UK pay growth is picking up strongly, consistent with the historical relationship with the job openings or vacancy rate*, a measure of labour market tightness. This relationship suggests a continued upswing through mid-2016, at least.

The three-month smoothing of average weekly regular earnings (i.e. excluding bonuses) rose by 2.7% in the year to April, the largest annual increase since February 2009. Total earnings and earnings per hour also grew by an annual 2.7%. Hourly earnings had been lagging the weekly measure (i.e. employees’ average weekly hours had been rising) but the gap closed in April – see first chart.

A post in September argued that weekly regular earnings growth, then below 1%, was about to rise significantly, since the job openings rate had surged over the prior two years and had almost regained its pre-recession peak, indicating a tight labour market – see second chart, which is reproduced from the earlier post. The Bank of England and consensus view, by contrast, was that hidden slack (e.g. a large number of part-time employees wishing to work full-time) and rapid labour supply expansion would limit upward pressure on pay.

The weakness of earnings growth in 2013-14 seemed to support the consensus view that the job openings rate was overstating labour market tightness. The two series had turned down simultaneously in 2008 so their divergence in 2013-14 suggested a structural break in the relationship.

As noted in the earlier post, however, the openings rate led earnings growth by between six and 12 quarters at turning points in the 1970s and 1980s – third chart. The simultaneous fall in 2008, therefore, was unusual but the divergence between weak earnings growth and a surging openings rate in 2013-14 was not.

The current earnings pick-up is consistent with the historical relationship. As noted in the earlier post, “the openings rate bottomed in 2009 but embarked on a sustained rise only in the second quarter of 2012. Based on the average nine-quarter lag following the three increases over 1970-90, this suggests an upswing in earnings growth starting in the third quarter of 2014.” Regular earnings growth has risen steadily from a low of 0.7% in the second quarter of 2014 – fourth chart**.

The increase in pay growth is more impressive against a backdrop of falling / low consumer price inflation, which would be expected to subdue wage demands.

The job openings rate rose further in the fourth and first quarters, surpassing its 2008 peak, though has since fallen slightly. If the first quarter were confirmed to be a peak, the minimum six-quarter lead in the 1970s-80s would suggest a continued uptrend in earnings growth through the third quarter of 2016, at least.

*Vacancies as a percentage of employee jobs plus vacancies.
**Quarterly data except for the last data points, which refer to the latest three months. 

The balance of US activity news has improved so far in June, supporting the widely-held view that the economy is rebounding from weather- and strike-related weakness in early 2015. Monetary trends suggest that the pick-up will extend into late 2015 but investors should be wary of extrapolating optimism into 2016, for several reasons.

First, monetary strength may be fading. Six-month growth of real narrow money peaked in February, though appears to have remained solid in May* – see first chart. Real narrow money leads activity (industrial output) by nine months on average**, so this suggests that economic growth will moderate at end-2015.

Secondly, corporate finances are deteriorating. The “financing gap” of non-financial corporations, i.e. capital spending minus retained earnings, rose to 1.2% of GDP in the first quarter, the highest since the second quarter of 2008 – second chart. The gap is not yet at a worrying level but increases historically have preceded economic slowdowns or recessions, albeit sometimes with a long lead – third chart.

Note that the financing gap does not include borrowing to fund share buy-backs and M&A. A wider deficit measure including net equity buying tends to lead the yield spread between non-investment-grade corporate bonds and Treasuries and reached 4.3% of GDP in the first quarter, suggesting future spread widening – fourth chart.

Thirdly, cycle analysis warns of a possible economic downturn in 2016-17. This was discussed in detail in a post last August but, to summarise, the Kitchin stockbuilding cycle is scheduled to reach a low between 2015 and 2017, and the Juglar business investment cycle between 2016 and 2020. There is a risk that the downswings in the two cycles will coincide in 2016-17, producing a recession.

A recession should be signalled well in advance by a sharp slowdown or, more likely, a contraction in real narrow money – as previously discussed, such a contraction occurred before 10 out the 11 post-WW2 recessions, the exception being the 1954 downturn, which had a large fiscal element***. No such signal has yet been given.

*Based on May monetary data and a forecast of the consumer price index.
**Based on a study of G7 data over the last 50 years. The study – available on request – also confirms that real narrow money is superior as a leading indicator to real broad money, real bank lending and the rate of change of real bank lending (i.e. the “credit impulse”).
***Real government spending fell by 6.4% between 1953 and 1954.