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Investment Strategy

Wells Fargo Investment Institute - January 22, 2020

A Not-So-Fine Balance between Wage and Price Inflation?

by Gary Schlossberg, Global Market Strategist

Key takeaways

  • Several headwinds to stronger U.S. wage inflation have slowed the recovery of labor’s share of national income from an historic low in 2014.
  • The good news for workers has been above-average increases in inflation-adjusted wages, or “purchasing power,” even as corporate profit margins, economy-wide, have been pressured by modest labor-productivity growth gains and weak business “pricing power.”

What it may mean for investors

  • In this environment, we favor selectivity. In our view, companies that are best-insulated from further margin pressure will be those positioned to tap into firming economic growth here and abroad to boost sales.

Download the report (PDF)

The silence from U.S. wage pressures—like price inflation—has been deafening as excess capacity begins to evaporate in an aging growth cycle. In the December jobs report, average hourly earnings climbed by less than 3% on a year-over-year basis for the first time since September 2018, despite an unemployment rate at, or near, a 50-year low of 3.5% for a fourth straight month.1 This was despite accelerated wage gains in retailing, hospitality, and certain other low-paying industries. Modest wage growth, along with a historically low unemployment rate, is undermining a once-sacrosanct relationship between these two measures in the Phillips Curve, traditionally linking lower unemployment rates with accelerated labor-cost increases.

In our view, hidden U.S. labor-market slack is less responsible for the uncoupling of wage growth and unemployment than it was earlier in the cycle. We believe that a stubbornly low labor-force participation rate—those who are employed plus individuals actively looking for work as a share of the working-age population—has been due less to an excess supply of labor than to delayed retirement by older workers. Older workers have a labor-force participation rate that is less than half that of workers in the prime, 25-54 year age bracket. As older workers’ share of the workforce rises, that pulls the overall average lower. Participation rates for those prime-age employees are at their historic norm of 82%. We believe that dwindling labor-market slack is better captured in “hardship unemployment.” That measure—including “discouraged” workers giving up looking for work, those working multiple jobs, and those forced by economic conditions to work half time—declined to a 19-year low of 7.5% in December.

So why haven’t accelerated wage gains accompanied an ultra-tight labor market? The explanations include inflation’s steady decline, undercutting business “pricing power,” and intensifying corporate efforts to contain labor and other expenses. Disappointing productivity gains also are to blame, by adding to unit labor costs—as wage, salary, and benefits increases adjusted for output per worker have a more direct effect on profits than just labor compensation alone. Reduced union membership—at 10.5% of 2019 employment compared to a peak 20% in 1980—may have left U.S. manufacturing and other economically weak sectors more susceptible to cost-cutting pressure.2

Whatever the reasons, labor’s historically low share of the economic pie has intensified debate over worsening income inequality, a hot-button issue in this election year. That 53.6% share of total income last fall was short of its most recent, 56.1% fourth-quarter 2018 peak, along with a record 58.3% high as recently as the mid-1980.3 That reduced share of total income translated to a $3,500 per worker loss had labor's income share held at its 2008 level. The loss amounts to $6,550 in comparing labor's share to its mid-1980 share of national income (based on our calculations using Commerce Department data).

What do these trends mean to Main Street and Wall Street?

For Main Street, the issue is the extent to which even modest wage gains could outpace inflation, providing “purchasing power” increases needed to boost living standards and sustain consumer-led growth. For investors (including those on Main Street), the issue is the extent to which the rise in pay and benefits may outrun labor-productivity gains and business selling-price increases, squeezing profit margins.

Chart 1. Workers’ “real” incomes rise and business margins fall, despite modest wage gains

Chart 1. Workers’ “real” incomes rise and business margins fall, despite modest wage gains

Sources U.S. Department of Commerce, U.S. Labor Department, Wells Fargo Investment Institute, January 16, 2020. *Based on four-quarter moving average data. Sales represents income derived from operations from which all costs are deducted to derive a measure of profits.

The good news for workers is that average hourly earnings, adjusted for inflation (i.e., purchasing power) were rising at more than double their long-term (rolling 10-year) average through 2019’s fourth quarter—a vital support for consumer-centric growth. In fact, wage increases before inflation adjustment have helped to lift labor’s share of national income modestly from its 2014 low.

Less favorable is news of margin pressure across large-, mid- and small-cap companies. Even modest wage gains, combined with tepid productivity growth (particularly among less efficient smaller companies), have kept increases in unit labor costs—wages and benefits adjusted for still-moderate changes in labor productivity—above the rise in selling prices since early 2015. That left corporate profit margins at a nine-year low by last year’s third quarter.4

The bottom line

We anticipate large-cap (S&P 500 Index) earnings of $175 this year, propelled by top-line revenue gains overcoming margin compression. We expect mid-cap earnings (for the Russell Midcap Index) to grow at modest single digits in 2020—also driven by revenue gains (but somewhat challenged by exposure to small manufacturers hit hardest by restructured global supply chains). We also expect profit-margin pressure to have a less debilitating effect on more U.S.-oriented, small caps’ profit growth as these companies typically are less exposed to weaker growth overseas. U.S. companies experiencing profit-margin pressure this year will be counting largely on sales gains, lower interest rates, and (in some cases) a weakening dollar to support stronger profit growth.


by Chao Ma, PhD, CFA, FRM, Global Portfolio and Quantitative Strategist

Are we in the late 1990s again?

