The Timely, Transatlantic Lesson From Cooling US CPI

We don’t think there is a definite way to know a bull market—a prolonged rise in equity markets—is underway early in its life. That didn’t stop US financial commentary we follow from claiming America’s S&P 500 breaching 20% up from its 12 October low last week proved just that.^[i] But, with that said, here is a pretty good sign a bull market is underway, in our view: When people move on from a big worry that accompanied the prior bear market (a prolonged, fundamentally driven broad equity market decline of -20% or worse) … but move on to another, similar issue that seems like the next shoe to drop.

So it went Tuesday, when the US Labor Department’s May Consumer Price Index (CPI, a government-produced index tracking prices of commonly consumed goods and services) report showed headline inflation slowing bigtime, from 4.9% y/y to 4.0%, whilst core CPI, which excludes food and energy, eased from 5.5% to 5.3%.^[ii] Some commentators we follow acknowledged the improvement. But many publications buried the news under an allegedly alarming story about UK wage growth jumping 7.2% y/y in the three months through April, sending long-term UK Gilt yields above their autumn 2022 highs. The argument: Rising wages will force companies to hike prices, which in turn brings higher wage demands from workers, creating a wage-price spiral the Bank of England (BoE) must ratchet rates far higher to counter, adding a more lasting force to earlier inflation pressures from energy and other goods prices.^[iii] But in our view, the US’s recent experience also shows why the UK edition doesn’t add up, likely rendering this another brick in what we increasingly think is a young bull market’s wall of worry.

Since peaking at 9.1% y/y in June 2022, US headline CPI has more than halved.^[iv] We think a lot of this has to do with energy costs’ substantial easing, but the core inflation rate has also improved notably—from 6.6% y/y last September to 5.3%.^[v] When you also exclude shelter—which we think is logical, considering the majority of that component is the (in our view) imaginary owner’s equivalent rent line item (or the amount homeowners would pay to rent their own house)—we get all the way down from 6.7% y/y last September to 3.4% in June.^[vi] That is quite close to the long-term average inflation rate, and it might be a sign inflationary forces have moderated substantially outside categories with big commodity exposure and supply quirks. And in our view, it is very, very positive news for markets. We don’t think inflation is a market driver, but in our experience, this was a big worry for investors and people just trying to make ends meet. Relief is usually a good thing.

We also think it should be encouraging for those now warning of more troublesome UK inflation: All of this improvement happened despite above-average wage growth. When we study this, we prefer using the Atlanta Federal Reserve’s wage growth tracker, which follows individual workers’ earning power rather than statistical aggregates. It is newer and has a shorter history than the US Bureau of Labor Statistics’ official measure, but it isn’t skewed by high-earning peoples retiring whilst young people enter the workforce—which our research suggests can have a massive, illusory downward drag on broad national pay data. As you will see, this measure of wage growth has topped the year-over-year core inflation rate since last October. Yet inflation has still slowed. Broaden your view to the full history, which starts in March 1997, and you will see wage growth regularly moves after inflation, peaking and troughing at a lag.

Exhibit 1: Wage Growth Follows Inflation

Source: St. Louis Federal Reserve and FactSet, as of 13/6/2023. Overall year-over-year wage growth and year-over-year core inflation rate, March 1997 – May 2023.

We don’t think this is surprising. In the late 1960s, Nobel laureate Milton Friedman gave a speech excoriating economists and monetary policymakers for presuming rising wages drive inflation.^[vii] He argued this couldn’t be true because employers factor in living costs when setting wages—making wages the last price to respond to inflationary forces. Therefore, anyone saying wages drive prices would be making a circular argument—not great logic, in our view. The next several decades’ worth of data proved him right, but it seems to us myths die hard.

This is why we think UK wage growth rang such alarm bells. UK inflation has been more stubborn than in the US, owing largely to the way the government handled spiking energy prices. In the US, the relatively free pricing system made both the initial spike and comparably fast subsequent relief show up in fuel and household energy bills swiftly.^[viii] But, as you know, the UK’s dual energy price caps have governed prices until recently. They reset at a lag, meaning the rise and fall of energy prices hit at a delay. So although wholesale energy costs have plunged, it hasn’t yet shown up in household costs—the regulatory cap is only now coming down to the government’s emergency ceiling. Meanwhile, coverage we read showed economists and even the BoE have zeroed in on stubborn food prices and wage growth as the UK’s inflation culprits, making that February – April pay acceleration such a big source of concern.

Here is another way to look at it: Wages have lagged UK inflation materially. Their 7.2% year-over-year growth rate may seem fast, but it pales next to the peak inflation rate of 9.6% y/y last October.^[ix] Just like US wages, British pay has seemingly moved after inflation.

But, here too, UK taxes have likely eaten a large share of this increase, as the government froze the income thresholds where the 20%, 40% and 45% tax rates kick in through 2026 in the name of shrinking the deficit.^[x] Several key credits and allowances have also been frozen, leading to incomes between £100,000 and about £125,000 facing an effective 60% tax rate. So for those whose wage growth increased the amount of earnings taxed at 60%, the raise is much less than meets the eye. We think this is a modest, partial catch-up on the heels of roughly 10% inflation, not some massive new buying power.

As food price spikes fade and falling energy costs finally filter through to UK CPI, the wage chatter should quiet down. Plodding consumer spending (up just 0.2% annualised in Q1) should help, too.^[xi] As for long term Gilt yields, this isn’t the first time they have suddenly freaked out, and it probably won’t be the last. Our research suggests Gilts can swing on sentiment every now and then, just like stocks. But in our view, markets weigh fundamentals over more meaningful stretches, and we see plenty of slowing UK inflation for them to weigh looking forward—just as we have seen in the US.