Inflation in the US has fallen faster than many had originally thought possible — and even more unexpectedly, this was achieved without sending the economy into recession or causing higher unemployment. Inflation has fallen from the peak of 9.1% y-o-y from June 2022 to 3.4% in the latest December 2023 Consumer Price Index (CPI) report. Meanwhile, US economic growth rose to 2.5% last year, faster than the 1.9% in 2022. The job market remains robust with the unemployment rate hovering near the lowest levels in decades, at only 3.7%. Some have coined this relatively painless drop in CPI “immaculate disinflation”. We have dis-cussed some of the reasons for this (including government largesse and excess savings as well as low fixed-rate borrowing costs during the Covid-19 pandemic) in previous articles.
Against this backdrop of disinflation, wage growth — on the back of the resilient economy and tight job market — has been outstripping inflation. In other words, real wage growth is positive, and has been since May 2023. And yet, over the past year, we have seen an uptick in strikes across the US, including several large-scale, high-profile ones involving auto workers, Hollywood actors and writers, pilots and healthcare workers. There has also been a discernible increase in union organisations.
Why are workers feeling so hard-pressed — when wage growth is outpacing rapidly falling inflation — that they are willing to risk the consequences, given the comparatively weak American labour laws?
Why is there so much labour — indeed, voter — discontent?
Surveys routinely show inflation and pessimism over the health of the economy topping the people’s concerns, despite the economic data proving otherwise — not a trivial matter in a presidential election year. Is it simply misguided perception? Are we innately biased towards the negatives and bad news? Perhaps. But there is also a data-based reason that we can, simplistically, explain with a few charts.
Let’s start with the severe supply disruptions during the pandemic. As we all know, the combination of international border closures and widespread lockdowns (resulting in massive supply chain disruptions and consumers shifting their spending from services to goods), huge fiscal stimulus and cash handouts, as well as the wealth effect from a booming stock market led to a surge in demand for goods. As demand far outstripped supply, prices (inflation) rose sharply higher. As you can see in Chart 1, the CPI index gradient turned very steep during this period (A), compared with pre-pandemic norms.
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Moving into 2022, as lockdowns were lifted, supply chain disruptions gradually normalised. And the CPI more or less reverted back to its longer-term (pre-pandemic) slope. This was the period of disinflation (B), where CPI dropped from the peak of 9.1% in June 2022 to 3.4% in December 2023. Disinflation does not mean that prices are falling — only that prices are rising at a slower clip. The slowdown in rates is to be expected. The headline CPI is a year-on-year (y-o-y) comparison, for example, the latest CPI of 3.4% compares prices from December 2023 to December 2022. Given the high base effect (after the price surge), inflation should be lower — unless prices are still rising at an accelerating pace.
But the fact remains, prices are much higher now, compared with if the pandemic surge did not happen and prices had continued to rise at the pre-pandemic pace over the last three years. This is illustrated as the difference between the blue and orange lines in Chart 1.
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Because of the surge in inflation in 2021- 2022, nominal wage growth lagged CPI and real wage growth turned negative (see Chart 2). In other words, adjusting for inflation, real wages fell during this period of high inflation, and only stabilised after the CPI peaked around mid-2022 (see Chart 3). Falling real wages means that workers are worse off in terms of purchasing power. In effect, people could buy less for the same amount of money.
Real wage growth only started to slowly recover after the CPI peaked in mid-2022 — and did not return to positive territory until May 2023. As such, real wages today are barely above pre-pandemic levels in 2019 — and they remain well below where they would have been, based on historical trend had the pandemic not happened (the gap between the blue and orange lines in Chart 4).
Real wages need to catch up after pandemic-driven inflation surge
In short, workers have valid reasons for their current dissatisfaction. Companies hiked selling prices sharply higher at the height of the pandemic, well in excess of actual cost increases (when demand exceeded supply) and enjoyed stronger margins for it. Case in point: margins for the S&P 500 companies rose to a high of 13% in 2Q2021, well above the average margin of 10.6% in the previous five years. This “greedflation” contributed to the overall surge in CPI, on top of actual cost increases.
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We believe it also means that wages would now have to grow faster than CPI for a time, for workers to catch up — restore their purchasing power — after the steep increase in prices during the pandemic. Case in point: last year’s striking workers won big concessions from companies. For example, the deals between the UAW (Union Auto Workers) and the three big automakers included a compounded base wage increase totalling 25% through April 2028, with an immediate increase of 11% upon ratification, plus reinstated cost-of-living adjustments, effectively giving workers a 33% raise.
