The key message from our leading indicators is that US inflation and wages continue to turn up.  This was one of our core themes for 2014 we discussed in December last year and is bearing out.  Core inflation and headline inflation are positive, while wages are turning up sharply.  This has implications for profit margins.  Wage increases inversely lead US corporate profits by two years.  We have with very high likelihood seen the peak in profit margins, and we would expect them to fall.

img1 img2Source: Bloomberg and Variant Perception

Wages in the US have shown signs of rising, and are now rising in real terms (just).  We see more job gains ahead.  There is much debate on whether the fall in the participation rate and the stretched number of long-term unemployed is structural or cyclical.  We have written about this elsewhere and our contention is that it is more the former than the latter.  This would mean tighter labour markets despite an unemployment rate higher than Fed estimates of where NAIRU is (~5.5%, while the current UER is 6.1%).  NAIRU is the non-accelerating-inflation rate of unemployment.

Indeed, our leading indicator for wages sees compensation for labour continuing to trend higher.


Source: Bloomberg and Variant Perception

This will likely feed into inflation.  Moreover, profit margins will suffer if wages rise.  There has been much written about profit margins, and whether they are mean reverting or not.  Also, whether thinking about profit margins on a sectoral basis (using the Kalecki-Levy equation) makes sense without considering wealth distribution in the household sector.  These are all very interesting and thoughtful discussions, but sometimes a chart tells a simpler, more elegant story:


Source: Bloomberg and Variant Perception

Clearly, rising wages will eat into profit margins.  Needless to say, a fall in corporate profit margins is not good news for investors who are chasing equities at high earnings multiples on peak profit margins.  Earnings multiples have been a huge source of S&P returns in recent years.  This is unlikely to continue.


Source: Bloomberg and Variant Perception

Profit margins and price earnings each on their own do not give a particularly good prediction for subsequent long-term returns (7-10 year) of the S&P.  However, the two together give over a 90% correlation, with each input equally as important.  With profit margins set to fall as wages rise, and price earnings multiples likely to run out steam, longer-term returns in the S&P are very likely to be disappointing.