Why rising wages will be a major headwind for stocks

From a social perspective, there’s a lot to like about this trend – but it has profound implications for investors

It’s a fine time to be looking for a job. But is it also a good time to be buying stocks? Maybe not quite as good as you think. Drum-tight labour markets in the U.S. and to a lesser degree in Canada are resulting in rising wage pressures. From a social perspective, there is a lot to like in this trend, but for investors, there are also dangers.

“As wages increase with tighter labour markets, profit margins may absorb the brunt of the impact,” warn Julian Richers and a team of economists at Morgan Stanley. In a report this week titled What the Workers Economy Means for Margins and Markets, they argue that rising paycheques pose a risk to U.S. stocks over the year ahead.

They also point to the profound implications of this trend continuing. Over the past couple of decades, shareholders have feasted while workers have subsisted on a strict diet. If these trends were to fully reverse, the profit margins of U.S. companies would shrink by a third. This would not be good news for share prices.

Granted, any talk of a labour resurgence seems like a remote prospect after years in which all trends have bent in the opposite direction. The rise of the gig economy over the past decade was based on the assumption that workers were in no position to demand regularly scheduled shifts, paid vacations or any of the other perks of full-time work.

By and large, this assumption was true. Starting in the 1990s, low-paid workers who asked for more often found themselves replaced by machines. Self-checkout stations took the place of human cashiers, automated voice menus filled in for customer-service reps, self-service pumps substituted for flesh-and-blood gas jockeys, accounting software replaced bookkeeping clerks, and so on.

The cumulative effect was to drive a wedge between growth in productivity and growth in incomes. Paycheques had historically expanded in pace with output growth, but beginning around 2000, that relationship fell apart in the United States.

“This divergence between real compensation and real productivity had never before been seen in the recorded data,” the Morgan Stanley team write. “While productivity growth continued, real wages flat-lined for more than a decade, from 2000 to 2014.” The unprecedented fall in the labour share of corporate income “marks a break in the fundamental structure of the economy,” they declare.

The big winners from this transformation have been companies and shareholders. In the 1990s, the average share of U.S. corporate income going to profits was 6.3 per cent after tax, the Morgan Stanley team calculates. Over the past decade, it has swelled to 11.2 per cent.

The supremacy of profits may now be in doubt, however. The Morgan Stanley economists note that both monetary and fiscal policy makers are making workers a top priority. The U.S. Federal Reserve, for instance, is explicitly focused on moving the economy toward “maximum employment.” The Biden administration is attempting to curtail market concentration and boost labour rights.

The Morgan Stanley team figures that if real labour compensation were to fully catch up with productivity growth over the next five years, the profit per unit of production would fall 33 per cent from current levels. To be sure, that seems rather drastic, but mentions of “higher wages,” “labour cost” and “labour shortage” have already surged to historical highs in transcripts of corporate presentations, they note. If nothing else, the 33-percent figure demonstrates how far behind workers have fallen in their perpetual tug of war with capital.

How should investors view all of this? Skeptics will scoff that labour shortages are – pardon the term – transitory and will fade with the pandemic. Canadian investors will also note that workers have generally fared better here than south of the border.

But you don’t have to count on massive gains in labour’s share of the pie to think that the new emphasis on ordinary workers could matter. Even a modest tilt back toward wage earners has the potential to ripple through the stock market in significant ways.

A 2019 research paper, “How the Wealth Was Won,” by Daniel Greenwald of the Massachusetts Institute of Technology, Martin Lettau of the University of California, Berkeley, and Sydney Ludvigson of New York University found that almost half the after-inflation increase in U.S. share prices from 1989 to 2017 was based on the reallocation of economic rewards away from workers and toward shareholders. In contrast, the things Wall Street typically puts so much emphasis on – economic growth, for instance, or lower interest rates – were only bit players in the stock market’s dramatic rise.

So as much as we may welcome higher wages as citizens and as working folk, watch out for the stock market impact. “The market may be set up for a negative surprise into next year as bottom-up consensus estimates call for [profit] margin expansion into 2022, but our macro analysis suggests margin deceleration,” the Morgan Stanley team write.

They say smaller companies with heavier labour costs – think hotels, restaurants and retailers – are the most vulnerable to disappointments. Don’t say you weren’t warned.