Mr. Market may not be a reliable weatherman.
While the gold price remains uplifted due to investors’ hopes for a dovish pivot, following the consensus can be akin to trading short-term gains for long-term pain. Moreover, while the crowd expects a sharp decline in inflation and a return to pre-pandemic monetary policy, the largest hedge fund in the world sees that as “the least likely path.”
Bridgewater Associates published its latest research report on Jan. 6; and with co-CIO Bob Prince’s analysis aligning with our expectations, the PMs should confront a turbulent backdrop in the months ahead. He wrote:
“The pandemic threw economies way out of equilibrium…. The key variable in the path to equilibrium is a sustainable 2% inflation rate. With respect to that target, wage inflation is a point of central tendency because a) wages produce income that gets spent, and b) wages are the biggest cost item for companies, an input to pricing.
“Therefore, c) if wages are high, consumers have the money to spend on higher-priced items and companies have the inducement to raise prices by about that amount. This reflexive linkage is inherently self-reinforcing until something stops the cycle.”
He added:
“Wage inflation has broken out to the upside, rising by about 5% in the U.S., and is pervasive across industries, with 14 of 15 major sectors in the US experiencing wage inflation of more than 4%. What that means is that even if goods inflation falls to 2% or below, if wage inflation remains near 5%, overall inflation will tend to revert toward 5%.”
As a result, while we have been warning for months that wage inflation is the canary in the coal mine, the crowd underestimates the implications for future Fed policy. Currently, the consensus expects inflation to decline linearly, with each new Consumer Price Index (CPI) release providing more support for risk assets like gold.
But, with hawkish economic data from Indeed, ADP and the Atlanta Fed highlighting wage growth that exceeds 6%, the fundamental backdrop does not support the optimism priced into the financial markets.
Please see below:
To explain, the Atlanta Fed updated its Wage Growth Tracker on Jan. 12, and the metric remains highly elevated at 6.1%.
Prince continued:
“Nominal spending growth and unemployment are now upward rather than downward pressures on wages…. In order for this quantity influence to be a downward force on wages, you need at least a 2% rise in unemployment sustained over a long enough period of time to impact the supply/demand balance for labor. Historically, this has been about 18 months….
“To push the unemployment rate up, nominal spending must fall relative to wages – i.e., revenues must fall relative to costs, squeezing margins, in order to induce layoffs.”
Please see below:
Source: Bridgewater Associates
To explain, the blue line above tracks the percentage change in annualized three-month wage growth, while the red line above tracks the inverted (down means up) percentage change in the unemployment rate. If you analyze the relationship, you can see that when the blue line is near 2% (the scale on the left), the red line often needs to rise by 2% (the scale on the right). Consequently, a 2% increase in the U.S. unemployment rate needs to be sustained to normalize wage inflation to a level that supports 2% output inflation.
Yet, if you focus your attention on the right side of the chart, you can see that the two lines are far from an inflation equilibrium. As such, the crowd misjudges the amount of demand destruction required to create the fundamental outcome that’s currently priced in.
To that point, Prince noted:
“There has never been a big rise in the unemployment rate without a decline in corporate earnings. Corporate earnings need to fall by about 20% in order to induce the degree of layoffs necessary to push the unemployment rate up by enough to bring wages down. This has also not happened yet.”
Please see below:
Source: Bridgewater Associates
To explain, the blue line above tracks the inverted percentage change in the U.S. unemployment rate, while the red line above tracks the percentage change in corporate earnings (excluding resources).
If you analyze the relationship, you can see that a 2% rise in the blue line often culminates with a 20% decline in the red line, and if a 2% rise in unemployment is needed to reduce wage inflation, the implications are highly bearish for corporate profits. Therefore, the rosy narrative contrasts fundamental reality.
Remember, narratives move markets in the short term, but they only hold weight over the medium term if they make sense. For example, if a fitness trainer said you could eat what you want, whenever you want, and still lose weight, you may be hesitant to believe that story.
Well, as it relates to the financial markets, investors’ recipe for 2% inflation and a soft landing is similar, as they lack the necessary ingredients to make their expectations a reality. Thus, Prince summarized:
Source: Bridgewater Associates
Overall, the bulls created a narrative and momentum has more investors buying into the proposition. In contrast, we have been consistent in our thesis that the Fed’s inflation fight is far from over. Historically, inflation does not decline linearly, and all instances since 1954 have resulted in interest rates peaking at significantly higher levels than where they are now.
Furthermore, as Prince pointed out, 5%+ wage inflation is not consistent with 2% output inflation; and while we have warned about this for many months, the ramifications are far from priced in. As a result, the crowds’ disdain for the details should upend several risk assets, including gold, silver and mining stocks, in the months ahead.
What do you think about Prince’s assessment? How does wage inflation come down without a sharp rise in the unemployment rate? Or, can the bulls create the outcome they want without the necessary economic conditions?
Alex Demolitor
Precious Metals Strategist