Thoughts through the cycle: W1 March ’21

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Wage inflation – does it mean something is afoot when the arch-disruptor gets disrupted?

  • The decade or so following the global financial crisis has very much been one where tech has been king. An easy-money environment has been the backdrop to a quest for digital innovation and disruption which has resulted in astonishing company valuations. Warren Buffett once said that interest rates are the gravity of asset prices, and with rates kept low by central banks, not only could equity values soar, but the usual capital discipline and cashflow orientation of early stage business operations could be set aside. Revenue growth has been key, with profit treated as an optional extra.
  • Prince among the disruptors is Uber (UBER.US), the ride-hailing app which has partially morphed into a food-delivery service during the pandemic, but which still has aspirations towards flying taxis. In the last five years (FY 2016-20), the company has raised $17.2bn in equity, has invested $6.7bn, but has also lost $12.9bn on operations. In this respect it would seem that the only thing that this particular disruptor has truly disrupted is the accounting principle of going concern. But selling something at $0.70 that is worth $1.00 is ok these days so long as you have a killer app.
  • This being so, the stock is doing pretty well, as the graph below shows. It seems that higher pandemic food delivery volumes have offset a fall in rides, even though the former are even less profitable than the latter. Enough said on markets for now. It is important though to distinguish between a popular service (Uber is cheap and convenient) and a flawed business model (it currently offers rides too cheaply to generate a positive operating free cashflow).

Source: Bloomberg, 26th February 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • One of the phenomena common to new industries or disruptive technologies is that the legal framework in which they operate is often lax, or that the disruption itself bypasses the currently regulated market and finds a new, unregulated space in which to operate. Uber is one such company, and it has managed to avoid the responsibilities that normally accompany being a large employer with respect to holidays and sick pay for its drivers by saying they are independent contractors, and it just facilitates the rides through its app. The same ‘drivers are contractors’ argument was the legal basis on which Uber tried to avoid paying VAT in the UK as well. Add back VAT and an Uber ride is not that much cheaper than one in a black cab.
  • On February 18th 2020, the UK Supreme Court ruled in favour of 35 Uber drivers who brought a case back in 2016 against their (apparently not) employer Uber saying that they were in fact employees, not independent contractors since the company controlled and allocated their work , while also dictating fare levels (‘Uber loses landmark UK battle as Supreme Court rules drivers are workers’, FT, 19/02/2021).
  • While this only initially affects the workers in the case, and only applies to the UK and its employment law, it provides a key moment in the narrative for disruptive tech firms. One of the reasons their valuations have soared is that they often find themselves unshackled by the responsibilities that more traditional business operations are burdened with. Write some code, get your stock potions, bro down. Uber faces similar challenges in other jurisdictions, and given its operating model is already inherently loss-making in its current guise, this may yet prove to be an existential issue for the company.
  • There is a wider point to be made here, which affects both the stock market but also society more broadly. Although it sounds a bit old fashioned, the last 50 years or so have witnessed a period where real wages have lagged relative to profits. What this means is that while productivity has risen (through technological and efficiency gains), workers have got less of that increase than capital, resulting in larger company profits which has been a key driver for equity valuations, especially in the US. The bum deal that gig workers get is not just a consequence of this – the very existence of gig working (zero-hours contracts) is the result of this long-term trend in capital gaining a higher share of income over labour.
  • The graph below is taken from an OECD working paper (‘The Labour Share in G20 Economies’, 2015), and illustrates the point more clearly. In this case, from 2000 onwards, the real wage index can be seen to lag productivity. Higher profit margins allow a multiple expansion in equities, and given the lop-sided nature of share ownership, this means the rich get richer and the poor stay poor. For those looking for a root cause for populism, this is a good starting point.

Source: The Labour Share in G20 Economies’, 2015.

