VOL. 129 | NO. 163 | Thursday, August 21, 2014
The Worldly Investor
Fed-Casting the Next Six Months
By David S. Waddell
The central questions for this aging bull market involve the timing, pace and degree of interest rate increases. Low interest rates make equity earnings larger and more valuable. Freeze interest rates here and stocks look cheap. Increase them to historical norms and stocks look expensive.
Therefore, by definition, higher rates equal lower valuations. As the interest rate debate heats up over the next six months, investors must understand what drives Fed policy to better calibrate investment decisions.
Don’t expect Janet Yellen’s Fed to tie rate policy to a prescribed unemployment rate nor a general inflation rate (ala the Bernanke Fed). Instead, expect the trajectory of real wages (wage rates minus inflation) to predict policy changes. With labor market participation low, and broader measures of unemployment high, the Fed’s focus has shifted to wages as the primary indicator of conditions.
Intuitively, a steady climb in wages indicates a tightening labor market and increased inflation risks. Therefore, if you want to predict Fed policy, you better watch wages.
For insight into U.S. Fed policy, consider central bank activity in the UK. The British economy has recovered briskly since the financial crisis, achieving new highs in GDP. Housing prices in the country have reached record levels and general consumer inflation has solidly encroached upon the Bank’s 2 percent target rate. The combination of rising GDP, rising asset prices and rising consumer inflation all but assured market participants of an imminent rate increase from the Bank of England.
Not so fast. In a statement released last Wednesday, the Bank of England stated that it would not increase rates until 2015. Defending its decision, the bank downgraded its expectation for wage growth from 2.5 percent to 1.25 percent for 2014. With wage growth moribund, the Bank opted to delay tightening well beyond expectations … even with every other measure signaling go! Foreshadowing?
Wages in the U.S. look no better than wages in the UK. The current wage growth run rate approximates 2 percent, well below the 3.5 percent to 4 percent the Fed deems healthy. Subtract out inflation, and real wages are going nowhere. A study of Janet Yellen’s history reveals the emphasis she places on wages. Paraphrasing her perspective, wages influence consumer spending, so no wage growth equals no spending growth. Given that consumer spending makes up two thirds of U.S. GDP, her feelings on wages therefore approximate her feelings on the economy.
Not all of her co-workers agree with her. Several voting members have dissented recently, accusing the Federal Reserve of being “behind the curve” on rate hikes. Look for Janet to hold her ground, perhaps even citing the “courage” of fellow policy makers across the pond.
Bottom Line: Record low interest rates have enabled stock investors to justify rising valuations. A shift in Fed policy might foreshadow a reversal in valuations. However, even with GDP accelerating and consumer inflation rising, real wages haven’t budged. Given Janet Yellen’s bias toward promoting real wage growth, expect interest rates to remain low until wage rates improve considerably.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.