Why next week’s US wage growth numbers may be even more important than usual

“As America’s S&P 500 index continues to rack up new highs, investors are sensibly asking themselves what could go wrong and puncture the bull run in US stocks. History suggests that a combination of rising interest rates, lofty valuations and earnings disappointments usually proves deadly,” says Russ Mould, AJ Bell Investment Director.

“Interest rates are rising (and the US Federal Reserve is also withdrawing Quantitative Easing) so factor is in place.

“Valuation remains a matter of debate. Professor Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) of 32 times suggests that US stocks have traded on a higher multiple of profits just twice in their history – and the previous occasions (1929 and 2000) ended in disaster.

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

“However, Shiller’s tool has been a poor guide to near-term returns (even if its longer-term record is much better) and it is possible for bulls to argue that US stocks are cheap. Research from Standard & Poor’s puts the S&P 500 index on 18 times earnings for 2018 and 16 times for 2019.

“These are way below the Shiller numbers and by no means out of the ordinary for the US market. S&P’s research shows that the post-1998 average one-year forward price/earnings (PE) ratio is around 15 times, with highs of around 30 times and 19 times at the market peaks of 2000 and 2007.“The best news is that earnings are not just meeting but beating expectations, so the main danger – profit disappointments – does not seem a threat, at least for now.

“Profit growth is actually accelerating. With just a handful of S&P 500 members yet to report, earnings look set to rise 43% year-on-year in the second quarter of 2018, up from the 20% growth seen in Q1.

Source: Standard & Poor’s

“Better still, earnings forecasts are still moving higher, helping to fuel the momentum in the headline stock indices like the S&P 500.

“But there may be one catch.

“Earnings per share figures already stand at record highs (the Q2 2018 figure of $38.72 compares to Q2 2007’s cyclical peak of $24.06) and corporate America’s operating margin of 11.6% is also the highest on record, easily beating the Q3 2006 peak of 9.6%.

Source: Standard & Poor’s

“This implies that for US stocks to look cheap, operating margins and earnings per share will have to keep marching higher, even from what are already record-high levels.

“Such a feat may be possible, at least for a while, with tax cuts, cheap debt and share buybacks all doing their bit for the earnings per share figures, but it does mean that investors need to be on the look-out for what could go wrong.

“An unexpected economic slowdown would hit the top line and thus profits but a further possible danger is not a let-down in sales but a surge in costs. Such concerns explain why investors remain nervous about the possible impact of trade wars and tariffs as they could slow trade growth, crimp demand or drive up costs, all issues flagged by firms such as bourbon maker Brown Forman, Caterpillar, Whirlpool, Honeywell and the big car makers.

“Investors also need to keep a close eye on another issue, namely wage growth. Shares in giant retailer Best Buy took a tumble earlier this week, as management steered down earnings expectations for the third quarter, citing a range of reasons, one of which was increases in pay for staff.

“US wage growth remains muted overall, at just 2.7% year-on-year, a surprisingly low figure given a headline unemployment figure in the States of just 3.8%.

“Should this start to tick up, investors might just take fright for three reasons, posing a challenge to the S&P 500’s near-10-year bull run in the process.

“First, it could persuade the Federal Reserve to jack up interest rates more quickly than expected. Second, it could lead to profit disappointment. And third, any major loss of profit momentum could leave US stocks looking expensive, especially if earnings actually start to fall.

“On balance, it seems logical to expect some rebound in wage growth at some stage. Data from the US Federal Reserve itself shows that American corporate profits standard at a record high, as a percentage of GDP, while labour’s share of the economic pie, through wages, stands at multi-decade lows. Should these trends ever reverse, the outlook for US stocks could be very different indeed, although companies seem to have coped with the first signs of increased wage growth perfectly well so far.

Source: FRED - St. Louis Federal Reserve database

“With the Fed poised to rate interest rates on 26 September and again on 19 December, central bankers, economists and investors alike may therefore be paying more attention than usual to the latest monthly US non-farm payroll, unemployment and wage growth figures that are due out on Friday 7 September.”

These articles are for information purposes only and are not a personal recommendation or advice.