  • The question is whether this balance between labour and capital is changing. The Uber case illustrated above at least suggests that regulation is starting to catch up with the tech disruptors, even if it is still early days in terms of legislative changes, better workers’ rights or horror of horrors, even the prospect of unionisation. On the 25th February, the European Commission said it was starting a consultation into the matter of extending the rights of gig-economy workers to match those of permanent employers. Clearly change is in the wind.
  • As with most things, the lead often comes from the US. The Biden administration has been vociferous about improving workers rights, although at the time of writing, the stimulus bill heading from the House to the Senate does not include provisions for a $15 minimum wage (the current minimum, which has been in place for over a decade, is $7.25). To some extent this hold up is procedural (the parliamentarian objected to a minimum wage clause being included in a revenue-based Budget Reconciliation bill), and there are mumblings about the White House looking at using tax hikes to punish firms who don’t have a $15 minimum hourly wage, even if the wage itself is not law.
  • Nonetheless, if the stats are to be believed, US wages have improved in the last 12 months. Whatever one calls the collapse and rally since last March, the word ‘recession’ doesn’t really seem to cover it, at least in a conventional sense. The graph below shows US hourly wages increase on a year-on-year basis. The spike in Q2 2020 relates to the CARES Act, but one can see that wages subsequently remained higher than pre-pandemic levels, with the latest data for January 2021 showing a year-on-year increase of 5.4%. This rate of change should be assessed in the context of the Fed’s favoured measure of inflation, the PCE deflator, which came in at 1.5% in January.

Source: Bloomberg, 26th February 2021.

  • One ought always to be careful about averages in economics as they, like easy-fit clothing with elasticated waist bands, can hide a multitude of sins. Fed Chairman Jay Powell says the real unemployment level in the US, when factoring in underemployment and lower participation rates, is nearer 10-11% of the workforce, much higher than the 6.3% headline rate recorded in January. The broader U-6 unemployment rate for January was 11.1%, down from a massive 22.9% in March 2020, but still significantly higher than the sub-7% level recorded pre-pandemic.
  • Yet the new relief bill passing through Congress includes provisions for an additional $400 per week for the unemployed through August. This is significant, especially given the bill also includes $1400 per person Covid-19 relief on top of the $600 checks approved in December. Beaucoup money one might say.
  • Such generous benefits are starting to look a little like universal basic income (UBI), even if it is a temporary policy at this stage. The question is always off the cliff – the sudden stop of government fiscal largesse even if the underlying problem (in this case high unemployment) is still extant. In the meantime, this all has a reflexive effect on companies’ wage policy – note Walmart (WMT.US) recently raising the wages for a number of its employees to $15 – the proposed level of the new minimum wage.
  • Why does all this matter? Inflation appears to be raising its head again in 2021, and the question is whether it is a passing phenomenon due to supply constraints resulting from pandemic-related disruption, or whether it is a nascent structural issue related to aggressive central bank monetary policy and crazy big government deficits, with a bit of supply-chain reorganisation and economic nationalism (especially resource nationalism) added in for good measure. The difference here is between ‘inflation’ (the thing they measure each month in terms of CPI, PCE deflator) and ‘an inflation’, a socio-economic event which changes the balance within society. The 1970s was ‘an inflation’ for example.
  • The link between wage inflation and unemployment started to be measured in the 1960s, and the statistical relationship is measured as the Phillips Curve. Initially, the correlation was negative, in that rising wages led to higher unemployment. And visa-versa. This correlation turned positive in the 1970s, with higher wages also accompanying higher unemployment. The relationship subsequently became more tenuous, not least because of the decline of collective wage-bargaining, outsourcing, automation of blue-collar work and so on.
  • So when you have a period of high unemployment, rising inflation, and rising wages, the relationship between these three elements (inflation, wages, unemployment) becomes a key way of judging not only whether we are in a period of reflation or inflation, but in the case of the latter, whether the inflation is transitory or a more permanent feature. That is where we are now, and thus monitoring the reflexive relationship between these metrics becomes a key part of the asset allocation process. Get it wrong during a period of structural inflation, and your money disappears very quickly indeed.
  • We have had a taste of that very recently. The current on-the-run 30yr US Treasury bond (the 1.875% of Feb 2051) came at a when-issued price of $98.68 on 16th With a sniff of inflation in the markets, the long end of the US yield curve sold off sharply, and this bond bottomed just below $89 on the 25th February. That is a 9.8% mark-to-market loss in just eight business days since issuance. In the 1970s, the 30yr Treasury bond was known as the widow-maker. The price action of the last few weeks is a salutary reminder that so far as inflation is concerned, risk can happen very quickly.

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Thoughts through the cycle: W4 March ’21

Can the markets tolerate higher inflations and therefore higher bond yields without becoming ‘disorderly’, the RWC Diversified Return team explore the conversation from this week’s Fed meeting…

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