What could spur US eq­ui­ties?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

A com­mon bias for in­vestors is to as­sume that re­la­tion­ships be­tween the mar­ket and econ­omy in one phase must persist in the next. For ex­am­ple, since 2009 US firms have mostly grown prof­its by ex­pand­ing mar­gins—i.e. cost­cut­ting. Hence, the logic runs that if wages start to rise, profit mar­gins must fall, lead­ing to weak profit growth, and hence lower eq­uity prices. Im­plicit in this logic is an as­sump­tion that mar­gins must drive prof­its. There is, of course an­other way: namely top-line growth.

In­deed, it is en­tirely plau­si­ble that the top-line is the only source of profit growth given con­tin­ued weak US pro­duc­tiv­ity and the sim­ple fact that firms have no more fat to cut—i.e. mar­gins can­not be ex­panded fur­ther. Still, for com­pa­nies to con­sis­tently grow sales, de­mand must rise and in the ab­sence of a strongly pos­i­tive de­mo­graphic tail­wind, that nec­es­sar­ily means that real me­dian in­come growth needs to rise.

Nice idea, but poli­cies of low real rates and quan­ti­ta­tive eas­ing have done noth­ing to im­prove US in­comes. In fact, the real me­dian in­come in the US of­fi­cially stands at $52,000 com­pared to a peak of $56,900 in 1999. So, for all the pol­icy ac­ro­bat­ics of the past 15 years, the av­er­age Joe is mak­ing -9% less. Such num­bers hardly speak to a new burst of de­mand sup­port­ing cor­po­rate profit growth. And yet given re­cent news of chunky wage rises at big em­ploy­ers such as Wal­Mart, the out­look for in­comes ap­pears to be bright­en­ing. Last week’s strong home starts num­ber for April cer­tainly sug­gests the US con­sumer is still kick­ing. More­over, the of­fi­cial house­hold in­come data is pro­duced with a big lag so it is nec­es­sary to look for other sources of guid­ance.

One such source is the Na­tional As­so­ci­a­tion of Re­al­tors which sur­veys house­holds monthly. De­flat­ing the NAR se­ries by the US CPI pro­duces a de­cent ap­prox­i­ma­tion of the of­fi­cial real me­dian in­come se­ries. The turn in the NAR read­ing of fam­ily in­come since 2012 is prob­a­bly ex­plained by the sharp decline in un­em­ploy­ment. Look­ing for­ward, if that curve is to keep ris­ing, wages must start ris­ing.

His­tory does not sug­gest that ris­ing wages are a prob­lem for US eq­ui­ties. In 1994-98 wage growth picked up from 2.4% YoY to 4.5%, while US cor­po­rate prof­its rose by 50% and the S&P 500 tripled. In­ter­est­ingly, that burst of wage growth fol­lowed re­cov­ery from the Sav­ings & Loans cri­sis, which caused a bal­ance sheet re­ces­sion. The next pe­riod of sus­tained wage growth was 2003-2007, when hourly earn­ings growth rose from 1.7% YoY to 4.2%. In this pe­riod, US do­mes­tic prof­its dou­bled and the S&P 500 rose by close to 40%.

Our point is not that the S&P 500 is about to soar to 6000. But it may be a mis­take to as­sume that earn­ings must weaken. The ef­fect of ris­ing wages on fi­nal de­mand, and with it to­pline growth, can over­whelm the neg­a­tive ef­fect of mar­gin com­pres­sion at the start of a wage growth cy­cle.

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