The U.S. unemployment rate is 3.6% — only a hair above its level just before the pandemic, which was a 50-year low. Corporate profits rocketed by 35% in 2021, and profit margins were at their widest since 1950. Yet stocks have been hammered lately: Two key stock indexes, the S&P 500 and the Nasdaq 100, have been deep in negative terrain since the start of the year.
What may seem a contradiction is actually a historical pattern. Hot labor markets and hot stock markets often don’t mix well.
In fact, times of low unemployment are correlated with somewhat subdued stock returns, while valuations trend higher on average during periods of high unemployment. Analysts explain this phenomenon as a plain function of the unemployment rate’s status as a “lagging indicator” — letting people know how the economy was faring in the immediate past — while the stock market constantly serves as a “leading indicator,” coldly, if somewhat imperfectly, projecting an evolving consensus about the fate of companies as time goes on.
“When unemployment is ultralow, the uppity times are behind us, and when it’s superhigh, there are good times ahead,” said Padhraic Garvey, head of research at ING, a global bank.
In 2007, for instance, unemployment sank as low as 4.4%, but the annual return for the S&P 500 index was only 5.5%. Stocks plunged during the financial crisis the next year — and then, in 2009, as unemployment ripped higher to 10%, the index gained 26.5%. (Breaks in the pattern occur, since various tail winds for big business, such as the tech boom of the 1990s, can briefly overpower historical trends.)
When recoveries peak, investor exuberance can lead to excessive risk-taking by businesses, which plants the seeds of the next downturn — just as workers are benefiting from being in high demand, with their higher wages cutting into corporate cash piles built up during good times, putting pressure on near-term profits. Financial investors also have to contend with the Federal Reserve’s response to the cycle — if there’s inflation, as there is now, a strong labor market may give it room to raise interest rates. A weak one can pressure it to cut rates. Action in either direction affects stock valuations.
This year, in addition to those forces, the war in Ukraine has slowed global growth and added to the pandemic’s strain on global supply chains, increasing the cost of raw materials.
Senior executives at Morgan Stanley wrote in a recent note that their “strategists see higher wages amid the tightening labor market and related labor shortages posing a risk to 2022 corporate profit margins,” adding a reminder that “what matters for markets isn’t always the same as what matters for the aggregate economy.”
Even though large companies achieved record profit margins last year, earnings estimates for many firms are declining compared with expectations set earlier this year.
Recent “wage inflation,” as many frame it, is seen by countless stock traders as adding one burden too many — rapid enough to worry not only executives but also some prominent liberal economists who typically shrug off complaints about labor expenses as overplayed.
Federal Reserve data shows that median annual pay increases are within the range — 3% to 7% — that prevailed from the 1980s until the 2007-09 recession. But a variety of leaders in business and in government, including Fed Chair Jerome Powell and Treasury Secretary Janet Yellen, have become more wary of their brisk pace.
In the nonfinancial “real” economy, intense competition for workers that leads to greater choice and compensation is positive “because we’re making more money, we have more money to spend, we can absorb inflation better because we’ve gotten raises,” said Liz Young, head of investment strategy at SoFi, a San Francisco-based financial services company. At the same time, she acknowledged, “The other thing with a tight labor market is that when wages increase, somebody has to pay for that.”
Through most of the swift recovery from the pandemic-induced recession, money managers made a simple bet on the strengthening labor market as a signal that more people earning more disposable income would lead to even more spending on goods and services sold by the companies they trade, enhancing their future earnings.
Now, the calculus on Wall Street isn’t so simple.
In the coming months, many financial analysts say they’ll pay less attention to data on job creation and focus instead on growth in average hourly earnings — cheering for them to flatten or at least moderate, so that labor costs can ebb.
After three years of outsized returns, the down year in markets is compounding the sour mood among the nation’s broadly defined middle class, whose wage gains have generally not kept up with inflation, and whose retirement savings and net worth (outside of home equity) are partly tied to such indexes. The University of Michigan consumer sentiment index has been hovering near lows not reached since the slow jobs recovery after the 2008 financial crisis.
Ultimately, this cranky disconnect between strong jobs data and the national mood may stem from an initial lag between relative winners and losers in this robust-but-rocky recovery: The economic benefits of tightening an already tight labor market are, in the short run, relatively concentrated — accruing to those with lower starting wages and less formal education, and to demographic cohorts like Black Americans, who are often “last hired, first fired” during business cycles. In the meantime, the downsides of even temporary high inflation are diffuse — spread broadly across the population, although frequently damaging the finances of lower-income groups the most.
It remains true that the increased demand for labor has helped millions of workers come out ahead. After adjusting for inflation, wages have fallen for middle- and high-income groups but risen for the bottom third of earners on average: The wages of the typically lower-paid employees of the leisure and hospitality industry — the broad sector focused on travel, dining, entertainment, recreation and tourism — have risen nearly 15% over the past year, far outpacing inflation.
A substantial bloc of economists are contending that wages are receiving too much blame for inflation. A recent analysis across 110 industries by the Economic Policy Institute, a progressive think tank based in Washington, concluded that wage growth wasn’t correlated with the surge in costs that suppliers dealt with last year, suggesting that much of inflation could still be stemming from other forces, like supply chain imbalances.
Many analysts believe that if unemployment stays low enough for long enough, the fruits of a hot labor market will widen — creating a virtuous cycle in which employers increase pay for various rungs of workers, while economizing their business models to become more efficient, increasing capacity, productivity and the health of corporate balance sheets.
That hope is under threat, as the Federal Reserve proceeds with a plan to increase borrowing costs by quickly raising interest rates to rein in some lending, consumer spending, business investment and demand for labor.
Despite various challenges, the most optimistic market participants predict that employers, workers and consumers can experience a so-called soft landing this year, in which the Fed increases borrowing costs, helping inflation and wage growth moderate without a painful slowdown that kills off the recovery. Morgan Stanley strategists, for instance, expect real wages to turn positive overall by midyear, outpacing price increases, as inflation eases and pay rates maintain some strength. That could be a boon for stocks as well.
“It’s possible that over the next few quarters the labor market continues to be tight despite the Fed hiking,” said Andrew Flowers, a labor economist at Appcast, a tech firm that helps companies target recruitment ads. He still sees an “overwhelming appetite” for hiring.
Although especially low unemployment isn’t typically a bullish sign for stocks, some recent years have bucked the trend. In 2019, when the S&P 500 returned roughly 30%, unemployment by year’s end had fallen to 3.6%, in line with present levels.
In such an uncertain environment, forecasts for how stocks will fare by the end of the year are varying widely among top Wall Street firms. By several technical measures, the market’s trajectory is near “make or break” levels.
Public companies have “become massively efficient, so from an operating performance basis, they’ve been able to take on these extra costs,” said Brian Belski, chief investment strategist at BMO Capital Markets. The outlook from Belski’s bank is among the most confident, with a call that the S&P 500 index will finish 2022 at 5,300 — 23% above Monday’s close, and far above most estimates.
“At the end of the day, I think for the economy it’s good that we are seeing these sort of wages,” he said. “Don’t ever bet against the U.S. consumer, ever.”
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