Please see the below article from AJ Bell, examining the potential effects on wage growth from current inflationary pressure and the implications for stock market valuations – received yesterday – 27/02/2022
Calls from both the Bank of England’s governor, Andrew Bailey, and its chief economist, Huw Pill, for wage restraint do not sit easily alongside the current headline inflation figures. Nor does Unilever’s statement (10 Feb) that it raised prices by 4.9% in the fourth quarter of last year and has planned further hikes in 2022, thanks to expected input cost inflation of 3% to 4%.
A few small caps, notably own-brand cleaning products specialist McBride, loo roll maker Accrol and retailer Joules, had dished out profit warnings as they have proved unable to raise prices far or fast enough to compensate for rising costs.
But Unilever is the biggest so far, as it forecast a drop in profit margins of some 1.4 to 2.4 percentage points in 2022, down to 16% to 17%. Even though not all of this is down to higher raw material, freight and packaging costs, as the food-to-personal care giant continues to invest heavily in product development and marketing, it does beg the question of who is able to defend product margins in an inflationary environment if Unilever cannot? After all, it can call upon the power of brands such as Marmite, Hellmans, Dove and Magnum.
Investors must again therefore address three key questions:
Will workers demand – and get – meaty wage rises in response to their rising bills and expenses? Lowly unemployment numbers would suggest this is their time to strike (either figuratively or literally speaking).
If they are successful will that drive wider inflation and force central banks to raise interest rates further and faster than currently anticipated by markets?
Will rising wages, alongside freight, raw materials, packaging, start to take a bite out of corporate profit margins? And, if so, what does that mean for stock market valuations, especially at a time when interest rates are rising?
Wage growth is cooling a little on both sides of the Atlantic, but the readings are still high by the standards of the (admittedly relative short) datasets that we have. In the UK, total pay rose by 4.8% year-on-year in the three months to December and US workers’ average hourly pay rose 5.7% year-on-year in January.
Low unemployment rates and high numbers of job vacancies relative to the numbers of those without work would suggest labour may just have the whip hand in any pay negotiations. Trades unionists and workers may be happy about that for political, philosophical and economic reasons as there can be little doubt that capital has had its wicked way with labour for much of the past four decades, and beyond.
Since 1947, Americans’ pay has fallen by more than four percentage points as a portion of GDP. American corporate profits have increased by around six percentage points over the same time frame.
A similar trend can be seen in the UK, where the data goes back to 1955. Since then, labour’s take-home slice of the economy has dropped by almost ten percentage points, while corporations have increased theirs by the thick end of six points.
Investors could therefore be forgiven for wondering what may happen next. After all, corporate profits stand at, or close to, a record high as a percentage of GDP in both the US and UK.
Any margin pressure could therefore restrict profit growth (and that is before UK-based firms face a jump in corporation tax to 25% from 19% from April 2023). And the combination of higher interest rates and slower profit growth is not an ideal one, especially in the US stock market, where valuations are at or near all-time peaks, based on market-cap-to-GDP and the Shiller cyclically adjusted price earnings CAPE ratio.
Yet all may not be lost for three reasons. Higher pay could help consumers’ keep spending. Companies report sales and profits in nominal, not real, inflation-adjusted terms. Sales up, costs up can still mean profits up, which is why stocks and shares are seen as offering a better hedge against inflation than say bonds.
Granted, some companies and industries may be better suited to coping with inflation than others. Areas where demand is relatively price inelastic, or insensitive, are one – they include oil and tobacco. Industries where demand growth outstrips supply growth (and it takes time to create fresh supply) are another – and that could include mining, especially as central banks cannot print copper, gold or cobalt.
And consumer staples or luxury goods companies with brands can be better placed than most to raise prices thanks to the customer loyalty and pricing power they confer. Luckily, the FTSE 100 has quite a few of those.
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