Why Wage Growth Holds the Key for the ASX in 2016

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Few people need any reminder of how testing 2016 is shaping up to be for investors. From the global economy, to the ASX, everything is tinged with a degree of uncertainty. After ending the year down 4.5%, 2016 looks to be another annus horribilis for the ASX.

Of course, it wasn’t supposed to be like this. The New Year was supposed to be the dawn for a new beginning. We were supposed to feel optimism about leaving a difficult 2015 behind us. All we’re left with instead is a nagging feeling that markets aren’t out of the woods.

We can sit here hoping that things will change for the better. In lieu of a real plan, hope is all we have. Yet placing faith in hope is the quickest way to destroy your wealth.

Why are we so certain that markets face a challenging year? There’s a good reason in fact to feel extremely wary about what this year holds for the ASX. Which way the scales tip could boil down to one thing: wages.

Slack wage growth holds the key for the ASX

The ‘low wage growth may kill global markets in 2016’ theory is simple enough to understand. It does require some scepticism on your part however. Not scepticism of the theory itself, but of the ‘official’ story on the global economy.

You’ll have heard policymakers bleat about a recovering economy time and again. From the US, to Australia, policymakers have parroted largely the same lines.

In the US, policymakers have even followed it up with some actual policy making. The Federal Reserve hiked rates in December for the first time in nine years. The rate hike itself didn’t mean much in isolation. But it was symbolic, crossing a threshold of sorts.

Rates typically go up when policymakers want to put the brakes on the economy. When rates are at near zero, then it’s a sign that economic conditions are improving. That’s what the Fed did. But it’s 0.25% hike seemed like a forced ploy to make everyone believe their line that the economy is actually improving. We’ll see.

Just how lasting this decision proves remains to be seen as well. But the point here remains. The rate hike was supposedly the first clue that the economic recovery, at least in the US, was on track.

Or was it? We don’t have to look far to see how hollow this ‘rebound’ really is.

In any true economic recovery, we typically see wages rise. That’s because rising wages reflect an increase in business spending. If businesses are spending, then economic conditions are sound. Simple enough.

Problem is, we’re not seeing that. Not in the US. Not in Australia. Not in the UK. Not anywhere really. Certainly not enough to match rising inflation.

Australian wages are growing at their slowest rate in over two decades. The wage price index for the September quarter rose 0.6%, at an annual rate of just 2.3%.

In the US, the situation is even worse. Up to 85% of the US labour force has seen wages rise by just 1.7%. To put this in perspective, the Fed’s wage growth target is 4.5%. All told, expectations aren’t matching up with realities.

Not only that, but wage growth is below the Fed’s inflation target of 2%. If the Fed’s inflation target was actually met, real wages would be declining.

Some recovery…

Promising wage growth, but never delivering

What’s the answer to this problem of low wage growth? Raising salaries would be a start, but things are never that simple. Or are they?

As it happens, businesses in the US have promised to do just that. Plans to lift wages are at their highest level since the GFC in the US (see chart below).

wages1

Source: Zerohedge

Sounds great, right? Well, it would be if businesses had a plan for funding these supposed wage hikes. But they don’t. Their intentions, as you’ll see, don’t match with realities.

You’ll be well aware that sound business relies on the same principles that govern household budgets. As every household knows, money must come in before it goes out. For businesses across the world, that means they must raise profits before raising wages. (We’ll ignore credit or debt funded wage growth for now.)

As you can see in the chart below, profits won’t rise unless prices do too. Right now, there’s a major discrepancy between these two metrics. In 2015, the difference between wages and prices lurched into negative territory. The last time it did was back during the financial crisis in 2008.

wages2

Source: Zerohedge

So what are we to make of all this? Essentially, we can look at this from two angles.

For one, it’s possible that businesses are flat out lying about their intentions. They may have no inclination or desire to raise wages anytime soon. However, if they’re telling the truth, then you can be sure profit margins are heading south in 2016.

Either way, even if wages remain stagnant, the news doesn’t get better for profit margins. Low wage growth is no tonic for growth. Why? Because unless inflation remains steady, household purchasing power will diminish as well. If people spend less, it means that businesses aren’t earning as much. Sometimes it really is that simple.

In the US, we can expect that wage growth will remain slack this year. At the least, it won’t grow enough to match rising inflation. Should that be the case, profit margins will be undercooked. As will the eventual flow on effect of this on stock markets.

So what does all this have to do with Australia?

We’re likely to see more or less the same thing happen here too. It’s true that the RBA hasn’t raised rates, unlike the Fed. But our borrowing costs are still steeper than the US, even with 2% interest rates. At the same time, Aussie businesses remain reluctant to spend, with mining investment particularly slack.

Should low wage growth continue in 2016, we can expect corporate profitability to slump. With weaker revenues and profits, investors will have less to cheer about. If companies aren’t making money, their stock price will reflect that. As will their dividend payouts, barring any debt fuelled buy backs of course.

All told, there’s little to feel optimistic about. Whether it’s the ASX, or the S&P500, the outlook is bleak. Without a bounce in profits, markets will face an uphill battle all year. And it means you’ll have to be extra careful about where to invest on the ASX.

Mat Spasic,

Junior Analyst, The Daily Reckoning

PS: The ASX ended 2015 almost 5% down. Unfortunately, 2016 may not provide any respite for investors. The Daily Reckoning’s Vern Gowdie says we’re heading towards a much larger crash.

Vern is the award-winning Founder of the Gowdie Letter and Gowdie Family Wealth advisory services. He’s ranked as one of Australia’s Top 50 financial planners.

Vern wants to help you avoid this coming wealth destruction. His special report, ‘Five Fatal Stocks You Must Sell Now’, will show you how. In it, Vern shows you which five blue chip Aussie companies could destroy your portfolio…you almost certainly own one of them. To find out how to download the report, click here.

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