LONDON (Reuters) - After a decade of near zero real income growth across the developed world, workers may well be seeing wages rising again at last and global markets do not like it. Why?
The global stock market sell-off that followed news of a surge in U.S. household earnings data on Friday appears counter-intuitive at first. After all, higher wages should mean more money for people to buy goods and services, boosting profits for firms making those goods and supporting the economic expansion.
But if rising wages cement expectations that long-absent inflation is returning to a booming world economy, then bond markets are already scrambling to price in the greater risk to future value fixed income returns over time, sending long-term bond yields higher to compensate.
Of course, bonds yields are rising from their lowest in history, the result of unprecedented stimulus let loose by central banks in an attempt to kick-start economies enfeebled by the 2008/9 financial crisis. And, in turn, those ultra-low debt yields have already underwritten one of the longest equity bull markets in history.
Those record-low rates on “risk-free” assets forced a global hunt for yield, boosting demand for shares which are riskier than bonds but offer superior returns. The price paid to compensate for taking the risk of investing in stocks rather than in bonds is defined as the “equity risk premium” (ERP).
So with bond yields now rising on expectations of higher inflation, the ERP premium looks less attractive and hence the significant retreat in share prices.
“There’s a mechanical effect”, explains Sylvain Goyon, head of equity strategy at Natixis.
Holding a 10-year U.S. Treasury bond currently yields a “risk-free” return of 2.85 percent (that was about 2.3 percent a year ago) and growing pressure on the Fed to “normalize” monetary policy puts that figure on an upward trend.
(To view a graphic on equity risk premium, click reut.rs/2EIr2WJ)
Reuters Graphic
CORRECTION?
One way to measure the ERP is to calculate how much on average company earnings represent in the market capitalization of the S&P 500 (currently very close to 4 percent) and to subtract the current yield of 10-year U.S. Treasury notes, which is about 2.85 percent.
The larger the difference between the two, the greater the premium investors receive for investing in risky assets such as stocks.
The smaller the difference, the lesser ERP investors receive, making so-called risk-free assets such as bonds more attractive.
As you can see with the blue line of the chart below, the earnings yield is on a downward trend and the market is adjusting to this new environment.
A number of economists have called the beginning of a “bear” markets for bonds, meaning that they expect interest rates to rise strongly as central banks across the globe tighten their policy to keep inflation in check.
“Rising U.S. Treasuries yields should continue to put pressure on U.S. equities, as we have seen over the last week”, SocGen analysts wrote on Monday.
“Indeed, our U.S. equities risk premium is back to 2.5 percent (a level only seen during the dotcom bubble), and thus it will be difficult to absorb higher bond yields”, they said.
The bears have not won the argument yet, however.
Others say the latest dip in share prices is not about sudden inflation panic, but a realization that 15 successive months of higher share prices were unprecedented since the 1950s and some profit taking around the turn of the month was normal.
“At our portfolio meetings, we were saying not ‘is a correction going to appear’ but ‘when is a correction going to appear?',” said Andrew Milligan, head of global strategy at Aberdeen Standard Investments.
Milligan warned against reading too much into Friday’s U.S. payroll numbers: “There is a long way to go between one monthly figure saying U.S. wages are a little more than expected to saying core inflation in the world economy is moving away.”
He said there were wage pressures in some industries across the world but these were not widespread, and there was no sign of a let-up in deflationary forces unleashed by the rise of online retail, automation, digitization and globalization.
(To view an interactive graphic: The wages tipping point, click tmsnrt.rs/2EBSYeO)
Additonal reporting by Tom Pfeiffer; Editing by Alison Williams
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