BlueBay AM: It’s all about wages (and football)

2 juli 2021

All eyes are on the data…

...except when they’re watching the England game.

A quiet week in the run-up to today’s US jobs report saw markets largely track sideways, with equity indices continuing to eke out new record highs as we reached the end of the second quarter.

Although rising Covid infection rates in the UK have raised concerns with respect to the Delta variant, it would appear that vaccines are largely mitigating serious illness and hospitalisations. In that context, the re-opening of economies continues to move ahead and markets have been largely non-plussed. 

However, it may be necessary to keep one eye on this data and the speed of transmission of the Delta variant must be a cause for some concern in those countries that have lagged regarding vaccination uptake. 

Wages & labour markets

Dialogue with policymakers has tended to highlight a growing view that relative sluggishness in labour markets over the past couple of months may reflect a shortage of supply, rather than a lack of job openings. Generous government benefits during the pandemic appear to have created a disincentive to work, but these are set to wind down, suggesting that there should be some normalisation. 

Nevertheless, in the short term there appears widespread and growing evidence of wage pressure building as companies seek to attract staff, particularly in lower paid jobs in the service sector, as hospitality re-opens. US GDP has already recovered the output lost during the pandemic, but employment has lagged. 

At an anecdotal level, this has meant that US airlines are struggling to run services due to an inability to source catering in hubs like Dallas. The Chipotle chain is offering new joiners free pet insurance as part of a benefits package, while in many US hotels, it is now difficult to order room service or even get beds remade every morning. This has prompted at least one hotel chain to make tips a compulsory upfront charge at the point of check-in, though it does seem odd to think of a practice in which gratuities are no longer discretionary.

Wage inflation is also apparent in the UK. Local restaurants in London that were paying service staff GBP9 per hour before the pandemic report a struggle to retain talent today, despite now paying more than double that rate. This is leading these outlets to bring in inexperienced staff, which in turn means that sectors from dog walkers to childcare providers are all struggling to find staff to meet demand. 

The situation has been exacerbated by an exodus of young overseas workers due to Brexit, as well as the pandemic. Farmers are worried about who will be available to pick produce and there seems plenty of talk within the small business community regarding passing on additional costs to consumers. 

It has been a long time since developed economies have experienced much by way of wage inflation, after a couple of decades in which median incomes have fallen in real terms, as the GDP share awarded to labour has shrunk relative to capital. 

Technological change has not come to a halt and the automisation of jobs has not gone away. However, workers may be in a stronger negotiating position than in the past – particularly if expansive fiscal policy and negative real interest rates continue to drive growth, with the outlook for consumption, investment and government expenditure all looking robust. 

Consequently, with most eyes focussed on the number of job additions within the monthly NFP report today, we will be equally interested to follow the trend in average hourly earnings, with this figure probably at its highest level since the inception of the data series in 2006 (notwithstanding a temporary spike last year) and set to trend higher, in our view.

We believe that focussing on wage developments is important, as labour costs tend to be the leading driver of service price inflation, as the biggest cost input. The next US CPI report will be closely watched in the middle of the month and we are inclined to see core prices move higher again in June. Booming house prices may start to feed into higher imputed rent costs. Within the goods sector, ongoing shortages in supply and rising shipping costs may also be factors leading prices higher, in line with indications given in recent purchasing manager surveys and input cost reports. 

In this context, we continue to feel that those in the camp describing the uptick in inflation as purely transitory could well be challenged in the days ahead.

Duration

Our views on growth and inflation cause us to retain conviction with respect to a short US duration bias. We have shifted most of our risk towards the 10-year part of the US yield curve, having realised gains on a short with respect to the front end of the curve in the wake of a more hawkish FOMC last month. 10-year rates rose by 55bps in the first half of 2021 and we project a similar gain during the second half of the year, taking yields above 2% by year-end. 

We continue to look for a Fed taper in September and a first rate hike at the end of 2022. If data are firm in the next couple of weeks, we would not be surprised to see Fed comments continue to turn a bit more hawkish. 

However, we would also note that in a broad sense, financial conditions remain very accommodative. Indeed, with inflation pushing higher, real interest rates are becoming even more negative in recent months and one can only wonder if that will further spur activity in interest rate-sensitive sectors, such as real estate. 

In this context, it remains debatable whether a modest withdrawal of monetary accommodation will do much to slow growth or impair the outlook for risk assets with corporate earnings leveraged to strong GDP gains.

Europe

Incoming data has seen us nudging up growth projections in recent weeks. The speed of the vaccination programme is making us more optimistic on economic re-openings across the continent and the deployment of Next Generation EU funds in quarters to come should also help to stimulate and sustain activity. 

We think that the ECB will start to wind down its Pandemic Purchase Programme at its September meeting, but seek to taper purchases so as not to disrupt markets as much as possible. With the Fed and the ECB possibly taking similar steps at the same time, it could point to September being a somewhat challenging month in markets, especially with heavy seasonal credit supply following the return from the summer break. However, we think that data will help to offset concerns around that time. Thus, any retracement may be modest and be seen as a buying opportunity by some who have missed out with respect to the rally.

Currencies

The ‘buy the dip’ mentality seems to also be supporting cryptocurrencies for the time being and it has been interesting to observe an uptick in institutional interest, even as those in the retail community using coins as a vehicle to get rich quick seem to be cooling on the trade, just as regulatory authorities also seem to be clamping down on unregulated markets. 

Elsewhere, in FX markets, the dollar has been edging stronger in recent days, but the greenback remains below levels seen immediately in the aftermath of the recent Federal Reserve meeting. We continue to have a modestly constructive view on the dollar based on US economic relative outperformance, but overall retain low conviction across FX, with opportunities in (US) rates being the area where we see the clearest macro investment opportunity for the time being.

Corporate credit

We continue to look for opportunities to trim exposure, but are happy to remain long carry as we enter the summer season. We think that paring exposure ahead of September may make some sense and valuations are far from compelling right now. However, with volatility dropping and equities at their highs, it seems that there is not a strong enough catalyst to promote a material or lasting reversal right now. The same is largely true for sovereigns. 

In Europe, the general apathy around French regional elections offered little new information and spreads remain supported by a sense of stability and solidarity within the EU for the time being. That said, it will be interesting to see how long this can last and whether spreads also come under a little more pressure once the ECB steps back from a position where it is buying more than the total volume of new debt supply later this year.

Looking ahead

We would reiterate that it’s all about the data. Each month, the US NFP and CPI reports represent the two big data events of the month and it is tempting to visualise a race track with two hurdles to clear every four weeks with the going pretty flat in between. 

In that context, if today’s data are benign then risk assets can continue to rally and volatility can continue to fall in a familiar pattern. However, an upside surprise runs the risk of changing the narrative and so hedging long risk positions with short rates around these data events appears an appealing strategy.

Yet, saying it’s all about the data at the moment would actually be a lie…because it isn’t. In truth, it’s all about the football! In the wake of England deposing Germany in the knockout stages of a tournament for the first time since 1966, national expectation is building. In that sense, there is only one way to end this week’s comment. COME ON ENGLAND!