We believe that 2019 was similar to 1998 in a few ways. The U.S. economy is in the latter stage of expansion, and many equity markets are at record high levels after multiple years of growth. The lion’s share of equity market returns in 2019 (and 1998) have been driven by higher valuations, instead of earnings growth. The Information Technology (IT) and Communication Services sectors led the U.S. equity market in both time periods, whereas the Energy and Materials sectors lagged behind.

Are we on a path similar to 1999, which led to the 2000 “tech” bubble—and ultimately—recession? While there are some similarities, we believe there are some important differences as well. Currently, U.S. stock valuations are at a high level, but they are not as stretched as they were in 1999. Additionally, we expect continued gross domestic product (GDP) growth, strong consumer spending, and an accommodative Federal Reserve (Fed) supporting a low-interest-rate environment. Although we expect some margin compression this year, they should remain at relatively healthy levels, supporting moderate earnings growth. Resilient fundamentals generally should be beneficial to the market.

With the potential for continuing geopolitical risk and market volatility in 2020, we believe that investors should emphasize quality assets in their portfolios. For equities, we prefer maintaining a portfolio weighting that is at or above market levels for U.S. and “larger market capitalization” stocks—and to sectors with stable earnings and a healthy debt structure, including IT.

Key takeaways

  • 2019 and 1998 share many similarities. Yet, current U.S. stock valuations are more robust and the macro environment is more supportive to the market than we saw in 1998 (and 1999).
  • We believe that investors should emphasize quality assets in portfolios, including U.S. and larger market cap equity classes, high-quality equity sectors, and stocks with stable earnings.

2019 was similar to 1998 in terms of market return drivers and equity sector performance

2019 was similar to 1998 in terms of market return drivers and equity sector performance

Sources: Bloomberg, Morningstar, Wells Fargo Investment Institute, as of December 31, 2019. EPS = earnings per share. P/E = price/earnings ratios. Sectors with relatively similar return ranking are colored in gold. Others are in blue. Sector returns are S&P 500 sector total returns. An index is not managed and not available for direct investment.


by Peter Wilson, Global Fixed Income Strategist

Emerging market currency risk—who needs it?

U.S. high-yield (HY) bonds returned 14.3% in 2019.5 Yet, we remain unfavorable, given tight spreads (over Treasury yields) and the risk/reward profile. We are neutral on U.S.-dollar-denominated (USD) emerging market (EM) debt, which returned 14.4% (based on JP Morgan Emerging Markets Bond Index Global (EMBIG)), demonstrating its value for income and return potential versus HY debt. (Incidentally, investment-grade U.S. corporates returned 14.5%,6 supporting our HY view that there are better risk-adjusted return opportunities elsewhere).

Local-currency EM sovereign bonds almost matched USD-denominated EM debt’s 14.4% return last year, gaining 13.8% (once returns are converted to dollars for U.S. investors). Yet, this was at the cost of higher return volatility, much of this driven by EM currency fluctuations. We found that USD-denominated bond returns were equally split between those fueled by Treasury yield declines (7.0%) and gains from narrowing of the spread over Treasury yields (6.9%). Local-currency returns were composed of interest income (6.1%), capital gains (6.4%, as local rates fell with many countries’ easier monetary policies), and only marginally positive currency returns (0.9%).

Many EM economies may remain challenged in 2020, and we do not expect strong 2020 EM-currency appreciation. Given this, we retain our view that EM-debt exposure should remain focused on dollar-denominated bonds, which compose our strategic index (EMBIG). We believe that adding local-currency bonds would increase volatility—but would be unlikely to enhance return.

Key takeaways

  • USD-denominated EM debt returned 14.4% in 2019, exceeding HY returns and reflecting its worth as an income alternative to HY, on which we remain cautious.
  • USD-denominated EM debt also outperformed local-currency EM debt for U.S. investors. Currency returns were marginal in 2019; we expect them to be unreliable looking ahead.

