The Piping Hot Labor Market Threatens Profit Margins

Head of Equity Strategy
Follow Jeff Weniger

I’m still thinking about the market’s shock a few weeks back when the nonfarm payrolls report showed an increase of 467,000 jobs in January, well ahead of the 150,000 that was expected by the market. 

I will not be surprised if that report is a taste of what is to come in the next few months, because I contend that this may be the hottest labor market of my career.

Wage inflation and a profit margin pinch is the hypothesis. 

As we get to the charts, think about what has worked in the stock market lately. Since November, the bears have been coming after stocks with distant cash flows whenever rates have headed higher, owing to the math behind discounting future values to the present. In contrast, companies that are profitable now—many of which populate value indexes—have held up.

It’s something like this:

Inflation “on” → More Fed hikes → Value stocks beating growth
Inflation “off” → Fewer Fed hikes → Growth stocks beating value

Figure 1 shows the steady climb in the U.S. quit rate over the last two years. People dump their jobs when they are confident that they can line up new ones. Critically, the biggest pay bumps often come when you go to a new company—and a lot of people are doing just that.

Figure 1: U.S. JOLTS Survey, Quit Rate 

Their confidence stems from basic arithmetic. We had a few years prior to Covid when, for the first time in generations, there were more job openings than unemployed people.

Lockdowns ended that.

But 2022 is not 2020; job postings once again exceed the ranks of the unemployed, this time by a country mile (figure 2).

Figure 2: JOLTS Survey, Total Job Openings Minus Total Unemployed (Thousands)

Figure 3 shows another way to look at it. As hot as the 2018–2019 job market got, this one far exceeds it.

Figure 3: U.S. Job Openings as % Unemployed 

You can glean a lot of information about the labor market by checking the National Federation of Independent Businesses (NFIB) survey. In January, the most recent report, 47% of small businesses said they had one or more jobs that were hard to fill (figure 4).

You know the old saw? “The cure for high commodity prices is high commodity prices.” If copper zooms, miners mine more copper, sending the price down. 

Well, if you post a job and can’t find anyone, the solution is to hike the pay. Applicants will show up…once you change the compensation.

Figure 4: NFIB Survey: “1 or More Jobs Hard to Fill”  

The same NFIB survey shows that 50% of employers were actively ratcheting up compensation toward the end of 2021, with 27% saying they intend to do so in the coming months (figure 5).

Figure 5: NFIB Survey, Worker Compensation

The Atlanta Fed’s wage growth tracker showed a 4% year-over-year increase in January. I suspect it’s headed higher (figure 6).

Figure 6: Atlanta Fed Wage Growth Tracker

In the wake of the most recent inflation report, which recorded a 7.5% year-over-year spike in the headline Consumer Price Index (CPI), the Fed Funds Futures market now expects the policy rate to be north of 1% by summer (figure 7).

Figure 7: Fed Funds Rate Probabilities, July 2022 FOMC Meeting 

The good news is that I think the labor market is going to be so hot that the Fed will not break this economy’s back just yet, at least not in 2022. The bad news is that we may be in for a shower of profit-margin warnings.

Because return on equity (ROE) math is a function of profit margins, the way to navigate this is by screening for firms that can give staff a pay bump without black ink turning red.

I did something new in figure 8. By dividing ROE by P/E, I came up with a quotient that will put in context how much high-quality equity baskets will cost you. The WisdomTree U.S. Value Fund (WTV) gets a particularly high score, 1.69. Maybe that’s the one to use if you have a theory that has inflation pinching profit margins.

Figure 8: ROE vs. P/E

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About the Contributor
Head of Equity Strategy
Follow Jeff Weniger
Jeff Weniger, CFA serves as Head of Equity Strategy at WisdomTree. In his role, Weniger helps to formulate the firm’s stock market outlook by assessing macro and fundamental trends. Prior to joining WisdomTree, he was Director, Senior Strategist at BMO, where he worked in the office of the CIO from 2006 to 2017. He served on the firm’s Asset Allocation Committee and co-managed the firm’s ETF model portfolios for both the U.S. and Canada. In 2013, at the age of 32, Jeff was chosen as the youngest member of BMO’s Global Investment Forum, which collected the firm’s top global strategists to formulate the firm’s official long-term outlook for investment trends and markets. Jeff has a B.S. in Finance from the University of Florida and an MBA from Notre Dame. He has been a CFA charterholder and a member of the CFA Society of Chicago since 2006. He has appeared in various financial publications such as Barron’s and the Wall Street Journal and makes regular appearances on Canada’s Business News Network (BNN) and Wharton Business Radio.