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Fixed-Income Insights

Wage increases seem to be one inflationary pressure worth watching, especially since these could be amplified by specific U.S. fiscal policies. 


In Brief

  • Inflation measures for February already exceed the U.S. Federal Reserve’s 2% target.
  • Year-over-year increases in energy prices pulled inflation higher, but that effect may reverse.
  • U.S. dollar strength reduces costs of imports and could keep inflation in check.
  • Perhaps the biggest inflationary concern is compensation—the biggest cost to companies.
  • Infrastructure spending and other U.S. fiscal policies could push wage inflation higher.
  • The key takeaway: Expect fixed-income markets and the Fed to be sensitive to factors that could stimulate wage pressures.

 

Rising inflation could push expectations and longer-term interest rates higher, or force the Federal Reserve (Fed) to adjust short rates more aggressively.  Inflation measures for February and early indications for March already exceed the Fed’s 2% target.  The Consumer Price Index (CPI) for March stands at 2.4%, and the Fed’s preferred measure, Personal Consumption Expenditures (PCE), was last at 2.1% for February.  Any further increase in inflation could force bond prices lower in order to provide additional compensatory yield or it could push monetary policymakers to become more aggressive to dampen inflationary pressures. 

An examination of the contributions to inflationary pressures can help investors assess the risks of this important influence on U.S. investment valuation.   

Energy Prices
March’s headline CPI of 2.4% may seem concerning to casual observers, but analysis reveals that the level may be less of a harbinger than investors fear.  In fact, a significant contributor to that number could reverse its impact within the next two months.  Energy was a deciding factor in higher CPI numbers in January, February, and March 2017, because the year-over-year increases in oil were so dramatic.  Recall that New York Mercantile Exchange (NYMEX) crude averaged $28 per barrel in January and February 2016.  At closer to $50 per barrel 12 months later, energy contributed meaningfully to a rising CPI.  The year-over-year effect of oil disappears quickly.  By April 2016, NYMEX crude averaged about $49 per barrel, meaning that with oil prices at close to the same levels they were in April 2017, the boost to first quarter 2017 CPI calculations is essentially reversed.  The April CPI may not drop to 1.9%, but the impact of energy prices is likely to pull the headline calculation lower than 2.4%.

Dollar Strength
Dollar strength relative to U.S. trading partners also can influence inflation by reducing the cost of imported goods and services.  Any success with the U.S. administration’s “America First” policy suggests that the United States may be an attractive place for U.S. and foreign companies to invest.  Interest from foreign manufacturers to build U.S. plants and expand capacity, including recent proposals from Foxconn and Toyota, suggest that the U.S. currency could strengthen.  Gradual rate hikes by the Fed also could attract investment flows to short-term U.S. securities that offer relatively attractive yield compared to that of many other countries.  Continued quantitative easing programs in the eurozone and Japan also keep interest rates on those fixed-income securities less attractive than comparable U.S. securities, supporting investment flows to the United States.  U.S. preferences to import substantially more than the country exports suggests U.S. dollar strength could influence CPI and PCE inflation measures lower as costs of imports are effectively reduced.

Wage Costs
Perhaps the biggest inflationary concern is not a component of either CPI or PCE but is instead compensation—the biggest cost to companies.  Average hourly earnings have risen by 2.7% over the past year according to the Department of Labor’s March employment report.  Continued increases, especially without productivity improvements, will increase corporate costs, and thus reduce profitability, unless those costs are passed on to consumers through higher prices.  Such wage-push inflation can be difficult to unwind, as increased compensation allows higher prices, producing a wage-price spiral.  While such a condition does not appear imminent, higher wages are not surprising, given that unemployment is 4.5%, that there are reports of an inability to find qualified workers, and because of recent increases in minimum-wage levels adopted by many states.  In fact, given these factors, combined with an historically low applicants-to-jobs ratio of 1.4 to 1.0 (courtesy of the Job Opportunity and Labor Turnover Survey), it is surprising that wage inflation is not substantially higher.  Nonetheless, wage inflation does not seem to have translated into broader inflation, nor has it alarmed Fed officials. 

Fiscal Policy
However, fiscal policies on the horizon have the potential to shift inflation higher, particularly wage inflation.  Infrastructure spending combined with additional business investment associated with repatriation of foreign cash or the expensing of capital projects could quickly create additional jobs.  If at the same time changes to immigration policies and (non-immigrant) H-1B visas (which allow U.S. employers to temporarily employ foreign workers in specialty occupations) restrict the supply of qualified labor, compensation could jump.  Companies would pay higher prices to fill new positions, while increasing compensation to existing workers to keep them.  Current wage inflation of 2.7% could rapidly spike, and although higher wages may take time to influence broader CPI or PCE higher, a hike toward 4% wage inflation would be advance warning to the Fed as well as to fixed-income markets.

Realistically, though, it remains to be seen what form fiscal policies take and whether they can be successfully implemented.   With threats of 45% tariffs, declarations of China as a “currency manipulator,” complete reconstruction of the North American Free Trade Agreement, and potential elimination of the North Atlantic Treaty Organization, it’s probably safe to say that current fiscal proposals and their inflation implications could change dramatically over coming months.  Meanwhile, it may be comforting to examine recent projections by the Federal Open Market Committee, the Congressional Budget Office, and Bloomberg surveys all expect inflation over the next few years to be no higher than 2.0%.

Summing Up
Demand-pull inflation or rising prices as a result of increased demand has been the Fed’s goal for a number of years.  Its expansionary monetary policy initially was designed to increase bank lending, promote corporate investment, and encourage household spending.  But what happened instead is that banks recapitalized and raised lending standards, companies refinanced expensive debt, households deleveraged, and the expected jump in growth and inflation has been slow to materialize.  Further, thus far into 2017, those patterns continue.  Growth in bank lending has slowed.  Company investment remains minimal. And while household spending has supported economic growth, consumption in early 2017 has slowed, auto sales have declined, and savings have increased.  Demand-pull inflation pressures, therefore, do not seem to be building.  Wage inflation seems to be one inflationary pressure worth watching, however, especially since it could be amplified by specific fiscal policies.  Expect fixed-income markets and the Fed to be sensitive to factors that could stimulate wage pressures higher, including restrictions on immigration and H-1B visas.


The Consumer Price Index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by U.S. households.

The Personal Consumption Expenditures (PCE) is the primary measure of consumer spending on goods and services in the U.S. economy.  Part of the personal income report issued by the Bureau of Economic Analysis of the Department of Commerce, the PCE accounts for about two-thirds of domestic final spending, and thus it is considered the primary engine that drives future economic growth.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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