For businesses, rising wages will, of course, erode margins over time. However, for now, a combination of booming demand and surging productivity continues to bolster profits.
Entering the second quarter earnings season, analysts now expect a 65% year-over-year gain in operating earnings. This, on its own, is very impressive and if earnings match the expectations of analysts for the rest of the year, S&P500 operating earnings would come in at $187.30 for 2021, up 19% from the previous record high of $157.12, posted in 2019. However, in recent months, far more companies than usual have been issuing positive guidance on earnings while analysts have been marking up their own expectations on earnings results. Statistical analysis suggests that this should mean a larger than normal number of positive earnings surprises in the next few weeks.
For financial markets, this is mostly very positive news. However, supercharged demand is also boosting inflation with a May PCE deflators showing a year-over-year increase of 3.9% overall and 3.4% excluding food and energy.
Some of this higher inflation may prove “sticky” at least into 2022. One reason for this is persistent fiscal stimulus. Last week’s agreement between the White House and a bipartisan group of senators on a relatively narrow infrastructure bill could well unlock 50 Senate votes to pass a more expansive reconciliation bill over the next few months, adding a booster shot of stimulus to an economy still absorbing the effects of covid relief bills.
However, in addition to the direct effects of fiscal stimulus, wage growth could remain elevated reflecting continued excess demand for labor. Finally, recently higher inflation expectations, revealed in surveys of consumers and economists and embedded in Treasury markets, could provide further support for stronger increases in both wages and consumer prices.
In the midst of all of this, the Federal Reserve has maintained a relatively patient outlook. However, their communications from their mid-June meeting did show some willingness to adjust their policy stance in response to changing economic conditions. Those conditions are continuing to warm over the summer and suggest that adjustments in both Fed policy and investor attitudes could well push long-term interest rates significantly higher by the end of the year. For this reason, investors should still consider underweighting fixed income and U.S. growth equities and overweight equities in the more cyclical U.S. value, European and Japanese equity markets.
David Kelly is chief global strategist at JPMorgan Funds.