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Main Street pay hike threatens Wall Street profits

Best states 2017

Workers, rejoice! After years of waiting, ongoing tightening in the labor market has finally flipped things in your favor. Time to ask for that raise.

The unemployment rate dropped to 4.4 percent last month, the lowest reading since May 2001. Job openings rebounded in March, up to 5.7 million positions for the fourth best month on record since 2000.  And with 12.8 million available workers, that works out to just above two workers per job opening -- the fourth tightest labor market on record. Wages are rising at an annualized rate of 3 percent, according to Goldman Sachs, the fastest growth since the recovery. 

But there's a downside: U.S. labor costs now constitute more than 10 percent of the revenues of S&P 500 companies, representing a large headwind to profitability.

The dynamic is set to continue. According to the latest survey of small businesses from the National Federation of Independent Businesses, a third of respondents say they have job openings going unfilled, the highest reading since November 2000. With the pool of desirable workers drying up, competition for the best applicants is likely to drive wages even higher.

These American workers haven't seen a raise in 16 years

Indeed, the nation's 4.4 percent unemployment rate is below the Federal Reserve's own estimate of the "natural" rate of unemployment. Federal Reserve Bank of Boston President Eric Rosengren recently warned that a further drop in the unemployment rate from here "would likely be accompanied by higher inflation, overheating the economy and prompting higher [interest] rates."

A combination of higher interest rates and higher wages would be a toxic one for the corporate sector just now recovering from a drop in profits linked to the plunge in energy price wipeout between 2014 and 2016. Goldman analysts warn that "we expect rising wages will prevent significant further expansion in S&P 500 margins during the next few years absent corporate tax reform."

Small-cap companies are even more vulnerable to higher wages, with wages representing 17 percent of sales for the Russell 2000.

Wall Street is already sniffing out the problem, as evidenced by the outperformance of a basket of companies with low sensitivity to labor costs: Goldman's "low labor cost" basket of 50 S&P 500 stocks is up 22 percent since July 2016, versus 11 percent for a basket of high labor cost stocks.

It's worth not that wage growth remains well below its peak in 2000 and 2001, when it approached five percent. And before we shed a tear for corporate profitability, labor's share of economic output also remains down after years of outsourcing, offshoring and the fallout from the Great Recession.

Thankfully for employees, that's changing now.