Sign in to the restaurant window.

Elizabeth W. Kearley | Moment open | Getty Images

Workers get higher wages, but at some point it could hurt companies’ profits.

As the economy reopens, the cost of everything from packaging and raw materials to shipping is increasing. In addition to these expenses, companies also pay more to get workers to come in the door.

However, the gap between labor costs and profits has been so great for so long that employers should be able to raise wages if they can raise the prices of goods and services or improve productivity.

McDonald’s said last week it would raise wages by 10% for the 36,500 hourly workers in company-owned stores, and Chipotle announced it would raise wages to an average of $ 15 an hour by the end of June. Bank of America announced that it would raise the minimum wage for its hourly workers from the current US $ 20 to US $ 25 an hour by 2025.

Sports equipment company Under Armor also announced that it would raise the minimum hourly wage for its retail and sales employees from $ 10 to $ 15.

“It’s one of the strongest wage increases in a quarter of a century,” said Mark Zandi, chief economist at Moody’s Analytics. He said the 3% wage growth for private workers in the first quarter was the strongest since the 1990s, while productivity increased at the same time.

“All the anecdotes we’ve gotten over the past few months suggest that things will continue,” he said.

Attract talent in a shortage

Jonathan Golub, chief US equity strategist at Credit Suisse, says employers are trying to address a labor shortage.

“The economy is overheating and even though we have high unemployment rates, companies cannot get the workers they need to meet demand and are forced to raise wages,” he said. “It happens with financial services. It happens in industry. It happens in retail. You see it everywhere.”

Golub said investors were right to wonder when higher labor costs could put pressure on profit margins, but he doesn’t think this could become a problem in the short term.

“If you see this pressure in an environment where the economy has been weaker, it would be a disaster, but we are not,” he said. “We see it in an environment where companies have tremendous pricing power, which means they can pass it on.”

However, Sam Stovall, CFRA’s chief investment strategist, said higher wages were one reason he had become neutral about the consumer discretionary sector, which includes retail and restaurants. The sector has only grown 4.1% so far this year. It is among the worst performing sectors, lagging behind the S&P 500.

“We have lowered our outlook on consumer discretion because it is so dependent on payroll,” said Stovall, noting that the sector is facing rising costs in many other areas as well. “Economists are calling for wages to rise by 3% in the second half of the year and increase them further next year.”

Golub said it is not clear how long companies will raise wages, but if it continues and becomes inflationary it will be a problem for profits.

“If this is a trend where people start expecting and demanding higher wages and there is a continuation, it becomes a problem,” he said. “We don’t know if this is a one-time adjustment.”

The “stickiness” of higher wages

Unlike temporary increases in raw materials or goods affected by bottlenecks in the supply chain, labor costs remain on a company’s balance sheet.

“The context is very important,” said Golub from Credit Suisse. “We know when the incentive wears off and the economy is no longer overwhelmed and the price of lumber and gasoline goes down, the people who have received higher wages will still have higher wages. Wages are sticky.”

Golub said wages are not a profitability issue in the short term and the market is now focused on reopening trade, not so much on margins.

“This is not guaranteed to become a margin problem, but it does pose a legitimate threat to margins,” he said.

“Markets react and should react to such things,” added Golub. “You can see that this is no accident, but the administration and others have pointed out that they want the workforce to have a bigger stake in the economy.”

Golub said he recommends investors to invest in cyclical sectors, which include industry, materials and finance. These companies have strong demand and pricing power. “I think it’s a cyclical stocks game,” he said.

Stress in the system

Economists said labor shortages showed in disappointing April employment report. Only 266,000 jobs were created, about a quarter of what economists expected.

Stronger growth is expected in the coming months. Some economists expect more workers to show up in September when the children return to school and also when the extended unemployment benefit expires.

“Right now you’re seeing more urgent wage increases due to the labor shortage,” Moody’s told Zandi. “Things are likely to settle down around the fall, when the supply side of the economy catches up and people get back to work and we’re on the other side of the pandemic.”

In the longer term, labor could remain scarce even if the US is back to full employment.

“It’s not a big deal this year, probably not next year, but as you move into 2023 or 2024, wages will become more and more important. Wage pressures will increase and weigh more heavily on corporate profits,” Zandi said. “Companies will try to raise prices.”

The ratio of total employee compensation to company profits has fallen from its high of more than eight times in the early 1980s to almost five times, Zandi noted. This means that the share of national income in the workforce has fallen and has remained low as firms have become more profitable.

“Compared to what has happened in the past since World War II, companies are getting a very large share of the economic pie, not as high as ever before, but high,” he said. “Big companies are very profitable.”

“The work share was very depressed … If everything roughly sticks to the script it should start to increase,” he said. “One of the policies of the new government, where they are working very hard, is to direct government support to low- and middle-income households.”

According to Zandi, companies are likely to invest in automation even in the service sector. “They will increasingly invest in labor-saving technology, which they haven’t done in the last few decades because labor was cheap,” he said.

Mike Englund, chief economist at Action Economics, said the sharp 6.1% increase in personal income last year was partly due to the surge in fiscal stimulus payments, which will continue to raise income this year. He also expects higher wages for employees, but income could remain unchanged until next year.

That 6.1% increase in income was due to corporate profits falling 5.8% over the past year.

Englund said the pandemic had resulted in some permanent changes in employment. “We’ve probably downsized the restaurant industry,” he said. Englund said the industry is likely to shrink in cities like New York, but it could grow in the suburbs as many restaurants have added takeout.

One result of the pandemic is that people have moved from cities or other regions. “With this shift … we’re seeing bottlenecks, a mismatch,” he said.