Stocks have faltered amid surging bond yields. Where will rates head next? Look to U.S. wage data for clues.
Key Takeaways
- U.S. wage growth may pick back up, potentially fanning inflation and putting upward pressure on rates, which could weigh on U.S. stocks.
- Deportations could reduce the number of available U.S. workers, contributing to tighter labor markets and further wage pressures.
- Investors may want to favor cyclicals and diversify into credit products, real assets and emerging market debt.
The recent surge in 10-year U.S. Treasury rates above 4.5% has challenged U.S. equities by making low-risk U.S. government bonds increasingly attractive relative to stocks that, in many cases, are already very richly priced. So, where will rates head from here?
Many investors looking for an answer have been ping-ponging between an obsessive focus on either inflation or the labor market, knowing that the Federal Reserve sets interest-rate policy based on its mandate to foster stable prices and maximum employment. Currently, based on recent government data on consumer prices and jobs in the U.S., markets seem to expect a “Goldilocks” scenario, in which inflation is stable and the labor market runs neither too hot, nor too cold.
However, Morgan Stanley’s Global Investment Committee is increasingly focused on wage growth as the guide to the direction of rates, as this metric is a good composite of real economic growth, inflation and labor market dynamics. On this score, we see two clear pieces of evidence pointing to growth in wages, which could ultimately put upward pressure on rates.
1. The labor market could heat back up.
Consider that workers’ average hourly earnings growth stopped slowing in June and is currently pacing around 4% annually. This has supported inflation-adjusted income growth and consumer spending, evident in December’s very strong retail sales data, signaling strong consumer demand that may give businesses room to keep raising prices. Also, the unemployment rate is no longer rising, suggesting there are fewer workers available for new job openings. Meanwhile, small business confidence, which correlates with hiring intentions, recently soared to a six-year high.
2. Immigration reform may add to wage pressures.
Since 2019, immigration has accounted for 88% of the growth in the total U.S. labor force, adding roughly 3 million workers. Industries like construction, agribusiness, hospitality and transportation have the highest rates of foreign-born workers. But large-scale deportation programs could significantly reduce the number of available workers, contributing to tighter labor market conditions and pressuring wages in these industries. In addition, foreign-born and undocumented workers hold a significant share of eldercare and childcare jobs; without these workers, the labor market could tighten further as employer demand for these workers outstrips supply.
Investor Considerations
It’s worth noting other developments could suggest cooling wages—declines in hiring rates and quit rates, for example, as well as higher unemployment claims. There is also the potential for improved productivity from generative AI, which could weigh on wage growth.
However, our sense is that the aforementioned factors may push wages higher, potentially keeping interest rates elevated and thus stock multiples anchored near recent levels.
Given this backdrop, within U.S. stocks, investors should consider adding cyclicals like financials, energy, domestic manufacturers and consumer services. These kinds of stocks tend to perform well when the economy is growing and consumers have money to spend.
Also consider diversifying opportunities in credit and spread products, real assets like master-limited partnerships (MLPs) and residential real estate investment trusts (REITs), select hedge fund strategies, preferred securities, and emerging market (EM) debt.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from January 27, 2025, “Focus on Wage Growth.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
