Wage inflation is edging up. Figures next week could show that, excluding bonuses, annual wage growth is at its highest rate since 2015. This poses the question: should equity investors worry about this?
The trivial reason for them to do so is that it might cause the Bank of England to raise interest rates. But there might be a bigger danger – that wages could rise at the expense of profits. Historically, shifts in the distribution of income between wages and profits have had big effects on share prices. New York University’s Sydney Ludvigson and colleagues have shown that most of the variation in long-term equity returns since the 1950s has been due to such shifts. A rising share of wages in GDP in the 1970s clobbered shares, and a falling share in the 1980s benefited them. And US equities good run in recent years has coincided with a fall in labour’s share.
There is, though, a counter-example to this. In the UK in the late 1990s wages rose at the expense of profits and yet shares did well. This alerts us to the possibility of what economists call wage-led growth. This is that a rise in wages at the expense of profits can be good for equities if it causes aggregate demand to rise; if this happens, lower profit margins will be offset by higher sales, resulting in good returns on capital. This didn’t just happen in the late 1990s. It was also a key reason for the economic success of the 1950s and 1960s.