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GUEST ARTICLE: Rising Wages Vs Corporate Profits - Should Investors Worry?
Julian Howard
GAM
22 September 2015
A trend in some large economies, such as the US, is for rises in statutory minimum wages as a way, advocates say, to improve pay. It is a standard critique that, other things being equal, state-enforced hikes in minimum pay that go above what would be agreed in a free market will cause unemployment, although there is debate on the specific impact depending on how labour- or capital-intensive, a sector is. But leaving aside the merits of minimum wage laws as economics or politics, what should investors conclude? Which sectors will benefit and lose out? This article, from George Osborne recently announced a national living wage, while in Germany the first-ever national minimum wage was approved last year. The role of productivity If productivity gains remain modest, forced wage increases must somehow be “paid for”. There are two options.The first is for higher workers’ pay to be simply passed on to a company’s customers via the prices of a firm’s goods and services. This is clearly the best result from an investor’s perspective since they effectively see no dent to profits. The second mechanism is for higher pay to be added to the firm’s cost base without being passed on but this hurts profitability and is the worst possible outcome from an investor’s angle. There are also trade-offs between the two approaches, with a proportion of higher pay passed on to customers and the rest simply absorbed. Predicting the corporate response today But it remains the case that higher “forced” wages are likely to negatively impact the profit outlooks of firms relying on low wage workers and whose customers don’t consume significantly more of their product as they get wealthier. The healthcare and mass-market service sectors are potentially vulnerable in this regard. In the healthcare context, consumption in advanced economies does not increase with affluence, but healthcare firms still have wage bills to foot. For popular fast food restaurant chains, management could be worried that a higher minimum wage would see its customers eat at more expensive restaurants instead. Any rise in pay potentially raises a risk to profits depending on a company’s profile. Consumers will be richer but in the corporate world there will be winners and losers. From an investment standpoint, higher pay will certainly offer attractive investment opportunities in a number of sectors.
The minimum wage is an emotive issue central to the equality debate, but it is also important for investors to assess how it will affect corporate profitability and, ultimately, the course of equity markets. Analyst forecasts of corporate profitability are a key driver of equity returns and in a gradually recovering economy these forecasts could be sensitive to external cost shocks that are beyond a firm’s control.
In the developed countries, particularly in the US and the UK, unemployment is now very low and upward pressure on pay is likely to start building as the labour market finally begins to tighten. This is already the case in specific areas where there are pockets of skills shortages, for example the UK construction sector. For investors, potentially rising wages should be good news if it means consumers have more money in their pockets to spend on goods and services. However, much will depend on how consumption for a particular company’s product changes as incomes rise, how people-intensive the business is and how skilled those employees are.
It would be better for corporate profitability if worker pay was organically “earned” in the sense that it came from increases in efficiency and output rather than legislation or labour market tightness. However, the western world is currently beset by a “productivity puzzle”, with growth in productivity low relative to the past. Among the most compelling explanations for this is that with global growth currently sub-trend, companies are being perfectly rational in not investing their cash piles for fear of a poor return on capital. Instead, the emphasis has been on quicker returns to shareholders via buybacks, dividends or mergers. Why invest in new kit if the return is likely to be both poor and long in the waiting? The result is that workers are held back without the right tools for the job, leaving them potentially less productive and less able to contribute to corporate profitability. This in turn deprives them of “deserved” pay rises which reflect the success of the firms they work for.
At the most simplistic level, higher wages should benefit many firms since their customers will have just got richer. This is especially the case if the savings rate stays the same and more is spent as income grows. A higher minimum wage might also boost longer term profitability by encouraging investment. Purchasing new equipment becomes a relatively more attractive alternative to hiring which should in turn increase the productivity and profitability contribution of existing employees. Combined with current low unemployment, this scenario is positive for both investors and equality campaigners.