U.S. corporations are worried about rising wages, and for a good reason.
Though only a handful of S&P 500 SPX, -0.06% companies have reported first-quarter earnings so far, nearly half of those firms have anecdotally, or otherwise, referred to wages and labor costs as “a fact that either had a negative impact on earnings in [the first quarter] or [one that] is expected to have a negative impact on future earnings,” according to John Butters, senior earnings analyst at FactSet, in a research note.
Meanwhile, broader economic data underline the case that this is no temporary problem, but one that could worsen in coming quarters and even threaten to trigger an economic recession, according to a Morgan Stanley research report published Monday.
“Large public companies and small businesses alike are discussing labor costs as a major headwind to profitability,” wrote Morgan Stanley equity strategist Adam Virgadamo. “Sustained wage pressures add to the likelihood of an earnings recession in 2019 as higher labor costs and slowing top line growth create a dangerous recipe for margins. In the bear case, the earnings recession could spur layoffs and raise the probability of an economic recession,” he warned.
While wage growth by some measures, like average hourly earnings, remain near historic averages, Virgadamo warns that underlying data, which show the broadening of wage gains and the acceleration of overall compensation growth, will combine with an apparent trend of slowing revenue growth to crimp margins, a development that could result in employees being laid off.
Average hourly earnings grew at an annual rate of 3.2% in March, down from 3.4% in February, but well above the 2.3% average annual pace seen over the past 10 years, according to the Labor Department. The Employment Cost Index, as pictured below, and which includes the growth of non-wage payments, like health-care benefits in addition to wages, has been accelerating more steadily: to 2.9% annually from 1.9% in 2016.
The Federal Reserve closely watches wage growth data, as it is seen as a significant contributor to inflation. The central bank’s recent decision to cease raising interest rates in 2019 indicates that it doesn’t see runaway wage growth as a problem. The minutes of the Fed’s March reading said that “economywide wage growth was seen as being consistent” with the Fed’s target of 2% annual inflation.
Nevertheless, Virgadamo cites the growing share of U.S. industries facing wage pressures as worrisome. “As of February 53.6% of industries were experiencing above-trend wage growth,” he wrote. “That compares with 46.9% in February a year ago, and an average level of 42% that prevailed throughout the expansion to date.”
He goes on to argue that once wage pressures become as broad as they are today, those pressures tend to accelerate as industries that haven’t yet seen wage growth are pressured to raise wages to keep their workers from leaving.
While it seems logical that rising wages could help companies boost revenue, as consumers have more money to spend, Virgadamo points out that wage momentum of the type occurring today typically happens late in an economic cycle, and can potentially trigger recessions as corporations fight the rising costs of labor with layoffs.
Another reason for investors to be skeptical of rising wages is the personal savings rate. “The bull case attached to rising wages is that higher wages can spur consumer spending and offer sales growth support for consumer facing companies,” wrote Virgadamo, but in recent years rising wages have been matched commensurately with rising savings. During recent years, “ an increasing percentage of higher wages are being saved.”
It is this dynamic that has Morgan Stanley analysts worried about an earnings recession, or worse, an economic one. “While it’s too early to make this call yet, our bear case for the US equity market is based on companies seeing more margin pressure than they can absorb, and cutting labor to help protect profits.”
But even if rising wages don’t lead to layoffs, they will very likely cause corporate profit margins to fall, creating a major headwind for stock valuations going forward.
“We see profit margins being compressed going forward as labor cost pressure continues to gradually build, productivity growth moderates, and prospects for increased pricing power remain limited,” wrote Lydia Boussour, senior U.S. economist at Oxford Economics in a Monday note.
While Boussour predicts modest earnings growth for the full-year 2019, she sees risks to corporate earnings as skewed to the downside, given the fragility of the global growth picture. “In the event of a sharper acceleration in US wage growth or a renewed slump in productivity growth,” she wrote, “profit margins could fall more sharply and feed back into slower investment and job creation.”
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