Expecting The Unexpected...

2017 turned out to be a banner year for investors. Stock markets around the globe produced stellar gains with limited volatility and even bonds inched ahead in the face of gradually rising rates. Understandably, most are wondering if this benign environment can continue in 2018.

In a recent article, the Financial Times predicted that this year may mark the end of the current “Goldilocks” investment regime characterized by solid economic growth and low inflation. Investors tend to use their recent experience as the baseline for what will happen in the future. But heightened expectations for the economy today can be the perfect set up for disappointment tomorrow.

So what might alter the current landscape? The list of possible culprits is long and includes any number of geopolitical calamities, cyber attacks and slowing growth in China. But the one I am keeping an eye on and I think is least “baked into” expectations is the possibility that after more than 25 years, inflation finally begins to rear its ugly head.

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Steady job gains have driven the unemployment rate from 10.0% in 2009 to 4.1% today, its lowest level since late 2000. Under normal conditions, the shrinking supply of workers would drive wages higher but paychecks have barely kept pace with inflation throughout this period. Economists have been scratching their heads trying to figure out why. Possible causes include the threat of low cost foreign labor to the rise of the “gig” economy and its related use of part-time workers. Whatever the cause, wage gains may finally be picking up steam. Median household income after inflation gained 5.2% in 2015 and another 3.2% in 2016.

The two charts on this page shed some light on the improving picture for workers. On a national level, manufacturing and other blue-collar occupations are witnessing some of the biggest increases with recent pay growth exceeding 4%. The cheaper dollar and higher energy prices are likely contributing to some of these gains. On a local level, smaller cities with low unemployment rates such as Minneapolis and Fort Myers are also seeing a pick up in wages.

Consumer spending continues to drive two-thirds of our nation’s economy so putting more cash in the hands of workers is not entirely a bad thing. But wage gains can also fuel inflation if employers pass these costs on to consumers in the form of higher prices. Whether they do or not has a lot to do with productivity. Rising productivity allows companies to produce more with the same amount of inputs and results when they invest in new technologies and processes. The problem here is that productivity gains in the U.S. have been fairly muted, rising just 0.8% a year over the last five years compared to the long run annual average of over 2%.

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Historically, a booming job market tends to be followed by increasing productivity as companies step up their investment in labor saving equipment and software to offset rising costs. Whether this form of “capital substitution” occurs will be central to whether inflation, and the higher interest rates that come with it, sneaks up on us in 2018.