Continued Disinflation With Strong Stocks?

Summary

• In my view disinflation with strong equity market performance is likely to continue.
• A post-pandemic productivity pickup is translating into lower labour costs rather than into higher wages, which supports further disinflation but adds downside risks to growth.
• The income share of profits is continuing to rise, which is translating into rising equity market capitalization relative to GDP. Equity markets could do well even with slower growth.

Market Implications

• I expect two more Fed cuts in 2025 and three in 2026 against the market pricing two more 2025 cuts and two 2026 cuts.

Strong Productivity Benefits Disinflation More Than Workers

Recent data shows both fast productivity and slow wage growth. In this note I argue that, although it implies a GDP growth slowdown, the combination is supportive of both disinflation and a strong stock market.

Recent growth data revisions have been consistently positive, with the Atlanta Fed Q3 nowcast currently at 3.8% QoQ SAAR, up from 2.3% when the nowcast was initiated on July 31^st (Chart 1). This is a marked acceleration from 1.6% average GDP growth in H1.

Growth has been productivity rather than employment driven. Based on Sam’s model’s forecast of a large positive employment surprise, Q3 NFP would still only increase by 0.5% QoQ SAAR, well below Q3 GDP growth. This discrepancy is very much in line with the fast productivity growth trend since 2023 (Chart 2). I don’t believe this reflects AI adoption yet but rather that businesses, having faced labour shortages during the pandemic, have adapted well to the reduced availability of labour caused by current immigration policies.

By contrast with the fast productivity growth, nominal wage growth has been slowing (Chart 3). As a result, unit labour costs (ULC), that are positively related to wages and negatively related to productivity, have been slowing too. The slowdown in nominal wage growth is striking as it has translated into an increase in real wages well below that of productivity. This points at weak worker bargaining power.

Historically, slower ULC growth has been associated with disinflation (Chart 4). That is, the current combination of slower wage growth and fast productivity growth suggests further disinflation.

Chart 1: Q3 Growth Close to 4% QoQ SAAR!	Chart 2: Post-Covid Productivity Pick Up
Chart 3: Wages Lag Productivity	Chart 4: Slower ULC Lower Inflation

At the same time, demand-side data suggests the Q3 growth pickup is likely not sustainable.

Greater Downside Risks to Growth Than to Equity Markets

H1 GDP data has been difficult to interpret because of the swing in net exports (Chart 5). For instance, capex (non-residential investment) seems to have been a stronger growth driver than consumption. This is misleading because of capex’s high import content and spending on imports does not raise GDP.

The import content of domestic spending cannot be easily estimated precisely as it would require detailed calculation based on input/output tables. Nevertheless, in order to get a rough idea of the actual contribution of consumption and capex to GDP, I’ve subtracted net imports of capital goods, industrial supplies and services (excluding personal travel) from capex and net imports of consumer goods, food products, cars, and personal travel from consumption (net imports = imports-exports).

The results can be seen on Chart 6. Once import content is taken into account, consumption contributed more to H1 growth than capex did (I’ve averaged Q1 and Q2 growth). Capex has recently largely been driven by AI-related investment but because of its high import content its actual impact on GDP has been limited.

Consumption strength however is unlikely to last. This is because the pickup in consumption reflects a decrease in the savings rate rather than an increase in consumer income (Chart 7).

The savings rate is low by historical standards, especially if we exclude the 2021-22 period when extremely large government transfers distorted the savings/consumption decision (Chart 8). This suggests the savings rate does not have much further downside (I will explore in greater details in future research what has been driving the savings rate).

The low growth in consumer income in turn reflects the slow growth in employment and wages mentioned above (Chart 9). Those suggests the pickup in Q3 growth is unlikely to be sustained. Softer growth would be supportive of disinflation, through higher unemployment and slower wage growth.

At the same time, slower GDP growth need not be negative for equity markets. The wage and employment numbers discussed above imply a continued decline in the income share of labour and a continued increase in that of profits (Chart 11). These income trends reflect factors such as increased business concentration, globalization, labour saving technological progress and regulatory and legal changes adverse to labour.

Historically, these trends have been the main drivers behind the steady rise in equity markets capitalization relative to GDP (Chart 12). This implies that equity markets can do well even if growth slows down, as long as the US does not get into a recession, which is not my base case scenario.

Chart 5: Net Exports Swings Drive H1 GDP	Chart 6: Consumption Drives GDP
Chart 7: Lower Savings Drive Consumption	Chart 8: Savings Rate Already Very Low
Chart 9: Slower Labour Income Growth	Chart 10: Disinflation to Continue
Chart 11: Profit Share Rising Further	Chart 12: Market Cap Growth Above GDP

I’ve changed my broad macro views. I no longer expect that the end of immigration will lead to stagflation and that Q3 GDP growth is likely to remain below potential. The changes reflect the GDP data revisions as well as the continued wage growth slowdown. The latter is particularly striking in view of the sharp decline in labour supply. It suggests weak worker bargaining power. It also implies that the Trump administration could struggle with its earlier goals of raising the income share of lower income Americans.

Market Consequences

I continue to expect medium-term inflation to surprise on the downside and the Fed to cut twice more in 2025, in line with market expectations and to cut three times in 2026 against markets pricing about two cuts.

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