Eye on corp margins as advanced economies' rules push firms to hike wages

Slack in job markets, low inflation, tech disruption kept wage growth, corporate profits subdued

Robust corporate profit margins, one of the underpinnings of the rally in developed market stocks over the past decade, could be put to the test in coming quarters as tighter labour markets push companies to hike wages at last more to stay competitive.

Slack in job markets, stubbornly low inflation and the disruptive effect of technology across industries from retailing to financial services along with off-shoring of manufacturing to low-cost locations have kept wage growth subdued and profit margins high across markets in the United States (US), Western Europe and the advanced economies of Asia.

Fat profit margins have lifted global stock markets to all-time highs yet wage growth remains well below average levels, giving credence to the old investment adage that what is good for shareholders is bad for employees.

Now, with most developed markets running at or near full employment and inflation potentially lurking around the corner, market participants say companies will likely face rising pressure to raise wages.

The world's biggest asset manager, BlackRock, noted the potential of wage pressures to build as one of the risks to their otherwise sanguine assessment of the outlook for global stock markets. The firm continues to prefer stocks over bonds.

"The share of income going to labour (wages) is historically low and corporate margins are elevated," BlackRock's strategists warned in their mid-year investment outlook review published this week.

"Any policies that reverse this trend or labour shortages causing wages to spike could erode margins and equity valuations."

Corporate profit margins in the US will be a key area to watch as second-quarter results season gets underway next week.

American companies' operating profit margins are currently running close to 20 percent, according to Thomson Reuters data, only slightly below the peaks seen in 2001 and 2007.

Higher wages and declining productivity will likely eat into corporate margins throughout the rest of this year and next as companies pay more to recruit and train workers at a time when unemployment is near multi-year lows, said Phil Orlando, chief equity strategist at Federated Investors in New York.

The trade-off

Global profit growth, running at about 10 percent currently, has far outpaced sales growth, which is less than half that, according to Thomson Reuters data. The difference points to profit growth being boosted in part by cost-cutting.

However, a global recovery in economic growth gathering steam points to demand finally picking up.

"This is the first year of a synchronised global recovery and a lot of the profit growth we're seeing is because of actual demand increasing and not just cost cuts. Wage growth will pick up albeit at a moderate pace," said Dale Winner, a fund manager at Wells Fargo Asset Management who runs a portfolio of global stocks.

Broadly, the outlook for equities remains bright as relative valuations compared with bonds remain appealing.

"I think we're going to deal with higher inflation, and companies with margin compression, but that's not necessarily a game-ender," said Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.

Investors are likely to increasingly distinguish, however, between companies and sectors that are able to pass on costs of a higher wage bill to their customers and protect margins versus those that will have to take the hit.

The crunch will hurt low-margin businesses like supermarkets the most, while leaving technology companies with larger margins — such as Microsoft or Oracle — relatively unscathed, Federated's Orlando said.

"If there's a trade-off between a faster-growing economy and rising wages hitting margins, I will take the faster-growing economy in a heartbeat," he said.