Labor Costs and Earnings

Bloomberg is reporting, “Labor Costs Accelerate, Threatening to End U.S. Earnings Streak”:
“The price of labor has taken a sudden jump and is likely to keep climbing, threatening to end the longest U.S. corporate profit boom in more than 40 years.

“‘You are starting to see wages tick up,’ says Henry McVey, chief investment strategist with Morgan Stanley in New York. ‘We’re at the point in the cycle when margins have hit peak levels.’

“Labor costs have shot up 3.2% over the past 12 months, after average increases of just 0.8% a year from 2000-2005, the Labor Department reported last week. Companies will have a hard time raising prices to recover those costs, as weakening consumer demand slows the economy for the rest of this year. That means profits will take a hit.

“‘Labor cost increases at this pace would be alarming from an inflation perspective if growth were not slowing,’ says Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, N.Y. ‘But it is, so the alarm should sound over corporate earnings forecasts instead.’ He expects earnings among companies in the Standard & Poor’s 500 to be down 10% by the fourth quarter of 2007.

“Morgan Stanley’s McVey predicts S&P 500 earnings growth will slow to about 5% in 2007, from a projected 11.4% in 2006.

“Either prediction would be a dramatic turnaround from recent results. U.S. companies’ earnings rose by an average of 19% in the second quarter. Commerce Department figures show U.S. corporate profits grew more than 10% in 15 of the last 16 quarters, better than in any comparable period going back to at least 1960…

“J.B. Hunt Transport Services Inc., the third-biggest U.S. trucker, reported second-quarter profit below analysts’ estimates as spending on wages and diesel fuel increased. The Lowell, Ark.-based company said it couldn’t hire enough drivers to meet demand.

“Transportation companies are among those that ‘are going to have to start sharing more of their revenue gains with workers,’ says Steven Wieting, director of economic and market analysis at Citigroup Global Markets Inc. in New York.

“Some companies may be able to maintain their profit margins by passing higher labor costs on to their customers.

“‘If the demand environment stays relatively robust, my fear is that you’ll get more pass-through into final prices,’ Wieting says.

“That’s just what the Federal Reserve doesn’t want to see. Fed policymakers left their interest rate target unchanged on Aug. 8, saying that while ‘some inflation risks remain,’ it expects inflationary pressures to ‘moderate’ as the economy slows…

“Almost all of the 113,000 jobs added in July were in services, and the biggest category posting gains was professional and business services, with 43,000 new jobs. The Labor Department noted gains among higher-paying jobs such as computer system design, architectural and engineering services, and management and technical consulting.

“‘The talent shortage in high-skilled and vocational jobs is driving wage inflation, from skilled machinists and operators to workers with college and advanced degrees,’ says Jonas Prising, president of the North American division of Milwaukee-based Manpower Inc., the world’s second-largest provider of temporary workers.

“Recent revisions to Commerce Department data suggest the acceleration of labor costs might have begun sooner than previously thought…

“‘Sales are slowing down while it looks like labor costs are picking up more sharply,’ says Andrew Tilton, an economist with Goldman Sachs in New York. ‘That’s likely to put a squeeze on margins, certainly within the next year, and most likely in the second half of 2006.'” 


Is it really labor costs that are threatening earnings, or is it the fact that consumers are tapped out and refusing to buy overpriced homes and take on more credit? Yes, I understand that revolving credit recently rose, but is that a demand for credit per se, or is it a result of home equity loans and cash-out refis sinking?

Outside of energy, earnings this cycle have been built on a marshland of debt.

Please consider this chart comparison of 1994 with 2000 and 2006:

Is This 1994?

(The above thanks to Contrary Investor. Note the chart as shown above is incomplete. The complete chart was posted here.)

Most striking in the “Is This 1994?” comparison is household cash, household debt, the negative savings rate, and the fact that year-over-year growth in consumer credit growth is collapsing.

Not shown on the above chart (or the complete chart, either) are the following ideas:

1. In 1994, we had an Internet boom to look forward to.
2. In 1994, we had a housing boom to look forward to.
3. In 1994, global wage arbitrage had not really kicked in full force.
4. In 1994, real wages were rising.
5. In 1994, oil prices were stable to slightly falling through 1999.

So while rising labor costs may eat into earnings, taking everything into consideration, are labor costs the real problem that will cause earnings to drop? I think not. The real cause for earnings to rise was a financial experiment, the greatest the world has ever seen. The Greenspan Fed blew the biggest bubble in credit finance the world has ever seen. That boom was also fueled (in the later stages) by global wage arbitrage.

Things Are Not What They Seem

Yes, some highly technical jobs and highly skilled jobs are still in demand. As a consequence, it seems that wages are rising.
Is this really inflationary? If so, in what sense?

Here are the current facts: Unemployment is starting to rise, countless refi experts at banks will soon be out of a job, fewer people are eating out at Applebee’s and other places, and growth in consumer credit is collapsing. Please also consider the tens of thousands of real estate agents that have not made a dime this quarter. The drop in wages of the self-employed is not reflected in the official charts.

Nor do I buy the talk from J.B. Hunt Transport Services Inc. Oil prices rose from $25 in 2003 to $70 now. Why the sudden concern? I see they are blaming their woes on “wages and diesel fuel.” OK, which is it? What I do buy is the fact there is a squeeze. They cannot get enough drivers at a price they want to pay. But because of falling demand for furniture, refrigerators, home appliances, etc., they really cannot pass on costs. This is a squeeze not only on J.B. Hunt, but on drivers everywhere. Does this look like the chart of a company with “pricing power”?:



In the end, demand will dictate that a gas price pass-through will not happen. Marginal trucking operators could be in trouble.

Wages may be rising, but at the expense of increased unemployment. For cash-strapped consumers, the latter is crucial. We are also shedding some of the low-paying jobs in retail, service, and housing jobs that fueled this boom. Helicopter Ben is going to need to spin those blades much faster to get any traction now.

Mike Shedlock ~ “Mish”
August 17, 2006