The Inflation Number Wall Street Should Be Watching

Wall Street investors paying too much attention to the food and energy prices, which have been driving consumer inflation numbers to a 40-year high, have probably missed another number that matters the most for corporate profitability: Unit Labor Costs (ULC) or ‘producers’ inflation.

The latest ULC rose 12.7% in Q2 2022, well above consumer inflation, meaning that higher labor costs are beginning to take a bite from corporate profitability, the “milk” of Wall Street.

“This is nothing new,” Bob Bilbruck, CEO at Captjur, told International Business Times in an email. “The hourly and salary labor rate(s) has been rising since Q4 2021. It’s been especially hard on SMB size companies that have a harder time passing these costs off. It absolutely amazes me that the fed and the media are so behind the curve on this.”

But listed companies have already noticed, telling their stockholders that rising labor costs have been a headwind for profitability. For instance, FactSet, which monitors corporate reports and shareholder conferences, has seen many S&P 500 companies identifying rising labor costs as headwinds for profitability going forward.

“Labor costs and shortages have been cited by the highest number companies in the index to date as a factor that either had a negative impact on earnings or revenues in Q2, or is expected to have a negative impact on earnings or revenues in future quarters,” said John Butters, VP of FactSet, in a corporate blog.

“Of these 18 companies, 11 (61%) have discussed a negative impact from this factor. After labor shortages and costs, supply chain costs and disruptions (10) have been discussed by the second-highest number of S&P 500 companies.”

ULC measures how much firms pay labor to produce one unit of output. Two things determine it. One is labor compensation, how much the firm pays workers per hour in wages and benefits. And two, labor productivity, how much output workers produce in that hour.

A rising ULC means that labor compensation rises faster than labor productivity. That’s due to a tight labor market, which gives labor the upper hand in negotiations with management.

“Unfortunately, the tight labor market has now become the biggest contributor to inflationary pressures,” Quo Vadis President John Zolidis said to his subscribers in an email. “Businesses are experiencing rising operating costs. And these companies are passing the costs back to consumers by raising product and service prices.”

While that may be a temporary fix to save corporate profitability, it can lead to a demand-pull-cost-push inflation spiral, which leads to stagflation.

“ULC captures what people refer to as “wage-price spiral” – when goods cost too much to produce, companies have to (or choose to) continue to raise prices, and the higher wages continue to chase a finite amount of goods/services,” Louis Ricci, Head Trader at Emles Advisors, said in an email to IBT.

“A recession/high unemployment rate (loose as opposed to tight labor market) solves this, but the paradox is how to nudge it lower without engineering a severe recession.”

But that isn’t a suitable environment for equities, especially for corporations operating in highly competitive sectors with no pricing power.

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