Blue Label Labs, which helps companies develop and market technology products, ratcheted up pay raises last year as it struggled to attract and retain employees.
That’s the good news.
The downside is that the salary increases hurt profits, forcing the New York City-based company to lay off several employees, among other strategies.
“It has created some stress and anxiety,” says Jordan Gurrieri, co-founder and chief operating officer of Blue Label, which has about 22 staff members. It also has about 40 contract employees.
The strong U.S. economy and 3.6% unemployment rate – a 50-year low – have spurred worker shortages that finally have triggered faster wage growth. Americans are spending those bigger paychecks, further bolstering the economy, or socking away some of the cash for retirement.
Yet pay increases are accelerating just as business revenue growth is slowing. As a result, they’re starting to narrow corporate profit margins, posing a threat to earnings and stocks, and to business hiring and investment plans. The trend eventually could temper economic growth, trigger layoffs and even contribute to the next recession, analysts say, depending on how sharply average wages rise.
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So far, the effects have been modest. But economists are debating whether they’re likely to intensify in coming quarters or stabilize and strike a healthy balance between the share of national income that goes to companies and workers.
Workers enjoy more leverage
Lately, employees have enjoyed more leverage. In March, there were 1.2 million more job openings than unemployed Americans, Labor Department figures show. Employers have been bidding up to attract workers, with annual wage increases topping 3% since August 2018.
Blue Label’s Gurrieri says he had to ramp up raises to 5% to 10% from a range of 2% to 5% to compete with the likes of Google, Microsoft and Amazon in an increasingly competitive labor market. “They have more resources,” he says.
Meanwhile, company sales increased a whopping 55% last year, but that’s down from 70% in 2017 and 80% in 2016.
All told, profit margins shrank by 5 to 7 percentage points, Gurrieri says. In response, the company this year has converted about a quarter of its staffers from full time to part time, temporary employees who are called on to complete specific projects. A few that couldn’t be shifted were laid off. And instead of hiring a typical five employees this year, Gurrieri is adding just two, though he may bring on more if needed.
Gurrieri isn’t alone. Eight percent of small businesses surveyed by the National Federation of Independent Business in April cited labor costs as their biggest problem, down just slightly from a record high 10% in February.
Companies feel pinch
Large publicly-held corporations are also feeling the pinch.
Revenue for Standard & Poor’s 500 companies increased 5.3% in the first quarter compared with a year earlier, the smallest gain since the second quarter of 2017, according to FactSet figures from the 98% of firms reporting results. Among the culprits: A strong dollar that hurt U.S. exports and a slowdown in tech product sales, says Jason Ware, chief investment officer at Albion Financial Group.
At the same time, S&P 500 earnings fell 0.4%, the first decline since early 2016. As a result, net profit margins for the companies fell from 11.3% in the fourth quarter to 11.1% in the first three months of 2019, the weakest showing since late 2017, according to FactSet.
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Lydia Boussour, senior U.S. economist at Oxford Economics, attributes the decline in earnings and margins largely to higher labor costs, as well as rising prices for materials and other expenses, coupled with slower sales growth.
“We see margins being compressed going forward as labor cost pressure continues to gradually build,” Boussour says. That could further roil a stock market already shaken by the escalating U.S. trade war with China.
According to FactSet’s February survey of 23 companies that reported first-quarter earnings, 43% said higher labor costs had a negative effect on earnings, second only to unfavorable foreign exchange rates.
And earlier this year, 53.6% of industries experienced above-trend wage growth, up from 46.9% a year earlier and an average 42% during the 10-year-old economic expansion, Morgan Stanley said in a report. Service-oriented, labor-intensive industries are most at risk of getting squeezed by rising wages, including retail, hotels and restaurants, personal care, security, education and human resources, the research firm said.
Aging economic expansion
The effect of accelerating wage growth on profit margins is a telltale sign of an aging economic expansion, Boussour says. Wage pressures “add to the likelihood of an earnings recession (two straight quarters of falling profits),” Morgan Stanley says. That, in turn, “could spur layoffs and raise the probability of an economic recession.”
A variety of companies cited concerns about rising labor costs in their most recent quarterly earnings calls with analysts. Among them:
• Texas Roadhouse, the steak restaurant chain, said earnings fell to $50.4 million from $54.5 million a year earlier. It cited rising wages as the main reason restaurant profit margins fell to 17.9% of sales from 19.2%.
“Bottom line profits this quarter were significantly impacted by higher labor costs,” CEO Scott Colosi told analysts last month, according to Seeking Alpha, which published the earnings call transcript. “We clearly expect this trend to continue for the rest of the year.”
• El Pollo Loco reported a drop in net income, noting that labor costs as a percentage of restaurant sales increased to 30.4% from 29.3%.
“We continue to expect labor inflation about 6% in 2019,” Chief Financial Officer Larry Roberts said.
• FedEx said per-share earnings fell 18.5%, largely because of slowing global growth. CFO Alan Graf also cited “the inflationary impact of the tight labor market on our purchase transportation rates and employee wages.”
• Marine Products, which makes fiberglass boats, saw its gross margin fall slightly “due to higher labor rates to assist with retention and higher headcount targeting improved quality,” CFO Ben Palmer said.
Some analysts believe rising wages can coexist with healthy profit margins. Ware of Albion notes that while profit margins fell last quarter they’ve remained historically high at double-digit levels since 2013. That’s because workers’ share of gross domestic product has fallen from nearly 58% in 2000 to about 52% recently, according to Oxford. Bridgewater Associates, an investment firm, largely blames the decline of unions, globalization, automation and weaker antitrust enforcement that has increased the market power of large companies.
Will faster wage gains increasingly squeeze corporate profits over the next year? Several factors could be key:
Gains in productivity, or output per worker, have been weak throughout the expansion but picked up last year and hit an annualized 3.7% in the first quarter, the strongest performance in more than nine years. If that continues, it would allow businesses to maintain margins despite higher wages.
Boussour isn’t optimistic, saying productivity has been bolstered by business investment in labor-saving technology but such outlays have slowed since the second half of last year.
Ware, however, says it could take time for solid business investment in 2017 and early 2018 to translate into productivity gains, extending the benefits to later this year and beyond.
If workers spend their higher wages, that would increase company revenues, sustaining strong profits despite the higher labor costs. But since the Great Recession ended in 2009, Americans have been cautious, saving an unusually large share of their income. The savings rate was 6.5% in March, compared with 2.7% to 4% during the mid-2000s economic expansion.
“An elevated savings rate may mean that rising wages are slower to translate into rising spending,” Morgan Stanley says.
Ware says that while higher-income Americans tend to save much of their added income, lower-paid workers typically spend virtually all of it. That, he says, should provide a boost to company sales and the economy.
Companies also could preserve margins by passing along their higher labor costs to shoppers. Inflation, however, has remained stubbornly low, partly because of long-term factors such as discounted online shopping and globalization.
“Companies are not gaining any pricing power,” Boussour says.
Ware thinks businesses will be able to pass on higher costs for some items, such as groceries and other consumer staples.
Ultimately, he believes firms can cope with wage growth that accelerates to 3.5% to 4%. But if the gains reach 4% to 5%, “All bets are off,” he says.