Weekly Investment Commentary: Inflation and wage pressures: where to invest
Bottom line up top
- Watch wage inflation. Hotter-than-expected inflation is the gift that keeps on taking — and wage inflation has chipped in more than its fair share. Last week’s CPI data showed levels not seen since the 1980s, which came on the heels of January’s blockbuster jobs report and a jump in average hourly earnings. We see the nearly 6% year-over-year wage increase as a wildcard in the overall inflation picture. And the Fed is eyeing it like — well, like a hawk. The chief risk is the Fed will err on the side of ratcheting up its already aggressive tightening plans, potentially sinking the recovery.
- Think beyond the basics to position portfolios for an environment in which higher wages, a smaller overall labor force and increased productivity may become longer-term fixtures and stronger drivers of investment performance. This could lead to opportunities in alternatives such as real estate and other inflation-hedging real assets, as well as in select municipal bonds.
There’s more to the wage inflation story
- The employment market may be more complex than some think. The number of job openings per unemployed worker spiked following the COVID-induced recession, with sharp wage increases kicking in a year later (Figure 1). But the economy recently added roughly half a million payrolls per month, and the labor force participation rate increased to 62.2% last month, showing some slack remains.
- Structural changes may be in play. For now, the economy is pulling more workers into jobs than it is losing to retirement. But long-term demographic trends and Covid-driven behaviors (e.g., the Great Resignation) may mean that a permanently smaller workforce isn’t out of the question. This could lead to stickier wage inflation that pressures corporate profit margins.
“Higher wages, a smaller overall labor force and increased productivity may become longer-term fixtures and stronger drivers of investment performance.”
Positioning for a high wage-inflation environment
- Wage inflation today could lead to higher productivity tomorrow, as employers that pay more have an incentive to ensure these employees can generate more output (Figure 2). We see opportunities in owning equity and credit of companies that prioritize real estate, equipment, technology and intellectual property. Likewise, these trends could spell opportunities for the energy and materials sectors.
- Inflation and wage trends could present less obvious opportunities, especially across private assets where control over profit margins creates attractive prospects.
- Real estate can offer capital appreciation and income opportunities when inflation rises. And many long-term leases have built-in rent escalators that protect real income generation. Higher wages can lead to more spending, which is a plus for single-family and multi-family residential housing. Further, from the perspective of owning and managing real estate properties, there is a clear benefit: control. As such, direct real estate managers have the flexibility to improve operations and focus on new technologies to manage costs. They can also use their properties creatively to generate revenue and offset higher wages, perhaps converting underutilized spaces like basements into amenity spaces, storage facilities or data centers.
- Agriculture and farmland can be excellent inflation hedges, but these asset classes are not entirely immune from inflation pressures. Certain areas, however, could provide relative advantages, such as agribusinesses that can pass the cost of higher wages onto customers. Farmland assets with long-term leases can also provide some insulation from rising costs.
- Select municipal bonds can also benefit, especially those with shorter duration. Rising wages are resulting in increasing tax revenues, a benefit to municipalities. From a credit standpoint, the impact of higher labor costs is project dependent. For example, we see relative advantages for sectors like toll roads (which are largely automated) over areas such as hospitals (especially smaller hospitals that lack scale and have high labor costs). However, selectivity and research are key.
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Endnotes
Sources
All market data from Bloomberg, Morningstar and FactSet
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