Statistically, accelerating month-on-month (m-o-m) CPI changes (orange line) in period C led to the surge in y-o-y CPI (blue line) numbers (see Chart 5). And the sharp drop in the m-o-m CPI numbers after mid-2022 led to the rapid disinflation in period D. Notably, m-o-m CPI has stabilised around the pre-pandemic range, rather than continuing to fall to lower levels. In other words, inflation has moderated back to trend — it is no longer accelerating but neither is it falling. This is reflected in the headline y-o-y CPI flatlining — instead of continuing to drop — in the past half year or so.
Thus, there is a lead and lag time in time series data. When we describe a rate of change of one economic variable versus another, one needs to be mindful of the time series applied.
For easier understanding, we summarised all of the above CPI and wage statistics in the Table below.
Services inflation is still rising faster than its long-term trend, driven by wage growth — which, as we have explained above, will likely continue for a period. Meanwhile, goods disinflation (after the steep rise) has flatlined now that pandemic supply disruptions have largely resolved, and there is no more excess demand as consumers have shifted their spending back to services (see Chart 6).
This is the reason why we believe a further drop in CPI will be incrementally more difficult, as we now have a lower y-o-y base effect going forward, and especially in a soft-landing scenario. Wages are sticky and account for about half of the total costs for all S&P 500 companies. Importantly, the percentage is higher for the services sector and lower for manufacturing, and the former makes up two-thirds of the US economy. Businesses will protect their margins as far as possible, by passing on the higher costs (wages) and generating inflation — unless the economy tips into recession.
It is also why we think current bullish stock market expectations based on the combined factors of rapid disinflation (and lower interest rates), a soft landing and double-digit earnings growth (with margins expansion) are inherently incompatible. They cannot all happen in the same breath. We will explore this further next week.
Box Article: Beware when ‘experts’ begin to form consensus
The ringgit has started 2024 on a weak note — falling rapidly from 4.59 at end-2023 to around 4.74 against the US dollar. This is contrary to consensus expectations, which is for the ringgit to strengthen this year. A quick tabulation shows prevailing forecasts ranging from 4.30 to 4.58, with a median estimate of 4.40 to the greenback. Almost all of the estimates were predicated on US federal funds rate cuts this year (see flashbacks and chart).
“Our current view for the ringgit to recover in 2024 is driven predominantly by expected Fed rate cuts in 2024, while Bank Negara is more likely to hold rates rather than cut. While the interest rate differentials may remain unfavourable against the ringgit, the relative change in direction should help the ringgit to recover against the US dollar. A more stable China and renminbi will also mean less of a drag on the ringgit,” Standard Chartered Bank’s Asean and South Asia chief economist Edward Lee told The Edge Malaysia in a recent interview.
“Rakuten Trade expects the ringgit to trend in the RM4.40 to RM4.50 range next year, supported by expectations of interest rate cuts by the US Federal Reserve (Fed) along with the massive foreign direct investments into Malaysia.”
To be sure, the year is still very young and there is ample time for things to change — and for the predictions to come true. That said, there was no material shift in Fed rate cut expectations (at least not until very recently) that would explain the rather steep slide in the ringgit. Based on Fed fund futures pricing data (at the point of writing), the highest probability for the March 2024 Fed meeting is for the first interest rate cut in this cycle, while consensus for Fed funds rate reductions by end-2024 remains at 1.5%.
Clearly, there are other factors at play. Interest rate differentials, while important, are not the sole determinant of exchange rates. Yes, we understand that the forex market is extremely unpredictable. Maybe analysts are just optimists by nature. But perhaps most analysts also aim to please, rather than offend, even at the expense of professional dishonesty — and they are increasingly doing sales to generate revenue? After all, how often do we see negative analyst reports, especially one that is contrarian?
— End of Box Article —
Stocks in the Malaysian Portfolio finally succumbed to some profit-taking after racking up a string of weekly gains. Total portfolio value fell 4.2% last week but still ended 8.6% higher for the month of January. The top losing stocks were Insas-WC (-15.9%), Insas Bhd (-7.9%) and Frasers Logistics & Commercial Trust BUOU (-2.9%). UOA Development Bhd (+1.1%) was the sole gainer while DBS Group Holdings closed unchanged from the previous week. Total portfolio returns now stand at 189.7% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 17.3%, by a long, long way.
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