With the unemployment rate at near fifty year lows, and job growth outpacing the growth of the labor force, it’s no surprise that U.S. companies are expressing concern about the effect of rising wages on their bottom lines.
Despite these worries, companies with low labor costs have been significantly underperforming the market, according to an analysis by Goldman Sachs, which argues that such stocks could be a good buy for those who think fears of a significant U.S. economic slowdown are overblown.
“If job and wage growth prove resilient, the relatively insulated stocks [with low labor costs] should outperform higher labor cost peers facing more rising more margin risk from rising input costs,” wrote Goldman analysts, led by equity strategist Ben Snider, in a Monday note to clients.
Goldman created a basket of the 50 companies with the S&P 500 index that have the lowest labor costs relative to their revenues, finding that it trades at a forward price-to-earnings ratio (P/E) of 13 times, versus a similar basket of 50 high labor-cost firms, which trade at a multiple of 22 times earnings. The median S&P 500 company sports a forward price-to-earnings ratio of 18 times.
While wage growth has slowed from a peak of 3.3% in the fourth quarter of 2018, the fastest since 2007, “leading indicators show that wage growth should remain at or slightly above its current pace of 3%,” Snider wrote.
That’s faster than projected economic growth of 2.5% and projected earnings growth of 2.6% in 2019, according to FactSet, and company management is concerned about the trend, according to surveys conducted by the National Federation of Independent Business and the National Association of Business Economics.
The Goldman basket of low labor-cost firms is sector neutral, and includes Dish Network Corp.
Altria Group Inc.
Dow Jones Industrial Average
component Apple Inc.
and Sykworks Solutions Inc.
all of which trade below the median S&P 500 company’s forward price-to-earnings ratio, and have labor costs of 6% or less of revenue.
Corporate profit margins rose to an all-time high level of more than 10% in 2018, but have fallen this year, with the consensus estimates showing a 0.6% decline this year, while projecting a 0.7% rise next year, which Goldman analysts think is too optimistic. “From a top-down perspective, our forecast of flat profit margins — due in part to rising labor costs — explains most of the difference between the 4% growth we expect in S&P 500 and the 12% growth currently embedded in consensus estimates.”
Another reason to expect continued wage pressure is the increasing incidence of rising minimum wages in states and localities across the U.S. “Although the federal minimum wage has been unchanged at $7.25 for a decade, rising state minimum wages continue to lift the effective national minimum,” Snider wrote. “The effective US national minimum wage grew by 4% in 2018 to $8.88, and current state laws indicate that it will rise by another 4% in 2019 to $9.18 even without any mandated increase at the federal level.”
To be sure, investing in these low labor-cost firms might not be advantageous if investors believe that a trend in lower bond yields, along with an inverted yield curve, signals a forthcoming recession, which would likely lead to rising unemployment and the easing of wage pressures.
Interestingly, there has been a strong correlation of late between the performance Goldman’s low-wage basket of stocks and the markets expectations for inflation.
The 10-year break-even inflation rate measures market expectations for inflation by taking the difference between the 10-year U.S. Treasure note and similar notes indexed for inflation. Looking at these data, it could be assumed that stock market investors are betting on a coming recession with the same conviction that bond market investors are, and were actually earlier to adopt that position.
But there are just as many reasons to remain bullish about the economy going forward, including a strong jobs market, high levels of consumer confidence, and indications that the Federal Reserve is willing to cut interest rates before hard evidence of a significant economic slowdown emerges. In that case, it could be that investors are just underestimating the advantages that firms with low labor costs will bring to the table.