As recently as March of this year, wage growth remained elusive in this cycle. Fast forward six months, and wage growth has picked up in a synchronous fashion across the G3—U.S., the euro area and Japan—standing at multi-year highs in all three geographies.
In the U.S., average hourly wages are growing by 2.9%Y (versus an average of 2.5%Y in 2017), euro area compensation per employee is rising by 2.3%Y (1.6%Y) while cash earnings per employee in Japan are growing by 1.1%Y at a 4Q moving average (0.4%Y).
With wages finally gathering steam, it’s natural to worry whether they will lift inflation meaningfully above central banks’ goals or dampen corporate profitability. My colleagues and I at Morgan Stanley Research believe that two key parameters—the ‘normal’ level of wage growth and unit labor costs—indicate that the starting point of wage growth is not yet a cause for concern. However, as I’ll detail in a moment, we will be watching corporate balance sheets for signs of stress.
Wage Growth Normalizing
Wage growth across the G3 remains below normal levels, but the gap has narrowed: Only when nominal wage growth outpaces our rule of thumb for normal wage growth—the trend of labor productivity growth plus central banks’ inflation goal—do inflationary spillover and corporate profit pressure occur. Over the past six months, the gap between actual and normal wage growth has narrowed by 14bp, 66bp and 124bp, respectively in the U.S., euro area and Japan. Currently, the gap in the U.S., euro area and Japan now stands at 50bp, 60bp and 110bp, respectively.
The recent improvement in productivity growth has held unit labor cost growth in check: Unit labor costs (which measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output) remain below prior peaks in the U.S. and Japan. In the euro area, they are approaching a nine-year high, thanks to the conclusion of recent rounds of wage negotiations, but they should moderate going forward as the impact of these negotiations drops out.
Wage Growth Not Inflationary Yet, but Gap to "Normal" is Narrowing
Weighing the Risks
How do we see wage dynamics evolving from here? In our base case, overall economic growth momentum is sustained and utilization ratios keep rising: Labor markets continue to tighten and wage growth improves further. However, we do not project wage growth crossing normal levels meaningfully, keeping unit labor costs contained. Against this backdrop, we do project inflation heading towards central banks’ goals (and, in the case of the U.S., moderately above) but view the chances that inflation significantly overshoots central bank goals as relatively low.
That said, we’re mindful of the risks that wage growth could go above normal, adding upward pressures to unit labor costs and corporate profitability. While the usual concern would be about potential upside risk to inflation, we see things differently. In the last two U.S. business cycles, wage growth accelerated to cycle highs, but the Core Personal Consumption Expenditure Price Index did not rise meaningfully above 2%Y.
We think the challenge to the cycle emanates from corporate credit risks: Increases in unit labor costs will eventually dent corporate profitability. Real rates will rise as central banks, observing that wage growth is accelerating and economic slack is diminishing, continue to tighten. Stress in the corporate balance sheet could therefore build up and emerge as a key downside risk to the macro outlook.
Labor markets do have some room to strengthen before challenges emerge and hence we think that this is not an immediate risk. However, it may materialize later in the cycle and is a key risk that we are watching. The next few months’ data points on wage dynamics will therefore warrant close monitoring.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” series (September 23, 2018). Ask your Morgan Stanley representative or Financial Advisor for the latest market strategy coverage and reports. Plus, more Ideas.
