The last few weeks, since early February, have been dominated by talk about resurgent inflation and latterly a US trade war with China.
This was sparked by a monthly jobs report in the US which measures employment growth and in particular, wage growth. This caused US equity markets to fall by 10 per cent at one point and immediately burst the complacent, low volatility, record breaking, bull market bubble that had been inflating throughout 2017.
These are slightly bizarre developments. Firstly, we were under the impression that wage growth, or the lack of it, was the one factor from the QE inspired recovery that has not occurred since the credit crisis. Just as we finally get some evidence that the benefits of all that stimulation is ending up in the wallet of Joe Six-pack, investors run for cover. Secondly, I am not sure what China is supposed to do about its trade deficit with the US. If the US was able to compete by manufacturing more cheaply then imports from China would fall but this will be difficult when wage costs are going up in the US.
The logic on wage growth causing inflation goes something like this: in a tight labour market, businesses struggle to recruit skilled staff and consequently have to offer higher salaries to attract them away from competitors. Those same competitors then have to do the same to retain their staff and also to attract new members and so on.
That’s great news for the staff but then the company has two choices. Either absorb the extra cost which hits profit margins and earnings or pass the cost on and raise prices. If everyone is doing it, then there is no competitive disadvantage and then you have a spiral which gets out of control until interest rates go up causing a recession and then a lot of those original jobs go.
The logic on trade tariffs causing inflation goes something like this: Trump has raised the cost of importing steel and aluminium from overseas. This raises the cost for manufacturers in the US regardless. They may start buying their steel and aluminium from US manufacturers, the principle reason, but they are still paying more for it.
Those manufacturers, whether they be General Motors or Boeing or the construction industry operate on thin margins. They have to pass this cost on as they can’t absorb it and will make losses. This pushes up the price of cars, aircraft and construction costs and hey presto, we have inflation as well as lower demand as consumers buy less as prices rise.
In addition, those overseas exporting countries now suffering tariffs will retaliate with their own tariffs on US exports. The net result is slower global economic growth and everybody loses. Neither of these inflation varieties are coming from excess consumer demand amid tight supply in an economic boom.
They are both cost push inflation which is always a function of input prices and production costs, in this case raw material costs and labour costs. The net result is that interest rates are more likely to go up and that is bad news for bond markets. In addition, the interest rate increases are not going up to slow a booming economy.
Trade tariffs and higher interest rates increase the costs for the global economy and slow growth which undermines equity markets. Some jobs may temporarily return to the rust belt of the US steel industry, but global demand will fall with economic weakness and those same jobs will eventually go anyway as the employer has to cut costs as demand falls.
Bizarrely, if Trump follows through with his tariffs and is successful in reducing the trade deficit with China and temporarily reinvigorates the US steel and aluminium industry, it will be a pyrrhic victory.
In the process, he will have also reduced US earnings of car manufacturers, and the like, through reduced profit margins and/or caused prices to rise but also the US economy will have suffered from retaliatory reciprocal tariffs from other countries. At the same time the FED will have had to raise interest rates more than they otherwise would have done, further slowing the economy.
Most economists are at a loss to explain Trump’s logic but until this becomes clearer it is unlikely the equity markets will make much further progress.