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Wage inflation is impacting fixed income investing

30 October 2018

Wage pressure at all levels is increasing, says David Jane, manager of Miton’s multi-asset fund range. This makes fixed income investing difficult.

Wage inflation has been picking up around the world recently, following a long period of stagnation. We think this trend will persist, and there are some important implications for investment.

The long period of low wage growth post the Global Financial Crisis (GFC) was variously attributed to poor productivity growth, a slow economic recovery or even quantitative easing. Whether any or all of these explanations are valid isn’t so relevant here, what’s clear is that many of the jobs created in recent years have been low wage, low productivity service sector jobs. As economic growth has recently accelerated, higher wage, higher productivity jobs are being created, and wage pressure at all levels is increasing.

To the degree that higher wages reflect more highly productive jobs, wage growth needn’t be a concern, if individuals are moving out of low value jobs into higher value jobs, this is good for all. This process is leading to pressure on wages at the bottom end. Amazon’s announcement of an across the board wage increase in the USA and UK wasn’t because of a new found generosity from Jeff Bezos. It’s simply economic reality: labour markets are tightening and Amazon is one of the largest employers of lower paid workers.

“Since the GFC, there’s been a substantial decline in the labour participation rate in the US. This suggests a significant number of potential workers are sitting on the sidelines waiting for conditions to improve, before potentially re-entering the workforce. In most cases, these workers will be looking for higher wage jobs than those Amazon has to offer, but it does suggest that the current low level of unemployment may not tell the whole picture about the labour market.

There’s something of a virtuous circle in wage growth which is easy to miss in the near term: higher incomes (reflecting a strong economy) get spent, leading to higher revenues for businesses and so on. However, the process will lead to winners and losers. Low value-add businesses with tight margins, high labour content and low economic sensitivity may suffer a margin squeeze. At the other extreme, capital intensive businesses will benefit relatively, particularly where they have pricing power.

This brings us on to whether the wage inflation we’re now seeing is part of a broader global reflationary trend. We think that, while there are clearly cyclical aspects to current wage growth, the broadly disinflationary era of the last 30 years is coming to an end, as continued global growth combined with significantly slower growth of the global pool of savings leads to higher required returns to attract investment. Supply and demand will ultimately lead to higher prices, whether for raw materials, labour or capital, particularly as an aging Chinese workforce moves from production and exporting to consumption, which is very stark in the recent Chinese economic data.

Our approach to dealing with ongoing inflation trends is to own businesses that should benefit from scarcity. Where they have unique and difficult to replace assets, such as airports, roads or even telecommunication networks, they should be able to pass on price increases, while their own costs, being largely legacy capital investments, will be growing more slowly. Other inflation hedges can be found in the raw materials space, such as mines, paper and packaging, and energy of course. These businesses have much greater cyclicality and are potentially therefore more risky, but margins should improve here in a geared way, with the prices they can achieve for their outputs growing. We have biased our portfolios strongly towards inflation beneficiaries with a near term preference for the more defensive ones over cyclical ones.

The difficulty in a rising inflation environment is in fixed income where rising rates inevitably go hand in hand with rising inflation, leading to capital losses. This is doubly compounded when real yields are starting from such a low level and are likely to be rising over time. We continue to stay very short duration and avoid highly leveraged businesses, particularly in industries that could suffer from this changing environment.

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