The U.S. economic numbers released last week preceded a slide in equities, prompting keen interest in what the data may have been signaling to markets.
While the data are noisy, and it’s risky to draw conclusions from one set of reports, we believe they may reflect some trends worth watching – chief among them rising capacity constraints and growing inflationary pressures.
Real productivity growth was surprisingly weak in the fourth quarter (down 0.1% from the prior quarter on a seasonally adjusted annual rate basis), and unit labor costs accelerated to 2.0% despite some moderation in real compensation growth.
The headline ISM Manufacturing Index moderated less than expected due to slowing supplier deliveries, while the production, new orders and employment indexes each declined. Meanwhile, the prices paid index increased to the highest level since 2011.
Labor market aggregate hours, which correlate with real economic output, declined 0.42% month-over-month in January, while average hourly earnings gained 0.3% month-over-month and rose 2.9% year-over-year – the highest rate since 2009.
Teasing out the data
These data come at a time when unemployment is below various estimates of the non-accelerating inflation rate of unemployment (NAIRU), broader measures of labor market underutilization are close to pre-crisis levels and payroll growth appears to have peaked for this cycle and is decelerating. More broadly, over the past 30 years, we’ve observed just one period when decelerating payroll growth coincided with accelerating real GDP growth: during the late-1990s productivity boom.
What is the takeaway from all of this? The U.S. is starting to look more like an economy that is in the later stages of its business cycle. Absent a pickup in productivity growth, slowing payroll growth and rising economic capacity constraints should coincide with a gradual deceleration in real economic activity and building inflationary pressures. Along these lines, the weak labor productivity report released last week may raise questions about whether and to what extent productivity will rise over the coming year in response to fiscal expansion.
Equity market behavior is mimicking historical periods of accelerating inflation, slowing growth
While a range of indicators show that U.S. economic activity accelerated in the second half of 2017, the equity market deterioration is more in line with historical behavior during periods of accelerating inflation and slowing growth. In a 2014 study1 that calculated global equity market Sharpe ratios conditioned on macroeconomic cycles, equity performance was shown to be best during periods of decelerating inflation and accelerating economic growth – the state of macroeconomic fundamentals over much of 2017. The reverse was also shown to be true.
Our own research backs this up: In an analysis of the U.S., U.K., European Union and Japan that conditioned equity market performance on our economic activity and inflation indicators, we found Sharpe ratios were generally highest when equities were held during periods of decelerating inflation, and vice versa – a pattern that held even in Japan, which has experienced a prolonged period of low inflation (the exception was the FTSE 100 in the U.K.).
The equity market slide began against a backdrop where our growth and inflation metrics indicate that inflation has been picking up for the past several months, while economic activity also continues to accelerate – an environment historically consistent with more muted, but still positive equity market performance in the U.S. However, could the recent equity moves reflect the possibility that last week’s data is the start of a broader inflection point? Perhaps markets are already trading on the probability that the U.S. moves into a new macroeconomic regime characterized by lower economic activity and firming inflation.
For more of PIMCO’s views on equities and other markets, see our recent Asset Allocation Outlook.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.
1 Antti Ilmanen, Thomas Maloney and Adrienne Ross. “Exploring Macroeconomic Sensitivities: How Investments Respond to Different Economic Environments,” The Journal of Portfolio Management, Vol. 40 No. 3, Spring 2014