What could spur US equities?

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.