Higher Nominal GDP Paves the Way for Average Hourly Wages

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By the same token it is also likely to lead to Higher Interest Rates

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By J. Richard Fredericks, Main Management

The economy bottomed in early 2009 and has slowly and steadily regained its momentum since aided by a very accommodative Fed policy and little pressure from inflation. The market has responded dramatically especially over the past year.

We believe the benign environment relative to inflation and interest rates is at a turning point and rates are poised to rise to more normalized levels while wage gains will begin to rise, reflecting a tight labor environment and a better ability of corporations to give raises.

The past 10 years have produced sub-par levels of Nominal GDP as evidenced by a median gain of only 3.48% (3.0% on average), which is 44% lower than the 6.22% median achievement since 1964. (Note: The average annual nominal GDP growth since 1948 was similar at 6.47%, which is as far back as our numbers go. We have used 1964 because it is the base year for a number of the other figures we use in this report).

We like to look at Nominal GDP because it is a good proxy for corporate revenue growth and as an indication of pricing power of corporations, their spending patterns, and their capacity to pay higher wages. Additionally, Nominal GDP is important because we live in a nominal world as wages are paid in nominal dollars out of nominal corporate revenues.

Regrettably, the growth in Nominal GDP has been slowing over the past number of expansionary periods as can be seen below. While higher Nominal GDP can lead to higher wages, lower Nominal GDP can act as a retardant and suppress wage growth as well. That has been the environment we have been experiencing lately although technology and the global marketplace have certainly played an important role as well.

 Average Year-over-Year Growth in NOMINAL GDP During Expansions

It appears to us that the third and fourth quarter of 2017 may finally be a turning point for Nominal GDP as the quarter-over-quarter annualized growth for both periods has approached or exceeded 5% and the annual growth was beginning to lift as evidenced by a year over year growth of 4.41% in the final quarter of 2017.

Because of the higher levels of Nominal GDP growth, we believe interest rates and wage gains have bottomed. It should be no surprise that corporations are hard pressed to lift wages (Average Hourly Earnings, or AHE) at a faster pace than revenues. That has been historically true and can be seen below. The following charts and table indicates that relationship over time. One can see that whether one looks at year over year changes during the past 50 years since 1967, or the past 40, 30, 20, 10, 5 or 1 year periods, the rate of change in Nominal GDP always exceeds the change in average hourly earnings, interest rates, and core inflation (by definition, Nominal GDP includes inflation so it will always be higher).

While we have delineated nominal GDP against AHE, 10-year interest rates, and Core CPI, what is not as obvious when viewed this way is that during the mid-1960s and throughout the 1970s, outsized nominal GDP was the catalyst for historically high interest rates and inflation. We don’t expect a repeat of those numbers by any means for the current cycle, but we do expect the higher nominal GDP to accelerate which will once again feed into higher rates and higher wage growth.

Since Nominal GDP typically leads moves in inflation by 6 months to a year, we expect inflation to head towards a 2-2.5% level by year end and higher yet in 2019. At this point, we feel this is a good outcome, as the tax bill will probably extend the economy, which has been exhibiting late stage characteristics, out until late 2019 or 2020 before we experience a recession.

The question for the stock market will then become whether the increased interest rates will be accepted as a byproduct of a good economy or whether the levels will act as an agent to choke off growth and lead us to a recession. Our own view, for now, is that the economy has a fairly clear runway until the 10-year bond hits 3.5%, at which time the market will have stronger competition from bond yields and investors will have to reassess.

J. Richard Fredericks is founding partner at Main Management, a participant in the ETF Strategist Channel.

A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering liquid, transparent and cost-effective investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency. http://www.mainmgt.com.

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