labor costs accelerate threat to us earnings

Labor Costs Accelerate, Threatening to End U.S. Earnings Streak
Aug. 14 (Bloomberg) -- The price of labor has taken a sudden jump and is likely to keep climbing, threatening to end the longest U.S. corporate profit boom in more than 40 years.

``You are starting to see wages tick up,'' says Henry McVey, chief investment strategist with Morgan Stanley in New York. ``We're at the point in the cycle when margins have hit peak levels.''

Labor costs have shot up 3.2 percent over the past 12 months, after average increases of just 0.8 percent a year from 2000 to 2005, the Labor Department reported last week. Companies will have a hard time raising prices to recover those costs, as weakening consumer demand slows the economy for the rest of this year. That means profits will take a hit.

``Labor cost increases at this pace would be alarming from an inflation perspective if growth were not slowing,'' says Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, New York. ``But it is, so the alarm should sound over corporate earnings forecasts instead.'' He expects earnings among companies in the Standard & Poor's 500 to be down 10 percent by the fourth quarter of 2007.

Morgan Stanley's McVey predicts S&P 500 earnings growth will slow to about 5 percent in 2007 from a projected 11.4 percent in 2006.

Either prediction would be a dramatic turnaround from recent results. U.S. companies' earnings rose by an average of 19 percent in the second quarter. Commerce Department figures show U.S. corporate profits grew more than 10 percent in 15 of the last 16 quarters, better than in any comparable period going back to at least 1960.

More Slack in Europe

Surging corporate profits in Europe will come under less pressure from labor costs because more slack remains in the job market there, says Dario Perkins, European economist at ABN Amro NV in London.

Already, some U.S. companies say labor costs are starting to pinch.

Lake Forest, California-based Apria Healthcare Group Inc., the biggest U.S. provider of specialized home health-care services and equipment, said July 27 that third-quarter profit won't exceed second-quarter results after the company increased wages at the beginning of last month.

``Getting skilled professionals will continue to be an issue for almost all health-care providers,'' says Nancy Weaver, an analyst with Stephens Inc. in Little Rock, Arkansas. ``That's a problem for earnings going forward.''

Truck Drivers

J.B. Hunt Transport Services Inc., the third-biggest U.S. trucker, reported second-quarter profit below analysts' estimates as spending on wages and diesel fuel increased. The Lowell, Arkansas-based company said it couldn't hire enough drivers to meet demand.

Transportation companies are among those that ``are going to have to start sharing more of their revenue gains with workers,'' says Steven Wieting, director of economic and market analysis at Citigroup Global Markets Inc. in New York.

Some companies may be able to maintain their profit margins by passing higher labor costs on to their customers.

``If the demand environment stays relatively robust, my fear is that you'll get more pass-through into final prices,'' Wieting says.

That's just what the Federal Reserve doesn't want to see. Fed policy makers left their interest-rate target unchanged on Aug. 8, saying that while ``some inflation risks remain,'' it expects inflationary pressures to ``moderate'' as the economy slows.

Concern for Investors

A cooling economy may make labor costs a bigger concern for investors than for the Fed, says David Rosenberg, chief North American economist at Merrill Lynch & Co. in New York. ``As consumer demand is poised to slow, labor costs are more likely to come out of margins than to show up in final prices,'' Rosenberg says.

Higher interest rates and energy prices also will squeeze profits, economists say. More worrisome, though, are labor costs, which average 70 percent of operating costs for corporations, according to Shepherdson.

While U.S. employers added fewer jobs than expected last month, economists say the positions being added are higher-paying than average.

``The vast majority of jobs we're creating, contrary to popular belief, do pay relatively well, so wages are going to rise more,'' says Diana Furchtgott-Roth, director of the center for employment policy at the Hudson Institute in Washington.

Services Jobs

Almost all of the 113,000 jobs added in July were in services, and the biggest category posting gains was professional and business services, with 43,000 new jobs. The Labor Department noted gains among higher-paying jobs such as computer system design, architectural and engineering services, and management and technical consulting.

``The talent shortage in high-skilled and vocational jobs is driving wage inflation, from skilled machinists and operators to workers with college and advanced degrees,'' says Jonas Prising, president of the North American division of Milwaukee-based Manpower Inc., the world's second-largest provider of temporary workers.

Recent revisions to Commerce Department data suggest the acceleration of labor costs might have begun sooner than previously thought.

The Commerce Department revised first-quarter data on growth in wage and salary disbursements, a broader measure of compensation than Labor Department data, to 6 percent year-over- year, from 4.2 percent. That picked up in the second quarter to 6.8 percent.

`Less Friendly Path'

``Combining these two points results in a much less friendly path for unit labor cost inflation than previously published,'' wrote Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, in a July 31 research note.

Cheap labor abroad will provide a safety valve for companies able to tap it.

International Business Machines Corp., the world's biggest computer-services provider, said it plans to invest $6 billion by 2009 to expand higher-margin services business in India, where it now has one in eight of its employees.

The Armonk, New York-based company said second-quarter profit rose 11 percent after the company reduced expenses by cutting jobs in Europe and shifting work to India, where salaries are about 12 percent of those in the West.

Many companies, however, will not have the luxury of offshoring, and will have to face a cooling economy with workers demanding bigger paychecks.

``Sales are slowing down while it looks like labor costs are picking up more sharply,'' says Andrew Tilton, an economist with Goldman Sachs in New York. ``That's likely to put a squeeze on margins, certainly within the next year, and most likely in the second half of 2006.''



To contact the reporter on this story:
Matthew Benjamin in Washington at
[email protected]

Last Updated: August 13, 2006 19:27 EDT