EM dollar bonds outperformed without foreign-exchange-driven volatility

EM dollar bonds outperformed without foreign-exchange-driven volatility

Sources: Bloomberg, JP Morgan Indices, Wells Fargo Investment Institute, January 13, 2020. Chart shows latest data as of December 31, 2019. The indices used are the JP Morgan Emerging Markets Bond Index Global (EMBIG) for U.S.-dollar-denominated bonds and the JP Morgan Government Bond Index – Emerging Markets (Global) for local-currency denominated bonds (returns are to a dollar-based investor). Please see disclosures for index definitions. An index is not managed and not available for direct investment. Past performance is not a guarantee of future results.


by Austin Pickle, CFA, Investment Strategy Analyst

“There is always a way to be honest without being brutal.” —Arthur Dobrin

Oil—will shale supply surprise in 2020?

Now that U.S./Iran tensions have ratcheted down considerably (at least for now), oil-market focus is shifting back to the supply/demand picture. How does that picture look? In a word: “uninspiring.” Oil demand expectations have moderated, and supply is ample. Some investors have pointed to forecasts for slowing U.S. production growth as a reason to be more optimistic about oil prices. After all, “capital discipline” has been the buzz phrase from shale-oil producers. We are skeptical of the lowered oil supply forecasts. Why?

For one, production efficiencies continue to be realized—as estimates suggest that frack spreads are able to complete 40% more wells than they did just one short year ago.7 There is also an enormous inventory of drilled but uncompleted wells (DUCs) that producers can complete to cost-effectively keep production growth chugging along. Last, but definitely not least, forecasters have habitually underestimated the production ability of U.S. shale. To illustrate this, we analyzed the track record of the major energy data source in the U.S.—the Energy Information Administration (EIA). We plotted the five most recent January forecasts (dashed lines) against actual U.S. oil production (solid blue line). An insightful trend emerged—the EIA has consistently, and considerably, underestimated U.S. oil production. Is 2020 the year that the EIA (and others) stop underestimating U.S. shale? We think it could be. But based on our research, we are skeptical. Our year-end 2020 West Texas Intermediate (WTI) oil-price target range is $55-$65 per barrel ($45-$55 for supply/demand and $10 for geopolitical risks).

Key takeaways

  • Oil-supply forecasts have tended to underestimate U.S. shale production.
  • Our year-end 2020 WTI oil-price target is $55-$65 per barrel ($45-$55 for supply/demand and $10 for geopolitical risks).

Actual U.S. oil production versus forecasts

Actual U.S. oil production versus forecasts

Sources: Energy Information Administration (EIA), Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, 2016 - December 31, 2021. Forecasts taken from the EIA's monthly Short-Term Energy Outlook report.


by James Sweetman, Global Alternative Investment Strategist

How did hedge funds perform in 2019?

Hedge funds closed 2019 with the strongest annual performance since 2009. The 1.8% December gain for the HFRI Fund Weighted Composite Index brought the annual return to 10.4%—the best annual performance since hedge funds surged 20.0% in 2009. Higher-beta strategies, such as Equity Hedge and Event Driven (particularly the Activist strategy), led returns, but all four hedge fund strategies gained and outperformed Wells Fargo Investment Institute’s (WFII) expected Capital Market Assumption (CMA) return for the year.

Hedge Fund Research, January 2020

Source: Hedge Fund Research, January 2020. *Based on WFII Capital Market Assumptions (CMA) as of July 16, 2019.

However, despite hedge funds’ strong 2019 returns, the S&P 500 Index gained 31.5%, the Bloomberg Barclays U.S. Aggregate Bond Index returned 8.7%, and the Bloomberg Commodity Index rose by 5.5% last year. In this environment, some investors may ask “Why hedge funds?” Clearly, the best-performing asset group over the past 11 years has been global equities, which have outperformed in 6 of those years.8

Yet, over those same 11 years, global alternatives have been the second best-performing asset group in 8 of those years.9 This continued last year. One of the primary reasons for including hedge funds in our WFII asset allocations is because alternatives historically tend to behave differently than typical stock, bond, and commodity investments. We believe that adding them to a portfolio may provide broader diversification, enhance risk-adjusted returns, and increase income potential.

Alternatives have provided diversification and absolute returns

Alternatives have provided diversification and absolute returns

Sources: Bloomberg, HFRI, January 15, 2020. Global commodities = Bloomberg Commodity Index; Global fixed income = Bloomberg Barclays U.S. Aggregate Bond Index; Global alternatives = HFRI Fund Weighted Composite Index; Global equities = MSCI All Country World Index. An index is not managed and not available for direct investment.

1 Bureau of Labor Statistics, January 2020.

2 U.S. Department of Labor, January 2020.

3 U.S. Commerce Department data, January 2020.

4 U.S. Commerce Department data, January 2020.

5 Based on the return of the Bloomberg Barclays U.S. High Yield Corporate Index.

6 Based on the return of the Bloomberg Barclays U.S. Corporate Index.

7 Frack spread is a fleet of well completion equipment (such as trucks and pumps), along with crew. The source for this statistic is Bloomberg New Energy Finance, January 2020.

8 Based on the returns of the MSCI All Country World Index.

9 Based on the performance of the HFRI Fund Weighted Composite Index.