Workers of the world, unite!
A significant feature of the last couple of decades has been flat or little income growth for most workers after taking account of inflation. With unemployment so low in most of the major economies, this should be the opportunity for employees to claw back some of their losses – hence their growing willingness to leave and find a new job, or threaten to strike for higher pay.
To give a few statistics, unemployment in the UK is close to record lows at 3.7%. Vacancies well above 1 million show the strong demand for labour as industry after industry recovers from the pandemic, while many workers are either suffering from long term illnesses or have decided to take early retirement. The result is much publicised problems facing industries such as airports and airlines to find enough staff.
Last week’s employment report for June in the USA showed some interesting trends. The economy added 372,000 jobs in June, not supporting the chit chat about a recession. However, volatile monthly data means it is necessary to look at the bigger picture. Payrolls rose by an average of 375,000 in the second quarter, down from an average 539,000 in the first quarter, indeed the smallest quarterly job gain since the end of 2020. A measure of the whole economy index of hours worked shows continued expansion, but down from close to 7% in mid-2021 to below 3% a year. Although the jobless rate remained at 3.6%, all the signs are that the trough has been seen.
What about wages? Certainly they show signs of strength as firms are forced to bid for staff. Average hourly earnings grew 5.1% from a year earlier. Economists at, for example, Goldman Sachs, suggest that such wages growth needs to fall towards 4% in order to meet the Fed’s inflation target, which chimes with the Fed’s forecast of a modest rise in the unemployment rate into 2023. This makes sense: job openings and quits are declining, and weekly jobless claims are rising as many publicly traded companies announce hiring freezes or slowdowns.
How are such wage pressures and the seemingly inexorable rise in raw material costs feeding through into headline inflation? Badly. In this week’s US inflation report for June, headline inflation was expected to reach 8.8-8.9% in the year to June – so the news was rather disappointing that the actual figure reached 9.1%. This was the fastest pace in four decades, and the details were distinctly unhelpful too – gasoline costs led the way, of course, but a wide range of price increases across housing, insurance and leisure meant the annualised rate of core inflation approached 8%. The only positive aspect for forecasters was the decline in oil and gasoline prices in July, suggesting June might be the inflation peak.
How are central banks responding to this mix? Markets have priced in a Fed move of 0.75% at the next meeting and are debating whether 1% is more likely. That would be followed by further increases of 0.5% in both September and November, and 0.25% in December. Other central banks are also under pressure. The big question is whether the ECB’s first rate hike next week will be 0.25% or 0.5%. The Euro moving towards parity versus the US dollar will add to such speculation. Elsewhere, Andrew Bailey warned that the Bank of England is prepared to hike rates in bigger steps as “There are no ifs or buts about its goal to bring inflation to 2%”. Investors are pricing in a hike of 0.5% at the August MPC meeting, especially after UK GDP growth was stronger than expected in May.
Of course the surge in raw material costs has also been acting as a squeeze on economic activity. Together with the shot to confidence from the Ukraine war, forecasts for GDP growth in Europe continue to decline. For example, Deutsche Bank has raised its probability of a forthcoming recession in Europe to 60%.
The upshot is that bond markets are trying to price in a full rates cycle, much higher in 2022 but then lower rates into 2023-24. US 2 year bond yields are now about 3.25% as they anticipate future Fed rate hikes, but 10 year benchmark yields have fallen below 3% as recessionary risks are priced in. Similarly, German bond yields have reacted to expectations of a rather different growth and inflation path. For example, a month ago markets were pricing the ECB’s deposit rate at 1.2% in December 2022 reaching 2.1% by June 2023. Now, the market is pricing in 0.9% for December and 1.3% in June 2023.
Global benchmark bond yields have started to fall back as such views gather pace. Central bankers will continue to pay close attention to labour markets, however; on the one hand are workers being laid off rapidly, suggesting that recessions are rather closer, or conversely do workers manage to extract even larger wage increases, suggesting that even higher interest rates are needed. The battle between labour and management has significant implications for fixed income markets in coming months.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 3.24 3.12 2.99
UK 1.95 1.84 2.12
Germany 0.55 0.92 1.20
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making