Why companies and investors are keeping a watchful eye on wage growth

Russ Mould
9 November 2018

“News of wage increases at JD Wetherspoon and Amazon, as well as the voluntary living wage, will give employees across the UK something to smile about, even if overall wage growth is still struggling to outpace inflation and therefore provide welcome real terms increases,” says Russ Mould, AJ Bell investment director. “In theory higher wages should give consumers more cash to spend and be good for company earnings, too, but at the moment it seems like investors are looking at this as an increase in costs and a potential danger to stock markets which are still trading at or near record highs in the case of the US and UK.

“It is understandable that wage growth could start to pick up, after what has been a fallow decade for workers.  With unemployment at its lowest level since 1975 in the UK and 1969 in the USA, it is logical to expect the laws of supply and demand start to push wages higher, as the airline industry is finding out with pilots’ pay, for example.

 
Source: US Bureau of Labor Statistics, ONS

“Wage growth has indeed started to pick up, reaching a nine-year high of 3.1% in the USA and it is creeping up in the UK, reaching 2.8% on this side of the Atlantic. But those numbers still pale compared to the 4% to 6% increases which were common in the UK during 2005-07, just as the boom came to an end, and shows what could happen if job markets stay tight.

“A sudden acceleration in wage growth could have two effects which may be bad for stock markets, despite the potential economic benefits of workers having more money in their pockets.

“First, central banks are watching wage growth very keenly. If they feel wages are starting to motor and embed expectations for higher prices and accelerating inflation across the board, they may start to tighten monetary policy faster than investors currently expect. Financial asset valuations have benefited hugely from ten years of zero interest rate policies (ZIRP) and Quantitative Easing (QE) as investors have fled cash and sought better returns on their savings from equities, bonds, property and alternative assets such as art, wine or vintage cars. In theory, improved returns on cash (and higher Government bond yields) may mean investors are happier to hold these lower-risk assets, or at least inclined to pay less for riskier options which may bring higher returns but also greater danger, especially stock markets.

“Second, higher labour costs could start to dent corporate profits. US firms are battling a stronger dollar, higher interest payments on their debt (as interest rates and bond yields rise) and now higher wages, as well as potentially higher fuel and energy bills, although at least the oil price has eased a little of late – firms such as Ralph Lauren, General Mills, Mondelez, Kraft Heinz and Hershey have all flagged these issues. US companies are also waiting to see if President Trump’s tariffs result in higher import costs. Many of these firms have hinted at price increases to compensate – which is why central banks may be on a state of alert – and it will be interesting to see if they can make prices rises stick (or whether they take the ‘shrinkflation’ route).

“Whatever their response, investors will be looking to see if corporate margins come under pressure as labour costs rise, challenging a multi-decade trend that has seen corporate earnings rise as a percentage of GDP while labour’ take-home pay has fallen as a percentage of GDP.

 
Source: FRED - US Federal Reserve database

“But it would be no shock, at a time when ‘populist’ movements are pushing back on austerity and the economic policies of the decade, if workers were to try and flex their muscles.

“That could be a potential headwind for stocks. It can be argued that the US and UK equity markets are still cheap based on forward earnings estimates, but that assumes profits (and presumably profit margins) will continue to rise from what are already all-time highs – and that might be an optimistic assumption if wage growth really does start to kick in.”

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