Labour accounts for 60% of corporate expenses, and it's going up

One of the bigger themes since the financial crisis has been the fattening of corporate profit margins as businesses across America hacked away at their cost structures and squeezed more out of their existing resources.

But with the economy rebounding and putting people back to work, the labour market has gotten much tighter. And today, that’s manifested in the form of wage growth as companies are being forced to raise pay in order to recruit and retain talent.

And as the business cycle proceeds, wage growth will eat into profit margins in a big way.

“Investors are appropriately worried about margins falling more sharply given that labour costs account for more than 60% of corporate expenses and small companies need to lift employee compensation but do not seem to have pricing power to offset related higher expenses,” Citi’s Tobias Levkovich said.

Now, much has been written about how turns in profit margins signal recessions.

But Levkovich isn’t that concerned about that as of yet.

“Fortunately, the conditions do not seem set for an economic downturn given that small business still has access to credit and continue to look to hire more workers,” he noted. “Furthermore, rising compensation costs are not that problematic for EPS growth as one could see some top-line acceleration from stronger consumer spending tied to more worker income and pent-up demand.”

Levkovich is positive on the stock market. He sees the S&P 500 heading to 2,300 by mid-2016. On September 4, he introduced a 2016 year-end target of 2,200.

“We remain generally constructive longer term while advising investors to buy on weakness rather than chasing the tape,” he said.

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