Wage pressure taking toll on potential earnings, giving investors pause

Don’t let its stupefied face fool you: The stock market can still distinguish good from bad. For instance, in earnings prospects.

Of particular interest to investors lately has been wage pressure. Since January, S&P 500 Index companies that dole out the smallest share of revenue as pay have beaten those with the highest labor costs by almost 4 percentage points, the biggest gap to start a year since at least 2010, data compiled by Goldman Sachs Group Inc. and Bloomberg show.

In previous years, the two groups moved together. The divergence could be a sign of investor anxiety about compensation and profit margins, which are already shrinking. According to Goldman Sachs estimates, a 1-percentage-point acceleration in labor cost growth would trim the S&P 500’s annual earnings by 0.7 percent. With equities at the highest valuations since the dot-com era, any potential hit to earnings gives buyers pause.

“As we enter the later stage of an economic cycle, anyone who’s inclined to be hired is already hired and any incremental hiring has to come at a higher cost,” Jack Ablin, chief investment officer at BMO Private Bank in Chicago, said by phone. “Investors are starting to get concerned about the impact of labor costs on profit margins.”

If such distinctions are being made in equities, it’s in contrast with bonds, where investors seem inured to inflation risk. Yields on 10-year Treasuries declined May 5 despite data showing the employment rate unexpectedly fell to a decade low of 4.4 percent.

Stock investors may face the more proximate threat, given the role of wages in S&P 500 profitability. According to Evercore ISI, labor costs account for almost 60 percent of U.S. economic output and the percentage has been rising since late 2015.

“The increase in labor costs is likely to impact corporate profitability more than actual inflation,” Dennis DeBusschere, Evercore ISI’s head of portfolio strategy, wrote in a note.

Restrained wage growth has been a key driver of the eight-year profit expansion.