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It is all about lags and the wage inflation spiral
Peter Garnry
Chief Investment Strategist
Summary: Jackson Hole turned out to be a non-event for markets with the Fed keeping all options open. However, Powell did touch on two important topics of assessing lags of monetary policy into the economy and the stronger link observed in wage dynamics and inflation. These two topics mean that risks to the monetary policy path are still high and warrant higher for longer to avoid the mistakes made in the 1970s. We maintain our defensive view on equities which means that we are still overweight energy, utilities, health care, and consumer staples.
Key points in this equity note
- Jackson Hole was a non-event judging from market reactions across equities and bond yields. Monetary policy risks are still tied to unpredictability in assessing the proper lags in monetary policy and the recently stronger link between wage dynamics and inflation.
- We maintain our defensive view on equities presented in our recent stagflation light call which means that we remain overweight defensive sectors such as energy, consumer staples, health care, and utilities.
Lags and spirals
Fed Chair Powell’s speech on Friday did not rock the boat with markets remaining calm. The short summary is that the Fed is keeping all options on the table, but as the market is correctly trying to price the Fed is getting more explicit that one more rate hike is still on the table. Inside the boring delivering there were two sections that caught our attention. The first was the mentioning about lags from which monetary policy starts working and that those were both time-varying, conditional on the inflation regime, and thus very difficult to assess. This induces considerable risks to monetary policy and the Fed is keen on avoiding the 1970s mistake in which the Fed eased the policy rate to quickly as inflation cooled creating the foundation for the second wage of inflation during the late 1970s.
The second interesting topic that Powell briefly touched at the very end of his speech was the observation that the link between wage dynamics and inflation had strengthened in a way that had not been seen in many decades. This is the Phillips curve echo from the 1970s in which the economy enters a wage inflation spiral. This is the ultimate fear of central banks because it means inflation has moved from ordinary demand supply dynamics and the goods economy to something that is more engrained in our expectations and thus suddenly because a social perception dynamics which is far more difficult for the central bank to crush.
The Fed’s favoured measure of tight labour markets is the number of job openings to the number of unemployed people in the economy. This measure is still showing that there are 1.6 job openings for every unemployed person. In other words, any negative impact from higher interest rates in certain parts of the economy will be absorbed in other less interest rate sensitive parts of the economy offsetting the objective the current monetary policy and extending the lag in the monetary policy transmission. Powell also said that nominal wages add to come back to levels consistent with the 2% inflation target which is roughly nominal wage growth of around 3.5% squaring real wages with estimated long-term productivity gains. The median wage growth in the US economy was 5.7% as of July.
Maintain defensive view on equities
Based on the fact that Jackson Hole was a non-event we maintain our stagflation light call on equities and thus overweight defensive sectors vs cyclical sectors. This means that we are still in favour of health care, energy, utilities, and consumer staples. The list below highlights the top largest companies in each sector for the US and European equity markets respectively.
Largest US defensive stocks
- Eli Lilly (Health care)
- UnitedHealth Group (Health care)
- Exxon Mobil (Energy)
- Chevron (Energy)
- Walmart (Consumer staples)
- Procter & Gamble (Consumer staples)
- NextEra Energy (Utilities)
- Southern (Utilities)
Largest European defensive stocks
- Novo Nordisk (Health care)
- Roche (Health care)
- Shell (Energy)
- TotalEnergies (Energy)
- Nestle (Consumer staples)
- L’Oreal (Consumer staples)
- Iberdrola (Utilities)
- Enel (Utilities)