Wall Street had a moment in 2021. The S&P 500 hit 70 new highs last year – more than 1 in 4 trading days. To put this in perspective, the last time this happened was in 1995, and before that, it was… never. Even with the recent pullback in January, FOMO still weighs heavily in the minds of investors. Every sell off seems to be accompanied not so much by fear of losses but by hope that the market’s pressure relief valve has been opened just enough to keep the good times rolling for a bit longer.
Fundamentally, rampant inflation and supply chain disruptions have not seemed to hurt the enthusiasm of consumers, who are delivering many companies their best earnings season in some time. The economy seems ready for this to continue; the market has only recently acknowledged the impact of a rise in interest rates on the cost of capital for investors and companies liberally using leverage to profit from this environment. Meanwhile, the risk of increased regulation seems to be declining with every Democratic legislative defeat.
The one blemish on this apparent Goldilocks scenario for corporate America is the labor market. Employers are having trouble filling jobs. Employees are quitting at historically high rates. The cost of labor has increased in a way that may look similar to past economic data but could be different this time around. In our opinion, today’s omnipresent chatter about inflation and interest rates should be viewed through the lens of the current labor market and by contemplating different scenarios of its impact on corporate earnings, consumer sentiment and the overall economy.
Shortly after the initial economic shock of the pandemic, many economic analysts on Wall Street began to pay closer attention to wage inflation to get some insight into the nature of the subsequent recovery. One of the most common measures used for this purpose are the year-over-year change in average hourly earnings as published by the US Bureau of Economic Statistics. However, this particular statistic is flawed, and it has led many analysts astray for more than a year now.
As we can see in Figure 1, the highest wage growth periods according to this measure take place during times of economic stress. Why? Because when workers are being laid off en masse, the layoffs tend to disproportionately affect lower-wage hourly employees across the economy. The more expensive manager-level employees may also lose their jobs, but not to the same proportional extent. We only need to look at our corner retail stores during the pandemic to see example after example of this. As a result, the average hourly earnings of the remaining workforce, when compared to the year prior, would appear to have increased substantially.
To be clear, a trained economic analyst would not entirely miss this realization. It would be hard to mistake the spike in average hourly earnings at the start of the pandemic as a sign of a robust hiring environment. However, memories are short, and there were more than a few who argued the increased year-over-year comparisons at the tail end of 2020 and again in recent months were signs of true wage inflation. They are only half right, and the truth is somewhat more nuanced. Unfortunately, as we have discovered time and time again throughout our careers, Wall Street does not do nuance well.
Aside from its counterintuitive direction, the volatility of this metric is another red flag that it is not what it seems. A more interesting statistic also published by the US Bureau of Labor Statistics is the employment cost index, though it is followed less closely due to its quarterly rather than monthly release frequency. We have included its year-over-year changes in Figure 1 as well. In this less volatile measure of employment costs (which also aims to capture benefits, taxes and other employment-related costs), we can find insights not as clearly found in average hourly earnings.
Figure 1: Year-over-year change in average hourly earnings (white) and employment cost index (blue) since 2011. (Source: Bloomberg Finance LP, US Bureau of Labor Statistics)
Note that, when normalized, we can see these two measures deviate during times of economic stress, further reinforcing that average hourly earnings may not be what they seem. In 2016, 2018 and 2020, we see the employment cost index decline (as we would expect in periods when the economy was shaken, which should shift the employment power dynamic toward employers) while average hourly earnings remained steady or even increased. In late 2020, Wall Street economists were insistent that wage inflation was a sign of a rapidly recovered economy. However, one can clearly see the correlation between the increases in average hourly earnings and the public policy changes (and resulting low-wage job instability) in response to the ebbs and flows of the COVID-19 pandemic; the same goes for the first half of 2021. The employment cost index, meanwhile, remained stubbornly unimpressed. Had the Fed reacted with the same vigor as those economists to reign in its loose monetary policy at that time, they would have likely shocked the economy further; exacerbated what turned out to be an already problematic inflation situation; and hurt the pocketbooks and employment status of many Americans just getting back on their feet.
However, those economists may very well turn out to be right for the wrong reasons this time around. Without realizing that the measure they track most closely is flawed, they are once again citing wage inflation as worthy of the Fed’s attention. The sudden upturn in the employment cost index makes the case that recent average hourly earnings numbers are telling a different story than they have over the last two years. Specifically, the increase seems to finally be a sign of rising labor costs.
