could take us back to 2000 levels in about 15 years from now. This is not an undisturbed situation.

 

The whole drive towards self-production of so-called essential items (often under the guise of national security) is a by-product of the anxiety over supply disruptions caused by the pandemic. An escape from economic common sense, if you will. Maybe a factory in Texas or Quebec will be able to produce items more efficiently than a plant in Asia (or perhaps Africa or Latin America), but if not the cost of those items will be higher than they need be. And if you can’t produce something cheaper and you want to maintain margin, then you charge more for it. Suffice to say, you aren’t as productive with the resources you put into that plant (compared to the other things those resources could have produced). If you are looking for a disinflationary force, this isn’t going to fit the bill.

 

Unfortunately, we are heading into a U.S. presidential election in 2024 and probably an election in Canada in the next couple of years. Other counties face their own political timetables, but “build at home” is resonating with the populace that we aren’t going to break out of this for the foreseeable future. This means that current inflation and interest rate expectations might be too low. For long duration equities, this suggests a revaluation is likely. For business and household borrowers, this also suggests a medium-term trajectory for interest rates that isn’t what is being factored into budgets and cash flows.  Oh and let’s keep in mind that central banks really don’t like doing anything substantially different in election years. Case in point, if Jerome Powell and the rest of the voting members on the FOMC believe that additional rate hikes are required to bring inflation back to the 2% target, they will probably want to get that done before next year.  

 

In summary, markets have to start factoring in some longer-term influences on the economy, prices and margins. These considerations don’t necessarily lead to a bearish long-term outlook.  Indeed, there are some positive inferences to pluck out from this. Companies may accelerate adoption of productivity-enhancing technology (like AI) to counter margin compression from higher labour and interest costs. Valuations that appear excessively high today based on current fundamentals may be fine when looking forward 5-10 years. For now, I do believe that a market that hasn’t adequately thought through secular productivity and cost trends is vulnerable to upsets and that reinforces the need for caution this half.

 

Clients of ours routinely reach out to us with questions on our newsletters and conference calls and for those of you who have started to read our views, I encourage you to contact Ally and myself with any questions you may have.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle, Senior Portfolio Manager, Senior Wealth Advisor

 

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