What Does An Overheating Labor Market Mean For Stocks? I’m Glad You Asked.

Ok, so the labor market is overheating.

We know that. For the Fed, the question is whether to act on that with “preemptive” tightening strikes, or whether to wait on realized inflation to move sustainably above target. The market is betting on the former.

Obviously, an overheating labor market presages upward pressure on wages. It’s supply and demand. Shit like that.

Well… ummm… that should crimp corporate margins, right? Probably.

I mean better tech, the rise of the machines, and lower taxes should help, but we may be at “peak that stuff” – so to speak. So if we are at “peak that stuff,” then that means wage pressure will be a headwind to profitability. That, in turn, would (or I guess “should” is better, because God knows nothing has stopped this market yet) be a headwind for equities.

That narrative makes sense – I think.

Goldman thinks it makes sense too. So much so that they decided to write some stuff about it.

There’s your amusingly deadpan intro.

And here are some excerpts that (maybe) you’ll like…

Via Goldman

The US labor market is at full employment. The elimination of slack from the economy has put upward pressure on wages, which should continue to rise and pose a growing headwind to corporate margins.

Although wages grew slowly in the early years of the post-crisis recovery, most measures suggest that wages are now growing at their fastest pace this cycle. The Employment Cost Index rose by 0.8% quarter/quarter in 1Q, the fastest growth since 2007. Our economists’ Wage Tracker, which combines the ECI and three other measures of wage growth, stands at a cycle high of 3.0%. The tight labor market should continue to support higher wages and broad price inflation as the cycle continues to mature.

S&P 500 margins have been flat at historical highs for the past three years, excluding the Energy sector, but rising wages will make it increasingly difficult for firms to sustain peak levels of profitability. S&P 500 margins reached a record high of 9.2% in 3Q 2014. Excluding Energy firms, which saw profits collapse along with crude oil prices in late 2014, index margins have since remained at roughly the same level. Margins have been lifted by long-term secular tailwinds from improving technology and operational efficiency alongside declining interest rates and tax rates. Since margins reached the current plateau in 2014 most costs have continued to decline relative to revenues, but accelerating wage growth has kept margins flat. Although the long-term upward trend in margins may continue eventually, we expect rising wages will prevent significant further expansion in S&P 500 margins during the next few years absent corporate tax reform.

Although wages should continue to accelerate, the rebound in corporate revenues this year should keep US labor costs flat as a share of sales in 2017.

We estimate that every percentage point acceleration in labor cost inflation weighs on S&P 500 EPS by 0.8%

On the margin, labor inflation should impact small-caps more than larger firms. S&P 500 companies have EBIT margins nearly twice the size of Russell 2000 margins, and net profit margins three times the size (9% vs. 3%). In addition to profitability, small-caps generate less revenue per employee and conduct a larger share of their business in the US. The median S&P 500 company allocates 11% of revenues to US labor costs compared with 17% for the median Russell 2000 firm. As a result, small-cap earnings are more vulnerable to an acceleration in labor inflation. We estimate that a 100 bp acceleration in labor cost inflation would pose a 2% headwind to Russell 2000 EPS, roughly double the 1% impact we estimate for the S&P 500.