The problem is this: Because analysts have unknowingly cried wolf for so long, we believe many have become complacent about the impacts of an uptick in their favorite wage inflation metric. For sure, there has been a lot of focus on record-setting levels of inflation. Many understand the role that supply chain disruptions have played in causing that inflation. But there is also a general assumption that higher wages have played a much bigger role than they actually have. As a result, the thinking goes, companies have figured out how to manage around the increased labor costs, and though this is a useful metric in thinking about future inflation (i.e. higher wages = more spending = more inflation = Fed, lookout!), the analysis and modeling stops there, short of what we believe to be the true insight.
To understand this further, we should remember how the typical Wall Street equity analyst evaluates companies. Ultimately, all the management calls, competitive analysis, channel checks and a variety of other tasks are performed in service of building a model to determine the value of the company being analyzed. If you look closer at a typical model, you will often find detailed projections of drivers, i.e. key input metrics that drive the output of the model.
So, for example, a deeper dive into an airline will not simply project revenue by growing past revenues by some projected growth rate. Rather, there will be more granular drivers to project with more confidence, such as revenue per seat and load factor on flights. Such measures, which are easier to project, enable the analyst to get a high degree of confidence in her forward-looking revenue expectations. The same process goes for cost of goods and services, some of which have market-observable projections (such as fuel in the airline example). However, when projecting other line items in a financial model, analysts tend to fall back on a less detailed approach. Advertising costs, for example, may be projected as a percentage of revenue or as a cost grown at a constant pace. Deviating from such assumptions is rare and usually only happens when a company guides the analyst community to do so.
When it comes to labor costs, we fear that most analysts are not recognizing the potentially huge impact of what seems to be the first real uptick in wages after several head fakes. Between their assumptions that wage inflation is not new news and the need to factor in an unexpected growth rate into their models without company guidance to do so, we expect this line item in most models is too low.
Meanwhile, the impact on a company’s ability to capitalize on the current environment of consumer spending is meaningful if the workforce isn’t there to do so. After all, no matter how strong the economy might be, if there are fewer employees to make, transport and sell a company’s goods and services, a company’s ability to capitalize on the strong economy will be impaired. For example, Steven Oakland, the CEO of Treehouse Foods1, specifically cited the need to “pivot our labor strategy” during their most recent earnings call alongside a disappointing decline in their gross margins due to unexpected cost increases, including labor. This is an urgent issue for Treehouse and many other manufacturing companies, and the current labor markets “require a more progressive strategy to staff our plants effectively.” Meanwhile, American Greetings, the maker of greeting cards, is a great example of a company who understands that their workforce is not just a cost but a key ingredient in the short- and long-term success of the business. In the process of finding ways to overcome a revenue decline in their 2021 fiscal year to deliver a +13% EBITDA increase, they showed an unwillingness to use headcount as a lever to reduce costs. Since then, their most recent quarter saw revenue increases with steady EBITDA margins, showing no reversal of the prior year’s bottom line gains. While many factors beyond their approach to their workforce led to this subsequent success, they have shown that committing to their employees and strong performance are not opposing forces and may very well be correlated.
Between labor cost assumptions and the actual impact on some companies, we expect Wall Street is being too optimistic in its margin and earnings assumptions for many (but not all) companies, and since equity values are often set as a multiple of earnings, in its valuations overall as well. At Zeo, labor costs are at the front of our minds when we are evaluating companies. Because we focus in on a smaller universe of issuers, it is easier for us to consider such line items on a company-by-company basis. Meanwhile, it is important to recognize that our view that ESG factors are credit factors also goes a long way to heading off such issues. By including labor relations in our creditworthiness evaluation, we end up selecting companies who are likely to be less susceptible to these issues as they play out over the coming years. After all, in our experience, happy employees tend to mean productive companies.
This is not to say that we are predicting that the current market declines will continue or lead to a more meaningful correction. We have seen too many downside risks dissipate due to unforeseen circumstances. But we do believe recent data points to a potential paradigm shift, with a new labor market dynamic that is not yet properly understood by the markets, in part because it might look more like the past than it actually is. Whenever we see this sort of potential misunderstanding, we tend to proceed cautiously, and we would suggest readers do the same.
By Venk Reddy
Originally published in Q4 2021 letter
1 It is worth noting here that, for this and other reasons, Treehouse Foods is not currently a company that meets our standards for creditworthiness. We will be keeping an eye on the management team’s new priorities to determine how deliberately and intentionally they address labor relations going forward.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Zeo Capital Advisors, LLC (“Zeo”)), or any non-investment related content, made reference to directly or indirectly in this article will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Zeo. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Zeo is neither a law firm, nor a certified public accounting firm, and no portion of the content should be construed as legal or accounting advice. A copy of Zeo’s current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.zeo.com/disclosures.