Stock Market Woes: The Recovery Eats Its Children

A common complaint among those whose sympathies lie more with Main Street than Wall Street is that the "recovery" since the financial crisis has benefited investors far more than workers. Since the S&P 500 bottomed out in March 2009, the index has more than tripled in value; average hourly earnings, by contrast, have grown by just over 20%. 

Apples and oranges, you may rightly object, but the market apparently saw a connection between the two measures when, on Friday, Feb. 2, the Bureau of Labor Statistics reported a 2.9% rise in average hourly earnings in the 12 months to January, the largest increase since 2009: the S&P closed down 2.1% on the day, then lost another 4.1% the following Monday (the steepest single-day fall since 2011).

If you see the economy as a tug-of-war between Wall Street (plus Sand Hill Road) and everyone else, you may have felt your suspicions were confirmed, but the logic that links rising wages to falling stocks is a bit more complex.

The day the employment report was released, inflation expectations – derived from Treasury rate spreads – reached their highest level since 2014, 2.35%.

One of the more puzzling features of the post-crisis recovery has been extremely muted inflation. The unemployment rate has been at or below 5% since late 2015, and the Fed funds rate, even after five hikes, is at the low end of its historical range. Prices' refusal to meet the Fed's target rate of 2% year-over-year core inflation has therefore bred caution and more than a little head-scratching.

There has been a persistent suspicion, though, that wages – if they ever did pick up – could take a pair of jumper cables to inflation, overheating the economy, forcing the Fed to exercise brute force, and leading ultimately to the next recession.

If rising wages were all there were to the story, stocks might have taken a deep breath and continued their inexorable upward slog. But the deficit-funded tax bill signed into law in December promises to add at least $1 trillion to the federal deficit over the coming decade, pushing up the yield on 10-year Treasury notes.

Combine that with the Fed's three expected hikes in 2018 (according to December's projections), and the result is higher short- and long-term rates. All of which is only exacerbated by a global change of mood among central bankers, who are cooling on the determined bond-buying that has driven yields below zero in some markets. Rising bond yields make stocks look risky and their dividends less attractive. (See also, The Bond Market Is Trying to Warn Us of Trouble.)

And of course these trends reinforce each other. Higher wages mean less money to pay dividends and buy back shares (in a sense there is a tug-of-war between labor and capital). The money workers save in taxes – for a time – only adds to those wage rises, potentially stoking inflation. And inflation reduces the value of coupon payments from bonds, driving up yields further.

It is ironic that factors once seen as evidence of an incomplete recovery are now being cited as portents of a bear market. Low inflation was evidence that workers who had left the labor force were still on the sidelines, which in turn kept wages low. In a two-dimensional, textbook economy, things are at their healthiest when everyone has a job with rising pay: more disposable income creates more consumption, creates more demand, creates more jobs, and so on. But that is precisely when an economy overheats, and in an environment where central banks reign supreme, their eventual reaction is the focus. The recovery contains the germ of its own destruction.

This market downturn could well reverse itself like so many others have since the crisis. A U.S. credit rating downgrade, a plunge in oil prices, a renminbi devaluation, fears of a Chinese hard landing – each has caused momentary panic, only to fade from the headlines. Then again, recent events recall the Big Rotation that Bank of America Merrill Lynch predicted shortly before the 2016 election: a Trump victory, a shift from deflationary to inflationary pressures, an end to central bank "omnipotence," an embrace of deficits, a Main Street advantage over Wall Street.