August market outlook: Solid growth continues

But rising wages may increase inflation, and Fed interest rate hikes could boost volatility.

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Three key takeaways

✔  Global economy continues to grow steadily.

✔  Rising wages may boost the current low inflation rate.

✔  More Federal Reserve rate hikes may raise volatility.

The market continues to add gains and inflation remains low. Dirk Hofschire, senior vice president of asset allocation research, offers insight on what this may mean for investors in his monthly market catch-up with Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company.

Schuster: Could you just review what's been happening in the markets most recently?

Hofschire: Not much has changed really. It's been a pretty calm summer here through the first couple months. Stocks and bonds have continued gradually to add to some of their gains this year. The global economy seems to be chugging along all right and in spite of that, the one distinctive feature that’s been at the top of the headlines a lot over the past few months is that we have yet to really see a material pickup in inflation even though growth has been pretty solid.

Schuster: Normally we would expect higher inflation given the positive economic growth but it has been more muted. Could you elaborate a little bit more?

Hofschire: If you think about inflation within the context of the business cycle, inflation typically picks up as the cycle gets more mature, because as the expansion rolls on, you’re absorbing a lot of slack that you had coming out of a recession.

Especially in the labor markets, unemployment starts out usually pretty high at the beginning of an expansion, then it comes down as jobs are added, wages pick up, and then you tend to see broader inflation as those wages rise. And it appears this time, for a number of reasons, this process has been really slow to take effect.

I think some other reasons are very long term, what we call secular in nature. Things like globalization—you have more competition from workers globally, there is technological advancement and automation. These things together hold down the prices, especially of manufactured goods. But there are also some nearer‐term things, cyclical things that have been happening. So a huge amount of slack that we started off with at the beginning of the cycle after the financial crisis, the terrible recession, 10%-plus unemployment, and beyond that we have a lot of extra unemployment in there that wasn’t showing up in the official numbers. People dropping out of the labor force not being counted, people working part time even though they wanted to work full time.

When you put this all together, long story short is I think some of these long‐term trends may not fade. We shouldn't expect that right around the corner is going to be this huge inflationary wage boom, but the good news is, the extra slack has been coming down, wages have been rising slowly over the past several years, and I’d expect that to continue to gradually increase inflation as we go forward.

Schuster: What's an investor to think about this in their portfolios?

Hofschire: So you think about that business cycle outlook again and that wage picture, the overall inflation picture has tended to be really important and oftentimes when it does pick up materially you see a move toward a later cycle phase in the economy. So wages, as they rise over time, tend to start to crimp profit margins, and the Federal Reserve tends to get more aggressive with its monetary tightening.

So if wages keep ticking up, even if they don't skyrocket, but they keep ticking up, we’re probably then moving into a more mature business cycle phase. Once that happens, we’ll expect more Federal Reserve rate hikes and even though this may be slow as we move forward, it could inject more, higher volatility in the markets as we go ahead.

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