Policies from Washington

The stock market is likely to be buoyed by favorable earnings reports and a friendly FOMC Statement this week.  While the impeachment of Trump is moving ahead, it is likely to be treated as background noise by the market.  The most important news from Washington will be hints on the new Administration's policies and how it plans to work with Congress to implement them.

There already was what appeared to be a market-positive message by Treasury Secretary nominee Yellen in her confirmation hearing.  She seemed to suggest a hike in corporate tax rates is not imminent.  She said: /1/ Corporate tax hikes wouldn't be acceptable until the the coronavirus is seen having been defeated.  /2/ The hikes would be implemented in the context of a global tax treaty, which presumably would take time to achieve (if at all).  /3/ While there were several other tax changes that would be proposed, Biden "does not support a complete repeal of the 2017 tax legislation."  

Yellen, however, made another point that could be problematic from a market perspective.  She stated a goal to restructure the economy to allow lower-income workers to receive a greater share of income while remaining competitive in the global economy.  The Administration's early moves toward this goal appear to rely on a hike in the minimum wage and giving more power to unions.  A minimum wage hike to $15/hour should not, by itself, have a significant impact on overall wage inflation, because a very small share of workers receive the minimum.  It becomes more problematic if it sparks increases across the job spectrum.  This possibility is enhanced by making unions more powerful.

There would seem to be only one way to raise labor costs and maintain their global competitiveness -- depreciate the dollar.  The latter would keep labor costs from rising in terms of other currencies.  But, it would reduce the standard of living of all US workers, making imports more expensive and shifting resources into export-producing industries.

A weaker dollar has not been stated as an explicit goal of the Administration, but a quiet acceptance of a further decline in the dollar may be in the cards.  To be sure, at some point, the combination of a speedup in wage rates and a weaker dollar is a recipe for higher interest rates.  The latter would restrain economic growth, hurting lower-income people in particular, as well as undercut the stock market.  Higher wage rates also would encourage greater substitution of capital for labor in the production process.  At the end of the day, the Administration's policies could backfire.

Other stock market implications of rising labor costs and falling dollar are mixed.  If higher wages are not passed through to prices, then profit margins will likely be squeezed.   But, a weaker dollar would lift earnings from abroad and may induce corporate takeovers as well as direct investment by non-US corporations.  A weakening dollar, however, would reduce foreign demand for US stocks in their portfolios.

It has not been easy to judge whether wage inflation already has begun to speed up.  Two of the three standard measures of labor costs in the aggregate -- Average Hourly Earnings and Compensation/Hour -- have been distorted upward by huge compositional shifts stemming from the virus-induced shutdowns.  Most of the lost jobs were low paid, being in Leisure/Hospitality and Retail.  As a result, these measures' compositions shifted significantly toward higher-paid workers, showing up as large sequential increases.

This week's release of the Q420 Employment Cost Index (ECI) is not affected by this compositional shift, as it holds job distribution constant.  So, it will provide a clearer view of the inflationary implications of wage inflation at this point.  Consensus looks for +0.5% q/q, the same rate as in Q320.  This pace is lower than the 0.7% average of the prior 6 quarters (ending in Q220), consistent with the weakness in the real economy.  If the Q420 ECI stays below this average, it would signal that, as of now, labor costs do not point to higher inflation ahead.

The other important US economic data this week will be Q420 Real GDP.  Consensus looks for +4.0%, which is well below the Atlanta Fed model's current forecast of 7.5% but still above trend. A print close to the Atlanta Fed estimate would be market positive.  But, market commentators may try to downplay the print by arguing that economic growth slowed sharply at the end of Q4 and early January.  There was certainly a hit to some areas of the economy in December from renewed shutdowns.  But, not all recent data are weak and the jury is still out with regard to Q121 Real GDP Growth.  Note that while Initial Claims have printed very high in the past two weeks, Labor Dept analysts warn that the shift to additive from multiplicative seasonal adjustment last summer could distort the data during a period with major holidays, as in recent weeks.  So, the latest prints have to be viewed with caution.