Rising Wages = Shrinking Corporate Profit Margins … And Falling Stock Prices?

Today's Wall Street Journal contains a couple of charts that illustrate a relationship that's not getting much media attention these days: The fact that tightening labor markets are forcing companies to raise wages, in the process squeezing their own profit margins. 

Historically this margin compression has been either a cause of or contributor to cyclical turning points — in other words it coincides with recessions and equity bear markets. 

The first chart shows wages rising after an unusually long period in which they didn't rise much at all. They've still yet to achieve the velocity of previous recoveries, but anecdotal evidence of desperate employers raising wages and lowering standards (see here, here and here) is now so widespread that continued wage gains are pretty much baked into the cake. 

What has this meant for corporate profit margins in the past? Big drops, as higher wages combined with an inability to raise prices commensurately left corporations with less money at the end of the day.

Since a share of stock is simply a claim on a portion of a public company's earnings, falling profits obviously lead to falling share prices: 

Here's an excerpt from the WSJ article: 

Rising wages are beginning to eat into the profits of some U.S. companies.

Businesses from dollar stores to hotel operators to fast-food chains have warned in recent months that higher labor costs have been a drag on their profits—a potential headwind for the nine-year stock-market rally as it struggles for momentum ahead of the second-quarter earnings season.

Average hourly earnings increased 2.7% in June from a year earlier, according to the Labor Department's monthly jobs data released Friday. Although that is below the 2.8% economists expected, wages have risen at least 2.5% for 16 of the past 17 months, a faster pace than recorded earlier in the economic expansion.

That is good news for U.S. workers who have seen tepid wage increases over the past few years and may benefit some businesses as consumers become more willing to open their wallets for discretionary purchases.

But the higher costs pose a threat to some U.S. companies that are already facing trade-related tensions and a limited ability to raise prices to keep up with inflation. Fears about rising wages sparked concerns back in February and sent stocks tumbling as investors worried the tightening labor market may finally trigger higher inflation.

Economists at Goldman Sachs predict that every percentage-point increase in labor-cost inflation will drag down earnings of companies in the S&P 500 by 0.8%. In total, the bank estimates labor costs equate to 13% of revenue for companies in the S&P 500.

"At the end of the day, I haven't heard this many CEOs talk about shortages in skilled labor and wage increases to attract talent in a long time—in at least a decade," said Will Muggia, president and chief executive at Westfield Capital Management in Boston.

In a traditional economic cycle, companies would attempt to pass along the increasing cost of labor to customers, but that doesn't appear to be happening this time.

Fed: "When The Yield Curve Creates Doubt, Throw It Out"

A few weeks ago we reported the Fed was getting hawkish despite what they were calling "low inflation."

In that article, we showed rates possibly being raised more than 4 times in 2019. But more importantly, we warned that anyone investing in the market should start preparing to expect the unexpected.

And right now, it looks like the Fed's bizarre moves are continuing.

This time it involves the yield curve. The yield curve represents the difference in interest rate paid on short-term Treasury notes and long-term Treasury notes in the bond market.

A common signal of economic health from the bond market involves looking at the difference between the 2-year and 10-year rates (also called the "spread").

Over the last three decades, when 2-year yields are lower than the 10-year bond yields, it signaled a healthy economic outlook.

But when that "spread" shrinks, the yield curve is said to be flattening. If it "reverses" entirely, the yield curve is inverted (or negative).

Since 1980, an inverted yield curve preceded an economic recession with reliable accuracy.

So the yield curve is a fairly reliable signal for imminent recession. And notice the downward trend of the yield curve on the right side of the graph. That indicates a flattening yield curve heading towards inversion.

And when we zoom in, the picture looks even more dire.

As of July 18th, 2018 the Treasury reported the difference between the 2-year and 10-year bonds to be 24 basis points (or 0.24% – see green line in the chart below).

This is the lowest spread since the 2008 Great Recession, and already much lower than the historical graph above.

There is no doubt the yield curve is flattening, and at an alarming pace.

Taking the historical data into account, if this trend continues and it does invert, that would be a signal of an imminent recession.

And one more Fed rate hike could invert it, according to Investing.com.

But strangely, it looks like the Fed wants to sweep the yield curve signal under the rug.

Fed: "When the Yield Curve Creates Doubt, Throw it Out"

So as the curve flattens, and gets ready to signal a recession, at a recent FOMC presentation the Fed examined the prospect of replacing it.

Wolf Richter commented on this presentation, and explained what the "new" indicator examined:

This new indicator – rather than looking at the spread between longer-term yields of two years and 10 years – is looking at the spread between short-term yields. It's "based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead derived from futures market prices."

There was no indication in this meeting that the FOMC members had any doubts about the reliability of the original yield curve signal.

But unusually, the "staff" did hint that the change-of-indicator may be made because they don't like what the flattening yield curve points to.

From the June 12-13 FOMC meeting minutes:

The staff noted that this measure may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons.

So the Fed doesn't favor an indicator that points out the distortions it is creating. Then it replaces that indicator with another one that doesn't do that?

[ZH: But The Fed now has a bigger problem as their 'new' yield curve has inverted too...]

And the divergence between the market and the Fed is extreme...

Seems awful fishy, like one of those shell games where you try to guess which shell the ball is under (but the ball isn't there).

Don't Let the Fed's "Shell Game" Damage Your Retirement

Gold is historically consistent during uncertain market conditions like these. In fact, central banks have remained buyers and demand all over the world is heating up.

So hedge your bets against the Fed "shell game" while there's still time.

*  *  *

[ZH: And then there was Larry Kudlow, selling America on paying attention to the 3mo-10Y spread, not the 2Y-10Y spread this morning]